Mr Heikensten discusses global capital: advantages, problems and remedies
Speech by Mr Lars Heikensten, First Deputy Governor of the Sveriges Riksbank, the Swedish central
bank to the Institute of International Affairs in Stockholm on 3 May 1999.
First a word of thanks for the invitation to talk here about the global financial markets. Many of the
questions raised by financial developments in recent years are clearly connected with foreign policy.
The crisis in the international financial system that began in Asia in summer 1997 developed, to cite
President Clinton, from being just 'a few small glitches in the road' into 'the worst financial crisis in
fifty years'. The extensive financial turbulence has fuelled the debate about globalisation and the
increasingly integrated world economy.
In certain respects it can be said that, compared with the present situation, the degree of economic
integration was greater at the beginning of this century. Expanding trade was accompanied by
innovations that simplified international dealing. A common currency was available in the form of
gold. In the years before World War One the net financial flows between countries, represented by
current-account deficits, were even larger than today. In certain periods, moreover, migration was
higher than at present.
All in all, however, integration is presumably more extensive today. Many more countries are now
participating in the global exchange, gross capital flows are larger and market reactions are much
swifter. New technology has paved the way for continued integration and is likely to go on
contributing to further developments in this direction.
Against this background my talk today focuses on global capital: its advantages and problems and the
remedies for the latter that are being discussed internationally. Let me begin by looking at what has
shaped the global financial markets as we know them today.
Emergence of today's global financial markets
Today's global financial markets largely date from the 1970s, when the oil-exporting countries
needed to invest surpluses and many western countries had incurred budget deficits that had to be
financed. There was thus a need for a more efficient international market for capital. Another factor
behind the development of financial markets was that after the collapse of the Bretton Woods system
in the early 1970s, the major world currencies started to float in relation to each other. This generated
a demand for instruments that would render the exchange rate movements less deleterious for
exporters and importers.
The evolution of the financial markets has been promoted by rapid technical advances that, besides
facilitating international communications and transactions, have aided calculations and made
advanced financial instruments available. This has been accompanied by theoretical work on the
pricing of risks. A market for risks has accordingly been established. Instruments whereby players
could choose a particular level of risk had existed for centuries but could now be made more
sophisticated.
Before the financial markets could be globalised, moreover, national economies had to be opened up
and the existing capital controls abolished. This process got under way in the 1970s and 1980s. The
players in financial markets had found ways of getting round the regulations, which in some cases had
thereby become virtually toothless. In Sweden, for example, the capital controls had gradually lost
much of their bite; companies were able to take up exchange positions, for instance, by shifting trade
credits over time. There was also a growing awareness that economic growth would benefit from
fewer controls. The interventionist line of economic policy had not been particularly successful. The
pace of deregulation varied from country to country and the process was rather protracted. Britain and
the United States led the way. Sweden was one of the last countries to abolish controls on
crosscountry flows of short-term capital.
Since the 1970s, financial market turnover has risen markedly and is now very much larger than the
flows generated by global cross-country trade in goods and other services. According to the latest BIS
study, from 1995, global exchange market turnover, for instance, was 1200 billion dollars, which is
approximately five times the value of Sweden's annual GDP. The figure is roughly twice the level at
the end of the 1980s. A new BIS study, for 1998, is due next week and can be expected to show a
further increase in global exchange market turnover. Equity and bond market turnovers have also
risen rapidly.
To some extent, the nature of the flows as well as the players in international financial markets have
changed. The earlier domination of investment and borrowing is giving way to increasing flows from
transactions in securities. New players have become more and more important. The quest for the best
possible return on private savings is giving insurance companies, pension funds and highly leveraged
funds a dominant position. Whereas the players used to be a more homogeneous group, consisting
mainly of banks, households are increasingly opting to have their savings managed more actively than
simple deposit accounts. While these changes have occurred in the various national financial markets,
they have obviously also had consequences for the international capital flows.
Advantages of free capital flows
International financial markets that are free and integrated can enhance global growth through more
efficient resource utilisation. Savings can be channelled to the best investment opportunities,
unrestricted by national borders. Capital-importing countries can build up productive facilities, obtain
access to modern technology and expand in sectors with relatively high productivity, while
capitalexporting countries can earn a higher return. The industrialisation of Sweden in the latter part of the
nineteenth century is a good example of what access to foreign capital can do; the construction of the
railway network, for example, was financed with foreign loans.
Financial markets also make it easier for economic agents to manage risks so that the economy
functions more efficiently. The wide variety of financial instruments enables investors and borrowers
to choose their preferred level of risk. Some players may want to avoid all exchange rate fluctuations
for a time, while others are prepared to take this risk in return for a premium; by operating in the
derivatives market they can arrive at the appropriate risk profile.
Globalisation has led to increased competition across countries and markets and aided the emergence
of new activities and structures. This in turn seems to have contributed to increased capital
productivity-more can be done than before with a given capital input. It is just these factors-more
efficient financial markets and higher capital productivity-that are often cited as the main forces
behind the American economic miracle: the combination of high growth and low inflation despite low
saving.
Problems
The globalisation of financial markets is also dogged by some problems. It affects the scope for
national economic policies. Moreover, financial market prices tend to fluctuate widely, sometimes for
little apparent reason.
Before considering these issues, I just want to say a few words about the reality behind the notion of
the financial market, which consists in practice of various categories of savers and borrowers. Besides
private individuals, these include national, regional and local governments, small and large
companies, high-risk hedge funds, banks, insurance companies and long-term pension funds. So the
market cannot be reduced to what goes on in trading rooms, even though, for want of a better
alternative, television's financial newscasting often visualises the market in such terms. Every saver
and borrower exerts some influence on the market but naturally not to the same degree. The stage is
set by the biggest players, be they individuals, companies or nations.
The scope for economic policy
Free capital mobility is sometimes criticised for encroaching on democracy and rendering economic
policy less effective.
Even in a world with integrated financial markets, economic policy is decided by the national political
systems. They are free in principle to alter tax rates, boost public spending and adjust interest rates
whenever they wish. In this direct sense, a more open economy does not mean that policy is restricted.
In many ways, access to international capital can actually enlarge the scope for action. Unlike the case
in earlier centuries, a country that is stricken today by severe crop failures, for instance, can borrow
external funds to buy seed. Similarly, a country wishing to strengthen its growth potential by more
than domestic saving permits can expand its production apparatus more rapidly with the aid of
imported capital.
At the same time, loans and other financial transactions do entail dependence. If a country's economic
policy does not inspire confidence, the consequences may be unfavourable. Perhaps investors will no
longer be prepared to provide new loans and may even stop existing credits. Long bond rates are
liable to rise, accompanied by a depreciating currency. Such reactions are the market's way of passing
judgement on economic policy and a country's creditworthiness. This mechanism is the same as that
for private borrowers. Access to credit enhances welfare but also exposes the borrower to the scrutiny
and discretion of creditors.
A good example of how this works is provided by the Swedish economy. From the mid 1970s,
problems with government finances led to external borrowing, which mitigated the effect on interest
rates. But debt accumulated and an acceleration of this trend in the early 1990s led to an acute loss of
confidence: interest rates shot up and after a time the krona fell.
Besides illustrating how a country can be hit if its economy is not managed properly or if problems
arise from other causes, this example shows that the imbalances may be generated gradually, so that
timely signals can be an advantage. Perhaps prompter warnings would have put a stop to the
economic mismanagement at an earlier stage. Something may thus be gained from the market sending
clear signals without delay.
But the situation should not be idealised. The functioning of financial markets is by no means perfect.
Real economic problems can build up without attracting attention and when they are detected, the
financial unrest is liable to spread to other countries for no apparent reason. The financial market's
reaction may also be out of proportion to the underlying imbalance. This brings me to the next type of
problem.
Financial instability in a global market
Just as in any other market, financial market prices are basically a function of supply and demand.
This means that they are dependent on the path of economic fundamentals; in the case of government
bonds, for example, the relevant factors include the budget balance, monetary policy and inflation
expectations.
Financial asset prices are highly susceptible both to expectations of how the market ought to move,
given the underlying conditions, and to how it will move, given the expectations of how other players
will act. This can result in wide fluctuations. Prices may deviate for a considerable time from what
could be regarded as their long-term equilibrium. Markedly inflated prices can result in 'bubbles', out
of touch with the level that seems to be fundamentally justified. Examples of this are the
developments in some Asian countries in the mid 1990s, as well as price movements in the Swedish
property market around the turn of the 1980s.
To some extent, such phenomena can be explained in terms of how economic policy is conducted. But
the causes of large price movements are also to be found in the construction of financial markets. If a
market is to function properly, all the relevant information should be available simultaneously to
every player. In practice, that is evidently not the case. Moreover, financial players can act in the
knowledge that what they do will influence the market. The fact that performance is assessed in the
short run, in many cases in comparisons with other players, makes herd behaviour common. The risk
models that are in use are liable to accentuate this phenomenon, even though such models are actually
intended to do the opposite, namely minimise risk and instability. A signal from a risk model can
trigger sales by numerous investors, whereupon prices fall still further. In this way, a mechanical
application of risk models is liable to exacerbate price fluctuations.
Financial market globalisation also leads, as I mentioned initially, to increased capital flows. Low
transaction costs and high liquidity enable individual investors to pledge assets in the market to a
greater degree. This leads to closer links and more interaction between different markets; a player
may take large positions not just in markets for different assets but also in markets in different
locations. Price movements may be affected if market players lose confidence in a particular
geographical market or incur losses that oblige them to dispose of other assets. Globalisation has
naturally increased such contagious effects, as we clearly saw last autumn.
Recurrent financial crises
In many ways, global economic development in the past two to three decades has been outstanding.
Annual growth since 1980 has averaged over 3 per cent. The rate in the industrialised countries has
averaged just over 2.5 per cent as against almost 5 per cent in the developing countries. Many East
Asian countries have achieved even higher growth and thereby a radical improvement in economic
prosperity. But development has by no means been smooth. The Latin American debt crisis in the
1980s, the Mexican crisis in 1995 and the turbulence that started in Asia in the autumn of 1997 are
some examples of the financial crises in recent decades. While the circumstances behind the various
crises differed, they did have certain features in common. The extensive problems have usually arisen
out of a combination of inadequate credit assessments by lenders and investors and shortcomings in
economic policy.
In an initial phase, credit stocks have risen rapidly in connection with hopes of a high return and the
perception of low risks, partly because investors trusted the financial system and the regulatory
apparatus. A characteristic example is the developing countries that were transformed in the 1990s
into emerging markets-the risks seemed to be virtually non-existent. When the inflow of credit
reduced interest rate differentials with the rest of the world, this strengthened the notion that
investment in these countries carried relatively small risks.
Exchange rate policy often contributed to the problem. Investors and creditors expected exchange
rates to remain fixed. Cross-country interest rate spreads encouraged the use of foreign-currency loans
for investment in domestic assets, often without matching the maturities of assets and liabilities. The
countries' central banks were expected to carry the exchange risk and convert at the predetermined
rate.
At some stage, however, there has been a reappraisal. Signs that the economies were less robust than
expected have led to a sudden change in the perception of risk. This checked the supply of credit,
which in some cases caused a dramatic increase in lending rates to these countries relative to
countries with a better credit rating. Exchange rate pressure grew and there have been acute currency
crises, with collapsing exchange rates and thereby increased uncertainty.
It seems that the stronger the inflow of credit in the first phase, the more serious have been the
consequences in the second, with declining production and rising unemployment. The reversal of
capital flows, if these were channelled through the banks, has also created difficulties in the financial
system. In many instances the financial system proved to lack the resilience to cope with the huge
flows.
The crisis that began in Asia in the autumn of 1997 had extensive contagious effects in other
countries. Some of the latter were countries that had conducted a broadly judicious economic policy
and were thus hit undeservedly. Singapore and Australia are two examples. Others were countries
with their own economic problems. One was Russia, which was obliged to suspend foreign debt
payments in August. This elicited contagious effects that hardly anyone had foreseen. The turbulence
spread to financial capital's citadel when an American hedge fund, Long-Term Capital Management,
encountered extensive problems that had repercussions throughout the US capital market.
Some of the crises that have begun in emerging markets have also been compounded by problems of a
different sort. The Asian crisis, as well as other financial crises, included elements of nepotism and
corruption. Bank lending was directed in some cases from the authorities or the government to favour
specific interests. Factual information, from private as well as public sources, was unsatisfactory in
many instances. As a result, appraisals of the countries' economic fundamentals were based on faulty
information and sometimes even on expectations that the close links between the political sphere and,
for example, the banks and corporate sector were a guarantee of government support should problems
arise.
Can the functioning of financial markets be improved?
The crises have made it obvious that the financial system needs to be strengthened, both in individual
countries and globally. Can this be done without losing the advantages I mentioned earlier? These
matters are being discussed intensively in various fora where the Riksbank is represented, such as the
IMF, BIS, OECD, G-10 and even in the European Union. The need to reconcile the desire for national
sovereignty in these questions with free capital movements, as well as international surveillance and
control, is a major political challenge. It is also a challenge with several dimensions: many different
technical changes are needed to strengthen the financial system at the same time as forms for
cooperation are developed and the question of who decides is tackled. Let me devote the rest of my
time to these matters, arranged under four headings.
1. Properly functioning economies
The primary condition for creating a more stable financial system is perhaps that the economies
function properly. Although the crises can be explained in terms of shortcomings in the workings of
the financial system, the instability has almost invariably stemmed from macroeconomic and
structural problems. A reasonable economic policy is, of course, not just a requirement in emerging
markets but also a standing order in the industrialised countries. Yet it is barely five years ago that
Sweden regained a fairly firm economic foundation after the profound crisis in the early 1990s. There
are many parallels between the Swedish crisis and the crisis in Thailand, for instance.
An important factor here is, as I mentioned, the exchange rate regime. Experience has shown that
exchange rates that are fixed but adjustable may often contribute to problems and currency crises.
They presuppose that fiscal policy is capable of countering economic shocks at the same time as they
invite speculation. In the debate it is therefore sometimes proposed that the emerging markets ought to
set up currency boards (a system whereby all outstanding currency can be converted into some hard
currency) or participate in some well-established regional monetary cooperation. These systems do
demand just as much of policy but their stronger links are intended to confer greater credibility. There
is a risk, however, of financial players being lured into a false sense of security, giving imbalances
more time in which to grow. Another feature that fixed exchange rates and currency boards have in
common is the negative effects they may exert on other countries if they have to be abandoned. This
is clear from the Asian crisis. The alternative is floating exchange rates. They have the advantage of
permitting interest rate adjustments to the needs of the domestic economy. But they also entail
exchange rate fluctuations and their drawbacks. The problem of exchange rate regimes is being
discussed internationally but a consensus has not been reached.
Financial market deregulation, moreover, must be adapted to the financial system of the country in
question and supported by a consistent economic policy. To some extent, the developments in Asia
probably had to do with an inappropriate sequence of deregulations; that was the case in Sweden in
the 1980s and it resulted in problems. Short-term foreign currency loans made the countries
vulnerable and subsequently resulted in currency outflows. The forms for deregulation have therefore
been considered in the international discussions. The International Monetary Fund will be taking
these aspects into account in future evaluations of individual countries. It is important, for example,
that deregulations are accompanied by a reinforcement of the supervision of financial institutions and
markets, so that any 'bubbles' are detected in good time.
2. Strengthening systems
A sounder macroeconomic policy improves the conditions for making systems more robust. This is
necessary but not always sufficient. A reinforcement of the financial system's infrastructure is also
needed. Such efforts are required both in the emerging markets and in the industrialised countries, as
well as at the global level. The emerging markets must build up better systems for oversight and
supervision. The IMF, the World Bank and the BIS are all involved in this work. Knowledge must be
enhanced. The rule systems in many Third World countries must also incorporate bankruptcy
legislation, arbitration procedures, and accountancy rules that are fair and transparent.
Extensive and well-motivated work on reforms in also in progress in many industrialised countries.
The tasks and methods of central banks and financial supervisors are being specified. Many private
institutions are reviewing risk models and adapting them to the global reality. Conventional models
must be augmented. Supervision also needs to be developed to cover new instruments and types of
risk, risks that the Asian crisis has brought to the fore. The Basle Committee is now working to
identify respects in which supervision may need to be extended, for instance to create standards for
the bank's transactions with highly leveraged institutions. The problems in LTCM clarified the central
importance of this.
At the global level, closer coordination of authorities' work on supervision is being called for; today,
such coordination is confined to sectors. A Financial Stability Forum has therefore been set up and
consists, at least for the time being, of representatives of the finance ministries, central banks and
supervisory authorities in the G-7 countries, together with IMF representatives. The Forum met for
the first time some weeks ago. Discussions are also in progress in what is known as the Group of
Thirty-Three, consisting of the participants in the G-10 and some twenty emerging market countries.
In its country evaluations, the IMF will also be paying more attention to the development of the
financial system. There is to be cooperation with the World Bank; these two organisations have
agreed on a joint model for the appraisal of national financial sectors. These appraisals are to be based
on the current minimum standards for banks and other financial institutions, a broad review of
developments and risks in the country's financial sector, and other conditions such as legislation,
accountancy rules, payment systems and financial markets, for example.
3. Greater transparency
A more stable development also calls for greater transparency. If the global capital markets are to
function as intended, their players must know about the actual risks and be in a position to make
realistic profit assessments. This in turn means that international organisations as well as
governments, private companies and financial institutions must convey a fair picture of the prevailing
conditions. As regards the IMF, increased transparency has been proposed in the country assessments,
for example. A pilot project has been initiated for the voluntary publication of material about
individual countries. Sweden has promised to participate in the project.
Transparency also applies to the individual countries and the private sector. One element in the recent
crisis has been a misleading account of both private debt and the size of foreign exchange reserves in
a number of countries. The standard for countries wishing to participate in the international capital
market-the Special Data Dissemination Standard-is being revised to give a better account of the
level of foreign reserves and the debt position in individual countries. At country level, moreover, a
code for monetary policy transparency and measures for maintaining financial stability is being drawn
up by the IMF together with the BIS, central banks, supervisors, the World Bank and the OECD. A
fiscal policy code is already in place.
4. Managing future crises
Even with these measures, we have probably not yet seen the last financial crisis. A readiness for the
management of future crises therefore needs to be created. A central issue in international discussions
is the distribution of risks among the parties concerned. While the IMF has been provided with
additional financial resources, it neither can nor should be prepared to contribute the main part of
what may be needed in a crisis. This is because expectations that any costs will always be carried by
someone else can result in an overall increase in exposure to risks, the problem of moral hazard. Such
expectations are liable to drive up credit supply and demand and can influence private agents as well
as national policy-makers.
One way of dealing with moral hazard among private investors is to arrange for them to carry a larger
share of the burden in a crisis. At the same time, there has been an ambition to construct any measures
so that they do not have larger negative consequences later on, for instance by deterring banks from
providing desirable credit. These two perspectives are liable to conflict. The discussion has focused
on preparatory measures as well as steps that can be taken in more extreme situations. As regards the
preparatory measures, it has been proposed, for example, that bond contracts be constructed so that
the renegotiation of scheduled repayment can be authorised by a majority. Another proposal is that
capital adequacy standards be constructed so as to limit the proportion of short-term interbank credits
from industrialised countries to emerging markets.
Recently, moreover, a decision was reached on contingent credits to countries that are judged to have
a sustainable economic policy and have nonetheless been hit by a loss of confidence and liquidity.
This is intended to reduce contagious effects. The IMF also plans to promote increased contacts
between the borrowers in the emerging markets and their private creditors.
If a crisis has already occurred-without there being a clause for renegotiation-credit to the country
in question can be renewed instead by the lenders acting in concert. The central banks in the countries
with the largest bank loans to the crisis area can then agree to try to persuade those banks to prolong
the loans. That is what happened in South Korea; the credits were renewed when the banks' loans had
been monitored.
Conclusion
Let me now summarise what I have said and draw some conclusions. The global capital markets are
here to stay. They have contributed to the good economic growth in many countries in recent decades
by providing capital efficiently.
At the same time it cannot be denied that the global capital markets can generate problems, as we
have seen in recent years. There have been marked fluctuations and they have spread from country to
country. Shortcomings in national economic policy have been the cause in many causes but not in all.
Small countries with less liquid markets have been heavily hit when highly leveraged funds have
shifted capital between markets. For some countries with a weak political and economic system, the
capital movements have been sufficient to elicit political crises and considerable social costs. A part
has also been played by problems in financial institutions in the industrialised countries, even in the
very centre of the international financial system through the Manhattan-based fund LTCM. Last
autumn the US Federal Reserve found it necessary to reduce the instrumental rate and take the
initiative in solving the problem of credit.
Against this background it is not surprising that an active discussion is now in progress about what is
called the new international financial architecture. International meetings are being held in quick
succession. For the time being at least, it is a matter, as I indicated earlier, of renovating and
extending the existing building rather than of executing drawings for a new one. A former British
colleague wrote recently in the Financial Times that 'the work on the new international architecture
should rather be called a plumbing activity'.
If the discussions have a common theme, it is risk: how risk is managed and priced, as well as who
should pay for any mistakes. This brings me to the last aspect of the ongoing discussion: how power
relationships in the world economy have shifted and the consequences of this for the institutions that
regulate and supervise the global financial markets.
As many former developing countries become more central players in the world economy, the balance
of power has gradually changed. These realities are not fully reflected in the institutional system that
was built up at the end of World War Two, in Bretton Woods and elsewhere; the United States still
has a major role in these institutions and so does Europe. Together with EMU, this raises many
questions about future representation in the international bodies. Those of us who represent Sweden
have the important but difficult task of maintaining our country's position in the international
financial cooperation in a constructive way, despite several decades of relatively weak economic
development.
Perhaps that should be a topic for a future discussion under the auspices of the Institute of
International Affairs.