Mr. Greenspan's testimony on the international economic and financial system  (Central Bank Articles and Speeches, 16 Sep 98)
Central bank: fed | Type: speech | Date: 1998-09-16

Mr.

Greenspan's testimony on the international economic and financial system Testimony of the Chairman of the Board of Governors of the US Federal Res System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of US House of Representatives on 16/9/98.As I testified before this Committee in the midst of the Mexican financial early 1995, major advances in technology have engendered a highly efficient and incre sophisticated international financial system.

The system has fostered impressive growth trade and in standards of living for the vast majority of nations who have chosen to pa it.But that same efficient financial system, as I also pointed out in tha testimony, has the capability to rapidly transmit the consequences of errors of ju private investments and public policies to all corners of the world at historically u speed.

Thus, problems that appeared first in Thailand more than a year ago quickly s other East Asian economies that are relatively new participants in the internationa system, and subsequently to Russia and to some degree to eastern Europe and Latin Am Even long-time participants in the international financial community, such as Austra Zealand, and Canada, have experienced the peripheral gusts of the financial turmoil.Japan, still trying to come to grips with the bursting of its equity and bubbles of the late 1980s, has experienced further setbacks as its major Asian custo been forced to retrench.

Reciprocally, its banking system problems and weakened economy exacerbated the difficulties of its Asian neighbors.The relative stability of China and India, countries whose restricti international financial flows have insulated them to some extent from the current maels led some to conclude that the relatively free flow of capital is detrimental to econo and standards of living.

Such conclusions, in my judgment, are decidedly mistaken.The most affected emerging East Asian economies, despite the sharp contrac in their economic output during the past year, have retraced, on average, only one-six per capita growth over the past ten years.

Even currently, their average per capita i more than 2½ times the levels of India and China despite the unquestioned gains both ha in recent years as they too have moved partially to join the international financial comMoreover, outside of Asia, several East European countries have made signif progress towards the adoption and implementation of market systems and have increas integrated their financial systems into the broader world context to the evident bene populations.

Latin American nations, though currently under pressure, have largely succ opening up their economies to international financial flows, and more rapidly risi standards have been the result.It is clear, nonetheless, that participation in the international financial all its benefits carries with it an obligation to maintain a level of stability and a transparent institutions and rules if an economy is to participate safely and effective that have become highly sensitive to misallocation of capital and other policy errors.When domestic financial systems fail for lack of adequate institut infrastructures, the solution is not to turn back to a less turbulent, but also lessregime of capital controls, but to strengthen the domestic institutions that are the pr engaging in today's international financial system.Blocking the exodus or repatriation of capital, as some of the newer partici the international financial system appear inclined to do after they get into trouble, the equivalent of the economy receiving a subsidized injection of funds.

If liquidity immediate effect of controls can be relief from the strain of meeting obligations and a sense of well-being.

This is an illusion however.

The obvious consequence of confiscat or all, of foreign investors' capital and/or income, is to ensure a sharp reduc availability of new foreign investment in the future.The presumption that controls can be imposed temporarily, while an econo stabilizes, and then removed, gives insufficient recognition to the imbalances in an ec emerge when controls are introduced.

Removing controls subsequently creates its own problems, which most governments, inclined to impose controls in the first place, are loathe to do.

Indeed, controls are often employed to avoid required -- but frequently difficult -- economic adjustments.

There are many examples in history of controls impo removed, but rarely without great difficulty and cost.To be sure, any economy can operate with its borders closed to for investment.

But the evidence is persuasive that an economy deprived of the benefits technologies, and inhospitable to risk capital, will be mired at a suboptimal standa and slow growth rate associated with out-of-date technologies.It is often stipulated that while controls on direct foreign investment associated technology transfer are growth inhibiting, controls on short-term inflow adversely affect economic welfare.

Arguably, however, the free flow of short-term facilitates the servicing of direct investments as well as the financing of trade.

Ind difficult to determine whether certain capital flows are direct investments or short te Chile is often cited as an example of the successful use of controls on short-term capi But in response to the most recent international financial turmoil, Chile has chosen barriers in order to encourage more inflows.Those economies at the cutting edge of technology clearly do not need fo direct investment to sustain living standards and economic growth.

The economy of the States in the 1950s, for example, needed little foreign investment and yet was far more in the world then, than it is today.That was a major change from our experiences of the latter half of the nin century, when the vast amount of investment and technology from abroad played a signi role in propelling the US economy to world-class status.Even today, though we lead the world in many of the critical technologies, need to borrow a substantial share of the mobile pool of world savings to finance ou domestic investment.

Were we unable to do so, our standard of living would surely suf the inflow of foreign capital would be much reduced if there were uncertainties about the capital could be freely repatriated.While historically there could be considerable risk in American investments example, some nineteenth century investments in American railroads entailed large loss freedom of repatriation and the sanctity of private contracts were, with rare exceptionsOur experiences, and those of others, raise the question of the sustaina free international capital flows when the conditions fostering and protecting them are absent.Specifically, an economy whose private and/or public sectors have become he net debtors in foreign currency is at risk of default, especially when its exc unexpectedly moves adversely.

Clearly, should default become widespread among a number economies, the flow of international capital to other economies perceived as poten similar circumstances will slow and in certain instances reverse.

The withdrawal of th benefits of free flowing capital, as recent history has so amply demonstrated, often ca and disruptive.The key question is obviously how do private sector entities and governments by extension, economies as a whole allow themselves through currency mismatches to reac edge of insolvency?

Indeed, where was the appropriate due diligence on the part of investors?Investors will, on occasion, make misjudgments, and borrowers will, at t misread their capabilities to service debt.

When market prices and interest rates adju to evidence of such mistakes, the consequences of the mistakes are generally contained rarely cumulate to pose significant systemic risk.There was some evidence of that process working in the latter part o nineteenth century and early twentieth century when international capital flows were uninhibited.

Losses, however, in an environment where gold standard rules were tig liquidity constrained, were quickly reflected in rapid increases in interest rates an capital generally.

This tended to delimit the misuse of capital and its consequences. were generally aborted before they got out of hand.

But following World War I such restraints on economies were seen as too inflexible to meet the economic policy goal twentieth century.From the 1930s through the 1960s and beyond, capital controls in many count including most industrial countries, inhibited international capital flows and to some associated financial instability -- presumably, however, at the cost of significant economic growth.

There were innumerable episodes, of course, where individual econo experienced severe exchange rate crises.

Contagion, however, was generally limited existence of restrictions on capital movements that were at least marginally effective.In the 1970s and 1980s, recognition of the inefficiencies associated with c along with newer technologies and the deregulation they fostered, gradually restored flow of international capital prevalent a century earlier.

In the late twentieth cent fiat currency regimes have replaced the rigid automaticity of the gold standard in i More elastic currencies and markets, arguably, are now less sensitive to and, hence, contain the misallocation of capital.

Market contagion across national borders has con been more prevalent and faster in today's international financial markets than appear been the case a century ago under comparable circumstances.As I pointed out before this Committee almost a year ago, a good part o capital that flowed into East Asia in recent years (largely in the 1990s) probably rlarge surge in equity prices in most industrial economies, especially in the United sharp rise induced a major portfolio adjustment out of then perceived fully priced inve western industry into the perceived bargain priced, but rapidly growing, enterpr economies of Asia.

The tendency to downplay the risks of lending in emerging mar reinforced by the propensity of governments explicitly or implicitly to guarant investments in a number of cases, doubtless led to an excess of lending that would not supported in an earlier age.As I also pointed out in previous testimony, standards of due diligence on of both lenders and borrowers turned somewhat lax in the face of all the largess gen abundant capital gains and all the optimism about the prospects for growth in the Asi The consequent emergence of heavy losses and near insolvency of a number of borrowing b and nonfinancial businesses engendered a rush by foreign capital to the exits and induc contractions in economies with which borrowers and policymakers were unprepared and un to cope.At that point the damage to confidence and the host economies had already done.

Endeavors now to block repatriation of foreign funds, while offering temporary c relief, have significant long-term costs and clearly should be avoided, if at all recognize that if problems are allowed to fester beyond the point of retrieval, no mark solution appears possible.

Short-term patchwork solutions to achieve stability are pre only feasible alternatives.

When that point is reached, an economy is seen as no long the capability of interacting normally with the international financial system, and i withdraw behind a wall of insulation.It must be remembered, however, that the financial disequilibria that cau initial problems would not have been addressed.

Unless they are, those problems will reAs I implied earlier with respect to the nineteenth century American exper there are certain conditions precedent to establishing a viable environment for int capital investment, one not subject to periodic systemic crises.Some mechanism must be in place to enhance due diligence on the part of len but especially of borrowers individually and collectively.

Losses of lenders do on occa systemic risks, but it is the failure of borrowers to maintain viable balance sheets an service their debts that creates the major risks to international stability.

The banki many emerging East Asian economies effectively collapsed in the aftermath of inappro borrowing, and large unhedged exposures, in foreign currencies.Much will be required to bolster the fragile market mechanisms of many, certainly not all, economies that have recently begun to participate in the internatio system.

Doubtless at the head of the list is reinforcing the capabilities of banking s emerging market economies.

Conditions that should be met before engaging in interna borrowing need to be promulgated and better monitored by domestic regulatory authoritiesMarket pricing and counterparty surveillance can be expected to do most o job of sustaining safety and soundness.

The experience of recent years in East Asia, ho clearly been less than reassuring.

To be sure, lack of transparency and timely data i more sophisticated risk evaluation systems from signaling danger.

But that lack itsel have set off alarms.

As one might readily expect, today's risk evaluation systems improved as a consequence of recent failures.Just as importantly, if not more so, unless weak banking systems are deterre engaging in the type of near reckless major international borrowing that some systems Asia engaged in during the first part of the 1990s, the overall system will continue better regime of bank supervision among those economies with access to the intern financial system needs to be fashioned. 1 In addition, the resolution of defaults and worko procedures require significant improvements in the legal infrastructures in many nation to participate in the international financial system. 2None of these critical improvements can be implemented quickly.

Transit support by the international financial community to those in difficulty will, dou required.

Such assistance has become especially important since it is evident from t unprecedented swings in currency exchange rates for some of the emerging market econo that the international financial system has become increasingly more sensitive than in shortcomings in domestic banks and other financial institutions.

The major advan technologically sophisticated financial products in recent years have imparted a dis market participants not seen in nearly a century.Whatever international financial assistance is provided must be carefully not to undermine that discipline.

As a consequence, any temporary financial assistance carefully tailored to be conditional and not encourage undue moral hazard.It can be hoped that despite the severe trauma that most of the newer part in the international financial system are currently experiencing, or perhaps beca improvements will emerge to the benefit, not only of the emerging market economies but, long-term participants of the system as well.1 Parenthetically, a century ago, banks were rarely subsidized and, hence, were required by the mark far more capital than they do now.

In today's environment, bank supervision and deposit insuran displaced the need for high capital-asset ratios in industrial countries.

Many of the new partic international financial system have had neither elevated capital, nor adequate supervision.

Thisnow generally recognized and being addressed.2 There are, of course, other reforms that I believe need to be addressed.

These were outlined in testimonies before this Committee.