Mr. Macfarlane puts recent suggestions for improving the operation of the international
financial system into perspective
Talk by the Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, to CEDA Annual
General Meeting Dinner in Melbourne on 25/11/98.
It is a pleasure to be in Melbourne again for CEDA's Annual General Meeting. The last time I
addressed this group two years ago I spoke about the Australian economy, monetary policy and
wages. Events have moved on a good deal since then, and I hope what I have to say tonight
reflects this.
The biggest change is that attention is now more focussed on the international economy than on
domestic events. This change can be dated from the start of the Asian crisis in the middle of
1997, and has continued through more recent episodes which have affected other emerging
markets as well as financial institutions in developed countries. These events have led a number
of participants in international markets, myself included, to question some aspects of the present
international financial system, and to make suggestions for improvements.
I have said a number of things recently that have sounded a bit out of character from a central
banker. Both I and my deputy have shown a lot of sympathy for our Asian neighbours and felt
that it is unfair to place the blame for their current plight solely on their own policy inadequacies.
We have also said that the present international financial system is unstable, that hedge funds
should be brought into the disclosure and supervision net and that the western policy
establishment was wrong to encourage emerging markets to embrace the free movement of
international capital so early in their development.
This has led some people to wonder what has come over us, and to question whether we have
deserted orthodox economics to follow more populist creeds. I have been asked whether we no
longer believe in markets, and whether we have become proponents of capital controls. These
questions worry me because they suggest that, for some people, there are only the two polar
positions, and that if you express some reservations about one, you are automatically placed in
the other. For these reasons, I want to spend some time tonight trying to place the recent
suggestions for improving the operation of the international financial system in some sort of
perspective.
1. From the Perspective of Australia
From the perspective of the Australian economy, the move to financial deregulation, and to the
lifting of restrictions on international capital movements, has been a success. We can date it
approximately from the floating of the exchange rate, and the abolition of exchange controls, in
1983. Although we characterise this 15-year period as being an era of deregulation, that is only a
very approximate description. While the authorities have stopped setting prices such as the
exchange rate or the interest rates banks can charge on mortgages, there is still a large
everevolving body of regulation in place aimed at ensuring financial stability and efficient and fair
markets. The stock exchange and the futures exchange have a comprehensive set of rules that
participants must adhere to, and, of course, they are also regulated by ASIC. The banks and
insurance companies are regulated by APRA, the payments system by the Reserve Bank, and
competition policy is enforced by the ACCC. Underlying all this, are the body of commercial law
and the accounting standards.
This approach to organising financial markets - which, in deference to common usage, I will call
the deregulated approach - has not been without its critics. A common criticism is that
international capital has forced the Australian Government to run macro-economic policies that
were not in the interests of the domestic economy. By this, the critics mean policies that are
tighter than the ones they favour. I have never agreed with this proposition. There has been an
on-going struggle in Australia by governments of both sides to return fiscal and monetary policy
to sustainable long-run settings after the turmoil of the 1970s. The influence of financial markets
has been a helpful one in bringing this about. Now that policies are in a sustainable and
responsible position, I am not aware of financial markets pushing for tighter policies.
The other common criticism is that financial markets in Australia have been unstable. The
simplest answer to this charge is to point out that they would have been more unstable over the
past 15 years if we had tried to find a path through the ups and downs of the world economy with
a managed exchange rate and a set of interest rate ceilings. We would not have had the daily
movements as under the present system, but the pressure would have built up and when the dam
broke, as it assuredly would have, the crisis would have been worse.
While I am confident that the deregulated system performed better than a continuation of the old
regulated one would have, I do not want to give the impression that it is without fault. We are
already on record as accepting that the exchange rate went down too far in the mid-1980s, that
asset prices such as shares and, later, commercial property underwent a boom and bust at the end
of the 1980s and beginning of the 1990s, partly as a result of excessive lending by
newlyderegulated banks. Our whole approach to foreign exchange intervention is based on our view
that the foreign exchange market is not "efficient" in the academic sense, but that it is prone to
overshooting in both directions from time to time.
In other words, we do not have an idealised view of how deregulated asset markets behave - we
have a realistic "warts and all" view. But even holding that view, we are confident that a
deregulated model with no obstacles to capital movements is the best one for Australia. It took us
a long time to adopt it, but there is now wide support for it at the political, policy adviser and
community level, and I hear no suggestions that we should change it. But that does not mean that
we should be urging every other country to adopt this model regardless of their state of
development. Eventually, I think it will be in the interest of emerging market economies to do so,
but the sequencing of this and other policies is crucial.
2. An Emerging Market Perspective
When we look at international capital movements from the perspective of an emerging market
economy, the view can be very different.
For a start, the size of the financial sector in an emerging market is often extremely small relative
to the flows of capital that emanate from developed countries. As Paul Volcker has put it:
"One common characteristic of (emerging market) countries, some large in
population and area, is the small size of their financial sector. The aggregate size of
the banks in the typical emerging country is now the size of a single regional bank in
the United States - precisely the kind of bank that is told that it is too small to survive
in today's turbulent markets."1
What is a small adjustment of investment strategy for a few major banks or mutual funds may be
a large injection or withdrawal of funds for an emerging market.
Second, it is clear that for most of the Asian emerging markets, some of the capital inflow that
occurred in the mid to late 1990s was not, in any sense, needed. It was more than the amount
required to finance their current account deficit, and it certainly was not needed to support their
exchange rate because these were under unwelcome upward pressure throughout the period. The
purist would say that if they did not want the inflow they should have let their exchange rates
float upwards. This would have eventually curtailed the short-term inflows that result when a
fixed exchange rate tries to co-exist with a positive interest differential. But what we do not
know is how high the exchange rate would have needed to rise in the process and the extent to
which this would have added to the economic difficulties. Remember the Thai currency crisis
was triggered by the perception that the baht had become over-valued because it was tied to a
rising US dollar. In short, if capital flows are very large relative to the size of the economies, they
are, one way or another, going to cause distortions.
Of course, the above considerations would not matter if the international capital markets were a
smoothly adjusting mechanism that constantly kept the exchange rate in line with the evolving
fundamentals. But this is not what people observe - they see booms and busts and do not believe
the proposition that the market is always right. Attempts by academic economists to persuade
them that the free market always, or nearly always, gives the correct equilibrium price are
unconvincing. The public's scepticism is well placed because the intellectual underpinning of the
free market position in relation to asset price determination - the Efficient Markets Hypothesis
is very weak. In all the exchange rate tests of which I am aware, the hypothesis has been
contradicted by the facts.
The third difference from an emerging market viewpoint is their relatively under-developed
financial infrastructures and regulatory frameworks. They do not have as strongly a based system
of regulating stock markets or banks or the underlying body of commercial (including
bankruptcy) law or accounting practices. They also have serious deficiencies in the allocation of
investment which unduly favours those who are well-connected to the government, the banks or
both (the so-called "crony capitalism"). I have no intention of denying that these are serious
shortcomings and that they should be rectified as quickly as possible if the countries concerned
are going to achieve first world living standards. But we have to be realistic about how quickly
these things can be achieved; in our own countries, these changes took decades or generations
rather than years.
Such problems are heightened by the phenomenon of contagion, a fourth element particularly
strong among emerging markets. In cases of panic, financial markets are not very discriminating.
When one country suffers a withdrawal of capital, others come under pressure. Partly, this can be
geography, as physical proximity can often mean economic and financial linkages. But even
economies on the other side of the globe, with few direct linkages, can be affected for no other
reason than that they are classified as "emerging markets".
Such countries might well have some weaknesses such as those noted above which, given time
and a measure of economic and financial stability, might be adequately addressed. But under
conditions of widespread desire to shed risk, they become immediate stumbling blocks for
markets. This can put intense pressure on the policy authorities and economies of these countries
- pressure which few countries can withstand easily.
For these reasons, the picture looks different from the perspective of the emerging market
economies. What is good for us after a long period of evolution need not be good for another
country at a much earlier stage of that evolution. In modern parlance, it is essential to get the
sequencing right. Countries have to attain a high standard of financial infrastructure and
regulation before they can submit themselves to the potential instability inherent in the totally
free movement of capital. In the meantime, they should integrate themselves as closely as they
can into the international capital market and, as their markets evolve towards maturity, they can
take additional steps progressively to liberalise their regulatory regimes. To expect them to do it
in the other order is to ask them to run before they can walk.
3. What Should We Do About It?
Fortunately, there is now a widespread agreement that something has to be done to improve the
international financial system. The degree of instability, if it continues unchecked, could lead
many participating countries to question the whole legitimacy of the system. The severity of the
contractions in Asia is the most striking example, but so is the sudden recognition that a hedge
fund can become so important that its failure could pose a systemic threat to the United States
and international economy. The fact that the second most important exchange rate in the world
the US dollar-Yen rate - could move by 20 per cent in a month without there being a material
change in fundamentals has also caused concern. I think there is now agreement that something
has to be done, and it is heartening to see that the United States has taken a leadership role,
including by convening the Group of 22 and its three working parties. I also think that the
Australian Government has played a very useful role - first by its representations to the IMF
urging more flexibility in its handling of the Indonesian crisis, and secondly by its attempt to
keep the momentum of APEC heading in the direction of more liberal trade policies.
Change is already occurring in that the western policy establishment is no longer pushing
emerging market economies to move quickly to full capital account convertibility. As recently as
October last year the IMF, at its Annual Meeting in Hong Kong, was hoping to get its members'
endorsement of a change to its Articles to make it easier for it to encourage countries to adopt
full convertibility. This proposal was not put forward at the 1998 Annual Meeting in Washington
because it was clear that it would not get support. There also seems to be greater tolerance for
countries which have a generally outward-looking policy framework, but which have put in place
some impediment to very short-term capital movements. I refer here to Chile's deposit
requirement on foreign borrowing and to Singapore's and Taiwan's restrictions on their banks
lending domestic currency offshore.
The more important task is to get on with the job of improving the international monetary
system, with the specific aim of reducing the degree of instability. Some of this is the job of the
emerging market countries, and in the first instance involves increasing disclosure by these
countries' governments, companies and banks. As well as making markets better informed, and
better able to judge the risks they are taking, the aim here is to make some progress on reducing
the previously opaque links between governments, banks and companies, or, in other words, to
improve governance. In addition, there is a lot of work to be done to bring the supervision of
financial institutions up to standard - a task which will take a lot of personnel, training and time.
These changes are extremely important and require a lot of effort on the part of the emerging
market countries. They also mean that a lot of time-honoured ways of doing things will have to
be replaced. This is bound to meet opposition, and it will require political courage as well as
economic expertise to achieve results. It will be made a lot easier if the developed economies are
also seen to be examining whether there are aspects of their regulations that are contributing to
the instability of the international system. The most obvious reform here is to do something
about the extent to which current regulations allow excessive leverage in financial markets. The
immediate focus should be the close inter-connections between hedge funds, investment banks
and commercial banks. The hedge funds have become the privileged children of the international
financial scene, being entitled to the benefits of free markets without any of the responsibilities.
Our reconstruction of the transactions that hedge funds undertook in Australia in June suggests
that they could engage in almost infinite leverage in their off-balance sheet transactions if they so
chose. One has to ask whether the Basle capital requirements are excessively generous in their
treatment of financial market activities. A related problem is the weakness in banks' credit
assessment processes that allowed them to build up some very large exposures to hedge funds
and other financial institutions.
No matter how effective the above changes turn out to be, no-one expects that they will eliminate
economic crises altogether. There still will be a need for improved crisis management.
Here, the most useful suggestion goes under the title of private sector burden sharing. This is
designed to be used in a future crisis when a country's international reserves are exhausted and
its exchange rate is plunging as a result of capital flight. In order to reassure markets, countries
are often tempted to guarantee a variety of foreign borrowings, with the result that their taxpayers
incur large losses while foreign lenders escape unscathed. Private sector burden sharing would
stop the capital flight by bringing foreign creditors, the debtor country and the IMF together to
work out a rescheduling, probably with a standfast arrangement to hold things together while
negotiations take place. Thus, the burden would be shared more evenly, and the pressures on
exchange rates could be reduced.
Another way in which crises can be handled better is illustrated by the recent IMF package for
Brazil. It was an improvement on the Asian packages in two respects. First, the conditions were
agreed on in advance in behind-the-scenes negotiations between the IMF and Brazilian
authorities. This was much better than the public tug-of-war between national authorities and the
IMF that occurred in Thailand and Indonesia. Second, I also note that the conditions are not as
wide-ranging as in Indonesia, for instance. I agree with Martin Feldstein2 that the IMF conditions
should confine themselves to matters that bear directly on the currency crisis, namely fiscal,
monetary and banking policy, rather than trying to reform the automobile, shipbuilding or clove
industry, as in Indonesia.
4. Conclusion
It is important that we find a way of reducing the present extreme variability in international
capital flows. It is also important that we find a way of managing future crises in a way that
reduces the cost to the crisis country and shares the burden more evenly, and so reduces the
moral hazard to lenders. If we do not succeed in doing these things, we face the prospect of a
significant number of countries losing faith in open, market-based economic systems. It would be
tragic if our failure to reform an unstable international capital market resulted in a return to
inward-looking policies in the international trade in goods and services. And that may yet
happen.
One reaction to the instability of the international financial system would be for countries to
unilaterally impose quite restrictive controls on inward and outward capital movements, and thus
miss out on the benefits that access to foreign capital can provide. We have already seen this
starting, and it would be regrettable if it were to spread. Even if this does not happen, there is still
a possibility of other reactions which may be equally, or more, unhelpful to the world economy.
In particular, I fear that a number of emerging market countries will take another form of
safetyfirst policy by building up large international reserves - a new type of mercantilism. The problem
with this solution is that to build up the reserves they would have to run current account
surpluses for the foreseeable future. How will they do this? Will they be tempted to restrict
imports, subsidise exports or maintain undervalued exchange rates? All of these are what used to
be called "beggar thy neighbour" policies. The whole world cannot do this, so who will run the
corresponding current account deficits? The final irony, if this situation eventuates, would be that
we would have an international system in which the poor countries lend to the rich so they can
spend more than their income.