Speech

ADB Seminar Series
Naoyuki Shinohara, Deputy Managing Director
International Monetary Fund
Tashkent, Uzbekistan
May 2, 2010

As prepared for delivery

1. Thank you for inviting me to speak with you today.

The Issues

2. Perhaps I should start by defining what we mean by the global or international monetary system (IMS). The IMS can be defined as the official arrangements governing balance of payments transactions—namely, exchange rates, reserve policies, and policies governing current and financial transactions.

3. The recent financial crisis—with its origins at the core of the global financial and monetary system—spread rapidly to all parts of the world economy, causing severe disruption far from the epicenter. Seemingly paradoxically, the dollar strengthened and capital flowed into the U.S., not away, as one might have expected for an economy in the midst of a financial crisis. This paradox points to a central feature of the IMS, namely, the use of a narrow set of national currencies in international trade and asset transactions. A liquidity crisis, and the subsequent flight to safety, results in an increase in the demand for reserve currencies.

4. The international monetary system faces many challenges.

• First, global economic imbalances have prevailed for long periods of time with no automatic mechanism of adjustment. When adjustment occurs, it tends to fall more heavily on deficit, non reserve issuing countries, rather than on surplus countries or reserve issuing deficit countries.
• Second, the uneven availability of liquidity reflects volatile capital flows and a heavy reliance on a handful of reserve assets. This reliance implies that shocks emanating from the “core” transmit instantly and rapidly to the rest of the world.

5. These problems in the IMS are reflected in the rapid buildup of foreign exchange reserves across countries, reaching 13 percent of global GDP today, a three-fold increase over ten years ago. For most emerging markets, reserve coverage far exceeds traditional norms, reaching 10 months of imports and 475 percent of short-term external debt in 2008. Reserves are concentrated in a handful of countries, most of which are in Asia.

What are the prospects for reform?

6. Addressing the imperfections of the IMS requires finding durable solutions on the “demand side” for reserves as well as on the “supply side.”

7. On the demand side, the rise in reserves reflects (i) a precautionary motive, given the vagaries of international capital flows; (ii) a non-precautionary motive, primarily the consequences of an export-led growth strategy, and (iii) structural reasons, such as inter-generational smoothing due to commodity booms or demographics. Accumulating reserves is costly—consumption and investment are foregone as a part of national savings are invested in safe, low-yielding international assets. Since reserve accumulation for structural reasons is generally advisable, I shall focus on the first two issues.

8. Reforms to mitigate the demand for precautionary reserves (or self insurance) could include:

• The development of guidelines on desirable ranges of precautionary reserve levels given country circumstances. Countries could agree to align their reserve accumulation policies to these guidelines over time.
• Strengthened surveillance of capital flows. This could include the provision of information on cross-border flows and exposures, which would enhance understanding of the volatility of capital flows and of the measures to address them, possibly within a multilateral framework.
• Improved financial safety net. The IMF could provide stronger insurance facilities, support regional financial arrangements, and develop an instrument for systemic crises that delivers short-term liquidity quickly and simultaneously to several countries.

• Last year’s major reform of IMF’s lending instruments introduced the Flexible Credit Line (FCL) for countries with very strong fundamentals. At a Board discussion in April on the future financing role of the IMF, one suggestion was to refine the FCL by extending its duration, increasing the predictability of qualification, and removing the informal cap on access amounts.
• The IMF Board also considered the adaptation of the existing precautionary arrangement into a more attractive Precautionary Credit Line (PCL) targeted at countries with sound policies but which do not qualify for the FCL.
• Development of a multi-country swap line (MSL) mechanism to enable the IMF to offer liquidity lines to a limited set of countries with sound policies and track record could also help to stem contagion from a systemic shock.

9. To address non-precautionary reserves demand:

• Strengthen peer pressure. One approach would be a multilateral framework of understandings among members to implement policy adjustments for the effective operation of the IMS. The G-20 mutual assessment process is a step in this direction.
• Foster a multilateral dialogue to limit foreign exchange market intervention and to encourage more flexible exchange rate regimes. In parallel, steps could be taken to strengthen the global reserve system, such as through enhancing the role of the SDR.
• Finally, a system of penalties, such as a reserve requirement on “excess” reserves or a tax on persistent current account imbalances beyond a certain threshold could be considered. But this may be impractical as penalties have a particularly poor history of implementation.

10. On the supply side, a diversification of reserve assets would naturally reduce individual country exposure to risks stemming from any single country. A more multi-polar reserve system is likely to develop over time, but in the near term there are no clear contenders to match the depth and liquidity of the U.S. dollar markets. More widespread use of alternative reserve assets, euro or yen or renminbi denominated, say, could be encouraged.

11. While a multi-polar system may not enjoy the benefits of broad use of a single reserve asset, the presence of alternatives provides a safety valve from unsound policies of any single reserve issuer. To encourage an orderly transition to a more diversified system, reserve holders may need to adjust portfolios only gradually, with mechanisms for collaboration to bolster the stability of the adjustment process (e.g. reporting on currency composition).

12. Another option could be to seek a more prominent role for the Special Drawing Right (SDR). With a value determined in terms of a basket, the SDR diversifies the currency and interest rate risks of its constituent parts. Thus, it has a more stable store of value and unit of account attributes. Moving to a more SDR-based system would require:

• Increased supply. E.g. large, regular emissions of SDRs, which currently constitute less than 4 percent of the global reserves stock. Targeted emissions to emerging markets might also be considered, although this would require an amendment of the IMF’s Articles of Agreement.
• Greater liquidity. The SDR market would need to be deepened. A reconstitution requirement could support this objective.
• Transparent, automatic rules for determination of the currency composition of the SDR basket, which are essential for wider private sector use
.
• In addition, issuance by governments of SDR-denominated bonds or activation of a substitution account could promote the use of the SDR basket.

13. In principle, a new global currency—“bancor”, in honor of Keynes who proposed such a solution—issued by a global central bank, with robust governance and institutional features, could provide a nominal anchor and risk-free asset for the system independent of national currencies. The global central bank could also serve as a lender of last resort. But any such step requires considerably more debate on its merits and feasibility.

In Conclusion

14. The current IMS has many benefits. Discretion in the choice of exchange rates, reserves policies, and policies on capital flows have given countries important instruments to help achieve domestic policy objectives, while underpinning a large expansion in global trade and global output. But it has its imperfections, such as the absence of automatic adjustment to imbalances and uneven provision of liquidity caused by volatile capital flows. These imperfections have been reflected in rapid reserve accumulation in recent years, concentrated on a narrow supply of assets.

15. A number of steps can be taken to strengthen the IMS, including better surveillance of capital flows, an improved global financial safety net, peer pressure, more flexible exchange rate regimes, and an enhanced role for the SDR. Of course, governance reform of the IMF remains a critical pre-requisite for the IMF to play an effective role in reforming the IMS.

16. Thank you very much.