Richard Melson

July 2006

BIS: Financial Globalization

http://www.bis.org

Conference proceedings

Past events:

19-20 Jun 2006 Financial Globalisation

Fifth BIS Annual Conference. (Brunnen, Switzerland)

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14-15 Mar 2006 Central banks and the challenge of development

A special meeting of governors at the BIS. (Basel, Switzerland)

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18-19 Nov 2005 Concentration Risk in Credit Portfolios

A Workshop on Applied Banking Research. (Frankfurt/Eltville, Germany)

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11-12 Nov 2005 Accounting, risk management and prudential regulation

Workshop organised by the BIS. (Basel, Switzerland)

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8-9 Nov 2005 Fourth Joint Central Bank Research Conference on Risk Measurement and Systemic Risk

Announcement and call for papers. (Frankfurt, Germany)

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27-29 Jun 2005 Past and Future of Central Bank Cooperation

Fourth BIS Annual Conference celebrating 75 years of the Bank for International Settlements, 1930 - 2005. (Basel, Switzerland)

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9-10 Sep 2004 The pricing of credit risk

Workshop organised by the BIS. (Basel, Switzerland)

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18-19 Jun 2004 Understanding Low Inflation and Deflation

Conference organised by the BIS. (Brunnen, Switzerland)

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17-18 May 2004 Accounting, Transparency and Bank Stability

Workshop jointly organised by the Basel Committee on Banking Supervision, the Centre for Economic Policy Research, and the Journal of Financial Intermediation. (Basel, Switzerland)

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30 Oct - 1 Nov 2003 Market Discipline: The Evidence across Countries and Industries

Conference cosponsored by the BIS and the Federal Reserve Bank of Chicago.

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28-29 Mar 2003 Monetary stability, financial stability and the business cycle

Conference organised by the BIS.

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13-14 Jun 2002 Risk and stability in the financial system: what role for regulators, management and market discipline?

Conference jointly organised by Bocconi University and the Bank for International Settlements on the occasion of the Bocconi University Centennial, Bocconi University. (Milan, Italy)

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17-18 May 2002 Basel II: An Economic Assessment

Workshop jointly organised by the Basel Committee on Banking Supervision, the Centre for Economic Policy Research, and the Journal of Financial Intermediation. (Basel, Switzerland)

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7-8 Mar 2002 Third Joint Central Bank Research Conference on Risk Measurement and Systemic Risk

The third conference in a series of Joint Central Bank Research Conferences on Risk Measurement and Systemic Risk. (Basel, Switzerland)

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6 Mar 2002 Changes in risk through time: measurement and policy options

Conference organised by the BIS. (Basel, Switzerland)

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14 Jun 1999 Estimating and interpreting probability density functions

Proceedings of the workshop held at the BIS.

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18-19 Feb 1999 Measures of underlying inflation and their role in the conduct of monetary policy

Proceedings of the workshop of central bank model builders held at the BIS.

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Publications & research

Conference proceedings

Fifth BIS Annual Conference:

Financial Globalisation

Brunnen, 19-20 June 2006

Programme

Monday, 19 June 2006

09.00 Opening remarks: William White (BIS)

09.15 Morning Chair: Kazumasa Iwata (Bank of Japan)

Session 1: Democracy and globalisation (PDF, 46 pages, 189 kb)

Authors: Barry Eichengreen (University of California, Berkeley)

David Leblang (University of Colorado, Boulder)

Presentation (PDF, 24 pages, 70 kb)

Discussants: Marc Flandreau (Institut d'Etudes Politiques de Paris)

Harold James (Princeton University)

11.15 Session 2: Globalisation and asset prices (PDF, 57 pages, 485 kb) Authors: Geert Bekaert (Columbia University)

Presentation (PDF, 37 pages, 365 kb)

Discussants: Alan Bollard (Reserve Bank of New Zealand)

Presentation (PDF, 18 pages, 119 kb)

Sushil Wadhwani (Wadhwani Asset Management)

14.15 Afternoon Chair: Lorenzo Bini Smaghi (ECB)

Session 3: Sudden stop and recovery: lessons and policies (PDF, 41 pages, 418 kb) Authors: Guillermo Calvo (Inter-American Development Bank)

Presentation (PDF, 37 pages, 414 kb)

Discussants: Randall Kroszner (Board of Governors of the Federal Reserve System)

Presentation (PDF, 21 pages, 355 kb)

Takatoshi Ito (University of Tokyo)

Presentation (PDF, 17 pages, 662 kb)

16.15 Session 4: Panel on "Review of recent trends and issues in financial sector globalisation"

Background reports:

Foreign direct investment in the financial sector of emerging market economies (CGFS Publications No 22)

Foreign direct investment in the financial sector - experiences in Asia, central and eastern Europe and Latin America (CGFS Publications No 25)

Lead-off presenter: Christine Cumming (Federal Reserve Bank of New York)

Presentation (PDF, 18 pages, 68 kb)

Other panellists: José Luis de Mora (Banco Santander Central Hispano)

Presentation (PDF, 27 pages, 2110 kb)

David Llewellyn (Loughborough University)

Presentation (PDF, 21 pages, 59 kb)

Guillermo Ortiz (Banco de México)

Presentation (PDF, 15 pages, 393 kb)

Tuesday, 20 June 2006

09.00 Morning Chair: Donald Kohn (Board of Governors of the Federal Reserve System)

Session 5: Financial globalisation, governance and the evolution of the home bias (PDF, 52 pages, 202 kb) Authors: René Stulz (Ohio State University), Bong-Chan Kho (Seoul National University), Francis E Warnock (University of Virginia)

Presentation (PDF, 22 pages, 131 kb)

Discussants: Philip Lane (Institute for International Integration Studies)

Presentation (PDF, 11 pages, 52 kb)

José Vińals (Banco de Espańa)

Presentation (PDF, 14 pages, 75 kb)

11.00 Session 6: Global "imbalances" (PDF, 58 pages, 962 kb) Authors: Ricardo Caballero (Massachusetts Institute of Technology)

Presentation (PDF, 44 pages, 248 kb)

Emmanuel Farhi (Massachusetts Institute of Technology)

Pierre-Olivier Gourinchas (University of California, Berkeley)

Discussants: Jeffrey Frankel (Harvard University)

Presentation (PDF, 57 pages, 315 kb)

Michael Mussa (Institute for International Economics)

14.00 Afternoon Chair: Malcolm Knight (BIS)

Session 7: Policy panel Panellists: Vittorio Corbo (Banco Central de Chile)

Presentation (PDF, 12 pages, 103 kb)

Raghuram Rajan (IMF)

Usha Thorat (Reserve Bank of India)

Zdenik Tuma (Czech National Bank)

15.30 Close of conference

BIS home Press & speeches BIS management speeches

Financial Globalisation


Opening remarks by Mr William R White, Economic Adviser and Head of Monetary and Economic Department of the Bank for International Settlements, at the BIS Fifth Annual Research Conference on "Financial Globalisation", Brunnen, 19 June 2006.


Abstract

Global financial integration has a number of implications and can pose complications for policymakers. As to implications, consider the rising correlation among global asset prices, the greater ease with which current account deficits can now be financed and the wealth effects on creditors holding huge amounts of US dollar denominated assets should the dollar fall. As to complications for policy makers, both monetary tightening and easing is different when the effects of exchange rate changes do much of the work. As well, supervisors face formidable home-host issues as do providers of Emerging Lending Assistance. Finally, the absence of burden sharing agreements in a globalised world could impede the process of crisis management.

Full speech

May I begin by welcoming you all to Brunnen. As happened two years ago, the fact that the Basel Art Fair coincided with our planned conference meant that there was effectively no hotel accommodation to be found in the city. Accordingly, we all find ourselves in this beautiful place, albeit somewhat harder to reach than Basel. May I also say, representing the central bankers assembled here, that I am particularly pleased to welcome our many friends from universities and think tanks around the world. As on previous occasions, we central bankers will gain a great deal from your analysis of the problems that we face. And, by the same token, I hope that that you will have a clearer idea after this conference what central bankers think the problems are. And putting the two together, I also hope that you might be inspired to think about these problems still further after the conference ends.

Policymaking has always been a difficult business, but recent structural changes in the global economy have made things more difficult still. In light of these changes, the pessimists would contend that the fundamental analytical framework we use needs to be seriously reconsidered; in particular, I believe the post War Keynesian consensus needs to be confronted with pre-War business cycle theory. Others are more optimistic about the continuing relevance of their model, but even they are still troubled by significant parameter shifts and large forecasting errors. Everywhere, one senses a growing modesty in our assessment of what we really know. The underlying issue is what Hayek in his 1974 Nobel Lecture called "The pretence of knowledge", and what Larry Summers has referred to more recently as "The scientific illusion in empirical macroeconomics".

The structural changes I refer to are three in nature; one real, one monetary and one financial, the last being the topic of this conference. The first change has profoundly affected the real global economy. Liberalisation of product and factor markets, allied with technological developments, has increased output in many countries and particularly so in the previously centrally planned economies. I believe that these developments have aided central bankers everywhere in their attempts to reduce inflation and to keep it low. The second major change has in fact been the growing, global commitment to this objective after the Great Inflation of the 1970s. The third major structural change, again reflecting both deregulation and technology, has been the growing completeness and integration of world financial markets. While the efficiency gains associated with such developments are not in question, it could also be contended that they pose a particular challenge to central bankers, and not only during the transition period to a more liberalised regime.

I will not spend much time "proving" that financial markets today have become highly globalised in character, and thus more complete. While the size of international capital flows (relative to output) was likely higher prior to World War 1, the short term nature of many of today's flows, the high turnover in financial markets, the multiplicity of agents, the number and complexity of instruments, and the speed with which market participants can react to new information is surely unprecedented. Moreover, the global reach of financial institutions, particularly banks, also needs to be noted. In large parts of Latin America, Central and Eastern Europe and Africa, foreign banks constitute the largest part of the banking system. Moreover, they are both borrowing and lending in local currency and are being increasingly integrated into the local economy.

These cross border developments have had a number of implications. Let me briefly consider a few of these, before turning to how they can significantly complicate the lives of policy makers.

Perhaps the first implication to note has been the growing integration of financial markets, including those in emerging market countries, with subsequent impacts on the covariance (perhaps even "excessive covariance") of asset prices. Over the last year or two, equity prices in virtually every emerging market economy (EME) have risen strongly while sovereign spreads dipped to record lows. Even more astonishing, the sharp increase in house prices in most industrial countries has also been reflected by similar sharp increases in many EMEs. While arguments can be put forward to explain these developments in terms of "pull" factors (better policies) in EMEs, there seems a reasonable chance that "push" factors are also in play. The sharp increase in competition in the financial services industry in the industrial world, together with high hurdle rates and very low policy rates, have fostered a search for yield that has affected markets everywhere.

A second implication is that current account deficits have become easier to finance than before. We saw this in Mexico in the early 1990s, East Asia a few years later, and in central and Eastern Europe more recently. The ease with which the United States has managed to attract funds to support its current account deficit, and large capital investments abroad, is also remarkable. This said, the growing proportion of inflows in the form of shorter term and inherently safer instruments (Treasuries and agencies) and the growing role of official purchases (especially by Asian central banks) may both indicate a private sector appetite for dollar denominated assets that is finally beginning to wane.

A final implication has to do with currency mismatch effects. We are all aware of the devastating effects that currency mismatches had in the Mexican crisis of 1994, the Asian crisis of 1997, and the Argentine crisis of 2001. In those cases, borrowers had borrowed in foreign currency and devaluation punished the debtors. Today, we have a similar phenomenon in that the US has borrowed heavily abroad, but almost entirely using dollar denominated liabilities. This implies that, just at the time creditor countries could be facing the challenge of appreciating currencies and more competitive trade markets, they would also be facing the "headwinds" of sharp wealth losses on dollar denominated assets. This will hinder, not help, the process of global current account adjustment.

In what way does the international dimension complicate the lives of central bankers. Consider first, the conduct of monetary policy in tightening mode, with price stability as the ultimate objective of policy. As interest rates begin to rise, the currency will tend to strengthen. This will have a downward influence on inflation, implying that interest rates have to rise less than otherwise. This can have two dangerous effects. First, if the combined effect on the price of tradables is greater than on non tradables, the trade account may deteriorate. Second, with domestic interest rates relatively low, asset prices could rise and even take on "bubble" like dimensions. With spending further supported by this phenomenon, there would likely be further deleterious affects on the trade account. In the end, the markets could lose patience and a crisis might follow.

This sounds very much like the dynamics of the Mexican and South East Asian crises, and the more recent experiences of Iceland, Hungary, New Zealand and a number of others. Indeed, the external and internal imbalances faced by the New Zealand authorities, the pioneers of inflation targeting, have recently led them to undertake a complete review of their current monetary framework. And while it would be tempting to say that the international complication is really only material for small open economies, what has been going on in the English speaking countries, in particular the United States, also seems qualitatively similar. The rate at which the US is becoming externally indebted is, in itself, a cause for concern. Moreover, such concerns must be heightened by the recognition that the money lent by foreigners has been spent on bigger houses and higher oil prices, rather than investment in the tradable goods sector. The US deficit also has the potential to unleash a bout of global protectionism, which is not the case when small economies run into similar problems.

Easing monetary policy in a financially integrated world also has complications. One possibility is that the exchange rate will again do the lion's share of the work. The danger here is that an orderly decline will turn into a disorderly one, necessitating a sharp increase in policy rates to stabilise the situation. We saw this on a number of occasions in Canada in the 1980s, and we have had a more recent example in Turkey. The end result of such policies could be, tightening, rather than the intended easing. It is not a pleasant experience to find yourself going in the opposite direction from that originally intended.

In contrast, the exchange rate might not move enough to stimulate the economy, via the trade side, perhaps because the counties that would have an appreciating exchange rate in consequence, refuse to allow it to happen. This was the situation which presented itself to the United States between 2001 and 2004, as China and (to a lesser degree) other Asian countries refused to allow their currencies to appreciate. The upshot of this situation was that the US had to rely disproportionately on lower policy rates to do the stimulative work, while China and other countries turned to easier (or at least not tighter) monetary policy to resist currency appreciation. The result was a world awash in liquidity, saved from inflation only by the massive increase in global supply potential arising from the re-entry into the global economy of countries like India and China.

But the globalisation of the financial system poses other policy complications as well. For those of us who work at the BIS, questions having to do with financial stability are only slightly less important than those having to do with monetary or price stability. Banking supervision in a globalised world poses huge challenges for the relationship between home and host supervisors as they collectively seek to prevent crises from happening. The oversight of international payment and settlement systems is another important cross-border issue. And in a financial crisis where Emergency Liquidity Assistance is required, who is to give it? Home? Host? And in what currency, given the multilateral commitments of the financial firm likely to be in trouble? There are a lot of issues to think about here, particularly since the absence of clarity about the limited role of the public sector positively encourages moral hazard. It is already possible that many firms already consider themselves either too big or too complex to fail.

Should the global financial system be subject to a sharp shock somewhere, the issue of how large, complex financial institutions might be wound down remains unresolved. There are continuing concerns about the limitations of information sharing among the various countries affected. Moreover, the question of who might bear the costs still remains undecided. At the worst, this leaves open the possibility of the failure of a global bank that is "too big to save" for a relatively small home country. At the best, this opens the possibility of "gaming" in the midst of a global problem as officials try to act in their own national interest. And, in addition, there is the problem of relatively small countries whose banking and financial systems are dominated by financial firms from other countries. How are they to continue operating efficiently when such dominant firms fail?

To finish my comments, this is all by way of a typically, rather dark, BIS welcome to those who have joined us here in Brunnen. The globalisation of financial markets provides both enormous opportunities and enormous challenges. I hope that in the course of the next day and a half, we will show some evidence of having responded to the challenges in particular. In anticipation of this outcome, let me thank all of you who have come long distances to be here, especially our academic friends. And finally let me thank my economist colleagues at the BIS, Claudio Borio, Gabriele Galati and Andy Filardo, and also Janet Plancherel for all the logistics. Everyone has put in great efforts to make this event happen. My thanks to all.

Krzysztof Rybiński: Globalization versus financial markets

Address by Mr Krzysztof Rybiński, Deputy President of the National Bank of Poland, at the "Index"

Students’ Association for Capital Markets and the Department of Capital Markets series of seminars,

Cracow University of Economics, Cracow, 20 April 2006.

* * *

Ladies and Gentlemen,

Whilst preparing for today’s address, I entered "globalne, Kraków" into the Google search engine. The

following websites, among others, have been found: the website of the Regional Examination Board

that provides information on lower secondary school graduation exams, the TVP3 regional service that

informs of an increase in the number of Ryanair flights from Cracow, Wrocław and Poznań, and the

website of the most beautiful cities of Europe, where Cracow is duly mentioned next to Florence and

London. The Google search has found 97,400 websites containing the sought phrase in 0.49 seconds.

A similar attempt for other cities has resulted in the following: Poznań 75,000, Gdańsk 68,900,

Białystok 20,500, Warszawa 163,000 and Wrocław 306,000. A search for "global London" results in

236 million websites, "global Berlin" – 67.6 million, "global Bangalore" – 12 million websites, and

"global Krakow / Kraków / Cracow" – 3.6 million websites.

Obviously, the results are incomparable – for numerous reasons. The English language is much more

popular than Polish – it is the online lingua franca and at the same time spoken in India and the UK.

Moreover, whilst searching for "globalne, Kraków" one would have to enter the words in various

declinations. Nonetheless, this exercise shows that Cracow and the entire Poland have fast become a

part of the global economy. Dissemination of information and telecommunication technologies is

bound to drive the acceleration of the globalization process, which will in turn enhance labour

productivity. At the same time, a search for "derivatives" gives 55 million websites, "global markets" –

287 million, "currencies" – 97 million and "stocks" – 244 million. This shows that financial markets are

global. Let us consider the reasons behind and the effects of globalization of financial markets.

Globalization on financial markets

Globalization of financial markets is part of a wider phenomenon of globalization of national

economies. The rapid growth of the international trade in goods and services, which has been in

progress since the beginning of the 1960s, has entailed an increase in capital flows. Between 1970

and 2000 the value of world exports of goods and services increased twenty-five fold, accompanied by

a fifty-fold increase in Foreign Direct Investment (FDI) (Chart 1 and Chart 2). Many countries, having

realized that the FDI is an important factor that accelerates the economic growth, have introduced

changes to their legal regulations, aimed to attract foreign capital (Table 1). The globalization process

on the financial markets started following the decline of the Bretton Woods system. Globalization of

the financial markets exhibited a pronounced acceleration in the 1980s and 1990s. Since 1973,

international trade has been growing on average by 11% per annum (from 22% of the GDP in 1973 to

over 40% of the GDP in 2002), whereas the capital flows1 increased from 7% of the global GDP in

1973 up to over 20% of the GDP in 2002.

1 Capital flows are defined here as a total of the FDI, portfolio investments and other investments recognized in the financial

account of the balance of payments statement, exclusive of changes in receivables and liabilities of monetary authorities

and the central government.

BIS Review 60/2006 1

Chart 1: World exports of goods and services, 1960-2002

USD billion

6 414.1 6 426.9

3 500.3

130.1 316.4

2 031.2

1 610.6 1 511.9

824.7

385.4

0 0 0

1 000

2 000

3 000

4 000

5 000

6 000

7 000

1960 1970 1980 1990 2000 2002

Exports of goods Exports of services

Source: UNCTAD

Chart 2: Foreign Direct Investment

1393

647 651

824

209

55 13

243

711

1 201

54 14

0

200

400

600

800

1 000

1 200

1 400

1 600

1970 1980 1990 2000 2001 2002

USD billion

Inflows Outflows

Source: UNCTAD

2 BIS Review 60/2006

Table 1: Changes in national legal regulations regarding FDI, 1992-2002

1992 1995 1999 2002

Number of countries which introduced legal

changes regarding investments

43 64 63 70

Number of legal changes, of which: 79 112 140 248

- changes favouring FDI 79 106 131 235

- changes more restrictive for FDI 0 6 9 12

Source: UNCTAD

Along with an increase in the value of international trade, enterprises have become active participants

of the FX market. Between 1989 and 2004 the turnover in the global spot FX market increased by

nearly 100% (Chart 3).

Chart 3: Average daily net turnover in the global spot FX market

USD billion

317

394

494

568

387

621

0

100

200

300

400

500

600

700

1989 1992 1995 1998 2001 2004

Source: BIS

An increase in international capital flows and the development of information and communication

technologies have triggered portfolio investments on international markets. On the other hand,

enterprises and banks have increasingly frequently raised capital abroad. For instance, between 1989

and 2000, the value of cross-border investments in shares increased over twelve-fold, whereas

between 1994 and 2005, the value of debt securities issued on foreign markets increased six-fold

(Chart 4 and Chart 5). Non-bank financing of enterprises has also gained in significance. In 1980,

enterprises raised USD 4.5 trillion on the capital market, whereas in 2004, the figure stood at over

USD 60 trillion (Chart 6).

BIS Review 60/2006 3

Chart 4 : Cross-border investments in shares, 1989-2002

USD trillion

1.0 2.1

4.8 5.5 7.1

10.9 9.4 7.5 3.0

5.7

8.0

9.7

15.0

11.9

11.2

0.6

1.4 1.5

0

5

10

15

20

25

30

1989 1992 1995 1997 1998 1999 2000 2001 2002

Purchase of domestic security by a foreign investor (CAGR - 16%)

Purchase of foreign security on investors' local exchange (CAGR - 22%)

2.1

21.3

25.9

16.8

13.5

10.5

5.1

2.4

18.7

CAGR Ż Compounded Average Growth Rate.

Source: McKinsey Global Institute.

Chart 5: Debt instruments outstanding in the international financial market

USD billion

0

2 000

4 000

6 000

8 000

10 000

12 000

14 000

16 000

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Bonds issued in the international market

Debt instruments issued in the international market

Source: BIS

4 BIS Review 60/2006

Chart 6: Volume and structure of global financial assets (USD trillion)

USD billion

14.3 20.0 36.5 31.9 32.1

56.4 11.7 15.9

20.2 30.7 29.8

60.6

10.6

13.1

14.4 20.1 21.4

33.4

16.4

20.0

25.0

35.4 35.7

2.8 1.7 2.2

58.5

5.4

0

50

100

150

200

250

1980 1993 1996 1999 2003 2004* 2010**

Bank deposits (CAGR* - 7,8%)

Government debt securities (CAGR - 6,9%)

Private debt securities (CAGR - 10,2%)

Equity securities (CAGR - 8,6%)

12

118

96

69

53

209

119

CAGR – Compounded Average Growth Rate.

* - preliminary data.

** Ż forecast by McKinsey Global Institute.

Source: McKinsey Global Institute.

As opposed to green-field investments, the portfolio capital is very mobile and, depending on the

situation (macroeconomic or political) it may move easily among local markets. This may lead to high

instability on the FX market causing significant exchange rates fluctuations. One of the methods of

hedging against the risk of currency appreciation or depreciation is taking positions in derivatives. A

dynamic growth of the derivatives market is the result of an increase in the cross-border flows in the

financial markets. Between 1995 and 2004, the turnover on the global derivatives market grew nearly

two-fold, whereas during the same period the activity on all exchange-traded derivatives grew almost

three-fold (Chart 7).

Chart 7: Average daily net turnover in global derivatives market, 1995-2004

USD billion

688

959 853

151 265 489

1025 1 221 1 382

2 180

4 657

1 292

0

500

1 000

1 500

2 000

2 500

3 000

3 500

4 000

4 500

5 000

1995 1998 2001 2004

OTC FX derivatives market OTC interest rate derivatives market

Exchange-traded derivatives

Source: BIS.

BIS Review 60/2006 5

Reasons for globalization of financial markets

The key factors that brought about the aforementioned changes in capital flows and in the structure of

the global financial market comprise the following:

liberalization of national financial markets and the related growing competition among

financial institutions,

technological progress in IT and telecommunications,

faster flow of information and its standardisation,

globalization of national economies in their various aspects (commerce, institutions,

ownership structure, capital and knowledge).

The liberalization of national financial markets has eliminated restrictions in the operations of both

domestic and foreign financial entities. Regulations regarding the range of services performed by the

banks and other financial institutions have been changed. Legal framework has been established to

facilitate the activities of non-banking financial institutions. Last but not least, restrictions on nonresidents’

access to domestic financial markets have been reduced or removed. However, the factor of

the greatest significance from the point of view of globalization of financial markets was the

liberalization of capital flows. First and foremost, it consisted in the removal of restrictions that

impaired free capital flow among countries, including in particular:2

removal of restrictions related to FDI and trade in goods and services with non-residents,

transition of the developed countries to the floating exchange rate regimes, establishing

of the euro area, and other supranational integration initiatives,

reduction of tax on cross-border transactions (Chart 8).

In some countries, liberalization of capital flows and financial markets ensued from the implementation

of stability programmes recommended by the World Bank and the International Monetary Fund. As a

consequence, a group of countries named emerging markets have appeared on the world economic

map. These countries play a vital role both in the global financial system and in the global economy.

Chart 8 Customs tariff rates in the developing countries, applicable to Most-Favoured-

Nations (MFN)

19.7

22.2

17.9

11.4

9.9

11

14.1

0

5

10

15

20

25

1980-1983 1984-1987 1988-1990 1991-1993 1994-1996 1997-1999 2000-2001

%

Source: UNCTAD.

2 Ariyoshi A. "Country Experiences with the Use and Liberalisation of Capital Controls", International Monetary Fund 1999, p.

7.

6 BIS Review 60/2006

The technological progress in IT and telecommunications, in particular the dynamic growth of the

Internet and database systems, has significantly impacted the globalization of financial markets.

Technological changes would not have been possible without a huge reduction in the cost of computer

memory and data transmission. At present, the cost of manufacturing of a microprocessor is nearly

1,000 times lower than it was 30 years ago, and the cost of data transmission (1 byte over a distance

of 1 km) is over a hundred-fold lower. Modern technologies have enhanced the capacity of creating

and marketing new, less expensive goods and services. The increased computing power has

facilitated valuation of complex financial instruments, such as options, swaps and convertible bonds,

which has contributed to a rapid development of derivatives market.

The development of IT and telecommunications has streamlined prompt acquisition and processing of

information necessary for operations on the financial market. Information used on the financial market

has become as much of a commodity as any other (e.g. washing powder). It is produced according to

specific standards and is comparable (the format of data on inflation, balance of payments or quarterly

performance of a listed company are presented in a similar manner, irrespective of the country that

publishes the data).

Today, we all take it for granted. Whereas only in 1997, when I became the chief economist

responsible for the analysis of the Polish economy with a large international financial institution,

releases of the macroeconomic data were not scheduled. Data on inflation or output simply appeared

in information services at certain times. The NBP used to send the data on the balance of payments

by fax to those analysts who requested for them. When, as the first financial markets economist in

Poland, I launched a weekly macroeconomic service for customers, an analysis, which was one or two

pages long, would be put on the pre-programmed fax machine, and it was not until the afternoon that

the transmission was accomplished. At present, nearly every bank in Poland has its chief economist

supported by a team of analysts who send hundreds or thousands of e-mails every morning, which

reach tens of thousands of investors worldwide (banks, investment funds, arbitrage funds, company

managements, wealthy private banking customers, decision-makers and central bankers). At present,

the management of a large fund may receive hundreds of e-mails daily that contain analyses of listed

companies, currencies, or macroeconomic and political developments. Nowadays, the problem does

no longer involve access to information, but pertains to the excessive amounts of information and

analyses that must be skilfully selected.

In response to these – and other – challenges3 international standards have been elaborated in the

recent years. Not only the quantity, but also the quality of information and the comparability of data

have been increasingly appreciated. In addition, unification of principles that govern the functioning of

individual financial market areas has been a precondition for the development of effective competition

in the international financial system. Uniform and commonly applicable standards lower the cost of

acquisition and analysis of information and reinforce the financial system stability. The most significant

standards include, inter alia, the following:

the principles of effective banking supervision, drawn up by the Basel Committee on Banking

Supervision (BCBS),

international accounting standards, over 100 countries have adopted or based their own

accounting standards on the International Accounting Standards (IAS) or the International

Financial Reporting Standards (IFRS),

master agreements on executing transactions on the interbank market Ż ISDA, ISMA,

statistical methodologies elaborated by, inter alia, the IMF, the BIS, and the WB that ensure

compliance of the data gathered with the statistical guidelines and their international

comparability,

the principles of best practice, elaborated by professional associations of financiers.

The development of the modern financial market infrastructure has also covered regulatory changes

(e.g. the bankruptcy law) and the establishment of modern transactional systems, payment systems,

settlement systems, risk management systems, and information services – such as Reuters or

Bloomberg. Stock exchanges and brokers have created modern trading platforms which enable

3 Hannoun H. "Internalisation of financial services: implications and challenges for central banks", speech at the 41st

Conference of the South East Asian Central Banks (SEACEN), Brunei Darussalam, 4 March, 2006.

BIS Review 60/2006 7

prompt offer-matching, executing transactions and straight through processing. Development of the

infrastructure has removed barriers to further market globalization. For instance, a factor that impeded

the FX market development in the 1990s was the settlement risk. In response to that, the banks that

were the most active on the FX market created CLS – a new settlement system that operates based

on the payment versus payment principle.4 The new, supranational system has significantly reduced

the credit risk and liquidity risk of FX operations, and thus increased banks’ activity on the FX market.

At present, 15 currencies are settled in the CLS Bank. The system has also lowered costs incurred by

the banks, as it helped decrease the number of payment instructions and the value of funds

transferred in local payment systems.5

In view of the fast progressing globalization of financial markets, it seems reasonable to raise

the question whether the world has benefited from the globalization of financial markets, or

whether it has become more risky.

The effects of globalization of financial markets are diverse. The openness of economies and free

capital flows induce investors to deposit their funds where they can generate the highest rate of return,

which prompts financial institutions to execute transactions on new, poorly developed and non-liquid

markets. It favours the increase in the liquidity of financial markets6 and the decrease in the cost of

transactions.

Globalization has a significant impact on the lower cost of capital acquisition by enterprises. They

increasingly often use forms of raising capital alternative to the bank loan, especially the issue of

securities on the financial markets. The reasons behind this phenomenon are the decreasing

expectations of investors as to the expected rate of return that compensates the assumed risk. At the

same time, better transparency of enterprises (monitoring of the senior management, supervision over

shareholders, and making them subject to the market discipline) entails a decrease in the agency

costs that result from the mismatch of investment objectives between the management and the

shareholders. As a consequence, enterprises can more easily raise funds for financing their

initiatives.7 Large companies are more inclined to promote regulations and laws that improve the

transparency of financial markets and reduce the asymmetry of information among market

participants. In addition, institutional reforms that improve the market transparency and the quality of

communicated information are implemented, under the influence of investors. The deregulation that is

taking place removes artificial market entry barriers and facilitates their smooth operation. Thus,

globalization stimulates the financial market development, which in turn gives enterprises easier

access to capital. Higher availability of funds may impact investments and in this way stimulate the

economic growth.8

Introduction of the euro has eliminated the FX risk and contributed to abolition of investment limits

related to the items of securities portfolio denominated in foreign currency. This has lowered the cost

of raising capital from 0.5 to 3 percentage points. At the same time, the convergence of those costs

took place among the EU-15 within the same economy sectors.9

The global financial market enables business entities, including banks, to raise funds for business

development from a larger number of investors than it would have been possible on domestic markets.

For instance, in many smaller EU countries, a significant number of bank transactions is carried out

with foreign partners.10

Access to the international capital market for banks and other financial institutions translates not only

to the possibility of development, but also to the pressure on improvement of efficiency. The growing

4 Galati G. "Settlement risk in foreign exchange markets and CLS Bank", w: "BIS Quarterly Review" December 2002, Bank for

International Settlements, pp. 55-65.

5 "CLS - purpose, concept and implications", in: "ECB Monthly Bulletin", January 2003, European Central Bank, pp. 53-65.

6 Rajan R. "Has financial development made the world riskier?", Working paper 11728, NBER 2005.

7 Stulz R. "Globalization of equity market and the cost of capital", Working paper 7021, NBER 1999.

8 Mishkin F. "Is financial globalization beneficial?", Working paper 11891, NBER 2005.

9 Hardouvelis G., Malliaropulos D., Priestley R., "The impact of globalization on the equity cost of capital", CEPR Discussion

paper 4346, 2004.

10 Schoenmaker D., Oosterioo S. "Cross-Border Issues in European Financial Supervision", in: Mayes D., Wood G. (editors)

"The Structure of Financial Regulation", London 2005.

8 BIS Review 60/2006

efficiency and better risk management improves the security of deposits placed with banks. Foreign

competition is also an important catalyst for dissemination of financial innovations.11 Moreover,

domestic banks that compete with foreign banks exhibit more interest in introducing new accounting

standards and financial reporting requirements, so that better quality of information on the companies

financed allows them to extend more profitable loans. Domestic financial institutions are becoming

more efficient, due the new technologies and best practice provided to the market by foreign

companies.

Integration of financial markets worldwide enables better risk diversification. Residents do not have to

invest their savings in their own country and thus they are not exposed to the business cycle risk. They

are free to invest in many countries and could obtain a better ratio of expected return to assumed risk.

Globalization of financial markets also entails new challenges and threats. The lack of transparency,

resulting from asymmetry, raises the risk of speculative bubbles and herd behaviour of investors.

Uneven access to information in the global markets environment may lead to a negative selection in

the financing of the enterprise sector and the moral hazard in a situation where the bankruptcy of a

given institution would jeopardize the banking sector.12

Economic reforms and opening the country to international trade in the emerging markets attract

foreign capital, which, however, in the case of deteriorating economic situation, is withdrawn quickly.

This invokes FX crises, which, as a result of an increase in interest rates, may turn into bank crises.13

Additionally, international links of institutions and the speed of transmission of information among

markets streamline the spreading of such crises over other economies. International financial crises

that started in Thailand in 1997, in Russia in 1998 and in Brazil in 1999 and subsequently spread over

to other countries in the region and even as far as to other continents, may serve as an example.

Frederic Mishkin gives other examples of threats posed by globalization.14 Financial liberalisation

reduces the number of instruments which discipline the banking activities. This has led to credit booms

in many countries, often financed by foreign entities and in foreign currencies. Credit booms have thus

become a frequent source of banking crises.15 Banking crises, on the other hand, have generated

significant costs for the economy, inter alia, through the necessity of liquidity injections to some banks

or through limiting the supply of loans to companies.

Increased share of foreign capital in local financial markets raises their sensitivity to the developments

on foreign markets. For instance, an increase in interest rates in another country may cause an

outflow of short-term capital, and in consequence lead to an increase in interests rates and a decrease

in liquidity on a local market. Banks operating on the global financial market are subject to higher

competition, also due to the fact that investors compare the banks’ performance results on an ongoing

basis. As noticed by Raghuram Rajan, banks nowadays focus more than ever on maintaining their

income on a high level, at the cost of assuming higher risk.16 Financial instruments traded by banks

are becoming increasingly complex and thus less liquid and carrying higher risk.

The effect of globalization is the establishment of international financial conglomerates. In the case of

an economic crisis, the conglomerates may channel it through to other markets. Such companies

could be very important for the stability of the financial system in a country or region. Their bankruptcy

may evoke a crisis, even in a steadily growing economy and even in the situation when the financial

problems have stemmed from a foreign market. The lack of standard procedure for solving problems

of international financial institutions impairs prevention and solving of financial crises. The existing

safety net established by national economic authorities is frequently a source of moral hazard for large

11 Issing O. "The globalization of financial market", 2000, www.ecb.int.

12 Lutkowski K., "Mechanizm przepływów kapitałowych w epoce globalizacji" in: "Globalizacja od A do Z", NBP 2004.

13 Małecki W., Sławiński A., Piasecki R., Żuławska U. "Kryzysy walutowe", PWN, Warsaw 2001.

14 Mishkin F.C. "Is Globalization Beneficial?", NBER Working Paper 11891, 2005.

15 Kamisky G. L, Reinhart C.M. "The Twin Crises: The Causes of Banking and Balance of Payments Problems", American

Economic Review 89, 1999, pp. 473–500. Caprio G., Klingebiel D. "Episodes of systemic and borderline financial crises",

the World Bank , mimeo, 2003.

16 Rajan R. G. "Has Financial Development Made the World Riskier?" NBER Working Paper 11728, 2005.

BIS Review 60/2006 9

financial institutions,17 which apply less restrictive policy of financing business entities, expecting that

when problems arise, the taxpayers of a given country will pay part of the bill.

Last but not least, an unfavourable effect of globalization is the centralisation of risk management and

sometimes even of liquidity management at the bank group level. The process results in transferring

operations from small, local markets to more developed ones. This phenomenon has been observed

e.g. in Poland. Owners of foreign banks operating in Poland more and more often decide to transfer

their activity on the zloty market and the FX options market to London (Chart 9). It reduces the liquidity

of the domestic market, and the zloty exchange rate becomes ever-more dependent upon investment

decisions of non-residents.18

Chart 9: Turnover in the zloty market and the zloty currency options, by entity (April 2004)

36.46

8.95

33.33

20.38

30.72

61.20 34.62

32.82 29.85

61.08

45.00

5.59

0

20

40

60

80

100

Spot market FX swap market Outright-forward

market

FX option market

%

Transactions between non-residents (offshore market)

Resident - non-resident transactions

Transactions between residents

Source: NBP and BIS.

Does globalization really take place: well-known economic puzzles

The data and mechanisms presented above illustrate the fast progressing globalization of financial

markets. Nevertheless, numerous studies have shown phenomena that should not occur in a situation

of growing commercial and financial links. For instance, if there existed a global financial market,

capital should flow from the developed countries to the developing ones. This is, however, not the

case, as noted by Robert Lucas19, and the "Lucas puzzle" named after the author was formulated.

There have been numerous works that attempted to resolve this puzzle. One of the most recent works,

which presents a panel analysis of nearly a hundred countries in the period 1970-2000, has shown

that the prevailing reason for the lack of capital flow from wealthy to poor countries are institutional

factors.20 or instance, improving the quality of operation of institutions in Peru to catch up with

Australia would mean a four-fold increase in foreign investment, and improving the quality of operation

of institutions in Turkey to catch up with the UK would increase foreign investment by 60%.

Another puzzle, which over some time made challenging the fact that globalization of financial markets

was actually taking place possible, was the "Feldstein-Horioka puzzle."21 Both authors in their famous

17 Too big to fail, too complex to fail.

18 "Rozwój systemu finansowego w Polsce w 2004 r.",NBP Warsaw 2005, pp. 275- 286, 303-314.

19 Lucas R. "Why doesn’t Capital Flow from Rich to Poor Countries", American Economic Review 80, 1990.

20 Alfaro L., Kalemni-Ozcan S., Volosovych V. "Why doesn’t Capital Flow from Rich to Poor Countries? An Empirical

Investigation", University of Houston Working Paper, November 2005.

21 Feldstein M., Horioka C. "Domestic Savings and International Capital Flows", Economic Journal, June 1980.

10 BIS Review 60/2006

work of 1980 estimated the correlation between the national savings rate and the investment rate in

the years 1960-1974 at 0.89. This correlation for the years 1990-1997 was estimated at 0.60, and

having included South Korea – at 0.76. Despite a pronounced fall, the correlation between the national

savings and investment remained high.22 his constituted a peculiar puzzle, as in the global world of

finance there were no good reasons for which investments were to be financed with residents’ savings

rather than with loans drawn on the global financial market. As in the case of the "Lucas puzzle",

numerous works have been written to explain this phenomenon. In the most recent work by Martin

Feldstein regarding this subject,23 the newly estimated correlation rate gradually decreased over

subsequent decades to reach a mere 0.19 in the decade ending in 2002. The decreases regard

mostly smaller countries, but the estimates for large countries also show that the correlation rate fell

from 0.92 down to 0.59. Therefore, it seems that over 10 recent years the process of globalization of

financial markets exhibited a pronounced deepening.

One may wonder why the recent years have witnessed acceleration and deepening of the

globalization process, given that some phenomena that are universally deemed the reasons behind

globalization, started a few decades ago. It seems that apart from the – growing for a few years now –

role of the global financial markets and the liberalization of commerce, new factors have emerged,

such as taking advantage of the technological progress in the ICT and joining the global economy by

China and India. Thomas Friedman, author of the famous book entitled "The World Is Flat: A Brief

History of the Twenty-First Century",24 hows how radical the changes in the organization of the

manufacturing process and service performance have been over the recent years, as a result of, inter

alia, the use of new communication technologies, such as the Internet, mobile phones, or the

appearance of such techniques of gaining and processing information as the Google search engine. I

may share my personal thought with you. I have just completed my work on the first draft of a paper

discussing global imbalances. Owing to the Internet and new websites providing specialist information

and knowledge in the area of economy, it took me three months to write the article. I worked on it only

in my free time, of which I do not have much as the deputy president of the central bank. Ten years

ago, over a three–month period, I would probably not have been able to collect even half of the

literature, not to mention the ongoing monitoring of speeches delivered at all important conferences

dedicated to global imbalances. It goes without saying that progress in the ICT has contributed to the

deepening of the globalization process and significantly enhanced labour productivity in many sectors.

Global imbalances

One of the manifestations of globalization in recent years are global imbalances. In 2005, the US

current account deficit approached 6.5% of the GDP, and many forecasts of investment banks point to

its further increase in 2006 and 2007.25 The negative net investment position of the world’s largest

economy has moved towards 30% of the GDP in 2005 and, according to all available forecasts, it is

bound to deteriorate at a high rate.

The large current account deficit in the US is related to the negative savings of households and a

strong growth in real property prices. These phenomena have occurred in the recent years not only in

the US but also in all Anglo-Saxon countries.26 Moreover, the current account deficit in the US is

financed in a great measure by purchases of American debt securities by the Asian central banks. It

entails a significant increase in the exchange reserves of the said banks. For instance, the reserves of

the People’s Bank of China went up from USD 166 billion in December 2000 to USD 819 billion in

December 2005 and over USD 850 billion in March 2006. It means that China is now ahead of Japan

22 Obstfeld M., Rogoff K. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?", NBER

Working Paper 7777, 2000.

23 Feldstein M. "Monetary Policy in a Changing International Environment: The Role of Capital Flows", NBER Working Paper

11856, December 2005.

24 Friedman T. "The World is Flat. A Brief History of XXI Century", Farrar, Straus and Giroux, New York, 2005.

25 According to the World Economic Outlook published by the IMF in September 2005, the forecasted US current account

deficit will amount to USD 759 billion in 2005 and will increase to USD 805 billion in 2006. Both values correspond to 6.1%

of the forecasted GDP. Some forecasts by investments banks, however, indicate an increase in the forecasted current

account deficit to 6.5% of the GDP in 2005 and to 7-8% of the GDP in 2006 and 2007.

26 An extensive discussion of the real property market can be found in A. Ahearne et al. „House Prices and Monetary Policy: A

Cross Country Study", Fed Board of Governors, International Finance Discussion Papers, September 2005.

BIS Review 60/2006 11

– the country most abundant in foreign reserves, whose reserves amounted to USD 847 billion in

December 2005. The Chinese foreign reserves are expected to exceed USD 1 trillion (a thousand

billion) in 2006.27 n the years 2004-2005, the current account deficit in the US was in ever-greater part

financed from purchases of American bonds by public institutions that managed foreign reserves in oilexporting

countries.

Chart 10: The US current account deficit and the geographic structure of the deficit-financing

capital inflow (current account surplus), 1980-2005.

-1 000

-800

-600

-400

-200

0

200

400

600

800

1980 1983 1986 1989 1992 1995 1998 2001 2004

USD billion

Other Asian

countires

Euro area

USA

Japan

China

OPEC

countries

Source: MFW, World Economic Outlook.

The situation where the world’s largest economy and at the same time the issuer of the global reserve

currency has such a large savings deficit financed in such an unusual way has triggered a hot

economic debate on the two following issues. Firstly, attempts are being made to explain how global

imbalances have come into being. Secondly, both academic economists and strategists with

investment banks are trying to assess the possible scenarios of further developments. Are global

imbalances a regular phenomenon in the global economy and can they increase further without any

harm to the outlook for the long-term global growth? Can a radical adjustment of these imbalances

occur – and if yes, what will be the mechanism of such an adjustment and what will its consequences

for the global growth be?

Let us begin with the presentation of the main hypotheses that explain the phenomenon of global

imbalances. In 2003, three economists presented a hypothesis that an informal Bretton Woods regime

had been reactivated.28 The original Bretton Woods system was established after WWII and consisted

in a formal commitment of its participant countries to maintain foreign exchange rates, determined

against a gold parity, at a specific level, with acceptable deviations not exceeding 1 percent. The

system ceased to exist in 1971, after president Nixon had taken a decision that the US would no

longer exchange dollars for gold according to the parity determined. The nature of the reactivated

Bretton Woods, often called Bretton Woods 2, is well conveyed in the motto used by the authors of this

concept:

"(…) if I had an agreement with my tailor that whatever money I pay him returns to me on the

very same day as a loan, I would have no objection at all to ordering more suits from him"

(Jacques Rueff, 1965, after Dooley et al. (2003).

27 Taking into account the fact that China has already used USD 60 billion of its foreign exchange reserves for capital

injections to two commercial banks, the People’s Bank of China has a level of reserves that exceeds USD 900 billion.

28 A series of articles on the topic was commenced with the work of M.Dooley, D.Folkerts-Landau and P.Garber „An Essay on

the Revived Bretton Woods System", NBER Working Paper 9971, September 2003.

12 BIS Review 60/2006

The hypothesis of the existence of an informal Breton Woods 2 says that a system has been

established in which it is profitable for the Asian countries to finance the US current account deficit,

because it enables them to increase their exports to this market. Thus, it supports the economic

growth of the Asian countries and makes it possible for them to create new jobs, which is particularly

important in China, where – according to various estimates – each year between 10 and 20 million of

jobs must be created, due to migration of the population from rural areas to cities. In order to maintain

the competitiveness of their exports, the Asian countries intervene on the FX market, thus preventing

appreciation of their currencies. The purchased US dollars are invested in American bonds, and thus

the American current account deficit is financed.

Another hypothesis that explains the mechanism of occurrence of global imbalances has been

formulated by the current Chairman of the Federal Reserve, Ben Bernanke.29 His major concept is

that the large US current account deficit cannot be explained solely by internal factors. In the opinion

of Bernanke, external factors, which he has defined as the global savings glut, have played a key role.

The hypothesis says that a significant surplus of savings over investments in the Asian countries, in

combination with the structurally high savings in Germany and Japan, have caused the global savings

glut. The savings glut has in turn had a contribution into the increase in prices on the stock exchanges

in the US, and subsequently to the increase of property prices, which has in turn lowered the level

of savings of American households.

The International Monetary Fund argues against the hypotheses of Bretton Woods 2 and the global

savings glut by stating that the source of the current account surplus is an exceedingly low level of

investments in Asia, except for China. Therefore, one should speak of a global investment draught

rather than anything else,30 as over the five years following the Asian crisis in 1997-1998, the

investment level was by 7 percentage points lower than in the five-year period preceding that crisis.

Considering the above, an appropriate recommendation for those countries is not limiting their savings

rate, but rather improving their investment climate.

There are numerous theories that attempt to explain the occurrence of global imbalances. According

to some of them, the major reason behind global imbalances is the low level of savings in the US

household and public sectors,31 i.e. the fact that Americans spend more than they earn, and that the

budget deficit, from a substantial surplus in the year 2000, turned into a level estimated at 4.7% of the

GDP in 2004. Other hypotheses suggest that the factor that induces global imbalances is the change

in the economic policy of the Asian countries after the crisis of 1997-1998, when the decision was

taken in many countries to establish huge foreign exchange reserves for the purpose of hedging

against similar changes in the sentiment on financial markets in the future.32 Economists also state

that the factor that invokes global imbalances is the higher investment attractiveness of the US region

as compared to other regions, measured with, among others, higher potential economic growth rate.33

here exists another hypothesis, according to which such a high current account deficit is optimal,34 in

the face of the expected higher future growth rate of the American economy in comparison to that of

other developed economies. According to that hypothesis, Americans increase their consumption

financed from loans, anticipating high future earnings that will allow them to pay off the loans, which is

perfectly correct. Finally, there are papers which try to prove that there is … no deficit. An article by

29 The hypothesis of the global savings glut was formed for the first time in the speech by Ben Bernanke at the meeting of

Virginia economists’ association in March 2005.

30 E.g. in speeches by Rodrigo Rato, head of the IMF, and Raghuram Rajan, head of the IMF Research Department in

January and February 2006.

31 E.g. M. Chinn "Getting Serious about Twin Deficits", working paper, The Bernard and Irene Schwartz Series on the Future of

American Competitiveness, CSR No. 10, September 2005.

32 This hypothesis has been justified in: Aizenman J., Lee J. "International Reserves: Precautionary vs. Mercantilist Views,

Theory and Evidence", IMF Working Paper WP/05/198, October 2005; and Gosselin M.A., Parent N. "An Empirical Analysis

of Foreign Exchange Reserves in Emerging Asia", Bank of Canada working paper 2005-38, December 2005.

33 R.Caballero et al. "An Equilibrium Model of Global Imbalances and Low Interest Rates", MIT mimeo, September 2005.

34 C. Engel, J. Rogers "The U.S. Current Account Deficit and the Expected Share of World Output", NBER working paper

11921, 2006.

BIS Review 60/2006 13

Hausmann and Sturzenegger35 that argues the existence of the "dark matter" is an example of this

approach.

In spite of many attempts to prove that the US current account deficit is in fact lower than it is believed

to be, and that it is even desirable, a vast majority of academic economists and many central bankers

are seriously alarmed by the scale of global imbalances. Many papers have been written which show

what may be the consequences of the scenario in which the financial markets – in view of no

adequate measures undertaken by economic decision-makers – initiate adjustment processes by

themselves.36 If the financial markets come to the view that the investment risk premium for American

debt securities has increased, the outflow of capital from this market – or even decreased capital

inflows – may lead to a fall in bond prices, i.e. to a sharp increase in long-term interest rates,

a slowdown on the housing market, depreciation of the dollar and, as a result, stagnation or even

recession, which may be observed globally.

In order to mitigate the probability of such a scenario, structural reforms should be implemented in

many countries. The US should substantially reduce its budget deficit and – via a reform of the

pension system and the healthcare system – increase the household savings rate. In the EU and

Japan a series of structural reforms should be accelerated to raise the flexibility and competitiveness

of the labour market and the market of goods and services. In the Asian countries, and first of all in

China, the exchange rate regime needs to be made more flexible, which should be preceded by the

reforms that would strengthen the financial system, also via a greater openness to foreign capital

inflows.

At present, it is difficult to assess the likelihood of the scenario involving a serious slowdown in the

global growth; nevertheless, implementation of necessary reforms proceeds slowly.

Should monetary policy take into account speculative bubbles?

The globalization process is a great challenge for central banks and financial market regulators.

Following the increase in global workforce resources, relative to the capital resources, the workforce

costs decreased and resulted in the fall of costs of manufacturing of many goods and services. Having

deducted the cost of fuel, whose increase also results from the globalization process, inflation remains

very low in many countries, whereas a surge in the global labour supply mitigates the possibility of

occurrence of the second-round effects i.e. wage increases in response to a rise in current inflation.

On the other hand, the global surplus of savings over investments causes the capital to be deposited

on various asset markets entailing an increase in assets prices. Increases in stock exchange indices,

bond prices or real property prices in the Anglo-Saxon countries may serve as examples here.

Naturally, a question arises what monetary policy should be conducted in such conditions. In

particular, the question is whether it should respond to the increase in the asset prices, despite the fact

that inflation of consumer goods and services is low or very low. A debate continues over that issue,

where both arguments in favour of the necessity to respond to the bubbles on the asset markets,37 nd

those against it, are raised.38

The issue of response of monetary policy to changes in assets prices was raised by Donald Kohn,

member of the Board of Governors of the Federal Reserve, in his speech delivered in the previous

month.39 According to Kohn, two approaches are possible. In one of them, described as the

35 R. Husmann, F. Sturzenegger "Global imbalances or bad accounting? The missing dark matter in the wealth of nations",

Harvard University working paper, December 2005.

36 Examples of such estimations can be found in: S. Edwards "Is the U.S. Current Account Deficit Sustainable? And if not,

How Costly Is Adjustment Likely to Be?", NBER working paper 11541, 2005; Orderly or Disorderly Rebalancing?", New

York University Working Paper; M. Obstfeld, K. Rogoff "The Unsustainable US Current Account Deficit Position Revisited",

prepared for 12-13 July 2004 NBER conference on G-7 Current Account Imbalances: Sustainability and Adjustment; H.

Faruqee et al. "Smooth Landing or Crash? Model Based Scenarios of Global Current Account Rebalancing", NBER Working

Paper 11583; O. Blanchard et al. „The U.S. Current Account and the Dollar", NBER Working Paper 11137 and many others.

37 Roubini N. "Why Central Banks Should Burst Bubbles", mimeo, Stern School of Business and Roubini Global Economics,

January 2006.

38 Posen A. "Why Central Banks Should Not Burst Bubbles", Institute for International Economics, Working Paper WP 06-1,

January 2006.

39 Kohn D. "Remarks by Donald Kohn at Monetary Policy: A Journey from Theory to Practice, An ECB Colloquium held in

honor of Otmar Issing", 16 March, 2006.

14 BIS Review 60/2006

conventional monetary policy, the central bank focuses on stabilising the inflation, treats changes in

asset prices as an exogenous process, and does not attempt to influence asset prices whatsoever.

The other option, described by Kohn as the "extra action" policy, provides for a deviation of current

inflation from a level determined as stable, in return for an improvement of the perspectives of

achieving price stability in the future. However, the extra action policy does not mean bursting

speculative bubbles by central banks. It rather means "buying" additional insurance against possible

negative shocks, which may happen in the future. In Kohn’s opinion, the extra action policy may be run

very rarely and only where the three conditions are met:

the central bank must be able to identify bubbles on the asset market in a timely manner and

with high certainty as to the correctness of conclusions from the analysis,

the probability that a slight tightening of monetary policy will be able to stand against the

speculative activity on a given asset market must be high,

the expected improvement of the future economic situation resulting from a smaller

speculative bubble must be significant and higher than the costs incurred by the economy in

the aftermath of running the additional action policy.

In view of the available studies, it may be stated that it is extremely difficult to sufficiently fulfil the three

abovementioned conditions. It may not be excluded, however, that in the future, the understanding of

economic processes will improve as much as to enable running the additional action policy in justified

cases.

In the discussion over the correct relation of economic policy to the bubbles building up on the asset

market, there is a dominant conviction that the supervisory policy is a much better response. For this

very reason, supervision over financial markets should be independent of politicians, as it may turn out

necessary to take up actions aimed at limiting the rate of building up of the speculative bubble at a

time when it is not convenient for politicians, considering the elections cycle.

New challenges for regulators/supervisors

Globalization of financial markets changes the operation conditions of financial institutions by opening

new development opportunities for them, but also by creating new types of risk for the stability of the

financial systems.

Globalization creates new opportunities in the area of risk management, including but not limited to the

most important banking risk, i.e. the credit risk. Development of new risk transfer instruments (credit

derivatives and securitisation) and increase in the number of their purchasers enable more effective

use of banks’ capital. New instruments, however, pose some threats.40 Both market participants and

markets supervisors indicate the issues of progressive complexity of derivatives, and difficulties in

complete understanding and estimating the risk related thereto.41 Difficulty in evaluating risk flow

directions and lack of basic data on some unregulated financial institutions, which are becoming

increasingly active on the derivatives market, are also a problem. What I mean here are in particular

the hedge funds, which manage increasing funds.

New services offered by banks on the FX market, such as the prime brokerage, also create difficulties.

Under a prime brokerage agreement, the bank makes its credit limits available to other institutions that

speculate on the FX market, most frequently to hedge funds. As the product becomes widely used,

supervisors are faced with a growing difficulty in monitoring the credit risk and liquidity risk of

operations concluded on the FX market,42 where the average daily net turnover amounts to USD

1,900 trillion. This creates quite a challenge for supervisors, who must have human and financial

capital available to properly assess the risk in the increasingly global and complex world of finance.

The understanding of the mechanics of financial markets is a never-ending challenge for supervisors.

40 Kapstein E. "Architects of stability? International cooperation among financial supervisors", BIS Working Papers No 1999,

February 2006.

41 Schinasi G. J. "Safeguarding financial stability: theory and practice", Washington, D.C., IMF, 2005.

42 Kos D. "Developments In the FX Market: New Opportunities, Risks and Responsibilities", a speech at the "Future of FX"

conference in New York, October 24, 2003.

BIS Review 60/2006 15

The response of bank supervisors gathered in the Basel Committee on Banking Supervision to the

increasing complexity of financial instruments in banks’ portfolios is the New Capital Accord ("Basel

II"), which is to replace the regulations currently applicable in over 100 countries. The new capital

regulation is an attempt of precise risk measurement, including but not limited to the credit risk, and its

reflection in the capital requirements.

Newly emerging institutions operating in several segments and on several markets increase the

operational risk. It seems that the scale of threats related thereto grows in line with the technological

development. Globalization of financial markets and relations among institutions of various segments

trigger a disruption that may bear consequences not only for individual institutions, but which may,

through the payment system, spread over to many other entities, including those in the real sector.43

The operational risk problem has been noted by the Basel Committee on Banking Supervision, which

for the very first time has included it in its supervisory regulations (the New Capital Accord). Banks and

investment funds have been obligated to gather information on operational risk incidents and to

estimate capital to cover this risk.

Capital mobility and business activity of large, international financial corporations also translate into

institutional changes on local markets and challenges to be faced by supervisory authorities

responsible for financial stability. Financial markets of the new EU Member States, whose large share

is held by foreign investors, i.e. institutions operating globally or regionally, may serve as an example.

In addition to the capital necessary for the development of the institutions and markets on which they

operate, the presence of industry institutional investors has brought about a number of other positive

results. These include better risk management, a modern range of products offered to customers, or

the development of new distribution channels, to name just a few.

Regional integration within the EU, however, means that the application of a uniform bank or

insurance licence (i.e. taking up activity in any Member State under a licence obtained in the home

country) may cause certain asymmetry in the availability of data and a conflict of interest between

supervisors of the host country on the one hand, and institution owners and supervisors from the

home country on the other. Such conflict may occur as a result of transformation of foreign bank

subsidiaries, operating under local laws and fully supervised by the supervisory authorities of the host

country, into branches supervised by foreign supervisory authorities. Individual foreign bank branches

operating in the new EU Member States frequently constitute a vital element of the banking system,

both in terms of the value of assets and deposits, operations on the domestic interbank market and the

share in settlements in the payment system. Therefore, they are described as institutions of systemic

importance for the domestic market. At the same time, they are not always equally important

components of an international banking group, in terms of their size and the profit generated. In such a

case, a relatively low importance of an institution may result in less focus on its supervision, both by

the foreign bank and the supervisory authority of the home country in which the given bank has

obtained its licence.

As I have mentioned before, supervisory authorities of the home country are responsible for direct

supervision. However, supervisory authorities of the host country are always responsible for the

financial system stability. Responsibility for the financial stability translates not only to preventive

measures, but also to crisis management, including financial support to institutions or – in a broader

sense – to markets that have lost their liquidity, but remain solvent. Appropriate authorities of the host

country should thus have access to comprehensive information that enables a proper assessment of

risk and financial standing of large financial institutions operating in its territory. The need to provide

information has not been adequately articulated so far by international organisations that shape the

supervisory architecture; however, the recent years have brought changes in this respect. The idea to

transform the Nordea Bank, operating in the Baltic countries, into the so-called European company,

and the subsequent transformation of its subsidiaries into branches, has supported the changes. For

some countries, this operation means a loss of supervisory control over a significant part of the

43 An example of one of the first major incidents of operational nature were the problems of the Bank of New York. As a result

of a computer system error in November 1985, the bank was unable to transfer to customers’ accounts the Treasury

securities purchased for them, and enforce payments. In the meantime, the bank’s account was debited with payments for

the securities. This caused a gigantic deficit on the current account held with the central bank and a necessity of emergency

support from the FED. The financial consequences of a computer system error were incurred not only by the Bank of New

York, but also by many of its counterparties. Illing M. "A Review of Notable Financial Stress Events", in: "Essays on

Financial Stability", Bank of Canada, September 2003.

16 BIS Review 60/2006

banking system, and dilemmas regarding the crisis support and the deposit guarantee system.44 The

question whether the taxpayers of the host country, or solely those of the home country, should pay for

possible bankruptcy of a bank, remains open.

Conducting operations in various countries and segments of the financial market (including but not

limited to combination of the banking and insurance activities) leads to creation of complex structures

of financial groups. This phenomenon has been included in the banking supervision organisation. At

the EU level, this fact is reflected in the Directive on supplementary supervision of credit institutions,

insurance companies and investment firms in a financial conglomerate,45 and in Poland – by the

Supplementary Supervision Act.46 The merit of the Act is a complex risk analysis within a single capital

group and coordination of control and supervisory activities by a leading supervisor, with the

collaboration of authorities that supervise other entities in the financial conglomerate.47 The Act sets

forth cooperation with foreign supervisors.

Globalization of financial markets brings about new challenges for central banks as regards crisis

management. The terrorist attack of 11 September 2001 has revealed how far-reaching implications

for the international payment system may be brought about by switching off a large-value payment

system in a single country. In the circumstances of the increasingly integrated financial markets,

central banks must also cooperate more closely and have their contingency plans in place to inject

liquidity to the global financial system in a crisis situation.48 The private sector goes even further to

suggest that in a crisis situation central banks should extend intraday credit facility to all banks (not

only the domestic ones). Intraday credit could be collateralized by foreign currencies or securities

denominated in foreign currencies – cross-border collateral pool facilities.49

Conclusions

Ladies and Gentlemen, globalization of financial markets, trade, manufacturing, services and

knowledge is a great opportunity for the global economy. Owing to this process, the developing

countries may modernise and grow faster than they have ever done before. On the other hand, both

manufacturers and consumers in the developed countries take advantage of the access to the huge

global labour market, which makes it possible to lower the costs of manufacturing, enhance

productivity and – consequently – lower the prices of many goods and services. Both consumers and

producers are also beneficiaries of globalization of the financial markets, which offer a wide range of

products and enable a better adjustment of the risk profile and the expected return or cost to the

preferences of investors and borrowers.

Globalization also has its drawbacks. It generates new types of risk, which constitute challenges to

central banks and supervisors of financial markets. Globalization of financial markets and the related

rapid growth of turnover in credit derivatives, such as CDOs or default swaps, force a focus on

understanding, what types of risk are generated in particular market segments. Such risks should be

continuously analysed by central banks and supervisory authorities.

It may happen in the future that the social groups which incur losses in the process of globalization will

force the decision-makers to take up protectionist actions, which may contribute to significant lowering

of the future economic growth, through limiting the benefits from international trade. Therefore,

economic policy, especially in the countries with a large share in the global product, should be

44 Schoenmaker D., Oosterioo S. "Cross-Border Issues in European Financial Supervision", in: Mayes D., Wood G. (editors)

"The Structure of Financial Regulation", London 2005.

45 Directive 2002/87/EC of the European Parliament and of the Council of 16 December 2002 on the supplementary

supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending

Council Directives 73/239/EEC, 79/267/EEC, 92/49/EEC, 92/96/EEC, 93/6/EEC and 93/22/EEC, and Directives 98/78/EC

and 2000/12/EC of the European Parliament and of the Council.

46 The Act on supplementary supervision over credit institutions, insurance companies and investment companies in a

financial conglomerate of 15 April, 2005, (the Journal of Laws No. 83/2005, item 719).

47 In Poland there has been no need so far to appoint a leading supervisor, as the links among financial entities do not indicate

the existence of financial conglomerates under the said Act.

48 Simson B.A. "The future of central bank cooperation", BIS Working Papers No 200, February 2006.

49 "Managing Payment Liquidity in Global Markets: Risk Issues and Solutions", a report prepared by Cross-border Collateral

Pool Task Force, New York, March 2003.

BIS Review 60/2006 17

conducted in a manner that would enable to avoid the scenario of protectionism growth. After all, one

of the greater threats which are difficult to evaluate is the risk of adjustment of global imbalances,

especially where it results from market forces without support from adequate reforms.

So far, globalization has served humanity well. I truly hope that the ever-greater knowledge of risk

types related to globalization will make it possible for us to conduct economic policy that will facilitate

benefiting from globalization to the future generations the homo sapiens globalus.

Thank you very much for your attention.

18 BIS Review 60/2006

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