Economist's View: Global Imbalances and the International Financial Architecture

リンク: Economist's View: Global Imbalances and the International Financial Architecture.

September 13, 2006

Global Imbalances and the International Financial Architecture

Martin Wolf looks at why developing countries choose to accumulate foreign currency reserves and generate global imbalances, and how that affects the IMF. At the end, he says "change is surely needed" so I've included remarks from Brad Setser summarizing one direction I believe is worth pursuing, the suggestion by Larry Summers to create a new financial institution that would reduce the investment risk faced by developing countries and encourage them to pursue assets other than U.S. Treasury bills:

Bad news for the IMF is good for its clients, by Martin Wolf, Commentary, Financial Times: The International Monetary Fund is in financial crisis. ...[T]he reason the IMF is facing financial disaster is that its clients are not. ... Fund credit outstanding has fallen to its lowest level in 25 years. The Fund’s income ... is expected to fall ..., expenses are expected to rise...

Financial markets herald the reduction in the perceived riskiness of emerging market finance. Spreads have ... collapsed... Investors are ... pouring money in... “We do not need this money, thank you,” said the recipients. “After all, we are running an aggregate current account surplus of $232bn, which we are determined to keep.” So, they pushed the money right back out again, predominantly into the liabilities of an insufficiently grateful US Treasury. ....

[A] paper ... presented at the Jackson Hole conference ... suggests they may have been right to do so: “Developing countries that have relied more on foreign finance have not grown faster in the long run, and have typically grown more slowly. By contrast, ... industrial countries ... that rely more on foreign finance do appear to grow faster.”

Emerging economies with current account surpluses grow faster. Consequently, “the current anomaly of poor countries financing rich countries may not really hurt the former’s growth”, largely because of of their inadequate institutional and financial structures.

Does this mean that foreign finance plays no role in development? Not at all. As Frederic Mishkin ..., a governor of the Federal Reserve, argues ... foreign capital can bring big gains at the microeconomic level... Inflows of foreign direct investment into the financial system itself are particularly valuable to an emerging country.

What this does mean, however, is that there seems to be no benefit to being a net importer of capital. ... Why might that be? ... It may well be because the fastest-growing countries save a great deal already and so do not need the extra capital foreigners wish to provide...

Another explanation seems to be the financial systems ... are incapable of allocating capital inflows successfully. ... Moreover, large net inflows of private capital will lead to an appreciation of the real exchange rates... That will damage industries producing tradeables, particularly manufactures.

Most important of all, I suggest, is the link between large current account deficits and financial crises, particularly when inflows consist largely of foreign currency denominated debt. ... Then, when the exchange rate falls – as will happen once the capital inflow stops – mass bankruptcy is the result.

For many individual emerging market economies, the decision not to be a net importer of capital appears to make sense. But that series of decisions also has global consequences ..., other countries must run deficits. The US does, acting as the world’s largest emerging borrower. ...

Investors consider emerging market economies appealing destinations, but the governments of many of the most courted countries hate the idea of absorbing the capital. So they resist pressure for currency appreciation and recycle the inflow predominantly into US liabilities. The US then complains about the deficits, while enjoying the inflow of resources.

Ironically, therefore, the very changes that have helped make emerging market economies less crisis-prone have led to the “global imbalances” with which the Fund is now grappling. But the Fund has no leverage on the US as a deficit country and has never had leverage on countries in surplus. ...

Between the end of 1999 and May of this year, the world as a whole accumulated $2,780bn in additional foreign currency reserves. .... So much then for the myth that we live in a world of floating exchange rates! It is almost impossible to believe that these have been the highest return investments the world’s governments could make. But it is the one they have decided to make, largely to preserve export competitiveness and the strong current account positions they desire.

The Fund’s economists seem to suggest that it makes sense for a country to allow sizeable net inflows of capital only when it has a first-rate financial system. If that is how long the world has to wait, we cannot hold our breath. But it does not make sense for the people of poor countries to finance consumers in the richest. Change is surely needed. But it is unlikely to come easily or soon.

This post by Brad Setser takes these issues further. Brad follows up with another post discussing something I think is worth pursuing, the creation of financial institutions that will allow developing countries to risk investing in assets with a higher return than they can get pursuing the less risky strategy of accumulating foreign currency reserves:

Summers on reserves, exchange rates, the international financial architecture and other big topics close to my heart, by Brad Setser: Larry Summers has always believed that capital should flow from the already rich and aging societies that constitute the current core of the world economy to the poor and young countries on the periphery. So it is not entirely a surprise that Summers thinks "the most surprising development in the international financial system over the last half a dozen years" is "the large flow of capital from the world's most successful emerging markets to the traditional industrial countries, and the associated build-up of reserves in the developing world." ...

Summers ... doesn't think emerging market central banks investment in the US is all that good an idea, at least financially. ... Summers thinks emerging markets central banks will get a negative real return on their current investments in the US - as low real US rates fail to compensate them for the risk of a real depreciation against the dollar...

The headline from Summers speech was "central banks shouldn't be so keen on holding Treasuries." Perhaps more importantly though, Summers also suggested that the time has come to start to reconceptualize the role of the international financial institutions.

In many ways, both the Fund and the Bank were designed for a world where emerging markets were short on reserves and short on savings, and thus occasionally needed to borrow reserves from the Fund (in principle for short-periods) and savings from the Bank (in principle for long-periods). The profits on this lending, in turn, cross-subsidized the provision of global public goods and grants and concessional lending to the world's poorest countries.

Summers argues that there may be a need for a new international financial institution (or facility inside the existing institutions) to help emerging market central bankers get a slightly higher return on their excess reserves ...  This new institution would charge a fee for its services - and help to finance the provision of global public goods and concessional financing for the world's poorest economies.

There may be something to this idea. It is hard to imagine that financing the US government is the best use of the large sum of Chinese savings represented by China's reserves. Yet it would be hard for say the Chinese government to invest heavily in say GM debt. Or in a range of perhaps more attractive assets that carry with them both the potential for losses and the potential of obtaining control over US firms.

Summers also argues that the IMF needs to take its mandate to do exchange rate surveillance a bit more seriously - and pay as much attention to countries with current account surpluses as to countries with current account deficits. ... I agree. ...

Posted by Mark Thoma on September 13, 2006 at 03:45 AM in Economics, Financial System, International Finance | Permalink


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