Vítor Constâncio: The future of the international monetary system
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, for the
Golden Series lecture at the Official Monetary and Financial Institutions Forum (OMFIF),
London, 23 November 2011.
* * *
Ladies and Gentlemen,
It is with pleasure that I have accepted the invitation from the OMFIF Golden Series on World
Money to talk about the future of the international monetary system. This subject has
become very topical this year, not least in view of the discussions and progress achieved at
the very recent Cannes Summit.
I will start by briefly recalling the key features of a good international monetary system and
on this basis, I will try to define what are, in my view, the main weaknesses of the present
system (or "non-system" as many describe it). This will allow me to dwell upon the possible
evolution over the medium run of some of the main components of the international monetary
system. When concluding, I will assess whether such an evolution may prove to be an
adequate response to the challenges we are confronted with.
What can we expect from a good-quality international monetary system?
The ultimate goal of the international monetary system (hereafter: IMS) is to maintain an
orderly system of payments among nations. To this aim, the IMS has to provide the services
of an international currency, ensure adequate creation of global liquidity, define an exchange
rate regime among national currencies and include an adjustment mechanism to avoid
excessive external real and financial imbalances across nations.
Both global liquidity and the adjustment mechanism can be interpreted as global public
goods (see e.g. Eichengreen 1987, Camdessus 1999, Dorrucci and McKay 2011). It is
indeed only through access to global liquidity that it becomes possible to participate in, and
finance, the global economy by using one or more reserve currencies as a means of
payment, a unit of account or a store of value.
And it is only through an efficient and effective adjustment mechanism that it becomes
possible to benefit from "external stability", namely a global sustainable constellation of
cross-country economic linkages (e.g. via current accounts and asset/liability positions).
Once external stability is achieved, cross-country linkages do not give rise to disruptive
developments, such as disorderly exchange rate and asset price swings or contractions in
real output and employment. External stability crucially depends on the policy behaviour of
those issuers and holders of international currencies that are systemically relevant.
The exchange rate and capital flow regimes are probably the core elements of the
adjustment mechanism, since they define the degree of flexibility of each IMS, i.e. its
adaptability to changing economic circumstances. In contrast to the Bretton Woods system
with fixed exchanges rates, semi-closed capital accounts and a strict adjustment mechanism,
an IMS such as the present one enjoys a much higher degree of adaptability. Each country is
free to choose its exchange rate and capital account regime, and the reserve-issuing
countries face no IMS-embedded limits to the creation of global liquidity. This is a
fundamental strength of today's system, but it may also become - as we will see - a major
weakness to the extent that it creates scope for unsustainable domestic growth models and
the ensuing accumulation of real and financial imbalances.
What are the shortcomings of the present "non-system"
Besides the persistent external imbalances, there are many other shortcomings being
mentioned about the present "non-system". I can mention a few of them: abrupt reversal of
capital flows; systematic inflows going from emerging to developed countries; inefficient
accumulation of reserves by emerging countries; excessive exchange rate volatility
ineffective to ensure external balance; asymmetry of adjustment pressure between deficit
and surplus countries; absence of mechanisms to ensure the sufficient and timely supply of
global liquidity in times of financial crises.
This list means that, potentially, all the features of an IMS can be at stake in the present
discussion, contrary to what happened in the late nineties when the discussion revolved
around the functioning of the financial sector and the crisis prevention and resolution in
emerging economies. The debate then was not about the reform of the IMS but rather about
a new Global Financial Architecture, meaning the international framework for safeguarding
and ensuring the efficient functioning of the global financial system.
Today, after the start of the crisis in 2007, the issues under discussion are at the core of what
constitutes an International Monetary System: 1) Are new international currencies necessary
and/or unavoidable in the present circumstances? 2) Should changes be introduced in the
foreign exchange regime? 3) Does the system need new and stronger instruments of liquidity
provision, especially in times of financial crises? 4) What changes should be introduced in
the adjustment mechanism? 5) Which reforms are needed in the about international
regulation of the financial sector?
I will not address this last point. Regarding the second issue on the exchange rate regime, I
will only mention that I see no justification to change the floating regime among the major
currencies or to modify the recommendation that big emerging economies should also adopt
much more flexible rate regimes. This means that in the conflict characterised by MacKinnon
(1994) between the international adjustment view of exchange rates and the monetary
standard view, I take the side of the former. Also, the present situation of financial
globalisation confirms the early "bipolar view" of Alexander Swoboda that with high capital
mobility the only stable exchange rate regimes are floating rates or hard pegs, of which
monetary unions are an extreme example (see Eichengreen, 2010).
Towards an unavoidable, but desirable, multi-polar IMS?
There are many predictions about the gradual addition of other currencies to the dollar as
truly international currencies. What seems to make this unavoidable it is not only the
emergence of the euro, the increasing strength of China or the growing vulnerabilities of the
US. The growth in importance of emerging countries, that have seen their share in the world
GDP augmented by 15 percentage points in the last 20 years, creates a structural increase
for the demand of reserves that the developed countries, including the USA, will not be in a
position to supply.
This question is linked with the problem of the provision of official international liquidity. As
Maurice Obstfeld (2011) has recently recalled, there is a fiscal dimension to the supply of
official reserves. No single country in the world could indefinitely offer its currency as the
reserve asset that could satisfy all the needs of a growing rest of the world. In the present
circumstances where deficit and debt ratios need to be decreased, the US could not offer its
bonds and T-bills as the almost exclusive reserve asset of the world. In this context, Euro
assets are necessary. Even if they are clearly seen as an unrealistic prospect, Eurobonds,
from the pure perspective of the International Monetary System, would be useful as a
reserve asset for the world economy. In the future, the system will also need assets in the
Chinese currency, when China will have a convertible currency, a flexible exchange rate and
a developed bond market.
All this implies that one possible scenario is the evolution towards a truly multi-polar IMS,
which, as many have recently observed, would produce credible alternatives to
dollardenominated investments, thereby enhancing policy discipline in the core reserve issuer.
Also, a multi-currency world would imply greater monetary policy autonomy in emerging
economies such as China, which would thus be in a better position to tackle its own
imbalances (see e.g. Bini Smaghi 2011).
 There are five key conditions for a currency to become a major international
currency. The first one is having a very large economy, which engenders network
externalities and lowers transaction costs. The second is given by deep, efficient
and open financial markets. Third, good political and macroeconomic governance is
of course of the essence to preserve the external value of a currency. Fourth, full
enforcement of the rule of law is equally crucial as it ensures the protection of
investors' property rights. Fifth, one should not overlook the importance of
geopolitical influence and political stability.
 It is therefore not easy for a currency to fill all the conditions necessary for it to have
an international role. Consequently, I do not think that we will see a major change in
the role of the US dollar over the next 10-15 years - though the conclusion may well
be different over a longer horizon. The appearance of the euro as a new globally
important currency has not produced a shift to a genuine duopoly in the supply of
international currencies, and had little impact on the dollar's centrality in the IMS.
We are likely to see the shares of other currencies growing over time, but it is
unlikely that there will be just one currency replacing the US dollar's hegemony.
The euro has established itself as the second most important international currency after the
US dollar. At the same time, this role is predominantly regional in nature, since the euro is
mainly used by economic agents resident in euro area neighbouring countries with special
political and economic ties to the European Union and the euro area. More recently, it is
known that Asian investors and foreign central banks accounted for a sizable share of the
demand for bonds issued by the European Financial Stability Facility (EFSF).
Looking ahead, the share of the euro in international markets has the potential to rise further
once financial stability and market integration is restored in the euro area. The ongoing
efforts to improve the governance of the euro area and provide it with a credible crisis
resolution mechanism will also indirectly affect the international use of the euro, even if the
ECB and the Eurosystem do not take any initiatives to directly promote its use (Angeloni,
Sapir 2011). This neutral stance - neither foster nor hinder - is based on our conviction that
the international use of currencies should be a by-product of autonomous market decisions
driven by the aforementioned five determinants.
Turning to the Chinese renminbi, one can observe that the use of the renminbi as an
international currency has remained limited although China is now the third largest economy
(after the United States and the euro area) and second largest exporter (after the euro area)
of the world.
The Chinese authorities have launched several initiatives since March 2009 to promote a
wider international use of the renminbi, e.g. in trade invoicing, in deepening the role of the
offshore centre played by Hong Kong S.A.R., or in agreeing local currency swap agreements
with several central banks.
Nevertheless, the full potential of the renminbi can ultimately only be achieved with the
liberalisation of the capital account, accompanied by the reform of domestic financial
markets. Once these will be in place, a major internationalisation of the renminbi will happen
as a by-product. For the time being, Chinese authorities seem to be trying to prudently
promote financial liberalization via experimenting with market-driven renminbi securities in
Hong Kong S.A.R.. But this comes at the expense of increasing exposure to capital flows
which poses challenges for the macro-prudential set-up, especially given the current
undervaluation of the renminbi. Hence, Chinese authorities may also slow down the use of
the renminbi abroad should tensions for domestic policy makers mount. All in all, the
potential for the renminbi to upgrade as an international currency is clearly huge, but the
timing is difficult to predict.
The necessary reform of the adjustment mechanism
I share Kregel's (2010) view that "the basic problem [with the current IMS] is not the
particular national liability that serves as the international currency, but the failure of an
efficient adjustment mechanism for global imbalances".
Indeed, one needs only to look at the problem of global payment imbalances to find
weaknesses of the current IMS, or rather "non-system". The build up of increasingly large
current account surpluses in some export-oriented economies, which rely on a growth-model
based on over-savings, was, in conjunction with accumulating deficits in a number of
consumption-driven economies, a major source of concern in the years which preceded the
global financial crisis. Such imbalances were coupled with "twin gluts" in global liquidity and
planned savings which led to historically low risk premia - the main symptom that systemic
risk was escalating in the presence of easy finance accommodating complacent borrowers.
Even the global financial crisis and the policy responses have reduced the imbalances only
partly and temporarily over the most recent years. The fact that these imbalances have
persisted for so long exposes a key weakness of the system, namely the inadequacy of the
adjustment mechanisms. Let me explain this in more detail by looking at the various
stakeholders:
National authorities in deficit and surplus countries had little incentives to depart from their
growth model and policy course. Indeed, prior to the crisis the economies with the largest
external imbalances were often outperforming their peers in terms of GDP growth: the larger
the imbalance, the higher was the growth rate over the short run. Moreover, the deficit and
surplus countries, rather than exerting policy discipline on each other, in fact accommodated
the other in the pursuit of their respective growth models (see Dooley et al. 2003).
Market discipline also proved partly unreliable for a number of reasons.
Firstly, markets frequently do not function in line with fundamentals as expected, leading to
mispricing and undue volatility in, for example, exchange rates and credit risk premia. This
may be explained in part by factors such as herding behaviour, but also the lack of a shared
view on the relevant fundamentals.
Secondly, market behaviour has also been constrained by structural factors and policy
regimes. On the deficit side, the fact that the United States provides the deepest and most
liquid financial market - and issues the dominant reserve currency - provides it with an
unparalleled platform to offer "safe" debt instruments. The insatiable demand for such debt
instruments puts strong pressure on the US financial system and its incentives (Caballero
2009). At the same time, the US derives its "exorbitant privilege" from this situation. The
demand for US assets constrains the growth in credit and exchange rate risk premia charged
by markets on rising US debt. This effectively limits the increase in external borrowing costs,
thus removing an incentive to curb borrowing. On the surplus side, the semi-fixed exchange
rate regimes and the semi-closed capital account of some major surplus countries prevent
markets from exerting excessive pressure on capital flows or the exchange rate of such
countries.
Thirdly, accommodated by a trend towards self-regulation, financial markets encouraged
rather than tamed excessive borrowing. Income constraints on debt accumulation were
circumvented through innovative debt instruments, which were insufficiently checked by
quality credit analysis and internal controls. Moreover, in the search for yield and
diversification, capital flows to emerging markets and "carry trade economies" have surged,
prompting, in certain cases, the imposition of capital controls to limit the potentially disruptive
influences of both excess inflows and their reversals.
The international community has a role to play in exerting pressure on countries to adjust,
primarily the International Monetary Fund (IMF) and the G20. Although helpful policy
recommendations have been put forward at the global level, the traction gained by the
international community has often not been as strong as it needed to be. The IMF, to some
extent, has been hampered in its efforts to ensure the stability of the IMS. The existing rules
were designed for the pre-globalisation era and the enforcement mechanisms are not
sufficiently effective.
Regarding the rules, these were agreed in an era of fixed exchange rates, closed capital
accounts and highly regulated financial markets when the financial sector was the
handmaiden of the real economy. This was well before the widespread liberalisation of trade,
financial markets and capital accounts that defines globalisation. For example, under the IMF
Articles of Agreement, members are free to pursue capital account regimes and exchange
rate regimes of their choice, with only limited constraints.
The outcome is a global constellation of exchange rate regimes that does not ensure
sustained economic, financial and monetary stability. The peg of currencies of a number of
emerging economies to the US dollar creates a symbiosis that fosters ever larger imbalances
and hence risks of disorderly adjustment. Particularly when one of the emerging economies
is very large, the pegging of its currency to another risks limiting the flexibility of adjustment
in both, which in turn threatens to distort the exchange rate of other major currency pairs,
with implications for global economic performance.
Turning to the enforcement mechanisms, surveillance and peer policy review have an
essential role to play in identifying risks and encouraging remedial policy action. But
international pressure - including via the IMF and the G20 - still suffers from lack of grip.
Even when risks are correctly identified and policy recommendations are appropriate, as it
happened during IMF's multilateral consultations in 2006-07, there is no guarantee of
necessary policy adjustments being made. This remains the weakest aspect of the
surveillance process.
The crisis has led to increased efforts to improve surveillance, e.g. with the transformation of
the Financial Stability Forum into the Financial Stability Board (FSB) with an enlarged
membership and broadened mandate, changes inside the IMF, and the launching of the G20
Framework for Strong, Sustainable, and Balanced Growth and its Mutual Assessment
Process. There is a general recognition of the need to strengthen the multilateral angle of
surveillance, to better encompass interlinkages and spillover effects, and to better integrate
macroeconomic and financial sector.
More work needs to be done, however, to further strengthen the effectiveness of
surveillance. There is no widespread consensus yet on how a country's policies impact on
other countries and - more importantly - no willingness of countries to submit themselves to
closer scrutiny. By contrast, we can observe a lot of mutual finger-pointing, mainly between
advanced and emerging economies, but to some extent also within the two groups. It follows
that EMEs push for an inclusion of global liquidity and its drivers into multilateral surveillance,
whereas advanced countries see a need for more scrutiny of reserve accumulation practices,
exchange rate policies and capital controls. Against this background, it is also obvious that a
lot of countries do not have any appetite to change the IMF's Articles of Agreement to ratify a
broadening and strengthening of surveillance.
What can be done in such circumstances? I think that first of all we need to work even harder
to achieve a better understanding of interlinkages and spillover effects. This implies the need
for more and better analysis. The new pilot spillover reports that the IMF started this year
with a handful of systemically important countries are one welcome step in that direction.
Further research on the impact of policies in systemically important economies on global
liquidity conditions and on capital flows will also help framing the discussions.
Going forward, better awareness, a certain spirit of multilateralism and, last but not least,
improved mechanisms to foster traction of policy advice will be crucial elements to
strengthen the effectiveness of surveillance in contributing to global stability.
Evolution of global official liquidity
Another area in which views are very much divided is the debate about the enhancement of
official liquidity provision. One idea is to strength the so-called global financial safety net
(GFSN). It would be used in those exceptional situations when countries with sound
fundamentals suffer from financial market disruptions - such as foreign currency liquidity
shortages or sudden stops in capital inflows - caused by contagion from major (e.g.
Lehmantype) external shocks .
Also here significant progress has been achieved over the last years: IMF resources have
been tripled compared to 2008, access rights to IMF financing increased, and new facilities
were created. But some believe that this is not enough, and argue with pertinent arguments,
that further enhancing the global financial safety net would provide incentives for countries to
decrease their reserve holdings (see Fahri, Gourinchas and Rey, 2011). However, as I
mentioned earlier, the accumulation of large stocks of reserves is not only based on
precautionary motives. Even the most customer-friendly IMF facilities might not lead
countries to lower their reserves since they offer a higher level of comfort and convenience
than IMF facilities. At the same time, countries might face problems in actually using their
reserves in times of crisis, given that markets might not focus on the absolute level, but
rather on the relative changes.
Further reforms of the Fund's toolkit need to be based on a thorough assessment of the
experience with the existing tools and the resource implications further insurance-type
facilities would have. The call for increased Fund resources, which is recently being voiced
again, has also to be assessed carefully in light of existing and potential demand for Fund
support. Concerning another SDR allocation, one should consider that during the recent
crisis only a very small amount of SDRs allocated in 2009 has actually been converted into
usable currencies.
What would seem to be justified is to foresee established mechanisms to provide liquidity in
times of financial crises when private liquidity suddenly disappears. In this context there have
been also calls on central banks to establish a permanent scheme of swap lines to help
countries in times of systemic stress. However, while central banks will certainly continue to
assume their responsibilities in times of distress, they cannot commit ex-ante to any
significant provision of liquidity as this could interfere with their mandate and create moral
hazard.
Concluding remarks: is this enough?
Will the changes in the IMS which, based on current information, we are likely to witness
over the next ten-fifteen years be sufficient to make it resilient and sustainable? I am
certainly not among those who consider that this is the case. But then, what further changes
are indispensable? The answer to this question depends upon the longer-term vision. If we
are really heading towards a multi-polar system, this may well set stronger incentives for
policy discipline, since the exorbitant privilege will be more widely shared.
But will the road towards the new multi-polar system be smooth or very bumpy? Well, a lot
will depend on the path of further financial market development, capital account liberalisation
and exchange rate flexibility in EMEs, since this will progressively reduce the demand for
safe debt instruments issued by advanced economies. It will also allow a better channelling
of domestic credit to investment and consumption, which in turn will help to promote growth
driven by domestic demand. And a lot will obviously also depend on the ability of advanced
economies, starting with the euro area, to learn the appropriate lessons from the current
sovereign debt and banking crisis. The speed and scope of this process will depend on
decisions of policy makers and market participants in the various parts of this world. If this
whole process will be resolute and gradual at the same time, it should allow for an orderly
transition towards a multi-polar IMS.
Another question is whether the new IMS would be steady in nature or whether a new
hegemon would emerge possibly to accomplish the "hegemonic stability theory" promoted by
Kindleberger (Kindleberger, 1970). The answer will, again, depend predominantly on
policymakers. It remains to be seen whether the currency competitors of such a multi-polar world
will be of relatively close weight, both in economic and financial terms, but also with respect
to the political and governance factors discussed before when considering the preconditions
for a currency to become a major international currency.
As regards the necessary changes to international cooperation, we will need to see a greater
awareness among global partners about their interlinkages and the ensuing responsibilities
to ensure the stability of the whole system. I am convinced that, without a minimum spirit of
multilateralism and a minimum degree of cooperation, no future IMS will remain stable for
long. It is to be hoped that countries, especially those with systemic relevance, understand
that it is in their best self-interest to consider externalities and cooperate. But such
"enlightenment" alone will not be sufficient to ensure stability. If the IMS as such does not
deliver the right incentives, the international community will have to eventually agree on
enhanced adjustment mechanisms, e.g. in order to foster the traction of policy
recommendations. It is to be hoped that we do not need another global crisis to instil the
necessary incentives.
References
Angeloni, Bénassy-Quéré, Carton, Darvas, Destais, Pisani-Ferry, Sapir and Vallée (2011):
"Global currencies for tomorrow: A European perspective", Bruegel Blueprint Series, vol. XIII.
Angeloni, I and Sapir, A. (2011), The international monetary system is changing: What
opportunities for Europe?, paper for Bruegel-PIIE Conference The Transatlantic Relationship
in an Era of Growing Multipolarity, Berlin, 27 September 2010.
Bini Smaghi, L. (2011): "The Triffin dilemma revisited", speech at the Conference on the
International Monetary System: sustainability and reform proposals, marking the
100th anniversary of Robert Triffin; the Triffin International Foundation, Brussels,
3 October 2011.
Caballero, R. (2009), "The 'Other' Imbalance and the Financial Crisis", paper for the
Baffi Lecture delivered at the Banca d'Italia, 10 December.
Camdessus, M. (1999), "International Financial and Monetary Stability: A Global Public
Good?", remarks at the IMF/Research Conference entitled "Key Issues in Reform of the
International Monetary and Financial System", Washington, D.C., 28 May.
Dorrucci, E. and McKay, J. (2011), The International Monetary System after the Financial
Crisis, Occasional Paper Series, No 123, ECB, Frankfurt am Mai, February.
Dooley, M.P., Folkerts-Landau, D. and Garber, P. (2003), "An essay on the revived
Bretton Woods System", NBER Working Papers, No 9971, National Bureau of Economic
Research, September.
Eichengreen, B. (2010) "Exchange rate regimes and capital mobility: how much of the
Swoboda thesis survives?" in Charles Wyplosz (ed) "The New International Monetary
System" Routledge.
Eichengreen, B. (2011), Exorbitant Privilege - The Decline of the Dollar and the Future of the
International Monetary System, Oxford University Press, January.
Eichengreen (1987), "Hegemonic Stability Theories of the International Monetary System",
NBER Working Papers, No 2193, National Bureau of Economic Research, March.
Farhi, E., Gourinchas, P-O and Rey, H. (2011) "Reforming the International Monetary
System" CEPR
Kindleberger, C. (1970): "Power and Money. The Economics of International Politics and the
Politics of International Economics", Basic Books, New York.
Kregel, J. (2010), "An Alternative Perspective on Global Imbalances and International
Reserve Currencies" - Economic Public Policy Brief Archive, Levy Economics Institute
McKinnon, Ronald (1994) Discussion of Peter Kenen "Floating exchange rate regimes
reconsidered" in Peter B. Kenen et al (ed) "The International Monetary System" Cambridge
University Press, page 165
Obstfeld, Maurice (2011) "International liquidity: the fiscal dimension" Keynote speech at the
Bank of Japan, Institute of Monetary and Economic Studies, International Conference,
Tokyo, June 2-3, 2011.
Triffin, R. (1960): "Gold and the dollar crisis", Yale University Press, New Haven.