UNCTAD BOARD EXAMINES ISSUE OF THE DAY: THE CAUSES, MANAGEMENT AND PREVENTION OF FINANCIAL CRISIS

The first week of the annual session (12-23 October) of the UNCTAD Trade and Development Board focussed largely on an in-depth intergovernmental debate about the causes, management and prevention of financial crisis. The UNCTAD Trade and Development Report 1998 (TDR98) released in September (see TAD/INF/PR/9821) proved to be a most useful guide for the discussions. It was presented to the Board by the recently appointed Director of UNCTAD’s Division on Globalization and Development Strategies, Mr. John Toye (see Note to Correspondents N°27), and UNCTAD’s macro-economist, Mr. Yilmaz Akyüz.

There is need for a new institutional financial structure, panel agrees

On Tuesday 13 October, the Board held an informal discussion chaired by Ambassador Carlos Perez del Castillo from Uruguay. The panellists were: Ms. Stephanie Griffith-Jones, Institute of Development Studies, University of Sussex, UK; Mr. Will Hutton, Editor-in-Chief, The Observer, London; Mr. Martin Mayer, Brookings Institution, Washington D.C.; and Mr. Yung Chul Park, Former President, Korea Institute of Finance, Seoul.

Summing up, the Chairman said that the need for more international supervision and monitoring of the movement of short-term speculative capital was considered crucial. The shortcomings, deficiencies and limitations of the existing international financial system were emphasized by all participants. There was a consensus in favour of working towards a new institutional structure at the international level. But views differed on the dimension and scope of the reforms needed, ranging from just filling gaps in the regulations and provisions of the existing institutional system to the establishment of a new world financial authority with functions extending to the supervision of hedge funds.

It was felt that in order to prevent future financial crises, it would be important to incorporate the - at present missing - function of lender of last resort in the new international financial system . However, some countries questioned the viability of this proposal in the light of the availability of necessary financial resources.

The Chairman said there had been an interesting discussion on the defence mechanisms or measures which could be adopted by countries confronted with sudden massive withdrawals of foreign capital and sustained attacks on their currencies. It was considered important that the international financial system should be able to incorporate safeguard measures for the countries affected by financial crises like the current crisis, such as the measures provided by the World Trade Organization (WTO) in the area of trade. In this connection, the participants discussed the measures provided for in the Trade and Development Report, 1998, in particular the standstill measures in the payment of foreign debt, accompanied by negotiations on restructuring the debt, measures to control or restrict short-term capital flows or the application of certain principles such as those contained in Chapter 11 of the United States bankruptcy code.

All participants agreed that the crisis had demonstrated the value of sound, independent and timely analysis such as that produced by the UNCTAD secretariat. Support was expressed for UNCTAD’s active participation with the international financial and monetary organizations in the process of reform currently under way.

Following is a cross-section of statements made by delegates during plenary sessions on 12 and 14 October.

Ambassador Javier Diaz of Costa Rica, speaking on behalf of the Group of 77 and China (G77), said that as a result of the East Asian financial crisis growth forecasts for all developing regions had been revised significantly downwards, and the developing world as a whole was unlikely to attain positive per capita growth this year. It was important to sustain sound and stable macroeconomic policies and not to reverse liberalization or resort to protectionist measures, he said. However, the major industrial countries should revise their macroeconomic policies in a coordinated way in order to avoid a worldwide recession. The surplus countries, in particular, should take measures to stimulate demand.

The East Asian crisis had been caused not only by domestic factors, but also by weaknesses in the international financial system. The institutional and regulatory framework for that system had not kept pace with rapid financial globalization. An increasing share of international financial transactions was motivated by gains from speculation and arbitrage, and the volatility of these flows had important repercussions on exchange rates and the real economy. There was thus a need for greater coherence in international policy-making in trade, financial and monetary affairs and the developing countries needed to have a greater say in the management of the global financial system.

In certain developing countries, Ambassador Diaz said, the capital account had been liberalized too early and too fast. While many developing countries still needed to strengthen their financial sectors domestically, they also had to be protected against the vagaries of international financial markets. The international community therefore needed to explore collectively the possibility of designing new mechanisms for global financial governance. Moreover, countries should be better equipped with instruments to respond to currency attacks in order to prevent liquidity crises from becoming solvency crises.

Ambassador K. G. Anthony Hill of Jamaica stressed the importance of the participation of developing countries in the decision-making process within the international financial system and its institutions. The current financial crisis was only the latest event in a series of episodes over the last three decades which had prevented many developing countries from benefiting from the radiating growth of an increasingly interdependent global economy. These episodes included the oil price shocks, bouts of high inflation, major debt crises and financial market volatility. The decade was ending with the return to poverty of large sections of populations, dramatic increases in unemployment, and increasing income disparities.

Mr. Agus Tarmidzi of Indonesia said that the reversal of capital flows to East Asia had been caused by a turnaround in the initially favourable external environment and by shortcomings in the deployment of these funds and their intermediation in the receiving countries. Despite its excellent macroeconomic management, Indonesia had been severely affected by the loss of confidence resulting from the crisis. Measures taken to alleviate the social impact of the crisis had substantially increased the budget deficit, the financing of which was possible only with external support in the form of partial rescheduling of the public debt. Since the crisis was a systemic problem, innovative measures at the national, regional and global levels were required to address the lack of surveillance, the regulation of short-term capital flows and the volatility of currency markets. UNCTAD should play a key role in strengthening the international financial architecture.

Mr. Chul Ki Ju of the Republic of Korea said that the East Asian crisis was only partly due to domestic problems in the countries directly affected. Deficiencies in the mechanisms of the world economy had also played an important role. The international community had to assume the task of preventing a worsening of the crisis and its spread to other regions. It also had to help the affected countries to recover. In the medium and long-term, management and prevention of financial crises had to be improved. Like other countries in the region, the Republic of Korea had made painful efforts to undertake necessary reforms, while braving many hardships and tolerating great social distress, including many lay-offs.

International action was needed to ensure that emerging markets enjoyed continued access to external capital flows through official credit lines and investment insurance. To prevent financial crises in the future, it would be necessary to reach general agreement on a new global financial structure, maintaining a balance between the need for more effective monitoring of capital flows on the one hand and the avoidance of over-regulation on the other. UNCTAD’s proposals in this regard were an important contribution.

Ambassador Carmen Luz Guarda of Chile said that the crisis that had begun in East Asia had taken on unexpected dimensions, as it was spreading to other regions, including Latin America. Sound macroeconomic policies were now called for, and the process of trade liberalization needed to continue. Chile was affected by the crisis directly because the countries of East Asia were major trading partners, and indirectly because of falling prices for copper, on which it was highly dependent for export earnings. Additionally, international investors were generally reassessing the risks in emerging markets. The drop in the country´s export earnings would increase the current account deficit and make it difficult to maintain the recent growth trend. But the economy was better prepared to face a crisis than it had been in 1992.

Mr. U. S. Bhatia, Joint Secretary of Commerce of India, speaking on behalf of the Asian Group, noted that financial crises had occurred with increasing frequency since the collapse of the Bretton Woods system. Many of these, including the latest one, had been preceded by the liberalization of the economy, notably the financial sector. The approach towards capital account convertibility therefore had to be properly sequenced and carefully calibrated. Restraint on short-term cross-border borrowing and lending might even have to be viewed as a prudential norm rather than a restriction on capital flows. Temporary measures to control a crisis might also be viewed as a legitimate safeguard action.

In a highly interdependent global economy, Mr. Bhatia said, it was no longer possible for any country to remain unaffected by developments elsewhere or to contain the damage to the domestic economy by the pursuit of domestic measures alone. The international community must come together not only to mitigate the social and economic effects and human suffering which resulted from financial crises but also to prevent the frequency and the scale, if not the recurrence, of such crises. An action programme should include an immediate joint programme of the IMF and the countries concerned for restoration of confidence and stability; an international safety net for vulnerable countries; concerted macroeconomic action by the major industrial countries to avoid a global recession; maintenance and improvement of an open international trading regime; a thorough reform of the international monetary and financial system; a thorough review of IMF operational policies and procedures; and a new global commitment to strengthening official development assistance (ODA).

Mr. Krit Garnjana-Goonchorn of Thailand said that UNCTAD´s warning of the contagion effect resulting from the Asian crisis was, regrettably, proving justified. Although the analysis and proposals in the Trade and Development Report 1998 seemed to be at odds with policies pursued in the Asian economies affected by the crisis, the international community should give active consideration to these proposals and embark on a more balanced approach in order to reduce the risk of capital volatility and its adverse impact on the international financial and trading system. UNCTAD should contribute to the debate on a new international financial architecture, and support the developing countries in their effective participation in designing a balanced international financial system conducive to long-term economic growth and development.

Mr. Mansour Raza of Pakistan stressed the urgent need for action to maintain growth and demand in the global economy, and for the provision of an adequate level of liquidity, for example through the recycling of the budget surpluses of some Asian countries. Issues related to a temporary debt standstill and an orderly workout of debt situations needed to be explored in greater depth. Countries should be given greater autonomy in taking measures designed to resolve a crisis, since standard prescriptions had proven not to work satisfactorily in all countries.

The case for further trade liberalization needed to be reconsidered, since the pace with which the countries now affected by the crisis had liberalized their trade regimes might have been too fast for their supply capacities and external competitiveness. The resulting trade deficits had been financed by short-term capital inflows whose reversal had eventually triggered the crisis. Against this background, the international financial architecture appeared to be inadequate, and the way in which the development process was managed and development strategies were pursued needed to be reconsidered. UNCTAD had an important role to play in the urgently needed reconsideration of the linkages between trade, finance and development.

Developed Countries

Ms. Gudrun Graf of Austria, speaking on behalf of the European Union, said that the issues raised by the current financial turmoil in the world economy were complex. The Trade and Development Report provided a clear, if at times provocative, discussion of these issues. Appropriate measures to solve the crisis and to stimulate economic growth needed to be taken, not only in the affected economies but also in the industrial countries. But any such efforts had to be accompanied by reforms in the international financial system along the lines recently suggested by the European Union and the United States.

The Trade and Development Report 1998, she said, had provided a useful analysis of the multiple mechanisms that had led to the spread of the East Asian crisis within and beyond the region. It had also raised a basic dilemma facing the international monetary system: on the one hand, the limits of fixed exchange rates became pressing in the face of inflationary and structural constraints; on the other, freely flexible regimes had many problems in the absence of any clear anchors. Solving this dilemma could not be separated from the question of the appropriate role of international institutions in tackling financial turmoil.

Mr. Yoshiki Mine of Japan said that, despite the current crisis, it should not be forgotten that East Asia’s rapid economic development had been attained through liberalization of both trade and finance. UNCTAD should remain a strong vehicle for combatting any protectionist backsliding. Japan’s current challenge was to bring about recovery of its domestic economy and to assist other crisis-ridden Asian economies. In April 1998, the Government had announced a large policy package to stimulate the domestic economy. Since August 1997, he pointed out, Japan had been by far the greatest supporter of the other economies in Asia; it had provided a total of $43 billion in the form of long-term financing, trade insurance, grant aid and technical assistance. Additional bilateral support in response to the Asian crisis, worth $30 billion, had been announced in early October 1998.

Even though the Asian crisis had shown that the risks and costs of liberalized short-term capital movements can sometimes exceed their benefits, the development strategy based on the market mechanism was still essentially valid, Mr. Mine stated. However, capital account liberalization needed to be appropriately sequenced, starting with foreign direct investment and long-term capital flows. There was also a need for improved monitoring of international capital flows, in particular with regard to the activities of large institutional investors such as hedge funds. Consideration needed to be given to effective measures to protect emerging economies from the adverse effects of excessive short-term capital flows. The Trade and Development Report 1998 had raised important issues in this regard, but more analysis of possible instruments and further creative thinking was required.

For Ambassador Bjørn Skogmo of Norway, the international financial architecture needed to be improved. Policy recommendations of international institutions had to be more coherent. In this context synergies could be found more easily now, given that the mainstream of world economic thinking was moving towards UNCTAD’s views. The independent voice should, nonetheless, not be discouraged.

The Asian crisis illustrated that even well managed economies were vulnerable to external shocks. There was a need for a more supportive external environment, with better schemes for debt relief, improved market access and a higher share of capital flows directed to productive use rather than to short-term speculative gains. The Heavily Indebted Poor Countries (HIPC) initiative was the most constructive multilateral scheme launched so far, but additional measures were required. Norway had adopted a debt relief strategy which, in addition to supporting existing multilateral schemes, included bilateral debt reduction measures. Norway encouraged other creditor nations to develop similar arrangements. The UNCTAD secretariat’s good analytical work needed to be translated into effective policy advice to individual countries so as to enable their Governments to adopt proactive policies to avoid the adverse effects of globalization.

Countries in Transition

According to Mr. Syargei Mikhnevich of Belarus, the East Asian crisis showed the urgent need to create efficient new mechanisms for the prevention of financial crises. As long as supranational instruments for crisis prevention were absent, Governments should have the possibility of using national measures to avert a destabilization of the domestic financial system. Belarus was following a gradual approach in reforming its economy. The goal was an open, socially-oriented economy; and the policy mix included "flexible monetarism" as well as elements of state regulation. Unfortunately, this approach had not received adequate support from the IMF and the World Bank.

Mr. Yuri Afanassiev of the Russian Federation also saw an urgent need to discuss the reform of the international financial system. The main issues in such a debate would be the reform of the Bretton Woods institutions; new instruments for the IMF to prevent financial crises in individual countries; the elaboration of "rules of conduct" for government action in the area of external financial relations; improving the monitoring of international financial transactions; strengthening coordination among the international financial and banking institutions; better international coordination of financial and economic policies; and instruments for the regulation and control of international capital movements, especially short-term speculative flows.

Statements on this item were made also by the representatives of China, Sri Lanka, Senegal, Switzerland, Malaysia, Cuba, Guatemala, Egypt, Poland, Uganda, Brazil, Bulgaria, South Africa and the International Federation of Free Trade Unions, an NGO in status with UNCTAD.

The discussion on financial crisis will continue at a "High-Level Segment" of the Board on 22 October, chaired by Dr. Supachai Panitchpakdi, Deputy Prime Minister of Thailand (see TAD/INF/PR/9830).