Financial Stability in the World of Global Finance

• Author: Haizhou Huang and S. Kal Wajid
• Position: Deputy Division Chief, and Haizhou Huang an Economist, in the IMF's Monetary and Exchange Affairs Department

To reduce their vulnerability to national and international financial crises, countries must address the weaknesses in their financial systems.

Since the mid-1990s, financial crises have erupted in half a dozen developing and emerging market countries in Asia and Latin America as well as in Russia. The costs for the countries affected have been heavy, with the crises leading to bank failures, corporate bankruptcies, job losses, increased fiscal burdens, depletion of foreign exchange reserves, depressed economic activity, and even, in a few cases, political and social turbulence.

Initial research on the causes of the crises highlighted weaknesses in the afflicted countries' economic fundamentals, excessive short-term foreign borrowing by governments and private sector entities, and volatile short-term capital flows. Recent studies, however, increasingly point to the important role of weaknesses in national financial systems in triggering or exacerbating crises. For this reason, the international community has been stepping up its assistance in strengthening banks and other financial institutions. After all, the whole-the international financial system-cannot be healthy if its parts are not.

Why are countries vulnerable?

With the globalization of finance, firms and sovereign borrowers in countries around the world have increasingly obtained financing in the international financial markets. Between 1970 and 2000, cross-border capital flows increased from less than 3 percent of GDP to 17 percent for advanced economies and from virtually nothing to about 5 percent of GDP for developing economies.

The fundamental benefits of financial globalization are well known-by channeling funds to their most productive uses, it can help developed and developing countries alike achieve higher standards of living. But sudden reversals of capital flows-which may occur because investors have doubts about the viability of domestic policies or financial institutions, are retrenching in response to crises in another part of the world, or are shunning countries with similarities to a country in crisis-can threaten national and international financial stability. Banks with substantial net foreign exchange liabilities or outstanding foreign-currency loans to domestic companies with revenues in local currency may be hit especially hard if the currency depreciates, as the Thai baht did in 1997, or if interbank credit lines are withdrawn.

Recent research suggests that the chances of a country experiencing a financial crisis may have increased with globalization, possibly because technological advances enable funds to move into and out of countries more rapidly. A study carried out by Barry Eichengreen and Michael Bordo in 2001 reveals that the probability of a randomly selected country experiencing a crisis has doubled since 1973. In addition, currency crises became much more frequent in the final quarter of the twentieth century, both alone and in conjunction with banking crises. Also, financial instability in a single country can threaten the stability of the entire international financial system, as was the case in 1998 when Russia defaulted on its debt and devalued the ruble. Investors around the world incurred large losses and stock markets tumbled in both emerging markets and industrial countries.

To achieve financial stability, countries need financial systems that are deep, broad, and resilient; they must address the weaknesses that make their systems vulnerable to shocks. To help countries strengthen their financial sectors and to preserve the stability of the international financial system, the IMF-as part of an international effort-has intensified its work on financial sector issues.

The IMF's role

The IMF has adopted a three-pronged approach: (1) helping member countries carry out comprehensive assessments of financial sector vulnerabilities and developmental needs; (2) strengthening the monitoring and analysis of financial sectors, developing guidelines, and promoting transparency and integrity; and (3) helping countries build strong institutions.

Assessment of financial...