## Accumulated impulse responses to a one-standard deviation growth shock

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### Key findings on integration, growth, and systemic vulnerabilities
- Growth and integration
  - Over the past 40 years there has been very rapid growth in global per capita GDP growth, trade, and gross capital flows.
  - External assets and liabilities exceed four times the size of global GDP.
  - Average trade flows (exports plus imports) exceed half of GDP for most advanced and large emerging market economies.
  - Output shocks to the largest economies have larger and more lasting repercussions throughout the system than 40 years ago.

- Symptoms of system malfunction
  - Recurring crises throughout the post-Bretton Woods period, with some taking a systemic dimension (predominantly among emerging markets, but including advanced economies during systemic events).
  - Observed symptoms include persistent current account imbalances, exchange rate misalignment subject to abrupt adjustments, volatile capital flows and exchange rates, and very large build-up of international reserves.
  - The aggregate systemic crisis index: a country is under stress if its systemic crisis index is above one standard deviation from its mean.

- Risks
  - Imbalances are unsustainable indefinitely and raise the possibility of episodic destabilizing adjustments.
  - Policy choices that lead to depreciated currencies have generated tension and raise the risk of a protectionist backlash.
  - Lower global growth outcomes are possible if deficit countries adjust (e.g., through deleveraging or macro policies) while surplus countries do not, leading to a decline in global aggregate demand.

### Inadequate global adjustment mechanisms
- Role and ideal properties of adjustment mechanisms
  - Global adjustment mechanisms are needed to allow the global economy to respond to exogenous shocks or internal transformations, and to ensure policies across countries add up to deliver sustainable growth and external deficits.
  - A desirable mechanism: adjustment that occurs smoothly rather than through crises or high inflation, with the smallest impact on growth.

- Current dynamics and limitations
  - Individual country adjustment occurs through changes in domestic savings/investment balances (often via real effective exchange rates) or financing through official or private flows.
  - Because global adjustments must add up, how each country adjusts directly affects others; absent agreement on roles of different adjustment channels, deficits typically bear the brunt of adjustment unless a reserve-currency issuer can defer adjustment.
  - The contemporary IMS gives countries broad discretion over exchange rate and capital account regimes while limiting obligations to aim for domestic stability, increasing risk of inconsistent regime or policy choices across countries.

- Examples of inconsistency externalities
  - If all systemic countries pursue export-led growth by compressing domestic absorption, ex post the only possible outcome is lower global growth.
  - Fixing currencies can create misalignments across other currency pairs, with greater systemic consequences if both players are systemic.
  - A floating exchange rate country with a current account deficit seeking to rebalance without reducing domestic absorption may loosen monetary policy, triggering capital outflows that affect other countries.
  - Large capital outflows relative to recipient economies can adversely affect their financial or macroeconomic stability.
  - Idiosyncratic shocks and differing policy preferences across countries can allow imbalances to build to dangerous levels.

- Implication
  - The current IMS is underdetermined; high national discretion may be globally suboptimal. Reducing discretion through collaboration agreements or rules could increase likelihood of better global outcomes.

### Cross-border capital flows: drivers, impacts, and governance gap
- Impact and benefits
  - Cross-border capital flows enhance access to financing for productive activity, can improve global resource allocation, induce competition, deepen domestic capital markets, and generate efficiency gains.

- Risks and amplification
  - Large flows and complex financial networks can create macroeconomic and financial stability risks, increase vulnerabilities, and transmit shocks across borders.
  - Capital flows have been an important source of exchange rate volatility, beyond helping correct exchange rate misalignments.
  - Monetary policy in advanced countries can significantly influence the size and composition of flows to emerging markets.
  - The burden of adjustment to inflow surges and reversals has usually rested on recipient countries.

- Drivers
  - Expectations of rates of return (interest rate differentials adjusted for credit and currency risk) are the key driver of cross-border capital flows.

- Governance gap
  - There is no universal global framework addressing cross-border capital flows; existing frameworks are mainly regional and bilateral and do not approach capital account issues from the perspective of global stability.
  - The absence of a global framework leads to risk externalities from large cross-border financial institutions, regulatory arbitrage, procyclicality, herd behavior, excessive risk taking, and contagion.

### Systemic liquidity provision and the global safety net
- Collective and national safety nets
  - The size of the collective financial safety net (IMF resources and regional arrangements) has remained broadly constant as a share of global GDP but has declined massively relative to the size of global capital flows.
  - In the absence of adequate collective insurance, markets have incentives to bet against countries at the first sign of liquidity pressure.
  - Most countries have built large buffers of international reserves; these reserves now dwarf the amount of collective insurance available.

- Ad hoc liquidity provision
  - There is no mechanism to ensure availability of substantial resources in a systemic liquidity crisis at the global level.
  - Access to global liquidity has occurred through ad hoc actions of key central banks.
  - The U.S. Federal Reserve alone deployed over $600 billion (more than twice the IMF’s resources at the time).

- Implication
  - Stabilizing market conditions in systemic liquidity crises requires potentially substantial resources and a mechanism for systemic liquidity provision.

### Structural challenges (overview)
- The growing complexity and interconnectedness of trade and financial networks have increased the risk of larger adverse outcomes that could set back globalization.
- Reform motivation: reduce sources of instability and better manage residual volatility without introducing excessive moral hazard.
- While there has been some post-crisis progress, more ambitious reforms are needed to durably strengthen the international monetary system.

### Role of the U.S. dollar
- Dollar’s preeminence and systemic concentration
  - The U.S. dollar is preeminent as a unit of account and medium of exchange for international trade and financial transactions, denomination of international debt securities, commodity pricing, anchor for monetary regimes, and as a store of value.
  - Attractive characteristics identified: liquidity, widespread acceptance, and success as a store of value.
  - Evidence of safe-haven demand: “at the peak of crisis” safe haven demand for U.S. dollars sharply appreciated its exchange rate even though the crisis erupted at the core of the U.S. financial system.
  - Risk from concentration: “concentration of many functions of the IMS in the currency of one nation leaves the IMS exposed to risks stemming from idiosyncratic shocks or policy decisions in that country that may not be appropriate for the rest of the world.”

- Global safe assets and reserve accumulation
  - Core argument (Caballero, 2006): global imbalances driven in large part by a structural gap between the ability of parts of the world to generate highly liquid safe assets (especially fixed income ones concentrated in the U.S., particularly government paper) and a rising demand for such assets.
  - Rising demand source: fast growing high savings emerging market economies with financial sectors lacking depth to provide diversified stores of value.
  - Manifestation: large official reserve accumulation and analogous private savings behavior.

- The changing “core” of the IMS
  - Rapid growth differential: emerging markets now account for half of global output, up from just over a quarter in 1971.
  - G7 share dynamics: fluctuated around 65 percent of global output from 1971 to 2002, then falling to 51 percent by 2010 — described as a historically large and rapid shift.
  - Implications as large emerging markets become central:
    - Large shifts in global savings and investment behavior are likely.
    - Initially global savings rise as share of global income of high-savings countries increases.
    - Over time, adjustments expected from factors including decline in precautionary household savings as social safety nets are extended, rising productivity and infrastructure needs, and increasing financial depth.
    - Aging in advanced economies complements these effects, implying further large shifts in asset allocations—and their relative prices.
  - Historical pattern: when an established core added a new country/group, the emergent country tended to share key characteristics of the core (e.g., exchange rate and capital account regime). Current challenge: integrating highly dissimilar countries into the core.

- Transition to multipolarity and risks
  - View: as global GDP and financial assets diversify, the dollar’s preeminence will over time be eroded, giving room to a more multi-polar system with several currencies playing a key and broadly comparable role globally.
  - Key risk: the speed of transition matters for stability. If perception shifts to need for currency diversification of both flows and stocks of assets, a disorderly adjustment would likely ensue.

- IMS reform: key avenues
  - Reform should proceed along four complementary paths:
    - policy collaboration;
    - monitoring and management of capital flows;
    - global financial safety net;
    - structural strengthening through financial deepening and reserve asset diversification.
  - Objective: prevent crises and contain their costs.

### A. Policy collaboration — progress and options
- Crisis-time collaboration
  - Limited policy coordination prior to 2008; crisis led to coordinated global stimulus under G20 auspices with Fund advice.
  - Importance of preserving crisis-era cooperation emphasized.

- Processes to sustain collaboration
  - Mutual Assessment Process (late 2009, G20) — extensive information sharing on policy plans, Fund analysis of combined global effects, suggestions for global policy mix; assessment guidelines in process of being defined.
  - Experimental “spillover reports” by the Fund on the five most systemic economies (China, Euro Area, Japan, U.K., and the U.S.) to articulate concerns and analyze spillovers.

- Additional ideas for consideration
  - Multilateral commitment: options include recommending members take into account systemic spillovers and giving greater emphasis to domestic policies, or more ambitiously amending Article IV to introduce an obligation to gear domestic policies toward global as well as domestic stability.
  - Strengthened accountability:
    - Policy norms: adoption of objective or widely agreed criteria to judge whether a policy stance is detrimental to domestic and global stability; indicator-based approaches face practical difficulties without broad membership acceptance.
    - Incentives: proposals for “carrots and sticks” (e.g., elevation to ministerial-level examination, publication of critical assessments) to encourage compliance; material sanctions noted as radical given Fund’s cooperative culture and absence of enforcement tradition comparable to WTO.

### B. Monitoring and management of capital flows — progress and guidance
- Executive Board agreed on need to strengthen Fund’s role regarding international capital flows (December 2010).

- Two fronts of Fund work
  - Analysis:
    - Rebound of inflows to emerging markets after crisis prompted reassessment of drivers.
    - Majority of cross-border capital flows occur between advanced economies and can pose greater systemic challenges.
    - Combining understanding of global liquidity with transmission channels aims to improve surveillance and crisis preparedness; work advanced via targeted research agenda and data adequacy evaluation.
  - Guidelines:
    - Fund’s analysis supports development and application of broadly accepted guidelines on policies to deal with capital flows in recipient and source countries.
    - Work cited: Staff Position Note, Capital Inflows: the Role of Controls; Board paper on Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Policy Framework; Staff Discussion Note, Managing Capital Inflows: What Tools to Use.
    - Advisory framework endorsed by a majority of the Board signifies first-round institutional views and could improve consistency and evenhandedness in policy advice; diversity of Director views remains on how to incorporate the framework into Fund surveillance.

- Additional idea
  - Consider incorporating the institutional view into Fund surveillance to provide guidance on the scope of members’ obligations under Article IV once broader work is completed.

- Selected findings from recent IMF work on capital flows (Box 1)
  - Net flows have become slightly more volatile for all economies over time, with volatility in emerging markets (EM) measurably higher than in advanced economies (AE).
  - Across all types of flows, debt-creating net flows are somewhat more volatile and less persistent than equity-creating inflows.
  - Temporary tides in capital flows to EMs are strongly correlated with changes in global financing conditions; net flows to EMs rise and fall sharply around periods with relatively low global interest rates and relatively high tolerance for risk.
  - Tightening of U.S. monetary policy has a negative marginal effect on net flows elsewhere; effect is sharper for EMs more integrated with global financial and foreign exchange markets, but smaller for economies with greater financial depth and relatively strong growth performance.
  - Net flows respond more sharply to a tightening in U.S. monetary policy in economies with nonpegged exchange rate regimes as opposed to those with pegged regimes.
  - Inflow episodes start at different times across countries but often end together; different start times reflect country-specific “pull” factors while similar endpoints suggest reversal of “push” factors (e.g., increase in global risk aversion) dominates in ending inflow episodes.

### Global financial regulation
- Progress noted in strengthening domestic financial regulation, but scope remains to strengthen multilateral collaboration among national regulators, reduce regulatory arbitrage, and tackle sources of excess volatility in an integrated way between source and recipient countries.
- Role for the Fund (in collaboration with institutions like the FSB): take a more active stance in promoting collaboration, identifying systemic risk sources, and suggesting national regulatory steps.
- Ambitious proposals: a World Financial Organization with supranational supervisory powers has been suggested but deemed unlikely in the foreseeable future; harmonization of regulatory regimes and lessons from European Union developments merit examination.

### Amending the Articles — proposals and rationale
- Purpose: Amend the IMF’s Articles of Agreement to better reflect the critical role of capital flows in the functioning of the IMS and give more weight to financial stability.

- Specific amendment options discussed
  - Broaden the definition of systemic stability in Article IV (currently limited to stability of the system of exchange rates) to include financial stability.
  - Establish an obligation to ultimately liberalize the capital account subject to appropriate safeguards and exceptions, similar to the existing current account obligation (proposal referenced as suggested by the Palais Royal Initiative (2011) and previously dismissed by many Executive Directors).
  - Introduce a specific obligation under Article IV, Section 1, related to capital account policies.
  - Replace Article VI, Section 3, with an obligation for members to collaborate with the Fund and other members on capital account policies, analogous to the collaboration obligation in the chapeau of Article IV (option discussed in the Fund’s Role paper and received more favorably).
  - Introduce into the purposes of the Fund (Article I) an explicit reference to global financial stability alongside monetary stability.

- Rationale and context
  - Amending Articles could provide a more complete framework to address complex issues related to international capital flows and the Fund’s role regarding cross-border capital flows.

### C. Financial Safety Nets — Progress to date
- Strong crisis response
  - Introduction of the Flexible Credit Line to provide contingent financing for members with very strong policy fundamentals and frameworks, with ex ante conditionality and review in two-year arrangements.
  - Introduction of the Precautionary Credit Line for members with sound fundamentals but moderate vulnerabilities, combining ex ante qualification with focused ex post conditionality.
  - Support for a tripling in Fund resources at the G20 Leaders’ Summit in London in April 2009 helped restore market confidence.
  - Agreement on a doubling of the Fund’s quota resources strengthened the Fund’s ability to act as a global safety net.

- Reserve adequacy analytical work
  - Work to determine adequate reserve levels for precautionary/self-insurance purposes to help avoid costly excessive reserve accumulation.
  - For emerging market countries dominated by capital account flows, approaches beyond traditional metrics are useful, encompassing sudden stops of new financing, withdrawal of foreign portfolio investments, capital flight, and current account vulnerabilities.
  - Fund staff proposed a risk-weighted metric with a range of 100–150 percent of the new metric intended as a reasonable basic test of adequacy across countries.
  - Assessment at the individual country level requires more detailed examination of vulnerabilities and available resources.
  - The new metric suggests significant scope in most countries for suspending and possibly reversing reserve accumulation, though coordination and signaling considerations may complicate the process.
  - Countries’ comfort with reversing accumulation depends importantly on the reliability of the insurance provided by the global safety net.

### C. Financial Safety Nets — Additional ideas for consideration
- Understanding past crises
  - Ongoing Fund work aims to clarify propagation of systemic crises and identify policy measures successful at defusing stress, especially regarding liquidity.
  - Emerging messages: systemic crises are rare but propagate rapidly, affecting many and raising costs; liquidity provision mitigates costs and financing speed is key.
  - Further work could identify characteristics of measures or a menu of measures to deploy proactively against systemic funding stress.

- Global swap network
  - During the recent crisis, central bank swap lines acted as a global lender-of-last-resort, stabilizing markets.
  - Lack of clear qualification criteria or triggers may limit predictable use in future crises.
  - Central bank liquidity focused on bank funding may be less effective for government funding problems.
  - The Fund could complement central bank tools by considering approval of financial assistance to cover members’ liquidity needs, including through pre-qualification under existing or additional lending facilities.
  - A global swap network—where the Fund works with governments, central banks, and regional pools to facilitate liquidity provision—could mutualize benefits of skewed national safety nets (reserve holdings).

- Regional tier
  - Effective crisis-resolution and prevention requires efforts at multiple levels.
  - Recent Eurozone turbulence highlighted the role of regional safety nets and the complementary benefits of the Fund’s expertise and resources, especially for regionally-dimensioned crises.
  - Promoting synergies between the Fund and regional financing arrangements in surveillance, lending, and precautionary crisis-prevention measures is welcome.

- Resources
  - A more secure and flexible global safety net may require mobilizing additional resources; need depends on availability of alternatives (swap lines, regional arrangements, SDR allocations).
  - There may be circumstances where augmenting the Fund’s own resources significantly is necessary or preferable for effectiveness.
  - In 2009–10 it was possible to turn to member countries for resources but the process took time and may not always be politically feasible.
  - Exploring modalities for the Fund to borrow from markets at short notice to supplement resources could be worth exploring and could offer a relative safe haven asset during global market stress.

- Risk management and moral hazard
  - Expanding the global safety net reduces crisis stability costs but may increase moral hazard and excessive risk taking.
  - Precautions to contain moral hazard are essential, including stronger regulations on borrowing/leverage in the financial system.
  - Strengthened surveillance and prudent lending policies (tailored ex ante and ex post conditionality), enhanced financial regulation and supervision are key.
  - Further reflection is needed on ensuring the private sector effectively bears responsibility for excessive risk taking, through more predictable procedures for involving the private sector in liquidity runs.

### D. Financial Deepening and Currency Internationalization
- Financial deepening
  - Rationale:
    - Deeper domestic financial markets help allocate capital and diversify risk, potentially improving countries’ ability to cope with surges and flights of capital.
    - Liquid, long-term domestic currency bond markets for emerging markets may enhance hedging opportunities and reduce need to borrow in foreign currencies.
    - Financial depth is not a guarantee against underpricing of risk but understanding its relationship to absorption, volatility, and management of capital flows can sharpen Fund advice.
  - Promoting financial depth:
    - Analytical work is underway to make explicit links between domestic financial development and IMS stability, including links between financial depth and financial integration and determinants ranging from macro policies (e.g., exchange rates) to micro determinants (e.g., regulatory and institutional quality).
    - Work will draw on cross-country experiences and select case studies of successful and unsuccessful financial deepening across countries and income levels, and sequencing of policies.

- Currency internationalization
  - Issue:
    - Only a few currencies are truly global because network externalities favor common usage; this efficiency also contributes to systemic fragility.
    - Currently four currencies are recognized by the Fund as freely usable: the U.S. dollar, Euro, British pound, and the Yen. Those four currencies made up 96 percent of global international reserves in 2010.
  - Benefits of broader internationalization:
    - International use of emerging market currencies could reduce uneven distribution of exchange rate risk, deepen domestic financial markets, and increase liquidity and demand for domestic currency assets.
    - Over time, this could create alternatives to channel domestic savings, create alternative sources of reserve assets, improve capital allocation and risk sharing, reduce global imbalances, and enhance system resiliency.
  - Determinants and risks:
    - Determinants of internationalization include size of the economy, trade volume, capital market depth and liquidity, and currency stability and convertibility.
    - The process is largely market driven; government initiatives can help but do not guarantee success.
    - Internationalization involves risks to domestic financial stability and monetary policy control.
  - Further study:
    - Staff work is under way to distill lessons from cross-country experience in internationalizing currencies and apply lessons to emerging market currencies to assess potential as reserve currencies.

### E. Role of the SDR
- Potential contributions of the SDR to IMS stability
  - Regular SDR allocations could expand the stock of SDRs, meeting some precautionary reserve needs and alleviating the global safe asset shortage and global imbalances.
  - Encouraging use of the SDR as a unit of account to price global trade and denominate financial assets could mitigate exchange rate volatility and create natural demand for official SDR or SDR-denominated assets.
  - Sovereigns and IFIs could kick start a market for SDR-denominated assets by issuing and investing in those assets, enhancing liquidity and encouraging private markets; the Fund could also issue such assets to supplement resources.
  - Expanding the SDR basket from the current four currencies to include widely used emerging market currencies would reflect emerging markets’ increasing weight and could facilitate internationalization of those currencies while supporting an enhanced role for the SDR.
  - Note: The issue of whether a currency is determined by the Fund to be freely usable would need to be addressed in this context.

- Next steps and technical challenges
  - Technical challenges and consensus-building/policy coordination are required for the SDR to play a more useful role.
  - Further work under way includes:
    - i) safeguards to ensure regular SDR allocations do not undermine macroeconomic stability or overly burden the voluntary SDR market;
    - ii) development of a private market for SDR-denominated assets and wider stakeholder consultation; and
    - iii) reviewing the SDR valuation methodology to enhance SDR’s role and assess potential for expanding the basket to include currencies of large emerging market economies and related interest rate setting issues.

### III. Conclusion and Issues for Discussion
- Summary
  - The paper identifies multiple shortcomings in the architecture and functioning of the current IMS and proposes four complementary reform paths.
  - No single shortcoming is lethal alone, but together they can significantly disturb sustained global growth and can lead to major crises in adverse states.
  - Few “low hanging fruits” remain; most reform ideas require greater multilateral collaboration and may imply perceived diminished sovereignty and long implementation time frames.

- Questions for Director discussion
  - What are the most critical problems requiring fixing in the architecture or functioning of the IMS?
  - Is there a case for further strengthening macroeconomic policy collaboration? How can Fund surveillance best contribute in the short run and the longer run?
  - How can the Fund best help maximize the benefits of cross-border capital flows? Is explicit emphasis on cross-border financial flows in the Fund’s mandate desirable?
  - Is the current balance between global, regional, and national safety nets appropriate? If not, what reforms should be prioritized?
  - Are financial deepening in emerging markets and internationalization of their currencies promising avenues to explore further? Should the international community seek to facilitate such developments?
  - Does the recently agreed work program on the role of the SDR remain adequate? Which strands should be prioritized?

### Appendix figure 1. Trade and capital flows — key points and statistics
- Trade openness (exports plus imports of goods and services as percent of GDP) is shown for G7, BRICs (excluding Russia before 1991), Other G20, and World.
- External assets plus liabilities (in percent of global GDP) increased for ROW, Other G20, BRICs (data for China starts in 1981, and for Russia in 1993), and G7 over 1970–2005.
- For large emerging markets the ratio of external assets plus liabilities to own GDP rose from 20 percent of own GDP to 100 percent over the period referenced.
- For the largest emerging markets, 60 percent of BRIC external assets are held in the form of reserves.
- Accumulated impulse responses to a one standard deviation growth shock are shown in percent of GDP for shocks to US, Euro area, UK, Japan, and ROW over sample periods 1970 Q2–1990 Q1 and 1991 Q1–2010 Q2.
- Currently four currencies are recognized by the Fund as freely usable: the U.S. dollar, Euro, British pound, and the Yen; those four currencies made up 96 percent of global international reserves in 2010.

_Italic: Source — IMF content unit: “_032311” (PDF)._

### 1. Accumulated impulse responses to a one-standard deviation growth shock .........................5

### 1. Accumulated impulse responses to a one-standard deviation growth shock .........................5

### Key findings on integration, growth, and systemic vulnerabilities
- Growth and integration
  - Over the past 40 years there has been very rapid growth in global per capita GDP growth, trade, and gross capital flows.
  - External assets and liabilities exceed four times the size of global GDP.
  - Average trade flows (exports plus imports) exceed half of GDP for most advanced and large emerging market economies.
  - Output shocks to the largest economies have larger and more lasting repercussions throughout the system than 40 years ago.

- Symptoms of system malfunction
  - Recurring crises throughout the post-Bretton Woods period, with some taking a systemic dimension (predominantly among emerging markets, but including advanced economies during systemic events).
  - Observed symptoms include persistent current account imbalances, exchange rate misalignment subject to abrupt adjustments, volatile capital flows and exchange rates, and very large build-up of international reserves.
  - The aggregate systemic crisis index: a country is under stress if its systemic crisis index is above one standard deviation from its mean.

- Risks
  - Imbalances are unsustainable indefinitely and raise the possibility of episodic destabilizing adjustments.
  - Policy choices that lead to depreciated currencies have generated tension and raise the risk of a protectionist backlash.
  - Lower global growth outcomes are possible if deficit countries adjust (e.g., through deleveraging or macro policies) while surplus countries do not, leading to a decline in global aggregate demand.

### Inadequate global adjustment mechanisms
- Role and ideal properties of adjustment mechanisms
  - Global adjustment mechanisms are needed to allow the global economy to respond to exogenous shocks or internal transformations, and to ensure policies across countries add up to deliver sustainable growth and external deficits.
  - A desirable mechanism: adjustment that occurs smoothly rather than through crises or high inflation, with the smallest impact on growth.

- Current dynamics and limitations
  - Individual country adjustment occurs through changes in domestic savings/investment balances (often via real effective exchange rates) or financing through official or private flows.
  - Because global adjustments must add up, how each country adjusts directly affects others; absent agreement on roles of different adjustment channels, deficits typically bear the brunt of adjustment unless a reserve-currency issuer can defer adjustment.
  - The contemporary IMS gives countries broad discretion over exchange rate and capital account regimes while limiting obligations to aim for domestic stability, increasing risk of inconsistent regime or policy choices across countries.

- Examples of inconsistency externalities (as stated)
  - If all systemic countries pursue export-led growth by compressing domestic absorption, ex post the only possible outcome is lower global growth.
  - Fixing currencies can create misalignments across other currency pairs, with greater systemic consequences if both players are systemic.
  - A floating exchange rate country with a current account deficit seeking to rebalance without reducing domestic absorption may loosen monetary policy, triggering capital outflows that affect other countries.
  - Large capital outflows relative to recipient economies can adversely affect their financial or macroeconomic stability.
  - Idiosyncratic shocks and differing policy preferences across countries can allow imbalances to build to dangerous levels.

- Implication
  - The current IMS is underdetermined; high national discretion may be globally suboptimal. Reducing discretion through collaboration agreements or rules could increase likelihood of better global outcomes.

### Cross-border capital flows: drivers, impacts, and governance gap
- Impact and benefits
  - Cross-border capital flows enhance access to financing for productive activity, can improve global resource allocation, induce competition, deepen domestic capital markets, and generate efficiency gains.

- Risks and amplification
  - Large flows and complex financial networks can create macroeconomic and financial stability risks, increase vulnerabilities, and transmit shocks across borders.
  - Capital flows have been an important source of exchange rate volatility, beyond helping correct exchange rate misalignments.
  - Monetary policy in advanced countries can significantly influence the size and composition of flows to emerging markets.
  - The burden of adjustment to inflow surges and reversals has usually rested on recipient countries.

- Drivers
  - Expectations of rates of return (interest rate differentials adjusted for credit and currency risk) are the key driver of cross-border capital flows.

- Governance gap
  - There is no universal global framework addressing cross-border capital flows; existing frameworks are mainly regional and bilateral and do not approach capital account issues from the perspective of global stability.
  - The absence of a global framework leads to risk externalities from large cross-border financial institutions, regulatory arbitrage, procyclicality, herd behavior, excessive risk taking, and contagion.
  - Cross-border claims of BIS reporting banks (selected countries, December 2009) illustrate the magnitude and cross-border reach of banking claims (figure referenced).

### Systemic liquidity provision and the global safety net
- Collective and national safety nets
  - The size of the collective financial safety net (IMF resources and regional arrangements) has remained broadly constant as a share of global GDP but has declined massively relative to the size of global capital flows.
  - In the absence of adequate collective insurance, markets have incentives to bet against countries at the first sign of liquidity pressure.
  - Most countries have built large buffers of international reserves; these reserves now dwarf the amount of collective insurance available.

- Ad hoc liquidity provision
  - There is no mechanism to ensure availability of substantial resources in a systemic liquidity crisis at the global level.
  - Access to global liquidity has occurred through ad hoc actions of key central banks.
  - The U.S. Federal Reserve alone deployed over $600 billion (more than twice the IMF’s resources at the time).

- Implication
  - Stabilizing market conditions in systemic liquidity crises requires potentially substantial resources and a mechanism for systemic liquidity provision.

### Structural challenges (overview)
- The growing complexity and interconnectedness of trade and financial networks have increased the risk of larger adverse outcomes that could set back globalization.
- Reform motivation: reduce sources of instability and better manage residual volatility without introducing excessive moral hazard.
- While there has been some post-crisis progress, more ambitious reforms are needed to durably strengthen the international monetary system.

*1. Accumulated impulse responses to a one-standard deviation growth shock .........................5*

### 15.      Role of the U.S. dollar. The U.S. dollar is preeminent as a unit of account and

### Role of the U.S. dollar

### Dollar’s preeminence and systemic concentration
- The U.S. dollar is preeminent as a unit of account and medium of exchange for international trade and financial transactions, denomination of international debt securities, commodity pricing, anchor for monetary regimes, and as a store of value.
- Attractive characteristics identified: liquidity, widespread acceptance, and success as a store of value.
- Evidence of safe-haven demand: “at the peak of crisis” safe haven demand for U.S. dollars sharply appreciated its exchange rate even though the crisis erupted at the core of the U.S. financial system.
- Risk from concentration: “concentration of many functions of the IMS in the currency of one nation leaves the IMS exposed to risks stemming from idiosyncratic shocks or policy decisions in that country that may not be appropriate for the rest of the world.”

### Global safe assets and reserve accumulation
- Core argument (Caballero, 2006): global imbalances driven in large part by a structural gap between the ability of parts of the world to generate highly liquid safe assets (especially fixed income ones concentrated in the U.S., particularly government paper) and a rising demand for such assets.
- Rising demand source: fast growing high savings emerging market economies with financial sectors lacking depth to provide diversified stores of value.
- Manifestation: large official reserve accumulation and analogous private savings behavior.

### The changing “core” of the IMS
- Rapid growth differential: emerging markets now account for half of global output, up from just over a quarter in 1971 (see Figure 6).
- G7 share dynamics: fluctuated around 65 percent of global output from 1971 to 2002, then falling to 51 percent by 2010 — described as a historically large and rapid shift.
- Implications as large emerging markets become central:
  - Large shifts in global savings and investment behavior are likely.
  - Initially global savings rise as share of global income of high-savings countries increases.
  - Over time, adjustments expected from factors including decline in precautionary household savings as social safety nets are extended, rising productivity and infrastructure needs, and increasing financial depth.
  - Aging in advanced economies complements these effects, implying further large shifts in asset allocations—and their relative prices.
- Historical pattern: when an established core added a new country/group, the emergent country tended to share key characteristics of the core (e.g., exchange rate and capital account regime). Current challenge: integrating highly dissimilar countries into the core.

### Transition to multipolarity and risks
- View: as global GDP and financial assets diversify, the dollar’s preeminence will over time be eroded, giving room to a more multi-polar system with several currencies playing a key and broadly comparable role globally.
- Key risk: the speed of transition matters for stability. If perception shifts to need for currency diversification of both flows and stocks of assets, a disorderly adjustment would likely ensue.

### IMS reform: key avenues (diagnosis and four reform paths)
- Reform should proceed along four complementary paths:
  - policy collaboration;
  - monitoring and management of capital flows;
  - global financial safety net;
  - structural strengthening through financial deepening and reserve asset diversification.
- Objective: prevent crises and contain their costs.

### A. Policy collaboration — progress and options
- Crisis-time collaboration: limited policy coordination prior to 2008; crisis led to coordinated global stimulus under G20 auspices with Fund advice. Importance of preserving crisis-era cooperation emphasized.
- Two processes to sustain collaboration:
  - Mutual Assessment Process (late 2009, G20) — extensive information sharing on policy plans, Fund analysis of combined global effects, suggestions for global policy mix; assessment guidelines in process of being defined.
  - Experimental “spillover reports” by the Fund on the five most systemic economies (China, Euro Area, Japan, U.K., and the U.S.) to articulate concerns and analyze spillovers.
- Additional ideas for consideration:
  - Multilateral commitment: weaknesses noted in the IMF Articles of Agreement focusing obligations exclusively on exchange rate policies; possible options include recommending members take into account systemic spillovers and giving greater emphasis to domestic policies, or more ambitiously amending Article IV to introduce an obligation to gear domestic policies toward global as well as domestic stability.
  - Strengthened accountability:
    - Policy norms: adoption of objective or widely agreed criteria to judge whether a policy stance is detrimental to domestic and global stability; indicator-based approaches face practical difficulties without broad membership acceptance.
    - Incentives: proposals for “carrots and sticks” (e.g., elevation to ministerial-level examination, publication of critical assessments) to encourage compliance; material sanctions noted as radical given Fund’s cooperative culture and absence of enforcement tradition comparable to WTO.

### B. Monitoring and management of capital flows — progress and guidance
- Executive Board agreed on need to strengthen Fund’s role regarding international capital flows (December 2010).
- Two fronts of Fund work:
  - Analysis:
    - Rebound of inflows to emerging markets after crisis prompted reassessment of drivers.
    - Majority of cross-border capital flows occur between advanced economies and can pose greater systemic challenges.
    - Combining understanding of global liquidity with transmission channels aims to improve surveillance and crisis preparedness; work advanced via targeted research agenda and data adequacy evaluation.
  - Guidelines:
    - Fund’s analysis supports development and application of broadly accepted guidelines on policies to deal with capital flows in recipient and source countries.
    - Work cited: Staff Position Note, Capital Inflows: the Role of Controls; Board paper on Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Policy Framework; Staff Discussion Note, Managing Capital Inflows: What Tools to Use.
    - Advisory framework endorsed by a majority of the Board signifies first-round institutional views and could improve consistency and evenhandedness in policy advice; diversity of Director views remains on how to incorporate the framework into Fund surveillance.
- Additional idea:
  - Consider incorporating the institutional view into Fund surveillance to provide guidance on the scope of members’ obligations under Article IV once broader work is completed.

### Box 1 — Selected findings from recent IMF work on capital flows
- Net flows have become slightly more volatile for all economies over time, with volatility in emerging markets (EM) measurably higher than in advanced economies (AE).
- Across all types of flows, debt-creating net flows are somewhat more volatile and less persistent than equity-creating inflows.
- Temporary tides in capital flows to EMs are strongly correlated with changes in global financing conditions; net flows to EMs rise and fall sharply around periods with relatively low global interest rates and relatively high tolerance for risk.
- Tightening of U.S. monetary policy has a negative marginal effect on net flows elsewhere; effect is sharper for EMs more integrated with global financial and foreign exchange markets, but smaller for economies with greater financial depth and relatively strong growth performance.
- Net flows respond more sharply to a tightening in U.S. monetary policy in economies with nonpegged exchange rate regimes as opposed to those with pegged regimes.
- Inflow episodes start at different times across countries but often end together; different start times reflect country-specific “pull” factors while similar endpoints suggest reversal of “push” factors (e.g., increase in global risk aversion) dominates in ending inflow episodes.

### Global financial regulation
- Progress noted in strengthening domestic financial regulation, but scope remains to strengthen multilateral collaboration among national regulators, reduce regulatory arbitrage, and tackle sources of excess volatility in an integrated way between source and recipient countries.
- Role for the Fund (in collaboration with institutions like the FSB): take a more active stance in promoting collaboration, identifying systemic risk sources, and suggesting national regulatory steps.
- Ambitious proposals: a World Financial Organization with supranational supervisory powers has been suggested but deemed unlikely in the foreseeable future; harmonization of regulatory regimes and lessons from European Union developments merit examination.

*Source: IMF PDF chapter titled "Role of the U.S. dollar."*

### 27.      Amending the Articles. Another possible step would be to amend the IMF’s Articles

### 27.      Amending the Articles. Another possible step would be to amend the IMF’s Articles

### Amending the Articles — proposals and rationale
- Purpose: Amend the IMF’s Articles of Agreement to better reflect the critical role of capital flows in the functioning of the IMS and give more weight to financial stability.
- Specific amendment options discussed:
  - Broaden the definition of systemic stability in Article IV (currently limited to stability of the system of exchange rates) to include financial stability.
  - Establish an obligation to ultimately liberalize the capital account subject to appropriate safeguards and exceptions, similar to the existing current account obligation (proposal referenced as suggested by the Palais Royal Initiative (2011) and previously dismissed by many Executive Directors).
  - Introduce a specific obligation under Article IV, Section 1, related to capital account policies.
  - Replace Article VI, Section 3, with an obligation for members to collaborate with the Fund and other members on capital account policies, analogous to the collaboration obligation in the chapeau of Article IV (option discussed in the Fund’s Role paper and received more favorably).
  - Introduce into the purposes of the Fund (Article I) an explicit reference to global financial stability alongside monetary stability.

### Rationale and context
- Amending Articles could provide a more complete framework to address complex issues related to international capital flows and the Fund’s role regarding cross-border capital flows.

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### C. Financial Safety Nets — Progress to date
- Strong crisis response:
  - Introduction of the Flexible Credit Line to provide contingent financing for members with very strong policy fundamentals and frameworks, with ex ante conditionality and review in two-year arrangements.
  - Introduction of the Precautionary Credit Line for members with sound fundamentals but moderate vulnerabilities, combining ex ante qualification with focused ex post conditionality.
  - Support for a tripling in Fund resources at the G20 Leaders’ Summit in London in April 2009 helped restore market confidence.
  - Agreement on a doubling of the Fund’s quota resources strengthened the Fund’s ability to act as a global safety net.
- Reserve adequacy analytical work:
  - Work to determine adequate reserve levels for precautionary/self-insurance purposes to help avoid costly excessive reserve accumulation.
  - For emerging market countries dominated by capital account flows, approaches beyond traditional metrics are useful, encompassing sudden stops of new financing, withdrawal of foreign portfolio investments, capital flight, and current account vulnerabilities.
  - Fund staff proposed a risk-weighted metric with a range of 100–150 percent of the new metric intended as a reasonable basic test of adequacy across countries.
  - Assessment at the individual country level requires more detailed examination of vulnerabilities and available resources.
  - The new metric suggests significant scope in most countries for suspending and possibly reversing reserve accumulation, though coordination and signaling considerations may complicate the process.
  - Countries’ comfort with reversing accumulation depends importantly on the reliability of the insurance provided by the global safety net.

### C. Financial Safety Nets — Additional ideas for consideration
- Understanding past crises:
  - Ongoing Fund work aims to clarify propagation of systemic crises and identify policy measures successful at defusing stress, especially regarding liquidity.
  - Emerging messages: systemic crises are rare but propagate rapidly, affecting many and raising costs; liquidity provision mitigates costs and financing speed is key.
  - Further work could identify characteristics of measures or a menu of measures to deploy proactively against systemic funding stress.
- Global swap network:
  - During the recent crisis, central bank swap lines acted as a global lender-of-last-resort, stabilizing markets.
  - Lack of clear qualification criteria or triggers may limit predictable use in future crises.
  - Central bank liquidity focused on bank funding may be less effective for government funding problems.
  - The Fund could complement central bank tools by considering approval of financial assistance to cover members’ liquidity needs, including through pre-qualification under existing or additional lending facilities.
  - A global swap network—where the Fund works with governments, central banks, and regional pools to facilitate liquidity provision—could mutualize benefits of skewed national safety nets (reserve holdings).
- Regional tier:
  - Effective crisis-resolution and prevention requires efforts at multiple levels.
  - Recent Eurozone turbulence highlighted the role of regional safety nets and the complementary benefits of the Fund’s expertise and resources, especially for regionally-dimensioned crises.
  - Promoting synergies between the Fund and regional financing arrangements in surveillance, lending, and precautionary crisis-prevention measures is welcome.
- Resources:
  - A more secure and flexible global safety net may require mobilizing additional resources; need depends on availability of alternatives (swap lines, regional arrangements, SDR allocations).
  - There may be circumstances where augmenting the Fund’s own resources significantly is necessary or preferable for effectiveness.
  - In 2009–10 it was possible to turn to member countries for resources but the process took time and may not always be politically feasible.
  - Exploring modalities for the Fund to borrow from markets at short notice to supplement resources could be worth exploring and could offer a relative safe haven asset during global market stress.
- Risk management and moral hazard:
  - Expanding the global safety net reduces crisis stability costs but may increase moral hazard and excessive risk taking.
  - Precautions to contain moral hazard are essential, including stronger regulations on borrowing/leverage in the financial system.
  - Strengthened surveillance and prudent lending policies (tailored ex ante and ex post conditionality), enhanced financial regulation and supervision are key.
  - Further reflection is needed on ensuring the private sector effectively bears responsibility for excessive risk taking, through more predictable procedures for involving the private sector in liquidity runs.

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### D. Financial Deepening and Currency Internationalization
- Financial deepening
  - Rationale:
    - Deeper domestic financial markets help allocate capital and diversify risk, potentially improving countries’ ability to cope with surges and flights of capital.
    - Liquid, long-term domestic currency bond markets for emerging markets may enhance hedging opportunities and reduce need to borrow in foreign currencies.
    - Financial depth is not a guarantee against underpricing of risk but understanding its relationship to absorption, volatility, and management of capital flows can sharpen Fund advice.
  - Promoting financial depth:
    - Analytical work is underway to make explicit links between domestic financial development and IMS stability, including links between financial depth and financial integration and determinants ranging from macro policies (e.g., exchange rates) to micro determinants (e.g., regulatory and institutional quality).
    - Work will draw on cross-country experiences and select case studies of successful and unsuccessful financial deepening across countries and income levels, and sequencing of policies.
- Currency internationalization
  - Issue:
    - Only a few currencies are truly global because network externalities favor common usage; this efficiency also contributes to systemic fragility.
    - Currently four currencies are recognized by the Fund as freely usable: the U.S. dollar, Euro, British pound, and the Yen. Those four currencies made up 96 percent of global international reserves in 2010.
  - Benefits of broader internationalization:
    - International use of emerging market currencies could reduce uneven distribution of exchange rate risk, deepen domestic financial markets, and increase liquidity and demand for domestic currency assets.
    - Over time, this could create alternatives to channel domestic savings, create alternative sources of reserve assets, improve capital allocation and risk sharing, reduce global imbalances, and enhance system resiliency.
    - It is debated whether the system could efficiently handle a somewhat larger number of international currencies (cited views referenced).
  - Determinants and risks:
    - Determinants of internationalization include size of the economy, trade volume, capital market depth and liquidity, and currency stability and convertibility.
    - The process is largely market driven; government initiatives can help but do not guarantee success.
    - Internationalization involves risks to domestic financial stability and monetary policy control.
  - Further study:
    - Staff work is under way to distill lessons from cross-country experience in internationalizing currencies and apply lessons to emerging market currencies to assess potential as reserve currencies.

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### E. Role of the SDR
- Potential contributions of the SDR to IMS stability:
  - Regular SDR allocations could expand the stock of SDRs, meeting some precautionary reserve needs and alleviating the global safe asset shortage and global imbalances.
  - Encouraging use of the SDR as a unit of account to price global trade and denominate financial assets could mitigate exchange rate volatility and create natural demand for official SDR or SDR-denominated assets.
  - Sovereigns and IFIs could kick start a market for SDR-denominated assets by issuing and investing in those assets, enhancing liquidity and encouraging private markets; the Fund could also issue such assets to supplement resources.
  - Expanding the SDR basket from the current four currencies to include widely used emerging market currencies would reflect emerging markets’ increasing weight and could facilitate internationalization of those currencies while supporting an enhanced role for the SDR.
  - Note: The issue of whether a currency is determined by the Fund to be freely usable would need to be addressed in this context.
- Next steps and technical challenges:
  - Technical challenges and consensus-building/policy coordination are required for the SDR to play a more useful role.
  - Further work under way includes:
    - i) safeguards to ensure regular SDR allocations do not undermine macroeconomic stability or overly burden the voluntary SDR market;
    - ii) development of a private market for SDR-denominated assets and wider stakeholder consultation; and
    - iii) reviewing the SDR valuation methodology to enhance SDR’s role and assess potential for expanding the basket to include currencies of large emerging market economies and related interest rate setting issues.

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### III. Conclusion and Issues for Discussion
- Summary:
  - The paper identifies multiple shortcomings in the architecture and functioning of the current IMS and proposes four complementary reform paths.
  - No single shortcoming is lethal alone, but together they can significantly disturb sustained global growth and can lead to major crises in adverse states.
  - Few “low hanging fruits” remain; most reform ideas require greater multilateral collaboration and may imply perceived diminished sovereignty and long implementation time frames.
- Questions for Director discussion:
  - What are the most critical problems requiring fixing in the architecture or functioning of the IMS?
  - Is there a case for further strengthening macroeconomic policy collaboration? How can Fund surveillance best contribute in the short run and the longer run?
  - How can the Fund best help maximize the benefits of cross-border capital flows? Is explicit emphasis on cross-border financial flows in the Fund’s mandate desirable?
  - Is the current balance between global, regional, and national safety nets appropriate? If not, what reforms should be prioritized?
  - Are financial deepening in emerging markets and internationalization of their currencies promising avenues to explore further? Should the international community seek to facilitate such developments?
  - Does the recently agreed work program on the role of the SDR remain adequate? Which strands should be prioritized?

_Italic: Source — IMF content unit: “27. Amending the Articles. Another possible step would be to amend the IMF’s Articles” (PDF)._

### Appendix figure 1. Trade and capital flows

### Appendix figure 1. Trade and capital flows

### Global trends in trade and capital integration
- Trade openness (exports plus imports of goods and services as percent of GDP) is shown for G7, BRICs (excluding Russia before 1991), Other G20, and World (source: WEO). (See Appendix Figure 3.)
- External assets plus liabilities (in percent of global GDP) increased for ROW, Other G20, BRICs 1/ (data for China starts in 1981, and for Russia in 1993), and G7 over 1970–2005. (See Appendix Figure 4; Source: Updated and extended version of Lane and Milesi-Ferretti (2007) dataset.)
- Trends in capital account openness are documented (See Appendix Figure 5; Source: Chinn and Ito (2008).)
- For large emerging markets the ratio of external assets plus liabilities to own GDP rose from 20 percent of own GDP to 100 percent over the period referenced (textual statement).

### Increased macro-financial spillovers and interconnectedness
- Bayoumi and Bui (WP/10/139) indicate significant macro-financial spillovers among major economies and to the rest of the world, with growth over the past two decades; shocks from the U.S., Euro Area, and U.K. generate the largest impacts, with financial spillovers increasing when analysis includes the global crisis period. (See Appendix Figure 6.)
- “Systemic nodes” have emerged—economies with a central role in network functioning that act as shock transmitters across global networks. (See Understanding Financial Interconnectedness.)

### Symptoms of malfunction in the international monetary and financial system
- Persistent imbalances and misalignment:
  - End of formal Bretton Woods exchange rate parities and capital account opening led to market-based adjustment of external imbalances; pressures have been relatively nonexistent for countries with external surpluses and weak for deficit countries issuing international reserve currencies.
  - Result: large and persistent real exchange rate misalignments (See Appendix Figure 7) and current account imbalances (See Appendix Figure 8).
- Excess demand for reserve assets:
  - Large net capital flows—often official flows from reserve accumulation and sovereign wealth funds—concentrated in a narrow range of reserve assets, notably U.S. Treasury debt, may have contributed to durably loose financial conditions in core reserve issuers.
  - Private savings from emerging markets with shallow domestic financial markets were directed to “safe” assets produced in main international financial centers.
- Volatile capital flows and exchange rates:
  - Cross-border capital flows have often been very volatile (See Appendix Figure 9), contributing to many emerging market crises and to the 2008 global crisis.
  - Volatile exchange rates measured by high standard deviations of nominal or real rates (See Appendix Figures 10–12). Examples of shown series:
    - Exchange rates against the dollar, Jan 1999=100 (a rise is an appreciation): Mark, Euro, Yen, Sterling (Appendix Figure 10).
    - Exchange rate indices: rolling five-day standard deviations (Appendix Figure 11).
    - Real effective exchange rates: rolling 24-month standard deviations of monthly growth rates (Appendix Figure 12).
  - Volatility implications:
    - At short horizons volatility can be hedged, but hedging costs increase with volatility.
    - Volatility at longer horizons includes wide drifting or swinging of bilateral and effective nominal and real exchange rates, complicating real investment decisions and international exchange activity for many firms.
    - Empirical literature is inconclusive on overall output costs of volatility and must be balanced against shock-absorption benefits of market-based exchange rate determination.

### Key analytical observations and supporting empirical notes
- For the largest emerging markets, 60 percent of BRIC external assets are held in the form of reserves (textual statement).
- Accumulated impulse responses to a one standard deviation growth shock are shown in percent of GDP for shocks to US, Euro area, UK, Japan, and ROW over sample periods 1970 Q2–1990 Q1 and 1991 Q1–2010 Q2 (See Appendix Figure 6).
- Global imbalances are depicted as current account balances in percent of world GDP with components labeled EUR Deficit, ROW OIL, EMA CHN EUR Surplus, JPN U.S., Net foreign assets in percent of world GDP, and Discrepancy (See Appendix Figure 8).
- Appendix Figure 9 shows percent change in gross capital inflows for a sample of 57 advanced and emerging markets (Source: IFS).

### Citations and empirical sources referenced in text (selection)
- King (2011), drawing on Maddison (2006) (source for Appendix figure 1).
- Bayoumi and Bui (WP/10/139) — macro-financial spillover analysis.
- Chinn and Ito (2008) — capital account openness.
- Lane and Milesi-Ferretti (2007) dataset — external assets and liabilities.
- WEO — trade openness and global imbalances figures.
- IFS — gross capital inflows data.
- Additional referenced works: Bernanke (2011), Warnock and Warnock (2009), Cooper (2006), Campa and Goldberg (1999), Goldberg and Klein (1998), among others cited in the References section.

*Source: _032311 - Appendix figure 1. Trade and capital flows*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_032311.pdf_