Article - Reforming the IMS to rebalance economic power
The current international monetary system (henceforth “IMS” or “the system”), in place since the end of the Bretton Woods system in 1971, has been based on an imperfect prevalence of floating exchange rates and the supremacy of the US dollar as the international reserve currency. Under America’s leadership, this system has been a major driver of the rapid expansion in world output, the rise of international capital markets, and the increased integration of new actors into the world economy, leading to economic growth, development and poverty reduction at the global level.
However, the period has also been marked by frequent crises around the globe, drawing observers’ attention to new vulnerabilities emanating from emerging economies and to the challenges facing the IMS to address it. Real and financial imbalances increased continuously since the 1990s, until the recent global crisis which originated in developed countries. These events have progressively challenged the ability of the system to deliver stability as before, and many economists and policy makers, such as Ignazio Visco, argue that the system has even facilitated the rise of the global imbalances that led to the crisis.
In their misfortune, international authorities – in particular, the IMF and multilateral forums like the G20 – should consider the current slowdowns and the rethinking it imposes on them as an opportunity to truly engage in reforming the IMS, i.e. the official way of regulating the key components of balance of payments: international reserves, exchange rates, capital flows and current payments.
In this paper we outline some developments that led discussions on the future of the IMS to restart, and we focus on the question of reserve currencies in a post-crisis system. We argue that the new fundamental structure of the world economy makes the dollar-centered system obsolete and requires a shift towards a multi-polar monetary system, with several reserve currencies operating on par. While the question of viable alternatives to the greenback remains, we advocate for increased policy coordination in the transition process.
Rising macroeconomic imbalances and their link with the IMS
The US dollar has been the cornerstone of the international monetary system since 1944, all the more since the end of its convertibility to gold in 1971. Roughly two thirds of international reserve assets are denominated in US dollars, which makes it the first reserve currency in the world. For decades, this predominance has provided great advantages to the US financial system and economy: US companies are free from conversion costs; banks do not need to hedge against exchange rate fluctuations; and the high demand for US Treasury bonds keeps US interest rates low, not to mention seigniorage revenue. In addition, the use of the dollar as a vehicle currency far beyond exchanges involving the United States, such as in the oil trade, has contributed to reinforce the central role of the US monetary policy (as explained for instance by L. Goldberg and C. Tille in the Journal of Monetary Economics).
In this context, although criticisms have been raised against the “dollar glut” since the 1960’s – the Triffin’s critique being the most notable one – the international monetary system was structured to support the development of international trade and financial exchanges. And it worked quite well. In 2013, the average daily turnover in the global foreign exchange market has reached USD5.3 trillion, according to the triennial survey from the Bank of International Settlement in September 2013. It was USD0.6 trillion in 1989 and USD1.2 trillion in 2001.
However the explosion in trade came with the widening of global imbalances. The US current account deficit widened steadily in the 1990s to unsustainable levels, while other countries accumulated surpluses, first in Europe and Japan, then in China and the Asian region. Financial deregulation magnified imbalances through large-scale non supervised operations in the direction of emerging countries and growing risk-taking in a context of increasing demand for safe financial assets that far exceeded their availability. This contributed, inter alia, to the Asian crisis in 1997. The unstable environment distorted the allocation of global capital, with a huge increase of demand for reserve currencies – from USD1.3 trillion (5 percent of world GDP) in 1995 to USD10.7 trillion (15 percent) in 2012. With two-thirds of the total held by emerging economies – notably China, other Asian States and oil exporting countries – global imbalances got bigger and bigger.
The view of some economists is that certain features of the international monetary system contributed to the accumulation of these imbalances and ultimately to the unfolding of the global crisis in 2007, through its incapacity to provide the necessary discipline to ensure external financial stability, i.e. a public good and an essential part of its mandate (see this ECB report). Others point to imbalances in the US economy and to the role of the US dollar as the main reserve currency in leading to the current crisis. Barry Eichengreen puts forward the “exorbitant privilege” of the United States as the world remains so dollar-centric although the declining contribution of the country to the world output and the rise of economies such as China and other emerging countries.
The dollar status at the centre of the debate
While some commentators like Paul Krugman argue that the international role of the dollar is a “non-issue” and is not a major factor of the US economic primacy, there is an ongoing debate around the future of the top currency, which we intend to summarize in the following lines. The picture in which a single performer dominates the global economic scene is outdated for years. A number of signs put in the direction of a redefined monetary landscape to better reflect the new economic balance of power.
The dominant position of the US economy has gradually eroded since the 1970s. Despite resilient financial and forex markets as well as a historical track record of macroeconomic stability, America’s fundamentals are showing signs of fragility – high budget deficits, money creation and current-account deficits –, which became more apparent in the recent crisis and have undermined global faith in the long term worth of the US economy.
As outlined by Jeffrey Frankel, the line taken by some US congressmen in October 2013, who encouraged the Treasury to default on its legal obligations, has further casted doubts on the dollar’s international status.
New reserve currencies have risen in emerging market economies, in addition to the Euro. Consequently, the share of the greenback in international reserves is declining, from about 80 percent in the mid 70s to 61.4 percent in 2013, according to the IMF’s database on composition of foreign reserves. Although the reduction does not hold in absolute terms, there is a trend towards foreign reserve diversification in certain countries like China and Russia. The same countries, along with others like Saudi Arabia, Iran and Venezuela, are also making oil trading agreements with each other to move away from using the US dollar and favor the exchange of national currencies.
At the same time, too pessimistic views about the future of the dollar should be nuanced for the following reasons:
The US dollar remains the dominant currency, with still an 85 percent share of the world’s foreign exchange trades in 2013 (BIS), and about 80 percent of the value of Special Drawing Rights, the reserve asset used in transactions between the IMF and its member countries. This situation leaves other countries, including the 54 which still have their currency pegged to the dollar, vulnerable to America’s domestic monetary policy. According to many informed commentators, the US dollar will remain the major investment currency in the short term although its central position will be progressively re-assessed.
While the shock of the global crisis in 2007-2008 could have resulted in the collapse of the dollar on the foreign exchange market, global investors actually fled to the US. For Jeffrey Frankel this is a clear sign that they still consider US Treasury bonds as safe assets and the dollar as the top global currency.
The latter argument is particularly true given the lack of viable alternatives in the short run. This is a major concern of observers (see for instance columns in VoxEU or Forbes) that the possible contenders qualify only partially for the job, i.e. for the time being the Euro is crippled by the Eurozone fiscal situation, the British Pound is not associated with a market deep enough to absorb financial turmoil at the global level, the Yen suffers from Japan’s public debt – the highest of the world in terms of percentage of GDP – and the Renminbi is hampered by the Chinese government’s grasp on forex market, to make it short.
Towards a multi-polar currency and reserve system
The fact that there is no single currency imposing itself as the next international reserve unit is not really an issue, because the solution to the failures of the current IMS precisely rests with the establishment of a system that would relieve the international community from the dominance of a unique country and would align with the changing structure of the global economy.
There are two possible approaches. The most ambitious one, inspired by Keynes’s “bancor”, would be to create a global currency to serve as a supranational store of value circulating alongside standard national currencies. A basket-based reserve system such as the use of the IMF’s Special Drawing Rights (SDRs) could also be considered as a less integrated version of a common store of value. However the technical and political difficulties raised by these options in terms of governance and supervision make it unlikely to happen for a long time.
The second option, which we perceive as the most promising in a shorter term, would be to progressively move to a multi-polar system where multiple currencies operate as substitutes. Recently, the United Nations called for “a new global reserve system (…) that no longer relies on the United States dollar as the single major reserve currency” and the IMF has been issuing official reports promoting a diversified supply of reserves.
As interestingly suggested in ecomonitor, emerging markets, led by China and India, should both benefit and take responsibility for their growing role as global economic leaders. Today the size of emerging countries is not reflected in the governance of the IMS, which justifies the claims of China to internationalize the Renminbi and take part in reforming the system. At the same time acquiring a central position in the complex global financial architecture brings challenges to the concerned players. Angeloni and Sapir provide a detailed analysis of the task ahead for Europe to resolve its debt crisis and accelerate fiscal and financial integration if the Euro is to strengthen its position in the coming years. Likewise, much remains to be done by emerging countries to move from an export-led growth model to home-based innovation and to increase their market exposure and integration (see Project Syndicate on this issue). From the United States’ perspective, a multi-polar system would not necessarily lead to the massive fall of the US dollar, as certain countries such as China have invested a lot in the greenback and do not want its collapse. However America would be confronted with the need to reduce its macroeconomic imbalances, starting with its trade deficits.
In any event, the IMF warned about the potential downsides implied by a more diverse currency system, including short-term exchange rates volatility in the absence of improved policy coordination among issuers (see this 2000 report). It is the role of the Fund to support the distribution of benefits and responsibilities and to facilitate the transition towards a multiple currency system, in particular by engaging with potential major reserve issuers to help remove barriers to a broader use of their currencies.
In a speech made at a high level conference on the IMS, the Governor of the Bank of Thailand Prasarn Trairatvoraku called for a renewed currency system in which the role of the BRICS and other emerging countries would be enhanced. He insisted on the necessary policy coordination among reserve issuing countries as well as on the supporting role of the IMF, but he warned that emerging countries are not supportive of a rule-based approach in addressing capital flow issues. His words remind us that in this post-crisis time, there is still a long way to go to reconcile diverging interests around a reformed international monetary system.
As underlined by Reza Moghadam, the fact that there are discussions does not mean that reform will actually happen. Meanwhile, the current IMS must continue to be resilient and to ensure that the transition to a new IMS occurs in a stable environment.
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