Partnership for financial stability

This is the first of two articles based on a paper delivered by the managing director of the International Monetary Fund Horst Kohler before the Institute for International Finance in Hong Kong SAR, on May 31.

HONG KONG: The current slowdown in world economic activity has intensified pressures on vulnerable countries and weak financial institutions. Declines in world equity markets and the recent difficulties in Turkey and Argentina have also heightened consciousness of the downside risks and interdependencies in the global economy. But still our best guess is that the slowdown in global growth will be relatively short-lived, with a recovery beginning later this year and gathering strength in 2002. What is important is vigorous policy action to ensure this outcome materializes.

For this reason, I am encouraged that discussions last month at the IMF's International Monetary and Financial Committee (IMFC) demonstrated a growing sense of shared responsibility among the IMF's member countries to safeguard global economic growth. In the United States, the probability of an upturn later this year has increased, as a result of aggressive interest rate reductions by the Federal Reserve and the recently approved tax cut. But we know that there are still considerable uncertainties.

The goods news is that, worldwide, there is a growing awareness of interconnections. For instance, the effects of the US slowdown on growth in Europe have proved stronger than expected. I welcome the recent reduction in interest rates by the European Central Bank, and I am sure that the ECB is now more vigilant than ever.

But we are also aware that the key to stronger European growth is not monetary policy, but the adoption of more ambitious structural reforms, particularly in labor and product markets and tax and pension systems. Japan, for its part, has rightly adopted a new monetary framework to fight the risk of deflation. Even more encouraging is the recognition by the new Prime Minister of the importance of accelerating overdue structural reforms of the banking and corporate sectors, which we hope will soon be translated into action.

To further underpin world economic growth, we need leadership by the advanced countries in resisting protectionist pressures and supporting a new round of multilateral trade negotiations.

The slowdown in global activity is also testing the resilience of emerging market economies. Here in Asia, the past two years have brought a sharp recovery from the financial crises of 1997 and 1998. As a result of domestic policy reforms and strong export demand from the advanced economies, growth in Asia has resumed, fiscal and external positions have strengthened, and many countries have regained access to international capital markets.

Now there are concerns that the weakening of exports and capital inflows may trigger a reversal of these gains. I believe that Asia will weather the storm. In most Asian countries the risk of a new crisis has been greatly reduced through stronger macroeconomic fundamentals and the adoption of more flexible exchange rate policies.

Unfortunately, the record is mixed when it comes to financial sector reform, improving governance, and strengthening the investment climate, and these remain sources of vulnerability in some cases. But it is clear that markets do differentiate, and countries that stay the course on these essential reforms should experience relatively good growth performance. And it also goes without saying that political stability and respect for law and order are crucial for investment, growth, and job creation.

The IMF, for its part, can make its greatest contribution to continued world economic expansion:

* First, by promoting macroeconomic and financial stability in member countries, as a precondition for sustained growth.

* Second, by helping our members to develop sound financial sectors, in order to protect them against vulnerability and mobilize financing for productive investment;

* And third, by safeguarding the stability and integrity of the international financial system, as a global public good.

By focusing on these core areas of responsibility, the IMF can help its member countries to take advantage of the opportunities and contain the risks of globalization.

Asian countries have demonstrated that integration into the global trade and financial systems can bring opportunities for higher productivity, increased trade, stronger growth, and more jobs and higher incomes. But the pace of change constantly challenges the ability of societies and political structures to adapt.

Support for integration into the global economy is undermined by the fact that too many people in the world have so far failed to share in the benefits. And some countries in Asia feel that they have been left too exposed to volatility in international capital flows. Safeguarding stability and world prosperity obliges us to find better methods of international cooperation to address all of these concerns.

In the wake of the Asian crisis, a broad work program was launched to strengthen the international financial architecture.

This has drawn on efforts by multilateral institutions, like the IMF and World Bank; standard-setting organizations, like the Basle Committee on Banking Supervision; and other regional and international bodies.

* One of the lessons the IMF has drawn from the Asian crisis is the need for proper sequencing of capital account liberalization and financial sector development-including supervision and regulation, risk management, and transparency.

* In cooperation with the World Bank, the IMF has established a three-part work program to help members detect weaknesses in their domestic financial systems and devise remedial measures.

This includes our Financial Sector Assessment Program (FSAP), reviews of offshore financial sectors, and our contributions to the international effort to fight money laundering. Together these form a comprehensive approach to strengthening the financial systems in member countries and, thereby, the soundness of the international financial system as a whole.

* With a number of other institutions, we have developed internationally-recognized standards and codes that can guide institutional development in member countries. We are now assessing their observance as a part of the IMF's surveillance process.

* The IMF has taken steps to facilitate risk assessment by private creditors and eliminate unpleasant surprises, by improving the availability of economic data and the overall climate of transparency. The IMF itself is making use of new information made available through our data initiatives and financial sector assessments, to strengthen our analysis of exchange systems and capital flows.

* We have streamlined the IMF's financing facilities, to give our member countries incentives to avoid excessively large or prolonged use of Fund resources, while making our facilities more effective in preventing and responding to crises. We are now in the process of making the Contingent Lines of Credit (CCL) operational as a way of rewarding good policies and helping to resist contagion.

* Private financial institutions, for their part, have been deleveraging and introducing better risk management systems. And financial supervisors have continued to adapt their standards and procedures to new market realities and strengthen cooperation to deal with cross-border issues.

I do think that these initiatives are making the international financial system more resilient. And while there can be no guarantees, this should give us greater confidence that the international financial system will withstand the current period of testing.

In parallel with the initiatives to strengthen the international financial system, the IMF has increased its support for regional cooperation and integration, as a way to promote strong policies and institutions in neighboring countries and stepping stone toward successful integration into global markets.

I am encouraged by the recent announcement of enhanced swap arrangements among several Asian countries under the Chiang Mai Initiative, which I view as a potentially important complement to the IMF's activities in the region.

Despite all that has been accomplished, developments in international financial markets over the past few months underscore the importance of concentrating even more on crisis prevention.

Last month's IMFC meeting confirmed the IMF's strategy and work program in this area. We will be looking, in particular, for ways to heighten the impact of the IMF's surveillance.

In the process, the risks to global financial stability stemming from imbalances in advanced economies will need to be addressed with the same vigor as those posed by developments in emerging market economies.