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How to Escap financial contagion

G. Srinivasan

FOLLOWING THE Asian flu in mid-1997, the global stock market crash, and the Russian crisis in August 1998, stentorian calls were given to evolve a global financial architecture that would warn unsuspecting nations about the transmission and contagion eff ect of financial crisis to enable them to be better prepared. But even four years after the Asian flu, little has been done to develop an effective vaccine against a fresh outbreak.

However, one of the United Nations oldest outfits, the Economic and Social Commission for Asia and the Pacific (Escap) -- which has done much in the area of economic and financial monitoring and surveillance, in its 2000 Economic and Social Survey of Asia and the Pacific -- said the Asian crisis amply corroborated the crucial need for regional initiatives which could go a long way in supplementing the global monitoring and surveillance mechanism.

The Asian crisis triggered worldwide interest in reforming the financial system to ensure that the potential benefits of the globalisation of markets are realised and that the risks inherent in the process are mitigated. The changing milieu, including te chnological advances in communications that speed financial market integration, and the massive and volatile fund flows render risky the managing of national and international financial systems.

At its 55th session, in April 1999, Escap adopted a resolution on economic and financial monitoring and surveillance in the region and asked its Secretariat to the study the possibilities of evolving mechanisms for exchange of information and warning sys tems on the financial and economic situation in the countries of the region, with a focus on crisis prevention and reduction of the vulnerability of countries to economic and financial turmoil.

Escap concedes that designing an effective surveillance or monitoring mechanism is complicated as history is replete with failed attempts at the global level. In many regions, especially such as ASEAN or SAARC where trade issues have tended to dominate t he agenda, cooperation on financial matters is quite novel.

Escap rightly states that the growing interdependence among the countries has stepped up the need to engage in international economic cooperation. The more extensive the trading and investment links between countries, the deeper the spillovers. Spillover s, or externalities, could be either positive or negative.

For instance, a high economic growth rate in a country implies a healthy demand for imports from trading partners, whereas a recession in one country can have a negative effect on the performance of the export sector of its trading partners. The rational e of economic cooperation is, thus, to exploit the positive externalities and minimise the negative ones.

Again, the public goods facet of overall economic stability at the global level provides another aim for international cooperation. Public goods might be purveyed by a government agency at the domestic level, such as a central bank that oversees the fina ncial and economic stability of a country, but there is no comparable institution at the international level.

Without modalities for coordination, countries may be tempted to seek the benefits of stability without assuming their share of the burden (free rider problem). The public good of stability may, thus, be undersupplied and that is why international cooper ation aims to instill in countries an understanding of their onus in contributing to a stable economic and financial milieu.

Yet another reason for global co-operation stems from the growth of open capital accounts and highly integrated capital markets of various sorts. Financial markets are inherently prone to instability, owing to the fractional reserve system on which they are based. Weak financial systems at the national level can have long-lasting and insidious macroeconomic implications. Monetary stability and financial stability are two sides of the same coin. With integrated markets, financial instability is unlikely to remain contained within national borders.

The Escap report aptly states that all financial disruptions are likely to have a global dimension because the three planks of a domestic financial system -- financial institutions, financial markets, and payment and settlement systems -- are increasingly global.

The financial crises seem to come in waves; they tend to be regional in scope and though they may have more severe effects within the region of origin, no region is spared. Truly, the grim prospect of financial contagion argues for greater consultation a nd cooperation.

Escap pinpoints three important features of today's capital markets that raise different perspectives on risk. First, a multiplicity of channels characterises the transmission of financial strains from one system to another.

Though trade and investment links were deemed to be the main transmission tool of disturbances across boundaries traditionally, it is now clear that the transmission mechanism is wider and can include a sell-off spurred by a reassessment by the creditors of a country that gets exposed to a previously ignored weakness in another country. A raft of competitive devaluations in response to a similar action initiated by a country that faces an imminent currency crisis constitutes another channel for the tran smission of contagion in a region.

Second, today, the capital market is marked by the extremely high speed of transmission of information and transactions. The third feature is the asymmetries of size, particularly between the financial resources available to the private capital market pa rticipants and the liquid assets of the official financial sector, and between the size of private capital flows and that of the domestic financial system of an emerging market.

In short, the pace of change in modern financial markets is extraordinary, ongoing and irreversible, and financial transactions are becoming complicated and opaque, entailing an ever-widening and altering cast of actors. New participants, such as pension funds, mutual funds and hedge funds, are not likely to behave in the same way as traditional banks, implying new uncertainties about how the global financial system would react during periods of stress.

Multilateral agencies such as the International Monetary Fund (IMF), the Bank for International Settlements (BIS), the Institute of International Finance, and credit rating agencies such as Moody's and Standard and Poor's do perform the surveillance role of global financial systems effectively; some headway has been made on at least two aspects of the new global financial architecture: Enhancing transparency, and fostering and implementing standards and codes for various supervisory functions. But genui ne doubts exists about any effective implementation in these seemingly agreed areas partly because global bodies such as IMF or BIS do not always have adequate leverage on national policy-making processes.

It is against this setting that the recent Asian crisis provided some useful pointers on why regional initiatives can heighten the effectiveness of surveillance and monitoring to signal an impending crisis or to spur preemptive responses. The role sugges ted for Escap in supporting national, sub-regional and regional initiatives and complementing the global one has three main features.

First, Escap can convene and backstop exchanges of experience among groups of countries in concert with other multilateral agencies on various topics of interest to the group. Second, it can organise training courses in collaboration with multilateral in stitutions. And, third, Escap can provide an independent regional perspective on Asia and the Pacific for use by countries or global bodies and analyse emerging issues and problems of particular interest to member-countries.

This way the members of ESCAP can guard themselves against any potential risk of financial contagion even as they get increasingly sucked into the vortex of globalisation and growing deregulation of financial markets.