Globalization and the International Financial System

NYU-Stern Global Business Conference 2001 Globalization: Risks and Rewards

November 30, 2001

It is a pleasure to be with you today and to have the opportunity to offer some thoughts about globalization and the international financial system. I congratulate the organizers of this conference for a well-planned and timely program.

My intention is not to rehearse the arguments about the risks and rewards of globalization. I suspect that most in the audience could come up with longer and more sophisticated lists of arguments and counter-arguments in both categories than I can. Many of you, after all, aspire to embark upon careers in which you are required to assess those risks and rewards every minute of every day, or have already set sail on such careers. On the other hand, I can pretend to have the detachment to offer a few thoughts on globalization and the international financial system, unencumbered by any current, direct responsibility either to make money or to make policy.

My basic message is the following: against the background of the many complex controversies about globalization, the challenges facing individuals and institutions that participate in the international financial system are daunting, and these challenges need to be taken seriously. I say this for three reasons. Let me explain.

First, with respect to our domestic economies, the level of understanding about the role of finance is very limited. It is not easy to establish intuitively the positive linkages between the activities of Wall Street and the activities of Main Street. For example, I have been asked hundreds of times over the past 30 years or so to explain the connection between deposits in banks or purchases of equities and the Economist's concept of investment, in the sense of savings and investment as they are recorded in the national income accounts. One of my many failures as an Economist is that I have yet to come up with a satisfactory one-sentence answer.

Second, and still in the context of our domestic economies, even for those with some intuitive feel for the role of finance in a market economy, the visceral feeling among those who borrow money or take on debt is that those who lend or manage money are rapacious by nature. The local banker receives a certain degree of respect in his community, but one is hard pressed to find expressions of fondness or warmth for large financial institutions, their representatives, or their leaders, in this or any other country.

Third and finally, turning to the international financial arena, two ingredients strongly influence historic trends in international finance: integration and technical change. These basic forces have shaped the evolution of international finance for centuries. Global integration of money and capital markets is the essence of international finance; through such channels purchasing power over real resources today is transferred from areas of the world where expected rates of return are lower to areas of the world where expected rates of return are higher. (At least that is the theory.) This process, in turn, is facilitated in important respects by technical changes that have helped to speed not only the flow of funds but also the flow of information about investment opportunities. So far, so good!

However, recall that a significant portion of the debate about globalization and its effects on the real economy revolves around what portion of the process that supporters of globalization call "creative destruction" is attributable to trends in global integration, on the one hand, and what portion is attributable to trends in technical change, on the other hand. If one can establish that a significant share of the process of disruptive change in our economies is due to technical change, not global integration, the debate about globalization, per se, more clearly becomes one about whether one favors economic growth and progress or not, which is a somewhat easier debate for the proglobalizers in which to prevail. Of course, it is a challenge to try to disentangle the influence of those two trends in assessing the performance of the real economy, for example, with respect to job losses, but many observers are convinced that they are separable, at least at the conceptual level. Thus, the defenders of globalization in the area of trade make the point that the economic effects of technical change should not be attributed primarily to the influence of globalization. When it comes to international finance, such an attempt to separate global integration from technical change is not convincing, even as a debating point.

Thus, my argument is that international finance is particularly vulnerable to those who oppose increased globalization because the role of finance in our economies is poorly understood, financiers don't win popularity contests, and it is essentially impossible to separate the process of technical change from the process of global integration when it comes to international finance. If I am right, then those who operate in the international financial system and are responsible for its institutions, public and private, face unique challenges from the antiglobalizers.

The antiglobalizers in their criticisms, informed or uninformed, of the workings of the international economy and financial system are able to join with many others who decry what they perceive as the directionless sloshing of vast amounts of funds around the world. Those who express shock over what appear to be inexplicable and wide swings in exchange rates and other prices of financial assets. Those who view as irrational the contagion by which the economic and financial difficulties of Argentina adversely affect the access to financial markets by countries on the other side of the globe. And those who bemoan what they see as the disproportionate influence of the US economic slowdown-now officially a recession-on economic activity elsewhere in the world.

Having sketched a four-part indictment of the behavior of international financial markets by its critics both among the antiglobalizers and among some who would not be caught dead carrying placards denouncing the policies of the International Monetary Fund or the World Bank, I assume that you expect me to provide you with a persuasive response to each charge, preferably in sound-bite form. If that is your expectation, you are going to be disappointed.

If we had all afternoon, I am confident that I could provide a set of arguments that would satisfy most of you on these points. In part, my confidence derives from my assumption that most of you don't need a great deal of persuasion. However, we do not have all afternoon. Instead, I would like to leave you with the four criticisms as food for thought to illustrate my core message that the challenges facing the institutions and individuals that take part in the international financial system are daunting, particularly in the context of the overall debate about globalization and its management.
In order that you do not go into the afternoon sessions of this conference completely empty handed, or maybe I should say empty headed, I would like to offer some reflections on two areas that bear on these questions as well as on the overall debate about globalization and the international financial system: first, on the structure or composition of international financial flows and, second, on the ground rules conditioning those flows.

First, concerning the structure of international financial flows, many start from the position that the international financial system facilitates the reallocation of savings from locations with lower expected rates of return to higher expected rates of return. This is not a universally accepted view. The skeptics point to the apparent inconsistency of such a view with the fact that in recent years a major portion of net international capital flows has been directed toward the richest country of the world-the United States-where one would expect that rates of return on capital on average to be relatively low, rather than to emerging-market and other developing countries, where one would expect rates of return on average to be higher.

Moreover, with respect to emerging market economies, which have attracted considerable net capital inflows on balance over the past decade, one often hears the view expressed, as in the recent Economist survey on globalization and its critics, that "the inflow of capital may produce little or nothing of value, sometimes less than nothing. The money may be wasted or stolen. If it was borrowed, all there will be to show for it is an unsupportable debt to foreigners. Far from merely failing to advance development [by improving the global allocation of capital], this kind of financial integration sets it back." The Economist puts forward these words as representing the view of globalization skeptics. However, later on the authors comment, "One of the clearest lessons for international economics in the past few decades, with many a reminder in the past few years, has been that foreign capital is a mixed blessing." The authors go on to endorse foreign direct investment (FDI) as the lowest-risk type of capital inflow from the standpoint of the recipient country.

If a publication as conservative, certainly in the eyes of most critics of globalization, as the Economist can through its reporting implicitly support such a view questioning the benefits of global capital flows, then I would submit that practitioners of international finance have their work cut out for them in defending the social utility of their activity. If the benefits of global capital flows are not well established, we should not be surprised that many only think that they should be shut down, but also that they think that capital flows can be shut down, which would be more difficult than they think but would have tremendously adverse side-effects.

I, for one, also would take issue with the Economist's implicit view of the structure of capital flows and its endorsement of foreign direct investment as the preferred form of capital inflow from the standpoint of emerging market economies.

Of course, countries can get into trouble by relying too heavily on foreign borrowing as a temporary, easy way out of the box of growing fiscal deficits or low levels of national savings. However, the distinction found in the Economist piece between FDI and other forms of capital inflow is too glib, in my view. For example, in the analysis of external financial crises, it is an oversimplification to identify bank lending as the principal source of crises and financial instability merely because those institutions' claims generally have short maturities, which by their nature can run off more quickly as pressures build on the borrower. Countries, of course, may borrow too much at short term because, facing pressures, other sources of external finance dry up. In such cases, short-term borrowing may contribute to their problems, or postpone the adoption of needed policies, but more often than not such borrowing is a symptom of the need to adjust economic and financial policies, not a root cause of the subsequent crisis.

Thus, countries and the international financial community are justified in trying to discourage excessive reliance on short-term external borrowing, especially when it is not hedged; both lenders and borrowers make mistakes. However, a systemic response to this phenomenon that might, for example, propose to restrict sharply short-term external borrowing would be like bundling up children when they go outside in all seasons of the year merely because during winter not doing so increases the risk of their catching a cold.

Moreover, a misplaced concentration by some analysts on banking flows undervalues the fact that short-term financing is the major source of liquidity for all participants in the financial system, starting with the financing of international trade of developing countries. Indonesia's experience in 1998 illustrates this point; because it was cut off from trade finance, as a consequence of the failure of its domestic financial institutions and the uncertain condition of many of its enterprises, not only did Indonesia's imports collapse, as one might have expected, but also its exports because of a lack of trade finance.

Along the same lines, some observers argue that longer-term debt obligations are preferable to shorter-term obligations. However, longer-term debt obligations also come due regularly, and they are even less likely to be rolled over when the borrower comes under pressure than shorter-term banking obligations. For example, a substantial proportion of the drawdown of Brazil's foreign exchange reserves in late 1998, early 1999 was used to pay off long-term debt obligations of the Brazilian private and public sectors that came due during that period. Along similar lines, observers often argue that portfolio investments are preferable to debt obligations, but foreign investors can sell their portfolio investments, repatriate the earnings, and, thereby, put pressure either on a country's reserves or its currency.

Thus, many observers argue, along with the Economist, that foreign direct investment is preferable to portfolio investment. The reality is that foreign direct investment inflows also may dry up, and they cannot be relied upon as a stable counterpart to countries' current account deficits, as Brazil has learned during 2001. In addition to the cessation of capital inflows in the form of FDI, foreign direct investors can and do hedge their positions, exerting pressures on exchange rates and on international reserves. They can and do step up their repatriation of earnings, and they can and do cut back on extensions of credits and other financial inflows.

More fundamentally, given the ingenuity of today's financial markets and their capacity to unbundle exposures and redistribute risks, it is essentially impossible to distinguish different forms of international investment. For example, a foreign direct investor may still own a stake in a firm, but that investor can finance or refinance that stake in domestic currency, and thereby avoid any foreign exchange risk.

My conclusion on the structure of capital inflows is that not only do those who work in the arena of international finance have a selling job to demonstrate better the social utility of their work, but also they have an education job to do with respect to assessing the various risks associated with the structure of those flows.

Turning to my second set of reflections, on the conditioning environment for international financial flows, it is widely believed that the international financial system would benefit from a common set of rules of the game that are transparently followed and in which participants in international financial markets are held accountable when they do not adhere to those rules. This view has motivated much of the effort in recent years to reform the international financial architecture with respect to the crisis-prevention dimension. The official sector has invested heavily in the development of a broad array of codes and standards seeking to improve the functioning of the system. As you are probably aware, codes and standards have been drawn up for the most part by ten major standard-setting bodies. The list includes core principles for effective banking supervision, data dissemination standards, a code of good practices on transparency in monetary and financial policy, and international accounting standards. These efforts have been primarily focused on providing guidance to national financial supervisors and regulators in discharging their responsibilities within a common, internationally agreed framework; it is hoped that by increasing the robustness of national financial systems, the stability of the international financial system will be enhanced as well. In some areas, such as the accounting standards, the private sector has been more directly involved, and of course the intention is to affect the behavior of the private sector.

Despite widespread agreement that the international financial system and the global economy stand to benefit from the development and adoption of internationally agreed codes and standards, such efforts are not without their critics and detractors.

First is the question of authorship. Should the codes and standards be drawn up by experts or by politically responsible officials? Of course, experts are experts, and by definition technocrats know the most about their subjects. However, if the objective is to ensure that the codes and standards will be adopted and followed, the process is aided by involving from the start those more in tune with political processes.

Second is the question of legitimacy of the resulting rules of the game. Should representatives of a small group of industrial countries play a dominant role in their drafting or should there be broad country-representation on the standard-setting bodies, such as the Basel Committee on Banking Supervision? The case for broad participation is strong because the codes and standards are intended to apply in all major jurisdictions. On the other hand, not all agree with the principle of universal application, and it is more difficult to achieve consensus among representatives of a large number of countries, each with its own financial culture and historical experience. Moreover, the representatives of jurisdictions with high standards are reluctant to see their own standards eroded in a process that they fear may be tilted toward reaching agreement at the level of the lowest common denominator.

Third is the related issue of fundamental philosophy. For example, should the basic approach in supervision and regulation be one in which anything goes unless it is prohibited or is the better approach one in which only what is permitted is allowed? My sense is that the former approach is gradually gaining more adherents, but it has a long way to go before it achieves universal acceptance. A minor example involves highly leveraged institutions, in other words hedge funds. According to the restrictive approach to regulation, such entities should not be allowed to operate unless they are subject to direct supervision and regulation because of concern either about the systemic risks associated with their activities or about their impact on the behavior of markets. According to the expansive approach, such entities should be subject to indirect supervision by their counterparties in financial markets and, perhaps, a low degree of public disclosure; moreover, critics of the restrictive approach in this area often argue that to subject hedge funds to direct supervision is unnecessary because their operations involve sophisticated investors, and it is potentially dangerous because direct supervision may be interpreted as bringing them under the financial sector safety net.

Finally, widespread agreement on codes and standards governing participants in international financial markets does little to improve the functioning of the international financial system unless the codes and standards are adhered to and unless participants in international financial markets pay close attention to the extent and quality of their implementation. As someone who labored over many years to encourage the development and adoption of many of these codes and standards, I have my doubts about whether many market participants even know that most of them exist.

My conclusion is that although there is widespread agreement that the international financial system and the global economy stand to benefit from the development and adoption of internationally agreed codes and standards, the challenges in achieving this objective are considerable. Moreover, private market participants have to pull their weight if this approach to improving the functioning of the international financial system is to produce the type of results of which the supporters of globalization can be proud.

This conclusion is consistent with the broader message of my remarks today: the challenges facing the institutions and individuals that participate in the international financial system are daunting, particularly in the face of many of the criticisms from the opponents of globalization. As a consequence, all who have a stake in the further evolution and enhancement of the international financial system, which I take to include many in this audience, should bear this fact in mind as they go about their business.