“Towards amore balanced global monetary system”

Martín Redrado

The worldis moving to a multipolar landscape with a growing share of buoyant emergingmarket countries. They are gradually taking over the driver’s seat as reflectedby the rising power of their economic resources, their increasingdecision-making responsibilities in global financial institutions and theproliferation of multilateral and bilateral trade and financial agreements. 

Asa result, in the years to come we will witness an increasing role of emergingmarket currencies in the world economy, becoming a natural hedge against risksto global financial stability as economic and political institutions in thedeveloping world gain strength.

While it will take decades to consolidate thisprocess and several challenges remain, I believe there is a role for multilateralfinancial institutions to underpin it by providing instruments that helpminimizing the occurrence of episodes of financial disruption. 

This newlandscape has started to emerge several years ago but the magnitude of changeof the underlying forces became evident after the 2008/2009 crisis. While theemerging world has obviously been affected by sustained headwinds, the globalcrisis has exposed the macroeconomic and financial weaknesses andvulnerabilities of the largest economies in the world, exacerbating thisdynamic. After avoiding the collapse, policymakers in industrial countries havebeen puzzled with conditions that were typical in emerging markets in previousdecades. With limited instruments and increasing fiscal, external and politicalconstraints in an uncertain environment, the main challenge has been to boostgrowth while preserving financial and price stability at the same time. Infact, the crisis became an opportunity to revisit not only the way monetary andfinancial policy is conducted but also the design of the main frameworks andtheir effectiveness to respond to shocks. Not long ago a simple “Taylor rule”would have been enough to describe monetary policy. Now, a more complex centralbank “reaction function”, which entails a rebalancing of monetary policy andfinancial stability objectives and their contribution to long run macroeconomicstability, is called for.

The dollarhas shown resilience regardless of the position of the U.S. economy along thebusiness cycle. Even during times of weak growth and overwhelming monetarystimulus, flight to liquidity episodes buoyed the currency. This has been theconsequence not only of the U.S.’s weight in the world economy or itshighly-developed financial market but also of the sound economic and politicalinstitutions. The dollar preeminence, however, is inevitably bound to declineover time as emerging markets manage to sustain faster growth while maintainingmacro stability and making progress to reduce vulnerabilities. 

While theeuro has become a more global currency in recent years, it has struggled tomeet the demands of a group of countries with significant asymmetries. In myview, the obstacles remaining for full integration of euro-area markets arehindering the “competitiveness” of the euro in the world economy. The euro willgain further momentum as a major global currency only after the asymmetriesamong countries in the region are reversed and the structural impediments toeconomic growth in the region are lifted. This process is still incipient butEuropean policymakers have already started to lean on this direction withadequate doses of pragmatism, maximizing efforts to jump-start economic growthwhile preserving price and financial stability. 

Albeit withdivergences, in general, emerging market countries have proven increasinglyresilient in recent years, which reflected in overall stronger currencies. Theway these economies have handled the downfall of developed countries, thesubsequent period of extraordinary monetary expansion and, more recently, thebeginning of the retrenchment of global liquidity, has helped to test thesoundness, strength and effectiveness of the different macroeconomic policyframeworks. Emerging market economies seem to be less vulnerable to turbulencesin the global economy than in the past. This has been the result of what, in myview, is an underlying framework of sound macroeconomic policies. Policymakersin the emerging world have applied a common set of common macro principles,which has been tailored to each country’s particular circumstances withoutfollowing a unique recipe. Its main features include five pillars: i) strongfiscal positions; ii) external sustainability; iii) robust monetary andexchange rate policies; iv) sound financial regulation and supervision; and v)ample liquidity buffers.

First, mostof the emerging market economies feature stronger fiscal positions than in thepast. In previous decades, fiscal policy was by itself an additional source ofuncertainty as a result of overspending and over-indebtedness. This led torecurrent currency and balance-of-payments crises and episodes of macroeconomicinstability. In recent years, however, many countries have strengthened theirinstitutional frameworks by establishing fiscal rules and stabilization fundsin order to encourage macro discipline. For instance, last year generalgovernment gross debt remained below 40% of GDP for emerging markets and below50% of GDP for Latin America, in particular. This allowed for the buildup ofsavings to counteract a slowdown in economic activity or the impact of lowercommodity prices or capital outflows. Fiscal responsibility, including betterliability management, is no longer discussed in terms of left or right-leaningpolicies: it has been accepted as common sense and good macro policymanagement. While the tools vary from country to country and I acknowledge thatmany countries have had a hard time to build savings and enforce discipline,this approach has helped to preserve financial stability.

The secondfactor is the sustainability of external accounts. On average, emerging marketsmanaged to maintain lower current account deficits than in the past, whenexternal imbalances were the main source of macroeconomic vulnerability. InLatin America, for instance, the current account deficit averaged 0.5% of GDPin the last ten years, down from 2.3% in the 90s and 2.0% in the 80s. Higherreliance on foreign markets through bilateral free trade agreements ormultilateral alliances, export diversification both by product and destination(e.g. south-south trade has soared in the last ten years) and increasedexternal competitiveness as a result of sounder macro policies, structuralreforms and improved infrastructure has provided resilience to externalaccounts, thereby, strengthening the macro positions.

Third,monetary authorities have been able to build credibility upon the developmentof robust monetary and financial policy frameworks to better accomplish theirgoals. Central banks have gained autonomy and have expanded the set of tools athand. Regardless of their particular objectives and tools, independent centralbanks have been a key driver of the recent period of long-lasting macroeconomicstability in emerging countries. In recent years, inflation has remainedwell-contained in a context of robust growth and well-entrenched financialstability despite multiple shocks. The gap between inflation in an averageemerging market economy and an average advanced country declined from 49.5% inthe 90s to 4.5% in the last ten years. During turbulent times, central bankersin emerging markets have acted decisively to curb expectations and rebuildconfidence, showing capacity to rapidly execute and deliver. Several economiesrely on well-established inflation targeting regimes. While intervention in theforeign exchange market remains widespread, the exchange rate has played anincreasing role as a shock absorber. Many central banks have rested on exchangerate flexibility to accommodate domestic monetary conditions without having torely exclusively on interest rates. Economic agents, even in highly dollarizedeconomies, have gradually learned to deal with exchange rate volatility, whichcontributed to minimize the pass through.

Finally,the development of liquidity buffers both in foreign and local currency hasbeen a common pattern among emerging countries. This included three keyelements: i) the design and implementation of strong prudential regulatory andsupervision frameworks to ensure a well-balanced, well-capitalized, liquid, andsolvent banking system, avoiding currency mismatches or excessive exposure topublic sector debt (two of the key sins of the past at least in Latin America);ii) the buildup of foreign reserves to overcome periods of limited financialmarket access and heightened financial volatility, shielding domestic variablesfrom external headwinds (even countries with fully flexible exchange rateregimes have had in place mechanisms to use foreign reserves to mitigate marketconcerns over dollar availability); and iii) the development of a domesticcurrency capital market to act as a shock smoother rather than a shockamplifier, proving for financial stability amid volatile capital flows(countries have not only reduced overall indebtedness but also substitutedexternal by domestic debt). 

These,combined with the proliferation of financial vehicles and the deepening ofmarket liquidity has increased the demand for local currency assets,particularly sovereign, at the expense of dollar or euro-denominated assets.The widespread use of derivatives has expanded the set of instruments availablefor managing risk while widening the options for sources of financing. Theemergence of local currency instruments as an asset class has already faredwell-beyond of what could be a transitory trend driven only by “search foryield” and diversification. Increased access to international debt markets hastaken place vis à vis a decline in interest rates, particularly on long-terminstruments. 

Challengesto consolidate these macro principles, however, remain, which hinder thechances for local currencies to become global. I identify five main challenges:

First, notall emerging markets have shared this path: a number of countries have followedpopulist and anti-business policy frameworks, taking advantage of theextraordinary long period of accommodative monetary policy in the U.S. and highcommodity prices while doing little progress in advancingproductivity-enhancing reforms or reducing macro policy weaknesses. 

Second,these countries have struggled to cope with the rious effects of capitalflows (a particular concern for commodity exporters is that the same underlyingfundamentals in the global economy that worsen terms of trade affect negativelyglobal market access), which have led to significant volatility in currencymarkets. Finding the right balance between letting the exchange rate act as anautomatic stabilizer and intervening in the market to avoid destabilizingeffects on domestic monetary and financial conditions of a temporary exchange ratemisalignment remains a key challenge for central banks in the emerging world.Economic theory, however, is yet to capture the extent of the current effectivepractice of monetary and financial policy frameworks. Another factor in thisequation is the dollarization of balance sheets: the lower the liabilities inforeign currency, the larger the flexibility of the exchange rate to absorbshocks without destabilizing effects. 

Third,while the buildup of fiscal savings has allowed for a better-balanced policyresponse to lower commodity prices or a sudden reversal in capital outflows,coordination between the monetary, fiscal and financial policy responses isstill limited in many countries, particularly when dealing with sudden shiftsin capital flows or commodity price fluctuations (e.g. there is room forstate-owned banks to play a more central role in the stabilization efforts). Whilemonetary policy has been overburdened with multiple goals, fiscal policy stilllacks of flexibility to act counter cyclically.

Fourth, emerging economies are still lagging behind incompetitiveness as a result of lagged infrastructure investment, inefficientjudiciary systems, politically vulnerable institutions with limited checks andbalances and little progress achieved to reduce poverty and income inequalityor overhaul education, health care and public security systems. Fifth, inrecent years the corporate sector in emerging markets has continued to issuemostly in dollars, taking advantage of lower costs and abundant liquidity,increasing their exposure to currency mismatches and raising the risks to macroinstability. 

I believe international financial institutions could play amore active role to help countries dealing with sudden shifts in privatecapital flows that are not related to domestic fundamentals. While the IMFflexible credit line, for instance, is a well-intended instrument, the factthat only a handful of countries applied for it shows that there is significantroom for improvements on this front. On the development of local currency bondmarkets, further action can also be pursued by international financialinstitutions to help deepen and accelerate the process.

Toconclude, emerging market economies face significant challenges but are betterprepared to provide stronger assets to contribute to global financial andmonetary stability than in the past. A common set of macro principles builtupon past experiences has been applied in many of them without a pre-designedrecipe. The implementation has taken into account the idiosyncratic factors,the social preferences, the instruments available and the particularconstraints faced by policymakers in each country. Identifying adequatepolicies under specific circumstances for a country is not enough: the right timingand pace is also crucial for effective implementation. The buildup of liquiditybuffers, including foreign reserve accumulation and the development of a soundfinancial system, has been an effective addition to the traditional monetaryand fiscal policy tools to withstand increased volatility. The availability ofsuch policies has expanded substantially the room to maneuver, allowingpolicymakers to minimize the effects of external shocks on the real economy andstrengthen their currencies. Emerging market currencies are called to play abigger role in the future. Stronger economies and a more resilientmacroeconomic policy framework, will be key to provide stability to the globalmonetary and financial system.