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Regional Governance Architecture FES Briefing Paper February 2006 Page 1

How to Reform the International Financial System? A Chinese Perspective

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How to Reform the International Financial System? FES Briefing Paper 11 | September 2009 Page 2

1. The defects of the international G20 summits in November in Washington and in financial system are key factors April in London prioritized as causing the financial crisis the first priority for policy recommendations. Re- form of the international financial system The global financial tsunami triggered by the US seemed to be of secondary importance. Every sub-prime mortgage crisis has pushed the world country is utilizing inflationary monetary and fis- into recession. The crisis has not been cal policies to stimulate the economy. The les- caused by a mere mistake of US Federal Reserve sons on the cause of the financial crisis seemed , nor by the excessive creation of forgotten. Maybe everybody hopes that nothing financial derivatives that led to a distortion of fi- is going to change and we can continue to live nancial risk assessment. It was caused by multi- happily with . However, ple factors that induced chain disequilibrium, changes have already taken place. Sooner or lat- leading to a sudden melt-down of the economy. er the asset bubble will expand, well before the Among all the factors, notorious current account real economy starts to recover. deficits in the United States bred by excessive li- quidity played a very important role. Again, this If we hope to avoid such an international finan- problem is directly linked with the defects of the cial crisis from happening again, we ought to international financial system. start to reform the international financial system. At the second G20 London Summit, leaders De facto, the US Dollar standard in the interna- reached some consensus in this regard. IMF fi- tional monetary system enables the United nancial resources will be increased to US$ 500 States to irresponsibly neglect its current account billion. SDRs will be expand to 250 billion. Sur- deficit and the foreign exchange rate for its cur- veillance of the financial markets will be rency. As long as there is no replacement for the strengthened. However, key issues such as inter- US Dollar as the international key , the national key currency stability, exchange rate re- United States can use the Dollar to import cheap gimes, an adjustment mechanism for imbalances goods and services. By doing so, the US was able of international payments have not really been to use an inflationary monetary policy for its touched upon. own goods while neglecting the asset bubble. However, excessive debt in the US, both public The lack of institutional arrangements and stabil- and private, eventually lead to adjustment. ity mechanisms for key , such as the When commodity prices surged, and other US Dollar, the and the is at product and service prices rose, the inflationary the root of international financial turbulences. monetary policy had to change. Once the mone- After the collapse of the , tary policy was adjusted, the financial re- the system of international currencies diversified. sponded, triggering the subprime loan crisis. On the surface, this overcame the problem of Subsequently, the entire world had to follow the the Triffen Dilemma. But we believe that this de- US in stimulating the economy with inflationary fuses the problem rather than solving it. The es- monetary and fiscal policies, starting a new cycle sence of the Triffen Dilemma is that a national of bubble creation. In this process, the US could currency acts at the same time as an interna- reduce its debt relative to GDP, while the rest of tional currency, and this is the state of affairs to- the world had to suffer in sharing the costs. This day. After the Euro came onto the scene, dra- is why the international community reached matic fluctuations among the Dollar, the Euro consensus on the urgent need to reform the in- and the Japanese Yen become the principal fac- ternational financial system. tor for instability of the international financial system. This is why many developing countries 2. Priorities for a reform of the still maintain their currency peg to the Dollar. international financial system? Today, we are thus highly sensitive to US current account deficits and the US Dollar exchange rate Obviously, the G20 have not reached consensus trend. The core reason lies here too. on key issues. The US tried to focus exclusively on stimulating recovery and sought to avoid any We need to work more vigorously to gain con- major reform that might undermine the Dollar sensus on the key issues of reform. I believe that standard. Although the US accepted a compro- an exchange rate stability mechanism among mise on an IMF fund increase and SDR expan- major currencies is the foundation for a stable sion, and even proposed to adjust voting shares international financial system. You could name between Asian and European countries, Wash- many other factors that caused the shock to the ington is not likely to accept any reform that international financial system, but dramatic fluc- challenges the dominance of the US Dollar. Both tuations of the US Dollar exchange rate against How to Reform the International Financial System? FES Briefing Paper 11 | September 2009 Page 3 major currencies is the principal factor. Many fi- bility in the international financial system, we nancial crises have direct links to the shock of will be ready to establish a global exchange rate exchange rate fluctuations. Mainstream eco- stabilizing mechanism, and a more stable inter- nomic theory believed that floating exchange national financial system will emerge. For now rates would help to correct economic disequilib- we should encourage the expansion of SDRs and ria, especially correcting imbalances in interna- other currency internationalization and create tional accounts. However, in the real market, more competition in the international financial short term speculative capital flows dominated system. the exchange rate fluctuations and distorted ex- We are not advocating any repudiation of the change rate functions that may help to correct US Dollar as the key international currency. We economic disequilibria. In many cases, dramatic are actually accepting the fact that US Dollar will fluctuations of exchange rates instead cause still be the key currency. What we propose is problems. Another important point is that dra- that the key currency should bear responsibility matic fluctuations in currency exchange rates while it enjoys seigniorage. discourage real economic activities and increase the cost of and . If 3. The importance of an adjustment we can establish a certain kind of coordination mechanism for imbalances in among major currency exchange rates, we will international payments then create a kind of discipline, which could place some responsibility on key international The other important aspect of reform of the in- currencies. This is not easily accepted by the US ternational financial system is an adjustment government. So we should promote diversifica- mechanism for imbalances in international pay- tion of international currencies and enhance ments, again linked with the concept of respon- competition. At the same time, we need to en- sibility. The current system abandoned the prin- hance the function of SDRs as an international ciple of promoting and encouraging the balance . Theoretically speaking, a non- of international accounts. In practice, imbalances sovereign currency used as an international cur- of international payments are offset by shot- rency is the ultimate way to solve the Triffin Di- term capital flows and lemma. adjustments. Therefore, the international cur- rency issuing country, the US, makes full use of The Bretton Woods System laid the foundation its hegemonic position in the international sys- for the Dollar-dominated international system af- tem, carelessly expanding its current account ter World War II. Although the Bretton Woods deficit. It relies basically on capital inflows to System collapsed during the early 1970s, the US balance the current account deficit while being Dollar remained as the principal international reluctant to tighten the supply and raise currency for many reasons. Even without the re- the national savings ratio. On the other hand, sponsibility of maintaining value stability, namely many East Asian countries have been passively the stability of the US Dollar exchange rate, maintaining their international accounts in sur- backed by the US monetary authority, the US plus for fear of falling, again, into the trap of an Dollar continued to enjoy a hegemonic position Asian financial crisis. Some other deficit-prone in the international financial system. All of these developing countries have also learned from the reasons can be summed up in a word. That is, US and rely only on short-term capital inflows to that there is no competition that could provide maintain their balance. As a result, the global the same alternative function of an international imbalance is growing to the historically high lev- currency. However, this situation should not be els that breed international financial risk. Disor- allowed to last any longer without responsibility der in the mechanisms of adjustment of balance being assumed by the US government. We now of international payments represents in key ways have the Euro and several other international the contradiction between globalization and the currencies. None of them may replace US Dollar current international financial system. It distorts in the near future. If some day the Euro could the signals of interest rates, exchange rates etc. replace the Dollar, current problems would re- that are important for resource allocation, misdi- main as long as key international currency issu- rects international capital movements and ers bear no responsibility. Therefore, the first breeds financial instability and turbulences. step for us is to enhance fair competition among international currencies. When the diversification Under the Bretton Woods System, when a coun- of international reserve currencies reaches a level try ran a deficit that affected its fixed exchange that ensures that no one enjoys a dominant po- rate, pegged to the US Dollar, the deficit country sition or no one would refuse to take responsi- was obliged to adjust its deficit with the help of How to Reform the International Financial System? FES Briefing Paper 11 | September 2009 Page 4

IMF financial resources. Typically, with financial adjust in the global system should be shifted resources from the IMF, a course of tightening from deficit country to surplus country. monetary and fiscal policies was to be adopted. Although the fixed exchange rate system col- 4. Capital controls and their role in lapsed, the basic principles of the system em- stabilizing the international bodied in the IMF Agreement still remain in place, as the Fund is being preserved. The prin- The London G20 summit agreed to enhance su- ciple of the IMF Agreement that the deficit pervision and regulation of international capital country is obliged to adjust applies to every flows. However, how to implement this sort of member country, including the US. The only dif- supervision and regulation is as yet unclear. I be- ference is that the US does not need IMF lieve that liberalization does not to assist in adjustment. The responsibility to ad- mean freedom from supervision and regulation. just current account imbalances seemed, though, Every country needs to maintain certain capital to have been reversed as the US pushed surplus account controls in line with its economic and countries to adjust by appreciating their curren- market conditions. cies. However, exchange rate appreciation of surplus country currencies has not proven to be In the today’s world, the free flow of capital effectively in adjusting current account imbal- seemed to be a politically correct norm that ances. Historical Deutsche Mark and Japanese could not be challenged. Free flow advocates Yen appreciations, and more recent Chinese believed that without the free flow of capital, RMB appreciations, all show that exchange rate we would not have correct price signals and effi- appreciations of surplus countries were unable cient allocation of financial resources. However, to solve the adjustment problem. In the real in the real world, we also see frequent distor- world, it is the cross-border flow of increasingly tions of capital flows and excessive speculation large amounts of short term capital that helps and even manipulation in the financial market. ease the imbalance adjustment problem. How- This is of course neither good for efficient re- ever, these capital flows have caused many other source allocation, nor helping to adjust the im- problems, namely excessive speculation and dis- balance as distortions in capital flows often give tortions that create instabilities in the interna- the wrong signal for exchange rate fluctuations. tional financial market. Thus, we have seen long- What is more, exchange rates nowadays are in- lasting global imbalances and eventually the creasingly influenced by pure financial market outbreak of global financial crisis. flows instead of real economic fundamentals. Capital flows are affected more by people’s psy- Without a clear obligation based on an imbal- chological reflections and expectations. In a ance adjustment mechanism, we will not have a globalized financial market, the contagion effect stable international financial system. This is the is increasing rapidly. Herd behavior could en- key issue on which we need to have consensus gender a sudden shock on an economy originally at the next G20 summit. But the pity is that healthy, infecting this economy with the other China is being blamed for accumulating an in- market’s virus. Thus a chain reaction of capital creasing surplus in its . flows would take place, with one crisis following There are many structural reasons, including the another. Disorder of capital flows not only pro- impact of globalization for China’s increasing vides the condition for this kind of effect, it also surplus, as MNCs account for 58% of China’s worsens the degree of shock to the foreign ex- exports and the processing trade dominates change markets of developing countries. Thus, China’s international trade. China does need to creating some international standard for cross- import more and invest more abroad. China has border portfolio capital flows and allowing de- no intention to maintain such big surpluses and veloping countries to maintain certain control foreign exchange reserves. Actually Chinese im- measures on their capital accounts would help ports in the past 5 years have grown quite rap- to stabilize the international financial market. idly. However, China is passively accumulating The G20 should clearly understand this principal, foreign exchange reserves at increasing cost. The and not confuse this with . problem is that what China wants to import is more or less controlled by the US, and by the EU 5. The role of regional monetary as well. Therefore, the first step to take is to help cooperation in international China to import more technology-intensive financial system reform products from the developed countries to reduce the scale of the imbalance. Nonetheless, this The global financial crisis has made regional does not imply that the principal obligation to monetary cooperation more attractive. For in- How to Reform the International Financial System? FES Briefing Paper 11 | September 2009 Page 5 stance, East Asian monetary and financial coop- Foreign exchange rate fluctuations and external eration was launched during the East Asian fi- shocks have frequently made East Asian coun- nancial crisis that broke out in the late 1990s. tries a net loser in the international financial Since then, East Asian countries have made a lot market. The US has been trying to push East of progress in monetary and financial coopera- Asian countries to appreciate their currencies, tion under the ASEAN +3 framework. After the and China was only one of them. This kind of US financial crisis contagion spread into other adjustment pressure is not in the interest of parts of the world, East Asian countries believed countries in the region. While in times of crisis a they needed to deepen their regional monetary sudden outflow of capital would occur, with cooperation by announcing their intention to some countries facing sharp depreciation pres- upgrade the Chiang Mai Agreement into a sure, this would also affect the con- common reserve pool. Other measures of coop- cerned. The US Dollar would become again the eration are under discussion. most important means of intervention in the market. As a result, countries in the region Will regional cooperation help to stabilize the would passively hold more Dollars as a reserve ? The answer is yes. For currency. This kind of external pressure has put instance, when sudden outflows of capital in- East Asian countries in a dilemma. Therefore, duced by the US financial crisis led to a sharp enhancing monetary and financial cooperation depreciation of the won in the market, the Ko- to avoid external shocks and instability is impera- rean government needed the Chiang Mai Swap tively important. If we could achieve regional fi- Agreement to provide liquidity help. However, it nancial stability through regional cooperation, was not effective enough, and Korea had to this would contribute to global stability as well. come to the US and sign a US $ 30 billion bilat- eral swap agreement with the US government. If Last but not least, East Asia is the biggest holder there is an Asian Monetary Fund in place that of foreign exchange reserves, with more than US could help member countries when they need it, $ 3 trillion, which is 50% of the whole world’s this will certain create market confidence and reserves. A big proportion of these reserves is ease speculation. held in US Dollars. This is a precious resource that the region could make full use of for its For East Asian countries, regional monetary co- own economic development. However, the capi- operation has an additional function. As a region, tal was recycled back to the US and used by US East Asia has achieved the fastest economic financial institutions. East Asia bore the pure risk growth and has the highest savings rate in the of exchange rate depreciation and of world. East Asia’s problem is that its financial the US Dollar. As a result, rapid contraction of system is weak. The region on the one hand has the value of US assets during the crisis led to injected huge financial resources into the US fi- huge losses of value for East Asia. If we can co- nancial market, while on the other hand it has operate to avoid this kind of passiveness and attracted huge amounts of FDI from multina- speak with one voice in the international arena, tional corporations. In addition, the region is we could reduce our risk by taking common ac- highly dependent on traditional banking, and its tion and at the same time promoting reform of banking system has accumulated huge risks. Its the international system. financial markets and financial instruments are still underdeveloped. If East Asia could reduce the risk and develop the financial system through cooperation, the East Asian Economy would become a lot stronger and reduce its de- ^Äçìí=íÜÉ=^ìíÜçêW== = pendency on the US financial system. uì=jáåÖèá=áë=ëÉåáçê=êÉëÉ~êÅÜ=éêçÑÉëëçê=~åÇ=ÇÉéJ ìíó=ÇáêÉÅíçê=çÑ=íÜÉ=fåëíáíìíÉ=çÑ=tçêäÇ=bÅçåçãó=~í= íÜÉ=pÜ~åÖÜ~á=^Å~ÇÉãó=çÑ=pçÅá~ä=pÅáÉåÅÉëK=

How to Reform the International Financial System? FES Briefing Paper 11 | September 2009 Page 6

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The views expressed in this publication are not necessarily the ones of the Friedrich-Ebert-Stiftung or of the organization for which the author works. Friedrich-Ebert-Stiftung Department for Development Policy - Dialogue on Globalization – Hiroshimastrasse 28 10785 Berlin Germany Tel.: ++49 (0)30 26935-7404 Fax: ++49 (0)30 26935-9246 Mail: [email protected] www.fes-globalization.org