WPS6070 Policy Research Working Paper 6070 Reform of the International Monetary System A Jagged History and Uncertain Prospects Justin Yifu Lin Shahrokh Fardoust David Rosenblatt The World Bank Office of the Chief Economist Development Economics Vice Presidency May 2012 Policy Research Working Paper 6070
Box 1: Exorbitant Privilege
"...The original conception of this term dates back to the idea that the dominant reserve currency country does not have to “earn? foreign exchange to pay for its imports or other obligations – something akin to seigniorage.a In other words, a certain amount of goods or services or assets were acquired simply by exchanging currency that foreigners wished to hold as a reserve asset. In the modern world, reserves are mostly held in government bonds, so exorbitant privilege is a much broader concept to take into consideration the ease (cost) of borrowing overseas and the advantages of being able to do in the country’s own currency.
From a pure seigniorage perspective, one simple measure of the stock – not the flow of benefits—is the estimated $500 billion (about 3.5 percent of GDP) of US currency circulating overseas for which foreigners had to provide “free? goods and services (or assets) to obtain (Eichengreen, 2011a). This represents about half of the $1 trillion in total US dollar currency in circulation. A more contemporary definition – for a world where capital flows are dominating trade flows—is the excess returns to net foreign assets of the reserve currency country. In simpler terms, the status of a reserve currency issuer allows the country to borrow from abroad more cheaply than it lends. In addition, depreciations of the reserve currency improve the net foreign asset position of the reserve currency issuer, unlike developing countries that borrow in foreign currency. This creates the scope for depreciating (similar to inflating) one’s way out of debt on the global scale.
Some Estimates of benefits and costs of reserve currency status for the United States. McKinsey Global Institute (2009) estimates only $10 billion in annual benefits to the US from pure seigniorage, $90 billion in lower borrowing costs, and -$30 to -$60 billion from exchange rate appreciation for a net annual benefit of $40 to $70 billion – or about 0.3 to 0.5 percent of GDP. Studies cited in Eichengreen (2011a, page 118) point to interest rates that could be 50 to 90 basis points lower due to the dollar’s dominant reserve currency status. McKinsey Global Institute (2009) uses an estimate of 50 to 60 basis points for the calculations cited above. Warnock and Warnock (2006) arrived at an estimate of 90 basis points. World Bank (2011, page 126) presents estimates of $15 billion per year in seigniorage (since the early 1990s) and $80 billion annual savings (in recent years) from lower interest costs—fairly close to the McKinsey Global Institute estimates. In brief, the range of estimates for the net annual benefits to the United States– during normal times—of the dollar’s dominance as a reserve currency is in the range of $40 to $150 billion (the latter by nearly doubling the lower borrowing cost estimates if one were to use Warnock and Warnock estimates of the basis point savings). During a regional or global crisis, these net annual benefits could be larger than normal times, since the US dollar-denominated assets often act as “safe-haven,? thus enjoying even relatively lower yields due inflows of capital into US financial markets. In addition, in the aftermath of the global financial crisis, revenues from “pure? seigniorage , which is derived from the increase in real base money associated with increased demand for money due to increased economic activity and other factors, have risen sharply as monetary authorities in reserve currency-issuing countries have substantially increased their balance sheets through quantitative easing and bank support. IMF estimates that these revenues may have reached 8 percent of GDP (Fiscal Monitor, April 2012); however, it is not clear what portion of this burden is born by non-residents.
Other authors use the excess returns on net-foreign assets approach to analyze the benefits (Hausmann and Sturzenegger, 2006, Gourinchas and Rey, 2005, Lane and Milessi-Ferretti, 2007 and 2008, and Habib (2010)). Habib arrives an excess return of 330 basis points, which if applied as “savings? on the current US negative Net Foreign Asset Position of $2.5 trillion (2010), one gets an annual savings of $82 billion..."
"...Another approach to measuring international seigniorage would be to look at the growth of US currency in circulation and assume that half ends up in the hands of foreigners: free imports. Since 2000, the total currency in circulation increased by $484 billion. If half was absorbed externally, that would imply cumulative “international? seigniorage of about $240 billion or about $20 billion per year..."
"...Despite gains by the euro, however, the US dollar has remained the dominant international currency. Network externalities are often cited as a reason for the persistence of dominant currencies in the international monetary system. 34 Flandreau and Jobst (2009) cite empirical evidence of strong strategic externalities that help currencies become international on account of their low liquidity premia. Their evidence also strongly supports the hypothesis that economic size and share in international trade and payments play crucial role in determining a country’s role in monetary leadership..."
"... The transition to a genuine multi-currency reserve system could be gradual as has been the case since the creation of the euro. To a large extent the speed and nature of the transition will depend on the size, structure and speed of change of the global economy. However, historical precedent certainly exists for the rise and fall of reserve currencies. Between 1931 and 1945, the dollar overtook the pound sterling as the dominant reserve currency; however, the final decline of the pound was fairly sudden once a tipping point was reached much later. 38 The policy coordination among the key actors will be essential in determining whether the process of change will be orderly or not. The current situation in some ways resembles that at the end of Bretton Woods I, just before the collapse of the entire system. As mentioned earlier, the system that has evolved since the mid-1970s has been prone to episodic crisis as key players’ macroeconomic policies were not always consistent with what was needed to stabilize the international monetary system and this has resulted in a highly volatile capital flow and exchange rates and interest rates.
Persistent Payments Imbalances and Volatile Capital Flows. International capital markets virtually disappeared after the widespread debt defaults caused by the Great Depression. Capital movements in the interwar period mainly took the form of hot-money. The disappearance of private capital flows was assumed to be more or less permanent when the design of the World Bank and the IMF was being finalized at the Bretton Woods negotiations in 1944. The size of official assistance and lending soon would be dwarfed by the rapid revival of FDI in the 1950s and the subsequent reemergence of a market in financial capital. 39 Financial flows primarily took the form of floating-interest bank loans rather than the fixed-interest rate bond finance that had been prevalent in the pre-War period. 40 In the following 30 years, there was an explosive growth in bank lending, some of it in the shape of recycling of the so called petro-dollars following the oil price shocks of the 1970s.
38 Eichengreen and Flandreau (2008) date the dollar dominance (as a reserve currency) to the mid-1920s.
International financial integration accelerated after the Asian financial crisis in 1997-98. The gross cross-border flows rose from 5 percent of world GDP in the mid-1990s to around 20 percent by 2007, and international financial openness (external assets plus liabilities) rose sharply from 150 percent to 350 percent of world GDP in the same period. 41 In fact, the gross cross-border flows dwarfed net flows, and they flowed in the opposite direction of what would be implied by countries’ current account deficits and surpluses. For example, for the US the cumulative current account deficits between 2002 and 2007 amounted to $4.8 trillion while it experienced even larger gross outflows, amounting to more than $5.8 trillion- excluding outflows related to financial derivatives. These, however, were financed by around $10 trillion in gross inflows. 42 Financial innovation and development in both advanced countries and emerging economies further accelerated global financial integration. The rising share of cross-border ownership of financial institutions, together with increased funding from international capital markets, further enhanced international financial integration. As a result, the value of external assets and liabilities of banks doubled as a share of GDP from around 30 percent in the early 1990s to about 60 percent in 2007. 43 Rapid growth of world trade also contributed to the increased global financial integration through increased trade credits and export insurance. Nevertheless, international capital flows rose about three times faster than international trade as a result of financial liberalization and innovations, though they fell sharply in 2008 as a result of the economic and financial crisis. Emerging markets participated in this globalization process as they increased their share in international capital markets from 7 percent in 2000 to 17 percent 2007..."
39 By 2011, net flows from official creditors to developing countries amounted to $50 billion (mainly due to increased support during the global crisis) compared to $554 billion in net FDI flows to these countries (Global Economic Prospects, Jan. 2012, World Bank).
40 Williamson (1990) and Obstfeld and Taylor (2004).
41 OECD Economic Outlook, Paris, 2011.
42 These inflows into the US economy were distributed as follows: about $3 trillion in US official assets, including US Treasuries, $1 trillion in FDI, $1.4 trillion in stocks and $1.7 trillion in corporate bonds and $2.6 billion in other assets, including real estate, as reported by US based banks and brokerage firms – source: Economic Report of the Presisent: 2011 Report Spreadsheet tables B-103: http://www.gpoaccess.gov/eop/tables11.html. US Bureau of Economic Analysis, International Investment Position of the United States at Yearend: http://www.bea.gov/international/ai1.htm#BOPIIP
43 BIS Annual Report, Basel, 2010.
"...In the post-crisis period, advanced economies as a group have been running a relatively small deficit on their current account of balance of payments. This aggregate deficit amounted to about $100 billion or about 0.2 percent of their GDP in 2011. However, both this deficit and the current account surplus for developing countries, which amounted to $470 billion (1.9 percent of GDP) in 2011, and mask massive differences among various regions.
In 2011 , among the developing countries, about 40 percent of the overall surplus in current accounts or $200 billion was accounted for by Asian countries while most other developing countries (with the exception of oil exporters with a surplus of $580 billion) had deficits that were financed by capital inflows and drawing down reserves. The level of international reserves held by emerging and developing economies rose to $6.8 trillion or 67 percent of the total global foreign exchange reserve stock of $10.2 trillion as of end-2011. 47 China alone accounted for about 40 percent of the massive stock of reserves held by emerging and developing economies. However, the changes in reserve holdings were far smaller than the volume of capital flows. For example, in 2007, just before the start of the global crisis, the increase in total holdings of foreign reserves amounted to $1.5 trillion compared to about $8 trillion in capital flows, which were mainly among the advanced countries or originated from them and thus were driven to a large extent by their macroeconomic policy stances.
Among advanced economies, the US continued to experience a current account deficit of about $470 billion, which in 2011 amounted to 3.1 percent of its GDP. Its expansionary fiscal and monetary policy stance has played an important role in both sustaining the global economic recovery and its large current account deficit. On the other hand, the Euro area, Japan and the rest of advanced countries all had significant surpluses in current account, amounting to about $370 billion in 2011. These very large current account deficits and surpluses are matched by massive net capital flows across borders, which are in turn supported by much larger gross flows, induced to a large extent by the loose monetary stance in the reserve currency countries. According to IMF , the size of the global capital markets (sum of stock market capitalization, bonds, and bank assets) reached $256 trillion in 2010, which was 4 times larger than world GDP. 48 The persistence large deficits and surpluses carry substantial risks as they can cause disorderly adjustment which could lead to large exchange rate movements and cause substantial movements in capital as well as goods and services through their impact on prices. In addition, massive trade imbalances can lead to protectionist policies in deficit countries. According to OECD, about 60 percent of 268 episodes of large foreign capital inflows ended in “sudden stops,�? and about one in ten episodes ended in either a banking or currency crisis.49 This experience provides additional evidence in support of the hypothesis that the major weaknesses in the current international monetary system are harmful to all countries, including developing countries. These problems could become exacerbated in a multiple reserve currency system in the future--particularly if the reserve currency countries fail to closely coordinate their macroeconomic policies (see the following section).
Globalization and the expansion of the global economy have resulted in a sharp increase in the volume of international transactions. However, these trends, as well as the persistence of large balance of payments imbalances, have brought to light the limitations of the current international monetary system and national policies that were designed for a far less financially integrated world. As we argue below, a well designed international monetary system must have two key functions: (i) it should allow countries to run temporary surpluses and deficits on current account and accumulate net claims, which is a rather mechanical role and has been accomplished by the current system; and (ii) it should have a mechanism-cum-incentives to encourage countries to return to a balanced position. 50 This latter has been the biggest deficiency of the current system..."
"...Looking ahead, the international monetary system is likely to face three possible outcomes: (i) continuation of the current “non-system�? international monetary system with continuation of capital flows and exchange rate volatility and its outlook punctuated by regional and global financial crisis from time to time, as has been the case since the 1970s with a distinct possibility of the collapse of the system (a la Bretton Woods I and II); (ii) a more likely scenario with the evolution of the current system into a multi-reserve currency system supported by three major currencies – the dollar, the euro and the renminbi, along with smaller currencies, such as the yen and the Swiss franc, with possibly other large emerging economies (e.g. India and Brazil) joining later, with continued volatility of capital flows and exchange rates, mainly among the major reserve currencies (and with blocks of currencies pegged to each of them) in response to their national policy changes and or unexpected events; and (iii) a collective decision by major global economies to reform the IMS and move toward a new supernational currency a la Keynes’s Bancor. We focus here on the stability of the evolving multiple reserve-currency system in this section, given the relatively higher likelihood we attach to it as a possible medium-term scenario in the absence of a multilateral action to reform the entire system.."
"...Despite these somewhat subdued prospects, as discussed earlier in this paper, the dollar still accounts for more than 60 percent of total foreign exchange reserves, for about 40 percent of all international lending and bond issuance, and is involved in more than 80 percent of all foreign exchange transactions. The US economy continues to be the single largest economy in the world, a position that it is likely to retain for at least another decade. Therefore, on balance, unless US policy makers commit serious policy mistakes that could further hurt the country’s economic prospects and its credit rating, the US is likely to continue to remain a key global player with the dollar remaining a key reserve currency for at least another decade, though the US’s weight in the global economy as well as its fiscal and monetary capacity to provide much of the needed liquidity to a growing global economy, or implement counter- cyclical policies at the global level, are likely to continue to erode over time..."
Returning to the post:
Past IMS transitions have been marked by instability, and the evolving transition from the current system dominated by the US dollar to a multi-currency system is not expected to be exempt from such instability. In the past, instability was associated with the shift from one dominant reserve currency to another dominant reserve currency. In the future, none of the current and emerging major reserve currencies are likely to be dominant. The instability/volatility will be related to speculative movements of capital from one reserve currency country to another--induced partly by the inherent structural weakness of the reserve-currency countries and partly by the effect of excessive capital inflows and outflows due policy changes and speculation. In fact, such “musical chair? type of speculative movement has occurred since the 2008 global crisis, especially after the Euro zone debt crisis. As will be discussed in the section on stability below, after the US dollar, the euro, the yen, and eventually the renminbi, are expected to constitute the new multi-currency system. Each of these currencies will be associated with a significant share of world output and trade, as well as financial flows, and will likely serve as a monetary anchor for other currencies. Recent experience indicates that frequent shifts among these currencies, caused by policy shifts and economic news, results in volatility in exchange rates and capital flows that adversely affect global economic activity.