Mr Heikensten reviews the financial crisis and looks at monetary policy
Address by the Deputy Governor of the Bank of Sweden, Mr Lars Heikensten, to the Swedish
Shareholders' Association in Stockholm on 30/11/98.
Many thanks for the invitation to participate this evening. For more than a year now, discussions
about global economic developments have in many respects been occupied with the financial
crisis-the crisis that was first Asian, then also Russian and finally seen as global. Economic
analyses are full of words like uncertainty and unpredictability; no one can yet tell what the
effects will finally be.
The crisis has clearly demonstrated how mobile capital has become, as well as the close global
interrelatedness of national economies. This has intensified the debate about the global financial
system, its advantages and drawbacks. How can crises of this type be prevented from happening
again? And how can the present crisis be overcome? An answer to the latter question is of major
importance for future economic development. Things that happen in Bangkok have turned out to
be important for shareholders in Stockholm.
One night in Bangkok
For a number of years the rest of the world regarded the Asian economies as something of a
miracle. Their growth was astonishing and the high saving and investment ratios gave the
impression that this would continue. Orderly public finances were accompanied by exchange
rates that seemed to be completely firm. The prospect of undiminished growth attracted an
inflow of capital to the Asian Tigers from investors in the West who were looking for a high
return and a greater diversification of risk.
There is no single factor which explains why the tiger economies changed, in the eyes of
investors, into paper tigers. There are even those who argue that the crisis arose not so much
from altered economic conditions as from general nervousness among investors. The answer is
probably a combination of the two, with a number of economic and political factors that
triggered a chain reaction from country to country. One serious problem in these countries was
that their banking systems had not been fully prepared for the incoming avalanche of
international capital. In much the same way as in the 1980s in Sweden, the good supply of capital
had pushed up prices for equity and real estate, thereby creating a bubble. In some countries,
moreover, a current account deficit and the fixed exchange rate had become untenable. Another
common denominator was the very short-term profile of external borrowing.
Uncertainty about the future path of these economies gradually grew. Investors became
increasingly cautious. The devaluation of the Thai currency in July 1997 caused a sharp reaction.
Capital flows to the region were stopped. Currencies depreciated sharply and interest rates rose.
The currencies of Malaysia, Indonesia and South Korea followed in the wake of the Thai baht.
The gold turned to sand
At first the crisis was seen as a regional problem, with no substantial effects in other parts of the
global economy. Investors focused instead on other regions and last spring there was a quieter,
though still nervous, period. This proved, however, to be the calm before the storm. On 17
August the Russian government announced a freezing of rouble debt and a devaluation of the
rouble.
This markedly altered the mood among international investors. The combination of an
unexpectedly large devaluation and a unilateral suspension of rouble debt payments heightened
investors' aversion to risks. If this could happen in Russia, perhaps it could happen in other
countries, too. The imposition of capital controls in Malaysia accentuated the concern.
The crisis therefore spread to other emerging markets, not least in Latin America. Stock markets
fell around the world. The possibility that industrialised countries might be hit by other effects
than those related to trade gave the crisis a new dimension. The problems in the US hedge fund
Long Term Capital Management (LTCM, perhaps something of a misnomer for a company bent
on reaping quick profits on invested capital) aroused fears that large losses might make banks
excessively cautious and thereby restrict access to borrowed capital. Many forecasters now began
to revise their assessments of global economic development.
Watch out!
The most obvious cause of lower global growth is decreased net exports to the crisis-burdened
countries. Countries that trade with the debt-burdened countries experience a weakening of
growth as falling exports are accompanied by a gradual increase in their imports. At first the
direct trade effects are not expected to be all that large; but as other regions are affected by the
crisis, they may be more pronounced.
New risks then arise that are more difficult to assess because they relate to sentiment and
confidence. One factor of importance for the rate of global economic growth is consumer and
business
confidence. There are some statistical signs that confidence has fallen. Future prospects
have become less bright above all in the United States and the United Kingdom, but also in many
of the prospective euro countries. Swedish households are more doubtful about the general
economic future but still believe their personal economic situation will improve. Companies are
also somewhat more pessimistic.
Another potential threat to economic growth was detected in the summer and early autumn. The
credit
problems in LTCM led to talk of a crunch. Briefly, this is a situation in which banks, after
some bad experiences and loan losses, do all they can to reduce risk exposure and slim balance
sheets; as a result, the banks cannot be induced to finance even the most stunning commercial
ideas. Without access to investment capital, economic activity declines.
Certain signs of an approaching credit crunch could be discerned in financial markets, above all
in the United States. They first took the form of an aversion to supplying credit to all but the
soundest borrowers. Later there was a reluctance to provide long-term loans to anyone,
regardless of their credit rating.
The weakening of growth and inflation prospects in the light of the financial unrest has prompted
central banks to lower interest rates this autumn. The interest rate cuts have contributed to the
somewhat calmer situation recently in financial markets. Interest rate differentials between
industrialised countries and emerging market economies have tended to narrow from a high level
and so have spreads in the western markets between borrowers with different credit ratings. In
Sweden, the spread between treasury and housing bonds has fallen from 0.9 percentage points in
mid October to 0.5 percentage points at present.
Stock markets have also recovered from the sharp fall during the autumn. In the United States,
equity prices have now rebounded to the levels of before the period of nervousness. Current
equity prices are notably bullish and mirror expectations of very good growth and high business
profits. The recovery on the Stockholm Stock Exchange has not been quite as strong; after a fall
of around 40 per cent from July to October, the index is now at the same level as at the end of
August.
Although there now seems to be somewhat less risk of the global crisis becoming more
profound, it will probably still lead to a weaker international economic development that will
also affect the situation in Sweden, not least during 1999. During the autumn the Riksbank's
appraisal of both growth and inflation in Sweden has been revised downwards. Inflationary
pressure in our economy is very low and expectations seem to have been adjusted to it remaining
low. A more detailed picture of inflation prospects is contained in our Inflation Report, which is
to be published this Thursday.
The name of the game
Developments this autumn and the way in which the Asian crisis has spread across the globe
have broken some market perceptions. Loan payments were suddenly suspended unilaterally by
such a large country as Russia. And the problems in a single US hedge fund turned out to be so
large as to render the situation in financial markets uncertain and require rescue operations by the
major commercial banks. The world was not quite what it had been. A number of observers,
including the Chairman of the US Federal Reserve, even considered that what had happened was
without precedent in the global economy.
The crisis has enlivened the discussion about global financial systems. In the short run, it is the
acute crisis that must be resolved. The interest rate cuts, not least in the United States, have
played an important part here. In the longer term, conditions must be created whereby the global
financial system functions sensibly. Matters that are being discussed in the longer perspective
include the role of the IMF and how to help the problem countries. There is also the question of
ensuring that countries and private agents, instead of distorting reality, provide an accurate
picture of their situation. Other matters are the construction of systems so that early warnings are
sounded if, for example, the situation in the bank sector is becoming untenable, and how to
prevent investors from building up such large risks. The discussion also concerns the free
movement of capital and how its negative effects can be restricted.
Permit me to dwell fairly briefly on these large and important matters. This is a discussion to
which we at the Riksbank will no doubt be returning. Solutions to some of the questions are
relatively easy to find; others will require a great deal of lengthy discussion over a considerable
period and may even then not be entirely satisfactory.
The IMF to the rescue
The immediate resolution of the crises in Asian countries and, most recently, in Brazil has been
spearheaded by the International Monetary Fund (IMF). Thailand, Indonesia and South Korea
were offered financial support by the Fund, subject to certain conditions. These loan terms
concerned both the formulation of economic policy and some structural measures. Interest rates
were to be increased, accompanied by fiscal restrictions to restore a balance or a surplus to
government budgets. Consolidation of the banking system and stricter supervision were also
required. Reforms in other fields were demanded to make the economy function more efficiently.
The economic recession in the problem countries turned out to be considerably deeper than
expected. The IMF has been criticised for requiring tough restrictive measures. With growth in
the Japanese economy at a standstill, moreover, these countries did not have the benefit of an
external stimulus. International investors and banks were not prepared to renew loans to
countries which had obtained support from the Fund. The currency depreciation continued. Some
adjustments were made to the IMF programmes.
Broadly speaking, the Fund's management of the crisis has been criticised from two standpoints.
One is that the Fund's terms are too harsh and tend to contribute to domestic poverty without any
benefits in real economic or financial terms. The other standpoint is that the IMF hands out
money far too readily to all comers without demanding enough in return.
The support currently provided by the Fund is intended to enable the crisis-burdened countries to
spread the necessary adjustments over a longer period than would otherwise have been possible.
There is then less risk of output falling sharply. It can also help to forestall financial market
unrest. The latter can benefit other countries that might otherwise be hit, more or less
undeservedly, by large movements in exchange rates and interest rates. Moreover, IMF support
can induce other lenders to provide financial assistance. The programmes drawn up by the Fund
have led industrialised countries to come forward and contribute financial support.
In situations like this the IMF can also serve as a much-needed whipping-boy. Governments in
crisis-burdened countries can point to the Fund as the task-master behind various measures and
thereby achieve reforms that are essential but troublesome.
All this presupposes that the Fund's demands on the crisis-burdened countries are properly
balanced. The programmes must make financial markets confident that the countries will
ultimately be able to repay the loans. Some critics consider that the IMF, instead of adapting to
the changeover from previously regulated markets to globally interrelated markets, is simply
following the beaten track without sufficient heed to the new environment.
Earlier crises had more to do with purely macroeconomic factors which the IMF could remedy by
following a relatively simple diagnostic procedure - focusing on the balance of payments -
and prescribing the medicine that suited the country in question. Today's crises call for measures
over a wider field. Ordering an interest rate increase, for instance, as a cure for exchange rate
instability is not as self-evident a solution when higher interest rates are liable to worsen a weak
banking system's difficulties or undermine government finances.
At the same time it is important that the IMF concentrates on the crisis-burdened countries'
fundamental macroeconomic and financial problems. An ambition to tackle a wider range of
issues may run into trouble. No matter how well-grounded the structural changes may be, the
Fund can, for example, be accused of exerting an undue influence on policy in the problem
countries or of serving the trade policy interests of other countries.
There is broad agreement among the industrialised countries that it is the IMF which should act
in situations like the one in Asia. The IMF is also our own organisation; Sweden is represented
on the Board and cannot dissociate itself from what the Fund is doing. An active discussion is
now in progress to learn from recent developments. So far, however, no general consensus has
been reached except as regards increased transparency in many respects.
Openness and oversight
One recipe for a sounder financial system that has been discussed and agreed on is better
transparency both among private players and on the part of the IMF and various public agents.
Some of the problems could be avoided if a fair picture of the situation were provided, for
instance by ensuring that statistics are correct and generally available. In some cases, investors'
assessments concerning Southeast Asia had a misleading foundation, for example as regards the
situation among banks and large companies as well as the size of foreign reserves.
Advocating more transparency comes naturally to a Swede. We put the case frequently, at home
as well as in international fora. The IMF, for example, ought to be able to present its country
assessments more openly. We have already taken steps in this direction that we hope will exert
natural pressure on other countries to do likewise. At the same time, this is a good illustration of
the IMF as the sum of its members. Even in the group of Nordic countries there are members that
have pulled in a different direction.
The IMF should also go further in explaining its actions so that these are better understood. Just
as we consider that independent central banks have to be open in order to gain support for what
they are doing, so must the IMF generate greater popular and political support for its work.
Another requirement for a sounder financial system is better oversight and supervision of the
financial system in each country. Over the years there have been numerous instances of where
the combination of free capital movements and inadequate supervision can take us if things go
wrong. As Swedes, the bank crisis in the early 1990s gave us a ringside view of the
consequences. One good result of that crisis - a late compensation, if you will - is that today
the Swedish banks are less exposed.
A decade ago, international agreement was reached on the amount of capital banks are required
to hold so that they are in a position to weather troublesome times. Last year the Basle capital
adequacy requirements were augmented with 25 core principles for determining whether or not a
country's banking system is sound and its bank supervision effective. A first step towards better
bank supervision is to ensure that more countries are in fact complying with the rules and
principles that have already been established. It has been proposed that a country's access to
capital from the IMF be linked to the degree to which it observes these principles. The competent
national institutions for banking supervision should also be scrutinised and adapted, so that they
possess the resources for coping with the new financial environment.
Another step towards better supervision involves an ongoing development of the existing rules
and regulations so that they are appropriate for today's reality. One matter that is being discussed
is a review of the capital adequacy standards. The banks' lending operations, for instance to
LTCM, were astonishing. In this context I can mention the discussions that are in progress about
highly indebted players and how they can be included in supervision to prevent them taking
unduly large risks.
Sound risk diversification
One of the issues - probably one of the knottiest - that are being discussed is how problem
countries can obtain financial support without this giving rise to expectations that a country with
financial problems will always be rescued by some international institution.
If private investors get the idea that any profits will accrue to them and can rest assured that
someone else will intervene and absorb any losses, they will be all the more prone to take risky
positions. Investments that would normally not be attractive will find takers because there is
everything to gain and nothing to lose. This can result in the form of moral hazard that involves
unduly risky behaviour. Signs of such behaviour have been found. Spreads between government
bonds issued by industrialised countries and emerging market countries such as Russia suggest
that investors expected to be bailed out and were therefore not demanding full compensation for
risks.
Moral hazard could conceivably also result in a particular country or countries taking excessive
risks, though this is presumably much less likely. The political cost to a country of becoming
bankrupt is exceedingly high, as is almost too clear from developments in South Korea, Thailand
and Indonesia.
So what can be done to counter moral hazard in the financial system? One, seemingly
selfevident, remedy is to get the private players to carry a larger share of the burden when problems
arise. That in turn could make them act more prudently. This is being discussed. The crux,
however, is that the investors and banks concerned are caught in what is known as prisoner's
dilemma. Smart investors count on being able to take a little extra risk and then be the first to
exit when things go wrong. The dilemma they face, however, is that when everyone makes a
simultaneous dash for the exit, most of them are trapped because the market then ceases to be
liquid.
One possibility is a system, involving a third party, whereby individual investors are made to
realise that less headlong behaviour in the throes of a crisis could be more advantageous for them
as well as for everyone else. The remaining cake can then be divided more fairly among all those
involved. One procedure for this, adopted in connection with the Asian crisis, could be to
monitor bank lending globally. This was tried out in the case of South Korea; the banks were
persuaded to renew credits pending a more orderly solution. Another matter that is being
discussed is how bonds could be constructed with a clause that makes it possible to implement
the type of procedure that applies to default.
The markets and capital movements
The Asian crisis has clearly demonstrated the mobility of international capital. Technical and
financial developments have meant that positions can be taken and closed much more quickly
than before.
Some of the rapid shifts in many countries' exchange rates and interest rates do not seem to have
been motivated by changes in the macro economy or other fundamental factors. This raises
difficult questions. Capital movements of this kind may ultimately elicit political reactions that
threaten the existence of free capital markets.
The complexity of the issue is illustrated by consequences of the new Basle rules. These rules
prescribe capital cover for the mark-to-market value of many assets. This is basically a good
thing in that it reduces the risk of failures. But together with the models on which risk
assessments are based (using historical data), rules of this type probably also tend to accentuate
flock behaviour among international investors. Continuous marking to market does give a fair
picture of the situation in each company but probably also leads to an increased need for quick
financial rearrangements. A price change in one country immediately alters the spectrum of risks
and this triggers a wave of buying and selling.
Perhaps we must acknowledge at this stage that we have been a little too optimistic about the
workings of the international financial system and self-regulating mechanisms, in much the same
way as we were about Sweden in the late 1980s.
Seen in this light, the demands for extensive capital controls that are now being aired in the
debate are hardly surprising. This would not be practicable, however, particularly not in the
longer run.
There are examples - Chile in recent years is one - where measures for controlling short-term
capital seem to have worked well. It should be underscored, however, that these measures have
been one item in a very soundly implemented economic policy that also includes tight budgets,
institutional and growth-enhancing reforms, and lower inflation.
Chile's experience is therefore by no means directly applicable to other countries. Another
important point is that Chile's aim has been to become less dependent on short-term foreign
capital. The measures have not restricted outflows - which is liable to be counterproductive -
but made inflows less attractive.
Just where the discussion of capital movements will take us remains to be seen. Here, too, there
is reason to underscore the importance of transparency and rules that work properly. Another
matter that has been raised in the debate is the importance of carrying out deregulations and
structural changes both in an orderly manner and in the right sequence.
Measures of this type will probably not suffice to solve all the problems connected with free
capital movements. A continued discussion is therefore needed without an unduly strong
ideological gloss. However, such a discussion is unlikely to result in any dramatic changes in the
international financial system.
The winner takes it all?
The world economy has recently been going through a deep crisis - an Asian crisis that has
acquired a global dimension. The ultimate effects of the crisis are difficult to predict but its
course to date should be a lesson to many.
- Households have been reminded that saving in equity is not without risks. How long this
reminder will last is another matter - US stock markets have already shot up again
towards new all-time highs.
- Large investors with a high level of debt have also been cautioned. An exceptionally high
return presupposes exceptionally high risks and thereby entails large losses if things go
wrong.
- The banks have learned similar lessons, particularly those that used highly leveraged
funds as a way of accommodating high risks. But even those who function as overseers of
financial systems - governments and central banks - have learned something from the
latest crisis. Work has been stepped up to create a lastingly robust framework for the
satisfactory functioning of the global financial system.
Today I have concentrated on the financial system in the longer perspective. But in the midst of
all the uncertainty about the present situation, there is one thing about which we can be quite
sure: this is not the last financial crisis. Now that the situation in financial markets has become
somewhat more stable, we should not suppose that everything is all right again. The financial
market players - savers, investors, fund managers, supervisors and overseers - must not lower
their guard. Not again.