Mr Heikensten discusses global capital: advantages, problems and remedies  (Central Bank Articles and Speeches, 3 May 1999)
Central bank: riksbank | Type: speech | Date: 1999-05-03

## Mr Heikensten discusses global capital: advantages, problems and remediesSpeech by Mr Lars Heikensten, First Deputy Governor of the Sveriges Riksbank, the Swedish c bank to the Institute of International Affairs in Stockholm on 3 May 1999.First a word of thanks for the invitation to talk here about the global financial markets. questions raised by financial developments in recent years are clearly connected with foreigThe crisis in the international financial system that began in Asia in summer 1997 develop President Clinton, from being just 'a few small glitches in the road' into 'the worst finan fifty years'.

The extensive financial turbulence has fuelled the debate about globalisat increasingly integrated world economy.In certain respects it can be said that, compared with the present situation, the degree integration was greater at the beginning of this century.

Expanding trade was accompa innovations that simplified international dealing.

A common currency was available in the gold.

In the years before World War One the net financial flows between countries, repres current-account deficits, were even larger than today.

In certain periods, moreover, mig higher than at present.All in all, however, integration is presumably more extensive today.

Many more countries participating in the global exchange, gross capital flows are larger and market reaction swifter.

New technology has paved the way for continued integration and is likely to contributing to further developments in this direction.Against this background my talk today focuses on global capital: its advantages and problem remedies for the latter that are being discussed internationally.

Let me begin by looking shaped the global financial markets as we know them today.

## Emergence of today's global financial marketsToday's

global financial markets largely date from the 1970s, when the oil-exporting c needed to invest surpluses and many western countries had incurred budget deficits that financed.

There was thus a need for a more efficient international market for capital.

Ano behind the development of financial markets was that after the collapse of the Bretton Wood in the early 1970s, the major world currencies started to float in relation to each other. a demand for instruments that would render the exchange rate movements less deleterio exporters and importers.The evolution of the financial markets has been promoted by rapid technical advances that facilitating international communications and transactions, have aided calculations a advanced financial instruments available.

This has been accompanied by theoretical work pricing of risks.

A market for risks has accordingly been established.

Instruments whereb could choose a particular level of risk had existed for centuries but could now be m sophisticated.Before the financial markets could be globalised, moreover, national economies had to be o and the existing capital controls abolished.

This process got under way in the 1970s and 1 players in financial markets had found ways of getting round the regulations, which in some thereby become virtually toothless.

In Sweden, for example, the capital controls had grad much of their bite; companies were able to take up exchange positions, for instance, by shi credits over time.

There was also a growing awareness that economic growth would benefit fewer controls.

The interventionist line of economic policy had not been particularly succ pace of deregulation varied from country to country and the process was rather protracted.the United States led the way.

Sweden was one of the last countries to abolish controls on c country flows of short-term capital.Since the 1970s, financial market turnover has risen markedly and is now very much larger than flows generated by global cross-country trade in goods and other services.

According to the lates study, from 1995, global exchange market turnover, for instance, was 1200 billion dollars, whic approximately five times the value of Sweden's annual GDP.

The figure is roughly twice the level the end of the 1980s.

A new BIS study, for 1998, is due next week and can be expected to show further increase in global exchange market turnover.

Equity and bond market turnovers have al risen rapidly.To some extent, the nature of the flows as well as the players in international financial marke changed.

The earlier domination of investment and borrowing is giving way to increasing flows fr transactions in securities.

New players have become more and more important.

The quest for the b possible return on private savings is giving insurance companies, pension funds and highly lever funds a dominant position.

Whereas the players used to be a more homogeneous group, consistin mainly of banks, households are increasingly opting to have their savings managed more actively t simple deposit accounts.

While these changes have occurred in the various national financial mar they have obviously also had consequences for the international capital flows.

## Advantages of free capital flowsInternational financial markets that are free and integrated can enhance global growth through efficient

resource utilisation.

Savings can be channelled to the best investment opportun unrestricted by national borders.

Capital-importing countries can build up productive facilities access to modern technology and expand in sectors with relatively high productivity, while cap exporting countries can earn a higher return.

The industrialisation of Sweden in the latter par nineteenth century is a good example of what access to foreign capital can do; the construction railway network, for example, was financed with foreign loans.Financial markets also make it easier for economic agents to manage risks so that the econo functions more efficiently.

The wide variety of financial instruments enables investors and borr to choose their preferred level of risk.

Some players may want to avoid all exchange rate fluctu for a time, while others are prepared to take this risk in return for a premium; by operating derivatives market they can arrive at the appropriate risk profile.Globalisation has led to increased competition across countries and markets and aided the emerge of new activities and structures.

This in turn seems to have contributed to increased c productivity-more can be done than before with a given capital input.

It is just these factorsefficient financial markets and higher capital productivity-that are often cited as the main behind the American economic miracle: the combination of high growth and low inflation despite lo saving.

## ProblemsThe

globalisation of financial markets is also dogged by some problems.

It affects the scope national economic policies.

Moreover, financial market prices tend to fluctuate widely, sometime little apparent reason.Before considering these issues, I just want to say a few words about the reality behind the no the financial market, which consists in practice of various categories of savers and borrowers.

B private individuals, these include national, regional and local governments, small and l companies, high-risk hedge funds, banks, insurance companies and long-term pension funds.

So th market cannot be reduced to what goes on in trading rooms, even though, for want of a betalternative, television's financial newscasting often visualises the market in such terms. and borrower exerts some influence on the market but naturally not to the same degree.

The set by the biggest players, be they individuals, companies or nations.

## The scope for economic policyFree capital mobility is sometimes criticised for encroaching on democracy and rendering e policy less effective.Even in a world with integrated financial markets, economic policy is decided by the nationa systems.

They are free in principle to alter tax rates, boost public spending and adjust whenever they wish.

In this direct sense, a more open economy does not mean that policy is r In many ways, access to international capital can actually enlarge the scope for action.

Unl in earlier centuries, a country that is stricken today by severe crop failures, for instan external funds to buy seed.

Similarly, a country wishing to strengthen its growth potenti than domestic saving permits can expand its production apparatus more rapidly with the imported capital.At the same time, loans and other financial transactions do entail dependence.

If a country' policy does not inspire confidence, the consequences may be unfavourable.

Perhaps investors longer be prepared to provide new loans and may even stop existing credits.

Long bond r liable to rise, accompanied by a depreciating currency.

Such reactions are the market's way judgement on economic policy and a country's creditworthiness.

This mechanism is the same for private borrowers.

Access to credit enhances welfare but also exposes the borrower to t and discretion of creditors.A good example of how this works is provided by the Swedish economy.

From the mid 197 problems with government finances led to external borrowing, which mitigated the effect on rates.

But debt accumulated and an acceleration of this trend in the early 1990s led to an confidence: interest rates shot up and after a time the krona fell.Besides illustrating how a country can be hit if its economy is not managed properly or i arise from other causes, this example shows that the imbalances may be generated gradually timely signals can be an advantage.

Perhaps prompter warnings would have put a stop economic mismanagement at an earlier stage.

Something may thus be gained from the market se clear signals without delay.But the situation should not be idealised.

The functioning of financial markets is by no me Real economic problems can build up without attracting attention and when they are detec financial unrest is liable to spread to other countries for no apparent reason.

The finan reaction may also be out of proportion to the underlying imbalance.

This brings me to the n problem.

## Financial instability in a global marketJust as in any other market, financial market prices are basically a function of supply This means that they are dependent on the path of economic fundamentals; in the case of gov bonds, for example, the relevant factors include the budget balance, monetary policy and expectations.Financial asset prices are highly susceptible both to expectations of how the market ought to move, given the underlying conditions, and to how it will move, given the expectations of how other players will act.

This can result in wide fluctuations.

Prices may deviate for a considerable tim could be regarded as their long-term equilibrium.

Markedly inflated prices can result in 'bof touch with the level that seems to be fundamentally justified.

Examples of this are developments in some Asian countries in the mid 1990s, as well as price movements in the Swedis property market around the turn of the 1980s.To some extent, such phenomena can be explained in terms of how economic policy is conducted.

But the causes of large price movements are also to be found in the construction of financial market market is to function properly, all the relevant information should be available simultaneous every player.

In practice, that is evidently not the case.

Moreover, financial players can ac knowledge that what they do will influence the market.

The fact that performance is assessed in short run, in many cases in comparisons with other players, makes herd behaviour common.

The ris models that are in use are liable to accentuate this phenomenon, even though such models are act intended to do the opposite, namely minimise risk and instability.

A signal from a risk model trigger sales by numerous investors, whereupon prices fall still further.

In this way, a mec application of risk models is liable to exacerbate price fluctuations.Financial market globalisation also leads, as I mentioned initially, to increased capital flo transaction costs and high liquidity enable individual investors to pledge assets in the mark greater degree.

This leads to closer links and more interaction between different markets; a may take large positions not just in markets for different assets but also in markets in d locations.

Price movements may be affected if market players lose confidence in a particu geographical market or incur losses that oblige them to dispose of other assets.

Globalisatio naturally increased such contagious effects, as we clearly saw last autumn.

## Recurrent financial crisesIn many ways, global economic development in the past two to three decades has been outstanding Annual growth since 1980 has averaged over 3 per cent.

The rate in the industrialised countrie averaged just over 2.5 per cent as against almost 5 per cent in the developing countries.

Many Asian countries have achieved even higher growth and thereby a radical improvement in economic prosperity.

But development has by no means been smooth.

The Latin American debt crisis in th 1980s, the Mexican crisis in 1995 and the turbulence that started in Asia in the autumn of 199 some examples of the financial crises in recent decades.

While the circumstances behind the var crises differed, they did have certain features in common.

The extensive problems have usually a out of a combination of inadequate credit assessments by lenders and investors and shortcomings economic policy.In an initial phase, credit stocks have risen rapidly in connection with hopes of a high return perception of low risks, partly because investors trusted the financial system and the regu apparatus.

A characteristic example is the developing countries that were transformed in the 1 into emerging markets-the risks seemed to be virtually non-existent.

When the inflow of cred reduced interest rate differentials with the rest of the world, this strengthened the not investment in these countries carried relatively small risks.Exchange rate policy often contributed to the problem.

Investors and creditors expected excha rates to remain fixed.

Cross-country interest rate spreads encouraged the use of foreign-currency for investment in domestic assets, often without matching the maturities of assets and liabiliti countries' central banks were expected to carry the exchange risk and convert at the predeterm rate.At some stage, however, there has been a reappraisal.

Signs that the economies were less robust expected have led to a sudden change in the perception of risk.

This checked the supply of cr which in some cases caused a dramatic increase in lending rates to these countries relativ countries with a better credit rating.

Exchange rate pressure grew and there have been acute cur crises, with collapsing exchange rates and thereby increased uncertainty.It seems that the stronger the inflow of credit in the first phase, the more serious h consequences in the second, with declining production and rising unemployment.

The rever capital flows, if these were channelled through the banks, has also created difficulties in system.

In many instances the financial system proved to lack the resilience to cope with flows.The crisis that began in Asia in the autumn of 1997 had extensive contagious effects countries.

Some of the latter were countries that had conducted a broadly judicious econom and were thus hit undeservedly.

Singapore and Australia are two examples.

Others were co with their own economic problems.

One was Russia, which was obliged to suspend foreign payments in August.

This elicited contagious effects that hardly anyone had foreseen.

The t spread to financial capital's citadel when an American hedge fund, Long-Term Capital Manage encountered extensive problems that had repercussions throughout the US capital market.Some of the crises that have begun in emerging markets have also been compounded by problems different sort.

The Asian crisis, as well as other financial crises, included elements of corruption.

Bank lending was directed in some cases from the authorities or the government specific interests.

Factual information, from private as well as public sources, was unsa many instances.

As a result, appraisals of the countries' economic fundamentals were based information and sometimes even on expectations that the close links between the political s for example, the banks and corporate sector were a guarantee of government support should p arise.

## Can the functioning of financial markets be improved?The crises have made it obvious that the financial system needs to be strengthened,

both i countries and globally.

Can this be done without losing the advantages I mentioned earli matters are being discussed intensively in various fora where the Riksbank is represented, IMF, BIS, OECD, G-10 and even in the European Union.

The need to reconcile the desire for na sovereignty in these questions with free capital movements, as well as international surve control, is a major political challenge.

It is also a challenge with several dimensions: m technical changes are needed to strengthen the financial system at the same time as cooperation are developed and the question of who decides is tackled.

Let me devote the r time to these matters, arranged under four headings.

## 1.

Properly functioning economiesThe primary condition for creating a more stable financial system is perhaps that the function properly.

Although the crises can be explained in terms of shortcomings in the wo the financial system, the instability has almost invariably stemmed from macroeconomi structural problems.

A reasonable economic policy is, of course, not just a requirement i markets but also a standing order in the industrialised countries.

Yet it is barely five Sweden regained a fairly firm economic foundation after the profound crisis in the early 19 are many parallels between the Swedish crisis and the crisis in Thailand, for instance.An important factor here is, as I mentioned, the exchange rate regime.

Experience has sh exchange rates that are fixed but adjustable may often contribute to problems and curren They presuppose that fiscal policy is capable of countering economic shocks at the same tim invite speculation.

In the debate it is therefore sometimes proposed that the emerging marke set up currency boards (a system whereby all outstanding currency can be converted into so currency) or participate in some well-established regional monetary cooperation.

These sy demand just as much of policy but their stronger links are intended to confer greater credi is a risk, however, of financial players being lured into a false sense of security, givi more time in which to grow.

Another feature that fixed exchange rates and currency boardscommon is the negative effects they may exert on other countries if they have to be abandoned. is clear from the Asian crisis.

The alternative is floating exchange rates.

They have the advan permitting interest rate adjustments to the needs of the domestic economy.

But they also e exchange rate fluctuations and their drawbacks.

The problem of exchange rate regimes is bei discussed internationally but a consensus has not been reached.Financial market deregulation, moreover, must be adapted to the financial system of the countr question and supported by a consistent economic policy.

To some extent, the developments in As probably had to do with an inappropriate sequence of deregulations; that was the case in Swede the 1980s and it resulted in problems.

Short-term foreign currency loans made the countr vulnerable and subsequently resulted in currency outflows.

The forms for deregulation have there been considered in the international discussions.

The International Monetary Fund will be ta these aspects into account in future evaluations of individual countries.

It is important, for that deregulations are accompanied by a reinforcement of the supervision of financial institutio markets, so that any 'bubbles' are detected in good time.

## 2.

Strengthening systemsA sounder macroeconomic policy improves the conditions for making systems more robust.

This is necessary but not always sufficient.

A reinforcement of the financial system's infrastructure needed.

Such efforts are required both in the emerging markets and in the industrialised countri well as at the global level.

The emerging markets must build up better systems for oversight supervision.

The IMF, the World Bank and the BIS are all involved in this work.

Knowledge must b enhanced.

The rule systems in many Third World countries must also incorporate bankruptcy legislation, arbitration procedures, and accountancy rules that are fair and transparent.Extensive and well-motivated work on reforms in also in progress in many industrialised countr The tasks and methods of central banks and financial supervisors are being specified.

Many pri institutions are reviewing risk models and adapting them to the global reality.

Conventional m must be augmented.

Supervision also needs to be developed to cover new instruments and types o risk, risks that the Asian crisis has brought to the fore.

The Basle Committee is now worki identify respects in which supervision may need to be extended, for instance to create standar the bank's transactions with highly leveraged institutions.

The problems in L TCM clarified the central importance of this.At the global level, closer coordination of authorities' work on supervision is being called fo such coordination is confined to sectors.

A Financial Stability Forum has therefore been set u consists, at least for the time being, of representatives of the finance ministries, central supervisory authorities in the G-7 countries, together with IMF representatives.

The Forum met the first time some weeks ago.

Discussions are also in progress in what is known as the Grou Thirty-Three, consisting of the participants in the G-10 and some twenty emerging market countrieIn its country evaluations, the IMF will also be paying more attention to the development of financial system.

There is to be cooperation with the World Bank; these two organisations h agreed on a joint model for the appraisal of national financial sectors.

These appraisals are to on the current minimum standards for banks and other financial institutions, a broad review developments and risks in the country's financial sector, and other conditions such as legis accountancy rules, payment systems and financial markets, for example.

## 3.

Greater transparencyA more stable development also calls for greater transparency.

If the global capital markets function as intended, their players must know about the actual risks and be in a position to realistic profit assessments.

This in turn means that international organisations as wegovernments, private companies and financial institutions must convey a fair picture of the conditions.

As regards the IMF, increased transparency has been proposed in the country ass for example.

A pilot project has been initiated for the voluntary publication of mate individual countries.

Sweden has promised to participate in the project.Transparency also applies to the individual countries and the private sector.

One element i crisis has been a misleading account of both private debt and the size of foreign exchange a number of countries.

The standard for countries wishing to participate in the internati market-the Special Data Dissemination Standard-is being revised to give a better account level of foreign reserves and the debt position in individual countries.

At country level, code for monetary policy transparency and measures for maintaining financial stability is be up by the IMF together with the BIS, central banks, supervisors, the World Bank and the O fiscal policy code is already in place.

## 4.

Managing future crisesEven with these measures, we have probably not yet seen the last financial crisis.

A readin management of future crises therefore needs to be created.

A central issue in international is the distribution of risks among the parties concerned.

While the IMF has been provi additional financial resources, it neither can nor should be prepared to contribute the what may be needed in a crisis.

This is because expectations that any costs will always be someone else can result in an overall increase in exposure to risks, the problem of moral h expectations are liable to drive up credit supply and demand and can influence private age as national policy-makers.One way of dealing with moral hazard among private investors is to arrange for them to carr share of the burden in a crisis.

At the same time, there has been an ambition to construct a so that they do not have larger negative consequences later on, for instance by deterring providing desirable credit.

These two perspectives are liable to conflict.

The discussion on preparatory measures as well as steps that can be taken in more extreme situations.

As r preparatory measures, it has been proposed, for example, that bond contracts be construct the renegotiation of scheduled repayment can be authorised by a majority.

Another proposa capital adequacy standards be constructed so as to limit the proportion of short-term inter from industrialised countries to emerging markets.Recently, moreover, a decision was reached on contingent credits to countries that are judg a sustainable economic policy and have nonetheless been hit by a loss of confidence and This is intended to reduce contagious effects.

The IMF also plans to promote increased between the borrowers in the emerging markets and their private creditors.If a crisis has already occurred-without there being a clause for renegotiation-credit to t in question can be renewed instead by the lenders acting in concert.

The central banks in t with the largest bank loans to the crisis area can then agree to try to persuade those ban the loans.

That is what happened in South Korea; the credits were renewed when the banks' l been monitored.

## ConclusionLet me now summarise what I have said and draw some conclusions.

The global capital market here to stay.

They have contributed to the good economic growth in many countries in recent by providing capital efficiently.At the same time it cannot be denied that the global capital markets can generate proble have seen in recent years.

There have been marked fluctuations and they have spread from cocountry.

Shortcomings in national economic policy have been the cause in many causes but not in Small countries with less liquid markets have been heavily hit when highly leveraged funds h shifted capital between markets.

For some countries with a weak political and economic system, capital movements have been sufficient to elicit political crises and considerable social costs has also been played by problems in financial institutions in the industrialised countries, eve very centre of the international financial system through the Manhattan-based fund L TCM .

Last autumn the US Federal Reserve found it necessary to reduce the instrumental rate and take initiative in solving the problem of credit.Against this background it is not surprising that an active discussion is now in progress about called the new international financial architecture.

International meetings are being held in succession.

For the time being at least, it is a matter, as I indicated earlier, of renov extending the existing building rather than of executing drawings for a new one.

A former Bri colleague wrote recently in the Financial Times that 'the work on the new international archite should rather be called a plumbing activity'.If the discussions have a common theme, it is risk: how risk is managed and priced, as well as should pay for any mistakes.

This brings me to the last aspect of the ongoing discussion: how p relationships in the world economy have shifted and the consequences of this for the institution regulate and supervise the global financial markets.As many former developing countries become more central players in the world economy, the balance of power has gradually changed.

These realities are not fully reflected in the institutional sys was built up at the end of World War Two, in Bretton Woods and elsewhere; the United States st has a major role in these institutions and so does Europe.

Together with EMU, this raises m questions about future representation in the international bodies.

Those of us who represent Sw have the important but difficult task of maintaining our country's position in the interna financial cooperation in a constructive way, despite several decades of relatively weak econ development.Perhaps that should be a topic for a future discussion under the auspices of the Instit International Affairs.