I. Introduction

Ladies and Gentlemen. It is a great honour to address this distinguished audience at the beginning of the symposium. Despite its long history, I doubt that Kyoto has seen such a concentration of influential people in one room as is gathered here today: the level of combined cultural refinement is of course a totally different matter.

Joking aside, this symposium is a very timely one, since as we approach the new millennium it is becoming more and more obvious that maintaining a sound financial sector is a prerequisite for both industrial and emerging economies to achieve sustainable and stable economic growth and development. Our discussions beginning tomorrow will no doubt contribute to enhancing this message, not only in Japan and the United States but also throughout the world.

Needless to say, a sound financial sector in each country is indispensable to the stability of the international financial system as a whole. At the same time, without a backdrop of a stable international financial system, the financial sectors of countries, particularly the emerging economies, will not be as robust as it should be. I believe, therefore, it may be worth your time to look at the nature of various issues involved in the ongoing discussion on reforming the international financial architecture, and the current status of those discussions following the Cologne summit meeting last weekend.

As we all know, the financial crises of recent years, first in Mexico in 1994, then in Asia in 1997, and in Russia and Brazil in 1998, have clearly demonstrated that there is inherent instability in today’s liberalised market economy. This is not to say that these crisis countries were without flaws: in fact, there were many policy mistakes and inappropriate structural rigidities in these countries. However, what is striking is the abruptness with which these countries, particularly in Asia, fell from an admirable state of solid economic performance to near bankruptcy. In my opinion, this cannot be explained only by their structural problems. As the crisis spread to Russia and Brazil, even sceptics began to accept that the international financial system itself needed to be reformed.

Japan has been very vocal on this point from an early stage, arguing that there was a pressing need to reform the international financial system as a whole: our sense of urgency did not seem to be shared by many countries until the crisis erupted in Russia and Brazil. In December last year, Minister Miyazawa made a speech outlining Japan’s proposals for reform. The speech focused on what we think are the fundamental issues, namely how to cope with short-term capital flows, what is the appropriate exchange rate regime for an emerging economy, and how to improve the working of the international financial institutions, especially the IMF.

There have been many more speeches on this subject made by ministers and officials of various countries, and views have also been expressed by people in academia and the private sector. Eventually, after long and sometimes heated discussions among the G-7 countries, the Report of the G-7 Finance Ministers on the International Financial Architecture was finally produced and published last weekend. Although this is just the first step, I think that it is a major achievement by the G-7. I now would like to share with you the major elements of the Report, focussing on the three fundamental issues I mentioned earlier.

II. Crisis of the Capital Account

Nature of the crisis

There is no doubt that increasingly liberalised cross-border capital movements have resulted in strong economic development and a general rise in living standards in many emerging and developing countries, as economic theory teaches us. At the same time, on the creditors’ side, higher expected rates of return from investment in emerging economies are very attractive, especially when the creditor’s country is a mature economy facing the rapid ageing of its population.

As such, it appeared that free capital movements would only benefit the world economy as a whole. In fact, this is why the IMF Board seriously considered in the mid-1990s an amendment to its Articles of Agreement that would make the liberalisation of capital movements one of the purposes of the IMF.

However, matters turned out to be not so simple. First, in reality, free capital movements do not always bring about optimum allocation of resources, because investors often make their decisions based on imperfect and asymmetrical information.

Moreover, in some cases, especially in Asia, private investors who had lent to, or invested in, these countries in short-term instruments and in foreign currencies started to withdraw their funds en masse, almost regardless of the economic fundamentals of the recipient countries. This is what I call a ‘21st century-style crisis’, or a ‘crisis of the capital account’ as opposed to the traditional ‘crisis of the current account.’

All of the recent crises in Asia, Latin America, and Russia fell in this new category of crisis. For instance, in Thailand huge capital inflows, including those through offshore accounts, had created a boom in the economy. But, once market confidence in the sustainability of the virtual peg of the baht to the U.S. dollar was lost, there were massive capital outflows, and the baht collapsed. As the international community became more aware that capital flows could reverse direction very easily, and that no country could remain intact in the face of such an onslaught, enthusiasm for amending the IMF Articles subsided considerably.

However, even if the development of today’s financial technologies increases the ease with which investors can move around their capital, and hence bring about higher risks of crisis of the capital account, denying cross-border capital flows altogether would not solve the problem. The most important challenge now facing the international community, therefore, is to find ways to maximise the benefits of free capital movements while minimising the risk of crisis. This requires an analysis of why abrupt capital outflows occur.

The possibility of a crisis of the capital account may grow, first of all, when investors have not properly assessed the risks involved in their activities, either because their internal risk assessment procedure is inappropriate, or because they simply follow what other investors do (the so-called ‘herding’ behaviour). It is often argued that the activity of hedge funds, or Highly-Leveraged Institutions (HLIs), influences other market participants so greatly that when large-scale HLIs take a certain position in the market it practically determines the direction of market movements, thereby distorting the working of the markets.

The risk of crisis may also increase, when market confidence in a country’s economic policies is eroded. Damage to confidence may be greatest when investors are led to believe that the government implicitly or explicitly guarantees the investment proceeds, including by an ostensibly sustainable fixed exchange rate regime, and then that commitment starts to look increasingly untenable.

Thus, our approach to reducing the risks of such a crisis should focus on both the creditor’s side and the recipient side.

What Creditors Need to Do

On the creditor’s side, the Finance Ministers’ Report says that the G-7 will ‘encourage private firms to strengthen their own risk management practices’ and that ‘national authorities should ensure banking institutions in their countries implement adequate risk management practices in accordance with’ the Basle Committee’s recommendations in its paper on HLIs published early this year. At the same time, the Report notes that the newly-established Financial Stability Forum will study a number of issues related to HLIs, including instability possibly caused by HLIs in relatively small financial markets. Enhancing supervision in offshore centres is also encouraged in the Report.

Furthermore, in order to ensure that ‘private creditors know that they will bear the consequences of their investment decisions’, the Report identifies the principles that govern debtor/creditor relationships and the tools that may be used to promote appropriate private sector involvement in the resolution of crises, including an effective use of the ‘lending into arrears’ policy of the IMF. Legal and technical questions involved in implementing these specific approaches will be considered by the IMF by the time of the Annual Meetings in September this year.

What the Emerging Economies Need to Do

On the emerging economies’ side, the Report proposes concrete measures in four different areas: exchange rate regimes; capital flows; financial systems; and debt management.

Exchange Rate Regimes

First, on exchange rate regimes, the G-7 notes that ‘the choice of exchange rate regime is critical for emerging economies to achieve economic development.’ It says, ‘We agree that the most appropriate regime for any given economy may differ, depending on particular economic circumstances.’ For instance, ‘some emerging economies have sought to achieve exchange rate stability by adopting peg regimes against a single currency or a basket of currencies, often in the same region, of countries with which they have the closest trade and investment links.’

Adopting an appropriate regime is important, since it allows overseas investors to properly judge exchange risks they are taking. To make the regime reflect the changing degree of exchange risk, it must be continuously reviewed, so that it can be fine-tuned as ‘economic circumstances vary over time.’ In this context, the IMF should play a more active role ‘to enhance the attention it gives to exchange rate sustainability in the context of its surveillance activities.’ If a country intervenes heavily to defend an unsustainable exchange rate level, large-scale official financing should not be provided.

A simple hypothesis, the so-called ‘two-corner approach’ has sometimes been suggested in international circles, including by officials. This school of thought assumes that only a completely free-floating regime or a currency board are viable. The Report does not share this view. Although it does say that ‘countries choosing fixed rates must be willing … to subordinate other policy goals to that of fixing the exchange rate’ and that ‘arrangements institutionalising that policy can be useful to sustain a credible commitment to fixed rates,’ the common understanding among the G-7 countries is that the ‘arrangements’ referred to here are not limited to a currency board but include various measures.

Capital Flows

On capital flows, the Report recommends that ‘[C]apital account liberalisation should be carried out in a careful and well-sequenced manner, accompanied by a sound and well-regulated financial sector and by a consistent macroeconomic policy framework.’ It goes on to explain the G-7 consensus on controls on capital flows. It says, ‘The use of controls on capital inflows may be justified for a transitional period as countries strengthen the institutional and regulatory environment in their domestic financial systems.… More comprehensive controls on inflows have been employed by some countries as a means to shield themselves from market pressures. Such steps may carry costs and should not in any case be used as a substitute for reform. … [C]ontrols on capital outflows can carry even greater long term costs…, although they may be necessary in certain exceptional circumstances.’

It has sometimes been suggested by the press and others that Japan is advocating more controls on capital flows while other G-7 countries are arguing for free capital movements. This is simply not true. If one reads the Miyazawa speech of last December carefully, it is clear that Japan’s position from the outset was that maintaining market-friendly controls that would prevent turbulent capital inflows should be justified when a country wants to keep capital inflows at a manageable level according to the stage of development of its financial sector, and that there might be some cases that would justify the reintroduction of controls on capital outflows as an exception, for example, in order to avoid a bail-out by IMF loans. As the Report shows, this stance is shared by all G-7 countries.

Strengthening Financial Systems

As for financial systems, the Report calls for close coordination between the IMF and the World Bank when they give advice to emerging economies in the area of financial sector reform. It also welcomes commitments by the emerging economies of Asia and Latin America to take necessary steps towards the implementation of the Basle Core Principles for effective banking supervision.

Sound Debt Management

In addition, the G-7 thinks that best practices in debt management should be promoted, so that countries avoid too much reliance on short-term borrowing, particularly in foreign currencies. I expect that these principles will be discussed by the IMF Board in the near future.

III. Reform of the IMF

It is now clear that the IMF was unable to meet the challenges posed by this 21st century-style crisis in several Asian countries. The biggest mistake was that the IMF prescribed for the countries ‘medication’ that had been effective for the old-style crisis of the current account.

I have on several occasions discussed in detail what was inappropriate in IMF programmes for Thailand, Korea, and Indonesia. I shall therefore not repeat my arguments today. Should you be interested, some of my speeches and the Minister’s speeches can be found on the Ministry of Finance Homepage on the internet.

Of course, I firmly believe that the IMF should be at the heart of the stable international financial system. This is not to say, however, that the IMF can stay as it is now. In this connection, the G-7 Report says, ‘[B]uilding upon the experience of IMF-supported programmes in the financial crisis, the IMF should explore ways further to improve IMF surveillance and programmes so that they better reflect the changes in the world economy, in particular potentially abrupt large-scale cross border capital movements.’

The decision-making procedures of the IMF must be improved, too, so that Board members are better briefed by IMF staff and more closely consulted, as appropriate. The Report notes this point as well.

Incidentally, there are two new proposals in the Report concerning the governing structure of the IMF. First, it is proposed that the Interim Committee be given a permanent standing with a new name, ‘the International Financial and Monetary Committee.’ Second, it is suggested that an informal mechanism for dialogue among systemically important countries be established within the framework of the Bretton Woods institutional system. I expect that the G-7 and other countries will jointly consider these proposals with the view to reaching agreement in the near future.

The working of the IMF will also be improved through more transparency, especially through greater release of its Board documents and better internal and external evaluation efforts. The G-7 Report supports this point, too.

IV. Conclusion

One might be forgiven, on reading the G-7 Report, for thinking that the reform of the International Financial Architecture is now complete and the world economy will prosper without any further risk of crisis. Forgiven - especially after a good dinner - but wrong.

Wrong because as technological developments and other factors change the global economic and financial environment over time, the architecture needs to be continuously adapted to the evolving reality. Wrong, too, because what we have now is basically a list of concrete proposals. Their implementation is crucial: as the English say, ‘The proof of the pudding is in the eating.’

So, the G-7 has to continue to work hard among ourselves or at the IMF and World Bank Boards, so that our proposals can be implemented as quickly and as practically as possible.

Let me conclude by saying a few words about Japan’s contribution to this important endeavour. I do not mean to sound triumphant or boastful, but I just think that Japan has taken the lead in the discussion on the Architecture for the past two years or so. Many of Japan’s proposals and arguments have been supported, criticised, or mulled over, and now eventually have found their way into the G-7 Report. Of course, it is a team effort with other G-7 and non G-7 countries, and not like a zero-sum game where only the first advocate is rewarded. Nevertheless, I simply would like to declare that such intellectual contributions to the pressing issues of the world economy is what Japan will continue to strive to make. I am sure you will see more of these in the years to come.