10 May 2015
IMF SDR valuation review
The IMF is due to hold the first reading of the 2015 SDR valuation review during May. The five-yearly SDR review appears to be a more interesting affair than usual. The inclusion of the renminbi into the SDR basket is being considered in earnest. It would be the first meaningful innovation of the SDR since the early 1980s (Chart). China has lobbied intensively to have the renminbi included in the SDR basket. The inclusion of the renminbi is considered highly likely or at a minimum the adoption of a roadmap for prompt inclusion. Support for renminbi inclusion though is not clear amid alleged resistance by one of the IMF largest member countries. There are some indications that the May reading may be postponed possibly suggesting that the deliberations have become more complex than thought.
In April, the International Monetary and Financial Committee (IMFC), the steering body of the IMF, called for “collective efforts to strengthen the international monetary system and facilitate further integration of dynamic emerging markets.” The integration of emerging markets currencies into the international monetary system constitutes the frontier of international monetary developments. It remains to be seen if the IMF uses the SDR review as an opportunity to offer a broader role for the SDR. While some countries may call for more SDR allocations, this seems unlikely at the current juncture.
The SDR review will likely balance continuity versus representativeness. The former would aim to reinforce the conventional role of the SDR as a reserve asset. The latter would shift emphasis towards inclusiveness and address older concerns that the SDR should not unduly reinforce the status of the largest IMF member countries and needs to incorporate emerging markets. Current SDR basket inclusion are largely based on an assessment of currency usage amid the currency denomination of trade in goods and services and financial markets transactions and transaction volumes in the principal foreign exchange markets. The IMF needs to assess whether those criteria remain adequate given that the SDR has never been a proper reserve asset.
The inclusion of the renminbi would allow China to assume a direct stake in the international monetary system. It would be a critical element as part of China’s aim to promote renminbi internationalisation. While the latter will ultimately depend on China’s monetary policy framework, actual implementation and further announced measures to allow more international renminbi usage appear forthcoming. Central banks will also play a key role in the adoption of the renminbi and SDR basket inclusion is considered to support central bank renminbi adoption. So far, only US$13.2 billion are held as reserve assets denominated in renminbi (June 2014, IMF).
While the SDR has not and is unlikely to play in the near future a meaningful role in financial markets, the SDR could serve as an important signal that the international monetary system is due to change. Eventually, this could have significant implications for the demand and supply of currencies used in international transactions. As such the SDR could restore some of its former glory. It would also address the need for change of the international monetary system where a more diversified SDR basket could adopt a more forward looking role in line with the considerable diversification of the international economy.
The IMF revealed in April its semi-annual World Economic Outlook (WEO) offering the latest projections for world GDP. It represents undoubtedly one of the most closely watched economic projections. Yet, it also serves as a reminder of how difficult economic projections are. The IMF, similar to most others, has often been wrong, missed major turning points and has now recently overestimated growth continuously. Economic projections should therefore be handled with care.
The April WEO projections show that the world economy is forecast to expand by 3.9 percent in 2015 and 3.8 percent in 2016. Advanced economies are projected to grow 2.3 percent and 2.4 percent and emerging markets 5.3 percent and 4.7 percent. This is line with the average growth outcome in 2000-13 excluding 2008 and 2009. While advanced economies are seen to expand slightly, the IMF projects emerging markets economies to slow further from an average of 5.8 percent in 2010-13. China is projected to continue to slow to 6 percent by 2017 from an average of 8.8 percent in 2010-13.
The IMF has consistently overestimated projected output since 2010 in particular for advanced economies (Chart). The positive bias suggests that the IMF struggles to identify the factors containing advanced economies’ growth. This could indicate underlying structural transformations that dominate cyclical developments in the short-term, are hard to quantify and do not allow advanced economies to escape their relatively sluggish growth performance.
China and emerging markets are forecast to continue to grow faster than advanced economies now projected to represent 47 percent of world GDP by 2020. However, in the past, the IMF has significantly underestimated emerging markets’ growth performance and their resilience during the crisis. The future trajectory though will depend on whether emerging markets manage to contain rising vulnerabilities (see below Countries Vulnerability Indicator).
Central bank lending to governments
Central Banks historically were often established to finance governments in particular to wage wars. Since in particular the 1970s and 1980s, significant limits or outright restrictions on government lending were imposed on most central banks largely to strengthen central banks’ independence and ability to fight inflation. The start of large-scale government debt purchases by the ECB in March serves as a reminder how much central banks have moved into a different direction and how important they have become in bankrolling governments.
Central bank lending to governments has at least two dimensions: National and international lending. The former emerged mostly since 2008 with the global financial and economic crisis and adoption of “quantitative easing” by the U.S. Federal Reserve and the Bank of England. The latter rose to significance already since the early 2000s amid the rapid accumulation of central bank foreign exchange reserves, mostly invested in advanced economies treasury securities. Both mean that the share of central bank lending to governments in proportion to total outstanding debt has reached considerable amounts.
Central bank government securities purchases have been substantial and unprecedented in modern central banking times: The Bank of Japan holds about 35 percent of the total Japan Government Bonds (JGBs) outstanding; the Bank of England through the Asset Purchase Facility holds 35 percent of conventional gilts outstanding; and the Federal Reserve holds 20 percent of total U.S. Treasury marketable debt outstanding. The Federal Reserve, Bank of Japan and Bank of England hold US$5,270 billion of their respective governments’ debts (March 2015) representing 26 percent (weighted) of total benchmark government securities outstanding.
Central bank foreign exchange reserves have similarly increased to unprecedented levels from US$2,000 billion in 2000 to US$11,600 billion in 2014. Disclosure of central banks holdings of government securities as part of foreign exchange reserves remains limited and is often confidential. To estimate, government securities holdings, the currency composition of foreign exchange reserves as published by the IMF (COFER) is used as a proxy amid the assumption that central banks normally invest a very high proportion of reserves in government securities.
The combination of national and international central bank government lending shows that central bank holdings of government debt represents substantial portion of total government debt or in proportion to benchmark government debt (Chart): U.S. treasury marketable debt 77 percent; JGBs straight bonds 42 percent and Gilts 63 percent. Using the same approach to estimate central bank foreign exchange reserve holdings in German and French long-dated government securities, central banks represent already, excluding ECB purchases, 83 percent of Bundesanleihen, Bundesobligationen, OATs, BTANs and BTFs.
The high proportion of central bank lending to governments undermines central bank independence. Even foreign central banks may find it difficult to trade foreign exchange reserves freely if it may adversely affect the issuing country. The high proportion of central banks in key fixed income markets also undermines price discovery and price formation in these markets as central banks and private market participants may not pursue similar objectives. Central banks foreign exchange reserves have become very big and central banks’ quantitative easing policies have widely expanding central banks’ treasury market interventions. It is hard to see how so much central bank lending has remained consistent with the basic notion of markets.
CIGI T20│tepav Conference: Prioritizing international monetary and financial corporation, Ottawa 3-5 May—Summing-up
The summing-up is based on personal notes only and does not aim to offer a comprehensive account of the conference proceedings.
The conference aimed to provide input for the G20 agenda focusing on international financial, regulatory and environmental issues with a broad based participation of representatives from governments and central banks, IMF, academia and think tanks and former Prime Minister of Canada Paul Martin. The conference featured three keynote addresses on currency wars; strengthening the multilateral institutions; and the financial safety net; and was divided into six sessions: Turkey’s G20 Agenda; Enhancing Special Drawing Rights in a reformed international monetary system; Macroeconomic imbalances and macroprudential regulation; Managing severe sovereign debt crises; Structural financial reforms on global finance; Addressing environmental and sustainability risks through financial regulatory reforms.
- G20 to strengthen multilateral institutions: The view was expressed that governments appear in general ill prepared to confront global challenges. One participant emphasised that the G20 needs to strengthen the multilateral institutions to deal effectively with macroeconomic stability, food security, sovereign debt resolution, terrorist financing, climate change, cyber security. The participant explained that G20 support of the multilateral institutions is needed to ensure its legitimacy. The G20 was seen as a transition from the G7 to give greater voice to emerging markets to assume more responsibility in international affairs one participant added.
- G20 remit broad or narrow: Opinions differed about the desirable breadth of the G20’s remit. One participant voiced that to project its relevance the G20 needs to address important broader international policy challenges like the Mediterranean immigrant crisis and large refugee camp populations and that it would be a failure not to deal with climate change in particular ahead of the December Climate Change Conference in Paris. Another participant suggested that the G20 should adopt a youth unemployment target. Several participants contested a broader mandate and insisted that the G20’s competence and effectiveness lies in economic and financial affairs. One participant underscored that the current G20 agenda is largely uncontroversial and relies too heavily on individual countries’ plans. Another participant stressed the G20 has been struggling to generate meaningful deliverables.
- AIIB and renminbi internalisation: The Asian Infrastructure Investment Bank (AIIB) was highlighted as a new generation of international organisation. Several participants affirmed that the AIIB was established as a reaction to persistent dominance of the advanced economies at the IMF and World Bank. Several participants expressed that the U.S. resistance to advanced economies’ membership was deplorable. One participant indicated that the AIIB was a “diplomatic success” for China and the first time China set up successfully an international organisation. One participant suggested that the AIIB should use the renminbi as a vehicle for renminbi internationalisation and to promote greater international currency diversification.
- “Silly” U.S. stance on IMF reforms: Several participants stressed that the IMF was significantly impaired by the unwillingness of the U.S. to support needed governance reforms and that this undermines legitimacy of the institution. Several participants underlined that the lack of IMF reform diminishes the U.S.’s ability to maintain global leadership. One participant qualified the U.S.’ stance on the IMF as “silly” and “childish” amid a lack of understanding of international affairs and a reflection of the U.S.’ dysfunctional political system. Another participant hinted that the IMF reform will likely pass the U.S. Congress in the coming months while some other participants thought a resolution unlikely in the medium term. One participant explained that the U.S.’ attitude is due a fundamental resistance to ceding authority to thirds. Some participants also compared the U.S. lack of IMF reform support to its resistance to enlarging the SDR basket and advanced economies’ membership in the AIIB.
- Need for “new global financial infrastructure:” Some participant indicated that the international economy continues to lack an adequate financial infrastructure to allow an orderly integration of China and emerging markets. One participant stressed for the need to “look beyond IMF quotas” and build a new “global financial infrastructure” to facilitate international settlements and new rules to guide international investments.
- Currency war “oversold:” The importance of exchange rate movements for national stability and competitiveness was contested. Some participants argued that the notion of “currency wars” was oversold as the benefits from an exchange rate depreciation on net international trade or adjustment were small attributable at least in part to global supply chains and hedging. One participant stressed though that Germany’s record current account surplus does constitute the “ultimate currency war” and offers a strong argument against fixed exchange rates. Some participants indicated that quantitative easing and exchange market interventions were not the same while others saw important parallels.
- SDR to look forward: The 2015 SDR valuation review was seen as an important opportunity to reflect on developments in the international monetary system and the criteria guiding SDR basket inclusion. One participant highlighted “that the SDR was seen in the past as a currency basket but also a basket case” as it became increasingly irrelevant. The 2009 SDR allocation was seen as turning point but views differed as to its relevance for the SDR’s subsequent development. One participant offer a five-point plan for reforming the SDR comprising the need for more SDR allocations; allow reallocation to link allocations to financing needs of emerging markets; enforce reconstitution to promote dynamic use of SDRs; a substitution account to allow exchanging reserve assets for SDRs; and a revision of the SDR basket to allow greater currency inclusion. Other participants shared in particular the need for more allocations and reconstitution.
Views on broadening the currencies in the SDR basket differed. Some participants indicated support for renminbi inclusion and a broadening of the SDR basket more generally. One participant argued that the renminbi would meet the widely used criterion as the renminbi has been made convertible for most international financial transactions with the exception of fixed income instruments. The participant indicated that China is likely to continue managing its financial account through macroprudential measures while another participant underlined that it would be difficult to convince China to fully liberalise its balance of payments. The participant further suggested that renminbi inclusion could put more pressure on China’s domestic financial reforms. Another participant was critical of the inclusion of the renminbi as it is not fully convertible amid possible manipulation due to authorities’ foreign exchange market interventions. Another participant contested that the inclusion of the French franc prior could have attracted similar concerns.
Opinions were expressed on the future role of the SDR. One participant proposed to use SDR as a framework of bilateral swaps between central banks. Another participant underscored the need to rethink the role of the SDR and not maintain measures that are attributes of its originally intended but now outdated role as a major reserve asset. The participant proposed to use the SDR as a signalling device and framework to facilitate and foster international monetary diversification and offer a broad based diversification of the basket with other currencies apart from the renminbi to be included like the Australian dollar, Canadian dollar, Brazilian real, Korean won, Mexican peso, Turkish lira. Another participant highlighted that the SDR basket does not look like it will in 10 or 20 years and that the SDR should become more forward looking.
- International monetary diversification: Several participants indicated concerns about exchange rate stability in the event of greater international currency diversification. One participant indicated that more research is needed to establish the relationship between international currency diversification and exchange rate stability and that similar concerns were addressed in the 1970s by the Committee of Twenty that concluded at the time that there is no evidence that a multiple currency international monetary system would be more unstable. One participant underscored that there is uncertainty as to sharing the cost of new more diversified international monetary system.
- Central banks swaps, qualification and risk absorption: The emergence of different central bank swap networks raises adverse selection concerns. One participant indicated that the Federal Reserve found it difficult to decide which central bank to grant extension of a liquidity swap. One participant queried whether extension of swaps to the ECB was less risky than to emerging markets. One participant suggested that the IMF qualification criteria for the Flexible Credit Line (FCL) could be used as an objective gauge for selecting central banks in swap arrangements. On the basis of a comparative study with data of the current FCL countries Colombia, Mexico and Poland, countries qualifying would include Chile, Czech Republic, Malaysia, Philippines, Lithuania and South Korea. Another participant proposed that central banks could lend to the IMF and then the IMF to on-lend. Another participant indicated that the IMF itself is supposed to be a risk absorber. One participant highlighted the possible conflict of interest for central banks between their national mandates and taking external credit risk through swaps. Another participant underlined that swaps should be consistent with national mandates if such action helps to preserve national stability. One participant cautioned that foreign exchange swaps unless involving the Federal Reserve are not sources of net liquidity and only rely on existing stocks of foreign exchange reserves and that only the Federal Reserve can create dollar liquidity. Another participant indicated that swaps can still be used to redistribute liquidity.
- Trilemma “passé:” The relationship between exchange rate flexibility and monetary policy autonomy appears to weaken. One participant highlighted that recent observations show that countries with more flexible exchange rates are not necessarily more insulated from external shocks. The participant stressed that successful insulation can only be achieved with capital controls where Asia seems more successful amid permanent controls than Latin America’s temporary controls.
- Growth outlook and imbalances: Concerns for demand imbalances appear to have supplanted concerns for external imbalances. One participant underlined that the most important imbalances were due to a shortfall of demand, high unemployment and risk of deflation in particular in advanced economies. The participant stressed that there has been too much fiscal consolidation suggesting that stimulus could only come from countries with large current account surpluses where China had moved while Germany had not. One participant asked whether proposals for caps on current account imbalances could remerge as under the G20 Korea summit. Another participant reminded that in the current system only deficits countries receive pressures to adjust.
- Monetary policy guidance: Transparency and obfuscation are needed in monetary policy. One participant stressed that monetary policy should try to be as predictable as possible but that occasional surprises are needed. Another participant indicated that there should be multilateral guidance on asset prices.
- Contractual v. statutory approach in sovereign debt restructuring: The co-existence of contractual and statutory elements in sovereign debt workouts seems unavoidable. One participant affirmed that sovereign bond restructurings have been mostly successful amid generally high participation rates indicating that recourse to the courts is rare. The participant explained recent innovation in sovereign debt restructuring including aggregated collective action clauses (CACs), clarification of the pari passu provision indicating that Kazakhstan was the first country to issue bonds with aggregated CACs. The participant supported a contractual approach for sovereign debt restructuring rather than a statutory approach arguing that successful workouts will strictly depend on a sovereign’s willingness to engage with creditors. Another participant stressed that both contractual and statutory elements need to coexist reminding that in the case of Argentina creditors despite court action have still not collected and that the debate should not be about preference of one approach versus the other. Sovereign debt restructuring proceedings still suffer from discord on basic provisions such as equal treatment.
- Financial reforms and international bank resolution: Significant progress has been made to strengthen financial regulation including on reinforcing capital, liquidity and leverage provisions for banks, transforming shadow banking, ending too-big-to-fail and OTC derivatives exposures. One participant affirmed that more is needed in particular on shadow banking regulation, OTC derivatives amid inconsistencies between jurisdictions and international bank resolution due to persistent uncertainty over dominance of home versus host regulation stressing the importance of establishing trust between jurisdictions. The participant indicated that the U.S. and Canada may contemplate a bilateral agreement for bank resolution. The too-big-to-fail problem can only be solved with a well-functioning internationally harmonised banking resolution mechanism another participant stressed. Another participant underlined that the Total Loss Absorbing Capital (TLAC) provision for Global Systemically Important Banks (G-SIFs) represents important progress towards too-big-to-fail and should probably be sufficient to avoid the need for fiscal resources in the event of bank insolvency. One participant explained that the Financial Stability Board (FSB) will review the asset management industry to address concerns about large-scale fire sales and overshooting amid general trepidations about market-based finance.
Considerable progress on financial regulation in the EU was outlined by one participant citing the adoption of common supervision through the Single Supervisory Mechanism (SSM) making the ECB the largest bank supervisor by bank assets, common bank resolution included a single resolution fund and issuance of the Bank Recovery and Resolution Directive (BRRD) with provisions for holding additional bailinable capital for loss absorption (MREL) comparable though not identical to TLAC. The participant indicated that the banking crisis in the EU cost 14 percent of GDP.
Bank regulation may unduly depress lending. One participant voiced that bank regulation may not be socially optimal if it leads to under-lending while another participant indicated that studies have shown that industry concerns about under-lending were “hugely overstated” and more than compensated by reduced crisis prowess. Another participant voiced concern about the lack of accountability in banking supervision. One participant also emphasised that differential levels of economic and financial development may not allow common financial regulations.
- Carbon pricing and sustainability: Environmental concerns remain only partially integrated in macroeconomic analyses while climate change may represent one of the most pressing economic policy challenges. One participant highlighted that there are considerable finance challenges to meet investment needs to address set climate change targets. Another participant explained that the 2° C temperature increase target implies that the atmospheric concentration of CO2 should not surpass 450 parts per million (ppm) while another participant indicated that 450 ppm only implies that the probability of meeting the 2° C target is still only 50 percent where 350ppm would be the safe limit to ensure the temperature target will not be exceeded (the current CO2 level is 400ppm). Another participant highlighted that carbon pricing and the end to fossil fuel subsidies are needed to ensure adequate incentives to meet needed environmental standards. Another participant explained that a cap and trade scheme is set to be introduced in the U.S. In financial asset management Environmental, Social and Governance (ESG) standards have been adopted by some leading institutional investors and may represent an important source to link finance to environmental standards one participant explained. Another participant indicated that the FSB will review how the financial sector takes account of climate change.
- Stabilisation of CO2 emission and resource extraction: Possible limits to resources extraction may adversely affect company valuations. One participant outlined that stricter environmental standards could imply that a high proportion of extractable resources will not be allowed to be mined adversely affecting e.g. oil major that rely on oil reserves for valuation. This could also have significant implications for carbon resource-rich countries in particular in the Middle East another participant highlighted.
- G20 commitments and compliance: The G20 has on average shown a high level of compliance of its commitments. One participant explained that compliance and performance of the G20 is at 70 percent with the best compliers being the U.K. and Germany while implementation of labour and employment related commitments show the lowest compliance level.
Country vulnerability indicator
The slowdown in global economic growth has revealed countries’ underlying vulnerabilities. The country vulnerability indicator, a simple linear combination of economic growth, inflation, fiscal deficit, government debt and current account balance, uses the latest IMF World Economic data to show level and change of economic vulnerabilities for the 50 largest economies (for the methodology, see Countries' economic vulnerabilities (update), 22 October 2013). Economic conditions have on average improved but the distribution of relative vulnerabilities has changed significantly since April 2013 shifting from advanced economies to emerging markets. In Europe notably, there has been a significant decline in the vulnerability indicator including in Greece and Portugal. In emerging markets, Argentina and Brazil in particular show a significant increase in their vulnerability indicators. The aggregated vulnerability indicator for emerging markets has surpassed, being more vulnerable, that of advanced economies for the first time since 2003.
Table with indicators available on request.