Chapter 7:The International Financial Architecture and Emerging Economies

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Chapter 7The International Financial
Architecture and Emerging Economies

• A discussion of recent developments in the global
  capital markets--- the growth of foreign direct
  investment (FDI) 70 percent of these flows are
  among the developed economies.
• On capital flows to the emerging economies.
• 2. (a)The role of capital flows on economic
  growth and economic stability (b) there are
  benefits and risk to liberalized capital markets
  and that financial intermediaries are important
  to the efficient allocation of these capital
  flows (c ) the role of capital flows in recent
  financial crises capital controls.
• 3.(a) the issue on the appropriate type of
  exchange rate regime for the emerging economies,
  (b) discussion of dollarization(Chapter 3) and
  (b) the pros and cons of dollarization of the
  emerging economies are considered.

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The Emerging IFA and DFA

• Much of what is termed IFA lies in the realm of
  proposals (some of them wacky) rather than fact
  or probable fact. There exists a huge literature
  on proposals to reform the international
  financial system (See UNCTAD (2001) Trade
  Development Report, New York United Nations)
• Negotiations involving the financial sector and
  capital markets seem inconclusive in delivering
  an appropriate global result IFA (international
  financial architecture)
• From the point of view of emerging (largely
  developing countries), these have no voice in
  many of relevant forums of discussions.
• For IFA to be useful to emerging markets (in
  terms of smoothing volatility in financial
  conditions and diversifying national risk), these
  countries should be fully participants regardless
  of size and qualifications.

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International Financial Architecture (IFA)

• Two Features of the present international
  Scenario
• Large number of negotiations at the bilateral,
  regional, and multilateral levels
• Repeated financial crises in emerging markets in
  the 1990sAsia, Russia, Brazil, Argentina, Turkey
  etc
• All these crises share a characteristic
  perverse interaction between the domestic
  financial architecture (DFA) and the
  international financial architecture (IFA)
  suggesting that the building of institutions for
  a financially globalized world has an
  international and national dimension AND that
  there must be a minimum of coherence between the
  two.
• That is, if a new IFA is to be built, a new DFA
  must be designed as well.

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Two Hypotheses of the IFA-DFA

• Framework regulating financial intermediation
  (DFA) in a given economy should not be
  independent of developments in international
  markets and institutions applies to the design,
  reform, and management of regulations
• To reduce financial crises in emerging markets,
  the emerging IFA must be consistent with the DFA
  and take into account key features of developing
  economies (a) higher volatility of the
  macroeconomic and financial environment, (b) the
  underdevelopment of the market structure
  (imperfections, missing markets, high transaction
  costs), (c ) the weakness of institutions and as
  a consequence (d) the reduced number of
  countercyclical instruments available to
  authorities.
• Examining these two hypotheses leads to
  fundamental
• questions about the emerging IFA

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The Emerging IFA some questions and possibly no
clear-cut answers!

• What does this mean from the point of view of
  emerging markets goals of growth successful
  integration in the global economy?
• Does the suggested IFA make the international
  financial system more stable, efficient,
  transparent, and fair?
• Is the IFA neutral with respect to changes in
  risk, return, and structure, or are shifts within
  them important?
• Is an imperfect and poorly implemented IFA still
  an improvement over no system at all?

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International Financial Architecture (IFA)

• The phrase IFA rose after the Asia crisis. Now
  routinely used to describe a host of issues
  related to international financial management and
  governance BUT there is no clear understood
  definition of the term!
• Means governance, coordination of policies, and
  integration of the various entities that might
  play a role in stabilizing international
  financial activity.
• Narrower definition focus on the role of the IMF
  before, during, and after a financial crisis,
  especially in a developing country
• Broader definition places several aspects of
  the international financial system within IFA
  (preferred definition)
• Whichever definition is used, what is clear but
  not well-
• understood is the implication that the emerging
  IFA has for
• domestic financial systems, management, and
  governance.

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IFA-DFA Linkages

• Countries with regional agreements need to take
  into account the restrictions and the relation
  between deeper financial regional integration and
  commitments at the multilateral and regional
  levels.
• In Scheme 1, the arrow pointing downwards from
  IFA highlights the fact that international norms
  and institutions limit the set of strategies
  available for developing economies to become
  financially integrated. Example failure to
  tackle criminality can hinder negotiations on the
  liberalization of financial services.
• The DFA includes an assortment of legal norms,
  regulations, policies, and practices that
  influence the management governance of
  financial institutions, and thus their economic
  conduct performance. Like the IFA, we can adopt
  a narrow or broad interpretation of DFA
  Narrowaspects only related to the financial
  sector Broader includes elements associated
  with the macroeconomic regime. Since
  macroeconomic regimes are important, the broader
  definition of DFA is preferred. Thus at the
  bottom of Scheme 1, the DFA is a union of two
  rectangles one with elements of the financial
  sector and the other showing components of the
  macroeconomic regime.

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Scheme I IFA-DFA Relationships
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Changes in IFA and their impact on Emerging
Markets

• IFA changes directly affect the development and
  stability of the financial sector, the
  macroeconomic regime and the process of
  integration with international capital markets.
  To manage this process, authorities in the
  emerging market must introduce necessary changes
  in the DFA, i.e. the interaction between IFA
  DFA 3 points
• Identifying components of IFA DFA and the
  linkages between them
• How IFA-DFA interactions affect the structure,
  conduct and governance of the domestic financial
  sector and its relations to firms and investors
• How changes in the IFA and DFA can trigger
  effects that spillover into the macro-economy and
  the process of deeper integration with
  international capital markets.

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IFA-DFA Relationships1

• DFA and IFA are network of institutions that are
  not neutral with respect to economic efficiency
  and that transactions matter. Contracts
  enforceable through some legal action (investor
  rights) that is costly slow and corrupt judicial
  systems, weak supervision of banking and
  financial sectors, lack of transparency and less
  information available.
• Financial development in emerging markets
  influenced by high volatility. With uncertainty,
  it is difficult to design and implement financial
  contracts so, transactions dont place. As a
  result we have shallow financial markets and some
  missing markets (e.g. markets for long-term
  debt, derivative markets). These features suggest
  a perverse feedback channel between weak
  financial markets and volatility volatility is
  high because risk cannot be properly managed with
  shallow financial markets and these markets are
  shallow because volatility is high! Thus,
  improving DFA IFA is critical. Better designed
  DFAs can reduce market failures BUT this must be
  accompanied by an IFA that contributes to an
  emerging markets policy instruments
  (shock-absorbing)

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IFA-DFA Relationships2

• Since the IFA-DFA interactions are many, Scheme 1
  shows that the center involves 3 policy goals
  (a) achieving deeper integration with the global
  economy, (b) developing financial intermediation
  in a stable environment, and (c ) preserving
  macroeconomic stability.
• The two arrows (?,?) joining DFA and the deeper
  integration represent the interaction between DFA
  IFA that arise as the process of global
  interaction advances Example With Capital
  Account (recall BOP) convertibility, the need to
  adopt rules and regulations that allow for the
  country to compete internationally will increase
  financial systems have to be adapted to absorb
  global shocks authorities soon learn that poor
  fundamentals make the economy more vulnerable to
  global shocks and that domestically created
  shocks can jeopardize normal access to
  international capital markets.

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Emerging IFA1

• Focus on likely developments Scheme 1. The Asian
  crises were not unique in either causes, reaction
  of the IFIs, other lenders or their consequences.
  But their location, timing, and magnitude brought
  to the fore the role of volatile capital flows in
  causing crises, and the prescriptions of the IFIs
  (IMF) in resolving the crises. Thus, any
  definition of IFA must address the appropriate
  Capital Account regime and the need to understand
  and regulate international capital flows.
• Before these crises, the issue was (a) how banks
  assess risk and make provision for it Basel I
  and II standards for capital adequacy, (b)
  followed by G7, G20 and OECD discussions for
  accords related to tax havens and money
  laundering, (c) recent discussions on the
  emergence of electronic money and trading systems
  all important for systemic stability, monetary
  policy and the role of Central Banks.

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Emerging IFA2

• Volatility Crisis Management and Prevention
• Three issues (a) supply of capital issues, (b)
  managing (short-term) capital and the role of
  IFIs.
• A.Supply Side issues least progress regulation
  of sources of capital remains in national hands
  and the more risky capital such as hedge funds
  other short-term capital operate on the basis
  that the inherent risk of the investment is the
  best regulator!
• B.Short-term capital proposals such as the Tobin
  tax remain nonstarters. Domestic controls in
  Chile, Columbia and Malaysia are country-based
  schemes to stabilize their economies and alter
  the composition of capital flows.
• C.IFIs not clear how much blame they should
  take. Misdiagnosing the disease and therefore
  mistreating it key criticism remains very
  contentious. Rescue packages for Turkey
  Argentina were very small. Progress on enhancing
  availability of data, transparency, and
  coordination in international macroeconomic
  policy
• IMF -1996 developed the Special Data
  Dissemination Standard (SDDS) for countries
  having or seeking access to international
  markets. The General
• Data Dissemination System (GDDS) is designed for
  others. Many emerging countries have now signed
  up under SDDS should submit data organized in a
  certain format to provide reliable, timely, and
  useful data. The lack of such data has previously
  made the financial crises worse!

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Tackling Criminality in International Financial
Transactions

• Financial Action Task Force (FATF)housed in OECD
  
• Secretariat. After years of inactivity
  (1989-2000), it started
• naming offenders and creating a blacklist
  annually updated
• --- to shame countries into complying with a
  higher level of
• diligence in preventing money laundering.
• Four issues are still outstanding (a) the
  definition of money
• laundering is left to countries (France considers
  tax evasion to be money laundering but not
  Switzerland), (b) FATF has
• directed its public efforts at small poor
  countries, (c) no
• common framework under which there is coordinated
  effort to
• penalize offenders or improve accountability
  standards, (d)
• failure to link efforts to curb money laundering
  with tax
• evasion.

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DFA in Developing Countries1

• 1 The LHS rectangle in Scheme 1 lists the
  elements of the financial structure that
  constitutes the DFA legal and judicial
  infrastructure, regulatory framework, and a host
  of practices policies that affect structure,
  conduct and performance of financial institutions
  and corporate governance.
• The Macroeconomic Regime 4 elements are (a) the
  exchange rate, (b c) monetary and capital
  account regimes, (d) the capacity to manage
  non-diversifiable national risk. The literature
  on the choice of the exchange rate regimes and
  optimal currency areas has focused on (a) (c)
  while that on capital markets in open economies
  has focused on (d).
• Choice of an Exchange Rate Regime- decision on 3
  key areas (a) desired degree of autonomy of
  monetary policy, (b) the degree of openness
  determines the intensity of capital mobility, (c
  ) the degree of nominal exchange rate
  flexibility.
• With no restrictions on choice, authorities can
  assign monetary policy to domestic targets
  (inflation unemployment), ensure free capital
  to facilitate intertemporal allocation of
  resources and of risk, and a set stable nominal
  exchange rate that favors the stability of the
  private sectors formation of expectations

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DFA in Developing Countries2

• But there is very little space --- this
  constraint determines the
• appearance of a trilemma not possible to
  achieve
• simultaneously, exchange rate stability, free
  capital mobility
• and an autonomous monetary policy.
• Managing Non-Diversifiable National Risk
• If international capital markets were perfect,
  developing countries would access credit at the
  international interest rate and any global
  financial imbalances would not exist. The
  existence of transaction costs, sovereign risk,
  uncertainty, and asymmetric information prevents
  such a possibility. With crises, it is difficult
  to construct a portfolio for diversifying
  developing country risks.
• The role of the IMF as a lender of last resort
  helps in managing national risk.

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Summary

• The analog of IFA in the 60s was International
  Monetary Reform (IMR) more contentious then than
  now. The current debate on IFA lies in 4 areas
  (a) volatile capital flows, (b) inadequate
  financial sector regulation, (c ) inappropriate
  exchange rate regimes, and (d) the lack of lender
  of last resort. The emerging IFA reflects (b) and
  (c ) whereas most emerging markets grapple with
  (a) and (d).
• The design of a coherent IFA that resonates with
  individual DFA reforms is more helpful. That is,
  there is need for internal consistency of
  different DFA components and the external
  consistency between DFA and the IFA. 2 policies
• Domestic danger of patchwork approach to
  reforms and advocacy of a careful design and
  sequencing of the measures that affect different
  segments of the DFA.
• International calls for symmetric view of the
  problem of systemic instability in emerging
  markets, i.e. focus on what national institutions
  can do BUT also take the key role played by IFIs.
• The goal of IFA DFA should be market creation
  and not market liberalization