The Insecurity of International Money

Chaired by Helmut Schmidt and Malcolm Fraser
9-10 April 1999
The John F. Kennedy School of Government
Harvard University

Global financial markets have recently experienced an extraordinary increase in the volume of international capital flows and the magnitude of exchange rate movements. This volatility has contributed to real economic crises in many developing countries. Such crises pose a risk to the entire global financial network. Political leaders bear responsibility for insuring that in the future such risks are better understood and dealt with more effectively.

There are numerous causes of the problems now being observed in world financial markets. Domestic mismanagement, over-valued exchange rates and over-reliance on short-term foreign-currency denominated debt in many emerging markets were major factors. These problems, however, were exacerbated by poor lending practices and excessively volatile short-term capital flows. Technological change and aggressive competition have encouraged private financial institutions to search out higher rates of return in developing markets, returning profits to safe havens in industrialized countries.

Movements of goods, services, and capital are rapidly liberalizing and are being integrated internationally, while financial regulators generally operate within the framework of national borders. There are no international institutions, nor is there sufficient coordination between competent national authorities, to effectively supervise international financial markets. The result is a dangerous vacuum.

The combination of technology, international integration, and inadequate regulation create a situation in which volatile financial inflows and outflows can become highly disruptive, particularly when tied to exchange rate fluctuations. Developing countries, with open economies highly dependent on exchange rates, are vulnerable to rapid adverse movements of short-term capital. Such movements are often spurred by policy mistakes in developing countries, but are also exacerbated by movements in the exchange rates between the major currencies themselves.

Exchange Rate Stability: The Options

It is difficult or impossible for a small, open, diversified economy with a convertible currency to have a sustainable exchange rate policy if there is volatility in the exchange rates of the major world currencies. While an improved financial architecture can improve the robustness of the system, extreme fluctuations in exchange rates are a source of significant financial shocks. Significant improvements in exchange rate arrangements are required. The following suggestions should form a basis for discussion and future consultation.

· Exchange rate stability requires different approaches for emerging markets and the currencies of developed industrialized countries. The purpose must be to reduce the short-term volatility and uncertainty in financial markets, while allowing the flexibility required for adjustment in the medium-term.

· Given that the U.S. dollar and the Euro together will cover the great majority of world financial markets, the stability of the trans-Atlantic exchange rate is crucial for world stability. In view of the yen's importance in the Asian region, the stability of its exchange rates against the dollar and the Euro is also important.

· Representatives of the major world currencies should agree to consult about and coordinate their fundamental policy objectives and their implications for achieving greater exchange rate stability. Consideration should be given to reinforcing such a system by states pursuing more active market intervention around the equilibrium.

· Other countries, especially those with small, open economies, should choose their own exchange rate regime - no one system is appropriate at all times and in all places. However, their purpose should be to reduce volatility, to encourage investment, and allow for the flexibility necessary to adapt to changing circumstances. Technical assistance should be provided to them in choosing and maintaining the most appropriate regime.

An Improved Financial Infrastructure

The international financial system should be made more robust, and this goal would be furthered by more effective supervision of international financial transactions. An international framework for coordination and eventual harmonization of prudential supervision is a pre-requisite for the creation of sufficient international liquidity whilst discouraging reckless risk-taking on the part of lenders and borrowers. The Financial Stability Forum created in February by the G-7 is a valuable starting point. It is important, however, that participation in this framework not be limited to members of the G-7: other countries, particularly developing countries and those whose economies are in transition, should be included in these discussions.

An international regulatory authority should be established, building on the achievements of the Basle committees. Such an authority should establish standards of best practice in all forms of financial regulation, monitor compliance with those standards, and coordinate mechanisms for limiting the risks posed by non-compliance. In addition to prudential supervision, attention should be paid to the need for international standards of disclosure, market control, and cross-border mergers.

Achieving best practice in prudential regulation involves not only political commitment but also technical expertise. There is a need to expand the role of international institutions in assisting the developing countries to up-grade their technical capacity to deal with such increased regulatory burdens.

An important means of maintaining order in international financial markets is the balance between short-term and long-term capital flows. Equally important is consistency between a country's state of financial development and the speed with which capital can enter and exit its markets. The IMF should not, in the near future, require full capital account convertibility for all member states. In certain situations, it may be appropriate for some emerging markets to restrict short-term capital inflows, and to impede the movement of flight-capital belonging to national citizens.

The IMF should continue, with adequate conditions, to provide assistance to states experiencing financial crisis. In formulating the requirements for such funding the IMF should take particular account of a country's history and individual economic situation. It should not intrude on the World Bank's responsibility for long-term development issues. The IMF's financial resources should be strengthened as a means of averting crises through the provision of contingency funds. Adequate funding is necessary for international institutions to fulfill their role.

In any liquidity arrangement, the IMF should take care not to absolve lenders of their responsibility. The IMF should be given better ability to monitor short-term capital movements (including derivative positions).

It may be appropriate to allow the IMF, in certain emergency situations, to create SDRs for a limited period of time as a form of liquidity support. Such extraordinary issues of SDRs would allow rapid reaction to crises, and should be rapidly retired. In general, however, the IMF should serve as a catalyst for attracting private sector capital into the international market.