Professor of Finance and Executive Director, The Asia Pacific Institute of Business, The Chinese University of Hong Kong

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Financial systems experience bubbles when an economic shift which raises asset returns leads to self-fulfilling expectations of a rise in asset values, funded by incautious lenders. This eventually ends in a panic-stricken collapse of asset values. In its wake, a chastened country will set up regulatory safeguards against a repeat performance. Innovations in finance which bypass existing safeguards can lead to new financial bubbles which, in turn, require further developments in financial regulation.

The economic shift which precipitated the financial bubble of the 1920's was the advent of the technology of mass production. In the wake of the Great Crash of 1929 and the resulting Depression, the US congress passed a series of regulatory safeguards, such as the Glass-Steagall Act which barred banks from direct participation in the stock market, and strengthened the powers of the Federal Reserve to act as lender of last resort. In so doing, the US sought to continue minimizing its direct intervention in financial markets.

The economic shift which precipitated the latest global financial bubble was the advent of a number of developing economies with the capacity to manufacture using low cost, but high quality labour. A financial bubble was facilitated by the globalization of private sector finance. The collapse of this bubble has led to calls for a "new international financial architecture." The design awaits a better understanding of the problems, but it is already clear that implementation will require not only international collaboration but also some surrender of national sovereignty. Consequently, the architects shall have to overcome international political obstacles not faced by earlier regulatory reformers, who could work within the political system of one country which had just been chastened by national fiasco.

Until this new international architecture is in place no-one has any basis for arguing against direct intervention in financial markets, such as have taken place recently in Hong Kong and Malaysia. Moreover, any new architecture would be designed to limit systemic collapse of the global financial system. Even when it is in place, there could still be a case for a government to intervene to shift its economy from a low level equilibrium to a higher one.

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Toward a New International Financial Architecture

The regulator of a country's banks has the basic duty to guard against systemic collapse through a general loss of confidence in the banks' ability to meet their obligations. The first line of defense is the self-interest of the banks, which should guard against non-performing loans by demanding information from borrows about their balance sheets and cash flows.

The second line of defense is prudential regulation of banks to ensure that each has adequate capital to cover possible defaults in loans. This prudential regulation is enforced by the national regulator's statutory access to the balance sheets and income statements of all that nation's banks, including information about loan performance. The regulator can close banks whose capital has been eroded by non-performing loans, or force a merger with a sound institution. These steps are important in stopping the rot, since banks which are effectively insolvent have an incentive to make increasingly risky loans, knowing that the downside risk will eventually be borne by the general public to prevent systemic collapse.

As the last line of defense against systemic collapse, the central bank stands as lender of last resort to assure the public that sound banks can access enough funds to cover short-term withdrawals. This prevents contagion spreading to sound banks, as depositors withdraw in a self-fulfilling panic.

While these national defenses against systemic collapse of a nation's banks have developed to an advanced stage in developed economies, the globalization of capital markets has revealed regulatory gaps which have permitted the current crisis. The new international financial architecture required to plug these gaps is easy to design, but difficult to implement because:

1. Firms which borrow internationally have novel ways to dress up their balance sheets by shifting assets and liabilities amongst subsidiaries in different countries.
2. Banks have been slow to learn how to interpret the balance sheets of such firms.
3. International lending creates situations where the national regulatory authority with the responsibility for a bank lacks the requisite authority and vice versa.
4. Weakness in one country's institutions, such as its accounting standards and captial adequacy enforcement can undermine the efforts of regulators in other countries.

To see the problems in detail, consider firm 1 based in country A which borrows from banks in countries A, B and C.

1. By making simultaneous loan applications to the banks in A, B and C, firm 1 can raise a number of loans implicitly secured against the same assets without actually perjuring itself in any loan application. These loans can be hidden in the balance sheet reported in country A by looking them through subsidiaries in countries B and C. If firm 1 guarantees the loans, then these guarantees should be recorded as contingent liabilities in its balance sheet. However, if accounting standards in country A are poorly enunciated and enforced, then banks and regulators in countries B and C will learn about the difficulties of firm 1 only when it is too late.
2. The situation becomes even murkier if firm 1 borrows directly from a bank in country A, but that bank in turn borrows from a bank in country B. if the bank in country A are not closely regulated and have obscure accounting, then the country B bank will find it difficult to determine the quality of its loans.
3. The duty of country B's bank regulator is to guard against systemic collapse of banks incorporated in country B. However, it has no authority to penalize firms and banks incorporated in country A for lapses in accounts presented in country A. On the other hand, the authorities in country A may have access to information about its firms and banks, as well as authority to act against them, but it may attach low priority to ensuring full disclosure to banks incorporated in country B: the financial health of country B's banks are not their responsibility.
4. To address these problems requires international enforcement of accounting standards and of rules on capital adequacy, plus international pooling of information about the income statements and balance sheets of firms and banks. These requirements for a new international financial architecture will not be met any time soon, because they infringe upon national sovereignty.

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Financial Contagion

The lender of last resort for countries facing a balance of payments crisis is the IMF. This was set up at the end of the Second World War at the Bretton Woods conference to help countries address short-term macroeconomic inbalances. The IMF's funds are provided by national donations, hence are subject to national politics and international political jockeying. The IMF has run out of resources to meet the current crisis which, in East Asia, arises not from macroeconomic inbalances, but from the expansion of private capital flows. This makes the international financial system vulnerable to novel forms of systemic collapse, such as the refusal of all banks to roll over short-term US dollar loans to one country in a self-fulfilling panic, which drives the country's exchange rate down far below the levels indicated by Purchasing Power Parity.

The term "contagion" has entered the lexicon of international finance to denote the spread of fears about one country's financial system and currency to other countries. In addition to this external contagion, we should recognize the internal contagion which operates via a country's exchange rate. Thus, fears about the creditworthiness of some of country A's loans denominated in, say, US$ can lead to an exit from currency A, lowering its US$ value, hence the US$ value of the collateral of other US$ loans. This can lead to a self-fulfilling cumulative downward rating of all of country A's loans.

Such internal contagion can occur even if all the loans were originally in good standing. If country A's private sector has incurred a large number of US$ loans, international lenders could become alarmed that these loans would become unpayable if country A's currency depreciated substantially. At this point, currency speculators with resources which are large relative to A's foreign reserves could short A's currency, thereby precipitating a panic collapse of its spot exchange rate as more and more lenders refuse to roll over their US$ loans. This can be true even if the borrowers would have had no difficulty servicing their loans at the original exchange rate.

In technical terms, when a country's private sector takes out a large number of loans denominated in, say, US$, there might be two possible equilibrium values of its exchange rate. In one equilibrium, the local currency has a high value in terms of the US$, the US$ loans can be serviced and local interest rates are the same as those in the US because lenders require no risk premium. In the second equilibrium, the currency A has a low value in terms of the US$, all the firms in country A which have taken on US dollar loans are at or close to insolvency, so they can roll over their loans only by paying a high risk premium. This risk premium is required to compensate lenders not only for the current low value of assets-to-liabilities but also for their perceived exposure to further currency risk. Despite its low exchange rate, the country cannot export its way out of its problems in the short term because internal financial chaos makes trade credit unavailable or available only at a prohibitive cost.

The currency speculators may claim that they have made their money only by recognizing just ahead of everyone else that currency A is overvalued. In fact, their actions have shifted country A from the high to the low equilibrium. They have made their money via short sales which capture some of the reduction in country A's income which their short sales have brought about.

In these circumstances, it could be the duty of country A's government to intervene in financial markets to shift the country back to the higher equilibrium. Thus, there is no theoretical basis for asserting that such intervention is harmful, even when all the institutional requirements for a laissez-faire stance in international finance have been met. Since the architecture of international finance is still far from meeting that standard, policy interventions such as those by Malaysia and Hong Kong in recent weeks should be evaluated on a case-by-case rather than by pretending that they violate some universally valid economic principles.