FROM THE OFFICE OF PUBLIC AFFAIRS
September 22, 1999LS-111
TREASURY SECRETARY LAWRENCE H. SUMMERS
REMARKS AT YALE UNIVERSITY
NEW HAVEN, CT
A year ago the world was facing what was generally declared to be the most serious situation in global financial markets in fifty years. Now, as policy makers come together once again for the Annual Meetings of the World Bank and International Monetary Fund (IMF) in Washington, important challenges remain. But it is fair to say that we have pulled back from the abyss.
Rather than focus on current developments, today I would like to step back to consider the kind of global financial system we would like to see in the future, and what the past few years have taught us about how to get there.
- A Global Capital Market for the 21st Century
There may be no higher priority today than to build a global economy that can be truly global: that can make possible the safe and sustainable flow of goods, capital and ideas between the developed world and the developing one.
Supporting successful economic development in the developing world has always been - and will remain - an overriding global moral imperative. But it takes on increasing economic significance for the industrial countries today, when retirement rates in these nations are rising, rates of labor force growth are decreasing and the investment of retirement savings is a key concern. All of the world's population growth over the next 25 years, and most of its growth in productivity, will take place in the developing world.
We are thus entering an era when there will be exceptional global benefits to a growing and successful developing world. And let us be clear: a healthy capacity to mobilize capital in these economies - because of the trade that it finances, because of the technology it brings, and because of the opportunities it offers - has a very important part to play in that development.
A strong and safe system for a truly global flow of capital is what we should all want to see. Yet it is a vision that has been profoundly shaken, in recent years, by a new kind of threat: the threat of what might be called 21st century capital account crises.
In response, the United States has helped to lead a very far-reaching international effort to find the best ways to prevent these crises and respond to them when they arise. This has produced some important achievements, of which perhaps the most significant over the long term will be the rejection of the idea that it could be the work of the major industrial nations alone. We will see this reflected, this weekend, in the launch of what we will call the G20. This will be a permanent informal mechanism for dialogue on architectural issues among industrial and emerging market economies who between them will account for more than 80 percent of global GDP.
Now that the thick of these crises is behind us, now that we see signs of repair and reviving confidence in emerging markets and more balanced growth in the industrial nations - now is the moment to step back to reflect on these reform efforts, and on what the past few years have taught us.
As we do this, it will be crucial that we not turn our backs on the goal of a safe and sustainable, truly global financial system. But it will be equally important to recognize that such a system will not develop of its own accord - but will require a whole series of public and private actions, at the national and international level.
This is the goal that is truly at the center of global architectural reform. It will not be the construction of a single edifice. Nor will it be a journey to a concrete destination. Rather, it will be an ongoing and organic process comprising the work of many governments and private sector actors and the international community as a whole.
Let me reflect today on the core components of this effort - before highlighting the particular areas where we will be urging further action in the weeks and months ahead.
II. Our Strategy for Reform
The crises that began in Thailand in the summer of 1997 - and the Mexican crisis of 1995 - each had a variety of elements. But looking back we can now see that central to all of them was a sudden loss of confidence and large-scale withdrawal of capital by domestic and foreign investors - initially out of a concern about the fundamentals, but increasingly out of a concern not to be the last out as a kind of bank run psychology took hold.
In the wake of these experiences, the global imperative is easily stated. It is to build a global financial system in which capital account crises of this scale and frequency simply will not happen.
Our strategy for building such a system has had three core components:
- First, enhancing the capacity of emerging market economies to absorb capital safely.
- Second, reducing countries' vulnerability to sudden turnarounds in confidence, whatever their origin.
- Third, developing the most effective international tools for responding to these new kinds of crisis.
Of these, the first component - perhaps inevitably - has received the greatest amount of concerted international effort to date. This is because building safer systems will depend, first and foremost on countries getting the basics right.
These crises were novel in many ways but the root cause was as old as finance itself: too much money borrowed, much of it short-term, on the basis of too little capacity to repay. The best sources of protection against these crises in the future will be developing systems that can ensure that capital is better allocated - and that debts undertaken will more easily be repaid.
To be sure, the international community cannot impose these systems from the outside - we cannot force change if the national commitment is lacking. But we have established a broad consensus on the core ingredients for reform. And we developed much stronger support and incentives for countries to act.
A fundamental change in the basic quality of economic and financial policies in the emerging market economies has been - and must continue to be - at the core of our efforts to reduce the risk of these kinds of crises in the future. We must continue to raise the bar on what is expected of countries in these areas, and strengthen the incentives for countries to meet them.
However, we know well that in a more global capital market, even the best managed countries can have problems if unprepared for unexpected shocks: be it fluctuations in global financial and commodity markets, a crisis in a neighboring country, or a national disaster of their own. And at the international level, we know that crises - whether driven by bad policy or sheer bad luck - will inevitably occur.
As global confidence begins to return and memories of the crises begin to ebb, it becomes even more important for us press forward the frontier in the second and third parts of our strategy: to ensure that countries, investors and the international official sector are prepared for bad times as well as good.
II. Key Priorities for the Future: Reducing National Vulnerability to Shocks in Confidence
As I have said, these crises had many elements, but all were marked by a sudden turn in confidence that ultimately became self-perpetuating. As the psychology of the market shifted, investors began to weigh the level of a country's foreign reserves against the likely demands to take hard currency out in the succeeding months. The opportunity to fix the underlying problems that triggered the crisis without up-ending the economy drained away.
Countries need to work to find ways to reduce the risk of this kind of dynamic taking hold. In this regard, two areas have been especially highlighted by recent events:
First, more prudent management of national balance sheets
We have learned once again in these crises that countries need to pace the opening of their economy to foreign capital to their capacity safely to absorb that capital - or withstand its sudden withdrawal. But we should remember that the inflows which proved ultimately most destructive did not arrive uninvited.
Too many of the countries involved in recent crises were actively reaching for cheap short-term capital. We saw it in Mexico, with the increasing resort to issuing dollar-denominated Tesobonos in 1994. We saw it in Thailand with the Thai offshore banking facility and the government's decision to mortgage its reserves in forward markets. And we saw it in Russia in the encouragement of foreign purchases of GKOs.
In response to these crises, governments need to think long and hard about the strength of their own balance sheets - and the tax and regulatory incentives that are shaping the activities of private borrowers. The end goal should be debt structures - at the sovereign and private level - that help to cushion unexpected shocks, and that do not turn a slight dip in confidence into a rush for the door.
With significant contributions from the United States Federal Reserve, a number of international groups have looked at guidelines for improved risk management at a national level and some simple balance sheet rules for countries. These include rules of thumb for minimum levels of foreign reserves, and a suggested three-year minimum average maturity of public debt.
We believe that this work has provided a helpful starting point. The next steps must be to work with a wider range of economies to develop more sophisticated systems for evaluating an economy's vulnerability to different types of shock, and to establish stronger incentives for countries to put these in place.
That is why we successfully pressed for the IMF's new Contingent Credit Line to be structured to encourage safer debt management practices. And it why we are calling on the IMF and the World Bank to develop best practice guidelines in this area - and for broad macro-prudential indicators to be included in the next expansion of the SDDS.
Second, more sustainable exchange rate regimes
Looking at the crises of recent years, it is clear to us that a fixed, but not firmly institutionalized exchange rate regime holds enormous risks for emerging market economies in a world where fast-flowing capital and insufficiently developed domestic financial systems coincide.
- The promise of exchange rate stability has helped to encourage excessive foreign currency borrowing, both public and private, on terms which appeared attractive only because borrowers ignored the huge potential costs of an exchange rate move.
- The desire by governments to keep to that promise has led in many cases to still more borrowing to support continued defense of the exchange rate, leaving the country yet more vulnerable down the road.
- And when trouble came, the breaking of the promise has greatly exacerbated the general loss in investor confidence and withdrawal of capital that followed - with a spiraling impact on the debtor country's balance sheet.
It is also clear that when pegged exchange rates do collapse, the costs are visited far more widely than on the country itself - as we saw vividly in the spread of confidence problems across Asia and the emerging market economies as a group.
If international economic theory and experience teach us anything it is the incompatibility between maintaining both a fixed exchange rate and an independent monetary policy. A viable fixed exchange rate regime involves in some form the renunciation of monetary independence.
Going forward, the IMF must bring to the fore in its discussions with countries the challenges that this difficult reality brings to the choice of an exchange rate regime. The Articles of the IMF state that sovereign member countries are free to choose their exchange rate regime. This is as it should be. But the fact is that those policies are not made or implemented in a vacuum.
In particular:
- The IMF must help countries to avoid the trap of a regime that may appear to offer stability but that - if not solidly backed by credible institutional arrangements and consistent domestic policies - may encourage large risks to build up unnoticed.
- It must indicate clearly to the government concerned when domestic policies are on a collision course with the chosen exchange rate regime.
- And for countries that may use the exchange rate anchor as a response to hyperinflation, it must offer advice on how best to exit from this strategy before the costs become unacceptably high.
We further believe that the official sector should help shape the choices facing countries in favor of more sustainable regimes: via changed expectations about how it will respond to future crises.
With this in mind, the IMF's major shareholders agreed last June that it would be inappropriate for the international community to provide large scale official financing for a country intervening heavily to support a particular exchange rate level, except in certain limited exceptional circumstances, such as where the policy is backed by a strong and credible commitment with supporting institutional arrangements.
I would hope that this policy shift would influence country's currency choices going forward. Over time, we believe it should increasingly be the norm that countries involved with the world capital market avoid the "middle ground" of pegged exchange rates with discretionary monetary policies. And where countries choose the middle ground, and their own policies are not sufficient to stem an attack on a particular exchange rate level, the international community should have a compelling rationale before it provides funds for the country to defend it.
III. Crisis Response
After the experiences of the past few years, there is surely one point on which all can agree: when a crisis of the modern type is upon us, debtors, creditors and the international community as a whole all have an enormous stake in the restoration of confidence. And we all, going forward, have a stake in ensuring that we have the right means to achieve that in the different cases that will arise.
There are no easy answers to the question of what is the right mix of domestic policies, external official support and appropriate private sector involvement, if any, needed to restore confidence in the future crises that may arise. In this regard, recent experience has confirmed the need to have the flexibility to address diverse cases effectively. Certainly, investors should not consider official responses to one set of extraordinary circumstances to be a simple predictor of responses to the very different sets of circumstances that may arise in the future.
However, we can now say that recent experience yields some core guiding presumptions:
First, a crisis of confidence involving financing problems that are primarily of illiquidity should not be allowed to turn into something more serious. When investors start to withdraw large quantities of capital from a country whose underlying prospects are strong, the system as a whole has a stake in supporting policies that successfully turn those investors around. Here, the Supplemental Reserve Facility and the CCL - both of which allow for fast disbursing finance at premium interest rates and shorter maturities - have been important innovations.
We have also seen, notably in Korea in December of 1997 and Brazil last February, that voluntary private sector coordination in recognition of its mutual interest in avoiding withdrawals can be very constructive. Of course, emphasis on coordination problems and crises of confidence must never blind us to the fact that without the right national policies, any amount of external official support or extension of private debt obligations will be in vain.
Second, at one end of the wide spectrum of cases that we will need to confront will be those cases where the country has more fundamental problems; and where early restoration of market access on terms consistent with medium term sustainability may not be a realistic outcome. In these rare instances, a debt restructuring or reduction may be warranted.
This is never a step that can be taken lightly. The official sector should not and will not sanction a suspension of payments by a country that has the ability to pay, or that uses it as an alternative to adjustment or reform. To sanction opportunistic nonpayment would undermine the very basis of a global capital market.
However, a well functioning global capital market will also not be attained in a world that is distorted by the expectation that the official sector will protect investors - come what may. The official sector will not stand in the way of a suspension of payments when a country has an unsustainable debt load and is truly unable to meet payments.
In those cases where problems go beyond liquidity and debt restructuring is required, we would expect countries to develop an external financing plan as a core element of their IMF stabilization program - one that provides an appropriate balance of external financing between the official and private sectors. Such a plan must offer a viable solution to the immediate problem, without setting up new ones for the medium term.
While the IMF would set these broad parameters for an acceptable plan, we would expect the country itself to take prime responsibility for working with its creditors to devise that plan. In that context we will be looking for a solution that is reached cooperatively and transparently and that is broadly equitable across different categories of similarly situated credits. No one category of credits should be regarded as inherently privileged, but it is equally true that not every case will need to involve all categories of credits.
- Concluding Remarks
As I said at the outset, the reform of the global financial architecture is an organic and many-sided process that will never truly be completed. However, taken together, it is fair to say that the events of the past few years - and the changes they have helped to set in train - mark an important new stage in the system's evolution. What will be crucial going forward will to keep pushing back the frontiers in the areas I have highlighted - and to keep pressing for the safer policies and institutions at a national level upon which this new system will ultimately depend.