## _022216b

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---

### EXECUTIVE SUMMARY — Overview and purpose
- Provides an overview of the challenges facing the International Monetary System (IMS) and seeks to forge a common understanding of those challenges and shortcomings.
- Aims to lay the basis for discussing a possible roadmap for further work on reform areas and to identify follow-up work to flesh out reform ideas, including their feasibility.
- *Approved By Siddharth Tiwari, Strategy, Policy, and Review Department, in consultation with other departments*

### Strengths of the current IMS
- IMS evolved over the past four decades to be much less prescriptive than predecessors with more rigid rules.
- Key flexible characteristics:
  - freedom in the choice of exchange rate regime;
  - a de facto central role for the US dollar in the global financial system;
  - increased openness of trade and capital flows.
- The Fund adapted to support the post-Bretton Woods system and overhauled surveillance and lending toolkits.
- Evolution coincided with greater international trade and financial globalization, broad-based income growth and poverty reduction, but also increasing inequality.

### Weaknesses revealed by crises and subsequent developments
- The 2008/09 crisis revealed tensions between domestic policy pursuit and global stability and weaknesses in financial oversight that allowed vulnerabilities to build up.
- Fund responded with major overhauls of surveillance and lending toolkits; interagency coordination strengthened (e.g., Fund and FSB, the G20 Summit).
- Policy focus shifted to immediate challenges with the deepening euro area crisis in 2011, slowing broader impetus for reform.

### Structural shifts transforming the global economy (implications for the IMS)
- Center of global economic "gravity" shifting as emerging market and developing countries (EMDCs) integrate further.
- Financial interconnectedness more pronounced: financial cycles growing in amplitude and duration; capital flows more volatile; nonbanks gaining importance and altering systemic risk.
- Legacy factors and near-term prospects that present challenges:
  - Slow post-crisis global growth particularly in advanced economies (AE).
  - Prospect of monetary policy normalization coming in succession over the next few years from the reserve currency issuing central banks.
  - Major shifts including China’s rebalancing, slower growth in EMDCs, and the end of the commodity supercycle.
- Non-economic shocks (e.g., refugee flows, global epidemics) may have significant spillovers if unchecked.

### Key tensions and risks identified
- Global current account imbalances shrank, but post-crisis adjustment reflected mainly compressed demand in AE deficit countries, with limited contribution from real exchange rate movements.
- Policy and financial developments in major reserve issuing countries have significant spillover effects, constraining domestic policy choices in open economies and those with fixed exchange rates.
- Periodic episodes of capital flow volatility have become a feature of the new global landscape, contributing to financial pressures and balance-sheet mismatches, particularly in EMDCs.
- Build-up of financial risks in nonbank financial institutions highlights imperfections in global financial oversight.
- Liquidity shocks during stress periods could pose systemic risks; a more fragmented Global Financial Safety-Net (GFSN) could hinder effective support.

### Goals and characteristics of a well-functioning IMS
- Overarching goal: develop the orderly underlying conditions necessary for financial and economic stability and sustain sound economic growth.
- Components: rules (or conventions), mechanisms, and supporting institutions.
- Rules and conventions govern:
  - (a) exchange rates and exchange arrangements;
  - (b) payments and transfers for current international transactions;
  - (c) international capital movements;
  - (d) holding of international reserves and official arrangements through which countries have access to liquidity (the so-called Global Financial Safety-Net (GFSN)).
- Effective IMS characteristics:
  - Effective surveillance of individual countries and their interconnections to mitigate risk and ensure sustainable global macroeconomic and financial balances.
  - Rules and conventions to mitigate risks via current and capital account governance, borrowing, hedging, or risk-sharing instruments.
  - Provision of adequate global liquidity to support countries facing temporary liquidity constraints.
  - Robust resolution mechanisms with clear ex ante rules to address imbalances, including for overly indebted sovereigns.
- IMS functions well when it inhibits large stock or flow imbalances and is conducive to efficient international resource allocation.

### Roles and responsibilities
- Countries: responsible for implementing economic policies, adhering to rules and conventions, or availing themselves of mechanisms for adjustment.
- The Fund:
  - Primary global institution with central role; Articles of Agreement provide basis for oversight and promoting international monetary cooperation (Article I).
  - Provides financial support for balance of payments adjustment and allocates SDRs to supplement reserve assets.
- Other critical institutions: World Trade Organization, Bank for International Settlements (BIS), Financial Stability Board (FSB), World Bank.

### Possible reform avenues and areas for follow-up work
- Reform objectives: strengthen crisis prevention and global mechanisms for adjustment, cooperation, and liquidity provision given increased interconnectedness and openness.
- Three focus areas:
  - (i) mechanisms for crisis prevention and adjustment;
  - (ii) rules and institutions for enhanced global cooperation on issues and policies affecting global stability;
  - (iii) building a more coherent Global Financial Safety-Net (GFSN).
- Many reform ideas considered previously; recent events and structural changes argue for holistic reconsideration and feasibility follow-up.

---

### Legal framework and Articles references (Section 2(a))
- Section 2(a) prohibits members, without Fund approval, from imposing restrictions on the making of payments and transfers for current international transactions.
- Under the Articles, "current international transactions" includes some transactions capital in nature.
- Article VI, Section 1 permits the Fund to "request a member to exercise [capital] controls" to prevent the use of the Fund’s "general resources to meet a large or sustained outflow of capital."
- Further discussion referenced in IMF, 2010a.

### Historical overview of the IMS — key contrasts across regimes
- Classic Gold Standard (1819-1914): parity with gold; no capital account restrictions.
- Gold Exchange Standard (1925-31): USD pegged to gold; capital controls; USD as reserve currency.
- Bretton Woods System (1944-73): adjustable exchange rates for "fundamental disequilibrium"; IMF support for temporary BoP difficulties.
- Post-Bretton Woods Period (1973 onwards): diverse exchange regimes; USD predominant reserve asset; SDRs created 1969 with allocations in 1979-81 and 2009.

### Post-crisis assessment of IMS weaknesses (2011 staff identification)
- Four main weaknesses identified in 2011:
  - (i) inadequate global adjustment mechanisms;
  - (ii) no global oversight framework for cross-border capital flows;
  - (iii) lack of systematic liquidity provision mechanisms;
  - (iv) structural challenges in the supply of safe assets.
- Consequences: persistent current account imbalances and exchange rate misalignment, excessive volatility in capital flows and exchange rates, and large build-up of international reserves.
- Proposed reform focus areas:
  - (i) strengthening policy collaboration;
  - (ii) monitoring and management of capital flows;
  - (iii) enhancing global financial safety nets;
  - (iv) structural strengthening through financial deepening and reserve asset diversification.

### IMF reforms and operational changes after the crisis — surveillance, lending, governance
- Surveillance and policy tools:
  - 2012 Integrated Surveillance Decision (ISD) to integrate bilateral and multilateral surveillance and cover spillovers.
  - Introduction of External Stability and Spillover reports for largest members’ external positions.
  - Semi-annual Early Warning Exercise and Vulnerability Exercises; inclusion of risk assessment matrices in Article IV reports.
  - 2012 Financial Surveillance Strategy to enhance macrofinancial analysis; mandatory Financial Stability Assessments for economies with systemically important financial centers.
  - Adoption of an Institutional View on the liberalization and management of capital flows; refinement of macroprudential advice; development of a metric to assess reserve adequacy for self-insurance.
- Lending architecture and liquidity provision:
  - Doubling of access limits, streamlining conditionality, and introduction of new instruments: the Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL).
    - FCL: no ex post conditionality.
    - PLL: conditionality focuses on limited remaining vulnerabilities; created in 2011 to replace the Precautionary Credit Line (created in 2010) with addition of a six-month liquidity window and permitting approval of a PLL arrangement for actual and potential balance of payments needs.
  - LIC lending revamped in 2010 with new facilities and a doubling of access limits; access limits raised again in 2015 by 50 percent across the concessional facilities for all PRGT-eligible countries; cumulative access limits for the Rapid Credit Facility raised in 2013.
  - Temporary expansion of the New Arrangement to Borrow (NAB) and temporary bilateral borrowing agreements, followed by permanent increases in Fund resources via doubling of quotas under the 14th General Review of Quotas.
  - 2009 SDR allocations of SDR 182.6 billion injected additional liquidity; late 2015 Executive Board decision expanded currencies in the SDR basket to include the renminbi, effective October 1, 2016.
- Governance reforms:
  - 2010 package to better align governance with the global economy: realignment of quota shares (more than 6 percentage point shift to dynamic EMDCs), move to an all-elected Executive Board, and doubling of quotas. Late entry into force (early 2016) delayed further representativeness efforts envisaged in the 15th General Review of Quotas.

### Regional and bilateral cooperation developments
- G20: annual Leaders’ Summit since November 2008; Mutual Assessment Process (MAP) with Fund technical support.
- Financial Stability Board established in 2009 to coordinate national authorities and standard-setting bodies.
- Central banks engaged in bilateral currency swap agreements post-crisis to improve liquidity.
- Creation/enhancement of RFAs: European Stability Mechanism, Chiang Mai Initiative Multilateralization, Asian Infrastructure Investment Bank, BRICs Contingent Reserve Arrangement.

---

### Changing contours of the global economy — structural shifts and implications
- Multipolar trends:
  - EMDCs’ share of world GDP increased by more than two-thirds since 2000, reaching 40 percent in 2014 in market prices, dominated by the BRICS.
  - EMDCs represented 38 percent of global trade in 2014 (up by 16 percentage points since 2000); China represents 13 percent of global GDP (market prices) and 10 percent of world trade.
- Growth differentials:
  - EMDCs’ real GDP grew on average at 5.7 percent per year during 2007–14, compared to 1.0 percent for advanced economies.
- Financial integration and deepening:
  - Cross-border financial integration proceeded more slowly in EMDCs than in AEs; financial deepening gap widened between the mid-1990s and early 2000s.
  - Financial depth in EMDCs remains much lower than in AEs despite some closing of the gap after AE deleveraging.
  - Risk: if integration outpaces deepening and regulatory improvements, instability and capital flow volatility may ensue; "too much finance" can reduce growth and increase volatility.
- Cross-border liabilities and currency denomination:
  - EMDCs’ cross-border liabilities have tripled over the past decade, with nonbanks playing an increasingly important role.
  - Large share of cross-border activity denominated in dollars; dollar principal for trade settlement, cross-border payment systems, cross-border lending and reserve accumulation, followed by the euro.
  - Specific dollar-denominated figures:
    - globally US$20 trillion foreign currency denominated bank liabilities;
    - outstanding US dollar denominated debt issued by entities outside of the US totals about US$7 trillion.

### Financial globalization and capital flows — historical magnitudes
- Global capital flows:
  - 1970s average: 1.7 percent of global GDP per year (or US$109 billion).
  - 2000s average: more than 10 percent of global GDP; peaked at 20 percent on the eve of the crisis in 2007 ($11.4 trillion).
  - Capital flows declined sharply in 2007–08, then recovered and oscillated; by 2014 flows to EMDCs had approached pre-crisis levels in dollar terms.
- Global external liabilities:
  - Grew from 30 percent of global GDP ($3½ trillion) in 1980 to 166 percent ($120 trillion) in 2011.
- Context on capital account liberalization:
  - Capital flows increased more than 25-fold between 1980 and 2007, compared to an eight-fold expansion in global trade.
  - Under appropriate conditions, liberalization can provide benefits, but full liberalization is not necessarily the goal for all countries at all times.

---

### Financial globalization, cross-border credit, and domestic lending
- Financial globalization spurred cross-border credit—much of it in U.S. dollars—and domestic lending, contributing to asset price booms in numerous countries.
- Expansion of cross-border liabilities to EMDCs accompanied by a significant rise in domestic credit over the past decade; especially significant in Asia.
- Cross-border liability data available from 1995.

### Synchronization and amplitude of financial cycles
- Countries’ financial cycles appear synchronized; length and amplitude of the US financial cycle—proxied by the path of the credit to GDP ratio—have increased markedly since the mid-1980s.
- Correlations:
  - Some AEs (UK, Australia) highly correlated with the US cycle for decades; since the crisis most other AEs show correlation coefficients exceeding 0.9 for many countries.
  - Among EMDCs, India and South Africa have become increasingly correlated with the US cycle; China remains disconnected.
  - Median correlation of a wide range of financial assets increased from just above 0.4 to 0.7 since the crisis.
- Box 1 technical detail:
  - Financial cycles represented through credit gaps derived by filtering the private sector credit-to-GDP ratio using a Hodrick-Prescott filter with a smoothing parameter (lambda) of 400,000.

### Capital flows and the financial cycle
- Since around 1990, cyclical surges and troughs of capital flows have moved in tandem with the financial cycle, mirroring rising amplitude.
- Financial cycle and cycle of global capital inflows peaked before the crisis and have since turned; decline in global inflows compared to pre-crisis driven largely by AE slowdowns.

### Nonbanks, changing intermediation, and systemic risks
- Pre-crisis banking sector intermediated well over half of cross-border liabilities; by 2014 nonbanks were an equal or larger player.
- Nonbanks (insurance companies, asset managers, money market funds, hedge funds) do not take deposits and face different regulation; varying risk features depend on leverage, short-term funding dependence, holdings of illiquid assets.
- Shift from banks to less regulated nonbanks may generate new systemic risks.

### Weak global adjustment mechanisms and evolving global imbalances
- Global current account imbalances:
  - Peaked at just over 5 percent of global GDP in 2006–08, narrowed, and remained around 3 percent of global GDP in 2014.
- Fund estimates: the sum of actual current account imbalances for larger countries exceeded the level implied by fundamentals and desired policies by around 1.2 percent of global GDP in 2014.
- Post-crisis adjustment largely via demand compression in deficit countries and faster recovery in EMDCs and commodity exporters; lack of demand adjustment in many surplus countries tilted burden to deficit countries and was contractionary, especially at the zero lower bound.

### Exchange rates and limited role in post-crisis adjustment
- Historical estimate (1980–2014): a 10 percent depreciation of a country’s REER led on average to a 1.5 percent increase in real net exports.
- Empirical examples:
  - 2011–14 China’s current account surplus remained about 1-2 percent of GDP despite a 16 percent real appreciation.
  - Germany’s current account surplus rose from 6 to 7½ percent of GDP despite a stable REER.
  - Japan’s current account surplus declined 1½ percent of GDP despite a 26 percent real depreciation.
- Empirical notes:
  - Panel regressions indicate aggregate demand explains about 30 percent of reduction in global external imbalances; REER had no impact.
  - Cross-sectional/regression fit indicators: R^2 = 0.17 and R^2 = 0.19 in related analyses.

### Constrained domestic policy choices and international spillovers
- U.S. monetary and financial conditions migrate easily to the rest of the world; shocks transmitted through interest rates, capital flows, and asset prices.
- Open economies: capital inflows can appreciate exchange rates and increase financial sector risks.
- Fixed or heavily managed exchange rates: inflows may lead to reserve accumulation, expansion in domestic liquidity, and pressure on asset prices and credit growth.
- Floating regimes may not fully insulate monetary policy from global financial shocks when asset prices are highly correlated.
- Confluence of structural shifts raises tensions and risks: periodic capital flow volatility, build-up in nonbank risks, gaps in oversight, and fragmented GFSN increasing vulnerability.

---

### Trade-off between macro stabilization and financial stability
- Imported financial conditions reduce central banks’ ability to influence domestic interest rates independently of US yields.
- Exchange rate regime remains central, but monetary policy more constrained by imported conditions, complicating macroprudential management.
- Interest rate hikes to address overheating may attract additional capital inflows, creating difficult policy trade-offs.
- Foreign exchange intervention can help counter disorderly market conditions where reserves are adequate.

### Use and effectiveness of capital flow management measures (CFMs)
- Some countries introduced CFMs; inflow CFMs may be more successful when focused on financial stability or changing composition of flows rather than reducing flow volumes.
- Fund’s Institutional View: when capital flows contribute to systemic financial risks, measures that are both CFMs and macroprudential can help safeguard stability.
- CFMs useful when:
  - limited short-term scope to adjust macroeconomic policies;
  - other measures take time to deliver;
  - surges of inflows raise financial instability risks.
- CFMs can impose costs: reduced market discipline, tightened financing constraints, limited asset diversification, monitoring/enforcement costs, rent-seeking, corruption, financial repression, distortion of capital allocation.
- Limited knowledge remains on which CFMs are most effective and cross-border coordination challenges.

### International cooperation and systemic risks
- Effective international cooperation more important given integration shifts.
- Increased gross external positions can transmit shocks even when net positions appear contained; valuation and network effects create contagion.
- Regulatory reforms strengthened banks (Basel III elements), but uneven implementation across jurisdictions could limit global stability benefits and lead to regulatory arbitrage.
- Prudential perimeter expansion to nonbanks slower; shadow banking regulation stepped up in financial centers and FSB monitoring increased.
- Risks in AEs: rapid growth of leveraged hedge funds and open-ended mutual funds with large holdings of less liquid assets.
- Risks in EMDCs: surge in nonbank corporate borrowing can boost growth but fuel excessive corporate leverage or FX mismatches.

### Global liquidity, GFSN adequacy, and vulnerabilities
- Booms and busts in global liquidity disrupted the IMS; evaporation of US dollar funding in European markets during the crisis led the Federal Reserve to extend emergency swap lines.
- Concerns: excess global liquidity from unconventional monetary policies and potential liquidity shortages tied to China’s rebalancing, commodity cycle collapse, and AE monetary normalization.
- GFSN components and characteristics:
  - Reserves:
    - Official reserves dominate GFSN resources as first line of defense; doubts about willingness to run them down exist.
    - Reserve accumulation costly; reserve accumulation in EMs slowed since 2008.
    - Considerations discussed in Assessing Reserve Adequacy.
  - Bilateral Swap Lines (BSLs):
    - Typically cover very short-term FX funding needs and were critical during the crisis.
    - Many post-crisis US Fed lines targeted US dollar shortages in mostly AEs and have expired.
    - China expanded swap lines in renminbi, “equivalent to about US$500 billion”; BSLs involving non-reserve currencies have been growing.
  - Regional Financing Arrangements (RFAs):
    - Number increased since the crisis (e.g., Eurasian Fund for Stabilization and Development, ESM, BRICs Contingent Reserve Arrangement).
    - RFAs heterogeneous with large variations in resources and predictability; most have limited lending capacity compared with potential needs.
    - Local ownership and tailoring increase appeal and may reduce stigma relative to the Fund.
  - IMF:
    - Near-universal element of the safety net with widest array of insurance (FCL, PLL arrangements, SBAs treated as precautionary) and financing instruments.
    - Fund financing can be relatively slow in a crisis due to program-related condition discussions; arrangements largely time-bound and require approval for successive arrangements.
    - FCL and to some extent PLL used principally as contingent liquidity support for crisis prevention.

### Key uncertainties and knowledge gaps
- Limited knowledge on which CFMs are most effective and when benefits outweigh costs.
- Challenges in cross-border coordination of CFMs among recipient and source countries during systemic shocks.
- Need for further action to improve resolution frameworks for large, complex firms and expand prudential regulation to rapidly growing nonbank sectors.

---

### Reluctance, stigma, and conditionality
- Some countries delay seeking Fund support or RFA support requiring Fund involvement.
- Causes of delayed engagement:
  - Stigma from past engagements and Fund conditionality viewed as onerous.
  - Political sensitivities (2014 Review of the FCL, PLL, and RFI found political sensitivities to be a factor).
  - Countries’ unwillingness to adjust.
- Contrast: some countries view Fund programs as a signal of strength (example: Mexico).
- Conditionality:
  - Ex ante (FCL, PLL) and ex post conditionality facilitate adjustment and mitigate moral hazard.
- Policy challenge: move perception of Fund programs from stigma to signal of strength.

### Fragmentation of the Global Financial Safety Net (GFSN)
- Fragmentation increased over time; drivers include uncoordinated evolution of the GFSN, Fund stigma, and perceived slowness of Fund support.
- Major EMDCs tend to be underinsured by RFAs given region-wide shock risk and their role as liquidity suppliers.
- Cooperation between Fund and RFAs limited outside Europe; lack of testing raises concerns.
- Continued fragmentation would reduce effectiveness in addressing global systemic shocks and leave some countries vulnerable.
- Suggested mitigation: grant EMDCs greater voice in IMS governance to reduce stigma associated with Fund resources.

### Experience with Fund and European RFAs cooperation (Box 3) — key findings
- Crisis programs for Cyprus, Greece, Ireland, Portugal involved Fund, European Commission (EC), and ECB coordination; "Troika" arrangement.
- Programs for Hungary, Latvia, Romania involved cooperation with the EC.
- Fund provided most financing in some cases (Hungary, Romania); ESM provided most official financing in euro area cases; ECB provided substantial liquidity to euro area financial institutions.
- Division of roles:
  - Fund led macro framework and debt sustainability assessment.
  - EC led structural issues and fiscal target assessment.
- Implementation and risks:
  - MoUs often added conditions outside Fund core area, increasing strain on implementation capacity.
  - EU regional commitments could limit policy design room.
  - Coordination generally produced coherent macroeconomic and structural parameters.
- Lessons:
  - Deepen cooperation with regional partners while preserving clear roles per mandates.
  - Access to additional RFA funding alleviated financing constraints, allowing more gradual approaches.
  - Lack of overarching cooperation framework allowed flexibility but risked conditionality coherence.
  - Cooperation should continue in accordance with Fund’s mandate, legal framework, policies and procedures.

### Challenges in the evolving global context
- Structural and cyclical factors:
  - Slow post-crisis AE growth expected to continue.
  - China undertaking multi-year rebalancing toward slower sustainable growth.
  - Supply and demand factors suggest fall in commodity prices likely to be sustained.
  - Asynchronous monetary policy normalization may challenge EMDCs with dollar exposures and increase exchange rate volatility.
  - Non-economic shocks (refugee flows, epidemics) can have significant spillovers if unchecked.

### The way forward — three key areas for strengthening the IMS
- Overarching aim: strengthen global mechanisms for adjustment and liquidity provision so EMDCs can run modest current account deficits without the need for increasing self-insurance, and manage interconnectedness and openness risks.
- (i) Mechanisms for crisis prevention and adjustment:
  - Strengthen EMDC policy frameworks (CFMs and macroprudential measures) for resilience to capital flow pressures.
  - Discourage excessive leverage; promote longer-term equity financing and risk-sharing instruments.
  - Ensure equitable burden of adjustment across countries (surplus/deficit, source/recipient of flows).
  - Continue strengthening prudential regulation and supervision of shadow banking.
- (ii) Enhanced global cooperation on policies affecting global stability:
  - Countries should consider impacts of their policies on the rest of the world.
  - Greater cooperation needed on capital flow management and financial regulation as integration and spillovers increase.
- (iii) A large enough and more coherent GFSN:
  - Diagnostic work critical to define underlying GFSN problems.
  - Options may include ensuring liquidity support during systemic events and effective cooperation across GFSN layers to limit contagion to "innocent by-standers."
  - IMF monitoring or policy signaling could facilitate cooperation, allow creditors to rely on Fund expertise, and reduce moral hazard.

### Follow-up work and concrete next steps
- Capital flow management and FX intervention:
  - By late 2016, staff plans to take stock of implementation of policies on liberalization and management of capital flows.
  - CFMs and FX intervention issues to be analyzed as part of staff’s work developing an integrated view on use of policy tools (monetary policy, FX intervention, regulatory measures) to respond to exchange rate, liquidity, inflation and balance sheet pressures.
  - Depending on outcomes, further work on CFMs and FX intervention could follow.
- Global Financial Safety Net:
  - An informal Board discussion on the Adequacy of the Global Financial Safety Net will seek consensus on a common diagnosis to support staff reform proposals with detailed cost-benefit assessments.
  - A forthcoming paper "Adequacy of Fund Resources: Initial Considerations" will assess whether Fund resources suffice for its central GFSN role.
  - Follow-up discussions will cover future of the 2012 Borrowing Agreements, Review of Borrowing Guidelines and need to renew the NAB.
- Role of the SDR:
  - Following renminbi inclusion in the SDR basket, membership interest exists in discussing enhancing the SDR role; staff will return to this in due course.

### Issues for discussion (questions posed to Directors)
- Strategic importance of Fund exploring options to strengthen the IMS given ongoing changes.
- Most critical problems or gaps in current IMS functioning.
- How the Fund can facilitate financial deepening in EMDCs.
- How the Fund can best help maximize benefits and safeguard against risks from cross-border capital flows.
- The Fund’s role, as the global pillar, in promoting GFSN effectiveness.
- Priority reform areas.

*Source: _022216b (PDF).*

### EXECUTIVE SUMMARY

### _022216b - EXECUTIVE SUMMARY

### Overview and purpose
- Provides an overview of the challenges facing the International Monetary System (IMS) and seeks to forge a common understanding of those challenges and shortcomings.
- Aims to lay the basis for discussing a possible roadmap for further work on reform areas and to identify follow-up work to flesh out reform ideas, including their feasibility.

### Strengths of the current IMS
- The IMS has evolved over the past four decades to be much less prescriptive than predecessors with more rigid rules.
- Key characteristics that provided flexibility include freedom in the choice of exchange rate regime, a de facto central role for the US dollar in the global financial system, and increased openness of trade and capital flows.
- The Fund adapted to support the post-Bretton Woods system and has taken major steps to overhaul surveillance and lending toolkits.
- The evolution coincided with greater international trade and financial globalization, broad-based income growth and poverty reduction, but also increasing inequality.

### Weaknesses revealed by crises and subsequent developments
- The 2008/09 crisis revealed considerable weaknesses in the IMS, notably tensions between domestic policy pursuit and global stability and weaknesses in financial oversight that allowed vulnerabilities to build up.
- The Fund responded with major overhauls of surveillance and lending toolkits; other institutions and country groupings strengthened interagency coordination (e.g., between the Fund and FSB, the G20 Summit).
- Policy focus shifted toward more immediate challenges with the deepening euro area crisis in 2011, slowing broader impetus for reform.

### Structural shifts transforming the global economy (implications for the IMS)
- The center of global economic "gravity" continues to shift as emerging market and developing countries (EMDCs) integrate further into the global economy.
- Financial interconnectedness has become more pronounced: financial cycles are growing in amplitude and duration; capital flows have become more volatile; nonbanks have gained importance, altering the nature of systemic risk.
- Legacy factors and near-term prospects that present challenges:
  - Slow post-crisis global growth particularly in advanced economies (AE).
  - Prospect of monetary policy normalization coming in succession over the next few years from the reserve currency issuing central banks.
  - Major shifts including China’s rebalancing, slower growth in EMDCs, and the end of the commodity supercycle.
- Non-economic shocks (e.g., refugee flows from geopolitical conflicts, global epidemics) can have significant spillover effects if left unchecked.

### Key tensions and risks identified
- While global current account imbalances shrank, the post-crisis adjustment reflected mainly compressed demand in AE deficit countries, with limited contribution from real exchange rate movements.
- Policy and financial developments in major reserve issuing countries have significant spillover effects on others, constraining domestic policy choices in countries with open economies and less developed financial markets, and more so in those with fixed exchange rates.
- Periodic episodes of capital flow volatility appear to have become a feature of the new global landscape, contributing to financial pressures and balance-sheet mismatches, particularly in EMDCs where financial markets are less developed.
- Build-up of financial risks, particularly in nonbank financial institutions, highlights imperfections in oversight of the global financial system.
- Liquidity shocks during periods of financial stress could pose systemic risks and a more fragmented global financial safety-net (GFSN) could make it more difficult to effectively support countries during stress and crisis periods.

### Goals and characteristics of a well-functioning IMS
- Overarching goal: develop the orderly underlying conditions necessary for financial and economic stability and sustain sound economic growth.
- Components of the IMS: rules (or conventions), mechanisms, and supporting institutions.
- Rules and conventions govern:
  - (a) exchange rates and exchange arrangements;
  - (b) payments and transfers for current international transactions;
  - (c) international capital movements;
  - (d) holding of international reserves and official arrangements through which countries have access to liquidity (the so-called Global Financial Safety-Net (GFSN)).
- Effective IMS characteristics:
  - Underpinned by effective surveillance of individual countries and their interconnections to mitigate risk and ensure sustainable global macroeconomic and financial balances.
  - Provide a basis for countries to mitigate risks via rules and conventions governing current and capital account transactions, borrowing, hedging or other risk-sharing instruments to manage balance sheet risks.
  - Ensure provision of adequate global liquidity to support countries facing temporary liquidity constraints.
  - Provide robust resolution mechanisms with clear ex ante rules to address imbalances, including for overly indebted sovereigns.
- The IMS functions well when it inhibits the build-up of large stock or flow imbalances and is conducive to efficient allocation of resources among countries.

### Roles and responsibilities
- Countries are agents responsible for implementing economic policies, adhering to rules and conventions, or availing themselves of mechanisms for adjustment.
- The Fund is the primary global institution with a central role in the system: its Articles of Agreement provide the basis for oversight and promoting international monetary cooperation through “consultation and collaboration on international monetary problems” (Article I).
- The Fund provides financial support for balance of payments adjustment and allocates SDRs to supplement reserve assets.
- Other institutions with critical roles include the World Trade Organization, Bank for International Settlements (BIS), Financial Stability Board (FSB), and the World Bank.

### Possible reform avenues and areas for follow-up work
- Reform objectives: strengthen crisis prevention and global mechanisms for adjustment, cooperation, and liquidity provision given increased interconnectedness and openness.
- Three possible focus areas for reforms:
  - (i) mechanisms for crisis prevention and adjustment;
  - (ii) rules and institutions for enhanced global cooperation on issues and policies affecting global stability;
  - (iii) building a more coherent Global Financial Safety-Net (GFSN).
- Many reform ideas have been considered in the past; recent events and structural changes make it important to consider these ideas holistically and with a new perspective.
- Follow-up work could flesh out reform ideas, including their feasibility.

*Approved By Siddharth Tiwari, Strategy, Policy, and Review Department, in consultation with other departments*

### Section 2(a), which prohibits members, without Fund approval, from imposing restrictions on the making of

### _022216b - Section 2(a), which prohibits members, without Fund approval, from imposing restrictions on the making of

### Legal framework and Articles references
- Section 2(a) prohibits members, without Fund approval, from imposing restrictions on the making of payments and transfers for current international transactions.  
- Under the Articles, "current international transactions" includes some transactions capital in nature.  
- Article VI, Section 1 permits the Fund to "request a member to exercise [capital] controls" to prevent the use of the Fund’s "general resources to meet a large or sustained outflow of capital."  
- Further discussion referenced in IMF, 2010a.

### Historical overview of the International Monetary System (IMS) — key contrasts across regimes
- Classic Gold Standard (1819-1914): parity between each country's currency and gold; no capital account restrictions; gold as reserve asset; IMF as central institution not applicable then.  
- Gold Exchange Standard (1925-31): USD pegged to gold and other currencies pegged to USD; capital controls; USD as reserve currency; IMF central role emerging.  
- Bretton Woods System (1944-73): exchange rates adjustable if "fundamental disequilibrium"; more domestic policy autonomy; IMF support to bridge temporary BoP difficulties.  
- Post-Bretton Woods Period (1973 onwards): different exchange rate regimes; market-determined reserve assets with USD predominant; emergence of international fora (G7/20) and regional financing arrangements; SDRs created (1969) with allocations in 1979-81 and 2009.

### Post-crisis assessment of IMS weaknesses (2011 staff identification)
- Four main weaknesses identified in 2011:
  - (i) inadequate global adjustment mechanisms;
  - (ii) no global oversight framework for cross-border capital flows;
  - (iii) lack of systematic liquidity provision mechanisms;
  - (iv) structural challenges in the supply of safe assets.
- Consequences noted: persistent current account imbalances and exchange rate misalignment, excessive volatility in capital flows and exchange rates, and a very large build-up of international reserves.
- Proposed reform focus areas:
  - (i) strengthening policy collaboration;
  - (ii) monitoring and management of capital flows;
  - (iii) enhancing global financial safety nets;
  - (iv) structural strengthening through financial deepening and reserve asset diversification.

### IMF reforms and operational changes after the crisis
- Surveillance and policy tools:
  - 2012 Integrated Surveillance Decision (ISD) to integrate bilateral and multilateral surveillance and cover spillovers from domestic policies.
  - Introduction of External Stability and Spillover reports for multilaterally consistent assessments of largest members’ external positions.
  - Semi-annual Early Warning Exercise (tail risks) and Vulnerability Exercises; inclusion of risk assessment matrices in Article IV reports.
  - 2012 Financial Surveillance Strategy to enhance macrofinancial analysis in Article IV consultations; mandatory Financial Stability Assessments for economies with systemically important financial centers.
  - Adoption of an Institutional View on the liberalization and management of capital flows; refinement of macroprudential advice; development of a metric to assess reserve adequacy for self-insurance.
- Lending architecture and liquidity provision:
  - Doubling of access limits, streamlining conditionality, and introduction of new instruments: the Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL).  
    - FCL: no ex post conditionality.  
    - PLL: conditionality focuses on limited remaining vulnerabilities; created in 2011 to replace the Precautionary Credit Line (created in 2010) with addition of a six-month liquidity window and permitting approval of a PLL arrangement for actual and potential balance of payments needs.
  - LIC lending revamped in 2010 with new facilities and a doubling of access limits; access limits raised again in 2015 by 50 percent across the concessional facilities for all PRGT-eligible countries; cumulative access limits for the Rapid Credit Facility raised in 2013.
  - Temporary expansion of the New Arrangement to Borrow (NAB) and a series of temporary bilateral borrowing agreements, followed by permanent increases in Fund resources via the doubling of quotas under the 14th General Review of Quotas.
  - 2009 SDR allocations of SDR 182.6 billion injected additional liquidity; late 2015 Executive Board decision expanded currencies in the SDR basket to include the renminbi, effective October 1, 2016.
- Governance reforms:
  - 2010 package to better align governance with the global economy: realignment of quota shares (more than 6 percentage point shift to dynamic EMDCs), move to an all-elected Executive Board, and doubling of quotas. Late entry into force (early 2016) delayed further representativeness efforts envisaged in the 15th General Review of Quotas.

### Regional and bilateral cooperation developments
- G20: annual Leaders’ Summit since November 2008; Mutual Assessment Process (MAP) with technical support from the Fund.  
- Financial Stability Board established in 2009 to coordinate national authorities and standard-setting bodies.  
- Central banks engaged in bilateral currency swap agreements post-crisis to improve liquidity.  
- Creation or enhancement of regional financing arrangements: European Stability Mechanism, Chiang Mai Initiative Multilateralization, Asian Infrastructure Investment Bank, BRICs Contingent Reserve Arrangement.

### Changing contours of the global economy — structural shifts and implications
- Multipolar trends:
  - EMDCs’ share of world GDP increased by more than two-thirds since 2000, reaching 40 percent in 2014 in market prices, dominated by the BRICS.  
  - EMDCs represented 38 percent of global trade in 2014 (up by 16 percentage points since 2000); China represents 13 percent of global GDP (market prices) and 10 percent of world trade.
- Growth differentials:
  - EMDCs’ real GDP grew on average at 5.7 percent per year during 2007–14, compared to 1.0 percent for advanced economies.
- Financial integration and deepening:
  - Cross-border financial integration has proceeded more slowly in EMDCs than in AEs; financial deepening gap widened between the mid-1990s and early 2000s, reflecting rapid AE deepening.
  - Financial depth in EMDCs remains much lower than in AEs despite some closing of the gap after AE deleveraging.
  - Risks noted: if financial integration outpaces deepening and regulatory improvements, it could cause instability and capital flow volatility; "too much finance" can reduce growth and increase volatility.
- Cross-border liabilities and currency denomination:
  - EMDCs’ cross-border liabilities have tripled over the past decade, with nonbanks playing an increasingly important role.
  - Large share of cross-border activity denominated in dollars; the dollar is principal for trade settlement, cross-border payment systems, cross-border lending and reserve accumulation, followed by the euro.
  - Specific dollar-denominated figures cited: globally US$20 trillion foreign currency denominated bank liabilities; outstanding US dollar denominated debt issued by entities outside of the US totals about US$7 trillion.

### Financial globalization and capital flows — historical magnitudes
- Global capital flows:
  - 1970s average: 1.7 percent of global GDP per year (or US$109 billion).  
  - 2000s average: more than 10 percent of global GDP; peaked at 20 percent on the eve of the crisis in 2007 ($11.4 trillion).  
  - Capital flows declined sharply in 2007–08, then recovered and oscillated; by 2014 flows to EMDCs had approached pre-crisis levels in dollar terms.
- Global external liabilities:
  - Grew from 30 percent of global GDP ($3½ trillion) in 1980 to 166 percent ($120 trillion) in 2011.
- Contextual notes on capital account liberalization:
  - Capital flows increased more than 25-fold between 1980 and 2007, compared to an eight-fold expansion in global trade.
  - Under appropriate conditions (financial and institutional development, sound prudential frameworks), capital flow liberalization can provide macroeconomic and microeconomic benefits, but full liberalization is not necessarily the goal for all countries at all times.

*Source: _022216b - Section 2(a), which prohibits members, without Fund approval, from imposing restrictions on the making of (PDF).*

### 24.      Increased financial globalization has also provided an impetus to cross-border credit—

### _022216b - 24.      Increased financial globalization has also provided an impetus to cross-border credit—

### Financial globalization, cross-border credit, and domestic lending
- Increased financial globalization spurred cross-border credit—much of it in U.S. dollars—and domestic lending, contributing to asset price booms in numerous countries.
- The expansion of cross-border liabilities to EMDCs was accompanied by a significant rise in domestic credit over the past decade; the rise in cross-border liabilities and domestic credit was particularly significant in Asia.
- Cross-border liability data is only available from 1995.

### Synchronization and amplitude of financial cycles
- Countries’ financial cycles appear to have synchronized.
- The length and amplitude of the US financial cycle—proxied by the path of the credit to GDP ratio—have increased markedly since the mid-1980s, partly reflecting financial deregulation.
- While the cycles of some countries (such as the UK and Australia) have been highly correlated with the US cycle for decades, this pattern extended to most other AEs since the crisis, with correlation coefficients exceeding 0.9 for many countries.
- Among EMDCs, the domestic financial cycles in India and South Africa have become increasingly correlated with the US cycle; China’s financial cycle remains disconnected.
- The increased global synchronization is seen not only in credit gaps but also in the rise in the correlations of a wide range of financial assets since the crisis:
  - A marked increase in these correlations, from a median correlation coefficient just above 0.4 to 0.7, is documented.

- Box 1 (Financial Cycles) key technical detail:
  - Financial cycles can be represented through credit gaps derived by filtering the private sector credit-to-GDP ratio.
  - This is calculated by applying a Hodrick-Prescott filter with a smoothing parameter (lambda) of 400,000.

### Capital flows and the financial cycle
- Since around 1990, cyclical surges and troughs of capital flows seem to have moved in tandem with the financial cycle, mirroring its rising amplitude over the past decade.
- In the 1970s and 1980s, the relationship between the US financial cycle and the cycle of global capital inflows was weak; deregulation and financial globalization likely contributed to increasing synchronization since then.
- Both the financial cycle and the cycle of global capital inflows peaked in the run-up to the crisis and have since turned; the declining pace of global capital inflows compared to the pre-crisis period is largely driven by the slowdown of flows among AEs.

### Nonbanks, changing intermediation, and systemic risks
- With financial globalization and the evolution of regulation, nonbanks have grown in importance—in AEs as well as EMDCs—particularly in the provision of debt finance.
- Before the crisis, the banking sector intermediated well over half of cross-border liabilities, yet by 2014 nonbanks were an equal—if not larger—player.
- Nonbanks do not take deposits and are subject to different regulation from traditional banks; they include insurance companies, traditional asset managers, money market funds, and hedge funds, with differing risk features depending on leverage, dependence on short-term funding, or holdings of illiquid assets.
- The shift of private borrowing from banks to less regulated nonbanks may generate new risks in the system.

### Weak global adjustment mechanisms and evolving global imbalances
- Global current account imbalances have narrowed since the crisis and become more dispersed:
  - Imbalances peaked at just over 5 percent of global GDP in 2006–08, narrowed, and remained around 3 percent of global GDP in 2014.
- The reduced concentration of imbalances lowered the risk of a sudden reversal among a few large economies but raised concerns about the build-up of imbalances in a number of smaller countries; EMDCs would be particularly vulnerable given potential financing constraints.
- Fund estimates indicate the sum of actual current account imbalances for larger countries exceeded the level implied by fundamentals and desired policies by around 1.2 percent of global GDP in 2014.
- The post-crisis adjustment was largely achieved through demand compression in deficit countries and faster recovery in EMDCs and commodity exporters; the lack of demand adjustment in many surplus countries tilted the burden of adjustment to deficit countries and was contractionary, especially where countries were at the zero lower bound.

### Exchange rates and their limited role in post-crisis adjustment
- Real exchange rate movements appear to have played a limited role in the adjustment process; a number of countries experienced limited or perverse movements in their REERs during the post-crisis period.
- Historical estimate (1980–2014): a 10 percent depreciation of a country’s REER led on average to a 1.5 percent increase in real net exports, although in some cases the impact occurred with a lag.
- Examples cited:
  - From 2011–14 China’s current account surplus remained at about 1-2 percent of GDP despite a 16 percent real appreciation.
  - Germany’s current account surplus rose from 6 to 7½ percent of GDP during this period, despite a stable REER.
  - Japan’s current account surplus declined 1½ percent of GDP despite a 26 percent real depreciation.
- Possible explanations for the limited role of REERs include the global nature of the shock (safe haven effects), institutional factors (e.g., limited REER adjustment in the euro area), and a softening of the relationship between real exchange rates and trade flows in economies integrated in global value chains.
- Empirical notes:
  - Panel regressions indicate that aggregate demand explains about 30 percent of the reduction in global external imbalances, and the REER has had no impact.
  - Cross-sectional/regression fit indicators shown include R^2 = 0.17 and R^2 = 0.19 in related analyses of REERs and current account changes.

### Constrained domestic policy choices and international spillovers
- Growing financial interconnectedness, the size of the U.S. economy, and the central role of the dollar mean that U.S. monetary and financial conditions migrate more easily to the rest of the world; shocks are transmitted through interest rates, capital flows, and asset prices.
- Transmission can create challenges to economic and financial stability:
  - In open economies, capital inflows can appreciate exchange rates and increase financial sector risks.
  - In countries with fixed or heavily managed exchange rates, capital inflows may lead to reserve accumulation, expansion in domestic liquidity, and pressure on domestic asset prices and credit growth.
- Recent research suggests that in economies with floating exchange rate regimes, exchange rate flexibility may not fully insulate countries’ monetary policies from global financial shocks, especially when asset prices are highly correlated across borders.
- Even in floating regimes, the rise in asset values has a procyclical effect on domestic borrowing and asset markets; ignoring large exchange rate movements could be costly.
- The confluence of structural shifts—less concentrated but still material global imbalances, lack of global oversight of capital flows, central role of one or two reserve currencies, and growing nonbank financial intermediation—raises tensions and risks:
  - Periodic episodes of high capital flow volatility appear to have become a feature of the new global landscape, contributing to financial pressures and balance-sheet mismatches, particularly in EMDCs.
  - The build-up of financial risks, particularly in nonbank financial institutions, has highlighted gaps in the oversight of the global financial system.
  - During periods of stress, liquidity shocks could lead to systemic risks and the more fragmented GFSN could make it difficult to support countries.

*Source: _022216b (IMF chapter/section content provided in the supplied PDF excerpt).*

### 35.      In such an environment, the trade-off between macro stabilization and financial

### _022216b - 35.      In such an environment, the trade-off between macro stabilization and financial

### Trade-off between macro stabilization and financial stability
- Financial and monetary conditions migrating easily across countries reduce central banks’ ability to influence domestic interest rates independently of US yields.
- Exchange rate regime remains central to available policy responses, but monetary policy is more constrained by imported financial conditions, complicating macroprudential management.
- Interest rate hikes to address overheating may attract additional capital inflows, particularly when those flows have driven credit growth, creating a difficult policy trade-off among multiple objectives.
- When exchange rate movements risk amplifying shocks, foreign exchange intervention within a broader policy package can help counter disorderly market conditions, provided that reserves are adequate.

### Use and effectiveness of capital flow management measures (CFMs)
- Some countries introduced CFMs; evidence suggests inflow CFMs may have been more successful when focused on financial stability or changing the composition of capital flows, rather than when seeking to influence the volume of capital flows to reduce exchange market pressure.
- The Fund’s Institutional View: when capital flows contribute to systemic financial risks, measures that are both CFMs and macroprudential can help safeguard financial stability.
- CFMs can be useful in circumstances such as:
  - limited scope to adjust macroeconomic policies in the short term;
  - when policy measures will take time to deliver results;
  - surges of inflows raising risk of financial instability.
- CFMs can also impose costs, including:
  - reduced discipline in financial markets and public finances;
  - tightened financing constraints by restricting availability of foreign capital;
  - limited residents’ options for diversifying assets;
  - monitoring and enforcement costs, rent-seeking, corruption, financial repression, and distortion of capital allocation.
- There is limited knowledge on which CFMs are most effective, when benefits outweigh costs, and the cross-border coordination challenges among recipient and source countries in systemic shocks.

### International cooperation and the IMS
- Shifts in integration and their implications for the IMS increase the importance of effective international cooperation.
- Policies by individual countries are often at arm’s length from the end goal of system-wide stability; international cooperation during the global financial crisis occurred but there is scope for more.

### Systemic risks from capital flows and regulatory gaps
- Financial globalization, complex financial structures, rapid expansion of balance sheets, and high cross-border exposures increase the risk that surges in capital inflows/outflows will trigger financial crises.
- Gross external asset and liability positions have significantly increased over the past two decades and their composition has transformed; cross-border borrowing by banks and corporates has become a more important source of funding in EMDCs and associated with increases in domestic credit.
- These shifts contributed to balance sheet mismatches and migration of activity into nonbanking sectors in both AEs and EMDCs.
- Synchronized financial cycles mean cross-border shocks can have significant implications for mismatched balance sheets and financial stability; EMDCs with pegged exchange rates or very open markets are especially exposed to shifts in global sentiment and sudden stops.

### Transmission and contagion
- Increased gross exposures can transmit shocks even when net positions are contained; underlying gross flows created stock positions that generated large-scale contagion risks through valuation effects and network knock-on effects.

### Partial global financial regulation and uneven implementation
- Regulatory reforms since the crisis have strengthened banks and improved coordination, including implementing Basel III elements, improving capital and liquidity positions.
- Uneven implementation of Basel III across systemic economies (notably the US and within the EU) could limit global stability benefits and lead to regulatory arbitrage.
- Lack of supranational regulatory coordination allows circumvention of local regulations.
- Further action is needed in many jurisdictions to ease resolution of large, complex firms to contain spillovers and limit moral hazard.

### Risks from expansion of nonbank financial sector
- Progress in expanding the prudential regulatory perimeter to encompass nonbanks has been slower; shadow banking regulation is being stepped up in financial centers, and the FSB has increased its monitoring of shadow banks.
- Shift of private borrowing from banks to nonbanks may enhance efficiency but some entities are highly leveraged or hold illiquid assets; during the global crisis they were vulnerable to runs and fire sales that intensified turmoil.
- In AEs, risks include rapid growth of leveraged hedge funds and open-ended mutual funds with large holdings of less liquid assets.
- In EMDCs, surge in nonbank corporate borrowing can boost growth but also fuel excessive corporate leverage or foreign exchange mismatches.

### Global liquidity, GFSN adequacy, and vulnerabilities
- Booms and busts in global liquidity have disrupted the IMS; the evaporation of liquidity in European U.S. dollar funding markets during the crisis led the Federal Reserve to extend emergency swap lines.
- Concerns include excess global liquidity (spillovers from unconventional monetary policies) and resurfacing risks of liquidity shortages tied to events such as China’s rebalancing, the collapse in the commodity supercycle, and anticipated monetary policy normalization in some AEs.
- The adequacy and resilience of global liquidity remain key challenges, with potential for vulnerabilities including high leverage, mismatches in currencies and maturities, weak underwriting standards, and misallocation of investment.

### Global Financial Safety Net (GFSN) components — strengths and weaknesses
- GFSN resources have grown since the crisis—mostly reflecting reserve accumulation—but external liabilities have expanded rapidly, raising the probability of systemic risks from synchronized unwinding of external positions.
- In a systemic event with resident flight, needs could exceed collective resources available from the Fund, international reserves, and RFAs.
- Components and characteristics:
  - Reserves:
    - Official reserves dominate GFSN resources as the first line of defense, though doubts exist about countries’ ability/willingness to run them down.
    - Accumulating and holding reserves is costly for individual countries and globally, and reserve accumulation in EMs slowed since 2008.
    - Considerations for appropriate reserve levels and costs are discussed in the Fund’s work on Assessing Reserve Adequacy.
  - Bilateral Swap Lines (BSLs):
    - Typically cover very short-term foreign exchange funding needs and provided critical liquidity during the crisis.
    - Many post-crisis lines granted by the US Federal Reserve were targeted at US dollar shortages in the financial sector of mostly AEs and have since expired.
    - China expanded swap lines in renminbi, “equivalent to about US$500 billion,” reflecting domestic objectives and trade facilitation; BSLs involving non-reserve currencies have been growing.
  - Regional Financing Arrangements (RFAs):
    - Number of RFAs increased since the crisis (e.g., Eurasian Fund for Stabilization and Development, European Stability Mechanism, BRICs Contingent Reserve Arrangement).
    - RFAs are heterogeneous with large variations in resource availability and less predictable access; some provide precautionary insurance (e.g., BRICs), others emphasize lending instruments (e.g., ESM).
    - Local ownership and tailoring increase appeal and may reduce stigma relative to the Fund, but most RFAs have limited lending capacity compared with potential needs; their lending capacity is more aligned with smaller members’ needs.
  - IMF:
    - The Fund is the near-universal element of the safety net with the widest array of insurance (e.g., FCL, PLL arrangements, SBAs treated as precautionary) and financing instruments to meet members’ balance of payments needs.
    - Fund financing can be relatively slow in a crisis due to program-related condition discussions; arrangements are largely time-bound and require approval for successive arrangements.
    - FCL and to some extent PLL have been used principally as contingent liquidity support for crisis prevention, constituting credit lines for countries meeting qualification criteria; traditional instruments like the SBA involve ex post conditionality for countries facing balance of payments pressures.

### Key uncertainties and knowledge gaps
- Limited knowledge on which CFMs are most effective and when their benefits outweigh costs.
- Challenges from cross-border coordination (or lack thereof) of CFMs among recipient countries and between source and recipient countries during systemic shocks.
- Need for further action to improve resolution frameworks for large, complex firms and to expand prudential regulation to rapidly growing nonbank sectors.

*Source: Excerpt from IMF chapter “STRENGTHENING THE IMS” (pages 22–29).*

### 48.      Some countries remain reluctant to seek financial support from the Fund early. They

### Some countries remain reluctant to seek financial support from the Fund early.

### Reluctance, stigma, and conditionality
- Some countries take longer to approach the Fund when hit by a shock, or to seek support from RFAs that require a Fund-supported program or some other involvement by the Fund.
- Causes of delayed engagement:
  - Stigma partly due to the lingering effects of past financial engagements and partly to Fund conditionality (which, at times, has been viewed as onerous).
  - Political sensitivities can link directly to stigma (the 2014 Review of the FCL, PLL, and RFI found political sensitivities to be a factor).
  - Countries’ unwillingness to adjust.
- Contrast in perceptions:
  - Some countries see Fund programs as a signal of strength (example: Mexico) and use these to undertake successful reforms.
- Role of conditionality:
  - Conditionality—whether ex ante (as in the FCL and PLL) or ex post (as in other arrangements)—is to facilitate adjustment where necessary, and mitigate any risk of moral hazard associated with Fund lending by providing incentives for good policies.
- Policy challenge:
  - Move the perception of Fund programs from stigma to a signal of strength.

### Fragmentation of the Global Financial Safety Net (GFSN)
- Fragmentation has increased over time and is a key concern.
- Drivers of fragmentation:
  - Evolving GFSN network in a relatively uncoordinated way.
  - Fund stigma and to some extent its failure to deliver quickly have contributed to fragmentation.
  - Major EMDCs tend to be underinsured by RFAs given the risk of region-wide shocks and reflecting the fact that they tend to be the suppliers of liquidity in the pool.
  - Cooperation between different elements of the safety net has not yet been thoroughly tested; cooperation between the Fund and RFAs in providing financial support has been generally limited to Europe.
- Risks from fragmentation:
  - Continued fragmentation would reduce effectiveness in addressing global systemic shocks and leave some countries vulnerable (e.g., “innocent by-standers” including those outside RFAs).
- Suggested mitigation:
  - Continue to grant EMDCs greater voice in the institutions that govern the IMS to reduce the stigma associated with using Fund resources.

### Experience with cooperation between the Fund and the European RFAs (Box 3) — key findings
- Recent crises in Europe involved close cooperation between the Fund and EU institutions on program design and financing.
- Countries and modalities:
  - Programs with the four eurozone countries: Cyprus, Greece, Ireland, and Portugal involved Fund collaboration with the European Commission (EC) and the European Central Bank (ECB) in the “so called Troika” arrangement.
  - Programs with EU member states outside the EZ (Hungary, Latvia, and Romania) involved cooperation with the EC.
  - Countries requested financial assistance simultaneously from the Fund and EU institutions.
  - The Fund provided most of the financing in some countries (Hungary and Romania).
  - Most official financing came under the European Stability Mechanism (ESM), while the ECB provided substantial liquidity to euro area financial institutions.
- Division of roles in program design:
  - Cooperation on program design and conditionality reflected each institution’s mandate and comparative advantage, leading to coherent programs.
  - The Fund generally played a greater role in the design of the macro framework and the assessment of debt sustainability.
  - The EC took the lead on structural issues and the assessment of fiscal targets, ensuring consistency with EU-wide rules and institutions.
- Implementation and risks:
  - Program parameters were set in the Memorandum of Economic and Financial Policies (MEFP) of the Fund and the Memorandum of Understanding (MoU) of the EC.
  - MoUs generally added conditions, some outside the Fund’s core area, possibly increasing strain on authorities’ implementation capacity.
  - EU institutions’ regional commitments could have limited at times the room for maneuver for policy design.
  - Despite these issues, coordination generally resulted in a unified and consistent set of macroeconomic and structural parameters.
- Lessons:
  - Need to deepen cooperation with regional partners while preserving clear roles reflective of respective mandates.
  - Access to additional funding from RFAs alleviated financing constraints, allowing for more gradual approaches compared to previous crises—with large financing compensating for slower adjustment.
  - Lack of an overarching framework for cooperation allowed flexibility but carries risks for coherence of program conditionality.
  - Important that cooperation continue in accordance with the Fund’s mandate, legal framework, policies and procedures.

### Challenges in the evolving global context
- Structural and cyclical factors:
  - Legacy of slow post-crisis growth in AEs is expected to continue for some time.
  - China embarked on an ambitious multi-year rebalancing of its economy, toward slower, but sustainable growth.
  - Supply and demand factors suggest that the fall in commodity prices is likely to stay for a sustained period.
  - Asynchronous monetary policy normalization could add further challenges to EMDCs with dollar exposures, while raising the potential for increased exchange rate volatility.
  - Shocks of a non-economic origin—such as refugee flows triggered by geopolitical conflicts and global epidemics—affect some countries and regions and, if left unchecked, could have significant spillover effects on the global economy.

### The way forward — three key areas for strengthening the IMS
- Overarching aim:
  - Strengthen global mechanisms for adjustment and liquidity provision so EMDCs can run modest current account deficits without the need for increasing self-insurance, and manage risks associated with interconnectedness and openness.
- (i) Mechanisms for crisis prevention and adjustment:
  - Strengthen policy frameworks in EMDCs (including through CFMs and macroprudential measures) to enhance resilience to large capital flow pressures.
  - Discourage excessive leverage that strains balance sheets (e.g., promote longer-term equity based financing and/or develop financial instruments that allow risk-sharing with the private sector and across countries).
  - Ensure an equitable burden of adjustment across countries (e.g., surplus/deficit, source/recipient of capital flows).
  - Continue efforts to strengthen prudential regulation and supervision of systemic risks in rapidly growing shadow banking intermediation.
- (ii) Enhanced global cooperation on issues and policies affecting global stability:
  - Countries should commit to consider the impact of their policies on the rest of the world.
  - Greater cooperation is needed on capital flow management and financial regulation as integration and potential spillovers increase.
- (iii) A large enough and more coherent GFSN:
  - Further diagnostic work is critical to define the precise nature of underlying problems in the GFSN.
  - Options for reform may need to consider ensuring liquidity support during systemic events, and effective cooperation among different layers of the GFSN to limit contagion to innocent by-standers.
  - Some form of monitoring or policy signaling by the IMF could facilitate cooperation, allow creditors to rely on the Fund’s expertise, and reduce moral hazard in the system more generally.

### Follow-up work and concrete next steps
- Capital flow management and foreign exchange intervention:
  - By late 2016, staff plans to take stock of the implementation of policies on the liberalization and management of capital flows.
  - CFMs and FX intervention-related issues will be analyzed as part of staff’s work developing an integrated view on the use of policy tools (e.g., monetary policy, FX intervention, regulatory measures) to respond to exchange rate, liquidity, inflation and balance sheet pressures.
  - Depending on the outcome, staff could undertake further work on capital flow management measures and foreign exchange intervention.
- Global Financial Safety Net:
  - An informal Board discussion on the Adequacy of the Global Financial Safety Net will seek to build consensus around a common diagnosis of the GFSN, providing a basis for staff to develop reform proposals with detailed assessments of costs and benefits.
  - A forthcoming paper on the Adequacy of Fund Resources: Initial Considerations will assess whether Fund resources are sufficient for it to effectively play its central role in the GFSN and meet members’ financing needs in a changing world.
  - Follow-up discussions will cover the future of the 2012 Borrowing Agreements and Review of Borrowing Guidelines and the need to renew the NAB.
- Role of the SDR:
  - Following the recent inclusion of the renminbi in the SDR basket, many parts of the membership are interested in discussing enhancing the role of the SDR; staff will return to this in due course.

### Issues for discussion (questions posed to Directors)
- In view of ongoing changes in the global economic and financial environment, how do you view the strategic importance of the Fund exploring options to continue strengthening the IMS?
- What are the most critical problems or gaps in the current functioning of the IMS?
- How can the Fund facilitate financial deepening in emerging markets and developing countries?
- How can the Fund best help maximize the benefits, and safeguard against potential risks, from cross-border capital flows?
- What do you see as the Fund’s role, as the global pillar, in promoting the effectiveness of the overall GFSN?
- What are the priority reform areas?

*Source: Excerpt from IMF PDF chapter/section titled “STRENGTHENING THE IMS” (paragraphs 48–54, Box 3).*

### References

### References

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*Source: _022216b - References*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2016/_022216b.pdf_