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BETTER bank regulation is as much a task for rich-country as for poor-country governments. But in addition, the developing countries also need to implement many other financial reforms and improvements of their own. Few of them have the capacity to put imported capital safely to work. This capacity is something that governments can build, but a lot needs to be put right before openness to capital can be relied on to bring net benefits rather than net disappointment.

Reducing corruption would be high on the list even if economic efficiency were the only concern. Corruption particularly discourages inflows of FDI, the safest and most productive kind of capital inflow, so relatively speaking it favours bank lending, the riskiest kind of capital (see chart 8).

Work on the connection between corruption and the mix of capital inflows has been reviewed in a paper just published by the IMF. However corruption is measured, the answer comes out the same: corruption discourages inward FDI. Indeed, it appears to discourage it even more than do high corporate taxes.

Many developing-country governments, keen nowadays to attract FDI, try to appeal to investors by cutting corporate taxes or by offering subsidies. This often works, but the cost is quite heavy, and goes beyond the mere fiscal outlay or forgone revenue. Governments in most poor countries have to rely on a narrow tax base. They find it difficult to pay for social spending and economic infrastructure while keeping their own borrowing under control. Macroeconomic stability, as noted earlier, is an important contributor to financial safety. Special tax breaks for FDI may militate against such stability—and run a far greater risk, too, of distorting FDI decisions in favour of inefficient projects. In every respect, curbing corruption is a far better method of attracting FDI.

Reducing corruption is hard but not impossible. Measures include explicit restrictions on connected lending, better accounting standards and greater disclosure of financial information (and not just for the banks). In many countries, legal reforms will be needed as well. A constant theme of much of the recent research on finance and development is the importance of strong property rights. Without them, it is difficult, for instance, to offer collateral against a loan, or to resolve bankruptcies quickly and smoothly.

Faster and more accurate disclosure of information too is desirable in itself, for governments as well as for banks and private companies. A study by Gaston Gelos and Shang-Jin Wei, quoted in the IMF paper, looked at the investments of international equity funds between 1996 and 2000 to see if there was a connection with "transparency", measured in a number of different ways. It examined disclosure not just in the corporate sector but also in the release of official macroeconomic data and in the running of macroeconomic policy. All three aspects of transparency were found to be related to inward portfolio flows, even after allowing for the effect of many other factors (for example, incomes and market liquidity).

And these effects were big. For instance, on the macroeconomic-data measure, transparent countries received a share of global equity investment that was 48 percentage points higher than their market capitalisation (as a share of global market capitalisation) would suggest. Non-transparent countries received a share that was 25 percentage points lower than the same benchmark (see chart 9).

The same study found that herding among investors was substantially lower for countries with good disclosure than for the rest—presumably because greater transparency gives investors something more substantial to go on than what other investors are doing. Less herding is a good thing: when investors follow the crowd, they amplify the economic cycle, driving output and asset prices higher in booms and lower in slumps.

Also, in the event of a financial crisis, capital flight seems to be less of a problem in countries with better transparency. Again, this may be because information equips investors to see beyond the short-term emergency to more reassuring long-term fundamentals. "Overall," the study concludes, "the data suggest that an improvement in transparency might very well reduce the so-called sudden-stop phenomenon of 'hot money', and hence increase the stability of the domestic financial market in a developing country."

Most governments restrict foreign ownership of banks. State ownership, on the other hand, is typically extensive. It would be far better the other way round

There is evidence that ownership of the banks and other financial institutions in developing countries matters a lot. Most governments restrict foreign ownership of banks. State ownership, on the other hand, is typically extensive. It would be far better the other way round.

Foreign ownership of banks is just a particular form of FDI. In many ways, therefore, the benefits to the host country of foreign-owned banks are simply the financial-sector equivalent of the broader benefits of FDI. These include not just the initial capital inflow itself but also the introduction of better technology and new management skills, not to mention greater competition for the existing domestic institutions. But in finance there are additional advantages as well. The task of financial regulators is easier if foreigners come into the market and establish new and higher standards. With a heavy presence of foreigners, the government is much less likely to bail out the banks en masse if they get into trouble. Uninsured depositors will accordingly feel that much less secure—which is all to the good, from the standpoint of discipline and monitoring.

Banking-sector FDI also helps to fight corruption. Foreign-owned banks have their reputations at home and around the world to consider, not to mention their home-country regulators, so they will be less susceptible to corruption than incumbent domestic banks. They also have good reason to monitor what domestic banks are doing, and to expose corruption when they find it. From their point of view, improper conduct is a kind of unfair competition that puts them at a disadvantage.

Possibly most important of all, banking-sector FDI promotes diversification, which is a good way of reducing risk. The business of domestic banks in developing countries tends to be heavily concentrated at home. If the local economy turns down, all of their activities are exposed. Foreign banks have a far wider spread of risk, and can call on head office to help if need be.

For every advantage that banking FDI offers the emerging-market economy, state ownership brings with it a corresponding disadvantage. State-owned banks often institutionalise practices that would be called questionable or corrupt if undertaken by private banks. Connected lending, for instance, is not so much a consequence of state ownership as its very purpose: the whole idea is to make lending decisions on the basis of non-economic tests. This means state-owned banks must be expected to make losses, and will have to be sheltered from competition. Regulatory forbearance, in the same way, is not just likely, it is required. Monitoring by depositors and other creditors will be minimal: the promise of bail-out is as clear as it possibly can be. The evidence confirms that countries with the highest proportion of state-owned banks have the highest bank operating costs and the largest proportion of non-performing loans.

In addition to promoting access to information and curbing corruption—where greater foreign ownership can be of great help—developing-country governments need to weigh the case for explicit restrictions on certain kinds of financial activity. In systems that are otherwise clean and well-run, the need for further measures might be limited. Even then, some action may seem advisable, especially since bank regulation is likely to remain far from ideal. But in systems that are neither clean nor well-run, and where governments would find it difficult to put this right by more direct means, narrower restrictions may be necessary. Two kinds of capital stand out: short-term debt, and debt denominated in foreign currency. Short-term foreign-currency debt, combining the hazards of both, is therefore a prime concern.

Unpegged

Today the exchange-rate danger, at least, is smaller than before—not because currencies are more stable, but because the fragility of systems that merely appear to be stable is better understood. Fixed but adjustable exchange rates helped to worsen the plight of the East Asian economies and others in the late 1990s. The promise of a stable currency helped to draw in too much of the wrong sort of capital. Then, when events forced a devaluation, the economies concerned found themselves in trouble twice over—once for overborrowing in the first place, and then again because many of those debts had to be repaid in dollars or other hard currencies which had appreciated in the meantime.

The economic problem is even worse than this, because a heavy burden of foreign-currency debt makes it difficult for the government to cushion an economic slowdown in the orthodox way, by lowering interest rates. If it does that, it is likely to speed the flow of capital out of the country. This will drive the currency down further, increasing the burden of foreign debt yet again and dragging the economy into an even more ferocious recession.

Here, if nowhere else, lessons have been learned. All over the developing world, fixed but adjustable currencies have been replaced by more flexibly managed regimes (either pure floats or, more commonly, managed floats). Under floating-currency arrangements, the foreign investor comes in with a more realistic idea of the exchange-rate risk, and if the economy does get into trouble, the simple one-way bet of withdrawing capital before the currency peg gives way becomes more complicated. That is likely to encourage stability, both by tempering the inflow of capital during upswings of market sentiment and by encouraging long-term flows at the expense of short-term ones.

International monetary arrangements are improving, albeit slowly

In other respects as well, international monetary arrangements are improving, albeit more slowly. The IMF, for instance, has a keener sense of the harm that can be done by letting investors believe that it will protect their investments come what may: moral hazard, yet again. A great deal of attention has concentrated lately on making sure that, once a crisis strikes, investors fully share in the losses—and that they will be well aware of this in advance.

But although understanding of the IMF's role has improved, policy for the most part has not. The main reason is that big financial crises are usually political crises as well. It is the way of the world that, at such times, economic principles are swiftly set aside. Generous IMF support, pushed through by powerful members (notably the United States), has often been granted for political rather than economic reasons, and will continue to be.

Also, as the Basel bank-regulation saga confirms, institutional reform that requires international consensus takes years, if it happens at all. Anne Krueger, the Fund's deputy managing director, has proposed a scheme for dealing with "sovereign bankruptcy", which among other things would allow investors' losses on loans to developing countries to be apportioned faster and more predictably. It is a good plan, and has won the support of many expert observers. But many governments, including America's, are not keen. At the moment, its prospects look poor.

Besides, the extraordinary attention paid to reforms of the "international architecture" over the past five years has been out of proportion to its real importance. As this survey has argued, it is the quality of national financial policy, in rich countries and poor countries alike, that decides the safety of the global capital market. If that policy is wrong, no reform of the IMF or changes to other aspects of the international architecture, however ingenious, is going to make cross-border capital safe and productive.