Transcript

Transcript: Financial Markets: Coping With Turbulence

December 1, 1998

PARTICIPANTS

Shakour Shaalan, IMF Executive Director
Charles Adams, Assistant Director, IMF Research Department
Peter Fisher, Executive Vice President, Federal Reserve Bank of New York
Arminio Fraga, Managing Director, Soros Fund Management LLC
Desmond Lachman, Managing Director, Emerging Markets Economic Research, Salomon Smith Barney

PROCEEDINGS

MR. SHAALAN: Good afternoon, ladies and gentlemen. We are very happy to see so many of you around and I for one am most delighted to participate with you today in the discussion of a timely topic, namely "Coping with the Turbulence in Financial Markets."

In recent years, I really do not recall an issue with more far-reaching dimensions and extensive proliferation of views on causes and cures than the issue we are discussing today. Today we have four very distinguished panelists who should provide us with a lively discussion. Much, actually very much, has been written the past year and a half about what was widely believed to be a run-of-the-mill financial crisis that broke out in mid-1997. That, as we all know, soon developed into an Asian crisis, then into an emerging market crisis, threatening the development of a global financial crisis.

We have heard or read a wide variety of views on the causes of the crises ranging from the too often repeated cliches of lack of transparency and crony capitalism and the like to much more substantive issues such as capital flows, exchange and banking systems, and institutions that were ill-prepared to deal with the risks of globalization, and of course we have the additional issue of the transmission mechanisms of this crisis.

One area that I hope we will focus on this afternoon is the features of the structure and behavior of international financial markets that have contributed to the volatility of capital flows. Markets may be right and rational in the long run, but it would be extremely difficult to so characterize markets' behavior in the short-term. The excesses of financial markets both in terms of heavy inflows where risk was not properly assessed and which inevitably led to massive outflows magnified by the herd mentality are recent reminders of this.

Financial markets ignored Asia's heavy short-term indebtedness which was very evident in the early part of 1997 and continued to lend short-term. Then we had Russia which was viewed as a country too important to fail. This attracted much capital from the private markets without due regard to risk. Market volatility will obviously continue to be with us. Then the question becomes how to introduce changes in the current state of the international financial markets to reduce the frequency and intensity of such crisis. What should the role of the private sector be in effectively participating in the resolution of these crises? How can they be made to pay for their mistakes? Will the provision of more information contribute to more rational market behavior? Should short-term capital flows be regulated? These and other issues will be discussed by our distinguished panelists.

First, if I may, I will call on Mr. Peter Fisher, who is to my left, and he is Executive Vice President of the Federal Reserve Bank of New York. Mr. Fisher has held a variety of important posts since he joined the Federal Reserve Bank in 1985 and currently he is the manager of the all important System Open Market Account for the Federal Open Market Committee which oversees, as you know, domestic open market and foreign exchange trading operations.

Incidentally I should mention that Mr. Fisher was an active participant in the rescue operation of the Long Term Capital Management Fund Problem. Mr. Fisher.

MR. FISHER: Thank you very much. It's a pleasure to be here this afternoon on this occasion to talk about these important subjects. I will strive to meet my usual test of being interesting but not newsworthy. You will be the judges of whether I succeed on either or both counts. I will try to focus my remarks.

The overall topic I want to address is the problem that we haven't spent quite enough time on diagnosis and we may have moved to prescription a little too quickly. Now let me get into that first by discussing the problem of metaphor. The problem that we've identified is contagion and the remedy that we've come up with is architecture. Now most of us learned somewhere in our teenage years that buildings don't stop germs. But I think, therefore, we have to come back and think a little harder. If our basic diagnosis was right, the first thrust that the problem is contagion, I think we better not rush and call in the engineers and the architects too quickly, but work a little more on the biological metaphor.

Now let me be clear. I like the biological metaphor. I find it very helpful that when we look at markets, we are looking at the interaction of independent organisms with one another in a highly complex ecosystem like environment. The biological metaphor also helps us understand that in the natural order, the natural order can produce continuous adjustment process with a range of equilibriums and indeed that some of them we don't like very much, but we really, in the biological world we don't make moral judgments about these. The natural order, though, produces some outcomes we would admit to be bad. It produces diseases and things we don't like.

But in grappling with our understanding of the subject, we try to avoid moral judgments of that kind. Now I also like the biological or medical metaphor because it reminds us to begin where doctors do, do no harm. Now, of course, it's important to keep in mind how much doctors failed in that regard for several millennia. A friend of my family spent his life studying the history of the wound, three millennia of science directed at trying to treat open flesh. And his conclusion was that until 1945, you were better off not seeing a doctor. So for two millennia doctors were taking an oath to do no harm and every time there was an open wound they did harm.

Now, let me be clear. I don't mean to cast stones at my hosts. You've mentioned that I'm the manager of the System Open Market Account. I'm sure that a hundred years from now or so people will look back at my role in organizing foreign exchange intervention as one of the great voodoo doctors of the 20th century in a long line who thought by adjusting the foreign exchange asset composition of my balance sheet I would somehow stabilize markets. So I think we all have to suffer with the problem of jumping too quickly to prescription and come back to trying to do no harm and working on, as I like to think of it, the biological metaphor, the metaphor about ecosystems.

Now I thought I would try just to focus on one issue. I don't want to pretend that this is all embracing theory of all the problems of the financial world, but I would note that a year ago many of us were focused on the problem of the transition from fixed to floating exchange rate regimes, the difficulty of exit strategies, and in the past year, I think we've lost sight of that as we have rushed off looking for prescriptions before I think we finished the diagnosis.

Now speaking of this as the exit strategy problem I think underestimates, understates the problem. It's not a problem of excusing yourself politely and getting up from a table to leave a dinner party. It's somewhat more profound than that. We're talking of a complete change in regime, a radical change from a regime, and let's also be clear going back a year two years ago, we all underestimated how profound a regime shift it would be for a number of economies to move from fixed to floating. All of us in the public sector and almost everyone in the private sector underestimated how profound a change it would be.

Now let me note again, I do not want to focus on the zero sum debate about whether fixed or floating exchange rate regimes are better, A versus B? That's not a very helpful way to go. The problem is the transition. Now for my own purposes, I have no ideological bent here. I believe that some fixed or rigid exchange regimes can work and do work very well. I sleep sounder knowing the People's Republic of China has capital controls and they are working to improve them. I think that's a plus for the world economy. There are a full range, a Hong Kong, Chile, Israel, there are all kinds of exchange rate regimes with rigidities in them that work.

Floating regimes also work. That's not the issue. Now, one can make a list of the countries that have been under stress and then one can have a rather hollow debate it seems to me: is the problem that they move to floating or was the problem that they had fixed? Again, I want to focus our attention back on the problem of the transition and how difficult the transition is.

Now, I like to think of the problem of the official policy toward exchange rates with an insurance metaphor. The question is how are we going to bear the costs of exchange rate volatility? You can apportion the cost, the risk, any way you want. You can try to socialize it. New Zealand says with completely open floating exchange rate the private sector should insure itself. That's one way of organizing the cost of bearing exchange rate volatility. Hong Kong says we the public sector will take that on. We will be the insurance company and we will collect insurance premiums through a currency board with high interest rates and the opportunity costs associated with holding large reserves.

Those are two perfectly reasonable ways to allocate the costs of exchange rate volatility. Now, we also know, and I think consensus was emerging over the last couple of years, that the in-between variants are more difficult. The banded regime in which the government provides an implicit insurance guarantee and an insurance policy but does not collect sufficient premiums is an insurance company setting itself up for a fall. And that I think is something that we have seen happen.

Now, it was fashionable four or five years ago to talk about borrowing credibility across the exchange rate. I think what we might pick up on when we hear those words now echoing across the decade is ah, the official sector was using leverage, and it was using leverage to borrow credibility. And it turns out that both the leverage and the credibility have been destroyed when you move too abruptly from a fixed to a floating exchange rate regime.

Now, my point is to focus here and show that we still don't have an adequate understanding. We're just beginning our quest into the biological science to understand all of the incentive problems that go on there. I don't mean to suggest that--again, to repeat--that fixed is better or floating is better. Both can work. It's the transition that we know is difficult and we know we don't yet fully understand how to cope with.

Let me make another point on this and show from my own expertise an avenue of showing how different the regime is. In a banded exchange rate regime, the central bank, as one of the animals in the ecosystem, behaves as a constant provider of liquidity and comfort to the financial system. As the exchange rate approaches the outer band, the central bank provides liquidity endlessly as long as it can and it's a warm and fuzzy central bank trying to comfort the banking system from the strains that it may be experiencing.

In floating exchange rate regimes, such as we practice here in the United States and many countries do, central bank intervention is a form of inflicting pain. There's nothing warm and fuzzy about the effort on the part of the central bank to intervene in the exchange market. It's intended to cause losses, to shock market participants into behaving differently than they have been behaving. Now, getting an ecosystem to move where this one animal, the central bank, plays completely different roles--I'm only repeating myself to say this is a regime shift. It requires changes in habit and the whole modus operandi of a financial system has to be changed. And I think, as I said earlier, we all underestimated that.

Let me mention one other area that I think looking at this as ecosystems and behavior or animals is the issue that Western or industrialized financial firms have worked very hard for the last 15-20 years on improving their risk management systems. They have very rapid and accurate and efficient risk management systems that have allowed them, as a number of people have pointed out, to commoditize risk within the firm, to treat risk efficiently and recognize it wherever it emanates from. Now, reflecting on the last several months, it occurs to me that this risk management discipline allows these firms to be more robust, not always. Some of them get in trouble. I don't want to pretend otherwise. But the firm, by being aware of its risk position, can adjust more rapidly causing more volatility in the market. That is it adjusts its problems away. It doesn't hang on to souring positions.

Now in a world where we've opened up and brought in a number of other countries into the global financial system, the disparity now between these robust animals that have worked much harder to have adaptable responses to their environment makes for an extreme contrast to the financial, the banks, and financial sectors of emerging market economies. And that contrast makes the world in which the emerging market banks operate more challenging.

Now, again, my interest isn't in making a moral judgment about whether the fast animals are good and the slow ones bad or vice versa. Either way. But understanding that ecosystem and the impact it has, I think, is the challenge we have.

Let me close by noting--I hope we come back to questions and there are many other subjects we can come to--by noting that about a year and a half ago or so I sat in an audience like this and there was a panel discussing similar topics, and I was very puzzled because someone on the panel began talking about the problem of multiple equilibrium. Now I didn't understand this. It struck me that multiple equilibrium was a good thing. The fact that we can constantly have adjustments and the system is constantly adjusting to itself is a good thing. So it took me quite awhile to get inside the speaker's mind and understand that multiple equilibrium was viewed as a bad thing.

Now in its extreme form, I understand this view encompasses the notion that there is a single good equilibrium and a series of bad equilibriums and our goal is to get to the good one. Now from my perspective that's a very awkward approach to the concept of economies and how the world economy works. I think that the range of equilibrium and the adjustment mechanism is what we have to work on. Now let me conclude by being very clear. I don't mean that--I would not conclude that that means there is no need for regulation or changes in global capital flows. It does mean that we should understand acutely the incentive structures. We should be conscious that any change in regulation is a change in incentive structures in this ecosystem before we try to introduce them. But I'm sure we can come back to these in questions.

MR. SHAALAN: Thank you very much, Mr. Fisher, for a most original presentation. The way I understand it you have at least two major points. One, we prescribed solutions too early before diagnosing the problems more carefully. And the other issue on exchange rate regimes, which I think you're absolutely right, the question is not what regime a country follows, and there is no necessary better regime than another. No one regime is better than another. The problem is moving, and I think Mr. Fisher has put his finger on it, moving too abruptly in changing regimes particularly in the middle of a crisis. That's when you have serious problems.

But let's move on and I would like now to call on Mr. Desmond Lachman, who is sitting to my right, who I'm sure is well known to many of you, as he has deserted the Fund a few years ago after a distinguished career in the Fund. He left for greener pastures and I hope he has found them in Salomon Brothers where he rapidly moved up the ranks working mainly or I think altogether working on, mainly if I'm not mistaken, on emerging markets. He is now Managing Director and still working on emerging markets unless Salomon Brothers has changed the name of the unit recently. Mr. Lachman, the floor is yours.

MR. LACHMAN: I should first thank Mr. Shaalan for the introduction and I should inform Mr. Shaalan that I am very familiar with the parable about the prodigal son and the story is not yet over. But let me address the issue of capital flows particularly from an emerging market standpoint. I agree totally with Mr. Fisher that it's very important that we make the right diagnoses before we give the prescriptions, before we're too ready to change regulations, but each time that I talk about this emerging market crisis, I'm very much reminded of the story, which probably is apocryphal, about Zhou Enlai in 1989 on the 200th anniversary of the French Revolution. When they asked Zhou Enlai what did he think about the French Revolution, he suggested that it was premature to draw definitive conclusions.

[Laughter.]

MR. LACHMAN: I'm not sure that we've got the luxury in this case. We've seen massive movements in capital markets. We've seen drying up of liquidity, something that we haven't experienced in many years. We've seen spreads on emerging market assets moving out to extraordinary levels, countries having to borrow at long-term, instead of at something like ten percent, having to borrow at 20 percent. That has very real consequences. I am also of the camp that this crisis is far from over, but I think that we should look very carefully at the issue of contagion.

I think that it's useful in that sense to distinguish between different episodes of contagion, and I don't think that we want to paint everything with the same brush. I think that we are dealing with issues that are highly complex. The three episodes that I'm referring to are the Asian crisis, beginning July 1997, that was driven by very different forces, I think, than the Russian crisis that we had in August 1998, and the Latin American crisis that I think that we're experiencing right now.

I think that when we look at each of these crises, what we've got to be doing is we've got to be distinguishing between the fundamental factors that underlie these crises and what might be called the technical or institutional factors that amplify them and that might be a subject of deciding whether or not there is something that needs to be done. But if I look at--a point that I would want to stress is that in each of these episodes, we did have problems of a fundamental nature. We might not have seen it. We might have been carried away by market exuberance, but there's absolutely no doubt that if you look at Asia that there were problems that were common to many of the countries in the region, that the Thai baht devaluation might have been a wake-up call telling us that countries had borrowed excessively in short-term in foreign currency, that corporates hadn't hedged their positions, that bank lending hadn't been very good. So that when the crisis actually emerges, I think the contagion has a rational explanation to it.

I would say likewise in the case of Russia. Anybody who questions that Russia's fundamentals were worthy of investment you know wasn't operating in the markets at the time. I spoke to many investors during the course of the early part of this year. Most of them who did take positions on Russia were doing this on the argument that Russia was too big to fail and that the G-7 would be around to bail them out.

Likewise, right now what we're looking at when we're looking at the Brazilian situation, when we're looking at Latin America, large public sector borrowing requirements, large rapidly growing public debt stocks, overvalued currencies, all of this doesn't sound to me like the markets are being irrational in focusing on those fundamental factors. So I think that the fundamental factors really do play a part.

This gets amplified in markets with what Mr. Fisher is referring to as the incentive system that one sees in the markets, a tendency to focus very much on the short-term, a tendency for there to be too much leverage, not sufficient in the way of risk management, but that then begins to interact with the poor fundamental situation.

You know we saw that most clearly in August 1998 with the Russian debacle when we saw deleveraging on a scale that was truly tremendous and that has left lasting damage from the emerging market point of view. You know we believe that part of the investor base is now going to be damaged for awhile. We're having proprietary accounts being closed down. We're having crossover investing from high yield domestic asset managers in the United States who ventured into the emerging market world who are unlikely to return. So it's very likely that we're going to be living with high spreads for awhile.

The issue is what do we do about this, and I would share the notion that, you know, it's one thing to talk about architecture. Many of the things that are being said in the realm of architecture, it's difficult to disagree with that there should be more transparency, that there should be better bank supervision, that there should be better provision of statistics, all of that is fine and good. I have to confess, though, it has to me a ring of Halifax 1995 in the post-Mexico crisis to it. I'm not sure that that is going to get us too far.

But where I think the areas that I would say in terms of the architecture where more can be done would be in terms of IMF surveillance, you know where one could be getting very much closer surveillance, where one could be getting provision of judgments to the markets in a more timely way to try to influence them in some sort of way to alert them to the fundamental weaknesses to which I alluded, and I have to say that having been on Wall Street now for two years, I'm in the camp of those who would like to see some regulation of short-term capital flows by the countries involved. I'd be very sympathetic towards Chilean style capital controls. I'm not sure that I see what economic purpose short-term flows across borders do that one should be looking for some price-based way of regulating it.

Finally, I would just say a word, that on dealing with the fundamentals I think there are two areas that are certainly of concern right now: those pertaining to Asia, those pertaining to Latin America, where hopefully one is going to see the right sort of policies, but just in terms of the Asian story, what is of particular concern to me from the marketplace is whether or not the structural problems in Asia are being addressed with the forthrightness that they demand if we are to avoid a Japanese sort of situation where we're getting countries stuck at a very low level of growth. With that, I'll close my remarks.

MR. SHAALAN: Thank you very much, Desmond. Desmond has given us a view from Wall Street, and he has emphasized, as you must have noted, capital flows and possibly the need for some market-based regulation of these inflows. He has distinguished between three types of crisis: the Asian, the Russians and the Latin Americans. But he has come up with also a very provocative statement, namely that contagion is rational and in turn, of course, if one accepts that premise, then it would follow that markets are rational, too.

So I will stop here and maybe we can pick up that theme later. But for now, it's really a great pleasure to introduce to you Mr. Arminio Fraga, who is sitting to the far right here, who is Managing Director at Soros Fund Management. This unit, I should say, is the principal investment adviser to the Quantum Group of Funds. I understand--I hope correctly--that within this group the Quantum Fund is recognized as having the best performance of any investment fund in the world in the past 20 years. That's the whole history of the Fund.

I'm not, however, sure whether that enviable record includes the hedge fund, the Soros hedge fund. I don't know how it's related, but maybe Mr. Fraga can tell us. In addition to his demanding work at Soros, Mr. Fraga had an illustrious career both in academia and also with the Central Bank of Brazil where among other things he was negotiating with the IMF on behalf of Brazil. Currently, Mr. Fraga is a professor at Columbia University and has taught at the Wharton School. Mr. Fraga, it's a pleasure to have you with us.

MR. FRAGA: Thank you very much. Thanks for the kind introduction. The Quantum Fund is the hedge fund. And it's been in existence for 30 years. I've only been there for six years. But what I'd like to do is to follow up on my two colleagues here and address the topic of coping with turbulence and in particular I'd like to start with two questions.

First, can we avoid boom-bust sequences? And second, is contagion really a problem per se? So starting with boom-bust sequences, in preparing my remarks over the last few nights, I found myself in thinking about boom-bust sequences, I found myself flipping through a book by a Mexican historian that I am fond of mentioning called A Century of Debt Crisis in Latin America. And I emphasize a century. That made me think maybe this goal of avoiding boom-bust sequences is not a reasonable one, and to telegraph my conclusions I think the answer in the end is we cannot, but maybe that's not such a bad thing.

Now, the pattern or the patterns, the generic format of such sequences, has been studied and documented by a lot of people including, for example, Professor Charles Kindleberger, and they typically start with abundant liquidity, whatever that may mean. If you look at the current literature on the subject, the initial driving force seems to be on the side of the so-called external factors to a country as opposed to internally driven policies and so on.

After awhile, complacency sets in and we start seeing perhaps a little more consumption than would be advisable or bad investments or excessive budget deficits. You name it. And these phenomena tend to keep going while the liquidity is there and this may have to do with market technicals to which I'll return in a minute. And it's very hard to pinpoint exactly in this sequence what will lead to trouble and when the trouble will arise. And in particular I find it hard to predict whether we are going to see a crisis based on where the money goes, i.e., whether you've had a consumption boom a la Mexico or an investment boom like in Asia, or budget deficits like in Latin America in the '80s.

I'm not sure that really allows you to distinguish or to pinpoint a crisis or maybe we have a tautology here. What seems to me clear and to be a clear sign of danger is the third stage, which is when maturities start to shorten up; for some reason or another, companies, investors, start to get a little nervous and they think that they can deal with that by shortening the horizon of their lending and that to me is a crystal clear sign of trouble.

At that point, I would say then the system is ready for a shock, and when a shock comes, you know, it's always terrible. We never know exactly what's going to drive it, whether it's a reversal in monetary policy in one of the big countries, the Fed, or there's a war, or major default like in Russia. Again, I almost think it doesn't matter because it's the vulnerability that there that set the stage for a crisis.

Now, these cycles happen and they are all slightly different and each time we tend to forget the lessons we learn from the previous cycle, and that I think is going to be the pattern going forward as well. What is clear, and I don't want to sound like I'm completely ignoring the so-called internal factors as opposed to the external liquidity driven factors, because clearly not every country, for instance, gets into trouble when there is a problem. So the fact that we are in a world that is driven by these sequences doesn't mean countries don't have an incentive to behave.

Now, in looking at these sorts of situations, and as an investor I tried to focus on a few items, and I'll just mention them here for the sake of completeness. Definitely budget deficits, both explicit and implicit, i.e., deficits that may be there brewing in the financial sector or also on state-owned enterprises in addition to the regular measured budget deficits, weak financial intermediation practices, and particularly in situations where, as mentioned here before, you have bad perverse incentives. That's something always worth keeping an eye on.

And finally, last but not least, politics. We find it to be very, very common that governments acting in what typically are short horizons, the horizons of their mandates, may do some silly things. Maybe they try to sustain that exchange rate just a few months more and then by then they'll be out of office, that kind of thing. So these are three factors.

And so to conclude on the boom-bust sequences, my view is that they can't be avoided. In many ways, we're still learning how to deal with the post-Bretton Woods regime with more open capital flows, and it's a learning process. The hope is that we are really learning and that in the future, some of the lessons will be remembered, but we can't even be sure of that.

Moving on to the second question, the issue of contagion, I ask you does it really matter--contagion? And my view, if you accept the fact that boom-bust sequences are part of the nature of this financial world we live in, then contagion is probably not that relevant. It's the boom-bust phenomena that matters, not so much the contagion.

But what is this contagion? What are we talking about here? It would seem to be the case that it would matter if we had countries that were in beautiful financial shape and these countries all of a sudden got hit by an unforeseen event and they got punished as a result, and I find quite frankly that I have a hard time coming up with a good example of a country that's in that situation.

So anyway the other thing we tend to forget when we deal with contagion is that there is positive contagion as well--don't forget that--as part of these boom-bust things. When you're in the boom, you know, money goes in and it goes in everywhere and because one country is doing well, the other country may attract some money, and so it's not just a one-way street contagion hurts you. Where it comes from, and there is such a thing as part of these boom-bust situations, is it comes from portfolio adjustment of investors facing gains or losses in their portfolios and changing the weights or rebalancing their portfolios. It comes from capital management practices, and particularly what Peter Fisher mentioned I think is very, very important in these days where financial players try to maximize or optimize the use of their capital. If they're operating very close to capacity and something happens, they have to respond, they have to sell, and that tends to be problematic and, in fact, that's one instance of what I think is a general pattern of trend-following behavior in financial markets that Soros has discussed in his books and in some of his statements down here in Washington.

Anyway, just to sum up, therefore, I think contagion is not per se a problem. I think the problem is rather these major cycles and I'd love to discuss that. Moving on and getting close to the end here, I found a couple of the questions on the announcement for this roundtable were also questions that I wanted to address. One was when can we count on resumption of capital flows to the emerging or submerging world? And here I would keep an eye on two things, and I'm not making a prediction here, but I tell you what the thinking process could be.

One is the so-called push or external factors. I think we've seen a bit of a reversal there with the Federal Reserve cutting rates, Japan perhaps doing some things. And the second factor, of course, is adjustment in the borrowing countries, and I really believe that in the end the capital flows will resume when they are no longer necessary. So it's again standard practice amongst banks that they very much like to lend to people who don't need the money. Maybe there is a role, therefore, for this institution, for the World Bank, to lend in counter-cyclical fashion. I think that makes sense, particularly if you have this view that I have that markets are not quote-unquote "perfect" in the textbook sense.

Finally, there is the issue of the IMF, and I don't feel I'm in a position to give the IMF any advice having perhaps lived through these extremely difficult market moments of the last couple of years myself, but I would say that the emphasis on the financial sector is correct and is very important. I would add that somehow we need to learn how to deal with short-term capital flows as a policy matter.

When I was at the Central Bank of Brazil, we had a concern with the maturity profile of the debt of Brazil as we were renegotiating the external debt of the country and then as we were opening up the capital account. A major concern was that there was an externality at a macro-level and you don't want to allow your maturities to be concentrated. I think that's a lesson that is worth keeping in mind.

And finally I get the feeling--and I don't have more than that, it's a gut feeling--that we are probably now in a world where there are too many exchange rates, too many currencies, and maybe that we are overshooting here as well, maybe a boom in currencies after a Bretton Woods type of situation. And that maybe the IMF has a role in thinking about and perhaps coming up with or working with regions so that we have a less exuberant exchange rate menu. Anyway, I'll stop here. I've spoken too much. Thank you for the time.

MR. SHAALAN: Thank you very much, Mr. Fraga. You have added yet another dimension raising two good questions at least. One is the boom-bust sequence and certainly I for one would agree with you that it's going to be here to stay. It has been around for hundreds of years. It will continue to be here.

The second question is contagion, and you argue that it's probably not relevant. Because you define contagion as the crisis spreading to a perfect economy, and since you couldn't find the perfect economy, then, of course, the crisis had spread. Well, for that matter, I don't think there is a perfect economy exists in this world. So maybe we're looking for something that doesn't exist.

You rightly, I think, mentioned the liquidity problem. Liquidity, complacency, maybe increases, undue increases in consumption, and/or investments. But here, we as economists tend to have an unconscious bias towards believing that if the expansion is caused by investments, then it's not as bad as if it were caused by consumption. That's a questionable assumption because in many ways a boom that is based on excessive investments can be much more damaging than one that's based on consumption.

I will stop here and call on our final and last distinguished speaker, Charles Adams, who has been with the Fund for 15 years. I must say Charles, though he's been in the Fund for 15 years, does not stay put in any one place for any length of time. He has worked in five separate departments in the Fund, if I'm not mistaken. But that really gives him a broad experience and he is a scholar of great repute and for whom I personally have the highest regard. Charles, now you have heard from all our other three panelists. We're anxious to hear your views.

MR. ADAMS: Thank you very much for that introduction. Being the last speaker, I think I have the advantage of being able to respond or at least tailor my remarks very much to what my colleagues have said beforehand. So I'll deviate somewhat from my prepared text to deal and address some of the, I think, extremely important points that have gone forward thus far.

Let me go through a few of these points and then raise some additional ones. First of all, the issue was raised are we too quick to prescribe cures to the difficulties, for example, in Asia, and I think that the "we" here refers to the international community as a whole. I think, yes, there is clearly a sense in which we were, we did move quickly in the case of the Asian crisis, but, of course, a substantial measure of this has to do with dealing with the crisis when it happens and having to come up with solutions. What we have now with time is the opportunity to go back and rethink the approaches that are taken to try and address some of the fundamental questions about the sources of the problems and to deal with cures not just for immediate problems but cures also more generally.

And I think in this context I would note a couple of particular points about the lessons coming out of the Asian crisis. One is one does, of course, begin with the countries concerned, and of course the initial efforts have focused on identifying weaknesses in those countries in financial systems, et cetera, which contributed to the problems. I sense as we move through the spread of the crisis to other emerging markets, to Russia, and most recently to the pressures in Latin America, a greater recognition to ask the question are there features of the system--of a systemic aspect of the system-- that contribute to the difficulties over and above particular problems in individual countries?

And I think this approach, this questioning, is part of this process of trying to prescribe cures, but the issues raised are difficult, clearly difficult, and there is, of course, this extensive work program on what's called the international financial architecture. I would just note in passing one aspect of the system which I think is important, which I believe a couple of my colleagues have referred to.

Call it disparities, call it differences across countries, what we have at the moment is a system in which many emerging markets have begun to participate in international capital markets. We have simultaneously some very mature, sophisticated financial markets with strong financial infrastructure, strong financial systems, we have a range of countries in terms of degrees of strength of financial systems, accounting standards and the like.

I think one aspect of thinking about the Asian crisis and some of the emerging market crises is how this system operates with these disparities, with these differences. I think in an ideal world one might have imagined, one perhaps would have seen less capital flow into some of these emerging markets, given all the problems that have subsequently been noted about the markets, the lack of accounting, problems of supervision, but the capital did flow so we got ourselves in a system where we had the flows of capital before we had all the supporting infrastructure, financial strengthening that perhaps would have made it possible for this capital to be digested efficiently at appropriate risk. So we had a problem there.

And I think another aspect of the problem, and this is where perhaps things move somewhat fast, is that we have a system where capital can move very quickly in both directions, where when concerns are raised, it can move out very fast, and we don't really I think have the complete understanding and consensus of the role in this system of, for example, international lending versus international bankruptcy type procedures. We don't, in short, have all the elements of the crisis management there. So I think that's another sense in which things have moved fast in one area but perhaps not in another.

The issue of exchange rate regimes was raised and I think the focus on the transition between regimes is the appropriate focus and, of course, a difficult focus. I think in the case of the Asian crisis, this was an issue. We had countries that had relatively stable dollar exchange rates, who at the time of the crisis, several of whom went into what were relatively quote-unquote "freely floating exchanging rates," and there were enormous difficulties created given unhedged foreign exchange exposures, given these exposures in the financial system and we had a rather vicious circle set up.

So I think this is a key issue but I think in a proximate sense it's very difficult issue at a particular time, particularly in this case in the experience of Asia because while many of us might have liked to have seen, for example, discrete orderly adjustments in some exchange rates that had gotten out of line, in several cases these adjustments did not occur early. International reserves had reached low levels. Confidence had already been diminished significantly and any adjustment took place in anything but the most desirable of circumstances.

So a key aspect of transition, I think, coming out of the Asian experience is that transitions have to be done in a timely manner, but this at the same time I think raises the problem of how it is that you affect these transitions and particularly how you can prepare systems-- in terms of the extent of exposures and the like-- to foreign exchange risk. At least one of my colleagues mentioned the possible role of Chilean type taxes or more generally concerns about the volatility of short-term capital inflows.

I think one can see a case under certain conditions for Chilean type taxes on short-term capital inflows. But I would prefer to see these as part of a broader effort to strengthen prudential regulation, to strengthen liquidity management, to basically deal with the risk management of institutions. Against that background, a Chilean type tax may play some role, but of course one needs to recognize, number one, that the incentives that people have to avoid these taxes can be high. And secondly, that they're unlikely to really be, I think, a clear substitute for the underlying improvements that often need to be made.

There is the issue of the boom-bust cycles in international capital flows. I think this is a key issue and I think it's important, as several people have recognized and stated explicitly, this is not a new issue. We've had these cycles, cycles of rapid capital inflows and then rapid capital inflows. We've had them for at least a century or so. It's not a new problem. I don't think it's a problem that is suddenly caused by some new moral hazard in the system. This is a feature of markets.

But maybe part of the difficulty is that when we focus on the boom-bust cycles, we tend always to focus after the event on the bust and perhaps too little on the boom, and I say this because I think one of the aspects of the period leading up to the Asian crisis, which is notable, is that we saw a compression of spreads across a very wide range of debt instruments in the lead-up, in the build-up to that period. We saw a change in the pricing structure of risk. We saw significant types of capital inflows to particular countries.

There were at least some elements before the crisis which I think was starting to raise some alarm bells. I think if we are to deal with boom-bust cycles, and I agree that that is not the issue of avoiding these cycles, but hopefully reducing to some extent their amplitude, it's important in an ex ante sense to be able to identify the elements which may be characterizing this build up period and deal with that rather than simply after the event deal with the problems of the bust.

On the current crisis that we've seen in the last 12 months or so, the issue to my mind is how it is we get from initially a set of problems in Bangkok to problems in Seoul, to problems in Malaysia, to problems in Russia, and then to problems in Latin America. At one level, this is the issue of contagion, of course, but I think there are questions about how it is that we get this spreading of the crisis. And the case of the pressures most recently, there is, of course, the issue about how we got from the events in Russia to a situation in which we had liquidity problems, we had rising risk spreads in some of the deepest and most liquid capital markets in the world, and I'm talking here, of course, about some of the pressures in the U.S. markets that were faced.

I think there are substantive issues here to do with a period leading up to this time when there were very large build up of highly leveraged positions, where there were various plays being made on yield spreads which created a situation of vulnerability and fragility, and then we had a trigger event like Russia that perhaps through effecting a reevaluation of default risk and perhaps Malaysia's capital controls affecting transfer risk, which basically snapped this and led to a process of rapid adjustment and rapid deleveraging, which in the process caused these severe problems in the short-term.

I think there is both a plus and a minus there. The concern, of course, is about how these positions built up and the vulnerabilities. I think the positive side is that given the problems that occurred, the process of deleveraging occurred very quickly. We got quick adjustments and mistakes. We have in capital markets a process whereby these adjustments can be affected relatively quickly.

Let me turn now to the question that was raised about the outlook for the emerging markets. As has been noted in the aftermath of the Russian crisis, we saw this apparent general increase in risk aversion and an apparent reassessment of risk. The consequences for the emerging markets of this reassessment I think were fairly dramatic in at least two dimensions. One was we saw a very sharp blow out of spreads of emerging market debt and a fairly indiscriminate blowout. It wasn't just one or two countries. It was across a large range of countries. So basically there was a repricing of the external debt.

Secondly, and most importantly, new external financing for many emerging markets effectively ground to a halt for a couple of months following the crisis. If this had continued, this I think would have put severe pressures on many emerging markets and would have triggered even more severe problems. As things have evolved, we've had actions from a couple of central banks, at least on interest rates. The Fund has had a package with Brazil. We have seen the situation stabilize. Spreads are starting to come down and we are seeing a reopening of capital markets in some emerging markets. We are starting to see new financing come back, but still at a subdued scale, and I think as several people have noted the situation remains relatively fragile.

Looking forward when the current turbulence is through, I think there remains this issue about the boom-bust cycles. I think they are a reality in international financial markets and in financial markets in general. But perhaps the message for the emerging markets, until we make greater progress in trying to address issues about the amplitude of the cycles, I think the message is a message of trying to make one's financial systems as resilient as possible to these types of swings.

One clearly needs to improve financial sector resilience, but there are also, I think, other things that can be done. I think as the Argentine experience has shown, there is scope for various forms of prefunding, credit lines and the like that emerging markets can subscribe to in dealing with some of these periods. There are issues about reserve management and levels of reserves, and also, of course, there are these issues about the volatility of short-term capital.

But I think the reality is that one will see these cycles, hopefully with smaller amplitude. So the substantive issue really is to make financial systems more resilient. And on a more positive note I think when one looks at the experience of Latin America, which has been through these episodes many times, one has seen the efforts that have been made to improve financial sector resilience, to make the systems more able to withstand these swings. And I think those have contributed importantly to some of the Latin countries being able to withstand the recent turbulence. Well, on that, I'll end.

MR. SHAALAN: Thank you very much, Charles. Being the last speaker certainly has an advantage. You managed to pull together some of the issues raised by previous speakers, but you also raised a new one which I personally found interesting, namely the international monetary system we live in is not tailored to suit all countries and hence we're likely to have problems. You cite the fact that too many of these countries, the emerging markets, flows of capital were probably too sizable and too premature for their stage of development.

You were less inclined, I think, to favor capital inflow regulations a la Chilean type, preferring instead or suggesting that they should not be used as a substitute for appropriate economic policies, whereas our previous speakers have clearly--I think--clearly leaned more towards some form of capital regulation.

I hope with these differing views, we can have a lively discussion from the floor now. I would first like to thank our four distinguished panelists and invite questions from the floor. I'll get three or four questions at a time and then we'll answer them. The gentleman here.

QUESTION: I have a question for Mr. Fraga. He's suggested or said that there are too many currencies which suggest that there should be fewer currencies. And I'm asking if he could expand on that a bit? And for Peter Fisher, Mr. Adams referred to a recent turbulence of our own in the New York market on derivatives business with which the Federal Reserve Bank of New York was instrumental in addressing that, and I was wondering if Mr. Fisher could tell us as much as he can without being newsworthy what happened?

MR. SHAALAN: Okay. Can I ask for a few more questions? Yes.

QUESTION: To follow-up on Lang's question, and the point that Mr. Fraga had raised at a previous seminar where Richard Cooper was sitting where Mr. Fraga is, he said that he was becoming more and more persuaded of what he called a subversive opinion. He then said we have learned that the adjustable peg is inconsistent with liberal capital mobility and he said I'm becoming more and more persuaded of this subversive opinion that it is also--liberal capital mobility is also inconsistent with freely floating rates and is really consistent only with a common currency, which would point in the direction certainly of fewer currencies.

And I would be interested to hear the comments of the on this question.

MR. SHAALAN: Very well. I think I'll stop here because the two gentlemen have asked several. I was expecting four, but I think we have about ten questions now. Maybe Mr. Fraga, maybe you can start with the too many currencies notion.

MR. FRAGA: Okay. A few things led to that remark, some of which I think have to do with the classic question of an optimal currency area, but I was actually thinking--and I'll start there--about a much less perfect world where we're not quite dealing with the notion, the pure notion of an optimum currency regime or area. I had in mind just the historical experience or experiences of quite a few countries and I mentioned Brazil--being Brazilian, at least I'll offend only myself and some of my country folk present here--where quite frankly for Brazil--Brazil is a large economy. It may not be the best example. But maybe you can think of Mexico. Having had the right to issue its own currency over the last 50 years has not exactly been a good thing.

So that's kind of the basic starting point that I'm thinking about. But I believe it goes beyond that and I think in thinking of, therefore, having fewer currencies, the benefits come from a variety of factors. One is general discipline and credibility and that comes with history, and, you know, you can try to get it the hard way over time or you can try to join forces with some other countries. That was one idea.

But I also think it has to do with the depth and the maturity of a financial sector and perhaps more importantly the problems that can arise from that lack of depth and maturity and in other words, we should think, as you consolidate under a sturdier umbrella you do well.

And finally on Professor Cooper's view, I think it's now kind of the standard view, the consensus that migrating towards one of the extremes of either full float or some sort of currency union, currency board is the only way to go, and somehow reality is not quite there. There are very few pure regimes in the world, and I don't know that I agree with his view. I actually think you can have a floating exchange rate with free capital mobility provided your financial sector is deep enough and is well capitalized, well regulated, but maybe some of my colleagues will disagree with that or add to that.

MR. FISHER: I'd rather keep going along on the exchange rate issue than take up the other topics.

[Laughter.]

MR. FISHER: So let me be quick to jump in. I think Arminio is right to begin with the optimal currency zone issue. Whether there are too many or too few, there are all sorts of questions I think one has to sort out there. For whom? For whose benefit, I think is a real issue, and against what test are we judging? Now I will leave to people in this room more scholarly than I in this regard, but there are two aspects of the 20th century that we have to confront simultaneously. One is the terrible inflations that we have created through the invention of fiat money.

The second is the extraordinary rise in the standard of living of a large part of the world's population. Now I don't know what the cause-effect relationship is between the two: the movement to fiat money, government controlled money. Some countries, everyone can look at a 50 year history, as Arminio suggests, and say this doesn't look like it was a good thing, but I think to take a step back and look at the century as a whole, we have to deal with this irony: that we think inflation is bad and destructive and corrosive and all sorts of things that we central bankers certainly believe, but we also, more or less contemporaneous--perhaps the causation is more illusive with a movement to fiat monies--we've had a tremendous expansion increase in standards of living in the world.

So I think it's against those sorts of tests like that, standards of living and for whom that we ought to judge how many currencies, not what looks to me like sort of inside baseball issue about do we like volatility or not volatility on a two to five year horizon. That doesn't seem to me the useful stopping point or starting point for the question of are there too many or too few exchange rates.

I'd like to be clear, I mean I think clearly fixed regimes, floating regimes both work as I said. I like the selection of Hong Kong and New Zealand as offsetting examples. If there's an exogenous shock, they're both going to take it somewhere. I guess I've got a keener sense in my mind of what the current contraction is in Hong Kong. I think it's a little more extreme than in New Zealand at present, but I don't think that changes the calculus that either regime can work with more or less free flow of capital in both cases, but you can't have a free lunch. You're going to take the shock somewhere. And I think I'll leave it there.

MR. SHAALAN: So you get the shock regardless of the exchange regime then?

MR. FISHER: Yes, absolutely.

MR. SHAALAN: Any more views on the--Desmond--on the exchange rate?

MR. LACHMAN: What I would have thought that one of the lessons that one would have drawn from the Asian crisis was the dangers of having fixed exchange rates that were adjustable at times and holding on to exchange rate pegs for too long, and I think that once the dust is settled, you know, we might instead of focusing on the inflationary consequences of fixed exchange rate regimes, we might be seeing the price that one pays to hold on to an exchange rate, that we might be looking at very deep recessions and a deflationary process. I myself am very much in the camp of thinking that there really are only two logical possibilities.

One is you either within a currency board or else you've got to be having a system that has a considerable degree of flexibility in a world where you've got capital coming in and out.

MR. ADAMS: If I could just add two points. I mean I certainly agree with the points on the Asian experience and I think what happened there in exchange markets does raise some important issues. On the more general point, I'm not totally familiar with Professor Cooper's points, but I think one could kind of recreate some aspects of an argument that went along the lines of common currency areas typically but not always being, having the same political units, the same laws and the like, there being elements in those systems. Of the other extreme, we have many countries with different currencies. It's not entirely clear whether some of the volatility and noise we see is because of the different currencies, because of the different risks, because of different systems and the possibilities of capital controls.

There is many factors weighing on these things. And once you move away from that very clean case of a unit, a political unit with a single currency, free mobility of factors, I think it starts becoming very fuzzy.

But third as a final point, I think we are thinking much more carefully now and certainly some of us are becoming more skeptical about the ability of some of the smaller countries to be able to manage some of this noise in the system. I don't know whether that leads to reducing the number of currencies or to sort of more formalized rigid pegging within the context of regional exchange rate zones. I think these are various options. But I think one has to always remember there's at least exchange rate, capital control, political type dimensions to these things, and it's often difficult to sort them out.

MR. SHAALAN: Thank you very much, Charles. Maybe I should invite other questions. Young lady there.

QUESTION: I'd like to just say that I'm a little surprised by Mr. Fraga's fatalism, that there is nothing we can do, there always have been ups and downs, and so just get used to it and live with it, especially when we look at the human consequences of some of these ups and downs. I think in the United States at least since FDR, we have taken major steps to avoid some of the most dramatic sways within one political unit and I think the challenge now is to broaden that and so I would step back from the fatalism. So that's sort of a statement.

I'm interested in your comment, sort of a growing consensus almost of the need for some kind of regulation of short-term capital flows, but all that's been mentioned is a timid reference to the Chile tax, and I'm wondering if you would want to be more creative and say what other options are out there?

MR. SHAALAN: Thank you very much. Can I ask one more set, one question? Go ahead.

QUESTION: I would like to ask you all one question. That is how could you evaluate the current situation of financial turbulence in Asia? Has it already touched the bottom? Thank you very much.

MR. FRAGA: Just a comment on the comment. I definitely don't mean to say we should do nothing. What I do mean to say is that we should expect turbulence and then there are things you can do. For example, the countries that manage their economies well in a general sense are less hurt by turbulence so it's a pretty good incentive to do that. And I think the idea of having an international lender of last resort is intriguing and it's something we seem to be thinking about. That seems to be the key element in this recent G-7 communique. So I think there are a lot of things including what you mentioned, that is short-term capital flows.

I'm a little hesitant to get into detail in all that. I get the feeling that we're all now in a position of having a hard time disagreeing with Chile and I think we have to be careful because there are many other things that Chile did in managing its economy that were quite impressive, and so there's an identification problem, and here I think, sure, maybe you impose some constraints on short-term flows and they work for awhile, but I think it's more important to do what some of my colleagues have mentioned, that is to have sounder financial intermediation in general and hope for the best. But I think even if you do all of that, you still may find that markets will move up and down and they will behave in somewhat erratic fashion, and I think that's the price that is definitely worth paying as I think markets 99 percent of the time are acting rationally in a stabilizing fashion. And every now and then they don't and we call Peter.

[Laughter.]

MR. SHAALAN: Thank you very much.

MR. LACHMAN: I must say I've got sympathy for that question. While I agree with Arminio that we're not going to get rid of booms and busts, you know, I think that we can be doing stuff to moderate the amplitude, and I just don't think that we should be looking for very simple solutions. I think that these are complex problems, and if we look at this last round of boom and bust, you can think of many factors that contributed to it. Maybe we had too easy liquidity conditions, you know, through much of last year. Maybe there was moral hazard within the system that was encouraged. You know maybe if we do something on the short-term capital flows, if we improve surveillance, all of this, I think, could go towards moderating the amplitudes, but I don't think that you're wanting to throw the baby out with the bath water. I think that markets behave in this kind of fashion. What we've got to try to do is figure out how to moderate this --in the least detrimental way possible.

MR. FISHER: I'd also like to jump in on this. First, I think there's a shorthand that we've adopted here and in many other settings that we had an experiment in Southeast Asia of free flow of capital. And I think that that's really a highly limited and suspect assumption. We had free flow particularly of short-term capital in many cases but not of corporate control. When you raise the contrast to the U.S. model and our evolution, we had a 60 year development of a common market through the evolution of our commerce clause to the judicial system, creating an open market, continent-wide market for goods and services, and corporate control--very importantly. That you couldn't--the people in Tennessee couldn't prevent people in New York from buying companies in Tennessee. It was a very important aspect of the evolution of the commerce clause long before we had a single monetary policy. We had regional banking systems in this country before the creation of Federal Reserve System.

And if you look at Southeast Asia, and to sort of paraphrase, we let in capital but didn't have free flow of capital in the ownership of financial sector. So in a sense, you're importing the risk pool of capital globally for some purposes and not for others. And then you get caught in a mismatch there. And so I think we've got to be very careful about where we draw the line in our analysis and look at all the different layers of what it means to really truly have an experiment with free flow of capital.

Presumably along with that, many of us think should go corporate control, but it wasn't the case in many of the countries we're talking about.

MR. SHAALAN: Thank you, Peter. I think the conclusion of this last discussion, last part of the discussion, is the boom-bust is going to be with us whether we like it or not. So policies should be directed at reducing the amplitude, reducing the probabilities of the bust part, and the best way you can do that is by pursuing appropriate financial policies. And here that is the main task of the institution I'm associated with.

I now would like to conclude by thanking all of you for taking the time to participate with us, and I'd like to thank our distinguished panelists for their valuable views and the views were greatly appreciated. Thank you very much.