International Financial Architecture: Have we done enough to set it right?(Click for full text)
Benu Schneider, ODI

1. Recently, it has been shown that macro-stability is not enough to avert international financial crises. The new areas of concern are contagion and herding, as well as micro-factors such as the health of domestic financial systems' balance sheets.

2. Post East-Asian crisis progress in international financial architecture has focused on improving balance sheets of the banking system. The emphasis has been on strengthening players: stronger risk management, increaseed prudential standards and improved transparency. No progress has been made on counter-cyclical measures, lender of last resort issues and reform of international organisations. Although, the issues related to lender of last resort, transparency on part of international banks and hedge funds, appropriate exchange rate polices, social safety nets, volatility and sharp reversals of capital flows, and the role of credit rating agencies gained attention prior to East Asian recovery, the quick recovery has considerable weakened the political support for the debate.

3. The policy-responses that have been brought forward show some of the following areas of concern:

3.1 Transparency: While international organisations are increasingly arguing that more transparency is a panacea to crisis, some in the private sector are arguing that too much transparency is not necessarily a good thing.

- Arguments against transparency focus on the evidence that in the short run markets cannot distinguish between the good and the bad.
- Banks and investors are likely to buy what others are buying and sell what others are selling. They are therefore performance evaluated against each other.
- Discretionary judgement about risk to market-based and quantitative.
- Provision of information can backfire, it might highlight faults that are shared by many and publicised by only a few.
- Transparency alone cannot avert a crisis or contagion. Moreover , in a contagion situation, there is a distinction between fully informed traders who follow fundamentals and less informed 'noise trades'. In the Keynesian 'beauty contest' world, informed traders anticipate irrational trading by noise traders since it is not a question of what one's own beliefs or knowledge regarding fundamentals are but rather that of the common perception. Information may help ameliorate this situation but it is unlikely to eliminate it entirely.

3.2 Codes and Standards (CS): The need of CS has been enforced by the East Asian crisis, which is believed to be a result of weaknesses in the financial sector. Consequently, much effort has gone into defining prudential regulation, corporate governance and bankruptcy procedures. Concerns exist as to whether CS are enough to prevent a crisis, whether they are appropriate and whether it is necessary to implement standards uniformly across the developing world.

- Why the emphasis on CS? It is likely that CS are the lowest common denominator of agreement among key players regarding restructuring after the East Asian crisis. Their implementation requires little fresh effort by the G7 or OECD countries, leaving its burden with the developing world. But implementation of CS is a long and arduous process. Thus, core standards' implementation need to be prioritised, and should not detract from the resources devoted to other, more pressing development objectives. Moreover, there is historical evidence supporting the proposition that imported legal systems have in most cases not produced very efficient outcomes. However, voluntary compliance is important.

Pace, pattern and intensity should be left to the individual country and country ownership - it should not become a part of conditionality. Market incentives should play a key role. Greater involvement of the private sector in individual countries and public policy makers is needed.

- Link: Capital Account Liberalisation-CS. If one accepts the view that globalisation has come to stay, one has to infer that the challenge is to prepare developing countries for a highly integrated world. It is imperative that developing countries adopt a gradualist approach to capital account liberalisation. Each country needs to make its own decisions as to where they want to be on the spectrum of currency convertibility and make decisions of resources for implementing the various codes and standards. There is no evidence to support the view that a fully convertible capital account is a necessary pre-requisite for sustainable development. Similarly with capital account liberalisation, the decision about the degree and timing of adoption of CS should be left to the developing country.

Sequencing and pace for implementing codes and standards needs to be worked out differently for poorer countries. The degree to which these countries can open up their capital account is limited and it will take some years to make the progress on the necessary pre-conditions. It is important to finance the transition period with official borrowing. Therefore, whilst sequencing of capital account liberalisation will have to include codes and standards, these cannot take precedence over the priority of the removal of poverty.

3.3 Exchange rate policy: The composition of capital flows has implications for conduct of exchange rate policy. A stable exchange rate attracts bond flows, while equity investors prefer floating exchange rates, which stimulates competitiveness of enterprises in the host countries. Moreover, bonds are usually denominated in domestic currency, while equities of successful exporting business are hard currency and more protected. The implication is the avoidance of a fixed or pegged exchange rate with large bond markets.

Whether countries opt for a managed floating exchange rate regime or an exchange rate band - depending upon their circumstance - flexibility is important.

3.4 Regional Initiatives: After the outbreak of the crisis, Japan proposed the establishment of an Asian Monetary Fund. Korea produced a blueprint for regional arrangements to borrow. Latin American governments have shown interest in setting up a regional financing corporation, and for greater macro-economic co-operation.

ASEAN + 3 have come up with a regional mechanism for currency swaps out of regional reserves as a first line of defence. It has been announced recently that this should be tied to IMF conditions. This move will take the automaticity out of the arrangement. There is also the ownership issue with regard to international reserves.

A regional fund from the regions reserves has some merit. At present, many emerging market economies have built up reserve positions as self insurance above needs for adequate cover for imports, short-term debt and volatile capital flows. The level of reserves have implications for monetary management and are invested abroad at rates lower than at which they flow into these economies. A regional fund from reserves will be a form of group insurance and a first line of defence in the face of temporary shortages in liquidity. It would also prevent the emergence of full-blown crises.

3.5 HIPC initiative: For countries with thin and underdeveloped financial markets, it will take years to get systems to a level that attracts sufficient and stable private capital. The role of official capital must be stressed. Enhanced HIPC is not enough and suffers from flaws: most importantly, it does not take into account terms of trade shocks and the funds available are not enough to deal with the resource gap in these countries.

4. In conclusion: