Speech

Address by Michel Camdessus
Managing Director of the International Monetary Fund
at a Conference on "The Changing Role of Central Banks in Europe"
Vilnius, Lithuania, October 3, 1997

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Thank you, Mr. President, ladies and gentlemen. It is a pleasure to join you in commemorating the 75th anniversary of the Bank of Lithuania and the introduction of the litas. Certainly, you have a rich historical record to celebrate: the original litas was a strong currency, which, thanks to the prudent policies of the day, maintained its par value throughout the inter-war period and the early years of World War II. And I can easily imagine your feelings today as you are celebrating such an anniversary: remembrance of the frustration, anger and sadness at losing the key symbols of your national identity, remembrance of the sufferings of war but also of the unextinguished hope of a national Renaissance, and, of course, the memories we share with you: the enthusiasm at your recovering your freedom, the sacrifices and pains of rebuilding an independent nation, a market economy and a litas whose qualities would symbolize your national ambitions. So please accept our congratulations on this occasion.

Now Lithuania is in a new period of its history--and one that the IMF is proud to be a part of. A bold program of macroeconomic stabilization and structural reform has accelerated your country’s transition to a fully functioning market economy. And indeed, the reintroduction of the litas, with its supporting currency board arrangement, has been the cornerstone of this success. These are outstanding achievements you have every reason to be proud of.

Certainly, your country still faces a number of economic challenges, which I will return to in a moment. But Lithuania is no longer simply a country in transition. Rather, it is an increasingly active and well integrated participant in the global economy, as its growing external trade, rising level of direct foreign investment, and access to global capital markets all attest. Thus, it must not only concern itself with completing its transition, but prepare to meet the challenges of the global economy—whence a changing role for your central bank, as well as for many other central banks in Europe.

Like many of the governors joining us here today, I have just come from the Annual Meetings of the IMF and the World Bank in Hong Kong, where these global challenges were very much on the minds of the central bank governors and finance ministers of our 181 member countries. Let me share with you some of the conclusions that emerged from these meetings and discuss their implications for Lithuania and other countries in Europe.

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These meetings took place against the backdrop of the currency crisis in Thailand and its contagion effects in other southeast Asian markets. No doubt you are familiar with the basic outlines of Thailand’s difficulties—notably, a "temporary" relaxation of budgetary discipline, a loss of external competitiveness, and an unsustainable current account deficit. These problems, in turn, exposed underlying weaknesses in the domestic economy, among them: a fragile and over-exposed financial system, lagging industrial diversification, an inflated property market, and high levels of corporate debt. In its dialogue with the authorities over the previous 18 months, the IMF had expressed its diagnosis and pressed for urgent measures. Beginning last year, markets also expressed their uneasiness about these developments by exerting increasing pressure on the Thai currency, the baht. Eventually, in the absence of strong policy measures, the crisis broke. Meanwhile, the market’s anxieties spread to other countries in the region.

Fortunately, Thailand has now adopted a far-reaching adjustment program, which goes to the heart of the market’s concerns. In particular, efforts are under way to move the budget back into surplus, and to carry out a major restructuring of the financial sector. The Philippines, Indonesia, and Malaysia have also strengthened their policy stances. Naturally, it will take time and resolute action on the part of the Thai and other country authorities to rebuild market confidence. But I fully expect confidence to return as these adjustment efforts take hold. Indeed, I am confident that, after this period of adjustment, these economies will emerge stronger than before. In the meantime, however, the crisis has cost Thailand dearly and imposed substantial costs on its neighbors.

I mention all of this not with the intention of dwelling on the economic difficulties on the other side of the globe. But the fact is that the challenges of managing a small, open economy in the global economy are by no means unique to southeast Asia. Indeed, several central and eastern European countries have had to deal with similar pressures in recent months. Fortunately, these countries acted quickly to strengthen their policies and alleviate market concerns, and the effects of these pressures on their economies and their neighbors were therefore limited. Rather, my purpose is to draw your attention to the lessons that these events hold for thecentral banks and governments of small, open economies such as Lithuania that tap international capital markets. Let me briefly mention four of them.

1. No scope for mistakes

Perhaps the first conclusion to be drawn is that international capital markets give policymakers little scope for mistakes. Strong growth and substantial private capital inflows are generally seen as the hallmarks of a successful economy. And they are! But sometimes these outward signs of economic success can lull policymakers into complacency about underlying economic problems. It is important to keep in mind that even if markets are sometimes slow to react and sometimes over-react, eventually they do respond to economic imbalances and structural weaknesses—and at times with brutal force. And it is striking to see that, in the case of Thailand, that the victim of the crisis was a country which for years had performed well and benefitted from ample market financing. This is not a reason to shun the markets; on the contrary, access to global private capital markets offers tremendous opportunities to accelerate growth and development. Rather, it points to the importance of avoiding macroeconomic imbalances and structural weaknesses and correcting them promptly when they arise.

One particular source of vulnerability is a large current account deficit, especially when financed heavily by short-term capital inflows. We saw this in Mexico in 1994-95 and again in Thailand this year. Some countries in central and eastern Europe also have large deficits, and ones that are growing quickly. Often these deficits are the natural counterpart of strong foreign direct investment inflows associated with the modernization of the capital stock and the need to make the economy more competitive. But in Lithuania, as elsewhere in the Baltics, policymakers need to be vigilant that these deficits are sustainable. An assessment of the sustainability of these deficits must be based on a variety of factors, including how these deficits are financed, the strength of the fiscal positions, other developments in the capital account, and the efforts that the country is making to improve the domestic climate for private investment. It is the role of the Fund to assist countries and their central banks in keeping their situations under review and ensuring that deficits don’t get out of hand. As long as such vulnerability persists, the Fund must be ready to extend to these countries the precautionary arrangements they may need.

2. Banking system soundness

A second lesson concerns the importance of giving due attention to other aspects of the reform agenda, particularly the soundness of banking systems. Lithuania and other Baltic countries are well aware of the importance of this issue, having had to deal with costly banking crises early in their transitions. Of course,there are many reasons why countries need a sound banking system—to intermediate domestic savings, allocate credit, facilitate payment flows, aid in the implementation of monetary policy—in short, to provide the financial machinery countries need to develop and grow.

But countries that tap, or hope to tap, the international capital markets have further incentives to strengthen their banking systems. The markets recognize that when the banking sector is weak, policymakers face a dilemma: if they tighten policies when macroeconomic conditions suggest that tighter conditions are needed, they risk provoking a domestic banking crisis. If, on the other hand, they delay adjustment, the eventual adjustment will be more costly and put still more strain on already fragile banks. Knowing this, financial markets tend to lose confidence when they see signs that the health of the banking system is deteriorating. And, indeed, the market’s doubts can become a self-fulfilling prophecy. There is also the related risk that when international finance is readily available—and prudential standards and oversight are weak—domestic banks may over-borrow and on-lend to increasingly risky borrowers and projects. This behavior can weaken the banking system further—at a time when banking soundness is particularly important.

Many factors go into ensuring banking sector soundness. Certainly, the primary responsibility for ensuring that individual banks are sound and are operated safely lies with their owners and managers. In a well developed market economy, investors and depositors also provide an important element of discipline by forcing poorly managed banks to improve their performance or close their doors.

Governments can help promote good management and market discipline by establishing the necessary institutional framework for a sound banking system. This includes a legal system that facilitates the enforcement of contracts, loan recovery, and the collection of collateral, and a judicial system that is impartial, honest, and able to enforce economic rights and obligations. Indeed, Lithuania is taking some important steps to strengthen these institutions. But the role of governments and central banks does not end there. Especially in countries where the financial markets are not yet fully developed, governments and central banks need to ensure that an adequate system of regulatory and supervisory oversight is in place and that all banks comply with it.

The IMF, and the Basle Committee in particular, have done a lot of work on banking sector issues, which the Fund is now incorporating into its policy advice. To this end, the Fund has developed a framework for financial sector stability that will help it disseminate a set of internationally recognized best practices in the financial area. In many cases, however, the problem is not so much that policymakers are unsure of what should be done, but that politics stand in the way of doing it. As in allother aspects of economic policymaking, at the end of the day, it is up to the national authorities to exercise their leadership and take the difficult decisions. This includes actions to put the banking system on a solid footing.

3. Strengthening the economy

Third, for countries in transition, it is critically important that central banks in their collaboration with governments, keep very high on their agenda the need to ensure that the extra room for maneuver granted by foreign borrowing is used to strengthen the economy. If these resources are spent solely on consumption, the debt will become an impossible burden. Strengthening the economy means not only improving the climate for domestic and foreign investment. It also means speeding up reforms so as to complete the transformation of the role of the state—from one of interfering in all aspects of economic life to one of providing a fair and favorable environment for private sector activity. Lithuania is already well advanced on this path. Through privatization, it has withdrawn from many activities that can be better performed by the private sector. It should complete this process quickly—and do so in a transparent way, so that the public has confidence in the process.

A thriving market economy also requires a level playing field on which the private sector can operate; indeed this is one of the most fundamental responsibilities of government in a market economy. To achieve this, the government must establish a set of fair and transparent rules that apply equally to one and all, and ensure that these rules are fully enforced. Within such a framework, private investment can flourish, new business can spring up, and all enterprises have strong incentives to operate fully within the law. To show you how essential this framework is, let me emphasize three key elements:

•one, a simple and transparent regulatory system—so that businesses won’t waste precious time and resources trying to find out what the rules are and how to comply with them; so that new firms can enter the market without complication or being driven underground; and so that foreign investors are encouraged to bring in their capital, technology, and skills;

•two, an effective legal and judiciary system that protects property rights, enforces contracts, and helps create an atmosphere of law, order, and personal security—so that domestic and foreign investors will expand their businesses and create new ones;

•and three, a tax system that is simple and broad-based, with limited exemptions and reasonable and uniform rates—so that companies and individuals will not be discouraged from trying to fulfill their tax obligations; so that the tax systemcan be more easily enforced; and so that the government receives the revenues it needs to carry out its basic responsibilities, such as health and education.

Perhaps you are surprised to hear the IMF, the world’s central monetary institution, talking about such matters. But from our experience in 181 member countries, we have learned that keeping inflation under tight control, maintaining macroeconomic stability, and achieving sustained, high-quality growth cannot be achieved in isolation or exclusively through exemplary conduct of monetary policy by central banks, but requires a broad range of supporting institutional reforms.

4. Transparency

The fourth lesson applies also equally to central banks and governments; it concerns the importance of transparency—that is, providing complete, timely and accurate information to the public about economic policies and performance and a full accounting of how public resources are used. Indeed, a very strong consensus emerged at our Annual Meetings that transparency and the free flow of information are absolutely vital in this era of global capital markets. Why? Because when policy actions and performance are transparent, policymakers have more incentive to pursue responsible policies. Moreover, transparency allows markets to distinguish between good performers and not such good performers, and the risk of contagion is thereby diminished. And when markets are well informed, they are less prone to sudden shifts in sentiment. But transparency also serves a wider purpose: it diminishes the opportunities for corruption and provides a stronger basis for public confidence in their leaders and support for their policies, which, after all, is a prerequisite for continued reform.

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I leave to it you to decide to what extent these four lessons are relevant for Lithuania and to other countries now well advanced in the transition process. But let me mention two challenges that lie ahead for Lithuania in particular.

The first concerns how best to manage the transition from Lithuania’s currency board to new exchange arrangements. So far, the currency board has lent a considerable degree of credibility to the litas. Now, as Lithuania prepares to replace this arrangement, it must give top priority to how it will maintain and even strengthen this credibility. The authorities are on the right track in having announced a prudent, step-by-step transition to the new regime. But the success of these new arrangements will depend on the policies and institutions that underpin them. The same kind of policies that find support with the IMF—including continued fiscal consolidation, a strong and independent monetary policy geared toward low inflation, and an opentrade regime—are also those that would find favor with the markets and build confidence in the litas. Moreover, a further strengthening of the banking sector would also help convince markets that such a policy stance could, and would, be maintained.

The second challenge relates to Lithuania’s entry to the European Union. You referred to eurosceptics and euroenthusiasts. As regards Lithuania, I am a euro-optimist. Whatever procedural steps you will have to fulfill, your medium-term strategy will best serve this major objective of EU membership by giving the highest priority to a few elements which in any case must be part and parcel of a sound growth strategy: a stable macroeconomic framework; outward-looking trade policies; banking, legal, and regulatory systems that promote increased investment, including direct foreign investment; and domestic Lithuanian legislation well in line with that of the EU. These are the policies that will make your economy stronger and more dynamic and allow income levels in Lithuania to converge with those in western Europe within a reasonable period of time. As such, these are also the policies that offer the speediest route to full integration into the European Union and other multinational fora.

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Now, and following up on the Hong Kong statement, let me leave you with one further thought about the future. The benefits of an open and liberal system of capital movements—for individual countries and investors, and for the world economy at large—are widely recognized. Countries have a lot to gain from opening their capital accounts so that they can benefit fully from such a system. Now, there is unanimous agreement among the 181 members to amend the IMF’s charter to make the liberalization of capital movements an explicit part of the Fund’s mandate. The emphasis will be on fostering the smooth operation of international capital markets, and encouraging countries to remove capital controls in a way that is consistent with sustainable macroeconomic policies, strong monetary and financial sectors, and lasting liberalization. This will be good for recipient countries, good for investors, and good for the world economy. I am sure that Lithuania will also want to be among the countries that benefit fully from global markets, and this is another reason to take further steps to strengthen your economy now.

And now let me conclude on two notes of deep satisfaction. The first is to congratulate you on the fact that, although not yet 10 years old, Lithuania’s partnership with the international community through its membership in the International Monetary Fund has gone from strength to strength. The hallmark of this partnership has been a strong commitment to financial stability, open markets, and better governance, in a context of rapid and ongoing transformation. I am encouraged by growing evidence here and in the other Baltic countries of a willingness toimplement forward looking reforms that will eliminate long-standing rigidities and enhance the adaptability of the economy to the demands of the global environment of the twenty-first century. These are positive signs which point to a prosperous future.

The second is to pay tribute to the exemplary regional solidarity which has developed among Nordic countries, on the occasion of the Baltic countries joining the Bretton Woods institutions. This has been truly a success story, which owes a lot to the fact that each of the countries in your constituency speaks with the same voice in our executive boards. Among yourselves you have demonstrated the same generosity and lack of complacency that has long characterized the Nordic chair. For the world community it has been quite refreshing to hear this constructive voice grow even louder as the Baltic countries join their Scandinavian friends with a common message for the world.