Reform of the International Financial Architecture

[After-Dinner Speech]

I. Introduction

Ladies and Gentlemen. It is a great honour to address this distinguishedaudience at the beginning of the symposium. Despite its long history, I doubt that Kyotohas seen such a concentration of influential people in one room as is gathered here today:the level of combined cultural refinement is of course a totally different matter.

Joking aside, this symposium is a very timely one, since as we approachthe new millennium it is becoming more and more obvious that maintaining a sound financialsector is a prerequisite for both industrial and emerging economies to achieve sustainableand stable economic growth and development. Our discussions beginning tomorrow will nodoubt contribute to enhancing this message, not only in Japan and the United States butalso throughout the world.

Needless to say, a sound financial sector in each country is indispensableto the stability of the international financial system as a whole. At the same time,without a backdrop of a stable international financial system, the financial sectors ofcountries, particularly the emerging economies, will not be as robust as it should be. Ibelieve, therefore, it may be worth your time to look at the nature of various issuesinvolved in the ongoing discussion on reforming the international financial architecture,and the current status of those discussions following the Cologne summit meeting lastweekend.

As we all know, the financial crises of recent years, first in Mexico in1994, then in Asia in 1997, and in Russia and Brazil in 1998, have clearly demonstratedthat there is inherent instability in today’s liberalised market economy. This is notto say that these crisis countries were without flaws: in fact, there were many policymistakes and inappropriate structural rigidities in these countries. However, what isstriking is the abruptness with which these countries, particularly in Asia, fell from anadmirable state of solid economic performance to near bankruptcy. In my opinion, thiscannot be explained only by their structural problems. As the crisis spread to Russia andBrazil, even sceptics began to accept that the international financial system itselfneeded to be reformed.

Japan has been very vocal on this point from an early stage, arguing thatthere was a pressing need to reform the international financial system as a whole: oursense of urgency did not seem to be shared by many countries until the crisis erupted inRussia and Brazil. In December last year, Minister Miyazawa made a speech outliningJapan’s proposals for reform. The speech focused on what we think are the fundamentalissues, namely how to cope with short-term capital flows, what is the appropriate exchangerate regime for an emerging economy, and how to improve the working of the internationalfinancial institutions, especially the IMF.

There have been many more speeches on this subject made by ministers andofficials of various countries, and views have also been expressed by people in academiaand the private sector. Eventually, after long and sometimes heated discussions among theG-7 countries, the Report of the G-7 Finance Ministers on the International FinancialArchitecture was finally produced and published last weekend. Although this is just thefirst step, I think that it is a major achievement by the G-7. I now would like to sharewith you the major elements of the Report, focussing on the three fundamental issues Imentioned earlier.

II. Crisis of the Capital Account

Nature of the crisis

There is no doubt that increasingly liberalised cross-border capitalmovements have resulted in strong economic development and a general rise in livingstandards in many emerging and developing countries, as economic theory teaches us. At thesame time, on the creditors’ side, higher expected rates of return from investment inemerging economies are very attractive, especially when the creditor’s country is amature economy facing the rapid ageing of its population.

As such, it appeared that free capital movements would only benefit theworld economy as a whole. In fact, this is why the IMF Board seriously considered in themid-1990s an amendment to its Articles of Agreement that would make the liberalisation ofcapital movements one of the purposes of the IMF.

However, matters turned out to be not so simple. First, in reality, freecapital movements do not always bring about optimum allocation of resources, becauseinvestors often make their decisions based on imperfect and asymmetrical information.

Moreover, in some cases, especially in Asia, private investors who hadlent to, or invested in, these countries in short-term instruments and in foreigncurrencies started to withdraw their funds en masse, almost regardless of the economicfundamentals of the recipient countries. This is what I call a ‘21st century-stylecrisis’, or a ‘crisis of the capital account’ as opposed to the traditional‘crisis of the current account.’

All of the recent crises in Asia, Latin America, and Russia fell in thisnew category of crisis. For instance, in Thailand huge capital inflows, including thosethrough offshore accounts, had created a boom in the economy. But, once market confidencein the sustainability of the virtual peg of the baht to the U.S. dollar was lost, therewere massive capital outflows, and the baht collapsed. As the international communitybecame more aware that capital flows could reverse direction very easily, and that nocountry could remain intact in the face of such an onslaught, enthusiasm for amending theIMF Articles subsided considerably.

However, even if the development of today’s financial technologiesincreases the ease with which investors can move around their capital, and hence bringabout higher risks of crisis of the capital account, denying cross-border capital flowsaltogether would not solve the problem. The most important challenge now facing theinternational community, therefore, is to find ways to maximise the benefits of freecapital movements while minimising the risk of crisis. This requires an analysis of whyabrupt capital outflows occur.

The possibility of a crisis of the capital account may grow, first of all,when investors have not properly assessed the risks involved in their activities, eitherbecause their internal risk assessment procedure is inappropriate, or because they simplyfollow what other investors do (the so-called ‘herding’ behaviour). It is oftenargued that the activity of hedge funds, or Highly-Leveraged Institutions (HLIs),influences other market participants so greatly that when large-scale HLIs take a certainposition in the market it practically determines the direction of market movements,thereby distorting the working of the markets.

The risk of crisis may also increase, when market confidence in acountry’s economic policies is eroded. Damage to confidence may be greatest wheninvestors are led to believe that the government implicitly or explicitly guarantees theinvestment proceeds, including by an ostensibly sustainable fixed exchange rate regime,and then that commitment starts to look increasingly untenable.

Thus, our approach to reducing the risks of such a crisis should focus onboth the creditor’s side and the recipient side.

What Creditors Need to Do

On the creditor’s side, the Finance Ministers’ Report says thatthe G-7 will ‘encourage private firms to strengthen their own risk managementpractices’ and that ‘national authorities should ensure banking institutions intheir countries implement adequate risk management practices in accordance with’ theBasle Committee’s recommendations in its paper on HLIs published early this year. Atthe same time, the Report notes that the newly-established Financial Stability Forum willstudy a number of issues related to HLIs, including instability possibly caused by HLIs inrelatively small financial markets. Enhancing supervision in offshore centres is alsoencouraged in the Report.

Furthermore, in order to ensure that ‘private creditors know thatthey will bear the consequences of their investment decisions’, the Report identifiesthe principles that govern debtor/creditor relationships and the tools that may be used topromote appropriate private sector involvement in the resolution of crises, including aneffective use of the ‘lending into arrears’ policy of the IMF. Legal andtechnical questions involved in implementing these specific approaches will be consideredby the IMF by the time of the Annual Meetings in September this year.

What the Emerging Economies Need to Do

On the emerging economies’ side, the Report proposes concretemeasures in four different areas: exchange rate regimes; capital flows; financial systems;and debt management.

Exchange Rate Regimes

First, on exchange rate regimes, the G-7 notes that ‘the choice ofexchange rate regime is critical for emerging economies to achieve economicdevelopment.’ It says, ‘We agree that the most appropriate regime for any giveneconomy may differ, depending on particular economic circumstances.’ For instance,‘some emerging economies have sought to achieve exchange rate stability by adoptingpeg regimes against a single currency or a basket of currencies, often in the same region,of countries with which they have the closest trade and investment links.’

Adopting an appropriate regime is important, since it allows overseasinvestors to properly judge exchange risks they are taking. To make the regime reflect thechanging degree of exchange risk, it must be continuously reviewed, so that it can befine-tuned as ‘economic circumstances vary over time.’ In this context, the IMFshould play a more active role ‘to enhance the attention it gives to exchange ratesustainability in the context of its surveillance activities.’ If a countryintervenes heavily to defend an unsustainable exchange rate level, large-scale officialfinancing should not be provided.

A simple hypothesis, the so-called ‘two-corner approach’ hassometimes been suggested in international circles, including by officials. This school ofthought assumes that only a completely free-floating regime or a currency board areviable. The Report does not share this view. Although it does say that ‘countrieschoosing fixed rates must be willing … to subordinate other policy goals to that offixing the exchange rate’ and that ‘arrangements institutionalising that policycan be useful to sustain a credible commitment to fixed rates,’ the commonunderstanding among the G-7 countries is that the ‘arrangements’ referred tohere are not limited to a currency board but include various measures.

Capital Flows

On capital flows, the Report recommends that ‘[C]apital accountliberalisation should be carried out in a careful and well-sequenced manner, accompaniedby a sound and well-regulated financial sector and by a consistent macroeconomic policyframework.’ It goes on to explain the G-7 consensus on controls on capital flows. Itsays, ‘The use of controls on capital inflows may be justified for a transitionalperiod as countries strengthen the institutional and regulatory environment in theirdomestic financial systems.… More comprehensive controls on inflows have beenemployed by some countries as a means to shield themselves from market pressures. Suchsteps may carry costs and should not in any case be used as a substitute for reform.… [C]ontrols on capital outflows can carry even greater long term costs…,although they may be necessary in certain exceptional circumstances.’

It has sometimes been suggested by the press and others that Japan isadvocating more controls on capital flows while other G-7 countries are arguing for freecapital movements. This is simply not true. If one reads the Miyazawaspeech of last December carefully, it is clear that Japan’s position from theoutset was that maintaining market-friendly controls that would prevent turbulent capitalinflows should be justified when a country wants to keep capital inflows at a manageablelevel according to the stage of development of its financial sector, and that there mightbe some cases that would justify the reintroduction of controls on capital outflows as anexception, for example, in order to avoid a bail-out by IMF loans. As the Report shows,this stance is shared by all G-7 countries.

Strengthening Financial Systems

As for financial systems, the Report calls for close coordination betweenthe IMF and the World Bank when they give advice to emerging economies in the area offinancial sector reform. It also welcomes commitments by the emerging economies of Asiaand Latin America to take necessary steps towards the implementation of the Basle CorePrinciples for effective banking supervision.

Sound Debt Management

In addition, the G-7 thinks that best practices in debt management shouldbe promoted, so that countries avoid too much reliance on short-term borrowing,particularly in foreign currencies. I expect that these principles will be discussed bythe IMF Board in the near future.

III. Reform of the IMF

It is now clear that the IMF was unable to meet the challenges posed bythis 21st century-style crisis in several Asian countries. The biggest mistake was thatthe IMF prescribed for the countries ‘medication’ that had been effective forthe old-style crisis of the current account.

I have on several occasions discussed in detail what was inappropriate inIMF programmes for Thailand, Korea, and Indonesia. I shall therefore not repeat myarguments today. Should you be interested, some of my speeches and the Minister’sspeeches can be found on the Ministry of Finance Homepage on the internet.

Of course, I firmly believe that the IMF should be at the heart of thestable international financial system. This is not to say, however, that the IMF can stayas it is now. In this connection, the G-7 Report says, ‘[B]uilding upon theexperience of IMF-supported programmes in the financial crisis, the IMF should exploreways further to improve IMF surveillance and programmes so that they better reflect thechanges in the world economy, in particular potentially abrupt large-scale cross bordercapital movements.’

The decision-making procedures of the IMF must be improved, too, so thatBoard members are better briefed by IMF staff and more closely consulted, as appropriate.The Report notes this point as well.

Incidentally, there are two new proposals in the Report concerning thegoverning structure of the IMF. First, it is proposed that the Interim Committee be givena permanent standing with a new name, ‘the International Financial and MonetaryCommittee.’ Second, it is suggested that an informal mechanism for dialogue amongsystemically important countries be established within the framework of the Bretton Woodsinstitutional system. I expect that the G-7 and other countries will jointly considerthese proposals with the view to reaching agreement in the near future.

The working of the IMF will also be improved through more transparency,especially through greater release of its Board documents and better internal and externalevaluation efforts. The G-7 Report supports this point, too.

IV. Conclusion

One might be forgiven, on reading the G-7 Report, for thinking that thereform of the International Financial Architecture is now complete and the world economywill prosper without any further risk of crisis. Forgiven - especially after a good dinner- but wrong.

Wrong because as technological developments and other factors change theglobal economic and financial environment over time, the architecture needs to becontinuously adapted to the evolving reality. Wrong, too, because what we have now isbasically a list of concrete proposals. Their implementation is crucial: as the Englishsay, ‘The proof of the pudding is in the eating.’

So, the G-7 has to continue to work hard among ourselves or at the IMF andWorld Bank Boards, so that our proposals can be implemented as quickly and as practicallyas possible.

Let me conclude by saying a few words about Japan’s contribution tothis important endeavour. I do not mean to sound triumphant or boastful, but I just thinkthat Japan has taken the lead in the discussion on the Architecture for the past two yearsor so. Many of Japan’s proposals and arguments have been supported, criticised, ormulled over, and now eventually have found their way into the G-7 Report. Of course, it isa team effort with other G-7 and non G-7 countries, and not like a zero-sum game whereonly the first advocate is rewarded. Nevertheless, I simply would like to declare thatsuch intellectual contributions to the pressing issues of the world economy is what Japanwill continue to strive to make. I am sure you will see more of these in the years tocome.

Thank you very much for your attention.