Confronting the Coming Liquidity Crisis
Camila Villard Duran
This post was originally published on the Project Syndicate.
SAO PAULO – This month, G-20 leaders will meet in Antalya, Turkey, for their tenth summit since the 2007 global financial crisis. But, despite all of these meetings – high-profile events involving top decision-makers from the world’s most influential economies – no real progress has been made toward reforming the international financial architecture. Indeed, the group has not seriously engaged with the subject since the 2010 summit in Seoul. Put simply, the G-20 is failing in its primary and original purpose of enhancing global financial and monetary stability.
A big part of the problem is that the G-20 agenda has become increasingly congested over the years. At a time of looming financial upheaval, the G-20 must stop attempting to tackle a broad array of issues simultaneously – a goal that has proved impossible – and go back to basics.
The United States Federal Reserve is now preparing to raise interest rates, which it has kept near zero since the crisis. While monetary-policy tightening may be necessary, it risks triggering a serious liquidity crisis in developing countries, with a major impact on economic growth and development. That is why, at this month’s G-20 summit, participants must focus on providing a credible institutional backstop for the difficult times ahead.
Specifically, the G-20 should move to empower the International Monetary Fund, both by pushing it to do more with its existing powers and by championing institutional reform. Raghuram Rajan, the governor of India’s central bank, emphasized this at the recent annual meetings of the IMF and the World Bank in Lima, Peru, when he called for the Fund to build a sustainable global safety net to help countries in future liquidity crisis.
The necessary institutional arrangement already exists: the IMF’s Special Drawing Rights (SDR) department. Within this department, official entities can exchange SDRs – the IMF’s own international reserve asset – for other currencies. Moreover, the IMF can designate a country with a strong balance-of-payments position to provide the liquidity that another member needs. Through this so-called “designation mechanism” – which has never been used – the IMF can ensure certainty of access to global currencies in times of crisis.
Of course, if the IMF’s SDR department is to become a global liquidity hub capable of mitigating future crises, reform is vital. Ideally, major powers would support efforts to strengthen the IMF. But the US has so far been unwilling to do so, with domestic partisan politics spurring Congress to block the relevant reforms.
While the G-20 should not give up on IMF-strengthening reforms, it should hedge its bets. Specifically, it should work with a “coalition of the willing” – including the major emerging economies, concerned advanced countries, and other developing countries – to create an institutional mechanism with which to respond effectively to the next global liquidity crisis.
One obvious option would be to replicate the institutional design of the SDR department by incorporating it in an agreement among the coalition countries. The Bank for International Settlements, which was the counterparty in currency swaps under the Bretton Woods par value system in the 1960s, could be the manager of this system.
This approach undoubtedly has major shortcomings. Indeed, the key advantage of the IMF’s SDR department – that it is a quasi-universal and government-driven system whereby currencies are exchanged with reliable “collateral” (the SDR) – would be lost.
But the perfect should not be made the enemy of the good. As long as an ideal system is out of reach, an imperfect option will have to do. With the risk of a liquidity crisis intensifying, and the existing international financial architecture ill-equipped to respond to such a crisis, doing nothing is not an option.
In recent years, the international financial system has become increasingly fragmented, exemplified in the proliferation of bilateral and multilateral currency-swap arrangements. For example, the Chiang Mai Initiative Multilateralization involves the ASEAN countries, plus China, Japan, and South Korea. And the Contingent Reserve Arrangement (CRA) was created by the BRICS countries (Brazil, China, India, Russia, and South Africa).
Swap contracts involve pre-committed resources, which are not transferred to an international organization with a specific institutional mission. Instead, foreign-exchange reserves – that is, liquidity in currencies accepted for international payments – are held in national agencies until a swap’s activation.
This means that there is no guarantee that, in the event of a crisis, a central bank will actually provide the swap line it has pledged, at least not without attaching political strings. In the CRA, for example, members can opt out of providing support – and can request early repayment if a balance-of-payments need arises.
Clearly, the world’s ever-expanding network of currency-swap arrangements is far from a reliable mechanism for responding to crisis. This is particularly problematic for the emerging economies, which are especially vulnerable now.
Turkey, which currently holds the G-20 presidency, and China, which will take over next year, should have plenty of motivation to demand action to create safeguards against today’s liquidity risks. Beyond urging the US to approve IMF governance reforms, both countries should be hard at work building a coalition of the willing and designing an effective crisis-response mechanism.
So far, Turkey seems to be falling short, promoting an overcrowded and ineffective agenda. One hopes that its leaders come to their senses fast, so that the upcoming summit can produce the results that past summits have failed to provide – and that the world needs more than ever.
Camila Villard Duran is a professor of law at the University of São Paulo, is an Oxford-Princeton Global Leaders Fellow in the Global Economic Governance Program, University of Oxford.