The Case for a Global Policy UpgradeBy Christine Lagarde, Managing Director, International Monetary Fund
Farewell Symposium for Christian Noyer, Banque de France, Paris, January 12, 2016
As prepared for delivery
Ladies and gentlemen, distinguished guests, Christian, mon cher ami!
I am honored to pay tribute to someone who is greatly admired in all the different roles played in a very public life. As head of the Paris Club, Directeur du Trésor, Vice President of the ECB, Governor of the Banque de France, and Chairman of the BIS. All demanding roles, with different stakeholders, which you have fulfilled with diligence, distinction and courage.
At the helm of the Banque de France, you reigned with a steady hand. You came to be known as the “banquier anti-stress.”
Yet there is another quality that distinguishes you as a central banker—the ability to see all sides of an issue; to recognize that changes in the global economy necessitate a change in mindset and policies.
You recently said: “As the geography of the world economy changes, so will the shape of the international monetary system.”1
Dear Christian, with major shifts unfolding on the global landscape, the world today is more than ever in need of people that can see it from all sides. And this will be the theme of my remarks today!
In fact, I would like to talk about a subject that has been close to your heart since your days at the Paris Club—about the prospects of emerging and developing countries, and how monetary policies in advanced economies are impacting them. I will also discuss why a stronger international monetary system is essential—a topic which you have considered quite deeply.
1. The Role of Emerging and Developing Countries in the Global Economy
So why focus on emerging and developing economies? It is worth remembering that these countries are home to 85 percent of the world’s population. And it is not surprising that—slowly but steadily—these 85 percent have become a major engine of global activity!
Today, emerging and developing economies account for almost 60 percent of global GDP, up from just under half only a decade ago.2 They propped up the global economy as advanced countries grappled with the after effects of the financial crisis. Together they contributed more than 80 percent of global growth since the crisis.
Clearly, the 85 percent matter for the global economy!
China, of course, has emerged as an economic superpower. It has also recently become a member of the SDR currency basket—a decision based on a technical assessment that was wholeheartedly endorsed by our Executive Board.
After years of success, however, emerging and developing countries are now confronted with a new reality. Growth rates are down, and cyclical and structural forces have undermined the traditional growth paradigm.
On current forecasts, the emerging world will converge to advanced economy income levels at less than two-thirds the pace we had predicted just a decade ago. This is cause for concern.
China itself has embarked on an ambitious multi-year rebalancing of its economy, toward slower and more sustainable growth. This is a positive endeavor that, in the long run, will benefit everybody. In the short run, however, this transformation generates spillover effects – through trade and lower demand for commodities, and through financial channels as well.3
Not only have oil and metals prices fallen by around two-thirds from their most recent peak, but supply and demand side factors suggest that they are likely to stay low for a sustained period.
Many commodity exporting emerging and developing economies are under severe stress, and some currencies have already experienced very large depreciations. We have all seen it in Latin America, and I have seen it first-hand last week in Nigeria and Cameroon – two countries that are hit hard by lower oil prices and domestic fragilities.
So where does this leave economic policy? And what can the other 15 percent of the global population do for global growth, and to help emerging and developing countries adjust to the new global environment?
Certainly any solution must involve individual countries – both advanced and emerging –tackling their own vulnerabilities and policy constraints.
More generally, in advanced economies, monetary policy can no longer be the only game in town. It needs the support of fiscal policy and structural reforms to support aggregate demand and raise growth potential. And emerging economies need to redirect their economies toward new sources of growth.
2. Monetary Policy in Motion
We at the IMF have made these points repeatedly, and you know them well. Allow me therefore to focus only on monetary policy, which has arrived at a critical juncture. After all, we are here at the Banque de France and honoring a central banker par excellence!
In the Euro Area and Japan, weak growth and low inflation call for continued monetary accommodation. In the United States, firming activity laid the ground for monetary normalization by the Federal Reserve. Lift-off has gone smoothly. It was clearly communicated and priced in by financial markets.
The key issue going forward is the pace of normalization. I agree that it should be gradual, as the Fed has stressed, and based on clear evidence of firmer wage or price pressures.
But let us consider what this implies for emerging and developing countries – for the other 85 percent. This is an important issue, and I know that our IMFC Chairman Agustin Carstens will also say a few words on this later.
Clearly, emerging market are benefiting from the fact that many central banks in many advanced economies still have a very easy policy stance. And yet, if financial tightening by the U.S. were to coincide with further easing in the euro area and Japan, there could be further dollar appreciation vis-à-vis the euro and the yen.
For emerging economies, this could raise vulnerabilities in sectors with dollar exposures, especially corporates. Foreign exchange exposures by corporates have grown sharply over the last five years, in part because of the search for yield in a low interest rate environment, as Jean Tirole reminded us.4
Beyond dollar appreciation, there is also the potential for increased exchange rate volatility. This volatility could be induced not only by the divergence in monetary policies in major advanced economies, but also by uncertainty about their overall prospects and policy action.
Putting it all together, the key issue for emerging economies is that heightened volatility is manifesting at a time when many of them are already under stress. Another bout of global risk aversion could lead to further commodity price declines, widening spreads, and depreciating exchange rates.
Of course, this matters a lot for advanced economies too. It matters because of the current environment of elevated uncertainty and financial market volatility.
In such an environment, events and policy decisions that in “normal” times may have limited cross-border effects can now trigger much larger financial reactions. Just think of the market spike in response to China’s announcement of a new exchange rate arrangement last August. Or the financial rout last week triggered by the stock market plunge in Shanghai!
An equally compelling reason why advanced economies should heed what is happening in the emerging world is the impact on growth. Our own estimates show that a slowdown of one percent in the emerging world would lower growth in advanced countries by at least about 0.2 percentage points. 5 This is substantial given anemic growth rates, lack of employment, and increasing social tension in large parts of the advanced world.
Ladies and gentlemen, the 85 percent matter. The economic health of the emerging world is of first-order importance for the advanced economies.
3. A Stronger International Monetary System—The Case for a Global Policy Upgrade
With this, I would like to encourage you to think beyond the narrow policy debate we have been having so far.
I have many times called for economic policy upgrades in our member countries. But beyond putting individual countries’ houses in order, there is more that needs to be done. We need a policy upgrade at the global level.
We need an international monetary system that helps emerging and developing economies preserve stability, achieve stronger, more sustainable growth, and embark on a path of convergence with advanced economies. A system that reduces spillovers that hurt everybody.
What do I mean by that? I mean a stronger global financial safety net, and a framework for safer capital flows. Let me take each in turn.
A stronger global financial safety net
There have been important strides in improving the global financial safety net since the onset of the crisis. For example, the IMF’s lending framework was expanded to include insurance and liquidity instruments such as the Flexible Credit Line (FCL) and the Precautionary and Liquidity Line (PLL).
Beyond the Fund, the safety net has also expanded in size and coverage. But it has also become more fragmented and asymmetric. And it has not been fully tested.
Consider for a moment the problem of asymmetry created by the existing system of swap lines between central banks of major advanced economies. Many emerging and developing economies do not have access to these swap lines. This makes the global safety net stronger for advanced countries than it is for emerging economies. Yet emerging economies critically depend on advanced-country currencies in their trade and finance.6
To date, little has been done to adapt the safety net to the new global realities. The insurance aspect must be strengthened. Rather than relying on a fragmented and incomplete system of regional and bilateral arrangements, we need a functioning international network of precautionary instruments that works for everyone.
The size of the safety net also needs to be reconsidered. The good news here is that the recent approval of the 2010 Quota and Governance Reforms will strengthen the role of the IMF in this safety net.
It will place the institution on a more sustainable footing financially, and enhance the representation of dynamic emerging and developing economies in our governance. This is crucially important.
Even so, emerging and developing economies are now receiving up to $1.5 trillion of capital inflows per year. And it has become more difficult to prevent liquidity shocks from doing serious harm to an economy.
Unless countries be tempted to accumulate even more reserves for self-insurance, we need to find ways to increase the resources that can be brought to bear in times of need.
At the IMF, we are looking into these issues from various angles. These include the speed and duration of our instruments, associated cost and stigma, and of course, the related aspects of moral hazard. These issues will be part of a broader agenda on the global safety net that we will be examining in the coming few months.
A framework for safer capital flows
In addition to an adequate safety net, a stronger international monetary system should include a framework for safer capital flows.
There is a growing recognition that the short-term nature and inherent volatility of global capital flows are part of the problem affecting emerging economies today. There is also an inherent debt bias embedded in the global tax system. More generally, the international monetary system would benefit from a higher share of equity compared with debt flows.
This can this be achieved by examining instruments that alter the composition and nature of international flows—away from short-term debt and toward longer-term equity flows.
In source countries, the supervisory framework may need to be adjusted to ensure that prudent levels of capital are held behind short-term debt creating flows.
Recipient countries may consider policies to enhance the resilience of their financial systems to capital flows. Both prudential and tax policies can play a useful role here. For example, the tax system could be structured to provide incentives to rely less on debt and more on direct investment and equity financing.
Overall, a global shift toward more long-term, equity based capital flows would alleviate concerns about reversals, and lessen the need for insurance. It would also reduce the size of financial buffers that emerging and developing countries need to maintain.
Let me conclude. According to some estimates, a successful convergence process in the emerging world could triple the size of the global economy in the next 25 or 30 years.7 The global community cannot afford the costs of stalled convergence. The 85 percent matter!
I would like to leave you with this thought from Milton Friedman:
“Only a crisis - actual or perceived - produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes the politically inevitable.”8
I have pointed to some “alternatives to existing policies” that can help restore momentum and convergence in emerging and developing countries. And I hope I have impressed on you the urgency of considering these alternatives.
Dear Christian, I hope that we continue this work in the spirit that has guided you during your time at the Banque de France. I am sure you agree with me, in a nutshell, that a global policy upgrade is not only desirable, it is essential!
1 Christian Noyer, “Spheres of Influence in the International Monetary System” 21st Conference of Montreal, Montreal, 8 June 2015.
2 GDP measured at purchasing power parity.
3 The forthcoming April 2016 Global Financial Stability Report will examine the growing importance of financial spillovers from major emerging economies, including China.
4 Foreign exchange corporate debt of non-financial firms – including U.S. dollar but also euro- and yen-denominated debt – across major emerging economies is estimated at close to US$3 trillion in 2014, up from about US$1.8 trillion in 2010. Total corporate debt is much higher, estimated at over US$18 trillion in 2014 compared to just US$4 trillion in 2004. See Chapter 3 of the October 2015 Global Financial Stability Report.
6 Maurice Obstfeld, 2013. “The International Monetary System: Living With Asymmetry” in Robert C. Feenstra and Alan M. Taylor, eds. Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century, National Bureau of Economic Research.
8 Milton Friedman, 1962. Capitalism and Freedom. University of Chicago Press.