The second phase of the crisis came in the summer and autumn of 1998, when the financial crisis went global. Confidence in the global economy was challenged by several disquieting events in Asia - the increasing recession and slow pace of banking reform in Japan, the intervention of Hong Kong authorities to maintain the value of their stock market through direct purchases, and the introduction by Malaysia of foreign exchange controls. Then, on 17 August, Russia unilaterally devalued its currency and rescheduled its debt only three weeks after receiving yet another large IMF support package that mobilized GAB funds for the first time in two decades. Although no one within the G-7 had been enthusiastic about the prospects for the July package, the speed of Russia's collapse and the shock of a default and devaluation brought home the message that no country, even a member of the G-8, was too big to fail. It was soon apparent that the IMF, which still lacked the agreed-upon quota share increase, might not have sufficient funds to cope with crises on this scale.
The contagion, driven by plummeting commodity prices, soon spread to the emerging economies of the Americas, as interest rate spreads ballooned in all emerging markets. Brazil, which had a large fiscal deficit financed at floating interest rates, was particularly hard hit. As its interest rates soared, capital started to flee the country at the rate of up to US$1 billion a day. In early September, Columbia devalued its currency. Moody's downgraded Brazil's foreign currency bonds. Stock markets in the United States, Canada, Mexico, and the rest of the Americas continued the sharp fall begun in mid-summer.
By late August, when even healthy companies in the United States found it difficult to borrow money at reasonable rates, fears of an international credit crunch emerged. The crisis peaked in mid-September with the de facto collapse of Long Term Capital Management (LTCM), an American hedge fund, and its rescue by major American financial institutions under the guidance of the Federal Reserve. While the rescue was reassuring, the fear that similar funds might be on the verge of collapse compounded the freezing of credit markets in the United States. Along with continuing congressional refusal to authorize the United States share of the IMF quota increase, this meant that the world was deprived of its traditional lender of last resort. Indeed, the hitherto vibrant American economy was on the verge of being engulfed.
Throughout, Canada, along with the United States, Britain, and France, provided intellectual leadership in the IMF and other forums with detailed proposals on many items on an expanding crisis response and system reform agenda. The first set, part of Clinton's package announced in New York on 17 September, emphasized the desirability of interest rate cuts, a new IMF precautionary lending facility, and support for Brazil. But Paul Martin, who was dissatisfied with the central thrust of the plan and who thought that markets needed a stronger signal that governments were in control, prepared his own package which he unveiled at the Commonwealth finance ministers meeting in Ottawa on 29 September, just before the 3 October meeting in Washington of G-7 finance ministers.
The plan, which had six central points,16 began with stimulus - a carefully worded admonition to focus on 'the risks of an extended global slowdown' through, implicitly, an immediate lowering of interest rates by G-7 central banks. The second element was social targeting - a call to tailor IMF programmes to local conditions, particularly through a less restrictive fiscal policy in some Asian countries than IMF orthodoxy prescribed. The third element, prompted by the recent experience in Asia and Russia, was to extend international supervision to domestic banking and financial systems. The fourth element was capital control - a plea to adjust the move to capital account liberalization by allowing weak economies to impose transitional, non-distortionary controls on capital, particularly short-term capital inflows. The fifth was the introduction of an Emergency Standstill Clause, negotiated in advance and covering all private-sector instruments, including bank deposits. The clause could be invoked by countries suffering a crisis of confidence to preserve capital until payments could be restructured in an orderly fashion. In Canada's view, the failure of markets to differentiate between good and bad risk in the wake of the Russian devaluation underscored the need for an international bank holiday. Finally, the development and debt needs of the world's poorest countries were addressed.
The most urgent Canadian concern - a shift in focus from the threat of inflation to that of recession - presented an opportunity for a form of policy leadership with immediate origins. By September, the Canadian economy had suffered four months of no growth. On 27 August, after the Canadian dollar plummeted to a historic low of just over 63 cents to the United States dollar in the aftermath of the Russian devaluation, the Bank of Canada raised interest rates by a full percentage point. The day of Martin's speech, the United States Federal Reserve and the Bank of Canada immediately lowered interest rates by 25 basis points. In mid-October the Federal Reserve instituted a further unexpected cut, which Canada again matched. By the end of the month, Britain, Italy, and Japan had followed, and by November the continental European countries did the same. From 1 October to the end of 1998, a total of 34 central banks lowered interest rates on 66 occasions.
Canada's early call was not the major cause of the emergency action or of the historic shift in the G-7's decade-long macroeconomic focus on inflation-fighting. Yet the United States-Canadian-British initiative provided the policy leadership which met the short-term needs of the Canadian economy and proved critical in combating a paralyzing liquidity crisis in the United States that would have brought global collapse.
The second Canadian priority was to tailor IMF programmes to the particular situation in each country, with an emphasis on fiscal stimulus when necessary. It was evident in Canada's approach to Indonesia during the autumn. Canada repeatedly pressed for greater fiscal flexibility in the IMF adjustment programme so that Indonesian authorities could increase their spending, especially on targeted social programmes, development programmes, and public infrastructure. Canada also favoured a relaxation in the pace of privatization of Indonesian state enterprises.
Canada's other priorities made progress at the G-7 finance ministers meeting in Washington. Amidst what Clinton called the worst financial crisis in 50 years, the meeting produced a communiqué which reflected several major Canadian concerns.17 It signalled an easing of monetary policy to provide needed liquidity. At the end of the meeting, Canada, the United States, and Britain promised to maintain conditions for sustainable growth.
The communiqué also supported IMF programmes and a proactive role for the G-7, through the IMF, G-22, and elsewhere on the issues of architectural reform and a consensus on the core principles to guide it. Canada, along with Britain and the United States, was behind the push for an emphasis on transparency. Although the American and British approach to banking and financial system supervision largely prevailed, Canada made some progress in principle. An emphasis on private-sector involvement as a way of avoiding moral hazard reflected one of Martin's concerns, although here a German conviction dominated and no particular mechanism for private-sector 'bail in' was endorsed. Canada's greatest gain was in the diminished enthusiasm for rapid capital account liberalization, as the process for amending the IMF articles of agreement, initially slated for completion at the meeting, was extended another one to two years.
Despite this momentum, the G-7 avoided the badly needed immediate, co-ordinated macroeconomic management to stem a still burgeoning crisis in Brazil and in credit and equity markets in the United States and the rest of the developed world. In early October, the IMF cut its earlier estimate of world growth to a modest two per cent.18 Some relief came when congress passed the American IMF quota share increase on 14 October, and Japan's Diet passed its banking bill shortly thereafter. But the situation remained precarious.
For Canada, continued deterioration during October posed a major threat. Its primary fear was that the assault on Brazil would spread to Argentina and other Latin American countries, especially Mexico. With its credit market immobilized, it was unclear whether the United States would have the will or the ability to contain the threat in Mexico, as it had in the wake of the 20 December 1994 crisis. Mindful of how the Mexican crisis had threatened the Canadian dollar, of how that dollar, perceived as a commodity currency, was already at an all time low, and with a looming provincial election in Quebec to reawaken fears of disunity, the Canadian government concluded that further action was necessary.
With markets clearly not absorbing the G-7 message from the 3 October meeting, pressure began to mount to send a stronger signal, and to do so at the leaders' level. A proposal from the British prime minister, Tony Blair, for a special G-7 summit received enthusiastic support only from the French, who wanted the summit to involve a broader group of countries. The British chancellor of the exchequer, Gordon Brown, returned from the Washington meetings convinced of the need for a new G-7 statement which reflected a deeper degree of consensus than had previously been revealed. Canada, along with the United States and Japan, was initially sceptical about the value of either a statement or a special summit, in the absence of anything new to announce. But when congress finally approved the IMF quota share increase contribution, Japan passed its banking legislation, Brazil approached the IMF for assistance, and the G-7 came to an agreement through conference calls on Clinton's proposed precautionary facility, Canada concluded that a statement that cast these new developments in a positive light would be useful.
On 30 October, the G-7 released two statements, the first from the leaders and the second from finance ministers and central bankers,19 in which Canada achieved, at least in part, many of its objectives. In particular, it succeeded in mobilizing collective, proactive G-7 leadership in a way that reassured global financial markets, redirected policy from a preoccupation with combating inflation, and directed a far reaching reform of the IFIs in keeping with its Halifax initiative.
On the issue of capital controls, Martin's call for restrictions on short-term capital outflows, in the form of an Emergency Standstill Clause, got some support from other G-7 countries. The United States, however, remained adamantly opposed. The 30 October statement included carefully crafted language that amounted to a tacit acceptance of the concept of capital controls. The leaders' statement spoke of the need to minimize the 'risk of disruption' for 'an orderly and progressive approach to capital account liberalization' and for 'measures to ensure the orderly and cooperative resolution of future crises, in particular mechanisms to involve the private sector.' G-7 officials were directed to work out the mechanisms to give this principle effect over the next year. The G-7 finance deputies and central bank governors took up the issue at a meeting in Paris in mid-November.
A second area of substantial Canadian gain followed from Martin's initiative for stronger banking and financial sector supervision. The finance ministers' statement directly endorsed enhanced supervision through 'a process of peer review.' The IMF also agreed to devote more attention to the quality and capability of such supervision in its annual review of members' economies.20
Canada's influence could also be seen in the emphasis in the leaders' statement on dealing directly with the social dimensions of the financial crisis. The statement began by highlighting the 'impact on the poor and the most vulnerable.' It endorsed an emergency facility in the World Bank to offset the social damage caused by financial failure and called for principles of good practice in social policy to protect the most vulnerable social groups.
The final element of the G-7 response was its support package for Brazil, still being negotiated as the 30 October statement was released. When it was unveiled on 13 November, it contained several novel components. Brazil had voluntarily adopted a restraint package prior to the extension of G-7 assistance. In addition to IMF and other IFI funds, it would use bilateral national contributions from all G-7 members and other countries as part of a first, rather than a second, line of defence. Of the US$41.5 billion total, the IMF provided $18 billion, the IBRD $4.5 billion, the IDB $4.5 billion, and bilateral contributions, funneled through the Bank for International Settlements (BIS), $14.5 billion. For the first time, newly available NAB funds were used to support a non-NAB member. These funds were authorized by phone calls to the heads of G-7 finance ministries, who provided over 90 per cent of the total. At US$41.1billion, the package was well in excess of the $25 billion initially envisaged or the market-rumoured $30 billion. A full $37 billion of the total would be made available during the first year. The size and early availability of the package, and the willingness of all G-7 members to put their national funds on the front line to make it this large, was sufficient to demonstrate resolve and to deter markets from continued attack.
Canada's contribution to the bilateral first line of the Brazilian package, determined at a late stage in the process, was a relatively modest US$500 million, or one-tenth the United States contribution. The modesty of the contribution was driven by several considerations. The United States had not contributed to the Thai package in the spring, when Canada bore the burden from beyond the Asian region. As a major contributor to the IMF, IBRD, and IDB, Canada was already contributing substantially to the Brazilian package. Canada was unenthusiastic about Brazil's approach to the IMF and the creation of a new precautionary facility for which Brazil was the first test case. Nor was Canada eager to use NAB funds (which became available on 17 November) rather than the new regular funds made available by the United States quota share increase (which became available only later) for the IMF's multilateral portion of the Brazilian package.
Canada's concern about the prudent use of IMF resources was again evident in a subsequent G-7 debate about the speed of repaying the NAB. Because the United States wanted to show a still sceptical congress that the IMF could function as a profit centre, it preferred to rely as long as possible on the NAB, so as to reap its very high interest rates and delay a use of the IMF's regular quota increase. The French agreed. Canada, along with Britain, Germany, and Japan, wanted to pay off the NAB and revert to the lower cost regular IMF quota as soon as possible. Canada's position was driven in part by a desire to free the resources otherwise constrained by their commitment through the NAB to deter and defend against any currency crises to come.
The United States delay in making its IMF quota share increase available in time for Brazil to use it stemmed in part from a provision of the congressional authorizing legislation. It allowed funds to flow only 15 days after the secretary of the treasury and the chair of the Federal Reserve received assurances from the 'major shareholders' of the IMF that they were pressing for several conditions as part of IMF programmes. So that Rubin could act, the G-7 agreed that their executive directors at the IMF would collectively ask the managing director to meet such conditions. This unprecedented collective G-7 action, which publicly directed the managing director of the IMF to take action, proved effective and indicated that the G-7 collectively, and not the United States unilaterally, was the source of effective leadership for the IMF.
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