10:55 AM Jun 10, 1996

DEREGULATION SHOULD BE GRADUAL, CAREFULLY PHASED

Geneva 10 June (Chakravarthi Raghavan) -- The deregulation of the financial system in developing countries, particularly with respect to international influences, "should be both gradual and carefully phased."

At a time when developing countries are being pressed by the industrial world and by the IMF, World Bank and the WTO to "integrate" faster by liberalizing financial services and capital flows, the Basle-based Bank of International Settlements (BIS) has come up with a cautionary advice in terms of the Mexican crisis of December 1994.

In its 66th Annual Report, in a concluding chapter on "Fostering Stability in the Midst of Change", the BIS (the socalled Central Bank of the Central Banks of Europe) strikes this cautionary tone in welcoming developments in the international financial system which it notes continues to grow steadily in size, complexity and geographical scope.

Cross-border transactions in bonds and equities among the G7 nations (excluding the UK) rose from 35% of GDP in 1985 to around 140% in 1995. The outstanding notional value of derivative contracts (in April 1995, according to the survey carried out by Central banks) was over $40 trillion. Restrictions on cross-border rights of establishment for financial institutions have been virtually eliminated in industrial countries and are being sharply scaled back elsewhere. These developments are to be welcomed, the BIS says. They allow a more efficient allocation of capital both domestically and internationally, lead to lower-cost financial services, and offer new means for hedging risks of all sorts. Nevertheless, it cautions, three points need to be borne in mind.

Firstly, the fact that the system continued to function well in the face of a number of shocks -- the Mexican crisis, the failure of the Barings, the trading losses at Daiwa -- and the difficulties confronting the Japanese banking system should provide no grounds for complacency. "Banking systems are, or will be, under pressure almost everywhere, in spite of recent improvements in profitability."

Secondly, financial markets continue to be subject to large, unpredictable price swings.

And thirdly, different financial sectors and markets are inter-acting in increasingly complex ways that will challenge the ability of both regulators and the markets themselves to discipline participants effectively.

Despite a satisfactory outturn in several countries in 1995, profit rates in the banking sectors of industrial countries have been generally declining since mid-1980s and the pressure to contain costs seems likely to intensify.

Bank deposits are facing growing competition from other vehicles for savings, while traditional bank lending is threatened by other forms of financial intermediation involving the unbundling and marketing of discrete price and credit risks. The emergence of electronic or 'virtual' banking threatens the traditional retail banking.

All these imply continued restructuring and consolidation in industry.

Financial institutions need to become more responsive to competitive pressures to ensure a smooth process of adjustment and this requires clearer signals from authorities that the fate of the institution rests primarily in their own hands.

Referring to developing countries in this context, the BIS says that their banking systems would eventually have to deal with the same kinds of competitive forces as in developed world. But many developing countries had more immediate problems.

Liberalisation has often proceeded against a backdrop of local portfolios heavily weighted towards government-directed credits, inadequate loan diversification, high cost structures and an unhealthy degree of linkage between banks and commercial firms.

A number of countries have also recently experienced rapid rates of credit expansion, often closely related to property speculation, with clear risks in event of asset price bubble bursting. In several countries, banks may also be vulnerable to a squeezing of intermediation margins as inflation falls, and to capital outflows should confidence falter.

How to prevent or contain financial crises has therefore become a key policy issue.

One obvious conclusion for crisis prevention is that "deregulation of the financial system, particularly with respect to international influences, should be both gradual and carefully phased."

The experience of many industrial countries in recent years highlights the dangers inherent in the process.

Another lesson is that rapid credit growth should probably be treated as a more dangerous sign than it often is, particularly where bank credit is concentrated in certain sectors.

The BIS though thinks that in this regard allowing domestic banks which are sufficiently capitalized to diversify abroad might be helpful, while the restructuring of the banking system could be assisted in some cases by allowing foreign banks to play a greater role.

As for management of financial crises (like that in Mexico), it would be better to avoid such problems by taking steps to improve the health of the banking system, rather than having recourse to draconian measures as were required in Argentina and Mexico.

The BIS has also found a second source of concern in that developments in financial markets might threaten stability if rapid price changes take important participants by surprise -- leading to their bankruptcy.

While short-term volatility was not particularly high in 1995, nevertheless it finds some significant swings in bond prices and sharpness of reversal of the value of yen as hard to reconcile with movements in the underlying fundamentals.

Also worrisome to BIS, is "the renewed appetite for risk" on the part of investors prompted by general reduction in bond yields which may have contributed to the strength of stock markets.

"The potential for an abrupt change in this appetite for risk should not be under-estimated," it warns.

A third area of concern, a long-standing one, accentuated by the financial developments in 1995, BIS says, has been the blurring of distinctions between different market instruments and between different categories of market participants. This has made it harder to determine "who is doing what and why" and poses a challenge to the disciplinary powers of both regulators and markets.

BIS advocates public sector efforts to ensure high degree of disclosure by the private sector as well as steps by regulators to deal with blurring of lines between different kinds of financial institutions, building on the lines of the progress made by the Basle Committee and the International Organization of Security Commissions (IOSCO).

It points out in this regard, that supervision of the financial system in a number of developing countries has been inadequate. Over the medium term much needs to be done to increase effectiveness of rating agencies and market discipline, in particular to address the unsatisfactory state of accounting standards and other impediments to transparent disclosures.

"In the short-run, however, authorities cannot rely principally on market discipline: supervisory practices must be significantly strengthened as well. A major programme of education and training for supervisors, based on some agreed standards of prudent banking system would be helpful, as would efforts to insulate both banks and supervisors from political influences."

The BIS has also provided support to arguments of developing country economists against the Fund/Bank prescriptions for sharp devaluations as a way of stimulating exports and growth.

The developing countries, BIS says, have been cautious in discrete exchange rate adjustments and in moving to regimes with greater flexibility. This it notes is because depreciation in developing countries tends to have a sizable and immediate impact on domestic prices. Prices in emerging economies are very sensitive and respond quickly to changes in exchange rates. The Mexican peso depreciation, for example, raised consumer prices by 45 percentage points, fully twofifths of the rate of depreciation, while in Hungary the rate of depreciation of the forint in mid-1994 led to a sharp jump in price inflation. In Poland, a slower rate of depreciation of the zloty led to a sharp drop in the inflation rate.

In industrial countries, on the other hand, the exchange rate/price link appears to be much less close or less immediate. Despite a high import intensity of output, the European countries whose currencies depreciated sharply in the wake of the 1992 exchange rate crisis experienced only a small rise in inflation.

Even a depreciated exchange rate or band or a general move towards greater exchange rate flexibility in the developing world can create doubts in financial markets about the true intent and resolve of the authorities. It cites in this connection the steep decline in value of the Mexican peso in autumn of 1995 because of market doubts about political sustainability of macroeconomic policies, the turbulence in India over its new policy of managed floating (because of worries as to how far the government wanted the rupee to fall) and the problems of the South African rand early in 1996.

In a sobering antidote to the current advice to developing countries that foreign investments could compensate for domestic savings, BIS says that recent experience has underlined the central importance of national savings and investment rates in promoting growth.

"A greater reliance on domestic, rather than foreign, saving reduces the risk of a financial crisis triggered by capital outflows. Financial systems in countries with high rates of savings are likely to be more resilient to economic shocks."

It notes in this connection that except for India and the Philippines, savings rates in Asia have risen to well above 30% of GDP, while that in Africa and Latin America have been only around 20% and insufficient capital spending has limited growth.

How financial liberalisation affects aggregate savings, it notes is ambiguous. But, "in Asia, a mostly gradual process of liberalisation has been associated with higher savings."

Elsewhere, savings rates have fallen. An appreciable decline in savings rates was one of the transitional difficulties of the Latin American stabilisation and liberalisation programmes of the early 1990s... The implementation of the Real Plan in Brazil was likewise accompanied by a weakening of savings. Savings rates also fell in many countries outside Latin America. South Africa's savings rate has fallen below the level needed to generate higher employment. In eastern Europe, not only did savings rate drop sharply on liberalisation (a normal reaction to end of forced saving), but they have remained low as the transition has progressed.