The international monetary and financial system

Abstract

The suitable design of international monetary and financial arrangements for the global economy is a long-standing issue. A key shortcoming of the existing system is that it tends to heighten the risk of financial imbalances, leading to booms and busts in credit and asset prices with serious macroeconomic consequences. These imbalances often occur simultaneously across countries, deriving strength from international spillovers of various types. The global use of the dollar and the euro allows monetary conditions to affect borrowers well beyond the respective issuing economies. Many countries also import monetary conditions when setting policy rates to limit interest rate differentials and exchange rate movements against the major currencies. The global integration of financial markets tends to reinforce these dynamics, by allowing common factors to drive capital flows and a common price of risk to move bond and equity prices. Policies to keep one's own house in order by managing financial cycles would help to reduce such spillovers. In addition, central banks need to better internalise spillovers, not least to avoid the effects of their actions spilling back into their own economies. Moving beyond enlightened self-interest would require international cooperation on rules constraining domestic policies.

Full text

The suitable design of international monetary and financial arrangements for the global economy is a long-standing issue in economics. Putting in place mechanisms that facilitate the achievement of sustained, non-inflationary and balanced growth has proved elusive. In the wake of the Great Financial Crisis, the issue has again gained prominence on the international policy agenda.

Just as in the past, however, there is little agreement on what the key shortcomings of the current international monetary and financial system (IMFS) are, let alone on what to do about them. A common diagnosis has been that the system is unable to prevent the build-up of unsustainable current account imbalances and that this, in turn, has induced a contractionary bias: surplus countries have no incentive to adjust, while deficit countries are forced to do so. Indeed, current account imbalances have been a focus of G20 cooperative efforts.

This chapter provides a different perspective, by arguing that the main shortcoming of existing arrangements is that they tend to compound the weaknesses of domestic monetary and financial frameworks ("regimes"). In particular, the IMFS tends to heighten the risk of financial imbalances - that is, unsustainable credit and asset price booms that overstretch balance sheets and can lead to financial crises and serious macroeconomic damage. These imbalances occur simultaneously across countries, deriving strength from global monetary ease and cross-border financing. Put differently, the system exhibits "excess financial elasticity": think of an elastic band that can be stretched out further but that, as a result, eventually snaps back all the more violently.¹

The chapter is structured as follows. After outlining the key features of the IMFS, the first section explains and documents how the interaction of domestic monetary and financial regimes increases financial imbalances. It highlights several factors: (i) the role of monetary areas that for the key international currencies (notably the US dollar) extend well beyond national borders; (ii) the limited insulation properties of exchange rates, which induce policy responses designed to avoid large interest rate differentials vis-à-vis the main international currencies; and (iii) the powerful waves generated by freely mobile financial capital and global liquidity, which wash across currencies and borders, carrying financial conditions across the globe. The second section considers possible solutions. It highlights the need to adjust domestic policy frameworks and to strengthen international cooperation, going beyond the own-house-in-order doctrine.

The IMFS: main elements and weaknesses

Main elements

The IMFS comprises the arrangements governing transactions in goods, services and financial instruments among countries. Today, it consists of a set of domestically oriented policies in a world of largely free capital flows. Domestic monetary regimes focus mainly on price stability, while currencies are allowed to float to varying degrees: free floating among the principal international currencies coexists with greater or lesser management of other currencies. Financial regimes generally allow funds to move freely across currencies and borders, although some countries still impose restrictions. The main restraint on financial transactions takes the form of prudential regulation and supervision, in part based on internationally agreed standards.

Current arrangements differ markedly from the previous system, Bretton Woods (1946-73). At the time, the US dollar's convertibility into gold served as an external monetary anchor, and currencies were tied together through fixed but adjustable exchange rates (Table V.1). Domestic monetary regimes in general gave less priority to price stability and more to external balance and demand growth. While the anchor ultimately did not prove that strong, the arrangements contrast with present ones, in which the aggregation of monetary policies pursued under domestic mandates acts as the only overall constraint. During the Bretton Woods era, the leading international currency was the dollar, which now shares this role to some extent with others, mainly the euro. And international capital mobility was quite limited, reflecting a myriad of restrictions on "repressed" domestic financial systems.

The performance of the two systems has differed markedly as well. Bretton Woods did not see major episodes of financial instability, but eventually proved unable to ensure lasting global monetary stability. It broke down once the United States formally abandoned gold convertibility and exchange rates were allowed to float. Current arrangements have succeeded in promoting price stability more than financial stability.

Arguably, this is no coincidence. The 84th Annual Report, as further elaborated in other chapters of this Annual Report, explored why domestic monetary and financial regimes have so far been unable to ensure lasting financial stability. But their interaction through the IMFS has also played a role, by compounding rather than limiting the weaknesses of domestic regimes. Consider, in turn, the interaction of monetary and financial arrangements.

Interaction of domestic monetary regimes

The interaction of monetary regimes spreads easy monetary conditions from core economies to the rest of the world. The international use of reserve currencies does so directly, and the strategic conduct of monetary policy does so indirectly. Take each in turn.

The reliance on a single global currency has diminished slowly since Bretton Woods, but the US dollar continues to play a dominant role in international trade and finance, alongside the euro. As a means of exchange, the dollar is on one side of no less than 87% of foreign exchange market transactions (Table V.2), with an even higher share of forward and swap transactions. Its dominance in foreign exchange markets makes the dollar the sole intervention currency outside Europe and Japan, which supports its high share in foreign exchange reserves. More than half of world trade is invoiced and settled in dollars, pointing to the greenback's pre-eminent role as a unit of account.

Remarkably, the advent of the euro and the dollar's trend depreciation since the 1970s have not materially challenged the dollar's role as a store of value (Graph V.1, left-hand panel). At 63%, it maintains almost three times the share of the euro in foreign exchange reserves. Its share in both official reserves and private portfolios is sustained by the scale of what can be termed the "dollar zone" of economies whose currencies move more closely with the dollar than with the euro (Box V.A). At half or more of world GDP, the dollar zone is far larger than the US economy, which is less than a quarter.

Monetary policy settings for key international currencies influence financial conditions outside these currencies' home jurisdictions directly through their impact on interest rates and the valuation of assets or liabilities denominated in these currencies but held or owed by non-residents. In particular, dollar and euro credit to non-bank borrowers outside the United States and euro area stood at $9.5 trillion and €2.3 trillion ($2.7 trillion), respectively, at end-2014. The dollar debt represents a seventh of global GDP outside the United States (Box V.B).

The large stocks of dollar- and euro-denominated credit extended to borrowers outside the United States and the euro area, respectively, mean that Federal Reserve and ECB policies are transmitted directly to other economies. The impact depends on the characteristics of the instrument in question, notably its maturity and the flexibility of the corresponding interest rate. For instance, in the case of bank loans priced off of dollar Libor or Euribor, changes in short-term policy rates pass through within weeks. Over half of dollar and euro credit to borrowers outside the United States and euro area remains in the form of bank loans.

The pass-through is slower for bonds, given their generally fixed rates and longer maturity, but then quantities can respond too. In particular, some stocks of dollar bonds have changed quite markedly in response to unconventional monetary policy (Chapter IV). Low yields reflecting the Federal Reserve's large-scale purchases of Treasury and agency bonds, among other factors, led US and global investors to seek yield in lower-quality bonds. The impact was especially pronounced for non-US borrowers, who between 2009 and 2014 ramped up their dollar bond issuance by $1.8 trillion (Graph V.2, left-hand panel). Investor demand for such bonds proved highly responsive to the compression of the term premium, as measured by the spread between Treasury bond yields and expected bill yields: the lower the premium, the faster the growth of dollar bonds issued by non-US borrowers (hence the negative relationship after the first quarter of 2009 seen in the right-hand panel of Graph V.2).

By the same token, the recent ECB large-scale bond purchases and compression of term premia on euro-denominated bonds raise the question of whether borrowers outside the euro area will take advantage of the funding opportunity. In fact, by the end of 2014 the stock of euro bonds issued by such borrowers was already growing as fast as its dollar counterpart.

Post-crisis, offshore dollar credit has grown fastest in those jurisdictions where it has been cheapest relative to local funding, especially emerging market economies (EMEs).² Authorities around the world use capital controls or macroprudential policy to raise the cost of dollar borrowing at home, but their policy reach does not extend to activities of multinational firms, which can borrow dollars (or euros) offshore to sidestep tight domestic funding conditions. This is one reason for the rapid growth in various quantitative measures of "global liquidity", which denotes the ease of financing in global financial markets (Box V.B).

Monetary regimes also interact indirectly, through central bank responses to each other's policies. Central banks seem to set their policy rates with an eye on those of the Federal Reserve or ECB. This behaviour is sometimes explicitly noted, as in the cases of the Central Bank of Norway and the Swiss National Bank with reference to ECB policy, but appears to be widespread.

One reason is to limit exchange rate movements. Exchange rate flexibility has often been described as insulating the domestic economy from external developments, but this insulation is often overstated. In particular, appreciation can lead lenders to consider firms with debts denominated in foreign currency as better capitalised and therefore more creditworthy, reducing perceived risks associated with lending and increasing the availability of credit.³ Through this and other mechanisms, such as carry trades and momentum trading, currencies can overshoot, shrinking the traded goods sector and leaving the economy vulnerable to a turn in the ease of global financing. Then, depreciation can lead to financial distress among firms with foreign currency debt. During the dollar's downswing from 2002 to 2011 (with an interruption in late 2008), many central banks resisted unwelcome appreciation against the dollar, in setting their own policy rates and by intervening in the currency market.

Indeed, many countries - not only EMEs but also advanced economies - appear to have kept interest rates below those that traditional domestic benchmarks would indicate, partly in response to low rates in core currencies. In the 1990s, policy rates were broadly in line with the Taylor rule, a simple interest rate rule prescribing a mechanical reaction to the output gap and the deviation of inflation from target. In the early 2000s, however, actual policy rates drifted persistently below the levels implied by the Taylor rule, suggesting that monetary policy became systematically accommodative (Graph V.3). Many advanced economies apparently hesitated to raise interest rates during the boom, and have maintained them near zero since the crisis. For their part, EME authorities appear to have set policy rates low out of concern over capital flows and appreciation (Graph V.3, right-hand panel). The empirical significance of US interest rates in influencing policy rates elsewhere provides additional evidence for follow-the-leader behaviour (Box V.C). While this simple exercise has important limitations, it points to competitive easing as a way of sustaining external demand. More than 20 central banks have eased monetary policy since December 2014, some explicitly responding to external conditions (Chapter IV).

Resistance to appreciation has also taken the form of currency intervention, which itself feeds back into global monetary ease. Many central banks have intervened directly in the foreign exchange market, typically buying dollars, and then investing the proceeds in bonds issued by the major governments. Unlike major central banks' large-scale domestic bond purchases, reserve managers have not sought to lower yields in the bond markets in which they invest. Nevertheless, the secular reserve accumulation and balance sheet policies of major central banks have combined to push estimated official bond holdings to more than $12 trillion out of the $31 trillion in US, euro area, Japanese and UK government bonds (Graph II.9, left-hand panel). Such holdings account for over half of the outstanding stock of US Treasury securities and more than 40% of the combined stock of Treasury and agency securities (Graph II.9, right-hand panel).

As a result, monetary policies of advanced and emerging market economies have reinforced each other. Easy monetary conditions at the centre have led to easy monetary and financial conditions in the rest of the world: there, firms and governments have boosted dollar and euro borrowing and authorities have resisted unwelcome currency appreciation. In turn, their foreign exchange intervention has raised official investment in major bond markets, further compressing bond yields there. With central banks and reserve managers bidding for duration shoulder to shoulder with pension funds and life insurers, bond yields have declined to record lows and the term premium has turned negative (Chapter II).

Interaction of financial regimes

Financial market integration has allowed common global factors to drive capital flows and asset prices. The common factors have partly shifted between the two phases of global liquidity, pre- and post-crisis.

The bank flows that dominated in the first, pre-crisis, phase of global liquidity drew on easy leverage, predictable policy rates and low volatility, as proxied by the VIX.⁴ These flows enabled domestic credit booms, freeing them from the constraint of the domestic funding base. In a sample of 31 EMEs between early 2002 and 2008, a rise in the share of cross-border bank funding, extended both directly to domestic non-banks and indirectly through banks, helped boost the ratio of bank credit to GDP (Graph V.4, left-hand panel). Banks found non-core liabilities abroad to fund booming credit at home.⁵

Analysis of a broader sample of 62 countries and a more inclusive measure of international capital flows points to a similar dynamic. Here, the larger the net debt inflows, including both portfolio and bank flows, the larger the increase in an economy's ratio of bank credit to GDP (Graph V.4, right-hand panel). The inclusion of Ireland, Spain and the United Kingdom shows that a domestic credit boom's reliance on external financing is not a symptom of financial underdevelopment. In fact, in the subsample of 23 advanced economies the reliance on capital inflows is greater than among EMEs, as the steeper fitted line suggests.

In the second, post-crisis, phase of global liquidity, the term premium on sovereign bonds has become a more important driver of funding conditions. Although cross-border bank credit has continued to expand strongly in EMEs, it has contracted sharply among advanced economies, while bond financing has surged across the board. Even as bond flows have gained prominence, the term premium has emerged as the salient global price of risk in integrated financial markets.

Studies of the spillovers across global bond markets around official large-scale bond purchase announcements have highlighted the strong co-movement of bond yields. If investors treat bonds denominated in different currencies as close substitutes, purchases in one market also depress yields elsewhere. Table V.3 illustrates this point, summarising several studies that estimate the basis point moves in various advanced bond markets that correspond to a 100 basis point move in the US Treasury market. In addition, local currency EME bonds have also co-moved much more closely with Treasuries than a decade ago.⁶

Heretofore, the relationship across even major bond markets appeared asymmetric, with US bond yields driving those elsewhere, but in the past year this seems to have changed. In particular, there are signs that the euro area bond market has been moving its US counterpart. Anticipation of ECB large-scale bond purchases put downward pressure on French and German bond yields and, through co-movement of term premia, on US bond yields as well, despite the expected divergence in policy rates (Graph V.5, right-hand panel). This contrasts with the experience in early 1994, which epitomises previous patterns. At the time, the Federal Reserve was raising the policy rate while the Bank of France and the Deutsche Bundesbank were reducing theirs, but the backup in US bond yields was transmitted to Europe (Graph V.5, left-hand panel).⁷

Current concerns

To summarise, the workings of the IMFS post-crisis have spread easy monetary and financial conditions from the reserve currency areas to the rest of the world, just as they did pre-crisis. Global financial conditions have consequently loosened to an extent that may not prove consistent with lasting financial and macroeconomic stability. Credit booms in EMEs and some advanced economies less affected by the crisis have built up tell-tale financial imbalances. In the short run, the IMFS has tilted conditions towards expansion. But in the longer run, financial busts, were they to materialise, would tilt them towards contraction.

Monetary policy divergence across key currencies and renewed dollar appreciation pose risks. Ease in the euro area might prolong global ease, if firms and governments around the world can substitute euro funding for dollar funding. However, the large stock of dollar debt outstanding means that a tightening of dollar credit is likely to prove consequential. Thus, renewed dollar strength could expose vulnerabilities (Chapter III), especially in those firms that have collectively borrowed trillions of dollars. Admittedly, it is well known that the US economy has a short position in the dollar that funds a long position in other currencies. And by the same token, the rest of the world must hold more dollar assets than dollar liabilities and thus enjoy valuation gains in aggregate when the dollar appreciates. But even in a country with a long dollar position, the distribution of currency positions across sectors matters greatly for the outcome. For example, in many EMEs the official sector has a long dollar position whereas the corporate sector carries a short one (Box V.D). Absent transfers from the (gaining) official sector to the (losing) corporate sector, the economy may well be hurt by dollar strength.

Dollar strength, monetary policy divergence and heavy official holdings in the global bond market could lead to volatility. Were EMEs to draw down reserves substantially, their selling bonds in the key currencies could create unprecedented cross-currents in global bond markets. ECB and Bank of Japan bond purchases, EME selling and, eventually, the Federal Reserve's not rolling over maturing bonds could confront the remaining private investors with a difficult and shifting problem of bond pricing.

Limits and prospects in international policy coordination

Policies to address the issues raised in this chapter require more than each country managing its inflation and business cycle. A broader notion of keeping one's house in order suggests policymakers deploy monetary, prudential and fiscal policies to manage financial cycles to ensure lasting monetary, financial and macroeconomic stability (Chapters I and IV). The resulting reduction in the frequency and depth of credit booms and busts would greatly reduce negative cross-country spillovers.

In addition, policymakers could give more weight to international interactions, including shared exposures, spillovers and feedbacks, with a view to keeping the global village in order. Policies could either seek to prevent crises, through measures to restrain the build-up of financial imbalances, or to strengthen crisis management, including through safety nets. An ounce of crisis prevention is worth a pound of crisis management: there are clear welfare benefits from reducing the incidence and severity of crises and clear limits of foresight and moral hazard in designing effective safety nets.

International policy coordination can occur at various depths. Enlightened self-interest takes international spillovers into account to the extent that they spill back on one's own economy. However, even if countries did their best individually, this would still fall short of the mark if there were significant international spillovers, as in today's era of global liquidity. Moving towards a more efficient outcome would require greater cooperation, including ad hoc joint action, and possibly even agreement on rules of the game that constrain domestic policies.

Obstacles present themselves in terms of both analysis and cooperation. There is the difficulty of agreeing on a diagnosis of what ails the IMFS. And even if a common understanding of international spillovers and their causes emerged, it would remain challenging to forge and to maintain a common approach among multiple actors of varying sizes subject to differing domestic constraints.

Such possibilities and obstacles are evident in the discussion concerning crisis management. During the Great Financial Crisis, central banks proved able to make swift joint adjustments to their policy stances and to coordinate closely in extending foreign exchange swaps to each other. Funding extended under dollar swaps reached almost $600 billion (and, under euro swaps, €6 billion). The dollar swap lines supported financial stability by allowing the funding of foreign banks with limited access to Federal Reserve facilities. In turn, they also restored the monetary transmission mechanism after banks had been bidding up dollar Libor relative to the federal funds rate.

Today, proposals to modify and extend safety nets face obstacles. One reason is deep analytical disagreement. Is reserve accumulation a by-product of exchange rate management, or a form of self-insurance against domestic and external crises? Should international liquidity facilities, including currency swap lines between central banks, be broadened, and what is their best design? Would enhanced safety nets lead to smaller foreign exchange reserves? And, even if agreement were reached, many aspects of international risk-sharing would remain problematic. Despite the room for improvement, the status quo may well persist.

All this reinforces the case for crisis prevention. Here, central banks could seek to internalise the effects of their own policies. An improved exchange of information would help authorities to reach a better understanding of international spillovers and spillbacks. For instance, if the major central banks' monetary policies have indeed induced competitive easing among EMEs, the resulting financial imbalances may ultimately hurt the advanced economies. What is more, such spillbacks may be stronger than in the past, in line with EMEs' growing weight in the world economy (Chapter III). Similarly, the outsize official role in major bond markets points to the need for policymakers to pay attention to global effects. However, while global reserve managers might collectively benefit from taking into account the effect of their investment behaviour on global bond yields, their individual incentive is to ignore international spillovers.

It may be difficult to go beyond enlightened self-interest and to revisit rules of the game more broadly.⁸ Many reject a global perspective in the realm of monetary policy. Accordingly, domestic mandates ask major reserve-issuing central banks to set policy for a smaller economic domain than that occupied by their currencies.

This interpretation of domestic mandates contrasts sharply with successful international cooperation in the realm of financial regulation and supervision. There, national mandates have not precluded extensive international cooperation and the development of global rules.

A better understanding of the shortcomings of the current IMFS would already be a big step forward. A widely held view is that the main problem is the IMFS's apparent inability to prevent large current account imbalances. This view of imbalances is the prevailing one in international forums and implies specific adjustment policies, such as those associated with the G20 Mutual Assessment Process.⁹

The focus on current accounts and the corresponding net resource flows, however, arguably glosses over the IMFS's fundamental weakness. The aim of rebalancing global demand reduces the notion of imbalances to net flows in goods and services between countries, and neglects the greater risk of financial imbalances building up within and across countries. To be sure, large current account deficits often point to underlying problems, but financial booms and busts can and do develop in surplus countries as well. An aggregate surplus position may well conceal such vulnerabilities. Financial imbalances are more closely linked to domestic and international gross positions, and need not leave a mark on cross-border net flows - what current accounts represent.¹⁰ Indeed, financial imbalances may not show up in a country's balance of payments at all if multinationals issue debt offshore for their use abroad, for instance. This, in turn, raises the question of the appropriate unit of analysis in international finance, with consequences for how one should measure the risks (Box V.E). Making progress on the design of the IMFS thus calls for a new diagnosis that accounts for financial imbalances as a basis for broad adjustments to domestic policy regimes and their international interaction.

¹See C Borio, "The international monetary and financial system: its Achilles heel and what to do about it", BIS Working Papers, no 456, August 2014; and C Borio, H James and H S Shin, "The international monetary and financial system: a capital account historical perspective", BIS Working Papers, no 457, August 2014.

²See R McCauley, P McGuire and V Sushko, "Global dollar credit: links to US monetary policy and leverage", Economic Policy, vol 30, issue 82, April 2015, pp 189-229.

³See V Bruno and H S Shin, "Cross-border banking and global liquidity", Review of Economic Studies, vol 82, issue 2, April 2015, pp 535-64.

⁴See H Rey, "Dilemma not trilemma: the global financial cycle and monetary policy independence", in Global dimensions of unconventional monetary policy, proceedings of the Federal Reserve Bank of Kansas City Jackson Hole symposium, August 2013, pp 285-333.

⁵See J-H Hahm, H S Shin and K Shin, "Noncore bank liabilities and financial vulnerability", Journal of Money, Credit and Banking, vol 45, issue s1, April 2013, pp 3-36.

⁶Compare R McCauley and G Jiang, "Diversifying with Asian local currency bonds", BIS Quarterly Review, September 2004, pp 51-66 and the following: K Miyajima, M Mohanty and J Yetman, "Spillovers of US unconventional monetary policy to Asia: the role of long-term interest rates", BIS Working Papers, no 478, December 2014; Q Chen, A Filardo, D He and F Zhu, "Financial crisis, US unconventional monetary policy and international spillovers", BIS Working Papers, no 494, March 2015; and Box V.C.

⁷See C Borio and R McCauley, "The economics of recent bond yield volatility", BIS Economic Papers, no 45, July 1996.

⁸The case for change has been put forward by R Rajan, "Competitive monetary easing: is it yesterday once more?", remarks at the Brookings Institution, 10 April 2014. For more sceptical views on policy coordination, see eg S Fischer, "The Federal Reserve and the global economy", Per Jacobsson Foundation Lecture at the IMF/World Bank Annual Meetings, 11 October 2014; and B Cœuré, "Domestic and cross-border spillovers of unconventional monetary policies", remarks at the Swiss National Bank-IMF conference "Monetary policy challenges in a changing world", 12 May 2015. See also J Caruana, "The international monetary and financial system: eliminating the blind spot", remarks at the IMF conference "Rethinking macro policy III: progress or confusion?", 16 April 2015; and W Dudley, "US monetary policy and emerging market economies", remarks at the Federal Reserve Bank of New York roundtable discussion "Three decades of crises: what have we learned?", 27 March 2014.

⁹The European Commission's Macroeconomic Imbalance Procedure goes further in complementing its surveillance of external imbalances with indicators on internal financial imbalances.

¹⁰See C Borio and P Disyatat, "Global imbalances and the global crisis: link or no link?", BIS Working Papers, no 346, May 2011.