Canada's G7 Diplomacy and the Global Financial Crisis of 1998

The third phase of the crisis came in the summer and autumn of 1998, when a crisis that had begun in and hitherto been restricted to Asia went global. As Asian economies continued to test new bottoms during the summer, confidence in the global economy was challenged by several new disquieting events in Asia - the increasing recession and slow pace of banking reform in the Japanese economy, the intervention of Hong Kong authorities to maintain the value of their stock market through direct purchases, and the introduction by Malaysia in September of foreign exchange controls. These fears and moves to national closure were sharply compounded on August 17 when the new G8 and APEC member Russia, three weeks after receiving yet another large IMF support package that mobilized GAB funds for the first time in two decades, unilaterally devalued its currency and rescheduled its debt, in a way that foreign investors regarded as a de facto default. Although no-one within the G7 has been enthusiastic about the prospects for the July package, the speed of Russia's collapse and the shock of a default and devaluation, after the IMF and G7 had invested so much money and time since 1992, brought home the message that no country, including one now a G8 member, was too big to fail. It also indicated that the IMF, still lacking the agreed-upon quota share increase, might not have sufficient funds to cope with crises on this large scale. Soon afterward, the contagion, driven by plummeting commodity prices, spread to the emerging economies of the Americas, as interest rate spreads ballooned for all emerging markets. Particularly hard hit was Brazil, which has a large fiscal deficit financed at floating interest rates. As Brazilian interest rates soared, capital started to flee the country at the rate of up to US$1 billion a day. At the start of September Columbia devalued its currency. Moody's downgraded Brazil's foreign currency bonds. Stock markets in the US, Canada, Mexico and the rest of the Americas continued the sharp fall they had begun in mid-summer. By late August fears emerged of an international credit crunch, as evidence mounted that even healthy companies in the US were finding it difficult to borrow money at reasonable rates. The crisis peaked in mid September with the de facto collapse of US hedge fund Long Term Capital Management (LTCM) and its rescue under the guidance of the Federal Reserve by major US financial institutions. While the rescue was reassuring, the fear that other such funds might be on the verge of collapse compounded the freezing of credit markets in the US. With this paralysis of the US credit and financial system, and continuing US Congressional refusal to authorize the US share of the IMF quota increase, the crisis had come to deprive the world of its lender of last resort, and was on the verge of engulfing the hitherto vibrant US economy itself.

At a meeting of hemispheric finance ministers in early September Martin and Rubin emphasized how different the situations in the Americas and Russia were. Yet such verbal reassurance proved inadequate. Throughout this period, Canada, along with the US, Britain and France, provided the intellectual leadership in the IMF and other forums, offering detailed proposals on many of the items on an ever-expanding crisis response and architectural reform agenda. Canada's priorities during this phase remained grounded in its 1995 Halifax program and its experience with the December 20, 1994 Mexico financial crisis (Kirton 1995a, Kirton 1995b). During this time Paul Martin and his Prime Minister had developed a strong skepticism toward unrestricted capital flows, in the face of clear evidence that markets were prone to panic in ways that could have enormous destructive consequences for the public good. Martin had translated this skepticism into policy, when during the 1996 negotiations for the Canada-Chilean free trade agreement he had overcome resistance from the trade policy community within Ottawa to allow Chile to preserve its system of limiting the outflow of short term capital during the first year after its investment. At Halifax Martin had also developed a proposal, spurred by the collapse of Barings Bank, for improved supervision of national financial institutions. It was a concern reinforced by the knowledge that with globalization bringing more foreign banks to operate in Canada, the hitherto highly secure Canadian banking system and its stakeholders would become vulnerable to the quality of supervisory practices abroad.

Concerned that markets needed a strong signal that governments were in control, and dissatisfied with the central thrust of President Clinton's international financial reform package announced in New York on September 17, Martin prepared his own package. It was unveiled at the Commonwealth finance ministers meeting in Ottawa on September 29, 1998, just prior to the October 3 G7 Finance Ministers meeting in Washington, in the form of a six point plan to deal with the current crisis and its underlying causes (Canada 1998b).

The plan began with stimulus - an carefully worded admonition to focus on "the risks of an extended global slowdown," through, implicitly, an immediate lowering of interest rates by G7 central bankers, The second element was social targeting - a call to tailor IMF programs to local conditions, particularly by having 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, based on the summer discussions of the G7, APEC and Western Hemisphere Finance Ministers, the G22 and the IMF and IBRD Executive Boards. The fourth element was capital control - a plea to adjust the move to capital account liberalization, by allowing, as Canada had in negotiating the Canada-Chilean Free Trade Agreement in 1996, weak economies to impose transitional, non-distortionary controls on capital, particularly short term capital inflows. The fifth, flowing from the 1996 Reys Report of the G10 on sovereign debt workouts and the need for collective action clauses in bond contracts, was the introduction of an Emergency Standstill Clause, negotiated in advance and covering all private sector instruments including bank deposits, that 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 such a form of an international bank holiday. The final item was to address the development and debt needs of the world's poorest countries.

Martin's six point plan followed by 11 days a speech given by President Clinton on September 17 in which he emphasized the desirability of interest rate cuts, a new IMF precautionary lending facility, and support for Brazil. Yet its conceptual and institutional origins flowed directly from Canada's proposals for international financial institutional reform prepared for the Halifax G7 summit it hosted in 1995. Several of its proposals flowed in part from the pleas of domestic groups (relief for the poorest), and the Commonwealth countries to whom the plan was unveiled (short term capital controls, debt relief and development for the poorest) and Canada's regional diplomacy in APEC and the Americas.

The most immediate Canadian concern - the call for a shift in focus from the threat of inflation to that of recession - had more direct origins. By September, the Canadian economy had suffered from four months of no growth. In late August, as the Canadian dollar plummeted to historic lows of just over 63 cents to the US dollar in the immediate wake of the Russian devaluation-rescheduling, the Bank of Canada had been forced to raise interest rates sharply, by a full percentage point on August 27, to support the Canadian dollar. The day of Martin's speech, the US Federal Reserve and the Bank of Canada immediately lowered interest rates by 25 basis points. In mid-October the Fed instituted a further unexpected cut, which Canada again matched. By the end of the month, Britain, Italy and Japan had followed, with the continental European countries, including the Bundesbank, joining them in November. From October 1 to the end of 1998, a total of 34 central banks lowered interest rates on 66 occasions. Canada's early call was by no means a critical cause of this emergency action, and this historic shift in the G7's decade long macroeconomic stance focused on inflation-fighting. Yet US-Canadian-British initiative provided the policy leadership which others joined, which met the immediate needs of the Canadian economy, and which proved to be critical in combating a paralyzing liquidity crisis in the US that would have catalyzed a systemic crisis.

The second Canadian priority, to tailor IMF programs to the particular situation in each country, with an emphasis on fiscal stimulus where required, was evident in Canada's approach to Indonesia during the autumn. Canada repeatedly pressed for greater fiscal flexibility in the IMF adjustment program to allow for greater spending by the Indonesian authorities, especially for targeted social programs, for development programs and for public infrastructure. It also favoured a relaxation in the pace of privatization of Indonesian state enterprises.

Canada's other priorities were forwarded in the October 3 G7 Finance Ministers meeting in Washington. Taking place amidst what President Clinton called the worst financial crisis the world had faced in 50 years, the meeting generated a communique which well reflected several of Canada's core concerns (G7 1998a). It signaled an easing of monetary policy to provide the needed liquidity. At the end of the meeting, Canada, the US and Britain promised to act to maintain conditions for sustainable growth.

The communique also reflected several of Canada's other core concerns, notably support for IMF programs, a proactive role for the G7, through the IMF, G22 and elsewhere on the issues of architectural reform, and a consensus on the core principles to guide it. Canada, along with the UK and US, was behind the push for the G7 consensus on the principle of transparency. On banking and financial system supervision, while the US and UK approach largely prevailed, Canada made some progress in principle. The emphasis on private sector involvement as a way of avoiding moral hazard also reflected one of Martin's concerns, although here it was a German conviction that was dominant and no particular mechanism for private sector "bail in" was endorsed. Canada's greatest gain came in the diminished enthusiasm for rapid capital account liberalization, as the process for an amending the IMF articles of agreement, initially slated for completion at this IMF meeting, was extended another one to two years.

Despite this forward movement, many saw the G7 conclusions as avoiding the badly need task of immediate, co-ordinated macroeconomic management to stem a crisis that was still burgeoning in Brazil and in credit and equity markets in the US and the rest of the developed world. In early October, the IMF cut its earlier estimate of world growth to a modest 2% (IMF 1998). Some relief came with US Congressional passage of the US IMF quota share increase on October 14, and the passage by Japan's Diet of its banking bill shortly thereafter. But the situation remained precarious.

For Canada, the continuing deterioration during October represented a major threat. Its primary fear was that the assault on Brazil would spread, infecting Argentina, other Latin American countries, and especially Mexico. With the US credit market immobilized, it was unclear whether the US would have the will or the ability to react to contain the threat in Mexico, as it had in the wake of the December 20, 1994 crisis. Mindful of how the Mexican crisis had threatened the Canadian dollar, of how Canada's dollar, perceived as a commodity currency, was already at an all time low, and with a looming provincial election in Quebec reawakening fears of Canada's division, the Canadian government concluded that the Canadian economy was vulnerable indeed.

With markets clearly not absorbing the G7's message from the October 3 meeting, pressure began to mount to send a clearer, stronger message, and to do so at the leaders' level. British Prime Minister Tony Blair, as host of the G7, proposed holding a special G7 summit, but his proposal received enthusiastic support from only the French, who wanted such a Summit to involve a broader group of countries. British Chancellor of the Exchequor Gordon Brown returned from the Washington meetings concerned that markets were reacting poorly, and that a new G7 statement, fully reflecting a deeper degree of G7 consensus than had previously been revealed, would reassure them. Canada, along with the US and Japan was initially skeptical about the value of either a statement of special summit, in the absence of anything new to announce. But with Congress finally approving the US IMF quota share increase contribution, Japan's banking legislation passing, Brazil approaching the IMF for assistance, and the G7 coming to an agreement through conference calls on Clinton's proposed precautionary facility, Canada concluded it was useful to issue a statement highlighting these new developments and casting them in a positive light.

Britain, as G7 host, took the initiative in catalyzing the process and drafting the statements, along two tracks. The first was among G7 sherpas, with Blair dealing through Britain's sherpa, John Holmes, who was in touch with his counterparts and they in turn with their leaders. Leaders were also in direct contact with one another by fax and phone, a process which included calls from Clinton to Canada's Chretien, Britain's Blair, and, on several occasions, Germany's new Chancellor Gustav Schroeder, whose government was strongly opposed to Clinton's call for a new IMF precautionary facility. The second track was among the G7 finance ministers, with Brown working through the Finance deputies. At the last minute, the two statements composed on separate tracks were rendered compatible. Despite the rushed nature of the process, with conference call until the last minute, the substance of the final statement was genuinely a G7 product, and one which reflected most of Canada's core concerns.

On October 30, the G7 released two statements, the one from the leaders and a second from their finance ministers and central bankers (G7 1998b, G7 1998c). It was clear from the texts that Canada had achieved, at least in part, many of its objectives. Most importantly, it has succeeded in mobilizing collective, proactive G7 leadership, in a way that had reassured global financial markets, redirected policy from its decade long preoccupation with combating inflation, and used G7 leadership to direct a far reaching reform of the international financial institutions in keeping with its Halifax initiative. Moreover, many of its specific priorities were endorsed by the codified consensus.

On the issue of capital controls, Martin's September 29 call for restrictions on short term capital outflows, in the form of an Emergency Standstill Clause, had secured support from some other G7 countries. The US, however, had remained adamantly opposed. The October 30 G7 statement included, among its long term measures, carefully crafted language that represented 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." G7 officials were directed to work out the mechanisms to give this principle effect over the next year. A meeting of G7 finance deputies and central bank governors in Paris in mid-November took up the issue devising mechanisms, such as those used by Chile, to encourage long term rather than short term capital inflows.

A second area of substantial Canadian gain came in regard to Martin's initiative for stronger banking and financial sector supervision. The October 30 G7 Finance Ministers Statement directly endorsed enhanced supervision through "a process of peer review" as well as its regular Article IV surveillance. The IMF further agreed to devote more attention to the quality and capability of such supervision in its annual review of members' economies (Canada 1998e).

A third area of Canadian achievement was the Statement's emphasis on Canada's concern, supported by the British, with dealing directly with the social dimensions of the financial crisis, an element which Martin had continued to emphasize throughout October. The G7 leaders began their Statement with an emphasis on the "impact on the poor and the most vulnerable." They endorsed the establishment of 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 G7 response to phase three of the crisis was its support package for Brazil, still being negotiated as the October 30 Statement was released. When unveiled on November 13, it contained several novel components. The first was the fact that Brazil had adopted, of its own volition, a restraint package prior to the extension of G7 assistance. The second was the use, in addition to IMF and other IFI funds, of bilateral national contributions from all G7 members and other countries as part of the first, rather than 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 BIS, $14.5 billion. The third was the use, for the first time ever of newly available NAB funds in support of a non-NAB members. Its use was authorized by phone calls to the heads of G7 finance ministries, who provided over 90% of the total. The fourth was the size of the package which, at US$41.1 was well in excess of the initially envisaged $25 billion or market-rumoured $30 billion. The fifth was the fact that 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 G7 members to put their national funds on the front line to make it this large was sufficient to demonstrate resolve and deter markets from continuing their 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 $500 million, or one-tenth the US contribution. Canada's relatively modest contribution was driven by several considerations. One was the fact that the US had not contributed to the Thai package in the spring, when Canada bore the burden from beyond the region. The second was that Canada, as a major contributor to the IMF, IBRD and IBD, was already contributing in excess of US$ 500 million, in addition to its bilateral contribution. The third was that Canada was not enthusiastic about Brazil's approach to the IMF, and the creation of a new precautionary facility for which it was the first test case. Nor was Canada eager to use the NAB funds, which became available on November 17, rather than the US quota share, which became available only later, as a source of finance for the IMF's multilateral portion (through the Supplementary Reserve Facility) of the Brazilian package.

Canada's concern about the prudent use of IMF resources at a time of instability was evident in its approach to a subsequent G7 debate about the speed of repaying the NAB, whose funds had been mobilized for the first time for Brazil. The US, wishing to show a still skeptical Congress that the IMF could serve as a profit centre, wished to rely for the longest time possible on the NAB, in order to reap its very high interest rates and delay a use of the IMF's regular quota increase. The French, in line with the concern of their compatriot Michel Camdessus that the IMF husband its scare resources, agreed. Canada, along with Britain, Germany and Japan, wished to pay off the IMF 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 up, as a matter of practically, the resources otherwise constrained by their commitment through the NAB, to be freely available to deter and defend against any currency crises yet to come.

The US delay in making their IMF quota share increase available in time for use by Brazil from the start stemmed in part from a provision of the US Congressional authorizing legislation. It allowed US funds to flow only 15 days after the Secretary of the Treasury and Chairman of the federal reserve received assurances from the "major shareholders" of the IMF that they were pressing for several conditions as part of IMF programs. In order to provide Secretary Rubin with a way to meet this condition, the G7 arrived at the formula of their Executive Directors at the IMF collectively writing a letter to the Managing Director calling for such conditions to be met. This unprecedented act of the G7 collectively and publicly directing the IMF Managing Director proved effective. It served as an effective symbol, reflecting a reality that the US Congress had met in writing in the condition, that it was the G7 collectively and not the US unilaterally that was the source of effective leadership for the IMF.