Mr. Gramlich reviews the benefits and problems of world capital flows  (Central Bank Articles and Speeches, 15 Sep 98)
Central bank: fed | Type: speech | Date: 1998-09-15

Mr.

Gramlich reviews the benefits and problems of world capital flows Remarks by Mr.

Edward M.

Gramlich, a member of the Board of Governors of the US Federa Reserve System, on 'World Capital Flows' at the Carnegie Bosch Institute, University Ce Carnegie Mellon, Pittsburgh, Pennsylvania on 15/9/98.For many years it has been clear that free trade is generally more ef economically than protection.

There are still huge political fights within countries policies, and there may be occasions when countries are better off deviating from free tra trade normally wins the economic high ground in most policy arguments.But that is not true, or not as true, for international capital flows.

Large world debt levels combined with inadequate management of foreign currency risks have le collapse of banking systems in country after country, massive changes in exchange rates recession or depression in much of the world economy.

In view of these provocations, observers are now re-examining their preconceptions that free international capital optimal.

Particular countries such as Malaysia are clamping on exchange controls, fr economists such as Paul Krugman are suggesting currency controls as a least bad option, many others are recommending distortionary taxes on some capital flows, and almost everybod least re-examining their preconceptions.But before this process goes too far, I would like to enter a contrary plea. clear problems with the present system of international lending and borrowing.

But there and important benefits as well.

We know what the problems are.

Let's fix them as soon as and try to preserve the important benefits of international capital flows.

## The Benefits of World Capital FlowsLet

me start with the benefits of world capital flows.

Much of this is s neoclassical economics, but it bears repeating in these troubled times.

Countries' s investment propensities can differ markedly around the world.

If economies were closed to flows, domestic interest rates would equilibrate saving and investment in each countr interest rates would vary widely, which means that capital would have a different marginal each country.Suppose now the world were to be opened up to capital flows.

Capital would f out of those countries with low interest rates, where investment prospects are scarce co domestic saving, and towards countries where interest rates are high, where investment pros abundant relative to domestic saving.

Countries that import capital would benefit from stock of high productivity investments.

Countries that export capital would put their savi use.

Both countries would gain, and the world economy would also gain because scarce sav better allocated to capital markets around the world.This all may sound a bit academic, but the process has been very important world's economic development.

Countries undergoing development can sometimes squeeze t requisite saving out of their poor economies, as the United Kingdom did in the 19th cen Japan did in the 20th century.

Or they can import capital to supplement domestic saving United States, Canada, and Australia did in the 19th century and several countries in East and Asia have done in the 20th century.

This imported capital has been very important in th development process, and it has often brought with it other benefits, such as the in spreading of technological improvements.

Without world capital flows, the general le development in the world would be far less.ProblemsIf that's the story, what's the problem?

Why do world capital markets seem causing such anguish, in country after country?

Why are countries turning away from open markets?

It turns out that there is some fine print that goes with the neoclassical mod world economy has had some trouble with the fine print.

Here are some of the ways.- Exchange rate volatility.

Countries trade in different currencies, and e rates are necessary to make the conversions.

But in addition to being the for converting currencies, exchange rates play another important role i world economy - they also represent the mechanisms for bringing countries p structures in line in international trade.

Suppose one country's prices are for it to compete in world trade, either because it has suffered an adver shock, has had too much inflation, has too rigid labor contracts, or fo other reason.

The country can suffer a painful recession to get its prices line.

Or it can let its currency depreciate.

Depreciations are not ab necessary, as is asserted by advocates of fixed exchange rates.

But depreci or currency fluctuations in general, are often far less costly ways t international adjustments.

The next time you hear someone complain abo exchange rate changes, ask them what else they had in mind to rest international equilibrium.While exchange rate changes have this potentially stabilizing effect, th also be destabilizing.

When exchange rates are allowed to fluctuate, they in currency markets according to the demands and supplies of forward-look traders, and they can be very volatile, often overshooting long-term value volatility can destabilize trade and impart significant uncertainty to int lending.

Borrowers may borrow in international markets expecting to repay one exchange rate, and when the bill comes due, the exchange rate may di by a lot.

Lenders and borrowers can both hedge, but hedging is costly, institutions providing this hedge can go broke.- Financial institutions.

Financial institutions engage in what is known as transformation.

They take deposits from you and me, which deposits can redeemed any time we take out our check book, and make long-term loans mortgage borrowers and businesses.

There are fantastic efficiencies in process - consumers can get higher returns on their saving, and busines borrow and invest in productive equipment.

Indeed, banks and other finan institutions play the same role in allocating domestic saving to its best the international capital market plays for international capital.But as with capital flows, there are risks.

If the banks' loans go b institution is in trouble and may not be able to redeem deposits.

Wit country's borders there are often institutions such as deposit insurance t savers, but internationally the risks can be greater.Given that banks are involved in the domestic saving, investment process, not surprising that they have become heavily involved in the internat saving, investment process.

In general this process too has led to worl efficiencies, but here too there are risks.

In Japan, for example, the ba been hurt by a massive decline in real estate and other values, which ha many nonperforming loans on their books.

In Korea and Indonesia, the ban were hurt by the foreign currency exposure of their borrowers.- Incentive effects.

Incentive effects are always important in economics, ge complicating the analysis of policy measures.

Nowhere is this as true as international capital flows.- One incentive problem involves what is known as moral hazard.

Suppose national governments do intervene to protect the safety and soundness of b That intervention might seem sensible, but it could inspire more risky lend the banks, to let the government pick up the tab if things go bad.

A problem involves unilateral default on loan payments or currency obligat Defaults would appear to benefit debtors, but in the long run these debto have trouble getting new credit.

Or contagion effects.

Even if one borro perfectly sound, if other borrowers like it go under, lenders will be rel lend to similarly classified borrowers.

Discussions of international capit abound with these incentive effects.- Transparency.

A last issue involves transparency.

For the international market to work well, lenders must know the risks and rewards.

They must kn the aggregate debt of a country, the exchange rate risks they are taking, on and off-balance sheet liabilities of all relevant banks.

When they do n a good picture of these risks, they can get into serious trouble.While the world financial crisis has hit with uneven force in various countr while local situations have differed, the interaction between these four elements has alm been critical.

Sometimes big changes in exchange rates precipitated a crisis, sometimes bi in asset values put the banks in trouble, sometimes moral hazard issues generated unsound l almost everywhere there was a lack of transparency.

Once a crisis got going, unilateral de contagion effects spread it to other countries.

The result was a broadscale financial col then fed over to the real sector and caused bankruptcies, credit restraints, and recession income losses in turn magnified the financial problems.

## SolutionsAre there any solutions to this mess?

Many are calling for an end to open markets, as if the benefits are not worth the costs.

Others are calling for distortion protect countries from too much openness.

Should we go part or all of the way back to economies?I remain an optimist and I think not.

There may be occasional instances where restrictions are necessary to control extreme capital flows not justified by economic fun Moreover, the world capital system clearly is in need of repair.

But I hope we can repair back to a world where saving in whatever country goes to the country that needs it most, an pay the most to the saver.

And to a world where international capital flows are an importa for world economic development.

Let me discuss some remedies that should help in that proce- Financial institutions.

Two types of corrections are necessary.

A fi tantamount to preventive medicine - what should be done when institutions not in crisis?

The basic need here is for better bank supervision.

Supe must be improved to insure that proper risk management techniques are put place and followed.

Previous practices where banks, or those to whom ba made loans, loaded up on short-term hard currency denominated liabilities be curbed.

Market discipline can also be used to control risk, by expfinancial institutions to as much market discipline as possible and by l moral hazard problems.But even with all the preventive medicine in the world, the patient some gets sick, and banks in Japan and a number of other countries surely are. to be done then?Examination of a number of historical episodes suggests that there are important elements to dealing with a banking collapse.

First, the bank reg must go through the balance sheets, determine the problem loans, take the the banks' balance sheets, sell them, and have the public take whatever were entailed.

Second, the troubled institutions must be closed down wit management replaced and shareholders suffering losses.

Third, the heal institutions must then be recapitalized, preferably by new equity sales in markets.

The sooner these steps are taken, the better.

The longer they taken, the longer troubled banks will continue incurring losses, engaging i practices, threatening the safe institutions, generating contagion effects performing the banks' all-important maturity transformation function.

In here is a way foreign capital flows can be part of the solution to the because new foreign-owned banks that can perform this maturity transformat function can be invited to participate in credit-starved economies.- Maturity transformation.

While financial institutions perform matu transformation, there is no reason to unduly burden the system.

Countries often gotten into trouble when they have done too much maturit transformation - that is, borrowed from abroad at short maturities to f long-term investment.

Steps could be taken to limit such borrowing, e nationally or through bank supervision.

Some economists have used this ide propose taxes on short-term borrowing, though the tax rates necessary to d job could be very high and it might be more effective to use orthodox prin of bank supervision.- Transparency.

A further set of corrective mechanisms involves grea transparency.

It must be clearer to lenders and borrowers alike what risk are taking.

This requires better reporting by financial institutions, an requires better aggregate statistics on the uncommitted foreign reserve b of individual countries.

Transparency alone cannot do the job of good regulation, but it is hard to imagine a solution to the international problems of the day without more transparent accounting.- The IMF.

Last but not least I discuss the IMF.

Frankly, my own feeling is an institution like the IMF did not exist, we would want to invent somethi it.

Here is an international institution that, at least in principle, can finances of different countries without the accusations of big brother tha come about if the United States alone tried to put itself in this role.

Mo can organize other lending countries to bring support to countries in n liquidity assistance, as opposed to having the bill fall entirely on th States.Supporting the existence of something like the IMF does not suggest agreem with its exact structure or with all of its policies.

The present crisis i international preventive medicine provisions are weak.

It may be difficultIMF to perform this warning system role, but there is clearly a need for warnings about the risks of lending to certain countries, to prevent c vulnerabilities from building up as much as they did.

The IMF's 'one siz all' recommendations of fiscal austerity should also be re-examined, becau many Asian countries expansionary fiscal policies were clearly called indeed, still are called for - while the IMF initially recommended the reveBut the two biggest criticisms of the IMF involve the moral hazard issue exchange rate flexibility.

On moral hazard, the criticism is more or inevitable.

Any time there is any governmental attempt to increase safet soundness, moral hazard questions can be raised.

In the case of the IMF, there to bail out countries in a liquidity crisis, countries will be mor end up in liquidity crises.

The answer, it seems to me, is for the IMF t tight conditions on its lending, so that countries will certainly not loo to getting into debtor status.

In terms of underlying structural change, t of the few leverage points the international lending community has on borro countries, and it is important for the IMF to use its tool well.On exchange rate flexibility, the problem with the critics is that they saying the same thing.

Some say the IMF is too quick to let the exchange fall, some say it is not quick enough.

Both cannot be right at the same timAs a general rule, the exchange rate flexibility issue is a hard one and to make broad recommendations.

Sometimes a country's cost structure is cle out of line, or its inflation rate is clearly too high, and exchange rate seems to be the least costly way to bring prices and wages back into lin exchange rate flexibility will cause capital losses and will raise the cos of future capital transactions.

That does not mean that the exchange rate preserved at all costs, but it does mean that capital flows themselves p constraints on the normal international adjustment mechanisms.

Given all t is hard for me to take a firm policy on exchange flexibility, and I hav sympathy for the apparent open-mindedness of the IMF on the issue.Will these solutions be enough?

Who knows.

But I think we all have a stak making the world capital system work better.

Before we initiate more artificial restriction flows, we should try to improve the system to take advantage of its very large benefits.