Greenspan's Global Rx

Emerging market countries need to shore up and diversify their financial systems if they want to avoid future Asian-style currency crises or lessen their damage, Federal Reserve Chairman Alan Greenspan said Monday.

The global financial crisis of the past two years, Greenspan said, emphasized the necessity for these countries to pay attention to issues such as bank regulation and whether they are taking the right steps to build sound financial systems.

"Improving deficiencies in domestic banking systems in emerging markets will help to limit the toll of the next financial disturbance," Greenspan told finance ministers and central bank governors attending the annual meetings of the International Monetary Fund and the World Bank.

The sessions were moving to a broader venue Tuesday with the two organizations' 182 member nations starting a formal three-day session. World Bank President James Wolfensohn and IMF Managing Director Michel Camdessus were addressing the delegates.

Greenspan said the chief lessons learned from the Asian economic crisis were that countries with narrow capital markets in which there are no alternatives to banks suffer greater economic disruption than those with diverse capital markets.

"East Asia had no spare tires," Greenspan said in his speech. "Banks, being highly leveraged institutions, have throughout their history periodically fallen into crisis. When there was no backup, they pulled their economies down with them."

He also said countries increase the cost of recovery when they don't act promptly to deal with a financial crisis.

Global financial turmoil began in Thailand in July 1997 with a currency devaluation, then spread to Indonesia and South Korea later that year. The following summer Russia's economy collapsed and then Brazil had to devalue its currency in January.

"The failure of normal adjustment processes to contain the financial turmoil made this crisis longer and deeper than any of us had expected in its early days," Greenspan said.

To support his contention that sound financial institutions can reduce turbulence, Greenspan pointed to the functioning of the U.S. economy during the global financial crisis.

After Russia defaulted on billions of dollars in foreign debt in August 1998 and a large U.S. hedge fund nearly collapsed, "public capital markets in the United States virtually seized up," Greenspan said. Even top-quality borrowers were unable to find takers for their bonds in a nervous market unwilling to accept any new risks.

The Fed stepped in last year and cut interest rates by 0.75 percentage point as a way to restore confidence and avert a severe credit crunch from dragging the United States into recession.

Greenspan said the Fed's rate cuts were important, but he said it was far from the full explanation for the restoration of market confidence.

Rather, Greenspan said "at last as relevant was the existence of backup financial institutions, especially commercial banks," which stepped in and provided funds for businesses that were no longer able to raise money in the bond market.

"With the process of credit creation able to continue, the impact on the real economy of the capital market (problems) was blunted," Greenspan said.

He told the financial leaders that he believed this highlighted the importance of countries not only developing effective banking systems but also striving to have sound bond markets so that if one system gets into trouble, investors will have an alternative source of money.

This year the Fed has raised interest rates twice since June 30 in an effort to slow the U.S. economy to a more sustainable growth rate and keep inflation under control. While many economists believe the Fed will boost rates for a third time when policy-makers next meet on Oct. 5, Greenspan offered no clues about the direction of interest rates in his speech Monday.