The IMF vs. the private sector

The IMF's Horst Köhler wants a dialogue with the private sector

The Asian crisis left many casualties.

The one-time tiger economies are still struggling to find their feet.

At the time, the IMF was criticised for bailing out the private sector and thus encouraging it to lend recklessly to emerging economies.

Two years on from the crisis, the IMF is still working to reshape its relationship with the private sector, with a view to better management of crises in the future.

Once a friend

Typically, the friend of the private sector, banks only lend money after a financial crisis once the IMF has agreed its strict loan conditions with a country in crisis.

In return, the IMF generally insists that countries do not default on their loans to the private sector.

But during the Asian crisis, the IMF came under fire for bailing out the private sector.

At the height of the Asian crisis, the IMF led a $57bn loan to South Korea in December 1997, which resulted in full repayment of creditors - although western banks had to extend the maturity of their debts. In total $190bn was paid out in loan bail-outs around the world.

This strategy was thought to encourage reckless lending to emerging economies by the private sector, in the belief that the IMF would bail them out if borrowers defaulted.

Avoiding this 'moral hazard' now appears to be a central plank of IMF policy.

"It is important that the availability of official financing, including from the Fund, insofar as possible, not create moral hazard by providing incentives for inappropriate lending or borrowing," the IMF said in a a statement earlier this year.

The IMF bailed out Korea

Reckless lending

The justification for the bailouts was that they were needed to protect the global financial system from the shock of a country defaulting on its debt.

But many thought that the Asian crisis had its roots in reckless lending by the private sector.

The dilemma for the IMF is that the private sector has lent emerging economies $1.7 trillion over the past 10 years. This compares to $350bn from official sources.

If the private sector decides not to lend this cash - which has boosted growth in developing countries - it is not clear how the shortfall would be made up.

Or else, private lenders could charge punishing rates of interest, effectively shutting some borrowers out of the market.

Vicious circle

Squaring this circle has kept the two sides in slow-moving talks for much of the past two years.

In June this year, Horst Köhler, the new managing director of the IMF said that he is committed to finding ways to develop closer cooperation between the IMF and the private financial community.

The Institute of International Finance (IIF) has welcomed his initiative, stressing the interest of the private sector in working more closely with the IMF to help prevent and resolve crises in emerging market economies.

While lending to emerging economies was nowhere near the level seen prior to the Asian crisis, it has since picked up.

"The prospects for an upturn in both private capital flows and economic growth in emerging markets make this a good time for the private and public sectors to redouble their efforts toward a closer dialogue to strengthen the international financial system," Cees Maas, chief financial officer of ING group said in April this year.

Chance for change

Some options for the better handling of financial crises are emerging.

Progress has been made towards a framework which could help guide decisions in times of crises, the IMF said.

Details are, however, thin on the ground.

Some alternatives to bail outs have been put forward.

One alternative to large-scale financial rescues is a standstill on payments. This allows time for investor panic to calm down, hopefully reducing the chance of capital flight.

A massive withdrawal of capital typically creates a liquidity squeeze in the debtor country, often worsening the crisis.

Another alternative mooted is collective action clauses in bond 'contracts'.

This makes it easier to secure bondholder approval for debt negotiation, as it allows agreement to be reached with a majority of bondholders.