Financial Stability in Emerging Markets: The Unfinished Agenda--Khalid A. Mirza
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Financial Stability in Emerging Markets: The Unfinished Agenda Khalid A. Mirza
· I am also grateful to the Secretariat for asking me to speak on the question of financial stability in emerging markets which is an area that is very much a part of my responsibilities in the World Bank insofar as the East Asia and Pacific region is concerned. In my current position, I have primary responsibility for financial sector and private sector development in this region which certainly means that issues of financial stability that affect developing countries of East Asia are of direct relevance to my work. My presentation will also essentially focus on emerging market countries of East Asia. · Just to highlight the enormity of the issue of financial stability, I might mention that the World Bank has tracked close to 120 financial system crises in 93 countries over, say, the past quarter of a century with each of these crises having cost the affected countries an average of 16% of GDP. The overall aggregate budgetary cost of cleaning up these crises in developing countries is more than a trillion dollars. Interestingly, this is about equal to the total developmental assistance provided to developing countries in the second half of the 20th century. · The multi-country, 1997-98 Asian financial crisis, was really one of several such waves of financial crises, albeit this was probably the most widespread. It is also the crisis that got the world to sit up and notice and to reach the conclusion that fostering financial stability deserves international attention and prodding as a global issue in which all countries have a commonality of interest. · The natural question is: what are the probable causes of turbulence or crises in a financial system? Where are the vulnerabilities that need to be addressed and resolved so that the system remains trouble free? The answers to this line of rhetorical questioning are, in most instances, both quite obvious, and at the same time, incomplete. · I think even the most minimal application of mind by any reasonably competent finance professional would reveal whatever is specifically weak or wrong or untoward in a financial system that needs to be sorted out to prevent trouble from brewing. And there are, of course, over-arching, well-recognized causalities for financial system failure e.g. macro-economic imbalances, including fiscal anomalies, that could produce considerable stress in the banking system. Further, while there is considerable beneficial impact to be derived from a heightening of technological sophistication or from enhancing scale, and of course, globalization, the inability of the financial system to adequately respond or adjust to the change arising from these developments is often cited as being responsible for systemic malfunctioning. · However, more often than not, almost invariably, a financial crisis hits a country unawares, from sources quite unexpected. What triggers a crisis is almost always a surprise! Of course, once it occurs, it has to be tackled with both emergent and longer term measures, and the fault lines squarely addressed. Concurrently, the big issue is how to contain the crisis and not allow it to spread to other jurisdictions that are perceived to exhibit the same or similar deficiencies. Such international contagion, first seen in 1994-95, during the Tequila crisis, and later in the Asian financial crisis of 1997-98, is a worrisome characteristic of increasing globalization, and this is indeed the primary concern of the international community driving a variety of global initiatives such as the setting up of the Manila Framework Group and the Financial Stability Forum as well as measures to reform the international financial architecture by the G-20, and also more concerted moves by the international financial institutions to engender financial stability in the countries being served by them. · Now, let me turn to some of the fundamentals underlying financial stability and to what extent has progress been achieved by emerging market countries, particularly those in the Asia Pacific region: · FIRST, macro-economic stability, including fiscal health, and sound management of exchange rate, reserves, and debt policies are essential. As a general rule, unless there are good reasons to proceed otherwise, flexible exchange rate regimes are best for emerging market economies, and of course, there is consensus that prudent debt and liquidity management is a key element in crisis prevention. · It must be noted that a liberalized financial system, with all its benefits, is prone to react strongly to a loss, or even a perceived loss of macro-economic stability, and conversely if macro-economic policies are sound, a liberalized financial system would mean very much less frequent and less protracted financial sector disturbances. It is noteworthy here that in recent years the region has seen, barring very few countries, significant improvements in macro-economic management which augurs well for financial stability. In most East Asian countries, the economic parameters within which the financial sector operates, have improved substantially with positive implications for the risks borne by the financial sector. · SECOND, the regulatory agencies must be competent , they must be duly empowered, and be independent as well as fully coordinated with each other. This is perhaps the most critical aspect of financial stability and cannot be emphasized enough. While rigid and prescriptive, merit-based, regulatory systems are distortionary and prone to cause losses, a flexible, progressive, disclosure-based regulatory structure works best and is conducive to reducing the content of risk in a liberalized financial system. Further, the regulatory agencies must have demonstrated capacity to carry out credible monitoring, surveillance, and enforcement activities and above all must not only be independent but must be clearly seen to be independent. Regulatory agencies must have the autonomy, the requisite authority and the professional competence to respond in timely and adroit manner to changes in the external and internal environment in order to maintain the safety and soundness of the system. · Steady development of the financial system and a reduction in systemic risk is achieved by a regulatory style, that instead of second-guessing every decision of banks and other market participants, creates incentives and information structures that allow market participants to seek sensible risk adjusted choices. In addition, it is absolutely critical that in this present era of institutional integration and financial super markets, financial sector regulatory agencies coordinate closely with each other so that the regulation achieved is substantively holistic and seamless thereby also ensuring that nothing falls through the cracks, as it were, and the chances of regulatory arbitrage are diminished. If an emerging market is able to put in place an edifice of regulation that is effective and clearly independent, more than half the battle to achieve financial stability is won. · And it is in this area that East Asian countries appear weakest. Most regulatory agencies in the region are controlled by the Government and are thus subservient to political agendas. Their regulatory capacity needs considerable strengthening and coordination amongst the different regulatory agencies is either non-existent or inadequate. And, if I may say so, investor confidence and financial stability will remain “elusive” unless regulatory standards are raised to an acceptable level throughout the region. · THIRD, another essential element to ensure financial stability and lessen the possibility of crises is the existence of strong and capably managed financial institutions which operate within an incentive framework that promotes efficiency, prudential risk taking, and profitability. Here, by financial institutions, I not only mean banks and lending institutions but also institutions providing non-lending financial services or those that are closely inter-twined with the financial system like investment banks, securities companies, asset management companies, collective investment institutions, insurance companies, leasing companies, factoring companies and also institutions such as stock exchanges, credit rating agencies, credit bureaus, depositories, clearing and settlement agencies etc. Every jurisdiction needs a wholesome institutional framework that adequately covers all aspects of the financial system. · An unbalanced financial system skewed towards, say, banking does not have the comprehensive profile to handle all dimensions of risk; and, as a consequence banking comes under a lot of strain. If you put this alongside lending prompted by dubious political interventions and cronyism and the moral hazard associated with implicit or explicit government credit guarantees you have a crisis in the making. In any case, whether or not these negatives exist, there is a clear need for financial systems with depth --- that offer a wide-range of products and instrumentalities to not only prudently address varying risk preferences and engage in risk-adjusted resource allocation but also have the versatility to cushion the ill-effects arising from a disturbance in any part of the system. · I have to say that the financial systems in most emerging markets are unbalanced and lack depth. In East Asia, there is a heavy dominance of bank intermediation which in several jurisdictions is concentrated in state-owned banks, albeit there are sporadic instances of a few non-banking segments that have grown rapidly in recent years but in an environment of poor regulatory oversight and weak risk management capacity. While, following the crisis, there were fairly decisive steps taken to resolve distressed assets and a number of other steps taken to restore the health of banking institutions, it is obvious that, by and large, there is still a lot of ground to be covered before banking in East Asia can be said to have been restored to an even keel. · Also, there are still a large number of corporations with fragile balance sheets albeit the basic business models are sound --- while these corporates may not be fully bankable they could very well be appropriate clients for certain types of non-banking institutions. Unfortunately, however non-banking remains largely weak or inadequate. · Furthermore, I note that emerging markets in East Asia, as in other regions, have stock exchanges that are either run by Government or by stockbrokers neither of which is a healthy situation. There are very few demutualized exchanges albeit the trend is towards demutualization. All of this adds up to an institutional structure which has to improve a lot before it reaches an optimal level of sophistication and contributes to reducing the vulnerability of the financial system to external shocks. · FOURTH, another significant element that has a marked bearing on financial stability is the adequacy of governance. It is important for financial institutions to adhere to the principles of sound governance and have systems that are transparent, that call for due process, that enhance accountability, that provide for adequate parameters to resolve conflict, and that provide a fair return to all stakeholders. Of course, good governance also means the application of acceptable accounting standards and sound processes that ensure reliable audits or else the necessary degree of disclosure and transparency will be missing. · We have seen that the absence of adherence to norms of sound corporate governance results in cronyism, unwarranted political interventions, conflicted situations, a culture of favors, and perhaps even corrupt practices. All this undermines the health of financial institutions and renders them less capable of providing the services they are mandated to provide as well as much more vulnerable to external shocks. Also, clients of financial institutions that are not in compliance with corporate governance norms are generally less stable and riskier the obvious consequence of which is weaker portfolios of financial institutions with systemic implications. Furthermore, financial institutions that are essentially public utilities, like stock exchanges, must be fairly robust in the matter of corporate governance with capable and independent chief executives, otherwise investor confidence would be adversely affected. · In regard to corporate governance also, a lot of progress has been made in various jurisdictions and the situation in East Asia now is certainly an improvement over what was extant prior to the crisis of 1997-98. However, one still observes some persistence of governance structures that preceded the crisis and the consequent potential for instability and precipitation of systemic risk remains a cause for concern. · I have touched some of the aspects that are relevant to financial stability in East Asia with respect to which further progress is needed in order for developing countries in the region to be able to withstand the kinds of external shocks that could cause a crisis in a vulnerable economy. The key to preventing future financial crises is for emerging market economies to institute sound domestic economic policies, to build robust, well-governed financial institutions, and to put in place capable, fully empowered, and independent regulators. No improvements in the international financial architecture can make up for deficiencies in these crucial areas that, in the case of East Asia, had led to speculative excesses in asset markets and poor risk management. · At the end of the day, investor confidence is a key element in promoting financial stability. The essential impact of the four elements I have discussed, namely --- sound macro-economic policies, competent and autonomous regulators, robust financial institutions, and good corporate governance --- is the strengthening of investor confidence. Even if these aspects are not fully in place but sufficient progress has been made so as to engender the necessary confidence in the system, any sudden, exogenous, negative developments or for that matter any egregious attempts by significant market players to precipitate a crisis are bound to fail. · Currently, the outlook for global financial markets appears quite benign although it rests on a very fine balancing of opposing economic forces. Also, as a group emerging market countries have greatly improved their economic fundamentals which has reduced their overall external vulnerability. However, this masks a widening gulf between those that have made significant progress and those that have not. This is true of East Asia as elsewhere in other regions. · There are a number of risks that doyens of financial stability currently talk about e.g. a noticeable “herding” into risky and unfamiliar assets by investors seeking higher yields in circumstances of abundant liquidity; the increasing transfer of risks, in particular credit risk, from banking to non-banking sectors i.e. from relatively more regulated and transparent institutions to relatively less regulated and transparent institutions; a further sudden fall in the US Dollar that could occur if capital flows into the US decline sharply; a further substantial increase in oil prices; heavily indebted over investment in poor quality assets in some countries; and other risk factors. As yet, all these and similar risks are expected to have adverse repercussions but perhaps not of crisis proportions. This is my own view as well notwithstanding the fact that it is quite common for financial system problems to be identified and equally common for them to be minimized for one reason or another. As I said earlier, both the cause and the nature of a financial crisis is unpredictable --- usually not foreseen by most pundits. It is, therefore, essential --- as I said earlier on --- to take a holistic approach and strengthen all parts and significant aspects of the financial system as a bulwark against any untoward developments that could cause a turbulence in the system. · I would, of course, be very happy to respond to any questions or comments. |
