|Vice Minister's Speech on the Future International Financial Architecture|
and Regional Capital Market Development
at the Round Table on Capital Market Reform in Asia in Tokyo, 11 April, 2000
First of all, I would like to thank you for giving me this opportunity to speak before such a distinguished audience. Taking advantage of this opportunity, I would like to express my personal views on the future international financial architecture and regional capital market development.
I. Background and Necessity of Strengthening the International Financial Architecture
The Asian currency crisis began in the summer of 1997 in Thailand and instantly spread to Indonesia, Korea, and eventually all over Asia. During the crisis, about $100 billion worth of funds reportedly flowed out of Asia. A year later, Russia was hit by a currency crisis and at the end of 1998, it was Brazil's turn. During this 18-month period, many emerging economies had either been directly hit or at least affected by their worst crisis since World WarⅡ. These developments caused experts to conclude that these almost simultaneous global currency crises were caused not simply by inherent problems in individual emerging economies, but rather by defects in the international financial system.
II. G7 Finance Ministers' Report on Strengthening the International Financial Architecture
Thus, with the Group of Seven major countries at its core, the international community started to examine reform of the international financial system. At the Cologne summit last June, the G7 leaders welcomed the report prepared by their Finance Ministers on strengthening the international financial architecture.
In fact, the G7 countries had once reviewed the international financial system after the Mexican currency crisis of late 1994 to early 1995. However, at that time, they concluded only that the transparency of each country's economy should be increased and that the International Monetary Fund's financial resources should be strengthened.
Even immediately after the outbreak of the Asian currency crisis, the lack of transparency inherent in the public and private sectors of Asian economies, often dubbed "crony capitalism," was criticized sharply.
The G7 Finance Ministers' report eventually adopted at the Cologne summit was unprecedented in that the G7 leaders, taking fully into account the recent worldwide currency crisis, agreed to a comprehensive reform of the international financial architecture. Their report provides many useful and important principles and prescriptions to strengthen the international architecture.
III. Progress in Strengthening the International Financial Architecture
Now, I would like to review developments that have taken place in several areas since the G7 Finance Ministers' report was issued.
1. Strengthening and reforming international institutions and arrangements
There have been four major developments in the area of strengthening and reforming international institutions and arrangements
First, at the IMF's annual meeting last year, the Board of Governors decided to transform the IMF's Interim Committee into the International Monetary and Financial Committee, and to make it a permanent body.
Second, the Group of Twenty Finance Ministers and Central Governors, the so-called 'G20', was established to provide a new mechanism for informal dialogue in the framework of the Bretton Woods institutional system, to broaden discussions on key economic and financial policy issues, and to contribute to consensus building among its members. The inaugural meeting of the Group was held last December in Berlin.
Third, the Financial Stability Forum (FSF), which was created last year, has examined issues concerning highly leveraged institutions (HLIs), capital flows, and offshore financial centers. Final reports on the three topics were just released.
Fourth, the necessity of streamlining the IMF's facilities was recently emphasized by the United States. The essence of the U.S. proposal is that the IMF should be more limited in its financial involvement with member countries, in other words, it should lend selectively and with short maturities.
Concerning reform of the IMF, Japan has long expressed its views that (a) the focus of surveillance and programs should be responsive to potentially abrupt large-scale cross- border capital movements, (b) the involvement of the IMF in structural policies should be limited to cases directly related to crises, and (c) its transparency and decision- making process should be improved. These views are basically in line with the U.S.'s view that the IMF's lending should focus on coping with crises.
In order to provide appropriate and adequate international financial support for economies in crisis, it is extremely important to secure sufficient resources for the IMF. In this context, we have to continue to pay due attention to strengthening the financial base of the IMF.
Another imperative element of IMF reform is to redistribute quota shares to better reflect the changing economic realities of member countries since quota is a basis for each member's access limit to IMF resources as well as a basis for decision-making in the IMF.
2. Enhancing transparency and promoting best practices
Let me now turn to the area of enhancing transparency and promoting best practices.
Major steps have been taken to enhance the transparency and accountability of the IMF through disclosure of the content of IMF discussions, publication of IMF staff papers, and the voluntary disclosure of Article IV consultation papers. These developments are certainly welcome, but further efforts are needed.
The implementation of internationally agreed standards and codes is important in facilitating rational decision-making by investors, in helping financial markets function effectively, and in promoting responsible and sound policies by governments. Therefore, it is necessary to disseminate international standards and codes steadily, with due consideration for the specific circumstances of each country.
The IMF has decided to become a core mechanism for monitoring the implementation of standards and codes. This process will be carried out on a modular basis covering a wide range of standards and codes, with the IMF responsible for its core areas of expertise and other institutions such as the World Bank, the OECD, and the Basel Committee, taking responsibility for other areas.
3. Strengthening financial systems in emerging economies
It is vital that emerging economies select an appropriate exchange rate regime in order to reduce their vulnerability to crises. Concerning the type of exchange rate regime that should be adopted by emerging market economies, Japan has long expressed its reservations about the so-called 'two corner solution', which calls for either a fixed exchange rate system based on a currency board or some other rigid system, or a freely floating exchange rate system. A consensus has emerged in recent IMF discussions that the appropriate exchange rate regime would vary depending upon the country's circumstances. For example, for an open emerging economy, one option could be to aim at stabilizing the currency's value by adopting as a reference a basket of currencies of its major trade and investment partners.
4. Response to highly leveraged institutions (HLIs)
The issue of highly leveraged institutions is particularly important. In international discussions to date, a consensus has been reached on enhancing disclosure by all market participants, including HLIs, ensuring appropriate counter-party risk management in their transactions, and enhancing regulatory oversight as recommended by the FSF Working Group's final report on HLIs. Achieving progress in putting in place and implementing the necessary measures in this respect is certainly important. In addition, as the FSF's meeting last March emphasized, direct regulation should be reconsidered if, upon review, the implementation of the report's recommendations do not adequately address the concerns identified.
5. Private sector involvement for crisis prevention and resolution
It is extremely important to strengthen the involvement of the private sector in preventing and resolving crises. Since it would be difficult to continue the bail out of private investors using public funds, and this also involves moral hazard, there is an international consensus that it is essential to seek the cooperation of all private sector creditors, including bondholders. However, the actual implementation of such efforts is fraught with difficulty. I will touch upon this issue later.
IV. Regional Capital Market Development
Strengthening financial institutions and improving the supervision of financial systems are easier said than done. When it comes to supervising banks, there is an established international organization―the Basel Committee on Banking Supervision (BCBS)―however, its members are all from industrialized countries. If the IMF were to try to force emerging economies to abide by the rules decreed by the Basel Committee, such a move might be resisted.
Though it is dangerous for a country to depend on too much short-term capital from foreign countries, there is no simple standard suitable for all countries. The negative effects of regulating capital inflow also need to be considered.
Even if industrialized countries reinforced the risk management of financial institutions that lend money to HLIs, simply raising the risk weights required by the BCBS-set Basel Capital Accord would not be sufficient. It is also necessary to strengthen the risk-management capability of the financial institutions themselves.
For governments to be able to make HLIs, including hedge funds, disclose information, some form of legal action will be necessary, but there is a problem with this. Most hedge funds are established in offshore markets, where transactions are free from control by outside regulatory bodies. Also, given that most hedge funds are managed from the United States, whether the U. S. Congress accepts such a measure would be critical.
It is extremely difficult for governments to obtain private sector involvement, as this means asking private lenders to assume responsibility. When Korea was hit by a currency crisis in late 1997, the G7 countries asked their banks to rollover their loans to Korean banks. This drastically alleviated a critical situation. By complying with the moral suasion of their governments, the banks of G7 countries benefited and the self-sustained flow of funds was recovered. However, in most other cases, such measures have not been effective.
As regards the outstanding bonds issued by emerging countries, though Pakistan and Ukraine have recently succeeded in restructuring their debts without a contagion effect on other economies, generally speaking, restructuring emerging countries' debts has proved extremely difficult. Though various coercive measures have been discussed, including the forcible restructuring of debts through the so-called standstill approach or the imposition of restrictions on capital outflow, in the worst case, none of the measures would be easy to implement.
In short, although some intervention in the market, including financial supervision and private sector involvement, may be unavoidable if we are to ensure the smooth functioning of the global financial and capital markets, it will be a very difficult task.
Furthermore, market intervention risks hampering the inflow of funds to emerging countries could delay their economic growth. We have to remember that the massive capital flow into Asian countries between the mid-1980s and the mid-1990s brought about dramatic economic growth in the region, although in retrospect the inflow could be deemed excessive. In any event, we should not ruin the whole by trying to correct a small fault. The smooth inflow of funds to emerging countries needs to be secured by utilizing the functions of the global financial and capital markets. I believe that we have to explore 'a third way' to enhance stability.
To this end, the first crucial step would be to develop and maintain a market in which international funds, including those going to emerging economies, can flow without impediment. Efforts to help emerging economies develop their domestic capital markets are particularly important.
Since the saving ratio is as high as 30 to 40 percent in emerging Asian economies, their growth could have been largely achieved without overseas borrowing as far as the total amount of funds is concerned. However, when a substantial part of these savings was channeled overseas, short-term funds were imported in larger amounts to feed the economies, resulting in the Asian financial crisis and its global reverberations.
The most pressing need therefore is to develop capital markets in each emerging economy to facilitate the adequate flow of funds to where they are needed.
The establishment of fair accounting standards, settlement systems, and taxation systems, and the removal of unfair market domination are indispensable for the development of capital markets.
In emerging Asian economies, loans have been the most common method by far of raising capital, while stock markets have been widely targeted by speculative investors, and bond markets have been underdeveloped. This is why the New Miyazawa Initiative in the second stage places particular priority on the development of bond markets. The initiative aims at boosting financing through bond issuance by guaranteeing bonds issued by Asian countries.
The second step should be for Asia to establish a regional capital market, because capital providers have nationalities and regionalities although funds can move freely across borders. Such reasoning is the main factor behind Europe's great efforts to set up a regional capital market. Likewise, U.S. capital has been invested primarily in the United States and Latin America because ordinary investors have a greater understanding and trust of their own countries and neighboring countries.
Fortunately, in Asia, there is a large pool of savings that could be effectively used for mutual benefit through a regional capital market. A common mechanism to enhance the credibility of such a regional marketplace, standardized bonds for issuance in the region, and a regional credit-rating organization are measures worth considering to support the distribution of such funds within Asia.
It is vital, as a third step, to put in place sound macroeconomic, financial, and structural policies in Asian countries to enable markets to function smoothly.
A regional surveillance system, which has already been adopted under the Manila Framework, whose members include Australia, Japan, other key Asian countries, and the U.S., should be enforced through various forums. Also worth considering is the establishment of a safety net, linked to the surveillance system, to support the financial market.
Finally, to enable the financial and capital markets to contribute to the economic growth of the region, exchange rates must be stabilized to reflect the fundamentals of the regional economies.
Even though currently it would be difficult to set up a global mechanism to stabilize foreign exchange rates, a regional mechanism is possible and may be necessary. For example, many northern, central, and eastern European countries peg their currencies to the euro. In Latin America, a few countries peg their currencies to the dollar. It would be difficult for the yen in its own to play a role similar to that of the euro and the dollar; however, the region could start with a basket composed of the yen, the euro, and the dollar before imaging a common currency for Asia.
Ahead of the worldwide reform of the international financial system, and in the wake of the Asian crisis, emerging economies independently introduced various domestic controls and regulations. It is understandable that they resorted to such countermeasures; however, it is an undesirable solution for the long term. A shift from the individual nation approach to a coordinated regional strategy may be a practical alternative for emerging economies.