Testimony of Chairman Alan Greenspan of the Federal Reserve Board
Before the Committee on the Budget, U.S. Senate
September 23, 1998 -- The crisis in emerging market economies.
The crisis in emerging market economies that began in Thailand a little
over a year ago, spread to other economies in East Asia and Russia, and
has most recently been pressuring a number of economies in Latin
America. There is little evidence to suggest that the contagion has
subsided.
Moreover, the declines in Asian export markets only added to the
difficulties in Japan, which was struggling with a preexisting set of
corrosive banking problems. Those difficulties have contributed to that
economy's most protracted recession in the postwar era.
As I indicated several weeks ago to a university audience, it is just
not credible that the United States, or for that matter Europe, can
remain an oasis of prosperity unaffected by a world that is experiencing
greatly increased stress.
With few signs that the financial crisis that started in Asia last year
has subsided, or is about to do so, policymakers around the world have
to be especially sensitive to the deepening signs of global distress,
which can impact their own economies.
In emerging markets, after about six months of relative stability,
heightened perceptions of credit risk erupted in mid-August when Russia,
which seemed to have been making progress toward greater stability, fell
into renewed crisis.
Russia is not large in the world's trade accounts or critical to the
stability of the international financial system. Nevertheless, the
severity of its crisis and the authorities' inability to contain it
reflected a significant jump of contagion out of East Asia, which, until
then, had been assumed to have gone into remission.
The shock drove yields on dollar-denominated debt securities of emerging
market economies sharply higher across the globe, engulfing economies
that are as radically different as Korea, Brazil, Poland, South Africa,
and China. To be sure, some yields have increased only one to two
percentage points, while others have risen ten points or more. But all
these economies have experienced stress. The flight to safety has
significantly augmented the demand for U.S. Treasury securities, whose
yields have declined in tandem with the increases in yields on most
dollar-denominated sovereign debt in international bond markets.
In recent weeks, that shift internationally has also been accompanied by
a rising concern for risk in the United States, presumably reflecting
the fear that the contagion would adversely affect our economy.
When I testified before the Congress in July, I noted that some of the
effects of the international crisis had actually been positive for the
U.S. financial markets and economy, for example, by lowering long-term
interest rates paid by our households and businesses. However, the most
recent more virulent phase of the crisis has infected our markets as
well. Concerns about business profits and a general pulling back from
risk-taking in the midst of great uncertainty around the globe have
driven down stock prices and pushed up rates on the bonds of lower-rated
borrowers. Flows of funds through financial markets have been disrupted,
at least temporarily. Issuance of equity, and of bonds by lower-rated
corporations, has come virtually to a halt; even investment-grade
companies have cut back substantially on their borrowing in capital
markets. Banks also are reportedly becoming more cautious and more
expensive lenders to many companies.
There is little evidence to date, however, that foreign problems or the
tightening in financial conditions in domestic markets have produced any
significant underlying weakness in the American economy as a whole.
Moreover, labor markets remain tight and hourly compensation has
continued to grow more rapidly. Nonetheless, the increases in overall
costs and the CPI have been held to modest levels by reasonably good
productivity advances, lower oil prices, and foreign competition.
However, looking forward, the restraining effects of recent developments
on the U.S. economy are likely to intensify. As I noted in congressional
testimony last week, we can already see signs of the erosion of
production around the edges, especially in manufacturing. Disappointing
profits in a number of industries and less rapid expansion of sales
suggest some stretching out of capital investment plans in the months
ahead. Lower equity prices and higher financing costs should damp
household and business spending, and greater uncertainty and risk
aversion may also lead to more cautious spending behavior.
When I testified on monetary policy in July, I explained that the
Federal Open Market Committee was concerned that high--indeed
rising--demand for labor could produce cost pressures on our economy
that would disrupt the ongoing expansion. I also noted that a high real
federal funds rate was a necessary offset to expansionary conditions
elsewhere in financial markets. By mid-August the Committee believed
that disruptions abroad and more cautious behavior by investors at home
meant that the risks to the expansion had become evenly balanced. Since
then, deteriorating foreign economies and their spillover to domestic
markets have increased the possibility that the slowdown in the growth
of the American economy will be more than sufficient to hold inflation
in check.
As I have indicated in earlier presentations, the dramatic advances in
computer and telecommunications technologies over the last decade have
fostered a marked increase in the degree of sophistication of financial
products. A vast new array of debt, equity and hybrid instruments, as
well as newly crafted derivative products have fostered an unbundling of
risks, which, in turn, has enabled investors to optimize (as they see
it) their portfolios of financial assets. This has engendered a set of
market prices and interest rates that have guided business organizations
increasingly toward producing those capital investments that offer the
highest long-term rates of return, that is, those investments that most
closely align themselves with the prospective value preferences of
consumers. This process has effectively directed scarce savings into our
most potentially valuable productive capital assets. The result,
especially in the United States, where financial innovations are most
advanced, has been an evident acceleration in productivity and standards
of living, and, owing to the financial sector's increased contribution
to the process, a greater share of national income earned by it over the
past decade.
The new financial innovations, which have spread at a quickened pace,
have facilitated a rapid expansion of cross-border investment and trade,
and almost surely, as a consequence, a significant increase in standards
of living for those nations that have chosen to participate in what can
appropriately be called our new international financial system. The
system is new in the sense that its dynamics appear somewhat more
accelerated relative to the international financial structure of, say,
fifteen or twenty years ago. Owing to the newer technologies, market
prices have become more sensitively tuned to subtle changes in
preferences and, hence, react to those changes far faster than in
previous generations. The system is productive of increased standards of
living and more sensitive to capital misuse. It is a system more
calibrated than before to not only reward innovation but also to
discipline the mistakes of private investment or public policy.
Thus, the crises that have emerged out of this new financial structure,
while sharing most of the characteristics of past episodes, nonetheless,
appear different in important ways. It is not yet clear whether recent
crises are deeper than in the past, or just triggered more readily.
In early 1995, I characterized the Mexican crisis as the first crisis of
this new international financial system. The crisis that started in East
Asia more than a year ago, is its second.
Since the Mexican crisis, policymakers have been engaged in an
accelerated learning process of how this new system works.
There are certain elements that are becoming evident.
The sensitivity of market responses under the new regime has been
underscored by the startling declines of exchange rates of some emerging
market economies against the dollar, and most other major currencies, of
50 percent or more in response to what at first appeared to be
relatively modest financial difficulties. Market discipline appears far
more draconian and less forgiving than twenty or thirty years ago.
Capital, which in an earlier period may have flowed to a "merely
adequate" profit environment, owing to a lack of information or
opportunity, now shifts predominantly to those ventures or economies
that appear to excel. This capital, in times of stress, also flees more
readily to securities and markets of unquestioned quality and liquidity.
It has taken the longstanding participants in the international
financial community many decades to build sophisticated financial and
legal infrastructures that buffer shocks. Those infrastructures
discourage speculative attacks against a well entrenched currency
because financial systems are robust and are able to withstand vigorous
policy responses to such attacks. For the more recent participants in
global finance, their institutions, until recently, had not been tested
against the rigors of major league pitching, to use a baseball analogy.
The situation in many emerging market economies is illustrative. Under
stress, fixed exchange rate arrangements have failed from time to time.
Consequently, domestic currency interest rates, reflecting devaluation
probability premiums, are almost always higher in emerging market
economies with fixed exchange rates than in the economy of the major
currency to which the emerging economy has chosen to peg. That currency
is often the dollar.
This phenomenon, and its risky exploitation, is one important element in
the current crisis and a symptom of what has gone wrong generally. What
appeared to be a successful locking of currencies onto the dollar over a
period of years in East Asia and elsewhere, led, perhaps inevitably, to
large borrowings of cheaper dollars to lend at elevated domestic
interest rates, with the intermediary pocketing the devaluation risk
premium. When the amount of unhedged dollar borrowings finally became
excessive, as was almost inevitable, the exchange rate broke.
Incidentally, it also broke in Sweden in 1992 when large borrowings of
DM to lend in krona at higher interest rates met the same fate. Such
episodes are not uncommon, suggesting that investors, even sophisticated
ones, are prone to this type of gambling.
This heightened sensitivity of exchange rates of emerging economies
under stress would be of less concern if banks and other financial
institutions in those economies were strong and well capitalized.
Developed countries' banks are highly leveraged, but subject to
sufficiently effective supervision so that, in most countries, banking
problems do not escalate into international financial crises. Most banks
in emerging nations are also highly leveraged, but their supervision
often has not proved adequate to forestall failures and a general
financial crisis. The failure of some banks is highly contagious to
other banks and businesses that deal with them.
This weakness in banking supervision in emerging market economies was
not a major problem for the rest of the world prior to those economies'
growing participation in the international financial system over the
past decade or so. Exposure of an economy to short-term capital inflows,
before its financial system is sufficiently sturdy to handle a large
unanticipated withdrawal, is a highly risky venture.
It, thus, seems clear that some set of standards for participation in
the new highly sensitive international financial system is essential to
its effective functioning. There are many ways to promulgate such
standards without developing an inappropriately exclusive and
restrictive club of participants.
One is far greater transparency in the way domestic finance operates and
is supervised. This is essential if investors are to make more
knowledgeable commitments and supervisors are to judge the soundness of
such commitments by their financial institutions. A better understanding
of financial regimes as yet unseasoned in the vicissitudes of our
international financial system also will enable counterparties to more
appropriately evaluate the credit standing of institutions investing in
such financial systems. There is no mechanism, however, to insulate
investors from making foolish decisions, but some of the ill-advised
investing of recent years can be avoided in the future if investors,
their supervisors, and counterparties, are more appropriately
forewarned.
To the extent that policymakers are unable to anticipate or evaluate the
types of complex risks that the newer financial technologies are
producing, the answer, as it always has been, is less leverage, i.e.
less debt, more equity, and, hence, a larger buffer against adversity
and contagion.
I must also stress the obvious necessity of sound monetary and fiscal
policies whose absence was so often the cause of earlier international
financial crises. With increased emphasis on private international
capital flows, especially interbank flows, private misjudgments within
flawed economic structures have been the major contributors to recent
problems. But inappropriate macropolicies also have been a factor for
some emerging market economies in the current crisis.
Improvements in transparency, commercial and legal structures, as well
as supervision that I, and my colleagues, have supported in recent
months cannot be implemented quickly. Such improvements and the
transition to a more effective and stable international financial system
will take time. The current crisis, accordingly, will have to be
addressed with ad hoc remedies. It is essential, however, that those
remedies not conflict with a broader vision of how our new international
financial system will function as we enter the next century. |
