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Proceedings of the Standing Senate Committee on
Foreign Affairs

Issue 10 - Evidence


OTTAWA, Wednesday, March 11, 1998

The Standing Senate Committee on Foreign Affairs met this day at 3:20 p.m. to examine and report on the growing importance of the Asia-Pacific region for Canada (the impact of the Asian financial crisis on Canada).

Senator John B. Stewart (Chairman) in the Chair.

[English]

The Chairman: Honourable senators, we are beginning our work on the importance of the Asia-Pacific region to Canada and, specifically, our other concern is the impact of the Asian financial crisis on this country.

We have three expert witnesses before us today. They are, listed in alphabetical order of the bank names, representatives from the Canadian Imperial Bank of Commerce, the Bank of Montreal, and the Royal Bank of Canada.

I have biographical information on our witnesses which is highly detailed and very impressive. However, I suspect that, for the purposes of our record, it would be better to get on with hearing directly from the witnesses. Before I do that, I understand that we have guests here from several other countries -- Australia, Japan, and Russia, at least. Welcome to those visitors.

Witnesses, please proceed.

Mr. Joshua Mendelsohn, Senior Vice-President and Chief Economist, Canadian Imperial Bank of Commerce: I do not have a formal, prepared, introductory comment. I will focus on a few points. First, we should not assume that we are even past the financial crisis in Asia at this point. The region has the potential for many more surprises. That could lead to increased volatility in financial markets.

Perhaps more directly relevant to the Canadian economy and other economies, we have yet to suffer or to struggle through the economic restructuring and pain that will be going on within the Asian region. In some countries, that restructuring will lead to severe recessions and, in others, to severe slow-downs in growth and, with that, the potential for social and political instability.

Everyone is quite familiar with the developments in Indonesia, which is perhaps the most worrisome area. The potential is there for that to spread to other parts of Asia, particularly because of Singapore's reliance and relationship with Indonesia and Malaysia.

Of course, the key transmission link to North America and Europe is Japan, which will be one of the hardest hit countries and which is currently suffering stagnation, and its situation will be made that much more difficult because of other developments in Asia. Japan is itself contributing to some of the problems in Asia because of its inability to become one of the locomotives for helping Asia out of its problems.

There are other risks in the region, such as the continued indulgence of China in terms of not devaluing its currency and, in that sense, not adding to the turmoil in the region. I am sure, through the course of these discussions, some of these issues will be raised.

A number of estimates have been made of the effects on North America in particular and Canada more specifically. The difficulty with all the estimates is our inability to get a good measure of just how severe and how prolonged the Asian situation will be. Certainly Canada, at the very least, will face a similar effect to the United States, even though our trade with Asia, as a proportion of our total trade, is substantially lower than that of the United States. The fact that the trade sector in Canada is so much larger as a proportion of our economy than it is in the United States does not means the effects will be that different.

We must bear in mind some additional elements. Canada is a much more commodity-oriented country than the United States but far less so than Australia, despite the fact that the markets do not distinguish that. We do pay the price for the commodity price reductions even if those commodities do not go to Asia.

As well, we can get an additional knock-on effect from the United States. To the extent that the United States' economy slows down -- whether as a direct result of Asia or an indirect result of knock-on effects through other parts of the world affected by Asia -- we will feel it in Canada.

On a regional basis, of course, one is immediately focused on a province like British Columbia with all its resources, particularly the forest sector, and its much larger proportion of trade with Asia than any other province. The difficulties in that province are quite evident for anyone who has visited there in the last little while. There were difficulties there before Asia's problems started, beginning with the lumber exports to Japan, but the problems have been compounded in the last six to eight months.

Through the indirect effect on the United States, other parts of Canada will be affected. Again, it depends on the economic structure of any province or region. In terms of agriculture, some regions will be hurt even though they do not appear on the surface to have a strong tie to Asia.

Having put all these negatives forth, we should also look at some of the positives. Amongst those positives is the fact that Asia will contribute to keeping inflation down in North America. It will contribute to keeping monetary policy in the United States at bay for the time being. That in itself will help prolong the economic cycle, and that will help a good part of Canada, although not all of it, depending on the segments that trade to a greater or lesser degree with Asia.

I will let my colleagues pick up on these or other areas, and I would welcome any and all questions and discussion as we proceed.

Mr. Tim O'Neill, Executive Vice-President and Chief Economist, Bank of Montreal: Honourable senators, I have provided paper copies of my overheads if you wish to follow along. I will go through these with sufficient dispatch in order that I not hold up the proceedings.

The first chart lays out the factors that have influenced the Asian crisis. Overvalued currency, external imbalance, current account deficit, and significant short-term, foreign-held debt were causes of the initial shock in the system. It is important to focus on the fragility of the financial sector. Mr. Mendelsohn mentioned risks.

Economists and others describe as a moral hazard the problem of having borrowers and lenders, especially lenders, in the domestic Asian economies anticipating that if they do run into problems they will be bailed out. Foreign creditors operate in Asia under the assumption that they can take and make riskier investments and worry less about the consequences than they might in another environment. There is a problem of government-directed lending, but this is most profoundly a problem of weak, regulatory oversight.

The risks are there not only in terms of what may happen if Japan is weaker than we are currently expecting or in terms of if China devalues. Even a country like Indonesia, small as it is, can have a significant impact on Japan and Korea's banking sector because of the significant exposure that those banks have to Indonesia.

If one takes the Mexican crisis as a measure or an indicator of how quickly a region may bounce back, there are two critical differences. First, Japan is not the U.S. Japan is a very weak economy right now. Japan is not in the position that the U.S. was when Mexico went into the crisis in 1995. Second, there are significant intra-regional linkages in trade and finance in Asia that did not exist in Latin America, at least with respect to Mexico. Mexico was significantly tied to the U.S. economy and not to Argentina or Brazil. They, in turn, were affected in a limited way by the contagion from Mexico. That would be and has been a far more significant problem in Asia.

The next two or three charts simply point out what has happened to the currencies. The most obvious problem area is Indonesia. Indonesia is a problem that we can talk about at greater length.

The third and fourth charts address the impacts on the currencies in Asia. There has been an almost 80-per-cent decline in the value of the rupiah and significant declines in the Korean won and other Asian currencies. Similarly, you see stock market impacts.

In particular, please note that although Hong Kong has a pegged currency and Singapore experienced minimal impact on its currency, nonetheless the stock markets were significantly affected. There are two reasons for this: First, regarding the trade flow impacts, there is a significant linkage among the economies; and, second, there are financial institutions in both Hong Kong and Singapore that have significant exposures in Asia.

The next chart shows our forecasts for the growth in east Asia. For 1998, Japan is basically flat and China is down significantly from a few years ago. If you take Japan and China out of the picture, the ASEAN economies, east Asian countries and Korea, in particular, are actually in decline.

Indonesia, Thailand, and South Korea will be in recession this year. The worst will be Indonesia, with about a 6-per-cent decline. In our estimation, Korea and Thailand will have about 3-per-cent declines, as they will be getting some benefit on the export side. Iin the domestic economy, the hit will be even larger.

Mr. Mendelsohn made reference to the risks: the possibility of the Japanese recession, the contagion effect from Indonesia, Chinese devaluation, and South Korea, although it looks now as if they are prepared to put in place reforms required by the IMF package. There is also some potential for political and social unrest that may cause -- I would not say an unravelling -- but could cause a low risk of a reversal there.

Moving on to Latin America, I point out that the economy that was most affected but was already weak to begin with is Brazil. Latin America is in better shape than it was in the context of the Mexican crisis.

Moving to North America, and going through the channels through which the Asian crisis can have an impact on North America, exports to Asia obviously will decline. Imports from Asia will increase, primarily because of the significant currency devaluations. There is a question about how soon that will occur and how significant that will be, in part because many of the Asian economies have had trouble since the crisis obtaining, for example, export credit. At least temporarily, the so-called flood of imports from Asia has not been evident. However, I would not expect that we will see that continue forever.

Commodity price impacts have already been addressed -- most notably from a Canadian context, forest products and base metals. The grain exports to Asia will probably not be as affected by the crisis, but there will be some impact.

Wealth also affects the stock market and real estate. The blows received in October to the real estate market in British Columbia are an example.

Another wealth affect could well be on consumption spending. It has not been significant in North America. The stock markets are now at a better stage than they were at the time of the crisis. I am now talking about mid-October. The markets have actually gone beyond the highs they reached in the middle of last year.

Third country impacts refers to cases where it is not just the competition for domestic producers within North America from Asian imports but also competition in Europe and Latin America and other markets from potential displacement by cheap Asian exports to those economies.

I include monetary policy simply to make the point for those of my colleagues -- and I do not think either of the people sitting next to me are among that group -- who think deflation is a real possibility. If there were a significant impact on the economies, which I do not think will happen in North America, the monetary authorities obviously have the capacity to neutralize that through increasing liquidity in the economy, much as the Fed did -- I think overdid it -- after the stock market correction in 1987.

I do not think there will be deflation. We can talk about that later at greater length, if you wish. If there were a risk of that, then I believe the Bank of Canada, the Federal Reserve, and other central banks would step in to prevent that.

The next chart indicates that, if you take exports to the Asian economies as a percentage of GDP, it is just under 2 per cent for Canada and about 2.5 per cent for the U.S. The U.S. has a more significant volume of trade; however, as has been mentioned, they are a far less open economy than Canada. When one compares shared GDP, Canada and the U.S. are fairly close in terms of their reliance on Asian markets. That goes to the point about the transmission mechanism for impact. It will be relatively modest.

The next two charts show that the Asian crisis accelerated a trend that was already evident as at late 1996.

We think of that solely in terms of the U.S. dollar, but the Canadian dollar had been strengthening, until very recently, against all other currencies, and there were consequences with regard to our exports to Asia. The growth rates had fallen from late in 1996, and then actual export levels declined after the middle of 1997. You should note that that was before the real crisis, when the crisis involved just the ASEAN economies.

If you look at imports, you get exactly the same kind of picture, just the flip side. You have import growth rates rising from mid 1996, and then you see what has happened since the end of 1996.

That leads then to the next chart, which shows the impact on Canada.

I am sure you are all avid readers of the forecasts of all the bank economists, but, in case you do not remember, in October we put out a forecast.

Senator Bolduc: A forecast for when?

Mr. O'Neill: Right now, as of today. The forecast we had for 1998, in early October of 1997, would have been about 4 per cent, and the forecast for 1999 would not be much different from what I am showing you here. The point I make with this is that the impact on Canada is relatively limited. We are talking about, at most, 0.5 per cent on growth, and a similar number for the United States. The rest is thrown in for your own interest. You can see that if anyone had to worry about the potential for deflation, given that we are very close to zero inflation, we would be the ones. Yet most of the discussion about deflation is coming out of the U.S., not out of Canada.

This also shows that the unemployment rates will be going down, interest rates will continue to remain relatively low, and there will be a modest improvement in the Canadian dollar.

The next chart takes you to the regional impacts. You can see the percentage of exports to Asia for British Columbia. The highest absolute level of exports is at about $8.5 billion in 1996. Those are forest products, coal, and base metals. Those are key areas that will be affected by the Asian crisis.

The chart for Alberta deals with petrochemicals and crude oil. Petrochemicals will suffer a relatively limited impact. The problem with oil prices is partly due to the Asian crisis, but it is also due to Saudi Arabia and Venezuela playing the game of who will blink first in reducing output levels, as well as an impact from the prospect that Iraq will come back into the market.

Next, I deal with the impacts on Ontario and Quebec. Direct impacts are very modest because of the modesty of the relationship with Asia. The indirect impact to which Mr. Mendelsohn made reference would come through any impact on the U.S. economy, but I think that also will be limited.

The next chart simply goes through the top exports to the world from Asia, and you can see that the key exports are in areas, except for motor vehicles, where there is a relatively limited direct impact on Canada. However, if the impact on the U.S. were substantial, it obviously would have second-round effects in Canada.

The top areas of export from Canada are raw materials and semi-finished products, and they have been hit. They were hit by weaker commodity prices to begin with, which is shown on the next chart. The commodity price environment was not a real winner to begin with. There was a significant decline in 1996. Commodity prices were tracking sideways through 1997 until October, and then you can see the Asian impact as it occurred after mid-October. The Asian crisis simply added to an already weakened environment.

The final chart is the impact by sector. I should like to make just a few points. In the first four on the left-hand side, the impact is on both prices and on demand volumes. In the case of coal, Indonesia can actually displace Canadian production. It is not merely how big a demand level you have in Asia as a result of the weaker economies that determines that level, but there is actual direct competition in the coal market.

Next is the effect on steel and petrochemicals. Price weakness and the third-country market-penetration problem, where Asians displace Canadian and U.S. production, are not significant, but they are there.

Next is transportation equipment and the effect on North American imports rather than potential to displace domestic production. We must remember that the automobile industry has been particularly effective in the U.S. in finding ways to get Congress to impose voluntary export restraints. I suspect we may see some of that in the fall if, in fact, there is some significant impact on car producers.

The right-hand side deals with semiconductors and computers. That is an issue for the U.S. and not a big issue for Canada. It is mainly an issue for the south-west, California and Texas, but it could have indirect impacts on Canada.

Tourism is a West Coast issue primarily, although I suspect that our friends in Prince Edward Island will see fewer Japanese tourists coming to see Anne of Green Gables' house.

Finally, with regard to the financial services sector, I would simply make the point that we have limited direct Canadian exposure. There may even be opportunities for Canadian financial services institutions to provide advice to Asia about how to restructure its financial system. I do not hold out great hope for that. Our friends in the U.S., who have in some cases made some mistakes in their risk taking, may also be able to sell their advisory services to demonstrate how you can manage risk. Notwithstanding the fact that they may not have been excellent practitioners, they may find a way to offset their recent losses with fees for advice.

Mr. John McCallum, Senior Vice-President and Chief Economist, Royal Bank: My two learned brethren have put much on the table, and at some length. I am not sure what is left for me to say. I will try to focus on just a few issues.

We sometimes distinguish between uncertainty and risk. With risk, we at least know the parameters and the probabilities; uncertainty is more characterized by ignorance. I would say the Asian crisis is more in the category of uncertainty because we have not done this before. It is rather like the year 2000 computer problem. We have not had experience with changing millennia. While I agree fully with the mechanisms, we really do not know how this will evolve and what the order of magnitude of these impacts will be.

I would like to also speak about the IMF. The IMF is under attack from the left and the right, one might say. Perhaps that means on average they are doing okay, but I am not sure. From the left, and this is compounding the problem in Indonesia, it is being said that they are prescribing things that are inappropriate. The problem in Asia is not big deficits, so why prescribe cuts in government spending? It is also said by many in Asia that the IMF is using this as an excuse to advance U.S. interests in terms of letting U.S. companies buy up their companies at fire-sale prices and micromanage their domestic economy, particularly in Indonesia.

It has also not gone unnoticed in Asia that one of the main countries not to get hit by this crisis is the least open of all the countries, China, with its currency that is still non-convertible. A big debate will ensue, partly in opposition to the IMF but also more generally. This has put in question the argument that everyone is better off if you open up borders, liberalize your capital account, and so on. In my view, the answer is that these countries are not and should not turn back to closed economies.

The order in which you liberalize is very important. The crucial requirement is to get your own domestic institutions right, notably your banks, and then liberalize your capital account and allow short-term capital flows to come in and out. However, if you open yourself to these short-term capital flows with extremely weak domestic institutions, you are asking for trouble. I think this will be on the table.

Another way in which the IMF is under attack from the right -- I am not sure "right" is the correct word -- relates to this issue of moral hazard. The idea is that if you bail someone out, you will only encourage more reckless behaviour down the road, thereby leading to ever-larger crises. I think the IMF acknowledges this and does not yet have a solution. Before Christmas, they looked at the possibility of a Korean financial collapse, and they blinked. They accepted a little more moral hazard because they were afraid of the global implications; hence, they threw a lot of money at Korea and other countries.

I think I heard Stanley Fisher say -- and he is the number two person at the IMF -- that there is a moral hazard problem. The moral hazard does not apply to the countries; rather, it applies to the lenders. In particular, it applies to banks and to sovereign debt.

The IMF agenda is such that they want to find a way so that next time around they do not have to bail out western banks and those who lent money to the countries. I think we will see a great deal of debate -- acrimonious debate in some cases -- on the role of the IMF and where we go next in terms of opening up countries for liberalization.

Indonesia clearly is in a terrible and scary state. The linkages between Indonesian countries such as Malaysia and Singapore are major. The possibility of real violence and ethnic tension is great.

South Korea, on the other hand, looks to be in good shape. In their case, we should be cautious. We have a president who is very much in a honeymoon period. So far, he seems to be doing exactly the right things; yet, the real pain has scarcely begun. He must have staying power over a period of at least 12 or 18 months, when many people will be laid off and many companies will go bankrupt. That has hardly begun. Whether he will be able to survive beyond his honeymoon period and remain in a honeymoon phase or in control, given Korea's historically militant labour force, remains to be seen. However, it is true that Korea looks good at the moment.

My colleagues have covered the main points on the impact on Canada, and I do not disagree with what they said.

First, with respect to exports, only 8 per cent of our exports are to Asia, but it is extremely unequal across the country. It is essentially trivial for Ontario -- 3 per cent of Ontario's exports versus 35 per cent for British Columbia.

Second, with respect to imports, we are talking about a flood of cheap Asian goods into North American markets. To date we have not seen much of this, partly because some of the companies in these countries are having trouble getting their hands on working capital, but I think that will come. The industries likely to be adversely affected are the ones on Mr. O'Neill's list, such as steel, autos, consumer electronics, and so on.

Third, with respect to commodity prices, this is extremely important. Alberta is booming, but I do not know how long Alberta will boom if oil prices stay at $13 or even lower. This is where the possibility of a deeper or broader Asia crisis is very important, because there is a strong link from there to commodity prices. People say that Canada is now an information-based economy. That is partly true, but it remains the fact that 40 per cent of our exports are commodities. We are extremely vulnerable to changes in global commodity prices. I would put a major part of the risk there.

I would also add that the Canadian dollar has tended over history to move up and down with commodity prices. Our low dollar today is in large measure attributed to that and is to be welcomed because it provides a partial offset to the negative impact of those low commodity prices. I think and hope that from now on the Bank of Canada will pursue a policy of benign neglect and not try to prop up the dollar through higher interest rates.

My final point has not yet been mentioned. Another mechanism whereby the Asian crisis will hit us is rising U.S. protectionism. The U.S. Congress is already in a relatively ugly mood, having denied President Clinton fast-track on NAFTA. Nothing drives congressmen crazier than surging trade deficits with Japan and other Asian countries. That is exactly what they are going to get. I think we can expect rounds of anti-dumping and other protectionist behaviour coming out of the United States. While those will be aimed principally at Asia, I think that we in this country might suffer what the Americans would call a certain amount of collateral damage. We must be aware that if they are instituting anti-dumping laws to protect their industries and we sit and do nothing like good little Boy Scouts, it will not be very good for our industries.

The Chairman: We are fully indebted to all our witnesses for a detailed and candid preliminary statement of the situation.

Why have all these countries had this financial crisis at one time? If we compare the condition of the financial world in each of these countries -- Japan, South Korea, Indonesia, et cetera -- were there similar problems, or is it that once foreign investors decided there was a problem in one or two of these areas, a contagion set in? I suspect that one might be tempted to answer "some of both," but on which of those two would one put the emphasis? Was it that there were similar problems in the various countries that all at once produced a bad effect, or was it largely contagion?

Mr. Mendelsohn: I think your comment that there is some of both is the truth of the matter. One danger we face is that we put all the countries in one basket and say they all fall into the same category and all have the same problems. In point of fact, one can distinguish particular kinds of problems, and because of the nature of the problems and what it takes to deal with them, some of these countries will come out of this situation sooner than others.

Having said that, a number of countries were facing situations such as rising trade and current account deficits. In other cases, the structure of the financial system was not sufficiently sound, so you allow for a misallocation of capital.

In terms of the contagion, let me go back to the heart of the problem. You can categorize a number of countries as competing amongst each other for third markets. There are two sets of countries. There are countries in the no-technology, low-technology area, and there are countries in an area of higher technology. You can include in the low-technology area countries such as the Philippines, Indonesia, and Thailand. In the area of higher technology, you can include such countries as Malaysia, Singapore, Korea, and Taiwan.

The low- and the no-technology countries became squeezed as a result of the devaluation that occurred in 1994, and China started taking up part of that market. The high-technology countries began to get hurt as a result the depreciation of the Japanese yuan, which then put a squeeze on that sector. At the same time, we ran into a problem of reduced demand for electronic equipment in the western world. However, that is only one part of the problem.

A comment was made about the lack of sufficient advancement on the financial market structure. Clearly, that is the case. When you open yourself up to foreign capital inflows, as the Asian economies did -- and we all applauded this -- you must expect that foreign investors now have a personal interest in what is happening in these countries and will focus on problems when they emerge.

If I were to identify one problem in most of these countries, it is the issue of transparency -- the way business was being managed, whether it was directed by government, whether it was private enterprise operating without any government direction, and the way the financial system was operating. There has always been the so-called "Asian way." You do not have balance sheets, income statements, or any kind of real information. You know that you need special connections to make transactions. You need to know the right people and the right places. That lack of transparency and the flow of foreign capital contributed to that contagion. When you have a major development in any of these countries, it creates a question in the investors mind. "I already know there are some problems in these other countries, but what do I not know about these other countries that can blow up on me?" You start to take defensive measures and leave.

What compounded the problem -- and this happened in Mexico, too, because the first group to escape the Mexican peso were Mexican businesses -- is that as the currencies began to depreciate, local business people who were trying to hedge themselves, which they did not do before because they had the protection of a fixed currency went out to buy U.S. dollars. In that process, they accelerated the depreciation of the currency. With that, you then felt the full effect.

Korea did not get hurt early on because everyone was focused on southeast Asia. They had similar problems but got pulled in only as this contagion worked its way north. There is no single variable there. One must look at the countries. Korea was a directed economy. Thailand's problem was real estate and politics. Indonesia suffered from cronyism. There were different elements at work in these countries, but the process of doing business was quite similar.

There is no simple answer, but that is the way I view it.

Mr. O'Neill: Contagion is having uncertainty about what your neighbours really look like while looking for an answer. If they find that the answer involves the same problems, for example, a weak financial sector, directed lending or a very weak banking sector, then that contagion will be sustained. If the answer is that it is not the same, that there is not a significant problem here and this is a fundamentally sound economy, then the contagion will recede. You will then see the stock market come back sooner and the currency, if it is not pegged, will rebound more quickly.

You had contagion in Asia. That was part of the problem. Some fundamental micro-economic structural problems in the financial sector and some macro issues were common. A number of the countries had currencies pegged to the U.S. dollar, which was fine as long as the dollar was declining over a 10-year period from the mid-eighties to the mid-nineties, but not such a pleasant situation to be in when the U.S. dollar began to appreciate. At the same time, the corrective measures to slow the domestic economy were not taken. You had domestic stimulus, overvalued currencies, and external imbalances rising fairly sharply.

Finally, we can lose sight of the fact that there are significant intra-regional linkages. When the crisis hit in Mexico, there was contagion -- that is, the tequila effect that occurred through Latin America -- but it did not have a lasting, substantial effect. The contagion went looking for an answer, found some answers, and came back to Mexico. It hit Mexico significantly but did not hit the other economies quite as much.

If you had an entirely self-contained regional Asian economy, we would not even be here talking to you because there would not be an impact on North America. The fact is, however, that there are external linkages.

In Asia, a significant portion of the trade is within Asia. Financial flows are within Asia. Lending by banks involves Asian banks to Asian companies and to Asian governments. When you have those significant intra-regional flows, you can have a real problem because Indonesia's problem becomes a problem for South Korean and Japanese banks.

The Chairman: That is a domestic or a local contagion.

Mr. O'Neill: Yes, it is. Think of the U.S. economy as if it were totally self-contained. Throw in a severe financial sector crisis, a tightening monetary policy, and a Gulf war, and you get a modest recession in the early 1990s.

When you have those linkages, the impact will be larger and the so-called contagion will not be entirely speculative. It will not be looking for answers, it will be real because some fundamental problems emerge because of those linkages.

Mr. McCallum: If I had to state two reasons for this problem, they would be the bad banks and the lack of transparency in doing business, and the overbuilding, either in real estate or in other mega projects, which ultimately had little lasting value.

Many of the countries shared those two problems, but we always knew about that. They did not have a crisis before. They had overbuilding, crony capitalism, and lousy banks for years. Why, suddenly, a crisis? I guess that those mega projects could be handled if double digit massive growth was to go on forever. Those errors would be buried in all the growth. If that growth went on rapidly forever, the mistakes made by the banks could also be papered over.

What happened, starting with Thailand, was the realization that this huge growth would not continue forever. People then started to put these problems, which we already knew about in general terms, under a microscope. Once that happened -- and, with all the other factors that have also been mentioned -- the problem spread, and it was realized that much of this had become unsustainable.

Senator Bolduc: You have distinguished between risk and uncertainty. Risk involves mostly economic factors, and uncertainty involves political factors.

Let us talk about the political factors for a moment. I think everyone agrees that Indonesia is a major problem. The president does not agree with the IMF or the rules of the game. There is a huge population in Indonesia, but trade with them is relatively minor. I do not think that will affect China, for example, or have a big influence on them.

We have been talking about Japan for five years. We say that they have to make political and economic reforms. What is happening in Japan? Do we have the beginnings of reform of economic institutions? If Japan does not do it, the others will not either.

Mr. McCallum: Your first question was about Indonesia and your second was about Japan. I was told by the Canadian ambassador to Thailand that many of the richest families there have been hit quite hard by the reforms and that that is, in part, why the population is accepting the pain of a higher gasoline tax and things of that nature.

The opposite is true of Indonesia. A huge chunk of the country's wealth is in the hands of the president and his children, and his actions suggest that his number one priority is to protect that wealth and his job. The political foundations for success there are terrible, especially when you add to that his choice of vice-president, the ever-present bubbling ethnic tensions, and the fact that the IMF has been too intrusive. There is picture shown day after day on Indonesian television -- a little like the Quebec flag-stomping incident was used over and over here -- of Mr. Camdessus, the head of the IMF, standing over a kneeling Suharto as he signs the agreement. There is great nationalism and anti-western imperialism. It is a very dangerous brew. I am a simple economist, and I simply do not know how it will end up, but it is very bad.

Senator Bolduc: That being said, do you see major effects for China?

Mr. McCallum: That having been said, I see the potential for an economic melt-down, if you like, and for violence which would spread across the border into Malaysia and Singapore.

I do not see a huge impact on Canada, to take our own position very selfishly. Canada's exports to Indonesia are very small -- .08 per cent of our GDP. Less than one-tenth of 1 per cent is exported to Indonesia. However, the channels could spread beyond that. You could get China involved and a whole host of complexities. Once you go down that path, you do not know where you will end up. That would be a major worry.

In the case of Japan, I would argue that, notwithstanding its troubles, Japan is still the second richest country in the world. Japan has huge net foreign assets. Japan will not implode or go down the drain. At worst, it will continue to stagnate. Japan's problem has been one of political deadlock, if you like, particularly vis-à-vis the banks. Their real estate bubble burst in 1989, I believe, and they seem to have been doing nothing.

To put it in a Canadian context, the unpopularity of Canadian banks with Canadians is nothing compared to the unpopularity of Japanese banks with Japanese. For many years it was political suicide to suggest that public money would go to rescue Japanese banks. However, they have crossed that Rubicon now. They have committed public money. At one point, the amount was about the same as Canada's GDP, just to show you the scale of it. They have started very slowly to put some of that public money in. We do not yet know whether they will do it a right way or a wrong way. There are still many of uncertainties. I think they are gradually moving in the right direction in sorting out the problems of their financial systems, but it will take years, and Japan will stagnate or grow very slowly for some time to come. However, it will not go down the drain.

Mr. Mendelsohn: This is a point at which we will start to disagree a bit. I agree with Mr. McCallum's comments on Indonesia and the president's situation there. In fact, it is quite interesting that the IMF, in trying to keep its fingers in Indonesia and trying to maintain some credibility in the region, now appears to be acceding to the president's notion of setting up a currency board. Unfortunately, for the currency board, it is for the wrong reason. I am a cynic on many of these things, and I believe that the purpose of a currency board in Indonesia would be to allow the first family to take its wealth out of the country. If that is a way to get Suharto to leave the country with his family, so be it, but I am not at all certain the next generation of leadership will be a great deal different. It will come from the military. We will see what happens there. I agree that there is an enormous amount of social unrest. My sense is that it is a time bomb and it is just a question of whether Suharto can be replaced peacefully or quickly enough.

I do not really think that the social unrest directly will spread into Singapore or Malaysia. There are some problems in that foreign workers who were in Malaysia have not been sent back to Indonesia, which puts added pressure on the Malaysian and other economies where there are workers from other countries. However, it will not necessarily cause a social explosion in every country out of Indonesia.

By the way, the uncertainty is not only political; it is also economic. There are many numbers still hidden that we do not know about. For example, I mentioned that the contagion can go on to Singapore, although Singapore, with the exception of its stock market, has managed to work its way through this. We have no idea of what third party exposure from Singapore into Indonesia is. We do not have numbers on that. The contagion can still come back that way.

In Malaysia, in an attempt to draw in foreign capital, there have been some changes in the Bumiputra laws favouring the native Malays in terms of business enterprises. They are now opening it up to non-Malaysians, for a time at any rate.

Thailand did this in perhaps the most intelligent way. In the last four or five months, they opened up their financial sector and allowed foreign financial institutions to take full control for up to ten years, after which they are gradually diluted out. If they get their structures right in the ten-year period, the law can be changed and it can be made permanent. However, at least they have an "out" clause in terms of foreign ownership. In these countries, nationalism, in terms of foreign ownership, could become an issue in the future.

Senator Bolduc: The political elite is still Chinese, is it not?

Mr. Mendelsohn: At this time, the Chinese are the targets in Indonesia.

Korea concerns me on the social-political front. We have alluded to it in many ways. In the last 10 to 15 years, their economy has not had an unemployment rate exceeding 4 per cent. Now that rate will double, at least. Even though the president now has legislation which will allow lay-offs, it is not at all clear the rank and file workers will go along with this, and there may be some backtracking. Therefore, the uncertainty is both political and, to some extent, economic.

With regard to Japan, you will have to pardon my cynicism. I have been negative about Japan for the last six or seven years. Every time someone has said that there has been a turnaround in the economy there, I have disagreed. Japan has now spent roughly the equivalent of half a trillion dollars trying to promote economic recovery. They have not succeeded because it has always been predominantly through bringing forward public spending and public spending exercises.

Japan is about to do the same thing again. Unfortunately, at this point in time, I do not believe much of anything that is rumoured. Both the Japanese yen and the Japanese stock market are floating on rumours. I find it interesting that all the rumours of new policies and attempts to deal with the financial system really started in earnest about the end of January, beginning of February when the Nikkei index was falling from the 15,000 to 14,000 level, where it started really hurting the capital base of the banks. Many of the rumours are basically geared towards propping up the stock market because the banks use 45 per cent of their unrealized capital gains as tier-two capital and they need to meet BIS guidelines.

That is not to say that Japan has not started the process. As was mentioned, there is a watershed here, they have finally admitted that they must use public money to bail out the financial institutions. They are going about it in a wrong-headed way. Once again, they focus on what they refer to as a liquidity crunch. The banks are not lending because they must meet the BIS guidelines and so forth. However, there is a lack of demand. It is based on a lack of confidence on the part of consumers, partly because the official unemployment rate is around 3.5 per cent while the real unemployment rate is probably twice that. We saw what happened in Canada with job uncertainty.

In terms of the financial system, they are now using 13 trillion yen, approximately $100 billion, to recapitalize the banks. During recent months, in the name of reducing the liquidity crunch, many of the conditions that had been put in place to restructure the financial system have been eased.In fact, an environment has been created where one can recapitalize even insolvent institutions without increasing transparency. There is also allowance for redefining real estate value, and for having a choice as to what cost of equity values in terms of equity holdings. I find it retrogressive on the regulatory side. Public money may be used, but I wonder if more problems may not occur later on.

One other element is stifling Japan right now and that is all the scandals in the ministry of finance and in the Bank of Japan, which was viewed as sacrosanct and above reproach. That has paralyzed the bureaucrats, who have traditionally made all the decisions. No one knows whether they will be called on the carpet. The decision-making is not there.

My sense is Japan continues to stagnate. I agree totally with Mr. McCallum, you cannot write the country off. It is an extremely wealthy country. It is not going to renege on any debts in any way. However, the question one must ask is how long can the country continue to stagnate growing at 0, 0.5 or 1 per cent, before something gives. That is the uncertainty in Japan.

It must be reiterated that Japan was part of the origination of the problem. Japan is also clearly a significant part of the solution of the problem, both in terms of demand for production and investment from the area, but, equally important, Japan, to my mind, has not taken the leadership role which, as a member of the G-7, it has always wanted. That is an unfortunate situation.

Mr. O'Neill: I will not adjudicate between my colleagues on the issue of Indonesia.

Mr. McCallum: I do not think we disagree.

Mr. O'Neill: The issue of who is hit is really a fairly critical one here. There are three facets to it; two of them are political. One facet, which is accepting publicly that you have made mistakes in the past, is a difficult problem in many of the Asian economies. One of the reasons why there was denial at the early stages of the crisis and why there was something of a problem in Japan to admit that not only is the banking sector weak but that they have essentially been hiding it for a considerable period of time.

The second political issue is, if you are to recapitalize a system, you face, in Japan in particular, the lack of public support for that. That would be true whether you were discriminating or not in which banks were provided the assistance.

The economic issue related to that is also important and it is particularly the case in Japan as well as in the other economies. That is, if you are not discriminating about whether the whole banking sector will be supported as opposed to only the stronger parts will be given support, you do not allow failure to ultimately breed succession. You do not allow a working out of a situation in which you have some reasonably good players and you have some very bad players and the bad ones should be allowed to disappear from the system and their markets be taken over by the stronger players. There may be slightly more acceptance of that in Korea.

I will just make a point about a slight disagreement I have with Mr. Mendelsohn. I am less concerned about Korea precisely because of what they have done in the debate over who will and will not be affected by this. They have made it clear from the beginning, as clear as they could, especially with the labour unions, that the effect will be broad. In other words, everyone will have a role to play in the process of sacrificing. Therefore, to that extent, they have been able to at least buy off some of the more serious resistance to the structural reforms required and the recession that inevitably will be significant in Korea for at least this year and into 1999. On the "who is hit" issue, there is a very dramatic difference between Korea and Indonesia. It is one of the reasons why I think the problem in Indonesia is profoundly more serious than it is in a country such as Korea.

Senator Whelan: Mr. Chairman, I have just come from a meeting where they were talking about farm leadership. I thought it would be very fitting here if we had more leadership in the world banking industry. You mentioned the "Asian way." You did not say a word about China. Are they not part of Asia?

We are talking about the banks again and about bad administration. I remember when Campeau and all these big companies were financed by the banks in Canada, they lost millions of dollars. Would you not call that incompetence in our banking system? Hotels were sold and the Japanese were buying them in the United States, in Hawaii, at 20 cents on the dollar. Is there a great difference when the directors of the banks are the same people that their companies may be borrowing from at the same time? Do we not have some of that family interloping in our own banking system?

Farmers never paid over 3 per cent interest when the banks were charging us 14 and 15 and 20 per cent interest in agriculture. We never paid over 11 per cent under manufacturing loans, et cetera. We were paying these tremendously high rates and bankrupting all kinds of people in Canada when the Japanese economy was running faster than any other one in the world. Now we find they are corrupt and bad administrators.

You say it will not affect our commodities. I challenge you on that. It only takes a 2-per-cent surplus or a 2-per-cent shortage to create chaos in a market. When the United States cannot sell its soybeans or its wheat or its corn into Asia, it certainly will affect us in a terrible fashion. It is already doing that in our country.

When you are comparing Singapore to some of these other countries, I have strong reservations about a little country that you can walk across from one side to the other in a day. In Canada we have 4,000 miles from sea to sea and we can make a legitimate claim to being a world power.

Just think of the tremendous assets that we have in Canada. If I were a banker looking at Canada and observed a 70-cent dollar, I would also look at everything that we have in this country, such as the minerals, the water, the lumber and the agricultural production. I do not understand the banking industry but I do not understand economists either. I used to have 101 of them when I was Minister of Agriculture. I said they were like Dalmatian pups. I had 101 opinions, too, so I had to pick out the one that I thought would do the best for the country.

We should remember what happened in Mexico. We used to deal with Mexico a great deal. The Canadian banks were in Mexico. Certainly you can now see all the pitfalls that happened this Asia. Did you not see any of them before? Apparently you did not.

The Chairman: Did you have a question?

Senator Whelan: Yes, I did. I wanted to know why they did not mention China and the difference between Campeau and other big companies losing billions of dollars in the United States of America. What is the difference between our banking system and theirs? Is ours so pure? Why did you not mention China? It does not seem to be involved in this economic downturn or chaos. I also want to know why everyone said it is not going to affect our commodities. In Western Canada, it will affect the pork, cereal and soybean industries.

Mr. McCallum: Maybe I did not make myself clear. What I did say was that, from a Canadian point of view, the most serious part of this was commodity prices. If the Asian crisis deepens or broadens, we could have much lower commodity prices and that would hurt us very badly. I said that, so I am agreeing with you on that point.

On the question of banks, banks from time to time have bad loans, and Canada has not been an exception to this through our history. On the other hand, it is also a fact that we have had one of the most stable systems in the world. I think since 1923 we have had three minor bank failures, compared with thousands of them south of the border. We have made some bad lending decisions -- I was not working for the bank then -- but they have not been on the scale of what we see today in Japan or on the scale of the savings and loan problem in the U.S.

On the question of Japan, you are right, these things tend to be fads. Twenty years ago, we thought Japan was wonderful, a model for all of us. That is not so today. I guess what happened is they had this huge real estate bubble which burst, and also they caught up to us, more or less. You only get this huge growth in the catch-up phase. Japan has now caught up.

We mentioned China. So that is a stab at some of your questions.

Mr. Mendelsohn: If I may add something, China has huge banking problems. They have insolvent banks because they have been lending to their state-owned enterprises.

There is an interesting point that needs to be raised here. In Indonesia, Malaysia, China, Korea and even to an extent Japan, the problem was directed lending. That is, the banks were prompted, if not directed, to lend to the corporations and support the institutions which ultimately were not viable, and that resulted in the poor loans. Any kind of lending is a risky business. You will make mistakes. Even if you make loans based on business decisions -- rational, economic, financial decisions -- the numbers can look good one day and turn sour the next and you lose money. It is a different story when you must make those loans, and you do make those loans, because there is an overriding policy directive that says you must do it. However, who do you then hold accountable?

Senator Bolduc: They all have conflicts of interest.

Mr. Mendelsohn: That is the big difference between the two. China is clearly in the category of having directed its banks to lend and support the state-owned enterprises which in many cases are totally bankrupt.

Mr. O'Neill: If banks make mistakes -- and they do, like other businesses, make mistakes -- in North America and in Europe, they get punished for them. Shareholders punish them and the people who made the mistakes often find themselves looking for employment elsewhere. That has not been the case in these economies that we are discussing. In fact, the problems had been hidden rather than exposed, so there is not an opportunity for correcting the mistakes, learning from the mistakes, and doing better in the future. You need a strong, prudent, regulatory system, and you need transparency, and these are missing.

As far as China is concerned, the fact of the matter is they are now moving, it appears, to correct their banking system problem in two ways: by providing more capital but also by reforming the system in which the banks were captives of state-owned enterprises. They had no choice but to fund them. As that state-owned-enterprise sector shrinks and has a far smaller share of the economy in which to be involved, then the banking sector will be increasingly disengaged from it and a stronger banking sector will result. At least they are moving to make the kinds of reforms that are necessary.

We all agree that commodity prices would be hit. It is arguable whether food prices will be significantly hit. Purchase of food tends to be less influenced by changes in the level of economic activity or income levels. It will be hurt to some extent, but it will not be faced with the kinds of dramatic shifts in demand that you can have, for example, in the demand for base metals or for forest products. Those are the commodity sectors that will be most influenced by the crisis.

Senator Whelan: I read an article on Indonesia, and one of the disagreements that the IMF has with the Indonesian government is as a result of the tremendous increase in food prices. The government said they were still planning to subsidize the food prices and the IMF did not want that. While they did not necessarily want them to charge the people the actual price, they wanted to lower the extent to which the government subsidized them. The Indonesian government felt, as one of you said, that there could be civil insurrection around not being able to afford to eat.

I am somewhat confused by what you are saying, Mr. O'Neill, and when I read all these financial publications. What the food prices will be is one of the things that seems to be a big concern.

Mr. O'Neill: I thought the concern was that we had not talked about commodity prices, in particular how depressed they would be, and the fact is that we did.

Senator Whelan: You mean in Canada?

Mr. O'Neill: In the world markets. You are now speaking specifically of a particular problem in Indonesia, which has subsidized food prices and is faced, because of the huge currency depreciation, with a dramatic rise in the cost of imported food. That is hardly a shock. Whether or not the IMF is correct in that particular directive is a separate issue, however I thought we were talking about the broad issue of what will happen to commodity prices globally as a result of the Asian crisis.

Senator Whelan: I was talking about commodity prices. We have already seen a downward trend in wheat, soybeans and corn because orders are being cancelled.

The Chairman: We are talking about the impact of this situation on the volume of Canadian exports and the price thereof, rather than the domestic food problem in Indonesia.

Senator Whelan: With all due respect, they cover one another. As they have less buying power to buy the imported food they need, there is less of a market for our product. Our product is affected, even though the United States may have supplied 50 or 80 per cent of the product for that country. Our market is definitely affected by what happens in the United States because there is no duty on our products, such as soybeans or corn, one way or the other.

Senator Stollery: I have difficulty in the midst of a crisis to do other than watch with interest. The scenario is unfolding, so what can you say? I am trying to grasp the implications of the global financial markets. I have been sceptical about globalization, and I was the only senator to vote against the Chilean free trade agreement. I am not a protectionist, by the way. I would not want you to think that.

Just a few months ago, we were talking about globalization and the global financial markets. As far as I can make out, the financial markets in one important part of the world have collapsed. I would like you to explain the implications of globalization in the financial business, not just in the sense of trading goods and selling stocks or computers.

I am getting into an area that I do not really understand. There is a lot that I do understand, but when it comes to freeing the global financial markets, I would like to have three acknowledged experts explain what that means.

The Chairman: I have explained to some senators and others that Senator Stollery has taken the view -- and this may be an exaggeration -- that what we are doing in financial globalization is taking the bulkheads out of the ship so that we have hundreds of billions of dollars sloshing around. In effect, what is happening in one part of the world may well be transmitted to another part and produce almost unpredictable results.

Mr. O'Neill: Globalization means so many different things to different people that it has lost a lot of its currency. At a minimum, it means the integration of international markets, whether it is markets for capital or goods and services, or the market for human resources. We are talking about economies that are increasingly interrelated. One measure of that is the extent to which the expansion of trade internationally is moving at a greater rate than the expansion of output. In other words, trade is rising faster than output, which means that economies are becoming more linked together in the exchange of goods and services.

Senator Stollery: I understand that.

Mr. O'Neill: The notion that this suddenly burst upon the scene within the last 10 years ignores the history of the latter half of the 19th century and the early part of the 20th century when the share of trade as global GDP -- as best we can measure it from data in that period -- was not dramatically lower than it is now. We had a period of significant freeing of trade as a result of the repeal of the corn laws and the opening up by Britain and others to free international trade. In that period, we also had a tremendous flow of capital internationally. Where did we get the capital in Canada to build the railway system?

The point is that, first, this is not a new process. Second, in the capital markets, it has always been the case that the flow of capital has been freer than the flow of goods and services and the flow of people.

What has changed, of course, is the speed with which all of those things can occur. As we get improved technology in transportation, distance becomes less of a factor in trade and time becomes less of a factor. As we discover this technological change in information, the flow of information and the flow of transactions can happen more quickly than it could in the past -- it can happen instantaneously. If we are talking about financial markets, we are really talking about a change in the speed with which transactions take place. Given that the economy of the world is expanding, the volume of those transactions is increasing at the same time. It appears to be the case that we have this dramatic shift to globalized financial markets, one we have never seen before.

The fact is that it is a long-standing pattern that is continuing. It is being accelerated by both growth in the global economy and by technological change, particularly information technology, which allows us to transmit transactions and the information about them instantaneously.

Senator Stollery: The June IMF report on globalization -- the one which I suspect they wish they had not put out -- explains what you just said, but it also points out another difference. The great expansion and investment of capital that ended in 1914 had a characteristic it does not have today, which was that it was also the most internationally mobile period in history for labour. Capital followed labour. However, in the modern period we are talking about is in fact the least mobile period in history for labour. Capital moves around but labour cannot follow capital. There was investment in railways in the United States; there were all those people moving, et cetera. There is an important distinction to be made here.

The Chairman: I would like to build on that comment. We have talked about the new character of the global financial market. In Canada, we have the Office of the Superintendent of Financial Institutions. I gather you would share the view that that office does a good job in maintaining the stability and reputation of our financial system. Is there anything comparable in this rapid globalized finance market we are talking about?

Second, moving away from the whole market, what about those specific countries that are the subject of our discussion? Is there anything like an OSFI in Japan, South Korea or any of the other countries we have been discussing?

I am guessing that Senator Stollery's next question will be this: If we have this rapid globalized financial market and if in Canada we need an OSFI, how can we feel comfortable with a globalized financial market without a globalized OSFI?

Mr. McCallum: I should like to try to answer that question. I will also return to Senator Stollery's question. In terms of globalization, let us talk about goods and capital. I will then come to the OSFI question.

Clearly, there has been an increase in inequality in western countries, especially in the United States over the last decade. Some people blame that on trade and the opening up of borders. Perhaps that is why you voted against Chile.

Senator Stollery: I voted against it because the discussion was so one-sided that it could not be right.

Mr. McCallum: My reading of the evidence is that there is no doubt there has been this greater inequality. However, it is not because of the borders being opened to trade. The U.S., for example, has little trade relative to its economy and the biggest increase in inequality. Basically, around the western world you have a technological shock -- that is, a technological change -- which results in a reduction in the demand for unskilled labour relative to the demand for skilled labour. Essentially, that is what has given us our higher inequality and trade has taken a bum rap.

I will move now to capital flows, which is the main point. A decision must be made between long-term capital flows and foreign direct investment versus short-term hot money. Most countries around the world, including Canada, compete for as much foreign direct investment as they can get their hands on because it adds to their growth and creates jobs. Much of the capital flows have been foreign direct investment. That is not the controversial part. The controversial part is short-term hot money. There, the Asia crisis has provided a few arrows for one's quiver.

As I mentioned earlier, the least open of these countries, China, has so far escaped the crisis with its non-convertible currency. In the long run, the opening up of markets makes everyone richer. Therefore, it is a good thing to do. The order in which this is done is extremely important. You can get unstuck. If you open up your borders to short-term hot money without having previously made sure that your banks and other institutions were in good shape, then you are simply asking for trouble.

The Asia crisis is not a case for closing borders, but it is a case for ordering reform in a particular way or else you will get into trouble.

Mr. Larry Summers made an analogy about jets. He said that jets get us from point "A" to point "B" very fast and efficiently and, on the whole, safely. That is like opening borders. Not many people want jets to be abolished, but we do want safety procedures to be made more vigorous and enforced to minimize crashes. In this globalizing world with all these jets, we have become richer, more efficient and we can get from point "A" to "B" faster, but when a crash does happen it tends to be big crash. The idea is not to abolish jets but to improve our safety system.

Finally, this brings me to the OSFI question. Canada has a good OSFI. We have only had three bank failures since 1923. On paper, other countries such as Japan, Korea and even Indonesia will have their OSFI equivalents, but they are not good in many cases because they are subject to this lack of transparency, to crony capitalism, and to being arbitrarily fired by the president if you do not say the right thing. At the top of the list of reforms by the IMF and other international bodies is not reducing government deficits, because that is not a problem, but building up domestic OSFIs -- that is to say, domestic superintendents that are just as good, ultimately, as our own.

In addition -- and this is where some of the international organizations are moving -- there is a move towards international systems. That is, a greater role for an international association of OSFIs or some international body that will have the equivalent of generally accepted accounting standards and consistent application of supervision of financial institutions. It must be a combination of much more solid, national supervisory bodies, plus the build-up of international bodies which will probably play an increasingly important role as the world becomes more integrated.

Senator Bolduc: Along the model of Mr. Sorros' proposition?

Mr. McCallum: He has said some sensible things and some things that I thought were less sensible. If I remember correctly, he wanted to move towards a more international body to regulate. I think that is a good thing.

Mr. Mendelsohn: We have spoken about regulators but we have not spoken about the quality of the risk managers within the institutions. When you go to these countries and you talk to the institutions, it is not surprising that you find a lack of understanding and appreciation of risk management techniques and risk management approaches because of the nature of the banking being done and the kind of relationships that have existed in these countries. It is beginning to emerge, but it is a long process.

Unfortunately, you only learn those processes by making some of the very mistakes that we have made periodically and will invariably make in other ways. It is the case that you do need it at the base level of the institution, not just at the regulator level. If you were setting it purely for the regulators, you would need within the regulatory office, at least, a separate group responsible for each financial institution in the country.

The Chairman: In other words, you do not want the regulators running the banks.

Mr. Mendelsohn: You do not. You want a culture within the institutions that will worry before the regulator worries. By the time the regulator becomes worried, sometimes it is too late.

Senator Bolduc: There is also another factor, namely, the fact that there is a cultural problem here. If politicians are dirty, the public administration is, too. That goes together. We have seen that in the past in Canada and in some provinces. So that you cannot have a good administrative system or a good public service system, for example, if the whole political process is wrong.

Senator Stollery: This has been an interesting discussion. I should like to know more about the hot money. I understand the difference between investment and money and short-term loans, which is where the disasters seem to continually take place. I should like to know more about that.

I do not really understand why every eight years bankers repeatedly are so taken by surprise when corrupt local individuals take them to the cleaners for $1 billion. Would you care to expand on that? After a short period of time, there can be a scandal where local people know first and take the money. Is this something that we should be avoiding? How should we avoid this?

Mr. O'Neill: First, you have the possibility of people making mistakes, being irrationally exuberant and downplaying the risk of a particular credit extended or an investment made.

I am not sure that you can legislate against that kind of misjudgement, and I am not sure you would want to try to legislate against it.

Your statement implies that people do not learn from past mistakes. I would simply repeat a point I made earlier. With respect to Canadian financial institutions, the degree of exposure to Asia is very limited relative to what we may have seen in past episodes and certainly what we are seeing from some American and European banks.

Senator Stollery: The Germans are in for $5 million or so. Or is it billion?

Mr. O'Neill: So we allow the Germans to make the mistake, and we do not make it again.

Senator Stollery: However, in the famous global financial market, we are all part of the same pie, are we not? The Germans go in for an enormous sum of money, and it impacts on us for the reasons we have heard described.

Mr. Mendelsohn: It should not impact on us unless the particular foreign institution, such as a German bank, then falls into its own difficulty which disrupts its activities with other banks.

Thailand and Indonesia were always front and centre as potential problems. Korea was on the back burner, but we thought most of that had been corrected. What caught people off guard was the contagion, the speed and the breadth at which this took place across the region. Once it started, you could catch it. We all do this kind of work, and each institution in its own way tries to build up its risk management processes and culture to avoid that. I sometimes think that when you develop new techniques to measure risk, you perhaps give yourself a false sense of security and you do some new things. The world is changing so rapidly, and the products are changing so rapidly.

Mr. O'Neill: There were a few points I did not get a chance to make. The notion that you can legislate or regulate mistakes out of a system, whether it is an international or domestic system, whether we are talking about a financial or some other system, seems to me to be fundamentally, at the end of the day, wrong. You cannot do it. You cannot legislate and prevent people from making mistakes. In fact, you probably do not want to do that.

Senator Stollery: However we did that before when a bank collapsed. People still talk about it, and we have not had a bank collapse since, as you have pointed out.

Mr. O'Neill: You can put in place systems that minimize the risk. We are talking about what is necessary in the Asian economies. That is different from saying you need a multinational or global regulator which absolutely has the power -- you could not invest with that kind of power anyway -- and could by its role significantly reduce the potential for making those kinds of mistakes, or significantly prevent people from making mistakes. I do not think you can do it.

I will disagree with Mr. McCallum on the issue of short-term control. To my way of thinking, the idea of putting regulations in place even for less developed financial systems is somewhat akin to the old argument for tariff protection. The problem you could have is that that financial system never fully grows up because it can always make the argument or find the rationale for keeping those restrictions on capital flows in place.

What is the prospect that in Asia we will see better supervisory structures, better regulatory structures, precisely as a result of the crisis we have just been through? I would say the probability has gone up dramatically. If there had been systems in place to prevent that from happening, we might not have the potential for structural reform that we have now in the financial systems of those economies. They are forced to grow up faster than they might have wanted. They paid the price for doing that. However, at the end of the day, they are probably better off for having had to do it.

Mr. McCallum: I do not see where our disagreement is. As a consequence of the crisis, they will be more likely to have structural reform.

In terms of the basic question about why banks keep getting into trouble and what to do about it, I think partly it is human nature. It is said that there is a natural credit cycle where, first of all, you have greed, and then a crisis happens, and then you are dominated by fear. Gradually you get over your fear and the greed comes to the surface. To some extent, you will never get away from that.

There are two things that make it worse and two ways in which it can be addressed. First, within a bank, you may have inappropriate incentives. You may have the account managers who get paid for piling up maximum loans irrespective of quality. If they are allowed to get away with it, then you are sewing the seeds of disaster within your own institution. You need mechanisms and incentives within the bank that do not let that system get out of control.

The second thing that can make that greed and fear cycle worse is inappropriate government behaviour. If there is an implicit contract that if you get into trouble the government will bail you out, as to some extent you had in Asia, then that will make the banks rationally reckless, if you like, because they will understand that if they do get into trouble the government will bail them out.

You will never have a perfect world of no mistakes, and part of the responsibility lies with each bank to set incentive structures and compensation structures that encourage prudent behaviour. I would say we have done that, by the way, but I am talking about banks in general.

Governments must ensure that they do not offer implicit guarantees which simply cause rational agents to behave in a reckless fashion. That is an issue the IMF has not yet resolved. They are grappling with this right now, and no one has the right solution to that yet.

The Chairman: Honourable senators, we have gone beyond five o'clock. We have had a very good discussion. We are most appreciative, Mr. O'Neill, Mr. Mendelsohn, and Mr. McCallum, for the help you have given us. It has been very useful. Thank you.

The committee adjourned.


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