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Prospects for a New Financial Architecture and Economic Recovery
Managing the Global
Economy: Prospects for a
New Financial Architecture
and Economic Recovery1
NICHOLAS HOPKINSON
Deputy Director
Wilton Park
I
n the last twenty years, 125 countries have experienced at least one financial
crisis. Of particular interest among these episodes are those that took place in
the 1997–1998 Asian Crisis. Indeed, scholars and policymakers still debate
enthusiastically over many aspects of the Crisis. On one hand, “conventional wisdom” argues that the crises resulted primarily from a buildup of financial fragility
in the region during the preceding boom and inherent volatility in capital markets. According to such analysis, this financial fragility resulted from a toxic mix
of deteriorating macroeconomic fundamentals, including large current account
deficits, increasing reliance on short-term capital inflows, and overvalued exchange
rates; fixed or semifixed exchange rates that encouraged borrowing foreign currency, which was often lent again in domestic currency at higher interest rates;
inadequate financial supervision within the context of financial liberalization;
inadequate disclosure, which allowed problems to build up undetected, in terms
of both nonperforming loans and uncommitted foreign exchange reserves; and
overreliance on bank financing rather than on capital markets, with implicit government guarantees that resulted in reckless lending.
Granted, excessive risky lending generated asset price inflation, which in
turn brought investors to believe that the strength of financial intermediaries was
sounder than it was. This set the stage for a twin banking–balance of payments
crisis that required only a trigger, such as an economic slowdown or weakening of
exports, or indeed contagion from similar economies. When the bubble burst,
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falling asset prices made the insolvency of intermediaries visible, forcing them to
cease operations and resulting in further asset deflation. Once the crisis was underway, factors that contribute to market volatility, such as herd behavior of investors, offered an explanation of its actual course.
On the other hand, some argue that it was weak institutions and regulatory
policies in the public sector, rather than weaknesses in the banking sector and
borrowing habits, that permitted these problems to develop and fester. The situation was compounded by poor disclosure regulations and the failure to develop
robust bankruptcy regimes that permitted corporate problems to become banking problems. In sum, responsibility for preventing crises rests firmly with the
governments themselves.
Others argue that we delude ourselves if we believe that we understand the
crisis on the basis of the conventional analysis, or that we “managed” it well because the global economy has now recovered. Arguably, International Monetary
Fund (IMF) support and U.S. interest rate cuts worked to prevent the spread of
the crisis to Europe and North America. But financial fragility analysis worked
for only some Asian economies, such as Thailand, Korea, Indonesia and Malaysia. It cannot, however, explain Hong Kong, Taiwan and China. The volatility of
capital explanation is equally flawed. Capital flows fluctuate in volume, whether
it be hourly or yearly. It is only when there is an abrupt change in valuations that
we perceive a crisis. This issue is the cause of the sudden change in the valuation
of Asian assets, which in turn depends on market sentiment.
Proper sequencing of reforms is needed in order to prevent future crises.
This ensures that capital account liberalization does not result in the undermining of unprepared financial systems by unmanageable flows of hot money. Inter
alia there must be more transparency, better financial regulation, deeper capital
markets, and improved coherence between international financial institutions
(IFIs).
The Global Economic Outlook
There is widespread optimism about recovery in most Asian economies. Foreign
investors are returning, domestic consumption is increasing, and domestic financial structures are consolidating. For sustainable growth to take root, however,
reforms will all have to be implemented over the long term. It would be a mistake
for governments to abandon reforms due to the present economic recovery. As a
result, companies like Korea’s chaebols would feel less pressure to restructure.
Concerns remain about Japan’s economy. In spite of massive government
spending in the first half of 1999, the region’s key economy is still held back by
half-hearted financial reform and its citizens’ reluctance to consume. In the second half of 1999, public spending petered out and a strong yen hindered exports.
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With Japanese households continuing to save and firms reducing investment, the
domestic economy is continuing to stagnate. Thus, the focus must be on the
monetary side. With already low interest rates, and a large government fiscal deficit, the Japanese government cannot increase spending or cut taxes. Many analysts say the Bank of Japan should simply print lots of money and monetize part
of the fiscal deficit. This may be inflationary, but, given continuing deflation, the
impact on prices cannot be alarming. This would probably encourage consumers
to buy before prices increase. Japanese banks need a further public injection of
funds, ideally by means of share purchases. Given continued economic difficulties, it appears Japanese citizens will no longer be content to accept the status quo
and postpone difficult reforms.
Some fear a devaluation of the Chinese yuan will slow economic recovery
elsewhere in Asia. However, a devaluation of the yuan is unlikely within the next
two years. China’s sweeping reform of its state-owned enterprises will lead to a
gradual rise in unemployment. This means labor costs will remain stable, thus
maintaining China’s competitive edge and reducing any need to devalue the yuan.
The United States is enjoying its longest period of economic growth. Furthermore, unemployment is at its lowest level in thirty years. There are factors
other than the information technology revolution which are driving the “new
economy” in the United States: labor market flexibility; sound and active macroeconomic policy; the voluntary shift of substantial amounts of foreign money,
based on confidence in the United States’s ability to outperform other economies;
regulatory reform, notably in financial services, and growth in the number of
highly skilled workers. However, there is considerable concern about imbalances
in the U.S. economy. First, the current account deficit has grown from $150
billion in 1998 to a forecast $260 billion in 2000 (equivalent to 4 percent of
GDP). Superficially this suggests Americans are living beyond their means. However, it is incorrect to believe that trade deficits are necessarily bad—Americans
are merely investing more than they save. Second, the savings rate has declined 5
percent in the past few years. But offsetting this decrease in savings is an increase
in government saving and the perception that, paradoxically , the baby-boomer
generation appears to have more spare savings than previous generations. Third,
and most troubling, is the great increase in the value of the U.S. stock market, the
largest since the 1930s. However, the boom in information technology and telecommunications stocks masks the fact that the bulk of the market remains flat.
Investors no longer consider holding stocks as risky, and they have started to
invest in growth companies with large potential returns rather than in old companies with established profits records. Perhaps the greatest danger of all is the
complacency about any of these imbalances.
The long outperformance of the U.S. economy has attracted foreign investment in U.S. assets, which has strengthened the dollar and made financing
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the widening current account deficit easier. The dollar has been further strengthened by higher U.S. interest rates as the Federal Reserve tries to preempt any
significant rise in inflation. Higher interest rates do not undermine the dollar for
two reasons: (1) the U.S. technology sector is considered able to rise above any
adversity, including interest rate increases; and (2) the U.S. government has sharply
reduced its debt. The shortage of bonds, whose supply is projected to be 20 percent less at the end of 2000 than in 1995, has led to a reduction in long-term
interest rates from the level at which they otherwise would be. With bond investors looking for alternative investments, there has been a “crowding in” of private
investment. The buying back of public sector debt has been replaced with the
cheap financing of private companies. This in turn contributes to higher stock
prices.
Pessimists believe that the U.S. stock market bubble will eventually burst,
perhaps in 2000, with potentially more adverse consequences than in 1987 given
the economy’s greater dependence upon financial markets. European and Japanese portfolio flows into
If we believe in “new economics,” U.S. markets would dry up,
and the U.S. current acthen why should high growth be count deficit would become
confined only to the United States? harder to finance. If foreign
flows dry up, the dollar will
plummet, and the Federal Reserve could “overkill” with even higher rates, thus
causing U.S. growth to melt down. For the moment, though, any serious skepticism about the U.S. economy remains unfashionable.
The correct policy mix for the United States to deal with its internal and
external imbalances is to tighten fiscal policy to ease monetary policy and help
the dollar down gently. However, this is not going to happen, because politics
dictates that taxes only fall. Furthermore, monetary and fiscal authority are separated. Rising U.S. interest rates and an independently strong dollar are an unhelpful combination that obliges other economies either to accept a strong dollar
and weak domestic currency, or resist it by competing with rising U.S. interest
rates. Policy makers mistakenly choose to counter the strength of the dollar with
higher interest rates; as a result, the global recovery will stall.
If we believe in “new economics,” then why should high growth only be
confined to the United States? Information technology is easily transferable and
not overly expensive. The big question for Europe is not whether it can grow, but
whether reviving growth can replicate the type of cost-depressing and innovation-prompting investment experienced in the United States. Euroland can ride
the same wave but hasn’t done so yet, even though the soft euro and subdued
costs are contributing to respectable 3 percent growth. Euroland still badly needs
to undertake structural reform. Reform of capital, product and labor markets (in
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ascending order of difficulty) must be implemented, primarily in order to raise
employment and labor participation rates. It is best that reform is undertaken
while the economy is enjoying high growth, even though structural reform remains difficult to implement even in good times. There are signs that structural
change is underway. Economic and Monetary Union (EMU) will act as a catalyst
for structural reform and, indirectly, the lowering of taxes. Price transparency will
lead to greater competition throughout Euroland. The German government’s plans
to abolish capital gains tax on corporate shareholdings will allow diversified conglomerates to refocus their activities and encourage more overseas investment.
The European Central Bank must not choke off economic recovery through
excessive increases in interest rates. The lower openness of Euroland economies
means less attention is paid to the euro’s exchange rate, and indeed the European
Central Bank has no mandate to defend the euro’s value in foreign exchange
markets. The euro will rally when investors begin to believe that Euroland produces better returns on its investments than the United States.
It is an error for businesses to regard regions as a whole. Investors’ inability
to differentiate between countries within regions harmed many “similar” economies during the global financial crisis of the late 1990s. Following the crisis, a
greater awareness of individual macroeconomic fundamentals became the rule.
Bilateral aid flows, trade credits and official lending to developing countries in the 1990s have fallen in real terms. Foreign direct investment (FDI) and
portfolio flows have picked up much of the slack, although they have flowed to a
limited number of developing countries with sound macroeconomic fundamentals. Portfolio flows, unlike FDI, have been volatile. For instance, 10 percent of
portfolio funds invested in emerging markets was sold in 1999. There remains
scope for lending to balance any decline in private flows. Debt forgiveness has not
prevented access to international capital markets, but flows have not recovered to
previous levels.
Comprehensive stabilization and structural and fiscal reform will not be
adopted in Russia until after the Presidential elections this year. Even then the
will for serious reform is questionable. A thorough root-and-branch reform needs
to be achieved through a variety of methods, including: tough budget constraints;
a reduction in the flow of credits from quasi-fiscal institutions to firms; gradual
reduction of nonmonetary transactions; improvements in corporate governance
including protection of minority shareholders and creditors; sound property laws;
bankruptcy laws; simplification of the arbitrary tax system through the introduction of low corporate and income tax rates and higher indirect taxation; stronger
tax compliance; better targeting of social transfers; streamlined company registration procedures; selective recapitalization of banks, and better banking supervision.
Since the 1998 Crisis, adjustments in fiscal, monetary and exchange rate
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regimes have made Latin America more capable of dealing with external shocks.
For example, the new IMF program in Brazil has resulted in falls in real interest
and inflation rates and a narrowing of the current account deficit.
The International Financial Architecture
In the wake of the 1997–98 Asian, Russian and Latin American Crises, governments sought to strengthen the International Financial Architecture in order to
maximize benefits from global markets and minimize the risk of disruption. But
opinion remains divided as to how far the global system has actually been improved, with some believing the same systemic flaws—the potential for market
failures, volatile capital flows and exchange rates, vulnerable financial systems,
and international contagion—could trigger another crisis.
The New International Financial Architecture involves rules and conventions governing international economic and financial relations and institutional
arrangements for developing, monitoring and enforcing rules. The current architecture is a market-led system with flexible exchange rates, market-determined
adjustment, endogenous liquidity creation and open capital markets. Strengthening the architecture can involve crisis prevention (strengthening market functioning) and crisis management and resolution (strengthening institutional responses).
Crisis prevention involves better macroeconomic policies (international surveillance) and stronger financial systems (development and enforcement of codes of
prudent behavior). Sound macroeconomic policies require sustainable budgets,
structural policies and avoidance of unsustainable fixed but adjustable regimes.
Best practice codes for banks, securities houses, insurance companies and their
supervisors, risk management and capital adequacy must be implemented. There
must be functioning infrastructure including a sound legal system, corporate governance, payment and settlement system, and proper accounting practices. Crisis
resolution requires sustainable policies, financing the liquidity-solvency dilemma,
“burden-sharing” between creditors, private sector involvement, and techniques
such as moratoria, collective action clauses, rescheduling, and lending into arrears. International financial institutions, G7, standard setters, national regulators and national governments should be involved. Central to the New International Financial Architecture is the recently established Financial Stability Forum
(FSF), which seeks to identify vulnerabilities, develop codes, and promote international coordination. Many believe the FSF’s membership should be expanded.
The institutional responsibility for crisis resolution remains centered in the IMF,
but the level of its financial resources and the nature of its future role, whether
more focused or broader, needs to be determined. Many, for example, believe the
IMF should concentrate on its main task, leaving the World Bank to undertake
development financing.
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It is naive to believe that the market alone is sufficient; there is overwhelming agreement that there has to be at least some regulation. The difficulty is finding the right balance between the market and regulation and ensuring that regulation is neither too light nor too excessive. With the blurring of barriers between
banking and other financial markets, consistent global regulation might be helped
if more countries followed the United Kingdom’s lead in establishing a single
consolidated national regulatory authority for all financial services. This would
help prevent fragmented regulation between oft-competing agencies, and business activities would be less likely to escape the regulatory net. Other shortcomings in supervision can be attributed to lack of resources and sophistication. Another common shortcoming is regulators’ lack of adequate authority or independence to grant or withdraw banking licenses. It would require relatively simple
legislative change to achieve compliance with the Basel Core Principles, but Finance Ministries are reluctant to relinquish their say in who regulates the banks.
It would be misleading to suggest that banking crises are the only factor
behind the wave of reform efforts currently underway around the globe. Once a
crisis has occurred, the authorities no longer have the choice of procrastination,
and serious reform may be part of IMF conditionality. Precrisis reform, such as
tightening of prudential requirements or introduction of competition, are often
not undertaken because they are regarded as weakening the franchise value of
banks. Postcrisis, when value is often nonexistent, vested interests no longer stand
in the way.
Banking reforms go hand-in-hand with other reforms, including changes
in the ownership structure of the banking industry, accounting, legal and corporate governance frameworks; exiting of insolvent banks; and temporary restructuring measures, notably the recapitalization of banks and the creation of agencies to deal with large volumes of bad loans. Foreign banks are not just a source of
funds for bank rescues but an impetus to behavioral reform. They bring valuable
management expertise to the institutions they invest in and force other banks to
become more aware of performance.
Regulation and supervision can reinforce but cannot substitute for sound
risk management by the banks themselves. Loans should be directed towards creditworthy and profitable ventures, which are subjected to credit risk analysis, riskadjusted pricing, loan monitoring and debt-enforcement procedures. In transition economies, this means moving banks away from their command economy
role of effectively directing state funding towards designated industries and sectors. In other countries, it means ending government directed “policy” loans,
state interference in the enforcement of banking regulation, and the client relationships between banks and powerful corporations, including “insider” lending.
It is important that emerging market economies (EMEs) look very closely
at their own needs and vulnerabilities in supervisory liquidity requirements, par-
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ticularly as the Basel Committee has published only very limited guidance on
supervisory liquidity norms. Liquidity is less of a first-order consideration for
G10 countries than emerging markets; liquidity really becomes a key question
where solvency is uncertain. In the more volatile operating environment of emerging markets, and given the relatively poor record of accounting and auditing,
investor doubts about insolvency are likely to be more pronounced. This means
that banks generally need to be conservative about their liquidity management,
particularly where it involves currency mismatching.
Some larger banks have argued that they are required to hold excessive
capital against some credit risks and that regulators should permit lower capital
standards, for example, by reference to portfolio credit-risk models. However,
shortcomings in many risk control systems have been one factor in the judgment
of Bank of International Settlements (BIS) supervisors, who endeavor to maintain the overall amount of capital in the system. The Basel Committee has tried to
make it clear that their 8 percent capital adequacy standard is a minimum, tailored to large well-diversified international banks, but this message needs to be
reinforced and accompanied by more specific guidance for banks and highly leveraged institutions that do not fall into this category. The Basel Committee does
recognize that even with the new proposals, capital requirements will not adequately capture risk profiles, and recommends that supervisors conduct individual reviews of banks and their portfolios in order to set an overall capital requirement appropriate to the particular institution.
The rules of the game are changing. In particular, the Basel Committee has
proposed some fairly radical changes to the Basel Capital Accord. This may disappoint EMEs struggling to implement the existing set of standards fully. The Basel
Committee and EMEs need to work together to ensure that the Basel Standards
meet EME needs. This may mean producing more guidance on areas that seem
thinly covered, such as liquidity, and also ensuring that there are options in the
new accord that are practical and prudent for emerging market banking supervisors. In spite of regulatory gaps, increasing adoption of the Basel standards suggests regulatory systems are maturing.
Credit rating agencies can amplify bad lending behavior, especially given
the private sector’s inability to anticipate crises thus far. These agencies can stimulate “muddling through” when anticipated adjustments are needed. They can also
raise the cost of appropriate adjustments, even deterring their success when changing fundamentals are not grasped in a timely fashion. The use of ratings will most
likely do little to enhance risk sensitivity. Even worse, perhaps, is that existing
ratings are often not internationally comparable, so using them could imply erosion of capital. There is no obvious answer. Banking supervisors can be rigorous
in their recognition of rating agencies, but this does not overcome the problem of
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tee—namely, the use of internal ratings to set risk weights—may not be suitable
for all banking systems.
There has been more progress designing the rules for the New International Financial Architecture than on the institutions that underpin it. The roles
of IFIs at the outset of crises, devising the right remedies for short-term stabilization and medium-term adjustment, and restoring long-term growth, remains
controversial. Although IFI prescriptions did not cause the Asian financial crisis,
the lack of understanding and insufficient information about the likely economic
and social consequences, as well as contagion effects, may be at fault. Better and
timely disclosure of information is widely seen as crucial for improving market
discipline. However, greater transparency alone will not prevent new crises from
happening.
If the IMF’s mandate becomes too broad, it may easily become paralyzed
and associated with overly intrusive policies. Nevertheless, it is widely agreed that
the IMF should remain at the heart of the international financial system. Thanks
to its surveillance mandate—identifying and helping correct policy weaknesses
and vulnerabilities—and its universal membership, the IMF is a leader in reforming the International Financial Architecture, including elements such as transparency, standards and codes, financial sector soundness, capital controls, and fund
lending facilities.
In the past, the IMF’s “yellow card” transparency proposals failed because
countries didn’t heed their warnings. But decisions have been implemented under which the IMF is making far more information available on itself and its
views on member country
policies. There is a need to The need to formulate rules for
reassess the IMF’s possibly
conflicting roles as confi- private sector involvement is not
dential adviser to member as urgent as was once believed.
countries and provider of
information to the public and markets. A majority of IMF members feels a balance can be found and now support full disclosure. Published information must
be meaningful, understandable, timely and accurate. Incorrect information can
be worse than no information at all.
Standards and codes must underpin the provision of information. Codes
for the promulgation of information on country fiscal and monetary policies,
general country economic data, and principles by which to operate payments and
clearance systems are needed. Concerns with the way countries do or do not
implement commonly accepted standards have led to much greater attention to
the development and improvement of the standards themselves and to an examination of the extent to which countries actually adhere to those standards. The
IMF’s Reports on Standards and Codes (ROSC) will help only if markets take
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them seriously in credit assessments, and only if they are visible in the spreads
paid by countries in global financial markets. The World Bank and the IMF have
been asked to devote much more attention to financial sector assessments in member countries and have developed Financial Sector Assessment Programmes (FSAPs)
and Financial Sector Stability Assessments (FSSAs). In due course, ROSCs and
the FSSAs could become more important elements of IMF surveillance and contribute to the prevention of crises by strengthening the underlying market mechanisms.
Balance sheets and other statements by banks and corporations must be
built up on the basis of commonly accepted principles. Otherwise, poor analysis
of corporate and banking system vulnerabilities can result. Accounting standards
and audit procedures to assure adherence to those standards are necessarily required.
There is widespread acceptance that open capital markets can bring enormous benefits to countries. It is striking that only Malaysia reverted to temporary
capital controls during the recent crisis. In the aftermath of the crisis, there is
general acceptance of the prudential regulations used by Chile to try to restrain
short-term inflows and lengthen the maturity of such flows. At the same time,
there is less agreement about the benefits of the controls used by India and China.
Superficially it may appear that these countries managed to isolate themselves
from the turmoil of the Asian crisis. Nonetheless, there is widespread recognition
that the pace and sequencing of capital market liberalization must complement
careful development of domestic financial institutions.
There is little, if any, disagreement that the IMF should continue to help
finance adjustment. A minority believes the availability of potentially large amounts
of IMF financing encourages careless lending of large amounts with limited risk
(moral hazard) is such a major problem that the IMF should be closed. A larger
group believes that the IMF should limit the amounts it can make available. The
corollary is that if a country gets into difficulties, the private sector should contribute to relieving the pressure. Others modify this view to say that the IMF
should generally limit access to its financing. But to protect the process, some
would change the decision-making process and source of financing to “systemic”
operations. A last group wants the IMF to precommit resources to countries with
excellent policies and institutions to be drawn in the event of contagion. A subgroup believes that the IMF should become a lender of last resort.
The need to formulate rules for private sector involvement is not as urgent
as was once believed. Many officials still believe rules and procedures are needed
but are uncertain what they should be. While commercial banks were the main
creditor group in the 1980s, this is no longer the case. Bank Advisory Committees worked in the 1980s because the underlying creditor class consisted predominantly of banks. In the current environment it is more important to find a
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mechanism for consulting the views of nonbank investors. Private capital flows
now dominate international cross-border flows, and as a result, a broader range of
investors and debt instruments needs to be taken into account. The role of thousands of nonbank, often private, investors in debt workouts first became an issue
during the 1995 Mexican devaluation crisis. Bondholders became the beneficiaries of massive public sector bailout packages and generally were paid. Commercial debt negotiations did take place during the Asian crises, but they involved
principally trade and interbank exposure owed to commercial banks. Recent debt
workouts in Russia, Ukraine, Ecuador and Pakistan have been pragmatic solutions but do not herald a new era.
With the shift into securities and the general requirement to mark to market, investors are more likely to seek rapid resolutions. Sovereigns which are in
difficulties need to engage their creditors in a constructive process of discussion
and negotiation at an early stage but in so doing need to recognize that the environment is now significantly different from that in the 1980s. The willingness of
commercial banks then to make the necessary management resources available
for the London Club committee process to run effectively has diminished. The
key is not contractual provisions but effective engagement with the broad spectrum of investors. Accordingly, a wider range of solutions is likely to be required.
Debtors who do not engage in a meaningful dialogue are likely to suffer litigation.
Many are critical of the adverse social costs of structural adjustment programs. However, market economics is a matter of choices which aims to increase
welfare. Experience suggests that low government expenditure is correlated to
lower inflation and higher growth. International financial institutions are not the
root cause of government cuts. Furthermore, evidence from the last six years suggests that real expenditure on health and education has increased in countries
undertaking IMF programs. Policy coherence can help. For instance, it may not
be consistent to sell arms and offer aid to the same region. It would also be helpful
if donors set budgets over three years, because aid priorities vary from year to year.
Critics of the New International Financial Architecture believe it is overly
focused on what developing countries should do. There needs to be a greater
symmetry in the debate with more emphasis being placed on G7 cooperation and
economies. For example, the most troubling warning signals appear to be imbalances in the U.S. economy and doubts about the solvency of Japan’s life insurance
companies (although the situation is not believed to be as serious as that facing
Japan’s banks in the 1990s).
Pessimists predict there will soon be a major setback in the United States,with
serious consequences for the rest of the global economy. Even though there is
more information about the United States than any other economy, the writing
on the wall is often ignored. It is difficult to stand apart from the herd; if fund
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managers do not invest in a certain sector or bankers do not lend to a certain
sector or country, they may be punished. Markets then overestimate the depth
and length of crises. Optimists counter that these risks are known and containable, and that a lot of preventative work has been done in building the New
International Financial Architecture. Furthermore, periodic crises haven’t prevented
the United States and other G7 economies from being highly successful—countries can and do learn from painful experience. Some argue that it is not important to know where the next crisis will come from, but rather that we know how
to deal with it. This seems to suggest that we are content to manage crises rather
than engage in less-costly crisis prevention. So we must take the rough with the
smooth, the overall benefits with the occasional setbacks. After all, staying outside the global economy hardly seems to provide an attractive alternative. WA
Notes
1. This article is an essay summarizing main points from the 14–17 February 2000 592nd
Wilton Park conference in West Sussex, England with the same title. The report reflects the author’s
personal interpretations of the proceedings. As such they do not constitute any institutional policy
of Wilton Park or any other organization, nor do they necessarily represent the views of the
author.
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