PACIFIC BASIN ECONOMIC COUNCIL
MAIN PAGE | SPEECHES & EDITORIALS | 1999 | REFORMS TO INTERNATIONAL FINANCIAL ARCHITECTURE

Reforms to International Financial Architecture The Lessons of the Last Two Years The Honorable Peter Costello Treasurer, Australia Tuesday, May 18, 1999 The Challenges of the Next Century for the Pacific Basin 32nd International General Meeting of the Pacific Basin Economic Council Hong Kong Convention & Exhibition Centre Hong Kong, China May 17-19, 1999 Thank you, Dr Sohmen, ladies and gentlemen. It is a pleasure to be here in Hong Kong to speak to the 32nd International General Meeting of the Pacific Basin Economic Council. I was last in Hong Kong for the annual meeting of the International Monetary Fund in September 1997. It was the beginning of what we now call the Asian financial crisis. Although there had been, by that stage, severe financial instability in Thailand, and although it was clear pressures were emerging in markets in Malaysia, there was a certain note of triumphalism amongst delegates at the IMF meetings. The world economy looked strong, Asia had been a booming region for much of the last decade and the world economy had enjoyed years of uninterrupted growth. Academics were writing serious pieces on "the end of the business cycle" and forecasting decades of prosperity stretching out as far as the eye could see. China was continuing its market liberalisation. Hong Kong had successfully reverted to China in July. The Chinese Premier opened a meeting of the International Monetary Fund. The march of liberal market capitalism seemed unstoppable. Yet the Korean crisis was just around the comer and events began to later unfold in Indonesia which saw a dramatic drop in living standards, together with serious social instability. By the end of 1997 and throughout 1998, we recognised that the Asian region was in a full blown financial and economic crisis - the like of which we had not seen for 50 years. The tone of triumphalism gave rise to a tone of despair. During this period, Japan, Hong Kong, Korea, Indonesia, Malaysia, Thailand, New Zealand and Singapore were all to go through recession. in the Asian region, only China, Chinese Taipei and Australia continued to grow. In fact, the Australian economy strengthened its growth pattern, growing through 1998 at 4 3/4 per cent - one of the fastest growth rates amongst the developed nations of the world. In Australia, our growth was strong, our inflation was low (around I per cent), our budget was in surplus, we were reducing government debt and our interest rates were at all time lows (official rates remaining more or less stable throughout the period at 4 3/4 per cent). Our financial and stock markets didn't miss a beat. I have just come from the APEC Finance Ministers' meeting in Langkawi, Malaysia. If the triumphalism of 1997 gave way to the despair of 1998 1 discern now another mood shift, a growing confidence, that perhaps things have bottomed and the region is ready to return. But in many respects we are now entering the most dangerous phase of the episode known as the Asian financial crisis. The danger now is complacency. During periods of crisis, old ways are shown to have failed, reformers come to the fore, the public understands the need for change and there are opportunities to accomplish big structural reforms. During periods of recovery, reformers can be seen as unnecessarily troublesome, the urgency of change begins to dissipate, and the case for reform is undermined by equanimity. It is my view that if the structural reforms are not accomplished now, then at some future date the same weaknesses will lead to new problems. And I am not convinced that the necessary structural reforms are yet in place in the region or indeed in the international financial architecture. Australia has thought hard about these issues. The events of the last two years have had a profound impact on our region and our prospects. We have joined international financial support packages offering second tier financing in Thailand, Korea and Indonesia - the only country along with Japan to do so. Whilst our own economy has remained strong, we are conscious of the fact that in a strong region it could have been stronger. We are conscious of the fact that, like all the countries of the region, we have a strong interest in growth, prosperity and the political stability that it brings. A lot of work has been done analysing the causes of the financial instability in Asia in the last two years and, of course, Asia was not alone. We now have the experience of Russia and Brazil. I think that some common lessons can now be drawn from the experience. There was policy weakness. If it is possible to speak loosely of a single "Asian model" of government and business partnership, there is little doubt it contributed to strong regional economic growth for 30 years. But even before the crisis, the warning signs of stress, and the challenges of adaptation, were becoming apparent. While analysts still dispute the detail of East Asia's productivity performance, there seems to be wide agreement that resource accumulation - that is, high investment and labour force growth - was very important in explaining rapid growth through the 1970s and 1980s. But there is a variety of evidence that in the early 1990s the productivity of continuing very high investment levels generally declined. That decline was probably associated with the increased proportion of investments in non-traded sectors (such as real estate) or protected sectors (such as automobiles). In short, there was a decline in the "quality" of investment - a decline in the economic efficiency with which investment was allocated among competing uses. This slowdown of capital productivity growth reminds me of Australia's experience in the mid-1960s and 1970s, when capital productivity is now estimated to have actually declined. In Australia's case, this was because of bad work practices and inefficient resource allocation behind a tariff wall and restrictive foreign investment policies, which isolated Australian managers and employees from world's best practices. In Asia's case, I suspect the problems of the 1990s signaled, in large part, institutional weaknesses that made it difficult to achieve efficient resource allocation. The design of economic, commercial and legal institutions were limited in ways which had been disguised in the context of strong, steady growth during the transition phase of East Asian economic development. During the "catch up" period, efficient investment allocation and good management practices were not such an issue. The "rising tide" of high capital inflows and apparently unbounded growth was sufficient to "lift all boats". But the seaworthiness of boats is tested less by tides than by storms. By analogy, the decisive tests of economic institutions are their robustness in crises and when confronted by unforeseen economic storms of the sort which, historically, have occurred only once or twice in a lifetime. The Asian crisis has provided just such a "shock test", and has revealed many widely agreed institutional problems: Industry polices were not transparent. There were large implicit contingent liabilities which clouded the outlook for government budgets that had seemed, on the face of it, to be in good shape. The allocation of credit was frequently by connected or directed lending, and the absence of sophisticated credit analysis led also to "name lending" rather than proper risk management by banks. Accounting and auditing standards were deficient. Corporate governance was generally weak, and led to poor recognition of risks. Accordingly, prudential super-visors had limited capacity to identify risks to the banking sector from corporate lending, and to take resolute action to manage those risks. As the crisis broke, fixed exchange rate regimes had to be abandoned and because policy settings and institutions were not sufficiently credible to restrain capital flight, there were large exchange rate falls. Very high interest rates were necessary in the short run to arrest these problems, and this combination of exchange rate and interest rate movements damaged the viability of large parts of the financial and corporate sectors. The ensuing difficulties revealed the weaknesses of insolvency regimes and the absence in some countries of a strong legal culture to force effective, prompt debt work-outs and restructuring, or bankruptcies to put impaired assets back to work quickly. The scope of the institutional reform task in the region is widely recognised, and I know from my participation over the weekend in the APEC Finance Ministers' meeting that my colleagues throughout the region are committed to making a determined reform effort. But institutional reforms of this nature are intrinsically slower to achieve than pointing macroeconomic policies in the right direction, and there is a risk of "reform fatigue". Foreign investor and lender interest has started to return to the region as governments are making progress on reform, and in the anticipation that reform will continue. But if reform fades away, so will the investment. Our fortunes in Australia were supported by having pursued a comprehensive programme of economic reform: Reforms to deliver strong, forward looking and transparent macroeconomic policies; Continuing structural reforms; and Strong institutional and legal structures matching world's best practice. But our relatively strong economic performance has not lessened our interest in international financial system reform. At the request of the Australian Prime Minister, I chaired last year a taskforce of public and private sector representatives that addressed the causes of the crisis and the elements that would need to feature in reform of the international financial system. The report of the Taskforce on International Financial Reform released in December of last year, provides a comprehensive analysis of the issues. This analysis identified a number of weaknesses in the underlying fundamentals of crisis economies and weaknesses in the operation of global capital markets. It is fair to say, I think, that the risks and dynamics associated with the process of global financial intermediation were not as well understood when the crisis struck as they should have been - by both lenders and borrowers. Let me say it clearly. Open capital markets had brought enormous benefits. The very rapid economic growth, and rising living standards, of emerging economies in this region, was facilitated by large inflows of capital. It meant rising living standards, better infrastructure, more opportunities. But not enough was known about the structure of investment flows to predict the force of the pressures building in some of these economies. There were often large mismatches in currency and maturity of lending instruments that left economies so vulnerable to the shift in investor sentiment in 1997. We now know, also, that there were weaknesses in the behaviour of capital markets. We know that creditors had made poor risk assessments and that, when sentiment turned, the panic-driven rush for the exits produced capital flight. These shifts in market psychology generated overshooting and contagion on a scale that exceeded previous experience. And there was not just one form of capital flight. In different economies it comprised elements in varying degrees: the sudden and massive withdrawal of short term finance extended predominantly under interbank credit lines; non-resident investors - including speculators - dumping and short selling bonds and exiting foreign direct investment positions; and resident capital also taking flight as the panic widened. Let me come directly to the question of highly leveraged institutions. In my view, highly leveraged institutions exacerbated a volatile situation. I do not believe that they can be blamed for causing it. There was policy weakness. But in smaller economies, large players can create an awful lot of instability. Financial markets tend to overshoot and they overshoot a long way when large players are taking opportunistic positions. Does this mean that capital controls are necessary? In emerging markets capital controls may be necessary as a transitional measure if there are not domestic institutions which can handle large and highly volatile capital flows. But capital flows, on the whole, are beneficial for countries. Countries that cut themselves off from free capital movement will be countries that over the long term do themselves damage. Markets in the long term generate wealth and higher living standards. There is a case, I think, for greater transparency in disclosure by highly leveraged institutions. It seems strange that these institutions are able to take highly leveraged positions without transparent reporting, without making any of the disclosure which would be expected in other kinds of financial markets such as equity markets. It also seems strange that these institutions are able to practice techniques which have long since been chased out of good stock market practice. We have consistently argued for transparency in disclosure so we welcome moves to heighten reporting requirements for highly leveraged institutions. Together with Hong Kong, Australia is a member of a sub group of the Financial Stability Forum looking at this question and we will actively pursue it. The other important issue arising from the experience of the last two years is the significance of the private sector. Capital flows to the private sector dwarfed those of the official sector. In fact, they dwarfed international recovery funds put together even though these were the largest in world history. Governments are now just players, in some cases small players, in large financial markets. We do not seem to have adequately addressed this question. In international rescue funds, and our Government has been part of these, it is ultimately taxpayers' money that is put on the line. Taxpayers' money should not be put on the line to bail out the private sector if there is no contribution from the private sector. After all, for every bad borrower there is also a bad lender. It would be an unfair outcome if the lenders are protected at the expense of taxpayers at the end of the day. Where efforts have achieved a "bail in" of the private sector, there has been more success in stabilising economies. To "bail in" the private sector requires getting some kind of joint position with all private sector borrowers. Private sector borrowers are not going to forego immediate enforcement of their rights if it means deferring to a competitor. But there are occasions when they may be prepared to act jointly on the principle that if they do not hang together, they may hang separately. Getting this joint action can prove logistically difficult. Where there are diverse bond holders, "collective action" clauses can provide a mechanism or procedure to get agreement amongst lenders. These clauses provide for the modification of the terms of the bond including repayment schedules - by agreement between the borrower and some proportion of lenders. It is sometimes said that collective action clauses will mean people are more reticent to lend in the first place. But if they become accepted practice, if there is prudent attention to what will happen in the event of a problem, then this can always be priced into the transaction. Indeed, it is desirable to properly price risk into a transaction. This could have been one of the failures of the last two years. In relation to inter bank credit, there are a smaller number of players but sometimes much larger volumes. It is easier to get arrangements amongst a smaller number of players who may well be known to each other. This may involve agreements for a "stand still" while remedial action - to protect all institutions - is put in place. We have raised these issues at international fora and I think there is agreement they should at least be looked at. The APEC Finance Ministers have asked the private sector to do more work on these questions to see the extent to which they are feasible and the extent to which they will benefit affected economies. These are all issues which will take a degree of international cooperation. They go to what is called "the international financial architecture". But what can governments practically do to improve policy and generate confidence in the short term? One of the practical steps that we have taken in Australia is to prepare a transparency report. This report analyses our institutions and our policy against world's best practice in all areas: monetary policy, fiscal policy, corporate governance, financial regulation, accounting and audit standards. We did this not so much for others. We did this for ourselves. We wanted to see where our strengths were and where our weaknesses lie. it is a cathartic experience. It is good for policy makers to identify weaknesses and policy challenges. It is good for the public if it contributes to an understanding of where policy is and where it has to go. It is good for investors because it shows a government is in the game of renewing and improving on institutions. We are quite happy to send this out for peer review lest we prove too generous in self examination. The long sweep of economic history will show us that open markets and open economies are better at generating rising living standards and sustainable jobs. We should not lose sight of this. The challenges to open markets and open economies can take different forms. Sometimes they are over regulation. Sometimes they are practices which can destroy confidence or inhibit informed decision making. We should not be afraid to deal with those either. The sophistication of equity markets brought new and increasing rules to keep them open and fair. The sophistication of product markets has required a new approach to keep them open and fair - for example, with competition policy. And where there are challenges to open financial markets, we should deal with them in a mature and ordered way. But always with the goal in mind of keeping those markets open - open for investment, open for growth, open for economic development and open and flexible for human opportunity - the goal of our social policy as well as our economic policy.