Implications for the International Financial Architecture

Dissatisfaction in emerging markets with prevailing international monetary and financial arrangements is not new. Earlier instances where they were caught in the cross-winds were met mainly by steps to bullet-proof their economies, although there were also subsidiary efforts, mainly in Asia, to build regional supports. Insofar as the lessons of earlier crises motivated efforts to strengthen budgets, work down public debts, limit current account deficits, and more carefully manage foreign currency exposures, the resulting reduction in vulnerabilities and increase in policy space have been profoundly advantageous, as documented above.

Whether the accumulation of foreign reserves, the other approach to bullet proofing, has been equally beneficial is less obvious. The one thing it has clearly been is expensive. In the PRC reserves of more than US$1,500 per resident are the equivalent of 25% of per capita income. Devote those resources instead to physical investment where they would conservatively earn a rate of return of 8%, and the PRC would accrue the equivalent of another two percentage points of economic growth.²⁰ Or devote those resources to consumption, and living standards would be two percentage points higher. In Korea, where reserves were the equivalent of 20% of per capita income on the eve of the crisis, the implications are analogous. The situation is again similar in a variety of other high-reserve countries.

The problem with the strategy, besides the fact that it is expensive, is that it is not clear that the reserves in question can be used. When Korea's reserves threatened to fall below US$200 billion, a very high threshold, the markets showed alarm and the authorities were unable to access them further.²¹ To obtain resources with which to replace the private-sector dollar liquidity that had dried up the Bank of Korea had to negotiate a US$30 billion swap facility with the Federal Reserve.

None of this is to deny the value of insurance, but it does point to the need for more costeffective ways of obtaining it. Regional reserve pooling is one possibility. ASEAN+3 continues to elaborate the Chiang Mai Initiative, in the spring of 2009 taking another step toward its multilateralization and agreeing to the creation of a regional surveillance unit. But there has been reluctance on the part of the participants to activate their arrangement; if they were unwilling to do so in the wake of Lehman Brothers' bankruptcy it is hard to imagine circumstances under which they will. The core problems are conditionality and repayment: countries are reluctant to lend reserves without assurance that they will be paid back, and repayment can be confidently expected only when loans come packaged with conditions. But sovereigns hesitate to demand conditions of their neighbors since doing so threatens to poison diplomatic relations.²² ASEAN+3 would address this dilemma by outsourcing the authority to determine conditionality and disburse funds to a board of experts independent of governments.²³ So far, however, this remains a political bridge too far. And as long as Asian governments remain reluctant to cross it, their regional reserve pool will remain untapped.²⁴

In Latin America, where proto-reserve-pooling arrangements are at an even earlier stage, Colombia and Mexico have contracted for insurance with the IMF, qualifying for its new Short-Term Liquidity Facility. But the problem of stigma at the point of drawing evidently remains. When Mexico needed dollars late last fall it, like Korea, arranged a US$30 billion swap with the Federal Reserve. Evidently the Fed is the true reinsurer of last resort.²⁵ That in times of crisis such countries are the mercy of the US is explanation enough for their dissatisfaction with the prevailing architecture.

The obvious vehicle for efficient reserve pooling is the IMF. Insofar as balance-of-payments shocks are more highly correlated within than across regions, global reserve pooling has advantages over regional reserve pooling. And reserve pooling was in fact one of the original rationales for creating the IMF. Thus the reluctance of emerging markets to make freer use of the Fund is a serious inefficiency. The question is what can be done to mitigate the stigma associated with IMF programs. Knowing that they have more voice and influence in the institution may reassure emerging markets: hence the case for quota reform, for restructuring the executive board to reduce the overrepresentation of the G10, and for an open leadership selection process that might someday produce a managing director from an emerging-market country.

But it is not clear that such incremental reforms will cause such countries to flock back to the IMF.²⁶ Emerging markets need to specify exactly what changes in the structure of the institution they require in order to regard accessing its facilities as attractive. My own suggestion is not further steps to redress the political balance—since such steps haven't produced results when pursued at the regional level.²⁷ Rather, it is to remove politics from the Fund's short-term decision making by strengthening the independence of the management team and empowering it to make key operational decisions. The IMF could then provide emergency liquidity quickly, as did the Federal Reserve in November 2008, but without the sour taste of politics. Officials from emerging markets may not like this idea, but then they are obliged to specify what alternative reforms would render the IMF attractive for pooling their reserves.

Finally there is what emerging markets should see as the priorities for reforming the international monetary system in light of the crisis. Recent events have pointed up the problems with a dollar-based reserve system. Here officials from emerging markets may have become more vocal, but they have yet to adequately specify their objectives. Thus while both the PRC and Russia have been campaigning for an enhanced role for the Special Drawing Rights (SDR), they have also been taking steps to encourage the expanded use of their national currencies in their countries' own cross-border transactions, with their immediate neighbors in particular. Absent a more coherent message, there will not be coherent reform.

This flurry of initiatives is clearly open to alternative interpretations.²⁸ Mine is that the PRC's long-run objective is to enhance the yuan's own international-currency role, initially as a regional reserve currency and ultimately as a global reserve currency. (Russia and Brazil have similarly made noises about enhancing the use of their currencies in their respective parts of the world.) This is the best way of understanding recent initiatives designed to encourage firms in the PRC's southern provinces to settle more cross-border transactions in yuan as well as the yuan swap arrangements that the country has negotiated with various trading partners. Of course, making the yuan an attractive form in which to hold reserves will require not just that more of the PRC's trade be invoiced and settled in its own currency but also that it develop deep and liquid markets in yuan-denominated securities and that that the currency become convertible on capital account. The PRC has a plan for elevating Shanghai to the status of a major international financial center by 2020. Financial-center status similarly entailing capital-account convertibility, this suggests the relevant time frame for the associated steps.

To be sure, the US (and the euro area) will not have gone away. This points to the development of a multi-currency reserve system not unlike that which prevailed in the first era of globalization prior to 1914. With multiple countries possessing deep and liquid financial markets open to foreign investors, there will be multiple forms and places in which to hold reserves. In this multipolar world, not unlike the multipolar world that existed before 1914, no single issuer will monopolize the privilege of supplying the reserve unit.²⁹ And the fact that there will exist more than one country with deep and liquid markets in a position to supply reserves will be a constructive source of discipline on policy.

Where then does this leave the SDR and other more radical visions for international monetary reform—more regional monetary unions for example? The PRC, being aware that the longer it waits the more likely its economy and currency will dominate East Asia, is unlikely to evince much enthusiasm for pooling its monetary sovereignty. And if the PRC is serious about the yuan as a reserve currency, then surely it can't be serious about the SDR as well. My suspicion is that talk of an expanded role for the SDR is a way for the PRC and other emerging market to signal their concern that they might suffer losses on their existing dollar holdings. They would like to see a Substitution Account-like facility through which they could exchange some of their dollars for SDR-denominated claims on the margin. Alternatively they would like to see the US offer a guarantee against losses on their existing dollar holdings. To the extent that their cooperation is needed on other aspects of the global agenda (agreement on reduced carbon emissions, for example), one can imagine the outlines of a bargain. But it is implausible that the international community would agree to relieve the PRC of the entirety of its US$1 trillion-plus dollar reserve portfolio, much less that it would relieve emerging markets as a group of their dollar reserves. And it is even more implausible that the SDR could supplant national currencies as the main form of international reserves in our lifetimes.³⁰

Download this Paper [ PDF 110.3KB| 15 pages ].

Comment(s)

There are [0] comment(s) for this entry. Post a comment.