BRICS Economic Think Tank Forum, Beijing 6 November 2014
Ousmène Jacques Mandeng, Global Institutional Relations Group, Prudential Investment Management
Ladies and Gentlemen
It is a great pleasure to participate in this timely initiative to reflect on the international financial architecture through the prism of the BRICS countries. The considerable advances BRICS countries have made in the world economy remain in stark contrast to their role in the international financial system. There are few areas where this is more pronounced that in the international monetary sphere. The world economy has remained highly dependent on a narrow set of national currencies to conduct cross border financial transactions. This constitutes a critical vulnerability and disadvantage for BRICS countries. Commemorating the 70-year anniversary of the Bretton Woods Conference this year, it is an opportune moment to think about needed reforms of the international financial architecture. I will try to make the case for a BRICS payments union.
The Federal Reserve remains the only entity that can create international liquidity. This naturally means that the world economy relies to a large extent on the Federal Reserve to be able to conduct orderly balance of payments adjustments. The end of quantitative easing by the Fed but also recent monetary measures by the Bank of Japan serve as reminders that national considerations dominate monetary policy conduct and hence the supply of international liquidity. Possible conflicts between national and international liquidity needs therefore raise important welfare and stability questions. The significant increase in foreign exchange reserves and complementary balance of payments support arrangements—financial safety nets—aim to overcome possible international liquidity supply constraints. However, payments support measures merely offer a remedy rather than address the underlying cause. The cause of persistent reliance on a narrow set of national currencies—key currencies—rests in the scarcity of truly freely usable currencies and sufficiently liquid underlying financial markets. Policy efforts need to be directed at the cause rather than the remedy.
The vulnerability of the international monetary system rests in sudden movements in and out of one of the key currencies. This is no new phenomenon of course. During the 1930s, important conversions of sterling balances into gold and dollars played a decisive role in the sterling crisis of 1931 and Britain’s abandonment of the gold standard.1 The Lehman Brothers collapse of September 2008 similarly illustrated disruptive exchange rate movements amid a sudden loss in generalised market confidence. By simple conjecture, these movements are considered here to constitute sudden exchange market illiquidity, that is, the lack of sufficient dollar liquidity to allow orderly exchange rate adjustments (Figure 1). This rests largely on the high concentration of international transactions settled in dollar but also in euro—believed largely limited to transactions of and with the euro area—and sterling (Figure 2).
The importance of readily access to international liquidity constitutes the foundation of the international monetary system. Recent changes have radically altered the symmetry in liquidity distribution and upset the level playing field for balance of payments adjustment. The Federal Reserve in October 2013, converted the hitherto temporary swap facilities with the Bank of Canada, Bank of England, ECB, Bank of Japan, and the Swiss National Bank into standing arrangements. This has suddenly established a segmented dollar liquidity sphere between central banks with an ex-ante dollar backstop and those without establishing a considerable gap between dollar liquidity haves and have-nots. This may exacerbate market perception that countries without a Fed backstop are unduly risky and could bring forward safe haven motivated trades. Fed Vice Chairman Stanley Fischer’s remarks during the IMF Annual Meetings in October 2014 affirmed the Fed’s reluctance to move beyond its current international commitments.2 It has made it more urgent to confront the international liquidity gap.3
Efforts to address the liquidity gap have concentrated almost exclusively on providing alternative sources of finance. However, countries foreign exchange reserves, the Chiang May initiative, swap lines with the People’s Bank of China and the IMF facilities all merely recycle mostly the existing stock of dollar liquidity. This is also true for the recent BRICS Contingency Reserve Arrangement (CRA). There is a fundamental need for diversifying the existing sources of international liquidity. It would have to consist of allowing convertibility of currencies in the broadest sense to be able to conduct uninhibited international transactions and more importantly actual usability of currencies. The BRICS on the international monetary front, rather than focusing on external emergency measures through the CRA, should consider structural measures to lay the foundations for the reciprocal international use of their currencies.
The post-war European Payments Union (EPU) may offer a good example for the BRICS. The EPU was established in 1950 to address a chronic dollar shortage in the war raged European economies and amid failure to restore currency convertibility.4 The EPU comprised all countries of Western Europe including the sterling area but excluding Spain and Yugoslavia. The EPU allowed plurilateral net settlements of international trade among the EPU member countries to minimise recourse to convertible currencies. Net settlements were conducted once a month and were typically financed with credits or eventually in gold or dollars. The distinction between current and capital account transactions was abandoned. The EPU was linked to trade liberalisation and led to a significant increase in international trade. While during the inter-war period a large proportion of international trade was financed in sterling and dollars, during the immediate post-war period, the EPU resulted in international trade to be settled and financed predominantly by a large variety of currencies.5 The EPU tended to make all member currencies of equal importance and discourage settlements and payments in any particular one.6
The EPU was based on the fundamental notion that restoration of currency convertibility had to occur in concert among member countries. EPU members agreed in 1955 under the European Monetary Agreement to a collective approach for the adoption of convertibility by member countries.7 Delays in adopting convertibility were seen largely in the lack of adequate backstop facilities in particular to allow restoration of sterling convertibility. The increases in foreign exchange reserve holdings, large surpluses by some countries with the EPU, reduction of deficits with the dollar area—the Americas—and economic stabilisation eventually supported convertibility. The EPU was disbanded in 1958 upon adoption of currency convertibility on current transactions of the main European currencies.
The EPU exhibits several parallels with today’s international payments situation. At the same time, it also of course represents a foregone era and the world economy today is far more advanced in payments of current and capital transactions. Yet, the EPU was based fundamentally on the notion of a “European dollar problem,” that is, a belief that the net demand for dollar receipts cannot be managed without direct controls.8 The EPU was also accompanied by a special role attributed to Britain and the then firm assumption that Britain must lead restoration of convertibility of the European currencies given its important role in trade and finance. The former may well be comparable to the persistent dependence on the dollar for balance of payments adjustments and hence maintenance by some countries of financial account controls. The latter may be seen comparable to the role of China today where China’s lead is seen by many as essential for changing the balance of international currency uses. At the same time, Britain’s reluctance to restore convertibility was due to feared liquidation of the very large so-called sterling balances—sterling claims held mostly by sterling area countries—may also offer parallels to China’s concerns regarding its very large domestic monetary liabilities.
Consideration could be given to a BRICS payments union to promote current and financial settlements in national currencies among BRICS countries. While China has encouraged use of the renminbi for international payments and has advanced towards a renminbi clearing platform (CIPS), and has scored some important success, any initiative should be plurilateral in nature. This would give greater incentives for other countries to participate, establish greater symmetry in benefits and reduce payments pressure on any particular country. The BRICS CRA could be upgraded into a facility to support cross-border settlements by offering adequate backstops, a transparent settlement and payment infrastructure, liquidity and adequate credit facilities. The aim is not to give a similar status to all BRICS currencies from the outset and there will be currencies assuming primary and others only secondary roles in international settlements. However, then as today, the case for a collective approach for adoption of full convertibility remains strong. The BRICS are well positioned to set it up and should invite other countries to join. Upon full integration of the BRICS and possibly other emerging markets currencies into the international financial system, the BRICS payment union could be unwound.
The current fragile and uncertain international economic environment puts a premium on dollar liquidity. The Fed’s select backstop and reaffirmation of its reluctance to increase its international commitments has widened the safe haven zone making it more likely that money will hide there in the event of mounting economic and financial uncertainty. The critical principle of currency convertibility has historically been to allow multilateral uninhibited exchanges and therefore to create a level playing field for countries in the world economy. The Fed’s dollar liquidity rationing and hence the risk of an increasingly skewed distribution of dollar liquidity may have now put that increasingly at risk. The only sustainable remedy is to address the cause of dollar dependence by increasing the number of fully convertible currencies. Much more policy effort needs be directed at closing the liquidity gap. A BRICS payments union could play a vital role to promote BRICS currencies as the EPU did to support European currencies. For the BRICS, such effort may well represent their biggest contribution yet to support needed reforms of the international financial architecture.
1 See e.g. Triffin, R. (1957), Europe and the money muddle, Yale University Press, New Haven, CT.
2 Stanley Fischer, The Federal Reserve and the global economy, Per Jacobsson Foundation Lecture, 2014 Annual Meetings of the International Monetary Fund and the World Bank Group, Washington, D.C., October 11, 2014.
3 The Fed had of course responded proactively to sudden dollar liquidity needs arising after the Lehman Brothers collapse of 15 September 2008. On 18 September, it authorised expansion of its temporary reciprocal currency arrangements (swap lines) and establishment of new swap facilities with the Bank of Canada, Bank of England, the ECB, the Bank of Japan and the Swiss National Bank. On 24 September, new swap facilities were established with the Reserve Bank of Australia, National Bank of Denmark, Bank of Norway and the Bank of Sweden. On 29 October, reciprocal currency arrangements were further announced with the Bank of Brazil, Bank of Korea, Bank of Mexico and Monetary Authority of Singapore.
4 The EPU was based to an important extent on the proposal of an international clearing union as advocated by British economist John Maynard Keynes in 1942. The Keynes proposal—submitting for consideration at the Bretton Woods Conference but rejected—aimed at allowing a member country to offset its bilateral surpluses against its bilateral deficits thus avoiding largely immediate bilateral balance of payments pressures. The EPU allocated quotas—similar to the Keynes proposal—to countries, based on the level of a member country’s bilateral trade with other members, which determined the amount of credit facilities under the EPU.
5 See e.g. Lopper, J. (1955), Current usage of payments agreements and trade agreements, IMF Staff Papers, 339-397.
6See e.g. Hinshaw, R. (1958), Toward European convertibility, Essays in International Finance, no. 31, Princeton University
7 James, H. (1996), International monetary cooperation since Bretton Woods, Oxford University Press, Oxford.
8 Fetter, F. (1957), European Convertibility, American Economic Review, 588-595.