Since the onset of the global financial crisis of 2007-08, there has been much debate about the reforms that are needed to make the international financial system more resilient to the onset of financial crises through improvements in what has come to be known as the international financial architecture (IFA).
The concept of the IFA refers to the institutional and cooperative arrangements, such as the International Monetary Fund (IMF) and the Financial Stability Board (FSB), which governments have put in place to improve the functioning of the international financial system and to reduce the risk of financial crises.
The two institutions just mentioned represent, in effect, the twin peaks of the IFA.
The IMF exists to monitor developments in the global economic and financial system and the macroeconomic performance and policies of its member countries. It also provides emergency financing to countries facing financial difficulties associated with domestic or international shocks. The FSB was created to oversee the infrastructural aspects of the global financial system, in particular as regards the regulation of financial institutions, but also including, for example, international norms for accounting, corporate governance, deposit insurance and payments systems.
Over time, reforms to the IFA have tended to be driven by the onset of crisis, beginning with the breakdown of the gold exchange standard of the early 1970s, the Latin American debt crises of the 1980s, the Asian financial crisis of the late 1990s, and now the global financial crisis of 2007-08. The purpose of this paper is to examine the reforms that are under way, or should be considered, in the operations of the IMF. These relate to both its review or “surveillance” function and financing activities, as well as its governance structure and broader role in the international monetary system.
The mission of the IMF
The role of the IMF in the international monetary system has evolved in important ways since its inception at the Bretton Woods Conference of 1944. Initially under the “Bretton Woods” system, the IMF was created to oversee the operations of the gold exchange standard in which the value of the U.S. dollar was pegged to gold at an official price of US$35 per ounce, while the currencies of other members of the IMF were pegged to the U.S. dollar at a fixed “par value” that was approved by the IMF, and could only be changed with its concurrence.
Under this system, the United States was expected to provide the international liquidity, or medium of exchange and unit value that were needed for an orderly system of foreign currency transactions to support an expansion of international trade. For its part, the IMF was expected to work with countries to dismantle exchange restrictions and move towards current account convertibility in order to facilitate international payments for goods and services.
With the breakdown of the Bretton Woods system in 1971 as a result of the abandonment of the U.S. dollar’s official peg to gold, the international monetary system moved to a more ad hoc arrangement of fixed and floating exchange rates, according to each country’s preferences and circumstances. In 1978, members of the IMF agreed for the first time that the Fund should exercise oversight of the international monetary system by working with member governments on a bilateral basis to establish a stable system of exchange rates that would facilitate the flow of goods, services and capital and thereby the promotion of global economic growth.
Operationally, the role of the IMF was re-defined in terms of assessing the adequacy and sustainability of the exchange rate arrangement that each member country had chosen within the broader scope of an evaluation of its macroeconomic policy framework and prospects, which to the present day has been characterized as its “surveillance” function. Meanwhile, the financial resources of the IMF have been expanded over time, and its financing instruments have become more differentiated to accommodate the short, medium or long-term external financing requirements of member countries as defined by the nature of the balance of payments adjustment problem that they faced.
In each of the four crisis periods noted earlier, ex post critiques have been directed at the Fund and its collective membership for the inadequacy of its surveillance function in not identifying the seeds of financial instability in countries most affected by a regional/global crisis and in not sounding a sufficiently strong alarm to convince country authorities to alter financial policies so as to forestall the eruption of a crisis or minimize its impact. In addition, in the aftermath of a crisis, reform discussions have focused on the adequacy of the Fund’s financial resources and instruments for assisting countries most affected by crisis.
The IMF and the global financial crisis
The crisis of 2007-08 has provided a particularly strong example of the historical pattern of reform discussions just described. In its surveillance function, for example, the IMF has been criticized for its inability to deal with the problem of global imbalances that provided the financial environment in which the growth of highly leveraged “shadow banking” activities associated with housing “bubbles” across a number of advanced countries could take place. In the years preceding the crisis, there was a significant increase in global savings emanating from China, OPEC countries and other emerging market economies (a “global saving glut”), which was reflected in a growing current account surplus for these countries, large foreign reserve accumulations and a reduction in long-term real interest rates.
This expansion in global savings was not matched by an increase in public and/or private business investment in the advanced countries, but instead it supported a sharp growth in debt-financed consumption and home purchases in those countries (in particular, the U.S., Iceland, the U.K., and parts of the E.U.), which resulted in a significant increase in their current account deficits.
The nature of these developments reflected an important change in the global economic and financial system that has emerged in recent decades, and with particular strength since the end of the last century, as regards the integration of national economies through dense networks of trade and financial linkages.
These conditions, in turn, imply that the macroeconomic and financial policies of the major industrial and emerging market economies cannot be assessed only on an isolated case by case basis, but rather they need to take account of the cross-border spillover effects of policy adjustments in one country on other countries as well. This feature of economic and financial globalization also means that macroeconomic policies among the large advanced and emerging market economies need to be coordinated in order to achieve certain objectives in terms of the stabilization of global output, prices and financial flows.
In the lead-up to the recent financial crisis, the problem of growing current account imbalances required some coordinated effort among the major participants in order to bring about a more sustainable outcome through changes in demand management and exchange rate policies. While there was recognition within the IMF, both at the level of staff and its executive board, of the need for a coordinated policy adjustment, the Fund was powerless to bring this about. One example of this failing was the proposal by the Fund’s managing director in 2007 for an unprecedented, multilateral consultation procedure, which involved China, the E.U., Japan, Saudi Arabia and the United States.
While this was a welcome initiative, the procedure unfortunately turned out to be ineffective, largely because the participating countries were unwilling to allow the Fund to play an active role in judging the appropriateness of each country’s policy framework, and thereby guide agreement on adjustments to the policy course that each participant had been pursuing. Despite its warnings on global imbalances, however, the IMF largely ignored the associated risks that were building in the major financial centers with the growth of “shadow banking” activities and cross-border financial linkages.
When the crisis erupted in 2008, the locus of policy coordination shifted from the IMF to the Group of Twenty (G20) advanced and leading emerging market economies. The G20 had been created in the wake of the Asian financial crisis as a consultative body on the functioning of the IFA, but had been largely sidelined by the continuing dominance of the G7 industrial countries in international monetary affairs until the recent crisis erupted. In addition, the U.S. Federal Reserve took the lead in creating emergency swap lines with a number of other central banks most affected by the crisis to provide dollar liquidity for countries facing large capital outflows.
As a parallel, but clearly subordinate effort, given the relatively limited resources of the IMF, a decision was made by the G20 to augment its financial resources on a temporary basis and to introduce a new emergency line of credit to assist countries outside the central bank swap network.
The shift of efforts at international policy coordination from the IMF to the G20 represented a significant weakening of the Fund’s status within the IFA, as its role was relegated to that of a technical secretariat for the G20 policy discussions. The high point of G20 discussions was reached at the London Summit in October 2009, when finance ministers and heads of state reached agreement on a “Framework for Strong Sustainable and Balanced Growth” to coordinate aggregate demand and supply adjustments to restore global economic growth to its pre-crisis trajectory.
Along with this Framework, the G20 agreed on a “peer review” or Mutual Assessment Process (MAP) in which countries would be called to account in subsequent meetings for failure to deliver on the policy commitments that were made at that meeting.
Unfortunately, in subsequent meetings, the major countries within the G20 have failed to adhere to the MAP, notwithstanding the monitoring and guidance provided by the Fund, in a manner not dissimilar to the multilateral consultation procedure discussed earlier. In addition to the reluctance of countries to agree to policy changes that are not strictly determined according to domestic priorities, the G20 has become less focused on the macroeconomic policies to support global economic recovery, as its agenda has become more diffuse, with national governments and international agencies pressing to have its agenda expanded to cover a host of other matters of international concern. As a result, the more recent communiqués of the G20 have become a shopping list of economic, social, humanitarian, environmental and anti-terrorist objectives, each of which merits a coordinated international effort that the G20 has been called upon to push.
What is the road forward for international monetary reform?
As a result of the crisis, there are a number of reforms that should be considered to enhance the role of the IMF in the international monetary system. These can be organized in terms of its governance arrangements, its surveillance function and its financing capability.
Governance reform of the IMF is important in order to improve its legitimacy among its membership and to enhance its role in the reform and operations of the IFA. Given the growing complexity of the G20 agenda, it would make sense to shift discussions on global policy coordination from the G20 finance ministers to the International Monetary and Financial Committee (IMFC), which is the oversight committee of the IMF. There is a large degree of overlap in the membership of these two groups, but the latter has the virtue that its membership is determined in accordance of the Fund’s quota system, whereas the former is an ad hoc arrangement without any formal rules for membership.
The quota system (and formula) of the IMF, in turn, needs to be reformed, not only to reflect the growing importance of countries like Brazil and China in the global economy, but also to ensure that its financial resources expand in line with the growth of global trade and financial flows. In late 2010, agreement was reached within the IMFC on a revision of the quota formula that would significantly increase the quota share (and thus the voting power) of the leading emerging market economies, while doubling the size of the Fund’s financial resources. Unfortunately, however, this reform has not yet been approved by the requisite majority of national governments, largely because of delays in legislative approval by the U.S., which holds the largest quota share or voting power within the IMF (17 percent).
Another important governance reform that should be addressed is the process of leadership selection in the Fund (and World Bank), which by long-standing tradition has determined that the managing director of the IMF would always be a European, while the president of the World Bank would always be an American.
Along with governance reform, it would be important to strengthen the surveillance function of the IMF. While the IMF has continued to maintain the technical expertise and quality of its evaluations of the global economic and financial system and member country macroeconomic policy frameworks, these reports have not been used as a basis for coordinating policy adjustments among the major economies or bringing about recommended policy changes in individual countries.
Recently, the IMF has revised the scope of its surveillance activities by means of an “Integrated Surveillance Decision” which calls on the Fund to expand the scope of its annual review of members’ exchange rate and macroeconomic policies to include a multilateral perspective through, for example, the preparation of “spillover reports” for selected advanced countries and to initiate multilateral consultations to heighten awareness of the need for policy coordination. Financial stability issues and macro-financial linkages will also be given greater attention in the Fund’s bilateral surveillance.
However, the major shareholders in the Fund have decided not to use these reports in a manner that would enhance the impact of the Fund’s surveillance function while the G20 remains committed to its MAP. Ultimately, however, a strict system of peer review should be established within the IMFC in order for the IMF to fulfill its surveillance mandate. The imposition of well-defined financial penalties should also be considered, in somewhat analogous fashion to those used in WTO operations, in order to reinforce the Fund’s surveillance function.
As regards the IMF’s financial activities, a number of improvements should be considered. While the proposed doubling of the size of the Fund’s quotas, once it is approved, will raise its total financial resources to the equivalent of around $750 billion, this is still a relatively small amount in relation to the size of global payments imbalances or the value of official foreign reserves, which have increased substantially in recent years.
Along with further increases in the quotas of the IMF, a mechanism should be established to increase on a periodic basis the size of the lines of credit with major shareholders under the so-called New Agreements to Borrow (NAB) that the Fund can draw upon on a temporary basis in the event of future crises.
When the recent crisis erupted, the size of these lines of credit was increased on an ad hoc basis; however, when the increase in quota shares was agreed, it was decided to reverse the temporary increase in the size of the NAB. In addition, consideration could be given to establishing within the IMF a mechanism for activating swap arrangements among the major shareholders that would be coordinated with IMF lines of credit during future crises to replace the temporary, ad hoc arrangement that was created by the U.S. Federal System at the outbreak of the current crisis.
A more radical, but worthwhile initiative, would be to establish procedures for a regular increase in the Fund’s international reserve asset (Special Drawing Rights or SDRs), as well as selective increases during a time of financial crisis, to provide an alternative for sole reliance on the U.S. dollar as a “safe” financial asset and a supplement to international liquidity for crisis management. In a deeper sense, the problem of global imbalances and the rapid accumulation of official reserves by surplus countries prior to the recent crisis reflect a major defect in the current international monetary system, which is heavily reliant on U.S. current account imbalances for the provision of international liquidity.
The consequent growth in U.S. foreign obligations can lead over time to concerns about the sustainability of the government’s fiscal position and creditworthiness, which were heightened recently by the threat of default because of domestic political conflict over raising the debt limit imposed by the U.S. Congress. The accumulation of foreign reserves by emerging market countries during the last decade, as a form of self-insurance, is clearly inefficient, and reflects a lack of confidence in the IMF, because of its limited financial resources and defective governance arrangements.
The creation of the SDR in 1969 was intended over time gradually to reduce reliance on the U.S. dollar as a source of international liquidity, which became unsustainable under the Bretton Woods system, but since then the major shareholders have only allowed an increase in the Fund’s multilateral reserve asset on a sporadic basis.
The most recent issuance took place in 2009, again with the intention that further distributions would be repeated in the future, but no formal commitment has been made in this regard. With continued instability in the management of the U.S. dollar, it would be appropriate to consider a shift from an international monetary system based largely on a single currency to one based on a multilateral reserve asset (such as the SDR) that could be managed more easily to meet the needs of the global economy. Such a shift would be further enhanced if reforms were introduced to strengthen the Fund’s surveillance operations, as discussed earlier.