From Great Depression to Great Recession
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Chapter 14. Reforming the Global Reserve System

Editor(s):
Atish Ghosh, and Mahvash Qureshi
Published Date:
March 2017
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Author(s)
José Antonio Ocampo

The current global reserve system evolved out of the unilateral decision by the United States in 1971 to abandon the gold-dollar parity and convertibility of dollars for gold that was established at Bretton Woods in 1944. Although other currencies can compete with the US dollar as international means of payments and potential foreign exchange reserve assets, this competition has been weak owing to the “network externalities” in the use of currencies (whereby the value of a currency to a user depends on how widely it is used by others) and the fact that the United States has by far the largest market for liquid Treasury securities. According to IMF data on the composition of allocated foreign exchange reserves, in the fourth quarter of 2014, 62.9 percent of global reserves were held in US dollars, 22.2 percent in euros, and 14.9 percent in other currencies. Moreover, at least 80 percent of foreign exchange transactions are managed in US dollars. The current system can thus undoubtedly be called a fiduciary dollar standard—an important feature of which is that alternative reserve currencies float against each other. This chapter lays out the problems associated with the current international monetary system and discusses proposals for reform.

The Problems of the Current System

The current global monetary system can be characterized as facing three distinct problems, which can be identified in a historical sequence (Ocampo 2010b, 2010c). The first is the problem emphasized by John Maynard Keynes (1942–43) in his proposals for a global monetary system in the years leading up to the 1944 Bretton Woods Conference. Keynes noted that this problem had been a feature of all international monetary systems: the asymmetric adjustment pressures on deficit versus surplus countries. The former are forced to adjust, and the latter are not, which creates a recessionary pressure on the world economy. The asymmetric adjustment problem is, of course, felt with particular severity during global recessions, when deficit financing dries up.1

There is perhaps no better example of this problem than the experience of the euro area countries during the global financial crisis. As Figure 14.1 shows, since 2007 Greece, Ireland, Portugal, and Spain have experienced massive current account adjustments of 9 to 16 percentage points of GDP. Italy, the third largest economy in the euro area, has also experienced a significant adjustment of about 4 percentage points. By contrast, surplus countries—Germany, the Netherlands, and, to a lesser extent, Austria—have not reduced their surpluses by any significant amount; in fact, some surplus countries have even increased them.

Figure 14.1.Current Account Balance of Euro Area Countries

(Percent of GDP)

Source: IMF, World Economic Outlook database.

The second problem is generated by the use of a national currency (the US dollar) as the major international currency. This problem was formulated in the 1960s by the Belgian economist Robert Triffin and came to be known as the “Triffin dilemma” (Triffin 1961, 1968; for a recent formulation, see Padoa-Schioppa 2011). As discussed in Chapter 1 of this volume, the essential issue is that provision of international liquidity requires the reserve-issuing country or countries to run a balance of payments deficit, in either the current or the capital account, even though this could eventually lead to a loss of confidence in that currency. In the 1960s, this dilemma was reflected in the tendency of the United States to gradually lose gold reserves, but if the United States had tried to correct its deficit to avoid the loss, the action would have squeezed international liquidity. After failing to manage the loss of gold reserves through the Gold Pool (Eichengreen 2007, Chapter 2), the United States finally decided to abandon convertibility of dollars for gold in 1971.

This decision changed the nature of the Triffin dilemma. The United States was essentially left with no effective constraint to run balance of payments deficits, which generated both a long-term trend of rising current account deficits and strong fluctuations in the exchange rate of the dollar against other currencies (Figure 14.2). The former could be said to generate expansionary (and, under some conditions, inflationary) pressures on the global economy during the periods when the United States is running deficits; in turn, reductions of the US current account deficit have always been associated with global slowdowns or recessions (1980–82, 1990–91, 2008–09, and to some extent 2001). Thus, the system can be said to alternate between expansionary and recessionary biases. The instability of the US dollar exchange rate can be understood, in Triffin’s terms, as cycles of confidence in the US dollar as a reserve currency. The instability also implies that, since the early 1970s, the dollar has lacked an essential feature of the currency that is at the center of the global monetary system: a stable value.

Figure 14.2.US Current Account and Real Exchange Rate

Source: IMF, International Financial Statistics database.

Note: An increase in the real exchange rate is a real depreciation. CPI = consumer price index.

Being at the center of the system generates several advantages for the United States; among them are the appropriation of seigniorage from the use of the dollar as a global currency, the ability to borrow at low interest rates, and an increased demand for the services provided by its financial industry. But its position also has costs for the United States, particularly if (as has been the norm in recent decades) it involves current account deficits, which represent leakages in aggregate demand. This means, in turn, that the effectiveness of US expansionary policies is reduced by the spillovers these policies generate on the rest of the world during periods of dollar appreciation. This is what happened in the aftermath of the Lehman Brothers collapse in September 2008, so that part of the stimulus of US expansionary policies was exported to the rest of the world.2

The third problem with the current international monetary system is the inequities generated by the need of developing countries to accumulate foreign exchange reserves to manage the strong procyclical swings in capital flows, which are transfers of resources to reserve-issuing countries. This inequity bias became very visible in the 1990s, especially in the aftermath of the sequence of crises in emerging market economies that started in east Asia in the late 1990s. As Figure 14.3 indicates, until the 1980s the foreign exchange reserves of low- and middle-income countries were similar to those of high-income countries: 3 percent to 5 percent of GDP. Since then, however, they have diverged—sharply since the Asian crisis. Before the recent North Atlantic financial crisis (end-2007),3 high-income and low-middle-income countries, excluding China, held average reserves equivalent to 17.7 percent and 26.9 percent of GDP, respectively, while low-income countries held reserves of about 17.4 percent of GDP. With the exception of Japan, high-income Organisation for Economic Co-operation and Development (OECD) countries continued to hold reserves of less than 2 percent of GDP. Since the beginning of the financial crisis, however, low-income countries have lost reserves, while the OECD countries have increased their reserve holdings, but only to about 3.6 percent of GDP.

Figure 14.3.Total Reserves (Excluding Gold), by Level of Development

(Percent of GDP)

Source: IMF, International Financial Statistics database for total reserves excluding gold series. Note: Categorization by level of development according to World Bank for the year 2000. Organisation for Economic Co-operation and Development (OECD) excludes Japan. China and the Persian Gulf countries (Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates) are not included in any other category.

This phenomenon, which has come to be known as “self-insurance,” involves not only accumulating reserves to face an eventual sudden stop in external financing but also absorbing through reserve accumulation a large part of what countries consider excess capital inflows. The basic rationale for this policy is to avoid appreciation pressures and growing current account deficits during periods of booming capital inflows, which (as past experience amply demonstrates) are strong predictors of crises during the downswing of the capital account cycle that follows. There is increasing evidence that strong reserve positions and avoidance of overvaluation and current account deficits significantly contributed to the relatively good performance of developing countries during the North Atlantic financial crisis.4 In a broad sense, self-insurance is a prudential or countercyclical macroeconomic policy aimed at moderating the domestic effects of procyclical capital flows. Despite this positive effect, the policy generates a “fallacy of composition” effect: if many countries adopt a policy aimed at generating surplus or small current account deficits, they contribute to the generation of global imbalances.

Reforming the System

These deficiencies in the global monetary system are, in different ways, at the center of the reform proposals formulated at the beginning of the 2007 crisis. They included the proposal by the central bank governor of China to gradually eliminate the role of the dollar at the center of the system (Zhou 2009). In turn, the Stiglitz Commission, convened by the president of the United Nations General Assembly, proposed that reforms of the global reserve system should be at the center of the global reform agenda (UN 2009). The Palais Royal Initiative (2011), convened by former IMF managing director Michel Camdessus together with Alexandre Lamfalussy and Tommaso Padoa-Schioppa, also presented a series of reform proposals. However, actions have been limited, and the reforms of the international monetary system did not fully enter into either Group of Twenty (G20) or IMF debates.

There are essentially two paths forward, and they can be combined in a complementary way.5 The first—in a sense the inertial solution—is to enhance the multicurrency features of the current system. The increasing use of the euro for global transactions and as a global reserve asset is one of the possibilities, although the recent crisis has shown that there may be limits to this approach in the current setup, as the euro is backed by a heterogeneous group of countries with uneven strength, and there is in fact no homogeneous euro bond market. The internationalization of the renminbi is a complementary possibility. This process is being pushed by market forces and facilitated by Chinese authorities, but it is being constrained by the limited domestic financial development in China and by the inconvertibility of the renminbi (Yu 2014). However, full convertibility may not be necessary for the renminbi to play the role of a reserve asset if full convertibility is guaranteed for central banks that hold renminbi as reserves. This approach may be inconvenient for the Asian giant, as it can expose the country to destabilizing external shocks (Gallagher and others 2014). In addition to the euro and the renminbi, other currencies can play secondary roles, and local currencies can be used on a broader scale for intraregional trade.

The basic advantage of a multicurrency arrangement is that it allows reserve holders—especially emerging economies—to diversify the composition of their foreign exchange reserve assets and thus counteract the instability that characterizes all individual currencies under the current system. However, exchange rate flexibility among alternative reserve currencies would be not only an advantage but also a potential risk. Flexibility would make the system more resilient than the fixed gold-dollar parity that led to the collapse of the original Bretton Woods arrangement, but if central banks around the world actively substitute among currencies to enjoy the benefits of diversification, this could increase exchange rate volatility among major reserve currencies. For this reason, a multicurrency arrangement might need an IMF “substitution account” to serve as a stabilizing mechanism, which means that it might have to rely on at least some elements of the second alternative.

Also, this reform would not address any of the other deficiencies of the current system. The benefits from the reserve currency status would still be captured by industrialized countries and eventually by China, so the system would continue to be inequitable. This reform would not solve the asymmetric adjustment bias of the current system either, nor would it reduce emerging market and developing economies’ demand for self-insurance. Finally, in the light of the growing demand for reserves, the dominance of the US dollar could worsen the net external liability position of the United States and other problems associated with the Triffin dilemma.

The second alternative is to move toward a global currency, initially perhaps only as a reserve asset. Although other routes are possible,6 the best would be the use of Special Drawing Rights (SDRs) issued by the IMF; indeed, this would fulfill the aspiration written into the IMF’s Articles of Agreement when this instrument was created of “making the special drawing right the principle reserve asset in the international monetary system” (Article VIII, Section 7, and Article XXII).7 As Triffin (1968) envisioned, this would complete the transition that began in the nineteenth century of placing fiduciary currencies at the center of modern monetary systems.

Proposals for periodic SDR allocations follow two models. The first is countercyclical allocations—concentrating them in periods of global financial stress and possibly partially destroying them once financial conditions normalize (UN 1999; Camdessus 2000; Ocampo 2002; Akyüz 2005). This approach would develop a countercyclical element in world liquidity management. The second model proposes regular allocations in proportion to the additional global demand for reserves. Most estimates indicate that annual allocations of $200–$300 billion would be reasonable.8 These allocations would increase the share of SDRs in non-gold reserves only to somewhat above 10 percent in the 2020s, indicating that they would still largely complement other reserve assets.

Under current rules, the IMF makes SDR allocations on the basis of long-term global need and with the purpose of supplementing existing reserve assets. As mentioned in Chapter 1, so far there have been three general SDR allocations: the original in 1970–72 for SDR 9.3 billion; the second in 1979–81 for SDR 12.1 billion; and the third, proposed in 1997 partly to allocate SDRs to members that had joined after 1981 (not effective until the Fourth Amendment of the IMF Articles of Agreement, of which it was a part, was approved by the US Congress in 2009) for SDR 161.2 billion. In addition, the Fourth Amendment to the Articles of Agreement provided for a special one-time allocation of SDR 21.5 billion in 2009 as one of the measures to boost international liquidity during the North Atlantic financial crisis.

SDR allocations are based on IMF quotas and therefore are much larger for high-income countries. Table 14.1 shows that the share of high-income countries in the allocation has gradually declined over time, although it was still close to 70 percent in 2009, with the falling share of OECD countries partly compensated by the rise of high-income non-OECD (mainly Persian Gulf) countries. Middle-income countries have increased their share of allocations by 6 percentage points since the early 1970s, with China constituting over half of that. By contrast, low-income countries have seen their share reduced from already marginal levels.

Table 14.1.SDR Allocation, by Income Level
Allocations (Millions of SDRs)Allocation to Each Group

(Percent of Total Allocations)
1970-721979-8120091970-721979-812009
High-Income Countries: OECD6,8187,956114,90573.866.262.9
Japan37751411,3934.14.36.2
Excluding Japan6,4417,442103,51269.861.956.7
United States2,2942,60630,41624.821.716.7
High-Income Countries: Non-OECD4136310,7970.43.05.9
Gulf Countries12868,8350.02.44.8
Excluding Gulf Countries40771,9620.40.61.1
Middle-Income Countries2,1443,35953,34723.228.029.2
China02376,7530.02.03.7
Excluding China2,1443,12246,59423.226.025.5
Low-Income Countries2303383,6142.52.82.0
Total Allocation9,23412,016182,653100.0100.0100.0
Source: IMF International Financial Statistics database.Note: OECD = Organisation for Economic Co-operation and Development; SDR = Special Drawing Right.
Source: IMF International Financial Statistics database.Note: OECD = Organisation for Economic Co-operation and Development; SDR = Special Drawing Right.

SDRs are defined by the IMF as an “international reserve asset.”9 However, under the current rules, countries pay interest on allocations of SDRs and receive interest on holdings. In this sense, SDRs are both an asset and a liability. Moreover, since countries that use them make net interest payments to the IMF, they should also be considered as a credit line that can be used unconditionally by the holder, that is, an unconditional overdraft facility. However, the fact that all central banks accept SDRs makes them effectively an international reserve currency. Use of SDR allocations is widespread and works rather smoothly; developing countries use them frequently, but they have also been used by industrialized countries at critical junctures (Erten and Ocampo 2014, Chapter 9).

Perhaps the most important and simplest reform would be to finance all IMF lending and conduct all IMF operations with SDRs, thus making global monetary creation similar to domestic money creation by central banks. This idea was suggested by the IMF economist Jacques Polak in 1979. According to his proposal, IMF lending during crises would create new SDRs, but these SDRs would be automatically destroyed once the loans were repaid. The alternative I have suggested would be to treat the countries’ unused SDRs as deposits with (or lending to) the IMF that could then be used by the institution to lend to other countries in need (Ocampo 2010b). Either of these proposals would involve eliminating the distinction between the IMF’s General Resources and SDR accounts (which are offshoots of the debates of the 1960s) and make SDRs a relatively limited instrument of global monetary cooperation (Polak 2005, part II).

Using SDRs to finance IMF programs would also help correct the significant lags in increasing the size of the Fund in relation to that of the world economy, and especially in relation to the size of international capital flows (IMF 2010). An additional problem is that despite the agreed-upon reallocation of quotas in 2006 and 2010, the existing quotas do not reflect various countries’ shares of the world economy today. The underrepresentation of developing countries in the quota allocation increases the inequities associated with the fact that the largest demand for reserves comes from the developing world.

These inequities mean that efforts to reform quota allocations must continue. The inequities can be partially corrected with a mix of two types of reforms. The first is an asymmetric issuance of SDRs, in which all or a larger proportion of allocations would be given to countries with the highest demand for reserves; essentially, developing countries. One simple formula proposed by John Williamson (2010) is to give 80 percent of allocations to emerging market and developing economies and 20 percent to industrial countries, with allocations within each group determined according to IMF quotas. The second kind of reform would be to create a “development link” in SDR allocations. In this approach, the IMF could employ SDRs that are not used by member states to provide development financing or, better yet, leverage development financing by, for example, allowing unused SDRs to be used to buy bonds from multilateral development banks or institutions that contribute to the provision of global public goods, such as climate change mitigation and adaptation (UN 2009).10

Reforms such as this would go a long way to correct some major problems of the current system, particularly the Triffin dilemma and the inequity bias, but they would not solve the asymmetric adjustment bias. This problem could be partly solved by two further complementary reforms: (1) the creation of at least a moderate version of Keynes’s overdraft facility,11 and (2) withdrawing allocations of SDRs to countries with excessive reserves, using a definition of “excessive” that takes into account the high demand for reserves by emerging market and developing economies.

As noted earlier, SDRs should also be used to create a substitution account similar to that proposed in the debates of the late 1970s, which would allow countries to transform their dollar reserves (or those denominated in other currencies) for SDR-denominated assets issued by the IMF).12 This instrument would provide stability to the current system and, as already pointed out, might prove essential to manage some of the instabilities generated by the multicurrency arrangements. It would also be a transition mechanism for an ambitious reform effort (Kenen 2010b). Of course, it would be essential to negotiate how to distribute the potential costs of this mechanism. The literature contains conflicting estimates of the costs if a substitution account had been adopted in the past: Kenen (2010a) provides a positive view, while McCauley and Schenk (2014) provide a negative view.

The reform could also add more currencies to the SDR basket, as was already done with the renminbi in 2016, and could allow the broader use of SDRs in private transactions (as, for example, suggested by Kenen 1983; Eichengreen 2007; and Padoa-Schioppa 2011). One simple reform could be to allow deposits by financial institutions in central banks (either reserve requirements or excess reserves) to be held in SDRs. However, the system could also work if SDRs are used only as a reserve asset and a means of financing IMF lending, as long as central banks fulfill the basic commitment to convert SDRs into convertible currencies when needed, which is what makes SDRs an effective monetary instrument for transactions among central banks. Allowing the broader use of SDRs would make the reform costly for the United States and therefore is likely to elicit resistance, which could make SDRs subject to the instability that characterizes private markets. In any case, it might be necessary to embed the reforms in rules that make holding SDRs attractive for central banks (an adequate return) or other rules that guarantee an active demand for SDRs: for example, commitments to not reduce SDRs held by individual central banks below certain limits relative to the allocations they have received (obviously if they are not borrowing from the IMF).

Conclusions

The most desirable reform of the current global reserve system involves moving to a fully SDR-based IMF with a clear countercyclical focus. This would include countercyclical allocations of SDRs and countercyclical IMF financing entirely in SDRs. In the former case, it could include criteria for SDR allocations that take into account the very different demand for reserves by emerging and developing countries relative to industrial countries. The use of SDRs to finance IMF programs would help consolidate the reforms of the credit lines that were introduced during the North Atlantic financial crisis, particularly the creation of contingency credit lines and the much larger levels of financing relative to quotas. The introduction of a substitution account by which central banks could exchange SDRs for the reserves in currencies they no longer wish to hold would make SDRs a complement to the multicurrency arrangement that may be emerging; this approach could make the reforms more attractive to the United States. A combination of reforms is probably the best practical option for a stable international monetary system.

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A previous version of this paper was presented at the conference organized by the Central Bank of Austria and published in its Workshop Series No. 18. It draws in part from a World Institute for Development Economic Research (WIDER) Annual Lecture given by the author (Ocampo 2010a) and is part of a book on the international monetary system being prepared for WIDER.
1I have also referred to this problem as the “anti-Keynesian bias” of the system.
2This problem for the reserve-issuing country has been highlighted by Stiglitz (2006, Chapter 9) and can be seen as a lack of control by the reserve-issuing country over its balance of payments, as underscored by Greenwald and Stiglitz (2010).
3Following other authors, I will use this term rather than “global financial crisis.” The crisis did have global effects, but it was concentrated in the United States and western Europe.
5There are, of course, other alternatives. One would be going back to some form of gold standard or at least to a greater use of gold as a reserve asset. But this goes against long-term trends toward moving away from this “barbarous relic” (to use Keynes’s terminology), which includes the growing demonetization of gold since the 1970s. It would also go against the “embedded liberalism” of the post-WWII arrangements, as emphasized by Eichengreen (2008).
6The reform could also be implemented by creating a new institution (a Global Reserve Bank) or a network of regional arrangements. See, in this regard, UN 2009, Chapter 5. But creating new institutional frameworks would be time-consuming and may not be politically viable.
7See Solomon 1982, Chapters 48, for a history of the debates on global monetary issues that led to the creation of SDRs.
8For a survey of different estimates, see Erten and Ocampo 2014, Chapter 9.
10There is also the possibility of using the allocations to industrial countries to directly finance additional official development assistance and the provision of global public goods (Stiglitz 2006, Chapter 9). In the same line of reasoning, former IMF managing director Dominique Strauss-Kahn raised during his tenure the possibility of using them to finance programs to combat climate change. These proposals have many virtues but pose the problem that such transfers are fiscal in character and may thus require in every case approval by national parliaments.
11As already indicated, a possible interpretation is that SDRs, as currently designed, are in fact such a facility (Erten and Ocampo 2014, Chapter 9).
12Financial Times, December 11, 2007. “How to Solve the Problem of the Dollar,” http://www.iie.com/publications/opeds/oped.cfm?ResearchID=854.

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