Speech

The Challenges of the New Financial Economy: the Efforts of the IMF to Reduce the Risk of Financial Crises -- Statement by Flemming Larsen, Director, IMF Office in Europe

November 15, 2001

The Challenges of the New Financial Economy: the Efforts of the IMF to Reduce the Risk of Financial Crises

Mr. Chairman, Ladies and Gentlemen, members of the Commission des Finances and the Haut Conseil de la Coopération Internationale.

I would like to begin by thanking you for having invited me to take part in these hearings. My introductory remarks will place the actions of the International Monetary Fund in the context of the changing international monetary system, and I will go on to describe the reforms under way to enable the IMF and its member countries to face up to the challenges of an increasingly integrated international financial system.

A new financial economy

The term "new economy" usually applies to the revolution in information and communication technology (ICT) and its tremendous benefits for productivity and living standards. Another economic revolution under way for several decades already, which like the ICT revolution will take many more years to yield its full potential, is the emergence of a new financial economy.

Since the 1970s, economic reforms have gradually transformed financial systems all over the world and led to an enormous expansion in the role of market forces in pricing and allocating financial resources. This new financial economy has witnessed the emergence of many new financial instruments. It has also been characterized by rapid globalization, and the world's capital markets are more closely integrated today than ever before. As the financial revolution proceeds, the scope for further integration is considerable.

Large benefits ...

The new financial economy is generating huge benefits, which are felt by households and businesses alike. For example, an individual saving for retirement or a pension fund managing the pension contributions of enterprises and their employees can better diversify investment choices across domestic and international assets, thereby increasing rates of return. And businesses are better able to finance promising ideas and needed expansions of capacity. As a result, the financial resources are invested more efficiently, raising economic growth and living standards for all. It is the recognition of these benefits that has led so many countries around the world to liberalize their financial systems and dismantle restrictions on capital movements.

Furthermore, this transformation of the financial system has meant an end to the government—controlled systems that prevailed from the end of WWII until the 1970s or 1980s—and in some cases much longer. The government-controlled financial systems were highly regulated and designed to steer financial resources toward politically favored sectors and objectives. While these systems occasionally were subject to crises—sometimes forcing a country to devalue—they often appeared to be quite stable. However, this stability came at a considerable price in the form of a lack of competition, high costs of financial intermediation, and inefficient or outright wasteful allocation of scarce financial resources. Over time, two particularly serious drawbacks became increasingly apparent: the temptation of governments to finance growing budget deficits through their privileged access to more or less captive savings; and the inability of the regulated financial systems to sanction economic policies that led to high inflation. Financial liberalization has also made it much more costly for governments to pursue unsustainable fiscal and monetary policies—which is one of the key benefits of a market-based financial system.

... and new (and old) policy challenges as well

If the benefits of a market-based financial system are so obvious, why were the regulations put in place to start with? Why did not governments liberalize earlier? Here it is useful to recall that the government-controlled financial systems had been put in place as a reaction to perceived shortcomings of the liberal economic system that prevailed during the gold standard period prior to WWI. These shortcomings included economic instability and widespread social problems. Together with the establishment of social safety nets and the active use of macroeconomic policies for stabilization purposes, the government-controlled financial systems were also a response to the banking failures and the economic crises during the Great Depression. The implicit distrust in market forces played a key role in economic strategies adopted after WWII and remained prevalent throughout the industrial countries for several decades. Greater faith in markets has been gradually restored since the early 1970s when a search for new policies was prompted by an abrupt slowdown in economic growth, a sharp rise in unemployment, and a surge in inflation.

From such an historical perspective, it is perhaps not surprising that the return to a market-based financial system appears to be associated with a relatively high degree of financial volatility. However, while it is hard to dispute that the potential for financial volatility is greater in a market-based system, much can be done to prevent financial volatility from resulting in financial crises and also to reduce the severity of crises when they do occur.

In recent years, the international community has increasingly strengthened its understanding of the main risks and challenges associated with the new market-based financial system. It has also adopted a large number of measures designed to alleviate such risks and their consequences.

The most prominent challenges associated with the new financial economy include the following:

Destabilizing international capital flows. Many emerging market countries have been benefiting considerably from substantial inflows of foreign direct and portfolio investments. In a disturbingly large number of cases, however, changes in investor sentiment, often motivated by concerns about external or internal imbalances, subsequently led to abrupt capital outflows. Since 1994, such reversals of capital flows have contributed to severe financial crises in much of Latin America, large parts of South East Asia, and also in some transition countries.

Cross-border financial contagion. The globalization of financial markets has led many portfolio managers to invest across a large number of countries in specific industrial sectors or according to certain credit-rating categories. This strategy has increased the scope for contagion where market liquidity suddenly dries up for particular countries—not because of economic fundamentals in these countries, but because they may share some characteristics with another economy suffering a loss of market confidence. Contagion (and herding) can be especially prevalent where information about countries' financial health is limited.

Financial sector vulnerabilities and crisis proneness. The increased opportunities for profitable investment in a market-based system tend to augment rates of return. At the same time, they expose individual investors and financial institutions to greater risks, including those associated with speculative bubbles. Unless the increase in risk is appropriately managed, financial institutions can become vulnerable to unforeseen events that produce sudden declines in the prices of financial or real assets. A market-based financial system therefore can be associated with a greater risk of systemic crises, as witnessed by the many banking crises in both industrial and emerging market countries since the late 1980s. This problem may be particularly acute in the transition toward a market-based system because supervisory standards and risk management skills take time to develop.

Financial abuses. With globalized financial markets, there is a risk that it may become easier to launder illegally acquired money, for example stemming from drug trade or from corruption. A danger exists furthermore that it may become easier to evade taxes by investing in so-called tax shelters. Finally, there is concern that financial regulations and oversight mechanisms in offshore financial centers are not adequate, which can threaten systemic stability.

Growing public concern about these questions and associated equity considerations have been a key factor behind the protest movement against globalization in recent years. And the protesters in turn have increased the urgency for policymakers to address the problems.

Enhancing the Effective Operation of Market Forces and the Resilience of Financial Systems

Two conclusions in particular can be drawn from the recent financial crises. One is that for market forces to operate effectively, market participants need to have a much better understanding of the risks they take on than they appear to have had in emerging markets in the 1990s. The other is that a robust financial infrastructure is absolutely essential to reduce the likelihood that changes in market sentiment lead to self-fulfilling expectations of financial collapse and unjustified financial contagion across borders.

The international community has responded to these findings by developing and promoting the implementation of a range of international standards of good practices for economic policies and for the financial infrastructure (see Box). As countries implement these standards, the risk of disruptive shifts in market sentiment in response to surprises should diminish while their financial systems' resilience to financial crises should be enhanced.

The IMF and the World Bank, with our global membership (183 member countries), are particularly well placed to assist countries in the assessment and implementation of these standards. To this end, the Bank and the Fund are now preparing Reports on the Observance of Standards and Codes (ROSCs), working in cooperation with national authorities and standard-setting agencies. ROSCs are a vehicle for assembling summary assessments (or modules) of a country's progress in observing standards. The IMF is producing ROSC modules on data dissemination and fiscal transparency. The World Bank covers accounting and auditing, corporate governance, and insolvency and creditor rights. The IMF and the World Bank jointly undertake assessments of financial sector standards in the context of their Financial Sector Assessment Program (FSAP), which is aimed a assessing a country's financial sector strengths and vulnerabilities and constitutes the main instrument in our efforts to enhance financial sector stability. A ROSC module covering standards to combat financial abuses is currently under consideration.

Some concern has been raised that some of these standards may be too demanding for many developing countries. However, the standards are expected to be implemented only gradually, depending on individual circumstances and capacity for compliance, and on a voluntary basis. To foster ownership of this approach, countries are being encouraged to set their own agendas and priorities for reaching the standards.

The main aim is not to rate (or punish) countries but rather to provide constructive feedback to the authorities that can help them identify and implement regulatory and operational reforms needed for the development of countries' financial systems over time and their integration into global markets. The process is also used to identify priorities for technical assistance by the multilateral institutions themselves, by other standard-setting bodies, and by bilateral donors. Finally, the ROSCs provide market participants with timely information on countries' progress in implementing standards, which can serve as input into their risk assessment.

Currently, 164 ROSC modules for a total of 56 industrial, emerging market, and developing countries have been completed and over 100 ROSC modules have been published (see www.imf.org/external/np/rosc/rosc.asp).

Broader Efforts at Crisis Prevention and Resolution

The IMF is strengthening its crisis detection, prevention, and resolution instruments in many other ways as well. For example, to enhance our understanding of the constantly evolving international capital markets, the IMF's analytical work in this area has been concentrated in a new International Capital Markets Department, which began operations on August 1, 2001. In addition, a Capital Markets Consultative Group has been established to provide a forum for regular dialogue with financial market participants.

The Fund's ongoing monitoring and analysis of developments in both individual countries and in the global economy is increasingly being geared toward identifying vulnerabilities. We are developing analytic tools to provide early warning of looming crises. Of course, such tools are highly imprecise and need refining. There have been suggestions that the Fund should publish early warning indicators on a regular basis. However, this could be counterproductive because of the risk that such information could trigger a crisis. Instead, these indicators are likely to be used as an internal tool by the IMF to sharpen our attention to potential crises at an early stage. Their key purpose is to help the Fund provide appropriate advice to the relevant authorities sufficiently in advance to increase the chances that corrective measures will be taken in time. Examples of corrective measures could be a recommendation to modify an exchange rate system to reduce the risk of a speculative attack, or to adjust fiscal, monetary, or structural policies to address emerging imbalances in the economy.

Many international banks have also been developing early warning indicators in order to improve their risk management systems and meet the needs of their clients. The availability of such information makes it possible to differentiate better between countries. This helps to reduce the risk of contagion, which in fact has been much less of a problem in the wake of the recent crises in Turkey and Argentina than at the time of the Asian crises.

The IMF has also streamlined its lending policies in an effort to play a more effective role in preventing and resolving crises. This includes the establishment of new facilities, including the Contingent Credit Line (CCL), which is available to member countries with a strong economic track record. The basic idea behind the CCL is straightforward: the IMF offers a precautionary line of credit to countries that have met certain preconditions. This in effect augments the foreign exchange resources they can draw upon in a crisis. The knowledge that these resources are available may deter a speculative attack. By offering qualifying countries a seal of approval for their policies, it also reduces the risk that investors will pull their money out indiscriminately because of crises elsewhere. While our members have been reluctant to apply for the CCL—probably because of a concern that doing so might be perceived to indicate a fear of a crisis—several countries have in fact expressed an interest. This facility has the potential to become another important pillar of the financial architecture.

Many other reforms are taking place within the IMF to enhance the transparency of our policies and to learn from our experience—including the recent establishment of an internal evaluation office, whose director enjoys considerable independence.

Private Sector Involvement in Crisis Resolution

While much can be done to reduce the risk of financial crises, crises do occur. However, the costs of a crisis for the country concerned and for the rest of the world can be reduced considerably. This requires that an early understanding be reached that the country itself is taking the measures viewed as indispensable for addressing the root causes of the crisis. In support of such measures, which are intended to reestablish the country's external payments capacity, the IMF and perhaps other official creditors provide temporary financial assistance. The country's private creditors may thereby accept to roll over existing credit lines and maturing bonds and even to provide new financing. As a result, a liquidity crisis is prevented from turning into a costly solvency crisis, to everybody's benefit.

This illustrative crisis resolution scenario is the catalytic approach the IMF is always striving to pursue (except in rare circumstances when a country is deemed unable to return quickly to market financing, and is in need of external debt reduction). Unfortunately, in an actual crisis, things do not always work out smoothly, however, and the IMF continues to seek collaborative approaches to ensure private sector involvement. Recent crises have demonstrated the potential scope for reaching such agreements, although it is clear that their success depends crucially on the resolve of the authorities to implement needed reforms.

For private creditors, the expectation that such accords will be part of the crisis resolution process should help to reduce the risk of moral hazard—i.e., the perception that the IMF is always going to provide sufficient funds to permit private creditors to withdraw. While moral hazard concerns can certainly be exaggerated—as suggested by the considerable losses taken by private creditors in most of the recent crises and the high spreads on emerging market debt—it is unrealistic to expect the international community to provide ever-larger financial assistance in step with the rapid growth in cross-border financial transactions. Finding a constructive role for the private sector in the crisis resolution process is therefore a key priority for the IMF.

Tobin Tax ?

To reduce volatility in international capital markets, some have advocated the introduction of a small tax on foreign exchange transactions, to throw "sand in the wheels" and deter speculation (a.k.a. the Tobin tax, after the economist who first proposed it). The IMF is skeptical both about the feasibility of making such a tax universal (which would be necessary to avoid financial diversions) and about its effectiveness. In fact, to deter speculation—with prospects of large gains—a Tobin tax would need to be relatively high, which would also hit non-speculative, trade-related transactions. In addition, a Tobin tax would tend to reduce the incentive for "contrarian" investors to oppose market trends inconsistent with economic fundamentals. The danger is that a Tobin tax might reduce market liquidity and effectively increase volatility-clearly contrary to its suggested purpose. (Proponents of the Tobin tax sometimes heighten the appeal of the idea by advocating that its proceeds be earmarked for the poorest countries. Increasing development assistance is an objective that the IMF strongly supports but doing so does not require a Tobin tax.)

* * *

In conclusion, while a stronger international financial architecture is now emerging, the key to reducing the frequency and severity of crises requires that countries address policy weaknesses before the crisis hits. The failure to do so can be observed in virtually all of the emerging market countries that have experienced financial crises during the past decade. Indeed, one reality of the new financial economy is that for a country to enjoy the benefits of globalization and reduce the risk of destabilizing swings in investor sentiment, it will need to meet high standards in economic policies and institutions. Helping our members to do so remains a critical task for the IMF.