Very large and very small financial markets generally avoid the destabilising effects of international capital: it is the markets in the middle that are most vulnerable.
One of the primary responsibilities of a central bank is to maintain stability in the currency. This can be defined as internal price stability, as measured by a low inflation rate, or a stable external value for the currency, as measured by a stable exchange rate. Whatever the objective pursued - and it is the responsibility of the government to have this clearly laid down - the job of the central bank, or monetary authority, is to deliver it. Prudent economic policies are, of course, a necessary condition for currency stability. But, even assuming that prudent economic policies are pursued, currency stability is, relatively speaking, an easier task for certain economies and an increasingly challenging task for others. This is particularly so under the influence of the globalisation of financial markets, with international capital behaving at times in a most fickle manner, creating volatility that is systemically destabilising. Other things being equal, this difference can be attributable to two factors - the size and the openness of monetary systems.
The relevance of size can best be illustrated by the fact that we have seldom, if ever, heard of a currency crisis in the largest and the smallest monetary systems. For the smallest monetary systems, even in the unlikely event that they have a sophisticated financial infrastructure, there is often a lack of liquidity in financial markets for them to be of significant interest to international capital seeking portfolio investment opportunities. The pond is not big enough to attract the attention and the presence of the elephants. Without meaning in any way to be unhelpful, I would say, as an example, that the maintenance of currency stability in Macau is a relatively easy task. Indeed, Macau has not had a currency crisis in its recent history - the necessary prudent economic policies to support confidence in the currency are also sufficient to ensure its stability.
The same applies to the largest of monetary systems, where financial markets are big and liquid enough to absorb any amount of international capital. However fickly international capital may behave, the volatility it creates will not be so destabilising as to lead to systemic problems. The "pond" is big and robust enough to accommodate even the largest herd of elephants, and other animals besides. Indeed, if they are not careful, they could well drown in the water or become over-exposed to the sun as the tide in the market shifts. Nothing is big enough to make waves of systemic concern. Flows of international capital, large as they may be, are not large enough to undermine monetary and financial stability. The maintenance of currency stability under these circumstances becomes a relatively easy task. The United States is a close enough example of this ideal world. Ever heard of international capital flows affecting the exchange value of the US dollar or the level of US interest rates to such an extent as to undermine currency stability? Market concentration, for example, is also less of an issue in the large US financial markets than in others.
Turning to the openness of monetary systems: this, of course, encourages the international flow of capital to where it can be most efficiently deployed. Indeed, it is very much the motive behind financial liberalisation generally, and the development of financial markets in particular, in most economies. It is the efficient market approach to facilitate foreign direct investment as well as, with increasing popularity, foreign portfolio investment. The process has, in turn, led to the globalisation of financial markets that we have seen in the recent past. And the benefits are there for all to see, in terms of enhanced economic growth and development - witness the Asian miracle.
But openness brings with it significant risks to currency stability, particularly, as argued above, for monetary systems that are not too big or not too small. For example, the free availability of the domestic currency, through the banking system and derivatives of financial products, to international financial market participants who, understandably, are looking for short-term gains, can be destabilising. The management of such risks with a view to maintaining currency stability is therefore quite a challenge. The difficulties involved, dare I say, are not readily understood, either by those managing large monetary systems or by those in international financial institutions with responsibility for, or an interest in, global financial stability. This was at least the case at the height of the Asian financial crisis. Thankfully there is now greater understanding generally, although there is still no global consensus on how best to meet this challenge. Each monetary system is left to fend for itself, and this is not an easy task. Many have chosen to go slow or even step back from financial liberalisation through introducing or tightening restrictions and controls. We have, instead, chosen to enhance policy credibility through greater transparency and less discretion in the conduct of a rule-based monetary system.
Joseph Yam
14 March 2002
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