The Global Financial System: Status Report--Address by Shigemitsu Sugisaki
November 18, 1997Address by Shigemitsu Sugisaki
Deputy Managing Director of the International Monetary Fund
Prepared for presentation at the 11th International Conference of
the International Federation of Associations of Business Economists (IFABE)
The Global Economy: Three Worlds or One
Vancouver, Canada, November 18, 1997
It is a great pleasure for me to address this conference. Its title "The Global Economy: Three Worlds or One" is both timely and befitting. It takes place in the wake of the major events in Southeast Asia and its worldwide ramifications and at the threshold to the introduction of the euro as the currency of the Economic and Monetary Union.
In discussing the status of the global financial system, the main question I will address is whether the world’s financial system is developing in such a way as to serve an increasingly integrated global economy, or giving rise to such problems that it needs to be changed. I would argue the former but with the important caveat that economic policies are the Achilles heel. I will consider how the benefits of international financial integration in terms of growth and prosperity for the population can be maximized, and the costs and risks minimized, through policies both at the national and international level.
My presentation will first give a brief overview of the globalization of financial markets, how far it has gone and its potential benefits, and then turn to the policy requirements of financial globalization drawing on the lessons from the recent events in Southeast Asia. Finally, I will discuss the implications for international policy coordination and the way forward for the global financial system.
II. Globalization of financial markets
1. How far has globalization gone? The facts
During the last decade, the integration of financial markets has progressed significantly and has helped promote a better distribution of world savings. Let me describe the extent of integration of advanced, developing, and transition economies separately bearing in mind that these are not separate markets but an integrated market.
a. Advanced economies1
From the beginning of the 1970s through the early 1990s, advanced countries went through a process of dismantling of exchange and capital controls. This occurred at the same time as the deregulation of domestic financial markets and financial innovations. Moreover, with the improvements in communications, transaction costs decreased significantly. The resulting increase in international capital movements was initially concentrated in off-shore markets and banks but from the mid-1980s in reformed domestic markets and security markets.
As an illustration, cross-border transactions in bonds and equities in the major advanced countries that were less than 10 percent of GDP in 1980 had generally risen to over 100 percent of GDP in 1995.2 The daily turnover in the foreign exchange market expanded from about $200 billion in the mid-1980s to around $1.2 trillion in 1995, equivalent to 85 percent of all countries’ foreign exchange reserves. Another indicator of the integration of international financial markets is the significant narrowing in the interest differentials between onshore and offshore investments.
b. Developing countries
Private capital flows picked up substantially in the more successful developing countries following the lifting of controls on cross-border flows, especially on inflows. This followed progress in convertibility of current account transactions, which the IMF had strongly encouraged. In fact, 70 percent of all trade flows of developing countries, including most recently that of China, is now conducted under current account convertibility in that these countries have accepted the obligations under Article VIII under the IMF’s Articles of Agreement. Their exchange systems are virtually free of restrictions on current transactions of goods and services and interest payments. The acceptance of the obligations under Article VIII obliges countries to refrain from introducing new restrictions on current payments without the approval of the IMF, thus giving private markets an important signal of the commitment of the governments concerned to maintain liberal payment systems. Indeed, by today 100 developing countries have Article VIII status, more than double the number in the mid-1980s.
Reflecting the liberalization of the economies and the high growth performance and relative macroeconomic stability, capital flows have expanded quickly. In the period from 1990 to 1996, for example, net private inflows to developing countries more than doubled from about $80 billion in 1990 to more than $200 billion in 1996 benefitting particularly equity and portfolio investments in emerging market economies. The share of Asia rose particularly fast from one third of total private flows in 1990 to as much as half those flows in 1996.
c. Transition economies
In the early 1990s, transition economies relied more on official capital than on private capital to finance the transformation from a centrally planned to a market economy. Over time, greater access has been gained to private markets, first short-term financing, including repatriation of flight capital, and in the last few years medium-term and long-term financing. Indeed, several of these economies now have international credit ratings, and have recently successfully issued eurobonds and obtained medium-term syndicated loans. In terms of foreign direct investment, however, transition economies still lag behind. During the past five years, cumulative foreign direct investment inflows amounted to 4 percent of GDP in transition economies against 6 percent in Latin American countries and as much as 13 percent in East Asian developing countries.
2. Benefits from financial globalization
The benefits of financial globalization are well-known: it facilitates the transfer of savings across borders allowing savings to finance productive investment, promoting growth and job creation, as well as portfolio diversification. At the same time, the process of integration also injects healthy competition to the domestic banking system.
Just like integration of trade is promoted by liberalized trade regimes, financial integration is also facilitated by limited restrictions and controls on capital movements. However, there is an important question as to the appropriate speed by which countries that presently have capital controls should abolish them, a topic to which I will shortly return.
One of the clear lessons from the past decade of increased financial integration is that such integration tends to accentuate the benefits of good policies and the costs of bad policies. Foreign capital tends to be attracted to countries that enjoy macroeconomic stability characterized by prudent fiscal policies and monetary policies aimed at low inflation rates and a stable political situation. While capital can provide a valuable source of foreign savings, it also poses challenges to the policy makers. Large inflows attracted by relatively high interest rates might cause the money supply to expand thus endangering the inflation target. It might also be difficult for an embryonic banking system to efficiently channel large inflows to productive investments.
III. The recent currency and financial crisis and its lessons
Let me turn to the most recent currency and financial market crisis in Southeast Asia and discuss in this context the policy requirements for globalization of financial markets. It is useful to bring the crisis into perspective. First, let us not forget that the Southeast Asian countries—the so-called Asian Tigers—have displayed very strong economic performance for years exemplifying the advantages of globalization of trade and financial markets. There is no reason why—with appropriate economic policies—their performance should not continue to be strong in the medium term.
Second, this crisis is not an isolated event. In fact, the other two "worlds" referred to in the title of this conference have also witnessed a currency crisis in recent years: Europe in the context of the European Monetary System in 1992-93 and Mexico in 1995. In each of the three instances, the crisis was blamed on the financial markets, but the origin could be traced to imbalances in the economy and weaknesses in domestic policies. With each crisis, it is becoming increasingly evident how globalized financial markets have become. It is truly "one world."
What went wrong in the Southeast Asian economies?
The economic situation and problems differ in each of the countries although some of the features are common. In the case of Thailand, where the crisis began, macroeconomic warning indicators had been flashing for some time. Massive capital inflows had led to a significant increase in bank lending, in part invested unwisely in the property sector. A large part of the inflows were of short-term nature, and the Central Bank had sizeable short-term forward obligations in foreign exchange.
At the same time, the external current account deficit had increased to 8 percent of GDP, partly reflecting a slowing of export growth and real effective appreciation of the baht, which was pegged to the U.S. dollar. There is no magical number for a sustainable deficit across all countries. However, in general current account deficits above 5-8 percent of GDP deserve close monitoring. When the authorities finally tightened economic policies and the currency depreciated, the crisis was already in full swing. Investors—both domestic and foreign—were pulling funds out of the country and the exchange rate and equity prices fell precipitously.
What separated this currency crisis from currency crisis in many other countries was the extent of its contagion effect. The crisis quickly spread to other Southeast Asian economies, including the Philippines, Indonesia, Malaysia, and Hong Kong SAR. These economies shared some of the economic weaknesses of Thailand although their economic situation differed. But the crisis was not confined to the region. By the second half of October, the unrest became global, and markets in North America, Latin America, Europe, the Baltic states, and Russia all joined in. This is one of the first instances when a crisis in an emerging market has had world-wide financial implications on a significant scale.
Another feature of this crisis was that it hit severely a country like Indonesia that had macroeconomic indicators that did not provide warning signals of an imminent balance of payments crisis. For instance, the fiscal and external current account deficits were relatively small and short-term external debt was less of a problem than in Thailand. However, the strong overall performance masked a number of underlying structural weaknesses that made it vulnerable to adverse external developments. And once the contagion spread, markets began focusing on these weaknesses, including the health of the financial sector.
Besides financial markets, the Asian events are likely to slow foreign trade and economic growth in the short term, in particular in Japan, and to a more limited extent in Canada and the United States, to mention a few. Given the policy adjustments that are being undertaken, however, with support from the IMF, the World Bank, the Asian Development Bank and bilateral official creditors, hopefully the downturn in economic activity in Southeast Asia will be short-lived and growth resumed at the strong rate of the past.
What are the lessons to be learnt from this recent experience?
- First, the authorities should react to macroeconomic warning signals by taking economic action on a timely basis. Delays in taking the necessary medicine can be very costly, also for other countries. For countries that have a pegged exchange rate, the authorities should not wait too long before changing the exchange rate if required by the economic fundamentals. In support of currency depreciation, fiscal and monetary policies should be tightened. This evolves a tightrope balancing act. On the one hand, monetary policy should be tightened sufficiently, and this policy stance maintained for long enough, to restore market confidence in the currency. This is the first order of priority. On the other hand, tight monetary policy, including high interest rates, also risk increasing bankruptcies in the corporate sector and adding to the financial duress of the banking sector. There is no easy solution to this dilemma.
- Second, the crisis has once more underscored the importance of a sound banking system in a globalized world. The Southeast Asian countries are certainly not alone in having weak banking systems. The promotion of effective bank supervision and setting of prudential standards have to proceed or go hand-in-hand with the integration of financial markets. Without a well-functioning domestic financial system, foreign savings in the form of capital inflows cannot be translated into efficient use domestically. Substantial capital inflows often lead to a marked increase in bank lending, at times linked to investment in a booming property market. If the banking system is poorly supervised, and without adequate prudential regulations, the banking system can end up with assets of poor quality subject to major price fluctuations, and a net exposure in foreign currencies. Weaknesses in the domestic banking system are often revealed in the case of a reversal of short-term capital inflows or major exchange rate changes and ensuing losses. If restructuring or liquidation of financial institutions become necessary, this may involve a sizeable fiscal burden.
- Third, greater transparency of economic policies and data, including net international reserves and forward positions, is necessary. If markets are to function efficiently, they have to have adequate economic information. Transparency reduces the risk of sharp changes in market expectations that might occur if unexpected bad economic information, e.g., the size of international reserves, or the financial situation of individual financial institutions, is suddenly revealed. Transparency also has a disciplinary impact on policy makers promoting timely policy adjustment. Transparency in economic policies is simply an essential element of good governance and should be promoted in all countries.
- Fourth, given the trade and financial links, a crisis in one country has a direct economic impact on other countries. For instance, the Hong Kong dollar came under pressure as currencies in the region had depreciated, and they had all abandoned their peg to the U.S. dollar, including the New Taiwan Dollar. Their increase in competitiveness made markets question whether the peg of the Hong Kong dollar was tenable. There were good reasons, however, why the Hong Kong dollar remained pegged to the U.S. dollar under a currency board arrangement; this had been an important anchor for exchange rate and monetary policies for "one country, two economic systems" and remained credible because of the strong fiscal and reserves position of Hong Kong SAR.
- Fifth, given the interlinkages between economies, countries other than those immediately hit by a crisis have an interest in open and candid discussions of economic policies, and possibly coordination of policies. This is most obvious at the regional level but, as the latest events have shown, it applies also globally.
This last point brings me to today’s final subject, namely, international policy cooperation.
The European Union has a long experience in exchange of economic information and discussion of economic policies among its members. Such regional "surveillance"—as we call it in the IMF—is starting in the Asian countries, but there is a need for further deepening, which would help policy makers identify imminent risks. Regional surveillance and cooperation, however, cannot substitute for international cooperation. Let me mention the areas where the IMF—an international organization with 181 member countries—is involved.
The IMF engages in surveillance of economic policies in all its member countries as mandated by its Articles of Agreement. This is an ongoing process of policy dialogue with the authorities and includes regular reporting to the Executive Board of the IMF of the economic situation in member countries. The surveillance procedures were strengthened after the Mexican crisis to ensure that we provided candid advice to country authorities on a timely basis. In fact, the Thai authorities were repeatedly warned by the IMF’s Executive Board and Fund management and staff. However, the effectiveness of such advice ultimately depends on the willingness of the authorities to follow it.
In addition, when member countries encounter a balance of payments crisis, the IMF provides financial assistance linked to implementation of agreed economic policies, such as fiscal, monetary, and exchange rate policies, as well as those structural reforms that are most important for maintaining macroeconomic stability. Over the last few months, we have provided substantial financial assistance to the Phillippines, Thailand, and most recently Indonesia. By providing such financing in support of a strong economic program, the IMF helps restore market confidence. Again, the ball is in the court of the authorities. It is the task of the authorities to implement the policies agreed with us. Any delay in implementation risks changing market expectations quickly again. We also provide extensive technical assistance, e.g., in the context of monetary and fiscal policies, the foreign exchange system, central banking, and macroeconomic statistics.
The IMF increasingly promotes transparency and public disclosure in member countries of their policies and economic data. One particular aspect of data provision is the Special Data Dissemination Standard (SDDS), a standard for members having or seeking access to international financial markets to which they may subscribe on a voluntary basis. It was introduced in response to the lack of information in the case of Mexico. By today, 43 countries, primarily industrial and emerging market economies, have subscribed to the SDDS. You will hear more about this system this afternoon.
In light of the need to promote sound banking systems, in 1997 the IMF has developed a general framework for a sound and effective banking system focusing on those issues that are of macroeconomic relevance. In addition, because of its broad membership, the IMF also helps disseminate internationally agreed principles or standards of other institutions, e.g., the Core Principles for Effective Banking Supervision released by the Basle Committee in April 1997.
Finally, at the Annual Meetings of the IMF in Hong Kong SAR in September, it was agreed to move ahead to develop an amendment of the IMF Articles of Agreement to make liberalization of international capital flows one of the purposes of the Fund. This is a natural complement to the liberalization of current account transactions that has taken place in most countries. Globalization of financial markets inevitably has to follow globalization of trade if the world economy is to reap the full benefits of increased integration. The recent events have not led us to draw different conclusions. Elimination of existing capital controls, however, needs to be phased carefully with due regard to the economic situation of each country, including the strength of the balance of payments and the soundness of the domestic banking system. These issues will be high on the IMF’s agenda in the months ahead.
Globalization of financial markets offers great opportunities for increased economic growth and prosperity world-wide. But it also offers challenges and constraints on policy makers. Governments need to "abide by the rules" and pursue sound macroeconomic policies, give proper attention to the health of the banking system, develop government institutions that are subject to accountability and good governance, and ensure transparency of economic information. The goverment is, and should be, in the "driver’s seat." Market participants, on their part, should use available economic information responsibly to ensure that markets function efficiently. For the IMF, surveillance activities and financial and technical assistance will continue to remain the core activities, including the promotion of transparency in economic information and sound banking practices. The move toward capital account convertibility offers a historic opportunity to promote an orderly globalization of financial markets and their efficient functioning.
1Industrial countries, Israel, and four newly industrialized countries in Asia (Hong Kong Special Administrative Region, Korea, Singapore and Taiwan Province of China).
2See IMF, World Economic Outlook, May 1997.