FROM THE OFFICE OF PUBLIC AFFAIRS

Thank you. It's good to see so many old friends. Let me start by applauding the International Monetary Fund for organizing this conference. Some would consider it strange for the IMF to stick its head above the parapet on this question at a time when many are questioning the benefits of free and open global financial markets (and a good few are questioning the benefits of the IMF.) I consider it timely -- and absolutely essential. If there is one lesson to be drawn from the events of the recent past, it is that capital account issues are here to stay -- and they are issues with which the Fund will increasingly have to deal. Its charter ought to give it the tools to accomplish that task.

The emergence of today's global financial markets can be likened to the invention of the jet airplane. We can go where we want to go much more quickly, we can get there more comfortably, more cheaply and most of the time more safely -- but the crashes when they occur are that much more spectacular.

We regulate air safety. No-one sensible is against jet airplanes. But everyone sensible is for new kinds of regulations because they exist. We have seen too many financial crises in these last years of the century, crises that have come at unacceptable costs to the people in the countries affected by them. Those catastrophes add urgency to the challenge of promoting safety and stability.

There will no doubt be a full and vigorous debate on the best way to realize the opportunities of a world of free-flowing capital -- and manage the risks. I don't aspire to any kind of conclusive synthesis today. But let me offer five observations for your consideration.

1. Vulnerability to Crises Begins at Home

If we are to piece together the lessons of the recent crises and devise an effective approach to these issues it will be important to start from the right place. Some conjure a specter haunting the world's governments: the global capital markets whose advances they cannot resist, whose sudden rejections they cannot survive. The facts of the most recent financial crises tell a different story.

The truth is that the crises that have occurred have disproportionately involved the judgments of countries' own citizens. Careful studies by the G-10 and the IMF of the crises in the European exchange rate mechanism and the Mexican peso crisis were able to attribute only a small fraction of the capital flows involved to speculative trades by foreigners. This research was given added support by Jeff Frankel and Sergio Schmuckler's observation that the Mexican Bolsa, dominated by Mexican residents' transactions, responded much more quickly to the crisis than foreign investor-dominated closed-end mutual funds. I understand that these studies have been echoed in the very recent IMF study into the behavior of hedge funds in Asia.

Where foreign capital has been involved it has most often been foreign capital that governments have sought actively to attract: we saw this in Mexico, with the increasing resort to issuing dollar-denominated Tesobonos to put off adjustment day at home; we saw it in Thailand, in the tax breaks on off-shore foreign borrowing and other domestic incentives for Thai banks to take on unsustainable amounts of foreign debt; we saw it in Korea, where discriminatory controls kept long-term capital out, and ushered short-term capital in.

Before we come to the issue of placing controls on foreign borrowing, we should be considering the strong macroeconomic fundamentals that are critical to sustaining the confidence of a countries' own citizens -- and the kind of domestic safeguards needed to avoid dangerous practices associated with reckless pursuit of low cost capital. A better place to begin in drawing lessons from these events is that it is a bad idea for governments to reach excessively for capital, particularly if a disproportionate amount of that capital is denominated in foreign currency and is short-term and high yielding.

2. Successful Liberalization Depends on Sound Domestic Practices

The case for capital account liberalization is a case for capital seeking the highest productivity investments. We have seen in recent months in Asia -- as at many points in the past in other countries -- the danger of opening up the capital account when incentives are distorted and domestic regulation and supervision is inadequate. Inflows in search of fairly valued economic opportunities is one thing. Inflows in search of government guarantees or undertaken in the belief that they are immune from the standard risks are quite another.

The right response to these experiences is much less to slow the pace of capital account liberalization than to accelerate the pace of creating an environment in which capital will flow to its highest return use. And one of the best ways to accelerate the process of developing such a system it to open up to foreign financial service providers, and all the competition, capital and expertise which they bring with them. The recently concluded global financial services agreement demonstrates that countries recognize these beneficial effects of external liberalization.

Mexico took the second route in 1995 -- and has since reaped the benefits in rapid growth and a strengthened domestic financial system. It is striking that the countries that are currently faring best in Asia are those that have responded in the same way. Both the Korean and the Thai reform programs include sweeping liberalization of the domestic economy in addition to radical financial sector reform -- and both look to foreign competition and participation as a way of supporting those efforts. By contrast, some of the countries in the region that continue to look vulnerable are those that have seemed unwilling or unable to tackle domestic distortions -- and, indeed, have looked increasingly to the quick fix of capital controls instead.

The critical point is that when a country takes the more basic precautions that should be part of any liberalization process -- when a country has the proper supervisory and regulatory practices in place -- these have enormous potential to control the more risky forms of borrowing. Countries need to adapt and develop standards and rules to ensure safety and sound practice within a more liberalized system. Matched books, for example, is all very well: it means little if companies are taking on foreign currency debt service commitments on the basis of domestic assets that will not generate the ability to repay.

Effective prudential banking standards are especially vital. The Basle Committee has recently developed core principles for effective banking supervision that can serve as a blueprint for steps to improve supervision at the national level. IOSCO is working on a similar project. But the major responsibility lies with national governments. Of particular importance is ensuring that investment decisions and capital flows are not distorted by explicit or implicit government guarantees.

In short, governments can respond to the invention of jet airplane by lengthening the runway or by banning jet landings. It is obvious which is better.

3. The IMF Has A Critical Role in Promoting Open and Stable Financial Systems

In Mexico, in Asia, and throughout the world the IMF has become increasingly involved in helping countries realize the opportunities of global capital markets -- and manage the risks. That involvement has been de facto. We need to make it de jure. That is why we have supported speedy codification of its role in this area through the Amendment of the Fund's Articles of Agreement to include capital account liberalization.

This is not about bureaucratic tidiness. It is about ensuring that the IMF is in a position to respond to the challenges raised by the crises of recent years -- by working with countries to ensure that countries open their capital accounts in a way that best protects them, and the international financial system as a whole, from financial crises and the contagion which such crises can cause.

Each country must choose the approach that is right for them. Amending the Articles is entirely consistent with this. Under the proposed approach, countries will accept the obligation to liberalize the capital account fully, but what that means precisely will be up to them to decide in cooperation with the IMF. Until they are ready, they could avail themselves of transitional arrangements as approved by the Fund. They would simply have to commit not to backtrack without IMF approval.

I am open-minded about the appropriate phasing of liberalization. But it is worthwhile noting some of the potential drawbacks of capital controls: they can, in the wrong hands, be a way to avoid necessary policy adjustments, and thus a sure-fire route to prolonging and exacerbating the costs of those adjustments; they can undermine the goal of domestic liberalization by introducing new economic distortions and creating scope for official rent-seeking and corruption.

Even those countries most associated with "successful" use of short-term controls recognize that the drawbacks mount over time and do not see the controls as a permanent feature of the landscape. Once again, the end objective must be to reform those aspects of the domestic environment which leave scope for dangerous imbalances to develop in the first place.

I worry that ingenious arguments for speed bumps or other forms of capital controls are a little like the arguments developed over the past two centuries for the scientific tariff. They are logically correct. They relate to circumstances that are empirically relevant. But they are almost certainly invoked more frequently on behalf of the wrong policies than the right ones. In a different context the question has been asked whether, if it was discovered that ten percent of alcoholics could drink again without ill effects, it would be a service or a disservice to publicize this discovery.

It has been for too long that IMF could have stood for "it's mostly fiscal." In today's world, the preoccupation needs to be much more with helping countries grapple with the challenge of building a sound domestic financial system that can handle international capital

4. The Global Financial System Will Only Succeed if it is Safe for Failure The challenge of building a safe and efficient global financial system starts with the efforts of domestic authorities. It surely does not end there. We all need to look at the international financial system and do what we can to change it so we don't have crises like this every three years. There will never be enough money in the world to respond in any kind of official lender of last resort function to all the crises that potentially can come in developing countries and industrial countries as global capital flows increase. That cannot be the way forward.

I think some of the elements of a better solution are clear.

Greater transparency

If one were writing a history of the American capital market I would suggest to you that the single most important innovation shaping that capital market was the idea of generally accepted accounting principles. We need that internationally. It is a minor, but not insignificant, triumph of the IMF that in Korea somebody who teaches a night school class in accounting told me that he normally has 22 students in his winter term and this year he has 385. We need that at the corporate level. We need that at the national level. And we need that transparency to apply to central banks. In particular, we must recognize that it means nothing for a central bank to report its reserves if it does not report the encumbrances on those reserves.

Strengthening domestic financial systems

In keeping with my earlier comments, we need to focus our attention on strengthening financial systems, both globally and at the level of individual countries. That means improved prudential standards and the promotion of effective financial infrastructure. But the ingredients of sound banking systems go well beyond a list of internationally recognized standards -- it means cultivating a credit culture, sound supervision, limits on the quality of assets at a banks' disposal, and effective controls on self-dealing.

Creditor responsibility

We need to have an architecture in place, so that policy makers do not confront the choice between uncontrolled chaos and confusion and large bail outs which is too often the choice they confront today. That has got a microeconomic dimension and a macroeconomic dimension. Countries need bankruptcy laws. And they need effective judicial institutions to enforce them. That is part of being part of a global capital market. We also need procedures for dealing with situations where countries get themselves into very profound financial difficulties at the sovereign level.

We need systems that are consistent with legal procedures around the world. We need systems that can handle failure because until the system is safe for failure, we will not be able to count on success. We consider the American financial system to be strong, not because all of its institutions succeed, but in large part, at least, because the failure of one does not jeopardize the whole. We need to build more systems like that. For world capital markets to function properly, investors must make investments based on the fundamentals of national economies, and not the likelihood of international rescues. The enormously difficult analytical challenge -- for the IMF, for all of us -- is to find a way to build such a system safely, and without undermining the stability we are aiming to promote.

5. The Interests of Capital Are not the Only Interests That Count

One theme of my remarks today has been the need for governments and the international community collectively to consider the system as a whole in responding to the challenges of a global financial market. That means working to strengthen domestic and international financial systems. And it means working to develop effective safeguards against crises and effective mechanism for dealing with crises when they take place. But what it cannot mean -- what it must not mean, is focusing solely on the concerns of capital: be it domestic or international.

A focus on stabilizing capital flows is a means to a more ultimate objective. It is not an end in itself. In working to promote free flows of capital we must not neglect the broader risks they pose to the people this new global economy is meant to serve -- and the environment in which those people live. As capital becomes so much more mobile than labor there are legitimate concerns that companies will exploit that greater mobility by playing off competing jurisdictions against one an other. The fear is that we will find ourselves in a race to the bottom -- a bottom in which governments cannot promote fair taxes, uphold fair labor standards or protect the environment.

That is not the world we want to build. And it is not the world we are building. That is why we are working with other countries to promote global cooperation against corporate and legal tax havens. That is why we are working actively in the OECD on the issue of tax competition. It is why we have worked, within the IMF and the other IFIs to ensure that the concerns of labor and the environment get a fair hearing in devising reform programs and sustainable development strategies. And it is why fair labor and environmental standards have played a core role in our bilateral and multilateral trade liberalization initiatives.

None of these questions has easy answers. But we neglect them at our peril. These past years we have been laying the first foundations of a truly global economy. Trade, investment, capital, information and know-how are flowing more freely than ever before to the places where they can be most effective in creating wealth. But events in Asia are a further reminder that the tide of global integration brings serious challenges in its wake. The potential is breathtaking. It will require a new network of policies and institutional arrangements to ensure that this potential is realized. And it will, most definitely, depend on an effective IMF. Thank you.