international finance in the period of globalization (1)

8/6/2019 International Finance in the Period of Globalization (1)

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INTERNATIONAL FINANCE IN THE PERIOD OF GLOBALIZATION: CURRENT

TRENDS

Natalie Radovanovic

The contemporary debate about globalization has a very large impact on the structureand the practices of international public finance. As many critics are calling for reform of

the IMF and World Bank, others fear the consequences of the continued dominance of

less developed countries by the wealthy few. The games of power politics and economicsplay out even less equitably in the globalized world, according to the anti-globalizers.

Undoubtedly, however, and despite the recent financial crisis, current trends show that

private capital flows are high; institutional investors are more inclined to use their

leverage ; access to quick information that is not always thorough is increasing financialmarket instability ; and hedging and speculation are on the rise . As Ross Buckley

concludes, "[e]ach of these aspects of globalization tends to increase the volume of

portfolio capital flows to emerging market nations and the volatility of such flows.

Indeed, there is considerable evidence that the globalization of financial marketsincreases the volatility of such markets." Therefore, the increase of globalization

produces higher financial risks, and consequently also increased need for bailouts.

Pro-globalization advocates support the process of globalization, arguing that its long-term benefits will outweigh the short-term difficulties, with respect to the less developed

nations. They split, however, regarding the means of establishing a more globalized

economic and financial system. Some argue that structure in the system is necessary inorder to produce stability and more accountability. Others maintain that a laissez-faire

approach is most favorable to the higher levels of development, and to the absolute

wealth gain.

Anti-globalization movements are gaining increasing strength in their opposition tothe globalized economy. They point to the increased poverty and militarization, hazards

to environment, and lack of protection of human rights as evidence of the lack of success

of the current state of affairs.

A. CURRENT PRACTICES OF THE IMF AND THE WORLD BANK

The IMF and the World Bank continue to play their traditional roles in world global

finance, encouraging global capital movements, both private and public, and stepping in

to provide managed defaults and structured bail-outs. For example, the IMF dealt with

the global financial crisis of 1997-1998 by ensuring the bailout of large banks and otherlenders to the countries in crisis. Less developed countries have generous access to

foreign capital, which, as many would argue, is not beneficial for those countries, either

politically and economically. Examples of Mexico, the Asian states, and Russia, alldemonstrate that whatever the benefits globalization may have, it also produces many

undesirable effects.

1. GLOBALIZATION AND DEVELOPMENT
http://www.uiowa.edu/ifdebook/issues/globalization/readingtable/natalie_bio.shtmlhttp://www.uiowa.edu/ifdebook/issues/globalization/readingtable/natalie_bio.shtml


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It is hardly disputed, at least with regards to the short term situation, that the

globalization of capital can have bad effects on the less developed states. The repayment

of loans leads to higher national taxes, reduction of price substitution for essentialproducts, and decreasing spending on public health care, education, and infrastructure

(many recognize that the liberal capital inflows into these countries often end up

enriching the local rich who, when they cannot make the payments on these capitalinflows, subject their populations to the consequences of the capital outflows).

Still others point out the risks found in incurring further debt to finance the existing

loans "[b]ecause private banks and institutions often view a credit package as a "seal of

approval" that the nation is a reasonable investment, the IMF and the Bank havedeveloped into de facto analysts of a nation's economic health." Moreover, the IMF

bailouts are essentially long-term loans that are used to repay short-term creditors ,

particularly private and commercial developed world banks. Therefore, the bailouts arefunds to creditors who made bad loan decisions, rather than to the nations themselves.

Critics calling for reform of the IMF and World Bank, or for an alternative regime,

support their position by arguing that "even though the IMF identified poor localprudential regulation and underdeveloped local capital markets as two of the principalcontributing causes to the [1997-1998 financial] crisis, the IMF-orchestrated bailouts

contained not one dollar to correct these weaknesses.

Even the supporters of the globalized financial system and, in general, supporters ofthe IMF and the World Bank, criticize their current programs. Because the IMF and the

WB have a flawed vision of development, they argue, the continuous lending to

governments increases the state sector at the expense of the private sector. This produces

further debt, not development, and it stalls reform. These critics argue that theorganizations finance governments whose anti-growth policies of trade barriers, state-

owned corporations, and investment restrictions, among others, resulted in very highdebt.

2. THE LOCAL ENFORCEMENT PROBLEMS

Certain critics argue that the current situation is not conducive to globalization

because the majority of entrants to the global marketplace lack developed financial

structures, poor legal, accounting and regulatory framework, history of politicalinterference and cronyism.

3. THE CONTINUING ROLE OF DEBT

Many countries presently spend large amounts of their GDP, and millions of dollars

servicing their international debts. The IMF and G7 creditor nations have instituted a debt

relief plan for the most impoverished states (Heavily Indebted Poor Countries Initiative),which are located mostly in Africa. The HIPC Initiative has provided for a Trust Fund,

administered by the World Bank, which provides debt relief owed to multilateral

institutions, funded by the World Bank and certain donor countries. It also provides an


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ESAF-HIPC Trust which extends grants and loans to these countries, and subsidizes

interest rates through donors and IMF's Special Disbursement Account.

The problems inherent in these debt relief programs are that they are neverthelesswithin the IMF conditionality principle. The IMF provides the relief contingent on the

country's meeting the structural reforms required by the IMF, such as reduction ingovernment spending, which inevitably reduces state employment and social benefits.

Moreover, the IMF limits the "dimensions of the goal of broad participation" by limitingthe number of countries that are eligible and by imposing structural adjustment programs.

The proponents of debt relief on the pro-globalization side argue, however, that debt

relief coupled with reforms will eventually lead to a more efficient, high-growtheconomy.

There are many critics who call for flexible debt relief, especially for the least

developed nations, arguing in some cases that servicing the debt forces violations of

human rights in those countries: "By continuing to insist that poor states use their scarce

resources for debt service payments, rather than for improved access to health care,education, food, and basic shelter for their impoverished populations, the international

community becomes complicit in the wide-scale violation of human rights."

B. ALTERNATIVES TO THE CURRENT GLOBAL FINANCIAL SYSTEM

The current international financial system is governed by the IMF, the World Bank,

the WTO, and the OECD. The IMF regulates the transparency practices for central banks,

government finances, fiscal and monetary policy, and possesses broad economic,

financial, and sociodemographic data. The World Bank governs the development projectloans and the cross-border insolvency. The OECD regulates the principles of corporate

governance. The WTO replaces GATT, essentially regulating international trade.

Both the anti-globalizers and the pro-globalizers argue for some kind of alternative tothe current system. Some pro-globalizers still maintain their position that the laissez faire

approach is the best way to deal with financial issues in a globalized world. Along the

same lines, some anti-globalizers argue against a globalized monetary system per se. In

the middle, both the anti and the pro globalization advocates argue for a reformedmonetary institutional system. They differ in their specification of the kind of system that

would best serve the nation-states.

1. GLOBAL LENDER OF LAST RESORT

A lender of last resort lends to state and private banks "freely and quickly, on goodsecurity and at high interest rates, at times of need." As a result, the depositors do not bail

at the first sign of financial trouble, because they are sure that their banks will be able to

meet their account balances. This, in essence, assures that the debt crisis of the 1980sdoes not happen again. Although some refer to the IMF as an international lender of last

resort, the IMF actually does not lend "freely and quickly", but instead conditions its

loans on specified economic criteria. Moreover, the IMF disburses the funds slowly as


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compliance with its criteria is proven. Finally, because of its difficulties in securing funds

from its wealthy members, it does not have a sufficient amount of capital to serve as a

lender of last resort.

On the other hand, the establishment of a true lender of last resort would require that

both the borrowers and the lenders take responsibility for bad loans: "borrowers shouldrepay their debts, even when it is painful to do so [and] banks and investors who make

errors should suffer the consequences". Furthermore, such a lender would have to makeloans available for bailouts of international banks and member states so that they can

repay their loans, rather than to meet the financial needs of short-term private creditors

who make bad loans.

2. GLOBAL BANKRUPTCY COURT

Although not really a viable alternative due to the substantial limitations on

sovereignty that it would impose, an international bankruptcy court would be able to

more equitably allocate losses and improve the functioning of the system. On the otherhand, many nations have already surrendered their sovereignty to a number of

international courts and arbitration panels, as well as to the IMF and the World Bank.

3. REFORM OF THE IMF AND THE WORLD BANK PRACTICES

The IMF and the World Bank are criticized for their role in a globalized financial

system. Critics point out that these two organizations do not monitor their own standardsgiven the conflicts of interests they have inherent in their many roles, the political role of

their governance, and the increased bureaucratization and concentration of power in the

institutions.

Instead of advocating the withdrawal of the IMF and the World Bank, some argue thatthese institutions still have an important role to play in a global financial system, but that

they need to reform their lending practices. For example, the organizations could lend to

the nation without conditions and demand payment at the end of a specified period,which, if left unpaid, would result in a lack of extension of further loans. The problem

with this approach is that defaults would still inevitably occur, and when they did,

especially in economically and politically important nations whose stability is essential ina geopolitical sense, the IMF and World Bank would have to step in. This, in turn would

affect their credibility, in addition to not solving the bailout problem.

In the alternative, the IMF and the World Bank could impose limited conditionality,which allows for discrimination on the basis of the type of economic problems causingthe repayment difficulties (i.e., those problems that are caused by the nation's policies and

those that are beyond a nation's control). However, this approach also produces

challenges in that it would be extremely difficult for these organizations to police theseissues and to accurately identify their causes. The significance of this problem is

magnified in the global interdependent economy.


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Milena Makich-Macias argues that the IMF bailout program should remain intact,

coupled with a number of changes that would make it function better. Her proposal calls

for strengthening the macroeconomic stabilization policies, expanding the structuraladjustment reforms (such as low interest loans to poor countries), and exploring

innovative approaches to address social concerns so that emerging growth countries can

become and remain self-sufficient. Macias states that "[f]ocusing on macroeconomicstabilization and structural adjustment reforms allows the IMF to ameliorate social

concerns...In addition, by its promotion of a stable system of exchange rates which

promote the balanced growth of international trade, the IMF contributes to sustainableeconomic and human development."

4. SINGLE WORLD REGULATOR

Fratianni and Pattison argue that a single regulatory body would achieve the efficiency

and the ease of acting when mandated, to impose the best solution, limited by standards

of accountability. These standards would ensure that the regulator takes a strictly

regulatory approach, instead of a market-friendly regulatory approach. The agency shouldalso not be amenable to any particular country, and should be made in reliance on an

international agreement.

CONCLUSION

Globalization has produced an increase in interdependence of monetary and fiscal

policies, with the resulting movement of private and public capital and increased risks.

The globalization debate has certainly invaded the area of IMF and World Bank policies.

Depending on the particular side that one takes in the debate, different proposals as tohow to deal with challenges and problems of the interdependent world are made. The one

thing that all the commentators agree on, however, is that the system needs change. Theyonly differ as to the means for implementing this change.

Speeches and Papers

Globalization and the International Financial System

by Edwin M. Truman, Peterson Institute for International Economics

NYU-Stern Global Business Conference 2001Globalization: Risks and RewardsNovember 30, 2001

Peterson Institute for International Economics


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international finance; through such channels purchasing power over realresources today is transferred from areas of the world where expected rates ofreturn are lower to areas of the world where expected rates of return are higher.(At least that is the theory.) This process, in turn, is facilitated in importantrespects by technical changes that have helped to speed not only the flow of

funds but also the flow of information about investment opportunities. So far, sogood!

However, recall that a significant portion of the debate about globalization and itseffects on the real economy revolves around what portion of the process thatsupporters of globalization call "creative destruction" is attributable to trends inglobal integration, on the one hand, and what portion is attributable to trends intechnical change, on the other hand. If one can establish that a significant shareof the process of disruptive change in our economies is due to technical change,not global integration, the debate about globalization, per se, more clearlybecomes one about whether one favors economic growth and progress or not,

which is a somewhat easier debate for the proglobalizers in which to prevail. Ofcourse, it is a challenge to try to disentangle the influence of those two trends inassessing the performance of the real economy, for example, with respect to joblosses, but many observers are convinced that they are separable, at least at theconceptual level. Thus, the defenders of globalization in the area of trade makethe point that the economic effects of technical change should not be attributedprimarily to the influence of globalization. When it comes to international finance,such an attempt to separate global integration from technical change is notconvincing, even as a debating point.

Thus, my argument is that international finance is particularly vulnerable to those

who oppose increased globalization because the role of finance in oureconomies is poorly understood, financiers don't win popularity contests, and it isessentially impossible to separate the process of technical change from theprocess of global integration when it comes to international finance. If I am right,then those who operate in the international financial system and are responsiblefor its institutions, public and private, face unique challenges from theantiglobalizers.

The antiglobalizers in their criticisms, informed or uninformed, of the workings ofthe international economy and financial system are able to join with many otherswho decry what they perceive as the directionless sloshing of vast amounts offunds around the world. Those who express shock over what appear to beinexplicable and wide swings in exchange rates and other prices of financialassets. Those who view as irrational the contagion by which the economic andfinancial difficulties of Argentina adversely affect the access to financial marketsby countries on the other side of the globe. And those who bemoan what theysee as the disproportionate influence of the US economic slowdownnowofficially a recessionon economic activity elsewhere in the world.


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Having sketched a four-part indictment of the behavior of international financialmarkets by its critics both among the antiglobalizers and among some who wouldnot be caught dead carrying placards denouncing the policies of the InternationalMonetary Fund or the World Bank, I assume that you expect me to provide youwith a persuasive response to each charge, preferably in sound-bite form. If that

is your expectation, you are going to be disappointed.

If we had all afternoon, I am confident that I could provide a set of arguments thatwould satisfy most of you on these points. In part, my confidence derives frommy assumption that most of you don't need a great deal of persuasion. However,we do not have all afternoon. Instead, I would like to leave you with the fourcriticisms as food for thought to illustrate my core message that the challengesfacing the institutions and individuals that take part in the international financialsystem are daunting, particularly in the context of the overall debate aboutglobalization and its management.In order that you do not go into the afternoon sessions of this conference

completely empty handed, or maybe I should say empty headed, I would like tooffer some reflections on two areas that bear on these questions as well as onthe overall debate about globalization and the international financial system: first,on the structure or composition of international financial flows and, second, onthe ground rules conditioning those flows.

First, concerning the structure of international financial flows, many start from theposition that the international financial system facilitates the reallocation ofsavings from locations with lower expected rates of return to higher expectedrates of return. This is not a universally accepted view. The skeptics point to theapparent inconsistency of such a view with the fact that in recent years a major

portion of net international capital flows has been directed toward the richestcountry of the worldthe United Stateswhere one would expect that rates ofreturn on capital on average to be relatively low, rather than to emerging-marketand other developing countries, where one would expect rates of return onaverage to be higher.

Moreover, with respect to emerging market economies, which have attractedconsiderable net capital inflows on balance over the past decade, one oftenhears the view expressed, as in the recent Economistsurvey on globalizationand its critics, that "the inflow of capital may produce little or nothing of value,sometimes less than nothing. The money may be wasted or stolen. If it wasborrowed, all there will be to show for it is an unsupportable debt to foreigners.Far from merely failing to advance development [by improving the globalallocation of capital], this kind of financial integration sets it back." The Economistputs forward these words as representing the view of globalization skeptics.However, later on the authors comment, "One of the clearest lessons forinternational economics in the past few decades, with many a reminder in thepast few years, has been that foreign capital is a mixed blessing." The authors go


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on to endorse foreign direct investment (FDI) as the lowest-risk type of capitalinflow from the standpoint of the recipient country.

If a publication as conservative, certainly in the eyes of most critics ofglobalization, as the Economistcan through its reporting implicitly support such a

view questioning the benefits of global capital flows, then I would submit thatpractitioners of international finance have their work cut out for them in defendingthe social utility of their activity. If the benefits of global capital flows are not wellestablished, we should not be surprised that many only think that they should beshut down, but also that they think that capital flows can be shut down, whichwould be more difficult than they think but would have tremendously adverseside-effects.

I, for one, also would take issue with the Economist's implicit view of the structureof capital flows and its endorsement of foreign direct investment as the preferredform of capital inflow from the standpoint of emerging market economies.

Of course, countries can get into trouble by relying too heavily on foreignborrowing as a temporary, easy way out of the box of growing fiscal deficits orlow levels of national savings. However, the distinction found in the Economistpiece between FDI and other forms of capital inflow is too glib, in my view. Forexample, in the analysis of external financial crises, it is an oversimplification toidentify bank lending as the principal source of crises and financial instabilitymerely because those institutions' claims generally have short maturities, whichby their nature can run off more quickly as pressures build on the borrower.Countries, of course, may borrow too much at short term because, facingpressures, other sources of external finance dry up. In such cases, short-term

borrowing may contribute to their problems, or postpone the adoption of neededpolicies, but more often than not such borrowing is a symptom of the need toadjust economic and financial policies, not a root cause of the subsequent crisis.

Thus, countries and the international financial community are justified in trying todiscourage excessive reliance on short-term external borrowing, especially whenit is not hedged; both lenders and borrowers make mistakes. However, asystemic response to this phenomenon that might, for example, propose torestrict sharply short-term external borrowing would be like bundling up childrenwhen they go outside in all seasons of the year merely because during winter notdoing so increases the risk of their catching a cold.

Moreover, a misplaced concentration by some analysts on banking flowsundervalues the fact that short-term financing is the major source of liquidity forall participants in the financial system, starting with the financing of internationaltrade of developing countries. Indonesia's experience in 1998 illustrates thispoint; because it was cut off from trade finance, as a consequence of the failureof its domestic financial institutions and the uncertain condition of many of its


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enterprises, not only did Indonesia's imports collapse, as one might haveexpected, but also its exports because of a lack of trade finance.

Along the same lines, some observers argue that longer-term debt obligationsare preferable to shorter-term obligations. However, longer-term debt obligations

also come due regularly, and they are even less likely to be rolled over when theborrower comes under pressure than shorter-term banking obligations. Forexample, a substantial proportion of the drawdown of Brazil's foreign exchangereserves in late 1998, early 1999 was used to pay off long-term debt obligationsof the Brazilian private and public sectors that came due during that period.Along similar lines, observers often argue that portfolio investments arepreferable to debt obligations, but foreign investors can sell their portfolioinvestments, repatriate the earnings, and, thereby, put pressure either on acountry's reserves or its currency.

Thus, many observers argue, along with the Economist, that foreign direct

investment is preferable to portfolio investment. The reality is that foreign directinvestment inflows also may dry up, and they cannot be relied upon as a stablecounterpart to countries' current account deficits, as Brazil has learned during2001. In addition to the cessation of capital inflows in the form of FDI, foreigndirect investors can and do hedge their positions, exerting pressures onexchange rates and on international reserves. They can and do step up theirrepatriation of earnings, and they can and do cut back on extensions of creditsand other financial inflows.

More fundamentally, given the ingenuity of today's financial markets and theircapacity to unbundle exposures and redistribute risks, it is essentially impossible

to distinguish different forms of international investment. For example, a foreigndirect investor may still own a stake in a firm, but that investor can finance orrefinance that stake in domestic currency, and thereby avoid any foreignexchange risk.

My conclusion on the structure of capital inflows is that not only do those whowork in the arena of international finance have a selling job to demonstrate betterthe social utility of their work, but also they have an education job to do withrespect to assessing the various risks associated with the structure of thoseflows.

Turning to my second set of reflections, on the conditioning environment forinternational financial flows, it is widely believed that the international financialsystem would benefit from a common set of rules of the game that aretransparently followed and in which participants in international financial marketsare held accountable when they do not adhere to those rules. This view hasmotivated much of the effort in recent years to reform the international financialarchitecture with respect to the crisis-prevention dimension. The official sectorhas invested heavily in the development of a broad array of codes and standards


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seeking to improve the functioning of the system. As you are probably aware,codes and standards have been drawn up for the most part by ten majorstandard-setting bodies. The list includes core principles for effective bankingsupervision, data dissemination standards, a code of good practices ontransparency in monetary and financial policy, and international accounting

standards. These efforts have been primarily focused on providing guidance tonational financial supervisors and regulators in discharging their responsibilitieswithin a common, internationally agreed framework; it is hoped that by increasingthe robustness of national financial systems, the stability of the internationalfinancial system will be enhanced as well. In some areas, such as the accountingstandards, the private sector has been more directly involved, and of course theintention is to affect the behavior of the private sector.

Despite widespread agreement that the international financial system and theglobal economy stand to benefit from the development and adoption ofinternationally agreed codes and standards, such efforts are not without their

critics and detractors.

First is the question of authorship. Should the codes and standards be drawn upby experts or by politically responsible officials? Of course, experts are experts,and by definition technocrats know the most about their subjects. However, if theobjective is to ensure that the codes and standards will be adopted and followed,the process is aided by involving from the start those more in tune with politicalprocesses.

Second is the question of legitimacy of the resulting rules of the game. Shouldrepresentatives of a small group of industrial countries play a dominant role in

their drafting or should there be broad country-representation on the standard-setting bodies, such as the Basel Committee on Banking Supervision? The casefor broad participation is strong because the codes and standards are intended toapply in all major jurisdictions. On the other hand, not all agree with the principleof universal application, and it is more difficult to achieve consensus amongrepresentatives of a large number of countries, each with its own financial cultureand historical experience. Moreover, the representatives of jurisdictions with highstandards are reluctant to see their own standards eroded in a process that theyfear may be tilted toward reaching agreement at the level of the lowest commondenominator.

Third is the related issue of fundamental philosophy. For example, should thebasic approach in supervision and regulation be one in which anything goesunless it is prohibited or is the better approach one in which only what ispermitted is allowed? My sense is that the former approach is gradually gainingmore adherents, but it has a long way to go before it achieves universalacceptance. A minor example involves highly leveraged institutions, in otherwords hedge funds. According to the restrictive approach to regulation, suchentities should not be allowed to operate unless they are subject to direct


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supervision and regulation because of concern either about the systemic risksassociated with their activities or about their impact on the behavior of markets.According to the expansive approach, such entities should be subject to indirectsupervision by their counterparties in financial markets and, perhaps, a lowdegree of public disclosure; moreover, critics of the restrictive approach in this

area often argue that to subject hedge funds to direct supervision is unnecessarybecause their operations involve sophisticated investors, and it is potentiallydangerous because direct supervision may be interpreted as bringing them underthe financial sector safety net.

Finally, widespread agreement on codes and standards governing participants ininternational financial markets does little to improve the functioning of theinternational financial system unless the codes and standards are adhered to andunless participants in international financial markets pay close attention to theextent and quality of their implementation. As someone who labored over manyyears to encourage the development and adoption of many of these codes and

standards, I have my doubts about whether many market participants even knowthat most of them exist.

My conclusion is that although there is widespread agreement that theinternational financial system and the global economy stand to benefit from thedevelopment and adoption of internationally agreed codes and standards, thechallenges in achieving this objective are considerable. Moreover, private marketparticipants have to pull their weight if this approach to improving the functioningof the international financial system is to produce the type of results of which thesupporters of globalization can be proud.

This conclusion is consistent with the broader message of my remarks today: thechallenges facing the institutions and individuals that participate in theinternational financial system are daunting, particularly in the face of many of thecriticisms from the opponents of globalization. As a consequence, all who have astake in the further evolution and enhancement of the international financialsystem, which I take to include many in this audience, should bear this fact inmind as they go about their business

Speeches and Papers

Globalization and the International Financial System

by Edwin M. Truman, Peterson Institute for International Economics

NYU-Stern Global Business Conference 2001Globalization: Risks and RewardsNovember 30, 2001

Peterson Institute for International Economics


13/31

It is a pleasure to be with you today and to have the opportunity to offer some

thoughts about globalization and the international financial system. I congratulatethe organizers of this conference for a well-planned and timely program.

My intention is not to rehearse the arguments about the risks and rewards ofglobalization. I suspect that most in the audience could come up with longer andmore sophisticated lists of arguments and counter-arguments in both categoriesthan I can. Many of you, after all, aspire to embark upon careers in which you arerequired to assess those risks and rewards every minute of every day, or havealready set sail on such careers. On the other hand, I can pretend to have thedetachment to offer a few thoughts on globalization and the international financialsystem, unencumbered by any current, direct responsibility either to make money

or to make policy.

My basic message is the following: against the background of the many complexcontroversies about globalization, the challenges facing individuals andinstitutions that participate in the international financial system are daunting, andthese challenges need to be taken seriously. I say this for three reasons. Let meexplain.

First, with respect to our domestic economies, the level of understanding aboutthe role of finance is very limited. It is not easy to establish intuitively the positivelinkages between the activities of Wall Street and the activities of Main Street.

For example, I have been asked hundreds of times over the past 30 years or soto explain the connection between deposits in banks or purchases of equities andthe Economist's concept of investment, in the sense of savings and investmentas they are recorded in the national income accounts. One of my many failuresas an Economistis that I have yet to come up with a satisfactory one-sentenceanswer.

Second, and still in the context of our domestic economies, even for those withsome intuitive feel for the role of finance in a market economy, the visceralfeeling among those who borrow money or take on debt is that those who lend ormanage money are rapacious by nature. The local banker receives a certain

degree of respect in his community, but one is hard pressed to find expressionsof fondness or warmth for large financial institutions, their representatives, ortheir leaders, in this or any other country.

Third and finally, turning to the international financial arena, two ingredientsstrongly influence historic trends in international finance: integration and technicalchange. These basic forces have shaped the evolution of international finance forcenturies. Global integration of money and capital markets is the essence of


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It is a pleasure to be with you today and to have the opportunity to offer some

thoughts about globalization and the international financial system. I congratulatethe organizers of this conference for a well-planned and timely program.

My intention is not to rehearse the arguments about the risks and rewards ofglobalization. I suspect that most in the audience could come up with longer andmore sophisticated lists of arguments and counter-arguments in both categoriesthan I can. Many of you, after all, aspire to embark upon careers in which you arerequired to assess those risks and rewards every minute of every day, or havealready set sail on such careers. On the other hand, I can pretend to have thedetachment to offer a few thoughts on globalization and the international financialsystem, unencumbered by any current, direct responsibility either to make money

or to make policy.

My basic message is the following: against the background of the many complexcontroversies about globalization, the challenges facing individuals andinstitutions that participate in the international financial system are daunting, andthese challenges need to be taken seriously. I say this for three reasons. Let meexplain.

First, with respect to our domestic economies, the level of understanding aboutthe role of finance is very limited. It is not easy to establish intuitively the positivelinkages between the activities of Wall Street and the activities of Main Street.

For example, I have been asked hundreds of times over the past 30 years or soto explain the connection between deposits in banks or purchases of equities andthe Economist's concept of investment, in the sense of savings and investmentas they are recorded in the national income accounts. One of my many failuresas an Economistis that I have yet to come up with a satisfactory one-sentenceanswer.

Second, and still in the context of our domestic economies, even for those withsome intuitive feel for the role of finance in a market economy, the visceralfeeling among those who borrow money or take on debt is that those who lend ormanage money are rapacious by nature. The local banker receives a certain

degree of respect in his community, but one is hard pressed to find expressionsof fondness or warmth for large financial institutions, their representatives, ortheir leaders, in this or any other country.

Third and finally, turning to the international financial arena, two ingredientsstrongly influence historic trends in international finance: integration and technicalchange. These basic forces have shaped the evolution of international finance forcenturies. Global integration of money and capital markets is the essence of


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supervision and regulation because of concern either about the systemic risksassociated with their activities or about their impact on the behavior of markets.According to the expansive approach, such entities should be subject to indirectsupervision by their counterparties in financial markets and, perhaps, a lowdegree of public disclosure; moreover, critics of the restrictive approach in this

area often argue that to subject hedge funds to direct supervision is unnecessarybecause their operations involve sophisticated investors, and it is potentiallydangerous because direct supervision may be interpreted as bringing them underthe financial sector safety net.

Finally, widespread agreement on codes and standards governing participants ininternational financial markets does little to improve the functioning of theinternational financial system unless the codes and standards are adhered to andunless participants in international financial markets pay close attention to theextent and quality of their implementation. As someone who labored over manyyears to encourage the development and adoption of many of these codes and

standards, I have my doubts about whether many market participants even knowthat most of them exist.

My conclusion is that although there is widespread agreement that theinternational financial system and the global economy stand to benefit from thedevelopment and adoption of internationally agreed codes and standards, thechallenges in achieving this objective are considerable. Moreover, private marketparticipants have to pull their weight if this approach to improving the functioningof the international financial system is to produce the type of results of which thesupporters of globalization can be proud.

This conclusion is consistent with the broader message of my remarks today: thechallenges facing the institutions and individuals that participate in theinternational financial system are daunting, particularly in the face of many of thecriticisms from the opponents of globalization. As a consequence, all who have astake in the further evolution and enhancement of the international financialsystem, which I take to include many in this audience, should bear this fact inmind as they go about their business

The Globalization of FinanceGerd Husler

During the past two decades, financial markets around the world have become increasingly

interconnected. Financial globalization has brought considerable benefits to national economies and

to investors and savers, but it has also changed the structure of markets, creating new risks and

challenges for market participants and policymakers.
http://www.imf.org/external/pubs/ft/fandd/2002/03/hausler.htm#author%23authorhttp://www.imf.org/external/pubs/ft/fandd/2002/03/hausler.htm#author%23author


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Three decades ago, a manufacturer building a new factory would probably have been restricted to

borrowing from a domestic bank. Today it has many more options to choose from. It can shop

around the world for a loan with a lower interest rate and borrow in foreign currency if foreign-

currency loans offer more attractive terms than domestic-currency loans; it can issue stocks or

bonds in either domestic or international capital markets; and it can choose from a variety of

financial products designed to help it hedge against possible risks. It can even sell equity to a

foreign company.

A look at how financial globalization has occurred, and the form it is taking, offers insights into its

benefits as well as the new risks and challenges it has generated.

Forces driving globalization

What has driven the globalization of finance? Four main factors stand out.

Advances in information and computer technologies have made it easier for market participants and

country authorities to collect and process the information they need to measure, monitor, and

manage financial risk; to price and trade the complex new financial instruments that have been

developed in recent years; and to manage large books of transactions spread across international

financial centers in Asia, Europe, and the Western Hemisphere.

The globalization of national economies has advanced significantly as real economic activity

production, consumption, and physical investmenthas been dispersed over different countries or

regions. Today, the components of a television set may be manufactured in one country and

assembled in another, and the final product sold to consumers around the world. New multinational

companies have been created, each producing and distributing its goods and services through

networks that span the globe, while established multinationals have expanded internationally by

merging with or acquiring foreign companies. Many countries have lowered barriers to international

trade, and cross-border flows in goods and services have increased significantly. World exports of

goods and services, which averaged $2.3 billion a year during 1983-92, have more than tripled, to

an estimated $7.6 billion in 2001. These changes have stimulated demand for cross-border finance

and, in tandem with financial liberalization, fostered the creation of an internationally mobile pool of

capital and liquidity.

The liberalization of national financial and capital markets, coupled with the rapid improvements in

information technology and the globalization of national economies, has catalyzed financial

innovation and spurred the growth of cross-border capital movements. The globalization of financial

intermediation is partly a response to the demand for mechanisms to intermediate cross-border

flows and partly a response to declining barriers to trade in financial services and liberalized rules

governing the entry of foreign financial institutions into domestic capital markets. Global gross

capital flows in 2000 amounted to $7.5 trillion, a fourfold increase over 1990. The growth in cross-


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border capital movements also resulted in larger net capital flows, rising from $500 billion in 1990

to nearly $1.2 trillion in 2000.

Competition among the providers of intermediary services has increased because of technological

advances and financial liberalization. The regulatory authorities in many countries have altered rules

governing financial intermediation to allow a broader range of institutions to provide financial

services, and new classes of nonbank financial institutions, including institutional investors, have

emerged. Investment banks, securities firms, asset managers, mutual funds, insurance companies,

specialty and trade finance companies, hedge funds, and even telecommunications, software, and

food companies are starting to provide services similar to those traditionally provided by banks.

Changes in capital markets

These forces have, in turn, led to dramatic changes in the structure of national and international

capital markets.

First, banking systems in the major countries have gone through a process of disintermediation

that is, a greater share of financial intermediation is now taking place through tradable securities

(rather than bank loans and deposits). Both financial and nonfinancial entities, as well as savers and

investors, have played key roles in, and benefited from, this transformation. Banks have

increasingly moved financial risks (especially credit risks) off their balance sheets and into securities

marketsfor example, by pooling and converting assets into tradable securities and entering into

interest rate swaps and other derivatives transactionsin response both to regulatory incentives

such as capital requirements and to internal incentives to improve risk-adjusted returns on capital

for shareholders and to be more competitive. Corporations and governments have also come to rely

more heavily on national and international capital markets to finance their activities. Finally, a

growing and more diverse group of investors are willing to own an array of credit and other financial

risks, thanks to improvements in information technology that have made these risks easier to

monitor, analyze, and manage.

Second, cross-border financial activity has increased. Investors, including the institutional investors

that manage a growing share of global financial wealth, are trying to enhance their risk-adjusted

returns by diversifying their portfolios internationally and are seeking out the best investment

opportunities from a wider range of industries, countries, and currencies. At the wholesale level,

national financial markets have become increasingly integrated into a single global financial system.

The major financial centers now serve borrowers and investors around the world, and sovereign

borrowers at various stages of economic and financial development can access capital in

international markets. Multinational companies can tap a range of national and international capital

markets to finance their activities and fund cross-border mergers and acquisitions, while financial

intermediaries can raise funds and manage risks more flexibly by accessing markets and pools of

capital in the major international financial centers.


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Third, the nonbank financial institutions are competingsometimes aggressivelywith banks for

household savings and corporate finance mandates in national and international markets, driving

down the prices of financial instruments. They are garnering a rising share of savings, as

households bypass bank deposits to hold their funds in higher-return instrumentssuch as mutual

fundsissued by institutions that are better able to diversify risks, reduce tax burdens, and take

advantage of economies of scale, and have grown dramatically in size as well as in sophistication.

Fourth, banks have expanded beyond their traditional deposit-taking and balance-sheet-lending

businesses, as countries have relaxed regulatory barriers to allow commercial banks to enter

investment banking, asset management, and even insurance, enabling them to diversify their

revenue sources and business risks. The deepening and broadening of capital markets has created

another new source of business for banksthe underwriting of corporate bond and equity issues

as well as a new source of financing, as banks increasingly turn to capital markets to raise funds for

their own investment activities and rely on over-the-counter (OTC) derivatives markets

decentralized markets (as opposed to organized exchanges) where derivatives such as currency and

interest rate swaps are privately traded, usually between two partiesto manage risks and facilitate

intermediation.

Banks have been forced to find additional sources of revenue, including new ways of intermediating

funds and fee-based businesses, as growing competition from nonbank financial intermediaries has

reduced profit margins from banks' traditional businesscorporate lending financed by low-cost

depositsto extremely low levels. This is especially true in continental Europe, where there has

been relatively little consolidation of financial institutions. Elsewhere, particularly in North America

and the United Kingdom, banks are merging with other banks as well as with securities and

insurance firms in efforts to exploit economies of scale and scope to remain competitive and

increase their market shares.

Benefits versus risks

All in all, the radical change in the nature of capital markets has offered unprecedented benefits.

But it has also changed market dynamics in ways that are not yet fully understood.

One of the main benefits of the growing diversity of funding sources is that it reduces the risk of a

"credit crunch." When banks in their own country are under strain, borrowers can now raise funds

by issuing stocks or bonds in domestic securities markets or by seeking other financing sources in

international capital markets. Securitization makes the pricing and allocation of capital more

efficient because changes in financial risks are reflected much more quickly in asset prices and flows

than on bank balance sheets. The downside is that markets have become more volatile, and this

volatility could pose a threat to financial stability. For example, the OTC derivatives markets, which

accounted for nearly $100 trillion in notional principal and $3 trillion in off-balance-sheet credit

exposures in June 2001, can be unpredictable and, at times, turbulent. Accordingly, those in charge

of preserving financial stability need to better understand how the globalization of finance has


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changed the balance of risks in international capital markets and ensure that private risk-

management practices guard against these risks.

Another benefit of financial globalization is that, with more choices open to them, borrowers and

investors can obtain better terms on their financing. Corporations can finance physical investments

more cheaply, and investors can more easily diversify internationally and tailor portfolio risk to their

preferences. This encourages investment and saving, which facilitate real economic activity and

growth and improve economic welfare. However, asset prices may overshoot fundamentals during

booms and busts, causing excessive volatility and distorting the allocation of capital. For example,

real estate prices in Asia soared and then dropped precipitously before the crises of 1997-98,

leaving many banks with nonperforming loans backed by collateral that had lost much of its value.

Also, as financial risk becomes actively traded among institutions, investors, and countries, it

becomes harder to identify potential weaknesses and to gauge the magnitude of risk. Enhanced

transparency about economic and financial market fundamentals, along with a better understanding

of why asset market booms and busts occur, can help markets better manage these risks.

Finally, creditworthy banks and firms in emerging market countries can reduce their borrowing costs

now that they are able to tap a broader pool of capital from a more diverse and competitive array of

providers. However, as we saw during the Mexican crisis of 1994-95 and the Asian and Russian

crises of 1997-98, the risks involved can be considerableincluding sharp reversals of capital flows,

international spillovers, and contagion. (Even though the extent of contagion seems to have

decreased, for reasons that are still unclear, since the 1997-98 crises, the risk of contagion cannot

be ruled out.) Emerging market countries with weak or poorly regulated banks are particularly

vulnerable, but such crises can threaten the stability of the international financial system as well.

Safeguarding financial stability

The crises of the 1990s underscored the need for prudent sovereign debt management, properly

sequenced capital account liberalization, and well-regulated and resilient domestic financial

systems, to ensure national and international financial stability.

Private financial institutions and market participants can contribute to financial stability by

managing their businesses and financial risks well and avoiding imprudent risk takingin part by

responding to market incentives and governance mechanisms, such as maximizing shareholder

value and maintaining appropriate counterparty relationships in markets. In effect, the first lines of

defense against financial problems and systemic risks are sound financial institutions, efficient

financial markets, and effective market discipline.

But, because financial stability is also a global public good, national supervisors and regulators must

also play a role. Indeed, this role is becoming increasingly international in scopefor example,

through a strengthening of coordination and information sharing across countries and functional

areas (banking, insurance, securities) to identify financial problems before they become systemic.


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The IMF itself has an important role to play. In accordance with its global surveillance mandate, it

has launched a number of initiatives to enhance its ability to contribute to international financial

stability: identifying and monitoring weaknesses and vulnerabilities in international financial

markets; developing early warning systems for international financial

international finance in the period of globalization (1)

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