During the past quarter-century, economic and financial liberalisation across the world has led to the new, market-based financial economy in which we live. This transformation of the financial system has brought considerable benefits. But as the recent episode in Argentina reminds us, it has also been accompanied by too many financial crises, especially affecting emerging market countries.
Some NGOs, voices in the media, and a few economists blame “neo-liberal” economic reforms for these problems. But policymakers have little appetite for a return to strict government regulations and have concentrated instead on the need to make markets function better by adopting rules-based frameworks to guide financial policies and markets. In addition to crisis prevention, the objective is to make countries more resilient in times of financial turbulence.
The immediate benefits of the new financial economy are easy to illustrate. Investors, from individual savers to pension fund managers, can now better diversify their investment choices across domestic and international assets, thereby increasing rates of return. And businesses are better able to finance promising ideas and fund their expansion plans. As a result, financial resources are invested more efficiently, raising economic growth and living standards. Other advantages are more subtle, but arguably as important. In addition to the costs of sometimes wasteful allocation of scarce financial resources, the regulated financial systems that existed from the end of the Second World War until the 1970s and 1980s suffered from two serious drawbacks: the temptation of governments to finance growing budget deficits through their privileged access to savings “captured” in financial institutions that are constrained in their lending decisions; and the inability of the regulated financial systems to sanction economic policies that led to high inflation. Financial liberalisation has changed this by inciting governments to pursue sound fiscal policies and price stability.
If the benefits of a market-based financial system are so obvious, why were the regulations put in place to start with? Part of the aim was to respond to shortcomings of the liberal economic system that prevailed during the gold standard period prior to the First World War, including economic instability and widespread social problems. Together with the establishment of social safety nets and the active use of macroeconomic policies for stabilisation purposes, government-controlled financial systems were also a response to the Great Depression and its many banking failures. The implicit distrust in market forces played a key role in economic strategies adopted after 1945 and for several decades afterwards.
Faith in markets has gradually been restored since the early 1970s, when a search for new policies was prompted by the breakdown of the Bretton Woods system of fixed exchange rates, an abrupt economic slowdown, rising unemployment and surging inflation. Given this historical perspective, it is perhaps not surprising that the return to a market-based financial system appears to be associated, at least occasionally, with a relatively high degree of volatility in exchange rates, stock market values and other financial market prices. However, the international community has only gradually become fully aware of some of the more problematic consequences of the rapidly changing financial system, including those stemming from the pronounced integration of capital markets since the 1980s.
Many emerging market countries have benefited from substantial inflows of foreign direct and portfolio investments. However, particularly where short-term flows are concerned, changes in investor sentiment –often motivated by concerns over mounting public debt or financial imbalances – have led to abrupt capital outflows in all too many cases. Since 1994, such reversals have contributed to severe financial crises in most of Latin America, large parts of South East Asia, and also in some transition countries. These crises were often aggravated by cross-border financial contagion, where market liquidity suddenly dried up for particular countries – not because of economic fundamentals in these countries, but because they shared some characteristics with another economy suffering a loss of market confidence. Experience shows that the likelihood of contagion (and herding) mounts when information about a given country’s financial health is limited.
The greater investment opportunities of market-based systems also carry risks, including those associated with speculative bubbles. Unless the increase in risk appropriately managed, individuals and financial institutions can become vulnerable to swings in asset prices. This problem may be particularly acute in transition economies because supervisory standards and risk management skills take time to develop. Also, there is a danger that in globalised financial markets it may be easier to launder illegal money, whether from drug trade or corruption. And it may also become easier to evade taxes by investing in so-called tax shelters. The possibility that financial regulations and oversight mechanisms in offshore financial centres may be inadequate is an additional concern.
The responses to these problems can be broadly characterised as a new kind of réglementation – a framework of rules for the conduct of policies and a guide for financial markets. The approach is captured better by the French term than the English “regulation”, since the intention is not to decree what markets are or are not allowed to do (regulate), but rather to foster market decisions on the basis of a clearer understanding of the risk involved and of the principles guiding financial policies. The central idea is twofold: to reduce the risk of abrupt changes in market sentiment through greater transparency, and to enhance the resilience of financial systems when market sentiment does change, for example, as a result of external shocks.
To this end, the international community has developed and promoted a range of voluntary international standards of good practices for economic policies and for the financial infrastructure. (See box: “Building the framework”.) The IMF and the World Bank, with their global membership (183 member countries), are now preparing Reports on the Observance of Standards and Codes (ROSCs), working in co-operation with national authorities and standard-setting agencies, including the OECD, in order to assess a given country’s progress in meeting these standards. The aim is to provide constructive feedback that can help the authorities identify and implement the regulatory and operational reforms needed for the development of their countries’ financial systems and their integration into global markets. The process is also used to set priorities for technical assistance by the multilateral institutions themselves, by other standard-setting bodies, and by bilateral donors. Finally, the ROSCs provide market participants with timely information on progress in implementing standards, which can serve as input into their risk assessment.
As of January 2002, some 142 ROSC modules for 41 advanced, emerging market, and developing countries have been published (www.imf.org/external/np/rosc/rosc.asp).
While much can be done to reduce the risk of financial crises, these do occur. However, their costs can be cut considerably. First, an affected country has to address the root causes of the crisis. The international community, mainly through the IMF, can help identify those causes and provide temporary financial assistance. Private creditors may then respond by rolling over existing credit lines and maturing bonds and even providing new financing. Only then will a liquidity crisis be prevented from becoming a costly solvency crisis, to everybody’s benefit. Things can get a lot more complicated in those – fortunately – rare circumstances when a country is unable to return reasonably quickly to market financing and is in need of external debt restructuring to reduce its debt servicing burden. A lack of clear rules on how to resolve unsustainable debt situations for sovereign debtors is partly responsible. To fill this gap, the IMF’s first deputy managing director recently proposed the establishment of a legal framework to guide the restructuring process, including standstill provisions to give a country breathing space to begin to address its problems and negotiate with creditors. * The aim is to reduce the cost of restructuring for both sovereign debtors and their creditors. Many difficult issues will have to be resolved before such a framework can be made operational, but it could provide for greater predictability, facilitate the pricing of risk, and help place capital flows to emerging markets on a sounder footing.
The emerging framework of rules –réglementation – should help reduce the frequency and severity of financial crises. But such rules are not enough, and countries still need to address policy weaknesses before the crisis hits, including any inconsistencies between their choice of exchange rate regime and other policies. A failure to do so contributed to virtually all of the financial crises in emerging market countries during the past decade, including Argentina. The new financial economy throws up other challenges too, such as how to deal with unsustainable run-ups in the prices of financial assets or real estate, which can have devastating effects on any economy – emerging or advanced – when the bubbles eventually burst.
Another challenge is how to dampen the inherently pro-cyclical lending cycle of the banking system that often contributes to price swings. The most controversial – and arguably most important – issue concerns the role that monetary policy might play in “leaning against the wind” when asset prices rise sharply but inflation does not signal a need to tighten. Any consensus about the best approach to follow in this area is unlikely to emerge soon.
The new financial economy will probably always have some degree of financial volatility. We are in the process of learning how to identify and manage the associated risks. Much progress has already been made and the financial system seems more solid than a decade ago. But the architecture must continue to adapt as the financial revolution continues.
* See Anne Krueger’s addresses “A New Approach to Sovereign Debt Restructuring”, given at the National Economists’ Club, Washington DC, on 26 November, 2001 and at the Indian Council for Research on International Economic Relations, Delhi, on 20 December, 2001 (www.imf.org).
©OECD Observer No 230, January 2002