Mr Heikensten reviews the financial crisis and looks at monetary policy  (Central Bank Articles and Speeches, 30 Nov 98)
Central bank: riksbank | Type: speech | Date: 1998-11-30

## Mr Heikensten reviews the financial crisis and looks at monetary policyAddress by the Deputy Governor of the Bank of Sweden, Mr Lars Heikensten, to the Swed Shareholders' Association in Stockholm on 30/11/98.Many thanks for the invitation to participate this evening.

For more than a year now, d about global economic developments have in many respects been occupied with the fina crisis-the crisis that was first Asian, then also Russian and finally seen as global analyses are full of words like uncertainty and unpredictability; no one can yet te effects will finally be.The crisis has clearly demonstrated how mobile capital has become, as well as the clo interrelatedness of national economies.

This has intensified the debate about the glob system, its advantages and drawbacks.

How can crises of this type be prevented from ha again?

And how can the present crisis be overcome?

An answer to the latter question is importance for future economic development.

Things that happen in Bangkok have turned o be important for shareholders in Stockholm.

## One night in BangkokFor a number of years the rest of the world regarded the Asian economies as somethi miracle.

Their growth was astonishing and the high saving and investment ratios g impression that this would continue.

Orderly public finances were accompanied by exc rates that seemed to be completely firm.

The prospect of undiminished growth attra inflow of capital to the Asian Tigers from investors in the West who were looking fo return and a greater diversification of risk.There is no single factor which explains why the tiger economies changed, in the investors, into paper tigers.

There are even those who argue that the crisis arose n from altered economic conditions as from general nervousness among investors.

The answ probably a combination of the two, with a number of economic and political facto triggered a chain reaction from country to country.

One serious problem in these coun that their banking systems had not been fully prepared for the incoming avalan international capital.

In much the same way as in the 1980s in Sweden, the good supply o had pushed up prices for equity and real estate, thereby creating a bubble.

In some moreover, a current account deficit and the fixed exchange rate had become untenable. common denominator was the very short-term profile of external borrowing.Uncertainty about the future path of these economies gradually grew.

Investors increasingly cautious.

The devaluation of the Thai currency in July 1997 caused a sharp Capital flows to the region were stopped.

Currencies depreciated sharply and interest The currencies of Malaysia, Indonesia and South Korea followed in the wake of the Thai b

## The gold turned to sandAt first the crisis was seen as a regional problem, with no substantial effects in othe global economy.

Investors focused instead on other regions and last spring there was though still nervous, period.

This proved, however, to be the calm before the storm August the Russian government announced a freezing of rouble debt and a devaluation rouble.This markedly altered the mood among international investors.

The combination o unexpectedly large devaluation and a unilateral suspension of rouble debt payments hei investors' aversion to risks.

If this could happen in Russia, perhaps it could happ countries, too.

The imposition of capital controls in Malaysia accentuated the concern.The crisis therefore spread to other emerging markets, not least in Latin America.

Stoc fell around the world.

The possibility that industrialised countries might be hit by than those related to trade gave the crisis a new dimension.

The problems in the US he Long Term Capital Management (LTCM, perhaps something of a misnomer for a company bent on reaping quick profits on invested capital) aroused fears that large losses might m excessively cautious and thereby restrict access to borrowed capital.

Many forecasters to revise their assessments of global economic development.

## Watch out!The most obvious cause of lower global growth is decreased net exports to the crisis-burdened countries.

Countries that trade with the debt-burdened countries experience a weake growth as falling exports are accompanied by a gradual increase in their imports.

At direct trade effects are not expected to be all that large; but as other regions are crisis, they may be more pronounced.New risks then arise that are more difficult to assess because they relate to sen confidence.

One factor of importance for the rate of global economic growth is consumer and business confidence .

There are some statistical signs that confidence has fallen.

Future p have become less bright above all in the United States and the United Kingdom, but also of the prospective euro countries.

Swedish households are more doubtful about the economic future but still believe their personal economic situation will improve.

Comp also somewhat more pessimistic.Another potential threat to economic growth was detected in the summer and early autum problems in LTCM led to talk of a credit crunch .

Briefly, this is a situation in which banks, a some bad experiences and loan losses, do all they can to reduce risk exposure and sli sheets; as a result, the banks cannot be induced to finance even the most stunning c ideas.

Without access to investment capital, economic activity declines.Certain signs of an approaching credit crunch could be discerned in financial markets, in the United States.

They first took the form of an aversion to supplying credit to soundest borrowers.

Later there was a reluctance to provide long-term loans to regardless of their credit rating.The weakening of growth and inflation prospects in the light of the financial unrest ha central banks to lower interest rates this autumn.

The interest rate cuts have contri somewhat calmer situation recently in financial markets.

Interest rate differential industrialised countries and emerging market economies have tended to narrow from a hig and so have spreads in the western markets between borrowers with different credit ra Sweden, the spread between treasury and housing bonds has fallen from 0.9 percentage po mid October to 0.5 percentage points at present.Stock markets have also recovered from the sharp fall during the autumn.

In the Unite equity prices have now rebounded to the levels of before the period of nervousness. equity prices are notably bullish and mirror expectations of very good growth and highprofits.

The recovery on the Stockholm Stock Exchange has not been quite as strong; af of around 40 per cent from July to October, the index is now at the same level as at August.Although there now seems to be somewhat less risk of the global crisis becoming profound, it will probably still lead to a weaker international economic development also affect the situation in Sweden, not least during 1999.

During the autumn the R appraisal of both growth and inflation in Sweden has been revised downwards.

Infla pressure in our economy is very low and expectations seem to have been adjusted to it r low.

A more detailed picture of inflation prospects is contained in our Inflation Repo to be published this Thursday.

## The name of the gameDevelopments this autumn and the way in which the Asian crisis has spread across the have broken some market perceptions.

Loan payments were suddenly suspended unilaterall such a large country as Russia.

And the problems in a single US hedge fund turned out large as to render the situation in financial markets uncertain and require rescue oper major commercial banks.

The world was not quite what it had been.

A number of obser including the Chairman of the US Federal Reserve, even considered that what had happene without precedent in the global economy.The crisis has enlivened the discussion about global financial systems.

In the short r acute crisis that must be resolved.

The interest rate cuts, not least in the United played an important part here.

In the longer term, conditions must be created whereby t financial system functions sensibly.

Matters that are being discussed in the longer include the role of the IMF and how to help the problem countries.

There is also the q ensuring that countries and private agents, instead of distorting reality, provide picture of their situation.

Other matters are the construction of systems so that early sounded if, for example, the situation in the bank sector is becoming untenable, an prevent investors from building up such large risks.

The discussion also concerns movement of capital and how its negative effects can be restricted.Permit me to dwell fairly briefly on these large and important matters.

This is a di which we at the Riksbank will no doubt be returning.

Solutions to some of the quest relatively easy to find; others will require a great deal of lengthy discussion over a period and may even then not be entirely satisfactory.

## The IMF to the rescueThe immediate resolution of the crises in Asian countries and, most recently, in Brazi spearheaded by the International Monetary Fund (IMF).

Thailand, Indonesia and South K were offered financial support by the Fund, subject to certain conditions.

These l concerned both the formulation of economic policy and some structural measures.

Intere were to be increased, accompanied by fiscal restrictions to restore a balance or a government budgets.

Consolidation of the banking system and stricter supervision wer required.

Reforms in other fields were demanded to make the economy function more efficiThe economic recession in the problem countries turned out to be considerably deepe expected.

The IMF has been criticised for requiring tough restrictive measures.

With g the Japanese economy at a standstill, moreover, these countries did not have the benexternal stimulus.

International investors and banks were not prepared to renew countries which had obtained support from the Fund.

The currency depreciation continued adjustments were made to the IMF programmes.Broadly speaking, the Fund's management of the crisis has been criticised from two stan One is that the Fund's terms are too harsh and tend to contribute to domestic poverty w benefits in real economic or financial terms.

The other standpoint is that the IMF money far too readily to all comers without demanding enough in return.The support currently provided by the Fund is intended to enable the crisis-burdened co spread the necessary adjustments over a longer period than would otherwise have been p There is then less risk of output falling sharply.

It can also help to forestall fi unrest.

The latter can benefit other countries that might otherwise be hit, mor undeservedly, by large movements in exchange rates and interest rates.

Moreover, IMF s can induce other lenders to provide financial assistance.

The programmes drawn up by t have led industrialised countries to come forward and contribute financial support.In situations like this the IMF can also serve as a much-needed whipping-boy.

Governm crisis-burdened countries can point to the Fund as the task-master behind various meas thereby achieve reforms that are essential but troublesome.All this presupposes that the Fund's demands on the crisis-burdened countries are balanced.

The programmes must make financial markets confident that the countries ultimately be able to repay the loans.

Some critics consider that the IMF, instead of the changeover from previously regulated markets to globally interrelated markets, i following the beaten track without sufficient heed to the new environment.Earlier crises had more to do with purely macroeconomic factors which the IMF could reme following a relatively simple diagnostic procedure - focusing on the balance of payme and prescribing the medicine that suited the country in question.

Today's crises call f over a wider field.

Ordering an interest rate increase, for instance, as a cure for instability is not as self-evident a solution when higher interest rates are liable to banking system's difficulties or undermine government finances.At the same time it is important that the IMF concentrates on the crisis-burdened c fundamental macroeconomic and financial problems.

An ambition to tackle a wider rang issues may run into trouble.

No matter how well-grounded the structural changes may Fund can, for example, be accused of exerting an undue influence on policy in the countries or of serving the trade policy interests of other countries.There is broad agreement among the industrialised countries that it is the IMF which s in situations like the one in Asia.

The IMF is also our own organisation; Sweden is r on the Board and cannot dissociate itself from what the Fund is doing.

An active disc now in progress to learn from recent developments.

So far, however, no general consen been reached except as regards increased transparency in many respects.

## Openness and oversightOne

recipe for a sounder financial system that has been discussed and agreed on i better transparency both among private players and on the part of the IMF and various public a Some of the problems could be avoided if a fair picture of the situation were provinstance by ensuring that statistics are correct and generally available.

In some case assessments concerning Southeast Asia had a misleading foundation, for example as rega situation among banks and large companies as well as the size of foreign reserves.Advocating more transparency comes naturally to a Swede.

We put the case frequently, a as well as in international fora.

The IMF, for example, ought to be able to present assessments more openly.

We have already taken steps in this direction that we hope wi natural pressure on other countries to do likewise.

At the same time, this is a good i the IMF as the sum of its members.

Even in the group of Nordic countries there are memb have pulled in a different direction.The IMF should also go further in explaining its actions so that these are better unde as we consider that independent central banks have to be open in order to gain support they are doing, so must the IMF generate greater popular and political support for its wAnother requirement for a sounder financial system is better oversight and supervision of the financial system in each country.

Over the years there have been numerous instances o the combination of free capital movements and inadequate supervision can take us if t wrong.

As Swedes, the bank crisis in the early 1990s gave us a ringside view consequences.

One good result of that crisis - a late compensation, if you will - is t the Swedish banks are less exposed.A decade ago, international agreement was reached on the amount of capital banks are r to hold so that they are in a position to weather troublesome times.

Last year the Ba adequacy requirements were augmented with 25 core principles for determining whether or country's banking system is sound and its bank supervision effective.

A first step tow bank supervision is to ensure that more countries are in fact complying with the principles that have already been established.

It has been proposed that a country's capital from the IMF be linked to the degree to which it observes these principles.

The national institutions for banking supervision should also be scrutinised and adapted, possess the resources for coping with the new financial environment.Another step towards better supervision involves an ongoing development of the existi and regulations so that they are appropriate for today's reality.

One matter that is be is a review of the capital adequacy standards.

The banks' lending operations, for i LTCM, were astonishing.

In this context I can mention the discussions that are in progr highly indebted players and how they can be included in supervision to prevent them unduly large risks.

## Sound risk diversificationOne of the issues - probably one of the knottiest - that are being discussed is how countries can obtain financial support without this giving rise to expectations that a financial problems will always be rescued by some international institution.If private investors get the idea that any profits will accrue to them and can rest someone else will intervene and absorb any losses, they will be all the more prone to positions.

Investments that would normally not be attractive will find takers becaus everything to gain and nothing to lose.

This can result in the form of moral hazard th unduly risky behaviour.

Signs of such behaviour have been found.

Spreads between govern bonds issued by industrialised countries and emerging market countries such as Russiathat investors expected to be bailed out and were therefore not demanding full compens risks.Moral hazard could conceivably also result in a particular country or countries taking risks, though this is presumably much less likely.

The political cost to a country o bankrupt is exceedingly high, as is almost too clear from developments in South Korea, and Indonesia.So what can be done to counter moral hazard in the financial system?

One, seemingl evident, remedy is to get the private players to carry a larger share of the burden wh arise.

That in turn could make them act more prudently.

This is being discussed.

T however, is that the investors and banks concerned are caught in what is known as pr dilemma.

Smart investors count on being able to take a little extra risk and then be exit when things go wrong.

The dilemma they face, however, is that when everyone mak simultaneous dash for the exit, most of them are trapped because the market then ceas liquid.One possibility is a system, involving a third party, whereby individual investors a realise that less headlong behaviour in the throes of a crisis could be more advantageo as well as for everyone else.

The remaining cake can then be divided more fairly among involved.

One procedure for this, adopted in connection with the Asian crisis, cou monitor bank lending globally.

This was tried out in the case of South Korea; the ba persuaded to renew credits pending a more orderly solution.

Another matter that i discussed is how bonds could be constructed with a clause that makes it possible to i the type of procedure that applies to default.

## The markets and capital movementsThe Asian crisis has clearly demonstrated the mobility of international capital.

Tec financial developments have meant that positions can be taken and closed much more q than before.Some of the rapid shifts in many countries' exchange rates and interest rates do not se been motivated by changes in the macro economy or other fundamental factors.

This difficult questions.

Capital movements of this kind may ultimately elicit political re threaten the existence of free capital markets.The complexity of the issue is illustrated by consequences of the new Basle rules.

Th prescribe capital cover for the mark-to-market value of many assets.

This is basical thing in that it reduces the risk of failures.

But together with the models on assessments are based (using historical data), rules of this type probably also tend t flock behaviour among international investors.

Continuous marking to market does give picture of the situation in each company but probably also leads to an increased need financial rearrangements.

A price change in one country immediately alters the spectrum and this triggers a wave of buying and selling.Perhaps we must acknowledge at this stage that we have been a little too optimistic workings of the international financial system and self-regulating mechanisms, in much way as we were about Sweden in the late 1980s.Seen in this light, the demands for extensive capital controls that are now being a debate are hardly surprising.

This would not be practicable, however, particularly longer run.There are examples - Chile in recent years is one - where measures for controlling shor capital seem to have worked well.

It should be underscored, however, that these measur been one item in a very soundly implemented economic policy that also includes tight institutional and growth-enhancing reforms, and lower inflation.Chile's experience is therefore by no means directly applicable to other countries important point is that Chile's aim has been to become less dependent on short-term capital.

The measures have not restricted outflows - which is liable to be counterprod but made inflows less attractive.Just where the discussion of capital movements will take us remains to be seen.

Here, is reason to underscore the importance of transparency and rules that work properly. matter that has been raised in the debate is the importance of carrying out deregul structural changes both in an orderly manner and in the right sequence.Measures of this type will probably not suffice to solve all the problems connected capital movements.

A continued discussion is therefore needed without an unduly ideological gloss.

However, such a discussion is unlikely to result in any dramatic cha international financial system.

## The winner takes it all?The world economy has recently been going through a deep crisis - an Asian crisis th acquired

a global dimension.

The ultimate effects of the crisis are difficult to pr course to date should be a lesson to many.- -Households have been reminded that saving in equity is not without risks.

How lo reminder will last is another matter - US stock markets have already shot up towards new all-time highs.- -Large investors with a high level of debt have also been cautioned.

An exceptiona return presupposes exceptionally high risks and thereby entails large losses if wrong.- -The banks have learned similar lessons, particularly those that used highly l funds as a way of accommodating high risks.

But even those who function as overse financial systems - governments and central banks - have learned something from latest crisis.

Work has been stepped up to create a lastingly robust framework satisfactory functioning of the global financial system.Today I have concentrated on the financial system in the longer perspective.

But in th all the uncertainty about the present situation, there is one thing about which we c sure: this is not the last financial crisis.

Now that the situation in financial mark somewhat more stable, we should not suppose that everything is all right again.

The market players - savers, investors, fund managers, supervisors and overseers - must not their guard.

Not again.