July 2, 2010
Global imbalances and exchange-rate movements: governance and coordination at the international level
In an interdependent world, however, it is wrong to regard a strong profit-investment nexus as a sufficient condition for sustained economic growth. There must also be markets available to absorb the potential expansion in output that this implies.Building robust domestic markets is of course key to long-term growth and development, but exporting is also an essential feature of any balanced economy – although just how significant it is can vary from country to country. Certainly, successful exporting is contingent on favourable investment dynamics, a supportive macroeconomic environment, large domestic firms, etc., and hence, a wide range of conditions must come together for firms that are competitive domestically to become successful exporters in the global markets. It is also the case that the international environment must be supportive of efforts to forge a dynamic profitinvestment-export nexus in developing countries.
At the international level, rarely in the history of global economic governance have there been concerted efforts to imagine the long-term development of the global economy or to manage it.
The creation of the Bretton Woods institutions was certainly one such moment, and its architects gave to it a strongly Keynesian design covering monetary and fiscal concerns, governance issues and trade flows. The emergence of a series of UN development bodies, including my own, in the early 1960s was another such moment, and perhaps the establishment of the WTO in 1995 was the last.
UNCTAD has long advocated a multilateral approach to international finance. The principle that well-defined multilateral rules, with a transparent and fair arbitration process to adjudicate on the infringement of those rules by all players, underpins an open and stable economic system and is orthodoxy in the WTO. Yet the same thinking is somehow regarded as anathema when applied to the financial system.
Beggar-thy-neighbour policies on currency depreciation are tantamount to protectionism, and indeed can have a far more distorting effect than tariffs. At worst, they could also incite a cycle of retaliation either through competitive exchange-rate adjustments or through other protective measures.
Obviously, there are important differences between the impact of exchange-rate changes and tariffs on trade, the most important being that tariffs are product-specific, while exchange-rate changes affect the relative prices of all traded goods and services. Another important difference is that tariff changes are predictable, while exchange-rate movements are not. The latter are frequently unrelated to economic fundamentals and strongly influenced by the changing moods of financial market participants. But tariffs and exchange-rate changes both affect the competitive positions of domestic vis-à-vis foreign participants in goods markets, and thus both affect the geographical pattern of trade flows.
Financial markets are much more integrated and interdependent internationally than goods markets. As a result, adverse spillovers from exchange-rate and financial policies have much stronger repercussions on global stability and prosperity than trade policy. Therefore, it is even more imperative to ensure that any future reform of the international economic governance system envisages closer and more effective monetary cooperation within a strengthened framework of multilaterally agreed rules and regulations.
This should involve macroeconomic surveillance of, and advisory functions for all countries by an international body, similar to the framework of the multilateral trading system. Since experience has shown that under a regime of open capital accounts neither completely fixed nor fully flexible exchange rates can ensure financial stability, the solution must lie with intermediate regimes of managed floating.
Exchange-rate changes are necessary to compensate for the price and cost developments between a high-inflation and a low-inflation country. However, exchange-rate changes, and in particular, real exchange-rate changes that determine the competitiveness of the whole economy, cannot be left to the market.
Stabilizing rates within certain limits will require significant foreign exchange market interventions. On the other hand, it has to be acknowledged that attempts by many countries to keep their currencies at an undervalued rate may result in a race to the bottom or in competitive devaluations that would be as harmful for the world economy as in the 1930s.
Indeed, avoiding competitive devaluations was a central idea behind the foundation of the IMF. But the existing global economic governance system lacks institutional arrangements that could exercise multilateral discipline on exchange rates. Most of the financial crises in the post-Bretton Woods era of floating exchange rates have been characterized by nominal interest rate differentials that have triggered large short-term capital flows. As a rule, the quantity of inflows is big enough to increase the short-term attractiveness of the highinflation country's currency, resulting in appreciation, which further raises the return on investment.
In what is a clear systemic failure, an appreciation of the currency of the higher-inflation country fundamentally undermines the normal functioning of the “exchange-rate mechanism” in the short term. The high-inflation country's higher prices on the world market are not offset by a nominal depreciation, and the appreciation adds to the loss of competitiveness of that country and worsens the current account situation rapidly.
If exchange rates do not follow the purchasing power rule in the short term and destabilize the external accounts, the introduction of this rule as a political target is the only way out. The presence of the carry trade brings into question the widespread acceptance of floating as the only feasible solution to the problem of the external balance. Brazil's competitiveness, for example, is not helped by inflows of hot money that seek to exploit the high interest differential between Brazil and other countries. Such inflows contribute to appreciating the exchange rate and to any inflationary pressures that exist in the economy.
Conversely, the pressure on China to float its currency could actually end up encouraging carry trade and, with a depreciation of the renminbi, a further increase China's competitiveness. Such an outcome would accentuate global imbalances. In the same way as intended by multilateral trade rules, a well-designed global financial system has to create equal conditions for all parties involved and help to avoid unfair competition. Avoiding competitive depreciations and other monetary distortions that have negative effects on the functioning of the international trading system is more important in today's highly interdependent world than at any other time in history.
Instability in international currency and financial markets is the result of unregulated international financial activities and clearly cannot be remedied by national policies alone.
Therefore, apart from strengthening national and international frameworks of financial regulation, it is also imperative to provide for an institutional framework for better international coordination of financial regulation and supervision. Equally important is to reshape international monetary arrangements that help avoid the build-up of large current-account imbalances and their counterpart, large unbalanced asset positions across countries. Such an agreement would hopefully address the current potential for regulatory arbitrage, which under a system of loosely coordinated national policies, makes a mockery of efforts at financial system reform.
Speculative capital flows and the need for controls
The realization that in a globalized world “shocks” emanating from one segment of the financial sector of one country can be transmitted rapidly to other parts of the interconnected system, including those countries with only weakly developed financial sectors, raises some fundamental questions about the wisdom of global financial integration of developing countries in general.
The experience with the current financial crisis calls into question or debunks the conventional wisdom that dismantling all obstacles to cross-border private capital flows is the best recipe for countries to advance their economic development. This has been part of mainstream economic advice since the 1980s. While it is agreed that global finance has caused the current crisis, there is still a good deal of resistance to reforming the global financial architecture. Debates about reform focus primarily on improving national prudential regulation and supervision of financial players of systemic importance. These are important issues.
But the experience of this financial crisis also supports the case for a more fundamental rethinking of global financial governance with a view to stabilizing trade and financial relations by reducing the potential for gains from speculative capital flows. Promoting proactive capital-account management may be one element in a revised governance structure that could give countries sufficient flexibility to manage their domestic macroeconomic policies and improve their prospects for economic stability. Effective capital-account management not only helps prevent volatile private capital flows from causing exchange-rate volatility and misalignment, and thereby destabilizing the domestic financial system; it also helps improve the reliability of price signals in domestic markets and the conditions for efficient resource allocation and dynamic investment.
Assertions that capital controls are ineffective or harmful have been disproved by the actual experiences of emerging-market economies. This is a point that now appears to be accepted by senior IMF economists1, who acknowledge that they can be useful under certain conditions, such as economic crisis and indebtedness. These experiences show that different types of capital flows can be targeted and limited effectively by a variety of instruments.
These instruments range from outright bans or minimum-stay requirements to tax-based instruments like mandatory reserve requirements or taxes on foreign loans that are designed to offset interest rate differentials, as introduced by Brazil last October. Thus, in pursuing its surveillance function, the IMF should more actively encourage countries to use, whenever necessary, the introduction of capital controls, as provided for in its Articles of Agreement.
Reform of the global reserve currency and voting rights
One problem that has received renewed attention is dependence on the United States dollar as the main international reserve asset. An international reserve system that uses one or even a small number of national currencies as a reserve asset and as a means of international payments also has the disadvantage of being dependent on monetary policy decisions by the central banks issuing those currencies. However, their decisions are not taken in response to the needs of the international payments system and the world economy, but to national policy needs and preferences. Moreover, an economy whose currency is used as a reserve currency is not under the same obligation as others to make the necessary macroeconomic or exchange-rate adjustments for avoiding continuing current-account deficits.
In the current international reserve system, the burden of adjusting imbalances is greater for deficit countries (whose currencies do not serve as reserve currencies) than for surplus countries. Central banks can easily counter pressure for currency appreciation by buying foreign currency against their own currency, but they are less able to withstand pressure for currency depreciation, because their foreign exchange reserves are often limited. Since adjustment would imply a reduction of imports by the deficit country, there is a deflationary bias in the system, which makes it more difficult to achieve and maintain high employment. Against this background, a proposal first discussed in the late 1970s has recently resurfaced. It argues for facilitating reserve diversification away from dollars without the risk of a major dollar crisis by giving central banks the possibility to deposit dollar reserves in a special “substitution account” at the IMF, denominated in SDRs.
These SDRs could also be used to settle international payments. Indeed, in response to the increased needs for international liquidity in the current financial and economic crisis, the G20 at its London Summit in April 2009 announced its support for a new general SDR allocation, which would inject $250 billion into the world economy and increase global liquidity. This proposal was endorsed by the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System.
However, the new SDRs would be distributed according to member countries' quotas in the Fund. This would mean that the G7 countries, which have no real need for SDRs because they themselves issue reserve currencies or have easy access to international capital markets, would receive more than 45% of the newly allocated SDRs. Less than 40% would be allocated to developing countries and less than 8% to low-income countries. Thus the countries most in need of international liquidity from official sources would receive the smallest shares.
This raises the more general issue of the geographical and time dimensions of SDR allocation. Additionally, it is perhaps ironic that the European Union recently announced its intention to create a European Monetary Fund partly in response to the sovereign debt crisis in Greece.
After the Asian financial crisis of 1997/1998, the EU was sceptical and was opposed to the idea of Asian countries creating a regional monetary fund under the auspices of the Chiang Mai Initiative. In the aftermath of the crisis, some Asian countries felt that such regional mechanisms would provide a more flexible alternative to the IMF, as they are likely to have greater regional knowledge and could be quicker to respond; additionally, they increase 'competition' in global economic governance, which could also lead to more responsive multilateral institutions.
These arguments are still valid and the possibility of establishing a regional monetary fund in developing regions should be given serious consideration. From the standpoint of criteria for geographical distribution of SDRs, it has been suggested that in order for the SDR to become the main form of international liquidity and means of reserve holding, it should be distributed in response to the needs of countries.
Appropriate criteria for determining those needs would have to be worked out, but there can be no doubt that an allocation according to the current structure of IMF quotas is entirely out of line with needs. One approach would be to allow all countries unconditional access to IMF resources by an amount necessary to stabilize their exchange rates at a multilaterally agreed level.
Another approach could be to link the issuance of SDRs with the needs of developing economies for development finance by allowing the IMF to invest some of the funds made available through the issuance of SDRs in the bonds of multilateral development banks. Such a proposal was made by an UNCTAD panel of experts in the 1960s, before international liberalization of financial markets began, and when access to capital market financing by developing-country borrowers was very limited.
Whatever form an enhanced scheme of SDR allocation takes, it will only be acceptable to all countries of the system if the terms on which SDRs can be used as international liquidity are absolutely clear-cut. The Bretton Woods system and the European Monetary System provide precedents for what could be an appropriate solution.
In these systems the implicit rule was that the exchange rate between a national currency and the international currency was determined by the purchasing power of that currency expressed in all other currencies.
This rule may be difficult to introduce at the time the system starts, because of the problem of determining the initial purchasing power parities of each currency, but it would be straightforward and simple once the system was on track.
Financial speculation and oversight
It is regrettable that enthusiasm for a reform of the international monetary and financial system appears to be diminishing now that many observers and policymakers believe the worst of the financial crisis is over. I would argue that rethinking the international reserve system and regulation of speculative capital flows are as urgent as ever, especially as speculation affects many areas of the global economy.
For example, from 2006 to 2008, commodities increasingly became a target for speculative activity. Whilst market fundamentals (growing demand from emerging markets, the rundown of stocks, drought, decline in refining capacity, and so on) initiated price increases in many agricultural and non-agricultural commodities, clearly the link between supply and demand was distorted beyond all recognition by the impact of speculation. The simultaneous movement of commodities markets with other assets appears to demonstrate the influence of speculation.
Major commodity exchanges around the world witnessed record trading volumes: in 2007, agricultural futures and options trading grew by 32%, energy by 28.6% and industrial metals by 29.7%. In addition, according to statistics of the Bank for International Settlements, outstanding amounts of over-the counter commodity derivatives increased by close to 160% between June 2005 and June 2007. The number of futures and options contracts outstanding on commodity exchanges worldwide rose more than threefold between 2002 and mid-2008. During the same period, the notional value of commodityrelated contracts traded over-the-counter increased more than 14-fold, to $13 trillion. Commodity derivatives exerted a significant influence on spot prices and arguably distorted prices, which had punishing effects for consumers but could also have a negative impact on the future production plans of producers.
In general, the financial sector's lack of transparency and disclosure created a "shadow banking system", with off-balance-sheet assets worth 30% more than those on balance sheets ($16 trillion : $12 trillion).
Furthermore, and as I do not need to tell an audience of bankers, opaque innovation in financial products such as collateralized debt obligations and special purpose vehicles for off-balance-sheet assets, increased the systemic risk – just the opposite of what they purported to achieve.
Taken together with the huge leveraged debt binge in areas from swaps to real estate, the financial markets became completely detached from the real economy and ultimately created a systemic crisis in the banking sector, which spread to the global economy.
Needless to say, stronger monitoring, regulation and disclosure are required for limiting excessive speculation, especially in staple food commodities in the light of the 2008 food crisis. We at UNCTAD support the ongoing discussions in Europe and elsewhere on the restriction of certain instruments, such as credit-default swaps after last year's financial crisis, and the role of CDSs in exacerbating the recent sovereign debt crisis in Greece.
Additionally, the time has come to seriously rethink governance reform at the IMF, so that it can focus most properly on what it does best: macroeconomic surveillance and management. If it is to have a strengthened role in reserve currency management, it should remove itself from other areas, such as development finance and poverty reduction, which serve only to clutter and confuse its mandate.
The IMF should also strengthen its oversight and surveillance functions so that it is in a better position to warn of crises such as the one we are currently experiencing. In any reform of the international financial institutions, or any institutions governing economic activity for that matter, it is imperative that the composition of committees and supervisory boards reflects a diversity of economic views. One of the criticisms levelled at both the IMF and the Financial Stability Forum (now Board) was that the similarity of intellectual backgrounds of members led to a convergence and even reinforcement of opinion, which failed to foresee the coming crisis.
Instead of voices pulling in different directions to test views and policy recommendations, a kind of flocking emerged which proved nearly fatal for the global economy. It should, however, be said that there were several voices that did raise concern about the crisis and how it could be avoided, not least in UNCTAD, which has been analysing global imbalances since as early as 2004.
Conclusion
In the past year, mainstream economic thinking has been turned on its head by events in the real world. As the economist J.K. Galbraith once wrote, “idea yield not to the attack of other ideas, but, to the massive onslaught of circumstances with which they cannot contend”.
Ultimately, reconstructing economic governance may be the outcome of a more pragmatic policy stance against what was the biggest onslaught of economic events since the 1930s.
Economic governance should work primarily to achieve the goals of prosperity, security and stability, which are the prerequisites for sustainable poverty alleviation. This was the original intention of Keynes and the other architects of the Bretton Woods institutions, who looked to the 1930s and saw unemployment as essentially a waste of resources, and undervalued exchange-rate movements as a weapon for exporting unemployment.
For those pioneers, a regulated financial system was essential for an open and stable trading system. As developing countries, from the early 1960s, forced their own concerns on to the international economic agenda, international cooperation was extended to address the problem of weak or insufficient productive capacity through concessional development finance and support for sectoral and industrial policies; macroeconomic targets, such as maintaining low inflation or a balanced budget, were seen as policy tools, a means to serve the goal of rapid economic and industrial development – not the goal itself. In recent years, it could be thought that selected macroeconomic targeting has become governments' primary objective, and trust in the efficient factor allocation of the market has replaced government policy: growth and employment will result if the 'prices are right'.
From the perspective of 2010, as growth rates have tumbled and growing unemployment has hit both the North and the South, it should be obvious that these policies have not worked. The crisis was largely the result of a giant market failure: a mega-event in the cyclical pattern of contemporary economic growth. As I mentioned before, even the IMF now acknowledges that some of the policies it prescribed to governments were based on false assumptions.
UNCTAD has been warning for many years about the dangers of uncontrolled global imbalances and their implications for the world economy. These conditions have produced uneven and unstable growth and mixed results for development. To ensure the long-term sustainability and stability of countries' economic development, we need to adopt new measures at the national and international levels: we need a new agenda, which, incidentally, may draw on some old ideas.
For one thing, the new agenda should be based on improved regulation of financial markets, which should be based on a careful evaluation of the social costs and benefits of financial innovation. Financial sophistication with no social returns must be weeded out, and regulatory arbitrage avoided. Incentive structures in the financial industry must be overhauled to put an end to excessive risk-taking.
For another, developing countries must increase their resilience to external shocks by maintaining a competitive exchange rate and limiting currency and maturity mismatches in private and public balance sheets. As I have already explained above, the world also badly needs international coordination.
Regulators based in different countries should share information, aim at setting similar standards, and avoid races to the bottom in financial regulation. Special attention must also be paid to the plight of the poor economies, which means increasing development aid is yet another imperative.
UNCTAD research has found that past financial crises were followed by a substantial decline in foreign aid, ranging from 10% to 60%. And if Overseas Development Assistance (ODA) takes as long to recover from today's turmoil as it did previously – say, in three to four years' time, just when world markets are starting to pick up again – the poor countries could be caught short, lacking the resources needed to get back into exporting. Not only should current ODA pledges be kept, but they should be increased, substantially.
As to the international financial system, I believe that we need to rely more on a multilateral approach and the same rules and regulatory discipline that apply to international trade should also apply to international finance.
In this respect, a set of multilaterally agreed rules on exchanges rates, and a mechanism to correct long-term misalignment in exchange rates are long overdue. For rising economic welfare to be sustainable, it has to be shared without altering the relative competitive positions of countries.
In the 1920s, when the “market juggernaut” was rolling at full steam, John Maynard Keynes called for a “new wisdom for a new age” with “new policies and new instruments to adapt and control the workings of economic forces, so that they do not intolerably interfere with ideas as to what is fit and proper in the interests of social stability and social justice”.
Open-minded, tolerant and pragmatic approaches to the development challenge, consistent with today's increasingly interdependent world, are urgently needed to place economic policy and governance once again at the service of financial stability and economic prosperity for all.
http://www.un.org/
LINKS - MEETINGS AND EVENTS LEADING UP TO A GLOBAL ECONOMY ....
A New Reserve Currency ...
IMF: Lessen Dependence on Dollar says Dominique Strauss ...
