Written evidence submitted 24 November 2011
We warmly welcome the Treasury Committee’s decision to hold this inquiry, which is both timely and important. The Bretton Woods Project is an independent NGO established by a network of UK-based NGOs to monitor and advocate for change at the World Bank and International Monetary Fund (IMF). See www.brettonwoodsproject.org/about for more details.
The Committee’s 2009 inquiry into the international dimensions of the financial crisis also touched on this important subject. The Committee’s recommendation that the government would “need a clear idea of what the future international monetary architecture should ideally look like” was valuable. Unfortunately, the recommendation that “the Treasury provide, as a response to this Report, a paper on potential future designs of the international monetary system” was not taken up by the current or previous government. We hope the committee will continue to press the government to set out its thinking on this topic.
This submission is divided into the following four sections:
- Background – we note that global imbalances were a major contributing cause of the financial and economic crisis and are still a major problem. However, the costs of future adjustment should not harm developing countries’ efforts to eliminate poverty.
- Main causes of global imbalances – we argue that there are four main underlying causes: the lack of exchange rate coordination mechanisms; the dollar’s position as international reserve currency; IMF failures; and self-insurance.
- Proposals for reform – we offer the following suggestions:
- Need for concerted international action – based on a recognition that the scale of the problem requires a major international rethink involving all countries.
- Ending dollar dominance – move to a global reserve system – to provide a long term solution to the problems of global imbalances, the costs of holding reserves, and provide a more stable, equitable international monetary system.
- Reform of international institutions – in particular the IMF needs a radical makeover to restore lost legitimacy, beginning with the introduction of double majority voting, and including policy changes in conditionality and stance towards capital account regulations.
- Actions the UK government can take
Global imbalances – at the heart of the crisis and still a major problem
It is widely accepted that global imbalances were a major contributing factor to the recent global financial crisis. The ability of certain countries, particularly the United States, to run huge and persistent current account deficits – and the corresponding capital account surpluses that sucked finance into their countries – effectively allowed them to live beyond their means, supporting growth on the back of credit rather than savings and investment.
The UN Conference on Trade and Development (UNCTAD) set out in their 2009 report how imbalances also make the global financial system more subject to contagion – so that collapses in some countries can rapidly spread to others. They noted:
“.global imbalances served to spread quickly the financial crisis that originated in the United States to many other countries, because current-account imbalances are mirrored by capital account imbalances: the country with a current-account surplus has to credit the difference between its export revenue and its import expenditure to deficit countries. Financial losses in the deficit countries or the inability to repay borrowed funds then directly feed back to the surplus countries and imperil their financial system.”
Though imbalances diminished in the wake of the crisis (see graph below ), this was due to the overall fall off in production, trade and investment, not policy action, of which there has been very little. Professor Barry Eichengreen, one of the leading academics working on this issue, notes that “The International Monetary Fund’s forecasts anticipate essentially no reduction in existing imbalances in the next five years, assuming the continuance of current policies. And independent observers have suggested that, if anything, the IMF may be overly optimistic about the prospects.”
The G20 has tried to make imbalances a focus of its work, but beyond agreeing some basic measurement criteria, has taken few concrete actions that will help resolve the issue. While the IMF is now participating in the multilateral assessment process (MAP) under the G20, this has not yielded any concrete action plans that are eliminating global imbalances.
Development may require imbalances or compensation mechanisms
Poor and developing countries are playing catch up to rich industrialised countries. Economic development and industrialisation processes, because of the size of developing country markets, often rely on exports. This is the same strategy used by rich countries when they were developing. The process of industrialisation and growth means we should expect some period of imbalance on the current account for export-oriented growth strategies. In addition, different countries have different circumstances. These can include capital scarcity, smaller markets, or natural resource endowments. These will all affect the balance of payments of a country.
Hence, when recognising the need to significantly reduce global imbalances, it is important to emphasise that the responsibility for doing this, and any associated burdens must not be borne by developing countries, who need to focus on investing in infrastructure and public services to drive sustainable development.
As professor Jan Kregel of the Levy Economics Institute has pointed out in a recent paper, if developing countries, such as China, are to be persuaded to change domestic policies that contribute to imbalances, such as exchange rate management policies, then they will need to be compensated for the reduction in growth that may result. This is why an important part of addressing the problem will be ensuring the sustained real transfer of resources over time into developing countries, as they boost investment in infrastructure, housing, social services like health and education, and other spending. These transfers can take the form of aid, but also foreign investment. These may show up as imbalances on the capital account.
2. Main causes of global imbalances
Lack of exchange rate coordination mechanisms
The fundamental cause of global imbalances has been the failure of international institutions and negotiations to ensure an efficient management of the international monetary system. Until the early 1970s, under the Bretton Woods system, the IMF oversaw global exchange rate management arrangements. Since then, a variety of exchange rate regimes have been adopted across the world, but collective capacity and will to manage exchange rates in a way that can prevent the build up of global imbalances has only sporadically been present, and collapsed completely in recent decades.
Dollar as reserve currency
The US has been the principle current account deficit country. It was able to finance this deficit, and its fiscal deficit, cheaply thanks to the status of the dollar as the world’s reserve currency, which ensured a high and increasing demand for dollars.
IMF failures and self-insurance
Given the current international financial architecture, many countries have sought to maintain high levels of international reserves to ‘self-insure’ themselves. The insurance has two objectives: (1) to prevent self-fulfilling financial crises; and (2) to prevent the loss of sovereignty and negative impacts developing countries associate with turning to the IMF for a loan.
Preventing financial crises. Financial crises can arise even though a country may have a stable macroeconomic environment characterised by moderate inflation, healthy growth, and sustainable fiscal balances. These crises are usually associated with sudden movements in capital flows – both inward and outward – which can create instabilities. Particularly vulnerable are financial sectors which may, in aggregate, expose the country to excessive foreign exchange risk. The flows of “hot money” into and out of countries increase the risk of financial and economic crisis. Crises of these sorts have devastating social impacts, increasing poverty, worsening human development, and reversing the gains of economic development.
Countries will thus seek to run persistent surpluses and accumulate reserves. A sizeable war-chest of reserves deters currency speculators and provides the ammunition for a government or central bank to try to combat excessive volatility in capital markets.
This problem is partly due to the pressure for fully liberalised capital markets that has prevailed for the last 30 years, subjecting developing countries to higher risks. This trend has been driven by World Bank and IMF advice as well as by bilateral investment treaties, free trade agreements, and economic partnership agreements. Economists have called for these to be rolled back to enable countries to pursue pragmatic policies to mitigate risk, so that they feel the need to have less self-insurance.
Wariness of the IMF. During the Asian financial crisis from 1997-8, the IMF was perceived to have required policy changes that were detrimental to Asian countries, forcing devaluations, causing massive unemployment, corporate bankruptcy, and poverty. This has pushed countries, particularly in Asia, to opt for self-insurance in the form of foreign reserves rather than relying on the IMF as a crisis resolution mechanism. This is compounded by the perceived lack of legitimacy of the IMF’s governing structure.
While the IMF has reformed some of the conditionality attached to its lending, and no longer ties loan disbursements to meeting each provision of a wholesale economic restructuring programme, there are still concerns about its conditionality. Some of it is perception, but some of it is real. A particular problem is pro-cyclical conditions during downturns. A recent Jubilee USA report documents how damaging some of these conditions have been in low-income countries.
3. Proposals for reform
In our written evidence to the committee in 2009, we included a substantial section on the needed reforms to the international monetary system. We also gave oral evidence to the committee, which provides further elaboration of our concerns and recommendations.
Need for concerted international action
As the economic hegemony of the US wanes, there is a practical limit to how long the anachronistic system of a single country’s currency serving as the vehicle for all global reserve holdings can be maintained. Managing this transition to a credible, long-term alternative is perhaps the key economic challenge for policy makers in the medium term.
There is also a clear need for any reforms to the international monetary system to take into account the varying needs of countries. At different stages of economic development, there are differing concerns, including the balance between inflation, investment and employment creation. The size of economies also matters, with some more at risk from currency speculation or hot money flows, while others have more scope to manage such concerns. The system needs to be rules-based, but will need to have flexibility for countries in different circumstances.
With political leadership, times of crisis can present opportunities to undertake real reform. The current system – with international financial institutions, particularly the IMF, suffering from legitimacy deficits, a poor track record, and insufficient sway in major economies – needs serious overhaul. The informal G20 arrangement will not provide a sufficient framework, and is likely to continue to implement minor reforms at best.
Instead, we should continue to build the case for more far-reaching change, based on international agreement. Agreement on ambitious reforms such as these will take considerable negotiation. If the run up to the Bretton Woods conference in 1944 is any guide, it will take four years of work. A fair, transparent process will be needed to undertake these negotiations: ideally one that involves all countries of the world, and is open to civil society and parliaments, under the auspices of the United Nations.
Moving to a multi-currency reserve system is not the answer
Reforms to the international monetary system have been discussed at the IMF and G20 since 2009, but they have not focussed on an overhaul of the system. Instead they have taken the path of least resistance, which is to move towards a multi- currency reserve system, where there are 2, 3 or more international reserve currencies simultaneously. We do not believe this is a sensible or sustainable approach for the following reasons:
International spillovers: The policies of major economies, as the issuers of reserve currencies, have international spillovers, which those countries are not forced to think about when they decide their policies.The IMF now issues a Consolidated spillovers report, which recognises the problem, and notes the particular issues caused by spillovers from global financial centres, particularly the United States, but this has not yet affected policy.
Limits of IMF influence: Since the end of the Bretton Woods exchange rate system in the early 1970s, the IMF has not had the ability to concretely influence the policies of reserve issuing countries. Even in the current crisis in Europe, the IMF has been a bystander as Germany and France set policies for the zone. There is no mechanism except persuasive power to influence rich country policies. In the context of global imbalances, despite repeated exhortations to reserve issuing countries to rein in current account deficits, they have not taken action.
Risks to non-reserve issuing countries: Non-reserve issuing countries will remain vulnerable to swings in their exchange rates, which are a particular problem for developing countries and small economies. This will not change with a multi-currency system. In fact the entire system may become even more unstable as the major reserve currencies (potentially the dollar, euro and Chinese yuan) fluctuate against each other.
Direct costs. Aside from the costs of volatility in exchange rates, a multi-currency system will not obviate the need for non-reserve issuing countries to hold substantial reserves. Assets held in reserves are by definition those not used to finance productive activity, including investment in infrastructure, education, health or other activities which have long-run benefits in terms of growth, productivity, and employment. Additionally the need to ‘sterilise’ the accumulation of reserves to prevent inflation has a direct cost to the country concerned, as generally the interest a government must pay on the domestic debt that is issued in the sterilisation operation is higher than the interest received from the holding of foreign currency-denominated assets. In a multi-currency system these costs would increase as developing countries were forced to begin managing reserves in multiple currencies.
Ending dollar dominance – Move to global reserves system
As the 2009 international committee of experts, chaired by Nobel Laureate Joseph Stiglitz argued, a move to a new global reserve system is the only way the fundamental problems highlighted above can be resolved.
This would be best managed by the creation of a new international reserve currency. The IMF-managed Special Drawing Right (SDR) could form the basis of this. A greater role for the SDR would include: larger and more regular allocations, focussing on those countries most in need, a settlements system, the use of SDRs in trade and commodity pricing, and financial assets denominated in SDRs. Recent IMF research has concluded that in most likely scenarios, regular SDR issuance would not be inflationary.
In the interim period, regional currency arrangements can help moderate risk and improve the ability of countries to manage volatility. However, lessons will need to be learned from the current Euro crisis, which points to a greater role for regional reserves and exchange rate management rather than the creation of regional currencies.
Reform of international financial institutions
The IMF is the institution that was created to manage the international monetary system. However, its governance has not kept pace with changes in the world economy. Even after reforms in 2006 and 2009 its voting rights are dominated by rich countries, and its board dominated by Europeans. The IMF’s democratic deficit, combined with the perception that its prescriptions in the Asian financial crisis were influenced to the benefit of rich countries, has reduced the IMF’s legitimacy. With a lack of legitimacy, it will be difficult to give the IMF greater control or power in international monetary arrangements.
Adequate governance reforms must be in place before the IMF can resume a leading role in managing any international monetary system, including one with a supra-national international reserve asset. We have set out a comprehensive programme for IMF reform, based on the introduction of double majority voting – the introduction of a one country one vote system alongside the current share-based voting system.
In addition, the IMF has shown failings in its approach in the run up to the crisis. The IMF Independent Evaluation Office’s report on the crisis severely criticised the Fund, saying “the IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches.” The IMF needs policy change in a number of areas to both regain trust and play a better role in preventing crises
Two key areas we have highlighted for policy reform are conditionality and crisis prevention. Eliminating IMF economic policy conditionality, to reduce the stigma attached to using IMF credit facilities and the negative economic impacts of IMF demands, would help reduce the desire of countries to self-insure. Secondly, the IMF must do more to help developing countries use pragmatic capital account regulations to reduce the risks of financial crises, again reducing the incentives for countries to stockpile reserves.
4. Actions the UK Government can take:
- Support a rapid but fundamental overhaul of IMF governance, beginning with the introduction of double majority voting.
- With governance reforms in place, work with major emerging market partners to push for reform of all IMF lending facilities to reduce the stigma attached and the pro-cyclicality of the loans. This
- Work with the G20 and the IMF to promote and enforce more pragmatic crisis prevention policies, reducing the risks posed by hot money flows or currency speculation, by appropriately regulating financial markets and financial flows.
- Propose global discussion of how to gradually move to a global reserve currency system with more stable exchange rate arrangements.