Agenda to overhaul world financial system

JUST WHEN Asian countries are trying to focus on economic recovery following the financial crisis of 1997-98, the possibility of another bout of global instability has increased. It looks as if Argentina, one of Latin America's largest economies, is on the brink of a major crisis as it struggles to keep uptodate with its external debts totalling over $100 billion.

The swings between currency rates (especially between the three major currencies, of the U.S., Europe and Japan) have not stopped, and these have contributed to significant fluctuations in the currencies of developing countries. Thus, the need for reform to the global financial system is more acute than ever before.

Unfortunately, as the Trade and Development Report 2001 (TDR) released last week points out, there has been little or no progress on such reform. Instead, the discussions on "a new international financial architecture" (that had been launched during the Asian crisis) have focused on getting the developing countries to strengthen their banking and corporate systems. This in itself is an important task that can prepare these countries against risks of future crisis. However, national-level measures are insufficient, as the root causes of financial turbulence lie in the international system.

Five major areas

The TDR published yearly by the UNCTAD, focuses on five major areas of global reform that the "new financial architecture" should be working on, but have so far relatively ignored. The first two involve measures to prevent future crises: regulation of global capital flows and stabilisation of currencies. The third relate to better measures to manage a crisis once it has broken out. The last two deal with the need for institutional changes: reform of the International Monetary Fund and governance of the world financial system.

The UNCTAD report is probably the most in-depth and comprehensive report on the current debate on the global financial system, pointing out its weaknesses, criticising the so far extremely disappointing reform process, and providing detailed proposals for genuine reforms to the system.

The recent frequent bouts of financial crisis have shown that the problem is located in the system of global finance which since the early 1970s has been characterised by flexible exchange rates and large-scale private capital flows.

Crises blamed on debtors

According to the TDR, instead of establishing global-level institutions and mechanisms to reduce the risks of crises and manage them better, "there has been one-sided emphasis on reforming domestic institutions and policies in developing countries."

In the past few years, efforts were made to discipline debtors and provide costly self-defence mechanisms. Developing countries have been urged to adopt strict financial standards, improve transparency, adopt appropriate exchange rate regimes and carry large amounts of reserves.

These reforms have merit, but they presume that the cause of crises rests primarily with debtor countries and place the onus for reform on them. By contrast, little attention is given to the role of institutions and policies in the creditor countries in triggering crises.

The efforts to set up various financial codes and standards, while beneficial, offer little to protect developing countries from supply-driven fluctuations in international capital flows (caused mainly by policies and conditions in industrial countries), nor from currency exchange fluctuations.

Regulatory mechanisms

The UNCTAD report proposes the following reforms. First, there should be institutions or mechanisms to regulate and stabilise international capital flows. It mentions proposals made by prominent economists or market players for such institutions, such as a World Financial Authority that would set up, regulate and oversee financial enterprises.

The role of such international regulatory institutions or mechanisms is to prevent excessive risk taking in cross-border lending and investment, reduce systemic failures and eliminate weaknesses in regulatory regimes in both creditor and debtor countries.

Second, there is need to establish a global system of exchange rates. Since the breakdown of the Bretton Woods fixed exchange rate system (in 1973), there have in effect been no global arrangements. Countries have to make their own choice between a floating system, a fixed system, or something in between (adjustable or soft pegs).

Each of these systems has its own problems. The floating system, favoured by the major industrial countries, has failed to deliver, and is characterised by short-term currency volatility, and persistent currency misalignments and gyrations. The damage inflicted by disorderly exchange rate behaviour is limited for the reserve currency countries (the U.S., Japan and Europe) themselves, but the disorder is a major source of disturbance for developing countries as they have smaller economies and are more dependent on trade.

Currency stability

The UNCTAD proposes changes in the industrial countries: that they coordinate their macroeconomic policies and thus reduce instability, and that they stabilise their currencies against one another, especially the so-called G3 currencies (dollar, yen and euro).

One proposal to attain stable and properly aligned exchange rates mentioned by the UNCTAD is the introduction of target zones among the three major currencies with a commitment by the countries to defend such zones through coordinated intervention and macroeconomic policy action.

Meanwhile, if such stabilisation at global level does not take place, developing countries will still face currency instability, whichever system is chosen by an individual country, since there is instability among the three major reserve currencies.

"Whichever option is chosen, it will not be able to ensure appropriate alignment and stability of exchange rates in developing countries as long as the major reserve currencies themselves are so unstable and misaligned, and international capital flows are volatile and beyond the control of recipient countries," says the TDR.

Third, the UNCTAD proposes that there should be orderly workout mechanisms for international debt. In the absence of global reform, more crises are bound to occur. When they do, there needs to be a set of measures for the crisis-struck country to take to prevent the crisis from becoming unmanageable. Otherwise, foreign creditors and investors will "rush for the exit," each one trying to collect as much from the country as they can, leading to massive capital outflows, more devaluation of the currency and severe financial and economic crisis.

The TDR proposes that the principles of a bankruptcy court should apply within an internationally sanctioned orderly debt workout framework. First, the country can declare a temporary debt standstill, to prevent a "grab race" for assets among the creditors. Second, the debtor country continues to get access to working capital (that is, "lending into arrears") so that it can finance a recovery programme. Third, an arrangement is worked out to reorganise the debtor's assets and liabilities, including debt rollover, extension of existing loans and debt write-off or conversion to equity.

Since developing countries may face grave disapproval if they were to embark on such a move unilaterally, the UNCTAD suggests that there should be an internationally agreed system to sanction the debt standstill and debt work out system. Within that, a country can declare a mandatory standstill and then rely on an international independent panel to conduct the work out arrangements.Fourth, the TDR proposes a reform of the IMF. Its surveillance of countries and disciplines imposed on them have applied mainly to developing countries which are debtors. The IMF should also apply surveillance on the major industrial countries as their financial policies and instability of their currencies act as a catalyst for crises elsewhere in the world economy.

Thus, a priority of the reform process must be to strengthen the surveillance mechanism to achieve a minimum degree of coherence among the macroeconmic policies of the major countries. The UNCTAD also suggests a dispute settlement mechanism (similar to the one that exists for trade), where disagreements over the impact of macroeconomic and financial policies can be taken up and resolved.

The TDR also proposes a review of the IMF's policy conditions attached to its loans. It is critical of the expansion of such conditions, noting concerns of their undermining sovereignty, as well as how the excessive conditions intensified the Asian crisis.

Fifth, the TDR proposes reforms to the system of governance of international finance. It notes that the reform process has so far been driven by the interests of the major creditor countries, which hold most of the power in multilateral financial institutions. As a result, many issues of crucial importance to developing countries have been excluded from the reform agenda.

Because of the one-dollar-one-vote system, developed countries have 61 per cent of the voting rights in the IMF and the World Bank, compared to 17 per cent in the United Nations and 24 per cent in the WTO.

Reforms to existing financial structures must provide for much greater collective influence from developing countries. This will involve reviewing the representation system and decision-making practices in the institutions and a major reformulation of the reform agenda.

Common goals for developing nations

But the UNCTAD is also aware that developing countries themselves are not well organised to push for such reforms. It lists several areas on which they could agree in a common agenda: balanced treatment of creditors and debtors regarding standards, codes, transparency and regulation; more stable exchange rates; more balanced surveillance; less intrusive loan conditions; above all, more democratic and participatory multilateral institutions and processes.

Effective reform of the global financial system will ultimately depend on whether developing countries organise around such common goals, and whether the developed countries accept that these goals are essential to build a better system of global economic governance, concludes the UNCTAD. Reading the report, one is left wondering at the state of the world's economic system.

The proposals are eminently logical. Looking at the situation objectively, few can quarrel with the need for basic reforms along the lines of the UNCTAD analysis. However, vested interests that make huge profits from currency instability and from the free flow of funds are jealously guarding their "right" to benefit from an unstable and unfair system. And unfortunately they are currently in favour with the ruling political establishment in the developed countries.

The way forward is for developing countries to insist on their own rights to a fair and stable global financial system, and find ways to collectively put their agenda on the table. Unfortunately it may require more crises ahead, including those that also affect the developed countries themselves, before the message of the TDR is heard and acted on by the powers that be in the global system

Martin Khor

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