G7 Finances Ministers report to the Heads of State and Government on international monetary stability

LYON, 28 June 1996

The dramatic increase in trade and capital flows in the world has deepened economic and financial integration among all countries, and it creates a more complex financial environment, with a greater diversity of capital flows, creditors and borrowers. This process of globalisation creates new opportunities but also challenges for our countries and the international community, especially with regard to our international monetary and financial system.

In this context, the Heads of State and Government concluded at the Halifax summit that : "Close consultation and effective cooperation on macroeconomic policies among the G7 are important elements in promoting sustained non-inflationary growth avoiding the emergence of large external imbalances, and promoting greater exchange market stability", that "we have a shared interest in ensuring the international community remains able to manage the risks inherent in the growth of private capital flows, the increased integration of domestic capital markets, and the accelerating pace of financial innovation" and that "closer international cooperation in the regulation and supervision of financial institutions and markets is essential to safeguard the financial system and prevent an erosion of prudential standards."

In our discussions in Halifax last year we concluded, more specifically, that :

the most important foundation for exchange rate stability is the maintainance of sound macroeconomic policies aimed at achieving sustained non-inflationary growth and avoiding the emergence of large external or internal imbalances ;

flexibility in exchange rates of the major currencies is a basic feature of the system because unanticipated events occur, economic fundamentals change, and national financial and economic developments are sufficiently different that they require that policies be able to respond to them ;

exchange market intervention can be effective and even decisive in specific circumstances, but those circumstances are difficult to determine in advance ;

there is no effective regulatory structure or tax mechanism that will produce greater exchange rate stability without major costs in terms of other economic objectives.

These conclusions remain valid today.

Our overriding objective is to promote sustained non-inflationary growth. In this context, the G7 can best promote greater stability in exchange markets through the pursuit of appropriate macroeconomic policies along with close cooperation in the exchange markets where appropriate.

For the past two decades, the international monetary system has been based on a flexible exchange rate system among major currencies. There are circumstances when it is appropriate to allow exchange rates among major currencies to fluctuate rather than to adjust monetary and fiscal policies in a manner inconsistent with the needs of the economy.

Experience since 1973 suggests that major exchange rate adjustments have been caused by clearly identifiable changes or distortions in the underlying economic fundamentals or in macroeconomic policies. Efforts to preserve an exchange rate that is inconsistent with underlying fundamentals are likely to introduce distortions to and constraints on central instruments of economic management. At the same time, financial authorities cannot be indifferent to exchange rate fluctuations that do not appear justified on the basis of macro-economic policies or fundamentals and as a consequence could adversely affect output or prices. There are circumstances where close cooperation in exchange markets can reinforce sound economic policies and enhance stability in exchange markets.

The G7 has an important responsibility in promoting an effective and stable monetary system by advancing policies that will strengthen our capacity to manage risk and prevent crises and improve our ability to respond to such events when they occur. Towards this objective, we have adopted a number of initiatives over the past several years and improvements were initiated at Halifax. This paper reviews the main initiatives, and proposes, where appropriate, further improvements.

More effective macro-economic surveillance in the G7 meetings

It is important to pursue sound domestic economic policies aimed at achieving sustained non-inflationary growth and at avoiding the emergence of excessive external imbalances. Such policies are also a necessary condition for more exchange rate stability and for avoiding -or reducing- exchange rate misalignment. The dramatic deepening in economic integration increases the need for sound economic policies but also the potential gains from cooperation on macro-economic policies. The G7 surveillance process provides a framework for identifying and formulating appropriate responses to risks for our economies and for the stability of the international financial and monetary system.

Surveillance has been improved by the G7 in the past years, and some encouraging results have been reached in this informal framework :

• We have adopted a number of steps to improve the effectiveness of the G7 surveillance process. Building on these improvements, we would support the following additional steps :
• concentrate the discussion on potential risks to the outlook in the G7 and the appropriate policy response to those challenges. More attention could also be paid to medium-term economic and structural issues ;
• focus more attention on potential risks outside the G7 that could affect the international monetary and financial system, based in part on a presentation by the IMF Managing Director ;
• strengthen cooperation at the Deputies level in preparation for Ministerial meetings with appropriate involvement of central bank deputies and the IMF staff.
• Continuing G7 close cooperation in exchange markets
• Exchange rate misalignments can heighten uncertainty in the global economy and can be detrimental to growth and trade. When exchange rates appear to move out of line with underlying fundamentals, close monitoring is necessary and coordinated responses may be required.
• The "orderly reversal" in key exchange rates since April 1995 is a positive and promising development. Several factors lie behind it. Most important were changes in economic policies and fundamentals, but the signals given to the markets by the G7 in 1995, through communiqués and -under appropriate circumstances- concerted intervention, were helpful in providing impetus to bringing exchange rates better in line with fundamental trends.
• We should continue our close cooperation in exchange markets on this foundation, taking into account the fact that :
• a clear and consistent articulation of a common G7 view can have a stabilizing influence and help reinforce the credibility of our commitment to cooperate in the exchange market when circumstances warrant ;
• interventions can be effective in certain circumstances, especially when they reinforce changes in policies and/or underlying fundamentals that lead to changes in market expectations about future exchange rates ;
• the instrument of intervention must be used judiciously given its implications for monetary policy and the amount that the authorities can mobilize relative to the size of international capital markets. Nevertheless, these factors do not impede our joint ability to send a clear message to the markets, if and when appropriate ;
• interventions are more likely to be effective when they are concerted and reflect a common assessment ;
• an important condition for success is the appropriate timing of intervention.
• Better prudential safeguards in international financial markets
• The globalisation of financial markets and the substantial increase in cross-border capital flows have created a more complex financial environment. Comprehensive and effective financial regulation, market-reinforced prudential supervision and enhanced international cooperation among regulators are among the keystones for maintaining stability of the international financial and monetary system.
• Industrial countries have been cooperating in the development of prudential frameworks for many years. The BIS/Basle Committees have taken important steps to develop international standards for prudential supervision of banks and to strengthen payments and settlements systems which link international markets. IOSCO has undertaken similar work for prudential regulation of securities firms and markets. In recent years, banking and securities regulators have increased their contacts at the international level to address supervisory concerns that cut across markets.
• We recognise the substantial recent and ongoing cooperative work between the Basle and IOSCO Committees on derivatives to promote improved risk management, a common reporting framework and improved disclosure practices ;
• We welcome the publication in December 1995 of the Basle Committee capital adequacy standards for bank's exposure to market risk, which will be a very useful complement to existing prudential ratios.
• Nevertheless, the changes in the structure of global finance and the emergence of new participants and markets require the supervisory response, including international cooperation, to evolve continually. We welcome the Basle and IOSCO Committees' reports on prudential regulation and supervisory cooperation. These reports should pave the way for continuing progress on current initiatives and expanding efforts in the following directions :
• Enhance cooperation across markets to strengthen supervision of financial institutions. In this context, we welcome the joint efforts of the Basle and IOSCO Committees to enhance their collaborative arrangements and the work of the Joint Forum of banks, securities and insurance supervisors. Suitable arrangements should be established within which that cooperation can be better organised. It would be useful to clarify the role and responsibilities of the relevant supervisors to foster an appropriate degree of cooperation in the supervision of internationally-active financial institutions, and to establish a more comprehensive network of bilateral arrangements between authorities.
• Strengthen prudential standards in, and supervisory cooperation with, emerging markets. Effective prudential regulation and supervision must cover all important financial marketplaces, particularly those which are experiencing high growth rates and/or substantial capital flows. The Basle and IOSCO Committees are performing work in this area which reinforces bilateral and regional efforts underway. Because emerging markets are growing in significance, these Committees, and other appropriate fora should be encouraged to strengthen their outreach to and cooperation with emerging market supervisors in order to promote high prudential standards. The International Financial Institutions should give more attention to promoting effective regulatory and supervisory structures in emerging markets ;
• Encourage private sector efforts to enhance market transparency. Notwithstanding past or future regulatory activities, primary responsibility for risk management rests with market participants. Regulators should encourage -and where necessary exert pressure to induce- private sector efforts to enhance market transparency in order to strengthen market forces' capacity for sound and responsible risk taking and control ;
• Improve reporting and disclosure of derivatives activities. Effective monitoring of derivatives activities is crucial, and requires closer cooperation among supervisors. In this regard, we welcome the global market survey conducted in the spring of 1995 by the BIS, and the follow-up action which is being planned. We also look forward to the conclusion this year of a joint Basle/IOSCO approach to reporting standards for derivatives exposure and to further progress in improving derivatives disclosure practices ;
• Enhance cooperation among exchanges. We look forward to implementation of the recommendations in the Windsor Declaration for increasing cooperation among futures exchanges and regulators. We also note with approval the development of information sharing arrangements among securities exchanges and welcome conclusion of an information sharing arrangement among major futures exchanges and relevant regulatory authorities. We also look forward to the IOSCO study of methods to identify large firm exposures that may have an effect on the market and to protect market participants from potential defaults by firms.
• Strengthening of our collective ability to respond to financial crises
• The increased integration of global capital markets, the change in magnitude and composition of capital flows, and the increase in the diversity and number of creditors and borrowers present new opportunities and challenges to the financial system. At Halifax, Heads proposed a range of initiatives to strengthen the global financial system, with particular attention to the IMF's role. We strongly welcome their implementation :
• Improvement of the early warning system is being implemented : the IMF's surveillance capabilities have been enhanced ; the IMF has established standards for timely publication of economic and financial data, and subscription on a voluntary basis is underway.
• In order to better respond to crises, an emergency financing mechanism, aiming at faster procedures, has been set up in the IMF ;
• We welcome the agreement in principle reached on a doubling of the resources currently available to the IMF under the General Arrangements to Borrow. These arrangements will include a broader group of countries with the capacity to support the international monetary system. We welcome this sharing of monetary responsibilities, thereby adapting our cooperation to new economic circumstances ;
• We welcome the report of the G-10 Working Party on the Resolution of Sovereign Liquidity Crises ;
• We fully support the ongoing 11th review of IMF quotas to ensure that the IMF continues to have sufficient resources to meet its ongoing responsibilities. We believe it is important for the IMF to remain a quota based institution with the resources necessary to fulfill its important role in the global financial system.

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