Volatility in international financial markets. (Developing Further an Open Financial System).

"Since September 11th, there has been a global commitment towards discovering a multilateral solution to the war on terrorism. There is still much work to be done in the area of better global economic governance", said Stephany Griffith-Jones, Professor of the Institute of Development Studies at Sussex University, on releasing the report, "Capital Flow to Developing countries since the Asian Crises: How to manage their volatility", which is one of the twelve projects undertaken by the World Institute on Development Economic Research (WIDER).

WIDER, established by the United Nations University in Tokyo and based in Helsinki, Finland, is one of the leading research institutes devoted to development economics and provides a forum for professional interaction amongst economists from the United Nations, policy makers, scholars and other international organizations worldwide. Its work is carried out by staff researchers and visiting scholars and through networks of collaborating scholars and institutions around the world. The Institute recently organized a conference in New York, where participants discussed the increased volatility of the international financial market and the various aspects of international financial reform. WIDER, in collaboration with the UN Economic Commission in Latin America and the Carribbean (ECLAC) and the International Development Strategy (IDS), has attempted to provide a constructive approach to reduce the impact of the steep reduction of capital flow into the developing world.

Ms. Griffith-Jones, in her paper entitled "Capital flows to Developing countries", focused on how capital flows to these countries have changed since the Asian crises. The capital market had undergone extreme liberalization in the 1990s, which led to greater flows of private capital to the developing world. This took the form of stocks and bonds, which further broadened the class of global investor beyond banks and multinational corporations, to include individual investors and managed funds, as well as institutional investors such as pension funds, insurance companies, university endowments and foundations. These investors brought in increased capital flows, which in turn introduced greater exposure to the volatility of stock and bond prices in each developing country, and advanced capital markets. Prof. Griffith-Jones discusses at length how investors, lenders and other financial actors make their decisions to supply capital to developing countries, and how decision-making influences or determines their ma in features, in particular their tendency to pro-cyclicality and short terminism.

Her paper highlights two problematic aspects of capital flows to developing countries: their current very low levels and their strong reversibility.

Regarding the sharp decline in this new pattern of private flows, the paper states: "According to IMF (International Monetary Fund) data (2002), net private capital flows to emerging market economies, which had peaked in 1995 to almost $240 billion in 1996, having grown consistently throughout the first half of the 1990s, more or less halved to less than $120 billion in 1997, fell by around 40 percent to less than $70 billion in 1998 and 1999, collapsed to less than $10 billion in 2000, and recovered only very faintly to $31 billion in 2001."

The current capital flow into developing countries is a major cause of recent large and developmentally expensive crises. Very low or negative private flows are inhibiting growth in much of the developing world, especially in Latin America. Ricardo French Davis indicates in his paper, "Financial crises and National Policy Issues", that these problems are to an important extent caused by patterns of boom-bust behaviour by actors in the capital and credit markets of New York and London. He finds that the international capital markets are the major sources of shocks, both positive and negative, to emerging economies. The capital flows have largely taken place between private suppliers and demanders, and have been characterized by a lack of regulation or supervision on both supply and demand. He elaborates on why funds continue to flow towards emerging economies while fundamentals, such as sound fiscal accounts, dynamic exports, sustainable external deficits and net debts, non-outlier real exchange rates in host countries, had been deteriorating before the Asian crises, and why funding remains dry for long since 1998.

Mr. Davis proceeds further by providing a robust policy lesson, which includes: maintaining a sustainable volume and composition of external liabilities and capital flows; avoiding outlier exchange rates; adopting a flexible comprehensive prudential macroeconomic regulation; searching for a reform of the international financial architecture; and focussing on crises-prevention policy.

The group also found that banks have a considerable role to play in this whole process of volatility in the international financial market. As David Lubin states in his paper, "Bank lending of emerging markets: cross border lending", the probability and severity of crises in a developing country are largely dependent on the fragility of the domestic banking system. He highlights the importance of foreign ownership of developing countries' banking systems, which can help to diversify their capital base, improve the pricing of risk, regulation, accounting, information technology and the level of transparency.

It can help create a situation where foreign-owned banks continue to lend in an economic downturn since they have a more diversified funding base. Regarding the extraordinary collapse in cross-border lending to developing countries, he goes on to say that one cannot simply characterize bank behaviour in the past few years as a pure withdrawal from emerging market. However, there is a distinct redistribution of their emerging market portfolios from cross-border to in-country lending.

Randall Dodd, Director of the Derivatives Study Center, discussed his paper, "Derivatives and Capital flow", which studies the trends towards securitized capital flows and how it links to the increasing use of derivatives transactions in developing countries. He also set forth a set of policy recommendations in the form of prudential market regulations that are designed to reduce the vulnerability of the financial system and mitigate the impact of financial sector disruptions on the overall economy.

The whole project comprises of numerous other papers that researchers have contributed to this huge and far-impacting report, soon to be published as a book. It will provide an in-depth analysis of new trends in the supply of vehicles of capital flows and their determinants, as well as an evaluation of national policies to reduce volatility, which is basically a reflection of shortcomings in the countries' development process and the weakness of their mechanisms for regulating transactions that have opened the way for unusual financial crises in those systems. In order to restructure the current economic situation of the world and provide international financial reforms, the United Nations and related agencies, such as WIDER and ECLAC, as well as non-governmental organizations, economists and financial policy makers, have a considerable role to play. Not only do they need to encourage further research in this domain but they should also provide national policy makers with the appropriate mechanisms so that th ey could strengthen the domestic financial systems.