Cepr Governance

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Global Economic Governance:

Systemic Challenges, Institutional Responses, and the Role of the New Actors

Brussels (European Commission, Berlaymont Building, Hallstein Room)

17 February 2009

CEPR wishes to thank the European Commission for its financial and organizational support for this meeting.This document was prepared as part of Politics, Economics and Global Governance: The European

Dimensions (PEGGED), a Collaborative Project funded by the European Commission's Seventh Research

Framework Programme

The views expressed in this document are those of the author(s) and not those of the above-mentionedinstitutions or of CEPR which takes no institutional policy positions

Global Imbalances and Global Governance

Philip R. Lane


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Global Imbalances and Global Governance

Philip R. Lane

IIIS, Trinity College Dublin and CEPR

February 2009

Prepared for the Global Economic Governance: Systemic Challenges, Institutional Responses, and

the Role of the New Actors workshop in Brussels on February 17th 2009. Agustin Benetrix, Christiane

Hellmanzeik and Peter McQuade provided helpful research assistance. Email: [email protected]. Tel: +353 1

896 2259. Fax: +353 1 896 3939. Postal Address: The Sutherland Centre, Arts Block, Trinity College

Dublin, Dublin 2, Ireland.

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1 Introduction

Figure 1 shows the evolution of global imbalances in recent years, plus the projections

for the 2009-2013 period. The general dynamics are well known: the United States has

been running the worlds largest current account decit, while current account surpluses

have been generated by Japan, emerging Asia and the oil exporters (with the relative

contributions of these groups varying over time). Although the aggregate current account

balance of the euro area has been small, this obscures a wide dispersion of current account

positions across the member countries, with the large German surplus oset by decits in

countries such as Spain, Portugal, Greece and Ireland. The IMFs projections for 2009-2013

indicate a general contraction in current account imbalances, with the important exception

of emerging Asia.

Turning to net foreign asset positions, Figure 2 looks broadly similar to Figure 1, al-

though with some important modications. First, the pattern of net valuation gains and

losses until 2007 has been stabilising for countries such as the United States, such that

the deterioration in its net foreign asset position has been less than the size of current

account decits. Second, Figure 2 shows that the dispersion of net foreign asset positions

is projected to widen over 2009-2013, despite the expected contraction in current account

balances. This reects the reality that the projection for current account balances does not

anticipate widespread sign reversals in positions but just a dimunition of existing trends.

Moreover, it is not clear that the pattern for valuation eects over 2009-2013 will neces-

sarily be stabilising. Indeed, Milesi-Ferretti (2009) estimates that the pattern of valuation

eects during 2008 was destabilising, with the United States experiencing a major valu-

ation loss and some of the major surplus countries enjoying signicant valuation gains.

(The 2008 distribution of valuation gains reects the skewed composition of international

balance sheets, with the long equity, short debt prole of the United States leaving it very

exposed to the global equity price declines during 2008.)

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Accordingly, there are several reasons to remain concerned about the scale of global

imbalances. First, global imbalances were surely a contributory factor to the origin of the

current global nancial crisis (Portes 2009). While there remains considerable disagree-

ment about the appropriate weighting that should be attached to global imbalances in

developing a comprehensive explanation for the current crisis, it is important to further

improve our analytical understanding of the sources of global imbalances. Second, the on-

going persistence of global imbalances (in the current account and in the net foreign asset

position) continues to be a major risk factor for the world economy. Most obviously, the

risk of a disruptive dollar depreciation remains current, such that there is a clear policy

interest in continuing to focus on global imbalances.

Third, it important to consider new institutional arrangements that might help to avoid

the emergence of non-sustainable patterns in global imbalances in the future. Along one

dimension, it is plausible that the global tightening of regulations concerning the behaviour

of the nancial sector may help to avoid the amplication problem, by which capital inows

into the United States contributed to increases in leverage and the explosion in securiti-

sations. Accordingly, there is some level of coherence between the global moves to reform

the nancial sector and the debate concerning the role of governance reforms in redressing

global imbalances.

A second dimension concerns the impact of the monetary policies of the worlds leading

nancial economies on the distribution of global imbalances. While the current account

is clearly not a policy target for central banks, the relevant issue is whether the major

central banks responded appropriately to shifts in asset prices that may be traced back to

global imbalances. Again, it is possible that the current crisis may prompt a recasting ofthe intellectual framework that guides monetary policy decisions, extending to include a

greater appreciation of the role of international factors in driving domestic asset prices.

While these elements of global governance are important, I focus in this paper on how

reforms in the governance of the global nancial system may alter the incentives facing

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those emerging market economies that have opted to run large current account surpluses

over the last decade. These surpluses haven been accumulated in order to self insure

against the risks of disruptions in capital ows to these economies. Although the emerging

markets have not been the only source of current account surpluses, we focus on this group

of countries since these surpluses may be intepreted as globally inecient. In contrast,

the large surpluses run by oil exporters in recent years conform to neoclassical predictions of

optimising behaviour in response to a terms of trade windfall. Similarly, the chronic current

account surpluses of Japan and Germany can be largely attributed to demographic patterns

and the declining share of these economies in global GDP.1 While ecient current account

surpluses may still pose problems for the global system, the inecient surpluses run by

emerging market economies are arguably a more natural target for institutional reform.2

Although the epicenter of the global nancial crisis has clearly been in the nancial

systems of the advanced economies, the emerging markets have been substantially aected

by the crisis. The latest indicators suggest a major slowdown in output and trade volumes

and a reversal in capital inows to these economies. The decline in fundamentals is also

reected in major shifts in asset prices, with a substantial depreciation of the currencies of

most emerging market economies (China excepted), a decline in stock market values and an

increase in foreign-currency bond spreads. These negative developments illustrate that the

self insurance model has not enabled emerging market economies to remain immune from

negative global developments and reinforce the urgency of developing a new institutional

framework to support a more stable pattern of capital ows to emerging market economies.

1 See Lane (2008x) on the Japanese external position.2 Here, I use inecient in the sense of departing from the current account balance that would be run

under an international nancial system that has a superior institutional architecture.

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2 Shifts in the External Balance Sheets of Emerging

Market Economies

The external risk prole of emerging market economies has undergone a radical shift since

the mid 1990s.3 Figure 3 shows the degree of international nancial integration of the

major emerging market economies has trended upwards over time, where the IFI index is

the sum of foreign assets and foreign liabilities expressed as a ratio to GDP.4 As is analysed

by Lane and Milesi-Ferretti (2008a), the level of international nancial integration remains

far below that exhibited by the major advanced economies. However, it is much higher

in terms of gross positions than was the case during previous crisis episodes in the 1980s

and 1990s. The scale of gross positions grew rapidly over the last ve years, which was

mainly generated by an acceleration in gross capital ows. In addition, rising global asset

values increased the scale of balance sheets relative to GDP. Accordingly, in terms of gross

cross-border positions, the emerging market economies were much more integrated into the

global nancial system at the onset of the current global crisis.

As was noted in the previous section, the composition of the international investment

position of emerging market economies underwent a major shift. A major trend has been

the growing importance of FDI and portfolio equity as a source of nance (Figure 4).

This has been a positive development in terms of risk prole, since the foreign investor

absorbs the risk of state-contingent returns on these positions. We can gain further insight

by inspecting the scale of the portfolio holdings by advanced-economy investors that are

located in the major emerging market economies. Figure 5 expresses these holdings in terms

of their weight in the total international portfolios of the major investor nations. We observe3 The following material draws on Lane (2009).4 In what follows, the group of major emerging market economies typically comprises the following

members of the G20: Argentina, Brazil, Mexico, India, Indonesia, China, Korea, South Africa, Saudi

Arabia and Turkey.

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the increasing importance of emerging market destinations in portfolio equity assets, while

these countries are much less important in international portfolio debt holdings.

Figure 6 shows that the risk prole has been further improved by the rapid growth in

foreign-exchange reserves, which have increased from 5 percent of aggregate GDP in the

1980s to over 25 percent by 2007.5

Taken together, these trends have led to a striking shift in the international conguration

of portfolios.6 Figure 7 shows that the major emerging market economies have shifted from

a position in 1995 in which these countries were both net debtors and net recipients of

equity investments to a prole in which a much larger negative net equity position is nearly

matched by a very large long position in foreign debt holdings. The mirror-image trend is

evident for the major advanced economies, which increased their long position in foreign

equity while also taking on a larger short position in foreign debt.

The transformation of the external nancial prole of emerging market economies also

included a major reduction in net foreign liabilities (Figure 8). This was achieved by a

sustained period of running current account surpluses (Figure 9). While the long-term

allocative eciency of capital running uphill may be open to question, it should have

reduced the vulnerability of emerging market economies to capital ow reversals, since the

net external position has been a historical predictor of the incidence of crises.

The impact of these shifts in external capital structure has been to transform the ag-

gregate foreign-currency position of emerging market economies. Lane and Shambaugh

(2008) have developed an index of the foreign-currency exposure that is embedded in a

given level of foreign assets and foreign liabilities. This FXAGG index has the range

(

1; 1) where a country that has only foreign-currency liabilities and zero foreign-currency5 There is a rapidly-growing literature that seeks to explain the determinants of reserve accumulation.

The recent study by Obstfeld et al (2008) highlights nancial development as a driver of external reserves,

in order to oer investors protection against the risk of a double drain. See also the recent analysis in

ECB (2009).6 See also the analysis in Lane and Milesi-Ferretti (2007a).

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assets would score the value 1, while a country with zero foreign-currency foreign liabili-

ties and all of its foreign assets denominated in foreign currencies would score the value 1.

Table 1 shows the FXAGG index has become much less negative for most major emerging

market economies and indeed is substantially positive for a number of countries. For this

latter group, the depreciation of the domestic currency would actually generate a positive

balance-sheet eect, since the capital gain on its foreign-currency assets would exceed the

capital loss on its foreign-currency liabilities.

At one level, this general reconguration may be viewed as involving a major risk trans-

fer from the emerging markets to investors in the advanced economies. In turn, this should

be welfare improving to the extent that investors in the higher-income economies with

more developed nancial systems should be better equipped to manage risk. However, the

build up in large two-way gross positions also meant that failures in risk management and

illquidity problems in the advanced economies may be transmitted quickly to counterparts

in the emerging market economies.

However, while these steps have reduced the vulnerability to nancial crises, each in-

volves signicant ineciencies. In particular, this strategy has been costly in terms of

foregone domestic absorption opportunities and in the potential for superior international

risk sharing arrangements. Moreover, it exerts substantial spillover eects on the reserve-

issuing countries, through the impact of persistent trade surpluses and the ocial-sector

demand for liquid securities. Finally, the adverse impact of the current crisis on emerging

market economies demonstrates that vulnerabilities remain, such that the self-insurance

approach has not provided complete insulation.

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3 The Institutional Framework for Capital Flows be-

tween Advanced and Developing Economies

In relation to the medium-term goal of improving the structural foundations of the inter-

national nancial system, the over-riding principle is to reduce the risks faced by emerging

market economies in engaging with the international nancial system (Wolf 2009). In ad-

dition, in managing the residual risk, the goal is to develop mechanisms that reduce the

cost of insuring against such risks.

In general, the appropriate framework for thinking about medium-term reform is to

recognise that the emerging market economies suer from an incomplete level of interna-

tional nancial integration. Unlike very low income countries, these economies are su-

ciently integrated into the global nancial system to be exposed to severe nancial shocks.

However, at the same time, these countries are treated dierently by the global system in

comparison to the nancial environment that faces the most advanced economies. Empiri-

cally, Calvo et al (2008) and Kose et al (2008) nd that there is a threshold eect in terms

of the relation between international nancial integration and nancial stability. The goal

for the emerging market economies is to pass this threshold and thereby attain a more ro-

bust form of nancial integration. Importantly, as is emphasised by Kose et al (2008), the

nancial integration threshold is aected by key features of the domestic economy, includ-

ing the level of domestic nancial development, the quality of institutions and governance,

macroeconomic policy discipline and trade integration. Accordingly, reaping the gains from

nancial globalisation involves the same types of reforms that are also generally benecial

for domestic economic performance.In relation to the domestic reform eorts of the emerging market economies, the recent

increase in the cost of external capital should induce an intensication of eorts to develop

the domestic nancial system. Domestic nancial development is important for two rea-

sons. First, the improved domestic mobilisation of domestic savings reduces the importance

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of external capital as a funding source. Second, a deeper nancial system increases the span

of investable opportunities that are available to foreign investors. Financial development

should be broadly interpreted to encompass improvements in corporate governance and

the quality of the regulatory system. In particular, the current crisis has highlighted that

volume-based indices of nancial development (such as the stock of outstanding securities)

are not good measures if the nancial system is distorted by a poor regulatory environment.

It is also important to take into account that the empirical evidence indicates that

nancial reform policies only promote nancial development in environments in which pri-

vate property rights are secure from arbitrary political interference (Tressel and Detragiache

2008). Moreover, while the full impact of domestic nancial reform only unfolds over the

medium term, the credible announcement of a programme of nancial reforms should be

helpful even in the short term. While Figure ?? shows that the major emerging market

economies have made major progress in nancial reform, a considerable gap remains for

several countries relative to a fully-liberalised domestic nancial system (the maximum

score is 21 in the IMF index).

It should also be understood that domestic risk management extends beyond the nan-

cial system to include social insurance programmes. In advanced economies, risk manage-

ment is provided by a combination of public and private systems. However, the degree of

social insurance for major personal risks (illness, unemployment) is much less adequate in

a number of emerging market economies, leading to a high degree of precautionary saving

by households. Accordingly, part of the reform agenda is to improve the adequacy of social

insurance, via welfare systems and the public funding of relevant goods and services. In

similar fashion, institutional reform extends beyond the regulation of the nancial system.A striking illustration is provided by Naughton (2006), who shows how the ambiguous

ownership status of many enterprises in China generates an extraordinarily high level of

corporate savings, due to lack of clarity over the appropriate distribution of dividend pay-

ments.

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In relation to domestic reforms that directly aect the nature of international capital

ows, one key element is the development of local-currency debt markets. Burger and

Warnock (2006) investigate the determinants of success in promoting local-currency debt

markets and nd that key drivers include the attainment of macroeconomic stability (low

ination) and strong creditor protection. Indeed, these authors note that the requirements

for a thriving local-currency bond market are very similar to those for the development

of the domestic-currency banking system. Accordingly, reform eorts that are targeted

at improving the operation of debt nancing in general can serve the dual purpose of

promoting both the bond market and the banking system.7

So far, local-currency debt markets have been dominated by locally-resident investors,

with relatively little participation by foreign investors. While participation by domestic

residents is a major achievement in itself, it is also desirable to enable eective cross-border

capital ows in local currency. To this end, it is important that the development of local-

currency debt markets is complemented by the development of the currency derivatives

market, in order to allow investors to separately trade currency risk and credit risk.

The role of derivatives markets in cross-border risk transfer is not well understood at

the empirical level, with many derivative trades simply redistributing risk across domes-

tic residents. However, the evidence from a recent national survey in Australia is quite

striking. The analysis of this survey by Becker and Fabbro (2006) shows that currency

hedging allowed Australian residents to transform the risk prole of the external balance

sheet. In particular, foreign-currency debt of AUS$428 billion at the end of March 2005

was greatly reduced to AUS$90 billion through derivatives contracts with overseas coun-

terparties. These international hedges meant that the aggregate foreign-currency exposureof Australia turned from negative to positive. Accordingly, the Australian example illus-

7 Schmitz (2009) nds that domestic nancial reforms stimulates capital inows for a sample of emerging

European economies. A striking feature of his work is that it is banking-sector reform that is especially

important in attracting inows.

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trates how foreign-currency debt can be transformed via currency derivatives into domestic-

currency debt from the perspective of domestic residents.8

In addition to the promotion of local-currency debt markets, there is also considerable

scope to improve risk sharing via other types of state-contingent instruments. For instance,

the idea of GDP-indexed bonds has received considerable attention (see Borensztein and

Mauro 2004 for a recent and comprehensive review). In a series of contributions, Caballero

and a set of collaborators have advocated other types of state-contingent instruments (see

Caballero and Cowan 2007 for an overview of this line of work). On the liabilities side, a

commodities exporter might issue debt with a coupon that is indexed to global commodity

prices. More broadly, emerging markets might tie yields to the high-risk spread in the US

corporate debt market. The virtue of these types of instruments is that the contingent

element in the return is a function of external conditions, such that it cannot be manip-

ulated by the issuer. This feature eliminates the moral hazard problem that generically

aects state-contingent contracts. There is also scope for greater use of state-contingent

instruments on the asset side of the international balance sheet, since many of the risk

sharing benets of state-contingent liabilities can be replicated by an appropriate portfolio

of assets. However, the limitation of an asset-based approach is that, all else equal, it

involves the leveraging of the international balance sheet.

A second key element is to further promote international equity nancing. As indicated

earlier, the share of equity in the foreign liabilities of emerging markets has grown strongly

over the last decade. However, corporate governance and regulatory problems limit the

attractiveness of emerging-market stockmarkets for many investors (see, for example, the

evidence provided by Kho et al 2008). However, the evidence is that nancial reformis associated with an increase in the equity share in liabilities, such that investors do

8 This is not to under-estimate the regulatory and market design challenges in establishing a well-

functioning derivatives market. Again, the current crisis teaches us that poorly-functioning derivatives

markets can lead to non-fundamental volatility in the prices of the underlying assets.

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respond to shifts in the institutional environment (Faria et al 2007). Similar factors also

apply in relation to foreign direct investment. In addition, there are restrictions in some

countries that limit the capacity of foreign investors to acquire controlling stakes in certain

sectors that are deemed to be strategically important. However, in the other direction, it

is possible that the level of subsidies and tax breaks oered to foreign direct investors is

arguably excessive in a number of host countries, such that some shift away from foreign

direct investment could be desirable in some cases.

The importance of domestic institutional development extends beyond the nancial

sector. In particular, a fundamental goal for emerging market economies is to copperfasten

stability in macroeconomic policies. In relation to scal procyclicality, institutional reforms

can do much to improve the cyclical behaviour of scal policy (Lane 2003). While there

remains considerable variation across countries, the capacity of countries such as Chile to

develop scal processes that help to insulate the budget from the curse of procyclicality

has been impressive.

So far, we have discussed domestic reforms. An extension of this is to further pro-

mote regional nancial integration. The empirical evidence is that gravity factors such as

distance and cultural linkages are inuential in international asset trade (Portes and Rey

2005, Lane and Milesi-Ferretti 2008b). In addition, there is a strongly positive correlation

between trade in goods and services and trade in assets. Accordingly, there is much scope

for regional levels of nancial integration. In particular, regional capital ows may be more

stable in character, in view of the underlying linkages between neighbouring economies and

the lower level of bilateral exchange rate volatility. Accordingly, it is desirable that regional

groups intensify eorts to cooperate in the design of common institutional standards fornancial market development and work to lift barriers to cross-border asset trade.

Turning to the international dimension of reform, there is considerable scope for the

international community to support a more stable system of international nance for emerg-

ing market economies. The international nancial institutions have a clear role to play in

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terms of the provision of technical advice in the development of domestic nancial systems.

For instance, in relation to local-currency debt markets, the World Banks GEMLOC pro-

gram seeks to build a common knowledge base concerning the operation of these markets. 9

The IFIs could possibly do more in terms of issuing securities in the currencies of the

emerging market economies. Such issues have the potential to help to expand the depth

and liquidity of the domestic-currency bond markets, as well as allowing the international

nancial institutions to make local-currency loans to clients in those markets. Such issuance

could be in specic currencies, such as the RMB-denominated bond issues by the Asian

Development Bank and the International Finance Corporation (the so-called Panda Bonds).

In addition, securities could be issued that are indexed to a basket of emerging market

currencies (see also the discussion in Wolf 2009). More generally, in view of the free riding

problem and other externalities that inhibit the creation of new securities markets, the IFIs

potentially have a central role in helping to develop the types of state-contingent securities

that may improve the risk prole of the external liabilities of emerging markets.

The current crisis has vividly illustrated how public sources of funding must be available

in the event of the breakdown of nancial trade among private-sector counterparties. In

this respect, two major innovations stand out in terms of the expansion of public funding

for cross-border transactions. First, there has been the establishment of currency swap

arrangements among the worlds major central banks and also vis-a-vis selected emerging

market economies.10 As is discussed by Obstfeld et al (2009), the currency swaps with

emerging market economies have typically been with countries that have already very

high levels of reserves. Accordingly, the main function of the swaps has been to signal

the commitment of the participating central banks to ensure adequate foreign-currency9 GEMLOC stands for Global Emerging Market Local Currency Bond Fund Program.

10 See McGuire (2009) for an illuminating analysis of the global dollar shortage that was created by

international banks seeking to obtain dollar funding for the very large dollar asset positions that expanded

rapidly in recent years.

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liquidity for the countries in question.

Second, the IMF created the new Short-Term Liquidity Facility (SLF) that is available

to those member countries that have previously demonstrated strong fundamentals in terms

of sound policies, access to capital markets and sustainable debt burdens. Since it relies

on the track record of the applicant, the funds can be disbursed quickly and without

conditionality, such that the SLF has the potential to be helpful in tackling short-term

liquidity diculties. Accordingly, the SLF represents a potentially useful expansion in the

range of instruments available to the IMF in dealing with liquidity problems. However, as

with any public liquidity facility, the SLF faces the stigma problem, by which a country

may be reluctant to tap these funds in fear of the negative signal that such a move would

send to the markets.

More generally, the disruption in private capital ows reinforces the need for an ex-

pansion of the funding base for the IMF. In tandem with a redistribution of quotas, it is

appropriate that the largest emerging market economies join the advanced economies in

becoming substantial underwriters of the IMFs balance sheet. A better-nanced IMF that

stood ready to provide liquidity support would enable these economies to shed some of

their excess foreign-currency reserves and would be collectively more ecient. Accordingly,

the principle of major IMF renewal should be a key governance target.

That said, it is unlikely that major IMF reform can be achieved in the short term. The

recent agreement to reallocate quotas in a limited fashion took a considerable period to

be negotiated and has not yet been ratied by all member countries. A major shift in the

distribution of voting power at the IMF requires leadership by those regions that are cur-

rently over-represented, with the obvious potential for the consolidation of representationby member countries of the European Union.

The expansion of IMF resources need not wait for the completion of governance reform.

Already, Japan has oered $100 billion in nancing for the IMF, while other major surplus

economies may also be prepared to oer extra funding. Such funding sources should

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be explored in tandem with accelerated eorts to engineer a more radical shift in quota

allocations.

The current crisis has also revealed a major analytical failure in under-estimating the

risks embedded in the rapid increase in nancial balance sheets over 2002-2007. It is

important that the appropriate lessons from this episode be drawn and the IMF is best

positioned to conduct the research that analyses the sources of the crisis from a global

perspective. In turn, the IMF has a role to play in developing new analytical frameworks

to better understand international nancial linkages and in establishing a common level

of understanding across the member countries. As is emphasised by Eichengreen (2008),

this is a prerequisite for enabling any substantive level of policy coordination. Indeed, the

2006-2007 multilateral consultation process on global imbalances can be understood in this

way, as a mechanism to improve mutual understanding of the policy goals of the dierent

participants and identify areas of potential analytical disagreement. While such initiatives

do not immediately translate into coordinated policy decisions, the central role of national

governments in policy delivery means that a new framework for global nancial governance

must build linkages between national governments and the IMF, in addition to the functions

that can be addressed through supra-national institutions and purely inter-governmental

cooperative initiatives.

Improved analysis of global imbalances would be greatly facilitated by renewed eorts

to improve the collection of publicly-available high-quality data on international capital

ows and international investment positions. While data availability has improved with

initiatives such as the Coordinated Portfolio Investment Survey (CPIS), major data holes

remain. Indeed, measurement problems are growing in absolute scale, due to the rapidgrowth in the volume of cross-border transactions and the pace of nancial innovation. Lane

and Milesi-Ferretti (2009) have shown the extent of measurement problems in analysing

the US external position, while it is evident that there are substantial data problems in

understanding the international balance sheets of major emerging market economies. A

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major target must be to improve the quality of data concerning capital ows that are

intermediated through oshore nancial centres, in view of the very limited data availability

for these entitites.

In addition to the roles played by the international nancial institutions, there is also

room for a greater level of inter-governmental cooperation in regulating the global nancial

system. Angeloni (2008) provides an interesting study of the relative merits of dierent

vehicles for international policy coordination. To a degree, the global debate mirrors the

shifting preferences within the European Union concerning the conditions under which it

is appropriate to delegate powers to a supranational organisation such as the European

Commission or the European Central Bank versus decisions that are better reserved for

inter-governmental negotiation.Most recently, the focus has been on coordinating reforms

of national regulatory systems through the activities of the Financial Stability Forum. In

relation to international capital ows, one element in these reforms could be to achieve

a coordinated response to the treatment of foreign-currency claims by domestic nancial

institutions. In particular, it is worth investigating whether there are regulatory barriers

that unncessarily deter nancial institutions in the advanced economies from holding claims

that are denominated in the currencies of the emerging market economies (see also Portes

2009).

In addition to reform of the global nancial institutions, there is also room for a greater

level of regional initiatives. The limits to the potential resources of the IMF and the

heterogeneity of IMF membership means that there is scope for additional resource pooling

at the regional level.11 Most obviously, the bilateral swap arrangements among ASEAN+3

countries under the Chiang Mai Initiative demonstrate the viability of securing liquidityinsurance that is additional to IMF resources.12 Moreover, the current crisis has also shown

11 See Irwin et al (2008) for a model of how diversity across countries limits the capacity of the IMF to

function as a credit union.12 See Kohlscheen and Taylor (2008) for an analysis of the Chiang Mai bilateral swap arrangements. In

line with a risk pooling model, these authors nd that bilateral swaps among participants are larger, the

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a regional capability to quickly respond to the shift in international nancial conditions.

For example, major increases in the scale of the agreed bilateral swaps between China

and Korea and between Japan and Korea were announced in December 2008. There is

also room for the regional development banks to provide additional nancing in those cases

where private-sector credit markets have broken down.

Regional groupings may also be better placed in terms of continuous surveillance of

member country policies and in designing multi-dimensional forms of policy coordination,

by which regional integration in trade and factor mobility reinforces the incentives to co-

operate in terms of nancial support.13 The European experience also suggests that there

may be scope for regional cooperation in the development of processes that help in ensuring

the sustainability of the public nances (Lane 2008). While the scope for political inte-

gration clearly varies across regions and limits the transferability of institutional models

across regions, the general principle is to obtain those benets from regional integration

that are feasible in each particular setting.

Finally, it is important to appreciate that a broad reform programme at the domestic

and international levels could lead to a major re-conguration of the distribution of global

imbalances. In particular, the growing share of global GDP that is generated by emerging

market economies in combination with successful domestic nancial development and ap-

propriate international nancial reforms may lead to this group of countries seeking to be

a major net absorber of global capital ows.14 If this scenario plays out, other potential

weaker the correlation in reserves between the pair of countries. However, these authors also highlight the

limitations of a regional approach to risk pooling: the correlation in reserves growth is much higher within

regions than across regions.

13 The Chiang Mai agreement among the ASEAN+3 (China, Japan, Korea) provides for short-term

currency swap facilities. This agreement demonstrates the ability of governments to agree on forms of

policy coordination even when the level of political integration is quite low. See Lane (2008) on the lessons

to be drawn from the European approach to economic integration.14 Dollar and Kraay (2006) calibrate a model that projects current account decits for China on the order

of 5 percent of its GDP for a sustained 10-15 year period. While not approaching the size of the current US

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borrowers will receive smaller net capital inows and/or the level of global interest rates

will climb. For advanced economies seeking to save due to population ageing, this should

be a welcome development.

4 Conclusions

The self-insurance strategy adopted by many emerging market economies over the last

decade have been only partially successful in reducing exposure to international nancial

shocks. However, the limited role of domestic-currency debt in the funding of external liabil-

ities means that the nature of international nancial integration for the emerging marketeconomies remains quite dierent relative to the experience of the advanced economies.

Moreover, the self-insurance approach is collectively inecient in terms of the allocation

of resources within the emerging market economies and between the emerging markets

and the advanced economies. Moreover, the expansion in the gross scale of international

balance sheets means that the linkages between the emerging market economies and the

advanced economies have grown tighter, in terms of the exposure to breakdowns in the

normal operation of nancial markets.

Accordingly, there is a busy reform agenda at the domestic, regional and global levels

in order to develop a nancial system that improves the stability of external nancing

for emerging market economies. The reforms that will benet the emerging markets are

also the reforms that should improve global economic performance and global nancial

stability. Accordingly, improving the institutional framework that underpins international

capital ows should be a priority for global reform eorts.

decit relative to world GDP, it would still be a substantial call on global savings. See also the discussion

in Lane and Schmukler (2007).

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Net Foreign Asset PositionsWEO October 2008

1997 1999 2001 2003 2005 2007 2009 2011 2013

-9

-7

-5

-3

-1

1

3

5

7

9

1997 1999 2001 2003 2005 2007 2009 2011 2013

-9

-7

-5

-3

-1

1

3

5

7

9

United StatesEuro AreaJapanEmerging AsiaOil Exporters

Figure 2: Net Foreign Asset Positions. Source: World Economic Outlook (October 2008).

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International Financial Integration (% of GDP)

0

20

40

60

80

100

120

140

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Figure 3: International Financial Integration Ratio. Note: Sum of foreign assets and

liabilities, expressed as a ratio to GDP. Group of major emerging market economies. Source:

Authors calculations based on updated version of dataset compiled by Lane and Milesi-

Ferretti (2007a).

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Share of Equity Liabilities (% of total liabilities)

0

10

20

30

40

50

60

70

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Figure 4: Equity Share in Foreign Liabilities. Note: Group of major emerging market

economies. Source: Authors calculations based on updated version of dataset compiled by

Lane and Milesi-Ferretti (2007a).

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year

EMs: Portfolio SharesCPIS

2001 2002 2003 2004 2005 2006 20071

2

3

4

5

6

7

8

9

10

EquityDebt

Figure 5: Portfolio Allocations to Major Emerging Markets. Note: Portfolio holdings of

major investor nations (US, UK, Euro Area, Japan) in major emerging markets (Argentina,

Brazil, Mexico, Turkey, South Africa, Russia, Saudi Arabia, India, Indonesia, China, Ko-

rea). Source: Authors calculations based on IMFs Coordinated Portfolio Investment

Survey.

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Foreign Exchange Reserves (% of GDP)

0

5

10

15

20

25

30

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Figure 6: Foreign Exchange Reserves. Note: Group of major emerging market economies.

Source: Authors calculations based on updated version of dataset compiled by Lane and

Milesi-Ferretti (2007a).

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Advanced G17

(1995)

Advanced G17

(2007)

Emerging G17

(1995)

Emerging G17

(2007)

-35

-30

-25

-20

-15

-10

-5

0

5

10

15

20

-20 -15 -10 -5 0 5 10 15 20 25

Net Debt

Net Equity

Figure 7: Composition of External Balance Sheets. Note: Advanced G17 comprises US,

UK, Euro Area, Japan and Canada. Emerging G17 is group of major emerging market

economies. Source: Authors calculations based on updated version of dataset compiled by

Lane and Milesi-Ferretti (2007a).

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Net Foreign Assets (% of GDP)

-25

-20

-15

-10

-5

0

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Figure 8: Net Foreign Asset Position. Note: Group of major emerging market economies.

Source: Authors calculations based on updated version of dataset compiled by Lane and

Milesi-Ferretti (2007a).

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Current Account (% of GDP)

-3

-2

-1

0

1

2

3

4

5

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Figure 9: Current Account Balances. Note: Group of major emerging market economies.

Source: Authors calculations based on data from International Monetary Fund.

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Table 1: International Currency Exposures

FXAGG

Arg. Brazil China India Indo. Korea M exico Russia S.A rabia S.Africa Tur.

1995 -0.01 -0.13 0.15 -0.48 -0.56 0.00 -0.32 -0.02 0.59 0.02 -0.42

1996 0.01 -0.13 0.19 -0.42 -0.48 -0.05 -0.25 0.06 0.64 0.05 -0.38

1997 0.02 -0.17 0.26 -0.36 -0.55 -0.11 -0.20 0.13 0.58 0.10 -0.341998 -0.01 -0.24 0.31 -0.33 -0.52 -0.01 -0.22 0.01 0.48 0.20 -0.36

1999 0.02 -0.21 0.33 -0.27 -0.46 0.04 -0.20 0.06 0.48 0.27 -0.32

2000 0.02 -0.19 0.38 -0.21 -0.47 0.15 -0.15 0.17 0.54 0.31 -0.38

2001 -0.06 -0.17 0.37 -0.16 -0.46 0.15 -0.08 0.19 0.58 0.31 -0.34

2002 -0.08 -0.18 0.41 -0.07 -0.40 0.16 -0.09 0.24 0.63 0.29 -0.32

2003 -0.05 -0.12 0.43 0.03 -0.35 0.19 -0.09 0.22 0.66 0.33 -0.30

2004 -0.03 -0.05 0.43 0.07 -0.33 0.24 -0.06 0.23 0.72 0.34 -0.24

NETFX

Arg. Brazil China India Indo. Korea M exico Russia S.A rabia S.Africa Tur.

1995 -0.01 -0.07 0.08 -0.22 -0.42 0.00 -0.19 -0.01 0.68 0.01 -0.32

1996 0.01 -0.06 0.10 -0.16 -0.38 -0.02 -0.27 0.05 0.66 0.03 -0.27

1997 0.02 -0.08 0.14 -0.15 -0.43 -0.06 -0.19 0.10 0.58 0.07 -0.25

1998 -0.01 -0.13 0.19 -0.13 -0.42 0.00 -0.19 0.01 0.50 0.16 -0.27

1999 0.02 -0.13 0.22 -0.11 -0.94 0.04 -0.17 0.08 0.58 0.26 -0.26

2000 0.02 -0.17 0.27 -0.09 -0.71 0.15 -0.14 0.36 0.59 0.48 -0.40

2001 -0.07 -0.14 0.26 -0.07 -0.57 0.13 -0.06 0.32 0.58 0.45 -0.36

2002 -0.10 -0.16 0.30 -0.03 -0.48 0.15 -0.07 0.37 0.67 0.37 -0.43

2003 -0.16 -0.11 0.32 0.01 -0.36 0.18 -0.06 0.34 0.69 0.47 -0.34

2004 -0.07 -0.06 0.34 0.04 -0.31 0.25 -0.05 0.35 0.76 0.43 -0.26

Note: FXAGG is scaled between (-1,1) and denotes the aggregate foreign currency exposure for

a given level of foreign assets and liabilities; NETFX(= FXAGG IFI) is ratio of net foreign-

currency assets to GDP. Source: Authors calculations based on dataset compiled by Lane and

Shambaugh (2008).

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