(Archived Content)
Thank you. We come together at an important moment. While much of what was feared when the international financial community came together in Washington 6 months ago has not materialized and there are signs of increasing confidence in a number of countries, huge challenges remain.
Rather than focus on current developments, this evening I want to reflect on the profound challenges that a more global capital market presents to the international financial community: the threats that it poses, and the opportunities it offers to all of the world's people.
There are few things with as great a potential to raise human welfare than the creation of a safe and sustainable system for the flow of capital from the developed world to the developing one. The major industrial nations are crossing the threshold into an era of rising rates of retirement and much lower rates of labor force growth. Negative population growth is already a fact in some European countries and the investment of retirement saving is becoming a critical concern.
All of the world's population growth over the next 25 years -- and the lion's share of its growth in productivity -- will take place in the developing countries. The upshot is that we are heading into a period when there will be exceptional global benefits to successful economic development in the developing world. And make no mistake; a healthy capacity to mobilize capital in these economies -- because of the trade that it finances, because of the technology it brings, and because of the opportunities it offers -- has a very important part to play in that development.
That said, few would deny that the experience of developed country investment in developing ones has been decidedly mixed. In principle, new financial technologies and instruments offer considerable potential for better allocating global investment and managing its risks. But it would perhaps be a fair verdict on the ups and downs of emerging markets during the 1990s to say that this potential has yet to be realized.
The financial crises that began in Thailand in the summer of 1997 have to be a major concern for all of those who care about the global development effort and those who care about the global financial system. They are crises that have had grave human consequences in the economies worst affected, and whose effects have been felt in financial markets around the world.
This evening I would like to reflect on the roots of some of these crises and on some of the most important elements of what has come to be called the reform of the international financial architecture. This is not an undertaking that will finish at these meetings or at the Cologne Summit -- or indeed, at any future meeting. It is a continuing task and one that is impossible without close consultation and cooperation between lenders and borrowers in particular situations and the public and private sectors more generally. In this regard, I would observe that all of us in the public sector have benefited enormously from the work of the Institute of International Finance.
Key Sources of The Crises
Tolstoy once said that happy families are all alike, but every unhappy family is unhappy in its own way. The same can perhaps be said of financial crises: no diagnosis will ever quite fit all. At the broadest level, however, these crises can be said to have been marked by the combustion of two factors: weak underlying fundamentals along with imprudent lending, and sharp, self-fulfilling declines in confidence.
Deep macro-economic imbalances, untenable exchange rate regimes, widespread micro-economic distortions -- including too many implicit public guarantees for too many investors and institutions -- and deep weaknesses in financial systems: all of these are central to understanding the roots of the crises in Asia and elsewhere. The result was the same problem at the root of nearly all financial crises: too much money borrowed, and invested in ways that generated too little capacity to repay.
Serious though they were, in each case these weaknesses might possibly have been fixable in some time period. But when trouble came, these problems were compounded by the second factor: a self-perpetuating decline in market confidence. After a period of credit that was perhaps too easy, and too cheap, a kind of bank run psychology took hold, with investors thinking less about the fundamentals and more about what other investors were doing and who was going to be the last out.
As the psychology of the market shifted, investors began to weigh the level of foreign reserves against the likely incipient demands to take hard currency out of the country in the succeeding months. And the opportunity to fix the fundamentals without up-ending the economy drained away. The rest, you might say, is history.
The novelty of these crises -- and others that we have seen in recent years -- is that they have been what might be called capital account crises. The dominant source of pressure has been less economic contraction caused by the reluctance to finance expenditure in excess of national incomes than it has been pressure to withdraw a large amount of capital, caused by domestic and foreign investors alike.
Crises are, in a sense, accidents. As with accidents, crises will never be eliminated and are not amenable to silver bullet solutions. Think of auto accidents. If one looks back at any auto accident there are always many things that could have combined to produce greater safety. If the driver had been driving less recklessly -- or wearing a seatbelt -- it might not have happened. If the road had been better designed the markings clearer -- it might not have happened. If other drivers had been more attentive, or the weather less treacherous -- it might not have happened.
Accident prevention is inherently an ongoing and multifaceted matter. It is good because it reduces the cost of accidents, and because it is essential to building a transportation system that gets people where they want to go. In the same way, creating a safer, healthier financial system will be valuable because it reduces the number and cost of financial accidents, and because it will enable capital markets to make a larger contribution to growth and development in the developing countries and investment diversification in the industrial ones.
Effective efforts to improve safety will comprise two broad elements: strong national policies in emerging market economies; and improved policies at the international level, both for preventing crises and for resolving them when they occur.
Strong National Policies in the Developing Economies
The grandest schemes of global financial architects will achieve little without a major commitment to building safer, stronger systems for allocating capital in the developing countries. The international community cannot want stability in any country more than its own citizens and government. No amount of international support will build stability if the domestic will to reform is lacking.
Building safer national financial systems will mean getting the basics right: pursuing strong, mutually consistent monetary, fiscal and exchange rate policies. And it will mean governments putting in place legal and regulatory underpinnings for markets that lessen the probability that financial imbalances will arise, and can help contain the effects when they do occur.
Let me focus on three challenges for policy makers in emerging market economies whose importance has been especially highlighted by the events of the 1990s.
1. An Effective Financial Infrastructure
If one were writing a history of the American capital market I think one would conclude that the single most important innovation shaping that market was the idea of generally accepted accounting principles. GAAP are not a single institution. They are not a single magic bullet. They are an ongoing process that really is what makes our capital market work and makes it as stable as it is. Very much the same kind of thing is necessary in the emerging economies.
Among other things, an effective infrastructure means:
Creating the right kind of supervisory regime: including tough nondiscriminatory entry requirements; prudential norms for capital, liquidity and currency exposure; limits on directed lending; strict rules governing income recognition, classification and provisioning; reporting and disclosure requirements; a risk-based regime for remedial actions; consolidated supervision; an effective framework for dealing with insolvent institutions; and strict and transparent rules about the extent of depositor safety nets.
Developing a true credit culture within individual institutions and firms and the financial system as a whole, buttressed norms of accounting, transparency and effective corporate governance.
And it means all of these rules and practices being rooted in a rule of law and all that that implies, including independent judiciaries and bank supervisors and effective bankruptcy regimes.
Describing the ingredients for stronger domestic financial systems is one thing. The challenge for the international community is to find ways to induce countries to put them in place. Concrete steps toward this end include:
Efforts to expand and reinforce norms of transparency in economic and financial data, including the development and expansion of the IMF's Special Data Dissemination Standard (SDDS). This has now been widely adopted by industrial and emerging market economies and will incorporate full details on reserves, and any claims against them, from April 2000.
Development of new codes to help investors and the official community judge national policies better and set “best practice” standards for governments themselves. The IMF's new Code on Fiscal Policy has now been adopted, and a Code on Monetary and Financial Policy is expected to be formally adopted in October. International groups have now endorsed new standards on insolvency and debtor-creditor regimes.
Development of stronger standards and shared principles for the financial and corporate sector worldwide: the Basle Committee on Banking Supervision, the International Organization of Securities Commissions, and the OECD have adopted -- or will soon adopt -- new standards or principles for the financial sector, regulators, and corporations.
2. The Right Match of Capital Inflows to Domestic Capacity
We have seen, once again, in these crises, the risks that global capital flows can bring. Properly paced liberalization of the capital account is essential, as the damage that premature, patchwork liberalization can do is all too clear. It is also important to recognize that countries that have got into trouble have typically had major policy biases in favor of short-term capital.
We saw this in Mexico, with the increasing resort to issuing dollar-denominated Tesobonos in the lead-up to crisis.
We saw it in Thailand, in the tax breaks on offshore foreign borrowing and the government's decision to mortgage all of its reserves on forward markets.
We saw it in Korea, where discriminatory controls kept long-term capital out, and ushered short-term capital in.
And we saw it in Russia, in the government's determined efforts to attract international investors to the market for ruble-denominated GKOs.
There are reasons why governments were drawn into this kind of behavior: the interest cost of short-term debt is usually lower, and such flows are attractive compared to putting in place the reforms needed to attract longer-term investment flows. But as Secretary Rubin noted last week, the lesson of these experiences is surely that the price of longer term and less risky types of borrowing in such economies is a price worth paying.
Governments need to take this lesson to heart in their own debt management policies, and they need also to apply it in the design of tax and regulatory regimes, resisting tax incentives or special schemes that distort capital flows into the riskier forms of debt. As I will discuss later, among other things, provision of the IMF's new Contingency Credit Line will be structured around encouraging countries to adopt safer practices in this area.
3. Appropriate Exchange Rate Regime
Even economists who agree on most aspects of economic theory and practice will often be divided on the relative merits of fixed and floating exchange rates. For some, such as Milton Friedman, exchange rates are a price that should be flexible for the same reasons that others are. For others, it is a promise, one that should be firm and that should not be broken or devalued.
The choice between these two poses enormous difficulties and permits no easy answers. But history -- and economic theory -- do tell us that the three objectives of free capital mobility, an independent monetary policy and the maintenance of a fixed exchange rate objective will ultimately prove to be mutually incompatible. I suspect this means that as capital market integration increases, countries will be forced increasingly to more flexible or more purely fixed regimes.
While regimes in between these two extremes have had successes in a number of countries, the problem of the exit strategy is not one to which many governments have found a satisfactory solution. If one delays until there is no choice, the results are usually calamitous. But acting while the choice still exists can be tremendously difficult politically and may threaten to lose hard-won stability.
Once again, there is no single answer to these dilemmas and the right exchange rate regime is a choice for the individual country. But we have to recognize that the contagion caused by failed regimes gives the world an increasingly large stake in the right choices being made.
At the center of almost every recent crisis was a rigid, but not heavily institutionalized exchange rate regime that proved to be unsustainable. As Secretary Rubin has said, we believe that, under the circumstances, the international community's judgments in responding to these crises were the right ones. But the goal for the future cannot be simply to react appropriately to difficulties as they arise. It must also be to improve the quality of the options.
We believe that the international community needs to work to shape expectations about the official response to financial problems going forward, in order to strengthen the incentive to pursue sustainable regimes. As a matter of policy, we in the United States therefore believe that the international community should not provide exceptional large scale official finance to countries intervening heavily to defend an exchange rate peg, except where the peg is judged sustainable and where certain exceptional conditions have been met, such as when the necessary disciplines for policy makers have been institutionalized, or when an immediate shift away from a fixed rate is judged to pose systemic risks.
Recent events, along with the advent of European economic and monetary union, have sparked renewed discussion of dollarization in several Latin American countries. This would be a highly consequential step for any country, one that has to be considered with a careful eye to various potential costs and benefits.
As Secretary Rubin has said, we do not have an a priori view as to our reaction to the concept of dollarization. There are a variety of means and modalities for achieving it and we would expect to discuss these with any government seriously considering taking such a momentous step. There are, however, certain limits on the steps that the United States would be prepared to take in the context of such a decision: specifically, it would not, in our judgment, be appropriate for United States authorities to extend the net of bank supervision, to provide access to the Federal Reserve discount window, or to adjust bank supervisory responsibilities or the procedures or orientation of United States monetary policy in light of another country deciding to adopt the dollar.
An effective financial infrastructure, not reaching for short-term capital, more appropriate exchange rate regimes: taken together, these things, could have important implications. How different history might have been if Thailand and Korea had not invisibly mortgaged their reserves; if Russia and Indonesia had depended less on short-term capital and developed a credit culture with secure property rights and credible contract enforcement; if all the countries that experienced crises since Mexico in 1994 had either been able to harden and ultimately defend their exchange rate regime or pursued a more effective exit strategy.
Proper International Systems for Preventing and Resolving Crises
Beyond the encouragement of stronger national policies, there is much that the major industrial countries, lenders within those countries, and the international community as a whole can do to create an environment in which financial problems and crises are less likely to arise, and emerging market economies have the best possible prospects for successful growth.
Strong Policies in the Major Industrial Economies
Industrial countries can make an enormous contribution to growth and stability in the developing world simply by keeping their economies growing and their markets open. If the external economic climate had not deteriorated as sharply as it did in 1997 -- led by the rapidly declining performance of Japan -- it is fair to say that the wider Asian crisis might not have erupted at the time that it did, or with the same kind of severity.
Strong policies in the industrial economies to support growth and open markets are needed over the long term and they are needed today. The risks globally are still very much tilted toward lack of growth, spare capacity, and slowdown. Concerns are about excess supply not excess demand. And in many places worries about rising prices have given way to concern about falling prices.
We in the United States will do everything we can to preserve solid growth in our economy and keep our own markets open to the emerging economies. But the shift in the balance of global risks puts the burden of responsibility on all of the industrial economies -- in Europe and in Asia -- to pursue policies aimed at creating strong domestically generated growth and preserving open markets.
Just as financial events have been very important to what happens to global trade flows these past two years, it is likely that the reverse will be true in the months ahead. A crisis in the global financial system must not be permitted to give rise to a crisis in the world trading system
More Effective Inducements For Sound Practices Globally
It is important to remember that every ill-judged credit has both a lender and a borrower. Steps to induce better risk management and prudent decision-making on the part of financial institutions in the industrial economies must also be part of the reform effort going forward. Encouraging more prudent practices will be important for the flow of capital to the developing world, and more generally for avoiding the kind of systemic risk we faced last fall in the wake of the collapse of LTCM.
Here, concrete changes are in progress on a variety of fronts, including:
Encouragement of stronger international regulatory cooperation: a new Financial Stability Forum, which met for the first time on April 14, brings together national authorities, international financial institutions, and regulatory bodies to consider how best to strengthen supervision and reduce systemic risk. Going forward it will be important to reach out to involve a broad range of relevant countries in this effort.
Strengthened global incentives for prudent risk assessment and lending decisions: in this regard we believe it especially important that the Basle Committee complete its updating of the Basle Capital Accord, by expanding the number of credit risk categories and revising the current all-or-nothing system for classifying loans to sovereign borrowers busts.
Improved public reporting and disclosure by financial institutions and their creditors: to this end, the President's Working Group on Financial Markets, chaired jointly by the principal federal regulatory bodies in the United States and Secretary Rubin, will soon be releasing proposals to require more disclosure of the exposure of financial institutions to other financial institutions and to heavily leveraged market participants.
More Effective Resolution of Crises
Capital account crises of the modern type have many elements. But once they are upon us, they are centrally problems of confidence. It is then in the mutual interest of creditors and debtors that confidence be restored. Without the right national policies, any amount of external official support or extension of private debt obligations will be in vain. But as we saw in Korea in a particularly powerful way, where the reform commitment is present, conditioned provision of finance and private sector coordination may both be needed to create an environment of confidence.
The challenge we face is to devise mechanisms for responding to these new kinds of crisis, and the bank run psychology that can drive them. In this regard the Supplemental Reserve Facility, created in the fall of 1997, was a major innovation. We have now taken a very important further step with the development of the CCL.
Like the SRF, the CCL will carry premium interest rates and shorter maturities, to maximize countries' incentive to seek alternative, private sources of finance. It is designed to reduce the risk of contagion to countries with strong polices and institutions and directly encourage countries to reduce their vulnerability to crisis before the worst happens, through the adoption of sounder policies and practices.
The question of the appropriate private sector role in resolving such crises is a delicate one. We are very much aware that debt is an obligation which must be honored whenever possible; that growth depends on the continued flow of private sector capital, which in turn depends on meeting obligations; and that confidence is the mirror image of moral hazard. It is the irony of financial crises that while they are usually caused by too much lending, they are ended by lending more.
At the same time, private sector coordination in its mutual interest can play a crucial role in crisis resolution. Going forward, where countries are unable to service their debts in their entirety, public sector financing of private sector credit is neither effective nor appropriate. And instruments that were issued carrying spreads of many hundreds of basis points cannot be counted on with absolute certainty to be repaid on time.
As Secretary Rubin said last week, there is no reason why one category of unsecured private creditors should be regarded as inherently privileged relative to others in a similar position. When both are material, claims of bondholders should not be viewed as necessarily senior to claims of banks.
I am convinced that cookie-cutter formulae or preset procedures can never be pre-designed to respond o he various circumstances that will arise. A case-by-case approach, based on the interests of the country involved, its creditors, and the system as a whole, will work best.
As part of an evolving international financial market, there is case based on the mutual interests of all affected, for the voluntary adoption of provisions in bond contracts of clauses that can facilitate creditor coordination. There is understandable concern that to prepare for an organized approach to debt problems is to invite one. On the other hand, accidents will happen, and when they do creditors and debtors need to be free to reach a cooperative solutions without being held hostage to a recalcitrant few.
Conclusion
As Secretary Rubin has said many times as this effort has proceeded, building a stronger more stable global financial architecture for the next century poses immensely complex issues. They will not permit of magic bullets or grand solutions. But let there be no doubt about the basic ends or means: a strong and sustainable, truly global financial system is what we should all want to see. And with your help, that is what we are working to build. Thank you.