International Financial System Reform: Assessment and Outlook

  2011/10/7 source：

 Since the eruption of the Global Financial Crisis (GFC) originating from the US sub-prime mortgage crisis, reform of the International Financial System has been a major focus for relevant stakeholders. As the premier coordination forum on global economy, the G20 summit has played the driving role in promoting this reform. In the following report, there will be a review of the progress made towards reform since the onslaught of the GFC, an analysis of major outstanding areas for further reform, and a survey of the different views held by major stakeholders. This report seeks to provide various proposals in which China’s participation in the reform process will help achieve strategic national goals. 

I. Progress in Reforming the International Financial System since the Crisis

Since the GFC, there has been significant reform of International Financial System, having profound implications for both the structure of global economic governance as well as the ways in which it performs.

1. Reform of the International Monetary Fund (IMF)

Reform efforts within the IMF have been promoted in two phases since the GFC. The first phase is the year of 2008 reform and the second is the year of 2010 reform.

The First Phase 

Reform of quota and voicing rights has been seriously discussed since the annual meeting of IMF-World Bank in Singapore in 2006; however it wasn’t until after the eruption of the 2008 financial crisis that IMF reform has been substantially promoted. The reform package of the IMF in 2008 is comprised of three main parts.

Firstly, the IMF transferred 4.9% of the total quota among its members. The quota of 54 members was increased to 20 billion in Special Drawing Rights (SDR). This figure is equivalent to $30 billion, to which emerging countries are the most beneficiaries. South Korea’s quota increased by 106%, Singapore 63%, Turkey 51%, China 50%, Brazil 40% and Mexico’s by 40%.

Secondly, Basic Votes in the IMF have tripled, enhancing participation of low-income countries in IMF. The Basic Vote system was designed to reflect the principle of equality between all the countries, in order to enable the smallest and mostly the low-income countries to have a proportionate level of participation relative to larger income states. The members agreed that the share of Basic Votes in the total voting rights would be maintained in order to safeguard the achievements of the small and medium income countries in the current reform process, avoiding future reform to mitigate the interests of them.

Thirdly, African chairs on the IMF Board of Directors will enjoy greater flexibility in order to increase the representation of African countries. Prior to this reform, African countries had two director-chairs and each chair had one alternate. Yet, as the constituency of African countries is the largest in the IMF, it was necessary to enhance their representation. Thus, it was agreed that two African Directors will now have a second Alternate for each chair position. Then, African states will have two Directors and four Alternates, a substantial increase in representation.

The 2008 reform got the approval of 117 member countries, an 85.04% share of total voting rights leading to the implementation of the first phase IMF reform.

The Second Phase 

In October 2009, the IMFC required the IMF to transfer at least 5% of its quota from over-represented developed countries to underrepresented emerging and developing countries, based on the current formula. In November 2010, the Board of Directors of the IMF reached agreement on the new reform package. This included three elements.

First, the total quota was increased from SDR 238.4 billion to SDR 476.8 billion (around $750 billion), which significantly increased the overall financial resources of the IMF. If taking the bonds bought by the major members together, (i.e. that of the US, the EU, Japan, China, Russia, Brazil and India), the IMF will have much weightier financial resources going forward.

Secondly, the quota transfer was promoted further. More than 6% of the total quota will be transferred from developed and oil producing countries to emerging and developing countries. After this adjustment, developed states’ share will decrease to 57.7% from 60.5% in 2008; emerging and developing countries’ share will increase from 39.5% to 42.3%; and China, India, Russia, Brazil will see their quota shares increase from 3.996%, 2.442%, 2.494, 1.783% in 2008 to 6.394%, 2.751%, 2.706%, 2.316% (respectively). All of these later four countries will be among the top ten share holders, with China to be the third largest. The other six of top ten share holders include the US (17.407%), Japan (6.464%), Germany (5.586%), France (4.227%), the UK (4.227%) and Italy (3.161%). Saudi Arabia and Canada, the two former top ten share holders, will lose the status as their shares would be decreased to 2.096% and 2.312% respectively.

Second, the structure of the Board of Directors will be adjusted to strengthen the representation of emerging and developing countries in the daily decision-making of the IMF. The number of Directors from the developed European countries will be reduced by two; all the Directors will also be elected out, rather than appointed currently. The scale of the Board of Directors will remain at 24, with a review every 8 years. Further, the Council of Governors will discuss how to give other multi-countries constituencies more flexibility to have the second Alternate.

Although the 2010 reform package has been approved by the Council of Governors, it still needs approval of a 3/5 majority of all member countries and no less than 85% of total voting rights. Approval for said reforms will involve complex domestic procedures in many countries, and is likely not expected to pass until 2012.

2. Reform of the World Bank

The First Phase 

In the annual meeting of World Bank-IMF in October 2008, the first phase reform package was confirmed by the Development Committee and approved by the Council of Governors of the World Bank Group in January 2009. The main content includes: the addition of a new Director for the Sub-Saharan African constituency; the doubling of the Basic Vote structure thereby increasing the participation of developing countries in the IBRD by 1.46%, to 44.06%, and achieving at least the same level in the IDA; revising the Charter of the World Bank Group in order to complete the reform package; and lastly, establishing a donation trust foundation to increase the voting rights of developing countries in the IDA.

The Second Phase

In the April 2010 Spring meeting of World Bank and IMF members, 186 member states of the World Bank Group approved the capital increase of more than $86 billion and a plan to give developing countries more voting rights, building on the momentum of the first phase 2008 reform. The second phase reform is comprised of five parts.

The first priority is to enhance the financial capacity of the World Bank Group. Through general capital increases and selective capital increases based on voting rights, the IBRD increased its capital by $86.2 billion and the IFC increased its capital by $200 million (as part of the developing and transitional countries’ share increases). The IFC is also considering procuring more capital by selling mixed bonds to its share holders and other investment income; however this is still up to the approval of the Board of Directors.

The second priority is voting reform. (1) The voting rights of developing and transitional countries within the IBRD will increase by 3.13% to a total of 47.19% overall. Since 2008, these countries have altogether received 4.59 percentages of voting rights. China’s voting rights will increase from 2.78% to 4.42%, to be the third largest; Brazil and India will increase from 2.07% and 2.78% to 2.24% and 2.91% (respectively); Russia and South Africa will see some decline, with their voting rights decreasing from 2.78% and 0.85% to 2.77% and 0.76%; the US and Japan will fall from 16.36% and 7.85% to 15.85% and 6.84%; both the UK and France will decline from a 4.30% to a 3.75% share; and Germany will now have a 4% share, from 4.48%. These measures aim at fulfilling the commitment by the Development Committee made during the Istanbul Meeting in October 2009 that developed countries need to transfer at minimum 3% of voting rights to developing and transitional countries. (2) The IBRD’s 2010 capital restructure comes from the $27.8 billion selective capital increase and includes the $1.6 billion share payments. (3) The voting rights of developing countries and transitional countries in the IFC will increase to 39.84%, which is a 6.07% hike. (4) The IFC’s 2010 capital restructure comes from the $ 200 million selective capital increase and the Basic Vote increase by all members. (5) From 2015 onwards, the distribution of shares within the IBRD and the IDA will be subject to review every 5 years in order that voter equality be adequately realized.

A third priority will be reform of the Board of Directors. The World Bank Group will add a third Director for the Sub-Saharan African constituency, increasing the number of Directors from 24 to 25.

The fourth component of World Bank reform is reform of internal management. Three Deputy Presidents at the Bank as well as the Chief Economist are from developing countries for the first time in the history.

The fifth change will be in daily business operations. The World Bank will now disclose an increased level of non-classified information, leading the way amongst multilateral institutions in providing information freely to countries (especially the developing countries), reforming investment loans to enhance efficiency, accelerating and strengthening the process of risk management and placing more emphasis on better governance and anti-corruption. 

3. Progress in International Financial Regulation Reform

In this section, we summarize the international financial regulation reform in two parts: first, the institutional reform, where the Financial Stability Forum (FSF) was enlarged to become the Financial Stability Board (FSB), representing a key progress in overall global financial reform efforts; and second, the formulation of newly designed norms and rules on international financial regulation with the FSB as the chairing coordinator. 

From the FSF to the FSB

In 1999, the G7 established the FSF in order to strengthen the coordination between them and other international financial institutions with regards to regulation policy. The FSF members included the regulatory authorities of the respective countries, the main international financial standards-setting bodies, and the authorities of important financial centers. 

In November 2008, the G20 summit’s communiqué required the enlargement of the FSF. On March 12, 2009, the FSF expanded its membership to all G20 member countries, plus Spain and the European Commission. On April 2, 2009, the FSF formally renamed itself as the FSB. Its mandate got expanded as well. Besides identifying instability within the financial system, defining and monitoring of the corresponding solutions, and promoting coordination as well as information sharing between members, the new FSB is also mandated to monitor the overall development of financial markets and assess the implications of regulatory policies on them. Furthermore, the FSB will offer expertise on how to best satisfy the requirements of regulatory standards and develop an overarching review of the work done by international standards setting bodies. This comprehensive review will provide guidance and support for the establishment of a supervisory college of respective agencies. The effect will be of mitigating future cross-border economic crises by enabling strengthened cooperation with agencies such as the IMF and the implementation of early warning programs.

Key progress in the reform of international regulatory rules coordinated by the FSB

In keeping with the targets and timetable laid out at the G20 summits with respect to international financial regulatory reform, the FSB took charge of coordinating the reform and achieved substantial success. The two main successes include: the publication of Basel III and the establishment of a framework for resolving problems surrounding Systemically Important Financial Institutions (SIFIs).

The Basel Committee implemented large scale reform on current international banking sector regulatory rules, announcing a set of new standards called the Basel III. The Basel III guidelines reflect new thinking on financial regulation, with the combination of micro-prudential regulation and macro-prudential regulation. The guidelines place similar emphasis on capital regulation and liquidity regulation, requiring both increase in capital quantity and quality. These measures were put in place to maintain the appropriate capital and leverage ratios, demanding financial institutions to balance short-run and long-run effects. With the introduction of these new financial regulations, the Basel III can be deemed a milestone in international financial system reform.

In November 2010, the FSB submitted a framework to deal with SIFIs problems. The framework is mainly targeted to: increase the capability of SIFIs to absorb loss, strengthen the force and efficiency of regulating SIFIs, improve institutional arrangements on crisis management, consolidate the core infrastructure in financial markets and the regulatory policies of different countries over globally SIFIs, require peer reviews (through a peer review council to be created by the FSB), to set crisis management measures, and to restore or deal with the issues surrounding individual globally SIFIs.

There has also been some progress in reforming OTC derivatives, expanding the coverage of financial regulation, reforming international accounting standards, and in promoting the implementation of international regulatory standards overall.

4. Progress in International Monetary System Reform

The basic characteristics of the current international monetary system are as follows: the US dollar remains the most important international reserve currency; many countries’ currency exchange rates are still linked to the US dollar; and, fixed and flexible exchange rates widely exist together. The domination of the US dollar in the global economy has led many economists to call the current international monetary system Bretton Woods II. Concerns and doubts over the current international monetary system exist in four main areas. Firstly, although the dominance of the US economy is no longer globally absolute, the US dollar still plays the most important role. However, the US monetary authority has been charged as being irresponsible in the wake of the GFC. The second characteristic of the international monetary system is frequent and large fluctuations in exchange rates of major international currencies, i.e. the US dollar, the Euro, and the Yen.  These extreme fluctuations have negatively influenced the stability of the world economy, and in particular have impacted commodity prices. Third, under the current international monetary system many emerging market economies and developing countries feel it is necessary and desirable to accumulate huge foreign exchange reserves in order to avoid financial risks. This has been deemed by many as part of the reason why there is an imbalance in the global economy. Finally, in the past twenty years the speed of international capital flows has become much faster and more volatile, igniting shocks in both domestic and international financial markets.

Up to now, there has been some progress in reforming the international monetary reform. At the global level, through initiatives taken by the G20, the IMF increased its SDR, thereby enhancing the IMF’s rescue capacity. The G20 Seoul Summit also advocated for the establishment of a global financial safety network in order to reduce the necessity of accumulating huge foreign exchange reserves. At a regional level, East Asia and Europe have each made progress in establishing their own financial rescue mechanisms and capacities, with East Asia’s foreign exchange reserve pool of $120 billion, and Europe’s EFSF and EFSM for combating the European financial and sovereign debt crisis. Bilaterally, many central banks in the major economies alongside their trading and financial partners have reached a multitude of currency swap agreements, (both before and after the GFC), helping to promote financial stability. In terms of individual currencies, China is promoting the RMB’s internationalization and has made notable progress, while Russia is actively promoting the Rupee as a regional currency. These developments will likely provide the foundation for a future multi reserve currency system.

However, it is clear that the reform of the international monetary system reform still has a long way to go. There are too many divergent interests involved, and the global financial system is highly complex. In March 2011, France, this year’s chair of the G20, and China, co-sponsored a conference on international monetary reform, but a significant outcome has yet to be produced nor have any governmental agreements been made.

II. Major Issues That Should be Resolved In Further Reform

Although the reform of the international financial system has achieved great progress since the GFC, there are still many major issues to be resolved.  

1. Reform of International Monetary System

International reserve currencies, the exchange rate system, and adjustment measures for balance of payments are three “pillars” supporting the international monetary system. Given present conditions in the current international monetary system, all the three “pillars” are facing serious problems. 

Firstly, diversification in international reserve currencies is a slow process, and the US dollar remains the major international reserve currency. The growth of the Euro, the Japanese Yen, and the Pound does not alter the US dollar’s status as the major international reserve currency. The US dollar currently makes up 60% of all international reserve assets5. Without sticking to the gold baseline, the United States pursues an over-generous monetary policy in order to stimulate economic growth in recent years. After the international financial crisis, the Unites States put forward two rounds of quantitative easing, leading to a rapid increase in the amount of currency issued and to the level of excessive liquidity in the world as a whole. In such conditions, it is becoming increasingly difficult to stabilize the value of the US dollar. It has been suggested that the US dollar’s status as the international reserve currency should be substituted by SDR6, however, there are also practical difficulties in implementing this shift. Currently, the only practical method is to push forward the diversification of international reserve currencies. The development of multi-reserve currencies, including the RMB, will resolve many difficulties that the international monetary system is facing. 

Secondly, a floating exchange rate system leads to general instability in the exchange rate system as a whole. Although a floating rate can be helpful for many countries in achieving equilibrium of supply and demand in foreign currencies through market forces, and is helpful in adapting to an ever-changing world economy overall, due to the frequent and considerable fluctuation of exchange rates among major international currencies, this system can also lead to a lot of uncertainty, increase risks, and subsequently block international trade and investments. 

Thirdly, adjustment measures for balance of payments are currently inefficient, and the disequilibrium in the balance of payments on a global scale is of serious concern. International balance of payments is directly related to the stability of global economic development. Since the late 1990s, the current account surplus in emerging markets has been increasing, while the current account deficit in the United States has been increasing. This indicates that the global imbalance of payments has not only yet to be resolved, rather it has worsened. The major reason behind this phenomenon is that each of the measures employed to adjust the balance of payments are flawed to varied degrees. Specifically, the function of exchange rate system is deficient, interest rate adjustments have many side effects, the liquidity in international commercial financing is too high, and IMF loan conditions are too harsh. These measures have greatly reduced the efficiency of attempting to balance current accounts, and have made the global disequilibrium even more polarized.  

2. Reform of International Financial Institutions

The Bretton Woods regime, the World Bank and the International Monetary Fund (IMF) have some inherent shortcomings in their design. After the international financial crisis, the World Bank and the IMF underwent a number of reforms. However, representation of developing countries remains an issue. Thus, it can be said that the World Bank and the IMF have failed to fulfill one of their core global functions. 

Firstly, the decision making mechanisms in the World Bank and IMF are unfairly dominated by a few countries, such as the United States. This situation is sharply pronounced in the distribution of voting power among member states. After some reform, ratios in the voting rights of developing countries versus developed countries were 47.19:52.81 and 42.3:57.7, respectively developed countries enjoy a clearly dominant position, with the United States occupying a hegemonic status, with a 15.85% voting share in the World Bank and a 16.74% voting share in the IMF7. As decision-making rights are effectively determined by voting rights, the excessive concentration of voting power in developed countries has actually granted them a veto right. According to both the World Bank and IMF charters, adoption of any resolution needs a simple majority of the voting rights, and major resolution needs more than 85% of the voting rights. So, the United States’ voting share allows it virtual veto power in both institutions. This counteracts the principle of sovereign equality, “one country, one vote”, upon which both organizations were founded. Further troubling, the mechanisms for selecting senior managers in these institutions are not transparent, and lack standard criteria and a measure of bureaucratic process. It is commonly accepted that the President of World Bank will always be an American national, and the same is true of the IMF head being a European. Positions of senior managers in the two institutions are also dominated by U.S. and European citizens, further challenging adequate representation of developing countries. 

Secondly, IMF is still short on funding. IMF funds depend member country contributions, since the IMF does not issue currencies. When the resources of the IMF are limited, it cannot play its international role effectively.

Thirdly, as products of the obsolete Bretton Woods System, these two institutions should conduct thorough internal and external reform in order to adapt to current global economic and financial redistributions, starting from reforms of charters. The World Bank has put forward a plan to amend its charter, but IMF has not.

3. Reform of International Financial Regulation

International financial regulation is a key area where reforms were made after the international financial crisis; however there are still some areas that need to be improved. 

Firstly, a prudent macro management system weakly exists and should be further strengthened. The financial system normally carries with it inherent systematic risks. Even if an institution employs its own risk management, general risk to the international system may still exist. So, once problems arise in a single institution, it could impact the financial industry as a whole. Before the 2008 crisis, financial supervision focused on the micro level alone, neglecting to assess the systematic impacts. Different from micro supervision, prudent macro management takes into account all kinds of financial institutions, and measures the risks of the whole global financial system with respect to real GDP, thereby seeking to avoid instability resulting from a single financial institution. There is significant room for improvement in this area globally.

Secondly, key international financial supervision institutions have functional absence and dislocation. The existing international financial supervision institutions mainly comprise the IMF, the World Bank, the Basel Committee, and the Financial Stability Board (FSB). Due to functional absence and dislocation, these institutions failed to play their role as global economic supervisors effectively. For instance, the IMF has set up a series of prerequisites for emerging markets on capital control, including the stipulation of no artificial undervaluation of exchange rates, no excess in foreign reserves, and restrictions on reductions of interest rates in quickly-growing economies, etc. These prerequisites create new pressures on capital controls, rather than encourage capital control for many countries such as China. Furthermore, the IMF heavily scrutinizes capital inflows, more substantially experienced in emerging markets, while continues to have more relaxed standards for monetary policies promoting short-term capital out-flow countries, i.e. developed countries. This demonstrates IMF’s “crippled” macro supervision.

Lastly, global financial supervisory institutions lack cohesion and effective coordination amongst each other. The FSB now attaches significant weight to the standardization of financial norms and international cooperation. However, for norms such as the capital adequacy ratio and liquidity ratio, uncertainty over who is responsible for oversight still exists. The FSB did put forward sound ideas on global financial networks and financial intermediaries, but it is still unclear how these systems will operate. Now, international cooperation of financial supervision is suffering from a lack of global coordination between organizations, and agreements of supervision cooperation are not strictly binding. 

4. The Inherent Relationship among Major Issues

The major problems faced in addressing the international monetary system, international financial institutions, and international financial supervision are not independent from each other, but are in fact highly related. 

For example, the flawed international monetary system leads to difficulties in international financial supervision. The most obvious evidence for this is when, due to the lack of effective regulation, floods of the US dollar resulted in excessive global liquidity. The global supply of US currency was magnified, causing asset bubbles and ultimately ending in a financial crisis. Another example is how the lack of international financial supervision enables more international financial institutions to be negligent and irresponsible. International financial institutions, such as the IMF, did not regulate international financial markets sufficiently, leading to an excessive amount of risk accumulating in the international financial system, and causing a global crisis in 2008. 

So the connectivity between the international monetary system, international financial institutions, and the international supervision system must be taken into account when pursuing further reforms in the global financial system.

III. Views Regarding Further Reform of International Financial System

1. Deepening Reform of International Financial Governance

In 2010, the reform of IMF governance experienced great success. However, the draft adopted by the IMF Board of Governors on quota and governance reform is still awaiting the approval of member countries, which requires domestic legal approval before it can finally become a part of the IMF legal documents. Up until mid-April, only ten countries had approved this reform draft at home. The IMF and its member countries need to make a greater effort to push for approval of this draft before the 2012 IMF Annual Meeting. Some officials from emerging market economies also complained about the continuation of the major defect in the IMF governance, since the substantial asymmetry in distribution of quota and voices still exists. 8As for IMF personnel composition, it’s generally agreed upon that the selection of IMF senior officials should be made through an open and merit-based process, but greater efforts should be made to increase the diversity in nationalities of IMF staff. It’s also emphasized by developing countries that in addition to the tangible discriminatory treatment, there should be more efforts in removing the intangible “glass ceiling” impeding the further promotion of staff from developing countries.

 Following the discussion on indicative guidelines at the meeting of the G20 finance ministers and central bankers, the IMF will play a crucial role in monitoring the indicators contained within the indicative guidelines. Nonetheless, there is a critical disagreement over the major issues that should be targeted by the IMF monitoring system amongst member countries. In the view of developed economies, such as the US, IMF monitoring should mainly address any restrictive policies implemented by emerging economies on exchange rates and capital accounts, as well as the issue of foreign reserve accumulation, (thought to be a major cause of the global trade imbalance). Emerging market economies, on the other hand, have a different interpretation. In their view, the IMF needs to continue to increase the fairness and effectiveness of its monitoring. It should focus on the prevention of disorderly flows of international capital, which has caused instability in capital markets and excessive fluctuation of exchange rates in emerging market economies. The IMF should also be tasked with keeping close watch on any macroeconomic policy changes in major reserve currency issuance countries, so as to prevent and constrain them from causing too many spillover effects. It has also been proposed that in order to avoid the negative impacts brought about by disorderly international capital flows, developing countries would be authorized to take restrictive measures on the capital account.

2. Improving International Financial Regulation

First, this topic is concerned with international regulatory coordination and cooperation. Advanced economies have strongly argued for uniformity in regulatory rules and practices in different jurisdictions. The charge has been that there is a phenomenon of “forum shopping” due to the differences existing in different regulatory jurisdictions. Many financial institutions choose to register in countries or regions with lax regulatory rules, especially in some tax havens. After the G20 London Summit, the new Financial Stability Board (FSB), the IMF, and the Basel Committee together became the major institutions responsible for the unification of international financial regulatory rules. The FSB has issued some draft rules on the identification and prevention of systemic risk as well as the regulation of systematically important financial institutions (SIFIs). The Basel Committee also published the BASEL III document. With respect to the regulation of Global SIFIs and other financial institutions, it’s proposed that there should be close cooperation among the regulatory authorities of various countries, especially in terms of information exchange on regulatory practices and taxation, etc. Recently, Macao SAR government and seven countries in northern Europe signed the ‘Agreement on Taxation Information Exchange’, which demonstrates new developments in this area. Another proposal regarding transnational financial taxation has also received a lot of attention. The advantage of an international tax on the financial sector is twofold: on the one hand, it will help collect funds for future bailouts of financial institutions, and on the other hand, through the introduction of such kind of self-insurance measures, it will help mitigate risk-taking behaviors of financial institutions. Yet, people against this proposal believe that this measure would impose too great of a burden on financial institutions and further weaken the competitiveness of the banking industry. With the existence of policy differences among various countries, this may also bring about a competitiveness gap.

Secondly, there has been a lot of discussion about the macro-prudential policy framework. The global financial crisis triggered by the American subprime mortgage crisis demonstrated that in order to prevent systemic financial risk there should be a policy framework in place with both micro financial regulation and macro prudential supervision. The macro prudential policy framework on both a national and global level is conducive to reducing the accumulation of systemic risk and increasing the stability of the international monetary and financial system. On domestic level, besides the enhanced regulation of capital adequacy requirements, credit concentration ratios, and off balance sheet business, there also needs to be a prudential assessment of the effects of monetary and fiscal policies. There should also be adequate monitoring of international capital flows. On global level, the focus should be strengthening the IMF’s supervisory role, with the emphasis being put on monitoring early warning of any systemic risk. The IMF should keep a close watch on the macroeconomic policies of member countries and conduct its monitoring work in a balanced and comprehensive way. The IMF also needs to identify the sources of systemic risk and potential spillover effects, as well as provide effective oversight on and coordination of great volatility in global liquidity. In addition, the international macroeconomic policy coordination conducted through the G20 forum should help to promote the synergy between domestic policies and an IMF supervisory role. This may be conducive to reducing inconsistency in the macroeconomic policies of various countries and mismatches of major currency exchange rates, while also enhancing the orderly flow of international capital.

3. Pushing for Gradual Transformation of International Monetary System

Firstly, there is a lot of concern surrounding the diversification of reserve currencies. It is generally assumed that in a more diversified reserve currency system, the Dollar, the Euro and the RMB will become the three key reserve currencies. However, the prospects of this status for the latter two currencies are still uncertain. The economic problems in the Euro zone may constrain its’ capability to increase its share of global foreign reserves. The ECB and Euro zone countries have not demonstrated enough willingness to provide adequate amount of the Euro to fully perform the function of a reserve currency either. Compared with the Euro, the status of the RMB is just like a long term vision. For the time being, the RMB is still not freely convertible under the capital account, making it less viable under the requirements for inclusion into the SDR currency basket. The RMB’s share in global trade settlement and debt clearing is also very low. On the other hand, there are also a number of people who doubt the advantages to having multiple reserve currencies. They believe that this competitive reserve currency system will instead increase the turbulence in international foreign exchange markets.

 As for the role of SDR, a recent development is the 750 billion dollars in extra funding through the SDR and bond issuance by the IMF in accordance with the G20 London Summit’s Declaration. The enlargement of the scale of the SDR will to some extent strengthen its supplementary role to foreign exchange reserves. Yet, the two inherent shortcomings of the SDR may greatly constrain its future role. On the one hand, as a supranational currency managed by an international organization, the SDR has neither the guarantee of such precious metals as gold and silver, nor the support coming from the national wealth of sovereign states. Therefore, it lacks the primary credit base. On the other hand, the issuance system of the SDR also faces a legitimacy problem, which may provoke conflict between developed and developing countries where the criteria or standards for issuing SDR is concerned.

In the wake of the Asian financial crisis, in order to tackle the volatility in international capital flows as a result of the changes in American economic policies, non-reserve currency countries had to accumulate huge amounts of Dollar reserves. With emerging market economies as the example, many countries increased their Dollar reserve as a means of self insurance against the risk of sudden stop and capital flight. There are now two proposals presented for lowering the tendency and necessity of such kind of self insurance. The first idea is about a global financial safety net covering multiple levels of financial framework. On the global level, the IMF is considered the core institution of global cooperation. Its new lending instruments, such as the Flexible Credit Line (FCL) and Precautionary Credit Line (PCL), have to a large extent nullified the conditionality requirements from relevant member countries, which have satisfied the demand for liquidity financing of member countries under emergency. On a regional level, the European Financial Stability Facility that is currently at work and the permanent European Stability Mechanism that will be in place after 2013 will both important impacts. One is to stabilize market confidence, and another is to enforce a certain measure of fiscal discipline through conditionality requirements. The nascent East Asian Foreign Reserve Pool also provides institutional assurance for crisis bailouts. Beside this, the wide range of bilateral currency swap agreements has also increased the guarantee of financial security in of a lot of countries. The second proposal is to set up a substitution account in order to address the issue of accumulation in foreign reserves. This is a previous suggestion which has gained new ground. According to this proposal, member countries may voluntarily deposit their foreign reserves into a substitution account, to be provided by the IMF, which will then accumulate interest (based on a certain benchmark). The member countries can use the amount of money deposited in the account (and denominated in SDR) in order to address the problems existing in their balance of payments. The essence of this substitution account lies in gradually reducing the amount of accumulated foreign reserves.9 However, there are two preconditions implicit in this proposal. First, there must be a level of mutual trust between the IMF and its member countries. This requires IMF governance to be legitimate, fair, and effective. Second, the issuance of SDR should be at such a scale as to be enough to match the scale of global foreign exchange transactions.

Another related issue is the enhancement of regional financial cooperation in order to address financial risk. The current debate on global imbalances mainly focuses on the imbalance between the US and East Asian economies. The root cause of this imbalance lies in the Dollar’s dominance and the lack of an Asian exchange rate coordination mechanism or adequate financial integration. Foreign trade with East Asian economies is mainly conducted with the Dollar, a major reason behind the high accumulation of Dollar reserves in this region. Therefore, it’s generally acknowledged that the issue of external imbalance should be tackled through advancing the East Asian monetary system and improving overall financial integration. Currently, the amount of intra-Asia trade only accounts for about a half of total trade amount of the Asian economies. However, if the currencies inside this region could play a more active role, the intra-Asian trade share would be increased and the dependence on the markets out of Asian region would then be decreased.10 The East Asian economies should seize the opportunity provided by the setup of the East Asian Foreign Reserve Pool in order to further the formation of a certain kind of exchange rate arrangement among major currencies in this region. This will be conducive to reducing regional foreign exchange rate fluctuation. It could also reduce the dependence of East Asian economies on the Dollar for trading purposes. For this vision to come to fruition, China, Japan, and South Korea must take the lead in adopting these policies. 

IV. Policy Advice for China’s Participation in the Reform of International Financial System

There are two strategic goals for China’s participation in the reform of international financial system. One is to ensure global economic stability for its sustainable domestic development. Deeply integrated into the global economic system, China has developed into the largest trader of commodities, the largest holder of foreign reserves, and the second largest host state of FDI. A stable global financial system is critical for China’s economic transformation and growth. The other goal is to strengthen its position in global economic governance, helping to provide for a systemic framework that is conducive to strong, balanced and sustainable growth of the world economy. China has been the largest contributor to global economic development since 2007, and surpassed Japan to be the second largest world economy in 2010. A stable and prosperous world is now impossible without China. With increased voting rights in international economic organizations, China is faced with higher expectations and demands from international society, including both advanced and developing countries. It is of significant importance for China to think about how to respond to its new position, especially on how to safeguard the interests of the developing world and project its image as a preeminent power. This will help shape the prospects of both China’s economic development and the trajectory of the global economy. Policy advices are as follows:

1. Platform and Principle: G20 as the premium forum for a win-win outcome

Firstly, with the increasing diffusion of global power, any reform of international institutions would be impossible without positive cooperation between both established and emerging members. Thus, there is a need to accommodate the interests of all stakeholders. All countries should avoid confrontation and seek commonalities in their long-term strategic goals. Secondly, the macro-economic policy coordination mechanisms established post-financial crisis should be maintained and strengthened. As the inherent defects of the current international monetary system cannot be surmounted overnight, the G20 as the platform for short run economic coordination between major powers should be further strengthened. Thirdly, the G20’s vitality as the “premium platform” for global economic policy coordination in the post-crisis era depends on its efforts and achievements in pushing the long-term reform of international financial system. 

2. Pushing further reforms of international financial institutions

Firstly, the function of the IMF and other international financial institutions needs to be clarified and redefined. The IMF’s role in monitoring and providing early warning of systematic risks should be strengthened, covering macroeconomic policies of both developing and developed countries, especially the issuers of major international reserve currencies. Secondly, recruitment of personnel needs to be more diversified and performance-based so as to allow greater access for people of emerging and developing countries to obtain higher executive and professional positions. Thirdly, in keeping with the progress already achieved in the G20, quota and voting rights need to be reviewed periodically so as to reflect the changing dynamics of global economic power structures. Fourth, efforts also need to be made to increase the resources of international financial institutions and improve their conditionality clauses for providing bailouts and for providing cushions against external financial risks for weaker economies.

3. Enhancing regulation of international financial markets in an effective and coordinated way

Firstly, pushing forward global coordination and cooperation in setting and implementing global financial regulatory standards, avoiding the damages of regulatory competition on global financial system. Secondly, strengthening regulation on systematically important financial institutions, credit rating agencies among others. Thirdly, strengthening regulation on international hot money for a healthier development of emerging markets and the world economy. In the meanwhile, country variations should be taken into consideration when balancing between financial innovation and government regulation. For the United States and Europe, heavily impacted by the financial crises, the emphasis now is on how to strengthen financial market regulation. For China and other developing economies, on the other hand, financial markets are under-developed and in need of more innovation. This said, there are important regulatory lessons to be learned for all countries from the financial crisis. 

4. Promoting substantial progress in the reform of the international monetary system

Firstly, in order to promote diversity in international reserve currencies, there needs to be a more active role for the Euro and other currencies in stabilizing the international financial system. Secondly, in order to promote further discussions on the SDR, including its role, size, and conditions for new candidate currencies to join in the basket, etc., input from all parties should be considered. Thirdly, in order to promote the internationalization of the RMB, including realizing an orderly opening up of the RMB under capital account, the following steps should be taken: furthering the reform of the RMB exchange rate formation mechanism, expanding the number of international transactions conducted in RMB, facilitating FDI of Chinese enterprises in RMB, and increasing international sales of financial products in RMB. It would also be beneficial to consolidate HK’s status as the offshore financial center of the RMB. Overall, improving the domestic environment for the financial industry’s development and transforming Shanghai into an international financial center will help China to achieve internationalization of the RMB. The RMB as a key currency around the globe is the best defense for China against the risks posed by the international monetary system. Furthermore, the rise of the RMB is conducive to diversification and stability of the international monetary system.

5. Strengthening regional and bilateral financial cooperation in Asia as a crucial part of the global financial safety net

China’s first goal should be to expand and deepen East Asian financial cooperation. Catalyzed by the 1997 Asian financial crisis and the 2008 global financial crisis, financial cooperation in the East Asia has been institutionalized with a rudimentary framework. In the future, greater efforts are needed in order to improve the operational mechanisms of the foreign exchange reserve pool. Cooperation should also be expanded and deepened by establishing a foreign exchange coordination mechanism within the greater China Group and between China, Japan and Korea, which would be the Asian leg of the global financial safety net. The newly announced ASEAN 3 Macroeconomic Research Office (AMRO) could also serve as a primary platform for Asian financial cooperation. Deeper financial cooperation could possibly break the stalemate of the whole East Asia regional cooperation. Secondly, bilateral financial cooperation with other countries should also be encouraged, e.g., signing bilateral currency swap agreements with BRICS countries and other major trading partners. More coordination with the IMF is also needed to assure complimentarity and mutual benefit, as opposed to conflict between global and regional/bilateral financial cooperation.  

Project Director

YANG Jiemian, President of Shanghai Institutes for International Studies (SIIS)
Project Participants (Alphabetical Order)
LIU Zongyi Institute for World Economy Studies, SIIS
XUE Lei Institute for World Economy Studies, SIIS
YE Yu Institute for World Economy Studies, SIIS
ZHA Xiaogang Institute for World Economy Studies, SIIS
ZHANG Haibing Institute for World Economy Studies, SIIS 
（2011 Shanghai Institutes for International Studies. All rights reserved. ）