Anne O. Krueger
Anne O. Krueger


Japan and the IMF

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Financing the Future:
Why a Thriving Capital Market Matters

Anne O. Krueger
First Deputy Managing Director of the International Monetary Fund
Keynote Speech, National Economic Outlook Conference
Kuala Lumpur, Malaysia
December 9, 2003


I am delighted to be here with you today. It is good to be back in Malaysia after an absence of so many years. The conference is addressing an important topic—one of interest for all emerging market economies: so I was very pleased to be invited to speak.

You have a very full program, I know; and you will be hearing from my colleague, Luis Valdivieso, a little later this morning. He will be talking about the world economic outlook from the IMF's perspective. So I want to focus on the broad theme of the conference—"Developing a Dynamic Capital Market."

In particular, I want to look at some of the lessons learned from the financial crises of the 1990s. I don't plan to go over the history of the crises. Many others have done that, with varying degrees of success. Instead, I want to look at what the crises taught us. I am using "us" in the most inclusive sense. Governments directly affected, the international financial, academic and policy-making communities and the IMF itself all learned from the events in Mexico in 1994, in Asia in 1997-98, and in other countries subsequently.

Some of those lessons were painful. Some were taken to heart more than others. Some, I fear, have not yet been fully understood. So I also want to share with you some thoughts about how we might yet do more to avoid a repetition of, or at least minimize, the upheavals of recent years.

The Importance of the Financial Sector

If the 1990s taught us nothing else, the experience of those years surely underlined the central importance of the financial sector in economic development. A stable, properly functioning financial system plays a fundamental role in ensuring the efficient allocation of resources, especially capital. It is therefore vital for growth.

Nowadays, that might sound like a rather obvious truth. Hindsight is a wonderful thing. But there is no doubt that governments and economists knew, but seriously underestimated, the importance of a well-functioning financial sector in those heady pre-crisis days.

This is perhaps not so surprising, especially in a region like Asia that had grown so rapidly in such a short time. Many of the economies in the region had transformed themselves in just a few decades. Largely rural, peasant-based economies had industrialized rapidly. The Asian tigers did not acquire their nickname for nothing.

A Simple Model

Let's look for a moment at an economy that would have been typical of much of Asia in, say, 1950. It is difficult to imagine now, of course, because so much has changed. But our economy would have been predominantly rural. It might just have had a small manufacturing sector.

Allocating resources in such a simple economy is not difficult. Let's suppose it has a single textile mill. Not many challenges there. In fact, it is a little bit like Economics 101. The mill-owner is not really having to compete for access to capital, except perhaps with farmers, whose demands are unlikely to be significant.

So the financial sector, the banking system, in our simple economy will be equally simple. The role of the banks—or, more likely, one bank—as an intermediary is going to be pretty straightforward. The government, if it so chooses, can ration credit, to our textile mill and the odd farmer, without doing much economic harm.

Now let's make things a little more complicated. Suppose the textile mill, with a little help from the bank, is successful—so much so that somebody else decides to build one. Now the two mills are competing for finance. The bank has to find some way of choosing how to allocate credit between them. Still reasonably easy—but now some ability to assess business plans and risk is called for.

Then, suddenly, a steel mill is opened. Other banks start up, spotting the chance to earn better returns on capital. Depositors start to take their money from under the mattress as they realize that they can be handsomely rewarded for switching their savings in this way. It is not difficult to see how rapidly credit decisions and risk management can become complicated.

By the time our economy has reached this stage, credit rationing can start to do real economic harm. It removes incentives from both the banks and the mill-owners. If the government is dictating who gets what credit, the mills gain little from being more efficient and productive than their competitors. And the banks have absolutely no motive for attracting more depositors' funds, or offering borrowers competitive terms.

If, as was often the case, credit was allocated in proportion to market share, even high-cost firms were kept in business. And, since much growth is the result of the rates of return on capital, credit allocation mechanisms that lower the overall return on capital reduce growth later.

Nineteenth century Europe and America saws such rapid rises in economic and financial complexity, and Britain's industrialization had started even earlier. It is as precisely such junctures in economic development that the need for a well-functioning financial sector becomes critical. The growth of London as the principal world financial centre in the nineteenth century was in part a consequence of the industrial revolution and the need for investment and trade finance that accompanied it: but it also reflected the comparative advantage that London acquired because of its ability to assess risk.

Twentieth Century Growth

In the 20th century, of course, industrializing countries could to some extent rely on existing financial sectors in other countries to help channel credit where it had the highest risk-adjusted rate of return. Few developing economies—the countries we today call emerging market economies—put much effort into developing healthy financial systems. Instead, many of them continued to engage in credit rationing, as part of their efforts to direct economic activity and pick winners—companies that could spearhead the industrialization of their economy. In the 1960s, for example, Korea moved to positive real interest rates, but the government still allocated credit.

Did nobody notice what these nascent industrial economies were doing? Of course, many economists did, and many warned against such government interference as credit rationing. But such warnings went largely unheeded—or even unnoticed—at least in part because credit rationing wasn't confined to developing countries—and in part because those developing countries grew so rapidly that it did not appear important.

The Growth of Private Capital Flows

The reappearance of private international capital flows, and their very rapid growth in the late twentieth century, was unexpected. Remember, the architects of the Bretton Woods institutions worked on the assumption that private capital flows were an historical phenomenon. They never expected that significant amounts of private capital would once again flow across national borders. In that respect, the IMF, like governments and private institutions, has had to relearn how the world works—and has had to retool itself accordingly.

When private capital started flowing internationally again, it grew astonishingly fast. Net flows to emerging markets amounted to just under US$48 billion in 1990—equivalent to about 0.8% of their GDP. By 1996, these flows had peaked at US$212 billion, or about 3% of their GDP.

And such flows, as the Asian economies painfully discovered, can just as rapidly go into reverse. In the Asian crisis countries, net inflows were roughly 6.3% of GDP in 1995, and about 5.8% in 1996. The reversal was abrupt. In 1997, net outflows were 2% of GDP, and rose to 5.2% in 1998. That represents a swing of about 10% of GDP in just three years.

The consequence of these rapid outflows was, as we all know, disastrous for the countries concerned. But they were not capricious. The huge expansion of credit, over a relatively short period, had resulted in a growing number of bad loans; these bad loans had reduced the rate of return on capital and, in time, reduced the rate of growth. In Korea, for example, it became clear that the domestic banks had misallocated credit on a grand scale. Once the international capital markets recognized this, it was inevitable that they would reassess the risks involved in lending to countries whose fundamentals were less than sound.

Fixed exchange rate pegs compounded the problem once capital flows went into reverse. Poor regulation of the banking and financial sector in many countries had enabled banks to build up liabilities in one currency with their assets in another. And government assurances that exchange rates would remain pegged left currency mismatches unrecognized. The ensuing devaluation of the crisis countries left these financial institutions facing massive losses or insolvency. Once the cushion of foreign capital was removed the inadequacy of domestic banks was revealed, as was the damage this had inflicted on economic performance.

The contraction in GDP that most crisis countries suffered made things worse, of course. The number, and size, of non-performing loans grew rapidly. Neither the domestic banking system, nor its regulators, was prepared for such a speedy deterioration. And these financial sector weaknesses in turn had a negative impact on economic performance.

Firms in the non-tradeable sector were particularly vulnerable in the event of devaluation because they face increased import costs that they cannot offset by higher prices. Their problems compound the difficulties of the banking system, of course, and ultimately—because of contingent liability—the ability of the government to service its debts. Whatever the formal provisions, there is always an implicit guarantee underpinning the activities of the banks, because no government can afford to let its banking sector collapse.

The Asian tigers did not need to look far to see how calamitous a weak financial sector could be for a country's growth prospects. They had an example in Japan, once the miracle economy of the postwar period. By the 1990s the world's second biggest economy was struggling with economic stagnation—made far worse by its crippled banking sector. But not everyone fully recognized the importance of tackling the problems of the corporate sector at the same time. Without corporate restructuring and faster economic growth, the NPL problems of the banks simply get worse or reappear.

Why Weakness Matters

Weakness in the financial sector matters for two principal reasons. First, it hinders growth because it leads to poor allocation of resources within an economy. The real rate of return falls. Japan is a particularly striking illustration of this, in part because of the length of time over which its financial sector weaknesses have inflicted harm on the economy. Japanese deflation has, of course, made the problem far worse.

But as the Asian crisis showed, financial sector weakness also increases vulnerability to a crisis. This vulnerability can manifest itself in two ways—directly or indirectly. Research has shown that a country with a weak financial sector is more at risk from contagion effects.

Policy Responses I: Domestic

So we've learned that the financial sector has a vital role to play in the economic performance of emerging market economies; we also learned, as a result of the Asian crisis and some others that in many of those countries, the financial sector is not as robust as it needs to be. What are the policy implications?

At the domestic level, governments must take steps to ensure a sound banking system. That means addressing issues such as non-performing loans, capital adequacy ratios and effective regulation. It means ensuring there is proper competition within the banking sector. And it means ensuring that there are incentives in place so that financial institutions develop the appropriate skills needed to assess and manage credit risks and returns.

Some countries in Asia have done more than others to tackle the problems highlighted by the financial crisis. Singapore, for instance, has made considerable progress—and the financial markets have recognized that. Thailand has done much to strengthen the banking system, but more is needed, particularly in confronting the NPL problem.

NPLs are a big problem for the Chinese banking system, too. But the government has recently announced a series of measures that suggest it is keen to make progress in this area.

The message for domestic policymakers is clear. A healthy, efficient financial sector is a vital component of economic growth. Putting the necessary measures in place to ensure the banking system is sound, that non-bank financial institutions are well-managed, and that risk in the system is clearly identified, might not always be easy in the short term but will undoubtedly bring significant rewards in the medium and longer term.

Policy Responses II: International

There is also clearly a role for the international financial community, including the IMF. The financial crises in the 1990s led to a new focus on economic fundamentals; and changed the way we define and view those fundamentals.

We have always encouraged member governments to ensure that they have sustainable economic policies. Indeed, those governments that seek Fund support for their economic programs must satisfy the Executive Board—their peers, in other words—that those programs are sound and sustainable.

In that, little has changed from the way the Fund has always sought to support member governments in difficulty. But recent crises led the IMF to refine its definition of sustainability. We now pay particular attention to debt sustainability, for example—and debt sustainability analyses have become standard. Capital account crises invariably involve the market making a judgment that a country will not continue voluntarily to service its debt. Assessing a country's debt burden, and its ability to service that debt, is one way we can try to prevent crises.

But we also pay close attention to the health of the financial sector, not least because of the contingent liabilities involved. The health of the banking system—including the level of non-performing loans; the extent to which risk is clearly defined in the financial system as a whole; and the transparency of the system, are all ways in which we can make a judgment about the robustness of the financial sector.

As part of the attempt to refine this process, the Financial Sector Assessment Program (FSAP) was introduced in 1999. Many of you may be familiar with this. The FSAP is a joint program with the World Bank—at least insofar as low-income countries are concerned. The program aims to help member governments strengthen their financial systems by making it easier to detect vulnerabilities at an early stage; to identify key areas which need further work; to set policy priorities; and to provide technical assistance when this is need to strengthen supervisory and reporting frameworks. The end result is intended to ensure that the right processes are in place for countries to make their own substantive assessments.

The work carried out under the program involves a broad range of financial experts, many of them from outside the Fund. Some come with substantial experience in regulating the financial sector of individual member countries or are involved with international regulatory bodies. Others have specific qualifications needed for the tasks involved. The aim is to bring powerful expertise to bear in a detailed examination of the financial system of individual members.

The FSAP also forms the basis for Financial System Stability Assessments (FSSA) in which IMF staff address issues directly related to the Fund's surveillance work. These include risks to macroeconomic stability that might come from the financial sector and the capacity of the sector to absorb shocks.

We have also worked with the World Bank to develop a system of Standards and Codes—using internationally-recognized standards—that result in the rather literally-named Reports on Observance of Standards and Codes (ROSCs). These cover 12 areas, including banking supervision, securities regulation and insurance supervision. The financial sector ROSCs are an integral part of the FSAP and are published by agreement with the member country. They are used to sharpen discussions between the Fund—and, where appropriate the World Bank—and national authorities; and, in the private sector, including rating agencies, for risk assessment purposes.

International financial stability has always been the core objective of the IMF—and it remains so, in spite of the many changes that have taken place in the global economy in the past 60 years. But stability is, as I said earlier, a means to an end—global economic growth through the expansion of world trade. Our objective has remained constant, but the toolkit has been adapted.

Capital flows

The changes I've outlined are intended to help us focus on those factors that risk destabilizing the world economy. But don't misunderstand me. Our new focus on financial sector health and resilience does not mean we are opposed to international capital flows.

Private capital flows are, without question, beneficial for the global economy. They channel capital where it can be most productive and help generate economic growth. Healthy financial systems are necessary to underpin the free and expanding trade. And the free movement of capital goes hand in hand with trade liberalization. It is not possible to have one without the other over any extended period. Opening trade without opening capital markets runs a high risk of under or over-invoicing, for example, as export and import activity is used as a cover for capital exports.

Rather than trying to restrict capital flows, the IMF aims to help countries exploit the benefits while taking account of the risks. We've seen how serious capital account crises can be, both for individual national economies, as well as for the international financial system as a whole. There will always be crises: it is simply too costly to guard against every conceivable risk, however slight. The challenge is to head off trouble whenever it makes sense to do without a system for prevention that incurs unreasonable costs. Hence the new emphasis on financial sector soundness. It makes far more sense to harness the beneficent power of capital markets, rather than to curb them, and thus in turn, the economic opportunities they can bring.

So we are back to the fundamentals again—and I certainly make no apology for that. Investment will be most productive in a well-managed, market-friendly economy. Reaping the full benefit of capital markets means, among other things, listening—and responding—to the message they convey. The Asian crisis—and, indeed, the other capital account crises of the past few years—did not tell us that private capital flows were bad for a country's economic health.

No, they taught us that it will be very hard for countries to be fully integrated into the world economy—and benefit from that integration—if their economies and their financial sectors are not fundamentally sound.

Those crises also highlighted the risks that inappropriate exchange rate policies can bring, especially when, as in many instances in Asia, they were accompanied by weak financial sectors. It is clear that fixed exchange rates will make countries more vulnerable to capital account crises. They also sharply increase the risk of currency mismatches—in both the corporate and banking sector—that, in the event of a crisis can inflict catastrophic damage on the banking system.

In the past decade, capital markets have also been sensitive to potential trouble with sovereign debt levels. They have not lost that ability, and so it is worrying that many emerging market economies have not fully appreciated the risks they run in letting their debt levels rise. The financial markets are constantly making judgments about the course of future primary surpluses which in turn will determine a country's ability to service its debt. Emerging markets as a whole now have ratios of debt to GDP that are higher than the industrial countries. I make no secret of the fact that the Fund is concerned about high and rising levels of emerging market debt.

Now is the time when governments should be trying to bring such debt levels under control. The global economic upturn seems to be gathering pace—it certainly is in Asia, now the world's fastest growing region. A period of economic growth offers a chance for governments to get their fiscal affairs in order, to reduce their debts burdens and so reduce the risk of pro-cyclical fiscal tightening later.


Capital flows are, in some respects, like antibiotics. Anything capable of doing good is also powerful enough to inflict harm when wrongly used. That is not a reason to restrain capital flows, though, but to harness them so that they can do most good.

Regulation is necessary, of course. But let us not confuse regulation with restrictions. The aim should be to enable capital to flow—at both the national and international level—where it is most needed, and can do most good. That requires appropriate incentives for putting effective risk management in place. It requires a proper competitive structure. And it requires getting rid of bad regulation in many cases and replacing it with a system of appropriate market incentives and—and this is important—a level playing field for all those involved. Only if everybody is playing by the same competitive rules can the markets respond efficiently.

Thriving capital markets are the lifeblood of capitalism, with all of that economic system's attendant benefits. Capitalism is the best method yet devised of generating growth, raising living standards and reducing poverty. These are objectives I think we all share.

Of course, when it comes to developing a successful and dynamic capital market, the Fund's role is primarily that of a facilitator and advisor. But it is one to which we attach high priority and we remain ready to do whatever we can to help emerging market economies to develop the sound economic framework in which capital markets can best fulfill their role.

Thank you.


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