REFORMING THE WORLD’S FINANCIAL

ARCHITECTURE

Kimberly E. Smith

TIME FOR A CHANGE?

-Economic difficulties lead to a greater want for change

-For example: The Asian economic crisis of 1997

-International monetary system (mainly on the part of developing countries) needs an overhaul.

ASIAN ECONOMIC CRISIS• Economic growth of these countries was due to large capital investment, but lacked an increase in total factor productivity

• By the mid 1990’s Thailand, Indonesia and South Korea all had large private current account deficits.

• The US came out of recession (dollar was now more attractive) and Asian countries export growth had diminished (leaving little inflows)

• Exchange market became flooded with Asian currencies resulting in Asian countries pushing up their interest rates to attempt to limit capital flight. This lead to them floating their currencies.

• Floating lead to great depreciation of Asian currencies, foreign currency-denominated liabilities in turn grew in domestic terms, Thus

pushing Asian countries into a deepening crisis

What can be done to prevent this type of crisis from happening? Reforming the international capital market?

RETHINKING INTERNATIONAL CAPITAL MARKETS

• Market changes in one country have a strong ripple effect into other countries

• Similar to how economic interdependence formulated the Bretton Woods agreements, policy makers are putting international reforms into new plans

• Asian crisis put a reality on the difficulties of managing international macroeconomics.

POLICY TRILEMMA: THREE SHARED GOALS• Independence in monetary policy

• Stability in the exchange rate

-most important to developing countries because they have less influence on their terms of trade

-important for keeping low inflation and avoiding financial stress in developing countries.

• Free movement of capital • It is impossible to achieve all three goals at one time

-examples: currency crisis in Mexico and Asia

EXCHANGE RATE

STABILITY

FREEDOM OF CAPITAL

MOVEMENT

MONETARY POLICY AUTONOMY

CURRENCY BOARD

CAP

ITAL

CO

NTR

OLS

FLOATING EXCHANGE RATE

ADJUSTABLE PEG SYSTEM

• Until late 1970’s most developing countries maintained restrictions such as exchange rate controls and limited private capital movement

• Controls slowed movement of capital resulting in countries pegging exchange rates for periods, which in turn, produced exchange rate stability yet devaluing currencies occasionally making considerable monetary autonomy.

• PROBLEM: Imposed restrictions on international transactions reduce efficiency and contribute to corruption

20th Century Developing Countries

• Controls being lifted combined with improved technological communication lead to more mobility of capital

• Pegging system fell vulnerable to speculation

-capital would flee a currency if there was expected devaluation

• Developing countries are driven towards either a floating exchange rate or a currency board

-hard to sustain for developing countries because of exchange rate volatility

• Countries that “float” their currencies often have a “fear of floating” attitude

-limiting currency fluctuations over time

• Currency boards can deprive a countries central bank to help in financial crisis as the lender of last resort

20th Century Developing Countries

• Economists such as Columbia's Jagdish Bhagwati and Joseph Stiglitz along with Harvard's Dani Rodrik say that developing countries should control capital mobility

• Countries such as China and India keep plans on hold to liberalize capital accounts due to the Asian crisis

• Countries that did liberalize capital movements are contemplating putting restrictions back in place

HOWEVER….

• policy makers in both developed and developing countries believe capital controls are too difficult or impossible to enforce

• Hence, new plans for financial architecture is focused on ways of making remaining choices less painful

“PROPHYLATIC” MEASURES

Since risk of finacial crisis is the main focus of what exhange rate regimes should be implemented (and thus a lot of debate), new proposals attempt to reduce that risk

PROPOSALS INCLUDE:

1) More transparency

2) Stronger banking systems

3) Enhanced credit lines

4) Increase equity capital inflows relative to debt inflows

1: MORE TRANSPARANCY

• Better provision of financial information (similar to U.S. credit reports)

• Reduce the large inflow of money into a country when the economy is doing well

• Reduce the large outflows of money from the same country when economic conditions turn out to be less favorable then expected.

2: STRONGER BANKING SYSTEMS

• In the face of financial crisis, currency crisis interact with bank runs

• Closer regulation of risks banks take on and increasing capital requirements

• Stronger banks can ensure safety for ones money

3: ENHANCED CREDIT LINES

• They are credit lines that a nation can use upon a currency crisis.

• Adds effectively to a nations foreign exchange reserves.

• The existence of these lines would actually make them unnecessary.

-Speculators would not fear that their actions would spark a sudden devaluation because they would know that countries had enough credit to meet large outflows of funds.

4: INCREASED EQUITY CAPITAL INFLOWS RELATIVE TO DEBT

INFLOWS

• Financing large portions of private foreign capital inflows through equity portfolios and direct investment rather then debt insurance.

-lower the probability of debts

• Payments to foreigners would be linked closer to economic fortunes which would fall automatically during hard economic periods.

COPING WITH CRISIS

• Divided opinions in the role of IMF

Critical View: Abolish IMF

-IMF existence allows for irresponsible lending because lenders believe that they will always be saved (moral hazard).

Critical View: IMF is necessary

-Role of IMF needs to be reevaluated

-For example: IMF should restrict its use to narrow financial issues opposed to insisting on financial reform.

It should know its place.

Critical View: IMF is underfunded for its task

-It needs to be able to provide large loans quicker then it can now.

COPING WITH CRISIS

• Debts and international contracts

-contracts should be put in place to reduce costs of renegotiation between debtors and creditors

• Critics say that this will encourage countries to over borrow knowing they can easily renegotiate debts (moral hazard).

THE FUTURE??• Developed countries are comfortable with floating exchange rates and international capital mobility

• Developing countries do not have safe satisfactory alternatives

• Over the next few years we will see experimentation with different plans for reform

• Countries are already beginning to change

-For example:

-floating exchange rates-Mexico and Brazil

-capital controls-China and Malaysia

-currency board-Hong Kong

• A feasible approach would be adoption of dollar or euro domestic transactions—meaning the abolition of national currencies

Will the financial architecture be more stable and coherent in the future? We don’t know.