Fix the Global Financial System

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Within a year of its eruption the Asian currency crisis has spread across to Russia and Latin America, and threatens to drag the world economy into a deflationary recession. This has exposed the fragility of the world financial system and the perils of globalization for small open economies. The crisis-affected economies of Asia have been plunged into a deep recession, with their currencies grossly devalued, many banks and companies made insolvent, high unemployment, high inflation, acute social and political unrest. The "punishment" they suffered has been extreme and totally disproportionate to any crime that Thailand, Indonesia or South Korea may have committed. Their crime was that their private corporations and banks had over-borrowed from willing foreign banks, $80 billion (43% of Thailand's 1996 GDP), $85 billion (36% of Indonesia's 1996 GDP) and $161 billion (35% of South Korea's 1996 GDP).

The present system of floating exchange rates was settled by the U.S. and Europe because they were not able to reach any better solution when the Bretton Woods system of fixed exchange rates broke down in 1973. Since then financial markets have developed rapidly, driven by dramatic advances in information technology. Bankers, fund managers and hedge fund operators have produced a dazzling array of complex financial products. The International Monetary Fund and finance ministers of the Group of Seven advanced industrialized economies encouraged developing countries to liberalize their financial systems, but did not warn them that massive capital flows could be dangerous for those with weak banks, poor supervisory controls and lax corporate governance.

The global financial system has been the subject of intense debate by the international community since the crisis erupted. It will be many years before the U.S., E.U. and Japan can agree on a new architecture--the institutions and standards that regulate international financial movements. In the meantime, if they can reduce the wide fluctuations in exchange rates between the three major currencies--dollar, euro and yen--volatility in the exchange rates of developing countries will also be lessened. Most of them are pegged to one of the major currencies, or linked to a basket in which these currencies form a big part.

There is also a need for an institution like the IMF/World Bank to perform the function of lender of last resort in situations where the systemic risk of contagion is high, so that crisis-struck economies need not go into deep recession when private foreign capital suddenly flows out. With an injection of liquidity, domestic interest rates would not need to rise to unbearable levels, leading to corporate and banking distress.

But emerging countries and their companies are not totally helpless. They can protect themselves against the risks inherent in financial globalization. They need to strengthen their domestic financial systems and be more transparent. Their key economic data should be published and should meet international standards. If international investors know where they stand, there would be less of the "rush to the exit" panic at the first sign of trouble. Countries need international standards and best practices to benchmark themselves against. The IMF, World Bank and key regulatory agencies like the Bank for International Settlements (BIS) based in Basel should establish internationally agreed codes of best practices on monetary, financial and fiscal policy and corporate governance.

The immediate concern of international institutions should be to avoid a calamity similar to that which has befallen Thailand, Indonesia and South Korea. Lenders and investors follow each other and from time to time act irrationally as a herd. They cause asset "bubbles" when they move in massively and asset price destruction when they exit in panic. Developing countries will have to weigh the cost-benefit of full or partial participation in the globalized economy.

To shield themselves temporarily from the volatility in financial markets, those with weaker financial structures may need some form of capital controls, preferably market-based. China and India, two countries with such controls, have escaped the worst effects of the crisis. The cost will be lower foreign capital inflow and slower growth, but greater stability should result.

The G7 countries should take the lead in upholding standards. Best practices begin at home. They need to hold their own domestic institutions to high standards--including their investment banks and hedge funds. This crisis has shown that G7 countries are not immune to financial contagion. When Russia defaulted on its domestic debt, there was a world-wide "flight to quality" by investors, leading to a collapse in prices of all risky assets and a drying-up of liquidity in lower grade bond markets, including those in the U.S.

The challenge to the IMF/World Bank, BIS and G7 finance ministers is to structure a system such that the more fully a country participates in the global financial system, the more benefits it derives.