Capital Account Liberalization and the Role of the Fund - Remarks by Michel Camdessus
March 9, 199898/5 Remarks by Michel Camdessus
Managing Director of the International Monetary Fund
at the IMF Seminar on Capital Account Liberalization
Washington, D.C., March 9, 1998
Thank you, ladies and gentlemen.
I hope you have found this morning’s discussions interesting and thought-provoking. Certainly, we at the Fund value this exchange of views and the opportunity it provides to enrich our thinking about the liberalization of capital movements and how the Fund can help make this trend a success for individual members and the global economy.
Last September in Hong Kong, the Interim Committee of the IMF’s Board of Governors agreed that it was "time to add a new chapter to the Bretton Woods agreement." Thus, it invited the IMF’s Executive Board to complete work on a proposed amendment of the Fund’s Articles of Agreement to make the liberalization of capital movements one of the purposes of the Fund and extend its jurisdiction over capital movements. But with the deepening of the crisis in Asia since then, a number of questions have reemerged. Is capital account liberalization such a good thing after all? If countries do open their capital accounts, how should they proceed? And is the IMF the right institution to oversee their efforts? Let me offer some thoughts on these issues.
First, do open capital markets still make sense? From a theoretical standpoint, the answer is clearly "yes": free capital movements help channel resources into their most productive uses, and thereby increase economic growth and welfare—nationally and internationally. And in practice, there has been ample evidence over the years of the many benefits to be derived from open capital accounts: for emerging market economies, higher levels of investment, faster economic growth, and rising standards of living; for investors, higher returns and new opportunities for portfolio diversification; for countries that also open their financial sectors to foreign competition, more efficient, sophisticated domestic financial markets; for the global economy, new sources of economic dynamism to sustain world growth.
Of course, these are the customary arguments in favor of the freedom of capital movements. But are these points still valid in light of all the financial turmoil in Thailand, Indonesia, Korea, and elsewhere in Asia? Kim Dae-Jung, the new President of Korea, recently conveyed his thoughts on this to me. Do you know what his advice was? "Don’t let the crisis in Asia intimidate you!"
Indeed, the problem in Asia was not that countries had opened their capital accounts. In fact, the economies in the region with the most open capital accounts—Hong Kong and Singapore—have been among the most successful in contending with the crisis. Nor was the problem so much one of the speed of reform: the countries most affected by the crisis— Korea, Indonesia, and Thailand—had taken quite distinct approaches to capital account liberalization, which in some cases had been rather gradual. Rather, their difficulties arose from the macroeconomic environment and institutional setting in which they opened their capital accounts and the way in which measures to open their capital accounts were sequenced with other reforms.
On the macro side, all three countries maintained pegged exchange rates, and the high interest rates needed to sustain these pegs attracted massive inflows that were largely short term. Moreover, high interest rates at home encouraged excessive borrowing in foreign currencies, much of which was unhedged in the expectation that the exchange rate would remain fixed indefinitely.
On the institutional side, Thailand and Korea encouraged capital inflows to be channeled through domestic banking systems, where domestic regulation was inadequate, supervision was weak, and internal management was lax. Moreover, the lack of information on current economic and financial conditions and the record of strong performance in the past, led private markets to underestimate the risks. Likewise, implicit or explicit government guarantees encouraged overlending by foreign institutions and overborrowing by domestic firms. In the case of Indonesia, which has maintained a relatively liberal capital account, corporations became overexposed in the shorter maturities through direct borrowing from abroad. Domestic banks were unable—or unwilling—to exert discipline over corporations’ financial structures, but foreign creditors were willing to lend to these corporations.
The experience in Asia also underscores the importance of the proper sequencing of reform. In Korea, for example, exchange controls limited the ability of nonresidents to purchase equities and bonds issued by Korean corporations, as well as residents’ ability to borrow directly from international markets. As a result, large corporate conglomerates, or chaebols, came to depend heavily on debt intermediated by, or guaranteed by, Korean financial institutions. With the slowdown in growth and the emergence of financial difficulties in the key chaebols during 1997, non-performing loans grew rapidly and the banks’ spontaneous access to international capital markets collapsed. In this respect, the problem inKorea was not so much that capital account liberalization had gone too far, but that it had not gone far enough.
What should we conclude from the experience of Asian countries? Certainly, there are risks in tapping international financial markets, and countries need to be attentive to them. International capital markets tend to be very sensitive to macroeconomic policies, to the soundness of banking systems, and to economic and political developments. When markets function well, and policymakers are paying attention to signals they send, the markets can help reinforce good policies.
But markets are not always right. Sometimes capital inflows are too large, and sometimes they are maintained for too long. Then, having waited too long, markets sometimes overreact, triggering massive capital outflows and spillovers from one market to another. These risks are not grounds for turning away from capital account liberalization, but they are reason to proceed carefully.
How then should countries, the IMF, and the international community proceed? To begin with, countries need to ensure:
- one, that the macroeconomic policy framework is sound; in particular, monetary and fiscal policies have to be consistent with the choice of exchange rate regime;
- two, that the domestic financial system is strong. By now, there is broad consensus on what needs to be done to strengthen financial systems—improve supervision and prudential standards, ensure that banks meet capital requirements, provide for bad loans, limit connected lending, publish informative financial information, and ensure that insolvent institutions are dealt with promptly;
- three, that the opening of the capital account is phased in a way that takes account of the country’s macroeconomic and external situation, the development of its markets and institutions, and the impact of existing controls; and
- four, that timely, accurate, and comprehensive information, including detailed information on central bank reserves and forward operations, is being provided to the public—so that investors can make informed decisions, markets will be less prone to herd behavior, and policymakers will have incentives to address policy weaknesses early on.
Beyond these requirements at the national level, there is a need to continue to strengthen surveillance over market developments and to reinforce the Fund’s global surveillance with surveillance at the regional level.
As more countries gain access to international capital markets, there may be fewer occasions when official financing is required. But no matter how much prevention is improved, we cannot expect to avert every crisis. Moreover, the nature of future crises may be such that they require larger amounts of financing than the Fund has traditionally provided. With the introduction of the Supplemental Reserve Facility, the Fund is in a position to provide very large loans at a higher interest rate and shorter term than apply in its normal facilities. This facility is well suited to the Fund’s responsibility "to give confidence to members"—even when they face potentially large crises associated with the capital account.
This evolution—and the Fund’s involvement in the Asian crisis—have prompted much discussion of the moral hazard of lending to countries in financial crisis. This is a serious issue, but one which must, nonetheless, be kept in perspective. The prospect of IMF support could not possibly encourage countries to adopt policies that will bring the economic and social costs of a crisis. As for the creditors of the affected countries, as the crisis in Asia has unfolded, it has become quite clear that most have taken significant losses. Some short-term creditors have been protected, and this is one of many issues that need to be addressed as part of the broader effort to strengthen the architecture of the international financial system. But in the case of Korea, short-term creditors are nearing the conclusion of a voluntary conversion of their short-term loans into longer maturities.
Should the jurisdiction of the IMF be extended to capital movements? In fact, Fund involvement in capital account issues is not new. The IMF has always been concerned about the overall balance of payments in its surveillance and in the programs it supports. In decades past, when most balance of payments transactions tended to be in the current account, it made sense for the Fund to focus on current account issues, although of course it also paid attention to the financing of the current account via the capital account. But today the situation is different. To begin with, the way in which countries go about opening their capital accounts has profound implications for financial stability and economic growth in their own economies and in the world economy. The IMF, with its mandate over the smooth functioning of the international monetary system, has a keen interest in ensuring that the process of capital account liberalization carried forward in an orderly way. Moreover, with its nearly universal membership, the Fund is well-placed to distill and disseminate the lessons of experience from our 182 member countries. Finally, the fact that the Fund is being called upon to finance balance of payments problems associated with the capital account provides another compelling reason why the Fund’s jurisdiction should be extended to capital account issues.
These, then, are the considerations behind our view that capital account liberalization must be "bold in its vision, cautious in its implementation." In fact, our prime goal in seeking to extend the Fund’s jurisdiction over capital movements is to help ensure that the process of liberalization will be orderly. As has been the case with current account liberalization, we would envisage that members would seek to open their capital accounts gradually. During theprocess, they would have recourse to transitional arrangements analogous to the current provisions of Article XIV. Moreover, under its new jurisdiction, the Fund would develop policies to approve new restrictions that may be required under provisions analogous to existing Article VIII. Under such a system, existing restrictions could be adapted to changing circumstances, and new restrictions could be approved when needed for prudential reasons or to keep pace with market and/or institutional changes. Likewise, restrictions could also be approved on a temporary basis when needed, to address macroeconomic and balance of payments problems. As with Article VIII, acceptance of these new obligations regarding the capital account would send a clear signal to the international financial community about the member’s policy intentions and, in so doing, strengthen the member’s access to international markets.
As we move ahead, there are still a number of important details to work out. There is also a considerable amount of work to be done at the national and international level to ensure that the preconditions for the freedom of capital movements are in place. But the big picture is clear: there is an irreversible trend toward capital account convertibility, and all countries have an important stake in seeing that the process takes place in an orderly way, irrespective of where they themselves stand on the opening of their own capital accounts. With the amendment of its articles now being discussed, the Fund will be prepared to help members ensure that capital account liberalization is indeed a success.
I would again like to thank this group for contributing to our work on this critical issue.