STEPHANY GRIFFITH–JONES A New Financial Architecture for Reducing Risks and Severity of Crises* T he deep integration of developing countries into the global economy has many advantages and positive effects. In particular, capital flows to developing coun­tries have clear and important benefits. They are especially clear for foreign direct investment, which is not only more stable but also brings tech­nological know-how and access to markets. Other external flows also have important positive micro­economic effects, such as lowering the cost of capital for creditworthy firms. At a macro-econo­mic level, foreign capital flows can complement domestic savings, leading to higher investment and growth; this is very valuable for low-savings economies, but may be less clear for high-savings economies like those of East Asia. However, large surges of short-term and potentially reversible capital flows can also have very negative effects. Firstly, they pose complex policy dilemmas for macro-economic manage­ment, as they can initially push key macro-eco­nomic variables, such as exchange rates and prices of assets like property and shares, away from what could be considered their long-term equilibrium. Secondly, and more important, these flows pose the risk of very sharp reversals. These reversals can result in very serious losses of output, invest­ment and employment. This has been dramatically illustrated by the impact of the recent crisis in Asia. Asian-style currency crises raise a very serious concern about the net development benefits for developing countries of large flows of potentially reversible short-term international capital. While the high costs of reversals of those flows are evi­dent, the benefits are less clear. This is in sharp contrast with foreign direct investment( FDI ) and trade flows, where the very large developmental benefits clearly outweigh the costs. As a result, volatile short-term capital flows emerge as a poten­tial Achilles’ heel for the globalised economy and for the market economy in developing coun­tries. If the international community and national authorities do not learn to manage these flows better, there is a serious risk that such volatile flows could undermine the tremendous benefits that globalisation and free markets can otherwise bring. Analysis of the East Asian Crisis Eighteen months after the outbreak of the crisis in Asia, its financial aspects have not yet been fully contained. Increasingly the East Asian financial crisis has been transformed in the affected coun­tries into a serious crisis in the real economy, with highly negative social effects, as well as proble­matic consequences for political stability. It is noteworthy that the East Asian crisis itself, as well as its depth and length had been almost totally unexpected. The speed and extent of contagion was especially unexpected. It is therefore essential to understand both the causes that sparked off the East Asian crisis, as well as the causes that led to its deepening and spreading through contagion. Three key elements need to be noted. First, the roots of external imbalances were grounded in private sector deficits, as most East Asian econo­mies were running budget surpluses(here an important difference emerges with Brazil, where to an important extent the current account deficit was explained by the fiscal deficit). Second, in East Asia the crisis was a consequence of over-invest­ment(though some of it may have been misallo­cated, especially in the property and electronic sec­tors) and not of over-consumption. Third, an important cause of the crisis was a sharp deteriora­* Revised version of a paper originally prepared for the colloquium»The Euro and the New International Financial Order«, organised by the Friedrich Ebert Foundation in Brussels, on March 22 and 23, 1999 . I thank Jenny Kimmis and Jacques Cailloux for their very valuable inputs into this paper. IPG 3/99 Griffith-Jones, New Financial Architecture 263