CHAPTER 12. Remarks on “The Debate on the International Monetary System”

Il SaKong, and Olivier Blanchard
Published Date:
July 2010
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Changyong Rhee

The paper “The Debate on the International Monetary System,” prepared by Isabelle Mateos y Lago, Rupa Duttagupta, and Rishi Goyal, discusses the weaknesses of the current international monetary system and considers options from both the demand and supply sides to strengthen the system. The paper states:

…the current “non-system” has the inherent weaknesses of a setup with a dominant country-issued reserve currency, wherein the reserve issuer runs fiscal and external deficits to meet growing world demand for reserve assets and where there is no ready mechanism forcing surplus or reserve-issuing countries to adjust. The problem has amplified in recent years in line with a sharp rise in the demand for reserves, reflecting in part emerging markets’ tendency to selfinsure against costly capital account crises.

While Mateos y Lago, Duttagupta, and Goyal’s paper covers a broad range of contributors to the inherent weaknesses of the international monetary system, I would like to focus specifically on “self-insurance” as a significant contributor to the problem and ways in which the incentive for emerging markets to self-insure could be reduced.

Addressing the self-insurance issue is important for the G-20. One of the main agendas for the G-20 this year is the Framework for Strong, Sustainable, and Balanced Growth, and the purpose of the Framework is to help manage the transition of the global growth to a more balanced pattern of growth. Reducing the motivation to accumulate foreign reserves for self-insurance purposes will assist in rebalancing the global imbalance.

When looking at reducing the motivation to self-insure, I would like to bear in mind those countries that are pursuing sound macroeconomic policies and strong financial regulations and yet, just as the recent financial crisis has demonstrated, countries that can be victimized by sudden capital reversals. I would like to therefore cover the four areas presented by Mateos y Lago, Duttagupta, and Goyal’s paper—improving the IMF’s flexible credit line, FX liquidity insurance, regional and global reserve pool, and institutionalizing bilateral swaps—as ways to strengthen global financial safety nets and therefore reduce motivation for these countries to self-insure.

In discussing these options, I will cover the global responses first. Possible global responses include improving the existing Flexible Credit Lines available through the IMF and setting up an FX liquidity insurance scheme. Then, re gional responses such as the regional multilateral swap arrangements will be discussed. Finally, I will address how bilateral arrangements can help and be further strengthened.

12.1. Demand-Side Responses

12.1.1. At a Global Level Flexible Credit Line

One practical way the global safety net can be strengthened is to improve the Flexible Credit Line. Three countries have received help from the IMF during the recent crisis, demonstrating the usefulness of the facility. In Asia, however, it will take a long time to take away the stigma effects associated with receiving IMF’s help. We need to improve on this. One option could be to introduce a predetermined automatic eligibility condition. For example, we could let countries that have maintained sound macroeconomic policies with a certain level of reserves for a certain period be prequalified for these facilities. This could also have a positive effect of creating incentives for better macroeconomic management for emerging market economies.

In addition to putting in place predetermined and strict triggering conditions, we may need to increase the size beyond the excess cap of 1,000 percent and lengthen the duration of the Flexible Credit Line beyond the current 6 months to make the Flexible Credit Line even more useful. This will require new funding resources. Bilateral swaps, transfers to the IMF, special drawing rights, regional swap arrangements, and reserve pooling can be some of the answers. In addition, there has been much discussion about a financial transaction tax. While it has been suggested that the revenues be used to address climate change financing issues, I believe using it as a self-insurance mechanism would be an ideal solution. One of the arguments against the Tobin tax is reduced capital inflow and outflows. Using its revenues for an insurance mechanism would actually have a positive effect on capital flows, mitigating the distortionary effect of the Tobin tax. FX Liquidity Insurance

There could also be some form of FX liquidity insurance mechanism that combines all the attributes of the different options being discussed here. The idea is to link most central banks to the IMF and to let these central banks provide credit lines. The IMF would create some form of trust fund to operate as an insurance fund. Insurance premiums and special drawing rights, among others, can be sources of funding.

While in the 1980s and 1990s most emerging market crises arose from sovereign problems, in the recent crisis, the main root of the problem was liquidity shortage of individual financial institutions. There must be some mechanism not only to provide lending to governments but also to directly address the shortage problem in the private sector. But achieving this outcome is no easy task. It will require changing the mandate of the IMF, dealing with moral hazard problems, and calculating the right amount of the risk premiums, among other things. It will be a daunting task, but one that is worth exploring.

12.1.2. At a Regional Level

Another possible response to strengthening the safety nets to reduce the incentive to self-insure is to establish some linkages between regional multilateral swap arrangements such as the Chiang Mai Initiative with the IMF. For example, the Chiang Mai Initiative can be the first line of defense and the IMF can be the second line of defense. The role of the IMF can be direct lending to the Chiang Mai Initiative or co-financing lending using the Flexible Credit Line. This would require lots of political effort. Not only the IMF and advanced countries’ support, but also the political support of ASEAN+3 countries will be needed. There will be all kinds of politically difficult questions as well (such as who will be in charge of surveillance functions, what should be the risk allocation rules, and who will manage the reserve) that need to be resolved.

In the 10 years after the Asian financial crisis, Asian countries have come a long way. The Asian financial crisis led to increased regional cooperation, and we created the Asian bond market fund and the Chiang Mai Initiative mechanism. I hope that the recent crisis can provide another opportunity for us to further cooperate and make concerted efforts to improve the financial safety nets.

12.1.3. At a Bilateral Level

Bilateral swaps between major central banks have proven effective during the recent crisis, and it would be a waste if we let this kind of facility disappear. The problem is that they are ad hoc in nature. If a similar crisis arrives again, it will be important for emerging market economies to have access to this kind of facility. One feasible way to make sure of that may be to transfer bilateral swaps to multilateral institutions such as the IMF. This does not mean extending bilateral swaps without limit, but rather better utilizing the amounts central banks have already pledged to the IMF.

The other option may be the standardization of bilateral swaps so that when things go bad emerging market economies can always rely on the same facilities. In order to address the moral hazard problem, we can introduce a stringent triggering condition such that the swap would not be released if capital reversals are arising from domestic problems and not from exogenous shocks.

12.2. Supply-Side Responses

Finally, on the supply side, I agree with Mateos y Lago, Duttagupta, and Goyal’s paper that it will take a long time to establish a new reserve currency. Therefore if our objective is to create another reserve currency, there may be no easy solution. However, if we narrow down our focus to developing mechanisms that would reduce self-insurance motivation and help cope with sudden reversals, this may not be as difficult to achieve.

A colleague from the Bank of England enlightened me on the difference between a reserve holding incentive and lag of international liquidity. What appears to be happening currently is not the lag of international liquidity, but a kind of hoarding behavior by some countries which is adding to the problem of sharp rise in demand for reserves. Hence, even though special drawing rights allocation and creation cannot solve the real hard currency problems, we can utilize special drawing rights to reduce incentives to hold reserves.

For instance, during the recent crisis, we used special drawing right allocations to help emerging market economies ex-post, but it would have been much more helpful if it had been an ex-ante solution. Having a trigger condition and automatic special drawing right allocation rules when sudden capital reversal takes place might be another way of reducing the self-insurance motivation. While there are moral hazard problems associated with this option and more studies are required before it can be seriously considered, I believe there is merit in exploring this option further.

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