How to fix holes in the financial safety net

Source– The post is based on the article “How to fix holes in the financial safety net” published in “The Indian Express” on 22nd August 2023.

Syllabus: GS3- Economy

Relevance: Global financial system

News– The article explains the evolution of the global financial system and challenges faced by current financial architecture. It also explains the future of the global financial system.

How has the global financial system evolved until 2011?

The period before World War I was characterised by unrestricted movement of capital and fixed exchange rates tied to the gold standard. The gold standard’s success depended on cooperation between major global economic powers.

Following the interwar era, the gold standard was replaced by the post-1940s Bretton Woods system. The Bretton Woods conference led to the establishment of three significant international financial institutions: the IMF, World Bank, and later, GATT and WTO.

Until the 1970s, the International Monetary Fund managed the global financial safety net (GFSN) through the Bretton Woods system. It was  characterised by semi-fixed exchange rates and controlled capital movements.

However, this system collapsed in the early 1970s. There were doubts about the sustainability of the US dollar’s convertibility into gold at a fixed exchange rate and concerns about the availability of sufficient gold to match the increasing supply of US dollars.

This collapse gave rise to the present framework of flexible exchange rates disconnected from gold, and relatively unrestricted capital accounts.

The 1980s and 1990s were marked by frequent instances of balance of payments crises and macroeconomic instability in numerous emerging markets and developing economies.

The open capital accounts in these economies led to volatility in capital flows. It contributed to an escalation in the frequency and severity of financial crises.

From 1970 to 2011, there were a total of 147 systemic banking crises, 218 currency crises, and 66 sovereign debt crises, primarily occurring in EMDEs.

During this time, the IMF remained the sole but largely ineffective observer of the Global Financial Safety Net. Substantial transformations have since occurred.

The most significant event of the late 1990s was the Asian financial crisis. Many of the countries affected by this crisis felt that the conditionalities imposed by the IMF were too onerous, which led many to increase their foreign exchange reserves as self-insurance.

Ten ASEAN member states plus China, Japan, and South Korea (ASEAN+3) founded the Chiang Mai Initiative (CMI) in 2000. In 2010, it became the “Chiang Mai Initiative Multilateralisation” (CMIM).

The already existing ASEAN swap arrangements were expanded to facilitate bilateral currency swaps among all ASEAN +3 countries.

How has the global financial system transformed after the global financial crisis of 2008-09?

The 2008-09 North Atlantic Financial Crisis led to innovations in the Global Financial Safety Net. The US Federal Reserve set up bilateral swap lines with the major central banks in advanced economies along with a few emerging market economies.

For euro-area countries, the European Financial Stability Facility was created as a temporary crisis solution in 2010. It became the European Stability Mechanism in 2012, with a lending capacity of Euros 500 billion.

A global network of bilateral swap lines has proliferated. The number of  bilateral swap lines has increased from only a few in 2007 to 91 at the end of 2020. It amounts to a total of about USD 1.9 trillion.

There are now seven regional financial arrangements with total potential resources available of almost USD 800 billion.

What are issues related to the global financial system?

During the Covid crisis, the IMF lent USD 118 billion to 22 countries in the western hemisphere; USD 25 billion to 40 countries in sub-Saharan Africa.

The above data illustrates that when more developed countries suffer from crises, the magnitudes of loans to them are much larger than similar crises in emerging economies.

There has also been a perception that the conditionalities accompanying IMF programmes to advanced economies are less stringent than in emerging economies

There has been a growing dissatisfaction with the distribution of quotas and voice in IMF governance with the increasing economic size of emerging economies

The economic weight of emerging economies do not reflect adequately in the voting, quota, and governance structure of the IMF.

What will be the future shape of the global financial system?

The 16th review of quotas is currently ongoing. Many observers believe that there is little chance of the major member countries agreeing to the increased quota of emerging economies.

Without significant governance reform in the IMF being unlikely, its relative importance and effectiveness could get progressively eroded.

Thus, the GFSN of the future is likely to be a combination of different regional financial arrangements, bilateral swap lines, increasing foreign exchange reserves, and the IMF.

What are the options for India among transformations in the global financial safety net?

India is currently not part of any regional financial arrangements. In case of any macroeconomic and external crisis, it will have to rely on its bilateral swap lines, particularly with Japan, and the IMF.

India should consider approaching the “Chiang Mai Initiative Multilateralisation” for potential membership.

The pursuit of prudent macroeconomic policies encompassing fiscal, monetary, financial and development policies since the early 1990s, is the best financial safety net that India should aspire for.

It should also continue to build adequate foreign exchange reserves for its self-insurance.

It should be particularly careful in opening the capital account, especially to volatile debt inflows into its bond market.