From Nanjing to Paris

Economics, Premium POM

The Real High-Level Seminar on the International Financial Architecture

By JC Collins

Over the last months or so there has been much unsubstantiated information spreading around about a so-called Paris Accord or Nanjing Accord.  It is suggested that an agreement has already been made to “replace” the dollar with the SDR of the International Monetary Fund.

While the Special Drawing Right is clearly on the rise, and its use in the international financial system will be broadened, outrageous statements and proclamations such as “the dollar is dead and the SDR is replacing it” are both absurd and unfounded.

The shifting of the world’s monetary framework will take the efforts of all countries, with special significance placed on the largest players – China and the United States.  Those who first claimed that the RMB was going to replace the USD are now claiming that the SDR is going to replace the USD.  The switch occurred after it became obvious that the RMB will be one of three major reserve currencies, not the one major reserve currency.

It should be stated again for the purpose of clarity that no nation wants the responsibility of utilizing its domestic currency as the one and only international reserve currency.  The demands and inherent imbalances which develop are to be avoided in the developing multilateral monetary framework.

The SDR will be used as a liquidity tool in the initial stages of this transformation.  Its importance will increase piecemeal as the transition proceeds into the next decade.  It has been my contention all along that the SDR will be used as the solution to a liquidity crisis which is slowly developing.  The problem and reaction stages of this architecture transformation will soon shift into the solution stage.

But keep in mind that the transmutation of anything takes a considerable amount of time.  The gestation period for the new multilateral is a multi-decade endeavor which will continue to evolve in the future in response to unforeseen challenges which will become inherent in that particular system.

On March 31, 2016, Angel Gurria, the Secretary-General of the Organization for Economic Cooperation and Development (OECD) gave a prepared speech in Paris.  That speech reviewed much of the material which we have covered here on POM, including capital flows and the liberalization of China’s capital account.

The one statement from that speech which I would like to draw attention to is the following:

It can also constitute a very useful policy tool and mechanism in a context of future “tectonic shifts” in the international financial architecture, including the move from large emerging economies towards full capital account convertibility.

The full speech can be read at the OECD document titled High-Level Seminar on International Financial Architecture – “From Nanjing to Paris”.

The SDR was indeed a topic at this seminar, but not in the manner which has been reported elsewhere.  It has been agreed that the SDR should play a larger role in re-balancing the worlds monetary and financial systems, exactly how that role would look is still being debated.  Though we can expect that nations will have to draw on the SDR, and to a larger extent the IMF itself, to help transition through the storm of shifting liquidity in the months and years ahead.

The G20 and IMF are reviewing a broader use of the SDR, but that use will not be so dramatic and sudden that it will destroy the dollar.  As stated, it will be piecemeal and its use will creep forward under the guise of providing global liquidity.

In the meantime, a re-balancing between major reserve currencies will take place and the geopolitical realities will continue to shift along with it.

The OECD statement can be read in its entirety below.  – JC

As you all know well, this meeting comes at a time of great uncertainty for the state of the world economy, with pickup in growth remaining largely elusive – as I reported to you in Shanghai a few weeks ago.

Threats to financial stability and volatility have been on the rise, and a number of emerging markets face vulnerabilities linked to currency exposures and/or high domestic debts.

After strong capital inflows, several of them are now faced with sizeable capital outflows: the risk of “sudden stop” cannot be ruled out – and as the banker’s adage says, “it is not speed that kills, it is the sudden stop”!

In this challenging context, capital flow restrictions may look like an appealing proposal for policy makers – all the more that they may constitute a political easy short-term fix to deep-seated structural challenges that would actually require painful medicines.

Those easy fixes are likely to be “smoke and mirrors” however: even when used with a declared macro-prudential intent, they may bring an additional layer of more severe distortions, including exchange rate misalignments, more fragmentation in the global financial system, and, ultimately, increased volatility.  Recent OECD research actually shows that evidence on the impact of capital flow restrictions on decoupling the economy from global credit cycles is rather mixed.

We actually need to balance two objectives:

  • On the one hand, we should collectively strive to keep financial markets open. Combined with a sound regulatory framework, open capital markets support a better risk allocation, lower the overall cost of capital and ultimately foster a deeper global liquidity.  This is no coincidence that China and other large emerging economies have adopted long-term plans to liberalize their capital accounts.  However, OECD indicators suggest a worrying rise in capital flow measures since 2008 – often in the form of currency-based restrictions – together with a decrease in financial openness – as reflected by increased domestic saving-investment correlations. This is reversing an historic trend and should be a cause for concern. 
  • On the other hand, governments need an actionable toolbox of policy instruments to deal with capital flow volatility. Clearly, a sound policy framework must be established I order for an economy to fully benefit from a liberal, open capital account regime – this is the key lesson we drew from successive financial crisis over the last two decades. This framework can include well-tested and calibrated macro-prudential measures that can serve as counter-cyclical buffers.  Even is such measures may have costs in terms of distortions within the financial system, they may be needed to balance the cost of a single, large, and outright banking crisis.

The OECD Code of Liberalization of Capital Movements, the only binding international agreement on cross-border capital flows, signed by 34 OECD and 12 G20 members, offers a very relevant policy framework to achieve and strike the right balance between these two objectives: It offers the possibility and flexibility to adherent countries of reintroducing capital flow restrictions in specific circumstances, provided the latter are regularly reviewed by policymakers to ensure that restrictions are not maintained longer and more restrictive than necessary.

In other words, the Code provides the following trilogy – transparency and accountability, flexibility, and proportionality – which is key to reconciling governments need for concrete policy tools with the quest for open and integrated international capital markets.

In so doing, the Code is fully aligned with the G20 Coherent Conclusions’ of 2011, which called for currency measures to be “transparent, properly communicated, and targeted to specific risks identified.

It can also constitute a very useful policy tool and mechanism in a context of future “tectonic shifts” in the international financial architecture, including the move from large emerging economies towards full capital account convertibility.  The latter will require more, not less, international transparency, accountability, and cooperation in order to bring about growth and stability.

The OECD is now embarking on a review of the Code with the purpose to ensure its continued relevance in a fast-evolving international financial architecture.  We will report to next G20 Finance meetings in April in Washington in more detail.  But let me stress that, together with widening adherence, the review of the Code is an opportunity to transform the vision of the transparent, open and resilient world we want, into a reinvigorated multilateral agreement.  All G20 members are welcomed and encouraged to participate actively to design better financial policies for better lives.