After 2008, when central bank interest rates plummeted to combat the financial crisis, low investment yields in advanced economies caused many emerging markets to experience massive capital inflows, causing appreciating currencies. Now, as rates are beginning to rise again, especially at the US Federal Reserve, the reverse is likely – as the dollar value rises, capital should begin to flow out of these emerging markets and put downward pressure on their currencies.
This has focused attention on the resilience of the global monetary and economic system – which has to step in as emerging markets face this strain – as well as the stigma it faces from many governments around the world. In May, Argentina was forced to go to the International Monetary Fund for support, while Turkey is reeling from the effects of currency instability.
Recourse to the IMF is almost always a last resort. The stigma of requiring support from the Fund, with its attendant conditions, means it is a politically difficult option in many countries. But for now, it remains the best of the options available to economies under strain.
The safety net
The current global financial safety net has four elements: the IMF, bilateral central bank swaps, multilateral regional financial arrangements and national foreign exchange reserves. Each has its weaknesses.
Accessing IMF resources undermines sovereignty because of the conditions attached to borrowing and the invasive monitoring required while arrangements are in place. The IMF stigma is so great that even the Flexible Credit Line, which does not have conditions, has only been used by three countries – Mexico, Poland and Colombia.
Among central bank swaps – agreements between central banks to provide a line of credit between central banks in the event a experiences a liquidity crunch – the Federal Reserve swap line has the most liquidity, and so the most peace of mind for investors. But access to these swap lines is restricted to a few rich-world central banks – Canada, the UK, Japan, Switzerland and the European Central Bank, plus an agreement with Mexico.
This has given rise over the last 20 years to regional swap systems among emerging market economies such as the Chiang Mai Initiative and the BRICs Contingent Reserve Arrangement, which provide another line of defence. Members agree to offer swaps to partners in difficulty from their own reserves, which pools their liquidity. But this depends on the shock not affecting all partners simultaneously. Regional financial arrangements also carry a risk of moral hazard: countries may claim support too frequently or the safety net may promote reckless economic policies. For this reason Chiang Mai, for example, uses the IMF to monitor countries drawing on the facility.
Finally, the accumulation of precautionary reserves by individual countries contributes to global imbalances and ties up national resources in relatively low performing assets.
A history of backstops
These challenges are not new; the global financial safety net has always been multifaceted. The IMF was designed in 1947 to be the sole safety net to support the Bretton Woods pegged exchange rate system. But even at its origins, the conditions attached to borrowing from the Fund deterred countries from using it.
Instead, other arrangements such as the European Payments Union and the Sterling Area offered a regional or currency-based mutual support. Bilateral Federal Reserve swaps started in 1962 and grew rapidly to include 13 countries by the late 1960s. By 1970 the total facilities available amounted to 22 per cent of global financial reserves and peaked in value at the 2017 equivalent of $266 billion in 1975. This is much higher than today.
At the same time, central banks of G10 economies – the US, UK, France, West Germany, Italy, Japan, the Netherlands, Belgium and Sweden, joined eventually by an eleventh member, Switzerland – set up multilateral swap networks. Central bank governors negotiated these arrangements behind closed doors at the Bank for International Settlements (BIS) in Switzerland. They therefore avoided the political debate and stigma associated with the IMF. In 1964, for example, the value of support available to the Bank of England from G10 central banks amounted to the equivalent of the full package of support for Mexico in the 1994 peso crisis (including the IMF, BIS, the World Bank and bilateral credits).
Moreover, these swaps extended beyond the era of pegged exchange rates; the final multilateral safety net for sterling was arranged by the BIS in 1977 and was the first to be linked to IMF surveillance. The G10 central bank safety net allowed sterling to be gradually retired from its key currency role, but didn’t prevent the collapse of the dollar-based exchange rate system.
The safety nets of the 1960s and 1970s were also restricted to the club of richer industrialized economies. The rest of the world had to rely on the IMF, with its attendant conditionality and loss of policy sovereignty, especially during the 1980s sovereign debt crisis and the 1990s emerging market financial crisis. The stigma of becoming dependent on the IMF led to the accumulation of huge foreign exchange reserves in the 2000s by many emerging market economies.
The last resort
As this history shows, emerging market economies have always been poorly served by the global financial safety net. The conditions attached to IMF assistance mean that it remains a last resort, but it is still the best place to organize a global financial safety net, since it is inclusive and promotes longer term structural change, and has developed unrivaled expertise in monitoring and surveillance that can be outsourced to regional financial arrangements.
And as demonstrated by Argentina’s latest crisis, when those regional arrangements are not enough, countries – however begrudgingly – still have only one place to turn.