High-Level Expert Group Meeting
9-10 April 1999
The John F. Kennedy School of Government, Harvard University
Chaired by Helmut Schmidt and Malcolm Fraser
Global financial markets have recently experienced an
extraordinary increase in the volume of international
capital flows and the magnitude of exchange rate
movements. This volatility has contributed to real
economic crises in many developing countries. Such crises
pose a risk to the entire global financial network.
Political leaders bear responsibility for insuring that in
the future such risks are better understood and dealt with
more effectively.
There are numerous causes of the problems now being
observed in world financial markets. Domestic
mismanagement, over-valued exchange rates and
over-reliance on short-term foreign-currency denominated
debt in many emerging markets were major factors. These
problems, however, were exacerbated by poor lending
practices and excessively volatile short-term capital
flows. Technological change and aggressive competition
have encouraged private financial institutions to search
out higher rates of return in developing markets,
returning profits to safe havens in industrialized
countries.
Movements of goods, services, and capital are rapidly
liberalizing and are being integrated internationally,
while financial regulators generally operate within the
framework of national borders. There are no international
institutions, nor is there sufficient coordination between
competent national authorities, to effectively supervise
international financial markets. The result is a dangerous
vacuum.
The combination of technology, international integration,
and inadequate regulation create a situation in which
volatile financial inflows and outflows can become highly
disruptive, particularly when tied to exchange rate
fluctuations. Developing countries, with open economies
highly dependent on exchange rates, are vulnerable to
rapid adverse movements of short-term capital. Such
movements are often spurred by policy mistakes in
developing countries, but are also exacerbated by
movements in the exchange rates between the major
currencies themselves.
Exchange Rate Stability: The Options
It is difficult or impossible for a small, open,
diversified economy with a convertible currency to have a
sustainable exchange rate policy if there is volatility in
the exchange rates of the major world currencies. While an
improved financial architecture can improve the robustness
of the system, extreme fluctuations in exchange rates are
a source of significant financial shocks. Significant
improvements in exchange rate arrangements are required.
The following suggestions should form a basis for
discussion and future consultation.
- Exchange rate stability requires different approaches for emerging markets and the currencies of developed industrialized countries. The purpose must be to reduce the short-term volatility and uncertainty in financial markets, while allowing the flexibility required for adjustment in the medium-term.
- Given that the U.S. dollar and the Euro together will cover the great majority of world financial markets, the stability of the trans-Atlantic exchange rate is crucial for world stability. In view of the yen's importance in the Asian region, the stability of its exchange rates against the dollar and the Euro is also important.
- Representatives of the major world currencies should agree to consult about and coordinate their fundamental policy objectives and their implications for achieving greater exchange rate stability. Consideration should be given to reinforcing such a system by states pursuing more active market intervention around the equilibrium.
- Other countries, especially those with small, open economies, should choose their own exchange rate regime - no one system is appropriate at all times and in all places. However, their purpose should be to reduce volatility, to encourage investment, and allow for the flexibility necessary to adapt to changing circumstances. Technical assistance should be provided to them in choosing and maintaining the most appropriate regime.
An Improved Financial Infrastructure
The international financial system should be made more
robust, and this goal would be furthered by more effective
supervision of international financial transactions. An
international framework for coordination and eventual
harmonization of prudential supervision is a pre-requisite
for the creation of sufficient international liquidity
whilst discouraging reckless risk-taking on the part of
lenders and borrowers. The Financial Stability Forum
created in February by the G-7 is a valuable starting
point. It is important, however, that participation in
this framework not be limited to members of the G-7: other
countries, particularly developing countries and those
whose economies are in transition, should be included in
these discussions.
An international regulatory authority should be
established, building on the achievements of the Basle
committees. Such an authority should establish standards
of best practice in all forms of financial regulation,
monitor compliance with those standards, and coordinate
mechanisms for limiting the risks posed by non-compliance.
In addition to prudential supervision, attention should be
paid to the need for international standards of
disclosure, market control, and cross-border mergers.
Achieving best practice in prudential regulation involves
not only political commitment but also technical
expertise. There is a need to expand the role of
international institutions in assisting the developing
countries to up-grade their technical capacity to deal
with such increased regulatory burdens.
An important means of maintaining order in international
financial markets is the balance between short-term and
long-term capital flows. Equally important is consistency
between a country's state of financial development and the
speed with which capital can enter and exit its markets.
The IMF should not, in the near future, require full
capital account convertibility for all member states. In
certain situations, it may be appropriate for some
emerging markets to restrict short-term capital inflows,
and to impede the movement of flight-capital belonging to
national citizens.
The IMF should continue, with adequate conditions, to
provide assistance to states experiencing financial
crisis. In formulating the requirements for such funding
the IMF should take particular account of a country's
history and individual economic situation. It should not
intrude on the World Bank's responsibility for long-term
development issues. The IMF's financial resources should
be strengthened as a means of averting crises through the
provision of contingency funds. Adequate funding is
necessary for international institutions to fulfill their
role.
In any liquidity arrangement, the IMF should take care not
to absolve lenders of their responsibility. The IMF should
be given better ability to monitor short-term capital
movements (including derivative positions).
It may be appropriate to allow the IMF, in certain
emergency situations, to create SDRs for a limited period
of time as a form of liquidity support. Such extraordinary
issues of SDRs would allow rapid reaction to crises, and
should be rapidly retired. In general, however, the IMF
should serve as a catalyst for attracting private sector
capital into the international market.