Speech by Mr. Kiichi Miyazawa, the Minister of Finance,

At the Foreign Correspondents Club of Japan

December 15, 1998

I.       Experiences of the Recent Past
II.     Risks Posed by Short-Term Capital Movements,
        and Measures to Cope with Them
III.    The Exchange Rate Regime
IV.    Providing Liquidity to Crisis Countries
V.     Conclusion

Towards a New International
Financial Architecture

Speech by Mr. Kiichi Miyazawa, the Minister of Finance,

At the Foreign Correspondents Club of Japan

December 15, 1998

        Ladies and gentlemen, it is my great honor and pleasure to have an opportunity to speak at this distinguished gathering.

       Today, I wish to speak about the challenges facing the current international financial system and about ways to reform and improve its workings. These are very important issues, and unless we resolve them correctly, the world economy might not develop in a sound way in the next century.

        In order to look to the future, one should begin by looking back at recent experiences of the international financial system.

I. Experiences of the Recent Past

      Since the Mexican peso crisis in late 1994, there has been much discussion about reform of the international financial architecture. Beginning immediately after that crisis, various opinions were expressed, and the importance of transparency and disclosure emerged as the most important issues to be tackled, along with the need to reinforce IMF resources. It has been argued that if investors had known the true economic situation in Mexico, they would have been able to make rational investment decisions, and probably they would not have invested in that country in the first place. Following this line of reasoning, the IMF has decided to promote disclosure of each country's policies by compiling the SDDS (Special Data Dissemination Standard). In addition, it has been argued that IMF surveillance should be strengthened, and efforts accordingly have been made for that purpose.

      Then, last year, there came the crises in Asia. In contrast with previous crises, especially those in Latin America, where the main problems were ones of large fiscal deficits and over-consumption, the most significant aspects of the Asian crises were that they basically stemmed from heavy borrowing by private sector borrowers from private overseas creditors, and from excessive and/or inefficient investments made possible by such borrowing. The Asian crises revealed the weakness of financial sectors and the lack of proper financial sector supervision in these countries. This experience led to discussions about establishing appropriate financial supervision systems, and about the need for involving private-sector creditors in preventing and resolving the crises. Still, the sense of crisis did not seem to be shared evenly throughout the world: I suppose that this was because some observers attributed the Asian crises to specific deficiencies in the economic management of the Asian countries, including seemingly opaque and improper relationships between governments and businesses.

      However, when turmoil also took place in Russia and Brazil this year, it became very clear that crises such as those experienced in Asia are more general phenomena. One cannot help but realize that these successive crises stemmed not only from specific problems in particular economies, but also from general problems inherent in today's global economic system.

      The risks involved in large and abrupt movements of short-term capital are now keenly recognized, as shown in the crises in Asia as well as in Russia and Brazil. We have also been reminded that appropriate exchange rate regimes are clearly the key to the stability of the international financial system. It is now widely acknowledged that maintaining a virtual peg to the U.S. dollar was one of the main reasons for the crises in the emerging economies in Asia. The problems were made more serious because the U.S. dollar had greatly appreciated vis-a-vis the Japanese yen and other major currencies since 1995, which caused a loss of those economies' trade competitiveness.

      Against this background, active discussions are now underway on how to improve the international financial architecture. These include a variety of proposals, such as renewed appeals to strengthen standards for transparency and good governance in both the private and public sectors, and to improve the supervision of the financial sector, and new ideas about organizational realignment of the IMF, the World Bank, and others.

      Today, however, I wish to focus on what I think are the most fundamental issues underlying the present international financial architecture: they are (1) how to cope with short-term capital movements; (2) how to determine an appropriate exchange rate regime; and (3) how to provide liquidity to crisis countries. I strongly believe that these three issues are what we must tackle first and foremost, in order to effectively prevent and resolve crises.

      I am convinced that these questions must be urgently discussed and dealt with by the G7, while securing the involvement of key emerging economies. Japan, as a country in the Asian region where the people have been experiencing the very serious impact of the crises, would like to play an active and constructive role in dealing with such system-wide issues.

II.  Risks Posed by Short-Term Capital Movements, and Measures to Cope with Them

      The first fundamental issue is how to cope with large-scale short-term capital movements.

      It is true that the free movement of capital has often been a driving force behind economic growth in developing and emerging countries. Recently, however, a great leap in financial technological development has enabled international investors to invest and divest in the most exotic markets with ease. It is said that at present approximately $1.5 trillion worth of currencies are traded every day. If we assume that there are 250 business days in one year, currency transactions could total as much as $375 trillion per year. Considering the fact that the size of world trade for one year as a whole is merely $11 trillion, one has to recognize what a great influence capital movements could have on any country.

      The free movement of capital is supposed to provide optimum allocation of resources: in reality, this might not be the case, especially for short-term capital flows, because investors make their decisions based on imperfect and asymmetrical information, and they therefore tend to follow what other investors are doing. This phenomenon, known as "herding", could trigger abrupt movements of short-term capital, without major changes in the economic fundamentals. Excessive capital inflows can lead to overheating of an economy, including increases in unproductive investments, asset price "bubble", and inflation. And if outflows start, torrents of outgoing funds could ruin a nation's economy.

      Based on this recognition, first, even in an emerging or developing economy where capital account liberalization is an appropriate and necessary strategy for promoting further growth and efficiency in light of its stage of economic development, it is critical that such liberalization is implemented as and when certain appropriate conditions exist, such as a robust financial sector and a capable supervision system. Furthermore, the capital account liberalization should proceed in a well-sequenced manner. In particular, the need for prudential regulations cannot be exaggerated. Through them, for instance, risks associated with foreign exchange exposures and maturity mismatches should be properly monitored.

      Second, the monitoring of the movements of capital, particularly of short-term capital, needs to be enhanced. In conducting surveillance and in formulating programmes, the IMF should urge national authorities, and give assistance when appropriate, to compile and to monitor more detailed data concerning inflows and outflows of capital ? in terms of maturity, currency, form (direct investment, bank borrowing, securities investment, etc.), and borrower (sovereign, quasi-sovereign, financial institution, private corporation, etc.). Obviously, capital account liberalization has made it more difficult to collect data on capital transactions. However, the reporting obligations of both financial institutions and corporations that are borrowing from overseas creditors must be strengthened as needed.

      Third, an emerging or developing economy, in its process for capital account liberalization, might want to keep capital inflows to a manageable level, according to its economic size and the stage of development of its financial sectors. In such a case, maintaining market-friendly controls that would prevent turbulent capital inflows should be justified. Such measures have already been adopted by some Latin American countries, making best use of prudential regulations such as reserve requirements for foreign borrowing.

      Fourth, as for reintroduction of measures to prevent capital outflows, there are strong views against it. It is true that some measures might hamper useful capital inflows, such as direct investment, by eroding investor confidence. Some are either so discretionary or arbitrary that they might undermine the efficiency of the national economy. I fully understand the hesitation shown by people who, pointing out these problems, call for caution in approving the introduction of such measures.

      I believe, however, that there might be some cases that would justify the reintroduction of such measures, for instance, when preventing IMF loan proceeds from being used to bail-out foreign investors' money, and when preventing capital flight by residents. Of course such controls should not be the norm: they must be exceptions. Also, such measures need to be carefully designed, so that they will not adversely affect inflows of stable and useful long-term investment. I look to the IMF "to review the experience with the use of controls on capital movements, and the circumstances under which such measures might be appropriate" as instructed by the communiqué of the Interim Committee meeting held this October.

      Lastly, industrial countries can also contribute to the mitigation of risks posed by turbulent short-term capital movements, through strengthened monitoring on the lenders' side. We need sophisticated supervision systems to cope with various forms of investment, from simple portfolio investments to exotic off-balance-sheet derivatives. In particular, the authorities in such countries must pursue ways to address issues related to internationally active institutional investors, including hedge funds. In my view, we should examine the scope for measures including appropriate prudential rules or reporting requirements for financial institutions investing in or lending to hedge funds, especially those established in the offshore centers where regulations are deemed loose, and appropriate disclosure or reporting requirements for hedge funds themselves.

      In addition, in order to make the whole exercise effective, coordination among national and international regulators should be reinforced. For this purpose, it is worth considering the creation of a forum where major international regulatory bodies such as the Basle Committee of Banking Supervision and IOSCO (International Organization of Securities Commissions) , together with the IMF, the World Bank, and also national regulators, can discuss important issues of the time.

III.  The Exchange Rate Regime

      The second fundamental issue facing today's international financial system concerns the exchange rate regime.

      After the collapse of the Bretton-Woods system, all of the major countries and many others opted for a floating exchange rate regime, because it was believed at that time that a floating rate would shield a country from external shocks, including high inflation overseas, and that it had a built-in mechanism for rectifying current account imbalances among countries. These objectives have been achieved only partially at best.

      Under the floating rate regime, we have experienced problems of volatility and misalignment: exchange rates have sometimes shown large fluctuations; they have deviated, for a long period, at levels inconsistent with economic fundamentals; and large imbalances among the major countries have continued to exist. Moreover, as the movements of capital have increased in size and frequency, the fluctuations in exchange rates have become even greater, resulting in serious adverse effects on the real sectors of even large economies. Needless to say, violent effects of large-scale, short-term capital flows are felt more by smaller economies. They are not just adversely affected by volatile fluctuations of exchange rates: it has become more apparent that an emerging economy might face risks of default, due to difficulty in rolling over foreign currency loans, or to a run by international investors, even if it adopts a fully flexible exchange rate regime.

      A variety of efforts has been made to stabilize the exchange rates of the currencies of major industrial countries. In the late 1980s, macroeconomic policy coordination was pursued, but it did not result in as much stability of exchange rates as had been expected. In addition, the coordination of fiscal or monetary policies is not as easy a task as theories assume, because of constraints resulting from domestic concerns and political sensitivities. Nowadays, it is often argued that exchange rate stability would be better achieved through efforts by each industrial country towards sustainable low-inflation growth. The question still remains, however, if this would be sufficient.

      Some suggestions are reportedly being made in Europe concerning the need for greater stability among the major currencies. I agree that greater stability is desirable. It is our task to examine the possibility of creating an exchange rate regime that will bring about greater stability on the one hand and needed flexibility on the other, among the yen, the U.S. dollar, and the euro. Although it is a difficult challenge, we have to work hard to attain this "managed flexibility" among the three currencies.

      With regard to the currencies of emerging and developing countries, it is crucial what exchange rate regime we advise each country to adopt. Of course, the most appropriate exchange rate regime might differ from country to country, due to differences in the size of a nation's economy, the composition of its trade partners, the composition of its major trade items, the degree of its capital account liberalization, the nation's past experience with inflation, and other factors.

      At the same time, however, the recent experiences in Asia apparently revealed the risks of pegging a country's currency to a single foreign currency. Doing that often causes disregard of exchange risks by foreign investors as well as by domestic borrowers, and sustained misalignment of exchange rate level with economic fundamentals, and consequently leads to a bubble economy that later bursts. No country can afford a mistake in selecting an exchange rate regime, on which all economic policies hinge.

      It might be generally appropriate that emerging or developing countries peg their rates to a currency or to a basket of currencies of the developed countries with which they have the closest trade and investment interdependence, while adjusting the peg periodically so as to reflect developments in relative real effective exchange rates, unit prices, and current and capital account balances. Having said that, I would like to repeat that there is no simple set formula, and that case by case perusal of a country's specific situation is essential.

IV.  Providing Liquidity to Crisis Countries

      The third fundamental issue is how to provide liquidity to countries hit by crisis.

      According to the IMF World Economic Outlook (September, 1998), Asian countries attracted $28.8 billion of net private capital inflows in 1996, a trend that was brutally reversed in 1997, when there was a net outflow of $44.3 billion of private capital from these countries. Regardless of the health of a country's economic fundamentals, no country can weather such an onslaught.

      Also, Asian countries' access to capital markets has all but disappeared. In January of this year, for instance, Indonesia's sovereign risk was deemed so high that the premium for its sovereign bonds reached about 1,000 basis points above that of U.S. Treasury bonds. It rose as high as 1,800 basis points following the Russian turmoil during this past summer, although it came down again to about 1,000 basis points by November. Such a prohibitive premium was applied to many other sovereign bonds issued by emerging economies. Even if such countries were able to borrow in the market, such high interest payments would not be sustainable.

      There is much talk these days about loss of market confidence. This is actually a different way of saying that the crises of today are often essentially crises of liquidity. Overseas creditors pull out funds even from countries with appropriate policies and from otherwise solvent local institutions and corporations. The most appropriate response to this type of crisis is to provide liquidity. This would provide an economy with breathing space that could be used to calm the market, and that would make it possible to consider necessary policy measures to be taken after the crisis, according to the specific circumstances of each country. This also would mitigate panic among overseas creditors: knowing that there were sufficient funds, they would not have to rush to try to gain as big a slice as possible of a small pie.

      Incidentally, trying to calm the market by presenting policy adjustments that are too ambitious might at times become counterproductive: a very tight monetary policy in the absence of history of high inflation, and a very stringent fiscal policy in a country with a good track record concerning fiscal soundness could simply result in a contraction of the real economy and further deterioration of market confidence. In this regard, it might also be advisable for the IMF to refrain from requiring too broad or too ambitious structural reforms at a time of crisis, because such targets very likely will be missed, particularly amid the political confusion experienced during a crisis, and they could lead to even further erosion of market confidence. Of course, that is not to say that we should disregard necessary macroeconomic adjustments. But measures should be implemented with full awareness of the ongoing crisis. Likewise, much-needed structural policies should be addressed as mid- to long-term challenges.

      In sum, to prevent panic among investors and to restore confidence as quickly as possible, the international community needs to enhance its capacity to provide liquidity. The IMF, as the central institution of the international financial system, has to play an important role in this endeavor by assuming some role as the lender of last resort in an appropriate situation. In this regard, the coming into effect of the New Arrangement to Borrow and the progress being made towards the IMF quotas increase, both of which contribute to reinforcing IMF resources, are important steps.

      I now wish to spell out some concrete ideas about mechanisms for providing quicker and greater liquidity, in line with the views I have just presented.

      First, in order to provide liquidity to member countries hit by a crisis, the IMF could create a new facility that would be precautionary as well as quick in disbursement when needed. Such a facility would differ from the precautionary facility currently being discussed, in that my proposal would not require pre-agreed arrangements, but would base itself primarily on good track records certified through regular surveillance. This new facility would aim only at overcoming present difficulties; policy requirements should be limited to a minimum for serving this objective. Once a crisis has passed, necessary reforms could be implemented in the context of longer-term programmes of the IMF or the World Bank.

      Second, in order to enhance the IMF's capacity to provide large-scale, short-term liquidity, it is conceivable to allow the IMF to borrow in the market as the institution is granted the capacity to do so by its Articles. Such borrowed funds would be used exclusively for the existing SRF (Supplemental Reserve Facility), a precautionary facility currently under discussion, and the above-mentioned new facility. This is logical, inasmuch as such borrowing by the IMF would be a means to recycle private funds that have stopped flowing into, or have indeed flowed out from, emerging economies.

      Third, the IMF can augment countries' foreign reserves through a new general allocation of SDRs. Member countries agreed last year to carry out a special allocation that was intended to achieve a fair allocation of SDRs between the original members and new members of the IMF. However, considering the fact that there is a global need to supplement reserves, especially in the emerging economies, and that risks of inflation are low, the case for a new general allocation is very strong.

      Fourth, in order to complement the role and function of the IMF, I think that it is appropriate to consider establishing regional currency support mechanisms. The recent experience regarding Brazil has reinforced our conviction that, in order to strengthen the international community's capacity to provide liquidity at a time of crisis, it would be appropriate to complement IMF loans through some kind of regional mechanism that is anchored in a sense of solidarity and mutual dialogue among the countries in a region.

      These mechanisms, which could be established in each region such as Asia, Latin America, and Eastern Europe, would be funded by countries in the region that are strongly interdependent on each other in the fields of trade, investment, and so on, and that are conducting continuous dialogue with each other on their policy directions. Nonregional countries with economic or political interests in the stability of the region also could participate.

      Under the initiative carrying my name, the Japanese government has proposed a variety of financing schemes, totaling $30 billion, for Asian countries. I am hoping that this initiative could lead to further discussions towards a regional currency support mechanism of the type that I just mentioned.

V.  Conclusion

      Talks about reforming the international financial architecture should not be just a passing fancy. They are indispensable for creating a better environment in which the world economy will operate.

     In 1926 John Maynard Keynes said,

".......Many of the greatest economic evils of our time are the fruits of risk, uncertainty, and ignorance. … .."

I believe that the cure for these things is partly to be sought in the deliberate control of the currency and of credit by a central institution, and partly in the collection and dissemination on a great scale of data relating to the business situation, including the full publicity, by law if necessary, of all business facts which it is useful to know.
Based on this observation, he continued,

"....For my part, I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight."
(The End of Laisser-Faire)

As is usual, his foresight applies even today. It is the responsibility of all of us, who have a common stake in the stability and sound development of the international financial system, to work to create a new international financial architecture for the next century. And I firmly believe that Japan should play a leading role in this important task of preparing for the new century, which is only two years away.

Thank you very much.

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