- Laura Wallace
- Published Date:
- January 1999
Having heard these valuable contributions (and noting that Piero Ugolini based his thoughts on the results of a comprehensive study by the Monetary and Exchange Affairs Department of the IMF) it is perhaps safest simply to say “Amen”! All the major points and caveats regarding the development of sound banking systems and practices have been covered by the speakers.
Some points, however, deserve to be amplified and I will endeavor to do so, mainly in light of South Africa’s experiences. It is heartening to see the emphasis placed by our distinguished speakers on the importance of a stable macroeconomic environment as a prerequisite for developing sound banking practices and policies. While financial market specialists and regulators seem to agree more and more on this score, it would seem that this point has not been fully conveyed to the public at large. Within the increasingly democratic environment in most parts of the developing world, further efforts at communicating the benefits of stability to the broadest audience possible will be worthwhile.
While a stable macroeconomic environment and a sound banking system may well be a necessary condition for economic success, it may not be a sufficient condition. South Africa has unfortunately not yet been able to generate sufficient economic growth to make a meaningful impact on the level of unemployment prevailing in the country. The authorities nonetheless remain committed to prudent macroeconomic policies.
It is perhaps helpful to note the reservations in many developing countries regarding the globalization of finance, reservations that flow from the perception—and often the practice—that the most solid companies active in the economy concerned use overseas banks as their lead bankers, at least for certain categories of large transactions. It is sometimes alleged that foreign or foreign controlled banks simply pluck the best businesses in developing economies. The fundamental solution, although painful, costly, and time consuming, is, of course, to strengthen local human capital and to raise service levels and professionalism in the domestic banking sector. Indeed, both papers alluded to the shortage of well-trained nationals. Ironically, competition from abroad may well be needed to obtain such a transformation.
South Africa’s Experience
As you are aware, the political reforms in South Africa over the past five years opened up the way for major changes in our financial sector. With the removal of sanctions, boycotts, disinvestment campaigns, and the withdrawal of foreign loan funds from South Africa, the challenge was to reintroduce the South African financial markets in the world environment—and we have gone through quite a learning curve. This reintegration took place at a time when the international markets also changed drastically, and when the trend towards financial globalization gained momentum.
During the past few years, many international financial institutions have established themselves in South Africa to participate in the expansion of our markets. Explosive increases occurred in the volume of transactions, with total turnover in the secondary bond market rising to R 4.6 trillion in 1997 from R 2.3 trillion in 1995, and the total value of shares traded on the Johannesburg Stock Exchange increased to R 207 billion from R 63 billion over the same time period. The average daily turnover in our foreign exchange market jumped to over $10 billion in 1996 from about $4 billion in 1994—with nonresidents representing about 50 percent of the turnover. And during the first three months of 1998, nonresidents increased their holdings of South African securities (shares and bonds) by R 17 billion.
These greater volumes brought with them greater risk exposures, and thus a need for more modern, sophisticated risk management procedures. In the area of financial regulation and supervision, we now have internationally recognized principles and procedures for financial regulation and supervision (for example, the Basel Committee directives for bank regulation). Moreover, the importance of independent, well-trained bank supervisors is widely recognized. To quote Ugolini: “Unsound banks threaten the real sector, weaken monetary policy, impose fiscal costs, and produce exchange rate instability.”
The South African Reserve Bank also fully recognizes the value of on-site and off-site surveillance to identify weaknesses in a timely manner—and we have instituted these forms of surveillance. As an aside, there might be some divergence of opinion regarding whether overall supervision of the financial system should be concentrated in the central bank. My feeling is that with institutional capacity often limited in developing countries, the case for housing supervision in the central bank is the more persuasive.
Turning to an efficient domestic payments system—the importance of which was underscored by both Ugolini and Tsumba—there has been much activity on this front. The growth in value transferred through these systems, as well as systemic risk inherent in the clearing and settlement of payments, has compelled central banks worldwide to introduce risk-reduction measures. Following this trend, the South African Reserve Bank took the initiative in April 1994, together with the banking industry, to reform South Africa’s system. The problem was approached on an all-inclusive national level, and a strategy was formulated to upgrade our existing system to comply with world-class standards.
The project to implement a new electronic interbank settlement system was identified as the cornerstone of a new national payment-processing infrastructure. The South African Multiple Option Settlement system, introduced on March 9, 1998, was developed over a period of two years as a collaborative venture among the reserve bank, private banking institutions, and the technology suppliers. The system ushered in a new era in electronic payment and settlement in South Africa and will have a major impact on the future development of the national payment system. Furthermore, this system has already enabled the reserve bank to introduce new operational procedures for the execution of monetary policy. Under these arrangements, banks now participate in a daily tendering system, based on repurchase agreements, to obtain funds from, or to repay funds to, the reserve bank.
In terms of the sequencing of reforms, South Africa has reduced its government’s deficit (before borrowing) as a percentage of GDP to 4.1 percent in the 1997/98 fiscal year from 5.5 percent in the previous fiscal year, and is aiming for a further reduction to 3.5 percent in the current fiscal year. We have introduced a system of three-year rolling budgets, where we have increased transparency. And we have whittled down South African banks’ holdings of government debt to only 7 percent of their assets—a key reason why our banks, unlike banks in other countries, have no problems funding credit.
With South Africa lumped together with other countries in the emerging-markets’ class, the management of foreign-currency-denominated debt assumes even greater importance. Spreads over foreign benchmarks can widen dramatically as emerging-market paper comes under pressure. While wider spreads may affect future foreign borrowing costs, they do not immediately affect the country. But purchases of domestic debt by foreigners and the subsequent reversal of these positions can be disruptive to the domestic economy. It is thus imperative, in my view, that the management of debt be very carefully deliberated, and a balance found between foreign liabilities denominated in domestic currency and such liabilities denominated in foreign currency.
As for the legal framework, the reserve bank’s main task, as defined in terms of the South African Reserve Bank Act and in the country’s constitution, is to defend the value of the rand—that is, to keep inflation as low as possible. This is very much in line with contemporary central banking all over the world. The reserve bank’s independence is enshrined in the constitution. Section 32 of the Reserve Bank Act says that the bank must submit a monthly statement of its assets and liabilities and an annual report to parliament. The bank is, therefore, accountable to parliament. The governor of the reserve bank holds regular discussions with the minister of finance and appears before the Parliamentary Standing Committee on Finance from time to time.
On exchange controls, South Africa is in the process of liberalizing its remaining ones gradually, as and when circumstances permit. (In other words, the big-bang approach, advocated by some commentators, has been eschewed in favor of a gradualist approach.) This is part of our push to integrate our financial markets into the global system, in order to benefit from the worldwide flows of investment funds. For a country such as South Africa, where domestic savings are extremely low and the demand for capital investment is extremely high, financial globalization can bring many advantages. A net inflow of foreign investment capital will raise the country’s ability to increase its domestic economic growth rate, and to create more jobs for the many unemployed.
Finally, a brief word on exchange rates and transparency. We have found that transparency is the key to pacifying the markets, to convince the markets that we are moving in the right direction. That is why the reserve bank has published a paper on its forward book and now releases monthly data on its oversold position. I do not want to go into a detailed explanation of the forward book, except to say that we have a long history of providing forward cover, and are phasing out our participation in the forward market as circumstances permit. Indeed, the oversold forward book as of April 30, 1998, represented about 19 percent of the total contracts outstanding in the forward market, down sharply from about 30 percent five years earlier.
In closing, I would just like to underscore the importance of a number of issues that we have been discussing: sound domestic payment systems, accounting standards, legal standards, bank quality, loan quality, on-site inspections—something that we need to do more of—transparency of the financial system, and, as Leonard Tsumba noted, discipline and predictability.
It was a pleasure to read the concise and thoughtful papers of Leonard Tsumba and Piero Ugolini. I would agree with the importance of the challenges that Tsumba discussed, and with the general principles that Ugolini outlined. I believe, however, that there are a few issues that need to be addressed more directly, in light of the recent events in Asia. These are the issues that arose in reviewing possible causes of the crises in Asia—issues that may be relevant for African governments in formulating their own financial policies. I would like to discuss these by posing three questions.
Political Will and Bank Supervision
How strong should the institutional and technical capacities of bank supervision be before African countries embark on extensive liberalization of their financial systems, as Asian countries have done over the last 10 years or so? In Asia, many observers believe that bank supervision was inadequate when financial sectors were liberalized in Thailand and elsewhere, and that this premature liberalization contributed significantly to the banking system crises. If this is true, most African countries should wait a long time before proceeding on further liberalization, because their supervision capacities are not yet even as good as those that existed in the Asian countries.
In my view, though, the current banking system crises are more a result of the absence of political will rather than the presence of technical shortcomings. Political will involves the willingness to enforce the existing prudential regulations and to avoid government interventions that create moral hazard. Let me explain.
Banking crises are not new in Asia. Major crises occurred in Malaysia, the Philippines, and Thailand during the 1980s; and in Indonesia, a crisis that began in 1992 continues into 1998. In Malaysia and the Philippines, the health of the banking system has strengthened substantially over the years, thanks to a number of strong measures to enhance bank capital and strengthen prudential oversight. In Indonesia and Thailand, however, little progress has been made. Indonesia began to adopt similar measures in 1986, but delayed enforcement of key provisions and tolerated noncompliance of existing regulations. Thailand took some prudential measures, but they were too little, too late.
In Malaysia and the Philippines, nonperforming loans declined from very high levels in the 1980s to less than 4 percent of total assets by 1996 (see Table 1). Moreover, in Malaysia, banks accumulated a large amount of loan loss reserves, comparable in relation to the amount of nonperforming loans to that of Singapore (see Figure 1). Not surprisingly, therefore, the Bank for International Settlements described Malaysia’s banking system as “robust” in its 1996 Annual Report.
Figure 1Banks in Thailand and Indonesia Were Overexposed
By contrast, in Indonesia and Thailand, high-risk bank management continued, or even worsened from 1990–96. The ratio of liquid assets to short-term liabilities fell to extremely low levels (see Figure 1), and the reserve coverage of nonperforming loans was very low.
Moreover, Thai finance companies continued to expand their lending at a brisk pace—even after the asset market collapsed and the interest margin (loan rate minus borrowing rate) declined (see Figure 2).
Figure 2Finance Companies in Thailand Expanded Rapidly
Source: Elie Canetti and Michael Sarel, Thailand—Statistical Appendix, IMF Staff Country Report No. 96/83 (Washington: International Monetary Fund, 1996).
Thus, the difference between Malaysia and the Philippines on the one hand, and Indonesia and Thailand on the other, is the strength of political commitment to restoring banking soundness.
The experience of Kenya also underscores the importance of political commitment. As some of you are aware, Kenya encountered a major banking crisis in 1993, prompting the government to change the management of the central bank, close four major banks that were called “political banks,” and seize a number of assets to recover loans that the central bank had extended. Since then, the central bank has been vigilant in detecting problem banks early on and taking corrective measures quickly. A crisis has not recurred, and the Kenyans, I believe, have confidence in their banking system.
So what is the lesson here? I would conclude that if a sufficiently strong political commitment exists, liberalization of the financial system can proceed in most cases while the supervisory capacities are simultaneously being strengthened.
Pacing of Financial Integration
If African countries succeed in financial sector reforms and attract foreign capital, will they receive substantial long-term productive investment, or primarily short-term “hot” money?
In Thailand, the bulk of inflows over the last few years has been in the form of short-term investment while the volume of foreign direct investment has declined. In Africa, foreign investors’ preference for short-term investment would no doubt be even stronger, given concerns about political and social instability and economic governance. Even for short-term investment, relatively high interest rates would be demanded to accommodate risks that investors perceive. Indeed, Kenyan bankers and accountants estimate that if risk premiums, as well as high operating expenses and intermediation costs, were fully reflected, lending rates of around 25 percent would not be unreasonable.
Should further financial liberalization and integration with the global financial market be delayed in Africa until political risks decline and operating costs are reduced? My answer is “no.” Whether the financial market is open or closed to foreign investors, domestic interest rates will need to fully reflect risks and the costs. Otherwise, banks will not be able to set aside adequate provisions against future nonperforming loans, thus enhancing the chances of their eventually running into financial troubles. An alternative would be for banks to set interest rates lower and lend only to very safe borrowers. But if they did this, only a handful of corporations would receive bank loans—which is happening in many African countries—and smaller firms and new entrepreneurs would continue to be denied an opportunity to grow.
So what is the lesson here? It seems to me that most African governments should proceed with financial liberalization and, at the same time, reduce, as soon as possible, the political and social uncertainties, strengthen economic governance, and improve the operational efficiency of the banking systems. This, I believe, is the best way to promote long-term investment, both domestic and foreign, and to harness a sound banking system.
Exchange Rate and Monetary Policies
Are international capital flows so volatile that direct controls on capital flows, particularly short-term flows, are required to maintain macroeconomic stability and avoid financial crises?
In Asia, when the economy was booming, foreign investors moved in en masse, and helped generate the asset price bubbles. When the bubbles burst and the situation soured, foreign investors fled again en masse, leaving a severe crisis behind. Many observers in Asia apportion much of the blame to the imperfection or irrationality of international financial markets, and conclude that some form of controls on short-term capital flows are in order.
I would agree that international financial markets are imperfect. In my view, however, excessive capital inflows and the asset price bubbles largely reflected the exchange rate and monetary policies that these countries pursued, in addition to the imprudent lending by the financial institutions. I will explain.
It is now widely accepted that there is a close correlation between asset price inflation and growth of bank credit to the private sector. Indeed, such credit expanded rapidly in the Asian countries during the four-year period preceding the crises (see Table 2).
|Growth of private sector credit||23.12||20.81||40.34||23.17|
|Net foreign liabilities||1.23||−0.61||7.72||8.65|
|Growth of deposit liabilities1||24.68||21.46||26.70||15.25|
|Increase in money supply multiplier||2.96||−3.39||11.47||−1.18|
|Increase in reserve money||21.80||26.92||13.91||16.68|
|Contribution of both||−0.07||−2.07||1.32||−0.25|
|Growth of reserve money||21.80||26.92||13.91||16.68|
|Increase in foreign exchange reserves||27.70||21.95||31.52||37.21|
|Net lending to government||10.96||1.92||−35.34||12.49|
|Net lending to others||−16.86||3.05||17.73||−33.03|
Contribution equal to the ratio of the change during the period to the stock of domestic liabilities at the beginning of the period.
Contribution equal to the ratio of the change during the period to the stock of domestic liabilities at the beginning of the period.
How did this come about? Central bank purchases of foreign exchange were the main source of liquidity. These purchases reflected exchange market intervention that the central banks undertook to maintain the actual U.S. dollar peg in response to large capital inflows. These purchases were the largest in Thailand, where the exchange rate was most rigidly tied to the U.S. dollar, and the smallest in Malaysia, where the rate was more flexible.
The Philippines and Thailand almost fully sterilized the liquidity impact of exchange market intervention, and kept the growth of reserve money low. Sterilization also kept domestic interest rates high, however, prompting banks to undertake large foreign borrowings. As banks used these borrowings to help fund their lending, both countries ended up with high credit expansion. High domestic interest rates also encouraged nonbank institutions to continue to borrow from abroad.
So what is the lesson here? Had these countries allowed the exchange rate to be more flexible, the associated exchange risks would have worked as an effective deterrent to short-term capital inflows. Extensive sterilization would not have been necessary, and, instead, monetary policy could have been guided to keep domestic credit expansion in check.
The case for exchange rate flexibility can also be seen by comparing the experiences of Hong Kong and Singapore during this time period. In Hong Kong, where the U.S. dollar peg was maintained through a currency board arrangement, inflation consistently exceeded that of the United States (see Figure 3). In contrast, in Singapore, where flexible management of a basket peg was pursued, inflation was kept at 1–2 percent a year, and Singapore has been largely free of major financial crises.
Figure 3A Case for More Flexible Exchange Rates
Source: IMF, International Financial Statistics.
The recent experience of Kenya also supports the above policy conclusions. It is unfortunate that Micah Cheserem is not here to tell us how Kenya managed both very large capital inflows ($500 million) and a subsequent sudden reversal in the run-up to the elections in 1996. The key, I believe, was the willingness to allow the exchange rate to appreciate in the period of inflows, and to let the rate fall—by as much as a third—when investor confidence was shaken.
Recent Lessons from Asia
In closing, let me just say that the “new lessons” of the current crises may be the crucial importance of the following:
effective government—a strong commitment to sustained growth and stability, including the maintenance of an appropriate regulatory framework for the banking industry, as well as the avoidance of moral hazard that weakens the banking system;
strong institutions—sound banks and an efficient structure for bank supervision; and
pragmatism—flexible exchange rate management and the readiness to listen to market signals.
In a sense, these lessons are really just an application of the “old lessons” of the Asian miracle to the management of banking systems in our new, globalized financial markets. I am not advocating complete faith in market forces. It is essential to take appropriate safeguards, including steps to lessen the widening income disparity between the rich and the poor. Rather, what I am suggesting is the importance for Africa of not reversing or unnecessarily slowing the movement toward financial liberalization, as an overreaction to the Asian crisis. After all, the lessons of the Asian miracle still hold. The recent setbacks notwithstanding, these countries achieved tremendous economic growth over the last three decades, growth that is historically unparalleled. And this growth was in large part thanks to the capital inflows that came about in a liberal policy framework.