The future of the international monetary system

With little alternative to the US dollar in reliable global reserve currencies, emerging markets are forced to park substantial reserves in US dollars at near zero interest rates to safeguard against global economic instabilities. Effectively they are being made to pay for the problems created by advanced economies.

Setting up a global insurance mechanism would be a fairer solution to the paradox, according to Eswar Prasad, Tolani senior professor of Trade Policy, Cornell University.

Speaking at a lecture on the future of the international monetary system, jointly organised by NUS Business School and the Lee Kuan Yew School of Public Policy, Prasad said there was no currency that could effectively rival the US dollar as a reserve currency.

A global reserve currency needs to be backed by good legal and financial institutions, he said, as well as adjustment mechanisms through labour mobility and fiscal measures, liquidity and availability of assets.

While the euro had once been expected to challenge the dollar as a reserve currency, the recent and ongoing crisis in the eurozone – and worries over its future viability – has dulled its shine.

“We are learning right now that a German bond is not quite the same as a Greek bond or an Italian bond. So if you look at the size of the bond market in Europe, it starts shrinking as you think about what are really safe assets,” he said.

ThinkAloud4The Yen also is not a viable alternative, despite Japan having a large bond market, as much of the market’s assets are held domestically or by institutional investors and it is not as liquid as the US.

Prasad said the International Monetary Fund’s SDR (special drawing rights) could not be perceived as a reserve currency either, as it is a unit of account based on the average value of four major currencies – US dollar, Euro, Yen and British Pounds. With just 320 billion SDR in issue, it is also relatively modest in scope, accounting for just 3 per cent of the global stock and foreign reserves of about US$10.2 trillion.

“The bigger question on SDR is who gets to issue the currency,” Prasad said.

As such, in terms of reliable reserve currencies, the mighty greenback remains the only currency that fits the bill.

“The reason we have this child-like faith in the US dollar is because we believe that ultimately the US Congress or the US Treasury will not abrogate its responsibilities to the rest of the world. That faith is very important,” he said.

“The IMF is not a national government. It does not have the backing of the fiscal authority. So it can’t create this money out of thin air. After all, fiat money is a strange thing: it doesn’t have intrinsic value.”

Monetary policy has reached the limit of its ability to support growth

Professor Eswar Prasad

The irony, Prasad said, is that emerging markets have to stockpile reserves for buttressing against instabilities in the very advanced economies that are the source of the instabilities in the first place.

Prasad observed that advanced economies have been accounting for more of the global debt but less of global growth. From 2007, advanced economies accounted for nearly 90 per cent of the increase in net public debt around the world but contributed only one-third of global growth at market exchange rates, even less if calculated at purchasing power parity exchange rates.

It’s a situation set to get worse before it gets better. The IMF’s forecast for the next five years suggests that global public debt accumulation by the advanced economies will constitute 85 per cent of the increase in world debt, yet these countries will account for just 14 per cent of world growth.

Moral hazard

At the same time the financial systems of advanced economies are creating another source of instabilities. “The defaults undertaken so far are far from complete. There is an enormous amount of moral hazard that has been built into the system because central banks at the time of crisis do what they have to do to save the system from collapse,” he said.

fed280By trying to protect themselves from instability, emerging markets are building up “self insurance” by setting aside substantial foreign exchange reserves.

“Of the total $10.2 trillion foreign exchange reserves around the world, $6.8 trillion are being held by emerging markets, of which $3.3 trillion are accounted for by China,” Prasad said. “If you want to build up reserves, you need to park that money somewhere. So what do you do? You put it in US treasury bonds.”

This, he said, creates the “curious” scenario in which the US is able to borrow in its own currency at near zero interest rates. Consequently, the balance sheet risk for emerging markets is shifting considerably to the asset side.

“Monetary policies across the world are stretched to the limit. The US central bank –  the Fed – and Japan’s central bank are doing things that were inconceivable before the financial crisis. Monetary policy has reached the limit of its ability to support growth,” he said.

With central banks around the world attuning monetary policies to meet objectives of their domestic economy, monetary policies cannot be coordinated worldwide.

Prasad said that while there is no answer to what constitutes a legitimate monetary system, a global insurance system could help counter the worsening paradox of the international financial system.

He suggests setting up a system back-stopped by the world’s central banks through which countries that have a history of bad fiscal performance pay higher premiums, much like bad drivers being slapped with higher premiums in car insurance.

“That will essentially institutionalise what we saw happening in the global financial crisis – that the European Central Bank, the Bank of Japan and the Fed essentially provided lines of liquidity to many other central banks.  If you institutionalise this, perhaps the need for this won’t arise in the first place,” he said.

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