Business Day (Johannesburg)

4 October 2002

South Africa: The Will to Act Can Save Global Financial System

Johannesburg — Time rich nations pooled donations annually into special drawing rights scheme

THE international financial system is broken down in the sense that it fails to provide adequate capital to countries that need it most and qualify for it.

Global financial markets suck most of the world's savings to the centre, but fail to pump money back out to the periphery. Indeed, since 1997, there has been a reverse flow of capital from countries on the poor periphery of the world economy to those in the wealthy centre.

The facts speak for themselves. The US runs a chronic current account deficit approaching an astonishing 5% of gross domestic product (GDP); $242bn in the first half of this year. At the same time, Brazil which has followed sound economic policies and has healthy budget and trade surpluses cannot refinance its debt at acceptable rates.

The prevailing belief that market discipline corrects such imbalances is false, for two reasons. First, financial markets are inherently unstable. Second, the international financial system is biased in favour of the wealthy centre.

Instability arises because financial markets try to discount a future that depends on their own behaviour. It is now recognised this can lead to what economists call "multiple equilibria" but we continue to deny the clear implication that financial markets cannot be left to their own devices.

In practice, of course, international financial markets never have been left to their own devices. Rich countries, led by the US, are in charge. Their primary task is protecting their own interests. When these nations get into trouble, their authorities intervene forcefully.

Countries that cannot borrow in international markets in their own currency lack that power. They must turn to the International Monetary Fund (IMF), and the fund is more concerned with international financial stability than with enabling developing countries to pursue the countercyclical policies needed to avoid recession.

Until recently, IMF rescue programmes were designed to enable debtor nations to meet their obligations. Taxpayers in debtor states, such as Mexico, picked up the tab. It may have been unfair, but it kept money flowing to the periphery.

The emerging market crisis of 1997-98 changed all this. That crisis was attributed not to instability in the financial markets and the lopsidedness of the system, but to the "moral hazard" introduced by IMF bale-outs. This lead to a U-turn: from bale-outs to "bale-ins", and to private sector burden sharing.

Moral hazard has been curtailed but the risks of investing in emerging markets increased. Those risks are now reflected in market prices, and are the source of the problem.

What can prevent the situation from deteriorating further and perhaps culminating in a systemic crisis? In the broadest terms, we must create a more level playing field. There is nothing wrong with imposing market discipline on countries that follow unsound policies, but the risk-reward ratio for lending and investing has shifted too far against the periphery. Countries that qualify ought to have access to a lender of last resort and be empowered to pursue countercyclical policies.

Brazil, for example, confronts an unambiguous case of market failure. Although the maximum sustainable real interest rate is about 10%, Brazil's dollar-denominated debt yields 24,5%. A one-year real note pays 27%. At these rates, Brazil is heading for bankruptcy.

If no lender of last resort ensures that credit is available at or below 10%, Brazil cannot be expected to meet its obligations dealing a terrible blow both to Brazil and the international financial system.

Where there is a political will, there is a way. For instance, the central banks of the US, Europe, Japan, and Britain could accept Brazilian paper at their discount windows. The IMF could guarantee the central banks against market risk at current prices.

This would provide a tremendous boost to the market and drastically reduce interest rates. Naturally, all guarantees would be conditional on Brazil abiding by the IMF agreement. If successful, the IMF guarantee would never be invoked.

What I propose is novel: it would leverage the IMF's $30bn loan to Brazil tenfold and set a useful precedent. Unfortunately, such a scheme exceeds the imagination and political will of the IMF's shareholders. However, let's be clear: failure to address the problem could have disastrous consequences. After all, how would a Brazilian default affect Mexico?

Addressing the broader, systemwide problem, we must find ways to stimulate domestic-led growth in the periphery countries.

Countries that follow sound macroeconomic policies do not derive sufficient economic benefits from doing so. This generates political discontent that could have adverse consequences beyond the economic sphere.

At present, the US serves as the motor of the global economy. But a chronic current account deficit is unsound, unfair, and unsustainable in the long run. More urgently, the US motor is sputtering. It would be benefit all parties concerned to start another motor.

To this end, I proposed an annual issue of special drawing rights that rich countries would donate for international assistance. This is a proposal whose time has come because the world economy is hovering on the brink of deflation.

Until recently, globalisation unfolded against the background of a global boom; now we are experiencing a global bear market. I am afraid globalisation may not survive unless we find new ways to stimulate the global economy.

The special drawing rights donation scheme would activate resources that are currently idle, benefiting donors and recipients. It would also reduce the increasing inequality between rich and poor countries. Project Syndicate

George Soros is President of Soros Fund Management and Chairman of the Open Society Institute.

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