Since I assumed the post of OECD secretary-general in 1996 the global economic outlook has never been as uncertain and disquieting as it is today in the summer of 2003. Some have referred to the “perfect storm” of unforeseen events which have done much to undermine confidence in the future, a future which seemed so rosy just a short time ago during the era of the bubble. Remember talk of the “end of the business cycle,” the Dow at 35000, the irreversible locomotive of the new economy and the prospect of global free trade and investment destined to eradicate poverty in the developing world and engage all in a universal partnership on the road to peace and prosperity? Well, it has not quite happened that way.

The perfect storm caught us all by surprise. True, some had the wisdom to reject the “irrational exuberance” of a bull market that attributed huge capitalizations to dot.com companies with no earnings and little prospects of ever having any, and other areas of the economy such as telecoms, which had massively over-invested in infrastructure and expansion with concomitant shareholder dilution. But who could have foreseen the events of Sept. 11, 2001, the continuing threat of terrorism, the war in Iraq, corporate mischief or even fraud with the complicity of reputable auditing firms and investment bankers, the breakdown in corporate governance and the disregard by corporate executives of shareholder interests as opposed to their own. Who could have predicted the onset of SARS with its impact on tourism, business travel, and even trade and investment (which hopefully will be short lived)? A storm indeed, leaving much wreckage in its wake. But the resilience of our economies has also been confirmed because, despite all this, the global economy is still afloat and still growing. In my judgment this has much to do with the remarkable evolution of the global financial system.

While risks remain skewed to the downside, at the OECD we still foresee a near-term recovery. In this environment, it will be critical that financial markets, both domestic and international, continue to operate effectively and play their role in supporting recovery. As we have seen, when financial systems perform badly they can hold back a recovery and depress both short term and longer term economic performance. The Asian crises of the late 1990s and the continuing banking problems in Japan bear dramatic witness to this.

Taking a global perspective, what are the developments and factors, some of them recent and others ongoing, that have contributed to the growth and expansion of international financial markets and helped us to weather the storm? The disruptive events of the kind I have referred to have at times posed severe problems for policy makers, who have generally responded quite well. That said, there still remain issues to tackle, particularly regarding the restoration of confidence, which has been and remains severely shaken. This can be attributed more to a lack of faith in the integrity of our own stock markets than to geopolitics or terrorism.

For some time now, OECD countries have been living with the reality of increasingly globalized financial markets. One dramatic illustration of this is the growth in the volume of daily foreign exchange transactions. Every three years, the Bank for International Settlements publishes the results of its survey on this and the volume has been trending up dramatically. The drop-off in the most recent survey is due to the introduction of the euro and the elimination of the need to trade various European currencies. Just to give an idea of the orders of magnitude involved, the daily turnover was close to $1.2 trillion in 2001, the latest year for which information is available, compared with just over $1 trillion in 1989. Similar trends can be observed in other markets, such as equities and bonds.

The rapid globalization of these markets has been driven by a number of well-known factors. An important one has been financial-market liberalization. In OECD countries, financial markets have been significantly deregulated. This has permitted financial institutions to offer a wider variety of services and products to meet the needs of increasingly sophisticated borrowers and investors. An additional supporting factor has been the rapid and far-reaching improvements in technology, particularly information technology. Now market participants can not only stay in touch with what is happening but also react quickly and deal with counterparts all over the world. A third has been innovation in financial markets themselves. There are now a host of financial products, such as derivatives, which are available as investment vehicles or as methods to transfer risk.

Internationally, this expansion has largely followed trade and direct investment. Logically, as markets for goods and services have opened up, the need for financial services has grown. In addition, savers and financial institutions have increasingly recognized that there are advantages to channelling their savings into assets in other countries. By diversifying portfolios internationally, savers can increase their returns, without dramatically bearing more risk. On the receiving end, countries that do not have enough internal savings to achieve their potential can use international financial markets. Of course, to obtain access to international financial markets countries must up-grade the the governance of their financial systems. This in turn also improves the intermediation of domestic savings into productive investment, a source of finance that usually dwarfs the financial role of foreign direct investment. The latter of course brings added benefits of technology and management expertise, which in many cases is more valuable than the accompanying capital. 

The OECD membership and the Secretariat have also played a key role in promoting liberalization of financial markets. An important condition of membership in the Organisation is adherence to the OECD instruments, such as the Code of Liberalisation of Capital Movements, the Code of Liberalisation of Invisible Operations and the national treatment instrument. Briefly, these require countries to accept the obligation to remove or move towards removing all restrictions on capital movements and to permit foreign financial institutions to operate on an equal competitive footing with domestic institutions, both within their own markets and on a cross-border basis. In addition to promoting liberalization through its instruments, the organisation has encouraged member countries to deregulate and to modernise their domestic markets. The OECD believes that financial modernization and innovation have resulted in substantial benefits to our citizens while making our economies more flexible and more able to deal with emerging problems.

For the most part, in spite of enormous growth and change over the past decade or so, international financial markets have functioned smoothly. For example, even though the volume of foreign exchange transactions has more than doubled, there has been no particular trend in volatility among major foreign exchange rates, as illustrated in Figure 1. This is also true for stock and bond markets. That is encouraging. But the really worrisome problems arise not from volatility but from major sharp disruptions, and there have been a number of these over the past 15 years. Often the effects have spread quickly from one country to another. International integration of financial markets is so deep and so complex that OECD has faced a real challenge to identify the transmission mechanisms. Some of the better-known examples of disruption are:

• The 1987 stock market crash

• The 1995 Mexican crisis

• The 1997 Asian crisis

• The 1998 Russian crisis

• LTCM (long-term capital management) in 1998

• Argentina in 2002

• The current equity market correction.

These disruptions have raised a number of issues and challenges for policy makers.

When markets are hit by a shock, it is critical that they remain liquid. Without adequate liquidity, the financial sector cannot perform its role. During the October 1987 stock market crash, an event that started in the United States and quickly spread to other national equity markets, major central banks responded by injecting liquidity into financial markets. Similar timely responses were made during the LTCM debacle as well as during and after the terrorist attacks on September 11, 2001. These actions were crucial at a time of heightened uncertainty. They ensured that markets continued to function and helped enormously to limit potential damage to the financial sector. They are a major reason why there were no longlasting effects. The value of remaining in close contact with private-market participants has also been proven.

A number of middle income economies that depend heavily upon private capital flows have also experienced grave difficulties. Mexico and the countries of East Asia, including Korea, are examples. Unlike pre-1990 crises in emerging markets, large fiscal deficits were not always the root cause of external financing crises. These more recent crises were distinguished by a fixed, or quasi-fixed exchange rate system; excessive domestic expenditure, sometimes driven by the private sector; an inflation rate that was inappropriate for the exchange rate regime; and banking systems that were poorly equipped to intermediate credit on a market-oriented basis. These conditions combined to create what in retrospect were unsustainable situations.

In the aftermath of these crises, many of these countries adopted floating exchange rates and moved rapidly to put in measures to restore macroeconomic stability. Strengthening the domestic financial system was a high priority in all cases. After the Asian crisis, in particular, awareness grew of the urgent need to improve corporate governance practices. It is fair to say that, while no country has a perfect record, significant reforms have been implemented in most crisis countries and virtually all have returned to international capital markets. Korea is an important example where significant reforms were instituted, and it seems to have sailed through the recent economic downturn in remarkably good shape. At the same time, international investors have become more careful about lending. They are making more effort to evaluate the risks involved, in part because these exchange rates are now flexible.

It is not very wise policy to just wait and react. Policy makers must be forward-looking and identify existing problems that have not yet boiled up to the surface. But because we are talking about international financial markets, we need to think about international co-operation and information exchange— among the various official bodies, but also, where possible, with the private sector.

A number of fora do precisely this. Within the OECD, several committees of senior officials meet regularly to discuss issues that are relevant to the smooth working of the global economy and, in particular, the international financial system. Some of these committees focus on macroeconomic policy and others on various aspects of financial markets— banks, capital markets, insurance companies, pension funds and corporate governance, to name some of the more important aspects.

Much of this work has led officials to be more concerned about financial stability. While this is always an issue, a number of central banks have recently created special departments on financial stability and begun to publish regular reports on it. International efforts to coordinate financial supervision is also progressing at institutions such as the Basel Groups for banking, the International Organisation of Securities Commissions (IOSCO) for securities markets, and the International Association of Insurance Supervisors (IAIS) for insurance. Another important high-level forum for the exchange of this type of information is the Financial Stability Forum (FSF). The FSF brings together representatives of central banks, supervisory bodies, finance ministries and international organizations like the OECD to identify issues of concern for international financial stability. Major industrial countries and key emerging markets are represented. The function of the FSF is to ensure that all potential systemic issues are being addressed by a qualified body and duplication of effort is avoided.

A good example of co-ordination and co-operation is the current work undertaken with regard to the Basel Accords on Capital Adequacy. Over the past two decades, banking supervisors have worked together to develop a set of internationally recognized standards, norms and best practices. The original accords, agreed to in the 1980s, set minimum international standards for capital, that banks were expected to hold against various categories of assets. These standards are now being refined to reflect the various gradations of risk and different kinds of risk that banks typically assume, while also taking into account the growing capability of banks to identify and manage their own risks.

Unfortunately, the general public may not be fully aware of the extent of international co-operation that has already been achieved through this international network that is working to protect the integrity and smooth functioning of financial markets and hence the interests of the public at large.

All these developments have helped to improve the functioning of the financial sectors in the global economy. But there remain a number of challenges, some of particular significance, which have become apparent in the recent economic downturn.

Some parts of the financial sector have weathered the recent storms quite well. Banks have generally come through this period in relatively good shape. Outside of Japan and Germany, the evidence suggests that creditworthy borrowers do have adequate access to funds. This good performance is due to lessons learned from previous periods of difficulty. These institutions have developed much more robust risk management systems. As well, there are new products that have permitted them to better manage their risks. These risks, however, have moved elsewhere, hopefully to institutions that are better able to bear them. But it is not possible to be sure of this since there is insufficient transparency (or a lack of good data) on such risk transfer activities. This remains a matter of serious concern.

Since early 2000, international equity markets have been undergoing their most painful correction in a generation. The major stock exchanges have fallen 40 percent from their early 2000 peaks, with the “growth exchanges,” specialized in high tech companies, falling much more. Meanwhile defaults and the downgrading of corporate debt are at near record levels. Nevertheless, corporate bond markets have continued to function well. Risk spreads, after peaking late in 2002, have since come back down to levels consistent with historical norms. That said, the market for very high risk borrowers has not as yet come back, although this may be understandable given the continued hesitancy of the recovery and the increased risk aversion of investors.

The institutional investor sector has been battered by events of the past few years. The terrorist attacks of 2001 aggravated the already shaky profitability of property and casualty insurance companies. Life insurance companies, which accept long-term commitments to policyholders, must finance these liabilities through their own investment portfolios. In the 1990s, life insurance companies aggressively expanded business in investment-type products, including many with guaranteed returns, and are now suffering the consequences of bearish conditions in bond and equity markets. Similarly, many defined benefit pension plans developed large-scale funding gaps, since they were based on relatively optimistic assumptions concerning future returns on pension fund assets. The post-2000 correction has also left many large corporations with funding gaps in their pension schemes that are aggravating already serious problems of balance sheet quality.

A number of well known events that occurred during the downturn as part of the perfect storm I referred to earlier have created in their wake a legacy of mistrust. Prominent examples are the Enron, WorldCom and Global Crossing debacles, the accounting and auditing scandals surrounding the large Dutch firm Ahold, and the settlement with major Wall Street firms of cases of serious conflict of interest between their analysts and investment banking activities. These are events that have impaired confidence to a significant degree. In their aftermath, there has been a dramatic increase in the number of firms that have had to restate their accounts, as seen in Figure 2. Stock markets, which in some cases still appear to be somewhat overvalued, are being weighed down by this atmosphere of mistrust. Weak stock prices have meant a virtual drying up of the market for Initial Public Offerings and are impeding funding for new innovative firms.

At heart this is a governance issue, and it affects all aspects of how corporations interact with the financial system. In the worst cases, there was inadequate oversight on the part of boards of directors as to how firms were investing funds. In addition, auditors were not acting in an independent fashion, often because their own firms were heavily dependent on consulting fees from the enterprises that they were auditing.

The ongoing process of reform and integration of financial markets will, in all likelihood, give rise to new challenges for policy makers as well as active participants. We must continue to make progress and regain confidence that we have institutions that are flexible enough to deal with these future developments. The rewards of having a well-functioning and efficient financial system are real and tangible. OECD’s recent growth project finds that these markets play a critical role in supporting investment spending as well as in financing innovation. These are key factors when combined with the right structural policies, and they will perhaps reignite our dreams of the bright future we foresaw only a few years ago.