The International Monetary Fund and the Challenges of Globalization--Address by Michel Camdessus
November 28, 199595/20 Address by Michel Camdessus
Managing Director of the International Monetary Fund
The Free University
Amsterdam, November 28, 1995
Ladies and gentlemen, it is a great pleasure for me to be here with you today. I would particularly like to thank The Free University and your central bank for providing this opportunity for me to speak to you about one of the most important trends in the world economy today--globalization.
As the 20th century comes to a close, the international economic system is undergoing a profound change. Markets are now larger, more complex and more closely integrated than ever before. Perhaps the most striking manifestation of this trend is the globalization of the international financial markets--not only because of the sheer magnitude of the flows involved, but also because of the speed with which market sentiment can shift, and the powerful effects that such shifts can have on domestic economies and on the international economy at large. Those of you who follow the Bretton Woods institutions closely may be surprised to see how frequently the concept of globalization appears in my remarks. However, the explanation for this is simple: this is the aspect of the international economy that contrasts the most sharply with the world of segmented markets and pervasive exchange and capital controls that existed when the Bretton Woods institutions were established. This is why we must explore, and invite the world to explore, how to adapt to it.
In my remarks to you today, I will outline what globalization, particularly as it concerns the international capital and exchange markets, means for Fund members: for the developing countries and countries in transition now gaining access to the international capital markets; for other countries still unable to tap them; and for industrialized countries. I will then turn to the new challenges that globalization poses for the IMF and how it affects the ways in which the Fund carries out its traditional role of "promoting exchange rate stability" and "giving confidence to members to correct maladjustments in their balance of payments, without resorting to measures destructive of national or international prosperity."
By the late 1980s, a combination of domestic and international developments set the stage for a dramatic surge in capital flows to developing countries. Given the economic slowdown in industrial countries and the decline in interest rates, especially in the United States, industrial country investors were attracted to the higher yields and new investment opportunities available in emerging markets. Cost and geographic considerations also increased the interest of multinational firms in investing directly in developing countries, especially in Latin America and Asia. At the same time, the implementation of far-reaching programs of stabilization and market-oriented structural reforms, often with Fund support, along with some countries' normalization of relations with creditors, particularly in Latin America, greatly increased investment opportunities in developing countries and reduced investors' perceptions of country risk. As a result of these factors, total inflows to developing countries exploded to an average of $105 billion per year during 1990-94, compared to an average of less than $9 billion per year during 1983-89.1
Also noteworthy was the fundamental change in the composition of capital flows to developing countries. 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 earlier periods of private sector lending were mainly in the form of bank lending, the new surge in capital flows has consisted primarily of portfolio investment, with increased direct investment also playing a role. Indeed, not since the opening decades of the 20th century have private portfolio capital inflows been such a significant source of financing for developing countries.
The globalization of financial markets is a very positive development. For recipient countries, it provides opportunities to obtain additional resources for investment and thereby improve prospects for growth and employment. Moreover, when these flows take the form of direct investment or the purchase of shares in domestic equity markets, the risks on these investments are borne by investors. As a result, the country's external position is less vulnerable to changes in its debt service payments than it was in the 1970s, when commercial bank loans dominated private capital flows to developing countries. For those investing in developing countries, globalization has led to attractive returns on savings and opportunities for portfolio diversification. And for the international economy, globalization helps promote a more efficient allocation of global resources, thereby contributing to higher world growth.
But with these increased opportunities also come additional risks. First, countries that successfully attract capital inflows must recognize that their continued access to international capital is not automatic, nor are the terms and conditions of their access guaranteed. Generally speaking, access and terms are directly related to the soundness of the country's policies and the prospects for its economy. At times, however, the market's judgment on these fundamentals seems capricious--money flows in when policies are less than desirable, only to flow out again on a bandwagon of changed investor sentiment. Indeed, when the market's perception of underlying fundamentals does change, the consequences can be rather swift, brutal, and destabilizing. This is particularly the case if private inflows have been invested largely in financial instruments that can be liquidated quickly and the proceeds of which can be re-exported. Certainly, the vagaries of market sentiment can affect any country. However, developing countries, whose track records are generally less well-established, appear especially vulnerable.
Policymakers must also bear in mind that capital inflows can, in some circumstances, complicate domestic economic management. Ideally, capital inflows will finance an increase in imports of capital and intermediate goods that will lead, in turn, to higher domestic investment and export growth. However, if capital flows are used mainly to finance consumption and are not adequately sterilized, they may lead to an excessive expansion of domestic liquidity and higher inflation. Moreover, a rapid expansion of credit fueled by capital inflows can set the stage for problems in the financial sector, particularly if prudential supervision and capital regulation are inadequate. In the economies in transition, for example, financial sectors are still shifting from more directed methods of credit allocation to modern commercial practices based on sound credit appraisal. During this period, the expansion of domestic liquidity made possible by foreign capital inflows can lead to poor credit decisions and, eventually, to loan portfolio problems.
One suggestion for reducing the volatility of international capital flows has been "to throw sand in the wheels of international finance" by taxing international financial transactions. The idea, which was originally presented by Professor Tobin, is that such a tax would discourage short-term capital flows, which are considered to be more speculative and therefore more volatile. Such measures may have some merit in a limited number of cases--for example, where there is good reason to suppose that the inflows will indeed be short term and the measures introduced to discourage them will be of short duration, or to provide some useful breathing space to consider more fundamental measures. But by and large, trying to impede international financial transactions is not a satisfactory approach. From an economic standpoint, it would introduce new distortions in the allocation of capital and impair the efficiency of the international financial markets. There would be practical difficulties, as well. To avoid simply shifting the location of transactions to untaxed countries, such a tax would need to be adopted on a worldwide basis. Moreover, there is no easy way to design a uniform transactions tax or to distinguish effectively between short- and long-term transactions.
Clearly, there are more effective ways to promote stable long-term capital inflows. First and foremost, countries must maintain sound domestic macroeconomic policies that will attract and retain the market's confidence. In particular, policymakers must recognize that the scope for countries to depart from traditional macroeconomic policy discipline is now sharply reduced, and that the market can greatly amplify the adverse effects of any policy mistakes. Under no circumstances should the presence of large capital inflows--so often viewed as a sign of market confidence in a country's domestic economic performance--lull governments into relaxing policy discipline!
Second, determined structural reform can enhance countries' ability to maintain stable long-term capital inflows. Trade liberalization, privatization, and the establishment of transparent regulatory systems, among other measures, help create an environment in which capital inflows can be more readily used for long-term productive investment. Removing impediments to private sector activity in general will widen the channels for absorbing foreign capital and reduce the risks of sudden capital outflows. At the same time, it is critically important to establish solid domestic institutions--especially independent central banks and strong domestic banking systems--that can accommodate tighter fiscal and monetary conditions as the need arises.
Finally, there is a greater need to keep investors well-informed of economic and financial developments. Providing the market with accurate, comprehensive and up-to-date information on economic policies and performance also helps prevent market "surprises" and the sudden shifts in market sentiment that may follow.
But what about countries that are unable to tap the international capital markets? With so much attention focused on emerging market economies, one may ask whether these other countries are not in danger of being excluded from the benefits of the global economy. In my view, one of the greatest risks of globalization is the very serious possibility that countries that are unwilling or unable to adjust to its demands, especially the poorest, will become increasingly marginalized. The risk is compounded by the fact that, on the one hand, official aid budgets on which these countries have depended in the past are shrinking, while on the other hand, the private capital flows to successful emerging economies have vastly increased. It follows that the disparities among developing countries may well continue to increase unless the poorest countries are also able to attract private capital. It is encouraging to note that a number of these countries have embarked on programs of macroeconomic stabilization and structural reform and that some have begun to see results in the form of higher rates of export and real GDP growth. Countries that have not yet started this process should do so at once, especially since the more determined their adjustment efforts, the greater the support they can expect from the rest of the world. I shall return to this point shortly.
I think there is also a tendency to give insufficient attention to the challenges that globalization poses to industrial countries. One such challenge is the increased market discipline over the management of fiscal deficits. Now, more than ever, persistent fiscal deficits that appear out of line with industrial country norms are likely to be punished in money and exchange markets. In many countries, the fiscal problem is largely structural and is related to significant increases in social benefit programs and the aging of the population. In order not to discourage production and employment, the emphasis will need to be on cutting expenditure. Moreover, as the scope for minor budgetary cuts is exhausted, governments are being forced to reform major programs--including pension programs, public health care systems, subsidy programs, and indexation schemes--in order to reduce fiscal deficits and levels of public debt as a share of GDP. This will not be an easy task! Especially for countries with large stocks of outstanding debt, globalization has strengthened the link between financial markets and fiscal adjustment. For these countries, even relatively small changes in market sentiment and interest rates can provoke substantial fiscal difficulties.
A second challenge that globalization presents to industrial countries is increased trade competition, especially in agriculture and basic industries. To a great extent, this is the result of increased production in emerging economies, which has been facilitated by greater access to the international capital markets. Such competition is painful and can prompt protectionist reactions. Experience shows, however, that such reactions are self-defeating. The correct strategy is, rather, to find appropriate ways to encourage labor to shift from lower technology industries to more sophisticated ones, where industrial economies are more competitive.
Particularly in Europe, reforms are needed so that the labor markets can function more smoothly and structural unemployment can be reduced. Moreover, labor market reform that successfully addressed the problem of structural unemployment could enhance the credibility of longer-term plans for fiscal consolidation. This, in turn, could create a "virtuous circle"--where labor market reform improves market perceptions, thereby helping to ease interest rates; and where lower interest rates contribute to additional investment and growth, thereby improving employment conditions. Where such developments occur, they can go a long way toward alleviating market tensions, including those in currency markets.
Clearly, globalization has increased the stakes for IMF member countries--by opening up the new opportunities of a global marketplace and by subjecting policies and performance to the critical eye of the market. But what does globalization mean for the IMF itself?
For the reasons I have outlined above, financial crises can be expected to occur from time to time. But as we saw in the case of Mexico, they may break with greater speed and force than in the past and, unless promptly contained, spill over into other markets. In this new environment, the role of the Fund remains as critical as ever, but when new crises erupt, the size and speed of its response are likely to take on added significance.
There can be no doubt that prevention is better than cure. Thus, the Fund's first response to globalization has been to strengthen surveillance over the policies and performance of its member countries, so that emerging problems can be diagnosed and addressed, before they become full-blown crises.
In particular, the Fund is seeking to ensure that its dialogue with countries is more continuous, intensive, and probing. Its ability to do this, however, depends critically on the availability of accurate, comprehensive, and timely economic and financial data. The Interim Committee of the Fund's Board of Governors has therefore endorsed a core set of data categories, representing the minimum to be provided by all members on a regular and timely basis to the Fund for continuous surveillance.
At the same time, we are developing standards to guide members in the provision 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 invited to subscribe to a more demanding standard with regard to the coverage, periodicity and timeliness of the data they provide.
We are also paying greater attention to the soundness of domestic banking systems, to financial flows and their sustainability, to countries at risk, and to countries where financial market tensions are likely to have spill-over effects.
Recognizing that some crises may still occur, we have agreed on procedures through which the Fund can respond rapidly--as it did in Mexico--to help put appropriate adjustment measures in place and to avoid spill-over effects. We have made clear, however, that the use of such procedures will be limited to truly exceptional circumstances. The extent of our support will depend, as always, on the strength of the country's own adjustment effort, and we will take appropriate steps to ensure that its support remains catalytic in nature. Moreover, the existence of these procedures should in no way be misconstrued as a guarantee of bail-out in the event of sovereign default; future Fund support will never be automatic--we will always keep investors guessing.
At the same time, the Fund must have adequate resources so that it will be able to meet members' future needs, as and when they arise. 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. Indeed, 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 the Netherlands, 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 Review of Quotas is now under way, and this will remain our top priority. In order for the IMF to be able to continue providing adequate support in the years ahead, a doubling of quotas will, in my judgment, be essential.
Even if additional quota resources were assured, further action would be needed to ensure that the Fund remains relevant for the poorest countries as they strive to avoid marginalization and to integrate themselves into the global economy. This is why efforts are also under way to secure the resources needed for 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 in their basic macroeconomic stabilization and policy reform efforts.
The Fund's instrument for assisting the poorest countries is ESAF--the enhanced structural adjustment facility, which provides balance of payments financing on concessional terms to low-income countries in support of comprehensive structural adjustment programs. Last year, ESAF was enlarged and 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 ESAF in the interim period, before it becomes self-sustaining. We will be discussing options for financing an interim ESAF in the coming months.
I must point out, however, that as important as ESAF is in enabling the Fund to assist low-income countries, ESAF cannot do the job alone. If we are to succeed in ensuring that the poorest countries are not marginalized--that, in fact, they actually benefit from globalization--there must be a major effort on the part of the whole international community. In this regard, the replenishment of IDA, the concessional assistance window of the World Bank, is absolutely essential, as is the continuation of concessional bilateral aid. The Netherlands already provides generous support to developing countries. However, overall Official Development Assistance (ODA) has fallen to less than 0.3 percent of donor countries' GDP--its lowest level since 1973--and less than half of the UN target of 0.7 percent of GDP. Surely this trend must be reversed! The Paris Club's implementation of the Naples terms for debt reduction is another means of providing important assistance to the poorest countries.2 In addition, the IMF and the World Bank are also examining what more might need to be done for the few highly indebted poor countries whose debt to multilateral institutions may not be sustainable.
In response to the opportunities and risks of globalization, the IMF is adapting its methods of operation so that it can continue to exercise effective surveillance and to provide appropriate and timely support to members undertaking strong adjustment efforts. Nevertheless, we must be realistic about our expectations and modest about our capabilities. For example, while market sentiment should be sensitive to 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, except to invite countries to steadfastly pursue sound policies. 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, beyond trying to limit possible spill-over effects. I do believe, however, that despite these limitations, the Fund and its member countries are now in a stronger position to take advantage of the opportunities that globalization has to offer. This, in turn, strengthens the basis for sustained, non-inflationary growth in the global economy.
1. International Capital Markets: Developments, Prospects and Policy Issues (Washington: International Monetary Fund, August 1995).
2. Under the Naples terms, eligible countries can receive a 67 percent reduction in net present value terms in eligible non-ODA debt.