September 18, 2001
|Contact:||Gary Clyde Hufbauer||(202) 328-9000|
Washington, DCDebates about the international financial architecture received a fresh contribution in a new Institute study, World Capital Markets: Challenge to the G-10. According to the authorsVisiting Fellow Wendy Dobson and Reginald Jones Senior Fellow Gary Clyde Hufbauerchanging the rules of the game for G-10 financial institutions is equally important as structural reform in the emerging market economies.
Persistent moral hazard and limited IMF resources
In their policy recommendations, the authors focus on persistent moral hazard among the G-10 suppliers of international capital, particularly banks, and the contribution that bad lending behavior makes to systemic liquidity crises. Financial crises in the emerging markets impose severe economic, social, and political costs. These costs, in turn, build pressure for international safety nets anchored by the International Monetary Fund, which add to the moral hazard problem.
Moral hazard is one argument advanced by those who believe the IMF mandate should be more restricted. Dobson and Hufbauer provide another argument: they project a declining IMF capacity to cope with the growing private capital flows to emerging markets (see table 1). They also point out the key implication of a narrower IMF mandate: more effort will be required by G-10 governments and regulators on the supply side ex ante to change the incentive structures for the leading suppliers of volatile short-term capital, such as bank loans and portfolio investments.
Dobson and Hufbauer argue that reforms on the supply side should change the rules of the game with stronger supervision, better international coordination among financial regulators, and a clearer framework for involving the private sector in crisis management. They recommend:
Dominant position of G-10 financial institutions
These recommendations are based on analysis of the incentive structures for the 200 large financial institutions that are the major players in international financial markets. Located mainly in the G-10 countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States) and Spain. These 12 countries held 84 percent of the world's bank assets, 86 percent of the world's stock market capitalization, and 76 percent of the world's debt securities in 1999.
Special role of G-10 banks
Banks play a key role in modern financial systems by pooling the resources of disparate savers, applying their expertise to evaluate borrowers, and thereby improving overall resource allocation and the division of risk. Yet even as they grow larger and more complex, banks are perceived to enjoy implicit and explicit public safety nets. These safety nets in turn encourage banks to take risky short-term exposures in emerging markets. However, when adversity occurs, banks are quick to pull their interbank loans and lines of credit.
To reduce moral hazard and the inadvertent contribution that banks make to financial crises in emerging markets, the authors argue that public supervision and private monitoring should both be stepped up. The new Basel Capital Accord is a move in the right direction. But more action is required. Elected officials need to make supervisors more accountable for financial crises. In turn, supervisors should take more responsibility for the systemic consequences of risk-taking by the institutions they oversee, and they should share information with their G-10 counterparts in order to coordinate corrective action on a confidential basis. At the same time, market instruments that encourage greater transparency and private disciplinesuch as subordinated debtshould be introduced to complement the work of public supervisors.
An additional supply side approach for reducing moral hazard is to change the way financial crises are resolved. The authors advocate clear ex ante arrangements. They examine proposals for greater privatesector involvementsuch as standstills and collective-action clauses-that would reduce the need for an international safety net.
Dobson and Hufbauer conclude that G-10 reforms aimed at more appropriate evaluation and pricing of risk should become permanent features of world capital markets. In view of strong entrenched interests that seem to have deadlocked aspects of IMF reform, the authors suggest that political resources should be targeted on carrying forward the Basel II frameworkbeyond what regulators themselves alone can doand in improving cooperation between public and private officials in crisis prevention.
The contribution of international capital in promoting growth
These recommendations reflect the authors' assumption that a shift in the composition of international capital flows toward longer maturities is both feasible and desirable. The authors acknowledge that the evidence for substitutability across different forms of capital, such as foreign direct investment (FDI) for bank debt, is limited. However, they believe that new incentive structures can promote such desirable substitution.
Moreover, they present evidence that longer-term forms of capital contribute to economic growth in emerging markets. They cite estimates for the contribution to economic growth made by bank lending, portfolio investment, and FDI (see table 2). Econometric studies find little evidence that bank lending (including trade credits) contributes to higher GDP in emerging markets. FDI, on the other hand, makes a significant contribution: for every 10 percentage points rise in the ratio of FDI stock to the economy, GDP rises 4 percent. The contribution of portfolio investment is about half as great (2 percent increase in GDP for every 10 percentage points increase in portfolio investment as a ratio of GDP). Thus, while the available evidence points to greater growth benefits from FDI and portfolio capital, time series data shows that bank lending is more volatile than other forms of capital flow (see table 3). Higher volatility puts more stress on financial systems in emerging markets.
Dobson and Hufbauer conclude that the benefits from more foreign capital in emerging market economies are comparable to the latest estimates of the benefits from merchandise trade expansion-GDP levels are around 5 percent higher than they would be otherwise. In comparison, they calculate the costs of financial crises in the emerging market economies at 0.6 percent of GDP annually in the 1980s and 0.7 percent annually in the 1990s. These lossesdamaging and concentrated as they wereare substantially less than the estimated gains from international capital.
About the Authors
Wendy Dobson is professor at and director of the Institute for International Business at the University of Toronto. She was a visiting fellow at the Institute for International Economics in 1990-91. Between 1981 and 1987 she was president of the C.D. Howe Institute in Canada. From 1987 to 1989, she served as associate deputy minister of finance in the Canadian government with responsibility for international monetary affairs. Her most recent publications include Financial Services Liberalization in the WTO (Institute for International Economics, 1998) coauthored with Pierre Jacquet; Fiscal frameworks and financial systems in East Asia: How much do they matter? (University of Toronto Press, 1998); and Multinationals and East Asia Integration (1997) edited with Chia Siow Yue, which won the 1998 Ohira Prize.
Gary Clyde Hufbauer, Reginald Jones Senior Fellow, was formerly the Marcus Wallenberg Professor of International Finance Diplomacy at Georgetown University (1985-92); deputy director of the International Law Institute at Georgetown University (1979-81); deputy assistant secretary for international trade and investment policy of the US Treasury (1977-79); and director of the International Tax Staff at the Treasury (1974-76). He has written extensively on international trade, investment, and tax issues. He is coauthor of NAFTA and the Environment: Seven Years Later (2000); coeditor of Unfinished Business: Telecommunications after the Uruguay Round (1997); and coauthor of Economic Sanctions Reconsidered (2nd edition, 1990).
About the Institute
The Institute for International Economics is a private nonprofit research institution for the study and discussion of international economic policy. The Institute, directed by C. Fred Bergsten, provides fresh analyses of key economic, monetary, trade and investment issues, and recommends practical policy approaches for strengthening public policy toward these important topics. The Institute receives funding from a large number of private foundations and corporations.