IMF Strategic Review: Risks for Emerging

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IMF STRATEGIC REVIEW:

Risks for Emerging Market

Economies Amid Increasingly

Globalized Financial Markets

Joseph E. Stiglitz

Columbia University

June 2005

BASIC OBJECTIVE

• ENHANCING GLOBAL FINANCIAL

STABILITY

• AND THE FLOW OF FUNDS TO

DEVELOPING COUNTRIES

FINANCIAL STABILITY IS OF

CRITICAL IMPORTANCE

• FOR ECONOMIC STABILITY

• AND ECONOMIC STABILITY IS

IMPORTANT FOR

– GROWTH

– AND POVERTY ALLEVIATION

PRO GROWTH AND PRO POOR

STABILIZATION POLICIES

• WE HAVE LEARNED THAT GROWTH DOES

NOT NECESSARILY REDUCE POVERTY

– TRICKLE DOWN ECONOMICS DOES NOT WORK

– SOME POLICIES INTENDED TO PROMOTE

GROWTH MAY ACTUALLY INCREASE POVERTY

• IMPLICATION: WE HAVE TO HAVE PRO

POOR GROWTH POLICIES

• SO TOO, WE HAVE TO DESIGN

STABILIZATION POLICIES IN WAYS THAT

PROMOTE GROWTH AND REDUCE

POVERTY

RISK, GROWTH, AND POVERTY

• LONG BEEN RECOGNIZED THAT

ECONOMIC POLICIES SHOULD

– REDUCE VOLATILITY (reduce likelihood of crises, “vulnerability)

– RESPOND TO CRISES IN WAYS THAT

MINIMIZE DEPTH AND DURATION OF

DOWNTURNS

– ENSURE THAT ADVERSE EFFECTS ON

MINIMIZED

IMPACT OF POLICIES

• BUILT IN STABILIZERS (LIKE WELFARE PROGRAMS)

REDUCE VOLATILITY AS WELL AS PROTECTING

POOR

• SOME POLICIES (CML) EXPOSE COUNTRIES TO

MORE RISK AND REDUCE CAPACITY TO RESPOND

– And therefore policies may not even accomplish primary objective of improving efficiency of resource allocations and pace of economic growth

• SOME REGULATORY FRAMEWORKS (CAR) WHILE

THEY REDUCE LIKELIHOOD OF CRISES EX ANTE,

CAN INCREASE DEPTH OF DOWNTURN ONCE IT

SETS IN

– And therefore may not even accomplish original intent of having a sound banking system

• COUNTERCYCLICAL LENDING CAN

REDUCE MAGNITUDE OF

FLUCTUATIONS

• WELL DESIGNED BANKRUTPCY

REGIMES CAN BE AN IMPORTANT

PART OF RESPONSE

• NEED FOR BETTER WAYS OF

RESOLVING SOVEREIGN DEBTS

GENERAL POINTS:

1. POLICIES WHICH MAY HAVE BENEFIAL EFFECTS IN

REDUCING LIKELIHOOD OF A CRISIS MAY HAVE

ADVERSE EFFECTS ON THE CONSEQUENCES OF A

CRISIS WHEN THEY OCCUR, POSING

COMPLICATED TRADE-OFFS WHICH HAVE TO BE

CAREFULLY ASSESSED

2. POLICIES ADOPTED FOR WHATEVER PURPOSE

HAVE IMPLICATIONS FOR THE STABILITY OF THE

NATIONAL ECONOMY AND THE GLOBAL ECONOMIC

SYSTEM

– These effects may undermine ability of policies in achieving original objective

– Global impacts particularly import in the new era of globalization

– And paying attention—and calling attention—to these global impacts is especially the responsibility of the IMF

TWO MAJOR GLOBAL

PROBLEMS

• DEVELOPING COUNTRIES BEAR RISK

OF INTEREST RATE AND EXCHANGE

RATE FLUCTUATIONS

• GLOBAL RESERVE SYSTEM

CONTRIBUTE TO MAGNITUDE OF

GLOBAL VOLATILITY AND IMPACT OF

THIS VOLATILITY ON DEVELOPING

COUNTRIES

RISK BEARING

• IN WELL FUNCTIONING CAPITAL

MARKETS, RISK WOULD BE SHIFTED

FROM THOSE LESS ABLE TO THOSE

MORE ABLE TO BEAR IT

• BUT DEVELOPING COUNTRIES STILL

BEAR MOST OF THE RISKS OF

INTEREST RATE AND EXCHANGE RATE

FLUCTUATIONS

CONSEQUENCES

• THE CONSEQUENCES CAN BE ENORMOUS

• THE DEBT CRISIS OF THE 80S

– LATIN AMERICAN COUNTRIES BORE THE RISKS

OF INTEREST RATE INCREASES

– WHEN US RAISED INTEREST RATES TO

UNPRECEDENTED LEVEL COUNTRIES THESE

COUNTRIES WERE FORCED INTO DEFAULT

– LEADING TO THE LOST DECADE OF THE 80S

• INTEREST RATE INCREASES OF LATE 90S

HAD MUCH TO DO WITH CRISES AND POOR

PERFORMANCE

• SIMILAR PROBLEMS ASSOCIATED

WITH EXCHANGE RATE CHANGES

• IMPEDES PRUDENTIAL LEVELS OF

CAPITAL FLOWS

• WITH LESS CAPITAL AND MORE

VOLATILITY GROWTH IS LOWERED

AND POVERTY INCREASED

MAKING MARKETS WORK

BETTER

• WHAT COULD THE IMF DO TO SHIFT

MORE OF THE RISK BURDEN TO THE

ADVANCED DEVELOPED COUNTRIES?

• IN WAYS THAT DID NOT CREATE

“MORAL HAZARD” (WITH EXCHANGE

RATE FLUCTUATIONS)

REDUCING RISK

• AT THE VERY LEAST, MORE OF THE

FUNDING FROM IFI’S SHOULD ABSORB

MORE OF THE RISK IN THEIR OWN

LENDING

– COULD BE DONE BY HAVING

REPAYMENTS BASED ON BASKETS OF

SIMILAR CURRENCIES

– ESSENTIALLY ELIMINATING MORAL

HAZARD PROBLEM

GLOBAL RESERVE SYSTEM

• Essential for global stability

• But it has not been working well—growing dissatisfaction

– Stability

– Equity

– Deflationary bias

Deflationary Bias

• Every year, several hundred billion dollars of

“purchasing power” are buried in ground

• Under gold system, gold buried in ground gave rise to employment —though hardly productive

• Previously, profligate governments and lose monetary policies made up for deflationary bias

• Now US has played the role of “consumer of last resort”

– Offsets deflationary bias

– But causes problems of its own

Inequity

• Allows U.S. to have access to cheap credit

• Net transfer from developing countries

• Adversely affecting their growth

Instability

• Reserve currencies need to be good store of value

• Which is why inflation has always been viewed so negatively by central bankers

• But the credibility of a currency as a reserve currency depends also on exchange rates

• For foreign holders of dollars, weakening of the exchange rate is as bad as an increase in inflation

• Even true for domestic wealth holders, because of opportunity costs

DOLLARS HAVE BEEN USED AS RESERVE CURRENCY

• But can the current system continue?

• Negative dynamics—as confidence erodes, people move out of currency, weakens currency

• Now there are alternatives to dollar

• Problem is partly inherent—reserve currency country gets increasingly in debt as others hold its currency; ease of selling debt entices borrowing; but eventually, debt gets so large that credibility is questioned

• Is this happening today?

• Major shift in thinking among central banks

– Don’t need dollar as reserves

– What matters is value of reserves

– Reserves have to be managed like any other portfolio

– With due attention to risk

– With multiple hard currencies, prudent to hold reserves in multiple currencies

– And as dollar appears more risky, to shift out of dollar

– This process is already well under way

Implications for medium and long run

• During transition an extra source of weakness for the dollar —posing problems for Europe

• In the long run, increased potential instability, as changes in expectations can lead to more shifting in portfolios

The Hot Potato of Global Deficits

• Deficits long recognized as contributing to instability

• But sum of trade deficits must equal sum of trade surpluses

• Surpluses are as much a part of the problem as deficits

• But it is in the interests of each country to run surplus —to avoid consequences of crisis

• And well managed countries actually succeed in doing so

• But if there are some countries that persist

(prudentially) in having a surplus, the rest of the world must have a deficit

• If some country succeeds in eliminating its deficit, the deficit will appear somewhere else in the system (hence the term, deficits as hot potatoes)

• The current system “works” because the US has been willing to be “deficit of last resort”

• But even the United States has a problem in being “the deficit of last resort”

– With imports exceeding exports, creates deflationary bias in U.S.

– Requires huge fiscal deficits to offset

• It is not a solution for there to be a two-reserve currency system

– Europe too would then face a deflationary bias

– Given its institutional structure, Europe would not be able to respond effectively

A Simple Proposal

• Annual issue of global greenbacks (SDR’s, bancor)

• In amounts equal to amount of additions of reserves

• Would not be inflationary—would just undo deflationary bias of current system

• Allocation could be done in ways which promote global equity, help finance global public goods

A Simple Proposal

• Would enhance stability

• By eliminating the inherent instability from the reserve currency

• And countries would face risk of crisis only if the trade deficit exceeded their Bancor allocation —hence the “hot potato” problem would be reduced

Global Reserve System

• At the very least, there is a worry that the current global reserve system is not working well, that it is contributing to high level of exchange rate volatility, that this volatility has adverse effects on the global economic system

• It is essential for the functioning of the global economic system that the global financial system function well

• The global financial system and the global reserve system are changing rapidly

• But are they changing in ways which will enhance global economic stability?

• This should be one of the key questions being addressed by the IMF

Concluding Remarks

• The developing countries have experienced enormous instability

• At great cost to the people in their country

• Some of that instability is a result of instabilities in the global financial system

• And of the failure of markets to shift risk to those in the developed countries who could bear it better

THE IMF

NEEDS TO THINK CAREFULLY ABOUT

• THE IMPACT OF EACH OF ITS POLICIES ON

THE “RISK” PERFORMANCE OF NATIONAL

ECONOMIES AND THE GLOBAL ECONOMIC

SYSTEM

• HOW TO IMPROVE THE RISK

PERFORMANCE

• AND WHAT ROLE THEY CAN PLAY IN

REDUCING THE ADVERSE IMPACTS ON THE

DEVELOPING WORLD

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