Financial architecture still unable to withstand financial earthquakes (May 2014)

Rethinking Bretton Woods | Fri, May 23, 2014

By Aldo Caliari

This article reports on a panel discussion that shed light on the connection between the status of reforms in the international monetary system and the negative consequences the US Fed's policy of "tapering" is having on developing countries.  


Last December the US Federal Reserve began reducing the monthly asset purchases it had introduced as part of monetary easing policies designed to stimulate the economy after the 2008-09 global economic crisis. These gradual reductions in asset purchases have come to be generally known as “tapering.” Developing countries saw renewed pressure on their currencies, stocks and risk profiles, accompanied by capital outflows and worsening of their balance of payments situation. Although “tapering” only began in December, these effects were in evidence at the early moment that the measure was announced as likely last May --announcement that was lately withdrawn.


At a panel discussion on the theme “Financial tremors in developing countries: another earthquake on the way?” , participants focused on the impacts of “tapering” on developing countries. The event, held in the occasion of the World Bank and IMF Spring meetings (at the World Bank Headquarters in Washington DC) was sponsored by the Bretton Woods Project, the Center of Concern and Third World Network to reflect on the impacts that “tapering” is having on developing countries as a symptom of the unsatisfactory status quo of post-crisis reforms of the international financial architecture. Speakers’ presentations revealed that global finance reforms implemented after the recent global recession have been of limited effect in reducing asymmetries and shortcomings of the financial and monetary system. In particular, that they have been unable to protect developing country economies from being hostage to the vagaries of changes in Fed policy.


In his presentation Center of Concern’s Mr. Aldo Caliari recapped that the monetary easing by the United States had initially led to capital inflows into developing countries leading to appreciation of their currencies and negative impacts on their competitiveness. Now the flow was in the opposite direction. In both cases a policy by the Fed was driven by domestic concerns but had quite important impacts abroad.


“This is what happens when you have the domestic currency of one country serving as the main reserve and trading currency for the world. If there is a conflict between managing the currency in the domestic interest and managing it in the interest of the international community, the former will prevail,” he said. He added that the solution is a transition path towards a supranational currency that can be divorced from the specific dynamics of anyone economy, and managed in a fairer way, in the multilateral interest. But for this transition to be smooth international cooperation is needed.  Unfortunately, the momentum around reform of the international monetary system that was apparent in 2011 had been lost, and with it an opportunity to address the problem at the heart of the current woes of developing countries.


Mr. Amar Bhattacharya, Director of the G24 Secretariat, a representative grouping that coordinates the positions of finance ministers and central bank governors of developing countries, stated that a massive rebalancing had happened after the crisis, and mostly due to action by key developing countries to increase domestic demand.


"Some people blame the capital outflows on the fundamentals of countries experiencing them," he said, "without realizing that the fundamentals when the capital flows exited were much the same as what they were when those countries were experiencing large capital inflows." He was referring to the claims that the "fragile five," an expression the mainstream press has coined for Brazil, India, Indonesia, Turkey and South Africa, should have "put their house in order" during good times, instead of blaming the end of quantitative easing for their woes.


Mr. Bhattacharya explained that under the current system, private investors are able to always win. When monetary policy is eased in developed countries, they can borrow cheap and make a double profit by investing in developing countries and reaping the benefits of both currency appreciation and higher interest rates on lending. When monetary policy reverses and currencies in emerging markets come under pressure investors can gain by shorting their currencies. He added that "the reason why developing countries are hit and developed ones are not, is that the latter have deep and virtually unlimited safety nets, whereas emerging markets have only recourse to the IMF with more limited and more conditional resources."


In her remarks, Ms. Bhumika Muchhala from Third World Network stressed the need to focus on the North-South dynamics in political economy, which include the manner in which the tapering of the US Federal Reserve’s quantitative easing is taking place without effective coordination or communication with emerging market economies. The result has been a shift of the costs of macroeconomic adjustment from the advanced economies to emerging market economies. 


"According to the IMF's Global Financial Stability Report released last week (April 2014), international portfolio flows are responding to global financial conditions, not to the strength or weakness of developing country economies," she said. "This is why the ‘Fragile Five’ developing country economies, that of Brazil, India, Indonesia, South Africa and Turkey, are experiencing turbulence despite having pursued sound macroeconomic policies after learning costly lessons from past financial crises.”


“Another key concern is that IMF advice to developing countries is not consistent with the views of its own Global Financial Stability Report, nor its numerous Working Papers.  The Fund continues to recommend monetary policy tightening, contractionary fiscal policies, capital account liberalization, and so on.”


Ms. Muchhala said this was another example of an over-arching pattern whereby IMF research products tend to get things right, but Fund directives in surveillance and loan programmes often take a diametrically opposite turn.  This is due in large part to the political dynamics of the IMF’s Executive Board, whose asymmetric representation of developed countries remains to this day a fundamental flaw in global economic and financial governance, she said.


Speakers were generally of the view that developing countries needed full flexibility to implement capital controls. “Fortunately, the IMF Articles of Agreement still guarantee the right of countries to set capital controls,” said Caliari. “But the problem is, countries that implement them risk stigmatization. Creditors and investors look at the IMF’s opinion, not at the legal right countries have. This opinion remains, recent embellishments notwithstanding, that capital controls are a measure of last resort.”


Mr. Peter Chowla, of the Bretton Woods Project, and the moderator of the event, advanced the notion that the IMF should be more aggressive in its support of capital controls, and instead of its current timid expression of acceptance for limited situations, encourage countries to use them.