The Crisis of Money in the 21st Century

Speeches

28 Apr 1998

The Crisis of Money in the 21st Century

Andrew Sheng, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at City University of Hong Kong Guest Lecture, Hong Kong, reprinted in the HKMA Quarterly Bulletin Issue No.15)

Professor Stephen Cheung, Distinguished Guests, Ladies and Gentlemen,

  1. I am extremely honoured to be invited to present my inaugural lecture as an adjunct professor at the City University of Hong Kong. It is a time-honoured tradition that when one becomes a teacher, one first acknowledges one's debt of gratitude to one's own teachers. As a central banker for nearly a quarter of a century, I would like to pay tribute to three of the finest central bankers I have had the privilege to serve and to learn from. The first one is Tun Ismail Mohd Ali, the first Malaysian central bank governor and a legend in his lifetime, from whom I learnt the value of central banking and the pivotal role of the central bank as an institution in nation-building. From him and his successor, Tan Sri Aziz Taha, I learnt that the independence of a central bank rested not on laws but on the competence, professionalism and integrity of its staff. Third, but not least is my Chief Executive Joseph Yam, who brought me to Hong Kong and taught me how the free market works. From him, I realised that Hong Kong is the living model of how the free market can function for the benefit of social development. I humbly dedicate this essay to them, while acknowledging that none of the errors of the pupil should be attributed to his teachers.
  2. A professorial inaugural lecture is supposed to give fresh insights into old topics. I would therefore like to share with you a personal overview of what IMF Managing Director Mr Michel Camdessus has called the first financial crisis of the 21st century - the Asian financial crisis. Economists and historians will hotly debate the origins, causes and effects of the Asian crisis in the years to come. Its exposition has reached the status of a cult movie - like the Kurosawa film Rashomon. Everyone saw it unfold, no one predicted its speed or contagion, and now everyone has his own rationale of what caused it and who is to blame. So far, we have managed the whole range of micro and macro causes and alleged villains, from Asian values, bad policies, derivatives, hedge funds, overleveraged borrowers and technology to the El Nino Effect.
  3. What I intend this afternoon is to divide this lecture into three parts: firstly, a quick summary of what everyone says is the main causes of the Asian crisis. Secondly, my own analysis of the role of money in a new world of global flows; and finally, an overview of the issues facing the international monetary order - to use the latest clich? the new international financial architecture.

The Asian Financial Crisis

  1. The IMF's recent World Economic Outlook (1998) defined crisis as many types. A currency crisis occurs when a speculative attack on the exchange value of a currency results in a devaluation (or sharp depreciation) of the currency, or forces the authorities to defend the currency by expending large volumes of international reserves or sharply raising interest rates. A banking crisis, on the other hand, refers to actual or potential bank runs or failures which induce banks to suspend the internal convertibility of their liabilities or which compels the government to intervene to prevent this by extending assistance on a large scale. Systemic financial crises are severe disruptions of financial markets that, by impairing their ability to function effectively, can have large adverse effects on the real economy. A foreign debt crisis is a situation in which a country cannot service its foreign debt, whether sovereign or private. 2
  2. The IMF attributes common basic origins to crises of all types: the build-up of unsustainable economic imbalances, misalignments in asset prices or exchange rates, often in a context of financial sector distortions and structural rigidities. Such crises may be triggered by a sudden loss of confidence in the currency or banking systems, prompted by such developments as a sudden correction in asset prices, or by disruption to credit or external financing flows that expose underlying economic and financial weaknesses. In other words, crises may be considered to be the consequence of financial or economic disturbances when economies suffer from a high degree of vulnerability. These vulnerabilities include: unsustainable macroeconomic policies, weaknesses in financial structure, global financial conditions, exchange rate misalignments, political instability, and shifts in market sentiment. 3
  3. At the World Bank, I studied banking crises in eight economies in the 1980s and personally worked on the resolution of such crisis in another seven economies 4, so I have some insights into its nature and causes. In my view, a financial crisis is a sharp wealth loss by an economy, manifested in asset price collapses with threats to the stability of the currency and the banking system, and other macroeconomic effects such as declines in growth, growth in unemployment and the like. The most complex issue of a financial crisis is that these wealth losses have to be allocated. Moreover, they can be allocated through eight general channels to different classes of potential loss-bearers:
    • interest rate (depositors and borrowers),
    • exchange rate (foreigners),
    • tax rate (tax payers),
    • inflation (consumers - through the inflation tax)
    • asset prices (wealth holders - e.g. holders of shares, securities, land)
    • wages (workers through unemployment and reduction in real wages)
    • inter-generational transfers (through government debt)
  4. The political reason why resolution of banking and financial crisis is so complicated is that it involves loss allocation, not the easiest of democratic trade-offs. Since each group will wish to allocate blame and therefore avoid losses, the resolution of crisis tends to be protracted and politically difficult if not impossible. Two lessons from the 1980s are worth repeating here: "the sooner-the better" and "the problems are always worse than expected".
  5. Despite ample experience from the banking crises of the 1980s, including notably US S&Ls and Scandinavians banks, both Asians and the international community were shell-shocked that in a matter of months, three of the strongest economies in Asia fell into the fold of IMF programs. The asset wealth losses are some of the largest in recorded history: US Fed Chairman Greenspan pointed out that the equity losses, excluding Japan since June 1997 exceeded US$700 bn, 5 of which foreign losses was estimated by the IIF at US$80-100 bn, excluding bond losses of another US$10 bn and additional provisions of OECD banks to these economies of another US$10 bn.
  6. What exactly caused the crisis? Basically, there are two camps of thoughts. Both these views are not necessarily contending and their major disagreement lies in how much blame, or responsibility, should be attributed to economic mismanagement. The 'crony capitalism' view, usually associated with Professor Paul Krugman, says that bad policies formed the preconditions for the crisis, and as such, the crisis was homegrown. In particular, bad resource allocation to politically connected individuals and organisations, often without reference to repayment ability was the major culprit. Implicit government guarantees that backed these lending created the problem of moral hazard, in that banks had little incentive to evaluate and justify their lending decisions. The situation was exacerbated by the lack of effective bank supervision. 6
  7. Following the liberalisation of their financial markets and the gradual integration of these markets with global markets in the 1990s, huge foreign capital inflows allowed many corporations to expand beyond the bounds of prudence into speculative real estate ventures and heavy infrastructure spending, fuelled by unbounded enthusiasm over privatisation. To quote McKinnon and Pill (1995), these economies suffered from the 'overborrowing syndrome', in which euphoria and hubris generated by strong Asian Miracle of fast growth and low inflation led to excessive leverage that was ultimately unsustainable. Like a flock of flying geese, the Japanese bubble that deflated in early 1990s was followed by bubble and deflation in other Tigers and NIEs a few years later.
  8. According to the second camp, led by Professor Jeffrey Sachs of Harvard, what happened to Asia was basically financial panic in its classic version. The fractional reserve banking system and the maturity mismatch between long-term assets and short-run liabilities of banks have always carried with them the risk of bank runs. With fragile banking systems, speculative attacks against the currencies led to bank runs that ultimately led to capital flight. Such systemic effects were worse in Asia, because the maturity mismatch was made worse by a currency mismatch. The panic view suggests that in principle an economy can be 'fundamentally sound' and yet be dragged into crisis by illiquidity. It therefore maintains that the Asian economies were in relative good shape by conventional indicators of economic health, and that the depth of the crisis was far greater than their errors alone justify. 7
  9. Both theories carry overlapping elements of truth, but the policy conclusions are different. One says that Asian values, institutions and policies are to blame and the other attributes the flaw to the global architecture: that even if an emerging economy behaves reasonably soundly, the global tidal waves would overwhelm small markets without some kind of new mechanism to deal with these effects of globalisation.
  10. Let me put the Asian crisis in a global perspective. The crisis occurred when world trade and economic activity were growing at a healthy pace, with declining inflation. In 1996 and early 1997, the OECD economies were broadly in the pink of health, and Asian economies had high growth, high savings, low inflation and excluding Japan, no overall fiscal deficit. The only evident downside factors were frothy asset markets and widening current account deficits, but East Asia as a whole had no current account deficit, with surplus in North Asia and a deficit in Southeast Asia.
  11. All these were partly due to the opening up of new markets with the failure of central planning. Since the fall of the Berlin wall in 1989, three billion new workers and consumers were brought into the global market. Excess production capacity followed from the expansion of FDI into China, Eastern and Central Europe and Latin America, attracted by new sources of cheap labour, untapped natural resources and profit opportunities. With financial liberalisation, privatisation and opening up of emerging markets, increased savings in the OECD economies as a result of savings for retirement began to pour into new markets in search of higher yields. Improvements in telecommunications and computer technology globalised markets, and the creation of derivative instruments allowed new players to arbitrage inefficiencies between markets. Global liquidity was at a record high as Europe began to reflate in anticipation of the EMU and Japan loosened monetary policy to reflate the post-bubble economy.
  12. Amidst this potent mix of high liquidity, Asian policy makers were lulled by the flattery of capital inflows, while many borrowers took opportunity of the available liquidity to consume or invest in bubbly stock and real estate markets. Speculation against some Asian currencies first appeared in late 1996 and the rest is history.
  13. One immediate scapegoat of the Asian crisis was the exchange rate regime. Some observers felt that Asian policy makers hung on too long to the US dollar peg, and some even attribute the move to flexible exchange regimes as the precursor to a Yen bloc. What most failed to notice was that the two economies least affected by the Asian crisis were Hong Kong and Singapore, with sound fundamentals and deep financial markets, each running a different exchange rate regime - Hong Kong with the fixed exchange rate link and Singapore a managed float. All this seems to prove Charles Kindleberger's dictum that with sound fundamentals and flexible factor markets, the choice of the nominal exchange rate regime is immaterial. It is not the nominal exchange rate, but the real effective exchange rate or basic productivity that is at stake in Asia.
  14. Indeed, I would go one step further. What the Asian crisis has demonstrated to me personally is that the reason why Hong Kong and Singapore has withstood the test well is that both are the first globalised Asian economies, meeting global standards of productivity, supervision and transparency.
  15. As a global player, one can no longer measure productivity in the traditional Asian terms of strength of exports in manufactures or commodities. One must judge competitiveness in terms of policy flexibility and the efficacy of national risk management, namely, an efficient financial system that helps to manage risks effectively. Clearly, the straw that broke the Asian camel's back was poor financial intermediation and inadequate risk management. One must therefore build a balanced economy of manufacturing as well as the service sector.

Money in a Global World

  1. Let me now move to the second part of my lecture, the role of money in a global world. As an amateur economic historian, I have often been fascinated by the parallels between the current debate over the role of global money and the nineteenth century debate between the Bullionist versus credit schools on the role of domestic bank money. 8 It took nearly four centuries of bank failures, before the first central bank emerged in Holland to act as the lender of last resort. It took another series of panics and failures, until Thornton (1802) and others made the conceptual breakthrough to put 'money' and 'deposits' on essentially the same footing. It was as late as 1873, before the role of the central bank in resolving bank runs was elegantly expounded by Walter Bagehot in Lombard Street 9, a principle that remains valid today.
  2. In the 1960s and 1970s, the great debate was on the role of money in inflation and the efficacy of monetary policy. By the 1980s, great advances in finance theory meant that derivative products became the driver of financial markets, so much so that central bankers had to catch up in this field. It may be useful to comment on the role of money in the light of recent developments in finance theory as I understand it. I apologise if my exposition of money using the language of a modern asset manager is rather less rigorous than expected of a pure academic.
  3. The textbook definition of money is money is:
    • a unit of account,
    • a medium of exchange, and
    • a store of value.

    To which one would add:-

    • a property right with externalities
    • a derivative [of the real economy]
    • global

Money as a store of value

  1. The roles of money as a unit of account and medium of exchange are well understood, but I would like to comment on the role of money as a store of value. Professor Maxwell Fry (1991) defines 'hardness' 10 of money if its value is stable. The internal value of money is usually measured in terms of inflation and the external value of money is determined by the exchange rate. A currency is considered hard currency if its exchange rate is stable, inflation is low and it is well backed by foreign exchange reserves. What the Asian crisis has demonstrated is that there is a soft underbelly of money in the sense that even though inflation may be low, the purchasing power of money is also determined by asset prices and the quality of bank credit.
  2. In other words, while central bankers have tended to focus on consumer price inflation as a target to protect the value of money, asset price bubbles can also threaten monetary and financial stability. There is no wholly satisfactory explanation why bubbles occur, but we do know that undue exuberance does occur from time to time in various markets. Such undue exuberance is most dangerous when supply inelasticities combine with liberal bank credit. Since bank credit is the primary driver of broad money, the higher the degree of non-performing loans, the "softer" the currency. In a closed economy, raising interest rates to deflate asset bubbles may have some effect, but in an open economy, if investor sentiment mood is for the bubble to continue, raising interest rates would only attract capital inflows that sustain the bubble, creating an illusion of prosperity - an appreciation in both exchange rates and asset prices. The music stops when both reverse.
  3. While central bankers try to maintain a stable value of money, modern investors now have very sophisticated tools, such as Value at Risk models, to protect the value of their assets. Such tools attempt to measure the risks inherent in a portfolio and, therefore at the aggregate level, result in major portfolio shifts that create the volatile capital flows that we have witnessed in the last decade.
  4. Modern finance theory in fact teaches us that the value of an asset is not only a function of its risk profile, but also its liquidity and volatility characteristics. For example, we know that the value of an asset is highly correlated with its duration and the level of interest rates. The longer the duration, the larger is the decline in asset value due to an increase in interest rates. This may be summed up in what I call the law of changing duration:-

    "Under conditions of uncertainty, the duration of a financial institution's liabilities shortens and the duration of assets lengthens" [Sheng, February, 1996].

  5. It is this characteristic of the loss avoidance behaviour of investors - the shortening of duration to increase liquidity - that gives rise to financial fragility, since the compression of the duration of asset portfolios leads to a liquidity crisis, causing sharp increases in interest rates which further compress asset values - a liquidity crunch becomes a solvency crisis.

Money is a property right with externalities

  1. Once we begin to appreciate that money as a store of value can somehow be defined in modern finance terminology, it dawned on us that money is in essence a property right, the value of which is defined by the available information. The binary nature of property rights means that a right is normally an obligation of another party. Such contractual obligations form the networks between contractual parties in financial markets. It is these contractual networks that are the channels of transmission of contagion when participants in that network fail. In legal terms, money is a contract between the holder and issuer of an obligation. Even though bank deposits may be a private contract between two parties, it is clear that such contracts have externalities.
  2. In the era of coinage, Gresham's Law that "bad money drives out good" already foresaw the externalities or social costs of debasing the coinage that led to inflation. Cheating on the gold or silver content of coins by the sovereign is a private gain with social costs. Similarly, bad loans given by banks which ultimately lead to bank failure results in a private (depositor) loss that threatens to be socialised when the state enters into a bank rescue. This is no different from saying that running an unsustainable fiscal deficit is ultimately paid for through higher inflation.
  3. However, because money is widely used as a means of payment and store of value, financial markets in essence engage in transactions in property rights through millions of contracts between counterparties. In modern computer terminology, financial markets are networks linking counterparties, through which gains or losses in value are transmitted. Thus, contagion is spread through the fear of contractual failure, so that loss avoidance behaviour spreads loss between different contractual holders of obligations. In a closed economy, the losses are confined within the national boundaries, but in a global economy, the contagion spreads out. For example, when Korean investors held Russian and Latin American paper, their sales to relieve liquidity due to a cut in credit lines triggered sharp losses in the latter markets.
  4. So far we have explained contagion through the externalities of money, but not its volatility. Here, we begin to realise the impact of information theory, telecommunications and technology on financial markets. Because money is a property right, the value depends not only the information available on it, but also the contractual basis of that right. Perfect markets work only with perfect information and perfect contracts. Incomplete information causes volatility in market value, and fears of faulty contracts worsen that risk. Unfortunately, as we have learnt from the Asian crisis, markets do not work well with incomplete information and incomplete contracts. Indeed, it was the lack of relevant information and the fear of imperfect laws of bankruptcy that would further erode the value of assets that caused the panic bank runs and capital flight in Asia. There is however another element that added to volatility - the question of leverage. To understand this better, we need to move on to the issue of money as a derivative.

Money is a derivative of the real economy

  1. Finance is a derivative of the real sector. 11 The value of money depends on the net wealth of the economy that back that money supply. The lower the net wealth, the lower is the value of the currency. As Henry Kaufman has reminded us, the benefits of derivatives are three-fold: first, they allocate risks more efficiently, second, they generate useful information on market behaviour, and third, they lower the transaction costs of trading in the underlying asset. On the other hand, derivatives are considered dangerous because they add volatility to financial markets, they are not well understood (risks are opaque), and they are highly leveraged (Kaufman, 1994).
  2. Leverage is at the heart of contagion. Markets behave "normally", as long as private participants are solvent. However, as finance theory tells us, private agents maximise returns by using leverage. The higher the leverage, the higher are the risks and returns. At certain levels of leverage, the market participant crosses the risk-return frontier, and its losses are socialised. Market uncertainties are worsened by poor disclosure, so that neither the regulators nor market participants know when an insolvent player begins to double up losses.
  3. Simply put, derivatives enable the unbundling of property rights and risks to other parties. Derivatives were invented in order to split and trade property rights of lumpy assets i.e., they subdivide asset specificity into manageable parts, and in the same way that money was invented to facilitate transactions. What has made markets more efficient, but unfortunately more volatile is that we can almost derive property rights indefinitely. A share is a derivative of the underlying assets of a company. A stock index is the second order derivative of a basket of shares. A stock index option is the third order derivative and so forth.
  4. Because derivatives generate information, they have a value whose correlation with the underlying asset is not necessarily stable. The higher the order of derivative, the taller and more inter-twined is the credit pyramid of finance, which can unwind when the value of the underlying real economy suffers a serious reversal. Financial market fragility therefore is directly linked to the leverage order of derivatives in the economy.
  5. The derivative analogy of money brings home one aspect of the financial system: that derivative markets can only be efficient or stable if the underlying markets in real goods are efficient and stable. Consequently, we can always explain financial market failure because of underlying inefficiencies or structural deficiencies in the real economy. The policy conclusion from this observation is that to eliminate financial market failure, we must reform the underlying distortions in the real economy. Thus, in a global world, we must make the market work better.

Money is global

  1. To understand better and appreciate the radically changing nature of the modern world, we now turn to the distinguishing features of the global economy in the 21st century. Let me highlight just five key aspects that are relevant to our survey: technology, demographics and savings; capital flows; reserve currencies and potential deflation.

Technology and Finance

  1. As Fed Chairman Alan Greenspan said last year: "Dramatic advances in the global financial system have enabled us to materially improve the efficiency of the flows of capital and payments. Those advances, however, have also enhanced the ability of the system to rapidly transmit problems in one part of the globe to another."
  2. Technology has profoundly altered the magnitude and volatility of global capital flows by increasing the speed and volume of trading, while dramatically reducing the cost. Financial technology has also increased the variety of financial products to meet the needs of consumers and investors. The arrival of Internet has changed the structure of financial intermediation and commerce, by reducing the role of the middleman. Technology has also added operational and systemic risks on financial markets by the possibility of software and hardware failure. One of the top priorities in all financial markets by the dawn of the 21st century is the Y2K software glitch that must be resolved. The costs of investments in technology in terms of hardware and software, together with financial deregulation, have been partly responsible for the mega-mergers between banks and securities houses, banks and insurance companies, to create huge supermarkets of global finance. A single bank alone can spend up to US$1 bn annually on IT development costs, so that the small financial intermediary would find it difficult to compete in terms of global reach and service quality.

Demographics and savings

  1. One of the reasons for global growth in the last three decades has been the maturing of the post-war baby-boom generation, which is reaching retirement age. This is particularly evident in OECD countries, notably Japan and Europe. As a result of population ageing, pension and provident funds are growing in importance, relative to short-term savings in banks. In the US, Switzerland, Holland, Britain, and other English speaking countries, pension fund assets are already equal to 50-75% of GDP (Hale, 1998). With the exception of the US & UK, not more than 10% of European and Japanese pension funds have assets outside their own economy. The increase in pension and mutual fund investment overseas was one of the major causes of global capital flows. This trend is likely to continue in the 21st century.
  2. Indeed, the changing savings pattern has resulted in a dramatic change in the global financial structure. A few of these mind-boggling numbers would suffice. In the US, the mutual fund industry has more than doubled its size since 1993 to $4.5 trillion or roughly comparable to the size of the US banking system, as against less than 10% in the early 1980s. The boom in stock markets has increased household savings in equity through mutual and pension funds. Global stock market capitalisation now stands at US$20 trillion, with another US$20 trillion in bond markets. By comparison, the stock of international bank lending as at the end of 1997 was estimated at US$10 trillion 12. One estimate placed investible assets of high net worth individuals across the world to be $12 trillion. 13 This is roughly 1.5 times US annual GDP or 70 times Hong Kong's 1997 GDP.
  3. These are simply stock numbers above the line. Latest BIS data on the amount of outstanding derivative contracts was US$28.7 trillion at the end of June 1997, with first half 1997 trading volume at US$13.8 trillion. In short, global financial assets (measured both above and below the line) have far outstripped global GDP. The financial pyramid is growing rapidly in the 21st century.

Capital flows

  1. With such large stocks of financial assets, it is not surprising that capital flows globally have risen sharply. The BIS 1995 survey of FX markets recorded daily FX turnover of US$1.2 trillion in April 1995. The World Bank estimates that the amount of private capital flows into the developing countries are already five times that of official flows, 14amounting to US$173 billion in 1997, slowing down due to the Asian financial crisis. 15 If we realise that this amounts to less than 0.4% of the US$50 trillion of bank, bond and equity assets, we should not be surprised that in the 21st century, the amount of capital flows will increase rather than decrease.
  2. Not surprisingly, the IMF's recent estimates of the impact of hedge funds, roughly 1000 in number with US$110 billion in assets, pale in comparison with the portfolio activities of global investment funds. I personally would agree with the IMF study 16that hedge funds may be large relative to small emerging markets, but their role in influencing global capital flows globally has been exaggerated.

The rise of the Euro

  1. No one can seriously discuss the 21st century without mentioning the importance of the rise of the Euro in trade, growth and reserve currency terms. In GDP terms, when the EMU covers all 15 EU countries, the Euro area will become the largest single economy in the world. As Europe restructures itself to compete globally, the European financial markets together will dwarf those of Asia in size and liquidity. As someone who witnessed the volatility of financial markets when sterling lost its international reserve currency role to the dollar in the 1960s, all I can say is that the contention of at least three international reserve currencies in the 21st century, dollar, the Euro, and the yen, would again bring volatility.
  2. In Asia, we have a saying: "when elephants fight, the grass gets trampled". One wit added: "the grass gets trampled even when elephants make love". I would add that when grass shrivels, even elephants starve. Clearly, we live in an interdependent world.

Global Productivity and potential deflation

  1. One of the unsung successes in the last decade or so is the undeclared victory against inflation. Despite horrific hyperinflation in the 1980s and early 1990s in the highly indebted and transitional economies, there is no question that market reforms, tight monetary and fiscal policies, improved technology transfer, as well as corporate restructuring have by and large improved global productivity. Inflation has declined so much, and excess capacity has emerged to such a degree in commodities and manufactures, that financial markets are already concerned about global deflation.
  2. With strong monetary discipline being imposed in the EMU and exemplary inflation fighting in the US, there is some concern that as the Asian economies restructure, and large economies go into their cyclical downturn, whether a global deflation may emerge. Many of course fear the return of a 1930s-style Great Depression, which was only turned around with Keynesian reflation.
  3. In sum, global financial markets now dwarf single economies in size. Capital flows simply reflect portfolio adjustments as funds seek the highest returns with acceptable risks. To deal with these flows, financial systems need to be much more resilient, robust, well-capitalised and supervised than ever before. The world is inexorably converging towards global standards. Walter Bagehot said in 1873: "money will not manage itself, and Lombard Street has a great deal of money to manage". In the 21st century, who will manage global money - the private or the public sector?

The New International Financial Architecture

  1. Having put money and capital flows in a global perspective, we can begin to comprehend one of the most brutal lessons of the Asian financial crisis: in a global world with open capital account, one has lost monetary sovereignty. This is obvious from the Mundell-Fleming model of fixed exchange regimes, practised in Hong Kong, where monetary policy is ceded to the Fed. But even economies with flexible exchange rate regimes swept up in the tidal waves of capital flows have also shed monetary sovereignty. In fact, if one makes the mistake of mismanaging capital flows, an economy can end up losing aspects of domestic sovereignty, as those who entered the folds of IMF programmes discovered.
  2. As we learnt from the Asian financial crisis, raising interest rates with open capital accounts would invite in a ton of money, as long as investors think they can win from both high interest rate returns as well as an appreciation in the exchange rate. The interest rate tool has lost some of its effectiveness to combat asset price inflation. Even Singapore, with its flexible exchange rate regime, used supply-side instruments instead of interest rate tool to tame asset price inflation in 1996.
  3. Unfortunately, the issue of loss of monetary control under global capital flows is not an easy pill to swallow. Governments still look to international financial institutions for assistance. Ironically therefore, the fire engines used to fight the first crisis of the 21st century were designed essentially in the 1940s - namely, the Bretton Woods Conference of 1945/46. The tools of the international financial institutions, balance of payments financing under fixed exchange regimes by the International Monetary Fund and cross-subsidised long-term development financing by the multilateral development banks (MDBs) have largely been changed by the new global financial system.
  4. It must be crystal clear that a new international financial architecture is not only conducive to, but vital for, global monetary stability. In a perfect global environment, with one global currency and a unified global monetary policy, there could conceivably be a single lender of last resort. This call for a global lender of last resort (Kindleberger, 1989) is supported by Paul Krugman 17.
  5. Can the IMF play a lender of last resort role that complements national or domestic lenders of last resort to contain international contagion and prevent systemic global meltdown? Since this function usually entails the formation of a supra-national monetary authority with the power to issue money, I personally doubt whether the major shareholders will permit it to function in this role. Reserve currency issuers perhaps are not yet ready to cede monetary sovereignty to a supranational body, as readily as small open economies.
  6. Given such institutional constraints, we should thus examine what are the building blocks for the new international financial architecture. Let me first cite Mr. Camdessus's seven "pillars" for the new international monetary order. They are:
    • Fuller disclosure of economic and financial data;
    • Regional surveillance of countries' economic policies;
    • Financial sector reform, including strengthened prudential supervision and regulation;
    • Effective procedures for orderly debt workouts, including effective bankruptcy laws;
    • Orderly liberalization of capital account transactions;
    • Good governance and measures to tackle corruption; and
    • Adequate resourcing of multilateral lending institutions, including the IMF.
  7. Let me comment on a few issues. First is the question of resources. The IMF deserves every credit for mobilising in a matter of days total financing amounting to US$110 billion to deal with the Asian crises. However, against the background numbers of the global financial system, the total resources of the IFIs remain small: a total of US$400 billion for IMF, World Bank and ADB put together. Thus, the quota increases agreed in Hong Kong last September for the IMF are in my view the minimum necessary for strengthening global financial stability. I would therefore urge the major contributors to ratify the New Arrangements to Borrow, which Hong Kong was the first to do so. Moreover, I believe that the international community should fully support the quota increase for the IMF, which should be done as quickly as possible.
  8. Secondly, a favourite excuse of those who would like to refuse funding for the IFIs was the argument of moral hazard. Some went as far as to argue that the very existence of official funding is a moral hazard, causing the private sector to plunge recklessly to lend. This view, taken to its logical conclusion, borders on the surreal: it seems to say that crime should be blamed on the existence of policemen. In my view, former New York Fed President Gerry Corrigan puts it most eloquently:

    "Seemingly theological arguments about government intervention and moral hazard are interesting and useful, but in many ways miss the point, because when they have operational content, the niceties of debate will almost always be overcome by the realities of the circumstances, especially the fear of systemic chain reactions."

  9. Third is the issue of using the market to provide funding, to supplement official funding. Given the fact that official funding is ultimately taxpayers money, the process of accountability and legislative approval would mean that official funding to deal with financial crisis will never have the flexibility or the availability to be enough. Even though IFI conditionality can deal with the problem of moral hazard, the question of market illiquidity must be dealt with through market funding at market prices. This implies that the MDBs, which have already market access, should act as catalysts to signal how, under IMF conditionality, market funds should be able to return at the right pricing. Without some confidence signalling effect, market spreads can swing wildly from 80 to 800 bps within a matter of days, while drying up market access, as the Korean debt experience in December last year demonstrated.
  10. Indeed, if we agree that there cannot be an international lender of last resort for the various reasons discussed above, then there is no alternative to co-financing between official sources and private sector funding. It is this area of private sector-official cooperation in international financial crisis resolution that is relatively new to the present financial architecture.
  11. Fourth is the issue of one global standard. Arising from the above analysis of incomplete information and incomplete contracts, what is likely to happen first is one global standard (Wolfensohn, 1998 18). This global standard means greater transparency and disclosure, higher accountability, stronger domestic financial systems, liberal trade, open financial markets, a high quality of regulation and independent legal processes. The global standard of financial "best practice" also encompasses micro improvement at the corporate level, to quote Guy Pfeffermann. 19 By this he means a move towards the market in corporate governance or in the institutional framework within which businesses operate, such as rule of law, disclosure requirements, conflict resolution, auditing, and the treatment of minority shareholders. The global standards will be reinforced by the whole plethora of international institutions, including private sector standard-setting bodies.
  12. Because the evolution of global standards in itself can be highly controversial, the process of consensus building was begun at the April Interim Committee Meetings in Washington DC. The Willard Group of Finance Ministers and Central Bank Governors agreed to establish three ad hoc working groups to study and agree on action on (1) increased transparency, disclosure and accountability, (2) strengthening financial systems and market structures, and (3) appropriate burden-sharing between official and private sectors in times of crisis.

Concluding remarks

  1. To sum up, the globalisation of money has brought huge opportunities as well as risks. Badly flawed financial intermediation and inadequate risk management were mistakes of the Asian crisis that were savagely punished by the market. The pace of globalisation in the 21st century is likely to accelerate rather than decelerate. As the beneficiaries of free trade discovered, those who play by global standards will gain, while those who follow closed markets may find themselves left behind.
  2. The challenge of the 21st century is to promote shared growth, to prevent future crisis and to design a new international financial architecture that promotes resilient financial systems, efficient global resource allocation and a level playing field, with hopefully, one shared global standard. We have to make the market work better.
  3. As one of the freest market economies in the world and a leading financial centre, Hong Kong has learnt much from the market and therefore has much to share with other economies and emerging markets. We are honoured to participate in the work of the Willard Group, and hope that its work will contribute to a bright new international financial architecture, and a more prosperous, robust 21st century.

    Thank you very much.

References

Bagehot, Walter (1873), "Lombard Street", in The Collected Works on Walter Bagehot, Vol. 9, ed. By Norman St. John-Nevas (London: The Economist, 1978).

Bergsten, C. F., (1997) "The Dollar and the Euro", Foreign Affairs, Vol. 76, No. 4.

Camdessus, M. (1998) "The IMF and its Programs in Asia", remarks delivered at the Council on Foreign Relations, New York, February.

Camdessus, M. (1998b) "Reflections on the Crisis in Asia", address to the Extraordinary Ministerial Meeting of the Group of 24, Caracas, February.

Capon, A. (1997) "A New Type of Fund Manager, A Different Breed of Intermediary", in Global Investor, June 1997.

Corrigan, E. G., (1997), "Roundtable on Financial Stability and Supervision in Emerging Markets", Institute of International Finance, Inc., September

Crockett, A. (1997) "Why is Financial Stability a Goal of Public Policy?", in Federal Reserve Bank of Kansas City Economic Review, Vol. 82, number 4, pp. 5-22.

Economist, The (1998) "Towards a New Financial System", April 11-17th issue, pp. 62-64.

Fisher, P. (1997) "Global Currency Market: Risks and Rewards", paper presented at 19th Asia Pacific Financial Markets Assembly, Hong Kong, November.

Fischer, S (1998) "The IMF and the Asian Crisis", Los Angeles, March 20.

Fry, Maxwell J. (1990) "Money - Hard and Soft", Inaugural Lecture, University of Birmingham

Goodhart, C.A.E. (1989) Money, Information, and Uncertainty (London: Macmillan).

Greenspan, A. (1998) "Testimony before the Subcommittee on Foreign Operations of the Committee on Appropriations", U.S. Senate, March.

Hale, D. (1997) "How did Thailand Become the Creditanstalt of 1997?", in The Global Economic Observer, Zurich Research, Vol. 11, December, Vol. 11.

Hale, D. (1998) "How the Rise of Pension Funds Will Change the Global Economy in the 21st Century".

International Monetary Fund (1997), International Capital Markets, November 1997, (Washington, D.C.)

International Monetary Fund (1998), World Economic Outlook (Washington, D.C.)

Kaufman, Henry, (1994) "Structural Changes in the Financial Markets: Economic and Policy Significance", Economic Review, Federal Reserve Bank of Kansas City, Kansas City, Vol. 79, No.2.

Kindleberger, C.P. (1989) Manias, Panics, and Crashes, 2nd Edition (London: Macmillan).

Krugman, P. (1993) Currencies and Crises (Cambridge, Massachusetts: MIT).

Krugman, P. (1998) "Will Asia Bounce Back?", Credit Suisse First Boston Asian Investment Conference held in Hong Kong, March.

McKinnon, R. and Pill, H. (1995) "Credible Liberalizations and International Capital Flows: The "Overborrowing Syndrome", in Ito, T. and Krueger, A. (eds.) Fifth Annual East Asian Seminar on Economics, NBER.

Radelet, S. and Sachs, J. (1998a) "The Onset of the East Asian Financial Crisis", paper presented at a seminar at USAID, January 29, 1998, and at the National Bureau of Economic Research (NBER) Currency Crises Conference, February 6-7, 1998.

Radelet, S. and Sachs, J. (1998b) "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects", paper presented at the Brookings Panel, Washington D.C., March 26-27.

Rubin, R. (1998) "Strengthening the Architecture of the International Financial System", Remarks delivered at the Brookings Institution on 14 April, 1998.

Schumpeter, Joseph A. (1954) History of Economic Analysis (London: George Allen & Unwin).

Sheng, A. (1991), "Role of the Central Bank in Banking Crisis: An Overview" in Downes, P., and Vaez-Zadeh, R. (eds.) "The Evolving Role of Central Banks", International Monetary Fund, Washington, D.C.

Sheng, A.(1996a) "Managing the Risks of Growth: Hard Money and Resilient Financial Systems", Bank for International Settlements, February.

Sheng, A. (ed.) (1996b), "Bank Restructuring: Lessons from the 1980s, World Bank, Washington, D.C.

Sheng, A. (1997a), "Derivative Markets and Financial System Soundness", IMF Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets", Washington, DC. January

Sheng, A., (1997b), "Asset Prices, Capital Flows and Risk Management", Asian Securities Analysts Federation Conference, Bangkok, November.

Sheng, A. (1997c) "Bank Restructuring Revisited", in Conference on Preventing Banking Crisis: lessons from Recent Global Bank Failures", The Federal Reserve Bank of Chicago, Chicago, June.

Sheng, A. (1998) "Hong Kong as an International Financial Centre to 2010", paper presented at Lingnan College Public Seminar on "Hong Kong towards the Next Millennium: The Way Forward", Hong Kong, April.

Stiglitz, J. (1998) "Sound Finance and Sustainable Development in Asia", keynote address to the Asia Development Forum, Manila, March.

Summers, L. (1998) "Riding to the Rescue", in Newsweek, February 2.

Yam, J. (1998a) "The Hong Kong Dollar Link", keynote address delivered at Hong Kong Trade Development Council Financial Roadshow in Tokyo, March.

Yam, J. (1998b) "Eye of the Storm", paper presented at Hong Kong Economic and Trade Office and British Invisibles Seminar, London, March.

FOOTNOTE

  1. The author is grateful to Jessica Szeto of the HKMA for research assistance in the preparation of this paper, and to Helen Moy for secretarial assistance. The opinions expressed in this paper are entirely those of the author and not necessarily those of the HKMA.
  2. See IMF (1998), World Economic Outlook, p. 111.
  3. See IMF (1998), World Economic Outlook, p. 111-2.
  4. See Sheng (1996) and Sheng (1991)
  5. See Greenspan (1998).
  6. See Krugman (1998).
  7. See Radelet and Sachs (1998a and 1998b).
  8. On the latter debate see for example Schumpeter (1954). p. 717-31.
  9. In a bank run, the central bank should lend freely against security and at a penalty rate of interest (Bagehot, 1873)
  10. In more formal terms, the 'hardness' of money is defined as the degree of credit, liquidity, and market risks on the value of market participants' holdings of monetary assets. Using the monetary survey framework, the determinants of broad money comprise:

    M3 = NFA + NCg + NCp + NOA

    where NFA is net foreign assets, NCg is net credit to the government, NCp is net credit to the private sector, and NOA is net other assets. Thus, the value of money depends on the degree of fx backing (NFA), monetary creation through fiscal deficits (NCg), the quality of bank credit (NCp), and bank capital and reserves (NOA). The "real value" of money is determined by deflating the nominal value of money by the degree of interest rate, exchange rate, credit and other risks. The Hong Kong dollar is exceptionally hard because foreign currency reserves are about 45 percent of Hong Kong dollar M3, the budget is in surplus, bank credit quality is good by international standards and bank capital is high, with capital adequacy ratio exceeding 17% of risk assets.

  11. A derivative is the property right of a property right. The change in the value of the derivative with respect to the change in the value of the underlying asset is called the delta d. The second order derivative with respect to the change in the underlying asset is called gamma g, and so forth. In essence, the financial sector is basically a derivative of the real economy. In other words, we can say that central banks' search for the monetary transmission channel was a search for the d of money relative to the behaviour of the real economy.
  12. BIS International banking and Financial Market Developments, Basle, February 1998
  13. See Capon (1997).
  14. See World Bank (1997) Private Capital Flows to Developing Countries.
  15. See IMF (1998) World Economic Outlook, p.55.
  16. IMF (1998), Hedge Funds and Financial Market Dynamics, Occasional Paper 166, Washington DC., May
  17. Krugman, 1998.
  18. Wolfensohn, J. (1988) "Address to Development Committee", Washington DC, 17 April
  19. Pfeffermann, G. (1998) "Crisis in East Asia", Transition, World Bank, April.
Latest Speeches
Last revision date : 12 September 2011