Financial crises ; Developing countries ; Transparency

anonymous

English

Research Papers in Economics

STRENGTHENING THE EMERGING MARKET
ECONOMIES
Jeffrey A. Goldstein*
The theme of this roundtable is Policies to Prevent Future Crises. Of
course, crises are inevitable. But we can try to design policies to reduce
the probability of crises and mitigate their effects.
FACTORS AFFECTING THE FREQUENCY OF CRISES
To begin, I would like to recall some key factors that may explain
why we have seen a high frequency of ﬁnancial crises over the past two
decades. From my vantage point at the World Bank, I will focus on some
of the factors especially relevant to emerging market economies. These
include the following:
• The small size and greater volatility of many of these economies
and their ﬁnancial systems;
• The lack of adequate ﬁnancial “infrastructure” (including many of
the things we have talked about over the past couple of days—
adequate supervision, reliable legal systems, and effective account-
ing systems); and
• The lack of sufﬁcient transparency, which can hide many problems
and allow them to grow and, of course, create inefﬁcient allocation
of capital.
First, small size and greater volatility. Even with state-of-the-art
supervision and transparency, we should expect more crises in emerging
markets because they see a much greater level of uncertainty and
volatility. Some part of this volatility may stem from inappropriate
*Managing Director, The World Bank Group.policies. A large portion arises from small size and the lack of diversiﬁ-
cation of the real economy. Even if banks are well diversiﬁed within such
small systems, they are inevitably exposed to shocks, such as those when
leading sectors suffer from price declines. And many of these systems are
very small. In 1998, two-thirds of all countries had entire ﬁnancial systems
with less than $10 billion in assets each.
Second, lack of adequate ﬁnancial infrastructure. Even in countries
that have introduced reforms of their ﬁnancial systems, pieces of the
puzzle are missing. In a number of cases, the ﬁnancial liberalization that
has been undertaken in the past couple of decades has been sequenced by
implementing the easy and quick reforms (for example, interest rate
deregulation, more open entry) before those that are difﬁcult and time-
consuming (like building better ﬁnancial sector infrastructure). More-
over, building the ﬁnancial infrastructure that is needed is especially
costly in smaller economies. One example of the kind of micro-policy
consideration that is crucial in getting the infrastructure on track, but a
difﬁcult reform to make in emerging markets, is the amendment of civil
service policies to permit better pay for bank supervisors and central
bankers. Without this reform, it will be hard to attract people with the
necessary skills and to set up the right incentives for them.
But some countries have materially enhanced their ﬁnancial systems.
Not surprisingly, perhaps, by 1997 several Latin American countries that
underwent severe crises in the 1980s had altered their ﬁnancial regulatory
and supervisory framework, in particular by emphasizing market over-
sight in addition to ofﬁcial supervision. And as another response to the
need to strengthen domestic ﬁnancial systems, countries like Argentina
and Hungary are leading the way by allowing foreign banks to enter in
signiﬁcant numbers.
Third, lack of sufﬁcient transparency. A detailed World Bank review
of East Asian ﬁrms— conducted after the crises—indicated exceptionally
high debt/equity ratios and high ratios of short-term to long-term debt.
The ratios were not rising rapidly, but these fragile balance sheet
conditions prior to the crisis meant that these ﬁrms were highly vulner-
able. Because the fragility of these balance sheets had not been adequately
disclosed, market discipline was not exerted in a timely fashion.
ENCOURAGING SOUND PRACTICES
The task ahead lies in encouraging national authorities and private
participants in ﬁnancial markets to implement sound practices. Not a
novel idea, but worth emphasizing as some of the pressures have abated.
One focus of efforts has been the promulgation of standards for sound
practice in a broad range of areas— bank supervision, payments systems,
transparency of monetary and ﬁnancial policies, accounting. As empha-
sized yesterday, however, standards alone will not sufﬁce. There also has
STRENGTHENING THE EMERGING-MARKET ECONOMICS 229to be effective enforcement and disclosure, as well as a reliable legal
environment.
Another effort has been the development by the World Bank and the
IMF of a joint Financial Sector Assessment Program to identify key
strengths, vulnerabilities, and developmental issues in ﬁnancial systems.
The Program is helping provide key insights on how ﬁnancial institutions
and their supervisors are positioned in risk management and mitigation.
The assessments can then guide technical assistance. These efforts are all
part of a process of building the institutional and technical capacities that
are vital to the reduction in the number and severity of ﬁnancial crises. It
is a process that must be sustained, even when the immediate threat of
crisis is past.
In general, strengthening ﬁnancial systems involves building a
reliable legal and judicial environment, strengthening banking systems,
and fostering a more diverse ﬁnancial sector. I will touch brieﬂy on each
of these points, which have all been discussed earlier.
Strengthening Legal and Judicial Systems
Weaknesses in legal and judicial systems can create vulnerability.
Whereas it is sometimes easier to amend laws, affecting the manner in
which the courts enforce them is more problematic. Building a reliable
legal and judicial environment involves a transparent legal framework,
equitable and reasonably affordable access to the enforcement of legal
remedies, and competent and efﬁcient judicial and dispute resolution
mechanisms.
Strengthening Banking Systems
An adequate regulatory and supervisory environment is crucial for
sound banking. This has been well elaborated here at the conference. I
would emphasize that the private sector, not the bank supervisor, is
ultimately responsible for maintaining adequate standards of governance
and risk management in individual private banks. Banks’ shareholders
and management must address their individual banks’ problems, which
they will do only if they have real capital at stake. The private sector more
broadly must exert market discipline on banks, as a complement to
ofﬁcial supervision.
Developing Capital Markets
Finally, fostering a more diverse and resilient ﬁnancial system, in
part by developing capital markets. A diversiﬁed ﬁnancial sector has
many beneﬁts. As Alan Greenspan said at the 1999 World Bank–IMF
Annual Meeting, “The lack of a spare tire is of no concern if you do not
230 Jeffrey Goldsteinget a ﬂat. East Asia had no spare tires.” Capital markets not only can act
as the ﬁnancial system’s “spare tire,” they also facilitate debt manage-
ment and provide longer-term ﬁnance for business, infrastructure, and
housing investments. Various reforms, leading to the development of a
range of ﬁnancial institutions, are important in and of themselves, and
also can give an impetus to the development of capital markets. For
example, institutional investors such as pension funds, life insurance
companies, and mutual funds develop capital markets through the
mobilization of long-term contractual savings and their subsequent
investment in long-term instruments. They also help to strengthen
corporate governance.
THE TASK AHEAD
Financial systems in emerging market economies will not be
strengthened overnight. It takes time to build capacity. Time is needed to
improve the laws on collateral and bankruptcy, the accounting system,
the regulatory and supervisory framework, and the capital markets and
pension systems. Improvement in the enforcement of laws and regula-
tions will take even longer. Problems of governance are an obstacle to
reform. Corruption and insider lending plague many ﬁnancial sectors.
The initiatives that have been described by others here at this
conference, together with the ongoing work of the international ﬁnancial
institutions, can foster a better and more stable economic environment
and can help point the way to preventing some future crises. But
ultimately the private sector needs to be fully engaged, supported by
local national authorities, to strengthen domestic ﬁnancial systems. That
in turn will determine the extent to which crises will be mitigated, and the
extent to which sustained economic growth and poverty reduction will
take place.
STRENGTHENING THE EMERGING-MARKET ECONOMICS 231

Strengthening the emerging market economies

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Strengthening the emerging market economies

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