Removing the Deflationary Bias In the International Financial Architecture

Yilmaz Akyüz

10/05/2010

Opinión

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Three reforms are proposed to remove the global financial system's deflationary bias: increased development financing, provision of international liquidity during crises, and a debt workout mechanism.

Because of the global financial crisis, a number of developing countries and emerging economies are unable to import goods and services as much as required to satisfy the basic needs of their population, reduce poverty and sustain acceptable growth because of foreign exchange shortages even though these are among multilaterally agreed development objectives, notably in the MDGs.

These include not only small economies almost entirely dependent on commodity export earnings, but also large, populous countries with some degree of progress in industrial development.

This coexistence of glut in more advanced economies and unsatisfied needs in poor countries is a reflection of the failure of the multilateral system, notably the international financial arrangements, in providing the necessary financing to the latter. Consequently, reform of these arrangements should be an important part of post-crisis global restructuring for greater stability and sustained and broad-based growth.

The coming years may see payments constraints in the developing world becoming tighter. During the pre-crisis global expansion many developing countries succeeded in raising growth while keeping their current accounts broadly in balance or running moderate deficits. This included not only several poor commodity exporters in Africa and elsewhere but also some large emerging economies such as Brazil and India.

In a few emerging economies in Central and Eastern Europe and Africa receiving massive inflows of capital, growth was associated with sharp currency appreciations and large and growing deficits which these inflows more than covered.

Global economic conditions in the coming years may not allow the repeat of this experience. Returning to pre-crisis growth rates under conditions of a slowdown in exports would require faster growth of domestic demand which would, in turn, mean larger external deficits. A tightening of global financial conditions could make financing of these deficits difficult and onerous, thereby necessitating retrenchment in domestic absorption and cuts in growth.

The areas of reform needed are well known, widely discussed after almost every major financial crisis, only to be forgotten subsequently with economic recovery.

Need for Development Finance

First, there is a need for greatly increased, stable and predictable development financing for countries lacking adequate domestic resources for an acceptable growth rate in order to make a dent in poverty and close the income gap with richer countries.

In this respect we should move away from current arrangements where provision of such financing depends on the whims of the donors who serve their own interest rather than those of the poorest countries and communities.

Since poverty reduction has been declared a global public good in several UN summits and conferences in recent years, there is a strong rationale for establishing global sources of development finance. This could be achieved through agreements on international taxes, including currency and financial transactions taxes, environmental taxes and various other taxes such as those on arms trade, to be applied by all parties to the agreement on the transactions and activities concerned and pooled in a UN development fund.

International Liquidity During Crisis

The second major area of reform concerns provision of international liquidity at times of trade and financial shocks to enable countries to pursue countercyclical macroeconomic policies so as to minimize loss of output and employment. This should address the two major shortcomings in crisis lending by the IMF.

First, the Fund has traditionally been much more willing to provide financing to keep countries current on their debt and maintain open capital accounts than to finance imports and support trade, employment and growth.

Second, crisis lending is often associated with pro-cyclical policy conditionalities which only serve to deepen the deflationary impact of shocks. The practice during the current crisis is not an exception in these respects. A new facility, Flexible Credit Line, has been established for emerging economies deemed eligible on the basis of some predetermined criteria in order to enable them to finance large and persistent capital outflows while poor countries have been kept on a short leash for trade and current account financing.

Debt Restructuring Mechanism

The final important area of reform in this respect concerns sovereign debt to official creditors, both multilateral and bilateral. Despite repeated initiatives several poor countries continue to suffer from debt overhang, struggling to service unpayable debt, thereby diverting budgetary resources and foreign exchange away from development.

The main problem here is that there are no impartial debt workout mechanisms and the assessment of debt sustainability is left to creditors, notably the IMF. Sustainability is often judged on the basis of how much debt and debt servicing a country can tolerate without paying adequate attention to its implications for development and poverty, and debt servicing is given primacy over all other economic and social objectives.

A consensus appeared to emerge among the major players in the early months of the current crisis on the need for reform of the international financial architecture in these and many other areas. A number of ad hoc initiatives have been launched and proposals put forward in various fora including the United Nations, the Group of 20 and the Bretton Woods Institutions.

So far no definitive commitment has been made nor action taken to resolve any of these issues. The past record in this respect is not very encouraging. Despite a wide agreement on systemic reform to bring more effective governance to international finance after a series of crises in emerging economies in the 1990s and proliferation of proposals for reform, the Financing for Development initiative launched at the UN Conference in Monterrey in March 2002 has yielded no significant outcome in this respect.

It is particularly up to developing countries to secure that this is not the fate of the ongoing process initiated in the UN in the June 2009 Conference on the World Financial and Economic Crisis and its Impact on Development.

- Yilmaz Akyüz is the Special Economic Adviser of the South Centre. This is part of the Centre’s Research Paper No. 26 on Global Economic Prospects, and was published in the South Bulletin Issue No. 46 dated 3 May 2010.

www.southcentre.org

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