Reserve Reform

NEW YORK – Both China and the United Nations Commission on Reforms of the International Monetary and Financial System have called for a new global reserve system. That issue should be at the top of the agenda when the IMF’s International Monetary and Financial Committee next meet.

The essential idea is quite simple: in the long run, an international monetary system cannot be built on a national currency – a point made a half-century ago by the Belgian-American economist Robert Triffin. Recognition of this fundamental problem was the reason why the IMF’s Special Drawing Rights (SDRs) were created in the 1960’s.

The dollar standard with which the world has lived since the early 1970’s has three fundamental flaws. First, as with all systems that preceded it, it puts the burden of adjustment on deficit countries, not on surplus countries. The main exception is the United States, which, thanks to its reserve currency status, has so far been able to finance its deficit by issuing dollar liabilities that are held by the rest of the world.

Second, the system is unstable, because it makes the major reserve currency’s value dependent on US macroeconomic policy and the vagaries of the US balance of payments and associated domestic deficits. Since the abandonment of gold-dollar parity in 1971, the world has experienced increasingly intense cycles in the value of the dollar and the US current account. The dollar has lost what any reserve asset should have: a stable value. The governor of China’s central bank recently emphasized this basic point.

Third, the current system is inequitable, because it forces a transfer of resources from developing countries to the industrial nations that provide reserve currencies. This transfer has dramatically increased over the past two decades. Developing countries’ main defense against world financial instability has been to accumulate international reserves.

At the end of 2007, developing countries, excluding China, held reserves equivalent to 20.6% of their GDP, compared to just 3.7% in 1990. This generated a huge asymmetry in the world economy, as industrial countries, excluding Japan, hold only 2.6% of GDP in reserves. One basic reason is that the only “collective insurance” available is limited and highly conditional IMF lending.

It must be emphasized that a system based on competing reserve currencies would not solve the instability and inequities of the current system. In fact, it would add another one: the instability of the exchange rates among major reserve currencies. Indeed, this problem is already present in the current system.

The deficiencies of current arrangements are why the world monetary system should be based on a truly global reserve currency: a fiduciary currency backed by the world’s central banks. This is what was hoped for when SDRs were created in the 1960’s, and this process must be completed by transforming the SDRs into such a global currency.

A major advantage of an SDR-based system is that it would provide a mechanism for the IMF to provide finance with its own resources in an agile way during crises, thus operating in the same way as central banks have been doing on a massive scale in recent months. It would also be a much better mechanism with which to finance the IMF during crises than the credit lines to the IMF from a few countries (“arrangements to borrow”) that the G-20 is again advocating, as it is truly multilateral financing that does not depend on any individual country.

For such a program to work, it is essential that developing countries recognize that IMF financing is good “collective insurance,” so that their demand for foreign-exchange reserves would decline. This means that the IMF would have to lend rapidly during balance-of-payments crises, and do so without the overburdening conditionality of the past, particularly when crises stem from rapid reversal of capital flows or a sharp deterioration in terms of trade.

The IMF took steps in this direction in March, particularly by creating the Flexible Credit Line for crisis-prevention purposes, as well as expanding other credit lines and overhauling conditionality (relying more on ex-ante conditionality and eliminating structural performance criteria). The major problem with the new credit line is that it runs the risk of unduly dividing developing countries into two categories, with significant additional risks for the latter.

A better alternative would be to go back to John Maynard Keynes’s proposal of an overdraft (or, in IMF terminology, drawing) facility for all member countries, with countries that continue to use it eventually having to apply to a formal lending program. The overdraft facility could again be financed with counter-cyclical issues of SDRs.

The reform should also allow for a mechanism for countries to exchange their current dollar (and euro, yen, and pound) assets for SDRs, thus avoiding the disruptions that could be generated by the transition to the new system. As Fred Bergsten has reminded us, the mechanism is already available in the form of the “substitution account” that was negotiated in the IMF in 1980.

It is time to broaden the agenda of global financial reform, which so far has focused on an essential but still limited set of issues, particularly financial regulation. Reform of the global reserve system must be part of that broader agenda.