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[size=0.9em]What we really know about the global financial safety net
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[size=0.9em]Beatrice Scheubel, Livio Stracca
04 October 2016[size=0.9em]The global financial safety net is one of the key infrastructures of financial globalisation. However, its current constellation does not reflect a coherent design, but rather the interaction of different instruments used for different purposes and developed over time. This column presents the first database that brings together all of the relevant data for assessing the global financial safety net, including foreign exchange reserves, IMF instruments, regional financing arrangements, and central bank swap lines. An analysis shows that the availability of the net helps to cushion the effects of capital flow reversals.
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The optimal provision of financial safety nets at the global level – or rather, equivalently, the international lender of last resort (ILOLR) function – represents a perpetual question in the international debate. Under the Chinese presidency, the G20 has recently reinvigorated work on the global financial safety net (GFSN) by featuring it prominently in the agenda of the (re-established) G20 International Financial Architecture (IFA) Working Group. G20 Leaders, in their latest Summit in Hangzhou, confirmed that a strong GFSN remains a priority for the G20. The IMF is exploring ways to strengthen its approach to helping members manage volatility and uncertainty, which will be probably echoed at the upcoming IMF Annual Meetings (IMF 2016).
Undoubtedly, the GFSN is a key infrastructure of financial globalisation. Interestingly, the recent debate on the GFSN comes at a time when benefits and costs of global financial integration are being reconsidered. Quality, rather than quantity of financial integration, is seen as a worthwhile goal (Cœuré 2016); unfettered capital flows are not seen as unambiguously welfare-enhancing anymore. In this context, a key question is how the GFSN can be further enhanced in order to promote high-quality financial integration, for example based on more stable and/or more growth-inducing capital flows.
A daunting set of questionsThe question of the optimal design of the GFSN contains the same uncertainties and trade-offs surrounding the domestic provision of lender of last resort (LOLR) function, and then some more. At a general level, the main rationale for the GFSN is the same as the domestic LOLR – debt markets are plagued by market failures and asymmetric information. The combination of exposure to long-term risky assets with short-term debt financing may be a recipe for inefficient deleveraging and crises driven by panic, as well as negative externalities to other institutions or countries. The optimal provision of a LOLR must prevent inefficient deleveraging, without, however, inducing excessive accumulation of leverage and financial fragility – i.e. without fostering moral hazard. As is often the case for insurance provision, there is no perfect solution other than trying to mitigate the risks and to manage the unavoidable trade-offs. Because the central bank has ‘deep pockets’ and is usually well informed on the state of the financial sector, it is natural that the domestic LOLR function is normally entrusted to it.
What are the key differences between the domestic LOLR and the ILOLR function? At least three are regularly mentioned in the debate.
- First, foreign debt is often denominated in foreign currency. The process of inefficient deleveraging may therefore materialise in a sharp and sub-optimal currency depreciation, rather than (only) in a credit crunch. This implies the need for a LOLR that can provide foreign currency, requiring that a foreign lender, not the domestic central bank, has the deep pockets. However, the mandates of central banks are typically limited when it comes to providing liquidity for non-domestic purposes.
- Second, an ILOLR has fewer means to influence and discipline the behaviour of the borrower, for the simple reason that countries are sovereign. Imposing collateral requirements, for example, is far more difficult in the international context.
- Third, there is no world central bank, implying that any ILOLR is likely to have limited financial means.
It is important to note that the current constellation of the GFSN is not the result of coherent design, and there is no ‘benevolent social planner’ behind it. It is rather the result of the stratification and interaction of different factors and interests and historical developments, often pursuing domestic rather than global objectives. It currently includes four largely un-coordinated elements:
- IMF-based financing;
- regional financing arrangements (RFAs);
- central bank swap lines; and
- foreign exchange reserves (own insurance).
Traditionally, the central element of the GFSN has been the IMF. It has long experience in promoting sound economic policies and in addressing crises with its well-diversified toolkit and its well-developed lending technology based on conditionality. However, during the Global Crisis, RFA financing and, above all, central bank swap lines have been quantitatively more important (Lombardi 2016).
The lack of a coherent design does not by itself imply that the GFSN is incomplete or sub-optimal, but many economists have argued precisely this (e.g. Shafik 2015). In the international policy debate, it is often the emerging countries who are the most vocal critics of the current configuration of the GFSN, and who have brought it to the table of the G20.
The policy discussion: Three key questionsProbably the most important questions surrounding the design of the GFSN are:
- Is its overall size appropriate?
- Should the GFSN remain centred on the IMF (possibly flanked by RFAs) or on central bank swap lines?
- Should the bulk of the GFSN be provided with conditionality attached?
On its overall size, the evidence is mixed. Availability of the GFSN has certainly expanded – in particular, central bank swap lines (see Figure 1 for the worldwide coverage in 2014) – but this is not necessarily the case if scaled to gross external assets and liabilities. Denbee et al. (2015) calculate plausible scenarios on the need for GFSN, concluding that in most scenarios availability of the GFSN is appropriate. However, it is difficult to foresee how future crises will eventually play out.
Figure 1. A snapshot of the GFSN in 2014
Notes: Variable definitions: Reserve adequacy (total reserves relative to the average of 3M Imports, 100% of short-term debt and 20% of M2), IMF loan use (total amount actually disbursed to a country in a given year, as % of GDP), Regional Financing Arrangements (membership dummy), and Centra Bank Swap Lines (swap line dummy). Sources: IMF IFS, IMF MONA, IMF WEO, WB WDI, RFA websites, CB websites/reports, own calculations.
On the second question, some economists (e.g. Truman 2013) have argued that the GFSN should be centred on central bank swap lines, presumably mostly by the central banks of reserve currencies, because only these central banks have the deep pockets to perform the ILOLR function in a credible way. On the other hand, central banks do not have the legal mandate to perform the ILOLR in all circumstances. Moreover, central banks do not have the expertise that IMF staff have to perform the ILOLR function effectively, including by imposing conditionality. For those reasons, for example, the ECB (2016) argued that any review of the GFSN should focus primarily on how to strengthen the role of the IMF as the truly global hub of the GFSN, given its universal membership.
Third, conditionality is a distinct feature of the GFSN that is typically not present in the domestic LOLR, partly because, as noted, it is more difficult to impose collateral requirements in an international setting. In turn, lending under conditionality is a ‘lending technology’ (Jeanne and Zettelmeyer 2001) that the IMF has developed over the years and that central bank swap lines cannot easily replicate.1 However, views in the literature are surprisingly divided and the empirical evidence mixed on whether conditionality is beneficial in the context of the ILOLR.
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