A presentation at the Third MEFMI Central Bank Governors Forum, Surrey, UK, May 31, 1999.
A NEW OPTIMISM
- In contrast to what we herd from last year annual meetings of the Bretton Woods Institutions, the mid-year meetings last month in Washington DC, of the Interim Committee and the Development Committee voiced an optimistic views on the last several months of the international monetary and financial development. It was as if confirming the coming of spring in Washington DC that is well known of its beautiful cherry blossoms. The situation was almost euphoric, describing the situation of Asia by noting that activity has turned around in Korea and bottomed out in Thailand, while the rest of Asia shows to be recovering or close to be doing so.
- Everywhere else seems to register some positive signs; a revival of confidence in Brazil with its success in floating new bonds in the market, a more positive fiscal and banking policy in Japan, and a continued healthy growth of the US and Canadian economies. There has been a better sentiment of the market towards emerging market such that investors start coming back, while in the mature financial markets concerns about the risk of a liquidity shortage have subsided. In general there has been a new optimism in how the world economy is behaving after the Asian crisis that was followed by Russian and Brazilian and the threat of the stability of mature financial markets due to the collapse and the bail out of LTCM towards the end of last year.
- A basic question may be raised here, is this optimism warranted? For sure, the IMF World Economic Outlook cautioned against a euphoria. The Introduction starts with a sentence "Since the end of 1998 some positive developments in the world economy have been broadly balanced by some important setbacks, so that the global outlook is little change" The crisis in Brazil shows the instability of world finance dominated by a huge amount of short-term funds that could come and go abruptly in an economy and creating economic problems and crisis. The fragility of some financial sector in large emerging economies, like China and Russia keep threatening financial markets. Imbalances in global trade due to crisis in emerging economies and the uneven pattern of growth in the US, the Euro area and Japan, also threaten the stability of financial markets.
THE AFTERMATH OF CRISIS
- It has been generally accepted that two important factors in the last crisis are the large size of corporate short-term debts and structural weaknesses of the financial system of these countries. Indeed, observing data from these countries would reveal the fact that in crisis countries have high ratios of corporate debts in foreign currency to reserves held by their central banks. These countries have also high ratios of external debts to their GDPs. Banking system in these countries is weak. The size of non-performing loans is high, compliance to prudential measures is weak and banking supervision is loose and inadequate. In addition, transparency is lacking and governance is also weak. These two major weaknesses were made possible in an environment that has been characterized by an international financial system based on liberalization policy and free movements of capital.
- After the crisis, globalization is here to stay, declared First Deputy Managing Director of IMF Stanley Fischer. This is to say that that, despite some argument claiming that the crisis is partly due to the pursuance of policy for liberalization of the financial sector and full openness of capital account, most countries would be maintaining national policy to facilitate the process of integration to the international financial and monetary system.
- Of course, the crisis has also been serving as a 'wake-up call' for financial authorities to make corrections on some notions or concepts in policy management which were taken for granted prior to the crisis. The basic notions of openness, liberalization and privatization of a market economy in the mold of Washington Consensus were embraced by emerging countries, almost without questions. They were adopted without careful preparation as to their implications or requirements. Indonesia liberalized the capital account fully in the early seventies while the banking sector was liberalized in the late eighties prior to improvement of prudential measures and banking supervision, and without recourse to other improvements in financial infrastructures. The early lesson that people learn from the crisis, or rather the early reaction to the crisis has been the voice of concern about the implication of fast movement of short-term capital in a large volume in world finance. There are switches in policy advice as voiced by Paul Krugman and George Soros as well as actual policy of capital control by Malaysia. In the world forum steps for correcting current policies have been proposed to deal with some adverse effects of the working of global finance based on the Washington consensus. A more systematic approach is pursued through policy discussions in the Bretton Woods Institutions and other multilateral institutions, like the Basle Committee on Banking Supervision (BCBS), the Committee on the Global Financial System (CGFS), International association of Insurance Supervisors (IAS), International Accounting Standard Committee (IASC) and International Organization of Securities Commissions (IOSCO), in designing a new international financial architecture.
- Actually awareness of some issues believed to be a major cause of the crisis had been increasing for some time before, due in part to the socialization of the issues by IMF and other institutions. Discussions about the importance of sound banking system to support monetary policy had been started in the early nineties. However, it was only in the mid-nineties and after that these studies started to get proper hearing from monetary authorities. Indeed, all these studies and their socialization did not do much good in assisting monetary authorities of and market players in the emerging economies to be prepared to dealing with the virulent of the financial crisis. In my own experience of managing Bank Indonesia for several years prior to the crisis, I thought we in Indonesia had been working so hard to strengthen the banking system and to implement prudent monetary and foreign exchange policy such that we thought we were prepared to face external shocks . The shock in the financial market n July 1997 was definitely the work of a contagion that created a financial panic with a devastating effects such that what Indonesia did before the crisis, even if it was in the right direction, was just too little and too late.
@ Visiting Scholar, Harvard Institute for International Development (HIID), Cambridge, MA and former Governor of Bank Indonesia. (firstname.lastname@example.org or email@example.com).
1 These could be read from Communiqué of the Interim Committee, the Declaration of the G7 meeting as well as speeches of many Central Bank Governors and Ministers of Finance in the meetings.
2 Stanley Fischer, The Financial Crisis in Emerging Markets: Some Lessons, paper for the Economic Strategy Institute, April 28, 1999 (mimeo)
3 Paul Krugman, Saving Asia: It's Time to Get Radical, Fortune Investor, October 6, 1998 and George Soros, The Crisis of Global Capitalism, Perseus Books Group, 1998.
4 In 1991 IMF published a report of a study on cases of banking crisis, Banking Crisis: Cases and Issues, edited by Tomas Balino and V. Sundararajan (Washington, DC: IMF), 1991. But other related studies were only publishes much later, like Carl-Johan Lindgren,et al, Bank Soundness and Macroeconomic Policy, (Washington DC:IMF), 1996 and Banking Soundness and Monetary Policy:Issues and Experiences in the Global Economy, Charle Enoch and John Green, Eds. (Washington DC: IMF), 1997.
SOME NOTES ON THE INTERNATIONAL FINANCIAL ARCHITECTURE
- The awareness on the need to strengthen international financial system has been widely shared for some time before the Asian crisis. It started with acknowledgements by pundits and authorities on the close link between the soundness of financial sector and macroeconomic management, which had been manifested in different studies and communiqué or declaration of multilateral gatherings. But, the Asian crisis seems to be the driving force for the world to be more focus on what to do about the crisis. There are reports from studies by different working groups, and a hose of papers discussing the issues or advancing proposals to address the problems. In general the proposals for strengthening the architecture of the international financial system compose of the following areas:
- On transparency, international standards and surveillance
- Strengthening financial systems
- Capital account issues
- Promoting orderly integration of international financial markets, and
- Involving the private sector in the prevention and resolution of financial crisis.
- Let me touch on these issues in sequence based on the Indonesian experience. On the role of internationally accepted standards, the Interim Committee of the Fund reported that progress had been made in formulating codes of good practice for public and private sector entities to be adopted as benchmarks on which countries could be compared. They are comprised of strengthened SDDS, Code of Good Practices on Fiscal Transparency and Transparency on Monetary and Financial Policies and methodology for assessing implementation of the Basle Core Principles. But, these are very closely related to transparency issue itself. 'Transparency in the financial sector is a golden rule' Mr. Camdessus said. I think everyone accepts this. Both efforts of multilateral institutions as well as individual countries to increase transparency have been widely accepted now. This is also closely related to the surveillance issue that IMF is accepted as the institution in charge with. These are, of course, very encouraging. My only note is that we also have to prepare the public on some of the implication of transparency and more disclosures, namely a possibility of increasing market nervousness, especially if the problems of disclosures are not properly treated. The role of rating agencies and financial commentators in influencing public perceptions is very strong. There is no guarantee that they make accurate assessments that could be damaging to an economy, especially at the time when public confidence is fragile. We have been observing that market nervousness could lead to a panicky as a manifestation of 'herd instinct'.
- On issues of strengthening financial sector discussions have been more focused since there seems to be some consensus on how important for any economy to have a robust financial sector in the present wold finance which is liable to crisis. It is generally accepted that crisis cannot be eliminated, so the exercise is to mitigate the adverse effects and to reduce its occurrence, but not to eliminate crisis. We have to admit that the Fund has been instrumental in creating international awareness about the importance of bank soundness in monetary policy and macro-economic management in general. As stated before, beginning with studies on cases of banking crisis in the early nineties, and continued in mid nineties, monetary authorities all over the world were reminded and updated continuously about the issues. The fact that we still have Asian crisis with unsound banking problems at the center of it may only tell us that timeliness is so important. Had these problems were identified sooner and properly addressed, we might not have to experience Asian crises at all, or at least the effect would not be this devastating.
- It had been the Indonesian experience that the unsound banking sector had been constraining the implementation of monetary policies, the working of payment system as well as a strict adherence to prudential measures. It still has to be seen whether a sound banking sector could withstand contagion effects and crises. However, it is almost sure that an economy could withstand currency shock not to become a crisis. It has been well documented that in the past two decades more than two third of IMF member countries, developed as well as developing countries have been experiencing some sort of banking distress or crisis. The Asian crisis has also been dominated by problems of unsound banking sector. These development should be enough to convince monetary authorities and market players all over the world to get really focus in doing everything necessary to have sound banking system as part of economic fundamentals of each national economy.
- The issue of liberalization of capital account has been receiving so much attention, in the beginning on how to speed up the process, culminated in the Interim Committee declaration of 1997 in Hongkong to proceed with the mechanism for IMF member countries. However, the Asian crisis has led people to see that short-term capital flows has been prominent in causing the contagion, and more discussions on whether it should not be reconsidered has been dominating the theme. In the last Interim Committee Communiqué it was phrased in more realistic way, i.e. "The opening of the capital account must be carried out in orderly, gradual and well sequenced manner, keeping its pace in line with the strengthening of countries' ability to sustain its consequences".
- Of course, discussion on the liberalization of capital account is still on, especially since Malaysia introduced capital control towards the end of last year. In the April meeting of the Interim Committee it was stated in the MD Report on the issue that 'a case can be made that controls on capital inflows may be justified on prudential grounds in situations of weak domestic institutional and regulatory environment, and as a means of coping with external market pressures. My only note with this issue is that once a country chooses a path of liberalization, it is almost impossible to reverse. This is true in capital account liberalization, which in the case of Indonesia was done in the seventies. It is also true in the case of banking sector liberalization. In both cases there are requirements to be made, whether in conjunction with or prior to the liberalization. If you did not do that you will be in trouble. But, how would you do to correct, i.e. to retract the sequence when it was already done? Banking sector liberalization as a means to establish a sound banking sector should be done also in orderly manner. It has to be supported with sound financial infrastructure, including strict regulation and supervision plus good governance. But, if you had not been doing all these adequately, you will be in trouble. The problem is how could we correct this problem for those countries facing inorderly sequencing of liberalization in banking as well as in capital account.
- The private sector involvement in resolving and preventing crises is, I think, becoming very important, at least from the perspective of the Asian experience. I think, there has been some kind of consensus that in the most effected countries the private sector external debts have been one of the major problems causing the crisis. However, what has been the private sector's role in each case has not been very clear. Mr. Camdessus in one of his speeches on the subject acknowledged that this is, in fact, one of the most complex issues of the new agenda for international financial architecture. The Indonesian experience shows how difficult is to come up with a workable scheme to solve the private sector debts' problems. In the beginning, partly because of the IMF position on the issues, the government policy was absence except in stating that the government is not going to bail out corporations facing problems of default. Only after a long winding process that some formula of the government involvement in addressing the private sector debts problems in the end resulted. But, the problem is far from being clearly identified, let alone solved. It is been the experience of all crisis countries in Asia that banking restructuring could not be done without corporate debts restructuring, and visa versa. It has also been my observation that, in Korea, Thailand and Indonesia, the dept of the crisis and its turning around seems to depend on how a country effectively addresses corporate debt problem. Both Korea and Thailand dealt with corporate debt problems very early in the crisis, and their rebounding came sooner. While Indonesia has been muddling through in dealing with this problem, and the rebounding may not even starting yet. I think the private sector involvement in resolving current debt problems to finding formula for preventing future crises is very important. The fact that these issues have been recognized is an encouraging development. There is still a long way to go, but a preliminary step has been in the right direction.
- There is one observation that I would like to make here. The argument on moral hazard to explain the large exposures of investors in crisis countries has not been very convincing. If indeed, these investors were pouring money to these countries, assuming that the host countries' governments - and the Fund - would be bailing the debtors out in the event of default, then, if it turned out that there is no bail out, who is to blame? The fact is that their assumption is just not right in the first place. In the case of Indonesia, there has never been any implicit, let alone explicit, guarantee by the government. The reverse expectation is on the deposit guarantee. Some critics argue that the failing of bank closures in Indonesia was because there was no deposit guarantee. I do not buy this argument, since it was the fact that when the16 insolvent banks were closed in November 1997, there was no problem at all with the small depositors, despite the fact that the central bank had to deal with close to one million accounts in more than 400 bank branches all over the country, to repay small depositors who put their money in the closed banks before. The problem, in fact, came from big depositors who responded the bank closures by withdrawing their funds to be moved to other banks believed to be safer (the flight to safety). This was creating many banks experiencing bank runs.
5 Indeed, Indonesia could wither other external shock before, which was the ' tequila effect' in January 1996, as an adverse effect of the Mexican crisis in December 1995. And an internal shock in July of 1996 when Jakarta suffered from riots originated from a political incident when the headquarter of the Indonesian Nationalist Party was ransacked.
6 Communiqué of the Interim Committee of the Board of Governors of the International Monetary Fund, October 4,1998.
7 Report of the Managing Director to the Interim Committee on Progress in Strengthening the Architecture of the International Financial System, (Washington DC: IMF), April 26, 1999 (mimeo)