Rick Rowden offers a trio of measures to overhaul a creaking global financial system
Thanks to the historically ambitious scale of their fiscal and monetary policies, most of the rich countries have been able to kickstart their economies in the wake of the Covid-19 crisis. But the economic outlook in 2022 for many emerging markets and developing countries, where 75% of humanity lives, is not looking so good.
It is estimated that nearly 125m people were pushed into poverty in 2020 with 80% of them in the middle-income and emerging market economies. In fact, increased levels of sovereign debt distress, inflation, interest rates, and continuing supply-chain bottlenecks are all presenting huge challenges for developing countries. All of this makes their outlook quite precarious.
The global tumult from the Russian invasion of Ukraine has only worsened the outlook further. But what really undermines the successful economic development of these economies is a host of structural features of the world’s financial architecture.
Today’s global financial architecture was built by, and for, the rich countries. It was primarily designed after World War II, when the United Nations’ Monetary and Financial Conference met in Bretton Woods, New Hampshire, US, in 1944 to establish the International Monetary Fund (IMF) and World Bank.
After the global economic destruction of the Great Depression and two world wars, the task at Bretton Woods was to rebuild an international financial system that would produce international economic stability, rising prosperity, and peace. Based on a set of fixed exchange rates and controls on private capital flows, the system broadly achieved those goals during the 1950s and 1960s.
What really undermines the successful economic development of these economies is a host of structural features of the world’s financial architecture.
But in the 1970s, when it became difficult for the US to maintain the US Dollar-based international financial system, the G7 economies abandoned the Gold Standard and introduced a new system of fluctuating exchange rates.
That began a new era of deregulated finance and reduced taxes on financial activities that have characterised financial globalisation over the past few decades. The result has been a global economy that is decidedly less stable, with increasingly frequent financial crises and worsening economic inequality that threatens prosperity. The global financial architecture is creaking, and is in need of a major overhaul.
There are three major problems with the current global architecture [see box for a deeper assessment]:
- too much “hot money” flows in and out of emerging markets;
- there is no internationally-agreed procedure for orderly sovereign debt restructurings; and
- global tax evasion and illicit finance have reached ridiculous proportions.
The respective fixes for these problems are:
- the IMF should say capital controls are OK;
- establish an international sovereign debt workout mechanism; and
- close down offshore centers and tax havens.
Clearly there are also many other structural issues in the global financial architecture that must be addressed if the system is to live up to its goal of producing international economic stability, rising prosperity, and peace. For example, the world’s multilateral development banks must be significantly recapitalised to help finance the energy transition in developing countries; public development banks must be brought back in a big way, and the IMF should just listen to its own research department and stop pushing harmful economic austerity onto its borrowers.
The list is long, but taking action on these three big fixes would be a good start.
Triage: a closer look at the world’s financial ailments and their treatments.
Problem one – too much “hot money”
Thirty years of financial sector liberalisation reforms led many developing countries to abandon their capital controls and allow investors to put money into their economies and pull it out whenever they wanted. It was argued that doing so would make their economies more attractive to investors. It ended up making their economies more susceptible to financial instability because of volatile capital inflows and outflows.
Whenever the rich countries lower their interest rates, investors seek better returns from the higher interest rates in the emerging markets. This can trigger large capital inflows, which often pushes up their exchange rates, making their exports less competitive.
It happens in reverse, too. Once the rich countries decide to raise interest rates again, investors will start to pull out of the emerging markets to seek higher returns back in the rich countries. This causes the emerging market currencies to depreciate, sparking debt and insolvency crises.
For example, as the US Federal Reserve prepares to begin raising interest rates again, developing countries are expected to suffer the consequences. So, whenever too much money comes in or goes out too quickly, emerging markets regularly get buffeted by global financial flows beyond their control.
Fix one – capital controls are OK
A growing body of economic research has confirmed the efficacy of capital controls in terms of limiting financial crises in emerging markets. So the IMF, in 2012 modified its long-standing opposition to capital controls with the adoption of its Institutional View – but it has dragged its feet. In practice it still views capital controls as taboo, discouraging countries from adopting them.
To fix this, the IMF must unequivocally declare support for capital controls and provide assistance with implementation. If the IMF prefers the term, “capital flow management measures” instead, then so be it. As long as it gives developing countries a clear signal that it is OK for them to use such tools in a preemptive and permanent manner and as a routine part of the recommended policy toolbox.
This fix will also require the IMF and G20 to assist developing countries with renegotiating hundreds of International Investment Agreements (IIAs) they have signed with rich countries and others over the years that contain prohibitions on capital controls.
Problem two – sovereign debt restructurings
Even before the Covid-19 crisis hit, about half of all low-income countries had already been considered in external debt-distress. Six defaulted by the end of 2020, several more appear on the edge of default. We still lack anything like an international sovereign debt workout mechanism.
Whenever developing countries default on their foreign debt, it is an incredibly disorderly process as some creditors agree to restructure debts and/or accept a loss while other creditors drag out legal disputes for years. Developing countries end up being forced into repayment obligations with hundreds of individual creditors. This disorderly process hurts a country’s sovereign credit rating and undermines efforts to recover economically from a financial crisis. What’s worse, sometimes the national financial crises that typically coincide with sovereign debt defaults can trigger contagion in wider regional and global financial markets. So, the inability of the current global financial architecture to provide for orderly debt workouts for individual countries represents a constant threat to the financial stability of the entire global system.
Fix two – international sovereign debt workout
Twenty years ago, the financial services industry successfully lobbied to block a proposal for a Sovereign Debt Restructuring Mechanism. The industry claimed creditors should have the right to hold out and sue countries for full repayment, and not have to go along with restructurings.
But today, this gaping hole in the global architecture is undeniable, and getting it fixed is more important than the interests of individual creditors. The IMF, the G7 and the G20 must establish an international sovereign debt workout mechanism that sets agreed rules for orderly, predictable, transparent and equitable sovereign debt restructurings that includes and applies to all major public and private creditors.
Problem three – global tax evasion and illicit finance
The number of opportunities to engage in legal tax avoidance and illegal tax evasion around the world has increased exponentially over the decades. It is facilitated by legions of “enablers” such as tax accountancy firms offering aggressive tax planning services, banks, institutional asset managers, real estate brokers, traders and others.
They aid and abet in the transfer of illicit financial flows across the globe every day. Among the favoured tools are anonymous shell companies and trusts established in the world’s growing network of offshore centers and tax havens known as “secrecy jurisdictions”.
Estimates are that governments lose hundreds of billions of US dollars in tax revenues every year from multinational corporations, wealthy individuals and organised criminal networks who regularly evade taxation because of the secrecy.
Fix three – close down offshore centers and tax havens
It is good news that many financial services providers, including some of the enablers, are under increasing pressure to adopt a host of due diligence regulations required before they can provide credit or services. Such measures include knowing who their clients actually are (the “beneficial owners”), and applying a series of Anti-Money Laundering (AML) checks to verify the sources of their wealth.
Countries are also increasingly sharing tax-related information and adopting beneficial ownership registries to reduce anonymity. While these are steps forward, even more important is the need to mobilise international cooperation on eliminating the secrecy at the root of the system. That means dismantling the global network of offshore centers and tax havens. Each was originally established with specific legislation and regulations, and with sufficient political will, can be dismantled accordingly.