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Revamping the global financial system

April 06, 2009

A high priority for developing countries is to establish policies and systems to foster international financial stability and avoid speculation-driven activities. Originating from banking deregulation and excessive liquidity creation, the crisis has resulted in rampant speculation in capital and currency markets.

The developing countries have been hit by these speculative activities leading to violent fluctuations in capital flows. But because of highly costly self-insurance taken in large stock of foreign exchange reserves, these swings have not created the kind of dislocations seen in 1997 in Asia. An important part of the solution is to re-install firewalls and regulations to avoid speculative capital flows unrelated to real economic activities (trade and investment) and to establish a system of currency exchange where currency rates reflect underlying fundamentals. This should be a major priority in the reform of the international financial architecture.

In the absence of reform, and an international system, regulating these flows, developing countries must have the policy space and be allowed to undertake national policy measures to regulate capital flows and to defend themselves from speculation.

However, the required policy space to take the required measures is hindered by (1) IMF-World Bank conditionality that mandates an open capital account; (2) many North-South free trade agreements that (a) mandate the free and unregulated inflow and outflow of funds; (b) liberalisation of financial services, including the entry of foreign institutions for “new financial instruments”; (c) liberalisation and deregulation of investments.

These barriers (the loan conditionality and the FTA provisions) to the required regulation should be reviewed. Existing FTAs should be reviewed to consider amending clauses that prevent the required regulation. Current negotiations on FTAs such as the EPAs between the EU and the African and Pacific countries should fully take this into account.

A major plank of the new financial architecture is the reform of the IMF. Its policy conditionalities have previously not been appropriate in assisting developing countries to deal with crises. These include (1) the policy of an open capital account system, that deregulates capital flows (increasing financial vulnerability) and discourages or prevents capital controls over inflows and outflows; (2) pro- cyclical monetary and fiscal policies that have magnified contractionary conditions; (3) trade policy linked to extreme liberalisation of imports and industrial policy based on non-state intervention, which have damaged domestic agriculture and industry in many developing countries.

A preliminary review of recent crisis loans to 10 countries (including some developing countries) by the IMF show that contractionary financial and fiscal policies (such as a significant increase in interest rates, and a reduction of government spending) are still maintained as part of the loan conditions.

A reform of the IMF is thus crucial. Without the reform, it is premature to expand its funding and resources. The IMF should not impose or promote an open capital account or prevent regulation of capital flows. It should not deal with trade and industrial policies and other development related policies.

The reform process should lead to its creditor role being confined to providing short-term loans to countries to deal with temporary balance of payments difficulties. In that area, its policies should be counter cyclical and not pro-cyclical.

Countries should not be requested to provide loans to the IMF to augment its resources because this would compromise the ability of the IMF to carry out its surveillance function and to discipline the policies of countries that provide the loans.

It can obtain resources from the market or from the, issuance of SDRs, instead of obtaining loans from governments. The imbalances in the system of governance, with its present serious imbalance in voting rights and decision making, should also be addressed.

One major source of financial instability is that the international reserve currency is the currency of a single country (the United States). This causes instability as availability of reserves for the world economy, depends on the reserve currency country (the US) having growing current account deficits. This problem is worsened under the present crisis because of (a) the absence of multilateral discipline over exchange rate and the US's macroeconomic policies. (b) developing countries' increased vulnerability to fluctuations in capital flows and exchange rates; (c) pro cyclical behaviour of financial markets; (d) developing countries holding large stocks of foreign reserves at very high costs.

As an alternative, an international reserves system based on the SDRs could be established. The IMF could distribute SDRs to itself to make it available to members, and there should be greater automatic access to it.

The new financial architecture should include establishment of a multilateral fund or funds. This could be similar to the two oil facilities set up in the 1970s to assist countries cope with the oil price increases and to prevent a global recession. The fund can assist developing countries counter the recession and to offset the multiple losses of financing caused by reduced exports, migrant remittances, service payments, loans, investments, trade financing, etc. The shortfall facing developing countries may total many hundreds of billions of dollars a year. The fund should thus be of a major amount. The channels of funding and its multiple uses should be determined jointly by the international community.

Developing countries should also be encouraged to explore and expand regional financial cooperation. The new financial architecture should also deal with the threat of new debt crises. facing developing countries. The current account and overall balance of payments of many developing countries and their foreign reserves are or will be coming under increasing stress, due to a crisis that was not of their doing . The reform process should as a priority establish an international system of debt standstill and debt workout for countries that face debt servicing difficulties. Proposals on this (which originated at UNCTAD) had been rather extensively discussed, including at the IMF, but did not lead to any conclusions. Given the present crisis, this should again be a priority proposal. A new round, of debt elimination and debt relief 'should also be looked at now.

The crisis provides an opportunity to address the deficits and imbalances in the governance of global finance and economic issues. The United Nations used to play a central role in policy formulation and in reaching and implementing agreements. However in recent years, too much faith had been placed and power given instead to the markets and to international financial institutions which supported the drive towards “marketisation” and “financialisation.”

At the national level, in developed countries in the centre of the storm, the pendulum has swung, with the leadership and interventionist role of the state being emphasised. The international counterpart of this national level development should be the strengthening of the role of the United Nations, including its General Assembly and its economic arms, particularly ECOSOC. Greater authority provided to a strengthened and more effective UN should be a crucial element of the new global economic architecture.

(Edited extracts)

Courtesy South Centre Bulletin, Geneva