Speech

The Benefits and Risks Associated with the Wider Integration of International Financial Markets--Address by Shigemitsu Sugisaki

December 5, 1998

We must draw lessons from the events of the last 12 months, which have constituted one of the worst international financial crises in recent economic history, and reflect on what went wrong and what can be done to prevent future financial instability. This bears on the fundamental role of the IMF in giving policy advice to its member countries and helping strengthen the architecture of the international financial system.

The factors that have accounted for this surge in international financial transactions are well known and include the remarkable technological change that has reduced the costs for market participants; privatization of state assets; deregulation of financial markets in key industrial countries; growth of institutional investors; and macroeconomic and structural reforms in developing countries. This environment has encouraged institutional and private investors to hold a wide range of international securities. At the same time, financial innovations and international competition have made it difficult for countries to control international capital flows. Thus, the liberalization of domestic and international capital markets has implications for the kind of policies that governments will find it feasible to follow.

You may rightly ask what are the benefits and risks associated with the greater integration of financial markets. Economic theory tells us that the free movement of capital permits a more efficient global allocation of savings and directs resources toward their most efficient use. This movement raises the level of welfare in both the sending country and in the receiving country by creating opportunities for portfolio diversification, risk sharing, and inter-temporal trade. Indeed, in practice, the free flow of capital has been helpful in enhancing growth and raising the standards of living in those countries that have been successful in attracting capital and maximizing its use. We must not forget that if a number of countries in Asia and Latin America have been able to build vibrant economies and a modern industrial base, it is because their task was facilitated by free access to available external savings. This remains valid today, despite the increased focus on the risks, which is also appropriate. The risks to lenders and borrowers, and even to bystanders—which we refer to as contagion—have increased significantly for several reasons, which I will highlight using the examples of Asia and Russia.

As for Russia, in August 1998, the government de facto devalued the ruble, unilaterally restructured ruble-denominated public debt, and imposed a moratorium on foreign credit repayments. The crisis emerged because fiscal consolidation remained elusive and little headway was made in solving the underlying structural weaknesses. Moreover, insufficient progress was made in strengthening the rule of law and governance more generally. In the end, when markets doubted the sustainability of the commitment of policymakers to implement the economic policies, the crisis erupted. This teaches an important lesson for future reforms: that they be home-grown and enjoy wide political support. The experience also shows that financing of a budget deficit, in particular short-term financing or through the build-up of arrears, is no lasting substitute for fiscal adjustment.

Some of these problems can obviously be addressed by ensuring that serious financial imbalances are tackled in earnest, public debt is kept within reasonable bounds, and excessive leverage—especially in foreign currency debt—is avoided. Equally important is the need to strengthen the financial system and enhance its capacity to safely intermediate large foreign capital inflows. In a similar vein, much success can also be achieved by increasing transparency concerning the quality of the borrower. For this purpose, the systemic application of international standards for accounting, auditing, information disclosure, corporate governance, and the protection of lenders and investors from fraud and unfair practices will be immensely beneficial. These safeguards should be supplemented by strong, market-based incentives for prudential risk management by businesses, and especially by financial market participants. It should also be clear to market participants that shareholders, managers, and creditors will bear their share of the burden whenever an institution becomes insolvent. Finally, greater access to information on the flow of credit to emerging markets could provide early indications of excessive concentration of debt, which, together with more accurate assessment of economic risk, could lead to more prudent behavior on the lender’s side.

• The private sector has to be part of the prevention and the resolution of financial crises. The financing provided by the IMF and other official creditors cannot and should not substitute for private sector financing. Countries in crisis face two main options: to reach a voluntary agreement with private creditors or, as a last resort, introduce capital controls. Building on the experience from several cases that have recently required rapid and concrete action, the IMF will study further the use of market-based mechanisms to cope with the risk of sudden changes in investor sentiment leading to financial crises. As another way to ensure proper burden-sharing by the private sector, it has been agreed to broaden the existing policy—under certain conditions and on a case-by-case basis—that allows the IMF to provide financial assistance to countries in external arrears to private creditors.

• On capital account liberalization, as confirmed by the Interim Committee, the emphasis should be on an orderly and well-sequenced liberalization process. Introducing or tightening capital controls is not always appropriate to deal effectively with fundamental economic imbalances. Any temporary breathing space that such measures might bring would be outweighed by the long-term damage to investor confidence and the distorting effects in resource allocation. However, the IMF will review the experience with temporary impediments to capital movements and the circumstances under which such measures may be appropriate.

• The IMF, for its part, is contributing to transparency through greater openness about its own policies and about the advice it provides to members—and through publishing more external evaluations of the IMF’s operations and policies.

• Finally, there is a need to further develop and disseminate internationally accepted standards, including in the areas of fiscal transparency, monetary and financial policies, corporate governance, accountancy, and insolvency regimes to encourage good practices and to allow financial markets to differentiate better among borrowers. This will require close collaboration between the IMF and other international financial institutions. This is a tall order. What is called for is not "business as usual," but a fundamental change in the international monetary system.

Over the last decade or so, the MENA countries have made progress toward liberalizing their trade and exchange regimes and, to a lesser extent, moving toward achieving greater integration into the international financial system. Some countries, especially the Gulf Cooperation Council (GCC) countries, Lebanon, and Yemen, are already at an advanced stage of trade liberalization and capital account convertibility. Most MENA countries, such as the Maghreb countries, Egypt, and Jordan to mention a few, have made progress in eliminating import and exchange restrictions, lowering import tariffs, and adopting current account convertibility. In recent years, liberalization of inward capital movements has been pursued in most of these countries, together with a gradual relaxation of controls on outward capital flows.

These reforms, together with privatization and deregulation, were instrumental in promoting economic efficiency and attracting foreign direct investment—although the amounts were relatively small by world standards. They have also paved the way for increased economic cooperation with the European Union, leading in some cases to the conclusion of association agreements under the European Union’s Mediterranean Initiative.

With regard to financial integration into the world economy, MENA financial systems have remained less integrated into international financial markets, with the exception of Lebanon, the GCC countries, and to a lesser extent Egypt and Morocco. To be sure, efforts have been made in this area to strengthen financial intermediation by promoting market-based mechanisms, modernizing banking practices, and adopting international standards of supervision, as well as building the infrastructure of dynamic equity markets (Egypt, Morocco, Tunisia, Jordan, and GCC countries). These efforts have started to pay off in terms of mobilizing domestic savings and enhancing the attractiveness of the region to international investors; but more time and further efforts are needed for the rewards to become significant in terms of growth and employment creation.

Against this background, there are two ways of putting to use the lessons learned from the Asian crisis and from the unstable conditions in the international financial system:

• one is to halt or reverse the process of economic and financial liberalization on the grounds that the risks outweigh the benefits; and

• the other is to pursue the reforms with greater attention given to the need to manage a smooth transition to capital account liberalization, while putting in place adequate safeguards to reduce the risks of financial or currency crises. Proper sequencing of capital account liberalization is an important lesson that we have learned from the Asian financial crisis.

What should the MENA countries do? These countries have potential strengths on which they should build to ensure a safe transition to a greater integration into the international financial system. Among these strengths, I would mention, for example, the progress achieved in reducing fiscal and current account deficits, the relatively low inflation rates compared to past years, and the general reduction in external debt. Other strengths, in particular in the GCC countries, include the sizable amount of official foreign assets, the soundness and strength of financial intermediaries, and the low level of external indebtedness of the official and corporate sectors.

For all MENA countries, there is a need to strengthen further domestic financial systems by enhancing prudential regulations and supervision, in parallel with efforts to open up the sectors to foreign participation and to encourage competition. Steadfast progress in deepening capital markets would help improve liquidity, diversify sources of financing, and avoid asset price inflation in the wake of opening up stock markets to foreign investment.

Needless to say, sound macroeconomic management would help enhance confidence and strengthen these economies’ fundamentals. Unsustainable fiscal and current account deficits must be addressed in a timely and credible manner. In particular, while external debt has been reduced, total public debt has been increasing in a number of countries and should also be reduced. In the same vein, the monetary authorities must continue to exercise utmost vigilance in monitoring credit developments that could feed asset price inflation and weaken the quality of banks’ portfolios. Finally, MENA’s emerging markets—or those aspiring to become one—will need to establish a strong track record of openness and provision of economic and financial information. In this regard, several MENA countries are making substantial efforts to improve their economic and financial data and enhance its dissemination to the public. Early progress in these areas would help build a tradition of accountability, transparency, and good governance.

For those MENA countries that have not yet achieved full capital account convertibility (most MENA countries, except the GCC countries, Egypt, Jordan, Lebanon, and Yemen), there is a need to assess the appropriate sequencing of capital account liberalization and the strengthening of domestic financial systems. It is generally recommended that foreign direct investment should be liberalized first and, as the domestic financial systems gain strength and sophistication and the macroeconomic fundamentals improve, portfolio investment should then be gradually liberalized.

Let me now for a moment turn to the particular situation of the GCC countries, which have been adversely affected by the recent terms of trade shock. No doubt, the decline in oil prices has affected growth of non-oil activities and caused these countries’ fiscal and the external current account balances to deteriorate in 1998, and probably in 1999. When economies are heavily dependent on one single commodity, it is to be expected that the price instability of that commodity is transmitted to the overall economy. However, prompt and determined policy reforms must be introduced to reduce the financial imbalances, maintain private sector confidence, and sustain ongoing efforts at achieving a higher degree of economic diversification.

In concluding, I would like to say that the Asian crisis and the recent turbulence in international financial markets have been the product of domestic policy shortcomings and weaknesses in the architecture of the international monetary system. Now that we have learned the lessons of this crisis and the ensuing turbulence, our task is to address these shortcomings and weaknesses to ensure that the international community can continue to reap the benefits of free capital movements with minimal risks.