Mr Bäckström discusses international financial stability
Speech given by the Governor of the Sveriges Riksbank, Mr Urban Bäckström1, at a seminar at the
South African Reserve Bank in Pretoria on 9 August 1999.
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Introduction
Financial stability is a topical subject in the light of events in the past decade - years that saw financial
problems in a number of European countries as well as in Mexico and Asia, the devaluation of the
rouble and suspended payments in Russia, considerable turbulence in western financial markets and
financial unrest in Brazil. The crisis in the international financial system developed, to cite President
Clinton, from being "just a few small glitches in the road" into "the worst financial crisis in fifty
years".
The problem is that crises will always be intrinsically difficult to forecast. Recall that the scale of the
Mexican crisis in 1994 was foreseen by very few. In South-East Asia the onset, duration and scope of
the recession were all missed by the forecasting community. In the last spring, no one had anticipated
the extent of the turmoil in financial markets that would be generated by the Russian devaluation and
moratorium. The ways in which rising credit spreads led to losses by highly leveraged investors,
liquidity shortages and the virtual drying-up of some markets were generally not foreseen. The track
record shows that there are many things we do not understand and cannot predict. That conclusion is
underscored by a look at existing attempts to build early-warning systems for various types of crisis.
Either these systems miss out on crises that actually occur or they sound the alarm for crises that do
not occur.
Nevertheless, given the costs and the difficulties of managing the successive crises over the past
decade, we must continue to devote considerable efforts to avoiding future crises and try hard to
understand the kinds of vulnerability that lie behind them. The crises during the 1990s have revealed
serious flaws not only in macroeconomic management but also, just as important, in the structure and
regulation of the financial system in both debtor and creditor countries. The work now being carried
out in various international fora is thorough and can be summarised under three headings:
• Crisis prevention, including the development of good practice standards and transparency
codes, and incentives for both borrowers and lenders to act prudently.
• Crisis containment, including the establishment of official contingent lines and possible
forms of private sector finance which may reduce the severity of any crisis.
• Crisis resolution, where the emphasis is on possible ways of creating a more orderly
environment for restructuring external debt, on principles to guide the restructuring of
banking systems in the wake of a crisis, and on handling corporate insolvency.
Much of this work involves international institutions like, for instance, the International Monetary
Fund, the World Bank, the Bank for International Settlements, the Basel Committee on Banking
Supervision, and the OECD, as well as the newly created Financial Stability Forum.
However, the work, often hard, of implementing policies and codes lies with national authorities.
These measures will contribute to improved financial stability only if countries actually adopt and
implement them. A crucial ingredient in achieving this is of course to involve countries, formally or
informally, in the development of the policies, codes and standards. But even if that is achieved, I
know from my own experience how difficult the actual implementation sometimes can be, not least for
political reasons. I would also like to make the point that today's favourable trends in the world
economy should not lead us to conclude that the danger is over. Instead, policymakers throughout the
world must continue to work on forestalling new problems both because some evident threats to
international financial and economic stability still remain and because there may well be
vulnerabilities that are not so evident.
The run up to the financial turbulence of the 1990s
During the past twenty years, the financial systems in many countries have been deregulated. For the
first time since the outbreak of World War One, capital can again pass more or less freely across
national borders. Moreover, major changes in communication and information technology have paved
the way for new instruments and methods for risk management. Taken as a whole, this has led to the
financial system being more extensive and global today than ever before. This holds even though
capital flows relative to GDP were also large at the end of the last century.
The rapid financial development and internationalisation are per se a logical consequence of the
production of goods and services being globalised, with a massive increase in cross-border trade. They
also have to do with growing wealth in many parts of the world. This in turn has increased the need for
new financial solutions for businesses and households. The increasing globalisation of production and
trade in goods and services generates a demand for a more developed and internationalised financial
system so that the opportunities for increased prosperity can be used to the full. Note that this, as
always, involves a trade-off between risk and return. It is of course possible to substantially increase
stability, in the sense of lowering risk, by measures that result in very low returns. However the
solution is not to turn back to a less turbulent, but also less prosperous past regime of capital controls.
The transition to a more global financial system has certainly not been free from problems. It should
not be forgotten that extensive capital regulations entail a mispricing of risks. Deregulation then leads
to desirable price adjustments. But it is often during these transitional corrections that financial
problems are liable to occur. Changes have often occurred too quickly for the system, including the
institutional infrastructure, to be able to keep up. In most cases, neither the banks nor the public
authorities had the necessary prerequisites for adapting to the new conditions that were created by a
freer capital market. The expansion of lending had too free a rein in many countries and the authorities
did not properly monitor what was happening at either micro or macro level.
Economic overheating often followed the deregulation and opening up of the domestic financial
system due to a rapid expansion of credit rapidly. Asset prices rose sharply and imbalances developed.
Furthermore, in countries with a fixed exchange rate system, extensive short-term borrowing abroad
was stimulated. A large proportion of these funds was often channelled through the domestic banking
system and rendered this rather vulnerable. When capital flows subsequently reversed, the adjustment
was often violent. Production fell, unemployment rose and both the currency and the banking system
faced an acute crisis.
Apart from the actual process of financial market deregulation, there may have been other factors at
work. The openings for capital investment in so-called emerging markets created opportunities for
international investors for achieving high returns. Between 1990 and 1997, the annual flow to Asia
alone was equivalent to around 25% of the affected countries' aggregate GDP. This was a combination
of bank lending and portfolio investments; 60% of the lending from international banks was
shortterm.
That capital moves from one part of the world to another if the yield is seen to be higher is, of course,
positive in itself. The problem lay in the conditions for productive investments being less good than
had been hoped. Later, when the Asian economies ran into problems, the capital flows reversed and
serious financial turbulence broke out.
A further way of achieving a high return was to take increased risks by debt financing and complex
financial instruments. This created a starting point for so-called highly leveraged institutions. Long
Term Capital Management was one extreme example.
International banks engaged in lending directly to countries where the returns were high. At the same
time, they lent capital to hedge funds that invested in the same countries. In some cases, moreover, the
banks owned shares directly in these funds. There are grounds for saying that risk-taking was high in
many cases. The good profits created a culture of deceptive security and stimulated further risk-taking.
To this can be added the false sense of security that the new mathematical models imparted. They
were seen to function well under normal circumstances but failed to do so when they were most
needed, i.e. in turbulent times.
Domestic policies, institutions and rules, important factors behind crises ...
Although several of these factors may have played some part in the run-up to recent financial crises, it
is important to bear in mind that financial crises almost always originate in an unsuccessful domestic
economic policy and in the structure and regulation of the domestic financial system. While modern
international financial markets have possibly contributed to an earlier appearance of crises and to their
spreading, a deregulated financial system with free capital movements as such is not the basic
problem. It is striking that several countries most affected by financial turbulence in the 1990s were
relatively new participants in the international financial system without having first established a
sound domestic financial system and a sound economic policy. That conclusion also holds for my own
country, Sweden, which experienced a severe crisis in the early 1990s.
One obvious insight is, and I quote Fed Chairman Alan Greenspan, "that participation in the
international financial system with all its benefits carries with it an obligation to maintain a level of
stability and a set of strong and transparent institutions and rules if an economy is to participate safely
and effectively in markets that have become highly sensitive to misallocation of capital and other
policy errors".
Thus, emerging market economies must reform their domestic financial systems, just as we did in
Sweden after our crisis, if they want to enjoy the benefits of an open international financial system.
Accordingly, further progress in establishing a sound legal infrastructure, covering both bankruptcy
procedures and effective corporate governance, would seem to be very high on the list of priorities.
It is also important to understand the dangers inherent in adjustable peg exchange rate systems. It is
still far too early to draw the firm conclusion that the only viable exchange rate regimes, in all
circumstances, are a free float on the one hand and a currency board or a monetary union on the other.
Nevertheless, one common characteristic of the main crises of the recent past - Mexico, Thailand,
Indonesia, Korea, Russia, Brazil and, for that matter, my own country Sweden - has been that the
authorities had adopted a more or less rigid exchange rate regime that ultimately proved to be
unsustainable. One clear lesson seems to be that, in many circumstances, once a weak peg comes
under fire, defending it is often a losing battle, especially if the exchange rate does not properly reflect
the development in the real economy. Another drawback to a fixed, but adjustable, peg is that it may
stimulate excessive short-term capital inflow and thus in itself generate vulnerability because the
central bank is seemingly absorbing the exchange rate risk. Against this background, a key question is
the appropriate exit strategy to another exchange rate regime or a timely adjustment of the pegged
exchange rate should the need arise.
An additional insight is that the simultaneous occurrence of foreign exchange rate crises and banking
crises is probably the single most important reason why some countries have suffered much deeper
recessions when their currency pegs collapsed or came under a severe speculative attack. The
contractionary shock to most European countries in 1992-93 was clearly much smaller than for
Sweden and Finland in the early 1990s and for Mexico in 1995 and Asian countries in 1997-98.
Thus, authorities in countries that receive capital inflows should prepare for the day when the
movement might reverse. Countries that are vulnerable in this regard should carefully consider the
adequacy of their foreign exchange reserves, particularly in relation to their short-term external debt.
Since large numbers of countries cannot build up their reserves by increasing their trade surpluses
simultaneously, this would seem to argue for greater use of contingent lending facilities provided by
the private sector. Given such arrangements, recourse to the new IMF Contingent Credit Lines would
then add public sector to private sector affirmation that the domestic policies being followed by the
borrowing country are sensible and sustainable.
... but the international dimension should also be recognised
To say that the key to avoiding future crises in emerging markets must be found in domestic reforms is
not to deny that part of the solution may still lie in measures that change the way in which
international financial markets sometimes operate. While financial liberalisation and international
financial integration bring unquestionable benefits, they can also be subject to episodes of excessive
risk-taking. In recent years, there does seem to have been imprudent lending, and not just to emerging
market economies but also to borrowers within the industrial world.
In part this has been spurred by competitive forces. That such forces will diminish as financial
restructuring accelerates seems unlikely. However, the potential of public safety nets to distort
incentives and breed complacency can also be discerned and these structures should be re-evaluated. It
is important that all investors are held accountable for their decisions. The international community
should also ensure that all investors and lenders play their part in the resolution of any future financial
crisis and, to this end, should implement, inter alia, changes to international bond covenants that
would facilitate debt restructuring should this become necessary.
The events of the past decade have made it clear that greater efforts are needed to strengthen the
functioning of markets. Information asymmetries lie at the heart of market failure, and the market's
way of resolving them can give rise to unpredictable outcomes. Ensuring that markets have adequate
information about national economies, the strength of financial systems, aggregate positions and the
financial standing of counterparties is important. Equally, if not more, important is to ensure that
market participants' approach to risk management reflects the full balance of costs and rewards
implied in their decisions. Internal risk assessment procedures must recognise the interrelationships
that exist between categories of risk before, not when, markets are under strain.