Mr. Stals reviews the position of South Africa against the background of the global financial crisis  (Central Bank Articles and Speeches, 22 Oct 98)
Central bank: sarb | Type: speech | Date: 1998-10-22

Mr. Stals reviews the position of South Africa against the background of th global financial crisis Address by the Governor of the South African Reserve Bank, Dr. C.

Stal the Fifth Annual General Meeting of the South Africa - Canada Chamber of Business Johannesburg on 22/10/98.

## 1.

BackgroundAs could have been expected, this year's Annual Meetings of the Internati Monetary Fund and the World Bank held in Washington D.C. during the first week of October, dominated by a discussion of the global financial crisis.What started off more than a year ago as an East Asian crisis gradually exten other emerging market countries and eventually also affected a number of smaller well-de economies.

The most recent extension was an infliction on the financial systems of some industrial countries, such as the United States of America.

What started off as a mor problem of the countries surrounding the depressed economy of Japan, indeed became a g problem that is now demanding the serious attention of the entire international community. be a depressing thought, but it is nevertheless one of the more encouraging outcomes of t annual meetings of the IMF and the World Bank.

Now that so many countries, and also m industrial countries, are more directly involved in the financial crisis, there is a grea finding a solution.

## 2.

The causes of the problemMany reasons have been advanced for the world financial debacle.

Apart from adverse effects of a protracted recession in the Japanese economy, East Asian countries wer for lax macroeconomic financial policies, for insufficient disclosure of information on for movements and debt positions, for bad governance at government and private sector levels crony capitalism.Private international investors were blamed for irresponsible speculative att the foreign exchange rates of countries, destabilizing activity in the financial mar reluctance to share in the burden of eventual collapse and adjustment.The International Monetary Fund has been criticized and is still under attac many quarters for not diagnosing the problem at an earlier stage, and for the way the Fund handled the crisis situation in individual countries.

The medicine prescribed by the Fund 'conditionalities') is blamed for killing the patient, rather than curing the illness.Recent developments added a further dimension and exposed a possibly mor important basic cause for the global financial dilemma, and that is the excessive leverag that certain financial institutions were allowed to create in funding international c including speculative investments in emerging markets.

The near-collapse of the hedg Long-Term Capital Management (LTCM) in the United States of America in September exposed a astonishing balance sheet position for an important operator in the world financial ma balance sheet for a non-bank financial intermediary that used more than $50 of borrowe (mostly bank funds) for every one dollar of own capital!Finally, the nature and functioning of the present international financial s floating exchange rates, unrestricted capital movements and liberalised financial marketsbeing questioned.

This system, which gradually developed through an evolutionary process o past two decades after the final demise of the system of fixed par values in the 1970s, has in elements that encourage periodic occurrences of international financial instability.

Pa smaller economies of the world find it increasingly difficult to maintain orderly domesti conditions in an environment of financial globalisation, financial market integration and control liberalisation.The truth is perhaps that no solitary cause can be singled out as the only r the development of the present international financial crisis.

The erosion in the quality took place over a long period of time and the possible causes identified above most pro contributed to the weakening and eventual foundering of the system.

The restoration of stability in the international financial markets is therefore a cumbersome and complex pr will take some time to achieve.

The seriousness of the problem, however, demands a worl concerted effort that can best be accomplished by working through the available e infrastructure of the IMF and the World Bank.

## 3.

Implications of more recent developments in the crisisThree important events over the past few months contributed to a deepening o crisis, but at the same time also to a better understanding of the situation.Firstly, the decision of Malaysia to reintroduce rather restrictive and compr exchange controls on international capital movements focused attention on the real danger movement towards national protectionist and economic isolation policies.

It is true that traditionally a country with a high domestic savings rate and is therefore less dependant investment for the financing of its own internal economic development.

It is also tru presence of serious internal political division in Malaysia to some extent discredited Mr recent economic policy measures.

International investors, however, could not ignore the s the danger of a wider and more general recourse to direct governmental controls over inte capital movements, particularly over the more volatile short-term capital flows that disrupted the economies of so many of the emerging and developing countries of the world.Secondly, the default by Russia in respect of the redemption of its sho domestic and foreign sovereign debt caught many investors by surprise.

A huge overnight de the discounted value of Russian government bonds that was previously regarded as secure co for large banking loans extended to Russian borrowers forced massive losses on investors, a large provisions for bad debts from international banking institutions.

The Russian deb than anything else exposed the vulnerability of the world's banking system in the current s global financial turmoil.

It also partly exposed the role of hedge funds and short-term sp this evolving global drama.

More than one short-term non-banking financial intermediary and few banks were caught with their pants down in the Russian debacle, and were forced to abso losses.

The clear warning was for greater caution in the games they play in this environment of the global financial markets.Thirdly, the near collapse of Long-Term Capital Management and the decision of American Federal Reserve Bank System to get involved in the subsequent rescue operation o non-bank financial institution, exposed a new dimension of the emerging world financial remains a highly debatable issue of why the Federal Reserve was prepared to attach its nam not its funds, to the rescue of LTCM.

The only reason can be that the Fed was gravely c about possible adverse implications for the American banking system of a liquidation of LTit turned out to be, LTCM managed about $5 billion of selected clients funds, but had inves financial markets more than $250 billion of borrowed funds, mostly raised on a short-te from American banking institutions.Both the American authorities and representatives of the hedge fund movem recently went out of their way to explain that LTCM was not representative of the industr most other hedge funds maintained much more reasonable leverage positions on their balance The vulnerability of the world's financial system, and of many reputable multinational institutions, was nevertheless rudely exposed by the LTCM affair.

The real explanation that this stage be demanded from the American financial supervisory authorities is therefore no Fed got involved in the rescue operation of LTCM, but rather why such excessive gearin permitted by a financial institution that in the end turned out to hold a major systemic American banking system, and indeed for the emerging global financial system as a whole.The moment that the Fed decided to support the rescue operation for LTCM, whole ball game changed as far as the future role of hedge funds is concerned.

The fact become necessary for the monetary authorities of the most important financial structure in to lend their support to the rescue of an institution such as LTCM, surely recognises the of this type of institution for monetary policy in general, and for the protection of ove stability in particular.

But then it also demands financial disciplines and the adherence requirements of financial prudency, capital adequacy and risk-aversion policies fro institutions.The epicentre of risk exposure in the present global financial crisis has partly shifted from the East Asian or emerging and smaller developed economies of the w some of the world's major financial centres.

Important international banking institut become so involved in the problem of excessive leverage and speculative investments in th financial markets that they now also have to implement major and painful internal rest programmes.

A few examples of such forced financial reform programmes already surfaced in r weeks and more will most probably follow.

Maybe we are now much closer to finding a soluti the international financial crisis of the past year, which can surely no longer be bla macroeconomic mismanagement in the smaller economies of the world.

LTCM exposed one of th major sources of global financial instability.

## 4.

In search of a solutionThe causes of the current world financial crisis are complex and widespread solution therefore is not a simple one.

In particular no quick solution is available.It must firstly, be taken into account that the adverse developments in the markets will continue to have secondary effects that will, for some time to come, exert influence on global real economic activity.

Forecasts for world economic growth in 199 systematically been scaled down from a rather ambitious 4 per cent made towards the end year to only about 2 per cent at this stage.

In a number of East Asian economies, growth w be negative this year.Secondly, the restructuring of the banking systems in a number of the af countries will take some time before normality will be restored.

As is known, the Government has just recently provided an amount of more than Yen 60 trillion to recapitaJapanese banking system.

In the meantime only modest amounts of new bank loans will be ava for the financing of consumption and investment.Thirdly, the deleveraging process to reduce the absurd excessive gearing ra some mega-sized financial institutions can only be accomplished by a reduction in world l Taking account of the magnitude of the problem of over-leveraging as evidenced by the b sheet information recently released for LTCM, this can become a major constraint on the ava of new funds in the global financial market over the next year.Against this background, the world can only extricate itself from this c problem by a coordinated effort applied from three different levels:Firstly, many macroeconomic deficiencies were exposed in a number of countr that in the end suffered most from the global financial crisis.

It is dangerous to ge shortcomings as they would obviously differ from country to country and would therefor require specialised treatment suitable to the underlying situation in each one of t economies.

A number of countries such as Thailand, Korea and the Philippines have al addressed their problems with appropriate adjustment programmes, and are beginning to benefits from often painful corrective measures.

These adjustments provide for more disclo transparency, enhanced financial regulation and supervision, recapitalising of banking in more restrictive monetary and fiscal policies, exchange rate adjustments and improved gov in macroeconomic management in general.Secondly , all the criticism against the multinational institutions, and pa against the IMF, is not without foundation.

These institutions did not keep up with the a process of financial globalisation in recent years, and with the rapid integration of wo markets.

Economic policy models that may have been appropriate in the old system where c banks and governments could still exert strong influences on the direction of major aggregates such as interest and exchange rates and could effectively control changes in supply and in bank credit extension cannot be applied without adjustment in the new worl market forces now dominate the scene.

Some changes in the global financial system have b necessary and urgent.

These institutions are now concentrating on increasing their resou IMF quotas, on improving their surveillance functions and on revising the 'architecture' existing infrastructural frameworks.Thirdly , after the LTCM affair, there is an urgent need for multinational ban other financial institutions to revise their own internal risk control models.

The act Malaysia recently to reintroduce exchange controls on international capital movements and facto default by Russia in its inability to redeem its public debt eroded almost overnight what was regarded as secure collateral in terms of normal banking practices.

The develop more suitable risk management models cannot be left entirely to the official financial sup the world - private sector financial institutions should on their own initiative improve financial disciplines and controls.

## 5.

South Africa's position in the international financial crisisThe South African economy was also badly affected over the past six months by deteriorating international financial situation.

As non-resident investors reduced their South African bonds, we had to ride with the storms.

Although the authorities 'leaned ag wind', South Africa ended up with:- a decline in the value of the rand.

Changes in the exchange rate of the ra some turbulent fluctuations resulted in a currency that is now about 18 p weaker than at the beginning of this year;- higher interest rates.

The level of interest rates also moved up and down b stands at about 7 full percentage points above the level of six months ago;- some decline in overall liquidity in the banking sector which, however, again in recent weeks;- a depressed real domestic economy.

Growth in real gross domestic produ slowed down already last year and was further restrained by the recent ad developments in the financial markets.During this testing period, some structural weaknesses in the South African ec were once again exposed, but also some inherent strengths for which we should be grateful include a sound and well-managed domestic banking sector and financial markets that provid liquidity, the mechanisms and the resilience to adapt to the rapidly changing int environment.South Africa's approach to this worldwide financial market problem is to remai of the system and to lend our support for a global initiative to solve the problem.Action at the level of national governments, the multinational financial ins and private sector financial market operators is necessary to restore stability in the gl system:- Governments must recognise, analyze and define deficiencies in th macroeconomic policies and identify weaknesses in their financial struct and must take the necessary steps on a case by case basis to strengthe system at the national level.

Problems are different from country to count no standard macroeconomic module can be prescribed on a global basis f universal application.- The multinational institutions should concentrate on the obvious shortcomin the present infrastructure for international payments, international capi and the determination of exchange rates.

The process of financial globali worldwide financial market integration and liberalisation of financial inst moved faster than the global authorities themselves did with their contr surveillance systems.

The approach now should not be for the markets to stopped in their progress, but rather for the authorities to catch up.- Private sector financial market operators, including multinational ba institutions, hedge funds and institutional fund managers, must in thei interest reconsider and review their modus operandi in the markets.

In part risk management models must provide for the volatile global financ environment in which they now operate.Many encouraging signs emerged from the discussion in Washington D.C. to indic that progress is now being made at all three levels, and that greater stability is gradual the world financial system.

South Africa, like many other countries in a similar situation, these signs of hope with great interest.