*{MAINTAINING FINANCIAL STABILITY IN A GLOBAL ECONOMY:
IS THERE A ROLE FOR THE OECD?
9 December 1998
Discussion Paper for the 1998 BIAC Consultation with the OECD Liaison Committee
with International Non-Governmental Organisations

I. Introduction:} *partie=titre the Volatility of Financial Markets *partie=nil

1. The recent instability of global financial markets has resulted in widespread concerns about
an impending world crisis, and has prompted considerable debate about the causes of volatility and
the possible solutions. BIAC is pleased to present its analysis of the current situation and its
suggestions on what the OECD can do to restore confidence and stability in the international
financial system.

2. BIAC believes that liberalised capital flows are essential for promoting investment, growth
and employment in all economies. However, it must be recognised that global capital markets are
inherently unstable. Although they may not be subject to large-scale, especially downward,
changes every day, it is nearly inevitable that such movements will occur from time to time. We
believe that this risk needs to be better factored into public policy, as well as company strategy.

3. So far much of the recent public policy discussion on the financial crisis and the search for
its cause has focused on volatility and the possible “quick-fix” mechanisms for limiting it.
Unfortunately, many of the proposed solutions fail to address the reasons behind the large-scale
withdrawal of investment from an entire category of countries.

*partie=titre Financial contagion *partie=nil

4. Many experts argue that a large-scale breakdown of confidence in world financial markets
has negative effects on economies with sound fundamentals, and that limiting the spread of
volatility should thus be considered a primary objective. A general worsening of economic
conditions in a large number of countries can often force investors to reassess their willingness to
lend in other areas, without a change in the latter's intrinsic conditions. This can be the result of
lenders deciding to reduce their exposure in markets with relatively better fundamentals because of
the risk of macroeconomic contraction due to declining trade/investment flows between the
countries concerned. However, the recent volatility in many countries is better characterised by the
"demonstration effect", in that investors have felt compelled "to withdraw their capital from
countries with the same problems as were present in the first such country." *{1

1 From Michael Bordo, "International Rescues Versus Bailouts: An Historical Perspective", Cato Institute
Monetary Conference speech, 22 October 1998, pp. 7-9 available on www.cato.org/events/monetary.html.}

5. BIAC believes that two things are simultaneously true about the contagion aspects of the
crisis. First, it is clear that the onset of the crisis in Southeast Asia involved some economies with
comparatively sound "fundamentals" (measured in terms of government finances or the balance of
payments), although current account deficits were recognised to be high in some (e.g., Thailand
and Malaysia) in the run up to July 1997 *{2}. Second, it is equally true that the subsequent
withdrawal of funds from emerging markets in general as well as the present perception of global
risk arises from the vulnerability of a host of economies with much weaker fundamentals (e.g.,
Russia). The latter category, which forms the majority of emerging markets, does not consist of
"innocent bystanders", but rather economies that have been putting off necessary reforms for too
long. Of these two aspects, the first currently attracts the better part of international policy
attention – namely, how to protect economies with relatively sound fundamentals from sudden,
financially induced instability. However, most BIAC members believe that the basic question of
how to generate convergence towards sound macroeconomic policies among all major economies,
including the emerging ones, is at least as important as questions of international financial
architecture and supervision of financial flows and stocks at the country or international level.

*{2 Part of the problem was that some countries in Asia initially looked sound because their financial systems
lacked transparency so that foreign investors were not able to assess the level of corporate indebtedness until the crisis
exposed the weakness . However, this may not completely absolve foreign investors, which were investing in
enterprises without having clear information on their indebtedness, from responsibility. After all, lack of transparency
itself should be an important factor in investment decision-making.}

6. Nevertheless, one lesson learned from the recent crisis is clearly that exposure of an
economy to short-term foreign currency capital inflows, before its financial system is sufficiently
developed to handle a large unanticipated withdrawal, is a highly risky venture. This demonstrates
that economies cannot enjoy the advantages of a sophisticated international financial system
without the internal discipline that enables such economies to adjust to changing circumstances
without crisis. Areas crucial to increased discipline include appropriate bankruptcy and workout
procedures for defaulting private sector entities, new arrangements for risk sharing between
debtors and creditors, and ways to limit explicit and implicit government guarantees of private
debt.

7. We believe there have been many fundamental changes during the last ten or fifteen years
in the international system which have improved both the prospects and hope of the poorer
countries to develop in a mutually-beneficial way and the ability of the richer societies to interact
with the former as partners rather than benefactors or peacekeepers. These improvements should
remain as acquis. However, we would point out that the following conditions exhibited in an
economic environment are not mutually compatible:

i. that emerging economies should be able to pursue productivity improvement through trade
specialisation;
ii. that private capital should remain free to move to emerging economies, through direct
investment and various forms of lending;
iii. that firms should be able to choose freely the exact type of financial vehicle they use for a
given lending/borrowing relationship, including the choice between short term and long term
investments which is appropriate for the purposes of the business they are conducting;
iv. but, that emerging economies which receive investment should be free to pursue any type of
macroeconomic and institutional polices, including policies which base the pursuit of growth
and capacity building (exports at the expanse of their fellow emerging competitors) on shortterm
borrowing.

8. While an increasing number of commentators may be focusing attention on the politically
expedient solution of capital controls (i.e., eliminating the third condition), we believe that the
response ought to be sought in the area of surveillance of macroeconomic and institutional policies
(i.e., constraining the fourth proposition), unless we are prepared to sacrifice the first and second
propositions (which are linked by necessity.) Although there may be a need to examine the impact
of certain financial instruments such as hedge funds, recommendations for broad control of short
term capital flows would do more harm than good and thus should not be pursued. It is clear that
capital controls are certain to distort investment patterns, reduce real rates of growth, encourage
corruption and, at the same time, fail to reduce the frequency and probability of economic crises
and recessions.

*partie=titre Inadequate surveillance *partie=nil

9. We consider that policy attention should thus focus on what factors obstruct a prudent
assessment of the maturity of financial systems and related risks in the first place, especially when
such negligence occurs on a large scale for a prolonged period of time. Recently, the Bank for
International Settlements (BIS) provided an emphatic acknowledgement of how good economic
performance and circumstances may contain the seeds of future problems, with good domestic
"fundamentals" leading to spending excesses and attracting less-performing investment. *{3} This
leads us to conclude that, while it may not constitute a panacea, a permanent mechanism of
interaction and peer review between policy makers of significant economies would make a
valuable contribution to stability.

*{3 Bank of International Settlements, 68th Annual Report, Basle, 1998, pp. 162-163.}

10. But, while it is possible to understand that over-optimism can affect markets and, perhaps
even more so, policy-makers, we believe it is worth considering why over-optimism can become
so pervasive in world financial markets. Private sector credit rating agencies could not have been
expected to play the role of whistle-blowers, as these agencies are not designed nor supposed to
play a role in global surveillance. Such agencies are unlikely to predict a crisis coming. This is
because their projects are likely to be country- or company-specific whereas a crisis is necessarily
precipitated by a series of countries or (big) companies (or banks) running into trouble
simultaneously. In other words, it is the combination of events that normally precipitate a largescale
crisis.

*partie=titre II. Addressing the Fundamental Problems *partie=nil

11. This leads us to two interim conclusions. First, it is important to seize upon the "salutary
effects" of the crises like this to instil a proper sense of humility in international discussions. In
good times, governments and international organisations should not over-emphasise "success
stories" and endogenous, systemic developments, such as the rapid growth of private financial
flows to developing countries as goods in and of themselves. Public funds could be better used to
promote an understanding of how traditional, “old-fashioned” policy challenges and risks will
continue to be faced in the "new global age." Second, we believe it is time to reassess the
weaknesses of existing mechanisms for dialogue, monitoring and surveillance. In particular, it
must be understood that, most probably, the type of organisation that might actually contribute to
enhancing stability and strengthening institutions in the developing world are likely to consist of
low-key, discrete processes that maintain a long-term focus on issues and provide a venue for trustbased
contact between policy makers, rather than anything that might generate headlines in the
media.

*partie=titre Transparency of existing institutions *partie=nil

12. Transparency serves a purpose (such as forestalling currency or banking crises) when there
are institutions with mandate, capacity and clout to carry out analysis and assessment to be able to
give advance warning when fundamentals deteriorate. In turn, analysis can serve a purpose when
there is a clear process of surveillance. What then is the best mechanism to carry out surveillance?

13. BIAC strongly disagrees with the popular view that we simply need new institutions and
regulations at the international level, to make the globalised economy look more like a national
one. Because there is no world government, and that there cannot and probably should not be one,
littering the world economic landscape with institutions that can only function with sufficient
authority and legitimacy behind them will only add to the present confusion. Without clear
legitimacy and credibility, attempts to regulate at the world level would very likely be piecemeal
and incoherent at best. Notwithstanding the merits of reviewing the current system of international
financial surveillance, the debate about creating a new global "lender of last resort" is really not the
heart of the problem. The issue remains: how to influence economic policies carried out by
seemingly sovereign entities so that the function of lender of last resort does not need to be
exercised too often.

*partie=titre III. Revitalising Multilateral Policy Co-operation with New Players *partie=nil

14. If a world-wide financial regulatory authority or other forms of top-down (donor-recipient)
surveillance relationships have become even more difficult to exercise today, which they seem to
be, what other mechanisms are conceivable? How can sovereign nation states be persuaded to take
part in a voluntary but meaningful process of economic performance review that covers not only
their financial linkages with the rest of the world but also an evaluation of their "domestic"
institutions, macroeconomic policies and trends?

15. It is clear that such a process will need to involve regular interaction, even at times when
performance appears good, rather than being ad hoc, because as stated above, success may contain
the seeds of future troubles. It is also our view that, given the results of the past four or more
development decades, there is now an entire set of economies outside the OECD area which
simply cannot be treated as students in development in the hands of donor international financial
institutions (IFIs), given the capacities and aspirations of their leadership. To put it differently, any
surveillance mechanism for the task now envisaged must treat emerging economies as equals (to
advanced OECD economies). We believe that only this, i.e., reciprocity of participation in peer
review and surveillance, can generate a sufficient degree of interest and commitment by the
leadership of the emerging economies to enable them to participate in a meaningful way. Such a
process would give the new players a say in any policy review affecting today's advanced
economies as well.

*partie=titre "Outreach" versus mutual surveillance *partie=nil

16. The OECD has been reflecting on its role in the current world with increasing number of
national "players", as well as on how to "reach out" to the latter in its activities, for nearly a decade.
However, much of the outreach activity to date has taken the form of both ad hoc and top down
programmes, mainly conceived as vehicles for diffusing the policy experience gained within
OECD economies and the Organisation to the rest of the world. While these interactions are
clearly valuable, BIAC believes that the level of policy coherence required between the developed
and emerging economies will require a mechanism with a much higher scale and scope of
involvement between the economic policy making communities of both sides.

17. Recently there have been several multilateral initiatives to strengthen policy co-ordination.
One proposal is to create an ad hoc group of 22 countries – termed the "systematically significant
economies" – to work on issues of transparency and strengthening of the IFIs. The latter initiative
at present has a clearly defined task of studying policy options regarding the architecture and
wiring of IFIs. However, if at some later stage there was felt the need to engage in policy dialogue
on broader economic policies and performance, as we believe there should be, that mechanism
would also have to contain these significant economies. The OECD members constitute roughly
half of the G-22.

18. While the G-22 model may be perfectly adequate for its present task, it is hard to imagine
how any policy dialogue and co-ordination effort among country groups of similar composition –
i.e., cutting across the OECD-non-OECD boundary – can be maintained without clear
arrangements for an international and neutral secretariat and a clear and transparent process for
conducting policy review of its members. Experience with the G-7 model suggests that quasiinformal
high-level international mechanisms are not designed to address international questions
requiring a long-term focus of governmental departments, except where they can delegate most
actual substantive work to other organisations (as they often do to the OECD).

19. How then to create a mechanism which is at the same time:

- not ad hoc, sufficiently regular so that it receives a commitment from both high-level as well as
working-level policy-making establishment,

- where all members have equal status and commitment,

- involves small enough a number of countries to enable an effective working relationship
among their respective departments and the international secretariat, to work like today's
OECD does, and

- and, yet includes all significant economies?

20. Our recommendation is that government representatives should consider using and
expanding the existing OECD resources and model to develop an international economic
surveillance mechanism which would include regular participation of key economies. In our view,
engaging the systemically significant economies in periodic peer reviews would make an important
contribution to multilateral surveillance and transparency by generating greater understanding by
policy-makers of macroeconomic conditions and structural policy issues, and by offering a more
effective mechanism for policy co-ordination. We understand that some steps have already been
taken to invite key non-member economies to certain meetings on economic forecasting, and we
support this orientation.

21. Independently of any active role in economic surveillance, OECD might be well situated to
improve collection and analysis of statistics and institutional information on financial markets,
particularly concerning the emerging markets and the increasingly diverse new types of investment
vehicles used (including, for example, hedge funds). OECD's non-binding character and the
absence of tensions related to funding might actually enable a more suitable environment to
information sharing in these sensitive areas.

*partie=titre What can business contribute? *partie=nil

22. If the OECD ends up assuming a greater role in economic co-ordination with key nonmember
economies, business would be interested and prepared to participate in a comprehensive,
albeit informal way in the surveillance process. BIAC’s experience with informal annual contacts
with the Economics Department secretariat on economic forecasting has proven to be a valuable
dialogue, appreciated because it enables better understanding of the thinking which underlies each
other's forecasts. More direct and regular participation of business representatives in EPC and
EDRC processes should be considered.

23. Business also stands ready to contribute to a dialogue with governments on the monitoring
of capital flows, including their destination and composition, and assessment of potential risks
associated with debt/investment stocks. OECD could consider utilising the private sector as a
sounding board to check if statistics collected and evaluation carried out in this area are consistent
with reality.

*partie=titre A continuing role for best-practice policy promulgation *partie=nil

24. While the view that OECD should be the focus of multilateral surveillance is not
necessarily shared by all in the business community, there is broader agreement for an OECD role
to provide guidance to other significant economies in the area of structural reform, including
taxation, financial systems, and labour policy.

25. More importantly, BIAC believes that there is a need for respectable international economic
co-ordination bodies such as the OECD to come out strongly against hasty policy activism aimed
at curing the symptoms of the current crisis, such as new regulations to limit short-term capital
movements. Before governments rush to implement such "temporary" measures, policy makers
should be reminded of the widespread tendency of short-term measures to become permanent. We
would urge that governments conduct a thorough evaluation of the costs and benefits of any
proposed regulations as recommended in the OECD’s Regulatory Reform work.

*partie=titre Multilateral Framework on Investment *partie=nil

26. BIAC considers that the OECD also has an important role in continuing to promulgate
high-standard rules throughout the global economy. For example, we believe that the effects of the
current crisis could have been mitigated if the Multilateral Agreement on Investment had already
been in force. With structures in place that support accountability, transparency and nondiscrimination,
(a) investor choices can favour enterprises with real competitive advantages, thus
promoting economic efficiency and growth, and (b) as a result, investor confidence can be
strengthened, reducing the risk of sudden widespread capital flight.

27. An international framework of rules guaranteeing non-discriminatory treatment of foreign
direct investment would not have exacerbated the current situation by “giving multinational
enterprises greater rights than sovereign governments”, but would instead have promoted stability
by giving companies the confidence to make long-term, direct investments less prone to capital
flight*{4}. Direct investment is recognised to be the preferable mode of capital inflow in order to
ensure better efficiency of investment, avoid diversion of funds to current consumption, or
generate relatively stable and predictable flows of capital, among other things – all factors
contributing to stability and confidence*{5}.

*{4 J. Frankel and A. Rose, 1996, "Currency Crashes in Emerging Markets: Empirical Indicators", NBER
Working Paper No. 5437, quoted in H. Reisen, 1998, "Domestic causes of Currency Crises: Policy Lessons for Crisis
Avoidance", OECD Development Centre Technical Paper No. 136, June.
5 H. Reisen, 1998, op. cit., p. 27, and work cited therein.}

28. BIAC believes there will inevitably be an MAI-type agreement at some point because such
an agreement would be an essential component of the international economic system. Many
countries outside the OECD area aspire to meet internationally-agreed expectations, as they wish
to encourage foreign investors to choose their markets. The OECD has a critical role in helping
shape an international consensus of such expectations. We hope that work will continue on this
important endeavour, and that the discussion of necessary high standards will include key nonmember
recipients of foreign direct investment.

*partie=titre Corporate governance *partie=nil

29. Similarly, BIAC considers that OECD guidance on corporate governance could – provided
that it adequately represents the shared views of OECD governments – contribute usefully both to
promoting a comprehensive examination of corporate governance practices and promoting
confidence of investors in emerging markets where OECD guidance is usefully applied. We hope
that the exercise will continue to aim at increasing transparency and accountability of boards and
managers to shareholders, especially in so far as it stresses directors' responsibility for risk
management and for the viability and solvency of their business. BIAC would expect to participate
in full to any review exercise and elaboration of its conclusions, to ensure an adequate reflection of
the variety of corporate governance cultures and practices.

*partie=titre Combating bribery *partie=nil

30. The OECD Convention on Combating Bribery of Foreign Public Officials in International
Business Transactions is a very important tool for improving transparency, and is strongly
supported by business. BIAC believes that its full and speedy implementation both within and
outside the OECD membership, combined with strong statements by OECD governments against
extortion (an issue not covered by the Convention), could help promote transparent structures and
investor confidence.

*{IV. Conclusion:} *partie=titre a Pro-active Role for the OECD requires Commitment *partie=nil

31. BIAC realises that the recommendations in this paper may involve a substantial reorientation
in the OECD’s operations and relations with non-Member countries. Moreover,
expanding the Organisation’s role in averting, or at least promoting better understanding of future
financial crises will clearly involve a new commitment by Member countries to provide adequate
funding. BIAC considers that these questions must be addressed if the OECD is to make a
meaningful, pro-active (and not simply reactive) contribution to restoring confidence and stability
in the international financial system.