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For a Revamp of the Global Financial Architecture

The South Centre calls for a revamp of the global financial architecture that will be an inclusive process and will take into account all the concerns of the developing countries.

november 15, 2008 EPW Economic & Political Weekly30GLOBAL ECONOMIC CRISISunbroken control of that country’s formal political institutions.But behind these varied struggles one can hear a common theme: a demand for accountable, responsible government that puts the interests of a rising middle class first. I wrote at the beginning of this piece that the political discussion necessary to restructure the region’s economies carries with it all kinds of risks. We can see those played out daily in the streets of Bangkok and Seoul or on-line behind the firewalls that Beijing builds in its attempts to contain and control discussion of China’s future. These struggles threaten the workings of the economy, and they provide a profound challenge to elites that are accustomed to effecting minor corrections behind closed cockpit doors to national trajectories that have long been taken for granted.But the meltdown of American finance has closed the destination of an economy humming with industries for export. Whether Asia’s economies can chart a new course will determine their ability to ride out the present storm.For a Revamp of the Global Financial Architecture South CentreThe South Centre calls for a revamp of the global financial architecture that will be an inclusive process and will take into account all the concerns of the developing countries.The South Centre ( is an intergovernmental policy think tank of developing countries. The financial crisis that originated in the United States (US) a year ago has become a global financial crisis unprecedented since the Great Depres-sion. Since mid-September financial mar-kets have collapsed and the world is enter-ing into possibly the worst recession of the post-second world war period. The credit freeze has severely hit devel-oping countries through increasing risk premia and a severe cut in financing, even of short-term commercial lending. Capital outflows from developing countries have generated a collapse of stock markets and exchange rates and a loss of reserves. Com-modity prices have plunged and export orders are being cut worldwide. Even deve-loping countries that were seen as relatively invulnerable to a recession in the industrial world are now feeling the strain. The financial crisis has shown how dys-functional the current international finan-cial architecture is to manage the global economy of today, with its myriad inter-connections through which financial tur-moil spreads across the world and with its revealed and significant regulatory deficit. In the 1980s, the debt crisis in Latin America, Africa and other parts of the developing world, and in the late 1990s the succession of the Asian, Russian and Latin American crises, had already revealed that something was deeply wrong with that architecture. The industrial world did not understand the need for serious rethinking of the governance of global finance. The fact that this time developed countries are at the centre of the storm may now lead them into action. The call by some of them to engage in a reform of the current governance and con-vene a Bretton Woods II Conference is, therefore, most welcome. The South Centre wants to join its voice in the call for revamping global finance, based on six lines of action: (1) The Process and Institutional Design That It Develops Must Be Inclusive: We welcome the initiative of industrial coun-tries but underscore that any discussion process must be inclusive, giving adequate voice to both industrial and developing countries, and to both large and small countries. The governance system that it designs must be based on representative institutions, not on any one ad hoc group-ing of countries, be it the G-7, a G-13 or a G-20. We call, in particular, for a deeper involvement of the United Nations (UN) in any reform process, as it is the most repre-sentative global institution. Indeed, the follow-up to the Conference on Financing for Development to be held in Doha, Qatar, in late November and early December is the best occasion to launch a participatory process leading to a reform of the global financial architecture, with the backing and close collaboration of the UN and the Bretton Woods institutions. This process should include a discussion of the voice and representation of developing coun-tries in international economic decision making and norm setting, as mandated by the Monterrey Consensus. So far the only reforms in this area were undertaken by the International Monetary Fund (IMF) and were extremely modest. (2) The Regulatory Deficit of Global Finance Must Be Corrected: The magni-tude of the current crisis is clearly
Economic & Political Weekly EPW november 15, 200831GLOBAL ECONOMIC CRISISassociated with inadequate regulation and supervision of financial activities. Since the Asian crisis, it became an established criterion that financial liberalisation must be accompanied by stronger prudential regulation and supervision. This principle has been applied in many parts of the deve-loping world but was entirely disregarded in theUS, where further liberalisation was accompanied by deregulation and weak supervision of financial intermediation. The discussion on regulation must start by agreeing on basic regulatory principles. The first principle is that regulations must be comprehensive, to avoid the massive loopholes through non-banking intermedi-ation that led to the current turmoil. This will also include regulating the types of transactions that led to the current crises, particularly securitisation and derivatives, and force all the markets to be open and transparent and thus limit over-the-coun-ter operations. They should also have a strong counter-cyclical focus, thus avoid-ing excessive indebtedness (leverage) and force the accumulation of increasing capi-tal and provisions (reserves) during booms. This should also imply that, when pricing assets according to their market value (mark-to-market pricing) to maintain transparency, the system must have mech-anisms to avoid asset price bubbles from feeding into the credit expansion, and asset price busts from feeding into the credit squeeze (for instance, variable loan-to- value ratios through the business cycle). Reliance on the internal models of finan-cial institutions, the major focus of Basel II, should be discarded. It has already shown how perilous it can be, and how the use of similar risk models by financial institutions can lead to greater instability. To these new principles we must add well-established ones: restricting monopoly power, encour-aging diversification and avoiding unsafe financial products. Suffice it to say that even these well-established principles were not followed in recent years. Any system that is designed in this area should be based on a well functioning net-work of national and regional authorities (which is still missing in the European Union) and include truly international supervision of financial institutions with a global reach. The IMF should not be at the centre of the regulatory system. The Bank of International Settlements and the Basle Committee are better placed, but this would require a fundamental reform to broaden their membership and avoid two major problems that the Basle Committee has faced in recent years: the lack of repre-sentation of developing countries, and the excessive influence over regulation by large multinational banks. Alternatively, building on these institutions, a new “Global Financial Regulatory Authority” could be created.(3)The IMF Should Be Revamped: Four essential reforms of the IMF should be part of the reform agenda. The first is the crea-tion of a meaningful and truly global re-serve currency, which could be based on the IMF Special Drawing Rights (SDRs). This would overcome both the inequities but also the instability that is inherent in a global reserve system based on a national currency. Experience has indicated that this system is plagued by cycles of confidence in the US dollar and by periodic shocks due to policies of the reserve currency country that are adopted without any consideration of their international impact. A system based on competing currencies would also be inadequate, as it does not eliminate the inequities of the system (the unfair distri-bution of seigniorage powers and the need to transfer resources from the developing to industrial countries through the accumu-lation of foreign exchange reserves) and may be even more unstable, due to the volatility of the exchange rate among competing reserve currencies. The second issue is the need to place the IMF at the centre of global macroeconomic policy coordination, not the G-7 or in fact any group. This is the only way to give developing countries a voice on the issue. The multilateral surveillance on global im-balances launched by the IMF in 2006 was an interesting step in that direction, but it has lacked binding commitment by the parties and an accountability mechanism. The third issue is the need for the IMF to lend during balance of payments crises rap-idly and without overburdening condition-alities, particularly when the sources of the crises are a rapid reversal of capital flows and a sharp deterioration in the terms of trade. This means putting in place a pre-ventive credit line for capital account crises (such as the defunct Contingency Credit Line) and making active use of the Com-pensatory Financing Facility (which has not been used in recent years due to overbur-dening conditionalities) and of the Poverty Reduction and Growth Facility to manage the adverse terms of trade shocks faced by low-income countries. This implies that the IMF would act more like a central bank, providing liquidity in an agile way, the way central banks have actually been providing funds in industrial countries on a massive scale in recent months. In the case of the IMF, the financing for such liquidity could be counter-cyclical issues of SDRs. The current IMF agreement does not commit countries to capital account con-vertibility and thus leaves them with full autonomy to adopt capital account regula-tions, either to restrict excessive capital inflows during booms or to control capital flight during crises. The evidence of strong linkages through which both financial eu-phoria and panic are transmitted world-wide indicates that it would be wise to make more active use of capital account regulations. So, as a fourth issue, the re-form effort should encourage the IMF not only to tolerate but actually to encourage and advise countries on what regulations to impose under given circumstances. In-deed, the regulatory structure that must be developed to manage financial stability in the global era should include provisions that apply to cross-border capital move-ments, such as: generalised reserve require-ments on cross-border flows, minimum stay periods, and prohibitions to lend in foreign currencies to economic agents that do not have revenues in those currencies. (4) A Coordinated Global Macro-economic Policy Package Must Be Urgently Adopted: The global recession now under way calls for a strong policy response. This means a clear expansionary monetary and credit policies in all indus-trial countries (which is still missing in Europe) as well as expansionary fiscal policies. Developing countries should also be part of the solution, and should adopt equally expansionary policies. Those coun-tries that have accumulated large amounts of foreign exchange reserves do have more room to manoeuvre to adopt these policies than they had during previous crises. For

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