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Financial Crises, Liquidity and the International Monetary System

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Financial Crises, Liquidity and the International Monetary System | TSE

Women in Investment Management Opening Doors. Given the severity of the crisis, we have to ask ourselves: has it brought us to a new crossroads in the evolution of the international monetary system and what are the implications for the IMF? What the crisis most certainly did do was to alter the external circumstances. This is relevant at two levels. First, it became apparent that an initially national crisis might very quickly assume a global character by spreading through closely linked financial systems.

Second, the global financial system and the global real economy are so intertwined that a financial crisis can severely affect the real economy in both emerging and advanced economies. And regarding the relation between emerging and advanced economies, it is obvious that economic weights have shifted. Emerging economies acted as an important stabiliser at the height of the crisis, whereas major advanced economies are now facing a rather modest outlook for growth.

At the same time, they no longer enjoy the status of doubt-free solvency. What do these developments imply with regard to the role of the IMF? First of all, the crisis emphasised that the IMF is an indispensable global institution. It played a crucial role in fighting the financial crisis at a global level but also with regard to the sovereign debt crisis in Europe.

Regarding the latter case, the decision to involve the IMF was correct, even though this step was preceded by intense discussions. Furthermore, the analytical input provided by the IMF is essential for increasing the resilience of the global economy to future crises.

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However, it has to be acknowledged that the current crisis has not been a random event but can be traced back to specific causes such as inadequate institutional arrangements or mistakes made by market participants and policymakers alike. Thus, the ultimate objective should be to tackle the roots of the crisis instead of just creating ever more instruments to fight the symptoms. I would like to elaborate on this point with regard to two key features of the international monetary system: the supply of international liquidity and the issue of exchange rate and capital flow regimes.

Both features are part of the current debate: the first in the context of global financial safety nets and the second in the context of capital flow management. Let us begin with a few thoughts on global financial safety nets, a subject that is of direct relevance for the IMF.

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A core problem during the financial crisis was that money markets literally dried up and were no longer able to provide international liquidity. This particularly affected banks with foreign currency needs because banks usually do not have access to refinancing operations in foreign jurisdictions. Thus, they are dependent on the money market to obtain foreign currency funding.

To counter this liquidity squeeze, central banks introduced ad hoc swap lines with other central banks as an emergency measure. The objective was to provide each other with the capacity to deliver foreign currency funding to the national banking systems. These measures proved to be successful in securing the supply of international liquidity.

At present, there are discussions as to whether the ad hoc swap lines should be replaced with a more permanent mechanism in which the IMF would play a central role. Leaving aside the details, such a mechanism would, in essence, enable the IMF to provide almost unlimited liquidity support without adequate conditionality or pricing. Taking this as a starting point, I would like to raise some objections to such an institutionalised financial safety net. Enabling the IMF to offer quasi-unlimited amounts of short-term liquidity would implicitly require a pre-commitment from central banks to cover the potential financing needs of the IMF in times of stress.

This in turn reduces incentives for risky behaviour. Also, the IMF is not a world central bank and not a lender of last resort.

Financial crisis

In those cases where central banks do not provide swap lines in a systemic crisis, the IMF is well placed with its existing instruments to cover liquidity needs while staying within its resource envelope. More fundamentally, the main lesson of the financial crisis is that we need a better regulated financial market environment. This would be a true safety net for our societies and the international system.

In the same vein, the argument can be transferred to the financing side of the IMF. The idea of granting the IMF the option to issue SDR bonds to raise funds on capital markets is currently being discussed.

Central Bank and Monetary Policy After the Global Financial Crisis

This would replace the provision of foreign reserves via quota subscriptions. We could end up with an IMF that works like a hedge fund which leverages its quota resources with large amounts of additional debt. At the same time, adjustment efforts in countries borrowing from the IMF could be impaired given the quasi-unlimited availability of Fund resources. From a practical perspective, generating a secondary market for SDR bonds of sufficient critical mass liquidity would require substantial new SDR allocations and the use of SDRs — not only in the official but also in the private sector. This would influence global liquidity conditions and even interfere with the monetary policy of those central banks that issue the major reserve currencies. The IMF could also distort the risk assessment in international financial markets: it would pay the risk-free interest rate to finance itself and, as has been suggested by some commentators, invest those resources in risky assets of crisis countries.

This would lower the refinancing costs of the countries in question. Unless balanced by strict ex-post conditionality, this would further undermine the principles of sound incentives necessary for a stable international system. I am also not convinced of the need to again change facilities, which have only recently been introduced and already modified, or to invent ever more IMF facilities. For me, it is hard to imagine subsuming independent central banks under IMF crisis management coordination. Every crisis is different and needs different crisis managers.

Disruptions in the supply of international liquidity were undoubtedly a serious problem during the crisis. Recently, however, another aspect of the international monetary system has drawn some attention: capital flows.