Mrs Akhtar Aziz discusses
the international financial architecture
Official speech entitled "International Financial Architecture - The Challenge of Change" by Dr Zeti
Akhtar Aziz, the Deputy Governor of Bank Negara Malaysia, the Malaysian central bank, at the
Malaysian Capital Market Summit on 11 August 1999.
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Introduction
The significant fundamental changes that have taken place in the international financial environment
has brought with it new challenges and consequences to the global community and individual
economies at large. Change has become the only constant. The evolution of the changes in the
international financial environment has been facilitated by the significant advances in technology,
market innovations, financial liberalisation and the consolidation process in the financial services
sector. These developments have resulted in the intensification of the process of globalisation and
integration of financial markets. As a consequence, there has been a widespread transformation in the
international financial landscape reflecting the changes in the relative significance of players in the
market, the nature of the financial instruments and the volume of activity in the market.
This process of globalisation is supposed to result in enhanced opportunities for the world economy
that would lead to a more efficient allocation of resources across borders and thereby result in higher
growth and development across countries. The experience however, has shown that globalisation has
also brought with it risks that can lead to highly destabilising consequences that can result in costs that
far outweigh the benefits. The challenge facing the international community is how to ensure an
efficient functioning financial system, a system that is not vulnerable to market failures, a system that
would lead to an efficient allocation of resources across borders and provide enhanced prospects for
the world economy. At the individual country level, the challenge is how to participate in this changed
environment, how to be an integral part of the world economy without being vulnerable to violent
destabilising developments. The challenge for individual countries is to be able to be in a position to
experience the benefits of these changes while at the same time enhancing the potential for survival.
Changing trends in the world financial environment
As a result of the changes that have facilitated globalisation, financial flows have now far exceeded
world trade flows by four times. Such flows have now become the dominant factor in determining
exchange rate movements. While previously, exchange rate developments reflected the performance of
the balance of payments current account position, in the current environment, the capital account
performance has become the dominant factor in determining exchange rate movements. In particular,
the developments in the short-term capital account have become the important factor. In this current
environment the expansion of international financial activities has resulted in international
developments having a greater influence on the domestic economy.
The increased cross border flows also reflects the increased institutionalisation of savings and the now
relative importance of institutional investors in financial markets. In efforts to diversify risk and
enhance returns participation in foreign markets by institutional investors have increased
exponentially. This trend should in theory improve the allocation of world financial resources and
increase competitiveness and efficiency of the financial markets as well as open up new avenues for
enhancing prospects for growth.
In this process of globalisation the domestic financial conditions of individual countries have become
significantly influenced by international capital movements and external economic and financial
conditions and policies. The extreme form of this has been demonstrated by the contagion that has
occurred during the financial crisis that has been experienced in recent years, in particular during the
ERM crisis, the Mexican crisis and the East Asian crisis. The challenge has therefore been to operate
in an environment that has become more susceptible to greater uncertainty and volatility. In such
periods of excessive volatility and wide swings, market failure is seen to result as markets become
unstable, moving further and further away from equilibrium levels following over reaction and
irrational market behaviour amplified by herd behaviour. At the extreme, these eventually become
trigger factors for domestic outflows resulting in total collapse and devastation.
The sudden nature of capital movements also imply the increasing short-termism of the global market.
Such flows have tended to focus on short-term and immediate gains rather than having a more
medium-term perspective, taking into account structural elements for investment decisions. This has
led to excessive risk taking, reflecting the intense pressure for high returns. Market behaviour under
these circumstances has been characterised by sudden shifts from extreme exuberance to over
pessimism. These flows, in effect, do not reflect the underlying fundamentals.
In this environment, the challenge has been for enhanced access to information to allow for better
decision making. There have been calls for greater transparency and disclosure. Scrutiny and
surveillance by multilateral agencies, rating agencies and the market have intensified. At the same
time, however, there has not been adequate surveillance on short-term flows to allow greater
understanding of their nature and the dynamics of such flows. The increasing degree of sophistication
of the financial instruments and the complex nature of their operations has not allowed for a true
assessment of the implications of these developments. Of equal importance on the issue of
transparency, is the need to also ensure appropriate utilisation of the information.
In the context of these developments, the regulatory structure has lagged behind the financial
innovations and their internationalisation. It has been widely recognised that there is a widening gap
between outdated regulatory structures and advanced market instruments and developments. Given the
global dimension of the forces of change, the call for the strengthening of individual nations' financial
systems also needs to be matched by efforts to strengthen the international financial system.
In the past, changes in the financial environment have been met with corresponding changes in the
international financial system. Since the Plaza Accord in 1985, however, the changes in the financial
environment have not been matched by a parallel change in the management of the global financial
system, particularly in the 1990s. The international financial system has continued to operate within a
framework designed for a global environment of the 1970s and 1980s.
In this era of the expansion of capital flows there has essentially been an absence of the development
of the appropriate parallel prudential framework for the efficient functioning of the international
financial markets. In the case of trade, the push towards free trade was matched by adequate rules to
ensure orderly development. International rules on market opening measures and procedures for
dispute settlement were established. More importantly, there are safeguards to protect countries facing
balance-of-payments difficulties. In contrast, the push for a liberal environment for capital movements
has not been matched by a parallel development to establish rules for the efficient functioning of the
markets and for safeguards to individual economies from the adverse consequences of capital
movements. The challenge is therefore not only for the international community to evolve a viable
international system that can function efficiently in the current global environment, but also one that is
relevant to expected future changes.
Quest for a reformed international financial architecture
The forces of change that we are confronted with are essentially international in character. A global
perspective is therefore required to evolve a system in which all countries can participate and benefit
from the globalisation process. A permanent and sustainable outcome would be one that is developed
by the global community, taking into account the diverse backgrounds of countries that make up the
global community as well as its implications on the private sector. Efforts by individual countries to
strengthen their domestic systems and capabilities are important, but this is not a sufficient condition
for ensuring economic and financial stability.
Several international forums over the last two years have engaged in this exercise and have brought to
the forefront the issues and challenges at hand. While there is a general consensus among the
international community that the international financial system needs to be reformed to ensure a
system that is relevant to the current changed environment, there is no general consensus of how this
might be achieved.
The more recent initiatives by the G7 have provided the most encouraging progress that has been
made with the establishment of the Financial Stability Forum. It provides the opportunity for the
proposed changes to be translated into concrete implementation. While efforts are underway, it still
remains to be seen as to the degree to which changes will be made and the time frame for its
implementation. The urgency for the development of an efficient functioning system that would avoid
future crisis is vital, given that the strains and costs of such crisis occur not only for the affected
individual countries but also have widespread consequences across countries.
Rising to the challenge of change
While individual countries will continue to be vulnerable to changes in the external environment,
initiatives can be taken to build the foundation to enhance capabilities and capacities to not only
absorb change but also to be in a position to take advantage of the opportunities that globalisation
accords.
An important area towards achieving this is the process of liberalisation. There is now an international
consensus that the process of managing the liberalisation should ensure that countries have the
institutional framework to deal with international capital flows before liberalising capital transactions.
Financial liberalisation implemented in an orderly and well sequenced manner would allow the
domestic system to be adequately developed to cope with the challenges emerging from the
globalisation process. The necessary set of preconditions should therefore be in place prior to capital
account liberalisation. The East Asian crisis demonstrated that countries that have liberalised too
rapidly in the absence of the preconditions became relatively more vulnerable. All too often, external
pressure has been applied to emerging economies to hasten the pace of liberalisation without taking
into account the risks that would emerge.
However, it should also be noted that in spite of the best institutional framework, a country can still be
subsumed by a liberalised capital account framework under the current international financial system
that does not have any financial regulatory framework for capital flows. Management of domestic
risks must be matched by measures to ensure efficient markets. A parallel institution building and
surveillance system at the international level is necessary to secure greater stability.
Another important area where safeguards are necessary are the strategies for financing growth. In this
regard, development strategies by individual economies need to make balanced choices between debt
and equity, and the share between domestic and foreign financing. Excessive reliance on external debt
financing increases vulnerability to changes in interest rates of creditor countries as well as exchange
rates of both creditor and debtor countries. The different strategies pursued by the East Asian countries
in their financing strategies have resulted in different degrees of vulnerability to the external
developments. Here, the development of a deep and liquid capital market is important to provide
alternative sources of financing and thereby reduce excessive reliance on the banking system for such
financing.
For an individual country, the changed environment that has resulted in greater unpredictability and
uncertainty, makes risk management vital. Decisions need to be made on the acceptable levels of risk,
the degree of risk tolerance and for the development of strong risk culture. The methodology and
technology need to be developed to measure and monitor the increased risks. Adequate controls and
checks and balances need to be in place to ensure there is no excessive risk taking that could result in
adverse implications.
The process of globalisation and change also implies the need for the domestic financial system to
enhance its capacity to compete in world markets. In this regard, increased efficiency would provide
the competitive edge. The move for consolidation would enhance this process in obtaining gains from
increased economies of scale and cost saving. Gains from increased efficiency in the utilisation of
physical and human resources as well as higher technology become essential in this more competitive
environment. In the context of technological advantage, the application of IT will represent an
important enabling tool in this process. Efforts to upgrade skills will also be required. An enlarged size
will enable significant increases in investment in cutting edge technology and human resources. In
essence, in an environment of scarce resources, the efficient utilisation of resources becomes
important.
The process of globalisation and change also implies a need for the domestic economy to enhance its
capacity to compete in the world markets. Small open economies such as Malaysia face the challenges
to build a competitive edge in a product and service market that is also characterised by rapid change.
Many of Malaysia's exports face rapid technological and market changes. In this context, the strategy
has been for the diversification of the economic base, while at the same time enhancing efficiency and
increasing labour mobility. For this purpose there is also a need for more diversified and efficient
sources of financing. In relation to this, a financial system that is efficient and competitive as well as
an efficient functioning capital market is a key element in the process. Labour mobility also needs to
be enhanced through human resource development. On the corporate front, the current restructuring
and consolidation taking place would make the industries more resilient and efficient. As corporations
become more focused on their core activities and as their activities are streamlined, this will increase
the prospects for enhanced efficiency and competitiveness. The ability to tap IT and engage in
innovation becomes increasingly important to meet the increasingly more sophisticated demand.
Greater efforts will also be needed to promote more efficient flow and use of information. This will
enable industries to respond faster to the changing environment and move towards a more knowledge
based economy.
Conclusion
In this global environment of uncertainty and change, it is difficult to anticipate future risks. While the
future is unpredictable, it is important to understand how the future might change, not only to gauge
the viability of existing initiatives but also to develop new capabilities to operate in the changed
environment. Therefore, in moving forward, we need to look beyond the horizon to have an ability to
face an environment that is fundamentally different from the present one. What is needed is an
understanding of the range of possibilities that might occur and to be in a position to implement
strategies that will succeed under different circumstances. It is therefore important to identify the
forces that could determine these different possible environments. The ability to recognise the
potential future developments and to be able to adapt and adjust to these developments would provide
safeguards and increase our resilience and our prospects for survival and sustained growth.