FIXING GLOBAL FINANCE 1. Hopes Unfulfilled: capital flows and the emerging market crises Martin Wolf, Associate Editor

1. FIXING GLOBAL FINANCE1. Hopes Unfulfilled: capital flows and the emerging market crisesMartin Wolf, Associate Editor & Chief Economics Commentator, Financial Times The Bernard Schwartz Forum on Constructive Capitalism March 28th 2006

2. 2 Prologue: outline of the lectures �Global capital markets pose the same kinds of problems that jet planes do. They are faster, more comfortable, and they get you where you are going better. But the crashes are much more spectacular.� Larry Summers.

3. 3 Prologue: outline of the lectures Finance is the heart of capitalism: When it works, the financial system provides a uniquely effective mechanism for shifting resources from those who own them, but cannot use them, to those who can use them, but do not own them. But when it fails, the financial system generates huge losses and crises, whose costs endure for years. Purely domestic crises also occur. But nowadays these are relatively easily managed.

4. 4 Prologue: outline of the lectures Crises that involve foreigners tend to be both far more costly and more difficult to manage: They usually generate exchange-rate crises, which exacerbate domestic insolvency; And they make it impossible for the domestic authorities to act as guarantors of last resort. The failure to make the global finance system work tolerably has had large adverse consequences for individual countries and even groups of countries. It has also had adverse consequences for the world as a whole: It has created global economic shocks; It has re-awakened export-oriented mercantilism; and has undermined the legitimacy of globalisation.

5. 5 Prologue: outline of the lectures The failures of the financial system have been the biggest economic failure of globalisation. Happily, since the emerging market financial crises of 1997-98, the world has not witnessed another global financial crisis. This may suggest that stability has at last been attained. But that would be premature. Stability is rather the consequence of the new pattern of global capital flows: capital flows �upstream� � from the rest of the world to highly creditworthy high-income countries and, above all, the US.

6. 6 Prologue: outline of the lectures Meanwhile, emerging market economies �smoke, but do not inhale� in global capital markets. This pattern is not only undesirable but almost certainly unsustainable: It is undesirable, because one of the most important functions of capital markets � providing a net flow of resources to poor countries � has failed to take off. It is unsustainable, because the growth in US external liabilities cannot continue at current rates.

7. 7 Prologue: outline of the lectures We must ask ourselves two questions: What has gone wrong? What do we need to do to put it right? What has gone wrong? Here are seven failures: to understand the implications of financial liberalisation; to understand the risks of international financial integration; to accept fiscal discipline; to understand the risks of currency pegs to understand what it means to live in a multi-currency world; to abandon an outmoded mercantilism; and to modernise global institutions.

8. 8 Prologue: outline of the lectures What must be reformed? Here are four main areas for reform: The macroeconomic regime: exchange rates; monetary policy; and Fiscal management. The financial sector; Excessive reliance on exports; and The global institutions.

9. 9 Hopes unfulfilled: introduction �The free market system has failed and failed disastrously.� Mahathir Mohamad, Financial Times, 4th September 1998.

10. 10 Hopes unfulfilled: introduction �The people who benefit from roiling the world currency markets are speculators, and as far as I�m concerned, they provide not much useful value.� Paul O�Neill, Financial Times, 6th May 2002.

11. 11 Hopes unfulfilled: introduction The last 25 years has been an age of globalisation, similar, in many ways, to that before the first world war. It has also been similar to that era in the frequency of financial crises. What has happened and why?

12. 12 Hopes unfulfilled: outline Role of finance. The frequency of financial crises Anatomy of financial crises. Why financial crises happened. The legacy of the crises: a burned child fears the fire.

13. 13 2. The role of finance �The evidence that financial development and economic growth are linked is quite strong.� (Frederic Mishkin, 2005): King and Levine (1993) showed that the greater the financial development in 1960, the larger the economic growth over the subsequent 30 years; Levine, Loayza and Beck (2000) showed that a doubling of the size of private credit in an average developing country is associated with a two percentage point annual increase in the rate of economic growth; Frederic Mishkin, �Is Financial Globalization Beneficial?�, National Bureau of Economic Research Working Paper 11891, December 2005. Robert King and Ross Levine, �Finance and Growth: Schumpeter Might be Right�, Quarterly Journal of Economics, Vol.8, 1993, pp.717-737. Ross Levine, Norman Loayza and Thorsten Beck, �Financial Intermediation and Growth: Causality and Causes�, Journal of Monetary Economics, vol.46, August 2000, pp.31-77.Frederic Mishkin, �Is Financial Globalization Beneficial?�, National Bureau of Economic Research Working Paper 11891, December 2005. Robert King and Ross Levine, �Finance and Growth: Schumpeter Might be Right�, Quarterly Journal of Economics, Vol.8, 1993, pp.717-737. Ross Levine, Norman Loayza and Thorsten Beck, �Financial Intermediation and Growth: Causality and Causes�, Journal of Monetary Economics, vol.46, August 2000, pp.31-77.

14. 14 2. The role of finance Rajan and Zingales (1998) showed that industries and companies dependent on outside finance grow faster in countries with more developed financial systems; and Levine (2004) showed that financial development works by generating higher total factor productivity rather than higher investment In short, as World Bank (2001) notes �there is now a solid body of research strongly suggesting that improvements in financial arrangements precede and contribute to economic performance�. Raghuram Rajan and Luigi Zingales, �Financial Dependence and Growth�, American Economic Review, Vol. 88, June 1998, pp.559-586. Ross Levine, �Finance and Growth�, National Bureau of Economic Research Working Paper 10779, September 2004. World Bank, Finance for Growth: Policy Choices in a Volatile World (Washington D.C.: World Bank and Oxford University Press, 2001) p.5.Raghuram Rajan and Luigi Zingales, �Financial Dependence and Growth�, American Economic Review, Vol. 88, June 1998, pp.559-586. Ross Levine, �Finance and Growth�, National Bureau of Economic Research Working Paper 10779, September 2004. World Bank, Finance for Growth: Policy Choices in a Volatile World (Washington D.C.: World Bank and Oxford University Press, 2001) p.5.

15. 15 2. The role of finance In addition, Mishkin (2005), Rajan and Zingales (2003) and others argue persuasively that globalisation can spur financial development: Greater openness to trade generates a larger financial sector; It does so by increasing competition, which forces companies to seek outside finance; This will encourage non-financial companies to lobby for a more efficient and competitive financial sector; Globalisation also creates pressure for institutional reforms that promote financial development, such as improved accountancy, property rights, bankruptcy procedings; Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (New York: Crown Business, 2002)Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (New York: Crown Business, 2002)

16. 16 2. The role of finance Foreign competition forces domestic financial enterprises to improve their terms, if they are not to lose customers; Foreign ownership of financial institutions will improve the efficiency and services offered by the financial system, by increasing competition and offering global best practice; and Foreign involvement increases the liquidity of the financial system.

17. 17 3. Failings of finance So, with all these advantages, what is the problem with financial liberalisation? There are well-known difficulties inherent in even the best financial system, since it involves nothing more than trades in promises. Trust is always in short supply and knowledge always limited in the financial system. Gerard Caprio and Daniela Klingebiel, �Episodes of Systemic and Borderline Financial Crises�, World Bank, January 2003, www.worldbank.org.Gerard Caprio and Daniela Klingebiel, �Episodes of Systemic and Borderline Financial Crises�, World Bank, January 2003, www.worldbank.org.

18. 18 3. Failings of finance Inherent difficulties in financial markets are: Asymmetric information (which may mean some markets will never appear) Adverse selection (which means that providers may impose quantitative limits on their clients, especially in crises) Because of the inherent uncertainties, big mood swings occur in markets and sometimes panics: When participants know that they do not know what is going on, they may follow a few leaders and so show herding behaviour. They are more likely to behave in this way, the more unfamiliar are the markets in which they are engaged. Gerard Caprio and Daniela Klingebiel, �Episodes of Systemic and Borderline Financial Crises�, World Bank, January 2003, www.worldbank.org.Gerard Caprio and Daniela Klingebiel, �Episodes of Systemic and Borderline Financial Crises�, World Bank, January 2003, www.worldbank.org.

19. 19 3. Failings of finance To these inherent dangers must be added those that are prevalent in liberalising emerging market economies: Simple ignorance of the consequences of liberalisation; Corrupt insider relations between politicians and banks and between owners of banks and of non-financial businesses; Non-economic obligations imposed on banks; Poor regulation; Poor legal systems and inadequate property rights

20. 20 3. Failings of finance In addition, emerging market financial system are vulnerable to three (linked) macro-economic dangers: Fiscal indiscipline, with risks of large-scale monetary expansion; Or, partly as a result of a history of indiscipline, excessive reliance on borrowing denominated in foreign currency; And exchange-rate pegging, which gives an illusion of safety to foreign currency borrowing (and lending). The combination will inject additional fragility into any financial system.

21. 21 4. Anatomy of financial crises Financial crises have come thick and fast. The World Bank (2001) estimated that there were 112 systemic banking crises in ninety-three countries between the late 1970s and the end of the twentieth century. Eichengreen and Bordo (2002) counted ninety-five crises in emerging market economies and another forty-four in high-income countries between 1983 and 1997: World Bank, Finance for Growth: Policy Choices in a Volatile World (Washington D.C: World Bank, 2001) p.75. Barry Eichengreen,and Michael D. Bordo, �Crises Now and Then: What Lessons from the Last Era of Financial Globalization�, National Bureau of Economic Research Working Paper 8716, www.nber.org, January 2002. World Bank, Finance for Growth: Policy Choices in a Volatile World (Washington D.C: World Bank, 2001) p.75. Barry Eichengreen,and Michael D. Bordo, �Crises Now and Then: What Lessons from the Last Era of Financial Globalization�, National Bureau of Economic Research Working Paper 8716, www.nber.org, January 2002.

22. 22 4. Anatomy of financial crises Seventeen of the crises in emerging market economies were banking crises, fifty-seven were currency crises and twenty-one were �twin crises�, the most damaging of all. Nine of the crises in high-income countries were banking crises, twenty-nine were currency crises and six were twin crises. Altogether, there were twenty-six banking crises, eighty-six currency crises and twenty-seven twin crises.

23. 23 4. Anatomy of financial crises The twin crises are more significant and more interesting. These represent the interaction of the microeconomics of finance with the macroeconomics of exchange-rate regimes and monetary and fiscal policies.

24. 24 4. Anatomy of financial crises These crises can be very costly: According to Caprio and Klingebiel (2003), there have been 27 crises over the last quarter century with fiscal costs exceeding 10 per cent of gross domestic product and many more with costs of between 1 and 10 per cent of GDP These crises have afflicted high-income countries and emerging market economies. But the biggest have been in emerging market economies.

25. 25 4. Anatomy of financial crises The fiscal costs of some crises have exceeded 50 per cent of GDP. Most of the big crises have been twin crises (banking and exchange rate), but not all. The biggest crises have been in emerging market countries. But high-income countries have been affected, too. The fiscal costs of some crises have exceeded 50 per cent of GDP. Most of the big crises have been twin crises (banking and exchange rate), but not all. The biggest crises have been in emerging market countries. But high-income countries have been affected, too.

26. 26 4. Anatomy of financial crises

27. 27 4. Failings of finance What is the route to crisis? According to Mishkin (2005), there have been two fundamental errors explaining the emerging market financial crises: Mismanaged liberalisation and globalisation; and/or Fiscal imbalances. The road to the twin crises: Stage 1: liberalisation and/or fiscal imbalances; Stage 2: run-up to currency crisis; Stage 3: currency crisis; and Stage 4: currency crisis causes financial crisis.

28. 28 4. Failings of finance Stage 1 - liberalisation and/or fiscal imbalances: Excessive risk-taking by inexperienced (or corrupt) banks; Poor (or corrupt) regulation; Rapid growth of credit; Moral hazard from absolute government guaranties; Losses mount and banks cut back on lending; Banks fail and contagion affects even healthy banks; Further contraction of bank lending;

29. 29 4. Failings of finance Regulators are overwhelmed; Regulatory forbearance also means even more risk-taking; and, above all, Foreign lending adds fuel to the flames; In the case of Korea, the chaebol�s were no longer making money by the 1990s. The chaebol and the banks they influenced started to borrow directly and indirectly abroad, because they were guaranteed by the government. In addition, fiscal imbalances cause crises, particularly in banks: Argentina 2001-2002; Russia 1998; Turkey in 2001.

30. 30 4. Failings of finance Stage 2 - run up to currency crisis: Higher interest rates abroad undermine credit quality; A decline in cash flow and greater need to borrow when it has become more expensive; Failure of companies or political turmoil leads to panic; Declining asset prices undermines solvency even of good risks, particularly in the property sector (used as collateral); People �go for broke� as moral hazard factors become dominant: Mexico, Thailand, South Korea and Argentina all suffered from this.

31. 31 4. Failings of finance Stage 3 - currency crisis: Residents and foreign speculators start to sell the currency and lenders pull out short-term money � a �sudden stop�; This puts governments in a bind: if they raise interest rates, to support the currency, they undermine corporate solvency and worsen the crisis; if they do not raise interest rates then the currency collapses, wiping out companies (including banks) with large net liabilities in foreign currency; This gives speculators a �sure thing�; Large fiscal deficits also undermine banks, as default comes closer, and cause speculators to run for the exit; and

32. 32 4. Failings of finance Stage 4 � currency crisis triggers financial crisis: In countries with histories of inflation and default, loans tend to be short-term and denominated in foreign currency; Companies producing non-tradeables with foreign currency debt are wiped out; This undermines other creditworthy companies and banks; The crisis causes multiple bankruptcies in countries that also have inadequate bankruptcy procedures; Domestic credit seizes up; Inflation surges, as the currency falls, and there is a deep recession; Contagion spreads to other similarly-placed borrowing countries

33. 33 5. The systemic financial crises For the purposes of our story, however there have been a limited number of events with significant legacies: The Latin American debt crisis of the 1980s; The tequila crisis, which began in Mexico in 1994-95; The Asian financial crisis of 1997-98, which spread to Brazil and Russia in 1998 and 1999; and The Argentine crisis of 2001-02. Of these the most important was the Asian financial crisis, because it was so surprising and because of its wider influence in the region.

34. 34 5. The systemic financial crises The swings in current account deficits over time have been huge. There have been two big periods of deficits: the early 1980s and mid-1990s. Since 1997, there have been growing surpluses. The surpluses have been pervasive over that period. The swings in current account deficits over time have been huge. There have been two big periods of deficits: the early 1980s and mid-1990s. Since 1997, there have been growing surpluses. The surpluses have been pervasive over that period.

35. 35 5. The systemic financial crises The huge swings in current account deficits as a share of GDP. The Latin American adjustment after the 1982 debt crisis. The Asian adjustment after the 1997-98 crisis. The Latin American adjustment after the 1997-98 crisis.The huge swings in current account deficits as a share of GDP. The Latin American adjustment after the 1982 debt crisis. The Asian adjustment after the 1997-98 crisis. The Latin American adjustment after the 1997-98 crisis.

36. 36 5. The systemic financial crises Private sector finance has been extraordinarily unstable. Latin America and Asia have been the most affected regions.Private sector finance has been extraordinarily unstable. Latin America and Asia have been the most affected regions.

37. 37 5. The systemic financial crises For most of the time, the emerging countries have been quite conservative. They have accumulated reserves, even when they received large inflows. But since 1997, conservatism has turned into ultra-caution, as private capital has continued to flood in. The official sector has been a net recipient of funds in recent years. Domestic residents are net exporters of capital, particularly at times of crisis in the early 1980s and again in the 1990s.For most of the time, the emerging countries have been quite conservative. They have accumulated reserves, even when they received large inflows. But since 1997, conservatism has turned into ultra-caution, as private capital has continued to flood in. The official sector has been a net recipient of funds in recent years. Domestic residents are net exporters of capital, particularly at times of crisis in the early 1980s and again in the 1990s.

38. 38 5. The systemic financial crises Direct investment has been quite stable and growing. Portfolio investment has been reasonably stable. Commercial bank lending has been extremely unstable: it is the proximate cause of crisesDirect investment has been quite stable and growing. Portfolio investment has been reasonably stable. Commercial bank lending has been extremely unstable: it is the proximate cause of crises

39. 39 5. The systemic financial crises Market estimations of risk are hugely unstable and likely to create self-fulfilling panics. There was a big spike in credit spreads in the 1997-98 period an d again, for Brazil, in 2002. Spreads today are very low indeed, as they were in early 1997. Is this the precursor of another crisis? Probably not.Market estimations of risk are hugely unstable and likely to create self-fulfilling panics. There was a big spike in credit spreads in the 1997-98 period an d again, for Brazil, in 2002. Spreads today are very low indeed, as they were in early 1997. Is this the precursor of another crisis? Probably not.

40. 40 5. The systemic financial crises Latin American crises normally begin with resident capital outflow. Foreign private flows have been quite unstable. Reserve accumulations have become sizeable in recent years.Latin American crises normally begin with resident capital outflow. Foreign private flows have been quite unstable. Reserve accumulations have become sizeable in recent years.

41. 41 5. The systemic financial crises Direct investment has become big and quite stable. Portfolio investment is more unstrable. Commercial bank lending is dramatically unstable.Direct investment has become big and quite stable. Portfolio investment is more unstrable. Commercial bank lending is dramatically unstable.

42. 42 5. The systemic financial crises When crises hit, exchange rates collapse b y 50-80 per cent. This causes massive solvency problems in countries where much debt is denominated in foreign currency. When crises hit, exchange rates collapse b y 50-80 per cent. This causes massive solvency problems in countries where much debt is denominated in foreign currency.

43. 43 5. The systemic financial crises Crises normally cause big losses in GDP. This is partly because of mass bankruptcy. It is also because of higher interest rates Russia was an exception. But in these cases, GDP has fallen by up to 10 per cent in a single year after the crisis. It takes several years to recover. This was particularly true in the 1980s.Crises normally cause big losses in GDP. This is partly because of mass bankruptcy. It is also because of higher interest rates Russia was an exception. But in these cases, GDP has fallen by up to 10 per cent in a single year after the crisis. It takes several years to recover. This was particularly true in the 1980s.

44. 44 5. The systemic financial crises Capital flight was a marked feature of the Asian financial crises. So was continued reserve accumulation. Private inflows collapsed in 1997 and 1998. Since then they have recovered. But the Asian countries are recycling the inflow.Capital flight was a marked feature of the Asian financial crises. So was continued reserve accumulation. Private inflows collapsed in 1997 and 1998. Since then they have recovered. But the Asian countries are recycling the inflow.

45. 45 5. The systemic financial crises Direct investment has been very stable. Portfolio investment has been less stable Commercial bank capital flight was the trigger for the 1997-98 crisis.Direct investment has been very stable. Portfolio investment has been less stable Commercial bank capital flight was the trigger for the 1997-98 crisis.

46. 46 5. The systemic financial crises Barry Eichengreen, Capital Flows and Crises (Cambridge, Mass and London, England: MIT Press, 2004) p.264. The dependence of Asian emerging economies on short-term foreign currency borrowing became very large in the 1990s. Barry Eichengreen, Capital Flows and Crises (Cambridge, Mass and London, England: MIT Press, 2004) p.264. The dependence of Asian emerging economies on short-term foreign currency borrowing became very large in the 1990s.

47. 47 5. The systemic financial crises The exchange rate falls in Asia were also very large, particularly in Indonesia (where politics kicked in) This generated huge losses in the banking systems.The exchange rate falls in Asia were also very large, particularly in Indonesia (where politics kicked in) This generated huge losses in the banking systems.

48. 48 5. The systemic financial crises Barry Eichengreen, Capital Flows and Crises (Cambridge, Mass and London, England: MIT Press, 2004) p.264. In some cases foreign currency liabilities of the banking system were very large, as well. This generated huge losses when the currency collapsed.Barry Eichengreen, Capital Flows and Crises (Cambridge, Mass and London, England: MIT Press, 2004) p.264. In some cases foreign currency liabilities of the banking system were very large, as well. This generated huge losses when the currency collapsed.

49. 49 5. The systemic financial crises The crises were devastating, particularly for Indonesia. But there were also some rapid recoveries, particularly in South Korea.The crises were devastating, particularly for Indonesia. But there were also some rapid recoveries, particularly in South Korea.

50. 50 4. Anatomy of financial crises 1. The crisis-hit countries had very large fiscal losses. This was particularly true of Indonesia, Argentina and Chile in the early 1980s, Thailand after 1997 and Turkey after 2000.1. The crisis-hit countries had very large fiscal losses. This was particularly true of Indonesia, Argentina and Chile in the early 1980s, Thailand after 1997 and Turkey after 2000.

51. 51 6. The legacy of the crises These crises have had some beneficial and some malign long-term consequences The beneficial consequences have been better understanding of risks by all participants, stronger financial systems and better regulation This has occurred within the emerging market economies; Inside the global financial system; And in the international financial institutions

52. 52 6. A burned child fears the fire The malign consequences of the crises has been a widespread fear of deficits: Capital markets want to place capital in the emerging market economies, but governments are recycling them in the form of foreign currency reserves. As the emerging market economies have moved into surplus in the basic balance of payments (current account, plus private capital), global macroeconomic balance has been secured by a shift into deficit in high-income countries, above all the US. How this has happened and the implications for today�s world are the subject of the second lecture.