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Think Again: The International Financial
System
By Zanny Minton Beddoes*
The recent spate of crises in emerging markets around the world has shattered the consensus over the benefits of unfettered capital flows and prompted calls for a new global financial architecture. However, a closer examination of the world’s financial woes suggests the need not for radical restructuring, but for some commonsense repairs.
Contemporary conventional wisdom tells us that emerging-market crashes are more frequent and severe than ever before. But even a casual newspaper reader 15 years ago could have very well reached the same conclusion. The truth is, currency crises in emerging economies are nothing new. Judging by how much capital fled, Latin America saw worse crises in the 1980s than in the 1990s. In Asia, however, the late 1990s have brought far worse crises than anything experienced earlier. They have affected a greater share of global gross domestic product. They have also caused substantial recessions, though it seems that economic recovery is occurring more quickly than it did during the 1980s debt crisis.
In contrast to earlier crises, one of the most pernicious characteristics of today’s financial turmoil has been the virulence with which it has spread from one country to another. Thailand’s decision in July 1997 to float its currency, the baht, led to a pan-Asian crisis within a couple of months. The causes of this “contagion” are hard to understand. Many people blame panic among investors. Scared and irrational investors, the argument goes, pull their money out of all emerging markets. In fact, investors might be behaving in a perfectly rational manner. They might, for instance, be reevaluating their investments in light of new exchange rates or be reworking their overall portfolios. This makes perfect sense when applied at the level of the individual investor. However, collectively they create an irrational outcome, causing well-managed countries to suffer financial crises.
So what is the underlying cause of financial crises in the 1990s? More often than not, they have been triggered by external financial shocks that are amplified by failed fixed exchange rate regimes. However, the root cause is usually a weak banking system. In many developing countries, undercapitalized and badly supervised banks borrowed too much short-term money abroad and lent it to dubious projects at home. Cronyism and corruption made these weak banks even weaker as they made loans to very risky, unworthy projects owned by their shareholders and managers.
Foreign banks also bear their share of the blame. Convinced that governments would bail out insolvent banks in times of crisis, international lenders made extremely risky loans without due diligence. They were encouraged by faulty banking standards established by the Basle Capital Accords that favor short-term rather than long-term lending by banks and do not discriminate effectively between assets of different risks. Fortunately, a central theme of global financial reform is improving banking standards. Progress is rapidly being made on this front.
The frequency and severity of recent financial crises have fuelled calls for a radical redesign of the rules of global finance. President Bill Clinton wants to “adapt the international financial architecture to the 21st century”; British prime minister Tony Blair wants a “new Bretton Woods for a new millennium.” Countless academics and pundits have published papers and editorials on how to revamp the system. Some want to scrap the International Monetary Fund altogether; others want to create a global central bank, still others want a global bankruptcy court. Sadly, most of these radical ideas are either ill-advised or politically unfeasible (or both). A “new architecture” is therefore highly unlikely.
But there is a lot of interior decorating going on. Led by the Group of Seven countries, a modest but useful agenda of global reform is taking shape. It includes the development of international standards of good behavior on everything from information provision to corporate governance. The global financial structure may not be completely remodeled as a result, but it will certainly be spruced up.
Widespread crises, investor panic, bad banking, financial reform...what can we learn from them? Despite recent events, it would be a mistake to conclude that emerging markets will always be on the margin. In the long run, the reasons for investing there are as attractive as ever. The recent crises have been a wake-up call: They have shown the need for good policies, strong financial sectors, and transparency in emerging markets. These reforms are far more important than creating a “new global architecture.” Provided developing countries keep implementing these reforms, there is no reason why emerging markets should not become an ever growing asset class.
References
Barry Eichengreen’s Globalizing Capital: A History of the International Economic System (Princeton: Princeton University Press, 1996)
Eichengreen’s latest book, Toward a New International Financial Architecture: A Practical Post-Asia Agenda (Washington: Institute for International Economics, 1999)
Dani Rodrik’s “The New Global Economy and Developing Countries: Making Openness Work,” Overseas Development Council Policy Essay, no. 24, (Washington: Overseas Development Council, 1999).
George Soros’ The Crisis of Global Capitalism: Open Society Endangered (New York: PublicAffairs, 1998)
Foreign Policy magazine has served as a forum for extensive debate over how to reform the international financial system in the wake of the recent economic crises. See Robert Wade’s “The Fight Over Capital Flows” (Winter 1998–99), Claude Smadja’s “The End of Complacency” (Winter 1998–99), and David Rothkopf’s “The Disinformation Age” (Spring 1999).
Endnotes
*: Zanny Minton Beddoes is Washington economics correspondent for The Economist. Back.