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«THE (IN)SECURITY OF INTERNATIONAL FINANCE Valpy FitzGerald [Originally delivered as the first of the Wolfson College Lectures 1999 series on the ...»

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Developing countries have shallow and narrow capital markets, where relatively small flows of foreign capital can have a large effect on prices, particularly those of government bonds and privatization issues which tend to make up the bulk of traded securities. Their firms tend to be highly geared and dependent on borrowed funds, so that credit restrictions have a disproportionate effect upon production. Their populations in turn are vulnerable because much of their population lives near the poverty line, unprotected by modern welfare systems; so that macroeconomic fluctuations particularly large deteriorations in the exchange rate - can have serious social consequences.

Despite this vulnerability, rapid financial liberalization has been pressed by both international agencies and local modernizing elites in emerging market countries. As a result, large international liabilities have been built up by the private firms and households to finance both investment and consumption. The currency risk was perceived as low by foreign lenders due to the strong growth record and nominal exchange rate stability underpinned by the same capital inflows.

The volatility of short-term capital flows (or ‘capital surges’) is now recognized as a major problem for macroeconomic management in developing countries; which subsequently translates into investment, growth, employment and welfare.14 Government expenditure cannot be efficiently allocated to the satisfaction of social priorities when both the borrowing ability and the cost of funds varies so sharply.15 The impact of short flows on output and investment by firms through the availability of bank credit is also large, reducing private investment. Employment levels and real wage rates are affected by the influence of capital surges on real exchange rates and domestic demand levels.

Missing institutions In response to these problems, special institutional arrangements have emerged historically in industrial countries as part of the process of constructing orderly financial markets. It would seem logical, therefore, to expect that an orderly global capital market would require similar institutions at an intergovernmental level.

These would be four:16

first the core central banking functions of providing liquidity to the market, including lastresort lending under distress conditions in order to support otherwise sound banks and prevent contagion; this is the putative function of the IMF - although it at present has insufficient funds and is only empowered to lend to governments (or their central banks) and cannot deal directly with global or local private banks;

second, the prudential regulation of financial intermediaries, in order to prevent not only fraud but also unsafe lending with wider consequences; to some extent this service is provided by the Bank for International Settlements, but it leaves the greater part of global financial intermediaries still unregulated;

third, the existence of private financial institutions (‘market makers’) who stand ready to buy and sell assets at the current price - creating ‘depth’ and thus stability in the market and to take over insolvent financial intermediaries when necessary; such cooperation is notable by its absence - particularly in international rescue operations;

fourth, and possibly most significantly, a sound and transparent legal system that secures contracts and provides for efficient dispute settlement between contracting parties and between financial intermediaries and the regulators; such a ‘multilateral framework for investment’ which could stabilize expectations and thus asset values does not yet exist.


The Effectiveness of International Financial Institutions The existing international institutional ‘architecture’ to cope with these problems in emerging markets is based on the agencies founded at Bretton Woods in 1944; the International Monetary Fund in particular. As intergovernmental institutions, the IFIs are essentially lenders of last resort, against which facility they can impose policy conditionality designed to restore long-term solvency in return for the provision of liquidity. Whatever the effectiveness of this approach in the sovereign debt crises of the 1980s, or to the chronic economic problems of the least developed countries, it is not appropriate for the emerging market crises of the 1990s. The recent Latin American and East Asian crises are essentially related to private sector asset deflation and illiquidity, not state failure.

The root causes of the breakdown were not prevented (and possibly have been exacerbated) by Bretton Woods policies of accelerated financial liberalization, exchange rate anchoring and encouragement of private portfolio investment as a substitute for sovereign borrowing.17 The IFIs appear to have taken the pre-crisis position that because the external deficits reflect private investment-savings gaps rather than fiscal deficits, they must reflect rational market decisions and thus be respected. However, even had they wished to prevent such inflows, their ex-ante influence over lenders is limited to issuing negative macroeconomic evaluations with the consequent danger of market collapse.18 Ex-post, their insistence on large devaluations, high interest rates, credit restrictions and fiscal retrenchment have tended to further undermine both corporations and bank, worsening the crises they attempt to resolve. The failure of recent IMF interventions in East Asia and Mexico essentially derive from the failure to recognize and correct private debt problems. In the commercial world, of course, insolvent companies are placed under new management and the unserviceable debt is written off by the creditors. There is, however no equivalent in international debt crises.19 Of course, global surveillance is not only carried out by the IFIs. In principle, if the issue were one of information as such, the ratings agency should be able to invest in better information on country risk than any one investor and then provide what is effectively a public good for a modest fee. However, the failure of the leading private ratings agencies to predict collapse in Mexico and East Asia is notorious. The way in which information is used by ratings agencies seems to be deficient - an issue of economic interpretation rather than economic statistics.20 There are various reasons for this, including the methodology used to construct ratings (which is largely backward- rather than forward-looking) and the natural desire not to destabilize already fragile markets.21 One of the key reasons for the volatility of capital flows is doubts about the solvency of particular developing countries. The existence of a large international public debt overhang represents a major constraint on further long-term foreign investment on any significant scale - due to the uncertainty caused by the prospect of severe stabilization measures in order to meet debt service, or the sovereign risk inherent in debt default. This debt overhang is also a major disincentive to private domestic investors, for the same reason.

In effect, the process of financial intervention in developing countries by the Bretton Woods institutions has led to the transfer of sovereign debt from commercial creditors to the IFIs themselves. Once so refinanced, it has become almost impossible to write off. The main reason given for not cancelling this debt is one of ‘moral hazard’22 - the belief that if developing country sovereign debt is cancelled, then their governments - freed from the external constraint - will return to ‘irresponsible’ policies. Unfortunately, the current HIPC initiative23 is both insufficient in scale and too lengthy in process to make a substantive contribution to the reduction of investor uncertainty.

Global Financial Architecture The recurrent financial crises since Mexico in 1995 have naturally tested policy makers’ enthusiasm for deregulation; but no lasting lessons were drawn from Mexico: it was only the East Asian collapse of 1997 followed by the Russian and Brazilian collapses of 1998 that forced discussion of institutional reform. All four required the US Treasury to engage in large support operations24 through the IMF with somewhat reluctant assistance from Europe and Japan and without the consent of Congress. Indeed, Republican legislators remain unconvinced of the need to strengthen the capacity of the IMF to intervene in such crises, believing that losses should be fully borne by investors. It can be argued that it was only the collapse of Long Term Capital Management and its bailout by the Federal Reserve Bank of New York in order to prevent systemic collapse of Wall Street, that finally made the case for reform.25 It is generally agreed that reform is needed but there is little evidence of tangible progress. One problem is the lack of a clear idea as to what to do; but more crucial is the unwillingness of major states to act together. Even a minimal measure such as restoring the previous reserve requirements on international bank lending and doing so effectively would require concerted G10 action and vigilance of offshore operations. However, the US financial services industry has sufficient lobbying strength to block even this limited measure. Indeed similar supervision is required to combat the narcotics trade and has not yet been implemented.26 The two proposals on the table at present are relatively timid and yet the source of considerable


The ‘G22 proposal’ supported by Washington, is for the ad hoc grouping of leading industrial and emerging market countries convened by the US Treasury for the first time in 1998 to become more formalized. This is the only existing forum containing financial authorities from both developed and developing counties. The idea is to both strengthen financial supervision in emerging markets and maintain US control of the process.

Washington believes that Europe is over-represented in the G7, the G10 and even the IMF;

although abolition or restructuring of the IMF seems unlikely.

The UK proposal is for an international standing committee of the IMF, the World Bank, Bank for International Settlements and key national regulators to monitor international capital markets and report on the cross-border activities of major financial institutions. Supervisory authority would remain with national regulators, but the standing committee would ensure exchange of information; their work would be based on the Basle Committee’s ‘Core Principles for Effective Banking Supervision’, and the IMF’s ‘Framework for Financial Stability’ which is derived from it.27 None the less, regulators in industrial countries are responding to the increasing consolidation of the financial services sector itself. In the US cross-sectoral mergers are accelerating in anticipation of the repeal of legislation which prohibits linkages between banks and securities houses and insurance companies.28 Trans-border banking consolidation in Europe is being accelerated by the introduction of the Euro and thus riskless cross-border transactions. The ECB may be forced to take a more active part in bank regulation and act as lender of last resort like the Federal Reserve.

Finally, the reinstatement of capital controls are being reconsidered by a number of emerging market governments in the wake of the East Asian crisis.29 Although administrative controls are unlikely to return, financial liberalization is likely to be much more cautious in future. Taxes and reserve requirements on short-term capital flows based on the Chilean model are likely to become more common; while greater emphasis will be placed on encouraging FDI as a more stable form of external finance.30 Triad Coordination The provision of an orderly international capital market clearly requires not only improved banking regulation but also a reasonable degree of coordination between the three major currencies in order to reduce uncertainty and encourage longer-term lending. Indeed this was the aim - and achievement - of the post-War ‘Bretton Woods System’, although this was based on the US dollar

as a single world currency.

After the successful launch of the Euro, the dollar is no longer the only key trading and asset currency. Moreover, encouraged by this opening, the Japanese government is pressing for a currency grid system between the three currencies, supported by their respective central banks. In addition the Hong Kong Monetary Authority has suggested that an ‘Asian monetary area’ be established with cross asset holdings by central banks in the region (rather than holding reserves in dollar assets) and eventually a common currency for trading purposes. These notions are strongly opposed by Washington which fears the decline of the dollar as the leading world currency.

Moreover, the Federal Reserve is tasked to maintain low inflation and steady economic expansion in the United States. It is not responsible for the parity of the dollar, and traditional policy has been one of ‘benign neglect’ of the exchange rate. On the one hand, international financial affairs are the concern of the US Treasury. Indeed finance has become the principal instrument of US foreign policy since the end of the Cold War. On the other hand, Congress is wary of international monetary commitments, and has effectively prevented monetary coordination even with Canada and Mexico within the NAFTA - despite this being one of the contributory causes of the Mexican crisis in 1995.

The European Central Bank has an even narrower brief - to maintain low rates of inflation. Frankfurt has no responsibility for euro parity, and there is no provision for a central treasury function in Brussels either. Although there is every expectation that the euro will steadily strengthen against the dollar, this is not the result of a considered policy but rather due to demand for the euro as a reserve currency and the growing US trade deficit. The Bank of Japan is subject to the Ministry of Finance, which does attempt to intervene to stabilize the yen, but its effective powers are limited by the domestic banking crisis and thus the need to keep its own banks solvent and accommodate the reflationary fiscal initiatives of the government.

These are more than conjunctural limitations. In the case of the Federal Reserve and the European Central Bank they derive from a political axiom that monetary policy should be removed from elected governments and entrusted to ‘independent experts’ with strictly limited responsibilities.

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