Christian Noyer: The challenges of financial liberalisation for emerging market
economies
Speech by Mr Christian Noyer, Governor of the Bank of France, to RBI staff, Reserve Bank of India,
Central Office, Mumbai, 14 May 2007.
* * *
I am very pleased and honoured to be here and I want to thank warmly my good friend, Dr Reddy, for
having invited me to address the staff of the Reserve Bank of India (RBI).
The BIS recently announced that the RBI Vice-Governor, Mr Rakesh Mohan, will chair a new working
group on "Capital flows and emerging economies". I would like to congratulate him for accepting to
explore this complex issue. I will offer some views on a related topic: "the challenges of financial
liberalisation for Emerging Market Economies (EMEs)".
Financial liberalisation is defined here as the dismantling of internal and external controls on capital
flows. It exhibits many positive aspects, for instance:
•
it contributes to improving global capital allocation efficiency, be it at the national or at the
international level;
•
it fosters competition on capital markets and consequently reduces the cost of capital as well
as it brings about enhanced risk management;
•
it also increases the role of market discipline for firm managers and policy makers since it
raises the costs of poor governance.
While there is a consensus about these positive effects, experience has shown that financial
openness modifies the balance of risks at the macroeconomic level:
•
first, it may reduce some risks, for instance, by decreasing the correlation between
investment and savings;
•
second, it may nevertheless increase other risks: for instance, greater competition in the
banking system may prompt strong credit growth with a loosening of credit standards, as
domestic banks try to maintain their profits and market shares;
•
third, it may even create new risks, for instance through financial contagion, if risk appetite
for emerging markets suddenly reverses, given the prominent role played by hedge funds in
cross-border investments and the sudden shifts in their asset allocations. In this regard, the
Banque de France recently published a special issue of its Financial Stability Review
devoted to Hedge Funds, which may be of interest to the RBI (www.banque-france.fr).
In contrast with the French experience which took place in the 1980s, the Indian process of financial
liberalisation takes place in a context of intense globalisation and accelerated innovation. It is gradual
but successful and it is no surprise that India was one of the first countries to participate voluntarily in
the IMF Financial Stability Assessment Program (FSAP). In my view, the progressive and transparent
character of this process is fundamental to guarantee that a country reaps the full benefits of its
integration into the world economy.
The lessons that can be drawn from a comparison with the French experience may seem limited
since, in the 1980s, France was facing capital outflows, whereas emerging economies are now often
facing speculative capital inflows. However, I believe that, while the challenge has become more
demanding, successful financial liberalisation for EMEs still rests on the same two key conditions that
applied to France:
• Building a resilient domestic financial system while or before opening the capital account.
•
Shaping appropriate institutions and policies.
I will illustrate these two conditions in the reminder of my speech.
1. A successful liberalisation requires to strengthen the domestic financial system while,
or sometimes before, opening the capital account
I will briefly remind you why and how this can be done.
First, why? This is because an efficient financial sector ensures both a better financing of and a better
protection for the economy.
On the one hand, it ensures a better financing of the economy by broadening the investor base and
enhancing their ability to make use of diversified financial instruments.
Not only does competition within the financial sector contribute to limiting the cost of capital but it also
fosters innovation and thus allows for more efficient risk management. For example, securitisation
provides financial institutions with instruments to manage the composition of their balance sheets and
thus contributes to buttressing credit distribution while supporting the development of financial
markets. Moreover the development of bond markets allows for a better financing of public deficits
while providing instruments that enable international investors to diversify their portfolios. It provides a
reference for the market and may thus pave the way for the issuance of private bonds.
On the other hand, an efficient and developed financial sector offers better protection for the economy
against the risks of a capital account crisis. Most of the EMEs' crises of the 1990s were triggered or
accompanied by banking crises. To improve resilience to external shocks, it is essential that financial
players be able to manage interest and exchange rate risks in a more flexible environment, both for
themselves and their customers.
Now, how to achieve this in a smooth way?
There is a kind of paradox in the interaction between internal and external liberalisation: the former
may be a pre-requisite for the latter but external openness may help stimulate and enhance domestic
financial reforms. Actually, in the absence of the challenge created by foreign competition, domestic
financial reforms may not be broad and fast enough.
Moreover, in terms of best practices dissemination, the presence of foreigners in the capital of
domestic banks may ensure a faster adoption of international standards and codes, especially
concerning the monitoring, control and management of financial and operational risks. This is crucial
for the resilience and the stability of the financial system. The report of the CGFS Working Group on
"FDI in the financial sector of EMEs" highlighted that a lasting benefit of these FDI was their effects on
the financial sector efficiency, thanks to the generally associated technology transfers and innovations
in products and processes. In addition to their lower volatility, this is one more reason why attracting
long-term capital flows, such as FDIs, seems preferable to catching short-term flows, although the
lessons from the Chilean experience versus some Asian misadventures suggest there is no unique
model for all. But I saw that the size of FDIs in India which had been hitherto rather low is rising
significantly (16 billions USD in 2006-07) which is good sign of its attractiveness. In France also we
pay a lot of attention to inflows of FDIs (above 60 billions in 2006) as they matter as well in a more
mature economy.
So when setting the pace of internal versus external liberalisation, the authorities have to strike the
right balance and rhythm between the two sides. In this respect, let me evoke briefly the way we
managed this process in France in the 1980s. Financial liberalisation started with the domestic side
by:
•
Modernising the money market;
• Deepening the bond markets, using the public sector as a benchmark (in order to price risks
through a full yield curve for risk-free assets);
•
Broadening the basis of the equity markets (including privatisations);
• Last but not least, creating new financial markets (futures, options...).
Meanwhile, but sometimes with lags, the French capital account was liberalised. We switched from a
situation, in 1983, where the exchange rate controls were at their tightest, following speculative attacks
and three devaluations in 18 months, to a gradual removal of these controls beginning in 1984 and
completed in 1990. Trade-related operations were gradually liberalised, followed by most financial
transactions and, finally, residents were allowed to freely open foreign currency accounts and French
banks to lend French francs to non-residents.
Of course, the Indian experience differs from the French one as there is no "one-size-fits-all" transition
process. And I would be very interested in listening to your views on this.
2. But before, let me remind you that, to be successful, it is not sufficient to improve the
financial system: shaping appropriate institutions and economic policies is of the
essence
The need to set in place strong institutions should never be underestimated. A G20 work entitled
"Institution building in the financial sector" (in which both India and France participated) stressed the
importance of solid institutions along with deep and sophisticated financial markets as key elements to
maximise the benefits of globalisation and reduce the risks of financial crises. An appropriate
institutional framework includes among others a well functioning legal system, a reliable payment
system, a proper framework for regulation and supervision, an appropriate deposit insurance scheme,
and propitious conditions for implementing new developments in information and communication
technology.
As a central banker, I will of course argue that the role of the central Bank is crucial. It should be the
guardian of the health of the "financial ecosystem" through reinforced surveillance and a continuous
improvement of the regulatory and legal framework. Sound supervision must be promoted by an
independent body, which may be more or less related to the central bank. In France as in India,
banking supervision is indeed implemented by the central bank staff. Sound supervision and a clear
legal framework in turn are likely to encourage foreign participation and maximise the associated
benefits in terms of best practices.
The need for appropriate supervision is indeed not reduced but modified or may even be increased in
case of financial liberalisation. For instance, a working group in process at the BIS, in which both the
RBI and the BDF are currently participating, shows that the development of local bond markets
changes the types of risks faced domestically from currency risks to interest rate risks or maturity
mismatches. This requires to enhance and control adequate risk management in the banking sector
and in those institutions in which the risk may have been transferred. Indeed financial innovations such
as credit risk transfers may well spread risks but risk does not disappear.
The central bank is also responsible for producing and disseminating various sets of monetary and
financial statistics whose quality is of utmost importance for policy makers and investors. An efficient
statistical apparatus provides the basis for financial transparency, thus contributing to disseminating
best practices in terms of governance.
Besides, institutional quality also strongly influences the composition of inflows into emerging
economies. This is a key determinant of FDI flows, which tend to increase the benefits of financial
integration.
The need for sound economic policies and strategies should not either be neglected.
In a globalised world where countries compete to attract foreign capital, sound fiscal and monetary
policies influence not only the amount but the composition of inflows. Sound domestic policies
strengthen the resilience of the economy to external shocks and thus maximise the growth benefits of
capital account liberalisation.
Recent crises remind us how macroeconomic imbalances may be exacerbated by financial fragilities
and trigger capital account problems affecting economic growth. For instance, experience shows that
excessive fiscal deficits are more dangerous with open capital markets. Actually, market discipline is
not always at play or sufficient if there is excessive appetite for risk and not enough discrimination.
Therefore, internal rules as well as Government commitments may be needed as illustrated by the
socalled European Stability and Growth Pact.
In the same way, structural policies aiming at improving the efficiency of the labour and good markets
shall accompany financial liberalisation. They are indeed needed to enhance the capacity of the real
economy to attract and allocate capital as well as to reduce vulnerabilities and absorb potential
shocks. Here again, there is a nexus in the appropriate rhythm and interaction between the
liberalisation of financial versus real markets. Once financial liberalisation has started, the process
benefits from continuous innovation and from its own impetus. The same does not apply to reforms in
the labour and good markets where rigidities and obstacles are often deeply rooted.
Lastly, better integration into the global economy requires an appropriate exchange rate strategy. An
emerging economy with high productivity gains and potential growth in the tradable sector is prone to
receive large capital inflows and have a real appreciation of its currency in the long term. The latter
may come either or both from nominal appreciation or higher relative inflation.
Arguably, exchange rate appreciation, which may result in an overvalued currency, is a risk for
emerging economies that conduct export-led growth strategies. In order to stem appreciation and
maintain their competitiveness, some emerging economies - like China - have accumulated ever
larger amounts of foreign reserves. However, undervalued currencies also represent a significant risk,
not only for inflation but also because it allows foreigners to buy cheaply national assets. In addition,
undervalued currencies contribute to ballooning global imbalances. "En passant", I am pleased to note
that both India and the Euro area post significant but not extravagant levels of reserves and that
neither is responsible for the persistence of global imbalances.
Greater use of exchange rate flexibility in emerging countries that have experienced an excessive
accumulation of foreign exchange reserves is therefore one factor in the resolution of global
imbalances. Moreover, it may contribute to facilitating domestic monetary policy management
(decreasing inflationary pressures) and makes it possible to better contain liquidity growth and the
risks associated with reserve accumulation and sterilisation.
Of course, the gradual implementation of exchange rate flexibility requires that controls on capital
flows be lifted at a suitable pace. East Asia experienced this and I am eager to listen to your views on
the interaction between financial reforms, institutions and structural or macro-economic policies.
To conclude, let me say that, in the liberalisation process in which France and later India have
engaged, both may learn from each other since they share similar features and are key players in a
globalised world.
To this end, cooperation should be strengthened.
Cooperation between the RBI and the Banque de France is especially relevant since our two
institutions look alike, for instance in terms of diversity in activities, structures (including branches) or
staff recruitment for life through competitive examinations.
At the financial industry level, more cross-fertilisation should also help. The French financial industry
includes some of the largest European banks and insurance companies. Their business models are
solid and based on a broad domestic market and best international practices. This enables them to
generate strong profitability and develop abroad.
But above all, the French financial industry has some specific features that may be valuable for Indian
players. In particular, I would like to mention:
•
The historical links with the public sector, such as in India where public banks still dominate
the banking sector and
•
Banking sector expertise both in a rural environment, especially relevant for India, and in
large industrial groups, as indeed Indian industrial groups are active internationally.
In this respect, I am very pleased to participate with the RBI in the launching of the first French-Indian
Financial Forum on May 16, in Mumbai.
Thank you for your attention.