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New Urgency for International Financial Reform

by Stephany Griffith-Jones

The appalling attack on September 11th has moved the US administration towards seeking multilateral solutions in the fight against terrorism, which is now seen as a global problem. Similarly, the US administration has—after the terrorist attacks—started to move more in a multilateral direction in the economic field; this is reflected for example, in the new commitment to constrain tax havens, as well as improve their regulation. The US and others are also now far more committed to launching a new trade round, which is seen as essential to restoring growth and confidence.

This new attitude is to be welcomed. However, further steps on the road to better global economic governance are urgently needed, especially at a time when there is a serious threat of a marked slowdown in the world economy, with particularly negative effects for the poor and vulnerable.

In important fields like trade and international finance, global institutions—such as the WTO, the IMF and the World Bank—are already in place, providing some basis for global co-operation. These institutions need to be strengthened, and they need significant adaption if they are to meet the new challenges of the 21st Century. And they need to be made far more inclusive, to better represent the voices and interests of developing countries with the majority of the world’s population.​

Capital Flows to Developing Countries

One part of the international economy where important fault lines have been opening up is in the international financial system. In the first half of the 1990s, private flows to developing countries grew very rapidly. This offered the hope that private flows would increasingly replace official flows, and help support speedier growth in developing countries, by complementing domestic savings and bringing in know-how.

Unfortunately, only foreign direct investment (FDI) has contributed to fulfilling that promise, although recent UNCTAD estimates (calculated before September 11th) predict a six per cent fall in FDI flows to developing countries this year. All other private flows—bank loans and equity flows—initially boomed, but were shown to be volatile, sparking off crises that were costly to development. Moreover, all private capital flows to developing countries are heavily concentrated in a few larger and usually richer ones.

Perhaps most worrying, non-FDI flows to developing countries have fallen significantly since the Asian crisis in 1997, and have remained negative (on a net basis), as risk perceptions of lending to—or investing in—developing countries rose significantly, whilst expected returns declined. Projections by the Institute of International Finance, made shortly after the terrorist attacks in the United States, point to a sharp fall of around 37 per cent in net private capital flows to developing countries this year, reflecting deepening problems in the world economy and a further increase in risk aversion.

The need for important changes to the international financial system has been clear for several years, during which they have been much discussed. Recent tragic events just make them far more urgent, given the increased risk of a global economic slowdown. Hopefully the new commitment to global co-operatio​n will now increase their political feasibility.

Ways For​ward

First, imaginative measures are urgently needed to encourage a return of sufficient private flows to developing countries, especially of a more stable type. To help catalyse private flows, creation or better use of guarantee and co-financing mechanisms by multilateral banks can play a valuable role. The virtue of such mechanisms, if well designed, is that they can provide leverage in the use of official resources.

Second, measures that could further inhibit private flows to developing countries need to be rapidly revised. An important example is the proposed changes to the Basle Capital Accord. Although they have several positive features, there are serious concerns that measures such as the introduction of the internal ratings based approach could (as currently conceived) further and significantly discourage international bank lending to developing countries, and could further increase the pro-cyclical nature of any remaining lending as well as its cost. This could be very negative for developing countries’ growth prospects.

Fortunately, the Basle Committee is revising the current proposals. It is important that the revisions include changes that reduce, or hopefully eliminate, the excessive bias against bank lending to developing countries. Reducing the incentive towards pro-cyclical lending, which is harmful to both developed and developing countries, is also important.

Third, it seems important to ensure that sufficient official liquidity is available to developing countries, when private liquidity temporarily falls, especially when external shocks (such as a slowdown of the world economy) hit such countries. This would require a c​ontinued willingness for the IMF to supply large loans to countries in crisis, as well as some adaptation of IMF facilities, to make such loans more flexible and larger when required.​

An improvement of the Contingency Credit Line (CCL) of the IMF could facilit​ate speedier and more automatic disbursement of IMF loans to all countries following very good policies but hit by capital account crises caused by contagion. For countries heavily dependent on commodity exports, especially heavily indebted poor ones, better IMF mechanisms should exist to provide automatic temporary liquidity, when their terms of trade deteriorate.

An expansion of IMF loans of the levels required, either through existing or new mechanisms, may require additional resources. Such resources could be provided by temporary issues of Special Drawing Rights (SDRs) to be used in times of severe economic problems, either globally or within a large part of the developing world. When the situation improved, these loans could be paid back. Such a temporary and self-liquidating issue of liquidity would help sustain growth, but would not pose the risk of creating inflationary pressure when economies recovered.

Indeed, recent events have shown the importance of preparedness for exceptional and unforeseen circumstances, such as the possible rapid slowdown of the world economy. It is important that mechanisms exist to allow rapid and appropriate responses to such changes, and that such mechanisms also help protect developing countries, and especially poor people, from unforeseen events. Measures that help encourage higher and more sustained growth in the developing world would help give greater dynamism to developed country economies.
 

Stephany Griffith-Jones is a Professor at the Institute of Development Studies (IDS), Sussex University. Professor Griffith-Jones is, together with Ricardo Ffrench-Davis (UN Economic Commission for Latin America and the Caribbean), co-directing the WIDER project on ‘Capital Flows to Developing Countries since the Asian Crisis: How to Manage their Volatility’. Further information on this project can be found at www.wider.unu.edu. The IDS Web site is www.ids.ac.uk, and ECLAC’s Web site is www.eclac.org.