Outlook for International Monetary System - Essay Example

Outlook for International Monetary System Introduction The International Monetary System is the set of government practices as well as market forces that establish rates of exchange among national currencies and assets of reserves of internationally adequate assets. The IMF was originally established in order to encourage international co-operation to cope with recession and protectionism on a world scale and to discourage individual countries from pursuing policies that would beggar their neighbors and eventually themselves. The desire to improve on the international chaos of the 1930s led to the Bretton Woods Conference in 1944 and an attempt to devise a financial system which would provide a more permanent and acceptable framework for international transactions. It was intended that the emerging Bretton Woods system would generate benefits for international trade in the form of stable (though not necessarily fixed) exchange rates, whilst, at the same time, avoiding the deflationary rigidities of the gold standard mechanism. The system was designed to ensure a world of full employment and economic growth. Impact of IMF on the Exchange Market of the Developing Countries Exchange rates are assumed to reveal fundamental supply as well as demand conditions, which, sequentially, ought to be associated to fundamental macroeconomic and other primary factors. Undeniably, the academic literature offers constructive confirmation of the relationship between exchange rates and basics in the long term. Nonetheless, exchange rates frequently diverge considerably from values implied by fundamentals and equality conditions in the short term, even in well-functioning markets (Sarno and Taylor, 2002). The cut off between short-term exchange rate levels as well as macroeconomic basics may make a position for sterilized involvement, which affects the exchange rate mostly through its impact on prospect, risk premiums, as well as order flow. Especially, sterilized intervention can be used to stop unnecessary exchange rate movements resulting from short-term shocks that do not influence fundamental macroeconomic conditions. For economies experiencing macroeconomic imbalances or structural weaknesses, intervention can assist for the time being effortlessness exchange rate pressures merely if there is a reliable commitment to, and tangible progress on, macroeconomic as well as structural adjustments. A crucial element in international monetary reform is improvement in the balance of payments adjustment process. There is widespread agreement that this improvement requires more flexible exchange rates than under the Bretton Woods system, and the Jamaica agreement legitimizes flexible rates. Yet there have been objections that greater exchange rate flexibility will be detrimental to the less developed countries, as well as claims that the LDCs have already been injured by the Smithsonian realignment of exchange rates in December 1971, the February 1973 dollar devaluation, and the floating of major currencies thereafter. The IMF annual report specifically cited exchange market development as a major new cost that LDCs would have to bear under a system of flexible rates for industrial countries. However, the importance of this problem seems to have been exaggerated. Most LDC export and import contracts have traditionally been specified in the major foreign currencies, not in a local currency. To the extent that LDC traders wished to hedge against new relative movements of these foreign currencies, they could do so through established forward exchange markets in the financial centers of industrial countries. The absence in LDCs of forward exchange markets for this purpose therefore appears to be of little concern. When it is important to have local currency quotations for certain export and import contracts, the problem is one of forward cover not among currencies of developed countries but between a specific foreign currency and the domestic currency of the LDC. In this case new forward markets would undoubtedly be required; but it would seem they could be provided fairly simply. The reason is that most LDC exchange rates are overvalued, so that it would impose little expected cost on an LDC's central bank to guarantee, say, the current peso-dollar (or peso-SDR) rate for, say, six months to future recipients of dollars. There would be Do anticipation of peso appreciation so the central bank would not suffer loss. Once the forward market for pesos to dollars existed, the trader could then complete his coverage by using forward markets of the major foreign financial centers to convert to dollars from the currency in which payment was to be received. The argument that flexible rates among industrial countries would impose forward exchange costs on LDCs cannot be faulted in terms of direction; in terms of magnitude, however, it appears of only limited significance. In relation to terms of trade, the fears of adverse effects have little theoretical foundation and have not been realized in practice. Intervention in the exchange market may be more effective in many developing countries than in advanced ones, despite the problem of weaker market credibility in the former. Compared with advanced countries, developing countries often intervene in amounts that are significant relative to the market's turnover. Their central banks are usually large customers in the foreign exchange market, especially when the public sector is a significant foreign exchange earner. Exchange and capital controls may also allow central banks to gather more information than other market participants. This stems from, among other things, central bank reporting requirements, which enable central banks to observe aggregate order flow in the market and the net open positions of financial intermediaries. Currency crises in the 1990s, however, highlight the limited effectiveness of intervention as an independent policy tool. Mexico's yearlong defense of its crawling peg in 1994 ended suddenly when the market belatedly became aware of the central bank's depleted reserve position. Thailand's intervention in defense of the baht in the first half of 1997 failed, virtually exhausting the central bank's net international reserves. Case Study of Asian and Latin Countries The large increases in capital flows to developing countries in recent years, mainly to Asian and Latin American countries, have been associated with widening current account deficits in most regions, although many countries have been relatively successful in sterilizing a substantial proportion of the capital inflows and building up reserves. During the period ahead, net portfolio capital flows to developing countries seem likely to decline considerably, but the strong fundamentals and solid long-term growth prospects of most countries suggest little reason to expect any substantial downward shift in foreign direct investment flows. Among individual regions, net capital flows to the Western Hemisphere are expected to slow the most, largely owing to the crisis in Mexico. There may well be some lag in trade flows, however, and projections for current account deficits do not fully offset the likely decline in capital flows. Recent increases in commodity prices and strengthened competitiveness are important factors in the current account improvements projected for African countries. These improvements are especially significant for the CFA countries, where progress in controlling domestic price inflation has helped maintain competitiveness following the January 1994 devaluation. In Cote d'Ivoire the current account deficit is expected to narrow by over 2 percent of GDP in 1995-96. The external surplus in Egypt is expected to decline further in 1995-96, reflecting in part a real appreciation of the currency. The strengthening of oil prices in 1995 and stronger fiscal adjustment efforts should also contribute to improvements in external positions among the oil exporting countries, especially for the larger oil exporting countries. The increase in interest rates during 1994 has been reflected in a rise in debt-service ratios for sub-Saharan Africa and for countries in the Middle East and Europe. A more flexible approach to official bilateral debt reduction for low-income countries by the Paris Club, under the "Naples" terms agreed in December 1994 and consistent with the Interim Committee's Madrid Declaration, is expected to reduce debt burdens for low-income countries. Cambodia was the first country to be offered a 67 percent net present value reduction in eligible debt service by the Paris Club in January 1995; subsequently a number of other countries, Chad, Guinea-Bissau, and Togo, in February, and Bolivia and Nicaragua in March, were offered similar terms, whereas Guinea received a 50 percent reduction in January. Furthermore, in February, Uganda was the first country to receive a stock-of-debt operation under Naples terms involving a 67 percent reduction in the net present value of eligible debt. Confessional terms such as these should help reduce debt and debt-service payments of most low-income countries to more sustainable levels, provided that new debt instruments offered to these countries contain similar confessional elements. In the past six months, progress has continued to be made with debt-restructuring agreements in connection with the London Club and on a bilateral official basis. These include the commercial bank restructuring agreement with Ecuador involving $4.5 billion commercial bank debt and $2.9 billion in interest arrears. Algeria is also negotiating with commercial banks to restructure $4.2 billion debt. Haiti has settled its debt arrears to multilateral lenders, but arrears to the United States and other bilateral lenders remain to be cleared, and South Africa wrote off a $200 million debt owed by Namibia. Talks with regard to the commercial bank debt of Peru and Panama are continuing. Negotiations are also continuing with Nigeria and Venezuela regarding arrears and the management of outstanding debt. In the aftermath of the Mexican financial crisis, equity markets in a number of developing countries experienced significant increases in volatility, raising concerns about the potential contagion effects that could result from a general reappraisal of developing country investments. Policymakers in many of the countries that have witnessed large capital inflows face a difficult task of managing the impact of these inflows, especially in limiting the potential adverse consequences on real exchange rates and the buildup of inflationary pressures. In the current environment, they need to guard against the risk of sudden reversals of capital flows. These risks are likely to be particularly acute in countries where the capital inflows are primarily short term. There are important differences between the recent surge in capital inflows to developing countries and the experience of the late 1970s and early 1980s, when capital inflows consisted largely of bank lending to public sector borrowers. In Asia and in some Latin American countries, such as Chile, the rising share of foreign direct investment and portfolio investments in emerging stock markets has helped to reduce reliance on debt-creating flows. The October 1994 issue of the World Economic Outlook focused on many of the factors that have contributed to the increase in private capital flows, including the effect of the recent recessions and the associated decline in interest rates in the industrial countries, and discussed the policy response in some of the large recipient countries.(11) The rise in interest rates in the industrial countries since early 1994 and the strengthening of the recovery have resulted in some moderation of portfolio capital flows to developing countries, but domestic factors such as macroeconomic stability and the sustainability of external balances are still likely to be the key determinants of the sustainability of capital flows. The crisis in Mexico, however, will undoubtedly lead to a period of increased vigilance in financial markets. Even though the longer-term move toward greater international portfolio diversification for industrial country investors can be expected to continue, albeit at a much slower rate, foreign investors are likely to be more selective with regard to developing country investments. Significant progress in implementing structural reforms and fostering macroeconomic stability, particularly in Latin America and Asia, has generally played a key role in attracting capital inflows. Nevertheless there have been marked differences in macroeconomic performance and in how the recent capital inflows have been utilized. Capital inflows have raised aggregate expenditures in all countries. In the Asian countries, however, the ratio of private consumption expenditure to GDP declined by over 4 percentage points in the early 1990s compared with the mid-to-late 1980s, and the ratio of investment to GDP rose by almost 5 percentage points. In the Latin American countries, by contrast, the ratio of consumption to GDP increased by over 3 1/2 percentage points in the early 1990s compared with the 1980s, while the investment ratio was only marginally higher. For Latin America, this suggests that the capital inflows have tended to become a substitute for private sector saving. Although these countries have made substantial progress in reducing fiscal deficits, the improvement in public saving has been insufficient to offset the decline in private saving. In several of these countries, stronger programs of fiscal consolidation and structural reform would help to strengthen domestic saving, in line with the experience of Chile. During the early years of the recent surge in capital inflows, most countries attempted to intervene in foreign exchange markets to limit the appreciation of their nominal exchange rates, to reduce the impact of capital flows on money and credit growth, and to lessen the vulnerability of the financial system in the event of a sudden reversal of capital flows. The Asian countries were relatively successful in sterilizing the monetary effects of the rise in foreign exchange reserves. This helped to contain pressures on domestic inflation and to maintain relatively stable exchange rates. Among the Latin American countries, foreign exchange intervention was limited, and real exchange rates generally appreciated. In many cases, financial markets are not sufficiently well developed for central banks to sterilize the magnitude of capital flows that have been attracted in recent years. However, even when financial markets are relatively developed, sterilization is likely to be effective only in the short term and may not be sufficient to resist persistent pressures on the exchange rate. A particularly important drawback with sterilization is that it tends to raise domestic interest rates, which may attract more short-term capital flows. Even in countries such as Chile, where sterilization has been relatively successful, net costs to the central bank - the difference between domestic interest rates and the return on foreign currency reserves - have been substantial. In Chile, these quasi-fiscal costs were estimated to be around 3/4 of 1 percent of GDP in 1991. The inability to sterilize the effects of the inflows played an important role in Mexico's financial crisis. Since the late 1980s, the Mexican economy has attracted substantial capital inflows, accounting for over 40 percent of total flows to all Latin American countries during 1990-92 (Kiguel & Leiderman, 1993). These large inflows, significant increases in foreign direct investment, were attracted by prudent macroeconomic policies, privatization and extensive structural reforms, and the country's promising long-term prospects, not least in the light of the North American Free Trade Agreement. The large capital inflows, however, coupled with the quasi-fixed exchange rate system, also resulted in a substantial appreciation of the real exchange rate and a sharp increase in the external current account deficit. Much of this deficit reflected higher consumption expenditure and a substantial decline in private savings. Against this background, and because of adverse political events, foreign investors' concerns about the sustainability of the current account deficit began to increase during 1994. At the same time, significant increases in liquidity ran counter to the need to tighten domestic monetary conditions in order to stem the capital outflows. Concerns about the potential instability of capital flows, especially of portfolio investment in stock and bond markets, have led a number of countries to impose a variety of restrictions to deter short-term inflows, while still maintaining convertibility for longer-term capital account transactions. Among the more common measures are restrictions or ceilings on foreign borrowing by domestic enterprises and high reserve requirements on foreign currency deposits. Chile, for example, has limited the inflows of capital by imposing reserve requirements of 30 percent on all foreign currency credits. The Indian authorities have recently raised reserve requirements on foreign currency deposits to discourage new inflows. Such restrictions tend to raise the cost of finance for domestic firms and reduce the efficiency of the financial system. Nevertheless, in the short term they may help to limit the potential destabilizing effects of capital inflows on real exchange rates and provide policymakers time to address weaknesses in financial markets and to improve macroeconomic fundamentals. It is particularly important to limit the foreign exchange exposure of the banking system, which may exacerbate difficulties in the event of a sudden reversal of capital flows. This may require more effective bank regulations that limit potential mismatches of maturities and currency denominations of bank assets and liabilities, particularly in countries where low-cost deposit insurance encourages excessive risk exposure. Such prudential controls should be distinguished from broader controls on international capital flows, which are rarely effective in stemming either capital inflows or capital outflows over the longer term, especially when they become a substitute for efforts to address macroeconomic imbalances and to correct unsustainable exchange rates. For countries that are confronted with shifts in market sentiment, the Mexican episode underscores two important policy principles. First, in order to restore confidence and relieve exchange market pressures in a crisis situation, domestic and external macroeconomic imbalances have to be addressed forcefully, and as quickly as possible. In the short term, the appropriate measures should include a tightening of monetary conditions through increases in domestic interest rates as well as fiscal adjustments. Fiscal action may be needed even when the initial imbalances emanate from the private sector. Over the longer term, governments must address the underlying causes of external imbalances and low saving, including structural measures to correct relative price distortions. A second policy lesson concerns the potentially difficult decision regarding exchange rate regimes. Where countries have adopted nominal exchange rate anchors as part of a wider inflation stabilization strategy, the initial response to exchange market pressures should consist primarily of monetary tightening. However, under circumstances of sustained pressures, accepting devaluation or abandoning fixed exchange rate parity may be the only credible policy response. In order to limit the inflationary impact of the devaluation, the transition to a new parity or a floating exchange rate regime needs to be accompanied by supporting measures that include tight monetary and credit policy, as well as a fiscal stance that is consistent with the new policy regime. In recent years, the aggregate growth performance of developing countries has been sustained at remarkably high levels despite periods of protracted weakness in the industrial countries. In large part, this resilience to weak external conditions has been due to the strong macroeconomic stabilization and structural reform programs in a number of countries. But high aggregate growth rates also mask considerable differences among individual countries and regions. Although these divergences in growth rates are expected to narrow over the medium term, as policies and reform efforts strengthen in some of the weaker performing countries - primarily in Africa, but also in other parts of the developing world - significant disparities are likely to persist. The divergences in performance and stages of development give rise to very different priorities and policy challenges across individual countries, even though the basic requirements of market-oriented, outward-looking policies are common to all countries. In addressing the policy challenges facing developing countries, it is useful to classify countries into three broad categories: strong performers that are characterized by substantial high growth and rapid improvements in living standards; moderate performers that are catching up more slowly; and countries that have experienced negative growth over the recent past and where living standards continue to decline. The strong performers comprise countries that have managed to sustain a rapid pace of economic growth. Several of these now have high per capita incomes, while others are rapidly catching up from relatively low-income levels. Singapore's per capita growth rate, for example, has averaged over 7 percent a year over the past thirty years; measured at purchasing-power-parity exchange rates, per capita income in Singapore now exceeds that of many industrial countries. A number of countries in Asia, including Korea and Malaysia, have recorded similar strong growth performances. Many of these countries are confronted with policy challenges that are similar to those faced by industrial countries: sustaining growth while minimizing the risk of overheating. Some countries, such as Chile, China, Korea, Malaysia, and Thailand, are experiencing relatively tight conditions in labor markets and capacity constraints arising from the slower pace of improvements in infrastructure. For these countries, it is important to ensure that macroeconomic policies, particularly financial conditions, are adjusted appropriately in light of the strength of economic performance. In China, for example, growth rates of around 13 percent in 1992 and 1993 could not be sustained, and resulted in inflationary pressures. This required the adoption of stabilization measures to slow aggregate demand. In Korea, the authorities have faced similar difficulties in recent years. Higher investment in infrastructure to keep pace with growth represents a major challenge for these countries. In China, weaknesses in intercity transport systems have adversely affected the supply of coal, which is used to meet a large proportion of the country's rapidly growing electricity needs. In Thailand, the concentration of growth in Bangkok has placed increasing strains on infrastructure in and around the city. Other strong performers, such as Indonesia, Korea, Malaysia, and the Philippines, are experiencing increasing demands for public utilities and transportation systems. The challenge for many of these countries is to address their infrastructure needs, including environmental requirements, without putting undue strains on public finances or on their external positions. To this end, a number of countries have implemented large-scale privatization programs. Malaysia has successfully privatized a container port, telecommunications, and electricity supply; and privatization has played a significant role in eliminating chronic power shortages in the Philippines. Korea and Thailand, on the other hand, are encouraging private participation in infrastructure development. Several large public and private utility companies in Latin America, particularly in Argentina, Chile, and Mexico, have been able to finance infrastructure investment through foreign direct investment. Many of the infrastructure projects under consideration will require large-scale investments. There is often a presumption that such investments necessarily require foreign financing, but policies in a number of Asian countries are appropriately geared toward mobilizing domestic saving to help meet much of the financing for these projects. Conclusions Developing countries that are at a relatively advanced stage in liberalizing trade regimes and implementing market-oriented structural reforms have attracted large capital flows in recent years. In some cases, however, the capital inflows may be attracted primarily by high domestic interest rates stemming from an unbalanced mix of monetary and fiscal policy. For these countries, fiscal tightening will help to safeguard financial stability by improving the domestic saving-investment balance. For all such recipient countries, however, large-scale capital inflows have been accompanied by higher domestic spending and higher imports, which have increased fiscal revenues. Such increases in revenue may well be unsustainable, and as suggested by Mexico's experience, policymakers may need to aim for structural fiscal surpluses to provide a buffer that can be used in the event of large outflows. The experience of Mexico also underscores the role of fiscal policies in determining the credibility, and ultimately the sustainability, of pegged exchange rates. Devaluations that are not accompanied by strong fiscal measures are unlikely to gain credibility or deliver effective adjustment (See the October 1994 World Economic Outlook). Many developing countries have made substantial progress with economic policies since the 1980s and are now much better placed to reap the benefits of increased integration of goods and financial markets in the global economy. The resilient growth performance of developing countries in the 1990s is indicative of the progress that has been made. Although domestic policies have improved in a number of areas, improved fiscal policies have been a prime source of greater macroeconomic stability and increased confidence for investment. Compared with the 1980s, fiscal imbalances are markedly smaller in a large number of countries, despite significant differences in the underlying causes of fiscal deficits. For some countries, deficits have stemmed largely from inappropriate policy responses to terms of trade shocks, but in most cases, fiscal deficits reflect a legacy of excessive and unnecessary state involvement in economic activities, which in turn has impeded growth of both the economy and tax revenue bases. Among the more successful performers, rapid and sustained economic growth has increased the need for public sector provision of infrastructure to keep pace with private sector development. Despite differences in the underlying causes of deficits, fiscal consolidation measures have consisted primarily of expenditure cuts, reflecting a widespread consensus among policymakers on the adverse effects on growth of higher taxation. In some developing countries, rapid growth has also enabled governments to reduce taxation without reducing expenditures on essential public services. While sound fiscal policies have been established in a number of countries, in many others it is necessary to speed up the process of fiscal consolidation and ensure that programs already initiated stay on track. And in parallel with disciplined fiscal policies, radical structural reforms are still needed in many countries to elicit the private sector supply response and raise growth performance. With more open trade regimes and increased integration of capital markets, the costs of macroeconomic imbalances are likely to be even greater than in the past. Indeed, as some countries have already seen, adjustment forced by exchange markets can require sharp changes in expenditure policies and lead to large output losses. All countries need constantly to evaluate expenditure priorities and to limit the extent of public sector intervention and the associated distortions that may hinder private sector activity. For many of the strong performers, it will be imperative to ensure that public sector commitments to extend social security programs, including pension schemes, do not give rise to excessive fiscal burdens. These countries have the opportunity to avoid the costly mistakes of many industrial countries where pension entitlements have contributed to increasingly unsustainable fiscal burdens. Intervention is not an independent policy tool; its success is conditional upon the consistency of targeted exchange rates with macroeconomic policies. Exchange rate misalignments and disorderly markets--the most common justifications for intervention--are extremely difficult to detect, underscoring the need for central banks to be parsimonious in their interventions. Determining the timing and amount of intervention is a matter of judgment and depends heavily on ever-changing market conditions; hence, some degree of discretion is necessary. Exercising discretion judiciously and ensuring transparency in intervention policies and objectives are likely to enhance the effectiveness of intervention while minimizing its risks. IMF-supported adjustment programs can have important implications for official intervention in countries with flexible exchange rate regimes. In many programs, floors are set on net international reserves (NIRs), which limit the capacity of the central bank to sell foreign exchange. In effect, IMF programs often advise the authorities to confine their interventions to smoothing exchange rate volatility. The reserve accumulation envisaged under many IMF-supported programs--by gradually rising NIR floors--creates, by design, asymmetry in exchange rate and intervention policies. In particular, programs aim to limit interventions in defense of an exchange rate under downward pressure for a protracted period, especially if the exchange rate level is inconsistent with underlying macroeconomic policies. The challenge for many countries with IMF-supported programs is thus to accumulate reserves and meet their NIR flours while minimizing the impact of intervention on the exchange rate. This challenge is also faced by many other countries and can be tackled in several ways. First, like any other customer, the central bank can intervene in the market in a discreet fashion, without disclosing its purpose or market presence. Second, the central bank can preannounce periodic foreign exchange purchases. While this may minimize the impact on the exchange rate, advance knowledge of the timing and amount of its foreign exchange purchases may allow market participants to take advantage of the central bank. Interventions to calm disorderly markets and smooth exchange volatility should be rare and warrant particular scrutiny. Disorderly markets are difficult to detect and should not be used as an excuse to intervene in defense of a particular exchange rate level in what is purportedly a flexible exchange rate regime. Reference: Sarno, Lucio, and MarK P. Taylor, 2002. The Economics of Exchange Rates (Cambridge, U.K.: Cambridge University Press). See the October 1994 World Economic Outlook for extensive discussions of the recent surge in capital flows to developing countries and Annex I of the May 1995 Worm Economic Outlook for an evaluation of the causes of the sharp reversal of capital flows to Mexico in early 1995. Miguel A. Kiguel and Leonardo Leiderman, 1993. "On the Consequences of Sterilized Intervention in Latin America: The Case of Colombia and Chile" (World Bank: Washington). Read More