SUNS  4304 Monday 19 October 1998


FINANCE: SYSTEMIC CRISIS NEEDS BOLD REFORMS

Geneva, 16 Oct (Chakravarthi Raghavan) -- The current financial turmoil afflicting the world economy is a systemic one, and needs bold and far-reaching reforms to the system, both to prevent a crisis and to enable countries to better manage the crisis if it occurs.

This was a general consensus view that emerged from the discussion Tuesday at an informal meeting of the UNCTAD Trade and Development, Board on the causes, management and prevention of financial crisis.

Chaired by Uruguayan Ambassador, Mr. Carlos Perez Del Castillo, the informal session had the participation of four invited experts: Mr. Will Hutton (Editor of the London Observer), Mr. Martin Meyer (of the Brookings Institution and author of several books on financial subjects including banking and Wall street), Mr. Yung Chul Park (President of the Korean Institute of Finance) and Dr. Stephany Griffith-Jones (at the Institute of Development Studies, Sussex).

While the discussions, when envisaged and scheduled, were on the basis of the Asian crisis, and its subsequent spread to Russia and Latin America, the Board session and the informals have been
"enriched" by the "insights" into the world of financial capital that have come out of the sidelines of the recent Fund-Bank meetings, the effects of the crisis on the industrialized markets, the slowing-down, if not imminent world wide recession or depression, and the spectacular US Federal Reserve orchestrated rescue of the Long-Term Capital Management (LTCM) Fund, with connections of its partners and managers with Wall Street and Washington establishments.

The issue of the Impact of the Financial Crisis on Trade, Investment and Development will be the subject of the High-Level segment of the Board on October 22, to be chaired by the Thai Deputy Prime Minister, Supachai Panitchpakdi.

Perez Del Castillo, who as a vice-President of the Board, chaired the informals, summed up the discussions at the end and presented a summary on his own authority at the Board plenary next day. The summary was in Spanish, and no text was immediately available.

While recognising that there were some deficiencies and problems, particular and specific in each of the countries affected, the experts made short shrift of the attempts to blame the crisis as due to some peculiar problems in these countries, and said among the causes of the crisis were failures of the markets, the unbridled speculative activities and high leveraged operations on the financial markets, and systemic failures.

In his summary, the Uruguayan Ambassador said that there was general agreement that the current financial turmoil affecting the world economy is systemic in nature and that the countries most
directly affected could not effectively deal with the problem in isolation.

Any effective response would need to involve measures aimed at addressing both the internal and external factors, and these were complementary, and not separate from one another.

It was neither feasible nor desirable to provide a single recipe.

What is needed rather, are a set of domestic policies, tailored to specific circumstances which could quickly re-establish stability and revive economic growth, thereby helping to restore confidence
and ensure an orderly return to financial markets. Such an orderly return, at the minimum, implies better supervision and management of speculative capital flows. And how to better manage capital
flows is an element falling under the rubric of a new financial architecture.

Discussions at the informal on this last, Perez del Castillo said, ranged from specific measures to fill the missing gaps in the existing financial framework to the creation of a fully fledged World Financial authority to supersede existing arrangements.

Perez del Castillo said a general view was that a true global lender-of-last resort, although desirable in principle, was difficult to achieve in practice and, in the present climate, unrealistic. Regional mechanisms might accordingly provide a more useful point from which reform of the financial system might begin. And while prevention was ultimately the aim of reform efforts, in the current circumstances, immediate measures need to be put in place to help countries to manage better a financial crisis, if it arises.

Although controversial, there was a degree of willingness to explore the ideas of debt standstill mechanism and capital controls (proposals advanced in the UNCTAD Trade and Development Report), the chairman's summing up said, adding, an open and constructive discussion of the costs and benefits, and the practicalities of these measures, could make an important contribution to the policy debate.

Panellists and other participants, Perez del Castillo said, agreed on the value of greater transparency, as well as the need to avoid at all costs a protectionist response to the current crisis.

In some comments from the floor to the presentations of the panellists, the US, the EC and some of its members (notably France and Germany) suggested that the discussions should focus on NCTAD's remit of development, and not the new financial architecture (in the jealously guarded domain of the Washington IFIs).

But panellist Will Hutton dismissed this, pointing out that it was impossible to separate the issues relating to development from the issues of money and finance and new architecture.

The chairman's summing up said that it was recognized that UNCTAD has an important and potentially very constructive role to play in the discussion of international financial and monetary issues. Its focus on inter-dependence provides UNCTAD not only with a distinct perspective of financial crises, but is particularly suited to incorporating the development dimension missing from more conventional approaches. UNCTAD's track record in analysing the costs and benefits of financial flows provide the basis for a wider dissemination of the proposals on crisis management and prevention techniques in its TDR. But further research and analysis may be desirable in areas where the report has put some tentative proposals.

UNCTAD could also play a valuable role in the larger issue of designing a new financial architecture and, in particular, on matters related to debt.

During the presentations and discussions, Ms. Griffith-Jones said while developing countries opening up to FDI has benefits, short-term capital flows were highly volatile, and there were
doubts whether they were beneficial. The Indonesian experience showed that these capital flows led to instability and increased poverty. The crisis which began in Asia has now extended to the
rest of the developing world. And while there may be domestic causes, an important cause was the imperfections in capital markets.

Martin Meyer, while not being sure whether it was wise to hold such discussions when there was a state of near panic, and there was a general feeling among the public that no one was in charge. The current crisis was the worst since world war two. There was a definite dissonance in the views and comments of the same people. The public get the feeling that the CEOs of companies, heads of central banks and managers of hedge funds and international organizations did not seem to know what they were doing.

A background paper (a public policy brief, prepared by Mr. Meyer for the Jerome Levy Institute), provides a stinging commentary on the mathematical formula used to value risks, the manner in which banks are supposed to know what they are doing and hence little oversight in their use of derivatives and risk management and risk reserves, and central banks, given the profitability of the system and the franchise value of their banks, look askance at any proposals that might diminish this profitability.

[This assessment of Meyer explains why the US Treasury, the Federal Reserve and Central banks of Europe, frown heavily on any talk of regulating hedge funds, derivative instruments and other
instruments used by banks to make profits - given that due to the deregulation and competition banks no longer make profits from mediating transactions that were once the mainstay of banking -
with interests on bank deposits regulated, and profits coming from loans and assessment of borrowers credit worthiness and servicing of the loans. But recent remarks of the US Federal Reserve Chairman -- after the debacle of the Long-Term Capital Management Fund, and his thoughts of risks to the financial system -- suggests he may be having second thoughts and is beginning to be worried about risks of any major bank failure or run on a major bank, now that banks are deeply involved in various activities including lending to traders and trading on their own accounts and use of derivatives, revealed by the involvement of various major banks and wall street
investment houses as lenders and investors in the LTCM.]

[Other unconfirmed, and unconformable, market reports suggest that it has not only been the Italian Central Bank that was involved in "investing" in the LTCM to make its reserves work, but perhaps over a score of central banks - a case of regulators turning a blind eye to risks in the chase for greedy profits through speculation. And the reason why the lending banks never press hedge funds for full information on their operations and exposures is because the banks know that the funds make money through very closely guarded operations whose details are not known to others, and once it becomes known, others would follow and the profit margins would be shaved, drastically.]

Meyer points out that the system of risk evaluation is mathematically quite abstruse - hence the decision of the Basle Committee to permit banks to value their own derivative positions and examiners believing the banks know what they are doing, when in fact the banks are not well-informed.

Park challenged some of the views (after the crisis) about the Korean operations, the leveraged investments of the Korean banks and chaebals. Some of the recent disclosures showed that it was not emerging markets alone that seemed to have banking problems, but that there were serious banking problems in every country. Even problems about the herding of investors were known much before.

In some personal comments, UNCTAD Secretary-General Rubens Ricupero noted that in the 60s and 70s the discussions were all about the relative weight of external economic environment and national policies. In the late 80s and 90s, until the current crisis, the emphasis was all on national policies, and liberalization of financial markets and capital was advocated. But the current crisis
showed that countries like India and China, which were relatively less integrated into the global economy in terms of trade and finance had suffered less.

Now the IMF, in wanting changes to the Articles on capital convertibility, was saying that they did not want "irresponsible" liberalization of capital markets, but orderly, well-managed, well-sequenced and prudential liberalization. But what exactly these terms or adjectives about the objective of capital convertibility mean? What could be concrete content of these terms, which otherwise would be purely subjective.

Meyer agreed that these terms were very subjective and said that the distinctions between capital account and current account itself were no longer useful when they were talking of a situation
involving inter-changeability of various grades of paper.

In the discussions about the new financial architecture, Park drew on the Korean experience to conclude that there was an urgent need to reform the international financial architecture to ensure better management of global capital flows.

Other panellists generally seemed to agree with this, though their individual comments were nuanced.

In terms of management of a crisis, Park distinguished two aspects of IMF-promoted policy response.

On the one hand tighter macro-economic policies - in particular higher interest rates, aimed at stabilising the exchange rate and regaining the confidence of markets were advocated. On the other hand, structural reforms aimed at improving the efficiency of the financial institutions, strengthening corporate governance and increasing labour market flexibility were also pursued.

Focusing on structural reforms, Park underlined the serious problems in moving such proposals from the drawing board (of the IMF) to practice in the countries. Not only was it difficult to
reform labour markets in a democratic society, but rapid restructuring of the financial sector in the context of very high debt/equity ratios was certain to greatly increase business failures and lead to a more generalised credit crunch. The pursuit of structural reforms following the financial crisis in Korea, Park said, had helped to send the Korean economy further into recession.

An immediate response to the crisis should be a better sequencing of structural reforms to be pursued by restructuring of corporations before attempting to reform the banking sector.

But the issue was not merely one of sequencing. The belief among policy makers that a commitment to an IMF package would quickly restore market confidence had proved to be not well founded. Indeed in the case of Korea the opposite effect was recorded, with continued capital flight after the announcement of an IMF package. Oftentimes, he added the IMF statements about the health of the economy had not helped improve the standing of Korea on international capital markets. A degree of calm was restored only after agreement had been reached directly with international banks on debt repayment.

This perverse signalling effect of IMF packages pointed to coordination problems between the IMF and the international banking community as well as a lack of IMF expertise on these matters.
There was also a collective action problem associated with financial flows. Even when some market actors could see recovery and progress in a country, they would be unlikely to reenter a market if they could not be sure others would follow. In the absence of the first movers, pessimistic sentiments would prevail.

To date the IMF has failed to solve this problem. Park suggested that attention should now focus on prevention of crisis and four areas should be addressed:

There was need for better surveillance and improved bank supervision. This required common rules and standards, and raising questions about who would police such standards.
There was also need for greater transparency through better  provision of information. However, he warned against the idea of some optimal amount of information required to prevent financial crisis. He did not believe the lack of transparency had been a central issue in the Korean crisis.
Short-term capital flows need to be controlled and regulated. While controls were only one component of a more comprehensive regulatory framework, attention should move beyond the question of their desirability to more practical questions of their effectiveness and implementation.

Park did not consider it realistic, however desirable, to have a far-reaching reform of the IMF to make it a true lender of last resort. But more effective regional arrangements could be considered. To date the IMF had underpinned stability in emerging markets on behalf of the G-7. Regional financial arrangements could not only help correct this political imbalance, but could also improve the design of policies by providing better information flows, and reduce some of the onerous financial burdens of crisis management which is currently carried by the IMF.

Will Hutton said that the breadth and depth of the crisis showed that a bold response to reform was now desirable. Although such reforms would be politically challenging, the question of feasibility should not be allowed to preempt the reform process. What was or was not acceptable would only emerge as the reform process advanced.

Hutton also agreed with Park that the question of transparency was of secondary importance in the design of a new architecture. He advocated a move to establish a World Financial Authority which
would be charged with regulation of all cross-border flows.

To be effective, such an institution should not be an appendage of the IMF, rather it should be linked to key currencies and with lender of last resort capacity. Hutton suggested in this connection
that the introduction of the Euro from next year would radically alter the financial architecture by providing a countervailing currency to the US dollar. European monetary policy would thus be
key over the coming months. In this regard it was essential that the European Central Bank should adopt a broad approach to economic management among member countries of the EMU as well as taking into account developments in the world economy.

The move from the current floating exchange regime would mean that the World Financial Authority would have to have the authority to survey and police the policies that are consistent with managed
exchange rates.

This would require a reversal of moves towards capital account liberalization. Also, debt relief and issues related to trade should be brought into any new architecture in a more consistent manner.

Meyer suggested that in the past the role of the IMF had been to establish legitimacy for its stabilization programmes and to provide leadership and authority in a loosely integrated international financial system. However, that role had been overtaken by the pace of financial integration. The volume of flows was not too big to allow the IMF to play a lender of last resort
role. Even more, the idea that there was a common monetary policy applicable to all countries was clearly false.

In response to a financial crises, standstill agreement had to be found whereby an effective mixture of cooperation and supervision could calm markets and stem the flight of investors to the exit. No
doubt pursuing such arrangements would raise difficult practical issues given the different legal and cultural practices across countries.

In redesigning a financial architecture, Meyer felt that full consideration would have to be given to the diversity of short-term capital flows. Not all of them had a disruptive influence on the real economy. For e.g. trade credits played a very prominent role in facilitating world trade. These raised difficult questions concerning the regulation of short-term capital as well as the capabilities and competence of the regulators.

Initial reform measures, Meyer said, might best focus on introducing more stringent requirements on derivatives trading and inter-bank lending. Raising the cost to investors of entering markets, in his view, was the best way of dissuading the more disruptive players.

Ms Stephanie Griffith-Jones said that a system of global governance was now required to ensure a more efficient financial system. There was broad agreement on the main components of this system -- global regulation of capital flows, a lender of last restor facility and orderly debt work-outs. Griffith-Jones favoured an evolutionary approach to reforming the financial system. A sequential approach
should begin by filling regulatory gaps on such matters as hedge funds, mutual funds and inter-bank lending.

Once this was achieved, moves towards a World Financial Authority integrating regulations across all financial markets and with lender of last resort facilities could be considered. Such an
authority, in her view, would be better placed to act before crises developed,  rather than simply reacting to problems which had already become quite acute as was presently the case with the IMF.

However, the scale of the problems should not be under-estimated. In this respect, orderly debt workouts provided a realistic option which carried a less onerous financial burdens.

Such workouts need not be carried out within the IMF. The key issue would be burden sharing when faced with a massive debt overhang but procedures at the national level could be carried into the international level.