First, at the recipient end, a crucial condition for living with financial globalisation is improvement of market structures to ensure that capital inflows are productively employed. That involves attention to structural issues, such as accountancy standards, bankruptcy laws, and governance questions. It involves appropriate sequencing of capital account liberalisation – and arrangements to ensure that the particular risks to the borrowing country, for example, attaching to volatile short-term inflows are properly recognised – and reflected in the price paid by the borrower. That in turn involves effective management of foreign currency assets and liabilities in particular, including management of their relative liquidity, by both the public and private sectors. It involves, also, ensuring that borrowers, and their creditors, are unambiguously clear as to who is ultimately responsible for the liability at the time it is taken on. It involves increased attention more generally to the soundness of financial systems – which is to be the subject of our discussion this afternoon. And perhaps above all it involves improved transparency – of policies, of standards, and of financial and economic data - to enable investors and lenders to make informed assessments of risks. But there is a great deal too that the international financial community can do, as it were from the provider end. This includes the intensive efforts being made, particularly by the IMF, to encourage sound macro-economic and structural policies – and greater transparency – in all IMF member countries.
Each option has its pros and cons. Let me start with floating. At first blush the idea of allowing the exchange rate to take the strain, as a kind of buffer, insulating the domestic economy from shocks emanating abroad appears very attractive. Unfortunately it does not necessarily work like that. A floating exchange rate may move erratically in response to market news, causing unwarranted movements in the real exchange rate. That, of course, may be an important influence on domestic costs and prices; it may affect the relative competitiveness of domestically and foreign-produced goods and services leading to changes in the net external trade position, affecting aggregate demand in the domestic economy. So the insulation provided by a floating exchange rate may prove to be more apparent than real. The UK has been floating since 1992. For some years we experienced very little tension between our domestic and external policy needs. But then, from the autumn of 1996 we saw a sudden appreciation of some 20-25% in our Effective Exchange Rate against the core European currencies, and seemingly, largely related to uncertainties about the future characteristics of the European single currency. Whatever the reason the strengthening of the exchange rate had a dampening effect on the domestic price level, and a subsequent deterioration of our trade balance (accentuated over the past year or so by the global economic slowdown) reduced aggregate demand in the economy. Monetary policy accordingly needed to be less restrictive than would otherwise have been appropriate to offset these effects on domestic demand.