Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 8 - Evidence
OTTAWA, Wednesday, February 18, 1998
The Standing Senate Committee on Foreign Affairs met this day at 3:30 p.m. to examine and report on the growing importance of the Asia-Pacific region for Canada (the Asian financial crisis: the perspectives for reforming the Canadian, Asian and international financial systems.)
Senator John B. Stewart (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, normally when we meet on Wednesday at 1:30 the Senate is able to adjourn at three o'clock, thus allowing committees to meet at roughly 3:15. However, that was not possible today.
We are continuing our work relative to the growing importance of the Asia-Pacific Region for Canada. The specific subject for the meeting this afternoon is the Asian financial crisis and the perspectives for reforming the Canadian, Asian, and international financial systems.
We are to be assisted this afternoon by Mr. James Powell, Deputy Chief, International Department of the Bank of Canada; by Mr. Bruce Rayfuse, Senior Chief, International Finance and Economic Analysis Division, Department of Finance; and by Mr. John Thompson, Deputy Superintendent, Policy, from the Office of the Superintendent of Financial Institutions.
I have been meditating upon the fact that this committee produced an interim report on Canada and Asia-Pacific approximately nine months ago and upon the fact that, if we were producing a report today, the emphasis in that report might be quite a bit different from that of the interim report of June, 1997.
Important things have happened relative to financial institutions in part of Asia-Pacific. Those happenings have great implications. It is on that crisis and its implications that we concentrate our attention this afternoon.
I will ask Mr. Powell to lead off, Mr. Rayfuse to follow, and then Mr. Thompson to conclude the initial presentations. Mr. Powell, please proceed.
Mr. James Powell, Deputy Chief, International Department, Bank of Canada: I should first situate the Bank of Canada, and the International Department in particular, in international activities.
The International Department primarily focuses on analyzing events and developments in the major industrial countries -- the United States, the major European countries, and Japan. We also have a small group which looks at emerging market economies, particularly Mexico and Latin American countries. We help support the IMF Canadian office in Washington with advice on various IMF matters, including things that come to the IMF Board for discussion. We work closely with the Department of Finance on international financial issues, as well as with other central banks on that range of territory.
Turning to the issue at hand, I believe the committee is well aware of the proximate causes of the financial crisis in Asia. These include large growing current account deficits, a reliance on short-term capital to finance these deficits, over-valued exchange rates, weak financial systems and, in some cases, "crony-capitalism." I will not speak directly to these factors in my presentation today but will instead focus on what I call a "chain of guarantees" provided by governments that in my view underlie the Asian crisis. These guarantees distorted the incentives of borrowers and lenders and ultimately led to the financial disaster.
I should also add that these guarantees may have interacted in a pernicious fashion with steps taken by countries in the region to liberalize their domestic financial systems and to eliminate capital controls. While financial liberalization is clearly beneficial, experience from both industrial and developing countries has shown that, if done without due care, significant problems can arise.
In order for a financial system, either domestic or international, to function well, borrowers and lenders must bear the costs and rewards. Anything that alters the perceived risk/reward profile can have a distortional impact on market decisions and outcomes. I believe this is what occurred in Asia during the 1990s. The massive inflow of capital into the region and the associated large current account deficits and over-valued exchange rates were in large measure the result of perverse incentives associated with this chain of official guarantees. These perverse incentives were also at the heart of the speculative bubbles that developed in Asian equity and property markets in recent years and which so spectacularly collapsed over the past six months.
What are these guarantees? I can identify at least three links in this chain. They are firstly a fixed or quasi-fixed exchange rate; secondly, an implicit or explicit guarantee provided to financial institutions and in some cases non-financial corporations by governments, and thirdly, international support packages for countries that get into financial difficulties. Let me examine these links in order.
When a country pegs its exchange rate to another currency, it effectively promises the market that it will do everything necessary to ensure that that peg holds. If this promise is credible, the market participants will act accordingly. They will ignore foreign exchange risk and instead rely on the government's promise, notwithstanding the existence of interest rate differentials which would otherwise suggest that the exchange rate should change over time. Borrowing in foreign currency will be viewed as being no more risky than borrowing in domestic currency. Indeed, if domestic interest rates are higher than foreign interest rates, as is often the case in emerging markets, there is a strong incentive for residents to borrow in foreign currency, taking advantage of the lower cost of funds, and invest in higher yielding domestic assets on an unhedged basis. To maximize the spread between the cost of foreign borrowing and the yield on domestic assets, borrowers may also be tempted to borrow short-term funds and lend long-term funds in order to take advantage of the yield curve.
Lenders are also happy with this arrangement. By lending in foreign currency to entities in emerging markets, they can obtain a higher rate of interest than they could otherwise. However, in making their credit assessment of potential borrowers, they too are likely to discount the possibility of exchange rate movements at least in the short-term and the potential consequences on the financial health of the clients should the exchange rate peg fail.
This happy state of affairs can end in tears should circumstances change and market participants begin to question the credibility of the government's exchange rate pledge. When this happens, a rush for the exits can ensue as borrowers hedge their foreign exchange exposures, which at this point could be quite considerable, and lenders cut back on their lines of credit or sell local-currency assets. Capital flight is also likely to occur as residents try to protect the value of their savings.
This is what has happened in Asia over the past several months. As concerns intensified regarding the size of current account deficits, over-valued exchange rates, and dwindling international reserves, doubts began to emerge regarding the ability of national authorities to maintain their exchange rate pegs. Market participants also realized that the authorities in many countries felt constrained from increasing interests rates, the usual remedy in these circumstances, given weak financial systems. Higher interest rates would only put more pressure on financial institutions and their customers. The declining credibility of the exchange rate pegs precipitated a reversal of the massive inflow of foreign capital that had been previously attracted to Asian countries.
The second link in the chain of official guarantees is a guarantee that governments sometimes provide to their financial institutions and, in some cases, to non-financial corporations. These guarantees can be either explicit or implicit in nature. Some financial institutions may be viewed as being "too big to fail." Well-connected financial institutions or corporations may be viewed as having implicit government backing. This is particularly important in certain Asian countries where governments, banks, and non-financial corporations are often closely linked. In such circumstances, investors may lend to corporations on the possibly flawed assumption that the government will bail out such enterprises should they get into difficulty.
The willingness of governments to permit weak and potentially insolvent financial institutions to continue to operate on the basis of their guarantee instead of closing them or insisting upon recapitalization may have also contributed to the financial problems in Asia. At a recent conference I attended on the Asian crisis, such financial institutions were called "vampire" banks on the grounds that they infected others by the pursuit of speculative lending strategies aimed at gambling their way out of their financial difficulties -- a strategy that ultimately failed at great cost to national authorities and creditors, both domestic and foreign.
The third official guarantee I wish to mention is the possibility of international assistance packages typically organized through the IMF. As there has been considerable discussion about the moral hazards associated with IMF lending, I will not elaborate. Suffice it to say that an international lender of last resort can indeed help minimize the impact of irrational contagion on countries side-swiped by financial crises elsewhere. However, the mere existence of such a lender may bias the actions of governments and, more importantly, investors, toward more risky policies and investments.
Given this chain of guarantees, what can be done to reduce severity and frequency of financial crisis? The answer lies is breaking or at least weakening the links that make up the chain, thereby allowing markets to function better.
Most importantly, most countries should consider introducing flexible exchange rates or, at a minimum, exiting from fixed exchange rate systems on a timely basis. Too often crises have developed because of an unwillingness of the authorities to recognize that a pegged exchange rate was no longer tenable. Since a flexible exchange rate provides a two-way risk for borrowers and lenders, there are no one-way bets. As a consequence, the absolute level of capital flows may well decline under a flexible exchange rate system. As well, foreign currency borrowers would be much more likely to hedge their exchange risk.
This is not to say that some countries cannot sustain a fixed exchange rate. However, a fixed exchange rate requires policy to be directed at maintaining the currency peg. In the face of adverse shocks, this may not be credible unless the financial system is robust and the economy is very flexible, allowing domestic wages and prices to bear the burden of adjustment.
As well, emerging market economies need to improve their financial systems. Among other things, insolvent institutions must be closed and weak institutions recapitalized, with their balance sheets cleaned up and deposit insurance limited to the protection of the most vulnerable. Rules must also be introduced and enforced to control self-dealing and abuse by controlling shareholders. Best practices must be introduced regarding such things as accounting standards and corporate governance. More transparency is also required so that markets have the necessary information to make credit assessments. Supervisory systems must also be strengthened in order to buttress market discipline with official discipline.
Fortunately, the International Monetary Fund, the World Bank, the Basle Committee of Bank Supervisors, as well as other international agencies, are working closely with authorities in emerging market economies to improve financial systems in all countries. This process, however, will take time.
Finally, ways need to be found to reduce the moral hazards associated with international assistance packages. Some observers have gone so far as to propose the abolition of the IMF. This certainly would be an extreme solution and one that is unlikely to find much support among IMF members. However, consideration could still be given to involving the private sector at an earlier stage in international financial support packages. This would better ensure that the private sector bears its fair share of any costs.
Accordingly, debt standstills should be seriously considered. Such an approach would be consistent with the recommendations of the 1996 G-10 report on the resolution of sovereign liquidity crises. Debt standstills would also reduce the need for ever-larger lender-of-last-resort lending by the IMF and the international community more generally.
Before I conclude, I should like to say a few words about financial liberalization. In my introduction, I suggested that the chain of guarantees that I just described can interact in a dangerous fashion with efforts by countries to liberalize their domestic financial system, and move towards greater capital account liberalization.
In and of themselves, domestic financial sector liberalization and capital account convertibility are good things. A competitive, market-based financial system will enhance investment by lowering borrowing costs and fostering greater domestic savings through higher returns on deposits and a wider range of investment products. At the same time, open capital markets will encourage better allocation of savings and investment internationally. However, the removal of capital controls in emerging economies, which typically have under-developed financial systems, can lead to significant flows of foreign capital into the banking systems and, consequently, surges in credit expansion.
If banks simultaneously begin to exercise broader powers and are poorly regulated and supervised, they can venture into little understood high-risk types of lending. This is particularly a concern for institutions which, prior to liberalization, were primarily in the business of lending to governments or were directed by governments to lend to certain companies or sectors of the economy. Such institutions may have little experience assessing credit risk.
Given these problems, some might argue that it would be prudent for countries to reconsider financial liberalization altogether. I would contend, however, that this would be a mistake and represent a major forgone opportunity. The evidence has shown that controls are likely to be circumvented in the longer run. Hence, it would be better for authorities to be proactive and manage the reform process.
By tackling the chain of guarantees I have identified which would allow markets to function better and by strengthening prudential oversight, the benefits of a liberal market-oriented financial system can be enjoyed while at the same time severity and frequency of financial crises will hopefully be reduced.
Mr. Bruce Rayfuse, Senior Chief, International Finance and Economic Analysis Division, Finance Canada: Thank you for the invitation to appear before you again. Since I appeared before you on November 5, the crisis in Asia has both deepened and broadened. The situation in some of the original countries affected, particularly Indonesia, deteriorated, and the crisis widened to include other countries, notably Korea.
More recently, however, there are some signs that the situation may have stabilized in financial markets at least, particularly in Korea, though of course significant risks of further turbulence remain. Difficult economic adjustments in some of these countries remain to be made.
In my statement today, I should like to do three things. First, I should like to bring you up to date on developments in the region since my last appearance before you. Second, I should like to outline the reaction of the international community to events so far. Third, I should like to outline what will be done in the coming months.
When I last appeared before you, the Thai bhat had been under steady downward pressure since it was floated on July 2. By November 5, when I appeared, it had fallen 36 per cent. This is illustrated in Chart 1 in the package I have given you.
Thailand concluded an agreement with the IMF in August which, combined with the contributions of the World Bank, the Asian Development Bank, and nine Asian bilateral lenders, including Australia, made available some $17 billion U.S. for balance of payment support. Thailand's part of the bargain was to agree to some macro-economic performance targets and a series of structural reforms designed to open up the economy and strengthen the financial sector.
By early November, the crisis had spread beyond Thailand, but the most seriously affected were the so-called Asian four -- Thailand, Malaysia, Philippines, and Indonesia. Philippines received some additional aid from the IMF in the context of an existing extended arrangement. In late October, Indonesia concluded an agreement with the IMF that also called for macro-economic targets plus structural reforms. In exchange, the IMF, the World Bank, and the Asian Development Bank provided $18 billion in assistance to Indonesia.
In addition, seven countries pledged a total of approximately $23 billion U.S. as part of a so-called second line of defence whereby this assistance would be made available if the assistance provided by the IFIs was insufficient to stem the crisis. On Table 1, I have put a thicker line under the IFIs to stress that this is a second line of defence.
There had been pressures on other currencies and markets in the region, most disturbingly in Hong Kong, where a stock market drop in late October prompted sharp declines in most major stock markets in the world, including New York, where the Dow Jones Industrial Average fell 7.2 per cent on October 27, and Toronto, where the TSE 300 fell 6.2 per cent. Happily, fears of a stock market crash have not been realized and, indeed, the stock markets in New York and Toronto have made good their October losses.
This, then, was roughly the situation on November 5. The next big development in the crisis was the Korean government's approach to the IMF on November 21. A three-year standby agreement with the IMF was achieved on December 3.
Korea was one of the principal tiger economies and had achieved rapid growth over the past 20 years, largely through strong exports. Korea's export push was led by a relatively small number of large conglomerates called chaebols. A feature of the Korean economic model was tight relations between the chaebols, the Korean government, and the Korean banking sector. As a result of these tight relations, the chaebols essentially had preferential access to credit to facilitate their expansion. Given this preferential access, the chaebols were led to diversify into a broad range of products in which, in some cases, they had little expertise, and where, by the early 1990s, there was considerable excess capacity worldwide.
As a result, in recent years the chaebols were generally not profitable. Indeed, as excess capacity pressures intensified in 1997, many of them found themselves in serious financial trouble. For example, in 1997, eight of the top 30 chaebols filed for bankruptcy.
Naturally, when banks' major customers are going under, there is good reason to be concerned for the health of the banks themselves. Given this, and following the Hong Kong stock market decline and a downgrading of Korea's sovereign risk status by Standard & Poor's, new external financing had virtually dried up. Indeed, foreign creditors were refusing to roll over existing short-term credits. The result was a severe drain on Korea's international reserves as banks bought U.S. dollars from the Bank of Korea to meet their short-term obligations as they came due.
The IMF-led assistance package provided $35 billion from the international financial institutions. In addition, there was a second line of defence to be activated if the IFI resources were not sufficient. The second line totalled some $23 billion U.S. for a total package of almost $60 billion. Canada was a part of the second line of defence in the Korean package with a pledge of up to $1 billion U.S.
For the first time in the current crisis, the major international commercial banks were brought into the negotiations as well. In fact, it was made clear that a condition of activation for the second line of defence was that the major international commercial banks would play a role in the resolution of the crisis.
On December 28, agreement was reached to roll over approximately $15 billion of existing credits for a period of weeks. This was later extended for a period of a few months. At the same time, banks began negotiations with the Korean government to restructure corporate debt. Agreement on this was reached on January 28, where approximately $24 billion of Korean short-term private debt was to be restructured as medium-term obligations.
The good news is that this package and the determined implementation of structural reforms by the Korean government have apparently stabilized the situation. You can see from Chart 2 that, since mid-December, the Korean won has been more or less stable. Chart 4 shows that the Korean stock market has begun a rather pronounced recovery since mid-December. Indeed, stock markets in the region in general appeared to begin to recover around mid-January. This is evident in Chart 3.
The main cloud on the horizon is probably Indonesia at the moment. Doubts about the seriousness of the Indonesian government in carrying through with their agreed structural reforms emerged back in December. The doubts increased when, in early January, the government announced a budget that not only violated IMF targets but appeared to be based on implausibly optimistic economic assumptions. Confidence in Indonesian economic prospects was further shaken by rumours about the health of the president and concerns over a possible successor.
At any rate, in early January, more intense pressure on the rupiah emerged, and the rupiah fell to as low as 17,000 rupiah to the U.S. dollar, a decline of more than 80 per cent compared to its value at the start of the crisis in early July. This renewed pressure on the rupiah led to some renewed pressure, although nowhere near as severe on the currencies of the other Asian four economies.
In mid-January, a succession of high level officials from the IMF, the U.S.,and Germany paid visits to Indonesia to stress the importance of carrying through on the needed structural reforms. On January 15, Indonesia concluded a revised agreement with the IMF calling for even more significant structural reforms. Shortly after, Indonesia announced a temporary voluntary freeze on corporate external debt service payments. Steering committees of borrowers and creditors have begun to work out a voluntary payment work for debt restructuring.
Since then, the situation appears to have stabilized in the sense that the rupiah has not fallen further. It has, however, not recovered to the extent hoped for. Moreover, there have been signs of rising social tensions such as scattered food riots.
Last week, in a new development, the Indonesian government announced its intention to implement what is called a currency board, an even more rigid form of fixed exchange rate regime than existed in these countries before the crisis began. There are concerns in financial markets about whether such a regime is desirable or practical for Indonesia, and, as a result, a risk that markets will test the government's commitment to a currency board. Such a development could possibly lead to very sharp increases in interest rates in Indonesia, which could compound the difficulties of the financial sector in that country.
This is roughly the situation today, then. Difficulties are ahead for the Korean economy, although one can be guardedly optimistic. Prospects appear reasonably good for a turnaround in the Thai economy; however, it remains vulnerable to contagion from elsewhere in the region. The most serious risk in the near term is probably the Indonesian situation.
Let me now turn to the international policy response. Efforts to improve the stability of the international monetary system have been under way in various international forums for some time now. The Halifax summit took place in the wake of the Mexican crisis of 1994-95 and dealt almost exclusively with measures that could be taken to minimize the risk of future crises.
The measures agreed to in Halifax centred around three themes: First, improving the information available to markets, primarily the development of the IMF so-called special data dissemination standard; second, improving the speed with which the IMF could react to crises, the introduction of the emergency financing mechanism; and third, increasing the resources available to the IMF to respond to crises, including an increase in quotas and negotiations of so-called new arrangements to borrow. Agreements on these elements have been achieved over the past year and a half or so, but they await ratification and implementation. The biggest hurdle in the near term will be their passage in the U.S. Congress.
In addition, largely as a result of the G-7 summit process, work is ongoing in fora such as the IMF, the G-10, the Bank for International Settlements and the Basle Committee on Banking Supervision on issues such as strengthening domestic bank supervision, promoting robust financial systems in emerging market economies, increasing cross-border cooperation between regulators of internationally active financial groups and so on.
As the current crisis unfolded over the past two months, two trends are evident in terms of the involvement of the international community. The first is evident from the list of countries participating in the rescue packages outlined in Table 1.
While the Thai package involved the IMF, the World Bank, and the Asian Development Bank, and therefore could be said to involve the world community, you will note that the bilateral part of the Thai package was an exclusively Asian affair, again including Australia. In the Indonesian package, there is U.S. involvement in the bilateral part of the package. In the Korean package, the second line of defence was almost exclusively comprised of non-Asian economies.
The international involvement in efforts to contain the crisis has increased. As more countries have become involved in efforts to address the crisis, there has been increased recognition that we need a detailed look at mechanisms to reduce the risk of future crises and to deal effectively with the crises as they arise.
The second trend is the increased involvement of the private sector. As I indicated before, the international banks were involved in the Korean negotiations and Indonesia has begun negotiations with its creditors facts which reflect several considerations. First, to minimize moral hazard, it is necessary for the private interests to be there. Those who made the investments must bear some of the costs of cleaning up the mess. Second, there is a limit to the amount that governments can and should be asked to contribute to these efforts, either directly or through the international financial institutions.
On November 18 and 19, 1997, representatives of finance ministries and central banks from 14 Asia-Pacific economies, including Canada, met in Manila to discuss measures to deal with the spreading crisis. The outcome of this agreement was a new framework for enhanced Asian regional cooperation to promote financial stability, or the Manila Agreement.
The agreement proposed four things: The establishment of a regional surveillance mechanism to complement global surveillance by the IMF; enhanced economic and technical cooperation, particularly in strengthening domestic financial systems and regulatory capacities; measures to strengthen the IMF's capacity to respond to financial crises; and a cooperative financing arrangement that would supplement IMF resources.
Where are these proposals now? Japan has been charged with organizing a meeting to discuss further the set-up of the regional surveillance mechanism. Nothing has been announced so far. Negotiations for such a group have been complicated by the increased involvement of countries from outside the region. The European members of the G-7, for example, insisted on being in Manila. Although they did not participate in the actual meeting, they did meet with organizers after the meeting. Given their large involvement in the region, they have made it known that they will not be bystanders as measures to address the crisis are debated.
In terms of economic and technical cooperation and assistance, work is going on largely in the APEC forum. One of the collaborative initiatives agreed to at the APEC finance minister's meeting last April was to identify weaknesses in and proposed measures to strengthen financial, regulatory, and supervisory systems.
In September, Canada's Minister of Finance and the president of the World Bank jointly announced the formation of the Toronto International Leadership Centre for Financial Sector Supervision to be based at York University. Since then, Mr. Paul Cantor has been named executive director of the centre, and it is hoped that the first sessions will take place in July.
The third element, strengthening the capacity of the IMF to carry out its responsibilities, has seen the introduction of a supplemental reserve facility which would make money available to distressed countries faster and at the same time allow for accelerated repayments. The Korean package was the first to utilize this facility.
Finally, on the cooperative financing arrangement, countries have been asked to give themselves the legislative authority, where they do not have it already, to participate in second-line-of-defence arrangements, as with the Korean and Indonesian programs.
What to do next, both about the crisis itself and reforms to the international monetary system, to reduce the risk of further crises will be the subject of a series of meetings in the coming months. The G-7 financial ministers will be meeting in London this weekend, and the Asian crisis will figure prominently on the agenda. Sometime in the coming months, Japan will hold the meeting following up on the Manila Accord to further the setting up of a regional surveillance mechanism. On April 15 and 16, the G-7 finance ministers and the interim committee of the IMF will meet in Washington. The Asian crisis and the response of the IMF will no doubt be discussed at considerable length. On May 8, G-7 finance ministers will meet again in a lead-up to the G-8 summit in Birmingham, which will take place from May 15 to 17. From May 22 to 24, the finance ministers from the APEC economies will be meeting in Kananaskis, Alberta. As well, sometime in the next few months, the U.S. will be hosting a meeting of finance ministers and central bank governors from 22 developed, emerging, and transition economies to address issues arising out of the financial crisis in Asia.
While it is impossible to say exactly what will be discussed at the meetings and what will come out of them, I think we can say that five themes will figure predominantly. The first is improving the flow of information to financial markets so that they can make more informed decisions about the risks that attach to their investments. I can see two sets of issues here: first, whether new data should be made available as part of the SDDS, in particular whether increased information on financial sectors should be made available; second, whether the analysis of the IMF or some other surveillance mechanism should be made more public.
The second major theme will be improving domestic policy management. Here, issues that will receive attention likely include the choice of an appropriate exchange-rate regime, an appropriate monetary and fiscal policy mix, as well as the necessary structural reforms.
The third major theme will probably be the development of stronger financial systems both in individual countries and globally. This will certainly involve discussion of stronger bank supervision and efforts to promote sound banking practices.
The fourth major theme will be the role of capital account liberalization. Almost certainly efforts to promote greater liberalization will continue, but issues such as the sequencing of financial market reforms, the regulatory safeguards that should be in place, and so on will receive increased attention.
The final theme will be the role of the private sector in the resolution of crises. When should private interests be involved and how, what share of the burden they should bear, and so on will be major topics for discussion.
The Chairman: Thank you very much.
Mr. Rayfuse made reference to the problem of structural reforms and to supervision and regulation, and it is appropriate that we now turn to Mr. Thompson. I have asked Mr. Thompson to tell us very briefly about the work of OSFI in so far as institutions within Canada are concerned, and that I think will lay the groundwork for his discussion of regulation outside Canada.
Mr. John Thompson, Deputy Superintendent (Policy), Office of the Superintendent of Financial Institutions: Thank you very much. I will be glad to make a few comments on the general work of OSFI within Canada.
OSFI is the primary regulator of major financial institutions in this country. Notably we regulate all of the banks, which includes the licensing as well as supervision of the banks in Canada, right down to the point of deciding if a bank should continue in business. We would make the decision to recommend that it discontinue business if its affairs were not in good shape. OSFI supervises the major life insurance companies and the property and casualty insurance companies in Canada. We also supervise some of the pension plans in Canada, typically those pension plans for employees involved in cross-border transport and that sort of thing.
Specifically, our work relating to the subject today is in the supervision of banking. This would involve not only the supervision of Canadian domestic banks as they operate throughout the world but also the supervision of foreign banks that operate in Canada as subsidiaries of those foreign banks in Canada. We supervise both of those categories of banks.
Some of our work is done within our offices, such as receiving and assessing various documents that are filed with the banking regulators. That would relate specifically to the safety and soundness of those financial institutions, their financial strength, and their ability to meet obligations to depositors as they move ahead. We also go on site with those banks to ensure that what we are receiving is in fact an accurate representation of the true facts, so we do verify what is filed with us. At the same time, we would review the controls that management and the board have in place in those institutions to ensure that they are run in a safe and sound manner.
My comments will make reference to information that we receive from both our domestic banks and from the banks from the Asia region which operate here in Canada. The information that we receive comes from the formal material received from those institutions and also from information that we receive by going on site and looking at their financial records and discussing the situation with management.
I hope that is a reasonable introduction to the work of OSFI. It is a topic about which I could probably go on muh longer, but I hope that outline is adequate.
My role this afternoon is relatively brief by comparison with my colleagues from the Bank of Canada and the Department of Finance. They have given you a fairly good picture of the situation in the Asian region. My focus this afternoon will be on the monitoring work that OSFI has done in looking at the situation and dealing with the institutions themselves to ensure that we understand the stresses that the institutions face and to ensure that the institutions are in fact dealing with the situations and the stresses they are facing in an appropriate manner.
With this in mind, I want to make comments in three areas. The first area will be the effect on Canadian banks that have operations in the Asian region. I would then like to talk about the effect on the Canadian subsidiaries of banks that are domiciled in Asia. Finally, I will discuss very briefly the work of the Basle Committee on Banking Supervision to set international standards for supervision and oversight of financial services.
Late last year, OSFI began monitoring the events in Asia and assessing information on the possible effect on the institutions that we regulate. We asked these institutions to assess the impact on their loan portfolios and their operations generally. I am not able to provide you with any institution-specific information, as that obviously must be held confidential. However, I can say that in general terms the press coverage you read about in the past several months was quite close to the information we received in advance of those press releases.
I can, however, make a few comments on what we learned on the industry as a whole. We have been working with the institutions to monitor their loan exposures in the region. Where deterioration in the quality of those loans has occurred, the institution is expected to make appropriate provisions.
Some Canadian banks have only minimal exposures to the Asian markets. For institutions that have larger exposures in Asia, the reviews have obviously been more extensive, and in some cases they have even examined their loans on a loan-by-loan basis in carrying out that review.
For Canadian banks with operations in that region, the direct impact does not appear to be material. In fact, we do not expect that the financial impact on Canadian financial institutions generally -- and that would include our life insurance companies -- would be material in this area.
A number of Asian banks have operating subsidiaries here in Canada. In particular, banks from China, Hong Kong, Taiwan, Japan, Korea, and Singapore all have a presence here in Canada. Banks from Thailand, Indonesia, Malaysia and the Philippines do not have representation in Canada.
Generally, our review of these subsidiaries has revealed that most of the Asian banks operating in Canada provide banking services to the subsidiaries of companies located in their home jurisdiction and to residents in Canada who have come from that home jurisdiction. As a result, most of these banks have little loan exposure in Asia. Most of their loan exposure is, in fact, in Canada.
The asset quality of these subsidiary banks is generally good. Impaired loan levels are generally low, and liquidity does seem to be sufficient. These banks hold sufficient assets in Canada to meet their insured deposit liabilities in Canada.
We are pleased that both our domestic banks and the subsidiaries of the foreign banks have been rather proactive in dealing with the issues they have been facing in this area. We believe that has helped ease the disruption that might have been caused by this situation.
While we feel that Canadian banks with operations in Asia and Canadian subsidiaries of banks from Asia will not be adversely affected to any great extent, we still have some concerns. We expect that the full scope of the effects of the situation are not yet fully apparent. Second, banks must continue to deal with the effect of the events in Asia on the companies with which they do business. We feel that some of the companies from that region may not, themselves, have fully felt the brunt of this situation.
Third, it is possible that the provisions set by the banks around the world against their Asian exposures could increase generally. This may be required by regulators in other countries, or it could be by general practice based on the exposures of those banks in that region. If this were to happen, we could expect Canadian banks to follow that lead. As a result, OSFI will continue to monitor the levels and quality of loss exposures until the situation becomes stable. This requires that the institutions and OSFI continue the current monitoring levels for a few more months.
There is an increasing need for regulators to cooperate with each other and to strengthen supervisory standards around the world. This is increasingly obvious because of the increased international nature of the financial services industry. OSFI continues to work with the international supervisory standard setting groups, such as the Basle Committee on Banking Supervision, to do our part in strengthening the supervision of financial institutions internationally.
The Basle committee consists of representatives from the G-10 countries and operates with input from representatives of a number of other countries. It has been working since 1975 to improve banking supervision at the international level. Over the past year and a half, it has been examining how best to expand its efforts to strengthen prudential supervision throughout the world and beyond the group of 10 countries.
In September 1997, it released a document entitled "Core Principles for Effective Banking Supervision." This document is intended to serve as a basic reference for supervisory and other public authorities worldwide. These principles address a wide range of matters and include the preconditions for effective supervision, the licensing process and approvals for the change in the structures of these banks, the arrangements for ongoing bank supervision, the formal powers required for supervisors, and dealing with issues on cross-border banking.
Increasingly, the financial services business is becoming an international one, and the interdependence of financial services providers and sharing of services is growing. This means that regulators around the world must coordinate their activities with those of regulators in virtually all other jurisdictions.
At OSFI, we believe strongly that the type of initiatives undertaken by the Basle committee and similar bodies are the only ways to ensure the degree of information sharing, consistency in approach, and adequacy of regulation required to address an industry that has truly gone beyond national borders.
Throughout this period -- that is, since late last year -- we have been keeping contact on a regular basis with the primary regulators from both the United States and the United Kingdom to monitor their experiences and actions in dealing with the situation in Asia.
In summary, the Asian crisis has not had a significant effect on Canadian banks that operate in that region, nor has the crisis had a significant backlash on the Canadian subsidiaries of Asian banks. We believe that the need for increased provisions for non-performing loans may increase in the near future, but these increases should be able to be absorbed by our institutions.
The Chairman: If we put together the three statements we have heard, we have a very interesting and detailed survey of the situation.
I gather that a good deal of information was available about the risky nature of some of the institutional and government practices with regard to currency. A good deal of information was available to the IMF for a long time, yet the market seems to have been oblivious to this information. Why is there this gap between hard information on the one hand and the conduct of the market on the other hand? I thought markets were supposed to be virtually infallible.
Mr. Powell: They are never infallible.
The Chairman: Virtually.
Mr. Powell: After 10 years of good economic performance, market participants, as well as the governments in those regions, probably thought that things would work out, as they always had done. You expect good performance to continue.
I would also refer to the incentives for market participants. As long as those exchange rate regimes were seen to be credible, even if problems were brewing, there was always an incentive to say that it is not a problem and that we will be able to get out first. If the exchange rate regime looks like it is getting into difficulty, we can move fast and get out.
For many years before the crisis, there was a "carry trade" where banks, financial institutions, and residents in these countries would borrow in low interest yielding currencies and invest domestically. It was a very profitable business. When you see all these profits accumulate over the years, it is hard to think that this process is coming to an end. However, you hope that you will be able to get out the door first when it does. Of course, when everyone is trying to do that, panic arises.
Senator Carney: I do not think you answered the chairman's question. We have had this reference for some time to study the Asia Pacific region. We have heard from many experts from all government departments. We have met with businessmen and women who have told us of the difficulties of performing in these markets and obtaining financing, business plans and information. We are, therefore, bewildered that, after all this discussion, there was no advance notice to us that this crisis was brewing, although we have posts abroad and we chaired the economic section of APEC. At no time did anyone mention this kind of meltdown. You have not answered the chairman's question concerning why we did not know, and you may want to answer that.
First, who got hurt? What will it cost us? I will direct this question to Finance Canada because that is the department which must pay for this.
If you are pledging to the IMF, you must book this in the fiscal framework. Somewhere, the Government of Canada has had to earmark funds for this venture. I know that Mexico paid it back, but we must assume that if you book the funds, it is costing Canada money.
Second, Mr. Thompson made the point that non-performing loans may increase in the near future. That means that companies will go bankrupt. The banks may be okay, but their customers are being hurt. Therefore, who got hurt in terms of what it will cost Canada, and what companies in the market place are paying for it?
Who got hurt, what will it cost us and, to rephrase the chairman's question, why did no one tell us anything about this, considering the resources available to us?
Mr. Rayfuse: I will deal with your question about how much this will cost us. Perhaps I should clarify a bit about how the IMF packages work. Basically, they cost us nothing. This comes from money that we have on deposit at the IMF as part of our quota subscription. This counts as part of our foreign exchange reserves.
These packages are called bailouts, but we should be clear on what they are. They are loans to the affected governments. The IMF will make a loan to the Korean government, for example, out of the money that is placed by the members with the IMF. There is no additional cost to the Canadian taxpayer. This is money already on deposit at the IMF. Indeed, we get an interest-bearing asset out of this.
The loans are paid back to the IMF with interest. Therefore, the participation of the IMF costs the taxpayer nothing, although ultimately the taxpayer is at risk. If the IMF ever went completely bust, having made a bunch of bad loans, it is ultimately part of our foreign exchange.
Senator Grafstein: We have to replenish our quotas.
Senator Carney: We made pledges.
Mr. Rayfuse: That is right, but these are extremely secure loans. I am not aware that anyone has failed to pay back an IMF loan.
Senator Carney: Indonesia may be the first exception. Please continue.
Mr. Rayfuse: We may put some resources up in the second lines of defence, namely, the bilaterals. We are participating in the Korean second line of defence. At the moment, we have not put up anything. The second line has not been activated and it seems to be a long way from being activated. The recovery in the Korean stock market and the stabilization of the yüan is part of what putting the second line in place was supposed to accomplish, and it appears to have done that. It has cost us nothing so far.
Senator Carney: My question included the private sector. If your non-performing loans are increasing, someone is going bankrupt. In B.C., we have downgraded our economic growth.
Mr. Rayfuse: There is no question that there are problems in the private sector. I need only look at the emerging markets fund in my RRSP to know that.
Senator Carney: This is not a costless exercise for Canada. My province is affected, as are other provinces. People signed Team Canada contracts for billions of dollars in Thailand. Who is paying for this? Someone must be able to tell us.
Mr. Thompson: A number of individuals and companies end up paying. I cannot give you a complete list of who is paying, but when bank customers have borrowed money, either for trade financing, in this case, or for business loans of whatever sort, to the extent that the borrowers are unable to pay back those loans the bank customers are obviously hurt by the financial crisis and their businesses, or they as individuals, find themselves unable to pay their loans. They are obviously hurt.
The fact that the lending institution has not had its repayment schedules met on those loans means that the bank has lost money on those loans. The figures that we have seen coming out of the banks here in Canada are large. They are not material in terms of the size of those institutions, but they are losses and they are measured in hundreds of millions of dollars. Effectively, they will end up being charged back, in terms of the performance on the stocks and shares of those banks across the country.
A number of people in the banking chain are affected by this situation.
Senator Carney: I am sure that others will want to follow that up. People cannot pay their bank loan because their Thai customer did not pay them, and we are not hearing about the impact of this on the Canadian economy.
I ran into Gordon Smith, our former under-secretary of External Affairs, on the airplane back from the Davos Conference. Hesaid that the consensus at Davos was that China would be all right in this. Is that your assessment?
I understand that everyone is examining whether Hong Kong can remain pegged to the U.S. dollar. Since Hong Kong is our major re-export market to Asia, what is your assessment of what is happening? Also, what is the assessment for China? China is one of our biggest customers and no one is talking about it, mainly because we do not have any information on it.
Give me a risk analysis of Hong Kong and China.
Mr. Powell: China is going through its own set of economic problems. Its own financial system is in rough shape. A high percentage of the loans of the state banking system is non-performing, and the state-owned enterprises are a major burden on the financial system there. It is my understanding that they have started a process of trying to wind up some of these state-owned enterprises and shift more resources to the quasi-private sector to work their way out these problem loans.
The economy there has been slowing. Inflation has come down as well. They devalued their currency in 1994 and some cite that as the spark that got things going in Asia, because they suddenly became super competitive.
Analysts are debating whether or not they will devalue. The latest word is that they can hold the line. Indeed, it seems to be in their best interests at this point in time not to devalue, but who knows exactly what they wish to do.
In terms of Hong Kong, they have strong international reserve holdings themselves. The Chinese government has also said they are willing to backstop Hong Kong. The currency peg itself is the strongest of all currency pegs, and Hong Kong has a currency board. They have a lot of foreign currency backing their monetary base, and even broader definitions of money.Of all the countries, they can probably hold it. Their chances are very good.
Also working in favour of Hong Kong is the fact that, first, their major banks are well run, well regulated and sound institutions, unlike institutions in other parts of that region. Hong Kong also has a long history of good government generally. They just put down a budget yesterday which seems to be continuing that track record.
Their economy has also demonstrated that it is extremely flexible. That is a key advantage if you have a currency board. Indeed, over the last 10 years, we have seen Hong Kong transform itself from a manufacturing base to a regional financial centre.
Senator Stollery: Yes, based on real estate values.
Mr. Powell: Real estate is the Achilles heel of Hong Kong. Property prices have fallen, but the government controls the supply of land. So that it is a rigged market, in some respects, in terms of how much land gets out onto the market at any given time. Therefore, land prices could well stabilize.
Hong Kong has a good chance to survive intact, but there are no guarantees in these things.
Senator Carney: Mr. Chairman, you may wish to follow up on the question about the lack of advance warning on this -- that is, unless you feel that your question was answered. As a committee, we should look at this issue of who is getting hurt before we write a report that says, "Rah-rah for the rest of us."
The Chairman: I agree with that.
Senator Bolduc: Mr. Powell, you told us that the chain of guarantees provided by governments underlie the Asian crisis and Canada is part of that chain of guarantee. What do you think about that from the point of view of the Minister of Finance?
You told us that the chains underlie the crisis and Canada is part of the chain. I should like to have the view of the people from the Ministry of Finance on that. I suspect that sometimes you talk to each other.
Mr. Powell: We do talk. To the extent that Canada is a member of international financial institutions and the IMF is part of that chain of guarantees, yes, we are part of the problem. The IMF is a mixed blessing. As I mentioned, on the one hand, it is comforting to have a lender of last resort. Indeed, in a domestic setting, it is comforting to have a central bank to provide lender-of-last-resort assistance to financial institutions.It is part of the safety net that we have out there more generally. You can look at the IMF as part of the international safety net.
At the same time, while there are benefits, there are also costs to having those types of safety nets. Markets may not have the same incentives that they would have had were those safety nets not there. That is not to say that you would want to throw out everything. However, you must balance the costs and the benefits.Certainly, some of the efforts that my colleague here from Finance Canada mentioned, as well as looking at how to get the private sector involved at an earlier stage is part of the answer.
If you get the private sector involved earlier in the game, they must bear the burden of their bad decisions. That is what has happened, for example, to some extent in Korea. Generally, the banks were brought in.A standstill arrangement was then put in place and they extended their loans at terms for which they may not have done otherwise. They were at least brought in at an earlier stage than they had been in the case of Indonesia or Thailand.
Things are evolving. People are aware of the moral hazards associated with IMF lending and efforts are under way to try to mitigate those moral hazards.
Senator Bolduc: My second question concerns the kinds of internal or external controls about the financial institution. I have visited some of those countries a few times. I was left with the impression that we go only to the surface of the problem here. Under that you have the socio-economic structure. Those countries are led by cliques of a few bankers, a few politicians, and a few conglomerates of manufacturers.
Senator Carney: Yes, and the army.
Senator Bolduc: I suppose so, yes. I do not see how they can change by themselves. I suspect they also have financial supervision like we have in Canada, but in Canada the banking system is good all over the place. Mr. Thompson is performing well because the Royal Bank is also, but in those countries it is a different matter.
Is it not possible to have an international treaty that sets the standards of inspection or to institute a certification system so that either you behave or you will not be accepted in the system, such as we have for weapons of mass destruction vis-à-vis Iraq? If there is not an international organization to look at it from outside of the country, I do not see how you can improve it.
I do not believe the shake-up by the market will be sufficient. We have the example of Japan. For a country that is as developed as it is today, they have a financial system that is in trouble, and for the same reason. If Japan does not improve, I do not see how the others will follow.
Mr. Thompson: There are three or four bodies that are trying to work on the kind of issue that you have concern with, and that is setting international standards for supervision of financial institutions. We have the Basle Committee on Banking Supervision, which is looking at the banks around the world. Starting with the strongest financial countries, they are trying to establish standards that work in those countries and then applying those standards for any banks operating across borders.
This is a long and slow process. Japan is a member that attends meetings and signs agreements to these standards. We also have the International Association of Insurance Supervisors, a group of 70 countries from around the world that is also trying to set standards for insurance supervision, primarily dealing with companies that are active in a cross-border sense.
You are familiar with the work of IOSCO, the International Organization of Securities Commissions, which is basically doing the same work for securities commissions around the world. The other body that is relevant here is the Joint Forum on Financial Conglomerates, which is a body which has representation from the three bodies I have just named. They are trying to look at the process and the standards for the supervision of internationally active conglomerates. Those would be organizations that, like our big banks, are involved not only in banking but also in insurance and in securities. They operate in many jurisdictions. They are difficult entities to try to supervise.
Senator Bolduc: I will go further. If one does not have any certification, one cannot say, "I do not loan money." It is related. Either you are certified and then you get money or you are not.
If this system is not incorporated into it, I do not see how you can expect that they will behave because there are international standards.
Mr. Thompson: Much of the responsibility falls to the regulator in the local domestic jurisdiction. For example, it falls with us to keep an eye on the banking institutions that operate in Canada to ensure that they are able to meet their obligations in Canada.
You are suggesting that that sort of standard and approach be one that is adopted throughout the world. Many jurisdictions have neither the type of standards that are as high as the ones we have here nor the ones in the U.S. or the U.K., all of which have strong banking standards and banking supervisory models. That is not shared in many of the countries that we are talking about.
The only way to raise the standards in the current environment is to invoke peer pressure from those countries which are strong upon those countries which are not. If that does not work, the only alternative is to establish an international group that supervises supervisors or supervises financial institutions that operate across borders.
Senator Di Nino: I do not wish to be in disagreement with my colleague Senator Bolduc; however, I wish to ensure that we understand that a country like Canada, with its systems and developed rules and regulations, can still have horror stories.
The Chairman: Such as Confederation Life.
Senator Di Nino: Yes. With Dome Petroleum and the Bank of Commerce under OSFI supervision, let us not fool ourselves that we are the best in the world or that these horror stories cannot happen in Canada. These things can happen for a number of reasons, including mismanagement, greed, corruption and fraud.
To what degree can we find out how many of these horror stories have occurred as a result of corruption, fraud and stealing of the money?
Mr. Thompson: Before Mr. Powell answers this, I should like to draw a distinction.
The situations that Canada has gone through in the last few years have been institution-specific issues. The Canadian system is not structured in a way that prohibits a company from failing. Ours is a free-market system; it allows a company to fail through mismanagement, through aggressive management, or whatever reason.
Senator Di Nino: Some fail due to fraud.
Mr. Thompson: I am not aware that we have had that problem, but fraud could happen, yes.
When there is a competitive free-market system, you must allow people to take risks and when people take risks, they can fail. Many of our situations have occurred as a result of that. That is a different situation from one that we would call a systemic risk, when every single institution is faced with exactly the same problem because of what is happening in the marketplace.
Senator Di Nino: We are not talking about a problem which can be isolated. We are talking about a problem which is universal. You seem to be skirting around the issue. What is the problem? Are there people at the highest levels in some of these countries who are stealing this money? That is a question that should be asked.
You talked about Senator Carney's question concerning who pays -- and, I can do some quick calculations but I will not bore you with it -- and how much the Canadian taxpayers must pay indirectly and directly because of this mess. The finance minister should realize he could have balanced his budget some time ago.
To what degree are we able to discover whether this is mismanagement or is there something more sinister behind this?
Mr. Powell: I am not sure "sinister" is the right word to use. I hope it is not. Without a doubt, there is crony-capitalism, at its finest or, rather, at its worst, running rampant in these countries.
I am aware of a corruption index which ranks these countries. A number of countries in that region do not score many points. Yes, there is a large problem in this region.
Mr. Rayfuse mentioned the problems in connection with the government banks in Korea. The current government is trying to reform the chaebol system. I would not describe what went on there previously as "sinister", but it was a cosy type of relationship. When times were great, this looked like a wonderful system. As with the Asian model, it was the Japanese model that was spread throughout the region. It seemed to work. However, in about the last six months we have had another paradigm crash. About five or six years ago it was the Soviet Union's central planning model which crashed. This is another economic model that has gone down in flames. This is the problem.
There have also been press reports in Indonesia, for example, of family-owned banks being closed and reopened again, ready to take deposits and make loans.
Senator Di Nino: That is the question.
Mr. Powell: I do not know the answer to that question.
Senator Di Nino: How do we obtain an early warning system for these things so that when the bleeding starts it is not quite fatal and it only hurts instead of kills us?
Senator Grafstein: Last spring we saw the Bre-X matter. When it comes to Indonesia, this is not what we would refer to as a capitalist society; it was crony-capitalism at its worst.
There is a sovereign risk to a country and Indonesia had to be on the top of the list in terms of risk-size and growth. There was a fair warning to everyone in the world that if you are to be there, hedge your bets. I wish to make that comment to my colleague. I am sure that an astute businessman would make a measurement risk before he enters into any type of investment.
The problem we have is that Team Canada, and so on, creates an impression of solidity. We need to utilize Team Canada more, although it can create a false sense of security. One may say, "I do not have to do my sovereign risk." There is a reliance on that.
I have three areas of questions, the last one being the early warning system.
The one thing we have learned here is that when things happen in the interconnected marketplace, they happen so swiftly that it boggles the mind. We learned that with computer trading in the United States and now we have learned that here. There is a huge domino effect.
Let me deal with what I consider to be my priorities as a senator from Toronto.
First, Mr. Thompson, are we really satisfied that OSFI has taken the steps to ensure that financial institutions in Canada -- both Canadian, their subsidiaries abroad and subsidiaries of foreign banks or institutions in Canada -- have taken their proper write-downs fast? If we do not do that, in the end it costs the Canadian taxpayers through the question of insured indemnities through our banking system. Have we done that and done it swiftly?
The Chairman: We understood the question. Must we hear it three times?
Senator Grafstein: No, we have not understood the question. Bear with me for a moment.
I have looked at the witness's testimony carefully and it seems to say, "Yes, we sort of know but we have not moved." That is what the statement says. I looked at it carefully. I am not being critical.
Senator Di Nino: I agree with Senator Grafstein.
Senator Carney: So do I.
Senator Grafstein: It sounds like there is a soft landing here. I am interested in whether or not we should make a harsh landing now as opposed to later on. This relates to the witness's testimony and the tone of the testimony.
Mr. Thompson: The intent of my testimony was not to be mealy-mouthed on this issue at all. We have not granted any concessions to any of our banks, either the domestic Canadian banks or the subsidiaries of Asian banks operating in Canada. They must satisfy accounting standards, which require that they take provisions on loans that go non-performing immediately.
Senator Grafstein: Should we read about that in the next quarter?
Mr. Thompson: You should start seeing those figures coming out right away.
Senator Carney: Most of them will be from B.C.
Mr. Thompson: In fact, a lot of their loans are loans that are made in their operations outside of Canada. A lot of them are trade-financing types of loans in foreign jurisdictions. They also have a lot of debt in B.C. and in areas that are working actively in the Asian markets, as well as businesses that are working actively in the Asian markets, where contracts have failed and business opportunities have dried up and where they have invested heavily in attracting business, perhaps doing their part of a trade deal without having the other part of it being met.
I have heard stories from people in the manufacturing businesses, as well as people in the consulting and advice-giving businesses, typically in the Vancouver area, that have been affected by this rather harshly.
Senator Grafstein: To emphasize that point, when it applies to Canadian subsidiaries of Asian banks <#0107> that is, the Japanese, Hong Kong and Chinese banks -- I take it you put them on some sort of special watch to make sure that you have gone through this loan by loan?
I say that because we did have testimony several years ago where there was not that type of loan-by-loan supervision, but we are on public notice. I want to know whether or not you have done that. I want you to give us some assurance that this is being done in quite a rigorous way.
Mr. Thompson: This is being done in a rigorous way. We have not dictated that the loan reviews be done on a loan-by-loan basis except in situations where it is material. In smaller situations we have not run across anything material but where it is large, and where there are concentration-of-risk issues and a few situations like that, we have asked that loan-by-loan reviews be carried out.
Senator Grafstein: I wish to turn to a second topic, which is more of a systemic topic that the Chairman put us on to several months ago, namely, the role of the IMF.
The problem that we have now with respect to the IMF is that if you would have asked every senator in this committee a year ago whether they had confidence in the judgment of the IMF, there would have been a sterling response.
Senator Stollery: Exclude me from that statement.
Senator Grafstein: With the rare exception.
Senator Stollery: With one exception, on the record, please.
Senator Carney: I wish to be included in that, too.
Senator Di Nino: So do I.
Senator Grafstein: We are hearing great retrospectives here. I do not mind. Senators are as entitled to retrospectives as bankers are.
The Chairman: Senator Grafstein, in defence of Senator Stollery, he has a professional obligation to be a Cassandra, and he has performed his role admirably.
Senator Grafstein: Yes, every time. There is no question that if something goes down, Senator Stollery will have predicted it.
Senator Stollery: But you cannot include me in this unanimity.
Senator Grafstein: We will be asked, at one stage in the not-too-distant future, to replenish IMF. There will be a replenishment here in some form. We were asked some years ago to do that.
The problem, we gather now from the financial press, is that the IMF was not astute this time. In other words, they moved too precipitously and perhaps they did not move astutely. "Astutely" means to me that they were on top of the situation, they were forewarned about the situation and there was an early warning, which there was not. When they were into the morass, the melt-down, then they moved precipitously by triggering, in effect, a run on the banks in several of the marketplaces, which obviously had a trigger effect on others.
How do we get confidence? How do we regain our footings with respect to the integrity of the judgment of the IMF regarding early warning? We were not warned early so the IMF did not act as an early-warning system and, once they were forewarned, they did not march astutely. The IMF cost us, the international banking community, billions of dollars because they precipitated, in a crude way, a run on banks in several countries. I do not want to isolate them but you are all nodding and you all know what I am talking about.
How do we, as an astute Canadian banking community, which includes the Bank of Canada, regain our confidence in the IMF? How does Canada play a role to revive the credibility of the IMF, of which we are staunch supporters? That is a big problem for us. How do we do that?
Mr. Rayfuse: I have a couple of comments. First, I do not think it is entirely fair to say that the IMF did not see this coming. You have to look at the forums through which the IMF can express its warnings. It does that through so-called Article IV consultations, which are private. They are not made public, although there has been some move in recent years to make summaries of these consultations, called press information notices, public.
We have looked back at the Article IVs of Thailand, for example, and the IMF did see problems building up and they did warn the Thai government well before the crisis happened that the exchange-rate regime was unsustainable. They perhaps did not see the depth of the problem in the banking sector, but the IMF's specialty is not banking system analysis and regulation. They certainly did see the problems building up in Thailand. They warned the Thai authorities. The IMF, however, does not have means to make a country heed its warnings unless and until that country comes to the IMF for assistance. The Thai authorities were able to say, "Yes, we take your warnings, but we can handle it." There was essentially nothing that the IMF could do about it. When Thailand came to the IMF for assistance, the IMF rendered that assistance under certain conditions, including structural reforms.
In relation to Senator Di Nino's questions, I wish to state that these packages have all come with structural reforms attached to them to address some of the issues and some of the shortfalls in governance to which Senator Di Nino referred.
It is not fair to say that the IMF did not see this coming. They saw it coming. They issued warnings. Those warnings were not acted upon.
In terms of what they have done since then, I do not agree that they precipitated these crises. These countries came to the IMF.
Senator Grafstein: I did not mean "precipitate". They triggered a worsening of the problems in terms of some of those bankrupts.
Mr. Rayfuse: I do not agree with that because Korea came to the IMF when it was on its last legs. It was down to having a few days of international reserves left. It is not fair to say that the IMF precipitated that. In fact, Thailand as well came to the IMF as a last resort. When they floated their currency and got into trouble, their first reaction was to go to Japan to see if they could negotiate something privately with the Japanese banks. They were told to go to the IMF.
The IMF packages have come with the structural reforms attached which address the governance issues to which Mr. Powell referred as some of the links in the chain of guarantees. I think we can say -- although it is still early -- that the economies are beginning to respond. The situation in Korea has stabilized and turned around. Thailand is looking better. Again, I caveat that because there are all kinds of risks attached to this. However, it appears to have stabilized the situation and turned it around.
I wish to refer you back to the Mexican situation as well. Mexico had a serious crisis in 1994 and a serious economic contraction in 1995. It implemented an IMF package and rebounded in 1996 and 1997.
Again, you can quarrel with individual elements of the IMF program, but, in general, the IMF programs are achieving their objectives here.
Senator Bolduc: I take it you do not agree with the assessment in The Economist?
Mr. Rayfuse: No. It talks about the harmful effects of closing banks. As Mr. Powell clearly stated, one of the guarantees that caused this crisis was the notion that banks cannot fail. The IMF has said that as part of these packages, insolvent institutions must be allowed to close. Provisions have been made, to the extent possible, to protect depositors, and so on, but basically the institutions that got themselves in these situations must be able to pay the consequences.
Senator Grafstein: When it appears to the innocent mind who reads the financial presses without a degree of sophistication that a particular country -- and, I will name it because it is easy to name at this moment -- namely, Indonesia, is infested with the worst type of internal capitalism, what role should the IMF and international institutions play with respect to that country? Should we cut them off? The money goes into their central bank, which is corrupted by their political regime. How do we say to a country like Indonesia, which is now thumbing its nose at the international community, "You have to straighten yourself out. It is not right for the king and the king's sons and the court to be at the trough"? How do we deal with that?
Mr. Powell: There is no legal system.
Senator Grafstein: I understand that, but we are talking about writing a cheque now. It is as if we turn a blind eye to that cancerous capitalism.
Mr. Powell: In the case of Indonesia, the IMF is taking a hard line. It is doing things that Indonesia does not like. My understanding is that they are drawing a line in the sand, as it were. As my colleague from the Department of Finance said, many structural measures are required as pre-conditions. In order to get the money, countries must do certain things. For example, in the case of Indonesia, they had to break up many of these monopolies which were controlled by friends and family. It was the fund's opportunity. Until this point, Indonesia had not borrowed from the fund. The fund could complain about things, and had done so in the past, but there is nothing it can do until a country comes to it for financial assistance.
There was quite a large number of measures aimed at breaking up some of these corrupt practices. I am not competent to say whether or not they are sufficient, but that is certainly the direction of the program.
There has also been a lot of controversy over particularly the macro elements of fund programs. The argument is made that Asia is a different type of situation. It is not like Latin America 10 years ago. This was not a problem of lax government policy and profligate governments. Here is a case where governments of countries had followed apparently prudent macro policies for a long period of time. Thailand and Korea were running balanced or surplus budgets, so going around and demanding extraordinarily tight monetary and fiscal policy and trying to balance the budget as the economy is shrinking is seen as just adding to the problem. There is certainly an element of truth in that argument.
The counter argument that the fund and others make is that, on the monetary side, you need sufficiently high interest rates so that people are willing to hold that domestic currency. Yes, if interest rates are kept too high, then the financial system and domestic borrowers will suffer. However, many of these domestic corporations have huge foreign currency liabilities. If the currency is not stabilized, they will lose because of the burden of servicing these foreign currency debts.
The IMF is sort of caught between a rock and a hard place. The way they try to go about it is to have sufficiently high interest rates in order to stabilize the situation for the short run and, hopefully, to be able to lower the interest rates quickly enough once the situation is stabilized. That is a tough job and a tough call.
On the fiscal side, I do not think you can argue too much against closing some of these egregious prestige projects that have been popular in a number of these countries which are very low yielding. That is a tightening of fiscal policy, and that does go a way to helping confidence. You do not want to see the government wasting resources on things which do not yield a high return.
However, you need to allow the automatic stabilizers to work. You do not want to try to balance the books on the back of a shrinking economy. That would cause almost an economic implosion.
The IMF has been more flexible in the last while, recognizing that economies are weaker than hitherto thought, and has allowed fiscal deficits. That is to say, countries have not had to run fiscal surpluses or even balanced budgets but instead can run fiscal deficits to support the economy.
Senator Stollery: I do not intend to attack the witnesses, because that is a pointless exercise. The issue here is that it happened.
It happened in Mexico in 1982 and then in 1994. It happened in the Far East in 1998. In every case, the local people get their money out first because they all know first. This will happen again. There is a rule in finance. When everyone gets the big idea, do something else. This is just another example.
The IMF has been discredited with their report from June. I am sure you gentlemen saw the report on globalization in which Korea was put forward as an example of a country which has now achieved G-7 standards. Several other countries were mentioned, too. That finding was shot down within a few months. We have seen it happen before and we must remember that it will happen again.
The two large economies in the Far East are China and Japan. Countries like Indo-China are subcultures of China. The real question is: What will happen in China? We have no way of knowing because it is a secretive, corrupt dictatorship that will not tell us anything until it happens.
There have been a couple of extremely interesting articles in The Financial Times during these events. Mr. Sorros says that the global financial market does not work. In your evidence, you have taken the position that domestic financial-sector liberalization and CAP are good things. Mr. Sorros does not agree. He says that maximizing profits is the only interest of the financial community.
What do you think about that? Do you believe there will be another crisis? Do you think Mr. Sorros may be right? Do we need to take a look at the international financial institutions, especially given the speed of communications which emphasizes every one of these events?
Mr. Powell: I think you are right. There will be another crisis somewhere, sometime. No financial system or financial super-structure in the world can guarantee that there will not be a crisis somewhere down the road. They happen. It is important, though, to ensure that when crises do happen that they do not propagate around the world. These Asian economies suffered from the same types of problems.
Senator Stollery: The German banks are in for hundreds of billions of dollars.
Mr. Powell: However, the German banks will not go under as a result of this. If they have losses, they may smarten up and not make the same kinds of loans in the future.
Something good can come out of this if lenders, as well as borrowers, assess their risks more appropriately. There is a salutary element here. For these countries, this will be a painful experience for them, particularly for the very poor. This crisis will affect them the most.
Senator Stollery: What do you think about Mr. Sorros observations?
Mr. Powell: I think he is misguided.
Senator Stollery: I think that the Sorros's observation is a crucial one.
The Chairman: We are arranging another meeting on this topic with some of the bankers. This is not the last chance for you to ask your questions.
Senator De Bané: Recently, a former secretary of the United States Treasury and his former deputy wrote an article on why, in their opinion, this IMF thing is no good. It imposes suffering on the people. It saves financial institutions which have been reckless in their investments. Have you read that article?
Mr. Powell: Yes. It is a Wall Street Journal article.
Senator De Ban$: Yes, it was written by Mr. George Schultz and his deputy. That field is not my area of expertise, but I read the detailed explanations of the former secretary of the treasury that this remedy only imposes immense suffering on poor people and prevents huge financial institutions from having any loss.
You have read it. Where is the flaw in that article?
Mr. Powell: On the side of the country, I ask what would be the alternative if the fund was not there? The fund is providing resources to that country. The policy prescriptions that they are recommending are actions the countries would have to follow regardless. The fund is making the situation easier, not worse.
In terms of the lenders, you are quite right. That is a moral hazard with international lenders of last resort. It does distort the viewpoint of banks and other lenders when they are preparing to lend to a particular country. There would not be widespread support to do away with the fund entirely. Rather, we must do something about that moral hazard.
One of the things being discussed now is to get the private sector in early. Rather than have the IMF provide the money, let people get their money out, and then get the banks in.You would get the financial institutions up front, along with the IMF, to work out a solution. In that way, investors do not have a chance to get out with the IMF money.
The Chairman: Honourable senators, our appetites have been whetted. I expect full attendance at our next meeting. Perhaps next time we can start on time.
The committee adjourned.