The New International Financial Architecture

Exhaustive discussion over the past couple of years about a new International financial architecture has focused on better and possibly bigger International Monetary Fund (IMF) lending facilities for financially troubled emerging market economies such as Mexico, Thailand, Indonesia, South Korea, Russia, and Brazil. It will rise again to ministerial level at the World Bank/IMF meetings in Washington in September. Unfortunately, this discussion is largely misdirected. A new financial architecture is emerging, but it principally involves a transition from the dollar-based system of the past half-century to a truly new framework of floating exchange rates and monetary unions, which should reduce the IMF's role greatly. The most important policy challenge is to define currency relationships evolving among the dollar, the euro, and the yen, including how to deal with the unsustainably lopsided situation of record U.S. deficits offset by large surpluses in the other two key currency areas. This is the primary source of the large U.S. current account deficit (the trade deficit and other current transactions such as interest and dividend payments).

The emerging global financial architecture is a result of rapid growth in international trade and investment since the mid-1980s and a parallel integration of world capital markets. As a consequence, governments' attempts to defend exchange rates linked to the dollar have become very costly or simply unfeasible. Recent financial crises in Asia and elsewhere have all been triggered by governments' futile attempts to maintain a dollar-linked exchange rate, and the result for all six countries mentioned at the beginning of this article has been a shift to a floating exchange rate policy.

The new architecture, in fact, consists of two strong tendencies, toward either floating rates or monetary union, which can be called the "two corners architecture" to reflect this bipolarity. The monetary union option has been adopted in Europe through the formation of the European Monetary Union (EMU) and is being discussed within the Western hemisphere in terms of "dollarization," whereby other countries simply adopt the dollar as a replacement for their national currencies.

Managing the Float

The initial thrust of the new architecture, however, apart from the EMU, is almost entirely toward floating rates, qualified as a managed floating rate policy-and much depends on how we define managed. In particular, central bank intervention in currency markets, which can significantly affect exchange rates, needs more clearly defined guidelines and disciplines. In recent years, some nations have used such intervention as an instrument of trade policy, whereby the central bank buys large amounts of dollars to keep its exchange rate low and thus stimulate a trade surplus. This mercantilist objective was especially strong during 1990-96, when foreign central banks increased dollar holdings by $461 billion, equating to 90 percent of the U.S. current account deficit during those years. The outcome was a stronger U.S. dollar than would have resulted from market forces alone, and a possible doubling of the U.S. current account deficit by the end of the period. The financial crises of 1997-98 kept the dollar very strong on its own, but as recovery begins in 1999 some governments are showing renewed interest in having their central banks purchase dollars.

At this stage of the transition to the new architecture, the relationship among the dollar, the euro, and the yen is a managed float with, as noted earlier, very different definitions of "managed." The United States follows a basically free float with minimal currency market intervention by the Federal Reserve Board and the U.S. Treasury. The Fed's rare and highly publicized intervention to support the yen in June 1998 amounted to less than $1 billion. Japan, by contrast, has consistently used exchange market intervention as an instrument of trade policy. The Bank of Japan buys large amounts of dollars when the yen strengthens to the point of restraining Japanese exports. Official reserves have consequently increased from $72 billion in 1992 to $220 billion in 1998. When the yen rose to 110 in January 1999, the Bank of Japan immediately bought $8 billion to push the rate back down.

The EMU does not yet have an exchange rate policy. As long as the euro remains weak, there will be little interest in European Central Bank intervention, and the euro will float freely. But if the dollar rate should strengthen substantially while unemployment remains in double digits in key member states of the euro, pressures will quickly develop to buy dollars and avoid a decline in the European trade surplus.

Some 1,000 guests attend a private party at the Paris Bourse in celebration of the euro in January.

	Some 1,000 guests attend a private party at the Paris Bourse in celebration of the euro in January.

Other major trading nations, including Canada, Mexico, Brazil, South Korea, Thailand, and Indonesia, also have ill-defined floating rates. Such nations often combine interest rate policy with ccurrencymarket intervention to influence the exchange rate. For example, South Korea, now on the post-crisis recovery path, has been able to bring interest rates down below ppre-crisislevels while the central bank has been buying large amounts of dollars to keep the won weak and the trade surplus intact. A big question-mark country for the new architecture is China, with the yuan pegged to the dollar but on a non-convertible basis. The result has been a consistent Chinese trade surplus and the central bank's huge build-up of official reserves to $149 billion, more than 100 percent of annual imports. The obvious implication is that the nonconvertible yuan is undervalued, yet China threatens to move in the other direction and devalue it further. At some point, the yuan will have to become convertible, and then the same "two corners" pressures will come into play. Hong Kong will also be affected because the Hong Kong dollar has been linked to both the U.S. dollar and the Chinese yuan, and if the latter were to become more flexible through convertibility, Hong Kong would have to choose whether to link to the U.S. dollar or the yuan.

Less Need for IMF

With the broadening of the basic two-corner architecture, IMF loans would become less necessary or useful. Mexico, which floated its rate in 1995, went on to float successfully through the financial crises of 1997-98 without recourse to the IMF or other large official borrowing. It is doubtful that other emerging market economies now with floating rates will again require the kind of large financial packages put together over the past four years. A major benefit of a floating rate policy, in fact, is the discipline it imposes on governments not to let fiscal, banking, and other policies drift dangerously out of line.

The industrialized countries, which account for 65 percent of world trade, are now all clearly in one or the other corner of the emerging new financial architecture, with monetary union in much of Europe and managed floating rates elsewhere. One consequence is that it has been more than twenty years since any of these countries has taken out an IMF loan. As emerging market economies follow this path toward the two-corner orientation, the "IMF graduates" share of world trade should rise to 75 percent or more.

The IMF will still have a role as the international forum for developing guidelines and disciplines for the new system and for providing technical assistance for reforms in the banking and other sectors in developing countries' economies. But IMF lending programs, in addition to being much smaller, will increasingly focus on the poorer, mostly smaller countries on the periphery of the international trade and investment system. The geographic aspect of this shift will also increase the overlap between IMF and multilateral development bank programs and strengthen the case for merging the IMF and World Bank lending programs.

Avoiding a Hard Landing

From the U.S. perspective, the definitive shift from a dollar-linked to a floating rate financial architecture is equally stark. Canada and Mexico, the United States' two largest trading partners, accounting for one-third of total U.S. exports, are close to a free float policy. Adding Europe and Japan brings the share of U.S. exports up to 65 percent, and floating rate emerging market economies increase the share to at least 75 percent. China/Hong Kong and Argentina, in fact, are the only remaining major trading partners with exchange rates clearly pegged to the dollar.

The record U.S. trade and current account deficits can only be addressed in the context of this greatly changed set of financial relationships, and in particular the systemic shift to managed floating rates. In January 1999, then-Treasury Secretary Robert Rubin stated for the first time that the U.S. deficit is not sustainable, and the reasons are clear. The eighteen-year chronic current account deficit has transformed the United States from a net creditor nation of $350 billion in 1980 to a net debtor of $1.2 trillion in 1997, headed for $2 trillion by 2000. This equates to approximately 20 percent of U.S. gross domestic product and is projected to rise above 30 percent by 2005. With $300 billion or more of additional debt accumulating abroad each year from the current account deficit, sooner or later the market will exert downward pressure on the dollar to reduce the external imbalance. A slowdown in the U.S. economy or increased growth in Asia and Europe could trigger such a shift. In today's highly integrated financial markets the shift might be abrupt and substantially decrease U.S. economic growth and stock values. This is the "hard landing" scenario, and the policy question is what governments should or should not do within the new floating rate financial architecture to avert it.

One thing the United States should not do is increase import protection to reduce the trade deficit: that would be self-defeating and lead to an even harder landing. The best course is for governments-particularly the U. S., Japan, and Europe-not to resist an early, orderly decline in the dollar as market forces dictate. As noted ,earlier, some governments during the 1990s have used the exchange rate to further mercantilist trade policies, and\ this should stop or be stringently constrained. More precisely, trading partners that have current account surpluses or only modest deficits-which currently includes Japan, the European Union, China, and South Korea-should not increase foreign-exchange reserves through central-bank purchases of dollars. Actually, under a floating rate financial architecture, a prudent level of foreign exchange reserves would be lower than before, and countries with unusually high levels of reserves should, if anything, reduce excessive reserve holdings.

IMF and World Bank ministers should address these analytic and policy issues at the Bank/Fund meetings in September. A much smaller IMF lending program should be welcome, and the multilateral challenge of how to manage a soft landing for the dollar, including reasonable new disciplines on central bank intervention in currency markets, should be prominent on the agenda. Regrettably, however, the ministers will probably avoid such issues, for two reasons.

First, purveyors of IMF loans will resist the notion of a greatly reduced financial program. A big architectural innovation of 1999 was the creation of a new IMF contingent lending facility, which could cause some countries to seek more rather than less borrowing from the Fund. There is also a special problem with the Fund's largest borrower, Russia, which is currently in default to commercial lenders and needs additional IMF loans to pay its existing IMF obligations. That would render the Russian liabilities "non-performing assets" by commercial banking standards, but the IMF applies different standards.

Second, and more important, there is a widespread aversion to any discussion of whether the chronic U.S. current account deficit is sustainable and, if not, what to do about it. The U.S. deficit is a central challenge for the transition to a post-dollar, managed floating rate architecture, but any reduction in the U.S. deficit will reduce surpluses elsewhere, which is politically unwelcome for most U.S. trading partners. Finance ministers continue to be more ostrich-like than forward thinking regarding the key components of the new financial architecture.