News Release
Speech by Mervyn King, Deputy Governor, Bank of England - "Reforming the International Financial System: The Middle Way"
09 Spetember 1999
Delivered to a session of the Money Marketeers at the Federal Reserve Bank of New York
In his speech , Mervyn King looks at the recent financial crises in the emerging market economies and suggests practical steps which could be taken in reforming the international financial system.
Mr King sees the core of the problems faced by a number of emerging markets as the sharp reversal of capital flows and rapid contagion from one emerging market to other previously unaffected countries. The problems arise largely from short-term flows of debt finance, not long-term equity flows or direct investment. Either maturity or currency mismatches create the potential for sudden reversals of capital flows on a huge scale.
Mervyn King makes two observations: "First, capital flows in the form of foreign direct investment and portfolio equity investment should be encouraged. Emerging markets can do a great deal to increase these by adopting modern accounting standards, a transparent legal framework, and a stable market-friendly environment to which foreign investors will be prepared to commit long-term investments. Second, ways must be found to reduce the volatility of short-term flows of bank finance. The key is to avoid maturity and currency mismatches on the national balance sheet."
He considers how to design an appropriate infrastructure for the international capital market to prevent, or at least limit, the frequency of crises.
He dismisses the idea of an international lender of last resort as being politically impractical. Indeed, he observes that "serious moral hazard arises when the private sector ignores the risks of lending to a country because it believes that the country would be bailed out by the international community in the event of a liquidity crisis. And investors are encouraged to lend to emerging markets in forms - short-term debt - which are more likely to be bailed out."
Mervyn King also dismisses the imposition of permanent capital controls as they are likely to impede trade flows, they forsake all the economic benefits of a free capital market and they undermine the cause of market liberalisation.
Mervyn King proposes a "middle way" between these extreme solutions. He suggests five practical steps towards preventing crises.
- Emerging market countries should aim to provide self-insurance against liquidity crises. Ways of doing this include creating contingent credit facilities with international banks, building up foreign currency reserves, and regional self-insurance funds.
- They should manage their national balance sheets, and, as far as possible, avoid maturity and currency mismatches
- They should encourage inflows of equity rather than debt finance. A credible legal and institutional infrastructure for private investors would go a long way to encourage equity inflows.
- There should be better designed debt contracts which provided a framework for negotiation between creditors and debtors when financial difficulties arise.
- Countries should avoid, at all costs, the defence of fixed but adjustable exchange rate pegs when they are no longer consistent with internal and external equilibrium.
To help resolve crises, Mervyn King makes no proposals but argues that four approaches require analysis if a solution is to be found:
- The provision of official finance should be linked to the involvement of other creditors, including the private sector.
- Seek co-operative solutions negotiated between a debtor and its creditors.
- The use of temporary standstills - possibly sanctioned by the international community - to allow time for a country to negotiate with its creditors.
- Measures, including perhaps strictly temporary capital controls, to prevent capital flight by domestic residents in exceptional circumstances.
Mervyn King argues that, in the context of the middle way, greater transparency is crucial. "Transparency can help reduce the frequency of crises - by alerting not only markets but also policy-makers to problems on the horizon - and their severity - by minimising the surprises about the scale of any liquidity problems." "Transparency is not simply a question of making available certain data. It is an approach to economic policy, almost a way of life."
But he adds, "in a world of sovereign states, countries cannot, and should not, be compelled to disclose information if they do not wish to do so. A crucial substitute for the inability to make transparency mandatory is that we need transparency about transparency". He continues, "The need now is to make the production of Transparency Reports an integral part of the [the IMF's] Article IV process. There is no reason for further delay".
Finally, Mervyn King concludes: "Of course the immediate crisis has receded, and some of the Asian countries, in particular, have recovered sharply over the past year. But we should not be misled by the calm after the storm. There will be future storms, and now is the time to prepare for them. There is no need for another international conference of the kind which led to the creation of the Bretton Woods institutions. But there remains a need for thinking as original and imaginative as that which inspired the Bretton Woods conference.
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