Systemic issues of the international monetary and financial system Contribution to the informal review session on Chapter VI of the Monterrey Consensus Mojmir Mrak University of Ljubljana New York 11 March 2008

Objectives of the presentation Objective A: To present new trends in international finance after the Monterrey Consensus with an important influence on international monetary and financial system Objective A: To present new trends in international finance after the Monterrey Consensus with an important influence on international monetary and financial system –Substantially increased role of emerging economies in the global economy –Growing current account imbalances –New generation of financial crises –Continued marginalisation of IFIs, especially of BWI

Objectives of the presentation (II) Objective B: To discuss a selected number of systemic issues (old and new) that are of high importance for the international monetary and financial system Objective B: To discuss a selected number of systemic issues (old and new) that are of high importance for the international monetary and financial system –Instability of exchange rates –Current account imbalances –Reform of IFIs, especially of BWI –Financial crises prevention and management

A/1. Substantially increased role of emerging economies in global economy EE economies are growing in recent years much faster than developed economies; their share in global economy increased to over 50% in PPP terms EE economies are growing in recent years much faster than developed economies; their share in global economy increased to over 50% in PPP terms Source: Economist, 15 November 2007 Source: Economist, 15 November 2007 EE exports equivalent to 45% of the world exports EE exports equivalent to 45% of the world exports EE have strongly influenced global demand for food, energy and raw materials EE have strongly influenced global demand for food, energy and raw materials

A/1. Substantially increased role of EE in global economy (II) Since 2003, EE market index has jumped more than fourfold in $ terms (Americas S&P index has, for example, increased for 70% only) Since 2003, EE market index has jumped more than fourfold in $ terms (Americas S&P index has, for example, increased for 70% only) Certain decoupling of EE from developed ones has been happening (exports to other EE grows much faster than to developed; high increase of domestic consumption and investment) Certain decoupling of EE from developed ones has been happening (exports to other EE grows much faster than to developed; high increase of domestic consumption and investment) EE as group run a BOP surplus; however, there are large differences between two groups EE as group run a BOP surplus; however, there are large differences between two groups –EE with large BOP surpluses (they are strong net capital exporters and have large foreign exchange reserves; this group is rather resistant to shocks –EE with BOP deficits (more dependent on foreign capital); this group is more vulnerable to potential shocks

A/2. Growing current account imbalances In recent years, CA imbalances have increased substantially in nominal terms and as % of GDP In recent years, CA imbalances have increased substantially in nominal terms and as % of GDP Source: Raghuram Rajan. Current account imbalances, hard landing or soft landing, 2005 Source: Raghuram Rajan. Current account imbalances, hard landing or soft landing, 2005 Very large CA deficit of the US (over 6 % of GDP); large CA surplus of emerging Asia, Japan and oil exporting countries; Euro zone CA roughly in balance with large deficits / surpluses in individual countries Very large CA deficit of the US (over 6 % of GDP); large CA surplus of emerging Asia, Japan and oil exporting countries; Euro zone CA roughly in balance with large deficits / surpluses in individual countries

A/2. Growing current account imbalances (II) In the past, CA deficit of the US was mostly associated with surpluses in Europe and Japan; now, EE are important creditors of the US In the past, CA deficit of the US was mostly associated with surpluses in Europe and Japan; now, EE are important creditors of the US CA imbalances are complex subject, but their increase from 2000 onward is a combination of the following savings / investments trends: CA imbalances are complex subject, but their increase from 2000 onward is a combination of the following savings / investments trends: –Growing insufficiency of savings in the US caused mainly by highly increased budget deficits –Persistent surplus of savings over investment in emerging Asia (strong fall of investment after the Asian crises accompanied by stagnated savings); China an exception –Surplus of savings over investment in oil exporting countries caused by an increase of oil prices

A/3. New generation of financial crises While the 1980s and 1990s crises were crises of EE, the current crisis is largely the developed world event; even more, EE are for the first time considered as a kind of a safe havens While the 1980s and 1990s crises were crises of EE, the current crisis is largely the developed world event; even more, EE are for the first time considered as a kind of a safe havens While the 1980s and 1990s crises were geographically concentrated on a country / region, the current crisis is spread across the globe and with a strong spill over into global slow down While the 1980s and 1990s crises were geographically concentrated on a country / region, the current crisis is spread across the globe and with a strong spill over into global slow down While IFIs had rather important role in managing EE crises in the 1980s and 1990s, this is not the case during the current crisis While IFIs had rather important role in managing EE crises in the 1980s and 1990s, this is not the case during the current crisis

A/3. New generation of financial crises (II) While the 1980s and 1990s crises were addressed with practically no involvement of central banks from developed countries, this time they have been key players in managing the crisis While the 1980s and 1990s crises were addressed with practically no involvement of central banks from developed countries, this time they have been key players in managing the crisis Entirely new players, such as sovereign funds, have entered into the crisis resolution process this time while others, such as rating agencies, have performed an increasingly contradictory role Entirely new players, such as sovereign funds, have entered into the crisis resolution process this time while others, such as rating agencies, have performed an increasingly contradictory role While EE were the main victims of 1980s and 1990s crises, in the current crisis this role is being taken over by financial institutions in the developed world (losses of over 400 bn are being mentioned) While EE were the main victims of 1980s and 1990s crises, in the current crisis this role is being taken over by financial institutions in the developed world (losses of over 400 bn are being mentioned)

A/4. Continued marginalisation of IFIs, especially of BWI A growing number of member states has prepaid existing obligations to both BWI in recent years due to their improved economic standing (some of them have substantial BOP surpluses) and/or good access to international capital market A growing number of member states has prepaid existing obligations to both BWI in recent years due to their improved economic standing (some of them have substantial BOP surpluses) and/or good access to international capital market Steep decline of new commitments of BWI in middle- income countries; also some regional banks find it more and more difficult to continue lending to this group of countries (EBRD in Central Europe) Steep decline of new commitments of BWI in middle- income countries; also some regional banks find it more and more difficult to continue lending to this group of countries (EBRD in Central Europe) As a consequence, financial problems have emerged in some of the IFIs, especially in the IMF (deficit of 400 mn $ / year) As a consequence, financial problems have emerged in some of the IFIs, especially in the IMF (deficit of 400 mn $ / year)

B/1. Instability of exchange rates Key facts and problems Key facts and problems –Since the BW systems break up, we live in a world of flexible exchange rates; the rates are to be determined through coordination of foreign exchange policies –Coordination of exchange rate policies has been conceptually accepted, but in practice it has not been working well (a clear confirmation are growing CA disequilibrium) –Being aware of this fact, IMF Board has recently adopted a new decision on exchange rate surveillance which formally opens the way for the Fund to play a more productive role

B/1. Instability of exchange rates (II) What may be done to address this issue What may be done to address this issue –It is of utmost importance that the multilateral exchange rate surveillance procedure of the IMF starts to be implemented in practice –For this, full political commitment and support from the membership at large and in particular from the large members with substantial CA disequilibrium would be needed –It remains to be seen whether such a political commitment is to be achieved; there are some indications that do not confirm this

B/2. Current account imbalances Key facts and problems Key facts and problems –Symmetry in BOP adjustment is a characteristic of a good international monetary / financial system –In contrast to the gold standard system, the current international system does not have a mechanism for automatic BOP adjustment –As a consequence, BOP adjustment process today is strongly asymmetrical There is no real pressure on CA surplus countries to adjust (they simply pile foreign exchange reserves); there is also no pressure on the US as the country with the largest BOP deficit and debt There is no real pressure on CA surplus countries to adjust (they simply pile foreign exchange reserves); there is also no pressure on the US as the country with the largest BOP deficit and debt On the other side, strong pressure on CA deficit countries On the other side, strong pressure on CA deficit countries

B/2. Current account imbalances (II) What may be done to address this issue What may be done to address this issue –Expenditure changing policies through changing the level of macroeconomic aggregates CA deficit countries, especially US, through reduction of consumption and an increase of savings CA deficit countries, especially US, through reduction of consumption and an increase of savings CA surplus countries through an increase of consumption (China) and / or a decline of savings CA surplus countries through an increase of consumption (China) and / or a decline of savings –Expenditure switching policies through the already mentioned multilateral exchange rate surveillance process of the IMF CA deficit countries through exchange rate depreciation CA deficit countries through exchange rate depreciation CA surplus countries through exchange rate appreciation CA surplus countries through exchange rate appreciation

B/3. Reform of IFIs, especially of BWI Key facts and problems Key facts and problems –Mission problem in the changing worlds; The BWI have largely lost their relevance for all but low- income members; EBRD faces challenges upon EU accession of 10 Central European states –Governance problem; Governance structures of BWI continue to be largely unadjusted to structural changes in the global economy (voting rights, executive boards structures) though certain changes should not be neglected –Other problems; They, for example, include funding problems (IMF case), or credibility problems (BWI after the failure of the Washington consensus)

B/3. Reform of IFIs, especially of BWI (II) What may be done to address mission problem issue; Efforts should be intensified to articulate new roles for IFIs in the changed global economy What may be done to address mission problem issue; Efforts should be intensified to articulate new roles for IFIs in the changed global economy –IMF; (i) multilateral foreign exchange surveillance, (ii) funding role of the institution –WB; (i) concentration on low-income countries; (ii) strengthening of its knowledge bank concept, and (iii) policy advise to middle-income countries –EBRD; (i) in should remain an independent IFI for transition economies with strong cooperation with the EIB

B/3. Reform of IFIs, especially of BWI (III) What may be done to address governance problem issue; LDC / EE must get a stronger say in both BWI; this is absolutely necessary for legitimacy reasons What may be done to address governance problem issue; LDC / EE must get a stronger say in both BWI; this is absolutely necessary for legitimacy reasons –Continued adjustment of quotas in favor of LDC / EE in the IMF (to be agreed as soon as possible) –Basic votes in the IBWI should be increased so as to reflect a similar share that these votes had when these institution were created –No veto power for any individual member state –Number of LDC / EE constituencies should increase vis-a-vis the EU member state constituencies

B/4. Financial crises prevention and management Key facts and problems Key facts and problems –Financial flows are increasingly globalised while their control remains largely under national jurisdiction –Role of IFIs in managing crisis situations is today smaller than it was a decade ago –Inadequate risk assessment of complex structured instruments –Weaknesses in supervision of financial transactions –Conflict of interest in activities performed by the rating agencies

B/4. Financial crises prevention and management (II) What may be done to address this issue What may be done to address this issue –Chances for a kind of a global financial reform are now smaller than a decade ago (now, crisis is focused on developed countries; role of IFIs in the management of the current crisis is very limited) –Domestic reforms in developed countries are of crucial importance for crisis prevention and management (similar as were the reform in EE during the crises in 1980s and 1990s) –There is a strong need to improve cooperation of among national regulators and to encourage them to adopt common standards, like the Basel II, in various areas (bank liquidity, valuation of complex debt structures, activity of credit rating agencies)