Opinion How to fix holes in the financial safety net

In absence of significant governance reform, effectiveness of global financial safety institutions is eroding. India is better off relying, instead, on pursuit of prudent macroeconomic policies

Once ANRF is created, the government intends to invest Rs 50,000 crore in the next five years. Unless this adds to the budget allocation for the science and technology ministry, Rs 16,361 crore in 2023, effective funding will decline sharply. (Representational Photo)

Rakesh Mohan

Amshika Amar

August 22, 2023 02:54 PM IST First published on: Aug 22, 2023 at 05:15 AM IST

The pre-World War I period was characterised by free capital flows and fixed exchange rates linked to the gold standard. The success of the gold standard required cooperation among the major global economic powers of the time comprising countries of Europe and North America. After the chaos of the interwar period, the gold standard of the pre-World War I phase was replaced by the post-1940s Bretton Woods system. The landmark three-week conference at Bretton Woods gave birth to three major international financial institutions — IMF, World Bank, and later, GATT and WTO.

Until the 1970s, the global financial safety net (GFSN) was managed by the IMF through the relatively stable Bretton Woods system of semi-fixed exchange rates and controlled capital flows. This system collapsed in the early 1970s when questions arose over the sustainability of the US dollar’s convertibility to gold at a fixed exchange rate and the availability of enough gold to match the increasing supply of US dollars. From the debris of this collapse arose the current system of floating exchange rates with no link to gold, and relatively open capital accounts.

The 1980s and 1990s were then marked by frequent balance of payments crises and macro-economic instability in many emerging markets and developing economies (EMDEs), with open capital accounts resulting in repeated capital flow volatility. Consequently, the frequency and seriousness of financial crises increased significantly. Between 1970 and 2011, there were 147 systemic banking crises, 218 currency crises, and 66 sovereign debt crises, mostly in EMDEs. The IMF continued to be the sole (unsuccessful) guardian of the GFSN. A great deal of change has taken place then, effectively transforming the global arrangements for addressing sovereign financial crises.

How to fix holes in the financial safety net

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, which, in 2010, became the “Chiang Mai Initiative Multilateralisation” (CMIM), whose size expanded to USD 240 billion by 2014. The already existing ASEAN swap arrangements were expanded to facilitate bilateral currency swaps among all ASEAN +3 countries.

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The 2008-09 North Atlantic Financial Crisis (NAFC) led to a host of innovations in the GFSN. The US Federal Reserve set up bilateral swap lines (BSLs) with the major central banks in advanced economies (AEs) along with a few selected central banks in emerging market economies. For euro-area countries, the European Financial Stability Facility (EFSF) was created as a temporary crisis solution in 2010, which then became the European Stability Mechanism (ESM) in 2012, with a lending capacity of Euros 500 billion (USD 550 billion).

Individual country foreign exchange reserves have ballooned to about USD 15 trillion, and a global network of BSLs has proliferated dramatically. The number of BSLs has increased from only a few in 2007 to 91 at the end of 2020, amounting to a total of about USD 1.9 trillion. There are now seven regional financial arrangements (RFAs), of which only the ESM and CMIM are large and significant, with total potential resources available of almost USD 800 billion. The chart provides a snapshot of the evolution of the global financial safety net since 1995. So, the GFSN is no longer the sole preserve of the IMF.

During the NAFC in the 2010s, ESM provided Euros 295 billion to just five countries on the periphery of Europe, viz. Ireland, Greece, Cyprus, Portugal, and Spain. In addition, the IMF provided about USD 540 billion to almost 90 countries during that period.

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During the Covid crisis, the IMF has lent USD 118 billion to 22 countries in the western hemisphere; USD 25 billion to 40 countries in sub-Saharan Africa; about USD 17 billion to 14 countries in the Middle East and Central Asia, including Pakistan and Egypt; less than USD 7 billion to eight eastern European countries; and less than USD 3 billion to nine small countries in Asia and Pacific, but including Bangladesh. In addition, ESM has provided a credit line worth up to USD 264 billion to help euro-area member states cover healthcare costs related to Covid-19 in European countries during the pandemic-induced crisis.

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 EMDEs, though with some exceptions.

There has also been a perception that the conditionalities accompanying IMF programmes to advanced economies are less stringent and less austere than those in similar EMDE programmes. Further, with the increasing growth and economic size of EMDEs, particularly in Asia, there has been a growing dissatisfaction with the distribution of quotas and voice in IMF governance. The AEs’ share in global GDP had been broadly stable for almost 50 years until around 2000, and hence redistribution of any quotas was essentially within the advanced economies, including Japan after its economic rise.

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However, since the turn of the century, the economic weight of EMDEs has increased significantly without being reflected adequately in the voting, quota, and governance structure of the IMF. The 16th review of quotas is currently ongoing and is supposed to be completed by the end of 2023. Many observers believe that there is little chance of the major member countries agreeing to the consequences of such a quota review, which would significantly increase the quota share of China in particular.

With significant governance reform in the IMF being unlikely, currently, its relative importance and effectiveness could get progressively eroded. Thus, the GFSN of the future is likely to be a spaghetti of different RFAs, BSLs, increasing foreign exchange reserves, and of course the IMF. How this system will be governed is the emerging challenge facing the GFSN.

Turning to the position of India with respect to the GFSN: India is currently not part of any RFA, and in case of any macroeconomic and external crisis, it will have to rely on its BSLs, particularly that of USD 75 billion with Japan, and of course on the IMF. Hence there is a good argument for India to consider approaching the CMIM for potential membership.

The pursuit of prudent macroeconomic policies encompassing fiscal, monetary, financial and development policies, as we have practised since the early 1990s, is ultimately the best financial safety net that India should aspire for. As it has already been doing for more than a couple of decades 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. There is enough international evidence over the past three to four decades that suggests that volatile capital flows are among the leading reasons for overall macro and balance of payments instability.

Mohan is President Emeritus and Distinguished Fellow and Amar is Associate Fellow, Centre for Social and Economic Progress