WORLD TRADE
ORGANIZATIONWT/WGTDF/W/4
26 June 2002
(02-3575)
Working Group on Trade, Debt
and Finance
THE RELATIONSHIP BETWEEN TRADE AND FINANCE
A REVIEW OF SELECTED LITERATURE RELATED TO
FINANCIAL CRISES IN THE 1990S
Note by the Secretariat
I. INTRODUCTION
1. This Note has been prepared in response to a request from the Working Group at its first
meeting for a review of selected literature related to Item I of the Group's provisional work
programme.1  It focuses on ways in which trade can be affected by financial instability, with reference
particularly to the financial crisis in emerging market economies of 1997-98, and describes efforts
underway to strengthen the international financial system in the wake of that crisis.
II. THE LINKAGES BETWEEN INTERNATIONAL TRADE AND FINANCE
2. The expansion of international trade depends on a well-functioning international financial
system in several respects.  Amongst the most im portant are the relationship between exchange rates
and trade, financial flows and trade and balance-of-payments adjustment and trade.
A. E XCHANGE RATES AND TRADE
3. Traders and trade officials depend on a stable international price mechanism for conducting
cross-border transactions, for taking decisions on investment and production of tradeable goods andservices, and for setting price-based trade policies.  The uncertainty generated by small, short-term
fluctuations in nominal exchange rates generates commercial risk, but it can generally be tackled
effectively through financial hedging.  Wider and deeper fluctuations in exchange rates, and sustained
misalignment of exchange rates away from levels that reflect inflation rate differentials, send incorrect
price signals which can destabilize international trade flows (Dell'Ariccia, 1998). This increases
uncertainty for traders that often cannot (or is too costly to) be hedged effectively. It can inflict
adjustment and resource misallocation costs on an economy if it changes investment decisions and
results in shifts of resources between the tradeabl e and non-tradeable sectors of an economy that are
not justified by relative cost and productivity differentials.  It can destabilize levels of protection
against foreign competition provided by price-based trade restrictions, and generate pressure for
                                                     
1 WT/WGTDF/M/1 and W/1.This document has been prepared under the Secretariat's own
responsibility and without prejudice to the positions of Members
and to their rights and obligations under the WTOWT/WGTDF/W/4
Page 2
compensating trade restrictions to protect current patterns of supply (IMF, 1984).  Exchange rate
volatility can be a channel for instability to sp read from the financial to the real sectors of an
economy.2  Large exchange rate fluctuations can disrupt trade by creating inflationary pressures, by
causing large private capital movements that are not justified by underlying fundamentals in the real
economy, and by hindering the capacity of countries to repay foreign debt.
B. FINANCIAL FLOWS AND TRADE
4. The expansion of trade depends on a reliable, adequate and efficient source of financing, both
long-term (for investment in tradeable goods and services) and short-term (financial instruments that
allow "real" transactions to be protected from instability in asset prices, and for trade-financing).  An
efficient domestic banking system plays a key role in providing financing as well financial services
related to trade.  An important issue in this respect is balancing the advantages that can accrue from
liberalising trade in financial services with the need to ensure that liberalisation is properly timed,sequenced and prudentially managed so that it does not become a source of financial instability in its
own right.  Most developing countries remain heavily dependent on foreign sources of finance.
Private capital flows became a far more important source of foreign finance for developing countries
in the 1990s than official capital flows, and foreign direct investment (FDI) and portfolio investment
(bond and equity financing) became more important relative to bank lending, particularly in theemerging market economies (Table 1 and Annex Table 1).
5. According to UNCTAD, in the mid-1980s international bank lending accounted for over
50 per cent of total private capital flows to developing countries, FDI for 22 per cent, and foreign
portfolio investment for 18 per cent.
3  By the mid- to late-1990s, the data in Table 1 suggest that their
respective shares were about 14 per cent for bank lending, 52 per cent for FDI, and 34 per cent forforeign portfolio investment.  FDI exceeded foreign portfolio investment (including sovereign and
public bond financing) in developing countries in all years except 1993, and in most developing
countries FDI flows are a significantly more impor tant source of foreign financing than foreign
portfolio investment flows.  Both bond and equity por tfolio investment fell sharply at the time of the
Asian financial crisis, but equity investment flows proved the more resilient of the two, recoveringagain in 1999 and 2000.  They account now for around 15-20 per cent of private capital flows to
developing countries.
4
6. The fact that foreign portfolio investment is found to be more variable than FDI, because
portfolio investors generally have a shorter time horizon and are able to liquidate their investments
more easily, does not necessarily imply that it is inherently "volatile".  The difference between
variability and volatility is in practice mainly one of degree, but volatility carries with it also the
notion of large, more frequent, and unpredictable changes in the volume of capital inflows andoutflows.  When this happens, it can destabilize the domestic investment environment and be highly
detrimental to growth, development and macroeconomic management in the host country.
5  Sudden
and significant changes in foreign investment can undercut monetary, fiscal and exchange rate
policies.  They can also affect the availability of finance, and consequential changes in its cost and in
asset prices, which makes investment planning difficult.  Large capital inflows create excess liquidityin the domestic financial system, which can encourage asset bubbles and increase speculative
                                                     
2 WT/GC/W/444.
3 TD/B/COM.2/EM.6/2, and Corr.1 of 15 April 1999.
4 See World Bank, op cit , p. 46;  15 per cent based on capital market commitments, and 18 per cent
based on net long-term resource flows.
5 For an analysis of the causes and effects of portfolio investment volatility, see UNCTAD: “The
Growth of Domestic Capital Markets, Particularly in Developing Countries, and Its Relationship with Foreign
Portfolio Investment” (TD/B/COM.2/EM.4/2, 19 March 1998) and “Foreign Portfolio Investment: Implicationsfor the Growth of Emerging Capital markets” (UNCTAD/GDS/GFSB/4, 9 September 1998), and World Bank
Global Development Finance 2001, pp. 71-76.WT/WGTDF/W/4
Page 3
investments, while outflows drain liquidity from the system and can threaten the viability of otherwise
perfectly sound investments.
Table 1
Selected net long-term resource flows to developing countries, 1991-2000
(US$ billions)
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Total 123.0 155.8 220.4 223.7 261.2 311.2 342.6 334.9 264.5 295.8
of which :
Private flows 62.1 99.3 166.8 175.7 206.1 279.3 299.8 280.3 219.2 257.2
of which :
FDI 35.7 47.1 66.6 90.0 107.0 131.5 172.6 176.8 185.4 178.0
FP1 18.5 25.2 87.6 73.4 66.9 111.7 79.2 56.5 59.9 78.1
(Equity) (7.6) (14.1) (51.0) (35.2) (36.1) ( 49.2) (30.2) (15.6) (34.5) (47.9)
(Bond) (10.9) (11.1) (36.6) (38.2) (30.8) (62.5) (49.0) (40.9) (25.4) (30.3)
Bank Lending 5.0 16.2 3.4 8.7 30.5 33.7 45.2 50.0 24.6 0.7
Source: World Bank, Global Development Finance 2001 , Table 2.3.
Notes : Long-term resource flows have a maturity of one-year or more.  Inflows of debt (bonds and bank
lending) are net of amortization payments, and FDI is net of disinvestment.  Figures for bond financing include
sovereign, public, and private bond issues;  the IMF cal culates that in 1998-99 private bond issues accounted for
about 31 per cent of the total.6
7. The 1990s saw emerging market economies register a sharp increase in inflows of foreign
portfolio investment, and some of these economies experienced serious financial crises.  Clearly, the
behaviour of foreign portfolio investors contributed to both the timing and the amplitude of thefinancial crises.  At the same time, it would be simplistic to draw the conclusion that financial crisis is
an inevitable consequence of allowing increased flows of foreign portfolio investment.  By and large,
it seems likely that most categories of foreign portf olio investors (other than perhaps those operating
at the most speculative end of the market) are as averse to volatile capital market conditions as are the
governments and private enterprises of recipient countries, and that both have an equal interest in
seeing regulatory measures taken, and policies put in place, to limit volatility.
7
C. BALANCE -OF-PAYMENTS ADJUSTMENT AND TRADE
8. The expansion of trade depends on an appropriate mix of domestic macroeconomic
management and foreign financing to prevent balance-of-payments disequilibria from spilling over
into pressure on governments to apply restrictive trade or exchange policies.  Adequate foreign
financing for this purpose needs to be available from private capital markets and/or from international
financial institutions such as the IMF, and in normal circumstances this is the case.  However, asnoted above, large, frequent or unpredictable changes in foreign capital inflows and outflows that are
not justified by underlying macroeconomic fundamentals can place pressure on the balance-of-
payments, undercut sound domestic monetary and fiscal policies, and result in wide fluctuations in
exchange rate policies.  In such circumstances, recourse to private capital markets for balance-of-
payments financing purposes may not be an option, and relying solely on official financial flows cancreate problems of moral hazard for international financial institutions.  A government may then
search for stop-gap solutions to its balance-of-payments problem, and turn to quantitative trade or
                                                     
6 Ibid, p. 53.
7 For a discussion of policy options to address volatility, see World Bank op cit  and
UNCTAD/GDS/DFSB/5, pp. 38-39.WT/WGTDF/W/4
Page 4
exchange controls to restrict foreign exchange inflows and outflows.  To the extent that the burden of
adjustment to volatile inflows and outflows of foreign capital is placed entirely on a country's current
account for a sustained period of time, domestic aggregate demand and trade will be affected.
III. CHANGING GLOBAL TRADE AND FINANCIAL ENVIRONMENT
9. In the 1980s and 1990s, financial integration occurred on a global scale, with the deregulation
of domestic financial markets, the liberalization of international capital flows, and financial and
technological innovation (BIS, 1986).  One feature of this was a large increase in private capital flows
from developed to developing countries.  The lending exposure of G-7 banks to developing countries
stood at some US$ 1 trillion by mid-1998.  This brought with it greater vulnerability of these
countries to changes in sentiment by international in vestors, since market expectations play a key role
in setting financial asset prices and directing financial flows (IMF, 1998).
10. Episodes of more intense financial instability are to some extent a corollary of financial
deregulation and liberalization.  The decisive factor for many emerging market economies in the
1990s was that the seeds of instability had been sown in the more sheltered and controlled financial
environment that prevailed beforehand.  Competition exposed bloated and rigid cost structures, poor
management of risk, and ill-designed or non-existent prudential safety nets.  In some cases too, it
exposed unsustainable monetary policies and public and foreign debt obligations.
11. The resurgence of international financial crises in the 1990's, with its negative effects on
GDP, poverty and social development in the affected countries, has at times revived fears of the kind
of contagion that occurred in the 1930s – originatin g in the financial sector and spreading to the real
economy.  Fortunately that has not happened, and the WTO has played an important role in this
respect by ensuring that its Members did not resort to restrictive trade policies to try to cushion theadverse effects of international financial instability on the real sectors of their economies (WTO,
1998).  Nonetheless, a sense of vulnerability to instability in international financial markets and to
sudden changes in market sentiment large enough to create systemic difficulties for trade and the
trading system remains, particularly in emerging market economies.
12. A globalizing financial system can benefit the world economy through improved financial
intermediation and a more efficient international allocation of savings and investment.  These benefits
accrue as much to international trade and investment as to other economic activities, so that financial
integration is no enemy of trade integration;  tryi ng to draw a line between "good" and "bad" forms of
international capital flows is regarded as just as fruitless as attempts to distinguish between "good" an
"bad" imports of goods and services.  Instead, the lesson to be drawn is that if it is to function well,
the international financial system needs to be based on strong prudential rules, effective surveillance,
and transparency (Summers, Id, p. 3).
IV. CAUSES AND IMPLICATIONS OF FINANCIAL CRISES
13. There were several episodes of international financial crisis in the 1990s, affecting mainly
emerging market economies.  The first, and the largest in terms of financial flows involved, occurred
in 1992-93 within the European Monetary System.  It was followed by crises involving Mexico
(1995), South-East Asia, mainly Thailand, Indonesia and Korea (1997-98), Russia (1998) and Brazil(1998).  Each had its own causes and characteristics, but to some extent the crises that occurred in
1997-98 reflected a general movement of international portfolio investment out of emerging market
economies.  The threat of contagion among borrowers created serious problems for some lenders too,
and together this took on proportions of international systemic crisis in the late-1990s.WT/WGTDF/W/4
Page 5
A. C AUSES
14. There is a large body of literature on the causes and characteristics of these crises.  It is
generally acknowledged that capital account instability  played a much more significant role than in
the more traditional current account/balance-of-payments crises of the 1970s and 1980s, which were
linked to uncontrolled spending, high inflation, and excessive public debt.  However, there is no realconsensus on factors that triggered the crises in the 1990s, nor on appropriate policy responses (IMF,
2002b).
15. Financial sector fragility and inadequate banking supervision in the crisis-hit countries
is considered by many analysts to have been one of the principal factors involved.  In South-East
Asia, for example, financial sector fragility involved unhedged, short-term, foreign borrowing by
local financial institutions encouraged by the relative stability of nominal exchange rates, a mis-match
in bank balance sheets between long-term assets and short-term liabilities, and imprudent lending andover-exposure in real estate and equity markets.  This was combined with poor banking supervision,
low capital requirements, and in some cases accommodative monetary policies and poor sequencing
of capital account liberalization on the part of local monetary authorities.  These processes are
described by the IMF (Lane, 1999;  Berg 1999) as well as UNCTAD, 2001.
16. In this context, the role of highly leveraged financial institutions, hedge funds and
off-balance sheet operations  of some institutional investors, and lack of prudential control over their
activities, has been pointed at as a contributing factor.
8  "Herd" behaviour on the part of foreign
capital is felt by many to explain why the retreat turned into a rout in some of the crisis-hit countries,
where inadequate information, particularly about the level of foreign exchange reserves, made an
objective evaluation of the situation more difficult (Summers, 1999).  A number of analysts offeredinterpretations in terms of international liquidity crisis (Calvo, 1998;  Sachs, 1998).
17. The merits and demerits of capital account liberalization  in general, and its sequencing in
particular, have been analysed, since most financial crises followed the liberalization of capital
account transactions by the countries affected.  Most European countries had completed this by 1990
as part of the single market project.  As public debt and other domestic assets became tradedinternationally, large unhedged net capital inflows were recorded in France and Italy.  A similar
process was also observed in emerging markets.  Many consider in this respect that capital account
liberalization in itself is not the problem, but that it had not been accompanied by upgrading
prudential regulation and proper capitalization of domestic financial institutions.  Wyplosz (2001), for
example, found that while liberalization reduces foreign exchange pressure in the long run, it can be a
source of instability initially, particularly where credit growth is not kept under control.
18. Internal structural weaknesses  outside the financial sector are viewed by many as having
reduced the defences of the crisis-hit economies to external shocks.  Trade policy reviews by the
WTO suggested that trade liberalization and domestic deregulation had proceeded only selectively in
at least some of the crisis-hit countries, leaving them with high and uneven levels of assistance across
sectors and preventing market mechanisms from efficiently allocating resources.  Part of the approach
of the international financial institutions to resolving the crisis addressed these long-standingimpediments to growth.  This included, inter alia , promoting competition in the domestic economy,
restructuring insolvent corporate and financial institutions, and addressing deficiencies in governance
in various sectors of the economy.  (A description of World Bank's role during the Asian crisis is
available in section VII of IMF's Occasional Paper 178, Id.).
19. Related to this was deterioration in their terms of trade and erosion of their
competitiveness .  The Asian Development Bank noted that the Asian "dragons", encouraged by years
                                                     
8 A description of leverage strategies and hedge fund operations is provided in IMF (1998).WT/WGTDF/W/4
Page 6
of successful export-led industrial-targeting stra tegies, had invested massively throughout the 1990s
in capacity in highly cyclical manufacturing industries such as electronics, semi-conductors and steel.
The fall of international demand and prices for these products in 1996 led to a deterioration in their
terms of trade, and as a result of the export downturn investors diverted investment into less efficient
and more speculative activities (Kumar and Debroy, 1999).  There is no clear evidence of similarfactors at play in Mexico, East Asian countrie s, or Brazil (Kumar and Debroy, id., p. 10-11).
20. While most analysts agree that macroeconomic imbalance  was not the main factor behind
the crisis in South East Asia, the contribution of fiscal and monetary policies and current account
positions before the crisis broke out has been debated (Kumar et. al. 1999;  see also Stiglitz, 2002).
Most of the Asian countries involved had budget surpluses, high savings rates, reasonably low
inflation, and real exchange rates that did not appe ar to be out of line with fundamentals (Lane, 1999).
However, Summers points to concerns of international investors as the crisis deepened about theviability of exchange rates in most cases, the possibility of a devaluation-inflation spiral in some, the
fiscal deficit in Russia and Brazil, and current account deficits in Asia (Summers, 1999).  The IMF
and World Bank also point out that financial sector fragility had built-up on weakening
macroeconomic conditions in the year or two before the crisis broke (Lane et. al., 1999;  IMF 2002b;
World Bank, 1999).  Nonetheless, "although concerns over the sustainability of current accountdeficits and exchange rate pegs played a role, they do not explain the suddenness and magnitude in
the shift of the capital account" (IMF, 2002b).
B. I
MPLICATIONS
21. Following growth rates of 5 to 10 per cent a year from 1994 and 1997, GDP contracted by the
same magnitude in Indonesia, Malaysia, South Korea, the Philippines and Thailand in 1998, alongwith rising unemployment and inflation, and in some  cases, social dislocation.  Summers (1999) notes
that large swings in exchange rates exacerbated the fundamental weaknesses  described above
(financial fragility, external vulnerability, poor governance).  Real depreciations in exchange rates,
estimated at between 20 and 40 per cent for ASEAN-5 countries from mid-1997 to mid-1998, reduced
real incomes and spending, increased capital outflows and created the conditions for a banking crisisas the domestic currency value of foreign liabilities multiplied.  (Impact of the East Asian Financial
Crisis on Trade and of Industrial and Emerging Market Economies, 1998).  This created a vicious
circle:  the depreciation of currencies brought more  institutions into insolvency, further weakening
confidence and fuelling more capital flight (Lane, 1999).  In the affected countries, a long process of
bank and corporate restructuring began, involving the re-capitalization of banks, enhancement of
prudential rules, mergers and acquisitions, bank closures, and negotiations with international creditors
to re-schedule short-term debt.
22. One factor that affected trade of the crisis-hit countries adversely was the scarcity of
short-term trade-financing facilities (letters-of-credit)  (WTO , 1999;  IMF, 1998;  and Stephens,
1998).
9  Financing imports became a particular problem at the peak of the crisis in Indonesia, where
international banks reportedly refused to underwrite  letters-of-credit opened by local banks because of
a general loss of confidence in the local banking system.  Given the high import content of exports(over 40 per cent), Indonesia's growth of exports was seriously affected by the difficulty of financing
imported inputs for use in its export sectors.  To alleviate the problem, the Indonesian Government
and Central Bank extended guarantees to foreign banks for letters-of-credit opened by Indonesian
banks, and encouraged the Steering Committee of private borrowers and lenders to find an
                                                     
9 M. Stephens explains the mechanisms by which trad e finance, or the lack of it, has been perceived as
an important problem in South East Asia.  Its main conc lusions are that the export credit agencies in no sense or
prolonged the reduction in trade finance, but neither have they helped solve the problem.WT/WGTDF/W/4
Page 7
arrangement to maintain trade finance facilities and settle arrears.10  In the wake of the crisis, ASEAN
Members agreed on the principle of reducing their dependence on the U.S. dollar as a currency of
payment and promoting the use of local currencies in intra-regional trade (WTO, 1998, Trade Policy
Review of Indonesia).
23. The contraction of trade flows in 1998, particularly imports, in most emerging market
economies led to a short-lived reduction in world trade, although this was limited by sustained strong
import growth in the United States and the European Union (WTO, International Trade Statistics and
Annual Reports;  and OECD, 1998).  There was a conseq uent shift away from intra-regional trade, but
the export boom from currency depreciations in the crisis-hit countries that was anticipated did not
materialize in the short-run.  Van Rijckenghem et. al. (1999) concluded that financial market
spill-overs (whereby banks sell off assets in one country to make up for losses in another) played a far
larger role in these crises than trade spill-overs.11
C.  THE ROLE OF TRADE POLICY IN RESPONDING OR PREVENTING FINANCIAL CRISIS
1. Keeping markets open and preventing the spread of financial crisis through trade
channels
24. The value of a strong multilateral trading system was made evident during the South-East
Asian crisis.  Fears that the financial crisis would provoke a trade protectionist backlash , either in
the crisis-hit countries and/or in their major trading partners, proved to be largely unfounded.
25. Aside from a few tariff increases in Thailand and Malaysia, the crisis-hit countries themselves
did not view trade restriction as a useful contribution to their immediate problems.  The WTO
contributed to this outcome and to the return of confidence and recovery, as countries continued to
phase-in their Uruguay Round commitments and to undertake new multilateral liberalizationinitiatives (WTO, Annual Report, Chapter III "Overview of Developments in the International Trade
Environment" 1998, 1999 and 2000 and OECD id, p. 11-13) .  At the height of the financial crisis, in
December 1997, the WTO concluded the Agreement on Financial Services (5
th Protocol to the GATS)
and significant progress was made in enhancing financial services market access.  In doing so, WTO
Members gave a clear indication that increased foreign competition helped strengthen domesticfinancial sectors, by encouraging efficiency in the provision of financial services, promoting
institutional development and improving financial regulation (WTO 1999).
26. Exports from the crisis-hit countries of sensitive products (e.g., steel, semi-conductors,
electronics) did increase, stimulated by their excess capacity and depreciating exchange rates, but not
by as much as had been anticipated by some.  By and large, their exports were not met with a
tightening of restrictions abroad, although there was evidence of increased import surveillance in
some of their major trading partners, particularly for alleged dumping.
2. Trade policy reforms to improve effici ency and resilience to external shocks
27. As noted above, WTO Trade Policy Reviews of some of the crisis-hit countries described
how selective processes of trade and investment liberalization had created "dual" economies, of
sectors and industries that were outward-oriente d and highly competitive internationally alongside
                                                     
10 For details, see in particular WTO (1998), Trade Policy Review of Indonesia, p. 10 and p. 77, and
World Bank (1998).
11 Spillovers through trade links exist essentially at bilateral or regional level; with high levels of
bilateral trade, a financial crisis will negatively affect all other trading partners through loss of competitiveness
or fall in demand.WT/WGTDF/W/4
Page 8
others that were supported by complex mixtures of trade restrictions, implicit and explicit subsidies,
and internal restrictions on competition.
28. For example, the Trade Policy Review of Indonesia (WTO, 1998) described how internal and
external policies had consolidated the position of large public and private conglomerates, whose
expansion had been fuelled by the absence of clear competition rules and tolerance of internal andexternal marketing arrangements and cartels.  These conglomerates benefited from tax incentives,
subsidized lending, procurement awards and other forms of assistance, often in return for their
implementation of industrial policy objectives.  While this contributed to the diversification of
production, it also resulted in the concentration of production and private debt in the hands of a few
business groups.  In this sense, misallocation of resources in the real sector went hand-in-hand with
misallocation in the money/credit markets.
29. In the context of their programmes with the IMF and the World Bank, several crisis-hit
countries opened their trade regime further, as part of an effort to improve efficient resource
allocation, eliminate the anti-export bias that is inherent to restrictive import regimes, and remove
internal and external obstacles to growth.  The IMF has described the important role played by trade
liberalization in restoring macroeconomic stability and a viable external position, and how reforms
were sequenced to this aim (IMF, 2001, Trade Policy Conditionality in Fund Supported Programs,Annex to the Board Paper on "Conditionality in Fund-Supported Programs, February 2001).
30. The experience described above points to the role of the WTO as a "shock absorber", making
its Member countries' economies more resilient to external shocks by providing security and
predictability of trading conditions in periods of strain for the world economy.  It points also to the
role that domestic trade policy reform can play in individual countries.  A liberal trade policy canmake a major contribution to strengthening a country's balance-of-payments situation by improving
its export competitiveness.  Trade reform promotes an open business environment that attracts foreign
direct investment. It fosters stronger long-term economic growth by improving the efficiency of
resource allocation.  It helps improve transparency and governance.  In the specific case of financial
services, trade liberalization within a sensible prudential framework can help prevent crises fromoccurring.  A more competitive environment for the supply of financial services generates a more
efficient allocation of savings and credit, reduces transactions costs and spreads, disseminates modern
managerial and banking practices and promotes the use of internationally-accepted standards and
codes, and helps to reduce risk.  It can also help deal with financial crisis when it occurs.  In many
crisis-hit countries, foreign institutions contributed to the re-capitalization and restructuring of ailing
local banking sectors.
V. STRENGTHENING THE FINANCIAL ARCHITECTURE
31. The financial crises of the 1990s raised important challenges for the international financial
system.  These are being tackled through work on crisis prevention, in particular by fostering
transparency of financial policies, enhancing financial supervision, improving surveillance of the
financial system at the individual country level, and increasing the availability of key data for
vulnerability and sensitivity analysis.
A. T
RANSPARENCY AND FINANCIAL SUPERVISION
32. Improved transparency by increasing the flow and accuracy of information that is available
to the private sector and to policymakers aims to strengthen the discipline exerted by markets
(Eichengreen, 1999).  It involves enhanced surveillance by the IMF of capital markets and national
economic policies, and greater effort to make this information available to the public.  Greater accessto information on the flow of credit to emerging markets can provide an early indication of an
excessive concentration of debt, and together with more accurate assessments of economic risk thisWT/WGTDF/W/4
Page 9
can lead to more prudent behaviour on the part of lenders.  Improved information enhances
microeconomic efficiency, but it may not do much to improve macroeconomic stability, which is
dominated by the evolution of opinions and e xpectations rather than information (Ocampo, 2001,
p. 7).
33. Adopting and disseminating international standards and codes of good practice on
prudential supervision , and encouraging their use, particularly by emerging market economies, has
become the principal instrument of crisis-prevention  (Kenen, 2001).  The Financial Stability Forum,
established to strengthen cooperation amongst the international groups involved in financial
regulation and oversight, has identified twelve standards and codes as being of key importance for
sound financial systems.12  The best known, the SDDS, sets standards for the publication of economic
and financial data.  Internationally accepted standards contribute to an environment conducive to
investment and trade in goods and services, and scope for their use as regulatory disciplines inservices trade is contained in the GATS.
34. The Capital Markets Consultative Group, convened under the aegis of the IMF, is designed to
foster public-private sector cooperation to operationalize crisis prevention measures .  The view
among Fund members on standards has shifted dramatically and a growing number of participants in
the major financial centers are increasingly relying on standards assessment to inform credit andinvestment decisions (IMF, 2001).
B. S
TRENGTHENING FINANCIAL SYSTEMS AND IDENTIFYING VULNERABILITY
35. One of the main aims of the financial architecture exercise is to reduce the gap between the
fast pace of financial liberalization by emerging market economies and the slow pace of financial
sector reform (Kenen, 2001, 93).  Building institutional capacity in emerging market economies toimprove bank supervision and strengthen the banking sector is a long-term process.
36. In 1999, the IMF and the World Bank introduced the Financial Sector Assessment
Programme , which provides comprehensive analysis of members’ financial sectors and can
contribute to assessing their readiness to benefit fr om liberalising their financial sectors.  Under this
voluntary programme, experts assess, on a confidential basis, a country’s compliance with keystandards and codes to help identify problems and programme design.
13
37. One of the lessons drawn from the financial crises of the 1990s is that a country's
vulnerability to the withdrawal of capital could have been reduced by better knowledge and
management of its foreign asset and liability positions (IMF, 2001).  Considerable effort has gone
into discussing what is an adequate level of reserv es and how best to disclose adequate information to
markets.  The availability of capital flows to offset current account shocks should, on the face of it,
reduce the amount of reserves needed.  But access to capital is uncertain and inflows are subject torapid reversals.
38. Empirical tests confirm that the ratio of short-term external debt to reserves  is the
indicator best correlated with the incidence of fore ign exchange crises, and that holding reserves in
excess of short-term debt reduces the depth of crisis in emerging markets during periods of
contagion.
14  For countries with limited access to private capital, reserves must be sufficient to absorb
                                                     
12 Included are the IMF’s Special (or General) Data Dissemination Standard, the Code of Good
Practices in Monetary and Financial Policies and the Code of Good Practices on Fiscal Transparency;  the BIS’sCore Principles for Effective Banking Supervision and the Financial Action Task Force’s FortyRecommendations of the FATF.  (see:  www.fsforum.org)
13 For a description, see WT/WGTDF/W/2.
14 Emerging market economies have raised their rese rve holdings markedly in recent years.  The ratio
of reserves to short-term debt has risen from 100 per cent at end-1997 to 180 per cent at end-2000.WT/WGTDF/W/4
Page 10
and smooth shocks of declining exports or increasing import prices.15  While there is a strong case for
emerging market economies to accumulate adequate reserves, there are also costs involved, and
dangers to be avoided;  accumulating excessive reserves can lead to lax macroeconomic policies as
the external constraint is effectively relaxed (IMF, 2001, p. 28).
VI. FINANCIAL LIBERALIZATION AND FINANCIAL STABILITY
39. Lack of financial reform contributes to macroeconomic and banking sector weakness (Dobson
and Jacquet, 1997).  It can unwittingly provide incentives for policy makers to adopt bad
macroeconomic policies, while restrictions create an illusion on the part of the authorities that they are
immune to financial instability and thus pursue unsustainable policies (Wyplosz, 2001).
40. The transition to a liberal, market-based financial system  involves difficult and costly
institution-building (Wyplosz, 2001) recognizes the short-term costs of opening up the financial sector
(see e.g., Williamson and Mahar, 1998;  Steinherr and Perée, 1999).  Sequencing liberalizationproperly, in line with the building of adequate prudential structure and supervision, has been subject
to many studies.  Posen suggests that emerging markets and even developed small open economies
should import financial services;  not only does foreign direct investment in the financial sector ensure
the transfer of skills, technology and management techniques but it allows a small economy to benefit
from more diversified portfolios and better supervision (Posen, IIE, 2001).
41. The WTO’s General Agreement on Trade in Services (GATS) implicitly acknowledges that
there is no universally acceptable liberalization strategy and that a country must determine the specific
timing or sequencing of its financial reform in line with its individual circumstances.  Liberalization
can, in an inadequate policy environment, exacerbate the potential effects of shocks but it also
improves the ability to absorb them.  While initiall y a potential source of exchange rate instability, in
the long-run financial and capital account liberalization helps stabilize the exchange rate.  Trade in
financial services can also reduce the systemic risk for small financial markets that are less able to
absorb large shocks.  Vulnerability to terms-of-trade shocks or international interest and exchange rate
pressures cannot be avoided by attempting to insulate the financial sector from trade.  Interest and
exchange rate fluctuations can be hedged better in an open international environment.  A liberal traderegime allowing for capital flows can ease short-term balance-of-payments pressures (WTO, 1997).
However, as a crisis prevention strategy it is essential that governments adopt coherent policies
between financial sector reform and market-access commitments.  The WTO Agreement on Financial
Services leaves some leeway to Members to take home country measures to protect the soundness and
safety of the system, although they should not be used so as to restrict competition.  To the extent that
trade liberalization stimulates capital inflows, the reve rsal of such capital flows in a period of loss of
confidence can worsen the situation of financial in stitutions and, thereby, magnify the adverse effects
of poor macroeconomic and regulatory policies.
42. Financial services trade liberalization and  capital account liberalization  are two distinct
issues but they are closely linked.  Properly bala nced and sequenced capital account liberalization is
the only way to achieve maximum protection from financial crisis.  Some general principles which are
helpful in sequencing and coordinating capital account liberalization with structural policies tostrengthen domestic financial systems have been developed (see also e.g., IMF, 2002;  Islam, 2000;
and Dailami, 1999).  These include taking account of the initial condition of financial and non-
financial entities and their capacity to manage th e risks associated with international capital flows;
assessing the effectiveness of capital controls;  identifying and implementing urgent measures in
connection with reforms which require a long lead time;  and ensuring the sustainability of thereforms and the transparency of the liberalization process.  In most cases, it is desirable to liberalize
                                                     
15 Opening remarks by Stanley Fischer,  IMF/World Bank International Reserves: Policy< Issues
Forum, Washington, D.C. April 28, 2001.WT/WGTDF/W/4
Page 11
long-term flows, especially foreign direct investment  flows, before short-term flows (see in particular
Chapter IV of IMF, 2002).
43. Emerging market economies will need time to upgrade their financial systems, so they should
be encouraged to adopt interim measures that will insulate their financial systems from the intrinsic
volatility of international capital flows (Kenen, 2001).  The case for temporary capital controls  in
crisis prevention and resolution has been made by a variety of analysts (see e.g., Johnston and
Tamirisa, 1998;  Cooper, 1999).  The IMF states that “it appears that in the absence of adequate
macroeconomic and financial policies, capital account liberalization may increase vulnerability to
external and domestic shocks (IMF, 2000).  The Financial Stability Forum suggested that “capital
controls could be considered if they have a prudential element and fit into a risk management
framework”.  Others have posited the need for “Chilean-type capital inflow taxes as the only effective
solution for most developing countries with an open capital account but where risk management isinadequate and supervision and regulation less than effective” (Eichengreen, 1999).  Others consider
that without effective prudential banking regulations, restrictions on capital inflows are unlikely to
reduce a country’s vulnerability (Edwards, 1999).  The debate on capital controls should take into
account the lesson learned from experience with international trade policy.  If certain types of capital
flows are considered “hazardous”, tariff-like protection is more desirable than quantitative restrictionsor prohibitions (Schuknecht, 1999).WT/WGTDF/W/4
Page 12
ANNEX I
Table 1:
Net Private Capital Flows to Emerging Markets, 1992-99
(US$ billions)
1992 1993 1994 1995 1996 1997 1998 1999
Emerging markets
Total net private capital inflows
Net foreign direct investmentNet portfolio investmentBank loans and other112.6
35.4
56.121.0172.1
59.4
84.428.3136.3
84.0
109.6
-57.3226.9
92.6
36.997.4215.9
113.2
77.824.9147.6
138.6
52.9
-44.075.1
143.3
8.5
-76.780.5
149.8
23.3
-92.5
Africa
Total net private capital inflows
Net foreign direct investmentNet portfolio investmentBank loans and other-4.0
0.6
1.8
-6.4-1.8
1.9
1.0
-4.72.9
2.3
2.0
-1.410.9
2.2
1.47.37.5
4.8
1.31.416.7
7.4
3.75.611.5
5.2
4.32.014.8
9.5
4.40.9
Asia
Total net private capital inflows
Net foreign direct investment
Net portfolio investmentBank loans and other20.8
15.7
9.0
-3.957.4
33.9
21.8
1.763.6
47.1
11.8
4.7104.9
46.6
14.244.1104.1
53.1
12.938.1-1.4
55.5
3.5
-60.4-42.6
58.3
-17.9-82.9-27.0
49.9
-5.6
-71.3
Five crisis-affected Asian countries1
Total net private capital inflows
Net foreign direct investment
Net portfolio investment
Bank loans and other29.0
7.3
6.4
15.331.8
7.6
17.2
7.036.1
8.8
9.9
17.474.2
7.5
17.4
49.265.8
8.4
20.3
37.1-20.4
10.3
12.9
-43.6-25.6
8.6
-6.0
-28.2-24.6
10.2
6.3
-41.1
Europe
Total net private capital inflows
Net foreign direct investment
Net portfolio investment
Bank loans and other6.5
5.1
2.3
-0.827.4
6.7
12.4
8.41.8
6.1
21.5
-25.848.8
14.6
14.6
19.726.7
14.4
19.6
-7.432.2
20.3
23.3
-11.416.3
21.7
0.7
-6.118.0
24.2
6.6
-12.8
Middle East
Total net private capital inflows
Net foreign direct investmentNet portfolio investment
Bank loans and other33.7
0.2
12.7
20.822.3
3.5
5.1
13.618.6
5.4
7.6
5.69.1
4.6
3.8
0.85.6
1.4
3.0
1.214.6
2.3
3.3
9.019.9
2.0
6.7
11.220.6
2.6
7.3
10.8
Western Hemisphere
Total net private capital inflows
Net foreign direct investmentNet portfolio investmentBank loans and other55.6
13.9
30.311.466.8
13.4
44.0
9.449.4
23.1
66.7
-40.453.1
24.7
3.0
25.572.1
39.5
41.0
-8.485.5
53.1
19.213.270.0
56.1
14.7
-0.854.1
63.6
10.6
-20.1
Current account
Emerging marketsAfricaAsiaEurope
Middle East
Western Hemisphere-72.7
-10.0
3.6
-6.6
-25.1
-34.5-110.3
-11.2
-13.2-14.5
-25.4
-46.0-73.8
-11.5
-4.4
5.8
-11.5
-52.2-112.5
-16.5
-50.4
-3.1
-5.7
-36.8-96.0
-7.0
-38.5-20.0
7.8
-38.3-77.4
-7.4
18.0
-29.4
5.4
-64.1-49.5
-20.0
114.9
-23.6
-32.2
-88.621.5
-16.8
103.1
-6.6
-4.1
-54.2
As percent of emerging markets' GDP
Direct investmentPortfolio investmentBank loans and other0.7
1.10.41.0
1.50.51.4
1.9
-1.01.4
0.61.51.6
1.10.41.9
0.7
-0.62.1
0.1
-1.12.1
0.3
-1.3
Source: IMF, International Capital Markets , September 2000.
1Indonesia, Korea, Malaysia, Philippines, and Thailand.WT/WGTDF/W/4
Page 13
ANNEX II
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