Reforming the international monetary and financial system and
preserving monetary and financial stability in financially integrated
small and open economies
Már Guðmundsson, Governor of the Central Bank of Iceland, panel
comments in the 50th Anniversary Conference of the Central Bank of
Malta, Valletta, 4 May 2018.
Let me begin by congratulating all at the Central Bank of Malta on the Bank's
50th anniversary and thank Governor Vella for the invitation to speak at this
conference. I spoke in a Central Bank of Malta conference here in Valetta around
the middle of the 1990s. At that time Iceland had more or less fully liberalised
its capital account and had a pegged exchange rate. Malta also had a pegged
exchange rate but still had some capital controls. The world has changed since
then and our understanding of it even more. We in Iceland went towards a
flexible exchange rate and inflation targeting, while you entered monetary union.
Overall, we have both done well, but our road in Iceland has been bumpier.
The heading of this panel is Challenges facing central banks after the financial
crisis. That is a big menu. For my introductory remarks I choose two related
issues that have been high on my mind for years, both as a policy maker in a
small, open and financially integrated economy and during my tenure at the BIS.
These are potential reforms to the international monetary and financial system
(IMFS) and how small, open and financially integrated economies (SOFIEs) can
preserve monetary and financial stability in a world of global financial
integration and large and volatile capital flows. Both of these are unfinished
business and the road ahead is foggy.
The post-war global economic order was initially based on the principles of free
trade in goods, current account convertibility, and monetary stability through
fixed but adjustable exchange rates vis-à-vis the US dollar. Open capital
accounts were the exception, however. At the time, trade integration was seen to
be more important for economic progress than financial integration.
It worked well for a long while, and some call the period from 1950 to 1970 the
golden years. Yet there were inherent flaws in this set-up that contributed to its
demise in the early 1970s, not least the well-known Triffin dilemma regarding
the conflict between the domestic economic objectives of the country providing
the main reserve currency and the required international supply of that currency.
In this case it was the US dollar. Then capital accounts were opened up, with
strong momentum in the 1980s and early 1990s. Capital controls were
increasingly undermined by technology and financial innovation, and strong
arguments were being made to the effect that open capital accounts would bring
significant benefits. After all, ongoing real economic integration at a global level
demanded at least some degree of global financial integration. In turn, freer
capital movements, the ongoing cross-border financial integration, and the
growth of private capital flows that followed undermined pegged exchange rates
and thus contributed to the spread of flexible exchange rate regimes and inflation
targeting in many parts of the world, but in the European Union this development
provided part of the rationale for a monetary union.
The current international monetary system and the official part of the global
financial safety net largely reflect the contours of the global economy as they
were before global financial integration and private capital flows reached the
level we have seen in this century.
Back then, the global macroeconomic problem was related to global current
account imbalances and asymmetric adjustment. Keeping your own house in
order was in most cases both necessary and sufficient for maintaining economic
stability in individual countries. IMF facilities to lend to sovereigns of debtor
countries facing balance of payments difficulties were the most important part
of the global financial safety net (GFSN).
The world we currently live in is different. Financial imbalances in both net and
gross balance sheets can be more important than current account imbalances and
certainly were so in the build-up to the great financial crisis (GFC). This is a
world of cross-border spillovers and spillbacks. It is a world where, for small
and open economies (SOEs), keeping your own house in order is certainly
necessary but no longer sufficient, at least not if we restrict ourselves to
traditional demand management and prudential instruments. Financially
integrated small and open economies can still be overwhelmed by large and
volatile capital flows driven by push factors. It is a world that needs additions to
-
the GFSN, some of which we partly have such as FX liquidity provisions to
internationally active banks through central bank-swaps - but some of which we
do not have.
The international community is certainly aware of these issues. The IMF has
done good analytical work in this area and proposed reforms. Work has been
done under the auspices of the G20 looking at potential reforms to the
international monetary sytem (IMS), and currently the Eminent Persons Group
is working on a report to the G20 to be delivered at this year's autumn meetings
of the IMF. But progress in this area is slow and with current set-ups we are not
going to get far without having the main reserve currency country on board.
This raises the question that I will turn to next: in the absence of global (or
regional) reforms, what will individual SOEs have to do in order to reap the
benefits of cross-border financial integration in safe manner? In order to answer
this question, we need to understand how cross-border financial integration
affects the ability of SOEs to preserve both monetary and financial stability.1
First, a simple theory. If we have a world made up of one very large country and
several very small countries, with full cross-border financial integration (in the
1
For a more expanded version of what follows, see my published work, in particular
Gudmundsson (2008) and Gudmundsson (2016).
economic sense of these terms rather than the legal one), and assume that relative
risk premia are constant, then long-term interest rates in the small countries will
be pegged to long-term rates in the large one. This, of course, is an "unrealistic"
theoretical simplification. But it gives us a reference point to start to think about
these issues, and it indicates the direction we might be heading in as global
financial integration progresses.
In this type of world, the small countries could still have independent monetary
policy of a sort, provided that they have a flexible exchange rate regime. They
could pick their own inflation targets and set their own short-term rates that
would affect economic activity in the short run and inflation in the long run. In
this case, monetary policy works mostly through the exchange rate channel. If
exchange rates are "well behaved" and the financial sector is sufficiently
regulated and supervised, then a floating exchange rate and "keeping your own
house in order" is sufficient for independent monetary policy and financial
stability.
The problem is, however, that exchange rates are sometimes far from being
smooth reflections of underlying fundamentals. The evidence suggests that
foreign exchange markets exhibit excess volatility and that exchange rates
diverge from fundamentals for protracted periods. In some sense, the existence
of carry trade can be construed as evidence of this, as it involves betting that
interest rate differentials are not fully compensated by exchange rate
movements; i.e., that uncovered interest rate parity does not hold, except at long
horizons, and then often through sharp and disorderly corrections.
This, in turn, gives rise to two concerns: first, regarding detrimental effects on
the traded goods sector , and second, on financial stability where volatile capital
flows, currency mismatches, and rollover risk of foreign currency debt are
among the key players. Adverse effects on financial stability can be particularly
severe when a blocked interest rate channel and an erratic exchange rate channel
interact badly with other economic and financial risks that can face small, open,
and financially integrated economies - such as the global financial cycle,
domestic financial vulnerabilities, and policy conflicts.
We saw trends before the GFC that were consistent with this story. Data on
longterm interest rates and spreads in small advanced economies and in many
emerging markets economies showed strong and growing correlations with
longterm rates and spreads among core rate setters (mainly the US and the eurozone),
although still some way from the theoretical limiting case. The GFC reversed
this process somewhat, as risk premia skyrocketed, cross-border banking partly
retreated to home base, and restrictions on capital movements were in some cases
reintroduced. It has come back to a significant degree.
Before the crisis, some argued that these patterns could be due to common
shocks, convergence of monetary policy frameworks, and increased credibility
of those frameworks. However, case studies, comparisons of the pre- and post-
crisis periods, and other observations make it more and more plausible that
global financial integration is the main driver.
The bottom line is that it is becoming more difficult to conduct independent
monetary policy in small, open, and financially integrated economies, and
although a flexible exchange rate is a necessary condition for doing so, it might
not be sufficient, especially when we factor in the financial stability aspects.
This, I think, is why we find on occasion that we are closer to facing a dilemma
than a trilemma. I think it is still a trilemma, but with trade-offs of variable
severity.2
What can individual countries do about this?
First, those that have the option can enter a monetary union. That has its own
pros and cons, as you all know very well. But for a SOE were the MU constitutes
the biggest trading partner, issues of excess exchange rate volatility and domestic
currency mismatches become much less pronounced.
Second, they can give up on independent monetary policy while maintaining
their own currency by either pegging the exchange rate or pegging interest rates
to those of global rate setters. The problem with the first is that, as history shows,
it can be difficult to maintain with free capital movements. The problem with
both is that other policies, such as fiscal policy, will then have to take care of
domestic economic stabilisation. But will they?
Third, they can use FX intervention to reduce the effect of volatile capital flows
on the exchange rate.
Fourth, they can increase resilience and the ability to live with exchange rate
fluctuations (reduce the fear of floating) by strengthening financial regulation
and supervision or employing macroprudential tools.
Fifth, if everything else fails, they can introduce tools aimed directly at the
financial integration part in order to regain greater monetary independence and
shift the effect of monetary policy more to the interest rate channel and towards
the non-traded goods sector. These so-called capital flow management measures
are probably most needed when countries are faced with large capital inflows at
the same time as domestic conditions warrant significantly higher interest rates
than among core rate setters.
In Iceland, we have used many of these tools in recent years. We have used FX
intervention to reduce short-term exchange rate fluctuations and, in recent years,
to lean against strong appreciation pressures. We have introduced a liquidity
coverage ratio and a net stable funding ratio in foreign currencies. In 2016 we
were faced with strong capital inflows that flattened the yield curve as the policy
rate was being increased and more was signalled. We then introduced a special
2
Rey (2013) and Obstfeld (2015) analyse this issue and provide somewhat different views on
whether it is a dilemma or a trilemma.
non-renumerated reserve requirement of 40% with a holding period of a year on
capital inflows into the bond market and high-yielding deposits. It worked, and
monetary transmission through the interest rate channel was restored. As a result,
we also avoided the build-up of significant carry trade positions with the
associated risk to financial stability. We see such instruments as temporary and
only to be used as a third line of defence. Furthermore, it remains an open
question whether they will be seen to be more in the nature of macroprudential
tools or as infringements on our treaty obligations to maintain free capital
movements. We are hoping that everybody has learned the lessons of the crisis
where large and volatile capital flows played a key role.3
In concluding, let me come back to the IMFS and ask what I have said about the
plight of SOFIEs means in terms of desirable reforms. First, we need to continue
to adapt IMF surveillance and facilities and other parts of the GFSN to modern
realities. Second, we need to further reduce financial regulatory flaws and gaps
at the regional and global level regarding capital flows and cross-border banking.
Third, we need to try to find ways to make central bank swaps a more transparent
and reliable part of the GFSN. Finally, international organisations and treaties
need to accommodate but monitor SOFIEs' use of macroprudential and capital
flow management tools. With time, we might develop a new consensus on the
rules of the game.
References:
Central Bank of Iceland (2017). Special reserve requirement on capital inflows.
Monetary Bulletin 2017/4. Available at www.cb.is.
Gudmundsson, Már (2008). Financial globalisation: key trends and implications
for the transmission mechanism of monetary policy. BIS Papers No 39.
Available at www.bis.org.
Gudmundsson, Már (2016). Global financial integration and central bank
Singapore Economic
policies in small, open economies, Review.
Obstfeld, Maurice (2015). Trilemmas and trade-offs: living with financial
globalisation. BIS Working Papers 480. Available at www.bis.org.
Rey, Helene (2013). Dilemma not Trilemma: The Global Financial Cycle and
Monetary Policy Independence. Available at
www.kansascityfed.org/publicat/sympos/2013/2013Rey.pdf.