Challenges for the G20: The IMF and regulation
There are many important challenges facing G20 leaders when they meet in London in early April.
The first is to coordinate sufficiently large fiscal and other measures to ensure that world aggregate demand recovers, and a major recession is avoided.
It is also crucial that concrete measures are taken that will allow developing countries, especially those that may become foreign-exchange constrained, to sustain growth. This will not only be key for avoiding a large slowdown in growth and increase in poverty in those countries, but also to guarantee important demand for developed country exports. It is estimated that around 200 million people could be pushed into poverty, mainly in developing countries, if rapid action is not taken to soften the impact of the crisis on those countries.
QUICKLY REFORM THE IMF’s COMPENSATORY FINANCING
The calls for significantly expanding the resources of the International Monetary Fund (IMF) by several G20 leaders are welcome. One effective way of doing this would be through a counter-cyclical expansion of official liquidity, by a one-off, large issue of IMF Special Drawing Rights (SDRs). This would compensate for the large contraction of private liquidity, which has resulted in a sharp fall in private capital flows to developing countries. Once the situation normalizes, the SDRs could be reabsorbed by the IMF. The major objection to SDR issues in the past has been the threat of inflation. It has no validity at present. The dominant threat is of deflation and recession.
A complementary or alternative measure is for the IMF to modify its facilities so it can lend rapidly, at sufficient scale, and without overburdening borrowers with the heavy conditionalities of the past, especially when the sources of crises are exogenous.
Thus, there should be a major and quick reform of IMF compensatory financing .This has become urgent, given recent very sharp falls in commodity prices, with highly negative effects, especially on low income countries. Existing facilities for those countries are clearly insufficient, especially as regards the scale of their lending. It is therefore urgent to scale up these facilities.
The recent creation of a new IMF Short-Term Lending Facility (SLF) for countries with good policies facing short-term liquidity constraints is welcome. As yet, no country has used it. It may need modifying to extend its very short maturity and to make it accessible to a larger group of countries.
It is also important that aid to low-income countries is increased. Furthermore, multilateral and regional development banks need to rapidly and greatly expand their lending.
CORRECT THE REGULATORY DEFICIT OF GLOBAL FINANCE
The magnitude of the current crisis is clearly associated with inadequate regulation of banks and financial markets.
The new regulatory governance should be based on a well-functioning network of national authorities and include truly international regulation of global financial institutions . A global financial regulator needs to be created, building on institutions like the Bank for International Settlements.
This new institutional structure should have real power to influence decisions of national regulators, especially in the largest countries, including industrial countries. Secondly, it should take macro-prudential concerns clearly into account. Finally, it should consider the potential costs of financial instability on the real economy.
The current deep crisis and numerous previous ones that hit developing countries seem to demonstrate that crises are inevitable in deregulated financial systems. There is, therefore, ever-growing consensus that more complete and more effective financial regulation is required.
There are two broad principles on which future financial regulation needs to be built. The first is counter-cyclicality, in order to correct the main market failure of banking and financial markets — their boom-bust nature. The key idea is that provisions and/or capital required should increase as risks are incurred, that is, when loans are disbursed. In this way, provisions and capital requirements should increase during periods of rapid credit growth and decrease when lending expands at slower rates. This would strengthen banks in boom times and discourage them then from excessive lending. It would also make it easier for them to continue lending in difficult times. It is encouraging that the Basle banking Committee has recognized this principle in broad terms.
The second key principle for modern, effective regulation should be comprehensiveness. Economic theory tells us that for regulation to be effective, the domain of the regulator has to be the same as the domain of the market to be regulated. There is need for comprehensive and equivalent transparency, as well as regulation of all financial activities, instruments, and actors. Both minimum liquidity and solvency requirements need to be regulated.
Ensuring enough demand globally and in developing countries is crucial to avoid a large recession in the near future. Appropriate regulation of the financial sector is key to avoid future costly crises. Both tasks are difficult, but essential.