Chapter 41 Lessons for the International Financial System
- International Monetary Fund
- Published Date:
- January 2001
The currency turmoil in Asia—which now has extended to Russia as well—has been aggravated by a confidence crisis feeding on itself in a self-reinforcing and destructive way. Financial market “animal spirits” can be sensitive and fickle—which, I hasten to add, is not the same as saying that financial markets are irrational. And the nature of currency crises is such that they mutate over time, much like a virus. These factors make it extraordinarily difficult to predict crises. The initial triggers in a few countries like Thailand may have been reasonably visible, but the depth, timing, speed and spread of the events that followed were not foreseen.
At the broadest level, a key lesson from the latest crisis—common to earlier ones—is that we have to work hard in shaping both national and international efforts to contain their recurrence; needless to say, we are unlikely to be able to prevent them entirely, but we must find ways to minimize their severity and contagiousness. In both of these respects, a clear message from the ongoing crises is that sound financial markets and institutions, including their underlying legal, governance and accounting infrastructures, are critical. The speed, magnitude and flexibility of capital flows make international financial markets a strict taskmaster at the best of times; but, if we needed another reminder, recent events have demonstrated again that, in combination with significant weaknesses in domestic financial systems and their infrastructure, the effects of confidence shocks can be wide-ranging and debilitating.
The answer, however, does not lie in trying to turn back the clock by reverting to isolationism. Except perhaps in emergencies, a return to controls on international capital movements would be neither desirable nor effective. A distinction can be made here between cases of countries where controls have been maintained for some time, but the general direction of movement in the medium to long term is towards liberalization, and cases where countries have already liberalized, but try to backtrack on their previous policy direction. Such policy reversal is likely to be much more damaging, not only to the country itself but also to other countries engaged in liberalization efforts. Economies taking this route can impose a substantial negative externality on other countries by raising the perceived convertibility or transfer risk premium applied to them, and by increasing market nervousness. Current events in the international economy provide clear evidence of just this sort of negative externality.
Rather than backtracking on moves to a market-friendly environment, the dual objective of preventing crises and, when they do occur, minimizing their severity and spillovers are better served by mutually reinforcing actions in three main areas:
Improving the environment in which private markets function, to help them distinguish accurately between different situations and react more smoothly to both good and bad developments.
Equipping national authorities with the capacity to operate in an increasingly global environment, bearing in mind in particular that policy certainty and consistency are essential for stable financial markets.
Improving the surveillance capacity of the IMF and enhancing its contributions to the management and resolution of crises.
Progress in these three areas will require measures at both the national and the international, multilateral levels. Given the scope for domestic currency crises to spill over internationally, it will be important for the multilateral framework to provide an appropriate incentive structure for national authorities. While clearly much remains to be settled, there is a reasonable degree of consensus about many of the central aspects involved.
2. IMPROVING THE ENVIRONMENT IN WHICH MARKETS OPERATE
Improving the environment in which financial markets operate will require that greater attention be given to several areas. First, national financial systems and their legal and regulatory infrastructure need to be strengthened resolutely, both to support sound market development and to keep up with the risk management implications of market innovations. Where key financial institutions themselves have accumulated substantial balance sheet problems, these need to be dealt with promptly and in a fashion that provides strong incentives for avoiding relapses. Supervision and regulation of key financial institutions, deposit insurance schemes, and the operation and legal structure of payments systems, all need to underpin market and internal corporate incentives to help ensure that credit and other risks—not least currency and liquidity risks—are recognized and well managed. Beyond the financial institutions per se, bankruptcy and debt recovery laws, as well as the judiciary process that enforces them, need to work effectively and transparently. And internal governance structures need to provide for an appropriate separation between the corporate sector, the financial system, and the state.
Second, the quality and quantity of information available on financial markets often needs to be improved. Financial markets require good information flows to adjust smoothly to positive or negative developments, and to distinguish well between different countries in different situations. Transparency of the financial sector’s own conditions is critical here, as is qualitative information about the nature of the strengths and weaknesses of the infrastructure within which financial institutions operate. Clear, internationally comparable accounting standards, both for financial institutions and corporates are also required, along with appropriate public disclosure practices.
Third, and for related reasons, macroeconomic policy transparency also needs to be encouraged. Financial markets, and the public at large, will react particularly adversely when bad news about the economic and financial outlook, and the policy environment in particular, comes as a surprise. The temptation to conceal bad news can be strong. But it is out of tune with today’s global financial environment, which, in the context of crisis prevention, requires a precommitment mechanism. Governments and financial institutions need to commit to an ongoing arrangement to provide disclosure and transparency, so that if future deterioration occurs, it becomes visible at an early stage, thus providing an incentive for policymakers and financial institutions to address problems at an early date.
Fourth, besides transparency and disclosure, there is a need for comparability among countries. This is behind current interest in the development and promulgation of various standards and codes of good practice. In areas outside its expertise, the IMF has been helping in the dissemination and encouraging the adoption of norms developed by other international organizations, as in the case of accounting standards, and good practices in the domain of financial sector supervision and regulation. This role is discussed in the fund’s report Towards a Framework for Financial Stability, which includes the Basle Committee’s Core Principles, the development and dissemination of which the IMF has actively supported. Similar action to cooperate, as appropriate, with the work of the international groupings of securities (IOSCO) and insurance (IAIS) regulators is under way. The areas of monetary and exchange rate policy, and fiscal policy, have always been core areas of the fund’s mandate, and here we have taken the initiative to develop codes of good practice that would help ensure the transparency of members’ policy frameworks. We have recently completed a fiscal policy transparency code, and work is well underway on a code for monetary and financial policy transparency.
3. IMPROVING THE CAPACITY TO WORK WITH GLOBALIZED CAPITAL FLOWS
Catering to financial markets’ need for transparency and certainty are key parts of any broader strategy to balance the benefits and risks of participating in international financial markets, as are strengthening national financial systems and their legal, supervisory and judicial infrastructure. For many countries, however, the issue is how far and how fast to open their capital accounts to international financial markets, and how to prepare for such a liberalization. It is common knowledge that capital account liberalization in any specific case calls for careful attention to the pace and sequencing of policies and reforms. I do not believe there is a one-size-fits-all plan for an optimum speed and sequencing of capital account liberalization. But it is worth stressing that many of the reforms that would support capital account liberalization are likely to be highly desirable in their own right, irrespective of capital account liberalization; in turn, the discipline imposed by the latter may actually be helpful in encouraging the supporting measures to be taken. It is, therefore, more helpful to think of capital account liberalization as one part of a broader, mutually reinforcing reform process than as its end point.
In this regard, there are some key basic principles. Sound and well supervised financial sectors are clearly critical for a sustainable liberalization of the capital account; in particular, sound prudential frameworks are required to avoid excessive risk taking by financial institutions and corporates, especially in the form of short-term bank borrowing in foreign currencies. As already indicated, this includes aspects such as robust payments systems, good accounting and disclosure standards, workable insolvency and debt recovery processes, an effective corporate and financial sector governance process, and a well-designed and transparent boundary between the political world and the market, including one that minimizes moral hazard problems. Equally important are appropriately firm, consistent and coherent as well as transparent fiscal, monetary and exchange rate policies. Sooner or later, liberalized capital flows are likely to punish severely any real or perceived policy inadequacies or inconsistencies, like those related to attempts to pursue multiple objectives through single or insufficient policy instruments.
The complexity of the issues that need to be addressed to assure sustainable liberalization suggests that a simple linear approach to sequencing of capital account liberalization is unlikely to be adequate. This indicates that perhaps the single most important precondition for a successful and sustainable liberalization is a political willingness to recognize and deal determinedly with any weaknesses in the structure of the financial sector and the macroeconomic policy framework.
4. IMPROVING THE SURVEILLANCE CAPACITY OF THE IMF
The issues I have covered have important implications for the IMF’s surveillance, financial and technical assistance roles in general and point to the need to broaden the institution’s oversight over capital account liberalization, in particular. IMF surveillance will continue to play a crucial role in crisis prevention, and multilateral surveillance of broad international financial market trends will become even more important as a regular and ongoing aspect of its work.
The IMF’s traditional role has been in respect of macroeconomic policies, together with key structural measures to support stabilization and effective macroeconomic management. In this context, we have been providing technical assistance to member countries for many years on financial sector issues, and have been moving actively towards an integration of macro policy issues and financial sector issues since the early 1990s. The Asian crisis gives heightened emphasis and urgency to these issues, and this trend in IMF work with its member countries will be further intensified.
Apart from the moves to improve data quality, enhance transparency and disseminate international standards and guidelines in coordination with other international agencies, the IMF’s own surveillance of members is itself being broadened to look more specifically and directly into financial sector soundness issues. This is part of the broader global effort underway to strengthen financial systems worldwide. Where weaknesses are identified, technical assistance from the IMF and other international financial institutions can make an important contribution to rectifying deficiencies. Collaboration between the IMF and other multilateral institutions, especially the World Bank, is being intensified through a number of initiatives, aimed at both assisting in avoiding crises, and in dealing with crises effectively and efficiently if they arise. I need hardly mention that adequate funding of the IMF and other organizations is critical for crisis resolution.
Given the IMF’s existing mandate and its broad membership, the institution is uniquely positioned to oversee and advise on the capital account liberalization process in member countries. But its ability to get into meaningful discussions with members on capital account reform issues has been limited to date, because it has been outside the fund’s formal remit to look in depth at the kinds of capital flows a country is attracting, and whether the risks being assumed are well managed. Yet, the centrality of such issues to exchange rates and overall economic performance of individual members is obvious. Perhaps even more important are the multilateral aspects of countries’ actions; as we have amply seen of late, capital liberalizations that are inadequately supported by other policies, and liberalizations that are reversed can have very serious adverse spillovers on other countries. Recent developments thus strengthen the need for an appropriate extension of IMF jurisdiction to the capital account, as a means to promote prudent, orderly and sustainable liberalization.