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Towards a New International Financial Architecture

Towards a New International Financial Architecture

Speech by Mr. Kiichi Miyazawa, the Minister of Finance,
At the Foreign Correspondents Club of Japan
December 15, 1998

I.    Experiences of the Recent Past

II.   Risks Posed by Short-Term Capital Movements, and Measures to Cope with Them

III.   The Exchange Rate Regime

IV.   Providing Liquidity to Crisis Countries

V.    Conclusion


12/15/98 11:52 AM


Towards a New International Financial Architecture


Speech by Mr. Kiichi Miyazawa, the Minister of Finance,
At the Foreign Correspondents Club of Japan
December 15, 1998

        Ladies and gentlemen, it is mygreat honor and pleasure to have an opportunity to speak at this distinguished gathering.

       Today, I wish to speak about thechallenges facing the current international financial system and about ways to reform andimprove its workings. These are very important issues, and unless we resolve themcorrectly, the world economy might not develop in a sound way in the next century.

        In order to look to the future,one should begin by looking back at recent experiences of the international financialsystem.

I. Experiences of the Recent Past

      Since the Mexican peso crisis inlate 1994, there has been much discussion about reform of the international financialarchitecture. Beginning immediately after that crisis, various opinions were expressed,and the importance of transparency and disclosure emerged as the most importantissues to be tackled, along with the need to reinforce IMF resources. It has been arguedthat if investors had known the true economic situation in Mexico, they would have beenable to make rational investment decisions, and probably they would not have invested inthat country in the first place. Following this line of reasoning, the IMF has decided topromote disclosure of each country's policies by compiling the SDDS (Special DataDissemination Standard). In addition, it has been argued that IMF surveillanceshould be strengthened, and efforts accordingly have been made for that purpose.

      Then, last year, there came the crisesin Asia. In contrast with previous crises, especially those in Latin America, wherethe main problems were ones of large fiscal deficits and over-consumption, the mostsignificant aspects of the Asian crises were that they basically stemmed from heavyborrowing by private sector borrowers from private overseas creditors, and from excessiveand/or inefficient investments made possible by such borrowing. The Asian crises revealedthe weakness of financial sectors and the lack of proper financial sector supervision inthese countries. This experience led to discussions about establishing appropriatefinancial supervision systems, and about the need for involving private-sectorcreditors in preventing and resolving the crises. Still, the sense of crisis did notseem to be shared evenly throughout the world: I suppose that this was because someobservers attributed the Asian crises to specific deficiencies in the economic managementof the Asian countries, including seemingly opaque and improper relationships betweengovernments and businesses.

      However, when turmoil also took place in Russiaand Brazil this year, it became very clear that crises such as those experienced inAsia are more general phenomena. One cannot help but realize that these successive crisesstemmed not only from specific problems in particular economies, but also from generalproblems inherent in today's global economic system.

      The risks involved in large and abruptmovements of short-term capital are now keenly recognized, as shown in the crises inAsia as well as in Russia and Brazil. We have also been reminded that appropriateexchange rate regimes are clearly the key to the stability of the internationalfinancial system. It is now widely acknowledged that maintaining a virtual peg to the U.S.dollar was one of the main reasons for the crises in the emerging economies in Asia. Theproblems were made more serious because the U.S. dollar had greatly appreciated vis-a-visthe Japanese yen and other major currencies since 1995, which caused a loss of thoseeconomies' trade competitiveness.

      Against this background, activediscussions are now underway on how to improve the international financialarchitecture. These include a variety of proposals, such as renewed appeals to strengthenstandards for transparency and good governance in both the private and public sectors, andto improve the supervision of the financial sector, and new ideas about organizationalrealignment of the IMF, the World Bank, and others.

      Today, however, I wish to focus on what Ithink are the most fundamental issues underlying the present internationalfinancial architecture: they are (1) how to cope with short-term capital movements; (2)how to determine an appropriate exchange rate regime; and (3) how to provide liquidity tocrisis countries. I strongly believe that these three issues are what we must tackle firstand foremost, in order to effectively prevent and resolve crises.

      I am convinced that these questions must beurgently discussed and dealt with by the G7, while securing the involvement of keyemerging economies. Japan, as a country in the Asian region where the people have beenexperiencing the very serious impact of the crises, would like to play an active andconstructive role in dealing with such system-wide issues.

II.  Risks Posed by Short-Term Capital Movements, andMeasures to Cope with Them

      The first fundamental issue is how to copewith large-scale short-term capital movements.

      It is true that the free movement ofcapital has often been a driving force behind economic growth in developing andemerging countries. Recently, however, a great leap in financial technological developmenthas enabled international investors to invest and divest in the most exotic markets withease. It is said that at present approximately $1.5 trillion worth of currencies aretraded every day. If we assume that there are 250 business days in one year, currencytransactions could total as much as $375 trillion per year. Considering the fact that thesize of world trade for one year as a whole is merely $11 trillion, one has to recognizewhat a great influence capital movements could have on any country.

      The free movement of capital is supposed toprovide optimum allocation of resources: in reality, this might not be the case,especially for short-term capital flows, because investors make their decisions based onimperfect and asymmetrical information, and they therefore tend to follow what otherinvestors are doing. This phenomenon, known as "herding", could triggerabrupt movements of short-term capital, without major changes in the economicfundamentals. Excessive capital inflows can lead to overheating of an economy, includingincreases in unproductive investments, asset price "bubble", and inflation. Andif outflows start, torrents of outgoing funds could ruin a nation's economy.

      Based on this recognition, first, even inan emerging or developing economy where capital account liberalization is an appropriateand necessary strategy for promoting further growth and efficiency in light of its stageof economic development, it is critical that such liberalization is implemented as andwhen certain appropriate conditions exist, such as a robust financial sector and a capablesupervision system. Furthermore, the capital account liberalization should proceed in awell-sequenced manner. In particular, the need for prudential regulations cannot beexaggerated. Through them, for instance, risks associated with foreign exchange exposuresand maturity mismatches should be properly monitored.

      Second, the monitoring of the movementsof capital, particularly of short-term capital, needs to be enhanced. In conductingsurveillance and in formulating programmes, the IMF should urge national authorities, andgive assistance when appropriate, to compile and to monitor more detailed data concerninginflows and outflows of capital ? in terms of maturity, currency, form (direct investment,bank borrowing, securities investment, etc.), and borrower (sovereign, quasi-sovereign,financial institution, private corporation, etc.). Obviously, capital accountliberalization has made it more difficult to collect data on capital transactions.However, the reporting obligations of both financial institutions and corporations thatare borrowing from overseas creditors must be strengthened as needed.

      Third, an emerging or developing economy,in its process for capital account liberalization, might want to keep capital inflows to amanageable level, according to its economic size and the stage of development of itsfinancial sectors. In such a case, maintaining market-friendly controls that wouldprevent turbulent capital inflows should be justified. Such measures have already beenadopted by some Latin American countries, making best use of prudential regulations suchas reserve requirements for foreign borrowing.

      Fourth, as for reintroduction ofmeasures to prevent capital outflows, there are strong views against it. It is truethat some measures might hamper useful capital inflows, such as direct investment, byeroding investor confidence. Some are either so discretionary or arbitrary that they mightundermine the efficiency of the national economy. I fully understand the hesitation shownby people who, pointing out these problems, call for caution in approving the introductionof such measures.

      I believe, however, that there might be somecases that would justify the reintroduction of such measures, for instance, whenpreventing IMF loan proceeds from being used to bail-out foreign investors' money, andwhen preventing capital flight by residents. Of course such controls should not be thenorm: they must be exceptions. Also, such measures need to be carefully designed, so thatthey will not adversely affect inflows of stable and useful long-term investment. I lookto the IMF "to review the experience with the use of controls on capital movements,and the circumstances under which such measures might be appropriate" as instructedby the communiquEof the Interim Committee meeting held this October.

      Lastly, industrial countries can alsocontribute to the mitigation of risks posed by turbulent short-term capital movements,through strengthened monitoring on the lenders' side. We need sophisticatedsupervision systems to cope with various forms of investment, from simple portfolioinvestments to exotic off-balance-sheet derivatives. In particular, the authorities insuch countries must pursue ways to address issues related to internationally activeinstitutional investors, including hedge funds. In my view, we should examine the scopefor measures including appropriate prudential rules or reporting requirements forfinancial institutions investing in or lending to hedge funds, especially thoseestablished in the offshore centers where regulations are deemed loose, and appropriatedisclosure or reporting requirements for hedge funds themselves.

      In addition, in order to make the wholeexercise effective, coordination among national and international regulators shouldbe reinforced. For this purpose, it is worth considering the creation of a forum wheremajor international regulatory bodies such as the Basle Committee of Banking Supervisionand IOSCO (International Organization of Securities Commissions) , together with the IMF,the World Bank, and also national regulators, can discuss important issues of the time.

III.  The Exchange Rate Regime

      The second fundamental issue facing today'sinternational financial system concerns the exchange rate regime.

      After the collapse of the Bretton-Woodssystem, all of the major countries and many others opted for a floating exchange rateregime, because it was believed at that time that a floating rate would shield acountry from external shocks, including high inflation overseas, and that it had abuilt-in mechanism for rectifying current account imbalances among countries. Theseobjectives have been achieved only partially at best.

      Under the floating rate regime, we haveexperienced problems of volatility and misalignment: exchange rates have sometimesshown large fluctuations; they have deviated, for a long period, at levels inconsistentwith economic fundamentals; and large imbalances among the major countries have continuedto exist. Moreover, as the movements of capital have increased in size and frequency, thefluctuations in exchange rates have become even greater, resulting in serious adverseeffects on the real sectors of even large economies. Needless to say, violent effects oflarge-scale, short-term capital flows are felt more by smaller economies. They are notjust adversely affected by volatile fluctuations of exchange rates: it has become moreapparent that an emerging economy might face risks of default, due to difficulty inrolling over foreign currency loans, or to a run by international investors, even if itadopts a fully flexible exchange rate regime.

      A variety of efforts has been made tostabilize the exchange rates of the currencies of major industrial countries. Inthe late 1980s, macroeconomic policy coordination was pursued, but it did not result in asmuch stability of exchange rates as had been expected. In addition, the coordination offiscal or monetary policies is not as easy a task as theories assume, because ofconstraints resulting from domestic concerns and political sensitivities. Nowadays, it isoften argued that exchange rate stability would be better achieved through efforts by eachindustrial country towards sustainable low-inflation growth. The question still remains,however, if this would be sufficient.

      Some suggestions are reportedly being madein Europe concerning the need for greater stability among the major currencies. Iagree that greater stability is desirable. It is our task to examine the possibility ofcreating an exchange rate regime that will bring about greater stability on the one handand needed flexibility on the other, among the yen, the U.S. dollar, and the euro.Although it is a difficult challenge, we have to work hard to attain this "managedflexibility" among the three currencies.

      With regard to the currencies ofemerging and developing countries, it is crucial what exchange rate regime we adviseeach country to adopt. Of course, the most appropriate exchange rate regime might differfrom country to country, due to differences in the size of a nation's economy, thecomposition of its trade partners, the composition of its major trade items, the degree ofits capital account liberalization, the nation's past experience with inflation, and otherfactors.

      At the same time, however, the recentexperiences in Asia apparently revealed the risks of pegging a country's currency to asingle foreign currency. Doing that often causes disregard of exchange risks byforeign investors as well as by domestic borrowers, and sustained misalignment of exchangerate level with economic fundamentals, and consequently leads to a bubble economy thatlater bursts. No country can afford a mistake in selecting an exchange rate regime, onwhich all economic policies hinge.

      It might be generally appropriate thatemerging or developing countries peg their rates to a currency or to a basket ofcurrencies of the developed countries with which they have the closest trade andinvestment interdependence, while adjusting the peg periodically so as to reflectdevelopments in relative real effective exchange rates, unit prices, and current andcapital account balances. Having said that, I would like to repeat that there is no simpleset formula, and that case by case perusal of a country's specific situation is essential.

IV.  Providing Liquidity to Crisis Countries

      The third fundamental issue is how toprovide liquidity to countries hit by crisis.

      According to the IMF World Economic Outlook(September, 1998), Asian countries attracted $28.8 billion of net private capitalinflows in 1996, a trend that was brutally reversed in 1997, when there was a netoutflow of $44.3 billion of private capital from these countries. Regardless of the healthof a country's economic fundamentals, no country can weather such an onslaught.

      Also, Asian countries' access to capitalmarkets has all but disappeared. In January of this year, for instance, Indonesia'ssovereign risk was deemed so high that the premium for its sovereign bonds reached about1,000 basis points above that of U.S. Treasury bonds. It rose as high as 1,800 basispoints following the Russian turmoil during this past summer, although it came down againto about 1,000 basis points by November. Such a prohibitive premium was applied to manyother sovereign bonds issued by emerging economies. Even if such countries were able toborrow in the market, such high interest payments would not be sustainable.

      There is much talk these days about loss ofmarket confidence. This is actually a different way of saying that the crises of today areoften essentially crises of liquidity. Overseas creditors pull out funds even fromcountries with appropriate policies and from otherwise solvent local institutions andcorporations. The most appropriate response to this type of crisis is to provideliquidity. This would provide an economy with breathing space that could be used to calmthe market, and that would make it possible to consider necessary policy measures to betaken after the crisis, according to the specific circumstances of each country. This alsowould mitigate panic among overseas creditors: knowing that there were sufficient funds,they would not have to rush to try to gain as big a slice as possible of a small pie.

      Incidentally, trying to calm the market bypresenting policy adjustments that are too ambitious might at times becomecounterproductive: a very tight monetary policy in the absence of history of highinflation, and a very stringent fiscal policy in a country with a good track recordconcerning fiscal soundness could simply result in a contraction of the real economy andfurther deterioration of market confidence. In this regard, it might also be advisable forthe IMF to refrain from requiring too broad or too ambitious structural reforms at a timeof crisis, because such targets very likely will be missed, particularly amid thepolitical confusion experienced during a crisis, and they could lead to even furthererosion of market confidence. Of course, that is not to say that we should disregardnecessary macroeconomic adjustments. But measures should be implemented with fullawareness of the ongoing crisis. Likewise, much-needed structural policies should beaddressed as mid- to long-term challenges.

      In sum, to prevent panic among investorsand to restore confidence as quickly as possible, the international community needs toenhance its capacity to provide liquidity. The IMF, as the central institution of theinternational financial system, has to play an important role in this endeavor by assumingsome role as the lender of last resort in an appropriate situation. In this regard, thecoming into effect of the New Arrangement to Borrow and the progress being made towardsthe IMF quotas increase, both of which contribute to reinforcing IMF resources, areimportant steps.

      I now wish to spell out some concrete ideasabout mechanisms for providing quicker and greater liquidity, in line with the views Ihave just presented.

      First, in order to provide liquidity tomember countries hit by a crisis, the IMF could create a new facility that would beprecautionary as well as quick in disbursement when needed. Such a facility would differfrom the precautionary facility currently being discussed, in that my proposal would notrequire pre-agreed arrangements, but would base itself primarily on good track recordscertified through regular surveillance. This new facility would aim only at overcomingpresent difficulties; policy requirements should be limited to a minimum for serving thisobjective. Once a crisis has passed, necessary reforms could be implemented in the contextof longer-term programmes of the IMF or the World Bank.

      Second, in order to enhance the IMF'scapacity to provide large-scale, short-term liquidity, it is conceivable to allow theIMF to borrow in the market as the institution is granted the capacity to do so by itsArticles. Such borrowed funds would be used exclusively for the existing SRF (SupplementalReserve Facility), a precautionary facility currently under discussion, and theabove-mentioned new facility. This is logical, inasmuch as such borrowing by the IMF wouldbe a means to recycle private funds that have stopped flowing into, or have indeed flowedout from, emerging economies.

      Third, the IMF can augment countries'foreign reserves through a new general allocation of SDRs. Member countries agreedlast year to carry out a special allocation that was intended to achieve a fair allocationof SDRs between the original members and new members of the IMF. However, considering thefact that there is a global need to supplement reserves, especially in the emergingeconomies, and that risks of inflation are low, the case for a new general allocation isvery strong.

      Fourth, in order to complement the role andfunction of the IMF, I think that it is appropriate to consider establishing regionalcurrency support mechanisms. The recent experience regarding Brazil has reinforced ourconviction that, in order to strengthen the international community's capacity to provideliquidity at a time of crisis, it would be appropriate to complement IMF loans throughsome kind of regional mechanism that is anchored in a sense of solidarity and mutualdialogue among the countries in a region.

      These mechanisms, which could beestablished in each region such as Asia, Latin America, and Eastern Europe, would befunded by countries in the region that are strongly interdependent on each other in thefields of trade, investment, and so on, and that are conducting continuous dialogue witheach other on their policy directions. Nonregional countries with economic or politicalinterests in the stability of the region also could participate.

      Under the initiative carrying my name, theJapanese government has proposed a variety of financing schemes, totaling $30 billion, forAsian countries. I am hoping that this initiative could lead to further discussionstowards a regional currency support mechanism of the type that I just mentioned.

V.  Conclusion

      Talks about reforming the internationalfinancial architecture should not be just a passing fancy. They are indispensable forcreating a better environment in which the world economy will operate.

     In 1926 John Maynard Keynes said,

Many of the greatest economic evils of our time are the fruits of risk, uncertainty, and ignorance. … I believe that the cure for these things is partly to be sought in the deliberate control of the currency and of credit by a central institution, and partly in the collection and dissemination on a great scale of data relating to the business situation, including the full publicity, by law if necessary, of all business facts which it is useful to know.

Based on this observation, he continued,

For my part, I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight.
(The End of Laisser-Faire)

As is usual, his foresight applies even today.

      It is the responsibility of all of us, whohave a common stake in the stability and sound development of the international financialsystem, to work to create a new international financial architecture for the next century.And I firmly believe that Japan should play a leading role in this important task ofpreparing for the new century, which is only two years away.

      Thank you very much.