Eva Srejber: How do we create stability in financial markets?
Speech by Ms Eva Srejber, Second Deputy Governor of the Sveriges Riksbank, at a public hearing in
the Riksdag: "Economic policy in a global economy - is the Tobin tax an obstacle or an opportunity?",
Stockholm, 3 April 2001.
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Thank you for the invitation to come here. This is a subject that I am often asked to discuss in various
parts of the country. There is considerable interest in the challenges facing economic policy in an
increasingly internationalised world.
The credit market is central to a country's economy. Financial institutes are needed to mediate
payments for households and companies, such as wage and invoice payments. In addition, the
institutes mediate capital from savers to borrowers. This can comprise companies making investments
or households buying their own home. All in all, a well functioning financial sector is a necessary
condition for a country to achieve prosperity. However, mediating payments and lending money also
involves taking risks.
The international foreign exchange market in turn links together the national credit and payment
markets, so that payments in one currency can be exchanged for payments in another currency. This
enables trade, investment and foreign aid between countries. International capital flows enable
savings in countries with a capital surplus, after exchange on the foreign exchange market, to finance
investments in countries with a capital deficit. Countries like Sweden have made use of the
international capital market over the years, for instance, to finance large investments in the
infrastructure. Historically, foreign loans and investment have played an important role in the growth
and development of poor countries.
The financial markets thus perform an important function in society. However, over the years we have
seen that major problems sometimes arise in the financial markets. One example is the Asian crisis
1997-98. It is usually bank problems, resulting from bad loans, which lie behind such crises. When
confidence in the banking system fails, both domestic and foreign savers flee the country, and a
currency crisis may arise. The social costs of such a crisis are very serious. In the wake of the crises,
there is often a focus on the globalisation process in general, and the international capital markets in
particular. Demands have been made for measures to prevent the emergence of new crises. This has
included renewed discussion of the proposal for a tax on currency transactions, what is known as the
Tobin tax. However, I do not consider the Tobin tax to be the right method to use, as it does not solve
the fundamental problem, namely incorrect assessments of credit and risks and the lack of capital in
the banks to cover losses. Furthermore, I can see a number of risks if this proposal were adopted,
although I will return to that later. I would first like to accentuate the widespread and laborious work
carried out for many years, on both a national and international basis, to promote stability and prevent
crises from arising, but without impairing the functioning of the markets.
Experience shows that a necessary condition for avoiding crises is to pursue a fiscal and monetary
policy that is aimed at creating stability and that inspires confidence. The common denominator for
countries that have experienced financial crises is that the problems were based on mistakes in
economic policy and deficiencies in regulatory frameworks. The financial market is often merely the
messenger illustrating the fundamental problems. It is important that the choice of exchange rate
regime is in line with the economic policy pursued and with the capacity of the economy to adapt.
Countries that have experienced currency crises during the 1990s have had fixed, but adjustable,
exchange rates. Today, therefore, an increasing number of countries choose to have either floating
exchange rates with inflation targets, or completely fixed exchange rate regimes, such as currency
boards.
Experience also shows that it is necessary to have a general regulatory framework that is applied
properly, and that contains norms and institutions, in order for both national and international financial
markets to function well. Countries therefore cooperate in international organisations, such as the BIS,
the central banks' organisation in Basel, to work together on producing norms for suitable regulations
and norms in various fields important to financial stability. Great progress has been made in this field
in recent years, both in agreeing on norms and implementing them. For instance, norms have been
produced for payment systems, accounting and auditing, bankruptcy legislation, transparency in fiscal
and monetary policy and measures against money laundering. When I was the Nordic-Baltic
representative on the IMF's Executive Board, we worked hard to establish norms for correct and
detailed reporting of economic statistics. The World Bank, the IMF and other organisations support
countries wishing to adapt their legislation to meet the norms, by assisting with expert help. Several
Swedish experts take part in this work.
It is in the interests of all nations to apply these jointly agreed norms, as this reduces the risk of
financial crises. In addition, countries that do not follow the norms will find it more difficult to borrow on
the international capital market, since lending is more risky. Access to capital will therefore be more
restricted and interest rates will be higher.
It is also in the countries' own interests that other countries meet the norms, as financial crises in one
country have a tendency to spread to other countries in similar circumstances. We saw an example of
this during the Asian crisis 1997-98. As Sweden is a small country with an open economy and
therefore dependent on financial stability in the world around us, we contribute experts to the groups
working out the norms. Sweden also gives advice to countries wishing to improve their application of
these norms. Riksbank employees have provided assistance in countries all over the world, including
Latvia, Poland and Sri Lanka.
A good example of internationally agreed norms for increasing stability on the financial markets is the
capital adequacy rules for banks that were developed by the Basel Committee. These rules came into
force in 1988 and cover risks in for example lending, interest rate trading and foreign exchange
trading. In principle, they require that the greater the risk taken by a bank, the more capital it must
hold. As it costs money to hold capital, this creates an incentive for the banks to reduce their risk
taking. The rules also increase the banks' opportunities to cover any losses they may incur. The
current rules are applied in more than 120 countries. The proposal for new capital adequacy rules
recently presented makes an even closer connection between the capital requirement and the risks
taken, as well as reducing regulatory arbitrage and increasing the requirement for transparency. While
the Basel rules thus reduce excessive risk taking, they do not impair transactions made with the
purpose of redistributing risks between banks, enabling a healthy level of risk taking to be attained
within the respective institute. These transactions contribute to reducing the banks' risk taking and
currently comprise a large part of the turnover on the foreign exchange market.
Allow me to give an example of how this works. A Swedish export company with income in dollars, but
paying out wages and taxes in kronor, must exchange dollar income for kronor. The company
transfers the foreign exchange risk to the bank, by selling dollars for kronor. This can be done in two
ways: either the company sells the dollars when it receives them, on the spot market, or it sells its
future dollar income as soon as it receives an order, on the forward market. In both cases the bank
buys dollars and thus takes over the foreign exchange risk. The bank also makes a charge for doing
this. Today the margins in foreign exchange trading are 0.02 per cent. The bank's foreign exchange
risk thus increases, unless another client happens to make an equally large foreign exchange
transaction in the opposite direction at exactly the same time, ensuring that the bank's holdings of
various currencies remains unchanged. This is, of course, very unlikely. The export company's foreign
exchange transaction therefore gives rise to several transactions between banks, with the aim of
distributing the foreign exchange risk throughout the banking system. This means that the clients'
purchases and sales of various currencies and in various banks are matched against one another, to
avoid an increase in the total risk in the banking system. The first foreign exchange transaction will
therefore lead to many new transactions before all of the banks have once again achieved a healthy
level of risk taking.
The same applies to all types of foreign exchanges - for instance, when SIDA exchanges kronor for
foreign currency to provide foreign aid, when the pension funds buy foreign shares, when we buy
foreign insurance policies and when the mortgage institutes borrow abroad. I believe it is important to
be aware of how the risk distribution between the banks functions. Transactions on the foreign
exchange market do not need to be speculative at all, even if they do not have any direct link to
payments for trade, investment or aid between countries. It is not possible to take the total of all
crossborder payments for goods and services and say that all other foreign exchange deals are
unnecessary.
Finally, allow me to comment on the proposal of a Tobin tax. Taxes on financial transactions have
already been tested in a number of countries, including Sweden. At the end of the 1980s, we had a
securities transaction tax here. The result was that the turnover declined severely. Trade in securities
fell by around 80 per cent. Part of this trade was moved abroad and some ceased altogether. Nor did
the securities transaction tax manage to prevent the 1990s crisis. A Tobin tax would be difficult to
apply, as it assumes that all countries support it. This is unlikely, as the countries that did not apply the
tax would benefit, in that a large part of financial activity would move there. And even if it were
possible, I do not consider the Tobin tax to be a good method of reducing speculation and excessive
risk taking on the financial markets. On the contrary, there could be an increase in risk taking when the
possibilities for insuring oneself against financial fluctuations become too expensive and the banks'
opportunities for distributing risks are reduced. Instead, I see the international work already being
carried out into producing norms for various areas as a better means of promoting stability and
reducing risks.
To summarise, the credit and foreign exchange markets play an important role in society by mediating
payments and savings, both nationally and internationally. The best way to prevent excessive risk
taking is not to tax transactions, but to ensure that more countries pursue fiscal and monetary policy
aimed towards stability, with a suitable exchange rate regime, and follow the international regulations
and norms that promote stability. These norms must be continuously adapted to developments on the
financial markets and in the rest of the economy, in order to limit the risks in the financial sector.