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«Role Reversal in Global Finance Eswar S. Prasad I. Introduction The global financial crisis has sparked a reconsideration of the role of unfettered ...»

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The country drawing on this insurance would be required to pay back the borrowed amount within the one-year period in the same hard currency that it receives for the loan. So if a country’s currency depreciated in the ensuing year, it would have a higher debt burden in domestic currency terms, which to some extent would be a disincentive for the country to persist with bad policies under the protection provided by the credit line. The country would not be able to buy additional insurance until there was a full repayment of the initial draw from the insurance pool. Premiums would be raised 372 Eswar S. Prasad substantially if a country wished to renew its insurance in the next period after drawing on the credit line without any improvements in its policies.

Thus, the insurance would only be suitable for liquidity crises. For an economy beset by a solvency crisis, the insurance payout would effectively buy a limited amount of breathing space. Indeed, one could think of reserve accumulation as being relevant for solvency risk and this insurance mechanism as being relevant for liquidity risk. Once the credit line lapses and if the country turns out to have a solvency rather than liquidity problem (which may be difficult to determine ex-ante), then the premiums would rise to punitive levels. In that case, the country goes to the IMF for traditional borrowing with expost conditionality.

This mechanism is different from traditional insurance where the idea is to pool risks. In this case, the main risk may be global rather than country-specific. This also makes it hard to price the premiums in an actuarially “fair” way as the major risks are by definition correlated across countries shock if the underlying shock is global.

Why Can’t the IMF Provide Such Insurance?

In principle, the IMF is the right institution to manage such an insurance mechanism. It has become recognized as an independent arbiter of good policies. Besides, there is logic to this arrangement—if a credit rating agency had to stand behind its ratings by being on the hook for bailing out companies whose finances it rated as being rock solid, that would certainly make a difference to the quality of ratings.

However, there are three problems. First, the (much-needed) austerity policies that the IMF foists upon countries has made any involvement with the IMF toxic for politicians in emerging markets, especially in Asia. Hence the urge for countries to self-insure by accumulating reserves, even if that is costly. Second, IMF programs to pre-qualify countries for emergency assistance are a source of stigma.

Application for pre-qualification could itself be seen as a sign of weakness. Indeed, the fact that only three countries—Mexico, Colombia and Poland—have signed up for the IMF’s Flexible Credit Line (FCL), which was intended as a pre-qualification mechanism, points Role Reversal in Global Finance 373 to these problems.19 Third, IMF resources are simply not enough— even a trillion dollars is not what it used to be, especially in the context of a global crisis. Moreover, the value of an IMF loan used to be that the seal of approval of a country’s policy commitments accompanying that loan would induce private capital to flow in. As the events during the financial crisis have shown, that multiplier effect of IMF lending cannot be counted on during a global crisis.

A fundamental problem is that the IMF has two key roles in the international monetary system: the surveillance function—monitoring of countries’ economic policies and performance—and crisis lending. These two roles are incompatible if the objective is to provide global insurance through the IMF and reduce incentives for the systemically important emerging market economies to self-insure by building up huge war chests of reserves. The IMF cannot credibly commit to maintaining an open credit line and not imposing ex-post conditionality with its loans if a country that qualifies for the FCL starts running bad policies. Besides, what the IMF giveth the IMF can take away as the rules of the game can obviously be changed quickly in the midst of a crisis.

My proposal would free up the IMF to do what it does best—conducting surveillance and fixing the policies of countries that have brought upon themselves solvency problems in terms of domestic or external debt.

Other Questions Why can’t the Federal Reserve or the ECB directly provide credit lines to countries? The reason is that the determination of these credit lines then becomes a political matter. If there is uncertainty about which countries will receive the Federal Reserve’s benediction—during the recent crisis, countries like Mexico and South Korea did while others like Peru did not—emerging markets cannot count on being protected by the major central banks.

Can the IMF’s Special Drawing Rights (SDRs) provide such insurance? SDRs have limited value as an international reserve currency since they lack the fiscal backing of a sovereign government.20 Moreover, emergency SDR allocations distributed on the basis of existing 374 Eswar S. Prasad quotas would hardly be sufficient for the major emerging markets.

A reallocation of SDRs to deliver them where they are most needed again becomes a political decision. Most countries would want to avoid placing themselves at the mercy of shifting political winds at the IMF.

The crux of my proposal is that it depoliticizes access to liquidity, either from the major advanced economy central banks or through SDR allocations, in the event of a major global shock.

Is it politically feasible for a national government to pay premiums for such insurance? Given that this option would be cheaper than the quasi-fiscal costs of sterilizing reserves that are built up for insurance purposes, would not involve currency risk, and involves a relatively modest premium, it should not be difficult for a government to make a strong case to its constituents for participation in such a scheme.

Low-income countries might not be able to afford such insurance.

But they need developmental assistance, not protection from currency crises. So this would initially be an insurance pool meant primarily for systemically important countries or even a broader range of middleincome economies, although others would be welcome to join.

Participation Would the large economies, especially the major emerging markets, want to sign on to this program? Broad participation by the G-20 economies would be important for obviating the stigma effect.

Unlike in health insurance where broadening the pool by mandating universal participation reduces premiums and adverse selection, the broad mandate here would mainly be to deal with the stigma effect.

The solution is simple—make participation in this pool a condition for continued membership in a body such as the Financial Stability Board (FSB), where all countries would like to have a seat as it will have an important role in developing principles for international financial regulation (participation in the insurance pool would, however, not be a guarantee of membership in the FSB). This would remove the stigma effect and also have the virtue of tying together Role Reversal in Global Finance 375 financial and macroeconomic policies, as their interaction is clearly crucial for global economic outcomes. Indeed, the FSB or Bank for International Settlements could easily administer this program. No country would be forced to buy insurance, of course, but would have to pay the basic membership fee to be part of the pool.

Broader Benefits If the insurance-related motive for reserve accumulation were attenuated by this explicit insurance scheme, it could help discipline advanced economies’ fiscal policies by raising their borrowing costs.21 This would also tamp down private capital flows to emerging markets, an added benefit for countries in that group concerned that cheap money in the United States and other advanced economies is flowing disproportionately to them and causing complications in their domestic macroeconomic management.

The existence of such an insurance scheme would also help separate out the motives—mercantilist versus precautionary—behind foreign exchange intervention and related reserve accumulation. The costs of reserve accumulation are seen by some emerging market policymakers as being balanced by the joint benefits of insurance and maintaining trade competitiveness. By providing an alternative (and cheaper) option for insurance, the mechanism I propose would force emerging market economies to more directly consider the costs of protecting trade competitiveness through intervention in currency markets.

Global financial stability is in everyone’s interest but it involves solving a collective action problem. This scheme would help get the incentives right. First, it reduces the incentives for emerging market economies to self-insure; in the event of a liquidity crisis, they would have access to a large insurance pool with no conditions attached.

This would allow them to conduct better macroeconomic policies rather than focus on accumulating reserves. Second, it mitigates the risk of spiraling global macroeconomic imbalances and the attendant risks of crises and their spillover effects. Third, it creates a transparent mechanism by which the global costs of a country’s policies would be internalized to some extent or, at a minimum, made more visible.

376 Eswar S. Prasad VI. New Risks from Capital Inflows The next decade will be one where advanced economies are more vulnerable to external crises while emerging market economies are more exposed to domestic fragilities. Traditionally, emerging markets were exposed to risks through their dependence on capital inflows and the structure of their external liabilities. Few of the significant emerging markets are now heavily dependent on foreign finance in terms of net inflows. Even those economies like Brazil and India that are running current account deficits have large stocks of foreign exchange reserves.22 And the scourge of short-term foreign currency denominated debt has diminished substantially. Flexible exchange rate regimes adopted by many emerging markets have also made currency crashes, which often followed a long period of forced disequilibrium in currency markets, less of a concern.

Nevertheless, the high levels of financial integration do imply that emerging markets will be subject to greater policy spillovers and transmission of shocks from the advanced economies. For instance, pure contagion effects due to portfolio rebalancing by advanced economy investors could be larger as gross positions increase in size.

But these risks are still likely to be modest relative to domestic ones.

Capital Flows and Domestic Risks For emerging market economies, the risks of financial openness will increasingly be intermediated through domestic factors. For instance, narrow financial markets can result in asset market booms when capital flows into a country. In the absence of regulation that is effective and well implemented, inflows can inflate credit booms that eventually end badly.23 One solution is to foster a broader set of financial markets, including corporate bond markets and other securities markets for which there is already an intrinsic demand. This would help absorb inflows and direct them to more productive rather than speculative sectors of the economy.

Financial market development that fails to keep pace with increasing outward orientation of domestic firms also creates risks for emerging markets. Firms have an incentive to take on foreign-currency denominated debt as a way of hedging against (or even betting Role Reversal in Global Finance 377 on) currency appreciation. Broader derivatives markets can help deal with this source of risk.

Capital flows have distributional consequences, a matter of particular concern to emerging market economies that are nervous about social stability as many of them have threadbare social safety nets.24 More open economies tend to be prone to higher inequality for a number of reasons. First, during the early stages of an economy’s opening up, capital account openness tends to favor the rich and the elites. In the early stages, when there are still restrictions on foreign capital, politically well-connected firms obtain preferential access to foreign financing; large politically connected firms can become even larger relative to smaller domestic firms that are reliant on inefficient domestic financial institutions. This phenomenon of crony capitalism played a role in precipitating the Asian financial crisis.25 Larger firms in the manufacturing sector typically tend to be more capital intensive and generate less employment, further skewing the benefits from financial openness.

Second, foreign finance that pours into equity markets and raises valuations tends to have greater benefits for households that have more financial wealth in the form of equity investments. Third, capital account openness can create inequities in terms of diversification and risk sharing. Richer households are able to share risk through their international investments. Even in countries with open capital accounts, this is a problem for poorer households that simply do not have investment vehicles to invest abroad. Fourth, since poorer households have less access to foreign investment opportunities, they disproportionately bear the costs of domestic financial repression.

For instance, in China, capital controls on outflows have been eased, allowing households to take out $50,000 each per year, a large sum by most standards. However, relatively poor households do not have access to vehicles like mutual funds to easily invest abroad. So the available choices are either the highly volatile Chinese stock market or safe bank deposits that pay negative real interest rates.

The combination of weak policies and weak institutions generally has more adverse consequences in emerging markets compared to advanced economies. For instance, financial repression in advanced 378 Eswar S. Prasad economies is less of a concern from the perspective of generating inequitable outcomes as there are other investment opportunities available to retail investors, making them less reliant on domestic banks.

Ultimately, the main collateral benefit of financial opening might be that it forces national governments to put in place better policies.

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