The Challenges of the New Financial Economy: the Efforts of the IMF to Reduce the Risk of Financial Crises — Statement by Flemming Larsen
IMF News, November 15, 2001
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- Published: November 15, 2001
Overview
- Statement delivered to the Joint Meeting of the Commission des Finances of the French National Assembly and the Haut Conseil de la Coopération Internationale, Paris, November 15, 2001.
- Places IMF actions in the context of a changing international monetary system and describes reforms to enable the IMF and member countries to face an increasingly integrated international financial system.
- Emphasizes the emergence of a "new financial economy" driven by financial liberalization, new financial instruments, and rapid globalization of capital markets.
Large benefits of the new financial economy
- Greater diversification opportunities for individual savers and pension funds across domestic and international assets, increasing rates of return.
- Improved ability for businesses to finance expansion and innovation, leading to more efficient allocation of financial resources, higher economic growth, and improved living standards.
- Market-based financial systems increase costs of pursuing unsustainable fiscal and monetary policies, reducing governments' ability to finance deficits through captive savings and to evade the consequences of high inflation.
New and persistent policy challenges
- Historical reasons for earlier government-controlled systems: response to perceived shortcomings of pre-WWI liberal systems, banking failures, and the Great Depression; associated with social safety nets and active macroeconomic stabilization policies.
- Return to market-based systems associated with increased financial volatility; however, risk of volatility translating into systemic crisis can be mitigated.
Prominent challenges identified
- Destabilizing international capital flows
- Substantial inflows of foreign direct and portfolio investments to emerging markets have, in many cases since 1994, been followed by abrupt capital outflows contributing to severe financial crises in Latin America, much of South East Asia, and some transition countries.
- Cross-border financial contagion
- Globalized portfolio strategies increase scope for contagion when liquidity dries up for countries that share characteristics with economies suffering loss of market confidence.
- Financial sector vulnerabilities and crisis proneness
- Higher returns in market-based systems come with greater exposure to risks (including speculative bubbles) and potential systemic crises; transition economies particularly vulnerable due to developing supervisory standards and risk management skills.
- Financial abuses
- Increased risks of money laundering, tax evasion via tax shelters, and inadequate oversight in offshore financial centers.
Enhancing market effectiveness and financial-system resilience
- Two key conclusions:
- Market participants need better understanding of risks.
- Robust financial infrastructure is essential to reduce self-fulfilling collapses and unjustified contagion.
- International response: development and promotion of international standards of good practice for economic policies and financial infrastructure.
Key standards and issuing bodies (as described)
- Macroeconomic Policy and Data Transparency
- Code of Good Practices on Transparency in Monetary and Financial Policies — IMF
- Code of Good Practices on Fiscal Transparency — IMF
- Special Data Dissemination Standard (SDDS)/ General Data Dissemination System (GDDS) — IMF
- Institutional and Market Infrastructure
- Principles and Guidelines for Effective Insolvency and Creditor Rights Systems — World Bank
- Principles of Corporate Governance — OECD
- International Accounting Standards (IAS) — International Accounting Standards Board (IASB)
- International Standards on Auditing (ISA) — International Federation of Accountants (IFAC)
- Core Principles for Systemically Important Payment Systems — Committee on Payment and Settlement Systems (CPSS)
- The Forty Recommendations of the Financial Action Task Force on Money Laundering — Financial Action Task Force (FATF)
- Financial Regulation and Supervision
- Core Principles for Effective Banking Supervision — Basel Committee on Banking Supervision (BCBS)
- Objectives and Principles of Securities Regulation — International Organization of Securities Commissions (IOSCO)
- Insurance Core Principles — International Association of Insurance Supervisors (IAIS)
Reports on the Observance of Standards and Codes (ROSCs) and FSAP
- IMF and World Bank are preparing ROSCs to assemble summary assessments (modules) of countries' progress in observing standards.
- IMF producing ROSC modules on data dissemination and fiscal transparency.
- World Bank covering accounting and auditing, corporate governance, and insolvency and creditor rights.
- IMF and World Bank jointly undertake assessments of financial sector standards via the Financial Sector Assessment Program (FSAP).
- A ROSC module covering standards to combat financial abuses is under consideration.
- Implementation approach:
- Standards intended to be implemented gradually, on a voluntary basis, depending on country circumstances and capacity.
- Purpose is constructive feedback, to identify reforms and priorities for technical assistance, and to provide market participants timely information for risk assessment.
- Current ROSC coverage (as reported)
- 164 ROSC modules completed for a total of 56 industrial, emerging market, and developing countries.
- Over 100 ROSC modules have been published.
Broader crisis prevention efforts and tools
- Institutional reforms and analytical capacity
- International Capital Markets Department established; began operations on August 1, 2001.
- Capital Markets Consultative Group established to provide regular dialogue with financial market participants.
- Identifying vulnerabilities and early warning tools
- IMF developing analytic tools for early warning of looming crises; tools are imprecise and likely to be used internally to sharpen IMF attention and provide timely advice to authorities.
- Corrective measures may include recommendations to modify exchange rate systems or adjust fiscal, monetary, or structural policies.
- Many international banks are also developing early warning indicators, improving differentiation between countries and reducing contagion risk.
- Lending policy reforms
- Streamlining of IMF lending policies and establishment of new facilities, including the Contingent Credit Line (CCL).
- CCL description:
- Available to member countries with a strong economic track record.
- Offers a precautionary line of credit contingent on meeting preconditions, augmenting foreign exchange resources in a crisis.
- Intended to deter speculative attacks by providing a "seal of approval" and reducing risk of indiscriminate investor withdrawals.
- Members have been reluctant to apply—some concern that application may be perceived as indicating fear of a crisis—though several countries have expressed interest.
- CCL has the potential to become an important pillar of the financial architecture.
Crisis resolution and private sector involvement
- Catalytic crisis resolution approach:
- IMF and other official creditors provide temporary financial assistance conditional on authorities addressing root causes and reestablishing external payments capacity.
- Private creditors may then roll over credit, accept maturities, or provide new financing to prevent liquidity crises from becoming solvency crises.
- This catalytic approach is IMF's preferred strategy except when a country cannot return quickly to market financing and requires external debt reduction.
- Role of private sector and moral hazard
- Expectation of private sector involvement should reduce moral hazard.
- Evidence from recent crises shows private creditors have often taken substantial losses and faced high spreads on emerging market debt.
- IMF seeks collaborative approaches to ensure private sector participation when feasible.
Assessment of the Tobin tax proposal
- Tobin tax proposal: small tax on foreign exchange transactions to deter speculation.
- IMF's assessment and concerns:
- Skeptical about feasibility of universal implementation (necessary to avoid financial diversions).
- To deter speculation with prospects of large gains, the tax would need to be relatively high and would also affect non-speculative, trade-related transactions.
- Could reduce incentive for contrarian investors and reduce market liquidity, potentially increasing volatility.
- Proceeds earmarked for poorest countries are attractive in concept, but increasing development assistance does not require a Tobin tax.
Conclusions and policy implications
- A stronger international financial architecture is emerging, but reducing frequency and severity of crises requires countries to address policy weaknesses before crises occur.
- For countries to enjoy benefits of globalization and reduce the risk of destabilizing swings in investor sentiment, they will need to meet high standards in economic policies and institutions.
- Helping member countries meet these standards remains a critical IMF task.
Statement by Flemming Larsen, Director, IMF Office in Europe, Paris, November 15, 2001.