Jean-Claude Trichet: Reflections on the international financial system
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the Bundesbank
Lecture, Berlin, 21 June 2005.
* * *
It is an honour for me to be invited to give this year's Bundesbank lecture and address such a
distinguished audience. It is a particular pleasure for me to speak in Berlin, which symbolises more
than any other city the historic peaceful re-integration of Europe. I would therefore like to extend my
warm gratitude to President Axel Weber and the Board of the Bundesbank for the invitation to Berlin
this evening.
In my lecture, I will try to take stock and look ahead at the challenges our economy is facing today,
focusing on the challenges from global financial integration for the international financial system, its
architecture and its functioning.
In my view, international financial integration and the state of the international financial system are far
less abstract topics than one might think at first glance. They reflect one of the most complex,
intriguing and powerful aspects of the phenomenon that is generally referred to as globalisation. This
phenomenon represents a key issue that policy-makers in Europe and beyond have to deal with. It is
therefore of utmost importance that we understand the significance of this issue for our role as
economic policy-makers, and it is against this background that I would like to reflect on international
financial integration and the international financial system today.
Policy-makers often face very specific concerns about economic uncertainty and the risk of instability,
and we need to address these concerns. Monetary policy also has to play its part. We have created a
stable currency for 307 million people. We have created confidence in this currency. We have
anchored inflation expectations below, but close to, 2%. We have ensured monetary stability on our
continent. In the same way, other policies have to contribute to addressing the challenges of the
future. They have to boost confidence and ensure that the opening-up of borders turns into something
that is ultimately worthwhile in terms of economic development and institutional cooperation.
In my reflections today I will describe the recent developments in the international financial system and
how they have shaped the institutional setup of this system in recent years. I will then turn to the
current challenges facing both the international community and Europe, and the implications of those
challenges.
International financial integration
The clearest example of global economic integration is trade, and this is certainly true for this country.
The label "Made in Germany" is recognised the world over as standing for high quality. But
international trade is not a process in which only one party gains. Each export corresponds to an
import, and economies benefit mutually from each other. Many goods that are bought in the euro area
are made in other countries, far away from their consumers. Transport costs have decreased,
technology has become universal, information is readily available at low cost, and tastes have been
converging. During the last three decades tariffs have halved and over 230 trade agreements between
various countries have entered into force. All these developments have resulted in a steady opening of
markets in Europe and worldwide. In the early 1970s global exports accounted for only one tenth of
world GDP, but they have increased to one quarter of world GDP today. This is a reflection of the
dramatic deepening of global economic interlinkages in recent years. In my view, it is important to bear
in mind that regional trade integration does not hinder global integration, but is in fact one efficient way
of fostering it.
There is also a more recent phenomenon that is less visible, but even more dynamic, namely global
financial integration. By this I mean the integration of local and national financial markets into a more
unified international financial market. Only a few decades ago, the realisation of an investment project
was largely contingent on the availability of capital in the local economy. Today the opportunities to
raise finance as well as to invest capital are truly global. The substantial number of bilateral investment
treaties and the liberalisation of capital accounts have further encouraged cross-border investment.1
While in the 1970s over 80% of all countries restricted access to foreign capital, today only 60% of
developing countries and no industrialised countries have capital accounts which are still more or less
closed.2 In the 1970s, worldwide cross-border holdings of assets amounted to only one tenth of world
GDP. Since then, cross-border capital flows have steadily increased, and countries have now
accumulated foreign assets in an amount equivalent to the annual GDP of the entire world. In 2003,
euro area residents held foreign capital with a total value of 7.6 trillion euro, a figure that is somewhat
higher than the euro area's annual GDP.
But financial integration is also intrinsically linked to the real economy. Over the past 30 years, annual
foreign direct investment (or FDI) worldwide grew from around 8.5 billion euro (10 billion US dollars) to
almost one thousand billion euro (about 1200 billion US dollars). The value of foreign-owned
companies around the world - the stock of FDI - is equal to the annual GDP of the euro area. Taken
together, these companies would make up an economy approximately one third of the size of the euro
area. Each year they produce goods and services of a value equivalent to German GDP and employ
one and a half times the German workforce. For Europe, these international linkages are of particular
importance. European corporate businesses are among the most dynamic in the world, as they
provide half of world FDI. At the same time, half of world FDI is invested in Europe.3 Foreign-owned
companies contribute between 10% and 20% of euro area GDP.4 As a consequence, the relationship
between the euro area and the global economy is today characterised more by financial linkages than
by trade. We as policy-makers have to be aware of these linkages because they can be a very
powerful and fast transmission mechanism for shocks.
The benefits of this integration are obvious - a greater variety of goods and downward pressure on
prices benefiting consumers and households. But the benefits are even more substantial, as
production requires both human and financial capital. A skilled workforce cannot unleash its full
potential without financial capital. Europe's impressive economic recovery after World War II would
have been inconceivable without its integration into the global economy and its concentration on
highquality exports.
Today, many Asian economies are benefiting from global economic integration. Investment in the
appropriate technologies enables these countries to compete on the world market and increase
welfare substantially. This is by no means a phenomenon which only appears in national accounts.
Income disparities across the world have declined significantly.5 Not surprisingly, the benefits of this
financial integration are particularly clear for open economies, which have recorded higher average
growth rates in recent years.6
How should we assess these recent developments in the international financial system? We realise
that the benefits outweigh the costs. But there are costs of adjustment, often front-loaded and
concentrated on specific regions and sectors, which need to be taken into consideration. The change
in the structure of the global economy also requires structural adjustments to be made in local
economies. We know that the ability of a country to benefit from global financial integration very much
depends on the quality of its institutional and structural environment. All economies, including
advanced ones, such as the euro area, have to adapt to the changing needs of the world economy.
The European economy has undergone and will continue to undergo substantial structural changes,
which are necessary and beneficial because they will secure Europe's place in the global economy.
This structural adjustment has been and will continue to be a major phenomenon in the coming years.
1
According to the United Nations Commission for Trade and Development (UNCTAD) Bilateral Investment Treaties
Database, the number of bilateral investment treaties rose during the 1990s from around 500 to over 2000.
2
See: M. Ayhan Kose and Eswar Prasad: "Liberalizing Capital", International Monetary Fund, Finance and Development,
September 2004.
3
For a thorough report on the role of foreign direct investment in the global economy, see the UNCTAD World Investment
Report 2004.
4
Jos Jensen and Ad Stockman: "Foreign Direct Investment and International Business Cycle Comovement", European
Central Bank, Working Paper No 401, 2004.
5
Xavier Sala-i-Martin: "The Disturbing 'Rise' of Global Income Inequality", National Bureau of Economic Research, Working
Paper No 8904, 2002.
6
Jeffrey Sachs and Andrew Warner: "Fundamental sources of long-run growth", American Economic Review, papers and
proceedings, 1997.
BIS Review 47/2005
As the world's largest exporter, Europe clearly has a major interest in global economic integration and
is well placed to benefit from it.
Sceptics are concerned about the sustainability of global financial integration. They argue that
financial integration has gone too far, that market turnover has reached levels that are unhealthy.
Each day, foreign exchange transactions are carried out to a value equivalent to the annual GDP of
France. Financial integration is regarded by some as having the potential to destabilise the global
economy.
But there is also an opposing view. This view states that global financial integration not only
contributes to higher growth but also reduces the risks to the global economy. It states that the
availability of finance and opportunities to invest are crucial for the stabilisation of economic outcomes.
Let me give you just two examples.
The preference of investors for investing in local assets rather than diversifying internationally, known
in the economic literature as "home bias", has not yet disappeared. In a world without transaction and
information costs, all countries should hold the same portfolio. Each country should diversify its
investment in all other countries relative to the size of their financial markets. This would provide the
best insurance against shocks to any economy in the world, including the economy of the country in
question, and at the same time it would increase the returns for all countries. During the last decade
countries have indeed been reducing their risk positions through this mechanism. However, the world
economy is still far away from a theoretically optimal portfolio and, as yet, there is no strong empirical
evidence for economic stabilisation resulting from risk-sharing. This should be taken as an indication
that there is still scope for further reduction of risk and stabilisation of income.7]
The second example relates to the fact that most developing countries cannot yet borrow
internationally in their local currencies, and have to resort to foreign currency. Foreign currency debt
makes these countries more vulnerable to exchange rate movements. For example, the positive effect
of depreciation on international competitiveness may be outweighed by the government's higher debt
service on foreign currency bonds and by deteriorating economic conditions.8 Recent trends in
domestic and international financial markets point to developing countries also having improved
access to different types of finance. Therefore, further development and integration of financial
markets may contribute to a stabilisation of economic outcomes in these countries, which would also
benefit the industrial economies as their trading partners.
Overall, I consider the recent developments in international financial integration to be welcome,
because they reflect trends towards an efficient allocation of resources and, in this way, support
growth and promote welfare in the global economy. They do not only benefit the recipient economies,
but also the countries of origin, where they facilitate international risk sharing and participation in
returns abroad. However, the rapid integration of financial markets across borders is not without new
risks. These risks include adverse market dynamics, unwarranted spillovers, and challenges for
international financial stability. And this brings me to the second part of my reflections, which concerns
the institutional governance of the international financial system.
The international financial architecture: is it up to the task?
Potential risks stemming from international financial integration should be addressed with firm
governance, requiring solid institutional foundations and policies. These institutional foundations, often
referred to as the international financial architecture of the system, will help prevent adverse financial
pressure and deal with it when it arises.9 Therefore, the key questions for policy-makers are whether
the international financial architecture is at present sufficiently well-equipped to deal with this task, and
whether it is adjusting sufficiently fast to the ongoing changes in international financial integration.
These are clearly not trivial questions, and definite answers can be given only with the benefit of
hindsight. It is easy to count the crises that have occurred, but impossible to count those that have
been averted. However, without forgetting the necessary note of caution, I consider the adjustments
implemented in the international financial system in the aftermath of the Asian financial crisis
altogether sufficiently important that they now constitute a system that is significantly different from the
one prevailing before the crisis. Indeed, I would classify some of the changes implemented in the
international financial architecture since the Asian crisis as major ones. Let me expand on this
hypothesis.
The Asian crisis was indeed severe. It is estimated that 600 billion dollars' worth of national income
was lost within the first year of the crisis (1997-98).10 It is important to realise that significant
weaknesses in the various national financial systems and a lack of market orientation were at the roots
of the crisis. These weaknesses included balance sheet mismatches, banking sector vulnerabilities,
and inadequate supervision. The Asian crisis was triggered by a shift in market sentiment which led to
massive reversals of capital flows.11 This change in market sentiment spread rapidly across the region,
and then into other regions, making contagion a major factor in the development of the crisis.
With hindsight it turned out that both national authorities and international institutions were
insufficiently aware of the risks and perhaps also insufficiently equipped to deal with them once they
had materialised. The subsequent diagnosis of the origins of the crisis exposed three major
shortcomings: first, considerable information gaps between the authorities, financial market
participants and the international community; second, insufficient attention to financial sector issues in
macroeconomic surveillance; and third, the inadequate involvement of emerging countries in
international fora. These shortcomings have been addressed in recent years, which has led to
important changes in the approach of international financial institutions, national authorities and
market participants. The main thrust of these changes has been to strengthen market orientation
through an improved international financial architecture. Let me briefly discuss these three sets of
changes in turn.
First, concerning the provision of information, the IMF has made large strides towards increased
transparency in recent years. The bulk of its bilateral consultation reports are now published and the
Fund has pushed for greater dissemination of key economic and financial data. The fact that,
nowadays, data on foreign exchange reserves, external debt, and balance of payments flows as well
as other key data are reliable and available with little lag has been an important part of the transition
towards a more market-led international financial system.12 It has allowed market participants to price
value and risk regarding each particular borrower in a reliable and effective fashion and to help stem
spillovers across markets.
National authorities have also made considerable progress in increasing transparency, including in
displaying their fiscal policies and data. All major central banks have made great efforts to increase the
transparency of their monetary policy frameworks and they consider clear communication essential for
effective monetary policy-making. Nowadays, more than 15 of the 20 major central banks publish
bulletins or inflation reports, often with detailed explanations of policy decisions and background data.
Importantly, many countries that have been hit by a crisis in recent years are now publishing their
inflation reports, including Mexico, Korea, Thailand and Brazil. This too leads to a more informed
decision-making process in the markets, reducing adverse market dynamics and contagion.
Market participants themselves also embarked on a process aimed at strengthening the international
financial system, including through the provision of information. In my view, an important recent
milestone has been the agreement between sovereign bond issuers and private market participants
on a voluntary code of behaviour to keep channels of communication open in good times and to
facilitate collaborative solutions in cases of distress for a sovereign issuer, and a possible restructuring
of its debt. I myself launched this idea in a speech in Washington in September 2001. This agreement
has resulted in the "Principles for stable capital flows and fair debt restructuring in emerging markets",
previously known as the "Code of Conduct", and it was endorsed at the end of last year by the G20
ministers and governors, when we met here in Berlin.13 We welcomed the fact that sovereign issuers
and market participants have developed a pragmatic and voluntary approach to reinforce the
international financial system and have in that way taken ownership of an important strengthening of
the present financial system.
The second important change since the Asian crisis concerns the focus of the international community
on financial issues, as it was felt that not enough attention was given to financial sector surveillance. In
the meantime, the IMF has brought financial sector issues to the forefront of its work, and they are
now regularly included in consultations. Global market surveillance has been established, and
analytical tools for the understanding of crisis detection have been strengthened. The IMF has also
established the so-called Financial Sector Assessment Program, which aims to promote the
soundness of financial systems in the IMF's member countries. An important part of the Program is the
IMF's assessment of observance of financial sector standards and codes, which have been endorsed
by the international community. In fact, the IMF is producing separate reports on Observance of
Standards and Codes as a by-product of the Program. The IMF's nearly universal membership makes
it well-placed to carry on this important work, and I think the fact that around 120 countries have
already participated in the Financial Sector Assessment Program since its launch in 1999, or are
planning to participate in it, is clear evidence of this.
In order to further examine the linkages between financial and macroeconomic stability and across
sectors of the financial system on a global scale, the Financial Stability Forum was created in 1999.
The purpose of the FSF is to promote international financial stability and reduce the risks stemming
from the international financial system. The FSF is uniquely positioned to fulfil this task, as its
members include, in particular, the major international financial institutions, the international groupings
setting standards for accounting and for the regulation and supervision of financial institutions (by
which I mean banks, securities firms and insurance companies), the international committees of
central bank experts in the fields of financial markets and payment and settlement systems, as well as
the executive, monetary and supervisory authorities of the major financial centres. In my view, it has
been the first serious attempt to consider the global financial system as a truly single system, an
integrated structural entity where it is of major importance for each institution or authority - whether the
IMF or the Basel Committee on Banking Supervision or the International Accounting Standards Board,
for instance - to be fully aware of the systemic implications of its own orientations and decisions. From
that standpoint, I consider the Financial Stability Forum as a global conceptual clearing house, whose
role is likely to be more and more important to the extent that the global financial system itself - driven
by technology and globalisation - is more and more complex, universal and integrated.
The third shortcoming that was detected in the international financial architecture during the Asian
crisis was the inadequate involvement of emerging countries in international fora. During the
development of the Asian crisis, emerging market participation was addressed by the setting up of the
G20, which saw its inaugural meeting here in Berlin in December 1999. The G20 was established in
order to fully reflect the new nature of the global economy, an economy in which emerging economies
were playing a very important role from a systemic standpoint. The G20 is a truly global forum. It
enhances the dissemination of information by bringing together key industrial and emerging countries
in an informal setting with the aim of reaching a consensus on a number of topical issues related to the
international financial architecture. Since its establishment in 1999, the G20 has been instrumental in
implementing standards and codes that are applied at the global level, as it has led by an example by
carrying out the IMF's Financial Sector Assessment Programs and Reports on the Observance of
Standards and Codes at an early stage. By now, two thirds of the IMF membership has participated in
these reports, assessing their compliance with internationally recognised standards and codes. The
G20 also contributed to the identification of 12 major standards, on which global efforts are now
concentrating. These major standards include banking supervision, corporate governance, fiscal
transparency, monetary and financial policy transparency, and securities regulation. Without the kind
of global ownership of new concepts of the best practices, without reinforced transparency and
voluntary implementation of the Principles for stable capital flows and fair debt restructuring in
emerging markets that the G20 has delivered, our present financial architecture would not be as
strong as it is today.
These three major improvements - namely fostering transparency as a major strategic driver, focusing
on a more systemic conceptual approach, in particular, through the Financial Stability Forum, and
developing improved global ownership, in particular, through the establishment of the G20 - have
contributed to an international financial system which is more resilient than before. The international
financial system is today better equipped to detect vulnerabilities and deal with shocks than it was in
1997 or 1998. Although the success of crisis prevention can only be assessed with hindsight, the
absence of international financial contagion over the past few years is an important observation.
One important lesson from the recent crises has been that the private sector needs to play its role in
crisis management. Private sector involvement is needed in order to avoid the moral hazard problem
that is inherent in large financial assistance provided by the official sector.14 Furthermore, the role of
the private sector in crisis management is essential because official support is likely to be insufficient
to cover the financing needs of a crisis country at a time of increasing capital flows. There have been
some concrete achievements in the area of private sector involvement, most notably the increased
use of collective action clauses in sovereign bonds.
There remain a number of open issues in the international financial system that need further reflection.
One such issue is the role of the official sector in crisis resolution. Here, the international community
started to emphasise the importance of clearer rules for official sector support. This was done in order
to strengthen incentives for prudent risk management on the part of both policy-makers and private
sector investors. The IMF has established a framework, which is called the exceptional access policy,
for large financial assistance programmes that sets guidelines in order to make IMF lending more
predictable. It is now up to the international community to follow these rules. Another open issue is the
lack of clear guidelines for IMF involvement in the process of sovereign debt restructuring in the event
of a country facing an unsustainable debt situation. The case of Argentina is an example of a very
difficult debt restructuring process, which has taken a long time to complete and which has caused
uncertainty for all parties concerned. Argentina's debt restructuring process has shown that the
international community still needs a better framework for crisis resolution. Authorities have to
cooperate with the IMF and international creditors. The IMF, for its part, has to remain closely involved
in the process, and it needs to take an active role in providing information.
The IMF is currently undertaking a strategic review of its activities, which should set a roadmap for the
Fund for the coming years. In this strategic review, the IMF is contemplating measures to make its
surveillance more effective. I support the recent efforts to put more emphasis on regional surveillance,
in order to reflect the strong regional focus of trade patterns that is visible not only in Europe and Asia,
but also in other parts of the world. I also support attempts to review the functioning of the international
monetary system and the Fund's role in it. Specifically in this context, the IMF is well-placed to analyse
issues like reserve accumulation and the evolution of exchange rate regimes in emerging markets, to
take due account of their global implication. Finally, it is important to review the financial position of the
IMF and the implications of lower lending activities on the Fund's operational budget.
Current macroeconomic challenges
My reflections on the current state of the international financial system would be incomplete without
putting them into the context of the current global economic situation. First of all, I have to note that
this is no time for complacency and that we currently find ourselves in a challenging situation.
The global economy is expanding at a comfortable pace, but there are large global imbalances, which
have actually widened in recent years. These imbalances involve the industrialised countries as a
whole, which have a large aggregate current account deficit and amongst them, more particularly, the
United States, whose current account deficit has reached levels not seen before. The increase in the
current account in recent years has occurred against the background of a decline in national savings,
in turn attributable to rising budget deficits and a household savings rate that has fallen to levels not
far above zero. The financing of the current account deficit, which calls for inflows of the magnitude of
around two billion US dollars every working day, takes place largely through Asia. Central banks in the
region have been intervening heavily for various reasons, such as to prevent their currencies from
appreciating, and they have become large-scale purchasers of US debt securities in recent years.
While the current situation is rationalised by some observers, in particular as it supports strong growth
in both regions and smoothes the adjustment path, it clearly raises questions regarding the
sustainability of recent developments and associated policies.
Japan and Europe are also in the picture, Japan because it is posting a large current account surplus
and is growing slowly, and Europe because, although it has a balanced current account, it should also
contribute to increasing global growth - through raising its potential rate of growth - thereby alleviating
global imbalances. The orderly and effective correction of global imbalances is one of the major goals
for the international community. These imbalances represent a major risk to financial stability around
the world and, therefore, to global growth. There is no individual national or continental solution to that
issue. I trust that there is an absolute need to embark on a cooperative strategy comprising all four
major partners. The United States has to tackle its structural lack of savings both by reducing public
dissaving and by increasing household savings. Europe has to augment its growth potential through
structural reforms in order to deliver growth, contributing more effectively to global growth. Japan
should also increase its growth potential by implementing structural reforms. And, as a fully-fledged
member of this collective, cooperative, global endeavour, the emerging Asian economies would need
to accept an orderly realignment of their currencies. I would underline that all four partners together
would not only have a winning strategy for tackling global imbalances but they would also individually,
each of them, do what is in their best interest. This is true for China and emerging Asia, this is true for
America, this is true for Japan.
This is also true for Europe. We have to convince people that structural reforms are necessary to
revitalise our economies and make them fit for global competition. Moreover, they can enhance
resilience to the shocks inherent in open economies. Structural reforms are essential for Europe's
ability to respond to the challenges arising from the ongoing deepening in the global division of labour,
the rapid pace of technological change, and the ageing of the population. In my view, all the conditions
to benefit from such integration are there, and we should make the necessary structural adjustments
with full confidence in their long-term benefits for our economy.
Conclusion
In conclusion I would like to stress three points. First, in my view it is remarkable that the current global
imbalances have again brought to the fore the importance of monetary and exchange rate issues in
the global economy, namely issues of exchange rate configurations, reserve accumulation and global
liquidity. This underscores the fact that the focus on financial sector and market institution issues
should not be at the expense of macroeconomic and exchange rate surveillance. This is particularly
true for IMF surveillance.
Second, the scientific and technological revolution, the phenomenon of globalisation and the structural
changes that are ongoing on all continents, not the least in Europe, are calling for utmost vigilance and
for a permanent adaptation of the international financial architecture. We must keep a constant check
on whether we have taken the systemic interactions between the various pillars of the international
financial architecture into consideration in an appropriate manner. Much remains to be done in this
regard and, as I already said, this is no time for complacency. The ECB is keen to play its role fully in
this respect, not only by participating actively in the G7, the G20 and the Financial Stability Forum, and
by being fully dedicated to the G10 group of governors, but also by calling, when necessary, for a
larger, more comprehensive, more systemic view in a number of important fields. For instance, we
suggested additional considerations of financial stability in the context of the International Accounting
Standards Board, and these have now been done to our satisfaction.
Third, further work also remains to be done to achieve full inclusiveness of emerging economies and
economies in transition in the international financial architecture. The G20, as I said, is an emblematic
illustration of this new feature, which was overdue. In the field of central banking, the globa