Monitoring Policy Making at the United Nations |
| ||||||||||||
Responses to the Challenges of Globalization - Social and Economic Policy - Global Policy Forum Responses to the Challenges of Globalization:
European Commission
A Study on the International Monetary and Financial
System and on Financing for Development
February 13, 2002Brussels, 13 february 2002
SEC(2002) 185 final
Responses to the Challenges of Globalisation: A Study on the International Monetary and Financial System and on Financing for Development
WORKING DOCUMENT FROM THE COMMISSION SERVICES
TABLE OF CONTENTS
Chapter I : Globalisation : Where Do We stand? 8
A. Current Globalisation Trends 8
B. Forces Driving Globalisation 12
C. The Benefits of Globalisation 17
D. Challenges Facing the System 19
Chapter II : The International Financial System in a Globalised World 25
A. Trends and Achievements 25
B. Systemic Issues 28
B.1. International Monetary Stability 30
B.2. Abuses of the Global Financial System 32
C. Towards a More Stable and Better Functioning International Monetary and Financial System 33
C.1. Modalities of Crisis Prevention and Management 34
C.1.1. Crisis Prevention 35
C.1.2. Crisis Resolution 39
C.1.3. Excursion: Currency Transactions Taxes 42
C.2. Reducing the Abuses of the Financial System 46
C.3. Regional and Global Cooperation 49
C.4. Towards Improved Governance 53
Chapter III : Promoting and Financing Development 56
A. Assessment of Existing Instruments 57
A.1. ODA 57
A.1.1. Trends in ODA and the 0.7% Target 57
A.1.2. Improving Effectiveness and the Quality of Aid 60
A.2. Debt Reduction 65
A.2.1. Trends and Figures 65
A.2.2. Debt Reduction Mechanisms 66
A.2.3. Continued Debate 69
A.3. Integration into the Global Trade System 71
A.3.1. Trends in Trade 73
A.3.2. The Challenges of Integration 74
A.4. Attracting Foreign Direct Investment 81
A.4.1. Trends and Figures 82
A.4.2. Impact of FDI on Developing Countries 83
A.4.3. The Challenge of Attracting FDI 85
B. Alternative Financing Instruments 87
B.1. International Taxes 87
B.1.1. Taxes versus National Contributions 88
B.1.2. The framework of International Tax Proposals 89
B.1.3. Provisions and Features of the Tax Proposals 91
B.1.4. Legal Basis and Compatibility with Existing Legislation 97
B.2. Other Proposals 99
B.2.1. The De-Tax 99
B.2.2. An SDR Allocation 100
TABLE OF FIGURES
Figure 1: Trends in World Trade in Goods (volume) vs. GDP (1990 = 100) 8
Figure 2: Correlation Between Domestic Saving and Domestic Investment, and Capital Account as a % of GDP for 12 Major Countries 10
Figure 3: Composition of Private Capital Flows (1973-81, 1990-97) 11
Figure 4 : Long-term Trends in US Immigration 12
Figure 5: Relative Transportation and Communications Costs 13
Figure 6: Total Government Outlays to GDP (1913, 1960, 2000) 14
Figure 7: Life Expectancy by Country Grouping in 1997 and Increase on 1970 18
Figure 8: GDP Growth by Country Grouping (1960 2000) 19
Figure 9 : Net ODA in 2000 in % of GNI 59
Figure 10 : Developing Countries' Exports by Sector (in euro billion) 73
Figure 11 : EU Trade with Developing Countries (billion EUR) 74
Figure 12 : Tariff Escalation is Still Common 75
Figure 13: Pattern of Protection Facing LDC Exports (pre-EBA) 76
Figure 14: Distribution of World Inward FDI Stock (%) 82
LIST OF ABBREVIATIONS
ACP African, Caribbean and Pacific countries
ADB Asian Development Bank
ALA Asian and Latin American developing countries
ASEAN - Association of South-East Asian Nations
ATW Air Transport World
BAD Banque Africaine de Développement
BIS Bank for International Settlements
BITs Bilateral Investment Treaties
CAC Collective Action Clauses
CCL Contingent Credit Line
CDF Comprehensive Development Framework
CEEC Central and Eastern European Countries
CEMAC - Communauté Économique et Monétaire de l'Afrique Centrale
CIS Commonwealth of Independent States
CMEA Council for Mutual Economic Assistance
CTT Currency Transactions Tax
DAC Development Assistance Committee
DDA Doha Development Agenda
DQRS Data Quality Reference Sites
ESAF Enhanced Structural Adjustment Facility
EBA Everything but Arms (EU trade policy initiative)
EEA European Economic Area
EBRD European Bank for Reconstruction and Development
EIB European Investment Bank
ESC UN Economic Security Council
EU European Union
FATF Financial Action Task Force on Money Laundering
FDI Foreign Direct Investment
FIAS Foreign Investment Advisory Service
FSAP Financial Sector Assessment Program
FSF Financial Stability Forum
FSSA Financial System Stability Assessment
G7 Group of Seven leading industrialised nations (Canada, France, Germany, Italy, Japan, United Kingdom, United States)
G8 G7 plus Russia
G20 Group of Twenty
GATT General Agreement on Tariffs and Trade
GDDS General Data Dissemination System
GDP Gross Domestic Product
GFCF Gross Fixed Capital Formation
GNP Gross National Product
GSP Generalised System of Preferences
HIPC Heavily Indebted Poor Country
HLI Highly Leveraged Institution
IBRD International Bank for Reconstruction and Development
ICAO International Civil Aviation Organisation
ICT Information and Communication Technologies
IDA International Development Association
IDB Inter-American Development Bank
IFMS International Financial and Monetary System
ILO International Labour Organisation
IMF International Monetary Fund
IPCC Intergovernmental Panel on Climate Change
ITO International Tax Organisation
LDC Least Developed Country
LIC Low Income Countries
LOLR Lender of Last Resort
LTCM Long Term Capital Management
ODA Official Development Assistance
OECD Organisation for Economic Co-operation and Development
OTC Over-the-Counter
MAI Multilateral Agreement on Investment
MEDA Euro-Mediterranean Partnership
MFN Most Favoured Nation
MIGA Multilateral Investment Guarantee Agency
MNE Multi-National Enterprise
NAFTA - North American Free Trade Agreement
NPV Net Present Value
PIN Public Information Notice
PRGF Poverty Reduction and Growth Facility
PRSC Poverty Reduction Strategy Credit
PRSP Poverty Reduction Strategy Papers
PSI Private Sector Involvement
RTA Regional Trading Agreement
SDDS Special Data Dissemination Standards
SDR - Special Drawing Right
SPS Sanitary and Phytosanitary Measures
STABEX System to Stabilise Export Earnings
SYSMIN - System for Safeguarding and Developing Mineral Production
TBT Technical Barriers to Trade
TRTA/CB Trade Related Technical Assistance and Capacity Building
WAEMU West African Economic and Monetary Union
UN United Nations
UNCTAD United Nations Conference on Trade and Development
UNDP United Nations Development Programme
UNFCCC United Nations Framework Convention on Climate Change
US United States of America
WB World Bank
WEO World Economic Outlook
WTO World Trade Organisation
Responses to the Challenges of Globalisation A Study on the International Monetary and Financial System and on Financing for Development
Chapter I : Globalisation : Where Do We stand?
Globalisation can be characterised as a trend towards greater integration and interdependence between countries and regions of the globe. These growing linkages are often economic and political, but globalisation also has important social, environmental and cultural aspects. This introductory chapter will focus upon the economic aspects of globalisation, by looking at trends in international flows of goods and services, capital and labour (section A) and seeking to identify some of the driving forces (section B). It highlights the benefits that accrue to countries and regions that integrate successfully with the global economy (section C), but also identifies some of the limitations of current globalisation and the important public policy challenges that remain (section D).
A. Current Globalisation Trends
This section of the chapter describes trends in international flows of economic factors of production: goods and services, capital and labour.
Trade in Goods and Services
Figure 1: Trends in World Trade in Goods (volume) vs. GDP (1990 = 100)
[Graphic in PDF & Word format]
Source: Commission services based on WTO (2001)
When examining the economic interdependence of the globe, one obvious approach is to look at trade flows. Figure 1 compares the post-war evolution of world trade volumes in goods compared to world real GDP. A six-fold increase in global output has been accompanied by a 20-fold expansion of global merchandise trade flows(1). Merchandise trade growth was particularly strong during the 1990s. World trade in services also grew at a fast rate through the 1990s: more than doubling from 530bn ECU/ euro to 1194bn euro(2) between 1992 and 2000. Whilst some services are inherently difficult to trade (the classic example being a haircut), more and more services are becoming tradable(3).
The composition of trade in goods and services has also evolved over time. Rich countries increasingly trade similar, but differentiated, goods and services between themselves (intra-industry trade). Multinational firms now play an important role in the global economy and are frequently able to slice their production chain internationally, thus contributing to the estimate that roughly 30 per cent of world trade in manufactures is in intermediate rather than final goods (Yeats, 1998). Developing countries are playing an increasingly significant role in manufactures trade. The World Bank (2002) reports that the share of manufactures in developing country exports rose from 25% in 1980 to 80% in 1998. Increasing amounts of trade now flow between developing countries(4), but the poorest countries continue to play only a marginal role in international trade(5). Some countries, in particular those of Sub-Saharan Africa, have seen their share in world trade drop during the last two decades and have experienced a deterioration of their terms of trade.
International Flows of Capital
The extent of international flows of capital and of the information needed to make investment decisions can provide further evidence of international economic interdependence. Today, gross flows of short-term capital in particular are huge by long-term historical standards. The latest Bank of International Settlements data report average daily foreign exchange market turnover at US$ 1210bn in April 2001. This is roughly double the figure for 1989, but a decline of 19% on 1998(6). Daily turnover in over-the-counter derivatives, such as swaps and options, reached US$ 575bn in April 2001, compared to US$ 151bn in 1995 and US$ 265bn in 1998. A report by the Ministry of Finance, Finland (2001) notes(7) that gross direct investments by industrial countries rose steadily between 1993 and 1998, from US$ 212bn to US$ 585bn per year. The financial information that underpins investment decisions flows around the globe to investors who possess the appropriate technology almost instantaneously and in huge volumes nowadays. International capital now also flows into a wider range of economic activities than previously (CEPR, 2001). Late 19th century international capital flows, for example, were heavily focused upon infrastructure construction projects, such as railways.
There remains, however, a debate about the true extent of current global capital market integration relative to previous historical periods. Bordo et al (1999) argue that a combination of slower technology for transferring funds, information asymmetries, legal uncertainties, and the absence of adequate accounting standards limited the true extent of financial market integration in the late 19th century. In general, these imperfections are less significant today, but persist to some degree.
One way of assessing the degree of international capital market integration is to look at the absolute size of the current account relative to GDP. This is equivalent to the net capital in- or outflow, and thus provides a simple, if somewhat crude, indication of capital market integration(8). Another indicator of international capital mobility is the correlation between domestic saving and domestic investment. In a world of perfect capital mobility, there should exist no systematic relationship between domestic saving and domestic investment(9), since the savings of residents in any given country should be allocated to the investment project yielding the highest return, wherever it is geographically located.
Figure 2: Correlation Between Domestic Saving and Domestic Investment, and Capital Account as a % of GDP for 12 Major Countries
[Graphic in PDF & Word format]
Source: Commission services based on Baldwin and Martin (1999)
Figure 2 presents these two indicators averaged across 12 major countries(10) for the period 1870 to 1989. The current account data (the unweighted mean absolute average relative to GDP) show that larger proportional net flows of capital were occurring at the beginning of the 20th century than during the 1980s. According to the data on domestic savings/domestic investment correlation, international capital market integration was only beginning in the 1980s to get back to the level of the late nineteenth century. However, the data-set contains only a limited group of countries and there remains much debate about the appropriate methodology for assessing and comparing international capital mobility(11).
The structure of the capital flows described above has been evolving over time. In the Gold Standard era up until World War I, bonds were the dominant means of raising long-term capital. After the collapse of the Bretton Woods system in the early 1970s, syndicated bank lending became the dominant instrument. The position changed again in the 1990s as foreign-direct investment (FDI) grew markedly in importance, with equity finance, bonds and bank lending also playing a role. Financial crises featured in all of these periods(12).
Figure 3: Composition of Private Capital Flows (1973-81, 1990-97)
[Graphic in PDF & Word format]
Source: World Bank, Global Development Finance 2000
Crafts (2000) highlights the growing importance of FDI and points out that multinational enterprises nowadays play an increasingly important role in the global economy. UNCTAD numbers multinationals in the tens of thousands today, compared to only a few hundred at the end of the 19th century. Craft notes that the value of the US FDI stock in 1996 stood at around 20% of GNP; compared to roughly 7% in 1914. More generally, it is estimated that production by overseas facilities of multinationals represents a sixth of global industrial production.
A recent study by Venables et al (2001) for the European Commission also emphasises that FDI flows may link economies more strongly than trade flows alone suggest. For instance, it is reported that EU companies' subsidiaries in the US have sales in the US that are 3.6 times greater than the EU's exports to the US. This increased FDI is not evenly distributed globally, however. The UNCTAD World Investment Report 2001 points out that for 1998 to 2000, the EU, Japan and US accounted for 75% of inflows and 85% of outflows of FDI. The same regions combined account for roughly three-fifths of world-wide inward FDI stocks and four-fifths of outward stocks.
International Flows of Labour
As a result of much lower transport costs, people travel around the globe far more than they used to. As a basic indication, the ATW World Airline Report (2000) states that in 2000, total world traffic reached 1.82 billion passengers. A significant proportion of these journeys will not have been made for work purposes, but international business trips and short-term stays in foreign countries are facets of current globalisation.
However, long-term, international economic migration is not occurring on a huge scale by historical standards, in spite of the significant migration pressures that exist currently in a global economy in which wages for workers with similar skills vary hugely between countries at different stages of development(13). The data in figure 4 clearly show that immigration into the US was much higher at the beginning of the 20th century than more recently(14).
Figure 4 : Long-term Trends in US Immigration
[Graphic in PDF & Word format]
Source: Crafts (2000) based on US Bureau of the Census data
Large-scale legal immigration into Western Europe was at its height in the high-growth decades that followed the Second World War, as countries such as France and the UK accepted many immigrants from their former colonies. Germany also accepted large numbers of guest workers during this period. From 1960 to 1973, the proportion of foreign workers rose from 3% to 6% of the workforce (Hall, 2000). This so-called "primary" immigration reduced very considerably after 1973.
B. Forces Driving Globalisation
Globalisation is a process that has been ongoing, albeit not in a linear fashion, over a long period(15). The process is facilitated and driven by inter-related changes in technology, especially in communications and transportation, public policy both domestically and at international level - and the preferences of individual citizens regarding what and where they wish to consume, save and work(16).
Technological Progress
Figure 5: Relative Transportation and Communications Costs
[Graphic in PDF & Word format]
Source: World Bank (1995)
Technological progress has boosted the efficiency with which goods, services, capital, ideas and people move around the globe and has been a major driving force behind many of the phenomena described in the previous section. Figure 5 shows some of the technologies that have spurred this globalisation and demonstrates the steep price falls that occurred through the 20th century.More recent advances in information technology are discussed in detail in IMF WEO (Autumn 2001). An example of the precipitous price falls that have occurred for this technology is provided in Masson (2001): between 1960 and 2000, the price of "computers and peripheral equipment" relative to the GDP deflator fell by a factor of over 1800. Relative cost reductions on this scale make the technology widely available and have been instrumental in hugely increasing global information flows, for instance via the World Wide Web, which allow knowledge and new ideas to be disseminated around the globe more rapidly and in greater volume.
Public Policy
In addition to technological progress, public policy continues to play a crucial role in determining the extent to which countries participate in globalisation. As the inter-war period demonstrates, policy measures have at least the potential to reduce greatly the extent to which nations interact with one another, and so, at least temporarily, to reverse the course of globalisation. Since the Second World War, policies in many countries, albeit with exceptions, have generally been supportive of international economic integration. Over this period, industrialised countries progressively opened their economies and a number of developing economies also began a process of external liberalisation, particularly after 1980(17). In addition, the historic policy changes that signalled the end of the cold war in the late 1980s and early 1990s meant that a substantial number of countries became, to a far greater extent than had previously been the case, open to international flows of goods, services, people and ideas.
There remains, nevertheless, a significant group of countries that, partly due to policy choices, are not participating in the process of globalisation. However, dramatically improved communications technology means that citizens, even in very poor countries, are much better informed about political conditions and standards of living elsewhere. Technological progress itself may thus contribute to pressures for policy changes.
More generally, some authors have made a link between increased globalisation and the growth of the role of states in economic activity over the course of the last century (figure 6).
Figure 6: Total Government Outlays relative to GDP (1913, 1960, 2000)
[Graphic in PDF & Word format]
Source: Commission services based on IMF and OECD data
Rodrik (1996) provides a theoretical justification for this by claiming that higher government consumption and intra-societal transfers play a risk-reducing role in societies exposed to greater external competition and thus uncertainty.
In addition, the 20th century, and in particular the period immediately after the second world war, witnessed the creation of several international institutions and fora that provide governance at a level beyond national borders. These include the Bretton Woods institutions, the GATT/WTO and the wider United Nations system, which provides governance mechanisms in many fields through its programmes, funds and specialised agencies. Regional governance initiatives have also flourished in the 20th century, with the EU by far the most advanced regional example of supra-national governance.
Part of the growth in the number of international organisations and agreements in many policy areas is due to attempts to deliver coherent international rules. Another major driver for the increasing economic role of governments and the creation of international bodies has been the ex post recognition of the limitations and failures of the previously existing institutional arrangements. This is particularly true of the period immediately after the Second World War. If the process of globalisation continues in future as it has during the past 50 years, it would seem likely that yet more traditionally domestic issues will become "international", implying that the trend towards the need for increased supra-national decision-making has yet to run its course.
The remainder of this section looks at some specific technological and public policy factors that have influenced the developments in international trade, capital and labour integration described above.
Trade Flows
The rapid growth in post-war international trade has partly been due to reductions in transport costs, such as those described in figure 5, but has also been the result of lower tariffs and trade barriers. Table 1 shows the evolution in the tariffs of selected major industrialised countries over the past 125 years. The positive post-war developments shown are not without their limitations, however. Protection remains high in agricultural and textiles sectors in most countries, and industrialised countries continue to apply relatively high tariffs on a small number of manufacturing sectors. Most developing countries continue to apply comparatively high tariffs across the board(18) even in manufactures. The poorest countries generally trade very little. With the reduction in tariff levels, non-tariff barriers to trade, such as product standards and anti-dumping regulations, have also become more important in recent years.
Table 1: Selected Tariff Levels Over the Past 125 Years
[Graphic in PDF & Word format]
Source: Crafts (2000)
Nevertheless, the GATT/ WTO, set up shortly after World War II , has been a major innovation to the global trading system compared to the pre-war situation. Table 1 shows the rise in protectionism that occurred during the 1930s. No similar rise has occurred to date under GATT/ WTO, which has delivered consecutive reductions in the applied tariffs of its members and contributed to the elimination of quantitative restrictions, in parallel to creating a rules framework that provides greater predictability and transparency in international trade relations. Although heavily criticised from certain quarters in recent years, the GATT/ WTO, via the fundamental principles of MFN (Most Favoured Nation) treatment, non-discrimination and transparency and the binding of tariff obligations, has delivered a significantly more robust trading architecture than had existed previously.
Regional trading agreements (RTAs) have grown in number since WW II, particularly during the 1970s and 1990s. The EU, for example, has succeeded in completely removing tariff and quota restrictions on trade between members and has removed many non-tariff barriers to internal trade. Although a second best compared to multilateral liberalisation (bilateral agreements mean that non-members are discriminated against) the regional integration path can be used as a stepping stone towards developing countries' full integration in the international trade system. In particular, such arrangements can be an effective means of supporting the improvement of their domestic policy environment and their ability to create a climate conducive to economic growth and social development. In this context, there are strong arguments that "deep" RTAs that involve services and regulatory liberalisation should be based upon agreed multilateral norms.
Regional integration may also allow for efficiency gains in the regional market, which can pave the way for enhanced competitiveness in the world market and higher levels of investment and growth. In addition, RTAs offer useful fora for smaller countries to make their views heard internationally. However, unchecked regionalism has at least the potential to divert more trade than it creates and to undermine the primacy of the WTO as the multilateral rule-making body for international trade.
Capital Flows
The extent of international capital market integration depends heavily upon which policy instrument of international macroeconomics' "impossible trinity" of monetary policy, exchange rate policy and capital account convertibility countries choose to relinquish. At the end of the nineteenth century and up to 1914, the single global currency of the Gold Standard meant no domestic monetary policies, but encouraged international capital flows. The post-war Bretton Woods system on the other hand, allowed domestic monetary flexibility and fixed exchange rates given capital controls. Since the break-up of the Bretton Woods system, flexible exchange rate systems have made a comeback(19) and so have international capital flows, as countries have been able to liberalise their capital account. These policy choices partly explain the trends in figure 2.
Technological progress has played a key role in fostering faster and more efficient trading of traditional financial instruments and in the development of more complex financial products. Information technology has also enabled huge quantities of data to be sent around the world instantaneously and at minimal per unit cost. The gross daily trading volumes reported above are largely facilitated by information technology. Better information flows also facilitate the geographical and sectoral broadening of capital flows as lenders are better able to monitor borrowers.
Technological advances and innovations in methods of doing financial business provide part of the explanation for the changing composition of private capital flows. The 1990s surge in FDI is partly due to the growth of multinational enterprises and to many countries adopting favourable policies towards FDI. The trend was further supported by new FDI opportunities as a result of the "opening up" of numerous former Soviet Bloc countries, and the continued opening of countries such as China.
As in the trade sphere, the aftermath of WW II saw the creation of institutions (the IMF, in particular) to promote more stable international financial interaction. Further bodies were added to the governance structure of international finance as the century progressed. Although these institutions and bodies must adapt and develop to external developments, as in the trade sphere, global financial policymakers have a more mature set of financial bodies and institutions at their disposal now than at the beginning of the 20th century.
Labour Flows
Before the First World War individuals faced few policy restrictions upon where they chose to travel and work and levels of international migration were relatively high. However, in addition to linguistic and cultural difficulties, which continue to persist today for many migrants, the major barrier to international migration was that international travel was extremely expensive relative to ordinary incomes.
The situation at the beginning of the 21st century is quite different. Technological advances have dramatically reduced the costs of international travel. Short-term business (and holiday) travellers in general face relatively light restrictions in many countries. However, public policy in many countries restricts the rights that individuals have to settle and work in a foreign country(20). Many EU countries welcomed economic immigrants in the high-growth period that followed World War II, but these policies were generally curtailed after the first oil price shock of 1973. The US continues to adopt a more liberal approach to economic immigration than the EU, and is estimated to admit about 1m million immigrants per year. Some EU countries have recently taken limited measures to encourage inward migration of skilled workers.
C. The Benefits of Globalisation
How has globalisation affected human welfare? The second half of the 20th century, a period of increasing global economic integration, saw a six-fold increase in world GDP (figure 1) while the global population increased about two and a half times over the same period(21). These numbers translate into major improvements in the welfare and quality of life of many of the world's citizens, and not just in the richest countries. The past fifty years have seen major improvements in human life expectancies, basic hygiene, vaccinations against many communicable diseases, and lower rates of infant mortality. The period also witnessed improvements in domestic governance in many countries and a more robust set of international institutions and fora to deal with global policy challenges than existed during previous waves of globalisation.
Figure 7 shows the improvements that have been achieved in life expectancies between 1970 and 1997. The bars, relating to the left-hand axis, depict life expectancy at birth in industrial, middle-, and low-income countries(22) in 1997. Although low and middle income countries continue to lag the industrial countries, the catch-up indicated by the percentage increase in life expectancies since 1970, shown by the line relating to the right-hand axis, is striking. In terms of numbers of years, low and middle income country citizens born in 1997 could expect, on average, to live 10 years longer than had they been born in 1970, whereas those born in industrial countries in 1997 could expect to live 5 years longer on average. These are major improvements, largely due to better hygiene and health standards, that globalisation has helped to spread(23).
Figure 7: Life Expectancy by Country Grouping in 1997 and Increase on 1970
[Graphic in PDF & Word format]
Source: Commission services, based on World Development Indicators and IMF (2000a)
Correlation is, of course, much easier to observe than causation is to demonstrate and it is not simple to prove that the many benefits outlined above are also due to globalisation. Nevertheless, research indicates that countries that are able to pursue policies of external openness to foreign trade and capital, thus permitting the adoption of new technology and know-how, combined with respect for property rights and the rule of law domestically, have the best chance of rapid economic development. It is unlikely that any of these conditions is individually sufficient to deliver economic development, yet one of the most powerful observations in this debate is that there is not one example of a country that has achieved sustained economic growth by pursuing import-substitution policies of high trade protection (e.g. Masson, 2001). A reasonable degree of external openness would seem to be a necessary condition for sustained economic growth and continued poverty reduction.
Recent analysis from the World Bank identifies a group of developing countries - including China, India, Bangladesh, Vietnam and Uganda - which have opened up their economies to trade and investment in the last twenty years. Figure 8 compares the growth performance of these "post-1980 globalisers" with that of the rich countries and those developing countries that have not pursued international economic integration, the "non-globalisers". The figure clearly shows the superior growth performance of the "post-1980 globalisers" since they changed their policies. Of course, not all of the newly globalising countries have changed all of their international economic policies in favour of greater liberalisation. However, the research provides strong evidence of the beneficial effects upon developing countries' growth prospects of policies of international economic integration.
Figure 8: GDP Growth by Country Grouping (1960 2000)
[Graphic in PDF & Word format]
Source: Commission services based on Dollar (2001)
D. Challenges Facing the System
The major benefits that globalisation has brought to many have not come without costs. Major policy challenges remain to be tackled. These challenges include the leverage that national governments have in a world where competition may lead to a race to the bottom on social, environmental and other policies. A related issue is the provision of global public goods, which is seen as requiring close cooperation among governments and substantial amounts of financing. In this study, the focus is limited to those challenges that are related to the international financial and monetary system and to the issue of financing for development. In this context, three major concerns are related to trends in global income distribution, the increased volatility that may be associated with increased exposure to international trade and capital flows, and abuses of an essentially open international system.
National Governments in a Globalised World
Concerns have been expressed that the nature of today's liberal international financial system and the enhanced international competition implied by global market integration would increasingly curb the power of national governments to set rules and standards according to domestic public preferences and needs. While internationally mobile capital and regulatory competition between countries can help to discipline governments and enhance the efficiency of public institutions, it is argued that the political pressures created by the process of globalisation could place national governments in a regulatory race to the bottom that reaches well beyond the sphere of financial markets. Although economists(24) neither find significant evidence for governments losing power nor of a race to the bottom in environmental policies, labour market regulation or tax competition, the quality of labour and social standards, consumer and environmental protection are seen at risk(25). This concern raises a host of questions, including the optimum level of decision-taking, i.e. national versus supra-national. Summers (1999) argues that a country that pursues greater international integration and ensures appropriate domestic policies can no longer pursue many national policy goals independently.
Global Public Goods
Some aspects of this perceived need for international multilateral collaboration in a globalising economy are highlighted in the concept of global public goods. Stability of the international financial and monetary system, an open trading system or the protection of global environmental commons (e.g. climate, bio-diversity) are seen as goods that can only be provided and maintained on the basis of international co-operative behaviour and support. These goods as well as other goals, such as communicable diseases control, knowledge, peace and security, can be interpreted as international or global public goods (Box 1). Their provision generates important externalities to the benefit of, in principle, all people around the world regardless of their individual contribution to the production of these goods. In the absence of a supranational enforcement power, this creates an incentive for the individual, or the individual state, to free-ride. As a result, investment in the provision of global public goods tends to be sub-optimal if the allocation decision is left to markets alone. An efficient supply of these goods would thus require the development and implementation of internationally accepted rules and standards as well as adequate financing.(26)
Box 1: Global Public Goods
Public goods can be classified according to their spatial dimension in local (e.g. streetlights), national (e.g. national defence), regional (e.g. environmental protection of in the Baltic Sea) and global public goods (e.g. the ozone layer). A global public good is defined as a public good, the benefits of which accrue to essentially all geographical regions. Depending on the type of public good, its benefits can accrue to present as well as to future generations. Examples of widely accepted global public goods include the protection of the global environment, communicable disease control, the fight against internationally organised crime and terrorism, international trade, international financial and monetary stability and international security. Others advocate adding elements that are considered key for the development process of low-income countries such as basic education, knowledge diffusion and public research.
In contrast to private goods, a public good is characterised by two typical properties: (1) non-rivalry or non-congestion and (2) non-excludability in consumption. Non-rivalry or non-congestion implies that a public good can be consumed (used or enjoyed) by any individual without (significantly) diminishing the possibility of consumption for others. Non-excludability means that it is either very costly or technically impossible to exclude non-payers from consuming the public good. In other words, the provision of public goods generates positive externalities for non-payers. Goods that feature both attributes are referred to as pure public goods. Most public goods are impure and permit either some degree of selective exclusion of non-payers or incur some rivalry in consumption. National defence is regarded as a typical (national) public good as no resident can be excluded from nor do residents compete for its benefits. The opposite from a public good is a public bad, which is equally defined by non-rivalry and non-excludability. Examples of a public bad are communicable diseases, organised crime and pollution. The provision of a public good can often be considered in terms of reducing or removing a public bad.
The provision of public goods constitutes a formidable policy challenge. As the allocation mechanism of the market is failing, the optimum supply level of public goods is essentially determined by public choice. For pure public goods the lack of rivalry makes it unlikely for market clearing prices to emerge, and the problems of excluding non-payers from consumption make it difficult to establish property rights. These properties provide also a systematic incentive for consumers to understate the true value of their marginal benefit of consuming the public good and encourage free riding. As a consequence, the provision of pure public goods on the basis of (voluntary) individual contribution through private agents alone tends to be sub-optimal.
In order to achieve socially desired levels, the public sector needs to support private contributions and/or provide adequate incentives to enhance voluntary private sector contributions. At the local and national level, governments support the provision of public goods through taxes levied on its citizens. At the global level, this collective action problem is compounded by several factors. Due to the lack of a supranational government, the provision of global public goods is the result of international decision making among sovereign states or entities and hence based on voluntary contributions from those states. Given the diversity of actors and depending on the nature of the global public good, the benefits and costs related to the provision of global public goods as well as the ability to contribute to their provision are distributed asymmetrically across countries and across generations. Although the benefits of global public goods essentially spread globally, there can be significant differences in their visibility across countries, regions and over time. In some cases such as curbing global warming, the bulk of the benefits will accrue to future generations, while the present generation bears the costs related to the provision of the global public good today.
The type and magnitude of resources required to support the provision of global public goods depends essentially on the nature of the public good and the way it is produced. The World Banka estimates that annually some $ 16 billion go to finance international public goods in developing countries around the world and complementary domestic infrastructure that allows the absorption of these goods. These resources mainly support activities in health, environmental protection, knowledge creation and diffusion, and international peacekeeping. Instead of large-scale financing, the provision of public goods established on the basis of internationally agreed rules and regulations require the implementation of incentives for international co-operation and compliance. In some areas, such as international trade and the international financial and monetary system, multilateral institutions are in place to provide for the global public good and to discourage non-co-operative behaviour.
a) The World Bank, Global Development Finance 2001.
Trends in Global Income Distribution
There has been a great deal of recent academic work looking at the distribution and evolution of incomes across the globe and at the impact that globalisation, and in particular more liberal trade, has had upon income distribution. The literature stresses several important distinctions. Global income inequality can occur due to a mixture of income inequality between countries and within countries. It can occur because all are growing, but the rich are growing faster (absolute improvement, but relative worsening) or because the poor are getting poorer in absolute terms. In assessing whether or not globalisation has caused more or less income inequality, a distinction needs to be drawn between those countries that have pursued policies of increasing international integration and those that have not. Further, it is important to try to distinguish the effects of "globalisation policies" of increased openness that countries may or may not have pursued from other simultaneous (domestic) policy changes that may also have affected income distribution.
Given differences in measurement methods and data problems, different authors emphasise different aspects of trends in income inequality. Between 1900 and 2000 the world Gini coefficient rose from 0.40 to 0.48, implying an increase in global income inequality over the period, (IMF, 2000). Lindert and Williamson (2001), using data from Bourguignon and Morrisson (1999), report that between 1820 and 1992, global income inequality rose and was almost entirely due to increased inequality between countries, since within-country inequality has shown no marked trend. However, the picture may have begun to change in recent years. World Bank (2002) emphasises the post-war convergence in real incomes among developed countries and notes that the "post-1980 globalisers" have also begun to catch up with the rich countries (Figure 8), although there has been a simultaneous increase in within-country inequality in a number of countries. CEPR (2001) takes the view that global income inequality increased greatly during the 19th century, as some countries industrialised and others did not, continued to rise in the first half of the 20th century, but has changed little during the past fifty years. In terms of broader measures of welfare, life expectancies have increased significantly over the past fifty years in many developing countries, such that life expectancy convergence with the developed world has been much greater than income divergence.
However, extreme poverty continues to exist. The World Bank estimates that the number of people living on less than 1 dollar per day was roughly constant through the 1990s at 1.2 billion. At the regional level, East Asia and the Pacific have made sustained progress in most areas, while South Asia and Sub-Saharan Africa lag far behind. The impressive growth of East Asia and the Pacific is reflected in the improvements in the ratio of its income to that of high-income OECD countries, from around 1/10 to nearly 1/5 over 1960-98. In Sub-Saharan Africa the situation has worsened dramatically: per capita income, around of 1/9 of that in high-income OECD countries in 1960, deteriorated to around 1/18 by 1998. The share of people living on less than $1 a day is as high as 46% in Sub-Saharan Africa and 40% in South Asia, compared with 15% in East Asia and the Pacific and Latin America. In terms of growth, the performance of Sub-Saharan Africa has been disastrous: between 1975 and 1999 GDP per capita growth averaged 1%.
Economic theory suggests that liberalising trade should equalise factor incomes between countries, yet it is not clear that this is occurring(27). The recent work of the World Bank (2002) and Dollar and Kray (2001) argues that one must look at whether countries have embraced market opening "globalisation policies". As noted above, "post-1980 globalisers" have achieved superior growth performance compared to both rich countries and "non-globalising" developing countries. In addition, the "globalisers" did not, on average, experience higher income inequality. As a result, the poor shared in the benefits of higher per-capita GDP growth. However, some economists have criticised the methodologies used in cross-country work of this nature(28), and others have noted the lack of good case studies in this area(29).
The Dollar and Kray work focuses on the globalisation policies of developing countries. However, this chapter has noted that technological progress is a major driving force of globalisation. This process may well be increasing the premium available to skilled workers in all countries. This may tend to increase inequality between the skilled and the unskilled within countries, including in rich countries. Globalisation may thus increase the need for appropriate domestic policies to deal with the problems faced by low-skilled workers.
Whilst the evidence on recent trends in income inequality is not clear-cut, modern media technology means that all are aware of the differences in standards of living between rich and poor countries and regions. As such, it is a pressing policy issue. The effects of "globalisation policies" are probably too subtle to be categorised as simply good or bad for income inequality. Globalisation is likely to benefit substantially in aggregate those countries that are able to participate in it, but it does create adjustment costs which may be concentrated on some segments of the population, such as low-skilled workers in rich countries. The policy challenge is therefore to think through these complex interactions of policy and technological change and to conceive of mechanisms that can help those that may lose from globalisation, whilst allowing countries to reap the aggregate benefits.
Increased Exposure to Volatility
Increased external economic integration as a result of globalisation brings with it increased exposure to international economic events and thus economic shocks. Perhaps the most obvious manifestation of these shocks comes in the form of financial crises that have affected both rich and developing countries. In times of crisis there is a tendency in financial markets for a "flight to quality" of international capital, such as to the sovereign debt of rich, stable economies. This can leave emerging and developing country economies without access to new short-term international capital or at prohibitive rates. More generally, internationally traded commodities and exchange rates may diverge sharply from "fundamentals" due to swings in market sentiment. These swings may be particularly difficult for countries without diversified production structures to accommodate.
Price volatility is, of course, not only an international phenomenon. A diversified set of international buyers for the output of an open economy may serve to limit price fluctuations faced by domestic producers relative to those that would prevail in a closed economy. International economic integration may also bring access to international markets in insurance (e.g. futures markets) that smaller, closed domestic markets would not be able to support.
In spite of this, recent financial shocks in developing and emerging markets have had significant negative economic consequences (Masson, 2001). In particular, actual or potential macroeconomic instability may severely limit the extent to which private individuals are willing to engage in long-term investment in an economy. The next chapter will discuss in detail possible reforms to macroeconomic and financial frameworks that could improve upon the current situation.
Abuses of the International Financial System
There is increasing concern about the international financial system's vulnerability to abuses(30). Characterised by a high degree of openness and by the rapid development of new financing and payment tools, it has become more difficult to control the international financial system against abuses such as money laundering, the financing of criminal and terrorist activities, tax evasion and the circumvention of rules and standards. In some cases, corporate entities are deliberately established for such purposes.
Financial abuses can threaten the credibility and undermine the integrity of the international financial system. Their consequences affect countries at every stage of development and involve both onshore and offshore financial centres. The existence of abuses encourages illegal and criminal behaviour, including bribery and corruption. Moreover, there is concern that harmful tax practices could trigger reductions in tax revenues and limit the ability of governments to provide for public goods at the socially desired levels.
Chapter II: The International Financial System in a Globalised World
The occurrence of financial crises in various parts of the world in the last decade, and their impact on the economies of the affected countries and their population's living standards, has led to an intense debate about the causes of this new wave of financial instability. Much of the focus of policy makers has been on the soundness of the local financial sector, the consistencies in macroeconomic and structural reforms policies of the countries concerned and the appropriateness of their exchange rate regime. In addition, however, the question has arisen whether the international financial and monetary system more generally is still adequate to face the challenges of our time, in particular the globalisation of business and finance.
At the very general level, the international financial system consists of a set of principles, rules, decision-making procedures and institutions structuring the relations between states and private entities in the financial area. It provides the structure in which economic and financial activity takes place. While sound policies at the country level are clearly central pre-requisites, the main focus of this chapter will be on the role of an efficient international financial system for ensuring global financial stability. The chapter will first briefly characterise the evolution of the international financial environment (section A). Following a typology of the functions one could expect from a 'first-best' international financial system, adapted to the existing conditions of a globalised world economy, it will then present an analysis of some of the challenges that the current system poses to policy makers (section B). Section C will review proposals for dealing with these problems and for improving the overall architecture of the system.
A. Trends and Achievements
Globalisation has changed many aspects of how people, organisations and businesses operate. It affects societies and countries all over the planet in ways that are often difficult to predict. Perhaps more than in any other domain of economic activity, globalisation has had profound repercussions on the financial sector and on international financial and monetary relations. As a result, the rules, principles, and decision-making procedures that govern the system differ today quite substantially from those prevailing at the time of the Bretton Woods agreements in 1944.
Trends that characterise the evolution of the international financial system include:
Deeper integration of international financial markets, where major assets are traded almost continuously by a wide number of operators. In addition to the large financial enterprises that are connected to essentially all major financial centres, a growing number of increasingly diverse operators participate in international financial markets, including individual investors, pension and mutual funds, industrial enterprises and hedge funds. The emergence of this global financial market place owes much to the accelerating pace of technological progress in the field of Information and Communication Technologies (ICT), which has resulted in the availability of vast amounts of information(31), and in increasingly cheaper technical means to process it. This integration process is, however, far from being completed. Cross-border transactions remain generally more costly than domestic ones; regulations continue to differ across countries and market participants do not share similar access to information and/or processing capabilities.
Evolution of the role and function of exchange rate regimes. The Bretton Woods system was based on fixed but adjustable exchange rates to avoid excessive volatility and to prevent competitive devaluations while allowing for adjustment within an international framework. Today, exchange rates between the three major currencies fluctuate freely. Many industrial countries and emerging market countries have opted either for hard pegs (such as currency board arrangements, dollarisation or a single currency) or for floating rates resulting in a "hollowing out of the centre of fixed but adjustable rates".(32)
Fuller liberalisation of capital markets. This again contrasts with the features of the Bretton Woods system, where capital movements were heavily restricted (and continued to be even in some industrialised countries until the eighties). Capital controls have been dismantled in many countries because they were viewed as significant barriers to further economic development. In addition, they were increasingly perceived as ineffective instruments for maintaining exchange rate stability and an independent monetary policy. The pace of the drive towards capital liberalisation has, however, slowed down substantially following the emergence of financial crises in the middle of the nineties. It is now widely recognised that a strong domestic financial sector is a prerequisite for successful capital account liberalisation, which itself should be properly sequenced. The debate on capital flow liberalisation is now, inter alia, focusing on the possibility of introducing temporary capital controls in crisis situation and on the use of capital controls on inflows (such as in Chile) as part of a banking and financial system strengthening effort.(33)
The development of a large pool of savings in the developed world in search of returns and risk diversification. Income growth, the ageing of populations, the development of pension and mutual funds and the liberalisation of capital movements in many parts of the world have been among the factors enticing cross-border investment. The availability of these large pools of savings in search of returns and diversification is often regarded as a two-edged sword(34). On the one hand, when global markets correctly price the risks and returns associated with different investment opportunities, cross-border capital flows promote an efficient allocation of global savings to its most productive uses. It also allows developing countries, which may have low levels of saving, access to a larger pool of international capital. In particular, it allows developing countries to complement their domestic savings, thereby enhancing their growth potential. On the other hand, cross-border capital flows are also highly sensitive to relative yields and risk developments and are thus prone to substantial swings. In addition, these funds can exceed the "absorptive" capacity of developing countries and their financial system.
A change in the level and composition of capital flows to developing and emerging market countries. Gross capital flows to these countries have risen considerably as a share of GDP since the early 1980s. At the same time, net private flows to these countries that hovered around 0.5 % of GDP during the 1970s and the beginning of the 1980s rose sharply to reach 3% of GDP in the mid 1990s but fell back to 1.5% at the end of the decade.(35) Foreign Direct Investment (FDI) and equity flows have been playing an increasingly important role while syndicated bank lending and official assistance are declining. This phenomenon has been particularly visible during the last decade. FDI flows have become the most important and stable source of financing for these countries. This might be attributable, on the supply side, to the reduction of restrictions on cross-border equity investment and improvement in communications that have reduced the costs of acquiring information on assets abroad. On the demand side, explanatory factors are the broad improvements in the overall macro-economic fundamentals of developing countries, their opening to international capital flows and the wave of privatisations(36). However, these increased FDI and equity flows are heavily concentrated on a limited number of countries. The structure of external debt flows has also changed substantially with bonds substituting for a decline in bank lending.
The development of a wider array of increasingly complex financial instruments. The rapid growth and development of new and more complex financial instruments, such as over-the-counter (OTC) derivatives, has run in parallel with the emergence and development of internationally active financial institutions. These changes were made possible by spectacular advances in ICT. These new instruments, by allowing financial risks to be better tailored to yield expectations and risk preferences, have contributed to a more comprehensive set of market instruments and have improved market liquidity and depth. However, they require increasingly sophisticated management tools of financial risk assessment which often use the same mathematical models and techniques. Also, "OTC derivatives activities can contribute to the build up of vulnerabilities and to adverse market dynamics in some circumstances"(37), as demonstrated by the 1998 Long Term Capital management (LTCM) incident.
The emergence of new international fora and the development of sets of multilateral and national rules, codes and standards. Besides the evolution of the existing institutions, the last decade has seen the creation of a number of international fora and bodies and the establishment of new sets of standards, rules and codes including data dissemination, fiscal, monetary and financial policy transparency, banking regulation and supervision, foreign exchange management, securities and insurance regulation, accounting, auditing, bankruptcy and corporate governance. This creation of new fora and the establishment of new rules runs in parallel with a deregulation process of the economy characterised by a drive towards more flexibility (in labour, product and services markets) and the liberalisation of trade and financial flows. It might also be the result of the inadequacy of older rules to the working of the present system and the need for new ones. Associated with this trend is a debate about the legitimacy and efficiency of both existing bodies and newly created fora.
B. Systemic Issues
The characteristics of the current international financial market place make it different and to a large extent more challenging than the one prevailing up to the 1980s. As a result, the ability of the international economic and financial system (that was built in the aftermath of World War II and that was partly modified in the early seventies) to deal with current challenges has become the object of close scrutiny.
Any assessment of the performance of the present system is, explicitly or implicitly, based on views on the main functions that the international financial system should perform. These views are, by definition, normative. For the purpose of this report, the following assumptions have been made about the functions, objectives and requirements that a first-best international system should fulfil:
It should promote the international distribution of savings. It is in the interest of all countries that the large pool of worldwide savings, mostly originating from developed countries, can be invested in those countries with more profitable investment opportunities. This includes developing countries, which are often short of domestic capital, and offer high returns on investment. A smooth flow of savings would require an efficient payment, clearing and settlement system; solid financial institutions and markets that are able to intermediate international savings flows efficiently; recognised legal standards and norms for international contracts; and well-developed information and communication infrastructures.
It should support the adjustment of payments disequilibria. For a multitude of reasons, countries do sometimes face unsustainable debt levels and/or large payments imbalances that can lead to liquidity or solvency crises. In these circumstances, while the burden of adjustment must fall mostly on the country itself, other countries have an interest in ensuring that the international spill-over effects of domestic adjustment are contained. Examples of this common interest include large depreciations of the exchange rate of a country, where tensions may arise between the exchange rate adjustment supporting the adjustment process and the impact of the depreciation on other countries' trade and economic positions. More generally, in a world of floating exchange rates, there can be instances of strong negative externalities if all countries follow strategies of competitive devaluations. This requires the existence of policy co-ordination mechanisms to avoid the occurrence of such a non-co-operative and sub-optimal equilibrium.
The same holds for cases where a country follows an inconsistent macroeconomic policy that can lead to a rushed exit of foreign investors and precipitate an external payments crisis which can affect other countries. Also, it is important for the international system to ensure that countries' external debt and/or deficits do not become too large and unsustainable. This calls for international support for domestic adjustment efforts, through international mechanisms of policy surveillance and dialogue, and, were justified, external financial assistance.
It should help to promote financial stability, i.e. avoidance of excessive volatility and boom-bust financing cycles(38). Sound and sustainable domestic macroeconomic and financial policies are of primary importance to ensure financial stability. For countries willing to attract international capital (be it in the form of portfolio investment, direct investment in industrial or services businesses or through the issuance of international securities) it is important that investors have a clear understanding of the direction of economic policy, the state of the economy and the policy framework of the authorities. This would argue, inter alia, for international standards and rules on issues such as transparency, accounting and disclosure of data.
In times of financial stress, it should ensure monetary stability, meaning the provision of international liquidity when there are risks of a generalised blockage of international financial relations because of the unwillingness or incapability of economic agents to conduct financial transactions or to take on financial risks. Given the deep interlinkages between modern financial markets and financial institutions, a serious shock to the financial system can lead to the quick disappearance of liquidity. Provisions are then needed to prevent financial and economic crises(39). This may be seen as an example of the need for an international public good(40), which is not provided necessarily by government in normal times but becomes necessary in time of crisis. Recent years have seen at least two occurrences of such severe financial shocks. In the case of the failure of LTCM, no lender of last resort intervention was needed but the US central bank did intervene to assemble a coalition of domestic and foreign financial institutions to come to the rescue of the failed institutions, highlighting the need for international liquidity support. Second, in the wake of the 11 September attacks against the US, the need for international liquidity was met by swap arrangements between the Federal Reserve Bank of the US and the European Central Bank(41).
It should have an efficient governance framework. The above mentioned functions of the international financial system may require common bodies and institutions, mechanisms of co-operation and co-ordination and - where required - mechanisms that support and set penalties for the implementation, or lack thereof, of the commonly agreed rules. Such a framework will raise questions of efficiency and legitimacy.
Overall, the system has functioned well in channelling savings into productive investment and fostering prosperity and productivity growth in both developing and developed economies. Market discipline has generated a growing consensus regarding the merits of stability-oriented macroeconomic policies. Broad and deep markets are seen as key for the efficient pricing and management of risks, which in turn is looked at as a necessary condition to expand the range of financing opportunities at the disposal of actors, including in developing countries, many of which would otherwise be perceived as too risky by individual investors. Moreover, international competition in the financial sector has helped to reduce financing costs, rendering the intermediation of savings to investment more efficient and disciplining economic policies.
Nevertheless, recent experiences have brought to the fore a number of real or potential systemic weaknesses. The recurrence of financial crises in recent years has suggested that the system is not fully adequate any more to cope with the changed environment. In addition, it has been seen as allowing abuses in terms of money laundering, financing of illegal activities and tax evasion, and has segments that are largely unregulated.
B.1. International Monetary Stability
Although the integration of financial markets and the institutional and regulatory framework in which they operate have spurred economic growth, the international monetary and financial system has continued to be criticised for being crisis-prone. With the exception of the ERM crisis of 1993, the crises of the nineties have mainly affected developing countries and, for most of them, have had important consequences in terms of output loss, welfare, social conditions and unemployment. While there have been other historical periods when crises occurred at a relatively high frequency, in particular in the late 19th century and the 1920s and 1930s, the nature and systemic impact of crises in recent years has become a cause for concern.
Key features of the crises and of the environment in which they took place include:
An increased frequency and intensity. Compared to the Bretton Woods period, the frequency of crises post 1973 has doubled Bordo (2000). Crises have continued in the nineties, including Mexico (1994), East Asia (1997-1998) and Russia (1998). Turkey (2001) and Argentina (2001) are the most recent examples. While it is often claimed that in addition to becoming more frequent, modern crises have become more damaging, Bordo (2000) does not find evidence that recent crises have grown longer or output losses have become larger.
The multiplication of actors involved. Compared to the debt crises of the eighties, the current wave of financial crises are more difficult to deal with given the dominance of market-based financing, which involve a large number and variety of investors. When bank and official lending dominated international financing, the number of actors involved was much lower and it was easier to reach a co-operative solution. In the absence of a clear framework of crisis resolution, there is in addition an issue of moral hazard that has been linked to the provision of large international financial rescue packages to countries affected by capital flight.
The increased risk of crises becoming contagious and self-fulfilling. Contagion is not a new phenomenon; in the past, financial crises have often spread across countries. However, under the Bretton Woods regime of low capital mobility and limited linkages among key financial markets, contagion was less pervasive. On the contrary, recent years have seen a new wave of contagion crises, where countries that had relatively sound economic fundamentals were subject to speculative attacks. Contagion happens when market participants, because of developments in other countries, consider that economic fundamentals in a country have to be fundamentally re-assessed and that the price of its financial assets have become overvalued. Contagion has been most evident in the ERM crisis of 1992/1993, in Asia in 1997 and in Latin America in 2001. Contagion has also been exacerbated by financial market participants' tendency towards herd behaviour, i.e. the preference to follow the market's directions in order to minimise the risks associated with more extreme positions. The advances in information technology and risk management techniques, which have been adopted by most of the financial industry and often rely on similar models of risk evaluation and management, have reinforced the scope for this type of behaviour.
In addition, if market participants become convinced that there is some underlying factor justifying the possibility of a crisis, a crisis can become self-fulfilling. For example, foreign investors may sell the financial assets of a country that seems in good condition because this country is affected by a similar economic shock, it shares similar structural conditions (financial sector structure, debt levels) or it belongs to the same class of assets as an affected country. It is usually impossible to anticipate in advance which macroeconomic element or structural condition the markets will focus on to justify their expectation of a crisis, since almost all countries have economic weaknesses in some form or another.
Lastly, it has been claimed that the globalisation of financial markets has led to the faster transmission of economic and financial disturbances more generally with, in addition to the trade channel as a transmission mechanism, a greater synchronisation of business cycles across the world (IMF WEO Autumn 2001). Moreover, flexible exchange rate systems have only partly succeeded in insulating economies from international disturbances.
The increasing scope for information asymmetries. Information asymmetries mean that participants in a financial transaction do not have the same quality of information to evaluate the prospects of the transactions being carried out successfully. Typically, for example, a borrower has more information on his financial perspectives than the lender. With the globalisation of markets, the multiplication and diversity of investors involved in international financial transactions, the dominance of market-based finance relative to the more traditional bank financing, and the vast amount of information to be processed, information asymmetries have become more pervasive.
Pervasive information asymmetries have had two broad types of concrete consequences in the international financial area in recent years.(42) First, they tend to lead to credit rationing when lenders believe that they do not have the proper information to evaluate properly the riskiness of a proposed financial transaction. This may lead for example to a situation whereby good corporate risks in developing countries cannot access external financing directly because lenders do not possess enough information about the country, the company and its business. Second, and conversely, information asymmetries have led to boom cycles of capital towards some types of financial assets, for example, emerging market bonds or shares of telecommunications companies, as investors only focussed on the positive information.
The increased size and volatility of private capital flows towards developing countries. Following the two oil shocks, developing countries attracted record amounts of foreign capital, mostly in the form of traditional bank loans (syndicated or not). The prospects of default by Mexico and Argentina in the early eighties precipitated the end of this cycle of large capital inflows. In the early nineties, however, following the liberalisation of their capital accounts, a new cycle of private capital flow to developing countries began, but was stopped and reversed towards the middle of the decade in the wake of the Asian crisis.
A characteristic of this more recent reliance on external financing has been that a number of countries have taken on large debt-creating inflows with short-term maturities. Because they are often unable to borrow locally and with long term maturities, it is tempting for developing countries' governments and enterprises to borrow on international markets. Most of the borrowing takes place in foreign currencies (because of lower interest rates and easier availability than when borrowing on the local market in the domestic currency) and at relatively short term maturities (reflecting foreign lenders' preference for reducing their risks).
Foreign borrowing is particularly attractive under fixed exchange rates. However, if foreign investors decide to withdraw capital 'en masse', the economy is presented with a two-faced crisis. The first one is a traditional liquidity crisis; current financial resources are insufficient in the face of short-term maturing obligations and refinancing becomes difficult, if not impossible. In addition, because of the currency and maturity mismatches in the balance sheets of local banks and enterprises resulting from borrowing short term in foreign currency, the liquidity crisis can very rapidly translate into a solvency crisis. If a devaluation results and under the new macroeconomic conditions, the expected cash flows generated by the operations of local banks and companies are not adequate to meet their financial obligations.
B.2. Abuses of the Global Financial System
The global financial system has increasingly been used to 'launder' revenues generated by illegal activities, such as drugs related crime, and to channel funds to people and organisations involved in illegal activities, such as terrorism. The increasing ease of transferring funds across borders, the very extensive networks of all main banks (through their correspondents) and the growing number of countries that have opened their capital account imply that it has become more difficult to control the origin and the ultimate destination of funds entering the global financial system. Moreover, it has become increasingly clear that corporate vehicles are being used in money laundering and tax evasion schemes, organised criminal activity, and as a way to circumvent regulations and manipulate equity markets.
There are no estimates of the amount of money that is being processed in the international financial system to finance terrorist activities. With respect to money laundering, the IMF is quoted as estimating the aggregate size of money laundering in the world as being between two and five percent of global GDP, or roughly 600 to 1500 bn USD(43).
The abuse problem has been compounded by a number of countries and jurisdictions that have built their competitive advantage through very favourable tax and regulatory environments for non-residents funds, while at the same time limiting their co-operation with the judicial, tax and police authorities of other countries. In addition to providing an accommodating environment for money laundering and other crime-related financial activities, these jurisdictions undermine the ability of other governments to finance essential public goods and services by providing easy opportunities for tax evasion by non-residents. As a result, decisions on where to locate economic activities are distorted and the tax burden in the affected countries is shifted towards law-abiding taxpayers.
There are few estimates of the size of financial flows to financial and tax havens, and the available figures do not distinguish legitimate investments from investments resulting from the harmful features of these jurisdictions. However, they clearly highlight the growing importance of financial flows to these jurisdictions while showing the peculiarities of these flows. Hines and Rice (1994) note that tax havens account for only 1.2% of world population and 3% of world GDP, but they attract 26% of assets and 31% of profits of American multinationals(44). According to the OECD, foreign direct investment by companies in G7 countries in a number of low-tax jurisdictions in the Caribbean and in South Pacific island states increased more than five-fold over the period 1985-1994, to more than $200 billion, a rate of increase well in excess of the growth of total outbound Foreign Direct Investment(45).
In addition to the concerns associated with the misuse of the financial system, there are other worries that are related to the intensified linkages between markets, intermediaries and infrastructure and which may become sources of risk to systemic stability and hence to the economic stability of countries that participate in the international financial system. These worries relate to the growing use of sophisticated financial management techniques, a greater reliance on in-house procedures for risk assessment and, in particular, the regular recourse to leverage as a means to magnify potential gains on investment positions.
Highly leveraged institutions mainly hedge funds - play an important role in the international financial system by facilitating the efficient sharing of investor risk. However, the activities of hedge funds are often characterised by highly speculative behaviour. This behaviour of hedge funds, which are typically constructed so as to avoid regulation, has long been a source of concern to policymakers. The background to the most recent bout of concern about highly leveraged institutions was the destabilising effects of the Long Term Credit Management crisis in the autumn of 1998 and the earlier crises in South-east Asia and Russia.
The abuses, misuses and lack of regulation of the global financial system have been made easier because of the slow and difficult co-operation among cross-border judicial, tax and policy authorities. It should, however, be noted that the events of 11 September have significantly changed the position of some policy makers, in particular the US administration with regard to their assessment of the costs (in terms of compliance costs for financial institutions) and benefits (in terms of preventing illegal activity) of greater international oversight on financial flows as well as pressure on non-cooperative countries where practices have been adjudged to favour illegal financial activity. As the next section will show, there are increased efforts being made at international level to address these challenges.
C. Towards a More Stable and Better Functioning International Monetary and Financial System
Recent years have seen the emergence of numerous proposals on how best to adapt the international financial and monetary system (IFMS) to the changes and challenges of a global economy. While this reform drive was accelerated by - and became more public with - the frequency of financial crises in the 1990s, it is not a new phenomenon. Previous decades had seen other proposals to reform and adapt the IFMS to the evolution of economic and financial relations and to changes in relative economic and political powers. Examples include the creation of the WTO, which was preceded by the GATT but which became a fully-fledged international organisation only in the mid-1990s.(46) Others, even highly publicised ones, have had rather limited effects: already in 1974, the UN General Assembly adopted the Declaration and the Action Plan for a new world economic order.
This section on proposals for reforming the system limits itself to the current policy debate and to the main proposals. It provides a short analysis of the pros and cons of these proposals, their political and practical feasibility as well as an assessment of the necessary conditions for success.
For the purpose of this report, the reform proposals have been grouped into four categories: modalities of crisis prevention and management (C.1), initiatives to reduce the abuses of the international financial system (C.2), regional and global co-operation (C.3), and reform of the institutional framework (C.4). These broad categories address to some extent the perceived failures in the working of the IFMS that were developed in the previous chapter.
C.1. Modalities of Crisis Prevention and Management
In the wake of the financial crises of Mexico in 1994/1995 and in South-East Asia in 1997/98, a discussion re-emerged about the instability of the IFMS and its proneness to financial crises. The financial crises were seen to expose significant problems in the functioning of international financial markets and of the system governing them. These problems included the following:
Most participants (the IMF, like most other international institutions, major policymakers and credit rating agencies and private investors) were taken by surprise;
Capital inflows had been mismanaged by emerging market countries, with excessive short-term indebtedness provoking a rush for the exit by investors, thereby accentuating the severity of the crisis;
Private creditors were perceived to have taken excessive risks, a fact which was attributed to deficiencies in information provision and processing but also to the creation of expectations about an official bail-out (either by the debtor country or the international community) the 'moral-hazard-problem';
IMF-led assistance packages were perceived to be both huge from an historical perspective and in relation to the financial resources of the Fund and "too limited" to contain panic and prevent very severe fall-outs in crisis countries;
There was a sentiment that whereas gains from risky investments - that contributed to the crises - were accrued by the private sector, the official community (i.e. ultimately the taxpayer) had to pick up the bill when investments turned sour. While this was not true across-the-board (equity holders suffered huge losses in many crisis countries), the concern was valid with respect to short-term creditors, who had to a significant extent been able to limit their losses.
Against this background, calls were made to adapt the set of rules and practices governing the IFMS, and the role of the International Monetary Fund in it, to the challenges of free and large capital flows. These calls for reform were not only made by academics, journalists, or civil society but also came from the G7, other governments and indeed from the Fund itself.
Some of the proposals to make the international monetary and financial system less prone to crises are listed below, separating probably somewhat artificially the ones pertaining to crisis prevention from the ones related to crisis resolution. Some initiatives are in the process of being implemented reflecting a high degree of consensus of the international financial community; others lack at present sufficient political support or would imply a too high level of public intrusion in the markets. Whereas most of the proposed changes are being dealt with in the existing framework, some of the more ambitious ones require the creation of a new institution or a much more profound reform of the architecture.
C.1.1. Crisis Prevention
At crisis prevention level, i.e. ex-ante measures to improve market participants' risk assessment, strengthen market discipline and thereby minimise the risk of crises, much has been achieved but some suggestions for further action and progress have been made.
There is general recognition that pursuit of sound policies and the existence of sound macroeconomic and structural framework remains the major and essential condition for reducing the occurrence of financial crises. Sound policies require a continuous effort to which the IMF, through its surveillance, and private market participants, through the feedback they give to authorities, can contribute. Sound policies are, however, not always sufficient since financial market participants may fail to differentiate sufficiently between good performers and bad ones, are sometimes prone to herd behaviour or need sometimes to withdraw their funds from sound investments to meet margin calls in other markets(47).
Many efforts have been devoted to improving the flow of information to market participants. Initiatives were taken in order to obtain better quality and more timely information from countries (such as the IMF Special Data Dissemination Standard (SDDS) and General Data Dissemination System (GDDS), and the Data Quality Reference sites (DQRS)(48), at improving information disclosure by policymakers to markets (such as Public Information Notices (PINs), publication of Letters of Intent and Article IV Staff reports, fiscal, monetary and financial transparency codes) and at getting feedback from markets through the organisation of a more permanent dialogue between the IMF and market participants. This drive towards better information is also reflected in the progress with respect to information processing by the IMF itself through improved Fund surveillance and the development of early warning, or vulnerability, indicator systems.
However, this approach also has its limits. Perfect information is an illusion. The existence of information asymmetries in capital markets is a well known fact of financial life since a borrower, whatever the standards and his willingness to respect them, will always be better informed about his situation than his creditors. Standards can also sometimes induce perverse behaviour by creating a false sense of confidence and/or introducing a bias towards some type of capital flows or in favour of some specific countries without proper risk assessment. Moreover, standards and codes are not value-less and major political differences continue to exist about what they should cover, how normative they should be and how they should be implemented and/or enforced. Also, since the need for information on the economic situation and policies of a country depends, to some extent, on its access to financial markets and levels of development, an appropriate balance needs to be found between the voluntary or compulsory character of standards. Finally, efforts have so far concentrated on information to the markets, while it has been suggested that creditors could also be more transparent by releasing information on the composition of their asset portfolios.
Efforts to make countries less vulnerable to crises have also been geared at developing deeper and more liquid financial markets and at strengthening domestic financial systems. These efforts have been made by, or are underway in, not onlyemerging market countries but also in advanced countries since many of them experienced during the recent past or are experiencing (Japan) more or less acute forms of banking or financial crises(49). However, as recently demonstrated(50), banking crises tend to have a bigger negative impact, in GDP terms, in emerging market countries than in advanced countries because the former tend to rely more on bank financing in light of their level of economic and institutional development. Banking crises, because they tend to spread to the whole financial sector and to the whole economy, have generally much more acute (direct and indirect) costs for the economy than stock or bond price variations(51). Strengthening prudential regulation and supervision are among the most important micro-prudential tools to foster financial stability and to prevent financial crises. World-wide, supervisory efforts are currently directed at developing a sharper focus on the risks within a financial institution. G-10 countries, under the auspices of the Bank of International Settlements, have reinforced their role in preparing regulatory recommendations in the banking field that will set capital adequacy standards for the international community at large. Work is also underway on the convergence of supervisory practices. These efforts are complemented by the extension of IMF surveillance to domestic banking and financial systems through Financial Sector Assessment Program (FSAP) and Financial System Stability Assessments (FSSA). These exercises aim at identifying ex-ante the strengths and vulnerabilities of a country's financial system and how to address them. Increasing the governance and regulation of financial institutions in developing countries and emerging market economies is another priority, which runs in parallel with these IMF efforts. In addition, some policymakers argue that the development of a securities market should become a priority for emerging market countries(52). Deep and liquid securities and bond markets, however, require a legal and institutional framework (including disclosure requirements, contract enforcement, market rules and corporate governance) that takes time and costs to develop.
In the framework of the G-20 it has been argued that the strengthening of the country's foreign exchange reserves should become a priority for emerging market countries' policymakers. In that view, emerging market countries need a sufficient buffer of foreign exchange reserves relative to their debt (short term debt generally) in order to re-assure market participants about their ability to service their debt. While there is agreement that adequate foreign reserves are obviously confidence enhancing, it is difficult to determine a single level that would, irrespective of circumstances, provide insurance against market attacks. Moreover, holding excessive reserves can be costly for the central bank and the economy.
Progress is also being made on the following fronts but at a slower pace because these proposals are either of a less consensual nature or more difficult to implement in practice.
The IMF is stepping up its efforts to develop an early warning system(53) but also to stimulate emerging market countries' policy makers to clarify, during Article IV consultations, their possible policy responses to crises. While this approach has the advantage of increasing the preparedness of the IMF and debtor countries to potential crises, economic and political circumstances evolve rapidly and the intrinsic element of a crisis is surprise. Moreover, care needs to be taken to avoid that an IMF assessment would itself precipitate a crisis.
Though there seems to be a wide consensus on the theoretical merits of including collective action clauses (CAC) (majority action clauses, sharing clauses and representation arrangements) into new international bond issues of emerging market countries, implementation has been rather limited. CACs are expected to facilitate the inclusion of international bonds into comprehensive debt restructuring operations, and to improve the pricing of risks by bondholders. Some, however, fear that the inclusion of such clauses will increase the financing cost to emerging countries. Industrialised countries also differ on the idea of "leading by example" by introducing these clauses in their own international bond issues. Progress on CAC clearly necessitates a 'critical mass' of countries to move forward.
The idea of creating Clubs of Creditors is also appealing.(54) Such clubs would bring together all creditors of sovereign debtors and would allow to disseminate information among them on the situation of the debtor country so that they could collectively adopt more rapidly and efficiently the best solution in case of crisis. It would be preferable to establish them prior to crises and they could usefully complement CAC. These clubs would play a role similar to the ones of bank advisory committees in the eighties or the so-called London clubs in the first part of the century. Private market participants have so far been reluctant in organising themselves in such a way because they fear that by doing so they would implicitly facilitate default by sovereign debtors. Without international official financial community lobbying, there is little chance that they would take the initiative.
There is also a wide agreement that emerging market countries should develop and/or broaden the use of financing instruments that can be used as a first line of defence in case of crisis. Such instruments include private contingent credit lines (as already established e.g. by Argentina and Mexico) and call options in inter-bank loan contracts that would enable debtors to 'lock in' loans in the event of a crisis. As such, they reinforce official foreign exchange reserves, allow a better pricing of risk by market participants and enable debtors to hedge against their risks more efficiently. They are, however, quite costly and difficult to operate in practice since the 'trigger event' should neither create self-fulfilling crises nor moral hazard. Moreover, recent experience such as in Argentina has shown that calling on these credit lines might cause a full risk re-assessment by private creditors thereby provoking capital outflows and/or the evaporation of other sources of capital inflows.
Though the principle of free international flows remains solidly anchored in the IMFS and is considered to be a final objective for all countries, capital account liberalisation has been heavily discussed. International private capital flows have become the major source of finance and investment for essentially all emerging market economies. This process will probably extend itself to developing countries, perhaps with the exception of the poorest ones. The merits of opening up to capital inflows are widely acknowledged. However, while countries should be encouraged to open their capital markets, it is necessary to ensure that this takes place within an orderly and well-sequenced process. Whether and to what degree multilateral institutions should promote this process or even be given jurisdiction over capital movements remains an issue for discussion. There is widespread consensus that capital account liberalisation needs to be orderly and well-sequenced, starting preferably at the long end (including with FDI) and that the process should be consistent with the overall stability of the economy and, in particular, the soundness of its financial system. At the same time, one needs also to recognise the distortional effects of capital controls and the tendency to see their effectiveness erode over time. This provides an incentive to liberalise further the capital account. The role of the international community in the capital account liberalisation process has not been fully settled. The Asian crisis, which was widely perceived as linked to inappropriately sequenced capital account liberalisation, has reduced support for proposals to amend the IMF Articles of Agreement to make capital account liberalisation one of the purposes of the Fund. Such an amendment would not only provide an explicit legal base for the inclusion of capital account issues into Fund surveillance, which is taking place anyway, but would also enable the Fund to include capital account liberalisation into program conditionality and give the Fund jurisdiction over capital movements. The latter option would establish an obligation for members to liberalise them, which would broadly mirror the Fund's competence with regard to current account transactions.
Within that debate of capital account liberalisation, the question of taxes on capital inflows has received renewed attention. These taxes can take the form, as in Chile, of non-remunerated deposits for capital inflows but could also proceed as taxes or quantitative ceilings on short term foreign financial flows. They can, as shown by various studies(55), encourage longer term financing from international investors and thus discourage more volatile capital inflows. It is argued, however, that they need to be broad-based to avoid creating loopholes; temporary since their persistence would encourage tax evasion; and complemented by measures to strengthen the financial system.
Finally, a number of proposals have yet to gather sufficient support.
Sorosproposed in the midst of the 1997-1998 crisis of emerging markets the creation of an international debt insurance agency scheme that would be financed by a fee paid by borrowing countries(56). The mechanism would operate on the basis of a country-specific ceiling on international borrowing that would be assessed by the IMF in light of the country's financial and economic situation. This mechanism would require that the IMF would only be prepared to provide assistance to countries respecting the ceiling. If debtor countries were to borrow in excess of the ceiling, markets would be expected to request a higher risk premium to cover default.
The advantages of this proposal are a better pricing of risk (if the ceilings are assessed correctly); the avoidance of rush to exit in countries respecting the ceiling; and the implicit rejection of bail outs for countries disregarding the ceiling. However, it is quite difficult to set an economically sound ceiling, independent of changing economic and political circumstances and based on economic considerations only. Moreover, a few large international borrowers have already borrowed in excess of what could be reasonably considered as an economically sound ceiling and would thus not qualify. There are also doubts about the actual relevance of differentiating domestic/international borrowing and private/public debt and about whether the IMF (and the international financial community) would be in a position to refrain from intervening in support of countries disregarding the ceiling, particularly the systemic ones. The cost of borrowing for all emerging market countries (insurance fee and risk premium for unsinsured) would increase.
The creation of an international prudential supervisory agency has recently been proposed as a way to address the dichotomy between national supervision and globally operating financial institutions(57). As financial markets become more integrated, new rules are being developed within various fora such as the BIS, the FSF, the IMF/WB, the FATF and the OECD. These rules, codes of conduct, and standards to be implemented rely most of the time on the goodwill of countries. Under the proposal, they could be made compulsory and would be monitored by the international agency. This would have the advantage of making the rules more explicit, ensuring a level playing field, thereby possibly increasing information about the health of internationally active financial institutions. In case of crisis, co-ordination will be facilitated and the risk of contagion would diminish. The idea, however, requires a high degree of global political consensus since questions about the legal and enforcement powers of this international agency over financial institutions, national supervisors and central bankers would have to be settled.
C.1.2. Crisis Resolution
At crisis resolution level, progress has been more limited. The balancing exercise between adjustment by the debtor country, official financing, and private financing has become more complex than 20 years ago. Financial markets have grown more rapidly than the financial resources at the disposal of the Fund and the reserve assets of creditor countries. Capital market participants are more diverse and numerous and reaching a co-operative solution among them and the debtor country is much more arduous. Moreover, whereas sovereign borrowing used to dominate emerging market country financing, borrowers are now public institutions, financial companies and corporate entities, which sometimes benefit from an implicit or explicit public guarantee. Finally, most capital account restrictions have been removed, facilitating the use of official assistance money for capital outflows.
The question also arises whether, and to what extent, the balance should be tailored to specific country circumstances. While it has been claimed that the wide and varying number of actors, both on the debtor and creditor side, increases the need for a common framework for crisis resolution in order to ensure some fairness, some of the reform proposals acknowledge, sometimes explicitly(58), that "systemic" countries - those that could trigger contagion or are politically most important - need to be treated differently. Such a case-by-case approach to crisis resolution, however, gives the main IMF shareholder an advantage in influencing the terms of each rescue operation.
The IMF is currently engaged in a process of reviewing the conditionality attached to its financing. There is broad agreement that conditionality needs to focus on those policies that are critical to achieving the macroeconomic objectives of the programme(59). The question of how to associate the private sector in the resolution of crises has also received a lot of attention. Related to this discussion, proposals have also been formulated for a more radical change in the role of the IMF in handling country crises.
There is a consensus, at least on paper, on the need to further develop the principles for Private Sector Involvement, that were laid down in the IMFC Prague framework to involve the private sector in both the prevention and the resolution of financial crises. The objective is to provide clearer guidance for market participants, debtor countries and the official creditors. The key principles of the framework include:
the commitment to honour contracts whenever possible;
equitable burden sharing between the public and private sectors;
comparable treatment of different classes of creditors;
main re
