To Create a Stable International Financial System
Chaired by Kurt Furgler
28-29 March 1996
GLOBAL FINANCIAL FLOWS: A NEW CHALLENGE TO GLOBAL GOVERNANCE
Introduction: Financial Globalization
1. Over the last decade or so a number of important developments have been taking place in both the foreign exchange and the international capital markets. A major impact of such developments was to impose new constraints on the international economic system as well as provide new opportunities and challenges.
2. First of all there has been a dramatic change in the pattern of international capital flows with the integration of developing countries into the international capital markets. The new feature is the increasing scope of capital flows from the developed to the developing world, a totally new situation compared to what was the case a decade earlier.
3. A corollary to the first development is the change in the composition of capital flows; direct investment has soared over the last five years. At the end of the 1980’s, when large-scale capital flows resumed after the lost decade which followed the debt crisis, the new channel for capital transfer became investments rather than lendings. Other types of flows such as debt flows (bond issues and bank lendings) are still important but an unprecedented volume and share of capital flows to developing countries began to take the form of direct investment. Also, portfolio equity investment has become significant in some countries.
4. The third major change has to do with the scope of transactions on the foreign exchange market. Amounts of global foreign exchange transactions have been constantly on the rise and a widening gap has emerged between overall foreign exchange turnover and the transactions involving trade in goods and services.
5. These developments, which are all related to the increasing globalization of financial operations, may obviously have pervasive impacts on exchange rate movements, on international interest rate linkages as well as on the stability of the overall financial system.
6. There are as a result three major areas where stability can be increased and on which attention should be focused: These are emerging economies, the banking system and the exchange rate system.
CAPITAL FLOWS TO THE DEVELOPING WORLD
Emerging Economies and the Lessons from the Mexican Peso Crisis
7. The integration of capital markets is deemed to be fundamentally good because it allows a better allocation of resources and has disciplinary effects, as a consequence we should definitely not turn our backs on it. Yet in the context of increasing financial globalization, a major difficulty is to make sure that developing countries are not destabilized both by the volume of capital flows and by capital flow reversals.
8. As a matter of fact, in this context, one of the most important developments over the last few years was the Mexican peso crisis which exemplified the high vulnerability of emerging economies dependent upon huge short-term capital. Yet, surprisingly enough, there was a limited contagion effect after the Mexican crisis: the only countries to really suffer were those with weak fundamentals. A major positive lesson was thus to induce markets to discriminate among emerging economies.
9. However, actions have no doubt to be taken in order to prevent the occurrence of other such crises. As the source of the Mexican peso crisis was a combination of inappropriate policies, the key is to ensure that capital flows to less developed countries are met by appropriate policies (fiscal retrenchment, sterilization, exchange rate flexibility) and that the composition of these flows is also appropriate. Indeed capital flows may only enhance growth insofar as they fuel productive investment and not mere consumption expenditures. The answer cannot be capital controls; there may be some scope for selective controls on capital inflows but not on capital outflows.
10. Another contributing factor to the enhancement of stability is information dissemination. Providing more complete and timely information to the market can help prevent too large and abrupt capital flow reversals for two reasons. First, feeding the market with better information may contribute to a better understanding of the underlying macroeconomic situation thus allowing more consistent and rational decisions. One of the lessons to be drawn from the recent turbulence in Mexico is that a more thorough assessment of the overall macroeconomic situation is warranted. Secondly, imposing information disclosure may also have a disciplinary impact on host countries' governments.
11. The role of the IMF is of course paramount in this respect, and the “early warning system” it has been trying to put in place in the wake of the Mexican peso crisis should definitely be supported. By the same token, the various measures that are envisaged in order to respond to similar crises in the future should also be encouraged, provided they are attached to very strict conditionality provisions so as to avoid any moral hazard situations.
Redefining ODA Policy
12. In addition to the so-called “emerging economies,” which are the most advanced developing countries, a number of least developed countries have been increasingly marginalized over the last decade. Another area for enhancing the overall stability of the international economic system is Official Development Assistance (ODA). Indeed the maintenance of an appropriate level of ODA is no doubt an essential way to avoiding a further widening of the growth gap within the developing world. Such a development could only be detrimental to the stability of the global economic system.
13. In this respect, an interesting and promising direction for ODA orientation is the definition of precise and targeted conditionality provisions related for instance to family planning or military expenditure policies.
FINANCIAL AND BANKING SYSTEM
Explaining the Use and Utility of Derivative Markets ...
14. A major development in the international financial market has been the dramatic expansion of customer needs, enabling them to unbundle and transfer financial risks. Through such instruments, different categories of risks can now be identified and hedged against. Derivative markets provide derivative products. Derivatives are definitely useful instruments. They meet important insurance service to end-users (whether industrial and commercial companies, government agencies or financial institutions). They also provide a way of pricing, controlling and managing risk, at the microprudential, macroprudential and macroeconomic levels.
15. This point has yet to be put forward very forcefully so as to convince the general public that financial globalization is both necessary and desirable. In so doing, the difficulty is to manage to link this development with issues such as unemployment, which are of major concern to the public at large. Increased transparency and additional information disclosure are certainly key but is also better information of the public at large.
... and Mitigating the Risks of Financial Globalization
16. Although so far major bank losses have continued to stem from traditional lending business, derivatives provide scope for greater leverage and can therefore lead to substantial losses if not properly used. In order to manage the risk of instability as a result of losses from derivative transactions, regulation of the banking system should be enhanced through increased prudential measures. A promising option is for instance to encourage the implementation of value at risk accounting techniques.
17. More generally, two elements on internal controls probably deserve special attention in this context: i) ensuring that top management understands the activities its firm is engaged in, and ii) reviewing the compensation system of employees to see that it is not biased towards excessive risk-taking. Indeed, there is definitely a need to better organize compensation for dealers and supervisors. The bonus system should be altered to induce more responsibility. A possibility would be to set the bonus according to long-term performance.
18. The answer to the challenge thus lies in better management control, perhaps encouraged by competition. The general motto should be to increase transparency and reduce complexity. Yet, derivatives are only part of the story, more generally the dramatic growth in financial transactions calls for intervention and regulation. In this context, action should be taken at two levels: regulation and again information. Cooperation among regulators is certainly the answer because we will never have a supranational regulator. To that purpose surveillance and safeguard definition as designed by the Basle Committee should be promoted.
19. Moreover as far as regulation is concerned, there is definitely a need to bring other institutions than banking institutions into the gambit of regulation. As a result, coordination is needed across sectors (among banking regulators, security regulators and insurance regulators) as well as across countries.
Stabilizing the Exchange Rate System
20. The need to provide more predictability to the exchange rate system is generally recognized, as exchange rate uncertainty may have pervasive impacts on the real economy, not the least on trade flows. More than short-term exchange rate volatility, the true source of problems is the persistence of exchange rate misalignments over protracted periods of time. Be it as it may, it is undoubtedly appropriate for governments to concern themselves with the behaviour of exchange rates and to try to curb such misalignments.
21. Since exchange rates are influenced by expectations, appropriate and stable expectations should be formed on the basis of appropriate and sustainable economic policies. To this end, the sustainability of policies has to be achieved not only from a domestic but also from an international point of view, implying needs for international policy coordination and some role to be played by international institutions. Yet stable policies would not by themselves guarantee exchange rate stability.
22. The resort to target zones could certainly be an option to stabilize exchange rates even though it involves a number of practical difficulties. First of all there must be an agreement on the determination of a central rate. Secondly, there must also be an agreement on the conditions and frequency with which the central rate may have to be changed. More generally, while it is likely that such a scheme will lead to more stability, its feasibility is highly questionable. A major issue in this respect is the degree of commitment on the part of governments to the defense of target zones. Such commitment is however necessary to give the zone the credibility it would need to be effective. A further problem pertains to the identification of fundamental misalignments as opposed to mere noise-trading. Finally, the effective working of the scheme also hinges on the difficulty of realigning the rate without losing credibility.
23. Yet the definition of a reference range for the exchange rate, whatever the form it might take, would certainly help stabilize expectations and give more predictability to the overall system. Spelling out the conditions in which governments would step in to defend the exchange rate may be a compromise solution.
24. The problems of exchange rate stabilization does not only involve the G-3 members, namely the United States, Japan and the EU. First of all, problems related to exchange rate fluctuations also arise within the EU so that a framework for cooperation between future EMU members and other EU member countries certainly has to be encouraged. Moreover, as misalignments between two major currencies may have pervasive effects on third countries, such issues should be dealt with at the international rather than at the bilateral level. The intimate involvement of the IMF is therefore essential in exchange rate management.
25. Another issue related to exchange rate stabilization is the role the single European currency will play in the exchange rate system. If the single European currency plays the role of a reserve currency, it may have a disciplinary impact on the U.S. economy.
26. Finally, feeding the market with more financial and macroeconomic data may again also contribute to stabilizing the exchange rate system insofar as it is likely to ease expectation information. Providing such information should be part of the IMF mission. Yet more disclosure and information are no panacea as the market may also fail to read information appropriately.