The 2008 financial crisis revealed considerable fault lines in the international monetary system, and as such, the impetus for reform remains inevitable.
With this in mind, it cannot be said enough, how much the global economy today is increasingly multi-polar, complex, and interconnected. Towards this end, one needs to ask how the international monetary system can be strengthened so that emerging countries can restore momentum and more importantly, safely deepen economic and financial integration.
Fortunately, one of the world’s strongest financial institutions, the International Monetary Fund (IMF), has taken up the slack where this matter is concerned.
In fact, the Fund has been in consultation with its membership and has explored possible options to strengthen the resilience of the system.
Managing Director of the International Monetary Fund (IMF), Christine Lagarde posits that the entity has even overhauled its own surveillance toolkit to take better account of economic and financial interconnections and spillovers. It has also revamped its own institutional view on the management of capital flows.
Lagarde contends that this is crucial, to draw more attention to the risks and global implications of domestic policies. She said that the IMF is also enhancing its understanding of the impact of non-economic spillovers, such as epidemics.
She has also reported that the Fund’s role in the overall global financial safety net was also strengthened. Expounding on this topic a bit more, the IMF Chief articulated that the recent approval of the 2010 governance reforms led to a doubling of the Fund’s quota resources—to about US$660 billion. This increase will put the Fund on a stronger financial footing and boost its permanent lending capacity.
She noted that recent steps also bode well for greater representation of dynamic, emerging economies, in the governance of the Fund. With the quota reforms, the BRIC (Brazil, Russia, India and China) countries, Lagarde said, are now among its top 10 shareholders.
Lagarde said that there have also been improvements outside the Fund. The IMF Boss explained that today, there is also a network of bilateral swap lines that extend beyond the major advanced countries to include systemic emerging economies.
Again, China is becoming increasingly important in this network, with more than 30 swap lines in place, as of end-2015. These are equivalent to about US$500 billion and account for 85 percent of all global swap lines.
So, with all these important changes, a natural question is why the need for further reform of the international monetary system? In Lagarde’s view, the answer is simple. These reforms were implemented in response to the crisis back in 2008.
The IMF Boss said that the world today presents nations with new realities that require a different response. She stressed that ongoing financial globalization and integration is creating challenges that nations need to adapt to.
“I can think of a few such new and interrelated realities. The post-crisis adjustments and increased financial integration have contributed to the build-up of financial vulnerabilities. But the good news here is that global current account imbalances have narrowed since the crisis. The not-so-good news is that the nature of the adjustment – combined with increased financial integration in many emerging and developing economies – may have increased domestic vulnerabilities.”
Lagarde said that financial integration brings clear benefits in terms of better allocation of capital, globally, and greater risk sharing. But if not properly managed and regulated, Lagarde articulated that it can bring financial stability risks which the global financial safety net may not be adequate to handle.
As of end-2014, Lagarde said that total cross-border flows in emerging and developing economies stood at about US$20 trillion. She added that it is no surprise that cross-border borrowing, particularly for banks and corporate entities, has become an important source of funding for many emerging economies. Yet, this source of funding can contribute to balance sheet mismatches and possible liquidity pressures.
Lagarde said, “Let us also piece together the major elements of the financial safety net that can be called upon to alleviate such liquidity pressures. These would include four broad elements: individual countries’ foreign exchange reserves, bilateral swap lines, regional financing arrangements, and financing through multilateral institutions like the Fund.”
Together, these resources were “roughly” estimated at about US$16 trillion in 2014, of which the bulk—US$12 trillion—is individual countries’ foreign reserves. Yet, not all countries have equal access to the various elements of the safety net.
Lagarde explained that on one end of the spectrum, there are reserve currency-issuing advanced economies. These are best covered by all the elements of the existing framework. On the opposite end of the spectrum, there are the non-systemic emerging and developing economies, which face the most limited set of options in this safety net.
Clearly, we need a bigger – and more inclusive – net that captures all risks, Lagarde expressed. There is another reality that must be addressed and that has to do with capital flow volatility, which the IMF Boss said is becoming a permanent feature of the global landscape.
“Consider the exponential growth of cross-border flows over the past few years. These flows reflected both “push” factors, such as appropriately expansionary monetary policies in advanced economies, and “pull” factors, such as rapid growth in emerging economies. Yet today, uncertainty about global economic prospects and a synchronicity in monetary policies of major advanced economies pose a challenge for the emerging world,” explained Lagarde.
She said that nations should expect that episodes like the “taper tantrum” of May 2013 could be recurring, rather than one-off. She asserted that the turning of the credit cycle in emerging economies – as capital inflows decelerate or even reverse – is adding a further layer of complexity.
Last year, for example, emerging markets saw about $200 billion in net capital outflows, compared with $125 billion in net inflows in 2014. For a sample of 45 emerging market economies, the cumulative slowdown in capital inflows between 2010 and 2015 is estimated at about US$1.1 trillion. Relative to economic activity, the aggregate decline in net capital inflows represents about five percent of the sample’s GDP.
Lagarde said that these magnitudes can test the resilience of even the most robust macroeconomic frameworks. She said that quick liquidity support during systemic events becomes of paramount importance to stem the risk of broader contagion.
Another important aspect that must be taken into consideration, Lagarde opines, is the increased financial globalization, which also means that financial spillovers are the norm, not the exception.
Lagarde said that financial integration also strengthens spillovers, or knock-on effects, across countries. Think of the turmoil earlier this year that – for a while – wiped out the equivalent of US$6 trillion – or 8.5 percent of global GDP – in equity market indices.
She said that in the current international architecture, the central role of major reserve currencies means that policy and financial developments in reserve issuing currencies can have significant spillover effects on other countries. She said that these knock-on effects can constrain domestic policy choices, especially when countries are at different stages of the business cycle.
Even so, the IMF Boss is of the opinion that major advanced economies are no longer the only source of financial spillovers. She said that forthcoming research in the Global Financial Stability Report shows that financial spillovers from emerging economies – to both advanced and to other emerging economies – have become stronger since the crisis.
Lagarde said that this is particularly the case for spillovers from equity markets in emerging economies, which increased by 28 percent since the crisis. She noted that spillovers from some of the largest emerging economies, such as China and Brazil, were even bigger—at about 40 percent.
“So these are some of the new realities to which the international monetary system needs to adapt. There are others, of course. Think of the turbo-charged speed of financial transactions; think of digital currency and block chain technology; think of cyber-hacking—from which even central banks are not immune. So, speaking practically, where should the focus of the reforms be? In my view, it is along two key dimensions,” expressed Lagarde.
She said that the first dimension is to ensure that the global financial safety net is large enough, coherent, and works for all. Clearly, strong policies and effective Fund surveillance remains the cornerstone of crisis prevention. Still, a large enough and more coherent global safety net, with a well-resourced Fund, remains critical.
Lagarde opines that options should explore measures that would strengthen the reliability and reduce the stigma associated with accessing the safety net. At the Fund, Lagarde promised that efforts will be geared towards looking into ways to make resources and instruments more predictable for crisis prevention and resolution. She said that this includes further improving coordination among the various layers of the safety net.
For its part, the IMF boss said that the Fund will be taking stock of progress in the liberalization and management of capital flows, with a focus on capital flow measures and foreign exchange intervention. She asserted that the role of macro- and micro-prudential policies in limiting vulnerabilities in the non-bank sector will also be explored, along with options to promote greater equity finance.
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