Liberalization and integration of financial markets have been associated with an increase in capital movements and with financial crises. In particular, surges in foreign short-term debt have been blamed for crisis episodes in emerging economies in Asia (Thailand, Indonesia and South Korea) and Latin America (Mexico, Brazil, Ecuador and Argentina), as well as in the periphery of Europe (Turkey). These crises have proved costly in terms of output.
Several policy responses have been suggested. Among them, reduction of short term-debt levels, stock-market development, improved regulation and supervision of the domestic financial system, enhanced transparency requirements and market discipline, as well as the establishment of an international lender of last resort (LOLR). A catalog of “solutions” has been proposed to take care of the problems of banking in emerging economies, including moving to a narrow banking system, building a currency union, and leaving banking in the hands of foreign banks and offshore institutions.
In this paper I identify policy responses tailored to the needs of emergent and developing economies. The question is whether the regulatory policies and practices of developed economies can be recommended essentially without change or whether a different policy mix is needed. A basic theme is that more acute asymmetric information problems and a weak institutional structure in emerging economies call for policy prescriptions that are different not only from developed economies but also across emerging countries.
I focus particular attention on a consequence of the weak institutional structure in emerging countries, namely the lack of capacity for policy commitment. This lack of commitment may be due to the short horizons of public officials in the face of, say, political instability. The outcome is that the government of an emergent economy may bail out the private sector, while encouraging excessive risk-taking or moral hazard, and/or may devalue foreign investor claims by discouraging their investment in the first place. Indeed, a major problem in emerging markets is the implicit or explicit guarantee of a bailout in the event of a banking crisis, as experiences in Argentina, Mexico and Thailand have shown, and, in general, the use of inflation to devalue domestic-currency-denominated claims.
The end result is that domestic regulation may not be enough in countries that face a commitment problem, and those countries have to import discipline. However, some of the ways of importing discipline from abroad, such as increasing the role of short-term foreign debt, generate costs of their own. I examine the trade-offs imposed by the different ways discipline can be imported and classify countries according to the desirability of doing so. At the same time I analyze the catalog of solutions to the problems of financial systems in emerging economies and the potential role of an international agency such as the International Monetary Fund (IMF).
This paper is organized as follows. Section 2 deals with regulation in emerging countries: rationale, regulatory instruments and the optimal design of regulatory institutions. Section 3 examines the trade-offs for a small open economy associated with importing external discipline. Section 4 classifies a range of emergent economies according to the trade-offs examined, and provides an assessment of the cost and benefits of external discipline. Section 5 is devoted to solutions that have been proposed for emerging countries: narrow banking, currency unions, foreign banks, public banks and offshore banking. Section 6 studies the potential role of an international agency such as the IMF. Finally, Section 7 presents some concluding remarks.
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