I Introduction and Summary

International Monetary Fund
Published Date:
September 1996
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The years from 1992 to mid-1995 were marked by a series of crises in international financial markets; in contrast, the 12 months to June 1996 have been a period of relative calm. Indeed, the global financial system appears to have emerged stronger and more resilient from the costly and disruptive crises of the earlier years. Financial institutions in most of the major industrial countries have made important progress in implementing reforms to improve their ability to manage and control financial risk in the evolving international financial system. Furthermore, significant progress continues to be made in the major industrial countries in restructuring their financial regulatory and surveillance activities in line with developments in international markets, and in strengthening market infrastructures, in particular wholesale payment systems. Although much remains to be done, many emerging market countries have also initiated reforms to strengthen their domestic financial sectors to better withstand the rigors and vicissitudes of an open international financial environment. The fruits of these efforts are now clearly visible in recent market developments. Although the scale of financial activity is continuing to grow, market participants, including such risk-tolerant investors as the macro-hedge funds, are more disciplined, cautious, and less likely to ignore market fundamentals in their market activities, and markets appear better able to shrug off periods of turbulence, at least for now. Cases in point are the ease with which global markets recovered from the uncertainty in the U.S. bond market in early 1996 and the relatively rapid recoveries of some emerging market countries that experienced contagion effects during the Mexican financial crisis in late 1994.

Against this backdrop, this year’s capital markets report first discusses briefly how the control and management of financial risk have been strengthened by efforts in the official and private sectors in the major industrial countries. Recent crises appear to have been the inevitable by-product of the transformation and restructuring of international finance that has taken place during the past ten years. This transformation has forced both official and private participants in international financial markets to “move up the learning curve” in order to better manage the private and systemic risks posed by these developments.

This discussion is followed by a survey of developments in international financial markets. Although the fallout from the Mexican financial crisis has not entirely disappeared, capital flows to the emerging market countries have returned to levels attained prior to the crisis, and international investors are exercising greater differentiation among regions and among different types of assets than had been evident before the crisis. Nevertheless, a rapid increase in the issue of yen- and deutsche mark-denominated bonds raises questions regarding the ability of some emerging market countries to manage currency exposures prudently, and it also puts into question the ability of retail investors to assess adequately sovereign credit risk. A certain amount of volatility in capital flows is inevitable, but the changing composition of flows indicates a reduced risk of sudden large-scale withdrawals from developing countries. Meanwhile, the major international financial markets returned to a state of relative calm in the second half of 1995 after a period of financial market adjustments that began in early 1994 with bond market turbulence and that ended in mid-1995 with the elimination of a temporary misalignment involving the major currencies. Apart from occasional increases in volatility, markets have remained in this calmer state in 1996. in part also because the macroeconomic environment has been supportive of more stable financial markets.

The report also considers two remaining financial policy challenges whose resolution is essential for the stable evolution of the international financial system over the longer run. The first challenge is how to strengthen the international financial system by extending the successful supervisory and regulatory practices developed under existing Group of Ten multilateral arrangements to include the growing number of systemically important emerging market countries. The continuing globalization of financial markets, extending now gradually to a widening circle of emerging market countries, will increasingly demand a more inclusive multilateral approach to maintaining a sound and efficient financial system.

A second challenge, but one of a more technical nature, is how to reduce further the potential for disruptions in the global foreign exchange market—the core of the international financial system—where turnover now exceeds $1 trillion a day. Efforts to facilitate the clearance and settlement of foreign exchange transactions, as well as to reduce the outstanding settlement balances, are being given top priority by the major central banks, and several initiatives in this area are currently being undertaken by the major foreign exchange dealers. However, there does appear to be scope for greater official involvement in meeting the challenge of strengthening this vital segment of the international financial system. The report concludes with an appraisal of developments and recent initiatives in international capital markets.

The report is followed by a set of annexes that provide background material. Annexes I and II review and analyze developments in the major capital markets and the developing capital markets, respectively, since early 1995. Annex III reviews recent changes in the structure of global foreign exchange markets and discusses private and official initiatives to reduce the systemic risks inherent in these markets. Annex IV provides information on the framework for international cooperation in the supervision and regulation of financial institutions, and describes cooperative efforts to regulate both international banks and securities firms on a global, regional, and bilateral basis.

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