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Part 5: Conclusion and Appendices
Post-Crisis Financial Architecture
This conference is a very timely one, since as we approach the new millennium it is becoming more and more obvious that new thinking on the development paradigm is essential, particularly after the series of financial crises since 1994-95. Our discussions today will no doubt contribute to beginning a dialogue on this important issue.
Needless to say, a sound development strategy in each country is indispensable to the stability of the international financial system as a whole. At the same time, without a backdrop of a stable international financial system, development policies of countries will not be implemented smoothly. I believe, therefore, it may be worth your time to look at the nature of various issues involved in the ongoing discussion on reforming the international financial architecture, and the current status of those discussions following the Cologne summit meeting last June.
As we all know, the financial crises of recent years, first in Mexico in 1994, then in Asia in 1997, and in Russia and Brazil in 1998, have clearly demonstrated that there is inherent instability in today's liberalized market economy. This is not to say that the countries experiencing these crises were without flaws: in fact, there were many policy mistakes and inappropriate structural rigidities in these countries.
However, what is striking is the abruptness with which these countries, particularly in Asia, fell from an admirable state of solid economic performance to near bankruptcy. In my opinion, this cannot be explained only by their failure in policy implementation and structural problems. As the crisis spread to Russia and Brazil, even sceptics began to accept that the international financial system itself needed to be reformed.
Japan has been very vocal on this point from an early stage, arguing that there was a pressing need to reform the international financial system as a whole. However, our sense of urgency did not seem to be shared by many countries until the crisis erupted in Russia and Brazil. In December 1998, Minister Miyazawa made a speech outlining Japanfs proposals for reform.
The speech focused on what we think are the fundamental issues, namely how to cope with short-term capital flows, what is the appropriate exchange rate regime for an emerging economy, and how to improve the working of the international financial institutions, especially the IMF.
There have been many more speeches on this subject made by ministers and officials of various countries, and views have also been expressed by people in academia and the private sector. Eventually, after long and sometimes heated discussions among the G-7 countries, the Report of the G-7 Finance Ministers on the International Financial Architecture was finally produced and published last Juneõ. Although this is just the first step, I think that it is a major achievement by the G-7. I now would like to share with you the major elements of the Report, focusing on the three fundamental issues I mentioned earlier.
Crisis of the Capital Account: Nature of Crisis
There is no doubt that increasingly liberalized cross-border capital movements have resulted in strong economic development and a general rise in living standards in many emerging and developing countries, as economic theory teaches us. At the same time, on the creditorsf side, higher expected rates of return from investment in emerging economies are very attractive, especially when the creditorfs country is a mature economy facing the rapid aging of its population.
As such, its appeared that free capital movements would only benefit the world economy as a whole. In fact, this is why the IMF Board seriously considered in the mid-1990s an amendment to its Articles of Agreement that would make the liberalization of capital movements one of the goals of the IMF. However, matters turned out to be not so simple.
A sound development strategy in each country is indispensable to the stability of the international financial system as a whole.
First, in reality, free capital movements do not always bring about optimum allocation of resources, because investors often make their decisions based on imperfect and asymmetrical information.
Moreover, in some cases, especially in Asia, private investors who had lent to, or invested in, these countries in the short-term and in foreign currencies started to withdraw their funds en masse, almost regardless of the economic fundamentals of the recipient countries. This is what I call a e21st century-style crisisf, or a ecrisis of the capital accountf as opposed to the traditional ecrisis of the current accountf.
All of the recent crises in Asia, Latin America, and Russia fell into this new category of crisis. For instance, in Thailand huge capital inflows including those through offshore accounts had created a boom in the economy. But, once market confidence in the sustainability of the virtual peg of the baht to the U.S. dollar was lost, there were massive capital outflows, and the baht collapsed.
As the international community became more aware that capital flows could reverse direction very easily, and that no country could remain intact in the face of such an onslaught, enthusiasm for amending the IMF Articles subsided considerably.
However, even if the development of todayfs financial technologies increases the ease with which investors can move around their capital, and hence brings about higher risk of crisis of the capital account, denying crossborder capital flows altogether would not solve the problem. The most important challenge now facing the international community is to find ways to maximize the benefits of free capital movements while minimizing the risk of crisis. This requires an analysis of why abrupt capital outflows occur.
The possibility of a crisis of the capital account may grow, first of all, when investors have not properly assessed the risk involved in their activities, either because their internal risk assessment procedure is inappropriate, or because they simply follow what other investors do (the so-called eherdingf behavior). It is often argued that the activity of hedge funds, or Highly- Leveraged Institutions (HLIs), influence other market participants so greatly that when large-scale HLIs take a certain position 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 a country's economic policies is eroded. Damage to confidence may be greatest when investors are led to believe that the government implicitly or explicitly guarantees the investment 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 on both the creditorfs side and the recipientfs side.
What Creditors Need to Do
On the creditor's side, the Finance Ministers' Report says that the G-7 will encourage private firms to strengthen their own risk management practices and that national authorities should ensure banking institutions in their countries implement adequate risk management practice in accordance with the Basle Committee's recommendations in its paper on HLIs published early 1999. At the same time, the Report notes that the newly-established Financial Stability Forum will study a number of issues related to HLIs, including instability possibly caused by HLIs in relatively small financial markets. Enhancing supervision in offshore centers is also encouraged in the Report.
Furthermore, in order to ensure that private creditors know that they will bear the consequences of their investment decisions, the Report identifies the principles that govern debtor/creditor relationships and the tools that may be used to promote appropriate private sector involvement in the resolution of crises, including an effective use of the lending into arrears policy of the IMF. Legal and technical questions involved in implementing these specific approaches were considered by the IMF before the last annual meeting.
What Emerging Economies Need to DoOn the emerging economiesf side, the Report proposes concrete measures 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 of exchange rate regime is critical for emerging economies to achieve economic development.' It says, 'We agree that the most appropriate regime for any given economy may differ, depending on particular economic circumstances'. For instance, 'some emerging economies have sought to achieve exchange rate stability by adopting peg 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 overseas investors to properly judge exchange risks they are taking. To make the regime reflect the changing degree of exchange risk, it must be continuously reviewed, so that it can be fine-tuned as 'economic circumstances vary over time.' In this context, the IMF should play a more active role 'to enhance the attention it gives to exchange rate sustainability in the context of its surveillance activities.' If a country intervenes heavily to defend an unsustainable exchange rate level, large-scale official financing should not be provided.
A simple hypothesis, the so-called 'two-corner approach' (floating regime or fixed rate regime) has sometimes been suggested in international circles, including by officials. This school of thought assumes that only a completely free-floating regime or a currency board are viable. The Report does not share this view. Although it does say that 'countries choosing fixed rates must be willing to subordinate other policy goals to that of fixing the exchange rate' and that 'arrangements institutionalizing that policy can be useful to sustain a credible commitment to fixed rates,' the common understanding among the G-7 countries, including Japan, is that the 'arrangements' referred to here are not limited to a currency board but include various measures.
On capital flows, the Report recommends that '[C]apital account liberalization should be carried out in a careful and well-sequenced manner, accompanied by a sound and well-regulated financial sector and by consistent macroeconomic policy framework.' It goes on to explain the G-7 consensus on controls on capital inflow may be justified for a transitional period as countries strengthen the institutional and regulatory environment in their domestic financial systems.
More comprehensive controls on inflows have been employed by some countries as a means to shield themselves from market pressures. Such steps 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 is advocating more controls on capital flows while other G-7 countries are arguing for free capital movements. This is simply not true. If one reads the Miyazawa speech of December 1998 carefully, it is clear that Japan's position from the outset was that maintaining market-friendly controls that would prevent turbulent capital inflows should be justified when a country wants to keep capital inflows at a manageable level according to the stage of development of its financial sector, and that there might be some cases that would justify the reintroduction of controls on capital outflows as an exception, for example, in order to avoid a bail-out by IMF loans. As the Report shows, this stance, first expressed by Minister Miyazawa, is shared by all G-7 countries.
Strengthening Financial Systems
As for financial systems, the Report calls for close coordination between the IMF and the World Bank when they give advice to emerging economies in the area of financial sector reform. It also welcomes commitments by the emerging economies of Asia and Latin America to take necessary steps towards the implementation of the Basle Core Principles for effective banking supervision.
Sound Debt Management
In addition, the G-7 thinks that best practices in debt management should be promoted, so that countries avoid too much reliance on short-term borrowing, particularly in foreign countries. I expect that these principles will be discussed by the IMF Board in the near future.
Reform of the IMF
It is clear that the IMF was unable to meet the challenges posed by this 21st century-style crisis in several Asian countries. The biggest mistake was that the IMF prescribed for the countries emedicationf that had been effective for the old-style crisis of the current account.
I have on several occasions discussed in detail what was inappropriate in IMF programmes for Thailand, Korea, and Indonesia. I shall therefore not repeat my arguments today. Should you be interested, some of my speeches and the Ministerfs speeches can be found on the Ministry of Finance Homepage on the Internet (www.mof.go.jp/english/*).
Of course, I firmly believe that the IMF should be at the heart of the stable international financial system. This is not to say, however, that the IMF can stay as it is now. In this connection, the G-7 Report says, '[B]uilding upon the experience of IMF-supported programmes in the financial crisis, the IMF should explore ways further to improve IMF surveillance and programmes so that they better reflect the changes in the world economy, in particular potentially abrupt large-scale cross border capital movements'.
The decision-making procedures of the IMF must be improved, too, so that Board 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 the governing structure of the IMF. First, it is proposed that the Interim Committee be given a permanent standing with a new name, 'the International Financial and Monetary Committee.' Second, it is suggested that an informal mechanism for dialogue among systemically important countries be established within the framework of the Bretton Woods institutional system. It has materialized already. The working of the IMF will also be improved through more transparency, especially through greater release of its Board documents and better internal and external evaluation efforts. The G-7 Report supports this point, too.
The prescription given in the report could be described as muddling through or the middle way approach. Mervyn King, Deputy Governor of the Bank of England, in a recent speech, defined two extreme purist solutions: the one being free and open capital markets with international lender of last resort and the other being reinstating permanent capital controls.
Neither one of the two is politically feasible at this moment and the muddling through approach is the only feasible solution for now. This approach poses problems of implementation particularly when, like now, the immediate crisis is over. There seems to be some elements of complacency in both the private and the public sectors and the process of implementation seems to be somewhat delayed. Private sector participation, in general, has been resisted by institutions like the Institute for International Finance representing the interests of major financial institutions in the markets. Reform of the IMF does not seem to be proceeding as the Japanese government had hoped primarily because of the inertia of international bureaucracy and existing consultation forums.
Global and regional efforts for improving international architecture complement each other and should proceed simultaneously.
If this muddling through or middle way approach does not result in any noticeable progress which, given what are observed during past several months, is a distinct possibility, countries would be inevitably led to national or regional defense against possible future crises. Mervyn King calls one of those measures a do-it-yourself lender of last resort. He mentions these specific do-it-yourself lender of last resort policies.
First is the accumulation of net foreign reserves, which is taking place in many Asian countries now. In the face of resurgence of capital inflows, such accumulation is possible through foreign exchange intervention limiting the appreciation of currencies. Second would be the creation of contingency credit facilities with international banks as practiced by, for example, Argentina.
Third would be the creation of regional funds, such as Asian Monetary Fund. As Mervyn suggests, all of these approaches are likely to be pursued, particularly because the process of implementing global international financial architecture is slowing down due to complacency.
In this context, it is worthwhile noting that regional cooperation among Asian countries has started to proceed somewhat smoothly. The tripartite summit between PRC, Japan and Korea, for example, is an interesting forum while ASEAN plus three would provide a wider and a more meaningful venue for Pan Asian issues. Although nothing concrete came out of the ASEAN meeting in Manila, yet in relation to regional financial cooperation, starting a candid discussion on the issue in and of itself is quite meaningful.
Although I sincerely wish the G7 will continue to work hard among themselves and cooperate with the IMF and World Bank Boards so that proposals in the G7 communique can be implemented as quickly and as practically as possible, I think that Asian countries should try to construct credible mechanisms for regional cooperation both in trade and finance.
The Asian Development Bank and the ADB Institute can play a meaningful role in enhancing regional cooperation, which is consistent with global efforts to restructure the international finance system. I believe that global and regional efforts for improving international architecture complement each other and should proceed simultaneously.
2. List of Participants and Observers
Dr. Ramesh Adhikari, Senior Capacity Building Specialist, ADB Institute
Dr. Manzoor Ahmed, Director, United Nations Children's Fund Office in Japan
Mr. Javid Akram, Federal Secretary, Economic Affairs Division, Pakistan
Dr. Masahiko Aoki, Professor, Stanford University, United States
Mr. Megumi Araki, Senior Administrative Officer, ADB Institute
Mr. Susumu Atsuki, Director of the Research Division, International Bureau, Ministry of Finance, Japan
Mr. John Austin, Alternate Director, Asian Development Bank
Dr. Iwan Azis, Adjunct Professor, Cornell University
Mr. Stephen Baker, Alternate Director, Asian Development Bank
Dr. Gan Wee Beng, Advisor, Economics Department, Monetary Authority of Singapore
Dr. Barry Bosworth, Senior Fellow, Brookings Institution, United States
Mr. Rodrigo Payumo Castelo, Undersecretary, Department of Finance, Philippines
Mr. Chandi Chanmugam, Member of the Monetary Board, Sri Lanka; Advisory Council of ADB Institute
Prof. Edward K.Y. Chen, President, Centre for Asian Pacific Studies, Lingnan University, Hong Kong, China
Prof. Siow Yue Chia, Director, Institute of Southeast Asian Studies, Singapore
Dr. Yoon-Je Cho, Professor, Sogang University, Korea
Mr. Ng Wai Choong, Director, Economics Division, Ministry of Trade and Industry, Singapore
Mr. Abdul Hamid Chowdhury, Secretary, Planning Division, Ministry of Planning, Bangladesh
Mr. S. B. Chua, Director, Capacity Building & Training, ADB Institute
Mr. Hidir Mehmet Colpan, Representative, Representative Office in Tokyo, Central Bank of the Republic of Turkey, Japan
Mr. Lester Dally, Deputy Director, World Bank Tokyo Office, Japan
Mr. Donal Donovan, Director, IMF-Singapore Regional Training Institute, Singapore
Ms. N. Cinnamon Dornsife, Director, Asian Development Bank
Mr. Murray Edwards, Minister-Counsellor (Economic), Senior Treasury Representative Embassy of Australia, Japan
Mr. Erkin Fayzievich, Deputy Minister, Ministry of Finance of Uzbekistan, Uzbekistan
Dr. Greg Felker, Assistant Professor, Hong Kong University of Science and Technology, Hong Kong, China
Mr. Masao Fujioka, President, Japan Credit Rating Agency Ltd., Japan; Former ADB President
Dr. Prasad Shyama Gupta, Member, Planning Commission, Government of India
Dr. Hall Hill, Professor, Australia National UniversityMs. Keiko Hioki, Advisor to the President, Asian Development Bank
Dr. Helen Hughes, Professor Emeritus, Australian National University; Chair, Advisory Council of ADB Institute
Mr. Kyong Wook Hur, Director, International Finance Policy Division, Ministry of Finance and Economy, Republic of Korea
Mr. Fida Hussain, Economic Minister, Embassy of Pakistan, Japan
Mr. Shiro Inoue, Former President of ADB
Dr. Shigeru Ishikawa, Professor Emeritus, Hitotsubashi University, Japan
Mr. Takatoshi Itoh, Deputy Vice Minister of Finance for International Affairs, Ministry of Finance, Japan
Mr. Erik Johnsson, Director, Asian Development Bank
Mr. Othman Jusoh, Secretary, Management of Debt, Finance and Investment Division, Ministry of Finance, Malaysia
Dr. Haider Khan, Visiting Scholar, Asian Development Bank Institute
Mr. Hyoung-Kwon Ko, Senior Deputy Director, Fiscal Planning Coordination Division, Ministry of Planning and Budget, Republic of Korea
Mr. Chong Shun Kwok, Monetary Authority of Singapore
Dr. Mario B. Lamberte, Acting President, Philippine Institute of Development Studies, Philippines
Dr. Jin Soon Lee, President, Korea Development Institute, Republic of Korea
Dr. Jomo K. S., Professor, University of Malaya
Dr. Jungsoo Lee, Chief Economist, Asian Development Bank
Prof. Mai Lu, Senior Researcher, Development Research Centre of the State Council, Peoples Republic of China
Mr. Jean-Yves Marquet, Attache Financier, Embassy of France, Japan
Mr. Felipe Medalla, Director-General of the National Economic and Development Authority, Philippines
Mr. John Millett, Director, Asian Development Bank
Prof. Weifang Min, Executive Vice-President, Peking University, Peoples Republic of China
Mr. Kiichi Miyazawa, Minister of Finance, Japan
Mr. Zembei Mizoguchi, Director-General of the International Bureau, Ministry of Finance, Japan
Prof. Gulnara Moldasheva, Professor of Economics, Kazakhstan Institute of Management, Economics, and Strategic Research, Kazakhstan
Dr. Wadan Narsey, Associate Professor, The Department of Economics, School of Social & Economic Development, The University of the South Pacific, Fiji
Ms. Thanh Thi Kim Nguyen, Deputy Director, Monetary Department, State Bank of Viet Nam
Mr. Hitoshi Nishida, Director, Administration, Management & Coordination, ADB Institute
Mr. Shoji Nishimoto, Director, Strategy and Policy Department, Asian Development Bank
Mr. Akihiko Nojiri, Economist, IMF Regional Office for Asia Pacific, Japan
Mr. Yoshio Okubo, Director of the Coordination Division, International Bureau, Ministry of Finance, Japan
Mr. Hisashi Ono, Senior Executive Advisor to the President, Asian Development Bank
Mr. Xiaojian Pan, Deputy Director General, Department of International Affairs, Ministry of Finance, Peoples Republic of China
Mr. Stephen Parker, Senior Research Fellow, ADB Institute
Dr. Yingyi Qian, Professor, University of Maryland
Dr. Sarfraz Qureshi, Director, Pakistan Institute of Development Economics, Pakistan
Mr. Witit Rachatatanun, Assistant Secretary-General, National Economic and Social Development Board, Thailand
Mr. C. Ramachandran, Director, Asian Development Bank
Dr. Eisuke Sakakibara, Professor, Keio University
Mr. Nalin Samarasinghe, Director, Japanese Representative Office, Asian Development Bank, Tokyo
Mr. Mitsuo Sato, Senior Advisor, Dai-ichi Research Institute Inc., Japan; Former ADB President
Ms. Yuri Sato, Institute of Developing Economies, Japan
Dr. Jeffrey Shafer, Managing Director, Salomon Smith Barney Inc., United States; Advisory Council of ADB Institute
Dr. Jia-Dong Shea, Deputy Govenor, Central Bank of China, Taipei,China
Dr. Mizanur R. Shelley, Chairman, Centre for Development Research, Bangladesh
Mr. Shuji Shimokoji, Ministry of Foreign Affairs, Japan
Mr. Seiji Shimpo, Vice Minister for International Economic Affairs, Economic Planning Agency, Japan
Mr. Naoyuki Shinohara, Director, Asian Development Bank
Dr. Hadi Soesastro, Executive Director, Centre for Strategic and International Studies, Indonesia
Dr. Grant B. Stillman, Legal Adviser and Administrative Officer, ADB Institute
Dr. Chalongphob Sussangkarn, President, Thailand Development Research Institute, Thailand
Mr. Rintaro Tamaki, Director of the Development Institutions Division, Ministry of Finance, Japan
Mr. Kwong Yiu Tang, Government Economist, Financial Services Bureau, Government of the Hong Kong Special Administrative Region, Hong Kong, China
Mr. Kimimasa Tarumizu, Executive Advisor, Institute for International Cooperation, JICA, Japan; Former ADB President
Prof. Juro Teranishi, Director, Institute of Economic Research, Hitotsubashi University, Japan
Dr. Vo Tri Thanh, Deputy Director, Centre of Applied Economics, Central Institute of Economic Management, Viet Nam
Mr. Patrick Thomas, Director, Asian Development Bank
Mr. Jun Tian, Deputy Director General, State Development Planning Commission, Peoples Republic of China
Mr. Kenichi Tsukahara, Strategy and Policy Officer, Strategy and Policy Department, Asian Development Bank
Mr. Toshiyuki Tsukasaki, Vice-President, Institute of Fiscal and Monetary Policy, Ministry of Finance, Japan
Mr. Prasit Ujjin, Director, Asian Development Bank
Prof. Shujiro Urata, School of Social Sciences, Waseda University, Japan
Prof. Pravin Visaria, Director, Institute of Economic Growth, University of Delhi, India
Mr. Sun Vithespongse, Director, Loan Policy and Management Division, Public Debt Management Office, Ministry of Finance, Thailand
Dr. Victor Eng Lye Wee, Director, Macro Economic and Evaluation Section, Economic Planning Unit, Prime Ministers Department, Malaysia
Dr. John Williamson, Senior Fellow, Institute for International Economics, United States
Dr. Soekarno Wirokartono, Deputy Chairman, Fiscal and Monetary Affairs, National Development Planning Agency, Indonesia
Mr. Zhao Xiaoyu, Director, Asian Development Bank
Prof. Toru Yanagihara, Special Advisor to Dean for Research, ADB Institute
Dr. Ya-Hwei Yang, Research Fellow, Chung-Hua Institution for Economic Research, Taipei,China
Mr. Jeung-Hyun Yoon, Director, Asian Development Bank
Dr. Masaru Yoshitomi, Dean, ADB Institute
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