Ladies and gentlemen, it is a great pleasure to be here with you and to have this opportunity to address the Zurich Economics Society. Zurich has a tradition in the world of finance that dates back centuries. In my remarks to you today, I would like to focus on a very contemporary issue by offering you some thoughts on the globalization of the world's financial markets and, in particular, on the new challenges that today's global financial markets pose to the economies that tap them, especially the emerging market economies. As a case in point, I would like to describe the circumstances surrounding the Mexico crisis. Finally, I will turn to what this experience suggests about the future role of the IMF.
As the 20th century comes to a close, the international economic system is undergoing profound change. It is not just that markets are more vast, more complex, and more closely integrated than ever before; the fact is that the international economy is also increasingly a global one. This globalization has many facets, but perhaps the most striking is its effect on financial markets. The size and complexity of today's markets--and the speed at which information is communicated across them--would in fact have been inconceivable just a generation ago.
To begin with, let us consider just how large the world's financial markets have become. As of December 1994, the outstanding amount of international bond issues had increased to $2.4 trillion, more than a fourfold increase over the previous ten years. Over the same period, international bank loans more than tripled to $4.3 trillion. The outstanding amount of currency swaps grew by five and a half times between 1988 and 1994, reaching over $1 trillion, while the notional amounts outstanding of currency forwards, futures, and options increased to over $10 trillion in 1994.1 Trading volume in the global foreign exchange market has also accelerated--to over $1.2 trillion per day, according to the most recent survey by the BIS.2
The globalization of financial markets is a very positive development. It provides opportunities for borrowers to obtain additional resources for investment and growth, and for investors to obtain attractive returns on their savings, thereby promoting a more efficient allocation of global resources. Developing countries have seen a marked increase in capital inflows, which averaged over $130 billion per year during 1990-94, a nearly fourfold increase over the previous five-year period.3
Not only did the magnitude of inflows increase during this period, but their composition changed fundamentally. In particular, private market sources more than accounted for the surge in capital inflows, while official capital flows to developing countries fell in both absolute and relative terms. Moreover, while in earlier periods private sector lending had mainly been in the form of bank lending, the new surge in capital flows consisted primarily of portfolio investment, with increased direct investment also playing a role. Not since the opening decades of the twentieth century have private portfolio capital inflows been such a significant source of financing for developing countries.
To an important degree, the increased volume of international lending to developing countries has reflected a growing trend toward portfolio diversification and the desire for higher returns on the part of investors in the industrial countries. However, the implementation of far-reaching programs of stabilization and structural reform in a growing number of developing countries has also been an important factor. I can say without false modesty that the IMF has played a critical role in this process through its country surveillance, its lending programs, and its technical assistance efforts. In particular, the IMF has focused on creating the stable macroeconomic policy environments that are conducive to promoting investment and sustained economic growth, correcting overvalued exchange rates, eliminating trade barriers, liberalizing financial markets, and removing structural impediments to economic efficiency.
All that is well and good, but there are two sides to the coin. The presence of large capital inflows requires increased vigilance and foresight on the part of economic policymakers in borrowing countries. In some circumstances, capital inflows can complicate domestic economic management--for example, by putting upward pressure on the country's exchange rate or, if the inflows are not adequately sterilized, by permitting an excessive expansion of domestic liquidity. Moreover, a rapid expansion of credit fueled by capital inflows can set the stage for problems in the financial sector, particularly if prudential supervision is inadequate.
Further, countries that successfully attract large capital inflows must also bear in mind that their continued access to international capital is far from automatic, and the conditions attached to that access are not guaranteed. The decisive factor here is market perceptions: whether the country's policies are deemed basically sound and its economic future, promising. The corollary is that shifts in the market's perception of these underlying fundamentals can be quite swift, brutal, and destabilizing. Indeed, shifts in market sentiment can amplify the adverse effects of policy errors.
Thus, the fact that large capital inflows are often seen as a sign of market confidence in the domestic economy must not lull governments into relaxing policy discipline. Just the reverse! The globalization of world's financial markets has sharply reduced the scope for governments to depart from traditional macroeconomic policy discipline. Moreover, if countries are to retain market confidence, policymakers must be prepared to tighten policies when needed. This, in turn, points to the importance of establishing solid domestic institutions--especially strong domestic banking systems--that can accommodate tighter fiscal and monetary conditions as the need arises. It also highlights the importance of structural reforms--such as trade liberalization, privatization and the establishment of transparent regulatory systems--so that capital inflows can be more readily used for long-term productive investment.
Against this background, let me turn to the case of Mexico. During the period 1987-93, Mexico successfully pursued an ambitious program of economic adjustment and structural reform, building upon the economic progress that had already been achieved since 1982. The strategy was designed to lay the basis for strong, private sector-led growth, by reducing macroeconomic imbalances and the public sector's role in the economy and by restructuring the country's large external debt.
By some measures, this strategy yielded impressive results. The overall balance of the public sector shifted from a deficit (including interest) of 15 percent of GDP in 1986-87 to a surplus of 1.2 percent of GDP in 1992-93. Inflation declined from around 160 percent at the end of 1987 to under 10 percent in 1993, reaching single-digit levels for the first time in two decades. Meanwhile, important structural reforms were being carried out. These included, among other initiatives, a major tax reform, the freeing of interest rates and the elimination of credit controls, the privatization of Mexico's 18 commercial banks and a number of important public sector enterprises, and a constitutional amendment granting autonomy to the Bank of Mexico.
These and other reforms signaled the authorities' commitment to a market-based economy, which, along with Mexico's comprehensive restructuring of external debt, set the stage for renewed access to the international financial markets. Indeed, during 1990-93, private capital inflows surged to an average of over 6 percent of GDP, substantially strengthening international reserves. Nevertheless, the widening of the current account deficit to 6.5 percent in 1993, up from around 2 percent of GDP in 1988-89, and the fact that it was financed in part by short-term inflows, was cause for concern. Indeed, these concerns were distinctly expressed during the Fund's regular annual consultation with Mexico in February 1994, and reiterated in our Annual Report published in July of the same year.
Thereafter, several adverse developments at home and abroad helped provoke Mexico's exchange crisis. Internally, the assassination of the principal candidate for the presidency, the uprising in Chiapas, and the fact that 1994 was an election year contributed to a climate of economic and political uncertainty. Outside Mexico, the tightening of financial conditions in the United States and other markets prompted foreign investors to reassess their portfolio investment in emerging markets, including Mexico.
At the same time, some dubious policy choices by the authorities helped to deepen the crisis. One particular misstep was the authorities' decision to replace peso-denominated government debt with securities indexed to the U.S. dollar. While this may have helped stabilize financial markets for a time, it also increased Mexico's vulnerability to the exchange rate pressures that re-emerged in the following months. To be sure, Mexico did take steps in late December 1994 and in early 1995 to gradually tighten its economic policy. But the loss of confidence following the adoption of an expansionary policy, the devaluation of the peso, and the subsequent abandonment of the managed exchange rate regime, could not be reversed. The market's disenchantment set the stage for the market turmoil and sharp depreciation of the peso that continued into early 1995.
Although the ensuing crisis had serious effects on the Mexican economy, its impact was not limited to Mexico. Indeed, concern about the situation in Mexico prompted investors to scrutinize the investment climate in other emerging market economies more closely. Equity and currency markets came under pressure in Latin America and, to some extent, in Asia, raising the possibility of spillover effects. In fact, there was a very serious risk that the collapse of one of the most promising emerging markets could lead international private investors to interrupt the flow of their capital to other developing countries, thereby severely damaging economic performance in a number of them. In this event, the international economy would have been deprived of one of the driving forces of global economic growth in recent years.
But we should also acknowledge frankly that the problem was exacerbated by the difficulty of finding a cooperative solution at the international level--a task complicated by the difference of views between the United States administration and the Congress--as well as by the prevailing diagnosis in Europe--that the crisis was a regional problem, not a global one, which should be resolved within NAFTA.
Once it became clear that the U.S. Congress would not approve the proposed assistance of $40 billion and that the Europeans' contribution would be lean, should the IMF have resigned itself to the looming major crisis, or mobilize all means at its disposal in order to head it off? That is the situation we had to respond to in a matter of hours.
I do not feel comfortable talking about this today, with the Mexican exchange rate market still experiencing turbulence. But, at the same time, this should not make us forget the fundamental and welcome reorientation of Mexico's economic policy in the course of the past year. The health of public finance has been restored, the necessary external adjustment has taken place, and the country has regained its access to the international capital markets. Although economic conditions remain difficult, growth is expected to resume, and the markets will stabilize as economic agents become convinced of the authorities' policy commitment. Moreover, the potentially devastating spillover effects on other, primarily Latin American, countries have been contained. How was this achieved?
First, Mexico undertook a strong adjustment program designed in consultation with the IMF. Second, it had the support of a large international financial package. The IMF arrangement for Mexico was the largest ever approved for any member country, both in absolute amount and in relation to the member's share in the Fund. As you know, a number of questions have been raised--in Switzerland and in other IMF member countries--about this action. Let us consider the principal ones.
Was such exceptional support warranted? Yes. Mexico's adjustment program was strong, as was its track record in implementing previous adjustment programs. The strengthened program approved in March 1994 aimed at cutting the external current account deficit from about 8 percent of GDP in 1994 to 1 percent in 1995 and containing the inflationary impact of the peso's devaluation. In the event, Mexico's determination has paid off, and the program is on track. The current account deficit is projected to return to about balance this year, while monthly inflation has declined from 8 percent in April to about 2 percent in September. Interest rates have also declined from their levels earlier this year. As I just indicated, the markets are still undecided, but it is hard to imagine that they will persist in their hesitation if the authorities continue to apply a policy that has enabled to achieve such a rapid turnaround.
Should the IMF itself have lent such an extraordinary level of support to Mexico? Again, an emphatic yes. The IMF's support of Mexico fits squarely within the Fund's traditional mandate. The Fund's Articles of Agreement call upon it "to give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity." In the absence of our support, what alternative would the authorities have had in the aftermath of the peso's devaluation? One policy alternative would have been to impose exchange controls, a debt moratorium, and trade restrictions. Such an approach would have dealt a terrible blow to Mexico's past liberalization efforts and future market access; it would have certainly been followed for precautionary reasons by similar moves in almost all Latin American countries, and would have increased the possibility of spillover effects in other markets. A decade of unstinting international efforts to open markets and liberalize emerging economies would have been at risk. Instead, Mexico was able to address its problems, to put itself back on the path of recovery, while at the same time limiting the negative impact of the crisis on other countries.
Finally, questions have been raised as to whether the Fund's assistance to Mexico poses problems of moral hazard. Certainly the answer is "no". It would be perverse indeed for a country to allow a serious crisis to develop in the expectation of financial support in its aftermath; the resulting effects on interest rates, real income, employment, and financial market access should suffice to deter such behavior. As regards private investors, the message should be clear: the IMF never extends its assistance automatically--our policy will always be to keep investors guessing. And finally, when we do extend future Fund support, it will as always depend on the nature and seriousness of the problem and on the speed and strength of the member's policy response.
The Mexican experience demonstrated in a very concrete way that no country--OECD member or not--is immune to shifts in market sentiment, and that no country is exempted from the need for heightened policy discipline in today's world of global financial markets. But what conclusions should be drawn about the role of the IMF and the ways it fulfills it in this new environment?
I believe that the Mexican crisis shows that the role of the Fund in "giv[ing] confidence to members to correct maladjustments in their balance of payments" remains more relevant than ever. This is the essence of what the Fund did in Mexico. The experience with Mexico also demonstrated, however, that prevention is better than cure. Thus, considerable attention has been given to the ways in which Fund surveillance over the policies and performance of its member countries can be strengthened, so that emerging problems can be more readily addressed before they become full-blown crises. Let me share with you our major conclusions.
First, the experience underscored the importance of having information that is as up to date as possible. The Fund's ability to pinpoint impending problems in member countries, especially in the period between two consultations, depends critically on the availability of accurate, comprehensive economic and financial data that is communicated rapidly. Accordingly, the Interim Committee of the IMF Board of Governors has agreed on a list of core data categories, representing the minimum to be provided to the Fund by all members on a regular basis, and allowing for continuous monitoring. At the same time, we are developing standards to guide members in the dissemination of economic and financial data to the public, so that markets will be better informed--and less prone to surprises. We are aiming at a two-tier system in which all countries will be encouraged to meet a certain minimum standard for the public release of statistical information, while countries seeking to tap the international financial markets will be encouraged to meet more exacting standards with regard to the coverage and periodicity of the data they provide.
The phenomenon of globalization also persuades us that the Fund's policy dialogue with member countries needs to be further intensified. Thus, the Fund is seeking to develop a more continuous, intensive, and probing dialogue with members. It is also paying greater attention to the soundness of domestic banking systems, to financial flows and their sustainability, to the problems of countries at risk, and to countries where financial market tensions are likely to have spillover effects.
We also concluded that we needed to clarify the procedures whereby the Fund could respond rapidly to give confidence to members and the international monetary system. These procedures have now been clarified--as have, of course, the principles that the use of such procedures must be limited to truly exceptional circumstances; that our support must remain catalytic in nature; and that the possibility of Fund support should in no way be considered a guarantee against sovereign default.
One final point: the Mexican crisis demonstrated that the Fund must have adequate resources so that it can continue to fulfill its mandate. In addition to Mexico, there have been a number of other large Fund arrangements this year in support of major stabilization and reform programs--in Argentina, Russia, and Ukraine. The demands on the Fund's resources are likely to remain large, and its liquidity position is projected to weaken considerably over the next two years.
Several initiatives are therefore being pursued to strengthen Fund resources; I will mention them briefly. As you may know, the G-10 countries, including Switzerland, currently provide lines of credit to the Fund under the General Arrangements to Borrow (GAB). These countries are now working to establish parallel financing arrangements complementary to the GAB, with the aim of doubling the credit lines currently available to the Fund under this mechanism.
At the same time, there is full agreement among the Fund's membership that an expansion of the Fund's borrowing arrangements cannot be a substitute for an increase in member quotas, which, after all, remain the essential resource base for IMF lending. The Eleventh General Review of quotas is now underway, and this will remain our top priority. In order for the IMF to be able to continue providing support for countries in difficulty--as it did in Mexico--a doubling of quotas will, in my judgment, be essential.
Finally, I would be remiss if I did not also mention efforts to secure the necessary resources to enable the Fund to continue assisting its poorest member countries--not in their development efforts as such, since this is the task of the World Bank, but with macroeconomic stabilization and reform. The countries I have in mind are not those that are currently in the position to tap international capital markets, but rather, the many countries for which it is a struggle not to be excluded from the mainstream of the world economy. If we are to thwart this risk, and it is our duty to do so, we must provide firm support to the poorest countries. The Fund's instrument for assisting the poorest countries is the ESAF--the enhanced structural adjustment facility. Last year, with the generous support of Switzerland, the ESAF was extended; this year agreement was reached to establish a self-sustaining ESAF beginning early in the next century. The challenge now is to find a way to finance the ESAF in the interim period, before it becomes self-sustaining. We will be discussing options for financing an interim ESAF in the coming months.
In conclusion, I would like to emphasize again that the globalization of the world's financial markets is a positive development that enhances the growth prospects of developing countries. At the same time, the experience with Mexico has deepened the world's appreciation of the size and agility of these markets and the problems that may arise. Moreover, it has led to some healthy reflection on the part of countries that tap the market, as well as by the Fund. For countries, it has increased awareness of the need for strong policies and the need to reassess the appropriateness of economic policy continually. For the Fund, Mexico has reaffirmed the importance of the IMF's role in giving confidence to members and promoting stable exchange rates. But it has also prompted us to re-evaluate and strengthen our tools for exercising effective surveillance over member countries.
That being said, I believe that we must also be realistic about our expectations--and modest about our capabilities. For example, while market sentiment is supposed to be determined by underlying fundamentals, it is sometimes more volatile than the underlying economic fundamentals suggest that it should be. We have not found a satisfactory way to deal with this problem. There will also be cases where the shift in sentiment is sparked by political developments, or where there is an insufficient will to adjust; in such circumstances, there will be little the Fund can do, aside from trying to limit spillover effects.
As these reflections suggest, I do not expect that we will be able to avoid all future crises. However, I do believe that the Fund, its member countries, and the financial markets themselves are now in a stronger position to recognize and avert such crises. This provides greater assurance that the benefits of global financial markets will be realized, and thereby strengthens the basis for sustained, noninflationary growth in the global economy.
1. Global Economic Outlook (Washington, D.C.: International Monetary Fund, May 1995).
2. Press commmuniqué, October 24, 1995 (Basle: Bank for International Settlements).
3. Global Economic Outlook (Washington, D.C.: International Monetary Fund, May 1995).
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