Dubrovnik Economic Conference
Historically, financial crises have tended to follow liberalization efforts, and these crises have imposed huge costs—often in excess of 10 percent of GDP. Charles Wyplosz from the Graduate Institute of International Studies in Geneva and the Centre for Economic Policy Research in London asked whether financial liberalization creates financial fragility. Analyzing the effects of financial liberalization in 8 Organization for Economic Cooperation and Development and 19 developing countries, Wyplosz concluded that financial liberalization creates more disturbance in developing countries than in developed ones; capital account liberalization is more disruptive than, say, current account liberalization; and the effects of these financial crises are long lasting. Clearly, liberalization has positive effects in the long term, but countries need to be aware of the dangers of instability in the medium term and should liberalize with utmost caution, Wyplosz said.
If liberalization is risky, how should emerging markets be regulated? Curzio Giannini of Banca d’Italia suggested the wisest approach is “broad in scope, soft in method.” In other words, he argued for soft laws that can broadly be defined as rules that affect behavior but are usually not legally binding. Extending coverage of financial regulation and supervision to emerging markets should not be dictated, he added.
Liberalized or regulated, emerging markets seem to be prone to crises, and Craig Burnside of the World Bank set out to find what causes financial crises. One main culprit, he contended, is that governments tend to issue sizable contingent liabilities—such as various forms of guarantees—to the financial sector. Not only may contingent liabilities incur significant fiscal costs (when those contingencies are realized), but their very issuance may increase the probability of a crisis. In Burnside’s view, a government issuing sizable contingent liabilities needs to factor in all possible outcomes, including the probability of a crisis, when it considers appropriate policies and possible costs.
The consequences of financial crises are usually measured in terms of fiscal costs, but Michael Hutchinson and Ilan Neuberger, both from the University of California at Santa Cruz, looked into the output costs of currency and balance of payments crises. Using a panel data set for 32 countries over 1975–97, they concluded that serious currency and balance of payments crises reduce output over two to three years by about 5-8 percent cumulatively. Emerging market economies, which are dependent upon private capital markets, seem more sensitive to crises than developing economies. These currency and balance of payments crises are typically followed by abrupt reversals in capital inflows, and these reversals require substantial real sector adjustment and output loss, the authors found.
Can the choice of monetary policy make a difference for the real economy? And, if so, how can an appropriate regime be chosen? Frederick Mishkin of the Graduate School of Business at Columbia University and the National Bureau of Economic Research, in a paper co-written with the IMF’s Miguel Savastano, explored suitable monetary policy strategies in emerging market economies, based on case studies from Latin America. In their view, monetary policy strategy should sidestep the traditional debate between fixed and floating rates and focus instead on whether a particular policy regime appropriately constrains discretion in monetary policymaking.
Given the weak links between monetary aggregates and inflation, Mishkin and Savastano argued that monetary targeting is not an appropriate strategy. For countries, the pertinent choice is between hard exchange rate pegs and inflation targeting, with the decision ultimately dependent upon the country’s institutional environment. Hard pegs allow much less discretion and are thus the preferred option for countries with weak institutions. By contrast, inflation targeting requires good prudential supervision and a sustainable fiscal policy. But the authors cautioned that no monetary policy strategy can solve other basic problems, such as large fiscal deficits and weak financial systems.
With the eyes of most financial experts focused on Argentina these days, the presentation of Miguel Kiguel of Banco Hipotecario drew a lot of attention. Evaluating Argentina’s economic performance in the past decade and analyzing its main structural reforms, Kiguel argued that the problems the country faces today are very different from those it faced a decade ago. In the 1980s, Argentina grappled with high inflation, significant government intervention in the economy, and constant economic and social deterioration. After stabilizing the economy and implementing a series of privatizations, the biggest challenge the authorities now face is restoring and sustaining growth after three years of recession. Growth is essential, Kiguel emphasized, if Argentina is to manage its huge debt. And for growth, he said, Argentina still needs to strengthen its fiscal solvency, improve its saving rate, achieve more flexibility in the goods and labor markets, and increase its international trade.
Transition economy issues, which preoccupied the first five Dubrovnik conferences, were a significant feature of this conference as well. Examining debt developments in these economies, Ricardo Lago from the European Bank for Reconstruction and Development (EBRD) noted that while external debt has accumulated very rapidly among transition countries as a group, there is great variability among individual countries. Some are managing their debt on a sustainable basis; others are defaulting outright. Inspired by the Brady Plan for Latin America, Lago proposed debt reduction based on strong conditionality for some countries of the former Soviet Union. He also suggested debt-for-nuclear-safety swaps and debt-for-environmental-investment swaps.
Gur Ofer and Michael Keren, both from the Hebrew University of Jerusalem, examined empirical data on foreign direct investment (FDI) in the service sectors of transition economies and compared them with those for developing economies. The transition economies, they suggested, have distinctive structural and systemic characteristics. The transition economies have the advantage of existing infrastructure, such as railroads, but must undertake serious reforms—for example in the governance of state services—to attract FDI.
Boris Vujcic and Igor Jemric, of the Croatian National Bank, assessed the relative efficiency of Croatia’s banks. Their findings indicated that foreign-owned banks are, on average, the most efficient and that banks that began operations during the transition process are more efficient than those that had operated under socialism. György Szapáry of the Hungarian National Bank looked at the experience of Hungary’s banking sector in transition and drew a number of lessons for other transition economies. Bank consolidation should be based, he counseled, on an accurate assessment of bank balance sheets; banks are more efficient in working out bad loans than separate entities; the stock problem of bank recapitalization and the flow problem of new loans need to be addressed adequately; good corporate governance of banks is a necessity; effective supervision requires real autonomy, and the corporate sector must be reformed with the banking sector.
Understandably, capital flows were a dominant topic in this year’s discussions. Gunter Baer of the Bank for International Settlements looked at risk and capital flows to the emerging markets and theorized that the lower level of capital flows in recent years and the larger amount of FDI in these flows may leave emerging markets less vulnerable to contagion crises than they were in the past. Existing risks are now much better understood than before. FDI flows do represent a more stable form of capital flows, but this should not be overstated, he said.
James Dean and Kenneth Kassa of Simon Fraser University took an empirical look at capital flows in the euro area. Their findings suggested that reduced Euroland exchange rate volatility has been associated with less volatility in capital flows and with higher net cross-border flows. For potential members of the European Union, Dean and Kassa recommended that adoption of the euro precede EU membership. Unilateral adoption of the euro would, they argued, help stabilize and probably increase capital inflows.
In the aftermath of the Asian financial crisis, Yusuke Horiguchi, Director of the IMF’s Asia and Pacific Department, asked whether external borrowing by emerging market countries—which is almost always in foreign currency—should not be restrained. His clear answer was that it should be, particularly in economies where domestic saving is very high, as it is in most Asian countries. Such restraint should be imposed because market failures and policy distortions have skewed incentives toward external debt financing, leading to overborrowing and subsequently to financial crisis. He proposed a strict prudential rule regarding banks’ net open foreign currency position and a tax on nonfinancial corporations’ external borrowing. Horiguchi stressed, however, the importance of dismantling any impediments to FDI and portfolio inflows into stock markets. He also emphasized that those restraints on external borrowing should be phased out once emerging market countries attain the status of advanced economies through reforms of the financial system and corporate sector.
Jacques de Larosière, former Managing Director of the IMF and President of the EBRD, who is now with BNP Paribas, spoke about the risks and opportunities that globalization poses for emerging markets. Globalization has sharply increased trade and capital flows but has also limited the possibility of having stable exchange rates and an independent monetary policy at the same time. He stressed the link between developing human capital and attracting FDI, citing evidence that sophisticated investments and those with a large research and development component are going to economies with high levels of human capital. All of this, de Larosière said, underscores the need for emerging markets to give priority to investments in education.
Finally, Nobel prize winner Robert Mundell, a founder of and regular participant in the Dubrovnik Economic Conferences, strongly advocated—to no one’s surprise—monetary unions and the euro. Despite its present weakness, the euro, he said, has almost immediately become the second most important currency in the world. Mundell also vigorously cautioned against overregulated and overtaxed economies. For economies to succeed, he said, governments need strong markets and a business-friendly environment, and no country can hope to prosper without structural reforms and supply-side incentives.
For the full text of the papers presented at the Dubrovnik Economic Conference, please check the conference website (http://www.hnb.hr/dub-konf/dub-konf.htm).
Ian S. McDonald
Art Editor/Graphic Artist
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