A Stronger Financial Architecture for Tomorrow’s World

By Dominique Strauss-Kahn

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The international monetary system (IMS) is a topic that encompasses a wide range of issues—reserve currencies, exchange rates, capital flows, and the global financial safety net, to name a few. It is one of the key issues on the G-20’s work agenda for 2011, and a topic that is eliciting lively discussion—for instance the recent, insightful report of the group chaired by Michel Camdessus, called the “Palais-Royal Initiative”.

Some are of the view that the current system works well enough. While not perfect, they point to its resilience during the crisis, citing the role of the U.S. dollar served as a safe haven asset. And now that the global recovery is underway, they see little reason to worry about the IMS. In other words, “if it ain’t broke, don’t fix it”.

I take a less sanguine view. Certainly the world did not end in 2008, but mostly because extraordinary international policy cooperation helped avert a far worse outcome. Moreover, the recovery underway today is not the recovery we wanted. It’s certainly a recovery, but it is uneven. It’s a recovery where unemployment is not really going down and there are widening inequalities within countries.

And global imbalances are back, with issues that worried us before the crisis—large and volatile capital flows, exchange rate pressures, rapidly growing excess reserves—on the front burner once again. Left unresolved, these problems could even sow the seeds of the next crisis.

So, there is good reason to think that reforms to the IMS that help us get to the root of these imbalances could both bolster the recovery and strengthen the system’s ability to prevent future crises.

Let me set out three key questions that are guiding the IMF’s work in this area.

First, how can we strengthen policy cooperation and reduce volatility?

The crisis marked a watershed moment for international policy cooperation—leaders took the actions necessary to overcome domestic and global economic challenges. Now that the worst of the crisis has passed, how can we sustain this cooperation—so that countries adopt policies consistent with less volatile global growth?

The G-20’s Mutual Assessment Process has been an important first step towards creating a more permanent framework for global policy cooperation. IMF surveillance is a critical complement to the MAP—and also lies at the core of our mandate. Through this activity, the IMF seeks to identify the country-level policies that can deliver more stable global growth.

We have also strengthened Fund surveillance—for example, the early warning and vulnerability exercises. We are now increasing our focus on the impact of countries’ policies across their borders, particularly for the five most systemic economies—for which we have new dedicated “spillover reports” in preparation.

At the same time, we are delving deeper into macro-financial linkages. For the world’s 25 most systemic financial systems, Financial Sector Assessment Programs (FSAPs) are becoming mandatory. This tool will facilitate our efforts to catch dangerous build-ups of systemic risk in the financial sector—which is precisely what preceded the recent crisis. Beyond this, we should explore whether even more ambitious changes to our surveillance are needed—and we are conducting a major review to that effect.

My second question is: how best to cope with capital flow and exchange rate volatility?

Over the past decade, we have witnessed a dramatic increase in the size and volatility of capital flows. Broadly speaking, such flows are beneficial to the receiving economies. But they can also complicate macroeconomic management and threaten financial stability.

So, what are the tools? They are many, including macroeconomic adjustment, reserve accumulation, prudential measures and—when all this is put in place and still a country experiences some disruptive inflows—capital controls. Naturally, countries’ responses are driven primarily by domestic considerations. But their actions can have consequences for the rest of the world.

Given these spillovers, should we have globally agreed “rules of the road” for managing capital flows? Our members have asked us to look into this question, and we expect to present some concrete ideas in the near future.

A related issue is the volatility of exchange rates. The major currencies have fluctuated widely vis-à-vis each other and have not moved consistently in a direction promoting an orderly adjustment of imbalances. Large and persistent deviations of exchange rates from fundamentals can result in significant systemic distortions, which can be particularly problematic for small open economies. Addressing this issue requires setting economic and financial policies that promote global balance and reduce the volatility of capital flows, as I have just discussed.

My third and final question: how can we enhance liquidity provision in times of extreme volatility?

Since the crisis, we have come a long way in strengthening the global financial safety net. The Fund’s resource base has been increased significantly, and our financing toolkit has been made more flexible, in particular by adding the Flexible Credit Line and the Precautionary Credit Line.

But many countries remain to be convinced that the global financial safety net is strong enough to deal with the next crisis—and so the costly accumulation of reserves continues well in excess of precautionary needs. What else can be done?

One important avenue is to strengthen partnerships with regional financing arrangements. Another is how to improve the predictability of systemic liquidity provision more generally—as opposed to leaving this task to national central banks. A complementary question is how best to gauge the adequacy of precautionary reserves, and which benchmarks to use.

Over time, there may also be a role for the SDR to contribute to a more stable IMS. A paper the IMF is releasing today presents a range of ideas on this topic. But, increasing the role of the SDR would clearly require a major leap in international policy coordination. For this reason, the global reserve asset system will evolve only gradually, along with changes in the global economy, and at a pace that is not disruptive.

Let me wrap up. Reform of the IMS is wide-ranging and complex. Global debate is only just starting. But we must all recognize that this is not something academic or abstract. We need concrete ideas. This is linked to achieving the kind of well-balanced and sustainable recovery that the world needs—and it is linked to preventing the next crisis.

17 Responses

  1. […] the role of Special Drawing Rights in the international monetary system is another example. If we go in that direction, we can move slowly from, say, creating a market in […]

  2. […] am delighted to be back in China this week for a high-level seminar in Nanjing on the international monetary system. Every time I come to this part of the world, I am impressed by the dynamism of the economies and […]

  3. […] am delighted to be back in China this week for a high-level seminar in Nanjing on the international monetary system. Every time I come to this part of the world, I am impressed by the dynamism of the economies and […]

  4. […] the role of Special Drawing Rights in the international monetary system is another example. If we go in that direction, we can move slowly from, say, creating a market in […]

  5. @Dominique Strauss-Kahn “We need concrete ideas. This is linked to achieving the kind of well-balanced and sustainable recovery that the world needs—and it is linked to preventing the next crisis”

    But what if achieving the “kind of well-balanced and sustainable recovery that the world needs” has much more to do with the willingness of taking risks than with “preventing the next crisis”?

    Just for a starter, the current crisis was caused precisely by trying to prevent one, by means of pushing the banks into supposedly safe triple-A waters… where, unfortunately, as should have been expected by more savvy regulators, the sharks of the real economy were waiting for them.

  6. There is also a key issue to strenghten the global financial system: the reform of the OTC derivative markets which has to be adressed on a global basis and more seriously than has been the case so far.

    • The Palais Royale Initiative’s report of January 11th of this year by an international group of very eminent persons in the financial and monetary system realms says “significant vulnerabilities remain in the financial sector, related inter alia to the role of the shadow banking system”. It then points out how these vulnerabilities are generating urgency for monetary system reform. Doesn’t that suggest that we must resolve the vulnerabilities in the financial system FIRST.

      No one I have talked to so far believes that we have done much to address the OTC derivatives source of financial instability, which surely triggered the need for AIG’s bailout, other than to argue for larger bank reserves. That seems to me to be about as likely to be successful as beefing up the battlements of a castle in an era of rapid technological advance in projectile science,

      Looked at internally from the financial sector’s point of view, OTC derivatives make a lot of sense: they allow risks to be passed “upstream” to ……… ?? and that’s the point: ultimately, “upstream” means “to everyone else whenever the financial sector has indulged in exuberance”. In other words, OTC derivatives provide a channel for the passing of a massive, but hidden, externalization of future costs of exuberance in the financial sector to other, more real sectors.

      How can this not very obvious but very dangerous nonsense be ended? I believe we can only end it when we stop conflating “speculation” automatically with “investment”. These two words mean different things, but if you talk to most of the people involved in the making, promotion, rating, insuring, or, sad to say legislating or overseeing the regulationf of derivatives, you get a lot of conflating of these two meanings. So the IMF simply must get into this linguistic arena and it must do so fast.

  7. Exchange rate changes will not correct global trade imbalances. The unloved dollar standard will rehabilitate except global monetary reform.

  8. Strengthening the international financial architecture includes reforming the framework for financial regulation, establishing multilateral surveillance and policy coordination, structuring a global financial safety net, reforming the international reserve system and strengthening global economic governance.

    According to a UN report, the potential for moving to a multicurrency reserve system is limited. Because such a system may result in even higher exchange-rate volatility owing to the possibility of sharp shifts in demand from one international currency to another, since they are likely to be close substitutes. Greenwald and Stiglitz (2010) said it is not a solution for there to be a two-reserve currency system. Some in Europe had hoped that the Euro would take on this role as a reserve currency. This has happened, at least to some extent, but it has not been good for Europe, or the world. As the Euro becomes a reserve currency, Europe too then faces a deflationary bias. Given its institutional structure, a central bank focusing exclusively on inflation and a growth and stability pact restricting the use of expansionary fiscal policy, there are doubts about whether Europe is able to respond effectively to the consequences of having a reserve currency. If it does not, Europe, and the world, may face strong contractionary pressures. Moreover, just like the bimetallic system was viewed as more unstable than the gold standard, a multiple reserve currency system may be more unstable—with rapid shifts from one reserve currency to another with changing perceptions. Europe—and the world—should hope that it does not get its wish, to become a global reserve currency; but rather, that the world move to a new global reserve system, along the lines they have proposed.

    In his new book “The United States as a Debtor Nation” William Cline estimates that a 28% real effective real depreciation of the U.S. dollar would reduce the U.S. current account deficit from a projected 7.5% of GDP to 3% of GDP. McKinnon and Schnabl argue that his projection, which is based on an elasticities model of the U.S. balance of trade, is highly misleading. First downward deflationary pressure on overall foreign price levels from currency appreciation is not incorporated. Second, the negative impact of appreciation on foreign income and absorption is absent. Third, complementary and necessary adjustments in monetary and fiscal policies in the U.S. and its trading partners are not explicitly incorporated into Cline’s econometric framework. They conclude that the impact of massive dollar devaluation on the U.S. trade deficit would be ambiguous, but that the macroeconomic stability of the world economy could be seriously undermined. Exchange rate changes will not correct global trade imbalances. IMS needs to be reformed.

    Prabhat Patnaik said the theory of the Global Savings Glut of Mr. Ben Bernanke, Chairman of the Federal Reserve Board, however is fundamentally incorrect. Rejecting the savings glut argument does not mean an underestimation of the problem of world economic imbalances. In particular the fact that rapidly growing Asian economies, instead of improving the living standards of their own workers, continue to run huge current surpluses, cannot but be a matter of concern. But the explanation offered for these imbalances by the savings glut theory and the resolution suggested by it for the problem are both seriously flawed. The explanation does not lie in the spontaneous savings behaviour of these economies; and the resolution does not lie in mere fiscal measures on the part of the EMEs without a degree of “delinking” of their economies from the vortex of commodity and capital flows in the world economy. Savings glut and current account surplus are the same thing. Reforming IMS to correct imbalance is necessary.

  9. Official institutions to commit to act as market makers to construct a SDR’s yield curve may be necessary. A puttable SDR-denominated securities would be alternative choice to enhance SDR’s liquidity.

  10. In recent years, international reserve accumulation has accelerated rapidly. Systemic imperfections have been important drivers of reserve accumulation. These imperfections include uncertainty about the availability of international liquidity in a financial crisis; large and volatile capital flows; absence of automatic adjustment of global imbalances; and absence of good substitutes to the U.S. dollar as a reserve asset, which also reflects the fact that currency tends to be a natural monopoly(see Reserve Accumulation and International Monetary Stability, 2010).

  11. SDR has demonstrated its usefulness during the recent crisis with an exceptional allocation. It might be useful to re-explore its potential role (e.g. as a reserve asset or
    as a unit of account, etc.) in serving the public common good of monetary and financial stability in the new context of today’s globalized and increasingly multi-polar world. Furthermore, the
    issue of its potential role in a long term perspective should remain under consideration, not only
    to stay in compliance with the undertaking of the Articles of Agreement, but also in view of the role it could play in addressing potential demands that may arise(see Reform of the International Monetary System: A Cooperative Approach for the Twenty First Century (Jan. 18, 2011)).

  12. A more realistic path to reform the monetary system may be to broaden existing special drawing right (SDR) arrangements which could, over time, evolve into a widely accepted world reserve currency. Its liquidity is very important. This may also require broadening the composition of the SDR basket to make it more representative. All component currencies, however, should be fully convertible and have well-developed financial markets. Along with reducing the inherent instability of the current system, the greater use of SDRs may result in more democratic control of global liquidity.
    In August 2009, for the first time since the late 1960s, IMF member governments took a decision on a general SDR allocation by the IMF equivalent to $250 billion. This will be complemented by a network of voluntary arrangements allowing SDRs to be traded effectively among members. Together with the special one-time allocation of about $33 billion in September 2009, the outstanding stock of SDRs increased nearly tenfold,
    from about $33 billion to about $321 billion.

    Nevertheless, SDRs still represent less than 5 per cent of global foreign-exchange reserves. As not all members need to increase their international reserves, the Fund should explore mechanisms for redistributing SDRs to countries most in need, especially in times of crisis. Such allocations would be cancelled once the crisis has passed. The crisis allocations should not be linked to individual country situations, but rather to systemic risk stemming from liquidity shocks on a global or regional scale.
    For SDRs to take on a significant role, their issuance should be made regular,
    with possible linkage to expected additional long-term demand for foreign reserves. SDR use in international trade and financial transactions, as well as in a functioning settlement system to facilitate the direct exchange of SDR claims into all constituent currencies, needs to be enhanced. Thus far, a private SDR market has not taken off. Reaching a critical mass that would allow the development of a deep, diversified and liquid market for SDR instruments would likely be impossible without strong support from the public sector; actions could include some of those taken to foster the development of the European Currency Unit (ECU) market, including the issuance of SDR-denominated debt by national governments and multilateral institutions.

    Additionally, SDR-denominated reserve accounts may need to be established at the IMF. These would allow large reserve holders to exchange their currency reserves for SDR-denominated securities and deposits without encountering undesirable exchange-rate effects. The resulting shift of the exchange-rate risk from the original holders of currency reserves to other parties will require agreement on an appropriate burden-sharing arrangement.

    This issue was discussed when the substitution account was negotiated within the IMF more than a quarter century ago(see World Economic Situation
    and Prospects 2011).

  13. The problem with the euro is the euro. So the problem with the SDR is the SDR. How to and when one can construct a fair and representative full-term maturity structural yield curve of SDRs which value is even only based on four key international currencies?

  14. Macroecnomic devices have never helped to resolve social inequalities. Whether the U.S. dollar is the main currency in the IMS or not, decisions of this kind will certainly have very little impact on fostering solutions to the problem of unemployment, especially in developing countries. The correct way to solve these problems is to create programs to be applied by countries that will have a real social impact.

  15. […] This post was mentioned on Twitter by Matthew Lloyd, Global Updaid. Global Updaid said: IMF: A Stronger Financial Architecture for Tomorrow’s World http://bit.ly/h3zLae […]

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