Mr Greenspan offers some suggestions to improve the international financial
architecture
Testimony by the Chairman of the Board of Governors of the US Federal Reserve System,
Alan Greenspan, before the Committee on Banking and Financial Services of the US House of
Representatives on 20 May 1999.
Mr Chairman, Mr. LaFalce, and Members of the Committee, we at the Federal Reserve are in
broad agreement with the approach outlined by Secretary Rubin, and expect to continue to
work closely with the Treasury in this area.
As I have indicated previously before this committee, dramatic advances in computer and
telecommunications technologies in recent years have enabled a broad unbundling of risks
through innovative financial engineering. The financial instruments of a bygone era, common
stocks and debt obligations, have been augmented by a vast array of complex hybrid financial
products that has led to a far more efficient financial system. These same new technologies
and financial products, however, have challenged the ability of inward-looking and
protectionist economies to maintain effective barriers, which, along with the superior
performance of their more open trading partners, has led, over the past decade, to a major
dismantling of impediments to the free flow of trade and capital. The new international
financial system that has evolved as a consequence has been, despite recent setbacks, a major
factor in the marked increase in living standards for those economies that have chosen to
participate in it.
Notwithstanding the demonstrable advantages of the new international financial system, the
Mexican financial breakdown in late 1994 and, of course, the most recent episodes in East
Asia and elsewhere have raised questions about the inherent stability of this new system.
These newly open markets were exposed to a huge expansion in capital inflows that their
economic and financial systems were not ready to absorb. These flows in turn were
engendered by the increasing diversification out of industrial country investment portfolios,
augmented by huge capital gains through 1997. Net private capital inflows into emerging
markets roughly quadrupled between 1990 and the onset of the Asian crisis. Such
diversification was particularly directed at those economies in Asia that had been growing so
vigorously through the 1970s, 1980s, and into the 1990s - the so-called "Asian tigers." In the
event, these economies were ill prepared to absorb such volumes of funds. There were simply
not enough productive investment opportunities to yield the returns that investors in the West
were seeking. It was perhaps inevitable then that the excess cash found its way in too many
instances into ill conceived and unwisely financed real estate ventures.
What appeared to be a successful locking of currencies onto the dollar over a period of years
in East Asia, led, perhaps inevitably, to large borrowings of cheaper dollars to lend, unhedged,
at elevated domestic interest rates that reflected unheeded devaluation risk premiums. When
the amount of such unhedged dollar borrowings finally became excessive, as was almost
inevitable, the exchange rate broke.
While it might seem that the consequences were easily discernible, they were not. Problems
with imprudently financed real estate investments emerge with chronic frequency around the
globe without triggering the size of the collapse experienced in East Asia in 1997. The size of
the crisis became evident only when the normal buffers that any economy builds up to absorb
shocks were, in the case of the East Asian economies, so readily breached under pressure.
It has taken the longstanding participants in the international financial community many
decades to build sophisticated financial and legal infrastructures that buffer shocks. Those
infrastructures discourage speculative attacks against a well entrenched currency because
financial systems are robust and are able to withstand the consequences of vigorous policy
responses to such attacks. For the newer participants in global finance, their institutions, until
recently, had not been tested against the rigors of major league pitching, to use a baseball
analogy.
The heightened sensitivity of exchange rates of emerging economies under stress would be of
less concern if banks and other financial institutions in those economies were strong and well
capitalized. Developed countries' banks are highly leveraged, but subject to sufficiently
effective supervision both by counterparties and regulatory authorities, so that, in most
countries, banking problems do not escalate into international financial crises. Most banks in
emerging market economies are also highly leveraged, but their supervision often has not
proved adequate to forestall failures and a general financial crisis. The failure of some banks
is highly contagious to other banks and businesses that deal with them, as the Asian crisis has
so effectively demonstrated.
This weakness in banking supervision in emerging market economies was not a major
problem for the rest of the world prior to those economies' growing participation in the
international financial system over the past decade or so. Exposure of an economy to
shortterm capital inflows, before its financial system is sufficiently sturdy to handle a large
unanticipated withdrawal, is a highly risky venture.
It thus seems clear that some set of suggested standards that countries should strive to meet
would help the new highly sensitive international financial system function effectively. There
are many ways to promote such standards without developing an inappropriately exclusive
and restrictive club of participants.
For example, in any set of standards there should surely be an enhanced level of transparency
in the way domestic finance operates and is supervised. This is essential if investors are to
make more knowledgeable commitments and supervisors are to judge the soundness of such
commitments by their financial institutions. A better understanding of financial regimes as yet
unseasoned in the vicissitudes of our international financial system also will enable
counterparties to more appropriately evaluate the credit standing of institutions investing in
such financial systems. There should be no mechanism, however, to insulate investors from
making foolish decisions, but some of the ill-advised investing of recent years can be avoided
in the future if investors, their supervisors, and counterparties, are more appropriately
forewarned.
To be sure, counterparties often exchange otherwise confidential information as a condition of
a transaction. But broader dissemination of detailed disclosures by governments, financial
institutions, and firms is required if the greater risks inherent in our vastly expanded global
financial structure are to be contained. A market system can approach an appropriate
equilibrium only if the signals to which individual market participants respond are accurate
and adequate to the needs of the adjustment process. Product and asset prices, interest rates,
debt by maturity, and detailed accounts of central banks and private enterprises are among the
signals so essential to the effective functioning of a global economy. I find it difficult to
believe, for example, that the crises that arose in Thailand and Korea would have been nearly
so virulent had their central banks published data prior to the crises on net reserves instead of
the not very informative gross reserve positions only. Some inappropriate capital inflows
would almost surely have been withheld and policymakers would have been forced to make
difficult choices more promptly if earlier evidence of difficulty had emerged.
As a consequence, the G-10 central banks and the IMF initiated an effort to establish
standards for disclosure of on- and off-balance-sheet foreign currency activities of the public
sector by countries that participate, or aspire to participate, in international capital markets.
The focus of this work was the authorities' foreign currency liquidity position, which consists
of foreign exchange resources that can be easily mobilized, adjusted for potential drains on
those resources. This work was part of a larger effort to enhance disclosure of a broader set of
economic and financial data under the IMF Special Data Dissemination Standard.
Such transparency suggests a second standard worth considering. Countries that lack the
seasoning of a long history of dealing in international finance should manage their external
assets and liabilities in such a way that they are always able to live without new foreign
borrowing for up to, for example, one year. That is, usable foreign exchange reserves should
exceed scheduled amortizations of foreign currency debts (assuming no rollovers) during the
following year. This rule could be readily augmented to meet the additional test that the
average maturity of a country's external liabilities should exceed a certain threshold, such as
three years. This could be accomplished directly, or through the myriad innovations to
augment maturities through rollover options. The constraint on the average maturity ensures a
degree of private sector "burden sharing" in times of crisis, since in the event of a crisis, the
market value of longer maturities would doubtless fall sharply. Clearly few, if any, locked-in
holders of long-term investments could escape without significant loss. Short-term foreign
creditors, on the other hand, are able to exit without significant loss as their instruments
mature. If the preponderance of a country' s liabilities are short term, the entire burden of a
crisis would fall on the emerging market economy in the form of a run on reserves.
Some emerging market countries may argue that they have difficulty selling long-term
maturities. If that is indeed the case, their economies are being exposed to too high a risk
generally. For too long, too many emerging market economies have managed their external
liabilities so as to minimize their current borrowing cost. This short-sighted approach ignores
the insurance imbedded in long-term debt, insurance that is almost always well worth the
price.
Adherence to such a rule is no guarantee that all financial crises can be avoided. If the
confidence of domestic residents is undermined, they can generate demands for foreign
exchange that would not be captured in this analysis. But controlling the structure of external
assets and liabilities nonetheless could make a significant contribution to stability.
Considerable progress has been made in recent years in developing sophisticated financial
instruments. These developments create added complexity that all financial market
participants, including policymakers from emerging market economies, must manage.
However, they also create opportunities that emerging market economies should seek to
exploit. In doing so there are lessons they can learn from advances in risk management
strategies developed by major financial institutions.
To the extent that policymakers are unable to anticipate or evaluate the types of complex risks
that the newer financial technologies are producing, the answer, as it always has been, is less
leverage, i.e. less debt, more equity, and, hence, a larger buffer against adversity and
contagion.
A third standard could be a legal infrastructure that enables the inevitable bankruptcies that
will occur in today' s complex world to be adjudicated in a manner that minimizes the
disruption and contagion that can surface if ready resolutions to default are not available.
A fourth standard is the obvious necessity of sound monetary and fiscal policies whose
absence was so often the cause of earlier international financial crises. With increased
emphasis on private international capital flows, especially interbank flows, private
misjudgments within flawed economic structures have been the major contributors to recent
problems. But inappropriate macropolicies also have been a factor for some emerging market
economies in the current crisis.
There are, of course, numerous other elements of sound international finance that are worthy
of detailed consideration, but the aforementioned would constitute a good start. Even so,
improvements in transparency, commercial and legal structures, as well as supervision cannot
be implemented quickly. Such improvements and the transition to a more effective and stable
international financial system will take time. The current crisis, accordingly, has had to be
addressed with ad hoc remedies. It is essential, however, that those remedies not conflict with
a broader vision of how our new international financial system will function as we enter the
next century.