Global Markets and the Emerging Economies

I knew Fritz Leutwiler first of all as a central banker. In that role, I had the good fortune to become his professional comrade. I could observe first hand the role he had in building the prestige and influence not just of the Swiss National Bank, but of central banking generally. I am also aware—your presence here today testifies to the fact—his influence and associations extended far beyond the world of central banking. And most importantly for me, as for many of you, he became a close personal friend.

I know there are a great many people in this hall and elsewhere that can make the same proud claim. He was a part of your community. He epitomized in his life the best of the proud Swiss traditions of personal and financial integrity. But his interests ranged far wider. It was a constant source of amazement to me that he shared my wife Barbara's fascination with the Bloomsbury group in London; their unconventional lifestyle seemed to me about as far from the persona of a typical central banker (or my wife) as you could get. I am grateful Fritz Gerber has recalled so eloquently those personal qualities of mind and character that meant so much to all of us.

I, of course, knew Fritz Leutwiler from a different angle, as an international figure. We were fated to be thrown together most closely precisely at the times international financial affairs were most disturbed. If it’s true that times of crisis are a true test of a man’s character, and I think that must be right, then I was privileged to see Fritz meet that test time and again. He could always, always, be counted on to listen, and to respond calmly and candidly. And when necessary, he was ready to act, and to act quietly but directly, without fear or favor.

We first met a year or two before the breakdown of the Bretton Woods monetary system. It was a time of great uncertainty in financial markets. The familiar pattern of fixed exchange rates anchored to the United States dollar and a fixed gold price was giving way. And inevitably, the financial strains led to political tension as well.

By the nature of our positions, Fritz and I were fated to approach the problem from sharply different points of departure. As the United States Treasury Undersecretary responsible for international monetary affairs, I officially had the responsibility of setting out the concerns and policies of the dominant economic and financial power. To many in Europe and elsewhere, those concerns and policies were pursued with excessive zeal (a phrase they might have considered understated), placing the stability of the monetary system at unnecessary risk.

Switzerland’s position as a banking center and its perceived vulnerability to financial disturbance made its position particularly sensitive. Fritz, as the official of the National Bank directly concerned with international finance was my Swiss counterpart, and therefore a potential antagonist.

But that’s not the way it was. He, more than most, could appreciate the inherent dilemmas and weaknesses in the prevailing monetary system and the need for change. He may have held a little understood position in a small country, but that small country had a lot of financial prestige. Fritz could build on that platform with analytic insight and intellectual independence in a way that helped enormously to diffuse the tensions.

Those characteristics were brought to bear with much greater effect in the midst of the Latin American financial crisis of the 1980’s. The sudden inability of Mexico to meet its debt payments, with the inevitable repercussions of that failure elsewhere in Latin America, presented a clear and present danger not just to the economic development of Latin America but also to the heavily exposed international banking system. Fritz Leutwiler, by that time President of the Swiss National Bank, immediately sensed that the danger was not an American concern alone. In a matter of hours and days, he acted to marshal support, intellectual and financial, for the necessary emergency program. He continued to commit his personal prestige and the influence of his position as the President of the B.I.S. to the long and inherently frustrating effort to coordinate support for new lending programs—private and official—to contain and manage the continuing crisis.

I know you are aware of other instances when Fritz acted in that characteristic way to deal with seemingly intractable problems. Who but Fritz would have been both willing and able to diffuse the politically and emotionally freighted issue of South African debt when that country was still an international pariah? Would others have been able to act so effectively to assure Switzerland’s leading engineering company could secure its future as part of a larger and stronger European enterprise?

It was always done without fanfare. Fritz was the epitome of Swiss democracy—available to everyone, and everyone treated alike, without pretense or pomposity.

As an old friend, I will always miss Fritz Leutwiler. And I especially miss him today for an obvious reason. The Asian financial markets are roiling with possibly large implications for the world economy. I’d feel a lot more confident about the right approach toward those problems—and more confident about what I’m about to say—if Fritz were here to test my judgments.

An enormous amount has been invested in free and open world capital markets in recent years. That is literally true in the sense of the trillions of dollars of money passing across national boundaries and the many billions of dollars spent for computers and communication equipment, for vast new trading floors jammed with the latest electronic wizardry, and not least for the almost unimaginable bonuses paid men and women managing the money.

The intangible intellectual and ideological investment is even more impressive. In broad concept, the idea has swept the world that free and open markets, for finance as well as for goods and services, provide the avenue—the only sustainable avenue—to growth and prosperity. While there are many lapses in practice, the theoretical model of enhancing economic efficiency by permitting and encouraging money and capital to flow to wherever economic returns are maximized is widely accepted.

Given the strong underlying forces supporting growth in emerging economies in Asia, in Latin America, and potentially in Eastern Europe, those areas should be prime beneficiaries.

By encouraging and sustaining high levels of domestic investment and speeding technological transfers, a flow of capital from richer countries should enable the poorer to take full advantage of their plentiful and disciplined labor forces. Both their capacity to export to world markets and rapidly to raise living standards at home will be enhanced. And not so incidentally, the foreign investors will share in the potentially high rates of return.

Moreover, that process, if sustained, will create more than economic values. There is a lot of evidence that economic growth, open markets, and the free flow of goods and capital will encourage more broadly liberal societies, with democratic values. More specifically, a premium on economic efficiency and reliance on foreign capital will lead to demands for greater transparency and less corruption.

This is not just a matter of theorizing. There are plenty of examples of particular instances in which developing countries have been greatly assisted by inflows of international capital. Those benefits appear most clearly evident in the case of direct investment. Ownership and control—partial or more complete—by experienced international businesses typically imply a longer term commitment and bring technology and know-how as well as money.

Portfolio investment from abroad may be less directly tied to new investment, but it should normally enhance competition in local financial markets and increase the availability of capital. It will also potentially bridge a gap in a developing nation’s current account if and as its investment exceeds its domestic savings.

More broadly, we have seen in recent years an enormous and promising change—a really revolutionary change—in the policies and practices of many developing countries. Some have, of course, moved much further than others, and there is a lot political and institutional resistance. But almost everywhere trade barriers have been reduced. State enterprises are being privatized. Capital markets have been opened.

In sum, instead of looking inward, emerging countries have decided that, to prosper and grow, they must join the global economy. Certainly that approach has been endorsed and reinforced by international institutions. It is, indeed, one important manifestation of the end of the cold war and victory of democratic capitalism.

Nowhere has the sense of progress been greater than in Southeast Asia. Growth rates approaching 10 percent in some countries had been sustained for years. There were, and are, plenty of reasons to believe that performance was solidly based. An energetic and intelligent work force is in more than ample supply. Internal savings as a fraction of incomes are high, twice and more above Western standards. Technologically, there has been a lot of catching up to do, and surging foreign direct investment has helped speed that process.

I need to emphasize too, that progress in opening markets in the industrialized countries has been a key complement to more liberal policies of the emerging economies. Those countries need export markets to justify high levels of investment, to support rising imports and to service foreign loans.

But now, quite suddenly, the turbulence of East Asian financial markets has raised new questions. The capital flow has abruptly reversed, and the resulting financial crises have stalled economic growth.

Is that volatility simply a passing cloud—something that will soon be overcome and even forgotten in the larger momentum of growth? Or is it a symptom of something more profound, with systemic implications for the organization of world capital markets and the world economy?

In approaching those questions, I think we need to recognize that volatility has always been characteristic of free and active financial markets. With relatively rare exceptions, that volatility can usually be diffused without more than temporary setbacks within large and well diversified economies with a sturdy financial structure. For the largest economies—the United States and an economically unified Europe—that is true even for substantial changes in exchange rates.

The situation is different with smaller, open economies. They are typically much more dependent on external trade and much less diversified. And significantly, the actual and the potential flows of foreign capital are much larger relative to the size of their economies and financial systems.

The enormous growth of international capital markets has particular significance in that respect. Not only are the amounts of available financial capital much greater, but technology permits that money to move right around the world almost instantaneously, and with lower transactions cost than ever before. Communication is instantaneous worldwide. There aren’t any more many exclusive sources of information. Mutual funds and pension and endowment funds are now more important than long established banks and insurance companies in the United States and increasingly elsewhere. The highly paid professional managers of those enormous blocks of institutional money are under intense pressure to outperform each other, even quarter by quarter. Traditional and legal restraints on more exotic or foreign investments have been giving way. The growth of so-called hedge funds—some of which despite their name are prone to large speculative positions—is one manifestation of those pressures, but not the only one or the most significant.

Arguably these developments have amplified volatility of financial markets generally. Whatever the reality of that, the effects on smaller countries demonstrably can be quite overwhelming. The turbulence in East Asia, I would point out, is only the latest piece of evidence. There are clear parallels to the last Mexican crisis, with its contagious effects in Latin America. There are disconcerting similarities with Eastern Europe as well.

In all those areas, sudden reversals of portfolio capital have led to sharp setbacks in economic growth and renewed inflationary pressure. To be sure, in a year or two the economies have been able to rebound from recession. That is happening now in both Mexico and Argentina. But looked at in the perspective of the last decade, it’s been a struggle to maintain strong economic momentum in Latin America. What can’t be demonstrated—not yet at least—is that the emerging economies generally can sustain growth rates characteristic of the earlier Asian Tigers, or even of Latin America in the 1960’s and 1970’s, when those economies were relatively closed. Is the volatility of international capital flows undercutting much of the benefits of open financial markets, limiting otherwise bright prospects for growth?

Quite obviously, a lot rides on finding a good answer to that question. The stakes are not only economic. As I emphasized earlier, free and open economies go hand in hand with personal freedom and democracy. To question one part of the equation is to question the other.

The immediate reaction to the East Asian crisis of the IMF and of voices in the private community has been to reiterate and underscore the need for effective, responsible domestic policies. The emphasis in IMF programs has been on the need for restrained government spending, balanced budgets, stronger supervision of financial institutions, reduced government intervention in the economy, and an attack on endemic corruption. For all its familiarity, that remains a useful agenda for almost all countries, and certainly has application to the emerging nations. Surely sustained progress in those directions must be a quid pro quo for the kind of increasingly massive international financial assistance programs that recent crises have invoked.

The question I want to raise is whether that kind of response, generally valid as the advice may be, can provide anything like a full answer to what appears more and more a systemic question.

One difficulty is that the obstacles—economic and political—to pursuing the recommended policies with force and consistency are very great indeed. No country, large or small, democratic or not, will avoid mistakes in economic management. Radical change is required in embedded traditions.

Those problems are clearly apparent in Korea, a well-developed country now entering the OECD club of industrialized democracies. For the smaller emerging economies upon which I am concentrating in this lecture, the difficulties multiply. Administrative structures are weaker. Political constraints are many.

For those reasons alone, we should be cautious about the speed of recovery. But beyond those specifics, I think we can see a repetitive pattern at work—a pattern that suggests smaller emerging economies diligently and seemingly successfully working toward prudent and liberal policies will nonetheless remain vulnerable to market volatility. Paradoxically, the very impression of success may increase the vulnerability.

Consider that it was Mexico in the Salinas years that was, for good and substantial reasons, considered the Latin American exemplar of reform and liberalization. The charismatic Vaclav Klaus led the Czech Republic to the most orthodox economic policies in Eastern Europe. And, yes, Thailand in Southeast Asia became a kind of cynosure for the region, maintaining a good credit rating right up to the collapse.

Of course, in retrospect, we all understand those countries made some big mistakes along the way. But the fact is that their perceived success—a balanced budget, disinflation, growing exports, open markets, privatizations—attracted a lot of foreign capital. And the capital could cover over the mistakes and help sustain and amplify the growth process—that is until suddenly it went into reverse.

Let me suggest a highly simplified model, but a model that captures, in the spirit of an economics textbook, an important part of reality.

We have, on the one side, some relatively small emerging economies. Their indigenous banking and financial system is necessarily small and little developed. The long run growth potential is high. The government, following today’s accepted economic model, substantially liberalizes trade. Inflation is brought under control. The budget is balanced. Capital markets are substantially opened. Industry is privatized.

In the rest of the world, we have large investment institutions, some individually commanding portfolios well in excess of the annual gross national product of several economies. In competition with each other they are each aggressively seeking exceptional rates of return. To that end, they are committing small but increasing fractions of their assets to non-traditional outlets promising exceptional returns, certainly including rapidly expanding emerging economies. Given the herd instinct of the markets, early success of the pioneers will induce more and more institutions to follow suit, some created specifically for that purpose. The process is naturally encouraged by local banks, businesses, and governments. In the flush of expansion and with seemingly cheap finance available from abroad, they are tempted to leverage their positions and take large risks of foreign currency borrowing. In doing so, they are important contributors to the process and highly vulnerable to reversal.

The amounts involved may be marginal in significance to the American or European markets. Taken together, however, the impact on our model emerging economy can be overpowering. For instance, there are bound to be strong pressures toward a real exchange rate appreciation. That may be caused by an increase in the nominal exchange rate if the rate is not fixed against a major currency. Or, if the nominal appreciation is resisted, the flood of liquidity will induce inflation. The easy availability of funds from abroad will support a high level of investment, perceived as good for growth. But in time, the economic expansion will lead to unsustainably large current account deficits. Even initially well capitalized banks will find their asset growth outpacing their capital. High liquidity and rapid economic growth encourages more aggressive lending. In the circumstances, a real estate boom is almost inevitable.

Sooner or later, some event or events, internal or external, will raise questions about the sustainability of it all, particularly the size and persistence of the current account deficit. A mere cessation of the inward capital flow will bring downward pressure on the exchange rate, investors turn nervous and move to protect their investment. Reserves are run down and the crisis is at hand.

Heavy exchange losses and high real interest rates shake the small and overextended banking system to its foundation. Lending stops and insolvencies multiply. The financial crisis becomes a real economic crisis of uncertain magnitude and length. The pattern is all too familiar. The question is what it implies and what to do.

I can well understand and sympathize with the instinct of the official financial community to provide prompt assistance to bridge the external financial gap. At the same time the increased frequency and size of those rescue packages raise more insistently questions about their sustainability and long-term effectiveness.

One unfortunate effect of those programs—if not their purpose—is to provide a substantial element of protection against loss to the foreign investors and to imprudent borrowers. By doing so, they may inadvertently help encourage (or more accurately, fail to discourage) aggressive lending and borrowing.

In that respect, there’s a striking difference between the financial crises of the 1990’s and the Latin American debt crisis of the 1980’s. Much more limited official assistance was forthcoming in that earlier episode. That assistance was also dependent on the lending banks joining together to extend the maturity of their loans and to extend fresh credits. Eventually there was agreement among the banks to relieve the debtors of some portion of their obligation and to absorb the losses, paralleling private bankruptcy proceedings. It is not a coincidence that commercial banks have not been at the leading edge of the recent wave of lending to emerging countries.

With lenders now so widely scattered and with exposures so varied in nature and liquidity, no similar mechanism has been found to spread the pain among them. There is, of course, pain among the borrowers, governments and private banks and companies alike. The financial pain is reinforced by the fact that official assistance is logically and tightly tied to programs of financial and economic reform. But the question remains as to what can be done to more effectively reduce the risk of crisis, with all its implications for economic growth, for financial stability, and for political conflict.

One thing is quite certain. We cannot turn back the technological clock. A combination of electronic miracles and financial engineering have made possible increasingly liquid, impersonal global markets, interconnected with enormous complexity. Leaders of some emerging economies can rail about speculators and express their frustration about exchange markets. What they can’t feasibly do is opt out of world financial markets. The fact is finance is intertwined with trade and investment. There are so many ways for funds to flow, and so strong incentives to circumvent controls, that effective insulation would require a network of controls so intrusive as to be out of keeping with an open economy.

If a high degree of insulation isn’t possible consistent with growth, more modest measures can be helpful. Governments can at least resist— they should resist—measures that have the effect of actually encouraging potentially volatile short-term capital inflows. The infamous Mexican Tesabonos—very short-term notes with exchange rate protection—are a prime case in point. Thailand and others have de facto encouraged or permitted their banks and finance companies to assume large foreign currency obligations, a recipe for fragility.

Beyond that, some countries have found it possible, by one measure or another, to discourage an excessive inflow of short-term liquid capital by means that also help protect the liquidity and strength of their local institutions. Chile is a prime example, and it largely escaped the backwash of the Mexican crisis.

Switzerland has itself had experience with such policies. You also know something of their limitations, including the tendency of their effectiveness to diminish over time. Despite the limitations, I hope the IMF, in its apparent zeal to incorporate freedom of capital movements into its basic charter, does not lose sight of the usefulness of that approach. There is a very large difference between using a panoply of controls in an effort to maintain a basically unsustainable external position and adopting measures to slow an influx of “hot” money that will itself be unsustainable.

That approach is, of course, dealing more with the symptoms than the fundamentals of the problem. What we are seeing, I believe, are forces inexorably driving markets and smaller countries into more integration, not less.

Take for instance, the matter of foreign ownership of indigenous banks and other financial institutions. In the past, many smaller countries uniformly resisted such ownership as a vital matter of economic independence and national sovereignty. But attitudes are rapidly changing under duress of financial crisis. The priority has become protection against instability and bankruptcy. An important way to achieving that is to join with much larger, better diversified foreign institutions able to withstand volatility. In that sense liberalization of entry into financial services needs to go hand-in-hand with liberalization of trade and financial assets.

Another promising approach to the internationalization of financial markets has been the growth of global equity markets. There is, of course, no doubt about the inherent volatility of equity markets, often tied in with sharp changes in exchange markets. However, that volatility may not pose the same risk of financial crisis precisely because equity investors are better prepared to absorb losses. The “moral hazard” of official bailouts is much reduced.

Regional currency arrangements are a response to the high volatility of exchange markets. That kind of response has been strongly evident within Europe itself, now on the verge of a common currency. In the Americas, there are natural, if much weaker and informal, tendencies in the same direction. While they resist actual fixing or a formal target zone, both Canada and Mexico work to maintain a degree of stability against the U.S. dollar. A number of South American countries follow a similar approach, with Argentina practically adopting the dollar as a parallel currency.

That approach is helpful for smaller countries with trading patterns strongly focused on a large trading partner. It is not particularly useful for emerging economies with trading patterns that are widely diversified among the United States, Europe, and Japan.

Those large economic centers are themselves strongly concerned with maintaining the autonomy of their domestic fiscal and monetary policies. They are, because of their size and diversification, better able to absorb and diffuse fluctuations in financial flows and exchange rates. They have demonstrably been quite willing to permit their exchange rates to float.

The swings in their exchange rates have been extremely wide. The yen/dollar rate, for instance, has moved by more than 50 percent, up and down, over the past few years—a time when the domestic inflation rates of both countries were low and barely changing.

Fluctuations of that size simply are not consistent with making fine calculations of comparative advantage—the textbook rationale for free trade—nor do they parallel purchasing power parity. My own sense is that there are subtle but nonetheless real economic costs for the major countries themselves in terms of distorted investment decisions and trade flows.

Be that as it may, wide fluctuations among the major currencies present particularly painful problems for smaller countries just emerging into the developed economic and political world. The debate about whether emerging economies are better off with relatively fixed exchange rates or with much more flexible exchange rate policies waxes and wanes with every crisis. That confusion reflects the hard fact that, for small countries with trade widely dispersed, no exchange rate regime can work well when the cross rates of their major trading partners are fluctuating widely and unpredictably.

From their vantage point, the internationalization of trade and finance has seemingly left those countries with a Faustian bargain. Open markets and foreign capital are the keys to growth. But those same markets can and will generate instability and a loss of domestic control—all complicated by the emergence of more democratic political systems. Even in an area like East Asia, where the basic economic prospects seem so favorable, those prospects can be cast into doubt by financial volatility.

We in the developed world are free with our advice. We can produce a “quick fix”—or the illusion of a fix—by emergency infusions of credit. But the real problems are deeper than that.

The ultimate danger is that at some point the whole concept of liberal trade, emphasis on private enterprise, and open financial markets in the developing world will be politically challenged.

I share the general conviction that, in the end, global markets and liberal economic policies offer the best environment for growth and prosperity— a growth and prosperity that can be widely shared. The emerging economies, with all their potential for achieving and sustaining rapid rates of expansion, should be major beneficiaries. To make good on that promise, they will have to accept, I believe, the implications of greater integration with the world economy, not less.

The implications for us in the industrialized world are equally important, if less obvious to our citizenry:

The pressure to slow or even reverse the opening of our own markets needs to be firmly resisted. The supervision of our own financial institutions acting in international markets needs to be enhanced in the interest of better assuring their strength and stability. The important role of our multilateral institutions in encouraging constructive change needs to be sustained, while avoiding any sense that their resources are unlimited and that they can themselves protect lenders and investors from their own excesses. I would add, too, that it is long since time that the challenge of achieving greater stability among the major currencies needs to be addressed.

I well understand all that is easier for me to say than for others to do. But I have no doubt that if Fritz Leutwiler were here with us this evening, he’d be finding ways to help getting it done!

Fritz Leutwiler was a great central banker.