Reform of the international monetary system tops France’s agenda as G20 chair. French policymakers are not the first to be scrutinising the international monetary system (see for example Dooley and Gaber 2009 and Vines 2010), but the question remains: What about the international monetary system needs to change? A review of its core – the exchange-rate system – and how it functioned during the financial crisis suggests that the answer is: Not much. Instead, currency tensions point to the need for changes in the policies of the major economies.
Today’s monetary system
The international monetary system, a cooperative arrangement between sovereign nations, is composed of five main elements:
- a set of rules for setting exchange rates;
- a lender or lenders of last resort;
- instruments for providing liquidity and reserves (such as swap facilities among central banks and the special drawing right, an international reserve asset created by the IMF);
- provisions for surveillance;
- and a reserve currency or currencies.
Since 1945, the IMF – recently revitalised and recapitalised to deal with the crisis – has played an important role in managing various elements of the system.
Unlike previous systems – the pre-war gold standard and the Bretton Woods dollar standard – today’s arrangement is characterised by the pronounced tendency of countries to tailor their exchange-rate regime to their own needs. Most importantly, countries decide whether to float or peg their currency, and to what currency or mix of currencies they should peg. They also choose what combination of currencies and gold to use as reserves. Because central banks want to hold reserves in currencies that are widely used in transactions, markets largely determine which currencies are used as reserves (see Beattie).1
A minority of countries – 68 of the 188 countries classified by the IMF – have chosen to float their currency. However, this group includes nearly all of the advanced economies and several of the large developing countries, such as Brazil, Mexico, India, and South Africa; together, the group accounts for almost 80% of world GDP and 76% of world trade. Thus, in terms of economic weight, today’s exchange-rate system is overwhelmingly a floating system.
Of the 120 countries that elect to peg their currencies (or heavily manage them, according to the IMF classification), only seven countries account for more than 0.5% of world GDP – China, Russia, Saudi Arabia, Taiwan, Iran, Denmark, and Venezuela. China stands out in this group. With 9.3% of world GDP and more exports and foreign exchange reserves ($2.85 trillion at the end of 2010) than any other country, it is alone among the large economies to peg its currency, although it recently resumed gradually increasing the flexibility of the renminbi.
The system’s performance during the Great Recession
In previous briefs, we have reviewed the stability of the overall exchange-rate system during the crisis and found that, unlike previous systems – whose rigidity contributed to balance-of-payments crises and descents into protectionism, as during the Great Depression – the current system facilitated orderly adjustments during a historic downturn. The dollar retained its safe-haven status and most currencies followed a common path against it (depreciating during the worst of the crisis and appreciating thereafter). In addition, exchange-rate volatility was less pronounced than during the periods that preceded the gold and dollar standard collapses. Moreover, there is little sign of major new misalignments. Only seven of the 40 largest economies – four of which have strong current-account surpluses – saw their real exchange rates appreciate by more than 10% from their pre-crisis ten-year averages (see Dadush and Eidelman 2010a).
However, the crisis also confirmed a lesson from past currency regimes. That is, the smooth functioning of the international monetary system rests on the soundness of the economies at the core (see Dadush and Eidelman 2010b). With confidence down in the policies and financial systems of the US and the Eurozone, and with the core’s adoption of unprecedented expansionary monetary policies, all countries have become more sensitive to their exchange rate levels. China’s undervalued exchange rate and increasing economic role has only exacerbated these tensions.
Here, we turn from overall system stability to another aspect of the system’s crisis performance; the choice of currency regime by individual countries. We ask: How did countries perform during the Great Recession under different currency regimes? Will they need to alter their approach, and should the international monetary system be modified accordingly? We distinguish between financially integrated countries, which were hit by the full force of the financial shock, and those that were relatively insulated by closed capital accounts.
Financially integrated countries
Currently, 105 countries – including nearly all of the advanced countries and representing more than 80% of world GDP – have open capital accounts according to the Chinn-Ito Index.2 These economies can only use their monetary policy to affect domestic activity if they allow their exchange rate to float.3 As it turns out, about half choose that course and the other half opt to peg their currencies.
During the crisis, developing countries that float their currencies outperformed those that fix them. Over 2008 and 2009, average annual GDP growth was nearly 1 percentage point higher in floaters than in fixers, and floaters gained 0.2% of world export share compared to zero for fixers. Though average annual inflation was 1.3% higher in floaters than in fixers, it remained moderate in both groups.4
Figure 1. Financially integrated developing countries
Financially closed countries
Not surprisingly, given the vehemence of the global credit crunch, the 83 economies with closed capital accounts at the start of the crisis outperformed their financially integrated counterparts, irrespective of currency regime. They grew faster, gained more global export share, and saw moderate, though somewhat higher, inflation.
These economies include China, India, and Russia, but are for the most part small, open, developing economies5 and are typically attracted to a stable exchange rate. Being relatively insulated from global financial markets, they can retain control of their monetary policy if they “sterilise” the effect of their exchange-rate interventions on the domestic money supply by selling government bonds or changing banks’ reserve requirements. Accordingly, 59 countries in this group chose to peg their exchange rate and only 14 countries opted to float it.6
Interestingly, even among this group, the floaters outperformed the fixers during the crisis – their average annual GDP was higher and inflation was lower, though the fixers gained more export share.
Figure 2. Financially closed developing countries
These findings suggest that different exchange rate regimes helped account for modest – but not huge – differences in performances during the crisis.
- First, and not surprisingly (given the nature of the crisis), countries with closed capital accounts fared somewhat better, irrespective of currency regime.
- Second, developing countries with flexible currency regimes performed somewhat better than fixers, irrespective of their level of financial integration. In fact, nearly 20% of fixers switched to a float system between the onset of the crisis and spring 2009, opting for more monetary policy control when they needed it most (see Tsangarides 2010). Several countries have switched back to a pegged exchange rate since.7
Perhaps the greater lesson is that today’s international monetary system is remarkably resilient. The system maintained order even in the middle of a massive crisis, and it enabled countries to respond to their particular circumstances, including by temporarily or permanently adopting a more flexible exchange-rate regime.
But can the international monetary system work even better? The answer is almost certainly yes, though we find no evidence for a major overhaul rather than incremental change. For example, increasing the IMF’s firepower as the lender of last resort through periodic new special drawing right issuance or other means, as well as further bolstering its surveillance role – as the G20 intends to do – are steps in the right direction.
But the policy changes that would make a real difference have little to do with shortcomings of the system as a whole. Rather, they are related to the policies adopted by the largest players.
To begin with, China could accelerate reforms to increase the flexibility and convertibility of the renminbi and to deepen and globalise its financial markets. Such reforms would allow the renminbi to play a greater role in reserves, including the special drawing right basket, and induce faster appreciation, relieving a major source of tension with other countries. If these reforms are done too quickly and endanger the country’s financial stability and orderly growth, however, the cure may be worse than the disease, both for China and the global economy.
Most important for the international monetary system is that the US and the Eurozone return to a sustainable and fiscally-sound growth path. Over time, this will allow international interest rates to return to normal levels, alleviate fears of carry trades and hot-money inflows in emerging markets, and restore confidence in the main reserve currencies – precisely the changes needed to ensure that the international monetary system function smoothly.
Aizenman, J, Chinn M and H Ito (2010). “The Financial Crisis, Rethinking of the Global Financial Architecture, and the Trilemma”, ADBI Working Paper.
Beattie, A (2011), “Strength in reserve”, Financial Times, 9 February.
Chinn, M and H Ito (2010), “The Chinn-Ito Financial Openness Index”, 5 August.
Dooley, Michael and Peter Garber (2009), “Global imbalances and the crisis: A solution in search of a problem”, VoxEU.org, 21 March.
Dadush, U and V Eidelman (2010a), “Currency Tensions: What Historical Parallels Teach”, A VoxEU.org Publication, 20 December.
Dadush, U and V Eidelman (2010b), “How to Avoid a Currency War”, International Economic Bulletin, Carnegie Endowment for International Peace, 14 October.
Tsangarides, Charalambos (2010). “Crisis and Recovery: Role of the Exchange Rate Regime in Emerging Market Countries”, IMF.
Vines, David (2010), “European financial vulnerability and the need for a rules-based international monetary system”, VoxEU.org, 4 June.
1 Today, 61% of the world’s reserves are held in dollars and 27% in euros. Sterling and yen each account for 4% of total reserves, and a variety of other currencies comprise the remaining 4%.
2 We consider a country to have no capital controls if it ranks above zero on the most recent (2008) Chinn-Ito Index and to have capital controls if it ranks below zero.
3 As described by the Impossible Trio, it is impossible for any economy to achieve the following three desirable goals simultaneously: exchange rate stability, capital market integration, and monetary policy autonomy. Any two of the goals are achievable with a given exchange rate regime, but at the expense of the third.
4 Interestingly, among the advanced countries, the five fixers – Hong Kong, Malta, Cyprus, Denmark, and the Slovak Republic, all small open economies with relatively sound financial systems (with the possible exception of Denmark) – clearly outperformed the 28 floaters. Their GDP contraction was smaller, their exports gained more global share than did that of floaters, and their inflation rose by more but remained moderate.
5 Only four other countries in this group – Turkey, South Africa, Argentina, and Thailand – represent more than 0.5% of global GDP.
6 Several of these countries, such as Argentina and Thailand, may be imposing lessons from past crises, while others may be preparing for capital control liberalization; still others may simply prefer the insulation of a double-safety approach.
7 Twenty-three developing countries that were floating in 2007 had fixed exchange rate regimes in 2010. This is in keeping with the general tendency of developing countries to shift toward more stable regimes following crises (see Aizenmann et al. 2010).