UNCTAD presents innovative approach to reform of international monetary and financial system

Calls for new approach to multilateral exchange-rate managementto complement stricter financial regulation

Geneva, 7 September 2009 - More effective regulation and supervision of financial market activity is indispensable to prevent a repeat of the current global financial and economic crisis, a major UNCTAD report contends. But equally important is a reform of the international monetary and financial system aimed at reducing the scope for gains from currency speculation, and at avoiding large trade imbalances. The Trade and Development Report 2009 (1) (TDR) presents an innovative approach to such reform, emphasizing stability of real exchange rates.

The TDR 09, subtitled "Responding to the global crisis" and "Climate Change Mitigation and Development," was released today.

The current global financial and economic crisis is a reflection of the predominance that purely financial activities have gained over real productive activities, the study says. Blind faith in the efficiency of free financial markets lured governments and regulators into underestimating risk and pursuing excessive deregulation. The result was that private agents could engage in extreme leveraging and create havoc in national and international financial systems.

To weed out financial instruments with no social returns and to prevent future, similar financial crises requires more effective regulation of financial market activity. The authors of the report say such regulatory reform should be coordinated internationally and should be part of a profound overhaul of the entire international monetary and financial system.

New financial instruments often provide little social benefit but can harm economic activity in the real sector

Large parts of the financial markets have come to be entirely detached from "real" sector activities, the report contends. Securitization and other financial "innovations" have broken the relationship between lenders -- particularly banks -- and borrowers. As pointed out by UNCTAD Secretary-General Supachai Panitchpakdi in his overview to the TDR, "In the United States, the share of the financial industry in GDP grew from 5% to 8% between 1983 and 2007, while its share in total corporate profits rose from 7.5% to 40%".

"Policymakers should have been wary of an industry that constantly aims at generating double-digit returns in an economy that is growing at a much slower rate," he notes.

Many of the new financial instruments have weakened the capacity of financial institutions to manage risk, and have favoured the development of a non-transparent, poorly regulated and undercapitalized shadow financial system, the TDR says. The contribution of those financial markets to social welfare is highly questionable. The report shows that more finance does not always lead to faster output growth; there is a threshold after which larger financial systems can have a negative effect on output growth.

The large majority of financial market participants react to the same set of "news" with very similar patterns of risk taking. This is why financial speculation leads to upward and downward overshooting of prices, or even to price movements in a direction that is not justified by fundamentals. In particular, speculation has increased price volatility in commodity markets and has caused instability and misalignment of exchange rates. These can cause lasting damage to the real economy and to the international trading system.

"The experience with the current crisis calls into question the conventional wisdom that dismantling all obstacles to cross-border private capital flows is the best recipe for countries to advance their economic development," says the report. But liberalizing financial flows has been the credo of orthodox economics and of international financial institutions over the past 30 years. Promoting proactive capital-account management could give countries sufficient flexibility to manage their domestic macroeconomic policies and improve their prospects for economic stability. This approach would help prevent volatile private capital flows from causing exchange-rate volatility and misalignments that can destabilize domestic financial systems. It also could help improve the reliability of price signals in domestic markets and improve the conditions for efficient resource allocation and dynamic investment.

Greater international stability requires an overhaul of the entire monetary and financial system

The TDR 2009 also points to the weakness of an international reserve system that uses a national currency as a reserve asset. Such a system always depends on monetary policy decisions by the central bank that issues that currency, decisions that are taken according to national policy needs and preferences; they do not account for the needs of the international payments system and of the world economy. Another disadvantage of such a system is that at times of current account disequilibria it imposes the entire adjustment burden on deficit countries. The IMF has reinforced this deflationary bias by imposing restrictive policies on deficit countries as part of its loan conditions, rather than pressing surplus countries to carry out more expansionary policies. Only deficit countries that issue a reserve currency, as the United States, are under no obligation to adjust to growing current-account disequilibria.

But neither capital account management, nor a new international reserve currency will solve the main problem confronting many countries, in particular emerging-market economies, in a world with a high degree of financial integration: the problem of exchange-rate management. It is not possible for a country to absorb external shocks efficiently by adopting either entirely flexible or rigidly fixed exchange rates, UNCTAD economists argue in the report. They therefore suggest that countries should adopt a system of managed flexible exchange rates. This system would target a real exchange rate that is consistent with a sustainable current-account position. Since the exchange rate is a variable always involving at least two currencies, there is a much better chance of achieving a stable pattern of exchange rates in a multilaterally agreed framework for exchange-rate management.

UNCTAD argues that a new monetary system based on multilaterally agreed principles and rules is needed for macroeconomic stability in the globalized economy and for a level playing field for international trade. The report points to the importance of stabilizing real exchange rates at a sustainable level. Such a system would go a long way towards reducing the scope for speculative capital flows that generate volatility in the international financial system and distort the pattern of trade. A stable real exchange rate (RER) at a competitive level would achieve a number of targets simultaneously:

• It would curb speculation, because the main trigger for currency speculation is inflation and interest rate differentials, which would be compensated for by changes in nominal exchange rates.
• It would prevent currency crises, because the main incentive for speculating in currencies of high-inflation countries would disappear, and overvaluation, one of the main destabilizing factors for developing countries over the past 20 years, would not occur.
• It would prevent fundamental and long-lasting global imbalances and avoid subsequent debt traps for developing countries.
• It would avoid procyclical conditionality attached to International Monetary Fund (IMF) supported stabilization programmes, such as cutting government expenditures and raising interest rates. Countries facing strong depreciation pressure could automatically receive financial assistance through swap agreements or through symmetric intervention by countries facing the corresponding appreciation pressure.
• It would reduce the need to hold international reserves to defend exchange rates and could be combined with a stronger role for special drawing rights (SDR), if allocations are made in light of a country´s need for international liquidity to stabilize its real exchange rate at a multilaterally agreed level.

Such a multilateral system would tackle the problem of speculation and destabilizing capital flows at its source, the TDR says.