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For release on delivery
1 00 p m EDT
September 16, 1998

Statement by
Alan Greenspan
Chairman
Board of Governors of the Federal Reserve System
before the
Committee on Banking and Financial Services
U S House of Representatives
September 16, 1998

As I testified before this Committee in the midst of the Mexican financial crisis in early
1995, major advances in technology have engendered a highly efficient and increasingly
sophisticated international financial system The system has fostered impressive growth in world
trade and in standards of living for the vast majonty of nations who have chosen to participate in
it
But that same efficient financial system, as I also pointed out in that earlier testimony, has
the capability to rapidly transmit the consequences of errors of judgment in private investments
and public policies to all corners of the world at historically unprecedented speed Thus,
problems that appeared first in Thailand more than a year ago quickly spread to other East Asian
economies that are relatively new participants in the international financial system, and
subsequently to Russia and to some degree to eastern Europe and Latin America Even
long-time participants in the international financial community, such as Australia, New Zealand,
and Canada, have experienced the peripheral gusts of the financial turmoil
Japan, still trying to come to grips with the bursting of its equity and real estate bubbles
of the late 1980s, has experienced further setbacks as its major Asian customers have been forced
to retrench Reciprocally, its banking system problems and weakened economy have
exacerbated the difficulties of its Asian neighbors
The relative stability of China and India, countries whose restrictions on international
financial flows have insulated them to some extent from the current maelstrom, has led some to
conclude that the relatively free flow of capital is detrimental to economic growth and standards
of living Such conclusions, in my judgment, are decidedly mistaken
The most affected emerging East Asian economies, despite the sharp contraction in their
economic output during the past year, have retraced, on average, only one-sixth of their per

-2capita growth over the past ten years Even currently, their average per capita incomes are more
than 21/2times the levels of India and China despite the unquestioned gains both have made in
recent years as they too have moved partially to join the international financial community
Moreover, outside of Asia, several East European countries have made significant
progress towards the adoption and implementation of market systems and have increasingly
integrated their financial systems into the broader world context to the evident benefit of their
populations Latin American nations, though currently under pressure, have largely succeeded in
opening up their economies to international financial flows, and more rapidly rising living
standards have been the result
It is clear, nonetheless, that participation in the international financial system with all its
benefits carries with it an obligation to maintain a level of stability and a set of strong and
transparent institutions and rules if an economy is to participate safely and effectively in markets
that have become highly sensitive to misallocation of capital and other policy errors
When domestic financial systems fail for lack of adequate institutional infrastructures, the
solution is not to turn back to a less turbulent, but also less prosperous, past regime of capital
controls, but to strengthen the domestic institutions that are the prerequisite for engaging in
today's international financial system
Blocking the exodus or repatriation of capital, as some of the newer participants in the
international financial system appear inclined to do after they get into trouble, is, of course, the
equivalent of the economy receiving a subsidized injection of funds If liquidity is tight, the
immediate effect of controls can be relief from the strain of meeting obligations and a temporary
sense of well-being This is an illusion however The obvious consequence of confiscating part,

-3or all, of foreign investors' capital and/or income, is to ensure a sharp reduction in the availability
of new foreign investment in the future
The presumption that controls can be imposed temporarily, while an economy stabilizes,
and then removed, gives insufficient recognition to the imbalances in an economy that emerge
when controls are introduced Removing controls subsequently creates its own set of problems,
which most governments, inclined to impose controls in the first place, are therefore loathe to do
Indeed, controls are often employed to avoid required--but frequently politically
difficult—economic adjustments There are many examples in history of controls imposed and
removed, but rarely without great difficulty and cost
To be sure, any economy can operate with its borders closed to foreign investment But
the evidence is persuasive that an economy deprived of the benefits of new technologies, and
inhospitable to risk capital, will be mired at a suboptimal standard of living and slow growth rate
associated with out-of-date technologies
It is often stipulated that while controls on direct foreign investment and its associated
technology transfer are growth inhibiting, controls on short-term inflows do not adversely affect
economic welfare Arguably, however, the free flow of short-term capital facilitates the
servicing of direct investments as well as the financing of trade Indeed, it is often difficult to
determine whether certain capital flows are direct investments or short term in nature Chile is
often cited as an example of the successful use of controls on short-term capital inflows But in
response to the most recent international financial turmoil, Chile has chosen to lower its barriers
in order to encourage more inflows
Those economies at the cutting edge of technology clearly do not need foreign direct

-4investment to sustain living standards and economic growth The economy of the United States
in the 1950s, for example, needed little foreign investment and yet was far more dominant in the
world then, than it is today
That was a major change from our experiences of the latter half of the nineteenth century,
when the vast amount of investment and technology from abroad played a significant role in
propelling the U S economy to world-class status
Even today, though we lead the world in many of the cntical technologies, we still need
to borrow a substantial share of the mobile pool of world savings to finance our level of domestic
investment Were we unable to do so, our standard of living would surely suffer But the inflow
of foreign capital would be much reduced if there were uncertainties about whether the capital
could be freely repatriated
While historically there could be considerable risk in American investments-for
example, some nineteenth century investments in American railroads entailed large losses-the
freedom of repatriation and the sanctity of private contracts were, with rare exceptions, secure
Our experiences, and those of others, raise the question of the sustainability of free
international capital flows when the conditions fostering and protecting them are impaired or
absent
Specifically, an economy whose private and/or public sectors have become heavy net
debtors in foreign currency is at risk of default, especially when its exchange rate unexpectedly
moves adversely Clearly, should default become widespread among a number of economies, the
flow of international capital to other economies perceived as potentially in similar circumstances
will slow and in certain instances reverse The withdrawal of the ongoing benefits of free

-5flowing capital, as recent history has so amply demonstrated, often can be abrupt and disruptive
The key question is obviously how do private sector entities and governments and, by
extension, economies as a whole allow themselves through currency mismatches to reach the
edge of insolvency9 Indeed, where was the appropriate due diligence on the part of foreign
investors9
Investors will, on occasion, make misjudgments, and borrowers will, at times, misread
their capabilities to service debt When market pnces and interest rates adjust promptly to
evidence of such mistakes, the consequences of the mistakes are generally contained and, thus,
rarely cumulate to pose significant systemic risk
There was some evidence of that process working in the latter part of the nineteenth
century and early twentieth century when international capital flows were largely uninhibited
Losses, however, in an environment where gold standard rules were tight and liquidity
constrained, were quickly reflected in rapid increases in interest rates and the cost of capital
generally This tended to delimit the misuse of capital and its consequences Imbalances were
generally aborted before they got out of hand But following World War I such tight restraints
on economies were seen as too inflexible to meet the economic policy goals of the twentieth
century
From the 1930s through the 1960s and beyond, capital controls in many countries,
including most industrial countries, inhibited international capital flows and to some extent the
associated financial instability-presumably, however, at the cost of significant shortfalls in
economic growth There were innumerable episodes, of course, where individual economies
experienced severe exchange rate crises Contagion, however, was generally limited by the

-6existence of restrictions on capital movements that were at least marginally effective
In the 1970s and 1980s, recognition of the inefficiencies associated with controls, along
with newer technologies and the deregulation they fostered, gradually restored the free flow of
international capital prevalent a century earlier In the late twentieth century, however, fiat
currency regimes have replaced the rigid automaticity of the gold standard in its heyday More
elastic currencies and markets, arguably, are now less sensitive to and, hence, slower to contain
the misallocation of capital Market contagion across national borders has consequently been
more prevalent and faster in today's international financial markets than appears to have been the
case a century ago under comparable circumstances
As I pointed out before this Committee almost a year ago, a good part of the capital that
flowed into East Asia in recent years (largely in the 1990s) probably reflected the large surge in
equity prices in most industnal economies, especially in the United States The sharp rise
induced a major portfolio adjustment out of then perceived fully priced investments in western
industry into the perceived bargain priced, but rapidly growing, enterprises and economies of
Asia The tendency to downplay the risks of lending in emerging markets, reinforced by the
propensity of governments explicitly or implicitly to guarantee such investments in a number of
cases, doubtless led to an excess of lending that would not have been supported in an earlier age
As I also pointed out in previous testimony, standards of due diligence on the part of both
lenders and borrowers turned somewhat lax in the face of all the largess generated by abundant
capital gains and all the optimism about the prospects for growth in the Asian region The
consequent emergence of heavy losses and near insolvency of a number of borrowing banks and
nonfinancial businesses engendered a rush by foreign capital to the exits and induced severe

-7contractions in economies with which borrowers and policymakers were unprepared and unable
to cope
At that point the damage to confidence and the host economies had already been done
Endeavors now to block repatnation of foreign funds, while offering temporary cash flow relief,
have significant long-term costs and clearly should be avoided, if at all possible I recognize that
if problems are allowed to fester beyond the point of retrieval, no market-oriented solution
appears possible Short-term patchwork solutions to achieve stability are presumed the only
feasible alternatives When that point is reached, an economy is seen as no longer having the
capability of interacting normally with the international financial system, and is inclined to
withdraw behind a wall of insulation
It must be remembered, however, that the financial disequilibria that caused the initial
problems would not have been addressed Unless they are, those problems will reemerge
As I implied earlier with respect to the nineteenth century American experience, there are
certain conditions precedent to establishing a viable environment for international capital
investment, one not subject to periodic systemic crises
Some mechanism must be in place to enhance due diligence on the part of lenders, but
especially of borrowers individually and collectively Losses of lenders do on occasion evoke
systemic risks, but it is the failure of borrowers to maintain viable balance sheets and an ability
to service their debts that creates the major risks to international stability The banking systems
in many emerging East Asian economies effectively collapsed in the aftermath of inappropriate
borrowing, and large unhedged exposures, in foreign currencies
Much will be required to bolster the fragile market mechanisms of many, but certainly

not all, economies that have recently begun to participate in the international financial system
Doubtless at the head of the list is reinforcing the capabilities of banking supervision in emerging
market economies Conditions that should be met before engaging in international borrowing
need to be promulgated and better monitored by domestic regulatory authonties
Market pricing and counterparty surveillance can be expected to do most of the job of
sustaining safety and soundness The experience of recent years in East Asia, however, has
clearly been less than reassunng To be sure, lack of transparency and timely data inhibited the
more sophisticated risk evaluation systems from signaling danger But that lack itself ought to
have set off alarms As one might readily expect, today's risk evaluation systems are being
improved as a consequence of recent failures
Just as importantly, if not more so, unless weak banking systems are deterred from
engaging in the type of near reckless major international borrowing that some systems in East
Asia engaged in dunng the first part of the 1990s, the overall system will continue at risk A
better regime of bank supervision among those economies with access to the international
financial system needs to be fashioned ' In addition, the resolution of defaults and workout
procedures require significant improvements in the legal infrastructures in many nations seeking

1

Parenthetically, a century ago, banks were rarely subsidized and, hence, were required
by the market to hold far more capital than they do now In today's environment, bank
supervision and deposit insurance have displaced the need for high capital-asset ratios in
industrial countnes Many of the new participants in the international financial system have had
neither elevated capital, nor adequate supervision This shortfall is now generally recognized and
being addressed

-9to participate in the international financial system 2
None of these critical improvements can be implemented quickly Transition support by
the international financial community to those in difficulty will, doubtless, be required Such
assistance has become especially important since it is evident from the recent unprecedented
swings in currency exchange rates for some of the emerging market economies that the
international financial system has become increasingly more sensitive than in the past to
shortcomings in domestic banks and other financial institutions The major advances in
technologically sophisticated financial products in recent years have imparted a discipline on
market participants not seen in nearly a century
Whatever international financial assistance is provided must be carefully shaped not to
undermine that discipline As a consequence, any temporary financial assistance must be
carefully tailored to be conditional and not encourage undue moral hazard
It can be hoped that despite the severe trauma that most of the newer participants in the
international financial system are currently expenencing, or perhaps because of it, improvements
will emerge to the benefit, not only of the emerging market economies but, of the long-term
participants of the system as well

?

There are, of course, other reforms that I believe need to be addressed These were
outlined in my earlier testimonies before this Committee


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102