Javier Guzmán Calafell: Uncertainties about the global financial safety
net
Remarks by Mr Javier Guzmán Calafell, Deputy Governor of the Bank of Mexico, at the
7th Annual Conference of the Central Reserve Bank of Peru and the Reinventing Bretton
Woods Committee, Arequipa, Peru, 6 July 2016.
* * *
The views expressed in this document are strictly personal.
I am very glad to participate in this 7th Annual Conference of the Banco Central de Reserva
del Perú and the Reinventing Bretton Woods Committee. I thank Julio Velarde and Marc
Uzan for the invitation to attend this event.
Over the last several years, the International Monetary and Financial System (IMFS) has
been subject to a number of shocks that have compromised its adequate functioning. Indeed,
the global financial crisis made the weaknesses of the IMFS much clearer and highlighted
the consequent need to reform it on several fronts. The liquidity provisioning function of the
system, especially in times of crisis, is one of the most evident among them. Certainly, the
severe liquidity shortage that took place during 2008-2009, and the swings in global liquidity
that we have witnessed in subsequent years, have underlined that the current system needs
better mechanisms to allow it to fulfill, in a systematic, timely and efficient manner, the
liquidity requirements of the global economy during episodes of distress.
The demand for emergency liquidity in the global system should decline to the extent that
appropriate macroeconomic and financial policies are in place. However, the reality is that
financial and macroeconomic crises, as well as episodes of contagion to fundamentally
sound economies, are inevitable and hard to predict. Hence, the need for a sufficiently
funded and evenly balanced Global Financial Safety Net (GFSN) should not be overlooked.
This, not only because of its vital importance for the resolution of crises, but also, and
perhaps even more important, because of the significant role it may play in their prevention.
The GFSN has undergone a profound transformation as a result of the global financial crisis
of 2008-2009. To start with, in view of the prevailing uncertainty and in an effort to protect
themselves against external risks, many countries decided to increase substantially the size
of their international reserves. In addition, the financial resources available to the
International Monetary Fund (IMF) were enlarged and its financial facilities revamped.
Simultaneously, a number of new regional financial arrangements (RFAs) were created with
some of the existing ones strengthened. Finally, in an effort to tackle liquidity shortages,
central bank bilateral swap arrangements (BSAs) were made available to many countries.
Although distinct in nature, these four layers constitute the general structure of the GFSN as
it currently stands.
Notwithstanding its recent transformation, the GFSN still faces important challenges. First
and foremost, even though its financing potential has increased substantially in recent years,
this is mostly explained by reserve accumulation which, as explained below, has a number of
drawbacks. In fact, once international reserves are excluded, the evolution of GFSN
resources does not keep pace with the growth of global external liabilities in recent years.1
Furthermore, the GFSN's ability to prevent contagion is undermined by its uneven country
coverage, as sizeable financing gaps in many economies still remain unattended. In addition,
the growing size and complexity of the GFSN, in particular the proliferation of bilateral and
regional arrangements, has led to greater difficulty in coordinating its various components,
thus resulting in a more fragmented, less reliable framework. To this one must add high
costs, either of a financial or political nature, of several layers of the safety net, and the
absence of an appropriate conditionality structure in most of these layers, implying the
potential of inadequate policy incentives and moral hazard, among other risks.
Against the backdrop of persistently volatile international financial conditions, elevated risks
to the global economy stemming from cyclical and structural developments, and the lack of
sufficient space in both the fiscal and monetary policy fronts in many countries to
accommodate potential shocks, the implementation of measures aimed at tackling the
shortcomings affecting the current GFSN is of utmost relevance. In the absence of decisive
action in this direction, we may see increasing risks for the global financial system and an
additional accumulation of international reserves by individual countries.
The experience of the last years has underscored the merits of holding a comfortable level of
international reserves. However, reserve accumulation can also entail significant costs. At
the country level, the financial burden deriving from the sterilization operations that need to
be carried out in order to avoid the adverse macroeconomic implications of larger
international reserves cannot be disregarded. Such costs are potentially high due to the
uncertainty surrounding the definition of an adequate, or optimal, level of international
reserves, in light of which a precautionary over accumulation becomes more likely. At an
international level, the excess demand for safe, reserve assets contributes to global current
account imbalances, introduces downward pressures on international interest rates, and may
result in distortions in the valuation of assets; more leveraged positions by governments,
firms and households; and a search for yield, all of which contribute to a more fragile, less
stable IMFS.2
What should the international community do to strengthen the GFSN?
With an emerging market perspective in mind, from my point of view any strategy in this
direction should have the International Monetary Fund (IMF) at its center. Given its nearly
universal membership, ample financing, a wide range of facilities at its disposal, and a highly
qualified and experienced staff, the Fund is in a unique position to play this role. However, for
this to be a viable, fruitful path, further efforts in several areas are needed. Let me point to
three of them which I consider to be particularly important.
First of all, the IMF needs to have adequate resources. Certainly, the recent doubling in Fund
quotas under the 14th General Review, the largest ever, is a major step in this direction.
However, it should be noted that the net effect of this measure on the Fund's overall lending
capacity is negligible, vis-à-vis the amount available with the previous quota base and the
borrowing agreements negotiated in the aftermath of the global financial crisis. Furthermore,
standard indicators of the adequacy of Fund resources, such as the ratio of quotas to GDP,
trade and capital flows, and international reserves, suggest that an additional quota increase
is needed to endow the Fund with resources commensurate to potential demand. While an
excessive reliance on borrowed resources would have important shortcomings, this source of
funding has played a useful role when capital has to be mobilized swiftly. In this regard, it is
also important to emphasize that renewal of the New Arrangements to Borrow (NAB) for the
five year period starting in 2017 has yet to be discussed and agreed upon, and that there is a
risk that the bilateral borrowing agreements set forth in 2012 will not be extended and thus
start to expire later this year.
The current characteristics of the world economy also underline the need for a financially
strong IMF. The global economic and financial environment is bound to remain complex and
highly uncertain for a significant period. Not only are linkages among individual economies
expected to continue growing, but also legacies from the crisis in a number of key, systemic
players are likely to persist. Under such circumstances, the possibility of deeper, longer and
more frequent crises is a real one. Moreover, the global financial crisis has served as a
reminder that advanced economies (AEs) may also require emergency liquidity, implying
potentially large demands on the Fund.
Second, the IMF needs adequate financing tools. Indeed, the Fund has made significant
progress in recent years to streamline the financial facilities available to its members. In
addition to the more traditional, crisis resolution-oriented facilities it has historically offered, a
number of instruments were created after the eruption of the global financial crisis, with a
stronger focus on crisis prevention and higher access (the Flexible Credit Line and the
Precautionary and Liquidity Line). Unfortunately, demand for these instruments has in
general been modest.
While I concur with the view that there is still room to improve some of the features of the
available financing windows, this is unlikely to provide the explanation for their limited use.
Take the case of the FCL. The features of this facility in terms of access and flexibility of
resource use, among others, would have simply been unthinkable before the global financial
crisis. Yet, only three countries are at present supported by the FCL. This situation is
paradoxical, since some potential FCL beneficiaries would clearly profit from the availability
of additional external liquidity.
Although the reasons for this are clearly varied, one crucial element behind the reluctance to
demand Fund support is the stigma associated with use of the institution's resources. This is
related to factors such as the historical relationship with the IMF, the perceived success (or
lack thereof) of Fund programs, the conditionality typically associated to them, the political
sensitivities of each country and the legitimacy of Fund decision making, among others.
Clearly, the search for means to overcome this complex problem must continue, especially in
view of the potential benefits for the world economy of a more intensive use of financing
frameworks that stimulate crisis prevention. I would like to note in this regard that the FCL
has been instrumental to support macroeconomic and financial stability in Mexico through
several channels, including the availability of large amounts of external financing in case of
need, lower costs of international reserve accumulation, endorsement of the country's
policies under the most strict Fund standards and a reinforcement of the authorities'
commitment with sound fundamentals.
Third, the IMF has to be seen as a legitimate body. The recent implementation of the quota
and governance reforms under the 14th General Review of Quotas, has implied a major shift,
of around 6 percent points, in both quota shares and in voting power towards dynamic EMEs.
Additionally, the IMF's Executive Board will now consist entirely of elected Executive
Directors, effectively ending some countries' ability to directly appoint members of the
Board.3 These are major steps forward, but still insufficient. In particular, an important gap
between EME participation in the global economy and their IMF quota and voting share
remains, even after taking into account the recent reforms: as a group, EMEs accounted for
nearly 60 percent of world GDP (in PPP-adjusted terms) in 2015, while they contribute only
slightly over 40 percent to the IMF quotas under the current arrangements. Furthermore, a
modification of criteria for the designation of the Fund's top management has been
disregarded. In the absence of further reform of Fund governance, the institution ́s credibility
will be eroded, while the proliferation of alternative schemes for international cooperation will
possibly continue, thus undermining the Fund's role in the world economy and further
entangling global governance.
Naturally, a reliable and efficient GFSN cannot depend on IMF funding alone. An adequate
functioning of the other layers is also essential. I already referred to the role of international
reserves. Therefore, let me say now a few words about the other two components, namely
bilateral swap lines and regional financial arrangements.
The number of central bank swap lines increased sharply in the early years of the global
financial crisis, including arrangements between advanced economies only and also between
advanced and a few emerging market economies. In subsequent years, a small group of
advanced economies decided to maintain bilateral swaps among them as a means to face
the risk of new liquidity shortages. However, those negotiated with other advanced and
emerging market economies were allowed to expire.4
Bilateral swap agreements played a crucial role in stabilizing markets during the early stages
of the global financial crisis. Other features, such as their relative low cost and speed of
access, also contribute to make them an attractive vehicle for liquidity support in times of
stress. Not surprisingly, then, some countries have suggested the institutionalization of swap
lines. This is a sensible proposal, since to become a useful component of the GFSN, swaps
need to be a credible source of liquidity in case of need. The negotiation of swap agreements
ex post, though useful, does not meet this requirement.
Nevertheless, bilateral swap arrangements involve risks for the party providing the liquidity,
that are not easily dealt with through the use of collateral. In addition, there is a concern
among reserve currency issuers that the ex ante commitment by central banks to provide
bilateral swap lines may give rise to moral hazard. As a result, these institutions have been
reluctant to participate in arrangements of this nature with emerging market economies, thus
preferring to adopt a "constructive ambiguity" approach.
While these concerns are understandable, considering the potential contribution of an
institutionalized network of swap lines to the GFSN, options to increase its feasibility should
continue to be explored. One possible course of action that deserves to be looked at is a
mechanism including qualification criteria, sanctions and monitoring, coordinated jointly by
the participating reserve currency issuing central banks and the IMF.5 Another simpler option
is to condition country access to swap arrangements to an IMF "stamp of approval", be it
through a formal program or other acceptable means. Naturally, IMF involvement could imply
costs in terms of stigma and speed of access, but this would still be a superior option to the
status quo.
Let me turn now to RFAs.
Although frameworks aimed at providing financial support to countries in difficulties with
resources pooled at a regional level have existed for many years, the importance of RFAs as
a layer of the GFSN increased substantially following the global financial crisis. According to
some estimates, the total amount of resources currently available through RFAs amounts to
US$1.2 trillion, i.e. a lending capacity at least in theory somewhat above that of the IMF at
present.6
Indeed, RFAs can make an important contribution to the functioning of the GFSN. Beyond
the increased amount of resources available to face potential crises, they may allow a better
understanding of the participating economies and a higher degree of ownership of economic
adjustment programs. As shown by the experience of the European Financial Stability
Facility and the European Stability Mechanism, this kind of arrangements can play a crucial
role in times of severe stress.
Nevertheless, RFAs are also affected by a number of shortcomings: their resources are
unequally distributed, with many EMEs having no access to this source of financing; while
they can be a useful source of support to tackle problems faced by individual countries,
major limitations may arise in case of shocks of a global or regional nature; flexibility in the
use of resources may be limited; and, very importantly, the reliability of most of these
arrangements beyond short term periods has never been tested.
It is not easy to make recommendations of a generalized application to improve the
functioning of RFAs, since they constitute a very heterogeneous group. In my opinion, the
most important course of action of a general nature is to put in place the conditions for a
better coordination with the IMF. Several suggestions have been made to this effect over the
last years, including at the level of the G20, with the recent case of Europe providing a useful
experience. But the reality is that a more formal framework for cooperation between the Fund
and RFAs, focused on a rational division of responsibilities and a proper assimilation of
synergies, is still missing.
To conclude, I just want to note that it is difficult to expect that a transformation of the GFSN
along the lines suggested here will be thoroughly addressed any time soon, given difficulties
of a political nature and the sheer complexity of some of the issues raised. In the absence of
a stronger, more efficient GFSN, efforts to accumulate international reserves are likely to
continue, with the corresponding costs at the national and global levels. Hopefully, as
awareness of the disadvantages of this strategy increases and the merits of a solid GFSN
become more evident, efforts to follow the proper course of action will gain ground.