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In the context of economic uncertainty and the quickly materializing risk of a worldwide double-dip recession, it is a challenging task for the Council to find the right balance between addressing the short-term issues while developing a long-term narrative for the reform of the International Monetary System (IMS).
The Council prioritized the most pressing issues on the IMS agenda and focused on developing recommendations to address them. The Council’s analysis contributed to discussions with other Councils within the network to further develop multi-stakeholder solutions. Among the top priorities the Council singled out the analysis of the G20 policy-making processes and the role of international institutions to strengthen the IMS, as well as the rise of regionalism and its implications for the IMS.
In 2011, the World Economic Forum launched the “Euro, Dollar, Yuan Uncertainties” initiative, aiming to help stakeholders to better understand how these uncertainties may play out, what forces could bring about significant change, and how stakeholders can prepare for plausible, yet challenging, alternative scenarios. Members of the Global Agenda Council on the International Monetary System contributed to this project by analyzing some of the key uncertainties influencing the IMS – governance structures, capital markets, and economic growth prospects. The final report of the “Euro, Dollar, Yuan Uncertainties” initiative was launched in June 2012, and is available here:
Members of the Council engaged in a number of cross-council and multi-stakeholder deliberations. The Council provided its recommendations to the B20 taskforce group on Financing Growth and Development, highlighting the need to encourage financial inclusion and the finance of trade. The Council also collaborated with the Global Agenda Council on Fiscal Crises focusing on solutions for resolving the Eurozone crisis. Guillermo Ortiz, Chair of the Council, and Mario Blejer published an op-ed analyzing the lessons for the Eurozone crises from the sovereign debt crises in Latin America (http://www.economist.com/node/21547750).
Global Economic Outlook and the G20 agenda
The reform of the IMS was a top priority during the French presidency of the G20, the present crisis highlighting the extreme vulnerability of the current working arrangements. Although the epicentre of the crisis was the financial system of developed markets, the crisis brought to light two undeniable realities. First, the interconnectedness of financial systems across the world accelerates the transmission of financial shocks to the real economy. Second, the long-standing vulnerabilities of the system have become much more evident, including issues such as: the asymmetry in the adjustment process between debtor and creditor countries; global liquidity provision; and financial excesses, destabilizing capital flows, and the accumulation of international reserves for the purpose of self-insurance.
The G20 was created as a mechanism for dialogue between finance ministers and central bank governors after the Asian crisis of 1999. Following the 2008 global financial crisis, the meetings were given an executive dimension and began to be led by heads of state or government. This shift was initially a success. With the first meetings in London and Pittsburgh in 2009, important agreements were achieved, including the coordination of macroeconomic programs for stimulus, financial and macro-prudential regulation, and the start of governance reforms to the International Monetary Fund (IMF) and the World Bank (WB). However such meetings now provide diminishing returns and have contributed little recently to solving the structural problems of the world economy.
Despite the ambitions of the French presidency of the G20, the reform of the IMS and other long-term matters were eclipsed by much more pressing issues. The Cannes meeting of the G20 held in November 2011 was dominated by discussions regarding the Eurozone, and although the communiqué does make some reference to the reforms of the IMS, no real progress was achieved.
Perhaps the most important conclusion from the Cannes meeting was the confirmation that the rest of the world considers that the European financial crisis was not caused by a lack of resources, but rather is a political and institutional problem that Europeans need to solve on their own. It became clear that any involvement of the IMF or contributions from non-European countries would dependent on a much greater effort on the part of Europe to solve its own problems. It is an important conclusion, but the G20 was created with a more far-reaching purpose and is confronted now with the legacy of the 2008 financial crisis, which has morphed into a global fiscal crisis that is engulfing all developed markets. The role of the G20 is not only to respond in the short-run to current crises facing the world economy, but also to lay the groundwork for, and create the fundamental underpinnings of, long-term global economic stability and a more equitable distribution of the benefits of globalization. If no new and tangible developments are achieved, the G20 meetings will soon lose their relevance.
This leads to our next question – what should the agenda be for the next G20 meeting in Mexico in June 2012? The obvious risk is that substantive discussions on the reform of the IMS will again be pushed onto the back burner. It must be acknowledged that the political and economic environment for this meeting looks rather unfavourable.
On the political front, important members of the G20 face general elections in 2012, a situation prejudicial to an effective preparation of the agenda and which reduces the scope for agreeing long-term commitments. Mexico, the host country, will hold presidential and legislative elections on 1 July 2012, and the date proposed by the Mexican government for the heads of state and government meeting, 10 days before the election and just seven months after the Cannes meeting, was primarily driven by domestic political considerations. Russia and France will be represented by their new presidents, elected on 4 and 6 May 2012 respectively. However, the United States and China will change leadership at the end of 2012 or early 2013 and, consequently, will be represented at the G20 meeting by potentially preoccupied governments. The counterpart to this unfortunate situation is that the G20 meeting to be held in 2013 – likely after the German elections of September-October – will bring together recently elected heads of state and government in most of the important countries of the group and, probably, will represent a better window of opportunity for a reform of the IMS (if adequately prepared for between now and then).
On the economic front, the salient issues are broadly the same. The need for action on the long-standing areas of concern (e.g., international imbalances and the adjustment mechanism) is even more urgent. However, levels of risk-aversion are extremely high today due to the uncertainty in the Eurozone and the possibility of a breakdown of the euro system. The fiscal crisis in developed markets and the measures that are being taken to correct it has resulted in a further fall in domestic demand. The prospects for growth in developed markets look gloomy for the next few years. Furthermore, countries in surplus are failing to stimulate sufficient domestic consumption (e.g., China maintains an undervalued exchange rate, Germany is experiencing fiscal retrenchment, and Japan continues to carry high debt). The question therefore remains as to how to work our way out of the debacle of a continued shortfall in aggregate demand and increasingly severe fiscal retrenchment across the globe.
Given the political and economic environment of the Mexico G20 meeting, the Council explicitly divided its focus and recommendations between short- and medium-term problems. The Council’s short-term analysis centres on the European conundrum and the US stalemate, framed in the context of a discussion of the global adjustment. Medium-term issues include the already well-known questions relevant to the IMS reforms that were addressed in the original G20 French agenda and the Palais Royal Initiative. The fact that the 2012 G20 meeting will take place in a Latin American country for the first time brings an opportunity to compare regional experiences in managing short-term debt-imposed adjustment policies alongside medium-term growth-enhancing reforms, a crucial issue in Europe today and for the years to come.
1. International Imbalances and the Adjustment Mechanism: the Short-Run Dilemmas
Instead of moving towards a multiple-currency system following the mainstream view, the world is settling into a de facto “dollar by default” arrangement because the euro is in danger, the yen is compromised by Japan’s fiscal situation, and the role of the renminbi is constrained by its lack of convertibility and the gradual pace mindset of the Chinese leadership. Other international imbalances, such as asymmetric growth in different regions of the world, are also likely to persist for much longer.
In many ways, the world economy is now in a situation similar to that of 2008-2009, although the scope for stimulus is much smaller. Thus, the G20 should return to its initial objective: the coordination of national macroeconomic policies in order to achieve proper management of the world aggregate demand and global financial stability.
At the G20 meeting in Korea, some progress was made regarding the definition of the Indicative Guidelines, which provided a basis for the peer review exercises. World leaders recognized that in order to adjust international imbalances without causing a collapse of global demand, there must be some symmetry between the adjustment process of deficit and surplus countries. Unfortunately the opposition of China, Germany and, to a lesser extent, Japan, stalled any further progress on that matter. The priority now should be to concentrate again on the imbalances issue.
The world economy is at a precarious tipping point, with a very real risk of recession in many countries. The major economies that account for around 70% of global GDP are facing problems of stagnation in a synchronized way, although for different reasons.
Despite the crisis, the United States remains the world economy with the greatest structural strengths. However, its aggregate demand fundamentals are damaged. While consumption represents around 70% of aggregate demand, households are immersed in a process of deleveraging that will take several years to complete. Moreover, in 2012 the economy will likely suffer from modest “fiscal drag” as some tax exemptions have been extended. In addition, demand for exports suffers from, among other things, the Chinese system of exchange rate management. In spite of a significant financial surplus in the industrial sector, investment is low due to the negative demand outlook. Although recent data show a welcome recovery of output and employment in the manufacturing sectors, growth prospects remain low for the US economy.
Europe faces more complex problems than the US. Household indebtedness is less of an issue, but the weak institutional architecture of the monetary union, as evidenced by the crisis, and the perverse interrelationship between public debt and the under-capitalization of banks, create challenges of considerable magnitude. While European banks can absorb a significant haircut on the Greek debt, it is proving harder than expected to ring-fence Spain (which has a low debt-to-GDP ratio, but a substantial deficit) and Italy (which has a high debt-to-GDP ratio, but small deficit). What started as a financing problem for Greece, a small country in European Union terms, has turned into a crisis that threatens the whole monetary system. Everyone knows what is fundamentally required in order for the euro to survive: the monetary union needs a fiscal union that supports the issue of Eurobonds; and the ECB needs to act as a lender of last resort to governments. However everybody also agrees that current European institutions are not designed to make such sweeping decisions but can only deal with processes piecemeal. Moreover, the populations of the richest countries – Germany and its periphery, Holland, Luxemburg, and Austria – seem unwilling to enter a fully-fledged fiscal union, and their leaders are reluctant to move ahead of public opinion. While markets typically over-react, European governments have consistently remained behind the curve.
The decisions adopted in the meeting of the 27 heads of state and government of the European Union correctly defined the conditions required for a strengthened fiscal integration and a better economic cooperation. The new treaty, including a requirement for all 17 members of the Eurozone to adopt constitutional measures to balance their budget, should be signed shortly. However, fiscal retrenchment across the Eurozone for ever will hardly by itself improve competitiveness and restore growth. A two-speed Europe will probably slowly emerge: a “Northern Europe”, with Germany and its periphery along with France and Belgium, that could accept and deliver the political and economic commitments required by a true fiscal union; and a “Southern Europe”, for which monetary union would increasingly work like a “currency board”. Countries like Italy, and even more so, Spain, could hardly qualify as members of a fiscal union at this time, and would have to undertake a lengthy process of adjustment. The outlook for the Eurozone is one of political uncertainty, fiscal retrenchment, credit contraction, and sluggish growth. The immediate future seems extremely difficult. The experience of Latin America in successfully combining financial adjustment with structural reforms may be relevant to the European context. These and other lessons were discussed with experts from the Global Agenda Council on Fiscal Crises in Davos in January 2012.
Summing up, building upon the results of the past G20 meetings in Korea and France, the Council believes that the main task for the IMF is to support the G20 process in defining the mechanisms to correct international imbalances that are hindering the growth of global demand.
2. The Reform of the International Monetary System: the Medium-Term Issues
The issues involved in the reform of the IMS are well known and were addressed in particular in the Palais Royal Initiative: absence of effective discipline towards global adjustment in the system; difficulties in managing global liquidity; the volatility of exchange rates; questions surrounding the role of the SDR; and governance issues tied up in the decision making and operation of the system, including the possibilities for regional arrangements. All these issues are central to the definition of an enhanced agenda for the IMF in the medium-term. As discussed above, the international political environment does not seem to allow for any significant breakthrough in these areas in 2012. The challenge for the G20 meeting in Mexico is to set working arrangements that can effectively prepare the ground for decisions to be made in 2013, when reforms may benefit from more political traction.
Discipline towards global adjustment
As indicated above, this issue was initially addressed in the Korea G20 meeting and stalled because of strong opposition by China and Germany. It should be a major area of focus in the Mexico meeting in 2012, in both short- and medium-run perspectives. The IMF should develop and adopt “norms” and “guidelines” for members’ policies consistent with a sound global balance of the world economy. When policies of systematically important countries do not appear to meet these norms, compliance should be reviewed through a special mechanism.
Since monetary policies in developed markets have been very loose, there is ample liquidity in world markets. A few months ago the concern was that this abundant world liquidity would mostly flow to emerging markets, appreciating their currencies and reducing competitiveness. This gave rise to the discussion of the so-called “currency wars”.
Nevertheless, despite ample liquidity in the world, there are growing signs of a pre-Lehman Brothers syndrome in the Eurozone. The interbank market is not working (i.e., the spreads at which banks lend to each other have widened excessively) and most European banks now depend on the ECB for funding. Moreover, US money market funding to European banks has practically ceased. These factors are an inevitable result of the close linkage between the sovereign debt problem and the banking system. The sovereign debt crisis must be resolved first in order to begin to address the other issues, but this process has been stilted by the political dysfunctionality of the European project. Germany, which is in the driver’s seat, is emphasizing austerity and adjustment above all else. This exclusive priority impedes the prospect of an agreement over the involvement of the ECB as well as the role of the EFSF, presenting a crucial obstacle to dealing with the euro crisis.
In addition, contagion has spread well beyond Europe. In the US, the Fed has embarked on a new round of stress testing of the banks, under the scenario of a large-scale recession and the potential consequences of a breakdown of the Eurozone. In addition, political paralysis in the US will exacerbate fiscal contraction in 2012, and the world economy needs the American economy to grow next year. Contagion has also spread across the emerging markets. The market is pricing the probability of a breakdown of the Eurozone and continued economic and political paralysis in the US. Risk premiums are at historical highs, and there is an obvious flight to safety (for example, EM mutual funds have experienced net outflows of US$ 20-US$25 billion to date; a dramatic reversal of net inflows of almost US$ 150 billion in 2009-2010). Commodities, especially gold, remain some of the few safe places to which investors flock today. ‘Safe haven’ sovereign destinations, such as Switzerland or Germany, are sought after with further adverse effects on global financial balances. There has also been a backlash against policymakers and a shift to political extremes in some developed economies, which threatens to throw the world into dangerous territory. In summary, there is a strong need to restore confidence.
In the medium-term, the IMF and the BIS should work together to ensure proper surveillance of global liquidity. Together they should track developments in global liquidity much more closely and be able to play the alert role, which is indispensable.
Exchange rates, capital controls and global capital flows
Due to the overwhelming complexity of the current crisis, the world is now in mere survival mode. The flows to emerging markets have decreased considerably, and outflows to safer markets have increased. The issue of capital controls has become significantly less crucial.
In the medium-term, IMF surveillance mechanisms should include globally consistent norms for exchange rates of systematically important countries. Countries should be expected to refrain from policies that keep or push exchange rates away from those norms. SDRs might appropriately play an enhanced role in the longer-term to reduce the need for building up international self-insurance reserves in emerging countries and to allow the IMF to act as a lender of last resort to governments.
3. Governance of the international monetary system and the rise of regionalism
In the medium-term the IMS needs to adapt to the new circumstances and to the multipolar character of the present world. Such multipolarity manifests through a set of regional arrangements put in place to provide liquidity and surveillance among self-selected countries, for example the Chiang Mai Initiative in Asia, and similar arrangements in Russia, the CIS, and select Latin American countries.
The multipolarity of the monetary system would ensure greater stability of the global economy by diversifying economic risks between a number of leading currencies. Managing this transition and establishing balanced positions for various international currencies by increasing their convertibility, while minimizing volatility, remains a challenge that needs to be addressed.
The recent quota adjustments in the IMF acknowledge the increased influence of emerging countries, mostly at the expense of Europe, but a new round of adjustments seem to be required rather soon. A more structured organization to prepare for the G20, along with an enhanced involvement of the IMF, would be welcomed if the G20 is to evolve from a consultation forum to a decision-making force.
In this context, a global safety net of the main Central Banks (and the BIS), centred around the IMF, could play an important role to ensure smooth provision of liquidity across the different blocks. In an environment where several international currencies may share leadership and are considered close substitutes in global investor portfolios, it is important to preserve the availability of bilateral or multilateral swap lines. Indeed, perceived changes in, for example, the creditworthiness of the issuer of one of the international currencies, could lead to massive portfolio shifts and funding shortages (such as the dollar shortage for banks during 2008) with large associated destabilizing effects for the banking sector.
The benefits of regional arrangements include the capacity of a group of countries to quickly mobilize their resources, as well as to overcome any asymmetric information problems across trading partners. However, on a global scale, regional arrangements limit the possibilities for risk diversification for participating countries. In the case of a common economic shock, which is often regional in nature, a regional insurance scheme would only provide the first line of defence. On a broader scale, sharing a regional monetary arrangement may increase the likelihood of policy coordination on macroeconomic and financial policies across the block.
In the coming term, the Council will focus on an analysis of the challenges and opportunities presented by regional arrangements; on the roles of international and regional institutions; and on exploring the new emerging trends affecting the stability of the IMS.