Mr Sherwin discusses reform of the global financial architecture from a New Zealand
perspective
Address by Murray Sherwin, Deputy Governor of the Reserve Bank of New Zealand, to the
International Law Association in Wellington, New Zealand on 9 July 1999.
In October of last year, I gave an address to a meeting of the New Zealand Institute of International
Affairs under the title "Asian Prospects and Challenges". That address took place while the effects of
the Asian crisis were still unfolding and in the wake of the Russian default, the subsequent collapse
and rescue of the LTCM hedge fund, and the associated blowout in global risk premia. Brazil was in
strife at the time, and the calls for a substantial overhaul of the global financial architecture were loud
and strident. The key themes in that address were that:
• The countries of Asia had suffered a severe shock, and that the initial financial impact would be
followed by "real" impacts in the form of declining output and incomes, declining asset values,
company failures, rising unemployment along with increasing poverty and social stresses.
• The damage to balance sheets was enormous, with the financial sectors of the worst affected
countries carrying capital losses of the order of 25 to 50 percent of GDP. Substantial capital
losses had also occurred in the corporate sectors of those countries.
• Those balance sheet holes would have to be filled before any economic recovery could be
considered robust. Foreign investment would inevitably have to play a significant role in that task,
and would bring other benefits besides speeding the recovery.
• To entice private investors back into the region, it would be necessary to make substantial
progress on such basic components of market infrastructure such as accounting standards, audit
standards, transparency, the legal underpinnings of bankruptcy law proceedings and commercial
law more generally.
• Better risk identification and risk management would be necessary, in both the public and private
sectors.
• Asia would eventually recover, but growth would probably settle at something closer to 4 to 6
percent rather than the 7 to 10 percent growth rates of old.
In one sense, the 7 months since I made those comments have shown me to be the perennial pessimist
that economists traditionally are. It is not called the dismal science for nothing. Whereas in October,
the consensus expectation for the 1999 growth of the six most affected Asian economies was around
0.9 percent, the corresponding number now is +1.1 percent. Recovery has appeared earlier and
stronger than I had expected.
In another sense, however, I think my comments of last October remain absolutely valid. The list of
prerequisites for robust sustainable growth in Asia is unaltered. And while progress has been made on
many fronts, my concern is that the reform process remains inadequate. Indeed, the risk now is that an
early return to positive growth is, in some cases, weakening the political will to undertake those still
necessary domestic policy reforms. To that extent, the recovery now underway is that much more
susceptible to reversal and that much more vulnerable to further crises in the future.
While Asia has been recovering, the debate continues on what caused the crash, and how a repetition
can be avoided. If nothing else, the constant shuttling of international bureaucrats to meetings of this
"G" or that "G" has kept otherwise empty airlines and hotels in business.
What I would like to do today is survey some of the work taking place under the general heading of
"reforming the global financial architecture" and to put some New Zealand perspectives on that
process. Note that these are not necessarily the views of the New Zealand Government. Rather they
are the views of an individual who happens to have followed the discussion and attended a number of
meetings where these issues were under discussion. My comments will be necessarily partial and
selective. Why that is so is neatly summarized by Barry Eichengreen (University of California,
Berkeley) in a recent publication ("Toward a New International Financial Architecture. A practical
Post-Asia Agenda", Institute for International Economics, 1999).
Eichengreen notes that the list of proposals for reform grows longer day by day. Moreover, he notes
that:
"Many of these proposals are contradictory and mutually incompatible. Some recommend that
policymakers renew their efforts to liberalize international capital markets, while others plump for the
reimposition of capital controls. Some insist on the need for greater exchange rate flexibility, while
others regard nothing as more important than the re-establishment of stable, even fixed exchange rates
between currencies. Some suggest that the international community should respond more forcefully to
crises, while others recommend that it stand back and let nature, in the form of the markets, take its
course. Some emphasize the need for more funding for the IMF while others call for the abolition of
the institution. Some suggest that the Fund must root out corruption and compel countries to install
the institutional prerequisites for stable financial markets, while others insist that it should limit its
advice to monetary and fiscal policies and refrain from meddling in the internal affairs of its
members."
I will quote Eichengreen at length, largely because I find his analysis and assessment as persuasive as
any I have encountered on this subject - which is another way of saying that for the most part I agree
with him. I am particularly attracted to his dismissal of the more ambitious reform proposals,
including those sponsored by some G7 governments, as unworthy of much discussion simply because
"They have not a snowball's chance in hell of being implemented. They all assume a degree of
intellectual consensus and political will that simply does not exist."
Eichengreen goes on to list a set of key assumptions that condition his thinking on these issues. Those
also bear repeating:
• Liberalized financial markets have compelling benefits. This is an argument about savings
mobilization, and efficient allocation of investment, together with the benefits of allowing
consumption smoothing and risk diversification. Note that it is not a closed-minded piece of
ideology, but a proposition that, despite their obvious weaknesses, markets generally do a better
job of allocating resources than do governments.
• International financial liberalization and growing international capital flows are largely inevitable
and irreversible. At the core of the global trend towards financial liberalization lie changes in
information and communications technology. This rapidly emerging and pervasive technological
capability makes it more difficult to restrict the range of financial transactions in which market
participants engage. As the technology becomes more pervasive, and the benefits from accessing
it expand, so too the costs associated with constraints on its use must grow. Moreover, it is
difficult to limit international financial transactions when domestic financial transactions are
being freed. Given that the case for domestic capital market liberalisation is overwhelming, it
follows that it will be increasingly difficult and costly to limit international financial transactions.
• Notwithstanding the manifest benefits of financial liberalisation, capital markets do not work
perfectly; they are characterised by information asymmetries that give rise to sharp corrections
and, in the worst case, financial crises. Here, Eichengreen recognises that there are characteristics
of financial markets that make them prone to occasional distress, to overshooting and to herd
behaviour. The banking system will often be the point at which stresses associated with this
behaviour come to the surface. So, however positively we view markets, history and the structure
of financial markets warns us to expect periodic crises.
• This instability provides a compelling argument for erecting a financial safety net, despite the
moral hazard that may result. Eichengreen argues that history shows the need for deposit
insurance and a lender of last resort to contain systemic risks to the financial market. He suggests
that, by analogy, there is an argument for an international lender of last resort, but muses whether
the IMF or any other candidate has the capacity to carry out such a role, or the ability to contain
the moral hazard that results. In domestic markets, he argues that moral hazard concerns
underscore the need for vigorous supervision and regulation of financial institutions covered by
lender of last resort facilities.
It is in this area that I have the greatest reservations about the Eichengreen prescription, reflecting our
own aversion to excessive reliance on banking supervision and on well-intentioned, but ultimately
self-defeating, financial safety nets. But in accepting his previous point that occasional bouts of
financial instability are likely to be a characteristic of deregulated financial systems, we are
compelled to consider the need for some means of moderating the impact of those inevitable bouts of
instability. Where we differ, I think, is on the potential to push the management of those risks back to
the private sector.
• Information and transaction costs prevent decentralised markets from quickly and efficiently
resolving crises. Creditors face incentives to run for the exits at the first sign of trouble and, in
doing so, are likely to exacerbate any emerging problem. This makes it difficult to orchestrate
outcomes that might better preserve value and facilitate its "fairer" distribution. At the national
level, insolvency and bankruptcy codes exist which give the courts power to impose restructuring
and settlement terms. In Eichengreen's view, the absence of an international bankruptcy court
with similar powers is a problem.
Economic policy is framed in a politicised environment. This is a very simple but important point.
•
It cannot be assumed that regulators and other economic policy makers will carry out their tasks
without allowing themselves to be influenced by political considerations. And mostly, national
governments will not cede their sovereignty or control of domestic economic affairs to an
international body. That is a reality that should influence any thinking on the list of proposals to
reform the international financial architecture.
Pulling all of this together, Eichengreen's conclusions are "...predicated on the notion that
international capital mobility is now a financial fact of life, and the problem for policy is ensure that
the benefits of capital mobility exceed its costs rather than pretending that it can be made to go away.
They are based on the belief that financial markets can malfunction, creating a compelling case for a
financial safety net and therefore a role for the IMF, but also posing problems of moral hazard that
must be addressed. They acknowledge that crises will still occur and that there is a need to create
institutional mechanisms to overcome the information asymmetries and collective-action problems
that prevent them from being rapidly resolved. They acknowledge the existence of political
limits...[on the range of policy options]."
With that backdrop, let me turn to the efforts to reform the global financial architecture that are now
underway in a number of different international forums. What we can see, first up, is that those with
modest ambitions are least likely to be disappointed with what will emerge at the end of this process
of reform.
The current list of work underway is summarized in a paper presented in April this year to the IMF's
Interim Committee. That paper listed the following initiatives, in best IMF bureaucratese, as "reforms
that, at a general level, command broad support."
• To promote transparency and accountability, and to develop, disseminate and monitor
implementation of better standards and best practices;
• To strengthen financial systems, including through better supervision, and appropriate
mechanisms for managing bank failures;
• To pay greater attention to the orderly liberalization of capital markets;
• To involve the private sector more fully in forestalling and resolving crises;
• To ensure that systemic issues are adequately addressed, including the appropriate exchange rate
regimes and the adequacy of the Fund's resources.
The paper also made reference to the essential lead role of the World Bank in developing codes of
good practices in social policies and in developing social safety nets before crisis strikes.
To take each of those in turn:
Transparency and standards
Broadly, this looks like being the most significant product of the whole global financial architecture
reform effort. The primary initiatives include improved quality, coverage and timeliness of national
statistics; improved accounting and audit standards; developing codes of good practice on
transparency in fiscal, monetary and financial regulation policies; enhanced transparency within the
operations of the major international financial institutions; and improved bankruptcy, corporate
governance, insurance and securities regulation. It is mostly unspectacular, quite technical and
thoroughly conventional. It aims mostly at sharpening the incentives towards good governance,
together with improved risk identification and risk management within both the public and private
sectors. Generally it is about ensuring that domestic market and policy structures are compatible with
the reality and disciplines of internationally mobile capital.
In general, this seems like thoroughly sensible work. If there are reservations on my part, they relate
largely to the risk that international standard setting becomes a substitute for intelligent case-by-case
risk assessment. Standards of good practice can too readily become excessively rigid templates which
fail to adequately distinguish between diverse circumstances or fail to evolve with changing
circumstances. Form can come to dominate substance and, in those circumstances, such standards can
become an impediment to sensible risk management rather than an aid. In essence, the risk is that
those responsible for the management of banks or other enterprises stop thinking about the underlying
risks their businesses face and, instead, become focused on what is required to conform to the
regulators' standards.
Strengthening financial systems
A number of different agencies have fingers in this particular pie.
The Basel Committee of Banking Supervisors is reviewing gaps in its existing framework. The work
underway includes data related issues, methods for dealing with weak banks, disclosure standards,
financial sector safety nets, licensing, governance plus legal and judicial issues. In addition, a review
of the 1988 Capital Accord is underway. Banks' dealings with highly leveraged institutions (hedge
funds) have also been under review, with an eye to reducing the risk of further surprises of the LTCM
type.
The Financial Stability Forum has been established, under the chairmanship of Andrew Crockett,
General Manager of the BIS, with the aim of strengthening cooperation among the international
organisations, regulatory associations and expert groups with responsibilities in the field of financial
regulation and oversight. The core work is taking place in three groups looking at, respectively, hedge
funds, off-shore financial centres and short-term capital flows.
The International Accounting Standards Committee (IASC) is completing its work on developing a
core set of international accounting standards that could be adopted for international cross-border
listings.
The OECD and the World Bank have finalised the development of guiding principles on corporate
governance.
The IMF is strengthening its surveillance of countries' financial systems in the course of its Article IV
consultations, with a view to improving evaluations of their soundness and vulnerabilities. This is also
likely to include reviews of member countries' compliance with the various standards, guidelines and
principles referred to.
The IMF, World Bank and the UN Commission on International Trade Law (UNCITRAL) are all
working on guidelines for effective insolvency regimes, especially for use in developing countries.
Again, this work falls mostly into the category of good, sturdy but unspectacular. Nothing wrong with
that, of course. However, the most important work in the field of strengthening financial systems rests
not with the myriad of international agencies listed above, but with the countries now vulnerable to
financial crises. The hard effort will be in lifting management quality in banks in the developing and
emerging economies, in improving risk recognition and risk management, in improving the regulatory
regimes in those countries and improving the quality of regulators and supervisors. And the solution
for weak banking systems is not government underwriting. It lies in building structures in which
individual banks can be allowed to fail, and in which shareholders can be allowed to suffer losses,
without putting in jeopardy the entire financial system of the countries concerned.
To put some particular New Zealand perspectives on these issues, I feel that strengthening the market
disciplines on banks and other corporate entities is an important policy objective. Governments
cannot underwrite private entrepreneurial activity without encouraging over-investment and leaving
themselves vulnerable to subsequent collapses. In the banking sector, the empirical evidence seems
overwhelming that government-owned banks are likely to be weakest in risk management. (Depositors
assume they cannot fail, because of government ownership. The managers, for that reason, are less
likely to be sensitive to deteriorating asset quality). And government-owned banks are most likely to
be encouraged into dubious lending for reasons other than sound commercial judgement.
Moreover, you will not be surprised to hear a New Zealander argue that real benefits can flow from a
willingness to allow foreign ownership of banks. Those benefits include access to skills and control
systems that might not be available locally, the introduction of international business standards into
local markets, and reduced vulnerability to inappropriate political influence. Another important
element is that the introduction of foreign capital constitutes a useful device for spreading risk in
small and narrowly based economies. The consequences of unforeseen shocks are thus rendered less
damaging. Well capitalised and reputable foreign owned banks are less likely to fail and have the
capacity to bear some of the consequences of a localised shock. If necessary, foreign owners can
provide additional equity to support their local banking operation.
Capital account issues
There has been a long-standing presumption within the Western economic orthodoxy that the case for
liberalising capital account transactions is essentially analogous to that for liberalising trade. That
presumption has come under serious review and challenge subsequent to the Asian meltdown of 1997
and 1998. Recent debates at the Board of the IMF reflect that revisionism, with a new willingness to
accept that capital account liberalisation carries risks and needs to be managed. Discussion tends to
focus on issues of the speed and sequencing of capital account liberalisation, and on the role and
effectiveness of capital controls. On the question of controls, a new orthodoxy seems to be emerging
around the distinction between controls on inflows of capital à la Chile (more worthy in some
circumstances) and controls on outflows of capital (unworthy generally, although some still see a
temporary role in crisis situations).
The on-going work in this area within the IMF relates to reviewing the experience of countries in
using different forms of capital controls, and in liberalising different components of the capital
account, seeking to draw conclusions for best practices. There is also work underway to improve the
reporting and monitoring of capital flows, especially private sector short-term flows related to
interbank transactions.
As a very small economy, well integrated with global financial markets, New Zealand well
understands the concerns some countries have regarding the risks and uncertainties that international
capital mobility can pose. But like Eichengreen, I have long since come to accept that capital mobility
is just one of the realities of life. Like good food and wine, it can be wonderfully enjoyable - when
taken with due recognition of one's capacity to absorb it. But fatal when taken to excess. To take the
good food and wine metaphor a little further, the ready availability of essentially endless quantities of
gourmet fare simply makes all the more important the qualities of discipline and self-control. It is, of
course, possible that the restaurateur will assist you in exercising that self-restraint, but none of us
should rely on him to do so.
So it rests primarily with each country to manage its own affairs to gain the undoubted benefits of
access to the pool of international savings, while avoiding the damage from over-indulgence. To quote
Eichengreen again "... badly managed banks and open international capital markets are a combustible
mix. The most direct way of reducing this danger is to strengthen banks' risk-management practices
and supervisors' oversight and regulation of those practices".
But that doesn't leave the provider of capital without responsibility, which brings me to one of the
most challenging aspects of the current debate.
Involving the private sector in forestalling and resolving crises
By the time the Asian crisis had completed its first lap early in 1998, it had become abundantly clear
that, to use a term coined by Michel Camdessus, the world had just witnessed "the first financial crisis
of the 21st century". Camdessus was acknowledging that the Asian crisis was different from those
that the IMF had grown accustomed to dealing with over its first 50 years. No longer could the IMF
assume that failures of macro-policy, primarily monetary and fiscal policies, would lie at the core of
every crisis. Instead, Asia represented essentially a crisis of the private sector. I think that is an
important part of the explanation for why the IMF found it so difficult to respond to the Asian crisis,
and why its critics contend so vigorously that the IMF "got it wrong" in Asia. In essence, the Fund
was confronted with a set of problems that were, in many respects, new and unfamiliar.
If the origins of the Asian crisis lay in the private sector, what of the solutions? I think one important
conclusion that flows very readily from the Asian experience is that raising large scale public funding
for rescue packages, as occurred in Thailand and Indonesia, and was done more in "virtual" form for
Korea, will be difficult to repeat in the future. This is particularly the case where funds raised from
the taxpayers of the international community are seen to be going mostly to facilitate the escape of
private investors from investments that have turned, for whatever reason, to mush. For that reason, the
question of "bailing-in the private sector" has been a topic of intense debate amongst those who think
about international economic crisis management. This term covers a range of suggested measures by
which the private sector would be obliged to take a share of the downside risk of cross-border
investment activities.
I won't dwell on the particular proposals that have emerged. In general, there seems to be broad
acceptance of the principle that private investors should bear their fair share of the risks. However,
just what that means, and how that might be achieved are questions of enormous complexity. A key
issue, it seems, is that emerging countries are often in favour of the private foreign investors sharing
risks (ie, taking some losses when trouble strikes), but many seem reluctant to face the prospect of
increased cost of funds, and/or reduced supply of foreign investment, that will be associated with
contracts that put more risk on the investor. That is both unfortunate and misguided. Any increased
costs should be viewed in the same way as an insurance premium - the price paid for reduced risk.
There is a great deal that can be done to make countries less vulnerable to volatile capital flows - and
coincidentally, to reduce those insurance costs. These include:
Avoiding an accumulation of short-term debt and ensuring that reserves and banking system
•
liquidity are adequate to provide a significant buffer against a disruption in investment flows.
• Avoiding "off-balance sheet" transactions or loan contract clauses that have the effect of
allowing the lender to withdraw funding at short notice.
• Exploring the possibilities for private contingent credit lines that provide additional liquidity, or
reduce debt service burdens, at times of stress.
Also, some degree of consensus seems to be emerging around the need to re-assess the capital
standards established by the Basel Committee on Banking Supervision with a view to reducing the
perceived bias towards short-term interbank credit lines from industrial countries to emerging market
banks.
In addition, there is a great deal of work underway in exploring the possibilities of modified bond
contracts. This is aimed at making it easier to manage a restructuring of bond terms, for example, to
lengthen the maturity or defer interest payments temporarily, in the event of a crisis.
Systemic issues
Under this category comes research work to better understand the implications for economic policy
makers of the globalisation of the international monetary and financial system. A key area for
attention is that of exchange rate regimes, the impact of exchange rate volatility and how best to
manage the inevitable swings in capital flows.
I believe that much of this work will end up focusing heavily on strengthening financial systems -
stronger balance sheets with more equity, improved risk recognition and risk management, stronger
accounting and audit standards, increased transparency and improved standards of banking
supervision. This is all aimed at providing a more stable basis for cross-border investment flows
rather than trying to act directly to stabilise or control those flows.
Also under the "systemic issues" heading comes work on developing the IMF's capacity to respond to
crises. We have already seen the new Contingent Credit Line (CCL) introduced. Personally, I see very
little merit in this, and many dangers. For the IMF to be recommitting to support particular countries
simply raises the stakes when policy quality deteriorates to the point where the Fund should withdraw
that pre-commitment. It also implies that when faced with capital flight, access to additional funding
is a key part of the required response. The risk, or course, is that access to additional funding simply
further defers the necessary policy and asset price adjustments, and makes the subsequent collapse all
the more expensive.
In addition to the CCL, the IMF now has access to the NAB funding, which together with the GAB
gives it around US$ 46 billion in available resources for crisis management. It now has its 11th quota
increase in place as well, which lifts total quotas from around US$ 200 billion to US$ 290 billion.
The unfinished debates relate to the role of the IMF and World Bank going forward, issues of
representation at the key policy forums - the old established structures now in place in bodies like the
IMF and its Interim Committee now look to be thoroughly out of synch with the current global
distribution of economic weight. For all of that, as the G22/G33 progression showed, the old order is
not yet ready to die.
APEC
My final comments on this territory relate to the place of APEC in this territory. Much of the debate I
have covered will emerge in a variety of guises within the APEC Finance process. This is primarily
the responsibility of my Treasury and MFAT colleagues, rather than the Reserve Bank, so I will step
only lightly here.
The New Zealand priorities for the APEC Finance Ministers process will focus on three key themes:
• Open robust economies
• Credible, effective processes, and
• Strong global economies.
Under the first of these, finding ways to encourage the development of strong financial markets within
the APEC group is a key to meeting the long-term goal of open markets. APEC will not be looking to
duplicate work already taking place under the various umbrellas I have referred to. But it can draw on
that work, and use processes such at individual action plans (IAP's) and voluntary action plans
(VAP's) to give it momentum within APEC.
New Zealand is promoting a VAP on Supporting Freer and Stable Capital Flows. This is split into two
parts. Part 1 is an information-gathering phase and has already started. It includes some work being
commissioned from the IMF on countries' experiences with capital account liberalisation (including
the efficacy of capital controls as a transition measure), a PECC update of a 1995 survey of
impediments to investment within each APEC economy, and an ADB study of the role played by
capital in the economic development process along with work on reform sequencing. I understand that
Part 1 is intended to be completed in the next year or so, with a synthesis of the various studies being
submitted to APEC Finance Ministers in September 2000.
Part 2 is intended to take the form of Voluntary Action Plans by individual APEC economies, drawing
on the wisdom distilled in Part 1. An initiative on strengthening financial markets is being developed
as a pilot of part 2 of the VAP. This initiative will involve pulling together the relevant international
standards in the area of financial markets, as reference points for economies to self assess the
adequacy of their policies and to identify future reforms, and as a basis for peer review within APEC.
This initiative will focus on such matters as banking supervision, payments systems, corporate
governance and disclosure standards. This initiative will be discussed further at the APEC Finance
Deputies' meeting in Wellington in August.
The issue of developing domestic bond markets has also been prominent on the APEC Finance
Agenda. Guidelines of best practice in this field are being developed for preliminary discussion in
August. The objective here is to encourage APEC economies to remove the impediments to the
development of domestic bond markets, in recognition that some economies are very dependent on the
banking system for funding.
Other areas of work involve, for example, the ADB efforts to coordinate a project aimed at boosting
training for APEC area banking supervisors and securities market regulators and some useful work
already undertaken in the field of corporate governance.
APEC represents an interesting grouping of economies, with diverse experience and diverse
circumstances. Hopefully, New Zealand can apply its time in the chair to help focus the APEC
discussion on reform of the global financial architecture. If we are successful, we can ensure that
APEC is an effective "outreach" mechanism providing cogent, well thought through and influential
commentary to the G7, IMF and other key forums considering the architectural issues.