Jean-Pierre Landau: An international financial architecture for the
21st century - some thoughts
Remarks by Mr Jean-Pierre Landau, Second Deputy Governor of the Bank of France, at the
17th Central Banking Seminar of the Bank of Korea, Seoul, 1 June 2010.
17th Central Banking Seminar of the Bank of Korea; Seoul, 2 October 2009 (this text is a revised version:
1 June 2010).
* * *
International financial and monetary arrangements are currently extensively debated. For
many countries, both advanced and emerging, the crisis has shown that there is a close link
between internal and international financial stability. In addition, rebalancing of the world
economy stands at the forefront of the G20 policy agenda and there is a perception it may be
difficult to achieve under current arrangements.
In this paper, I would like to discuss the foundations for a future international financial and
monetary system. One central point I will make is that "financial" and "monetary" aspects
cannot be dissociated from one another. To a large extent, international monetary
arrangements, as well as current account imbalances, are the by-products of policy choices
made by countries on their capital account regimes and financial development. Therefore,
one must try and take a long term view, encompassing all aspects of the financial
interrelationships between nations. I will only deal tangentially with exchange rate regimes
and their implications for monetary policies. Those have been abundantly analysed and
discussed in the literature and the policy debate (Blanchard et al., 2005). Instead, I will focus
on three topics: international capital markets, the provision of international liquidity and the
newly emerging question of an international store of value. These are issues of joint and
common interest for all countries, whether emerging or developed, and whether their current
account is in surplus or deficit. Getting to a common understanding on those matters would
help in making progress on other, more contentious questions. Opinions expressed are
solely mine and do not represent the views of Banque de France or the Eurosystem.
What is an international monetary system?
According to
an apt definition, an international monetary system consists of (i) exchange rate
arrangements; (ii) capital flows; and (iii) a collection of institutions, rules, and conventions
that govern its operation (Carney, 2009). Presumably, the purpose of such "institutions, rules,
and conventions" is to ensure the sustainability and mutual consistency between national
policies. There may be also an implicit objective of "fairness" in the sense that, when
international imbalances need to be corrected, the burden of adjustment should be equitably
shared. Accordingly, an international monetary system should be based on explicit or implicit
"rules of the games" to which national economic policies would be subordinated.
This is an ambitious approach and it may seem too normative to some. But it has a long
history:

the gold standard, from which the phrase "rules of the games" originated, was based
on mechanisms which imposed automatic and symmetric adjustments in balance of
payments, according to specie flows.
 the Bretton Woods, system was built around an elaborate framework of rules,
disciplines and support mechanisms aimed at ensuring convertibility for the current
account - but, crucially, not the capital account - together with fixed but adjustable
exchange rates. All these conventions were enforced through IMF surveillance and
were supported by IMF facilities
With the generalisation of flexible exchange rate regimes, and the ensuing changes in the
IMF articles, the normative approach to the international monetary system was somehow
weakened. Capital account liberalisation led to entrust international financial markets with the
"disciplining" function. When it became apparent that the discipline would not be gradual and
progressive, but, instead, often lead to abrupt capital flows reversal and crisis, the
international community attempted to strengthen the IMF surveillance and develop its
facilities so as to pre-empt such shocks and make them more manageable. That is, basically,
where we are today.
Everything must be done to ensure that IMF surveillance works. But, like any "disciplinary"
approach, it meets with three essential difficulties:

first, diverging interests between countries. At any single point in time, conflicts may
arise as to how much adjustment is needed and by whom. Situations when all
national policies naturally point in the same direction - such as in the first quarter of
2009 - are very exceptional.

second, enforcement problems : the IMF has naturally more leverage on countries
that need its help than on others.

those two difficulties combine to produce a perception of asymmetry in
IMF surveillance. It may be compounded by a more fundamental and natural
asymmetry between surplus and deficit countries, when it comes to implementing
adjustment measures. And, some would say, there might also be a de facto
asymmetry between reserve and non reserve currencies, although, as I shall
mention later, the situation is more subtle.
These difficulties were apparent during the last part of the 20th century. They led to many
discussions about the proper role and organisation of the
IMF1. But what makes the
"disciplinary" approach almost impracticable today are the changes that have occurred in the
world at the turn of the 21st century. The world today stands in stark contrast with both the
Bretton Woods era and the period that followed immediately:

The first - and most obvious - difference is the number of countries that are active
participants to the system and have a stake in its functioning. The monetary and
financial world is becoming increasingly "multipolar". While the current system
comprises three currency blocs, at least one (the Chinese RMB) and may be other
additional systemic currencies will emerge in the future. Greater diversity goes with
increased complexity. "Hegemonic" systems are easier to build and manage than
multipolar ones where responsibility is more diffuse. So, in the future, one can
expect that coordination problems will be more difficult to solve. Charles
Kindleberger used to say, "the international financial system doesn't work unless
somebody takes the responsibility for
it" (as quoted by Fisher, 2008).

Second, those participants are more diverse from the point of view of their economic
structure, their demography, their level of development, and, more importantly, their
social choices and preferences. For instance, different saving rates may be seen as
resulting from divergent time preferences. Likewise, asymmetries in financial
development may, to some extent, reflect different choices and tradeoffs between
efficiency and stability in the organisation of capital markets and the architecture of
financial systems.

Finally, linkages between economies, whether through trade, capital or more
intangible "confidence" channels are continuously getting stronger as witnessed by
the speed and amplitude of contagion of economic and financial shocks during the
last eighteen months, which took everybody by surprise.
Pending some economic catastrophe, these characteristics will persist over time. A large
number of different countries, with different preferences, will permanently be linked and
interdependent through active, but imperfect capital markets. Any future international
architecture must be compatible with those basic features of today's world which, prima
facie, create the potential for more complexity and, maybe, instability.
International capital markets and the allocation of savings
Let's suppose, for an instant, that there is a unified, fully integrated, and complete world
capital market. Excess saving in some parts of the world would be efficiently allocated to
investments in other regions. Risk would also be efficiently shared between agents and
countries according to their respective needs and risk appetite. Shocks to GDP and/or
consumption would be smoothed over time. And, finally, liquidity would be permanently
available for those agents and countries whose solvency was not in doubt. In such a world,
balance of payments crisis would not exist. Current account imbalances would not matter as
they would reflect savings and investment decisions made by fully informed and non
constrained rational agents. This vision may serve as a reference for future reforms: "The
vision that underlies most proposals for reform of the international financial system is that the
international capital markets should operate at least as well as the better domestic capital
markets" (Fisher, 1999).
But, of course, we don't live in such an ideal world. Global capital markets are neither fully
integrated nor complete. Complete markets do not exist, either at the national or international
level, for a broad array of securities. Moreover financial markets are still naturally fragmented
by national borders. Specifically, we can identify five important deviations from the model of
perfect international markets:
1. Information asymmetries. These are natural features of all financial markets and
they give rise to significant frictions through, in particular, adverse selection and
moral hazard which prevent many profitable investments to be properly financed.
There are good reasons to think that information asymmetries are especially
prevalent in international capital markets since "foreign" investors find themselves at
a disadvantage when assessing "domestic" projects and investments.
2. Exchange rate risk is, obviously, specific to international capital allocation decisions.
3. So is sovereign risk, always present, if often remote and limited in ordinary times for
an increasing number of countries.
4. It is increasingly recognized that differences in financial development play a major
role in influencing capital flows and, consequently, current account imbalances. In
particular, capital tends to flow from financially repressed economies to countries
and markets which provide and abundant supply of safe and liquid assets. For the
same reason those countries' currencies are the main vehicle for holding official
foreign exchange reserves.
5. Finally, deliberately or not, public policies have a significant impact on the level and
national or international allocation of domestic savings. These influences can be
direct, as in the case of capital controls. They may be more diffuse, for instance
when authorities build up foreign exchange reserves. By doing so, public entities
essentially substitute themselves to private agents in managing and allocating part
of the nation's net foreign savings. Most likely, their choices and preferences will be
different from those of the private sector and, therefore, their intervention would alter
the country's external position, tilting it towards holding foreign assets in liquid
instruments.
The first three factors - information asymmetries, exchange and sovereign risk - account for
the well known "home bias" exhibited by most investors and asset managers who tend to
privilege their own domestic assets when deciding on portfolio allocation. They also explain
why, until recently, most emerging economies had to live with the "original sin" of not being
able to issue public debt denominated in their own currency. Because information
asymmetries have been reduced through the development of modern securities markets,
emerging economies have somehow freed themselves from this constraint, although less
than often assumed (Hausmann and Panizza, 2010).
The last two factors - differences in financial development and public interventions - may be
more pervasive and significant. Together, they have a major impact on the composition and
direction of capital flows, as well as the level and persistence of global imbalances.
Global imbalances in the 21st century
Current account imbalances have increased both in amplitude and durability during the last
decade. In fact, they have become a permanent characteristic of our economic environment.
This, by itself, may be a consequence of increased financial integration and greater
reallocation of savings across national borders. Since, at the same time, real long term
interest rates have kept to historically low levels, the situation has been characterized, as a
"saving glut" (Bernanke, 2005), a concept which has come to dominate our thinking about the
international economy.
However, for the saving glut to result in growing imbalances, net savings have to be more
and more asymmetrically distributed across nations. In addition, for more than a decade now,
capital has been continuously flowing "uphill", i.e. from poor to rich countries with current
accounts surpluses in emerging economies mirrored in growing deficits in the US. This is one
of the most salient and puzzling features of modern economic history and has attracted a lot
of attention.
Some explanations focus on the domestic drivers of private saving behaviours in both
emerging and advanced economies. Cyclical factors, such as productivity shocks, or fiscal
policies, have likely played a role (Bussière et al. 2010, and Henriksen and Lambert, 2009)
But this can only be part of the story. It may well be that saving / investment imbalances are
endogenous to the system itself..
According to the "Bretton Woods II" approach (Dooley et al. 2003, 2008, 2009), the pattern of
capital flows results from a mutually beneficial equilibrium between two groups of countries.
On the one hand, emerging economies which follow an export-led development strategy and
seek to prevent appreciation of their real exchange rates by constant foreign exchange
intervention (together with capital controls). As a consequence, they accept to accumulate
increasing stocks of liquid assets denominated in dollars. On the other hand, the US is happy
to get both reserve inflows to finance their deficits and cheap imports to fuel their demand for
consumption goods. Such equilibrium is stable by virtue of the mutual benefits it brings to
both groups. Moreover, the more it lasts, the more it is impossible to change since both
group become mutually dependant through the stock of claims and debts they have
reciprocally accumulated. Any significant break, for instance, in the allocation of reserves by
surplus countries, would both trigger major exchange and interest rate volatility in deficit
countries and lead to significant valuation losses in surplus countries. This "financial balance
of terror" is supposed to keep the system in place for a long period of time. Implicit behind
this doctrine, however, is the assumption that the creditor country can live with the risk of
losses on its reserves and accept that possibility as a price to pay for the success of its
growth strategy.
A more recent explanation is provided by the "asset shortage" theory (Caballero, 2006),
which helps and explains why asymmetries in financial developments generate both payment
imbalances and asset bubbles. According to the theory, the world has a shortage of liquid
and riskless assets. Moreover, the supply of those assets is asymmetrically distributed
between regions, with the US providing a large chunk of the total. Hence, there is a structural
excess demand for dollar denominated securities, which sustains permanent capital inflows
in the US. To the extent that the US financial system does not generate enough "pure" safe
assets, this creates an incentive for the financial sector to manufacture such assets from the
securitization of lower quality ones, but at the cost of greatly increased financial fragility
(Caballero, 2009).
Global imbalances and the policy agenda
Contemporary analysis therefore points to "structural" causes behind the pattern of capital
flows and global imbalances (Blanchard and Milesi-Ferretti, 2009). The policy consequences
are important.
First, current account imbalances will likely prove more resilient than expected to exchange
rate movements or inflexions in macro policies. If the causes are "structural", significant shifts
in demand and relative prices between countries may well lead to suboptimal growth and
excess volatility. In the immediate future, "financing" those imbalances should take
precedence over their "adjustment".
Second, global imbalances reflect a mix of different national preferences and inflexions
caused by public interventions. One important focus in the policy debate should be to
disentangle those two types of structural causes, and eliminate pure policy induced
distortions. Obviously, this is no easy task, but, in the end, a crucial one if imbalances are to
be addressed and reduced.
Finally, financial development matters. This is one area where preferences differ between
nations and public policies have a huge impact. This is also a source of major uncertainty for
the future. Will there be convergence or divergence in financial regulation across countries?
Will there be a move towards liberalisation of capital accounts or will existing restrictions and
controls be maintained in some parts of the world?
Under current international arrangements, this is a matter for sovereign choices: IMF articles,
in particular, do not cover capital account convertibility. Nevertheless, in a more diverse,
multipolar world, interactions between countries with different financial systems will become
more complex and, as the crisis has shown, very destabilizing.
International cooperation should therefore aim at creating an environment where incentives
to structural distortions in capital flows are reduced.
Opening the capital account exposes countries to increased financial volatility. The impact,
however, is different for capital importers and exporters. Capital importers face the possibility
that flows would abruptly dry up, thus inflicting damaging shocks to their financial systems
and national economies. Capital exporters accumulate claims on the outside world and,
therefore, run the risk of valuation losses (through exposure to country and exchange rate
risk). Ideally, an international open capital account regime would protect both capital
importers towards sudden liquidity shocks and capital exporters toward abrupt changes in
the value of their assets. This is, obviously, unrealistic in the current environment. But these
are potential avenues for progress and debate.
International liquidity
The provision of international liquidity has been severely disrupted during the crisis.
Emerging (and some industrialized) countries have suffered from acute dollar liquidity
shortages which had to be remedied, inter alia, through a network of currency swaps
between Central Banks. The crisis is a powerful reminder that liquidity - both domestic and
international - can never be taken for granted. How will international liquidity be provided in
the future, and by whom?
These are not new questions. Over the last ten years, the build up in foreign exchange
reserves in emerging economies has been spectacular, which is a sign that the supply of
international liquidity was seen both as insufficient and uncertain. More recently, Governor
Zhu, from the People Bank of China has raised the issue of reserve currencies. According to
Governor Zhu, current arrangements for liquidity provision are a source of instability and
have played a role in causing the crisis. Governor Zhu has mentioned, in particular, the
intrinsic contradiction embodied in the famous "Triffin dilemma". Because the dollar is the
major reserve currency, international liquidity supply depends on the US running a
sufficiently large current account deficit which, by itself, aggravates global imbalances and
creates instability. Governor Zhu suggested that the role and status of the SDR be
enhanced, with the long term objective of creating a "super reserve" currency.
However, international liquidity provision should now be considered in a broader framework.
The Triffin dilemma goes back to a period when international capital markets were poorly
developed. By then, international liquidity was limited to instruments used to settle payments
between official monetary authorities. It was represented by claims on such official entities.
By contrast, in today's world, most international liquidity is privately provided and represented
by claims on private institutions. Interbank markets play a crucial role in this process. The
more capital markets become integrated at the short end, the more international liquidity is
provided by the private sector.
As a consequence, there is a strong continuity and complementarities between domestic and
international liquidity. Both depend on the willingness of counterparties to extend credit to
each other. Both are subject to aggregate supply and demand shocks with sudden shifts in
risk aversion or liquidity preference. Both result from leveraging and deleveraging by private
institutions (Adrian and Shin, 2008). When markets seize, counterparty risk is perceived as
excessive, uncertainty settles in, financial institutions deleverage their positions towards non
residents, and then international liquidity dries up and disappears.
The importance of global private liquidity conditions has been apparent during the period
which followed Lehman's failure. Output and trade fell across the world with astonishing
simultaneity. It seemed natural to assume, at the time, that "traditional" forms of contagion
- through goods or capital markets - were at work. Policy makers were looking to trade
finance as a major channel. However, contagion takes time and cannot fully account for the
exceptional synchronization in the drop of output. With hindsight, the phenomenon may best
be seen as a global liquidity shock. Net supply of liquidity dried up at the same time
everywhere in the world. International banks faced a sudden and ample shortage of dollars.
Firms started to hoard liquidity. Investment and, for a part, production, came abruptly to a
halt.
When such a shock occurs, public provision of liquidity has to substitute to private provision.
In a domestic context, this is the function of the lender of last resort. But when the shortage is
about foreign currency liquidity, this role has to be played by foreign exchange reserves.
Foreign exchange reserves
Following the 1997-98 crisis, emerging countries have constantly sought to expand their
foreign exchange reserves. The emerging markets' average reserve ratio has more than
quintupled from 4 percent to over 20 percent of GDP since 1990 (Obstfeld et al. 2009,
Matteo y Lagos et al., 2009).
One cannot assume, however, that equilibrium has been reached and that the demand for
reserves will stabilize. On the contrary, there are strong indications that this trend will persist,
or even be amplified, following the crisis.
How much reserves are enough? Theoretical reasoning would balance the benefits of
holding reserves against their cost, with some notion that there is an optimum.
On the benefit side, reserves can be detained or accumulated for a variety of motives:

to smooth out the impact on consumption of shocks on the current account, which is
the most basic and traditional motive, even in the absence of international capital
flows

as a result or by-product of foreign market intervention to prevent exchange rate
appreciation. This is usually defined as a "mercantilist" motive.

as precaution against possible abrupt capital outflows (the "sudden stop" syndrome)

and, finally, to provide liquidity to domestic financial institutions. (Obstfeld et al.
2009). That use of foreign exchange reserves was especially apparent in 2008 when
Central Banks in many emerging (and some industrialized) countries put those
reserves at work to ease domestic tensions created by dollar liquidity shortages.
The costs of holding reserves are also well identified:

intermediation of national savings by a public entity is never neutral. By nature,
those entities don't have the same risk appetite and liquidity preference as private
agents. A significant part of national savings (up to 30% in some countries) might
find itself subject to a "directed" allocation towards liquid instruments denominated in
foreign currency.

as a consequence, there is a direct opportunity cost because foreign exchange
reserves' risk / return profile may be lower than for other, alternative, investments.

finally, as reserves accumulate, countries are getting increasingly exposed to
exchange rate risk and face the possibility of significant valuation losses.
This kind of cost / benefit analysis seems less and less able, however, to account for the true
behavior of reserve holders. First there may be immeasurable, but very powerful, benefits
such as increased security, lower external interest rates and lower exchange rate variability
over the long run. Second, part of the costs may be borne by the system itself and not fully
internalized by each individual country. And, finally, new precautionary motives may lead to a
fundamental indeterminacy in the demand for reserves.
The future demand for reserves
As mentioned above, during the crisis, foreign exchange reserves were used as a tool for
internal
- as well as external - financial stability. National Central Banks, especially in Latin
America, acted as dollar lenders of last resort to their domestic banks.
This function will develop in the future and is bound to impact the demand for reserves. In a
sense, countries face the same dilemma as private institutions. They need liquidity in times
of stress but it is costly to hold in normal times. Their reactions, however, are opposite.
Private institutions tend to underestimate their liquidity needs because, in case of shock, the
Central Bank can step in as a lender of last resort. For countries, the bias goes in the other
direction. Provision of international liquidity, whether private or official, is contingent,
conditional and uncertain. With no international lender of last resort, precautionary motives
could lead to unlimited accumulation of liquidity.
This may be seen as major market failure and source inefficiency but is also unavoidable in
the current financial architecture. One characteristic of liquidity shocks is that the net demand
for liquidity may become almost infinite. Ex ante, no buffer is ever big enough. No amount of
reserves will fully protect a financially open economy against a systemic shock. It is
noticeable that countries, such as Korea, which possessed very important amounts of
reserves prior to the crisis and has a flexible exchange rate regime, nevertheless felt the
need to enter into currency swaps with the Federal Reserve.
Financial openness and integration means that domestic banks will engage more and more
into foreign currency operations. In turn, the expansion of international balance sheets will
increase the potential demand for liquidity support in case of shocks. This trend should be
accepted as a normal consequence of open capital markets and international banking,
together with the predominance of a very limited number of currencies in international
finance.
As a consequence, past benchmarks used to assess the adequacy of reserves are no longer
valid. Current research (Obstfeld et al. 2009) shows that broad domestic money aggregates
may be the best explanatory factors for the amount of reserves. Internationalisation of
finance has created a fundamental indeterminacy in the demand for reserves, which reflects
the indeterminacy in the demand for liquidity.
Multilateral provision of international liquidity: the search for financial safety nets
The rationale for a multilateral source of liquidity provision is straightforward: stabilizing the
demand for international reserves would bring huge benefits in terms of world welfare.
At the moment, reserve accumulation can only occur through a conjunction of balance of
payment surplus and some degree of exchange rate intervention. In addition, if sterilization
proves difficult or impossible, it also leads to unwanted changes in monetary policy.
Therefore, precautionary reserve accumulation, however legitimate, unavoidably creates side
effects on domestic macro policies as well as spillover effects on other countries.
Now, suppose there is "ex ante" an existing pool of reserve assets which countries could tap
into under specific circumstances. If access to this pool is credible and predictable, there
would be no need for getting those reserves on the market. The search for precaution would
not impact domestic or foreign macroeconomic management. It would be neutral as regards
exchange rate regimes and polices. It would reduce the incentive for countries to conduct a
whole set of policies such as:

generating current account surpluses through active exchange rate management

ring fencing pools of liquidity and capital in local subsidiaries, therefore creating a
potential segmentation of international financial markets.

implementing "soft" capital controls to limit the impact of shocks and diminish the
need for reserves
All countries, therefore have a common interest in finding ways to disconnect reserve
accumulation from exchange rate management and, more generally, from balance of
payment situations and monetary policies
The need for national reserves could be reduced if credible mechanisms exist to provide for
the supply of official liquidity on a multilateral basis. Significant progress has been achieved
in this direction during the recent period. A dense network of forex swaps has been put into
place between major Central Banks in the midst of the crisis. Other recent official initiatives
include:

the creation by the IMF of a new facility - the Flexible Credit Line - aimed at easing
liquidity pressures on countries with no fundamental balance of payments
difficulties. It has been used, in particular, by Mexico and Poland and has powerfully
contributed to restoring confidence. It has marked a decisive step in the evolution of
the IMF towards a truly universal provider of international liquidity (and not only for
countries facing balance of payments difficulties)

A new SDR allocation, the biggest ever, for the equivalent of 250 bn USD, which
has been enacted by the IMF Executive Board. This will be complemented by a
network of voluntary arrangements allowing SDRs to be effectively traded between
members.
These are, however, revocable and limited sources of liquidity provision. Swap agreements
can be (and have been) terminated. Out of the total, only a small part of the SDR allocation
will benefit countries which may effectively need to use them. More may be needed to
substitute for national foreign exchange reserves as a permanent insurance mechanism.
Contingent liquidity
The search for new liquidity sources meets with an inescapable moral hazard problem. On
the one hand, to be equivalent to reserves going forward, multilateral liquidity must be
available ex ante and without condition. On the other, there is a danger that fully
unconditional liquidity be used to deal with fundamental "solvency" imbalances. In real life,
this is not an easy distinction to make. The dilemma is solved, at the domestic level, by the
provision of eligible collateral. This may prove very uneasy for international liquidity:
transferring ownership of substantial amounts of sovereign assets between countries or to
international institutions would meet with huge legal and political difficulties.
This is the rationale for conditionality. But, of course, conditionality creates an uncertainty
which is incompatible with the purpose of instant supply of liquidity. A conditional facility will
never be a perfect substitute for reserves. Many countries fully eligible to the Flexible Credit
Line (FCL) have used foreign swaps instead. Anecdotal evidence suggests that swaps are
often perceived as carrying less of a stigma effect.
One way to deal with moral hazard would be to distinguish explicitly between two different
risks facing each country: on the one hand idiosyncratic risk, created by national policies and
country specific shocks; on the other hand, "systemic" risk stemming from aggregate liquidity
shocks occurring on a broader - global or regional - scale. At the moment, foreign exchange
reserves are meant to cover both risks. Since systemic risk is not related to a country size or
GDP level there is potentially no limit to the demand for self insurance. A the same time, if
systemic risk is defined in such a way that it is truly independent from individual countries
behaviour or policies, protection through a multilateral mechanisms would not create any
moral hazard problem.
It should t