Mr. Macfarlane puts recent suggestions for improving the operation of the international financial system into perspective  (Central Bank Articles and Speeches, 25 Nov 98)
Central bank: rba | Type: speech | Date: 1998-11-25

## Mr. Macfarlane puts recent suggestions for improving the operation of the internation financial system into perspectiveTalk by the Governor of the Reserve Bank of Australia, Mr. I.J.

Macfarlane, to CEDA A General Meeting Dinner in Melbourne on 25/11/98.It is a pleasure to be in Melbourne again for CEDA's Annual General Meeting.

The last addressed this group two years ago I spoke about the Australian economy, monetary poli wages.

Events have moved on a good deal since then, and I hope what I have to say t reflects this.The biggest change is that attention is now more focussed on the international economy domestic events.

This change can be dated from the start of the Asian crisis in the 1997, and has continued through more recent episodes which have affected other eme markets as well as financial institutions in developed countries.

These events have le of participants in international markets, myself included, to question some aspects of international financial system, and to make suggestions for improvements.I have said a number of things recently that have sounded a bit out of character from banker.

Both I and my deputy have shown a lot of sympathy for our Asian neighbours an that it is unfair to place the blame for their current plight solely on their own polic We have also said that the present international financial system is unstable, that should be brought into the disclosure and supervision net and that the western establishment was wrong to encourage emerging markets to embrace the free movement international capital so early in their development.This has led some people to wonder what has come over us, and to question whether we deserted orthodox economics to follow more populist creeds.

I have been asked whether longer believe in markets, and whether we have become proponents of capital controls. questions worry me because they suggest that, for some people, there are only the t positions, and that if you express some reservations about one, you are automatically the other.

For these reasons, I want to spend some time tonight trying to place suggestions for improving the operation of the international financial system in som perspective.

## 1.

From the Perspective of AustraliaFrom the perspective of the Australian economy, the move to financial deregulation, an lifting of restrictions on international capital movements, has been a success.

We approximately from the floating of the exchange rate, and the abolition of exchange co 1983.

Although we characterise this 15-year period as being an era of deregulation, tha very approximate description.

While the authorities have stopped setting prices suc exchange rate or the interest rates banks can charge on mortgages, there is still a evolving body of regulation in place aimed at ensuring financial stability and effici markets.

The stock exchange and the futures exchange have a comprehensive set of rul participants must adhere to, and, of course, they are also regulated by ASIC.

The b insurance companies are regulated by APRA, the payments system by the Reserve Bank, competition policy is enforced by the ACCC.

Underlying all this, are the body of commerc and the accounting standards.This approach to organising financial markets - which, in deference to common usage, I the deregulated approach - has not been without its critics.

A common criticism international capital has forced the Australian Government to run macro-economic polic were not in the interests of the domestic economy.

By this, the critics mean polici tighter than the ones they favour.

I have never agreed with this proposition.

There h on-going struggle in Australia by governments of both sides to return fiscal and moneta to sustainable long-run settings after the turmoil of the 1970s.

The influence of finan has been a helpful one in bringing this about.

Now that policies are in a sustai responsible position, I am not aware of financial markets pushing for tighter policies.The other common criticism is that financial markets in Australia have been unstab simplest answer to this charge is to point out that they would have been more unstable past 15 years if we had tried to find a path through the ups and downs of the world eco a managed exchange rate and a set of interest rate ceilings.

We would not have had movements as under the present system, but the pressure would have built up and when t broke, as it assuredly would have, the crisis would have been worse.While I am confident that the deregulated system performed better than a continuation o regulated one would have, I do not want to give the impression that it is without fau already on record as accepting that the exchange rate went down too far in the mid-19 asset prices such as shares and, later, commercial property underwent a boom and bust a of the 1980s and beginning of the 1990s, partly as a result of excessive lending deregulated banks.

Our whole approach to foreign exchange intervention is based on ou that the foreign exchange market is not 'efficient' in the academic sense, but that i overshooting in both directions from time to time.In other words, we do not have an idealised view of how deregulated asset markets beha have a realistic 'warts and all' view.

But even holding that view, we are confide deregulated model with no obstacles to capital movements is the best one for Australia. a long time to adopt it, but there is now wide support for it at the political, poli community level, and I hear no suggestions that we should change it.

But that does not we should be urging every other country to adopt this model regardless of their development.

Eventually, I think it will be in the interest of emerging market economie but the sequencing of this and other policies is crucial.

## 2.

An Emerging Market PerspectiveWhen we look at international capital movements from the perspective of an emerging m economy, the view can be very different.For a start, the size of the financial sector in an emerging market is often extremely to the flows of capital that emanate from developed countries.

As Paul Volcker has put'One common characteristic of (emerging market) countries, some large in population and area, is the small size of their financial sector.

The aggregate s the banks in the typical emerging country is now the size of a single regional ban the United States - precisely the kind of bank that is told that it is too small t in today's turbulent markets.' 11Speech to Institute for International Finance, Washington, October 1998.What is a small adjustment of investment strategy for a few major banks or mutual funds a large injection or withdrawal of funds for an emerging market.Second, it is clear that for most of the Asian emerging markets, some of the capital occurred in the mid to late 1990s was not, in any sense, needed.

It was more than th required to finance their current account deficit, and it certainly was not needed to exchange rate because these were under unwelcome upward pressure throughout the period. purist would say that if they did not want the inflow they should have let their exc float upwards.

This would have eventually curtailed the short-term inflows that resul fixed exchange rate tries to co-exist with a positive interest differential.

But wha know is how high the exchange rate would have needed to rise in the process and the e which this would have added to the economic difficulties.

Remember the Thai currency was triggered by the perception that the baht had become over-valued because it was t rising US dollar.

In short, if capital flows are very large relative to the size of the are, one way or another, going to cause distortions.Of course, the above considerations would not matter if the international capital mark smoothly adjusting mechanism that constantly kept the exchange rate in line with the fundamentals.

But this is not what people observe - they see booms and busts and do not the proposition that the market is always right.

Attempts by academic economists to them that the free market always, or nearly always, gives the correct equilibrium unconvincing.

The public's scepticism is well placed because the intellectual underpinn free market position in relation to asset price determination - the Efficient Markets is very weak.

In all the exchange rate tests of which I am aware, the hypothesis contradicted by the facts.The third difference from an emerging market viewpoint is their relatively under-de financial infrastructures and regulatory frameworks.

They do not have as strongly a bas of regulating stock markets or banks or the underlying body of commercial (inc bankruptcy) law or accounting practices.

They also have serious deficiencies in the al investment which unduly favours those who are well-connected to the government, the ba both (the so-called 'crony capitalism').

I have no intention of denying that these shortcomings and that they should be rectified as quickly as possible if the countries are going to achieve first world living standards.

But we have to be realistic about these things can be achieved; in our own countries, these changes took decades or gen rather than years.Such problems are heightened by the phenomenon of contagion, a fourth element partic strong among emerging markets.

In cases of panic, financial markets are not very discri When one country suffers a withdrawal of capital, others come under pressure.

Partly, t geography, as physical proximity can often mean economic and financial linkages.

But economies on the other side of the globe, with few direct linkages, can be affected f reason than that they are classified as 'emerging markets'.Such countries might well have some weaknesses such as those noted above which, given and a measure of economic and financial stability, might be adequately addressed.

Bu conditions of widespread desire to shed risk, they become immediate stumbling bloc markets.

This can put intense pressure on the policy authorities and economies of these - pressure which few countries can withstand easily.For these reasons, the picture looks different from the perspective of the emergin economies.

What is good for us after a long period of evolution need not be good for country at a much earlier stage of that evolution.

In modern parlance, it is essenti sequencing right.

Countries have to attain a high standard of financial infrastr regulation before they can submit themselves to the potential instability inherent in free movement of capital.

In the meantime, they should integrate themselves as closel can into the international capital market and, as their markets evolve towards maturit take additional steps progressively to liberalise their regulatory regimes.

To expect t in the other order is to ask them to run before they can walk.

## 3.

What Should We Do About It?Fortunately, there is now a widespread agreement that something has to be done to impr international financial system.

The degree of instability, if it continues unchecked, many participating countries to question the whole legitimacy of the system.

The sever contractions in Asia is the most striking example, but so is the sudden recognition t fund can become so important that its failure could pose a systemic threat to the Uni and international economy.

The fact that the second most important exchange rate in the the US dollar-Yen rate - could move by 20 per cent in a month without there being a change in fundamentals has also caused concern.

I think there is now agreement that so has to be done, and it is heartening to see that the United States has taken a lea including by convening the Group of 22 and its three working parties.

I also think Australian Government has played a very useful role - first by its representations t urging more flexibility in its handling of the Indonesian crisis, and secondly by it keep the momentum of APEC heading in the direction of more liberal trade policies.Change is already occurring in that the western policy establishment is no longer emerging market economies to move quickly to full capital account convertibility.

As re October last year the IMF, at its Annual Meeting in Hong Kong, was hoping to get its m endorsement of a change to its Articles to make it easier for it to encourage countri full convertibility.

This proposal was not put forward at the 1998 Annual Meeting in Wa because it was clear that it would not get support.

There also seems to be greater to countries which have a generally outward-looking policy framework, but which have put i some impediment to very short-term capital movements.

I refer here to Chile's d requirement on foreign borrowing and to Singapore's and Taiwan's restrictions on thei lending domestic currency offshore.The more important task is to get on with the job of improving the international system, with the specific aim of reducing the degree of instability.

Some of this is t emerging market countries, and in the first instance involves increasing disclosure countries' governments, companies and banks.

As well as making markets better informed better able to judge the risks they are taking, the aim here is to make some progress the previously opaque links between governments, banks and companies, or, in other wor improve governance.

In addition, there is a lot of work to be done to bring the supe financial institutions up to standard - a task which will take a lot of personnel, traiThese changes are extremely important and require a lot of effort on the part of the market countries.

They also mean that a lot of time-honoured ways of doing things will be replaced.

This is bound to meet opposition, and it will require political courage economic expertise to achieve results.

It will be made a lot easier if the developed ec also seen to be examining whether there are aspects of their regulations that are conthe instability of the international system.

The most obvious reform here is to do about the extent to which current regulations allow excessive leverage in financial ma immediate focus should be the close inter-connections between hedge funds, investment and commercial banks.

The hedge funds have become the privileged children of the intern financial scene, being entitled to the benefits of free markets without any of the res Our reconstruction of the transactions that hedge funds undertook in Australia in June that they could engage in almost infinite leverage in their off-balance sheet transacti chose.

One has to ask whether the Basle capital requirements are excessively generous treatment of financial market activities.

A related problem is the weakness in ban assessment processes that allowed them to build up some very large exposures to hedge and other financial institutions.No matter how effective the above changes turn out to be, no-one expects that they will economic crises altogether.

There still will be a need for improved crisis management.Here, the most useful suggestion goes under the title of private sector burden shari designed to be used in a future crisis when a country's international reserves are ex its exchange rate is plunging as a result of capital flight.

In order to reassure mar are often tempted to guarantee a variety of foreign borrowings, with the result that th incur large losses while foreign lenders escape unscathed.

Private sector burden shar stop the capital flight by bringing foreign creditors, the debtor country and the IMF work out a rescheduling, probably with a standfast arrangement to hold things togeth negotiations take place.

Thus, the burden would be shared more evenly, and the press exchange rates could be reduced.Another way in which crises can be handled better is illustrated by the recent IMF pa Brazil.

It was an improvement on the Asian packages in two respects.

First, the condit agreed on in advance in behind-the-scenes negotiations between the IMF and Braz authorities.

This was much better than the public tug-of-war between national authoriti IMF that occurred in Thailand and Indonesia.

Second, I also note that the conditions wide-ranging as in Indonesia, for instance.

I agree with Martin Feldstein 2 that the IMF conditions should confine themselves to matters that bear directly on the currency crisis, nam monetary and banking policy, rather than trying to reform the automobile, shipbuilding industry, as in Indonesia.

## 4.

ConclusionIt is important that we find a way of reducing the present extreme variability in i capital flows.

It is also important that we find a way of managing future crises in reduces the cost to the crisis country and shares the burden more evenly, and so re moral hazard to lenders.

If we do not succeed in doing these things, we face the pro significant number of countries losing faith in open, market-based economic systems.

It tragic if our failure to reform an unstable international capital market resulted i inward-looking policies in the international trade in goods and services.

And that happen.One reaction to the instability of the international financial system would be for unilaterally impose quite restrictive controls on inward and outward capital movements, miss out on the benefits that access to foreign capital can provide.

We have alreadystarting, and it would be regrettable if it were to spread.

Even if this does not happe a possibility of other reactions which may be equally, or more, unhelpful to the world In particular, I fear that a number of emerging market countries will take another form first policy by building up large international reserves - a new type of mercantilism. with this solution is that to build up the reserves they would have to run curre surpluses for the foreseeable future.

How will they do this?

Will they be tempted t imports, subsidise exports or maintain undervalued exchange rates?

All of these are wha be called 'beggar thy neighbour' policies.

The whole world cannot do this, so who will corresponding current account deficits?

The final irony, if this situation eventuates, we would have an international system in which the poor countries lend to the rich so spend more than their income.