The G20 leaders’ communiqué from the Pittsburgh meeting in September 2009 commits the G20 countries to a “framework for strong, sustainable and balanced growth.” Underlying this communiqué is the commonly shared position, enunciated further in subsequent meetings, that global imbalances accumulated over the years were a central element in precipitating the crisis, and the belief that correcting them is necessary to achieve strong, sustainable and balanced growth. Before the crisis, attention focused on the large surpluses run by China and the resulting substantial reserve accumulation. The problem of imbalances has subsequently achieved renewed salience with the emergence of imbalances among the countries of the euro zone and the lack of an adjustment mechanism to deal with them.
These surpluses are both the result of underlying policies and a symptom of a broader problem with the international monetary system, and with the lack of adequate institutional arrangements within the euro zone.
The International Monetary System and Reserve Accumulation
The postwar international economic governance arrangements agreed at Bretton Woods included provision of credit by the International Monetary Fund (IMF) to finance the temporary current account deficits of its members, in order to prevent countries adopting restrictive trade measures to manage their balance of payments. Once the immediate postwar problems of European reconstruction were resolved, the IMF enabled members to manage their temporary current account deficits, a task that capital controls and limited private lending to sovereign borrowers — both a response to events in the interwar period — made easier.
International capital market developments over the past 30 years have enabled a growing number of countries to borrow from private sources to finance current account deficits. But access to private capital markets may cease when a country encounters balance-of-payments difficulties or in response to shifts in investor confidence. Then, the only lender is the IMF. Its ability to assist its members, however, is constrained by the fact that private lending typically dwarfs its own resources, so the IMF has often had to counsel a degree of adjustment effort that seems disproportionate to underlying imbalances.
Indeed, in the wake of the Asian financial crisis, many policy makers in developing countries consider the conditions imposed by the IMF to be too onerous — that the IMF has not struck a judicious balance between financing and adjustment. As a result, many countries, not just China, have resorted to reserve accumulation as a form of self-insurance. IMF governance needs reform to reanimate its central role in reserve pooling, and guard against policies that are destructive to national and international prosperity.
What Is an Adequate Reserve Level?
Before any significant capital account liberalization occurred, reserves equivalent to three months’ worth of imports were considered adequate. The international community responded to the special needs of commodity exporters that needed larger reserves because of more volatile exports by establishing the Compensatory Financing Facility (CFF) at the IMF in 1963. Under the CFF, loans with no conditionality were provided to countries facing a balance-of-payments deficit because of a large drop in export earnings from primary commodities. Later, loans were provided under the CFF when large cereal imports caused the deficit. Still later, when the scheme was further modified so that it resembled ordinary borrowings from the IMF with conditionality, interest of developing countries in the facility waned. The greater volatility of food prices in recent years will likely increase the temptation of developing countries to build up reserves to pay for food imports.
With much larger short-term borrowings by developing countries following capital account liberalization, reserve adequacy was to be guided by the so-called Guidotti-Greenspan rule, reserves should cover a country’s short-term debt. The rationale was that in uncertain times, short-term inflows are subject to reversals and “sudden stops,” and reserves should be able to accommodate the outflow. Yet, reserves of developing countries have risen beyond even the Guidotti-Greenspan rule, while reserves of developed countries have remained in the range of 20 to 30 percent of imports or three to four percent of GDP (IMF International Financial Statistics).
A possible explanation is that subsequent capital account liberalization allowed residents of a developing country to invest abroad. Then, uncertainty regarding a country’s exchange rate resulted not only in withdrawal of short-term capital, but residents of the country could convert their domestic money into foreign currency, and take it outside the country. Consequently, reserves must cover not merely a country’s short-term liabilities, but also transfers by residents; therefore, the appropriate indicator against which to measure reserves is the money supply.
The international economic architecture erected at the close of World War II included the IMF, which provided short-term balance-of-payments financing to countries facing temporary trade imbalances to obviate the need for countries to adopt trade-distorting measures to manage their balance of payments. In effect, the role of the IMF was to assist its members smooth the adjustment process and thereby avoid policies destructive to national and international prosperity. But with countries liberalizing their capital accounts and accessing private capital markets for balance-of-payments financing, the ability of the IMF to assist its members to strike the right balance between financing and adjustment was impaired.
Developing countries, the main borrowers from the IMF in the three decades before the current financial crisis, were able to avoid having to borrow from the IMF — and the conditions attached to IMF assistance — by building up reserves through running current account surpluses; the phenomenon of reserve buildup is more widespread than merely a feature of Chinese policy.
IMF policies need to be adjusted to reduce the incentive for reserve accumulation.