Speech

Remarks by Alassane Ouattara
Deputy Managing Director
International Monetary Fund
at the
Réunion des Gouverneurs des Banques Centrales des Pays Francophones
Ottawa, June 23, 1998

Trends toward the global liberalization of trade and finance are now well established. The liberalization of visible trade has been in process for some time, stimulated by the sustained pursuit of trade-oriented policies in the post-World War II period. The work of the General Agreement on Tariffs and Trade (GATT) toward increasing trade liberalization resulted in the successful completion of the Uruguay Round and the establishment of a regime of liberalized international trade, now embodied in the World Trade Organization (WTO). Services such as tourism are relatively free of trade restrictions, and measures are underway under the auspices of the WTO to liberalize trade in other services.

In recent decades, the volume and modalities of international financial flows have surged. In large measure this was part of a general evolution in which many countries deregulated financial markets, allowed greater scope for market forces and lifted capital controls, de facto or de jure. This evolution was over time underpinned by a variety of other factors: relatively high returns were available on portfolio investment in emerging financial markets, the economic outlook in emerging economies was favorable, and the technology of international financial transactions improved rapidly. All of these led to growing proportions of international funds flowing toward emerging economy countries.

East Asian economies attest to the benefits of integration into the global economy. In particular, their three decades of strong growth contrast sharply with the performance of relatively closed economies in other parts of the world. International capital mobility can benefit all countries by fostering the efficient use of financial resources, by relieving shortages of capital in previously segmented markets, by providing a competitive environment that encourages innovation, and by affording better returns to investors. But needless to say, globalization and liberalization also involve risks. Indeed, international capital flows have the potential to be destabilising if the process of market opening is not managed prudently and efficiently. Support from sound macroeconomic policies, an adequate institutional framework, internationally comparable prudential regulation and supervision standards, and improved quality and disclosure of information are all necessary. This much had been demonstrated by the Mexican crisis; but as if this were not enough, the message has been reiterated with a vengeance by the ongoing crisis in East Asia.

Sources of the East Asian Crisis

A variety of factors are behind the recent crises in East Asia. Macroeconomic policy inconsistencies and related external imbalances began to emerge, a situation that could continue only as long as foreign capital was willing to flow in. Such willingness, encouraged by economic growth at high rates, obscured growing weaknesses in the financial and corporate sectors, which rendered these sectors progressively vulnerable to reversals in international investors’ sentiment. Let’s take a closer look at the underlying factors.

Inconsistent Macroeconomic Policies

In Thailand, where the East Asian crisis was ignited, those international investors lost confidence when domestic financial management failed to address the increasingly obvious problems of an overheated economy and a consequently weakening external current account. Soon, doubts arose in international financial markets on the compatibility of the monetary and fiscal stance with an exchange rate regime that linked the currency tightly to the U.S. dollar. Hesitance and tardiness in addressing the inconsistency fueled an outflow of capital. Similar reactions began to emerge elsewhere in East Asia, in countries where the official policy response was perceived as inadequate to deal with large external deficits and rapidly rising prices and stock market values.

In turn, the high domestic interest rates called for to encourage the retention of resources in the economy encouraged further capital inflows and external borrowing by domestic residents. As a result, corporations and financial institutions assumed growing levels of foreign currency risk. This significantly hampered the resilience and increased the external vulnerability of these economies to external disturbances.

Inadequacies of Regulation and Supervision

The East Asian crisis unmasked inadequacies in the management, regulation and supervision of financial institutions. Banks had accumulated an unexpectedly large amount of risky and impaired assets, as well as of contingent liabilities, against which they held inadequate capital and reserves. In some cases, levels of lending to related parties were very high. Regulatory and supervisory forbearance prevented in fact the exposure of the extent of the impairment of balance sheets. In addition, standards for public disclosure fell short of what was necessary for economic agents to assess the fragility of financial institutions. Thus, the crisis identified a need to improve financial legislation; upgrade the supervision and regulation of financial institutions; review the strategies for dealing with troubled institutions; revisit the lender of last resort facilities, deposit insurance and the implied moral hazard; and set new standards for public disclosure.

Contagion

Repercussions disseminated through the region, with some economies experiencing capital outflows and declining stock market indices and asset prices because of contagion. Even countries with sound macroeconomic policies and healthy financial sectors suffered from the turbulence, but they were able to avert major financial and exchange rate crises. The process of contagion uncovered economic policy weaknesses that either had previously gone unnoticed or had not prompted reactions. In particular, weaknesses in financial sectors became evident in Indonesia, Thailand and South Korea, as well as in Malaysia and the Philippines. The already fragile condition of the financial sectors (due to maturity mismatches and poor liquidity management) worsened with currency depreciation, which increased the debt service costs of banks and those of their customers who had not hedged their positions. Economic contraction throughout the region curtailed exports, aggravating the general loss of creditworthiness. The repercussions were strongest for countries the weaker their economic performance, the stronger their economic and financial ties to economies already in crisis, and the more similar the structures of their financial systems.

Overreaction

Developments in global financial markets and in advanced economies since the early 1990s also contributed to the crises. Weak growth in Europe and Japan contributed to low interest rates in those economies. Hence, large capital flows headed toward emerging economies, particularly those in Asia, flows which eventually served to finance increasing domestic and external imbalances. During the pre-crisis period, the volume of inflows, especially short term, put pressure on domestic prices, thus eroding the competitiveness of some countries. Inflows continued despite the evidence of inflation of asset prices, especially those of real estate. In hindsight, it is clear that most of these inflows did not show sufficient concern for the potential risks. When exchange rate regimes prevailing in the region were deemed to have become unsustainable, capital outflows set in. As a result, exchange rates fell steeply in the most affected countries (as well as in most other countries in the region) and domestic residents rushed to hedge their liabilities, making currencies fall well beyond what was required to correct initial overvaluations.

The Depreciation of the Yen

The weakness of the yen raised fears of continuing exchange rate depreciation throughout the region. This sentiment contributed to the deteriorating investment climate in East Asia, and accelerated the reversal of capital flows. To the extent that the crisis uncovered weaknesses in the financial sectors of East Asian countries, and in the creditworthiness of firms, it may have added to international exchange rate uncertainty, through a ‘flight to quality’, away from the region.

Political and Policy Uncertainty

Lack of confidence in the authorities’ commitment to implement necessary reform and adjustment exacerbated the depreciation of exchange rates and the decline in stock market indices and asset prices. Perceptions that authorities might not carry through with adjustment strategies heightened uncertainty and increased turbulence in financial markets.

Lessons from the East Asian Crises

A number of lessons can be extracted from the East Asian experience. The severity of the crises in the region highlights the importance of understanding the risks involved in designing and implementing macroeconomic policies as well as the need to ensure financial sector soundness.

Macroeconomic Policies

With the globalization of financial markets, domestic macroeconomic policies must be credible, not only to domestic agents, but also to international lenders as well. Otherwise, the likelihood of volatile capital flows with abrupt reversals is high, with adverse consequences for macroeconomic management. Reluctance to undertake relatively restrained fiscal and monetary policies will likely precipitate circumstances in which a stronger policy stance will be required. In a world of increased capital mobility, the potence of sound, prompt fiscal and monetary action to correct incipient internal and external imbalances is enormously enhanced by market support. The counterpart of this premium the market provides for proper policy making is, of course, the stiff penalty it extracts from ill-advised and inopportune policy action.

Desirable Conditions for Liberalization

The East Asian crisis, as the Mexican crisis before, emphasizes the need to support financial sector liberalization with the establishment of an adequate framework for prudential regulation and supervision of financial institutions. The prudential and supervisory framework in the East Asian countries facing crises was clearly inadequate to ensure an efficient and cautious management of the risks of lending and other contracts by financial institutions.

In addition, the East Asian crisis exposed inadequacies in the application of existing best practices in banking and financial intermediation, both areas where better information and guidance were needed. These included information on contingent liabilities and off balance sheet claims, better safeguards, limits and insurance against risk, and up to date and comprehensive public disclosure.

Managing Capital Inflows

The long experience of the Asian economies prior to the recent crises shows how surges in capital inflows can be beneficial to recipient countries in easing the external constraint, keeping domestic interest rates down, thus facilitating higher investment and growth. Yet, as dramatically illustrated by the recent turmoil in the region, large capital inflows can also complicate economic management, create instability and become a serious policy concern. Typical signs of the problems large capital inflows can bring are widening current account deficits, unsustainable consumption levels, weaker monetary control and consequently upward inflation pressure and real appreciation, and consequently vulnerability to flow reversals.

A current account deficit may be sustained provided the economy grows fast enough to generate resources to service the capital inflow associated with it. This threshold is, of course, a matter of judgment, which depends on forecasts of economic growth and other assumptions. But judgements can differ, and investors may at some point take a widening current account as a sign of impending devaluation, causing a reversal of the capital inflow and with it, a prospect of exchange rate instability.

Capital flows and integration

A critical feature of the East Asian and crises was the extent to which it spread throughout the region. This was a painful proof that today’s setting no country can isolate itself from the effects of disturbances elsewhere. Awareness of the scope for contagion, however, together with a well capitalized, carefully supervised financial sector can help minimize its consequences. As can the authorities’ determination to adjust promptly fiscal and monetary policies to contain adverse repercussions.

Implications for Central Bank Policy

Central bankers play a key role in policy and decision making, and the experiences in the Asian region carry important implications for the conduct of central bank policy.

A primary responsibility of central bankers is to promote monetary stability, generally interpreted as domestic price stability, but which also calls for attention to be paid to exchange rate stability, of course. Another main function of central banks is to foster soundness of the financial sector. In fact, success in monetary stability over the medium term requires a sound financial sector as well as prudent fiscal policies.

Experience has shown that maintenance of monetary stability may be difficult in the context of large capital inflows. A conventional means to contain or neutralize the unwanted effects of large capital inflows, particularly in a fixed exchange rate setting, is to strengthen the fiscal stance. This tends to restrain demand, and with it, contain inflationary pressures, and avert real appreciation, but there are limits tocompensatory fiscal adjustment. A second, often-mentioned tool is sterilization of the capital inflow, partly or in full. But full sterilization is expensive, involving as it does, the re-exportation of the incoming capital, at a cost equal to the excess of the domestic interest paid on the incoming funds, over the foreign interest rate obtainable on the proceeds acquired by the monetary authority. Partial sterilization is less costly, at the expense, though, of permitting continued, monetary expansion, and with it, risking inflation pressure. In general, sterilization as a sustained response to inflows, is self-defeating, because by keeping domestic interest rates high, it will continue to attract the costly inflows that cause the problem.

Other means of coping with capital inflows include, of course, a flexible exchange rate arrangement, which helps provide a measure of insulation. It must be noted, though, that such insulation does not protect the economy from capital flow volatility, which can cause exchange rate misalignments.

Then, there is the often-mentioned option of capital controls. On a temporary basis, such action may help contain the adverse effects of capital inflows, while more permanent measures are put in place. In this context, there are also prudential considerations that call for close monitoring of short-term capital flows to ensure that the risks associated with them are properly managed. The frequently cited example of a reserve requirement on capital inflows, reimbursable after a lapse of time, can be so interpreted.

Central banks must also be concerned with the stability of exchange rates. Even when currencies are flexible, frequent exchange rate changes and sharp devaluations are undesirable in general. Small changes in flexible exchange rates are to be expected, but acceleration in the trend and abrupt changes pose problems. Indeed, a rationale for managing currencies flexibly is precisely to avoid the abrupt changes typically promoted by inconsistency between a fixed exchange rate and economic policy stance. Volatile exchange rates and large devaluations discourage investment, increase foreign currency risks, raise the specter of competitive devaluation and reduce the information content of exchange rate signals.

A number of countries aim to stabilize exchange rates through a mix of interest rate policy and foreign currency intervention. This strategy works best with a well developed financial market, where financial institutions and corporations fund their operations largely by the issue of securities and in a setting of confidence in monetary and fiscal policy.

For countries where financial markets are shallow and with few participants, as well as for countries with a history of high inflation, a peg to a major international currency may offer a better prospect of price and exchange rate stability. This course of action, of course, will impose constraints on domestic monetary and fiscal policies, which must be kept consistent with the peg. A particular variant of this strategy is the currency board system, in which domestic currency is issued only against foreign reserves held by the monetary authority. Under this system, liquidity and interest rates adjust automatically to foreign exchange flows and there is no scope for independent monetary policy.

Central banks (like other domestic policy-making institutions) need to be aware of the most likely sources of contagion—countries with whom they trade and/or compete, and with whom they share economic characteristics—and to monitor those countries’ performance closely, searching for signs of impending distress. Appearance of such signs make it advisable to take precautionary measures, such as augmenting foreign exchange reserves and suitably adapting the macroeconomic policy and prudential frameworks.

Contagion risk exposure can be contained by strengthening the regulatory framework, and setting guidelines for exposure limits, including in particular, those on foreign currency exposures. These steps, buttressed by adequate and timely disclosure of information on the performance of financial institutions and transparency in the policy framework, will help in turbulent circumstances. Lastly, measures to reduce the fragility of the financial system by dealing with weak institutions, through restructuring, reform or closure, help the country to distance itself from crises that have their origins in financial fragility abroad.

This said, though, regulatory measures alone cannot fully protect against contagion. Central banks must be prepared to take other defensive measures if necessary, such as increases in interest rates (supported, of course, by an appropriate fiscal stance). Whichever consequences these measures bring on output and activity, will be less adverse than those that would occur in the absence of policy action.

Central banks with a supervisory function have a key role to play in developing and implementing adequate prudential regulations and an effective supervision of financial institutions. Even in countries where these responsibilities have been assigned to independent agencies, central banks can and should contribute to ensure the adequate implementation and enforcement of prudential regulations and maintain close coordination and collaboration with the supervisory agencies.

Through experience, norms have been developed for limiting extreme risk (such as is implied in lending to related parties) and to provide insurance against risk (in the form of capital, reserves or other unencumbered funds). These norms, together with a system of monitoring their application and sanctioning those who violate them, can go a long way to contain danger. Financial institutions should be given incentives, and be held responsible, for improved risk management and hedging. Reporting mechanisms to provide timely and comprehensive information on international financial flows can be critical in this regard.

Over the past two decades, country financial institution supervisors have put together norms of good financial behavior; and they have made progress in the development of the regulatory framework. Guidance on regulatory and supervisory issues is available in the Basle Core Principles for Effective Banking Supervision, discussion papers on international accounting standards for financial institutions, BIS guidelines for measuring certain types of derivative risk, and IOSCO principles and recommendations for the regulation and supervision of securities markets. Discussions are ongoing in a variety of international groupings, where collaborative efforts are under way with the participation of international and domestic institutions, including the World Bank, the BIS, central banks, and the IMF, to strengthen the international prudential regulation framework.

The East Asian crisis stresses the importance of providing adequate information to financial and other economic agents, to minimize the scope for misinterpretation of economic circumstances and policies. In response to earlier crises, initiatives were already underway to improve international data collection and dissemination, with the IMF being assigned a pivotal role. Standards for the dissemination of data have been devised and approved, and countries have been invited to subscribe to either a Special Data Dissemination Standard (SDDS) for advanced countries, or to the General Data Dissemination Standard (GDDS). Technical assistance is provided to subscribers to bring their data management capability to the required level of proficiency.

The implementation of the Special Data Dissemination Standards is not complete, and further initiatives are being considered to improve the timeliness, quality and dissemination of information. Among the areas under consideration by theinternational community are guidelines for disclosure by private financial institutions, adoption of reporting guidelines for contingent claims and the timely publication of improved data on cross border financial flows.

All of these are areas of interest to central banks, institutions which can make important contributions to them. Indeed, central banks can set an example in the area of transparency. They can provide clear explanations of their policy objectives and instruments, report on their performance, follow internationally accepted accounting principles and practices in recording their operations, and disclose their financial statements on a timely basis.

Work is already under way for greater clarity in the formulation and implementation of monetary and fiscal policy. A ‘Code of Good Practices on Fiscal Transparency’ was adopted by the Interim Committee of the IMF’s Board of Directors in April this year, with provisions for the public availability of information and open budget preparation, execution and reporting. A similar code for monetary and financial policies is ongoing. And discussions are underway in several fora to improve the quality and quantity of data provided by financial institutions and large companies.

Concluding Remarks

In a closely integrated setting, where capital is progressively mobile, macroeconomic policy in general, and monetary policy in particular, are severely constrained. Not only the scope for policy independence has diminished, but the cost of policy errors has sharply risen. It is, thus, imperative for policy makers to lay out their policies transparently as a critical factor to underpin market decisions. Just as the cost of policy errors has increased, so has the premium on proper policy making. Central banks must take advantage of this premium.

The central bank and other financial regulators play a vital part in setting conditions for a country to benefit from international capital mobility by ensuring the soundness of the financial system. Systems which are well regulated and supervised, where information on financial performance is readily available, where vulnerable financial institutions are readily identified and appropriately dealt with, are likely to attract durable capital inflows. With a sound financial system contagion, when it occurs, has less severe consequences.

In sum, East Asian crisis reinforces the importance of transparent policy making that is supported by publicly available information and analysis, and consistent with otherpolicies and objectives. Such policies offer the best prospect of attracting long-term capital, and improving the prospects for growth. Inconsistent policies, and weak and ill-informed financial systems are likely to reduce the efficiency in the allocation of international financial flows. Perhaps, the main lesson that we have learned from recent financial crises is that the benefits of international capital mobility will be realized only if supported by appropriate macroeconomic policies, an adequate institutional framework, effective prudential regulation and supervision of financial institutions, and improved information disclosure.