Christian Noyer: International financial stability
Keynote address by Mr Christian Noyer, Governor of the Bank of France and Chairman of
the Board of Directors of the Bank for International Settlements, at the International
ParisEuroplace Financial Forum, Tokyo, 29 November 2010.
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Although the financial crisis originated in one country, it quickly became apparent that it was
truly global in nature. It brought home a simple message: capital markets are closely
interlinked around the world and, thus, domestic and international financial stability cannot be
dissociated. They really are two sides of the same coin.
Today, I would like to reflect upon international financial stability. The views expressed are
my own but, as you know, France now holds the Presidency of the G20 and I will try to put
my own thoughts in that perspective.
International financial instability has increased over the last period. Whether we look at
exchange rates, international capital flows or commodity prices, signs abound of more
intense volatility.
Volatility may not necessarily be a bad thing. To some extent, it is a sign of well functioning
financial markets. Movements in asset prices help the financial system to serve as a cushion,
an "absorber" for exogenous economic shocks. This is welfare improving since it avoids, or
mitigates, adjustment in more rigid goods or labor markets.
Volatility may also be driven by fundamentals. For instance, capital inflows to emerging
economies partly reflect very favorable long term growth prospects and high potential returns
on capital. This can't be seen as an anomaly. If anything, it remains counterintuitive that net
capital flows are still going "uphill" from emerging to developed economies. That means that
some of the poorest citizens of the world are lending money to some of the richest, allowing
those to finance their consumption.
The same holds true for commodities prices. Commodities markets increasingly function like
asset markets with the development of financial instruments based on commodities baskets.
In fact, commodities have become an asset class in themselves which warrants special
attention in terms of financial stability. On the other hand, there may be good reasons to think
that "fundamentals", such as strong growth in commodity intensive emerging economies
countries underpin the current behavior of many commodity markets.
Finally, financial volatility may be the product of some very specific features of the current
environment. The conjunction of economic uncertainty, high risk aversion and ample liquidity
worldwide is especially conducive to abrupt shifts in sentiment and portfolio allocations.
Volatility becomes a problem when it is policy induced and, therefore, financial markets
contribute to aggravating shocks instead of attenuating them. Then, durable instability settles
in and creates potential threats for the real economy. We may be in such a situation today as
there are doubts about the mutual consistency in economic strategies pursued by major
economies. At the same time, some of the policies implemented to deal with volatility may
cause additional damages and distortions in capital markets. I will address those two issues
before turning briefly to longer term challenges.
Global imbalances and financial stability
There is broad agreement on the need to rebalance aggregate demand across the world.
That shared objective has underpinned the cohesion exhibited by G20 countries during the
acute phase of the crisis. It has played an essential role in 2008 and 2009 in restoring
confidence and setting the path for the recovery. However, this concerted approach to global
imbalances may have weakened recently. There is clearly a debate going on about two
major and interrelated issues: first, the appropriate pace of the rebalancing, with advanced
countries feeling a greater sense of urgency; and second, on the most efficient strategies, in
particular regarding exchange rates.
It would a mistake to ascribe responsibility for imbalances to one specific cause. All countries
have legitimate concerns. We have seen in recent weeks a tendency by countries to
challenge each other monetary policy. This cannot produce a good outcome.
We have to start from three basic realities.
First, countries are free to conduct monetary policies they deemed appropriate. Indeed, when
Central Banks are independent, they are legally obliged to do so. Monetary policies are
conducted with domestic objectives in mind but, as you have noticed, all central banks have
the same mandate: to maintain price stability. This is true for all countries, whether small or
large. The world has enormously benefited from two decades of price stability resulting from
monetary regimes based on Central bank independence and a focus on internal price
stability.
Second, according to the IMF Articles, countries are free to choose their capital account and
exchange rate regimes with the proviso that they do not engage in currency manipulation.
This is a basic pillar of our current system. The proviso has proved very difficult to define, let
alone to implement. The IMF has met with some difficulties in trying to set up an efficient a
symmetric process of multilateral surveillance.
And, third, we live in a world of greater interdependence and complexity. International capital
flows have made countries truly interconnected. The monetary and financial system has
become "multipolar". An increasing number of countries, both developed and emerging, have
become active participants in the global capital market. Spillovers between national monetary
and economic policies have multiplied. And no country can truly be indifferent to actions
taken by others.
In current circumstances, those three basic realities have become much harder to reconcile.
Divergences in monetary policies are unavoidable given the uneven paths of recovery across
the world. And, for each country, this may be a time where price and financial stability
objectives may not coincide. In advanced economies, monetary easing, together with
inhibitions on credit growth, creates a potential for further financial imbalances. In many
emerging countries, inflationary pressures would warrant monetary tightening but there is a
clear risk this would trigger destabilizing capital inflows.
In those circumstances, there is a major role to play for macro prudential policies. For
advanced economies, they should aim at spurring credit growth, while increasing the
resilience of the financial sector. Supervisors should also stand ready to act if bubbles like
phenomena appear in some markets. For emerging economies, measures aimed at
stabilizing capital inflows may help and relieve the pressure on domestic financial conditions
and prevent further asset bubbles.
International financial architecture
In the longer run, however, we may need to work together towards a more efficient and
stable international financial architecture. Let me highlight three possible avenues for
progress.
First, we have to find ways of dealing with international capital flows volatility. For one given
country, capital controls may temporarily reduce the pressure on its capital account or even
permanently limit the volatility of its exchange rate. For the whole international system,
however, they may simply displace the pressure to other countries or asset classes and
exacerbate, rather than reduce, overall volatility. There might be ways to eliminate those
negative effects by creating a predictable framework defining the circumstances, modalities
and conditions through which temporary controls would be implemented.
Second, there would be benefits in finding ways to disconnect reserve accumulation from
exchange rate management and, more generally, from balance of payment situations and
monetary policies. At present, reserve accumulation can only occur through a conjunction of
balance of payment surplus and some degree of exchange rate intervention. Emerging
countries have increased their foreign exchange reserves from 4 percent of GDP in 1990 to
over 20 percent on average today. Precautionary reserve accumulation, however legitimate,
unavoidably creates side effects for domestic macro policies as well as spillover effects on
other countries. Stabilizing the demand for international reserves would therefore bring huge
benefits in terms of world welfare. The need for national reserves could be reduced if
credible mechanisms exist to provide for the supply of official liquidity on a multilateral basis.
Hence the current search for international financial safety nets which has taken first stage in
the G20.
Finally, I would like to say a few words about financial development. Differences between
countries, are striking, whether one looks at capital account regimes, the broadness and debt
of domestic financial markets or, more generally, their ability to generate locally a sufficient
supply of safe and liquid assets. Some of those differences reflect true social choices and
preferences that must be respected and accommodated. Others result from deliberate or
inadvertent policy-induced distortions, which should be reduced or eliminated.
Domestic financial imperfections and frictions in international capital flows interact with each
other to create and amplify imbalances. Ultimately, financial instability is a product of this
interaction. Part of this instability shows up in exchange rates movements. It is very unlikely
that a global capital market driven by constant frictions between highly different domestic
financial systems would lead to a stable - and fundamentals based - equilibrium in foreign
exchange markets.
Ensuring that our different financial systems interact harmoniously should be a policy priority.
Greater compatibility in approaches to financial regulation between advanced and emerging
economies is within reach. Significant advances are being made. The institutional framework
has adjusted to the new world reality. Emerging economies, now fully take their part and role
in the constellation of Committees which, in Basel, work on defining core principle of financial
regulation. The largest sit as full members of the Financial Stability Board, and its steering
Committee. Finally, a landmark agreement on IMF reform reached at the last G20 meeting
has fully recognized their role and place in the new financial environment. I am therefore
confident that we can - and will - make progress in tackling the difficult issues we face and
build a better and safer world financial system.