The international financial institutions (IFIs) will continue to play a crucial role in the world financial system, helping emerging market countries through financial crises and assisting poorer nations with development, says Timothy Geithner, a former under secretary of the treasury for international affairs. Recent reforms, increased funding, and new financial tools have helped make the IFIs more effective, Geithner says.

This interview was conducted by Economic Perspectives Managing Editor Warner Rose.

Question: Are the international community and the international financial institutions better able to prevent and contain financial crises today, when compared to five years ago?

Geithner: We live in a world of sovereign governments, and we live in a world of increasingly integrated capital markets. The system as a whole will always have a limited capacity to prevent sovereign governments from making decisions that will later either drag them into financial crises or fail to reduce their vulnerability to crises.

Most economists would agree that their capacity to predict crises effectively is very limited. And even where you think you have credible knowledge of the risks a country faces, it's hard to convince governments to address these risks early enough to make crises less likely or less severe. You have to start from that basic premise.

Because the world is so integrated now and because many large, emerging market economies that are systemically significant are more open to capital flows, the system as a whole is more vulnerable to the changes in sentiment that are inherent in all markets. Where capital is more mobile, the effects of shifts in confidence and changes in perceptions and fundamentals can have a more far-reaching, much more rapid effect on countries.

During the last five years, there have been a number of developments that equip the international financial institutions with much more powerful tools -- mostly financial tools -- to respond to crises and to help countries reduce their vulnerability to crisis.

The International Monetary Fund (IMF) also encourages countries to move to more resilient exchange rate arrangements, away from hard pegs that can result in a buildup in short-term external debt and other vulnerabilities that can be so devastating in a crisis. There has been a shift to a more flexible regime that makes the system itself more resilient. But probably the defining and most promising change has been a revolution in transparency -- the quality of information that the countries that belong to the IMF must disclose to the markets is much greater, much more comprehensive, and much more timely than ever before.

Q: What are the new tools for responding to crises?

Geithner: The main tools are greater resources for the IMF.

First, there was the 1999 increase in IMF members' quota contributions, which almost doubled the Fund's financial resources. Second, a new emergency financial reserve fund, called the New Arrangements to Borrow, a $50,000 million fund, went into effect in 1998. New IMF facilities were set up to provide the capacity for very large-scale finance in emergency situations. This finance is provided at an above-market interest rate -- a penalty interest rate -- on shorter maturity, so countries won't draw on the facility unless it is really necessary and will be encouraged to go back into the private markets as quickly as possible.

Q: What are the new facilities?

Geithner: The principal new facility is the Supplemental Reserve Facility, the SRF. A second is the Contingent Credit Line, or CCL, which has a slightly different character.

The SRF is designed for countries that experience crises resulting from a change in conditions that lead to a large movement of capital flows. Generally, this facility should be invoked only when there is some risk of contagion from the crisis. The SRF was first used for Korea in December 1997, then for Brazil in 1998.

The Contingent Credit Line is designed to induce countries to put in place in advance policies that might make them less vulnerable to crisis, by giving them the contingent capacity to draw potentially substantial funds when there is a crisis. While the CCL is up and ready, it has not yet been used.

Q: What other arrangements work with these tools?

Geithner: As a complement, the major creditor/donor countries have put in place innovative market-based arrangements for use during crises to deal with claims held by private investors, so that the debt can be restructured where it needs to be restructured, or a country's external creditors can be induced to maintain exposures or extend the maturity of those exposures when that is appropriate.

So there is now, in general, a better capacity to use official finance plus a constructive response from private investors to help bring a crisis to resolution more quickly.

Q: What has been the effect of these new facilities?

Geithner: They have given the IMF the capacity to respond with greater financial force when necessary to deal with a crisis that has systemic ramifications, and to make sure that it is done on conditions that are likely to restore confidence quickly.

It was this capacity that made the 1995 program for Mexico work and made it possible for the recoveries in Korea and Brazil to be as effective as they have been. These countries recovered much faster than most people had predicted.

The same sort of innovative financial packages have been used for crises that have followed, most recently in Argentina and Turkey.

Where there has been success, it has been because of the somewhat unprecedented mix of large-scale financial resources and a strong, credible economic reform program in the country. Where programs did not work, it was largely due to the failure of countries' political systems to make a credible effort to get confidence back.

Q: What about the issue of moral hazard -- that because these rescue tools exist, they encourage investors and countries to believe that the IMF will save them from bad investments and bad policies?

Geithner: Critics have argued that the assistance programs for Mexico, Korea, and Brazil increased the degree of moral hazard in the system.

But if you look at the emerging market finance business today, the default risk embedded in the interest rates those loans now carry, how much money now flows to emerging markets, and the form of those flows, there is little basis for concluding that a significant and dangerous degree of moral hazard has been induced in the system. Most of the good recent academic work on this subject comes to a similar conclusion. There is more differentiation than before in how credit risk across emerging markets is priced. That is a good indication of the success of improvements in transparency and a greater awareness of risk.

There will always be moral hazard in the system by virtue of the IMF's existence, and you necessarily increase that risk when you do what was done in recent years, which was to expand the resources available for crisis and make it clear you were prepared to use them. The challenge is to limit that risk while preserving the capacity to respond effectively to future crises.

Q: Is the IMF getting more involved in development programs?

Geithner: The view of what delivers durable development success has expanded over time. It is now recognized that growth requires more than credible macroeconomic policies. A huge amount depends on the quality of the institutional framework set up to enable a market economy to work. And a huge amount of what matters is the scale and quality of investments you make in health care and education and other things like that.

The Fund should focus primarily on the macroeconomic policy framework that is central to durable growth strategies. But there are things outside that narrow framework that also matter for financial stability, like the strength of the financial system itself. These issues are the province of the Fund. The broader issues of structural change and social programs should be the province of the multilateral development banks.

Q: How will the IMF and the World Bank work together? Where does one's task end and the other's begin?

Geithner: In most countries, the Bank and the Fund will probably work alongside each other for a significant period of time. That probably won't be the case in the emerging market economies; there, it will be more episodic, with the Fund involved temporarily. But in the transition economies, in the poorest countries, the two will likely be there alongside each other, working together, for a long period of time.

The Fund will do the basic macro framework, including exchange rate policy, that helps determine whether a country grows or whether money stays in that country or not. And the Bank will do the long-term investments in development policy to improve the quality of such public goods as health care, education, and agricultural development.

In the financial sector, the Fund and the Bank work together effectively, particularly in designing a program to strengthen a country's financial system.

Q: Where do the regional development banks fit into the division of labor?

Geithner: The World Bank and the regional developments banks need to sort out region by region, country by country, what things the Bank should be doing and what things the development banks should be doing. Everybody has an interest in figuring out a practical division of labor since resources are scarce, and they don't want to be all trying to do the same kind of thing. The development banks claim to be aware of the imperative of being complementary, not redundant.

Q: Should the development banks be lending to developing countries that already can borrow in world financial markets?

Geithner: The market access of developing countries is tenuous, fragile, vulnerable to reversal, partial, and expensive. This is true from Poland to Indonesia, from Brazil to Korea, and most of the poorest countries have no market access.

Even those countries that have established themselves in the private markets have at times found access disrupted or curtailed or limited or coming at a price that's very expensive with maturities that are very short. The experience of the past five years should, I think, demonstrate that the basic case for development banks laid out in the Bretton Woods conference in 1944 is better today than it was then because the world is more integrated, despite the fact that the private capital markets are now so big.

Q: What is the next step in the IMF/World Bank-managed Heavily Indebted Poor Countries (HIPC) debt relief initiative?

Geithner: Even though 22 countries have begun to benefit from the debt relief initiative, it is still in its early stages. The key objectives of the initiative are to put in place durable changes in how the IMF and the World Bank set development priorities and define policy conditionality and to change the way the beneficiary governments make decisions about how they use their resources. There needs to be a redirection of the economic policy priorities in these countries, new mechanisms for accountability and for greater participation by civil society, and a redirection of resources from debt relief to investment in core development priorities.

Looking ahead, the donor countries, including the United States, need to be very careful about their lending to the HIPC beneficiaries. All the major donor governments have bilateral lending programs in support of exports, including agricultural exports and things like that. It's very important that those bilateral agencies not push money on these countries at market rates in a way that makes their debt burdens worse.

The United States has encouraged other donor countries to commit to provide most of their development assistance as grants. That's something the United States did a long time ago. There is also a move to have more World Bank assistance for the poorest countries provided as grants, particularly to the highly indebted nations.

(Note: The opinions expressed in this interview do not necessarily reflect the views or policies of the U.S. government.)