Mr Yamaguchi discusses the role of central banks in international finance
Speech by Mr Yutaka Yamaguchi, Deputy Governor of the Bank of Japan at the Japan Center for
Economic Research in Tokyo on 13 July 1999.
Introduction
Today, I would like to discuss the role of central banks in international finance. The reasons why I
chose this subject, and not the Japanese economy or its financial system, or the monetary policy of the
Bank of Japan, are twofold. The first and foremost is that responding to the changes in the
international financial markets has become a very important issue to the future of the Japanese
economy, as evident from the financial crises involving the emerging economies since Thailand in the
summer of 1997. The other reason is because we feel that the international activities of the Bank of
Japan is not well understood, relative to the contributions the Bank has made so far. In the next hour
or so, I would begin with some salient features of recent international financial crises and the roles of
central banks therein. This would be followed by a discussion of the activities of the Bank for
International Settlements (BIS) Committee on the Global Financial System (CGFS), which I have had
the pleasure of chairing since last May. Finally, I would conclude my remarks today by briefly
explaining the role of the Bank of Japan in international finance.
The changing nature of international financial crises
International financial crises in the 1990s
Let me begin by laying down some observations on the changes in the phenomena we call
international financial crises. In the discussion of "international financial crises," we can, of course,
begin by arguing what is a "crisis" and whether a crisis becomes "international." Let us, however,
leave such question of exact definitions aside and look at those financial crises that had international
repercussions.
Such international financial crises are not something new. The British suffered a severe attack on the
Sterling in 1967. The US dollar's convertibility to gold was suspended in 1971, with serious
international consequences. The mounting debt borne by the developing countries was a serious
concern during the 1980s. We can conclude that the international financial markets had suffered a
number of shocks or crises in the past, and thus, crises have been recurrent. However, if we look back
on more recent crises, the Japanese bubble and its aftermath in the 1990s, the Nordic banking crises in
the first half of this decade, the attack on the ERM in 1992, the Mexican crisis of 1994-95, and the
turmoil in the emerging market economies beginning with east Asia in the summer of 1997 and
followed by Russia and Brazil, it seems that the nature of crises has been changing, from what we had
experienced in the 1960s to 1980s as we approach the next millennium. The most evident features are
that we are experiencing more frequent crises, and when crises occur, their effects are severer and
global. In this respect, I would like to draw your attention to the following four aspects.
Macroeconomic imbalances and the malfunctioning of credit allocation systems
The first point is that many international financial crises follow a period of unprecedented boom, and
is the result of or is aggravated by interactions between macroeconomic imbalances and the
malfunctioning of the banking or the credit allocation system. When an economy enters into an
unsustainable economic boom, expectations of strong growth in the demand of goods and services
becomes predominant. Investments are planned and conducted to fill these expected demands, and
this, in turn, increases actual demand. Such a cycle will also result in an expansion in credit, which
supports the investment boom. For example, in Japan during the bubble years, we have seen sizable
expansion of credit in the form of increases in bank lending and issuances in the capital markets.
Meanwhile, in the case of the Asian economies, bank lending from developed countries increased at
an annual rate of 19 per cent in the years between 1990 and 1996 (27 per cent per annum in the last
three years). Unfortunately, such a virtuous cycle cannot be maintained forever, and when it stops,
investments quickly turn into excess capacity and the recouping of capital becomes impossible. In the
course of this process, a large part of financial assets turn into non-performing assets. If the volumes
are large enough to impair the functioning of the financial system, the whole macroeconomy will
stagnate. In this way, the interaction between macroeconomic imbalances and the malfunctioning of
the financial system leads to financial crises. This relationship is often described by central banks as
the interaction between monetary and financial stability; the macroeconomic stability, i.e.
noninflationary sustainable growth and the stability of financial system are interdependent. Our
experiences of recent financial crises underscore the importance of such interaction
Volatility of short-term capital flows
The second point, which is closely related with the first, is the deepening of crises by sudden changes
in short-term capital flows. As I have mentioned already, bank credit to the Asian countries expanded
significantly in the years preceding the crisis. During the same period from 1990 to 1996, the share of
credit maturing in less than one year has increased by more than 10 percentage points, from 52 per
cent to 63 per cent. Short term extensions of credit do not cause problems if they are rolled over.
However, when the borrower can no longer roll over its debt, and funds begin to flow outwards, the
borrower quickly faces severe liquidity problems. The Asian crises showed us that the disruptions in
the economies and financial markets in these circumstances could be very serious. In a number of
cases, they could be far more serious than adjustments that would have been warranted to correct the
macroeconomic imbalances that existed before the crisis. In this context, while the merits of capital
inflows should also be fully recognized, the volatility of short term capital flows is an important issue
in dealing with international financial crises.
International contagion of crises
My third observation is that there seems to be more international transmission of financial crises. For
example, when the Latin American debt problem deepened in the 1980s, effects on other continents
were muted and Asia did not suffer serious financial crises. The situation was similar during the
Mexican crisis of 1994-95. However, in the most recent financial crisis beginning in 1997, the wave
of disruptions reached many emerging market economies, sometimes quickly, and in other cases
slowly. The transmission mechanism was not singular: rapid declines in credit extensions to the
region by developed countries were significant in some cases, whereas in others it was the proxy
hedge (i.e. hedging by selling other currencies with similar risk characteristics) or purely
psychological transmissions of bearish sentiments. It might be said that the crisis that began in Asia
swept around the world to end, seemingly, upon reaching Brazil. In the past, we have seen contagion
of financial crisis within a region where there are significant interactions in terms of trade and
investment flows and/or the economic structure is similar. Contagion to other regions of the globe is a
new phenomenon not observed in the 1970s or 1980s.
More diverse manifestation of crises
Finally, I should point out that financial crises are now manifesting themselves in diverse ways. A
classic financial crisis is when the financial system is strained by funding problems, for example
when bank after bank is hit by depositor runs. Of course, in the most recent crisis involving the
emerging market economies, many countries, such as Thailand, Korea, Russia and Brazil, suffered
quintessential foreign currency funding problems. Meanwhile, we saw another type of crisis: if a
classic financial crisis is precipitated by bank runs, the new type of crisis results from impairment of
market functioning and such crisis could be termed a "market run." When Long Term Capital
Management (LTCM) almost collapsed last autumn, liquidity dried up in many markets of the
developed countries as many market participants dumped their assets in "fire sales" and flight to
quality became ever more pronounced. If we recognize that an important function of financial markets
is to price financial assets and transfer risks at that price, i.e. "price discovery," the impairment of
such a function is threatening to market participants.
Why are international crises becoming more pronounced?
Having said that the four features of recent international financial crises are the interactions between
macroeconomic imbalances and the functioning of the financial system, the volatility of short-term
capital flows, international contagion, and diversity in the manifestation of crises, I would like to
spend some time to discuss why these changes might have occurred. I do not have a definite answer,
but I agree with many experts who point out that financial innovation and globalization, enabled by
advances in information technology, had a role. For example, cross-border flows of capital have
increased more than threefold in the last ten years. What strikes us more is that the cross-border
transfer of risks increased rapidly through derivatives transactions. As a hypothetical case, if we think
of an investment in a bond denominated in Thai baht issued by a Thai firm, the investor faces various
risks: foreign exchange risk, credit risk of the firm, interest rate risk, etc. Derivatives enable investors
to unbundle these risks packaged in a bond into component risks - e.g. the risk that the credit standing
of the issuing firm or the Thai baht exchange rate falls below a certain threshold - and transfer and/or
assume them at will. Financial innovation has enabled market participants to engage in these
operations at significantly lower costs, and this has resulted in an expansion of transaction volumes.
The expansion in transaction volumes draws the attention of market participants to the need of more
harmonized rules underlying financial transactions - payment and settlement systems and accounting
standards - and encourages reforms therein. These reforms push the rules in the direction of
standardization, which in turn, lower the costs of transactions and leads to a further increase in
transaction volumes. Such globalizing financial marketplace facilitates a further division of labor: the
development of risk appraisal services, investment funds, including hedge funds, tailored to suit
diverse risk appetites should be understood in this context.
Accordingly, risk evaluation and risk taking become more specialized and tightly focused. This could
result in a particular type of risk being singled out and transferred when crises or imbalances become
apparent. In the example of a Thai firm issuing bonds denominated in Thai baht, investors in the
bonds could guard against the depreciation of the baht by efficiently hedging the foreign exchange
risk with derivatives, which is likely to result in higher pressures of selling baht hedges.
It is, however, not fair to emphasize only the deepening of crises as a result of financial innovation
and globalization. In the case of East Asian countries, their incredible economic growth during the
1980s and up to the recent crisis was the result of their taking advantage of capital inflows from
abroad. Capital inflows not only supplemented domestic investment funds, but also facilitated the
transfer of industrial technology and know-how. In this context, derivatives enabled the unbundling of
various risks embedded in economic transactions and the transfer of risks to other market participants.
Such opportunities should have mitigated the perception of high risks associated with investments in
emerging market economies and stimulated investments. Meanwhile, in a broader context, market
discipline is also enforced through global market activities. Those that succeed in maintaining sound
economic performance through determined efforts of restructuring, be they firms, financial
institutions, or sovereign states, would be rewarded by the markets in the form of narrower credit
spreads and thus lower funding costs. Market discipline stemming from the global capital market,
therefore, is a driving force of robust economic growth in the long run.
Financial innovation and the globalization of financial markets, like any change, have both positive
and negative effects: although positive effects may materialize in the long run, some disruptions may
be expected in the short run. This means that our goal should be to devise plans to take the greatest
advantage of financial innovation and globalization and implement them as well as possible. In other
words, it is becoming important for each market participant, including firms, financial institutions and
sovereign states, to recognize the role of market discipline, and, at the same time, lay down rules and
practices that are compatible with the globalizing markets.
Central banks and international financial crises
In the international financial community, governments, central banks, financial institutions, and the
academia are now engaged in a hot debate over the reform of international financial system, including
exchange rate regimes and short term capital flows. The purpose of such discussions is to prevent a
resurgence of international financial crises, and they are founded on the recognition that the nature of
international financial crises may be changing, as I have just noted. In the next few minutes, I will
carve out a niche in this very broad debate, and try to explain the roles that central banks could play
with regard to international financial crises.
From this perspective, the most important responsibility for central banks is to maintain the stability
of their own macroeconomy. More precisely, central banks are expected to maintain sustainable
growth under stable prices. Putting one's house in order is the starting point. Unfortunately, however,
implementing the correct policies to maintain the stability of the domestic economy and financial
system alone does not guarantee a stable international financial system. The discussions on
international financial architecture, which I have just referred to, seem to underscore the fact that
efforts to maintain the functioning of international financial markets or the international financial
system are just as important.
Monitoring the state of the international financial system
First and foremost, central banks should strengthen their ability to understand the risks and
vulnerabilities in the international financial system. More simply, central banks should enhance their
monitoring abilities. As mentioned a little earlier, a period of strong growth may sow the seeds of the
next crisis by allowing excesses in consumption and investment. In fact, if we look back after the fact,
we can often find signs warning of "bubbles" or excesses. For example, before 1997, i.e. before the
Asian crisis, the BIS Banking Statistics indicated that banks in the developed countries were
increasing their short-term foreign currency lending to the Asian countries. The increase in short-term
foreign currency liabilities is likely to leave a country prone to a rapid outflow of capital and hence
could lead to foreign currency liquidity problems. The reason why such warning signs were
overlooked or ignored seems to be associated with national confidence. Past financial bubbles seem to
be inevitably associated with such confidence shared by the general public. In Asia, there was the talk
of the Asian miracle. A little earlier, during the Japanese bubble years, the oft-cited phrase "the
largest creditor country" was an indication of such confidence. When the mood of a country is upbeat,
the recognition of risks - even severe downside risks - are not easily acknowledged. Even if it were
possible to identify such risks, it would have been extremely difficult to take the necessary corrective
actions, either at the micro level (strengthening risk management) or at the macro level (tightening
monetary policy). Even if such risks are initially contained through appropriate corrective measures,
market participants' risk appetite may be so strong as to eventually render those corrective measures
ineffective, and lead to a bubble. There is no panacea which quickly dissipates macroeconomic risks.
Nevertheless, it is extremely important for central banks to understand the risk factors and
consciously analyze what could happen if there are significant changes in those risk factors. As a
result of the most recent financial crisis, it became widely recognized that private financial
institutions perform stress tests to identify vulnerabilities in their own portfolios. Stress tests may
seem to be technical, but they are not. They are actually fundamentally judgmental processes for the
management of financial institutions where various scenarios are employed to identify risks that
endanger the existence of each institution. Likewise, it has become apparent that central banks should
also adopt a similar approach - in effect stress testing at the macro level. By this, I am not arguing
that central banks can always make the right judgment concerning risks to the macroeconomy.
Nevertheless, I can stress that it is the raison d'être for central banks to identify risks that would
endanger the policy objectives that are conferred upon them, namely the stability of the
macroeconomy (sustainable growth under price stability) and the financial system. I should say,
therefore, that in this globalizing world, it is becoming ever more important for central banks to make
joint efforts to understand the risks in the global financial markets.
Policy recommendations for a more robust international financial system
Secondly, even if central banks could understand the conditions of the international financial system
in extreme detail, they would probably not be able to prevent every financial crisis. This means that,
central banks should contribute to the strengthening of the international financial system - building a
system that could withstand crises and stress that are facts of life - through appropriate policy
recommendations. I have used the word policy recommendations, because central banks do not
usually have direct authority to make rules or supervise the international financial markets or their
participants. For example, in the recent debate over how to deal with institutional investors including
hedge funds, most central banks do not have any rule-making or supervisory authority over them. In
such cases, the central banks look to other authorities to make and implement proper policy responses.
There are also areas where no regulator or supervisor has formal authority, and the authorities are
presently discussing how and whether to fill such gaps.
However, stemming from central banks' status as being players in markets, central banks have a
strong interest in improving the functioning of markets. Accordingly, central banks could adopt a
constructive approach: to analyze the global financial markets and make policy recommendations,
which are to be implemented through dialogs with market participants and supervisory authorities.
Along with such efforts, central banks must not neglect to improve their own operations, such as
payment and settlement services, which can be modified through their own initiatives in response to
the globalization of financial markets.
Responses to international financial crises
Third, but not the least, central banks must consider appropriate responses to international financial
crises once they happen. In many cases international crises involve rapid depreciation of currencies or
depletion of foreign exchange reserves, and manifest themselves as near or actual defaults of
governments or private market participants. In such instances, extension of assistance from
international financial institutions or governments could result in moral hazard, just like the domestic
context, so it should not be too readily extended. The recent emphasis of debate on private sector
involvement has sprung from this context. Nevertheless, if the effects on the international financial
system would have been deemed to be severe in the absence of public sector involvement, public
assistance had been granted. While such direct assistance has been the domain of IMF and national
governments, central banks have been more concerned with maintaining the stability of the
international financial system through maintaining the stability of domestic financial systems.
Central banks are "in the market," so to speak. As a result, they are able to collect up-to-date
information on ever changing market conditions. In this context, central banks occasionally function
as the lender of the last resort, in response to systemic risks posed by funding problems at private
financial institutions. Of course, central banks must be careful so as not to create moral hazard.
Meanwhile, when disruptions in international financial markets could affect the domestic financial
markets or the domestic economy through global linkages between markets, central banks may
consider lowering interest rates and supplying ample liquidity. For example, when the Federal
Reserve lowered its federal fund rates three times last autumn, as the US financial markets became
unsettled following the Russian crisis, the reason behind the move was to cushion the effects on
prospective economic growth of increasing weakness in foreign economies and of less
accommodative financial conditions domestically.
Committee on the Global Financial System
An international forum for central banks
The three elements of the role of central banks in international finance, which I have just mentioned,
understanding markets, formulating policy recommendations for strengthening the financial system,
and containing crises when they happen, have always been played by central banks in order to
maintain the stability of the domestic financial system. As a result, central banks tend to share a
common framework, which facilitates exchanges of information and views. This common framework
is further strengthened through central banks' interactions with the markets - markets that are
globalizing - in their day to day operations. There are many channels for such exchanges, and one of
the most important is through the Bank for International Settlements (BIS). Many of you would
probably know that the BIS is a unique international organization owned by central banks of more
than forty countries.
Many committees of central banks meet at the BIS, led by the Governors of the Central Banks of the
Group of Ten Countries (G10 Governors). The activities of the Committee on the Global Financial
System (CGFS), the Basle Committee on Banking Supervision, and the Committee on Payment and
Settlement Systems, in particular, are closely interconnected. Today, I would like to outline the
activities of the CGFS, which I am involved in, and which is closely related to the theme of my
discussion on the roles of central banks in international finance.
Monitoring of international financial markets
The activities of the CGFS can be grouped into three areas:
The first is to conduct comprehensive monitoring of the global financial market. This corresponds to
the accurate appraisal of risks in the global market, which I stressed just a few minutes ago. At the
quarterly meetings of the Committee, we focus on various risk factors and discuss what could be the
risks that central banks should be most aware of. Diverse issues are taken up, but much attention has
been paid to the origins and effects of the recent wave of financial crises beginning in Asia. For
example, why were the "Asian Tiger Economies" suddenly faced with currency crises? What were the
risks posed by the devaluation of the Thai baht to her Asian neighbors and to other emerging market
economies? Why does the devaluation by Brazil not seem to have had great effects at least in the short
run? We have also examined issues involving the developed countries such as the market trends in the
run up to and after the introduction of the euro at the beginning of this year, and the inherent risks in
the rising US equity markets. The Y2K risk premia observed in many markets for transactions over
this year's end is also an issue that we have focused on. Furthermore, as a longer term issue, we have
looked at the restructuring of the international banking industry, which is the reflection of changing
nature of banking business.
There is no standard methodology for such monitoring exercises, but one aspect that the Committee is
now particularly interested in is how to understand "positions" in the marketplace. For example, in the
case of market turmoil involving LTCM, it is said that there were considerable arbitrage positions
involving bonds of developed countries and emerging market economies: buying emerging market
bonds and selling developed country bonds with the expectation that the spreads between the two
classes of bonds should narrow. The speculation that this huge overhang of positions would be
unwound was behind the disruptions we saw following the Russian default and huge losses at hedge
funds. Of course, there are as many purchasers as sellers in the market, and all positions sum to zero.
Nevertheless, the reaction of the market following a shock is dependent on who holds the positions,
how concentrated the positions are, whether positions are correlated, etc. Paying attention to
positions, therefore, is based on a view of the economy or the market that the positions are no less
important factors in causing large market fluctuations than macroeconomic fundamentals. The CGFS
also shares such views.
Improving the functioning of markets
The second element of the work program of the CGFS is longer term research with a view to
improving market functioning. This begins with studies involving actual market practices: what sort
of transactions are conducted day to day, how such transactions are executed and settled, what are the
problems experienced by market participants, etc. Such information constitutes a part of
understanding the markets and is also very important as input into crisis management.
The third area of the Committee's activities is closely related to, in fact based on, such research:
examining alternate policy responses and the elaboration of corresponding policy recommendations to
promote the development of well-functioning and robust financial markets and systems. Needless to
say, these policy recommendations are shaped by past events and experiences in the international
financial markets and driven by the keen interests of the Committee to prevent another disruption in
market functions.
In this context, the most important activity of the Committee is its efforts to improve the transparency
of markets through improvements in disclosure and statistics. Substantial improvements of market
transparency would lead market participants to closely evaluate and select their counterparties and
hopefully market equilibrium would be achieved to a certain extent. Central banks have long attached
great importance to such mechanisms in the market that imposes self-discipline.
From this long line of work, I would like to draw your attention to the Committee's publication of a
report titled "Review of the Disclosure Template Regarding the Authorities' Foreign Currency
Liquidity Position" last autumn. This report is based on our recognition that one of the reasons for the
deepening of the Asian crisis may have been the lack of transparency in the levels of official foreign
exchange reserves: for example, Thai and Korean monetary authorities had conducted support
operations of their currencies in the forward markets or assisted the foreign currency funding of
domestic banks by depositing foreign currency at those banks. As a result of such operations, the
actual amount of foreign reserves available to the authorities had substantially declined, but it was not
reflected in official statistics on foreign exchange reserves. Accordingly, the Report recommends that
public authorities disclose a more comprehensive, detailed and timely information on their foreign
currency liquidity positions: e.g. the disclosure of potential drain on foreign exchange reserves
through forward and options transactions, and the amount of foreign exchange reserves deposited at
domestic banks, every month with one month timeliness. This initiative by the central banks was
taken up by the IMF and incorporated in the Special Data Dissemination Standards, with which many
countries, including Japan, are committed to comply.
Something that is as important as, if not more than, disclosure by public authorities is disclosure by
private market participants themselves. In this regard, we should not forget what happened to LTCM
last autumn. As we all know, LTCM was not able to fund itself when markets moved against its huge
leveraged positions. If counterparties to LTCM had been able to find out that LTCM was holding
some extreme positions through disclosures or macro statistics, market discipline might have been
able to appraise the levels of position taking. In order for market participants to accurately measure
various risks - market risk, credit risk, liquidity risk, etc. - improvements in disclosure and macro
statistics are two sides of the same coin, and the CGFS has pursued both issues.
As to disclosure by private market participants, the Committee published the Fisher Report in fall
1994, advocating that disclosure needs to evolve from one based on financial statements to one
providing information more accurately reflecting the risk profiles, including results of risk
management model calculations. In the Report, it was noted that since individual market participants
should wish to be correctly evaluated by the market, they should have the incentive to enhance
disclosure, and a competitive mechanism to improve disclosure might be at work. However, as I have
just pointed out, in the recent international financial crisis, one problem was that only insufficient
information was provided to market participants. If so, it becomes necessary to examine why the
competitive enhancement of disclosure did not materialize and what could we do to make it work. The
Committee, with inputs from market participants, is spending considerable efforts, with an aim to
devise a framework to enhance disclosure.
Along with these efforts to improve disclosure by the public sector and private market participants,
the CGFS is expending considerable resources to improve statistics on international financial markets.
For example, the BIS and national central banks, following a recommendation in a 1995 report by the
Committee, launched a comprehensive market survey of global derivatives markets, the first in 1995
and the second in 1998. Another product is a more regular statistics based on a survey of major
derivatives dealers covering more than 80% of global markets in derivatives ("Yoshikuni Statistics"),
which was first published in December last year. In addition, there have been constant upgrades to
existing BIS Banking Statistics: for example, the publication of the BIS Semiannual Consolidated
International Banking Statistics, which is now watched closely as a leading indicator of country risk,
is now approximately two months earlier than in the past. The CGFS is further looking into any gaps
in statistics that may be filled.
As I have mentioned, in addition to improving market transparency, there is another distinct group of
work in the activities of the CGFS. International financial crises are the consequences of market
participants' taking and unwinding of positions. The Committee has studied such dynamics of
markets and published recommendations based on its findings. One such example is the publication of
a report titled "Market Liquidity: Research Findings and Selected Policy Responses" in May this year.
Market liquidity is admittedly an elusive concept and is difficult to quantify. Nevertheless, market
participants and authorities are making their day to day decision on the assumption that market is
always liquid. One example is the risk management models, which is rapidly gaining acceptance.
Such models assume that assets and liabilities can always be liquidated in the market immediately at
prevailing market prices, i.e. the existence