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International Capital Flows: A Challenge for the 21st Century
Since Mexico in 1995 and on to Thailand, Indonesia, Korea, Russia, Brazil, Argentina and Turkey, all recent crises have tended to be "financial crises," that is capital-account dominated. They were accompanied by large shifts in interest rate spreads between emerging markets and world financial centers, and by sharp exchange rate movements. A recent Fund study compares emerging market spreads in the 1990s with those in the previous "golden era" for international capital market integration, 1870-1913.1 It finds that spreads are higher and more volatile now than they were in the pre-First World War period. Also, in recent years, sudden changes in spreads, normally associated with crises, tend to be mostly related to global events, whereas country events had a bigger role in 1870-1913. Finally, co-movement of spreads across emerging markets is higher today than it was in the historical sample. In other words, financial markets have become more volatile, and "globalization" and "contagion" have been a part of the story.
The International Monetary Fund (IMF) pays particular attention to capital flows in its analysis of economic trends, both at the global and at the national level. Its articles of agreement clearly state that "the Fund shall oversee the international monetary system in order to ensure its effective operation" (Article IV, Section 3). Moreover, the IMF should "seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions" (Article IV, Section 1).
The IMF has engaged in a number of efforts, together with other international organizations and national governments, to make our world less vulnerable to financial crises and to handle them as effectively as possible whenever they occur. As IMF Managing Director, Horst Köhler, said recently "Private capital flows are now a major source for promoting growth and productivity, but they can also be a source of abrupt volatility and crisis. To contain the latter and to promote the former is the issue at stake."2
Capital flows-particularly long-term flows, such as foreign direct investment-are a positive force in raising economic prosperity in developing and developed countries alike. The problem of some countries, particularly the least-developed countries, is not that they have attracted too many capital flows, and in the process have made their economies vulnerable and unstable. Rather, many of them failed to attract significant capital flows, often because of protracted macroeconomic imbalances and an inhospitable business environment, and therefore have not enough resources to invest. If your house is not in order you actually encourage capital flight by nationals trying to protect their savings by investing them abroad.
Therefore, the first aspect of preventing financial crises is to take appropriate steps to ensure proper macroeconomic stability and a sound business environment. Attention should also be given to external vulnerability and financial sector stability. Finally, countries should be encouraged to follow best international practices, particularly those related to financial markets, and to remain committed to providing more and better information about their policies and economic developments to financial markets and the public at large.
The work of the Fund in support of crisis prevention is broadly incorporated in our surveillance efforts, that is, our monitoring of the economies of member countries. Starting from an assessment of economic and financial conditions in the country-and policy recommendations developed by the staff-the IMF Executive Board makes a number of suggestions for consideration and implementation by the national authorities. Among the factors impinging on the external vulnerability of a country, four have proven to be crucial: the existence of macroeconomic imbalances, deficiencies in the management of domestic and external debt, inadequate exchange rate arrangements, and, last but not least, weak and poorly supervised financial systems.
Because of the importance of the latter, since 1999, the IMF, in collaboration with the World Bank, has been carrying out the Financial Sector Assessment Program (FSAP). Through this program, strengths and vulnerabilities in financial systems are identified and remedial measures proposed with the aim of reducing the likelihood and severity of financial crises. Financial Sector Stability Assessments of 24 countries are scheduled to be conducted in FY2001. The Fund has contributed to the work of the Basel Committee on Banking Supervision on new standards for capital adequacy, which we hope will be applied by all internationally active banks in 2004, but also by domestically-oriented banks around the world.
The IMF has also been fostering the development and implementation of internationally recognized codes of conduct, developed through a participatory process in which a broad range of players and institutions have made their contributions. These codes of conduct are geared towards promoting the efficient functioning of financial markets and improving national governance. The IMF itself has taken a lead in developing standards for data dissemination and codes of good practices for transparency in fiscal, monetary and financial policies. Other international organizations have developed-or are developing with our collaboration-standards of banking supervision and regulation, securities and insurance regulations, payment and settlement systems, accounting and auditing, corporate governance, and insolvency regimes.
Greater transparency in country economic developments and policies helps inform financial markets allowing them to distinguish more clearly the special circumstances of each country. The Fund has just completed its review of the experience with the publication of Article IV staff reports and will continue to encourage the voluntary publication of these reports by country authorities. The Fund is also promoting greater exchange of information and dialogue with the private financial sector as an important element of crisis prevention. For that purpose a Capital Markets Consultative Group was established at the IMF and had its first meeting in September 2000. A meeting with financial market executives in Asia was held in January 2001.
Country surveillance is complemented by global and regional surveillance, that is by the understanding of forces affecting the world economy and global financial markets that may be of concern to all countries or to countries in a region. The IMF reports on the World Economic Outlook and the International Capital Markets are examples of such work.
Regarding crisis management, the Fund has reviewed its facilities to make sure that they are well-tailored to help our member countries. A new loan facility, the Contingent Credit Line (CCL) was reformulated in 2000 to help countries that have undertaken appropriate policies to better withstand any negative impact on their economy from contagion effects. The basic idea is straightforward: the IMF offers a precautionary line of credit to countries that have demonstrably sound policies, but which nonetheless believe they may be vulnerable to contagion from crises elsewhere.
While the Fund's role is to provide a credible crisis response whenever prevention fails, creditors and borrowers must know that the IMF's resources are limited and that the private sector will have to be involved in the orderly and timely resolution of crises. Work on a suitable framework for private sector involvement continues. Valuable experience has been gained with securing the involvement of the private sector in the resolution of a number of recent crises. Despite progress, more needs to be done to strike the right balance between the clarity needed to guide market expectations and operational flexibility needed to allow the most effective response to each crisis situation. Work is ongoing on the comparability of treatment between official bilateral and private creditors and on prospects for market access for countries emerging from crises. A progress report is expected for the next International Monetary and Financial Committee meeting in April 2001.
There are a few forms of harmful international capital flows whose existence is due to in part to lack of sufficient collaboration among the international community. They include capital movements aimed at evading taxes and money laundering.
Regarding tax havens, the IMF supports the work being undertaken by the OECD on harmful tax competition, including the identification of non cooperating countries and territories. Prevention of money laundering is being pursued by the Financial Action Task Force set up by the G-7. The task force has developed a regulatory framework, which if effectively applied by all countries, would reduce greatly the opportunities for money laundering. Following recommendations of the Financial Stability Forum, the IMF is conducting an assessment of offshore financial centers, which will emphasize compliance with internationally agreed standards and codes, including those relating to the transparency of financial sector activities.
Short-term speculative flows are sometimes associated with financial crises, but are often difficult to distinguish from other short-term flows that finance trade and other worthwhile economic activities. The judicious use of controls on short-term inflows can help slowdown surges of capital flows, which could contribute to deepen the crisis. Two points, however, are difficult to dispute: (a) capital controls cannot be used successfully as a substitute for sound macroeconomic policies and an appropriate business environment and (b) kept for extended periods, capital controls are bound to be circumvented. Past experience with capital liberalization also shows that proper sequencing is essential, a lesson that we need to keep in mind in the future. Further research in this area is crucial. For example, a study on advanced country experiences with capital account liberalization will be conducted by the Fund staff in 2001 in cooperation with the OECD.
In the period ahead, it will be important to continue to work toward a better understanding of the dynamics of international capital flows, while at the same time, putting in place the building blocks that will ensure greater stability of capital movements and more generally good governance and smooth functioning of national and international financial systems. This is the challenge we need to face early in the 21st century.
1 Mauro, P., N. Sussman and Y. Yafeh "Emerging Market Spreads: Then Versus Now," IMF Working Papers, WP/00/190, November 2000.
2 Köhler, H., National Press Club Address, August 7, 2000. See also Köhler, H., "The IMF's Agenda for the New Year," Financial Times, January 8, 2001, p.17.
IMF EXTERNAL RELATIONS DEPARTMENT