Making the international

for development

TRADE AND DEVELOPMENT REPORT, 2015

U N I T E D N AT I O N S C O N F E R E N C E O N T R A D E A N D D E V E L O P M E N T

EMBARGOThe contents of this Report must not be

quoted or summarized in the print, broadcast or electronic media before6 October 2015, 17:00 hours GMT

�nancial architecture work

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENTGENEVA

TRADE AND DEVELOPMENTREPORT, 2015

Report by the secretariat of theUnited Nations Conference on Trade and Development

UNITED NATIONSNew York and Geneva, 2015

• Symbols ofUnitedNations documents arecomposed of capital letters combinedwithfigures.MentionofsuchasymbolindicatesareferencetoaUnitedNationsdocument.

• ThedesignationsemployedandthepresentationofthematerialinthispublicationdonotimplytheexpressionofanyopinionwhatsoeveronthepartoftheSecretariatoftheUnitedNationsconcerning the legal status of any country,territory,cityorarea,orofitsauthorities,orconcerningthedelimitationofitsfrontiersorboundaries.

• Material in this publicationmay be freelyquoted or reprinted, but acknowledgementisrequested,togetherwithareferencetothedocumentnumber.Acopyofthepublicationcontaining the quotation or reprint shouldbe sent to theUNCTADsecretariat; e-mail:tdr@unctad.org.

Note

UNCTAD/TDR/2015

UNiTeDNATioNSPUbliCATioN

Sales No.e.15.ii.D.4

iSbN978-92-1-112890-1 eiSbN978-92-1-057361-0

iSSN0255-4607

Copyright©UnitedNations,2015Allrightsreserved

iii

Explanatory notes .......................................................................................................................................ix

Abbreviations ...............................................................................................................................................x

OVERVIEW ...................................................................................................................................... I–XVIII

Trade and Development Report, 2015

Contents

Page

Chapter I

Current trends and Challenges in the World eConomy ...................................... 1

a. recent trends in the world economy ................................................................................................... 1 1. Globalgrowth .................................................................................................................................... 1 2. internationaltrade .............................................................................................................................. 6

B. recent developments in commodity markets ................................................................................... 10 1. evolutionofmaincommodityprices .............................................................................................. 10 2. Thecontinuinginfluenceoffinancialfactors .................................................................................. 14 3. impactandprospects ....................................................................................................................... 15

C. stagnation: secular or temporary? ................................................................................................... 16

notes ........................................................................................................................................................... 18

references .................................................................................................................................................. 19

Annex to chapter I

have Commodity markets de-Financialized? ....................................................................................... 21

Chapter II

FinanCialization and its maCroeConomiC disContents ....................................... 27

a. introduction ......................................................................................................................................... 27

B. the challenges of global liquidity expansion .................................................................................... 29 1. liquidityexpansionsbeforeandafterthecrisis .............................................................................. 29 2. TheriseandaggregaterisksofcapitalinflowstoDTes ................................................................. 30 3. Greaterfinancialintegrationandincreasinglyunstablecapitalflows ............................................. 33

iv

Page

C. Themacroeconomiccostsoffinancialization ................................................................................... 35 1. effectsofunfetteredfinancialintegrationonpricesandpolicy ...................................................... 35 2. learningfromthepast:Publicsectorfinancesandeconomicdevelopment afterfinancialcrises ......................................................................................................................... 39 3. loominglosses:Fiscalstance,macropolicyandaggregatedemand ............................................. 44

d. Concluding policy discussion ............................................................................................................. 46

notes ........................................................................................................................................................... 48

references .................................................................................................................................................. 50

Chapter III

systemiC Challenges in the international monetary system ........................ 55

a. introduction ......................................................................................................................................... 55

B. the international monetary system: main challenges and evolving responses ............................ 57 1. ThegoldstandardandthebrettonWoodssystem ........................................................................... 57 2. Thepost-brettonWoodsera ............................................................................................................ 58

C. reforming the international monetary system ................................................................................ 63 1. Creatinganewglobalmonetaryorder ............................................................................................ 63 2. Reformingthedollarstandard ......................................................................................................... 67 3. Strengtheningregionalandinterregionalcooperation ..................................................................... 71

d. Conclusions and policy agenda: merits and drawbacks of current reform proposals ................. 75

notes ........................................................................................................................................................... 78

references .................................................................................................................................................. 82

Chapter IV

FinanCial regulatory reForm aFter the Crisis ........................................................ 87

a. introduction ......................................................................................................................................... 87

B. Post-crisisfinancialreformandprudentialregulation ................................................................... 88 1. ThenewbaseliiiAccords .............................................................................................................. 89 2. Theproposedframeworkforsystemicallyimportantbanks .......................................................... 90 3. Theprudentialframeworkanddevelopingcountries ...................................................................... 92 4. Someattemptstoring-fencebankingoperations ............................................................................ 94

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Page

C. the rise of the shadow banking system ............................................................................................ 96 1. Theemergenceandprincipalfeaturesoftheshadowbankingsystem ............................................ 96 2. Howbigisshadowbanking? ........................................................................................................... 97 3. Risksassociatedwithshadowbanking .......................................................................................... 102 4. insufficientreforms ....................................................................................................................... 103d. Otherimportantissuesinfinancialregulation ............................................................................... 104 1. Creditratingagencies:Theneedformorethanacodeofconduct ............................................... 104 2. Thenegativeimpactsofspeculativeinternationalcapitalflows ................................................... 108 3. Foreignbankpresenceindevelopingcountries ............................................................................ 109e. Fixingfinance:Theneedforamorepositiveagenda .....................................................................111notes ......................................................................................................................................................... 113references ................................................................................................................................................ 115

Chapter V

external deBt and deBt Crises: groWing VulneraBilities and neW Challenges ................................................................................................................... 119

a. introduction ....................................................................................................................................... 119B. sustainability of external debt: main issues ................................................................................... 120C. trends in the volume and composition of external debt .............................................................. 122 1. evolutionofexternaldebtindevelopingandtransitioneconomies ............................................ 122 2. Publicandprivateborrowingandlending ..................................................................................... 124 3. Currency-relatedissues .................................................................................................................. 129 4. Thejurisdictionfordebtissuance .................................................................................................. 130d. external debt resolution ................................................................................................................... 130 1. externaldebtcrises:Arecurrentproblem ..................................................................................... 131 2. Sovereigndebtissuesinhistoricalperspective ............................................................................. 132 3. emergenceofafragmentedresolutionsystemforexternalsovereigndebt .................................. 133 4. Aninefficientandunbalancedapproachtodebtresolution .......................................................... 137e. alternative mechanisms for debt restructuring ............................................................................. 141 1. Contractualormarket-basedapproaches ....................................................................................... 141 2. NeedforinternationallyacceptedprinciplesforSDRMs ............................................................. 142 3. Statutoryapproachestomultilateraldebtrestructuring ................................................................ 145F. Conclusions ........................................................................................................................................ 147notes ......................................................................................................................................................... 147references ................................................................................................................................................ 150

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Page

Chapter VI

long-term international FinanCe For deVelopment: Challenges and possiBilities .............................................................................................. 153

a. introduction ....................................................................................................................................... 153

B. Financingthroughofficialcooperation ........................................................................................... 154 1. officialdevelopmentassistancefromdevelopedcountries .......................................................... 155 2. Developmentcooperationamongdevelopingcountries ............................................................... 157 3. Challengesofofficialcooperation ................................................................................................. 158

C. public-private partnerships for development ............................................................................... 160 1. Scale,scopeanduseofPPPs ......................................................................................................... 160 2. AssessingthecontributionsandcostsofPPPs .............................................................................. 163 3. Policyimplications ........................................................................................................................ 165

d. Can sovereign wealth funds make a difference? ............................................................................ 165

e. development banks: their evolution and potential for supporting development ..................... 166 1. Distinctivefeaturesofdevelopmentbanks .................................................................................... 166 2. Thechanginglandscapeofdevelopmentbanks ............................................................................ 168 3. ThepotentialfinancingroleofSouth-ledmultilateralbanks ........................................................ 170

F. Conclusions ........................................................................................................................................ 172

notes ......................................................................................................................................................... 174

references ................................................................................................................................................ 176

vii

List of charts

Chart Page

1.1 Worldtradebyvolume,January2005–May2015 ......................................................................... 7 1.2 Monthlycommoditypriceindicesbycommoditygroup,Jan.2002–June2015 .......................... 11 1.3 Moneymanagerpositionsandcrudeoilprices,March2014–July2015 ..................................... 14 1.A.1 Commodityassetsundermanagement,April2006–May2015 .................................................... 22 1.A.2 Correlationsbetweencommodityindexes,equityindexesandthedollar

exchangerate,2000–2015 .............................................................................................................. 22 1.A.3 ThecompositionoftotalopeninterestinWTicrudeoilonNYMeX,

bytradercategory,2006–2015 ..................................................................................................... 23 2.1 Foreigncapitalinflowsintodevelopingandtransitioneconomies

bycomponents,1970–2013 .......................................................................................................... 31 2.2 Foreignreservestocksindevelopingandtransitioneconomies,1970–2013 .............................. 32 2.3 Compositionofcapitalflows,selecteddevelopingandtransitioneconomies,2002–2013 ......... 34 2.4 Netcapitalinflows,nominalexchangeratesandnominalinterestratesin

selecteddevelopingandtransitioneconomies,2002–2013 ......................................................... 37 3.1 Foreignexchangeholdingsofselectedcountrygroups,bycurrencydenomination,

1995–2014 .................................................................................................................................... 61 3.2 Cross-borderliabilitiesandforeign-exchangereservesofselecteddeveloping

countries,2005–2013 ................................................................................................................... 70 3.3 Featuresofthecurrentdollarstandardandalternativereformproposals .................................... 76 4.1 Assetsofthefivelargestbanksasaproportionoftotalassetsofthebankingsector

inselectedeconomies,1998–2011 ............................................................................................... 91 4.2 Sizeofshadowbankingbydifferentmeasures,2001–2013 ...................................................... 100 5.1 externaldebt,selectedcountrygroupsandChina,1980–2013 ................................................. 123 5.2 externaldebtstockasaproportionofGNi,selectedcountrygroups

andChina,1980–2013 ................................................................................................................ 124 5.3 interestpaymentsonexternaldebtasaproportionofexports,selectedcountrygroups

andChina,1980–2013 ................................................................................................................ 124 5.4 externaldebtbytypeofdebtor,selectedcountrygroupsandChina,1980–2013 ..................... 125 5.5 long-termexternaldebtbytypeofcreditor,selectedcountrygroupsandChina,

1970–2013 .................................................................................................................................. 127 5.6 long-termexternaldebtowedtoprivatecreditors,bytypeofdebt,

selectedcountrygroupsandChina,1970–2013 ......................................................................... 128 6.1 oDAprovidedbyDACcountries,1990–2014 .......................................................................... 155 6.2 CompositionofdevelopmentaloDAbymaincategories,1990–2013 ...................................... 156 6.3 Privatesectorparticipationininfrastructure,1985–2013 .......................................................... 161 6.4 infrastructuresectorfinancingintheeuropeanUnion,bycategory,2009–2011 ..................... 162 6.5 Totalassetsandloans,selectednationaldevelopmentbanks,2014 ........................................... 169

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List of tables and boxes

Table Page

Box Page

1.1 Theeurozonecrisis,acaseofdéjàvu ........................................................................................... 4 4.1 Repos:Thecoretransactionoftheshadowbankingsystem ........................................................ 98 4.2 ShadowbankinginChina ........................................................................................................... 101 4.3 biasinginfluencesonCRAs’ratingsofsovereigndebt ............................................................. 106 5.1 ThelondonAgreementonGermanexternalDebt .................................................................... 134 5.2 belgianlegislationrelatingtovulturefundactivities ................................................................. 144

1.1 Worldoutputgrowth,2007–2015 ................................................................................................... 2 1.2 exportandimportvolumesofgoods,selectedregionsandcountries,2011–2014 ....................... 7 1.3 Worldprimarycommodityprices,2009–2015 ............................................................................. 12 2.1 Periodsoffinancialcrises,capitalflowsandpublicdebt ............................................................. 40 2.2 FinancialcrisisandpublicdebtinMexico,theRussianFederationandArgentina ..................... 44 4.1 baselimplementationindevelopingandtransitioneconomies ................................................... 93

ix

Classification by country or commodity group

The classification of countries in thisReport has been adopted solely for the purposes of statistical oranalyticalconvenienceanddoesnotnecessarilyimplyanyjudgementconcerningthestageofdevelopmentofaparticularcountryorarea.

Thereisnoestablishedconventionforthedesignationof“developing”,“transition”and“developed”countriesorareasintheUnitedNationssystem.ThisReportfollowstheclassificationasdefinedintheUNCTAD Handbook of Statistics 2014(UnitedNationspublication,salesno.b.14.ii.D.6)forthesethreemajorcountrygroupings(seehttp://unctad.org/en/Publicationslibrary/tdstat39_en.pdf).

Forstatisticalpurposes,regionalgroupingsandclassificationsbycommoditygroupusedinthisReportfollowgenerallythoseemployedintheUNCTAD Handbook of Statistics 2014unlessotherwisestated.ThedataforChinadonotincludethoseforHongKongSpecialAdministrativeRegion(HongKongSAR),MacaoSpecialAdministrativeRegion(MacaoSAR)andTaiwanProvinceofChina.

Theterms“country”/“economy”refer,asappropriate,alsototerritoriesorareas.

Referencesto“latinAmerica”inthetextortablesincludetheCaribbeancountriesunlessotherwiseindicated.

Referencesto“sub-SaharanAfrica”inthetextortablesincludeSouthAfricaunlessotherwiseindicated.

Other notes

ReferencesinthetexttoTDRaretotheTrade and Development Report(ofaparticularyear).Forexample,TDR 2014referstoTrade and Development Report, 2014(UnitedNationspublication,salesno.e.14.ii.D.4).

References in the text to theUnitedStatesare to theUnitedStatesofAmericaand those to theUnitedKingdomaretotheUnitedKingdomofGreatbritainandNorthernireland.

Theterm“dollar”($)referstoUnitedStatesdollars,unlessotherwisestated.Theterm“billion”signifies1,000million.Theterm“tons”referstometrictons.Annualratesofgrowthandchangerefertocompoundrates.exportsarevaluedFobandimportsCiF,unlessotherwisespecified.Useofadash(–)betweendatesrepresentingyears,e.g.1988–1990,signifiesthefullperiodinvolved,includingtheinitialandfinalyears.Anobliquestroke(/)betweentwoyears,e.g.2000/01,signifiesafiscalorcropyear.Adot(.)inatableindicatesthattheitemisnotapplicable.Twodots(..)inatableindicatethatthedataarenotavailable,orarenotseparatelyreported.Adash(-)orazero(0)inatableindicatesthattheamountisnilornegligible.Decimalsandpercentagesdonotnecessarilyadduptototalsbecauseofrounding.

Explanatory notes

x

Abbreviations

ADb AsianDevelopmentbankAfDb AfricanDevelopmentbankAiib AsianinfrastructureinvestmentbankASeAN AssociationofSouth-eastAsianNationsAUM assetsundermanagementbCbS baselCommitteeonbankingSupervisionbiS bankforinternationalSettlementsbNDeS bancoNacionaldeDesenvolvimentoeconômicoeSocial(Nationalbankfor

economicandSocialDevelopment,brazil)bRiCS brazil,theRussianFederation,india,ChinaandSouthAfrica(groupofcountries)CAC collectiveactionclauseCAF CorporaciónAndinadeFomento(AndeanDevelopmentCorporation)CDb ChinaDevelopmentbankCMi ChiangMaiinitiativeCMiM ChiangMaiinitiativeMultilateralizationCRA creditratingagencyDAC DevelopmentAssistanceCommittee(oftheoeCD)DTe developingandtransitioneconomieseC europeanCommissioneCb europeanCentralbankeib europeaninvestmentbankeU europeanUnionFCl flexiblecreditlineFDi foreigndirectinvestmentFSb FinancialStabilityboardG20 GroupofTwentyG8 GroupofeightGDP grossdomesticproductGNi grossnationalincomeHiPC heavilyindebtedpoorcountry(alsoHiPCinitiative)iADb inter-AmericanDevelopmentbankiCMA internationalCapitalManagementAssociation

xi

iCSiD internationalCentreforSettlementofinvestmentDisputesiCT informationandcommunicationstechnologyiDS internationalDebtStatistics(Worldbank)iMF internationalMonetaryFundiMS internationalmonetarysystemlAiA latinAmericanintegrationAssociationlDC leastdevelopedcountryMDRi MultilateralDebtReliefinitiativeMMMF moneymarketmutualfundNDb NewDevelopmentbankNSFR netstablefundingratiooDA officialdevelopmentassistanceoeCD organisationforeconomicCo-operationandDevelopmentoPeC organizationofthePetroleumexportingCountriesPboC People’sbankofChinaPll Precautionaryandliquidityline(ofiMF)PPi PrivateParticipationininfrastructure(database)PPP public-privatepartnershipQe quantitativeeasingRepo repurchaseagreementSDR specialdrawingright(oftheiMF)SDRM sovereigndebtrestructuringmechanismSMe smallandmedium-sizedenterpriseSMl SistemadePagosenMonedaslocales(localCurrencyPaymentSystem)SUCRe SistemaUnitariodeCompensaciónRegional(UnitarySystemofRegional

PaymentsCompensation)SWF sovereignwealthfundTDR TradeandDevelopmentReportTNC transnationalcorporationUNCTAD UnitedNationsConferenceonTradeandDevelopmentUN-DeSA UnitedNationsDepartmentofeconomicandSocialAffairs

I

OVERVIEw

Money makes the world go round, or so the song goes. It can also send it spinning out of control, as witnessed during the 2008 global financial crisis. In response to the soaring economic and social costs that followed, the international community called for a new financial songbook. Gordon Brown, chief conductor of the G20 choir at the time, placed the blame firmly on inadequately regulated financial institutions that had become less “stewards of people’s money” and more “speculators with people’s futures”; what was needed, he insisted, was new global rules underpinned by shared global values. Shortly after, the leaders of the BRIC countries, at their first summit in the Russian Federation, called for more democratic international financial institutions, along with a stable, predictable and more diversified international monetary system. The United Nations General Assembly added its universal voice with a blueprint for reforming the international financial system, noting, in particular, as an urgent priority, “comprehensive and fast-tracked reform of the IMF”.

A number of national legislators joined the chorus with a string of parliamentary hearings and expert commissions, many of which criticized the short-term bias of financial markets, their addiction to toxic and opaque financial instruments, and their failure to adequately service the financial needs of businesses and households. Serious reform, it seemed, was just a matter of time.

Seven years on, and against a backdrop of sluggish global aggregate demand, increasing income inequality and persistent financial fragility, the world economy remains vulnerable to the vagaries of money and finance. It would be wrong to suggest that the reform agenda never got beyond the drawing board; various measures have been adopted, at both the national and international levels, including some with real bite. But so far these have failed to get to grips with the systemic frailties and fragilities of a financialized world. Rather, to date we have, in the words of the Financial Times journalist Martin Wolf, little more than a “chastened version” of the previously unbalanced system.

The persistent short-term and speculative biases of global financial markets, and the inadequate measures to mitigate the risks of future crises, raise important questions about whether the heightened ambition of the international community with respect to a range of new developmental, social and environmental goals can be achieved within the desired time frame. On paper, this new agenda anticipates the biggest investment push in history, but in order to succeed it will require a supportive financial system. Accordingly, this year’s TradeandDevelopmentReport examines a series of interconnected challenges facing the international monetary and financial system, from liquidity provision, through banking regulation, to debt restructuring and long-term public financing. Solutions are available, but dedicated action by the international community will be needed if finance is to become the servant of a more dignified, stable and inclusive world.

II

From global financialization to global financial crisis

FollowingthecollapseofthebrettonWoodssystem,financebecamemoreprominent,powerfulandinterconnected; it alsogrewsteadilymoredistant from the real economy.From the1980s,mostmajordevelopedeconomiesrapidlyopeneduptheircapitalaccounts,followedadecadelaterbymanyemergingdevelopingeconomies.Asaresult,capitalbeganflowingacrossbordersonanunprecedentedscale.in1980,globaltradehadbeenatalevelrelativelyclosetothatofglobalfinance,ataroundaquarterofworldGDP,butby2008,justpriortothefinancialcrisis,globalfinancehadgrowntobecomeninetimesgreaterthanglobaltrade;bythattime,theglobalstockoffinancialassetsexceeded$200trillion.Atthesametimenewfinancial institutionsemergedandmore traditional intermediaries increasinglydiversified their rangeoffinancialproducts,inbothcaseswithfewerregulationsandlessoversight.intheprocess,financebecamemuchmoreinterconnected,withstandardmeasuresoffinancialintegrationhittinghistoricalhighsandglobalassetpricesmovingineverclosertandem.

inaveryshortperiodoftime,thesedevelopmentsoverwhelmedtheinstitutionalchecksandbalancesthathadensuredaremarkableperiodoffinancialstabilityduringthethreedecadesaftertheendoftheSecondWorldWar,andwhichhad,inturn,underpinnedasteadyriseininternationaltradeandanunprecedenteddriveincapitalformation.Anewgenerationofpolicymakersrespondedwithcallsfortherapiddismantlingofremainingfinancialregulations,extolling,instead,thevirtuesofself-regulatingmarketsasthebest,andonsomeaccountstheonly,approachforcombiningefficiencyandstabilityinaglobalizingworld.

Theresultingfinancialsystembecamefarmoregenerousincreatingcredit,moreinnovativeinmanagingriskandmoreskilledinabsorbingsmallshockstothesystem(theso-calledGreatModeration).However,itturnedouttobemuchlesscapableofidentifyingsystemicstressesandweaknessesandanticipatingbiggershocks(fromtheMexicanpesocrisistotheGreatRecession)ormitigatingtheresultantdamage.Theburdenofsuchcriseshas,instead,fallensquarelyonthebalancesheetofthepublicsector,andindeed,oncitizensatlarge.

Thescaleof the2008crisishas leftmanygovernmentsstrugglingtooffset theeffectsoffinancialretrenchmentsinbanks,businessesandhouseholdsastheyseektorepairtheirbalancesheets.Thisispartlybecauseasingularfocusonpricestabilityhasledpolicymakerstoabandontheartofmanagingmultiplemacroeconomicgoals;butalsobecausefinancializationhasbluntedorremovedarangeofpolicyinstrumentsthatareneededforeffectivemanagementofacomplexmoderneconomy.

Since the crisis,many developed economies have turned to “unconventional”monetary policyinstrumentsineffortsatrecovery.essentially,keycentralbankshavebeenbuyingupthesecuritiesheldbyleadingbanksinthehopethatincreasedreserveswouldgeneratenewlendingandstimulatenewspendingintherealeconomy.Theresultshavebeenunderwhelming:inmanydevelopedeconomies,recoveryfromthe2008crisishasbeenamongsttheweakestonrecord.Jobgrowthhasbeenslack,realwageshavestagnatedorfallen,investmenthasstruggledtopickup,andproductivitygrowthhasbeenstuckinsecondgear.bycontrast,stockmarketshaverecovered,propertymarketshaverebounded– insomeinstancesboomingagain–andprofitsareup,inmanycasesbeyondthehighsreachedbeforethecrisis.Meanwhile,debtlevelshavecontinuedtorise,withanestimated$57trillionaddedtoglobaldebtsince2007.

Tepid recovery in developed countries

backinmid-2014,followingaprolongedperiodofcrisismanagement,thereseemedtobeasenseof“businessasusual”returningtopolicycircles.Projectedgrowthratesforthecomingyearswereedgingup,theeurozonewasbackinpositiveterritoryandJapanseemedpoisedtopullitselfoutofyearsofeconomicstagnation.Meanwhile,unemploymentintheUnitedStateswasheadinglower,andtheFederalReservewasprogressivelyendingquantitativeeasing;oilpriceswerefallingandbusinessconfidencewasonthemend.

III

However,bytheendoftheyear,somedoubtshademergedand,ifanything,thecloudsonthehorizonhavesincedarkened.

Followingthe2008−2009crisisandthereboundin2010,theglobaleconomyhasbeengrowingataround2.5percent,belowtheconservativelyestimatedbenchmarkofa3percentpotentialgrowthrate,andsignificantlybelowthe4percentaverageofthepre-crisisyears.Thegrowthratefor2015isexpectedtoremainmoreorlessunchangedfromlastyear,at2.5percent−thecombinedresultofaslightaccelerationofgrowthindevelopedeconomies,amoderatedecelerationindevelopingeconomies,andamoreseveredeclineintransitioneconomies.

Developedcountriesareexpectedtogrowataround1.9percent,comparedwith1.6percentin2014,asgrowthintheeurozoneandJapanisexperiencingamoderateacceleration,althoughfromverylowrates.Recentimprovementsareduetostrongerdomesticdemandasaresultofincreasedhouseholdconsumptionandalessstringentfiscalstance.Theformerstemsfromareductionofenergyprices,wealtheffectsfromrisingequitymarketvaluationsandemploymentgrowthinanumberofcountries,notablyGermany,Japan,theUnitedKingdomandtheUnitedStates.inflationhasremainedsignificantlybelowtargetedratesinmostdevelopedcountries.

Monetary policies remain expansionary,with very low interest rates in all developed regions andadditional“quantitativeeasing”programmeslaunchedintheeurozoneandJapan.However,creditexpansionhasnotfollowed,wagesremainsubduedandbanksareshowingsignsofweakness.ThereisalsoreneweduncertaintyregardingthefutureofGreeceintheeurozoneandtheongoingtalkofapossible“Grexit”,whichrepresentsthemostimmediatethreattothesovereignyieldsofPortugal,Spainandothereuropeancountriesthathaverecentlystartedtorecoverfromthedepthofthecrisis.DoubtshavealsocreptbackconcerningthestrengthoftheJapaneserecovery.TheUnitedStatesisexpectedtocontinueitspost-crisisgrowthtrajectorywithanestimatedgrowthrateof2−2.5percent,which isbelowprevious recoveries;nevertheless, thisallowssteady−ifunspectacular−jobcreation,althoughstillwithoutasignificantimprovementinnominalwagegrowth.Moreover,householdbalancesheetsremainfragileandtheappreciatingdollarishurtingthecontributionofnetexportstoGDPgrowth.

Stagnation: Secular or seasonal?

overandabovetheseconjuncturalmovements,amuchbiggerconcernis thatdevelopedcountriescouldbestuckinaholdingpatternofslowgrowth.Secularstagnationisanoldideawithamoderntwist.Theideaofavanishinggrowthfrontierwasfirstraisedinthelate1930sandwaslinkedtounfavourabletechnologicalanddemographictrendsthatcouldonlybeoffsetbylargegovernmentdeficits.Atpresent,theobservationthatthegrowthpathinmanydevelopedcountrieshasremainedatsubstantiallylowerlevelsthanbeforethecrisis,despiteseveralyearsofaccommodativemonetarypolicy,hascreatedasenseofa“newnormal”.intoday’sfinancializedworld,themainstimuliusedaremountingprivatedebtsandassetbubbles.Thuscountriesmaybefacingatrade-offbetweenprolongedsubduedgrowthontheonehandandfinancialinstabilityontheother.

Sofarthereisnoconsensusonwhetherornotthereactuallyissecularstagnation,andifthereis,why.Someobserversholdthatthedeclineingrowthhasbeenduetoacombinationofsupply-sidefactors:weakinvestmentpropensities,alackoftechnologicaldynamismandunfavourabledemographicshifts.othersseeitmoreastheinevitable,prolonged,butultimatelyreversibledownsideofadebtsupercycle.ineithercase,therehasbeeninsufficientacknowledgmentofthedeclineinthewageshareindevelopedcountriesbyabout10percentagepointssincethe1980s,whichhasconsiderablyconstrainedincome-basedconsumerdemand,withattendantnegativeeffectsonprivateinvestment.Theseadversedemandeffectsfromworseningfunctionalincomedistributionhavebeenreinforcedbywideninginequalityinpersonalincomedistribution,

IV

astheshareintotalincomeoftherichesthouseholdshasstronglyincreasedandthesehouseholdstendtospendlessandsavemoreoftheirincomesthanotherhouseholds.Theyhavealsobeenreinforcedbythesingularrelianceonexpansionarymonetarypoliciestoaddressthedemandshortfall.Thishasledfirmstousetheirprofitsfordividenddistributionandinvestmentinfinancialassets,ratherthaninproductionfacilities.Thesespurassetpricesandexacerbatetheinequalitiesinwealthdistribution,therebyperpetuatingincomestagnationforthemajorityofthepopulation.

The attendantpolicydebatehasmainlybeenonwhether andwhich structural reformsmightbestspurprivateinvestmentandentrepreneurialdynamism.Someproposalsfocusonmeasureswhichwouldcorrectperceivedrigiditiesinproductandlabourmarkets.othershaveplacedgreateremphasisonwaystoreducethesizeofthepublicdebt.butwhilethesearepresentedwithagooddealofconviction,thereislittleindicationofwherethegrowthimpulseswillactuallycomefrom.inthisview,muchseemstorestonamutuallysupportingcombinationofrisingbusinessconfidenceandimprovinginternationalcompetitiveness.However,worldtraderemainsinthedoldrums.between2012and2014,worldmerchandisetradegrewbetween2and2.5percent(verysimilartotheratesofglobaloutput).Thesegrowthratesaresignificantlybelowtheaverageannualrateof7.2percentrecordedduringthe2003–2007pre-crisisperiod.in2014,worldmerchandisetrade,atcurrentprices,remainedalmoststagnant(growingonlyby0.3percent)duetothesignificantfallinthepricesofthemaincommodities.Preliminaryestimatesfor2015indicateamildincreaseinthevolumeofmerchandisetrade,whichcouldgrowatarateclosetothatofglobaloutput.buttheseimprovedtradeprospectsarelargelyduetoincreasedtradeamongdevelopedcountries,andprobablyreflectmoderate gains in their growthperformance. in any case, this improvement does not provide asignificantstimulustoglobaleconomicgrowth.

indeed,totheextentthatsecularstagnationismostlyademand-sidephenomenon,policyapproachesthatseektocontainlabourincomeandpublicspendingwilltendtoworsenratherthansolvetheproblem.Analternativeapproachgivesaprominentroletoincomespolicy(e.g.minimumwagelegislation,strengtheningofcollectivebargaininginstitutionsandsocialtransfers)andtopublicexpendituretoaddressweaknessesonboththedemandandsupplysides.Thefactthatanincreaseinpublicexpenditure,suchasoninfrastructure,hasbeenshowntohaveverysubstantialpositivemultipliereffectsinstagnatingeconomiessuggeststhatenhancingpublic investmentshouldbeakey instrumentforaddressingsecularstagnation.Moreover,aprogressiveincomespolicyincreasesdemandaswell,creatingoutletsforprivateinvestmentandresultinginwiderbenefits:higherwageincomesreducethefinancialpressureonpensionschemesandallowhouseholdstoincreasetheirconsumptionspendingwithoutaddingtohouseholddebt.Thereisalsosubstantialevidenceofapositiveimpactonlabourproductivity.indeed,increasedlevelsofactivityandemploymentareknowntofosterproductivity,creatingavirtuouscircleofdemandandsupplyexpansion.Thus,fiscalexpansionandincomegrowthwouldincreaseactualoutputandatthesametimeacceleratepotentialoutputgrowth,therebyanimatingavirtuousfeedbackrelationshipthatprovidesthebasisforfuturesustained,non-inflationarygrowth.

Financial spillovers to developing and transition economies

Whateverthefuturecourseofthestagnationdebate,thecombinationofaneasymonetarypolicyandasluggishrealeconomyhas, todate,encouragedexcess liquidity indevelopedeconomies tospillovertoemergingeconomies.Thiswasalreadyobservedafter thedot-combubbleburst,but ithasescalatedconsiderablysincethe2008crisis.

Since the turnof themillennium, the rateofprivatecapital inflows intodevelopingand transitioneconomies(DTes)hasacceleratedsubstantially.Asaproportionofgrossnationalincome(GNi),netexternalinflowsintoDTesincreasedfrom2.8percentin2002to5percentin2013,afterhavingreachedtwohistoricalrecordsof6.6percentin2007and6.2percentin2010.Atthesametime,manyDTesexperiencedstronggrowthandimprovingcurrentaccounts,accumulating,asagroup,considerableexternalreserveassets.

V

Mainstreamproponentsoffinancialintegrationwereenthusiasticaboutthesetrends,emphasizingthepositiveinteractionbetweenopencapitalaccounts,increasedprivatecapitalflows,soundpolicyframeworksandefficiencygains.However,thelinkshaveprovedelusivetoresearchers,andtheintegrationofmostDTesintoglobalfinancialmarketsappearstohavebeenonlyweaklyconnectedtotheirlong-termdevelopmentgoals.While foreigncapital canplayauseful role in closingdomestic savingsgaps and foreigndirectinvestment(FDi)canhelppromotedomesticproductivecapacity,particularlywheninvestedingreenfieldprojects,partofthechallengeisthatanincreasingproportionoftheinflowsareofashort-term,moreriskyandspeculativenature,exhibitingthetypeofvolatilityreminiscentofinflowsthatprecededpreviousfinancialcrisesinthe1980sand1990s.Asaresult,increasinglylargeandvolatileinternationalcapitalflows,eveniftheygiveashort-termboosttogrowth,canincreasevulnerabilitiestoexternalshocks,whilealsolimitingtheeffectivenessofpolicytoolstaskedwithmanagingthem.Therefore,theseflowsmaycompromisethemacroeconomic conditionsnecessary for supportingproductivitygrowth, structural transformation andinclusivedevelopmentinthelongterm.

Afterthecrisiseruptedin2008,manydeveloped-countrypoliciesofquantitativeeasing,coupled−afterabriefexpansionaryinterlude−withfiscalausterity,havecontinuedthispatternofgeneratingmoreliquidityintheprivatesectorbutwithlimitedgrowthreturns.inthiscontext,thepromiseofhigherreturnsoninvestmentsinDTes,andperceptionsthattheyposedlowerrisksthanbefore,madethemanattractivealternativeforinternationalinvestors.

Sincethesecapital inflowsoccurredat thesametimethatmostDTesexperiencedcurrentaccountsurplusesorlowerdeficits,itisunlikelythatfinancingtomeetdevelopmentneedswasthemaindriveroftheboominprivatecapital.DTesasawhole,particularlythelargereconomies,accumulatedconsiderableamountsof reserveassetsduring thisperiod, indicating that theamountof inflowsexceededwhatwasbroadlyconsistentwithdomesticspendingandinvestmentrequirements.itwasnotonlydeficitcountriesthatreceivedgrosscapitalinflows,butalsocountrieswithlargetradesurpluses,indicatingthatoftencapitalmovementsbecamethemajordriversofthebalanceofpayments,andwerelargelyunrelatedtorealeconomicactivities.SincetheratesofreturnpaidbyDTesontheirinternationalliabilitieshavebeenhigherthanthoseearnedontheirassets,thesecapitalinflowshavetendedtoreducebalancesintheincomeaccountleadingtoadeteriorationofthecurrentaccount.Thiscouldprompttheadoptionofrestrictivepoliciesandresultinincreasedfinancialfragilityinthedeficitcountries.Animportantquestionisthereforewhetherthesepatternsareconsistentwithfinancialstabilityandsustaineddemand,atboththenationalandgloballevels.

Managing capital flows: New vulnerabilities, old challenges

Atthepolicylevel,externalfinancialflows,andinparticularexcessiveshort-termspeculativeflows,canalterpricesandinfluencepolicyinwaysthatcouldcompromisethepotentialforsustainablegrowthanddevelopment.largecapitalinflowscangeneratepressuresforcurrencyappreciation.Theseeffectsareexacerbatedbyawidespreadcommitmenttomaintainingextremelylowratesofinflationasagoalinitself.The resultingmacroeconomic environment, characterizedbyhigh andvolatile interest rates, combinedwiththeappreciatedcurrency,runtheriskofdiscouragingbothrobustaggregatedemandandthetypesofinvestmentthatdeepenproductivecapacity.Thepossibilitytousefiscalpolicycansimilarlybeconstrainedbyacompulsiontomaintainafinance-friendlypublicstance,whichrequiresalighttouchonboththeexpenditureandrevenuesides.lessgovernmentactivitydirectlyreducesnationalincomebylimitingpublicspending;italsoindirectlylowersproductivecapacitybyrestrictingthetypesofpublicinvestmentinphysicalandhumancapitalthatsupportprivateinvestmentandproductivitygrowth.insomecases,particularlyinlatinAmericaandsub-SaharanAfrica,thesepriceandpolicyeffectshavereinforcedthetrendtowardsprematuredeindustrializationandinformalizationofwork.

Sincethe1980s,mostfinancialcrisesinDTeshavebeenprecededbyasurgeincapitalinflows.Theconsequentbuild-upoffinancialfragility,mainlyintheformofexcessiveprivatedebt,oftenculminates

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inacrisis,withsubstantialnegativerealeffectsandasoaringpublicdebt.Althoughfiscalprofligacyisafrequentrefraininmanyaccountsoffinancialcrises,itistypicallythelowergrowthresultingfromthecrisisandtheclearingupoftheprivatebustandallthecostsassociatedwithit(e.g.nationalizingprivatedebt,recapitalizingbanks,andtheimpactofcurrencydevaluationonthevalueofforeign-currencyliabilities)thatrunuppublicdebt.Suchboom-bustcycleshavecontinuedtobeheavilyinfluencedbycircumstancesexternaltotheeconomiesthathostthem,forexamplechangesinglobalcommoditypricesorinUnitedStatesinterestrates,orbythecontagioneffectsofcriseselsewhere.

inthiscontext,domesticmacroeconomicandstructuralweaknessesareexacerbatedbyalargerglobalfinancialsystemcharacterizedbytoomuchliquidityandnotenoughmacroprudentialregulation,givingrisetoaprocessofoptimism,excessiveprivaterisk-takingandoverborrowing.

inlightofthesesystemicvulnerabilities,thereareanumberofpolicyresponsesthatDTes−especiallythosecountriessusceptibletoexcessiveshort-termcapitalflows−canconsider,notonlyforbettermanagingtheamountandcompositionofprivatecapitalflowsandtheirmacroeconomiceffects,butalsoforstrengtheningthelinksbetweenfiscalandmonetarypoliciesanddevelopmentgoals.insteadofrelyingsolelyoninterestratesandverylowinflationtargetstomanagecapitalinflowsandthebalanceofpayments,whatisneededisajudiciouscombinationofappropriatecapitalaccountandexchange-ratemanagementthatmaintainsaccesstoproductiveexternalfinance,includingtradefinanceandFDithatbuildslocalproductivecapacity,whilealsoencouragingdomesticinvestment.inaddition,centralbankscanandshoulddomorethanjustmaintainpricestabilityorcompetitiveexchangeratestosupportdevelopment.Forinstance,theycouldusecreditallocationandinterestratepoliciestofacilitateindustrialupgradingandprovidekeysupporttodevelopmentbanksandfiscalpolicy,ashasbeendonebycentralbanksinmanyofthenewlyindustrializingcountries.However,asevidencedbythechallengesfacedbydevelopedcountriesinemergingfromtherecentcrisis,monetarypolicyaloneisnotenough;proactivefiscalandindustrialpoliciesarealsoessentialforgeneratingthestructuresandconditionsthatsupportdomesticproductivitygrowthandtheexpansionofaggregatedemand.

Giventhesheersizeofglobalcapitalflows,however,macroeconomicmanagementat thenationallevelmustbesupplementedbyglobalmeasuresthatdiscouragetheproliferationofspeculativefinancialflowsandprovidemoresubstantialmechanismsforcreditsupport,includingthroughsharedreservefundsattheregionallevel.

Slowdown and diversity in the developing world

Thenewvulnerabilitieslinkedtofinancializationdroppedoffthepolicyradarscreenattheturnofthemillennium,whenDTesenteredaperiodofstronggrowththatseemedtodecouplefromeconomictrendsindevelopedcountries.inresponsetotheinitialshockin2008–2009,manyofthemappliedmoreambitiouscountercyclicalpolicies,includingincreasedfiscalspendingandincomesupportmeasuresthatweresustainedlongenoughtoencourageacontinuingriseofhouseholdexpenditureand,byextension,ofprivateinvestment.Someofthesecountriesarenowscalingbackorevenreversingthepolicystimulusastheyfacecapitaloutflowsorlowerexportprices.oilimporters,bycontrast,havegreaterroomformanoeuvreasaresultoftherecentimprovementintheirtermsoftrade.

Developingcountriesasawholewillcontinuetoexpandatarateofmorethan4percent,thanks,inparticular, to the resilienceofmostof thecountries in theAsian region.However,other regionsareexperiencingasignificantslowdownduetolowercommoditypricesandcapitaloutflows,which,insomecountries, haveprompted tightermacroeconomicpolicies.latinAmerica,WestAsia and the transitioneconomiesareamongtheworstaffected,whileAfricansubregionspresentamixedpicture.

in2014,mosttradefigureswerebleakerthanthoseofthepreviousyears.inparticular,Africa’srealexportsshowedacontractiononaccountofshrinkingoilexportsinbothNorthandsub-SaharanAfrican

VII

economies.externaltradeinlatinAmericaandtheCaribbeansloweddowninvolume(andevenmoreinvalueterms),partlybecauseregionaleconomicstagnationnegativelyaffectedintraregionaltrade.eastAsiantradecontinuedtogrowinvolume,butatunusuallylowratesfortheregion(lessthan4percentin2014).Toalargeextent,thisreflectstheslowdownofChina’sinternationaltrade,wheretherealexportsgrowthratebecameslowerthanitsGDPgrowthrate,whilerealimportsdeceleratedevenmoremarkedly.ThesetrendsmayreflectastructuralchangeintheChineseeconomy,withgrowthdriversshiftingfromexportstodomesticdemandandimportsbeingusedmoreforfinalusewithinthecountryratherthanasinputsinexport-processingindustries.

Commoditymarketswitnessedparticularlyturbulenttimesin2014andthefirsthalfof2015.Mostcommoditypricesfellsignificantlyinthecourseof2014,continuingthedecliningtrendthatstartedafterthepeaksof2011−2012,withaparticularlynotableslumpincrudeoilprices.Thepaceofthepricedeclineacceleratedincomparisonwith2013,noticeablyforthecommoditygroupsforwhichdemandismorecloselylinkedtoglobaleconomicactivity,suchasminerals,oresandmetals,agriculturalrawmaterialsandoil.Marketfundamentalsappearedtobethemajordriverofcommoditypricemovements,althoughfinancializationofcommoditymarketscontinuedtoplayarole,asfinancialinvestorsreducedtheircommoditypositionsinconjunctionwiththedownturninpricesandreturns.Hedgefundsappeartohavebeenparticularlyactiveinoilmarkets,wheretheyamplifiedpricemovements.Furthermore,thestrongappreciationofthedollaroverthepastyearhasbeenanimportantfactorinthedecliningpricesofcommodities.

Theplungeinoilpricesresultedmainlyfromgreaterglobalproduction,especiallyshaleoil in theUnitedStates,andoPeC’sabandonmentofitsprice-targetingpolicy,presumablytodefenditsmarketsharebyattemptingtoundercuthighercostproducersinordertodrivethemoutofthemarket.Globaloildemandcontinuedtogrowin2014,butitsslowerratesofgrowthcouldnotabsorbthelargersupply.Theresultingloweroilpriceshavehadanimpactonothercommoditypricesthroughdifferentchannels.loweroilpricesprovideincentivestoincreasecommodityproductionasaresultofreductionsinsomeproductioncosts.Theymayalsodiscouragedemandforagriculturalproductsusedinbiofuelsandreducethepricesofsyntheticsubstitutesforagriculturalrawmaterials.Thisexerteddownwardpressureonthepricesofcommoditiessuchascottonandnaturalrubber.However,mostofthepriceevolutioninagriculturalmarketswasdeterminedbytheirownsupply,whichwasaffected,inparticular,bymeteorologicalconditions.Thedecliningpricesofmostminerals,oresandmetalswerealsoduemainlytolargersupplies,asinvestmentsofthelastdecadematuredinresponsetodemand,which,althoughstillgrowing,hasloststeam.

Prospectsforcommoditypricesareuncertain.lowercommoditypricescausedbyoversupplyarealreadyleadingtosomedownwardadjustmentsininvestmentandproductioncapacities,whilefuturedemandwouldappeartohingeonthepaceandpatternofrecoveryinthedevelopedeconomiesandongrowthprospectsinthelargeremergingeconomies.Still,recenttrendsareareminderofthechallengesthatmanycommodity-dependentdevelopingcountriesstillfaceandhowcrucialitisforthemtoproperlyusetheirresourcerentstoimplementdiversificationandindustrialpoliciesforachievingstructuralchangeandsustainedgrowth.

The transition economieshavebeen among the regionsmost affectedby lower commoditypricesandcapitaloutflows,andtheirGDPisexpectedtodeclinein2015.intheRussianFederationandUkraine,balance-of-paymentsrestrictionswereaggravatedbypoliticalconflicts.Steepcurrencydepreciationandinflationdampeneddomesticdemandanddeepenedeconomicrecession.This,inturn,affectedneighbouringcountriesforwhichtheRussianFederationisanimportantmarketandsourceofworkerremittances.Ukraineiscurrentlygrapplingwithadangerouscombinationofdecliningincomes,acollapsedcurrencyandanunsustainabledebtlevel,witharealpossibilityofdefault.

TheslowdowninthelatinAmericanandCaribbeanregionwhichstartedin2011islikelytocontinuein2015.inparticular,SouthAmericaandMexicohavebeenaffectedbylossesintheirtermsoftradeandbythevolatilityofcapitalflows.Aharsherexternalenvironmentanddifficultiesinpursuingcountercyclicalpolicies,includingcreditexpansion,haveweakenedthecapacitytoprovidesupportivepolicies;somecountries

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haveevenadoptedcontractionarypolicies.bycontrast,mostCentralAmericanandCaribbeancountriesarelikelytogrowatrateswellabovetheregionalaverage.Theyhavebenefitedfromloweroilprices,andhavebeenlessvulnerabletospeculativecapitaloutflows.

TheAfricanregionhasdisplayeddivergentdevelopments.WhilearmedconflictsareadverselyaffectingnationalincomesincountriesinCentralAfricaandotherssuchaslibya,WestAfricaislikelytocontinuesufferingfromtheimpactoftherecentoutbreakofebola.GrowthremainsstrongineastAfricancountries,whosetermsoftradehaveimproved.itistoremainsubduedinSouthAfrica,whilesomelargeandmedium-sizedsub-SaharaneconomiessuchasAngolaandNigeriaareaffectedbythedeclineincommodityprices,particularlyoil.

Asiahasagainbeenthemostdynamicregion,asinpreviousyears.east,SouthandSouth-eastAsiaarecontinuingtoexperiencerelativelystronggrowth,estimatedforallthreesubregionsat5.5−6percentin2015.Growthisessentiallybeingdrivenbydomesticdemand,withanincreasingcontributionofconsumption,bothpublicandprivate.Hence,evenifinvestmentratesremainveryhighcomparedwithotherregions(andarelikelytoremainso,particularlygiventheneedsforinfrastructuredevelopment),mostAsiancountries,especiallyChina,seemtoberebalancingthestructureofdemandsoastomakeitmoresustainableinthelongrun.TheburstingofthestockmarketbubbleinChinahasincreasedeconomicuncertainty,asitcouldaffectdomesticdemand.However,privateconsumptiongrowthisessentiallybasedonexpandingincomesratherthanoncredit,whichisalsoanimportantelementforgrowthsustainability.Furthermore,expansionaryfiscalandmonetarypoliciesseemsettocompensateforthesenegativefinancialshocks.Meanwhile,loweroilpriceshaveeasedcurrentaccountdeficitsinseveralcountries,suchasindiaandPakistan,whoseeconomiesareforecasttomaintainorslightlyimprovetheirgrowthrates.inWestAsia,Turkeyalsobenefitedfromthisdevelopment,eventhoughmostoftheoil-exportingeconomiesinthesubregionhavefaceddeterioratedtermsoftrade.inaddition,militaryconflictshavereducedgrowthprospectsinpartofthesubregion.

Developingeconomies’rapidreboundfromtheglobalfinancialcrisisseemedtoconfirmtheirescapefrom the gravitational pull of the developed countries and the establishment of their own independenteconomicorbit.butthisdecouplingthesislookslessconvincingnow,astherearesomeworryingsignsthatarealreadymakingheadlinesacrossthedevelopingworld:somecurrencieshavedepreciatedsharply,stockmarketsarewobbling,andinsomecasescollapsing,somelargeemergingeconomiesareinrecession,andinanumberofcountriesdeficitsarewideninganddebtlevelsclimbing.

This is thedifficult environment inwhich themultilateralfinancial institutionshave to fulfil theirmandatedtasks:tochartastablecoursefortheglobaleconomy,andtoquicklyextinguishanyfinancialfiresthatthreatentofantheflamesofawiderfinancialconflagration.butonethingthathasbecomeclearsincetheglobalfinancialcrisisis thattheinternationalfinancialarchitecturelacksthefire-fightingequipmentneededtotacklelargerblazes.Moreover,thepresentinternationalmonetarysystemhasacquireditsownpyromanictendencies,bypromotingpolicyinterventionsthathavefrequentlyexacerbatedrecessions,insteadofsofteningthem,andbyplacingalltheburdenofadjustmenttooheavilyonthedebtorsanddeficitcountries.

The liquidity conundrum: Too much and too little

Thebreakdownofthepost-warinternationalmonetarysystem(iMS)intheearly1970s,andtheopendoorpolicywithrespecttolarge-scaleprivateinternationalcapitalflowshavemeantthattheprovisionofgloballiquidityisnolongerlimitedto“official”sourcesfromaccumulatedforeign-exchangereserves,swaplinesbetweencentralbanksandfromallocationsofspecialdrawingrights(SDR)orloanagreementsbytheinternationalMonetaryFund(iMF).itcanbe,andhasincreasinglybeen,supplementedby“privateliquidity”resultingfromcross-borderoperationsoffinancialinstitutions,suchasbanks,andnon-financialinstitutions,suchasenterprisesthatprovidecross-bordercreditsand/orforeign-currency-denominatedloans.Thishaseffectivelymeantthemergingoftheinternationalmonetaryandfinancialsystems.

IX

Thesurgeofprivatelycreatedgloballiquidityhasliftedonepotentialconstraintongrowth,butithasalsoaddedtotheprocyclicalandunstablenatureoftheiMS.Manydevelopingcountrieshaverespondedbyaccumulatingofficialliquidityintheformofforeign-exchangereservesasatypeofself-insurance.Thosereservesserveasaninsuranceagainsteventualliquidityshortagesarisingfromasuddenstoporreversalofcapitalflows.Theyarealsoaby-productofinterventioninforeign-exchangemarketsdesignedtoavoidcurrencyappreciationresultingfromcapitalinflowsthatareunrelatedtothefinancingofimports.ThishastheaddedadvantageofavoidingtheneedtoresorttoiMFassistanceincrisissituations,andthepolicyconstraintsassociatedwithitslending.

The totalholdingsof foreign-exchange reserveshavegrownnoticeablysince thebeginningof themillennium,withdevelopingcountriesaccountingformostoftheincrease.Whilesomeofthesereserveshavebeengeneratedbycurrentaccountsurpluses,othershavebeenborrowedoninternationalcapitalmarkets.Theseholdings have sometimesbeen judged “excessive” basedon conventionalmeasures, such as thelevelsneededtocounterfluctuationsinexportearningsortorollovershort-term(uptooneyear)externaldebt.However,financialopenness,desiredexchange-ratestabilityandthesizeof thedomesticbankingsystemareadditionalconsiderationsindeterminingwhatshouldbethelevelofreserves.Theaccumulationofsubstantialreservesimpliesatransferofresourcestoreserve-currencycountries,asthosereservesaretypicallyheldintheformof“safe”butlow-yieldingassetsfromthesecountries.ThisisoneofthefactorsthatmaketheiMShighlyinequitable.

Thiscombinationofinadequacyandunfairnessindicatestheneedforgloballymorediversifiedandefficientformsofforeign-currency-denominatedliquidityprovision,especiallyincrisissituations,toreduce−andeventuallyreplace−largeholdingsofforeign-exchangereservesheldforprecautionarypurposes.ideally,newmultilateralarrangementsarethebestwaytocorrectthesystem’sweaknessesandbiases.StepstowardsamorediversifiediMSwouldentailthecurrentdollarstandardbeingreplacedbyamulti-currencysystemcomprisingarangeofinternationalcurrencies,suchasthedollar,theeuro,therenminbiandpossiblyothercurrencies.ScalingupSDRallocationsmightofferanalternativearrangement.

eitheroptionwouldhelpcutthecostofholdingborrowedreservesandreducethecurrentsystem’sbiasinfavourofthereserve-currencycountry.Whatismore,anSDR-basedsystemwoulddelinktheprovisionofofficialinternationalliquidityfromanynationalissuer.Andthecreationofarealalternativetonationalcurrenciesasreserveassetswouldallaytheconcernsofholdersoflargeforeign-exchangereservesaboutmaintaining the purchasingpower of their reserves.Also, sinceSDRs are basedon a currencybasket,diversificationoutofdollar-denominatedassetswouldinvolvemuchsmallerexchange-ratefluctuationsthanamulti-currencysystem,therebyminimizingthethreattoglobalfinancialstability.Severaladvantageswouldfollow,especiallyintermsofmoreelasticliquidityprovisioningandmoredisciplineinreserve-currencycountries,whichwouldpreventthemfromabusingthe“exorbitantprivilege”ofissuingareservecurrencytobolsternarrownationalconcernsattheexpenseofbroaderglobalinterests.

Possible steps towards the reform of the international monetary system

effectivemultilateral arrangements should remain the long-termobjective of any comprehensivereformagenda.However,theyimplywide-ranginginstitutionalchanges,fromanewagreementonrulesformultilateralexchange-ratemanagement,tothecreationofaglobalcentralbankandevenanewglobalcurrency.evenwith a less ambitious agenda, their effective functioningwould require comprehensivemacroeconomicpolicycoordination. inaddition, the iMF’s resourceswouldneed tobeaugmentedanditsgovernancereformedtobettermeettheneedsofdevelopingcountries,andtostrengthenitsabilitytosurveytheactionsofsystemicallyimportantcountries.eventhesechangesappeartobeoutofreachintheimmediatefuture,foranumberofeconomicandpoliticalreasons.

Thismeansthatdespiteallitsdeficiencies,theiMSislikelytomaintainthedollarstandardfortheforeseeablefuture.Thechallenge,therefore,ishowtoreformasystemthatreliesonnationalcurrencies,

X

widespreadfloatingandsizeableprivateinternationalcapitalflowssothatitisabletosecureareasonablelevel of globalmacroeconomic andfinancial stability.Thiswill require attenuating the role of privateinternationalcapitalflowsasasourceofinternationalliquidityandensuringthatinstitutionalmechanismscaneffectivelyprovidesufficientofficialinternationalliquidity,therebyreducingtheneedforthelarge-scaleaccumulationofforeign-exchangereservesasself-insurance,andensuringthatsurpluscountriessharetheburdenofadjustment.

onewaytheinternationalcommunityhasreactedtothechallengeisthroughthewideruseofcentralbankforeign-currencyswaparrangementsforaddressingemergencyliquidityproblems,andmakingtheUnitedStatesFederalReservethedefactointernationallenderoflastresort.Thishasreliedonthreemainpremises:first,centralbankscanactswiftly;second,theyfacevirtuallynolimitontheirmoney-creatingcapacities;andthird,swaparrangementswiththecentralbankthatissuesthecurrencyinwhichtheliquidityshortageoccursdoesnothaveanyadverseexchange-rateeffects.Theexistingswaparrangementsextendedbydeveloped-countrycentralbanksmainlycatertotheneedsofdevelopedcountriesandriskbeingdrivenbypoliticalexpediencyorbias.Recently,thePeople’sbankofChina(PboC)hasestablishedcurrencyswaparrangementswithawiderangeofothercentralbanks,mostlyfromdevelopingcountries.

Difficulties in thedesign and implementationof thevarious reformproposals have reinforced theperceptionthatself-insuranceintheformoflargeforeign-exchangeholdingsistheonlytoolavailabletodevelopingcountriestofosterexchange-ratestabilityandensurethepredictableandorderlyavailabilityof emergencyfinance.However,maintaining the status quoposes serious risks, particularlywhere theaccumulationof foreign-exchange reserves is the result ofborrowing in international creditmarketsorportfolio capital inflows.Apossible solution is to try and achieve current account surpluses.However,thisoptionwouldnotbeavailabletoallcountries,andtotheextentthatitrequiresdevaluation,itrunstheseriousriskoftriggeringacurrencywarorthreateningdebtsustainability.Moreover,theincreaseintheiMS’contractionarybiasassociatedwithwidespreadattemptstoaccumulateforeign-exchangereserveswouldhavetheeffectoffurtherholdingbackalreadyweakglobaldemandandeconomicrecovery.

Apreferredoptionfordevelopingcountriesmaybetoproactivelybuildonaseriesofregionalandinterregionalinitiativeswiththeaimsoffosteringregionalmacroeconomicandfinancialstability,reducingtheneedforforeign-exchangeaccumulation,andstrengtheningresilienceandcapabilitiestodealwithbalance-of-paymentscrises.Whileregionalarrangementshavesufferedfromsomeinstitutionalshortcomings,thegreatestproblemisprobablytheirlimitedsize,especiallyinsituationswhenalltheirmembersaresubjecttoexternalshockssimultaneously.Asawaytoaddressthesizeproblem,interregionalswaparrangementswouldbeparticularlyuseful.Anotherpossibilitymightbethecreationofacommonfundwithaperiodicincreaseofpaid-incapital,whichcouldbeusedbyaregionalclearingunionorreservepooltoincreaseitsliquidityprovisioncapabilitiesbyborrowingonitsown.Thiscouldevenbeaneffectivetoolforpreventingintraregional contagion in the event of external shockswith different intensities or varying time lags.Furthermore,inaheterogeneousinternationalcommunity,strongregionalinitiativescouldcombinewithglobal,otherregionalandnationalinstitutionstocreateabettergovernancesystemthananarrangementbasedsolelyonglobalfinancialinstitutions.Suchacombinationofinitiativesatvariouslevelscouldprovide,atleastpartially,analternativetoreserveaccumulation,andcouldhelpdealwiththecontractionarybiasoftheiMS,therebyservingasasteppingstonetomorecomprehensivereforminthefuture.

International financial regulation: A work in progress

Thecrisisconfirmedthegrowingdisconnectbetweentherealandfinancialeconomies;speculativecapitaltrumpedentrepreneurialcapital,whilehouseholdsavingswerenolongerprotected.bankshavebeensingledout−notunfairly−forattention,astheirinternationalpresencemadethemtoobigtofailbeforethecrisisandtoobigtobailafterithit.Strongeroversightofsystemicallyimportantfinancialinstitutionsisneeded,togetherwithagreaterdegreeofmanagementofcapitalaccounts.Todate,theiMFhasbeenreluctanttotakeonthistask,eventhoughthemonitoringofadversespilloversisnowanacceptedpartofitswork.

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Theinternationalreformagenda,undertheguidanceoftheFinancialStabilityboard(FSb),haspursuedanumberof regulatoryand supervisory initiatives, including the revisedbasel iii accordsand specificprovisionsfor“globallysystemicimportantbanks”.Althoughportrayedasagreatleapforward,thesereformsareunlikelytomakebankssignificantlymoreresilient.Whilebaseliiirequiresbankstomaintainhighercapitaladequacyratioscomparedwithbaselii,itsrisk-weightingmethodologyallowsbankstomaintainveryhighleverageratios,whilediscouraginglendingtosmallandmedium-sizedenterprises(SMes)andto start-upsand innovators.More regrettablyperhaps,prudential regulations still allow thebanks’ownevaluationsorcreditratingagencies’assessmentsforcalculatingtheirrisk-weightedassetsandthereforethelevelofcapitaltheyneedtocopewithunexpectedlosses.

Aparticularconcernfordevelopingcountriesthathavebeenvoluntarilyadoptingthebaselrulesisthatbaselguidelinesforcredit-riskmeasurementmayincreasethecapitalrequirementsforfinancingSMesandforinvestmentsinlong-termprojects.Moreover,policymakersindevelopingcountriesshouldbearinmindthatthebaselframeworkwasnotconceivedtomeettheirparticularneeds;itaimstoharmonizenationalregulationsandavoidregulatoryarbitrageacrosscountrieshostinglargeandcomplex,internationally-activefinancialinstitutions.

inparallel to theadoptionof theseregulatoryreformsat the international level,severaldevelopedcountriesdraftednewnationallegislationtoaddresssystemicrisksintheirfinancialsystems.Themostfar-reachingincludesprovisionsto“ring-fence”orseparatecommercialactivitiesfrominvestmentactivitiessoastoinsulate−andthusprotect−depositors’assetsfromriskybankactivitiesandlimittheprobabilityofabankrunincaseofinsolvency.However,eventhoughtheseinitiativesareaddressingkeyweaknessesinthebankingsystem,theyhavemetwithstrongresistancefromthebankingindustrylobby,whichhas(withsomesuccess)soughttopostponeanddowngradetheirimplementation.

Outstanding issues: Shadow banking and credit rating agencies

The focus on traditional banking hasmeant that inadequate attention has been paid to the risksinherentinanexpandingshadowbankingsector–anactivitywhichhasemergedoverseveraldecadesofliberalizationandderegulationofthefinancialsystem.innovativeformsofmarketintermediationfortheprovisionofcreditandanewbreedofassetmanagers(suchashedgefunds)andbroker-dealers(ofteninfinancialconglomerates)havetakenleveragingwithinthefinancialsystemtonewheights,withdangerousconsequencesforfinancialstability.oneoftheconcernsisthequalityofthefinancialproductsthathavebeencreatedandtraded.Measuringtoxicityisdifficult,butthereisaclearneedtodoso,andcreditratingagencies(CRAs)haveprovedtheyarenotuptothetask.Anotherconcernisthatshadowbankingmayamplifyfinancialcyclesbyfacilitatingleveragingwhenassetpricesarebuoyantandtriggeringrapidanddeepdeleveragingwhenconfidenceislost.

Despitethecrisis,shadowbankingremainsaverylargeactivityandiscontinuingtogrow,includinginseveraldevelopingcountries.in thesecountries, itgenerallydoesnot involvelong,complex,opaquechainsofintermediation;however,itcanstillposesystemicrisks,bothdirectly,asitsimportanceintheoverallfinancialsystemgrows,andindirectlythroughitsinterlinkageswiththeregulatedbankingsystem.indeed,thefocusofreformsontheregulatedfinancialsectormightevenbeinducingamigrationofbankingactivitiestowardstheshadowbankingsystem.

inaworldofmountingdebt,CRAsplayapivotalroleinthegovernanceofthefinancialsystem.Ahandfulofcompanies(the“bigThree”)whichdominatethisbusinesshaveapoortrackrecord.Theyhavebeenaccusedofconflictsofinterestandofdefraudinginvestorsbyofferingoverlyfavourableevaluationsof somefinancial instruments (often for the benefit of their paying clients), including extremely riskymortgage-relatedsecurities.Theyalsostronglyinfluenceinvestors’perceptionsofthecreditworthinessofsovereignissuers.The2008crisisexposedhowratingsaregenerallybasedonpredisposedviews,rather

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thanonmacroeconomic fundamentals,with potentially detrimental impacts on development strategiesduetoincreasedandunjustifiedborrowingcostsforanumberofgovernmentsthathavebeengivenlowerratings.ThewideuseofCRAratingsisnowbeingrecognizedasathreattofinancialstabilityandasourceofsystemicrisk.indeed,underFSbguidance,countriesarebeingrequiredtoreducemechanisticrelianceoncreditratingagencies.However,CRAassessmentsstillhaveastrongimpactonassetallocationandtheinterestratetheborrowermustpayforobtainingfinancing.Theirratingsareextensivelyusedbybanksforprudentialregulation,asboththebaseliiandiiiframeworksallowbankstodeterminetheriskweightsforcapitalrequirementsonthebasisofCRAs’evaluations.Creditratingsarealsousedforopenmarketoperationsconductedbycentralbanks,andprovideaguidelineforinvestmentfunds’strategies.

Thechallengeoftacklingfinancialinstabilityattheinternationallevelalsohasimplicationsformanydevelopingcountrieswhichhave agrowingcommercial presenceof foreign-ownedbanks.Suchbanksmaybesystemicallyimportantinthehostcountry,eventhoughtheiractivitiesmayrepresentonlyasmallproportionoftheirglobalbusiness.Thiscreatesregulatorychallengesforhostsupervisors,especiallywhenthereisalackofhome-hostcountrycoordinationinthesupervisionofthetransnationalbanks’activities.Also,whilethesebankscanfacilitateaccesstoforeigncapital,bythesametokentheycanalsocontributetoswingsincapitalflowsandtothebuild-upofdifferenttypesoffragilities,includingassetbubbles.Thisrequiresparticularregulatoryresponses.

Towards a bolder agenda

Post-crisisregulatoryreformshavebeenmorelikelytopreservethantotransformthefinancialsystem.Amoreambitiousreformagendaisnecessaryiffinanceistobecomelessfragileandbetterservetheneedsoftherealeconomyandofsociety.ongoingeffortstostrengthenprudentialregulationbyraisingcapitalandliquidityrequirementswillnotsuffice;itwillalsobenecessarytointroducestructuralreformsthatfocusbothonfinancialstabilityandondevelopmentandsocialobjectives.

Suchreformsshouldincludering-fencingoffinancialactivitiesthatrequiresastrictseparationofretailandinvestmentbanking,includingattheinternationallevel,andregulationoftheactivitiesnowperformedbytheshadowbankingsystem.However,ring-fencingalonewillnotensurethatthefinancialsystemwillallocateenoughresourcestomeetbroaddevelopmentalgoals.Asrisksinvolvedindevelopmentfinancearebeyondtheacceptancelimitsofcommercialbanks,variousmeasuresshouldbeundertakenbytheStatetohelpshapeamorediversifiedsystem,bothintermsofinstitutionsandfunctions.

Ratingcreditworthiness remainsofessential relevanceforahealthyfinancialsector.However, theexistingagencieshavedemonstratedapoorrecord,particularlywhenitcomestoanticipatingseriouscrises.FollowingthewidespreadrecognitionthatconcentrationofthesectorinthethreebiggestinternationalCRAshascreatedanuncompetitiveenvironment,substantialchangesareneededtocurbconflictsofinterest,forinstancebyshiftingfroman“issuerpays”toa“subscriberpays”businessmodel.butthisnewmodelwouldstillrequiresomekindofpublicsectorinvolvementtoavoidfree-riderissues.Moreradicalmeasuresincludecompletelyeliminatingtheuseofratingsforregulatorypurposes,ortransformingtheCRAsintopublicinstitutions,sincetheyprovideapublicgood.Also,bankscouldpayfeestoapublicentitythatassignsraters forgradingsecurities.Alternatively,bankscouldrevert towhathashistoricallybeenoneof theirmostimportanttasks,namelyassessingthecreditworthinessoftheirpotentialborrowersandtheeconomicviabilityoftheprojectstheyintendtofinance.

Regulationshouldnolongerdiscouragethefinancingoflong-terminvestmentorofinnovationandSMesjustbecausetheyseemmoreriskyfromanarrowlyprudentialpointofview.indeed,witheffectiveregulationsuchlendingwouldspurgrowth,andactuallyimprovetheoverallqualityofbanks’assets.

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The recurrent problem of external debt crises

FromAccratoKievandfromAthenstoSanJuan,externaldebtdifficultieshavebeenmakingfinancialheadlinesinrecentmonths.externaldebtisnotaprobleminitself;indeed,debtinstrumentsareanimportantelementofanyfinancingstrategy,andtotheextentthattheyareusedtoexpandproductioncapacities,theycontributetoboostingincomeandexportearningswhicharerequiredtoservicethatdebt.However,whereexternaldebtprimarilyresultsfromlargesurgesinprivatecapitalinflowsthataremostlyunrelatedtothefinancingoftradeandinvestmentintherealeconomy,theycanleadtoassetbubbles,currencyovervaluation,superfluousimportsandmacroeconomicinstability.Underthesecircumstances,theclaimsonthedebtorcanquicklyexceeditscapacitytogeneratetherequiredresourcestoserviceitsdebts.

overthepastdecadeorso,theexternaldebtpositionofmostdevelopingcountriesimprovedduetoacombinationofstrongeconomicgrowth,afavourableinterestrateenvironmentandinternationaldebtrelief.AsapercentageofGNi,thestockofexternaldebtfellmarkedlyfromitspeaklevelsinthe1990s,inmostregionstobelow30percent.Similarly,interestpaymentsonthisdebtamountedtobetween1and6percentofexportsin2013,comparedwith15percent(onaverage)inthe1980sand1990s.Thecompositionofthisdebtalsochangedfrompredominantlysyndicatedbanklendingtobondfinancing,withtherecentfirst-timeentryintointernationalbondmarketsofsomecountries,notablyfromsub-SaharanAfrica.Meanwhile,agrowingnumberof emergingdevelopingcountrieshavebeenable to attract foreign investors to local-currency-denominateddebt.

itwould,however,beprematuretotakethesetrendsasaguaranteeoffutureeconomicrobustness.Globaldebtlevelshavebeenrisingagainsince2011,ledbypublicsectorborrowinginsomedevelopedeconomies,butalsosharpincreasesinpublicsectorborrowinginlow-incomedevelopingcountries,aswellaspredominantlyprivatesectorborrowinginsomeemergingdevelopingeconomies.Foreignassetmanagerscanquicklyunloadentirepositionsinacountry’sdomesticdebtandexitthemarketforreasonswhichhavelittletodowithfundamentals,causingsevereimpactsonthatcountry’sdomesticinterestratesandexchangerate.Consequently,anumberofDTescouldencountergrowingdifficultiesinservicingtheirdebtsoverthecomingyears,ashistoricallylowinterestratesintheUnitedStatesarelikelytobegraduallyincreasedoverthenextfewyears,whileexportopportunitiestodevelopedcountriesremainsubduedandcommoditypricesarestagnatingorcontinuingtofall.TherapidriseofexternalprivatedebtrunsthedangerofrepeatingapatternseenpriortothelatinAmericancrisisofthe1980sandtheAsiancrisisofthe1990s,withprivateliabilitiesendinguponpublicsectorbalancesheets.Whilethesecountries’significantlyhigherlevelsofforeign-exchangeearningscouldpostponecrises,andsmooththeirimpactiftheyoccur,currenthighdebtlevelsnonethelesspresentsignificantvulnerabilitytoasuddendryingupofforeignborrowingpossibilities.

in truth, serious debt problems are likely to reflect irresponsible behaviour by both creditors andborrowers.However,withtheadventofrapidfinancialliberalizationandfinancialopenness,keyfactorscausingseriousrepaymentdifficultiesindevelopingcountriesarethechangingeconomicconditionsandriskperceptionsindevelopedcountries.Theexperienceofthelastfewdecadesshowsthatcapitalmovementscanreversesuddenly,sometimesasaresultofcontagion,andtriggerexternaldebtcrises.Steepcurrencydepreciations,bankingdifficulties,corporatebankruptciesand job lossescanquicklyfollow,promptingpublicsectorinterventionstocontainthecrises,suchasbailouts,emergencyfinancingandcountercyclicalmeasures.itisfromthissequencethatexternaldebtcrisesoftenturnintocrisesinpublicfinances.

Solongasprivatedebtdefaultsdonotaffectthewidereconomy,managingthemessentiallyinvolvesthe application of commercial law in the jurisdictionwhere the debtwas issued.However, sovereignexternaldebtposesadifferentsetofchallenges.Foremostamongst theseis,ofcourse, thefact that themacroeconomicmanagementof sovereigndebthas far-reaching social, economic andpolitical impactsonwholepopulations,particularlythroughtheprovisionofpublicgoods.inaddition,sovereignsarebothmoreandlessvulnerablethanprivatedebtors.ontheonehand,unlikeprivatedebtors,sovereignsthatare

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unabletoservicetheirdebtcannotseektheprotectionofbankruptcylawstorestructureordelaypayments.ontheotherhand,creditorscannoteasilyseizenon-commercialpublicassetsinpaymentforadefaultedsovereigndebt.Thus,historically,sovereigndebtissueshavebeenaddressedthroughdirectnegotiationsbetweensovereigndebtorsandtheircreditors.

Thecontemporarysystemofsovereigndebtrestructuringishighlyfragmentedandbasedonanumberofadhocarrangements.Thissystemhasgivenrisetonumerousinefficiencies.First,sovereignexternaldebtproblems tend tobeaddressed too latewith too little.Debtorgovernmentshavebeen reluctant toacknowledgesolvencyproblems for fearof triggeringcapitaloutflows,financialdistressandeconomiccrisis,whileprivatecreditorshaveanobviousinterestindelayingexplicitrecognitionofasolvencycrisis,asthisislikelytoentailhaircuts.Procrastinationisfrequentlyendorsedbyofficialcreditorswhoprovideemergencysupporttobridgepresumedliquidityshortages.Theseareoftenusedtorepayprivatecreditorsratherthantosupporteconomicrecovery.Second,thecurrentsystemplacesmostoftheburdenofadjustmentonthedebtoreconomiesthroughconditionalitiesattachedtolending,whichdemandausteritypoliciesandstructuralreformswithastrongrecessionarybias.Andfinally,withthefast-growingpromotionofcreditorrightsandtherapidriseofbondfinancinginexternaldebtmarkets,sovereigndebtrestructuringhasbecomeenormouslycomplex. inaddition to the involvementofoften thousandsofbondholderswithdiverginginterestsandmultiplejurisdictions,thishasalsofacilitatedtheemergenceofhighlyspeculativefundsrunbynon-cooperativebondholders,includingso-calledvulturefunds.Thesefundspurchasedefaultedsovereignbondsatasignificantdiscountwiththesoleintentionofsuinggovernmentsforrepaymentatfacevalueplusinterest,arrearsandlitigationcosts,resultinginprofitsofupto2,000percent.

Alternative approaches to sovereign debt restructuring

There is growing recognition that amore efficient,more equitable approach to sovereign debtrestructuringisurgentlyneeded.Threemutuallysupportiveapproachesareunderdiscussion.Thefirstseekstostrengthentheexistingmarket-basedapproachtodebtrestructuringbyclarifyingandadaptingitslegalunderpinnings.Thisincludes,forexample,improvementstoso-calledcollectiveactionclauses(CACs)inbondcontracts.Theseallowa(super-)majorityofbondholderstovoteinfavourofadebtrestructuringthatthenbecomeslegallybindingonallbondholders.otherexamplesincludeclarificationsoftheparipassu(equaltreatmentofbondholders)provisionindebtcontractsandcontingentpaymentprovisions.Thelattermakefuturepaymentsbysovereigndebtorscontingentonobservableeconomicconditions,forinstancethroughtheuseofGDP-indexedbondsorcontingent-convertiblebonds(so-calledCoCos).Themainadvantageofthisapproachisthatitremainsvoluntaryandconsensual.However,itdoesnotaddresspotentialproblemswithoutstandingdebtcontracts,oftenremainslimitedtoparticulartypesofdebt(suchasbonddebtinthecaseofCACs),andprovideslittleinthewayofdebtcrisispreventionandsovereigndebtresolutionaimedatfastmacroeconomicrecoveryandreturntogrowth.

Asecondapproach focuseson soft-lawprinciples contained in internationalpublic law. its aim istodevelopan internationallyacceptedsolution to sovereigndebt restructuring,withahigherdegreeofcoordination− andpossibly centralization− than themarket-based contractual approach.Suchgeneralprinciplesoflawusuallyreflectunwrittenrulesofbehaviourorcustomarypracticethatarerecognizedinmostdomestic legalsystemsandshouldbeapplicablein thecontextofexistinginternational law.Coreprinciplescurrentlyunderdiscussionincludesovereignty,legitimacy,impartiality,transparency,goodfaithandsustainability.

Aprinciples-based approach can be promoted in a variety ofways.one option focuses on theirinstitutionalizationandimplementationbasedongeneralguidelinesagreedattheinternationallevel,eitheratalreadyestablishedforumsorthroughnew,independentbodies.Anothercompatibleoptionisthroughdomesticlegislation,suchastheUnitedKingdomDebtRelief(DevelopingCountries)Actof2010ortherecentbelgianlaw“inrelationtothefightagainsttheactivitiesofvulturefunds”.Whilesuchprincipleslargely

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buildonexistingmechanismsofnegotiationandrestructuring,usingtheseflexibly,theircorelimitationistheirnon-bindingnature,withnoguaranteeofthewillingnessofacriticalmassofpartiestoadheretothem.

Thisisaproblemthatcanberesolvedonlythroughafullyfledgedmultilateralandstatutoryapproach.The core featureof this third approach to sovereigndebt restructuring is that legal decision-making inrestructuring caseswouldbegovernedby a bodyof international lawagreed in advance as part of aninternationaldebtworkoutmechanism.Thecorepurposeofanysovereigndebt restructuringfacilityortribunalwouldbetoprovidetransparent,predictable,fairandeffectivedebtresolution,anditsdecisionswouldbebindingonallpartiesaswellasuniversallyenforceable.

Advocatesofmultilateraldebtworkoutmechanismsandprocedureshaveoftendrawnattentiontotheasymmetrybetweenstrongnationalbankruptcylaws,asanintegralpartofahealthymarketeconomy,andtheabsenceofanycounterparttodealwithsovereigndebtrestructuring.Debtworkoutarrangementsshouldmeettwocoreobjectives.First,theyshouldhelppreventfinancialmeltdownincountriesfacingdifficultiesservicingtheirexternalobligations.Suchameltdownoftenresultsinalossofmarketconfidence,currencycollapseanddrasticinterestratehikes,seriouslydamagingpublicandprivatebalancesheets,andleadingto large losses inoutputandemploymentandasharp increase inpoverty.Second, theyshouldprovidemechanismstofacilitateanequitablerestructuringofdebtthatcannolongerbeservicedaccordingtotheoriginalcontract.Meetingthesegoalsimpliestheapplicationofafewsimplesteps:atemporarystandstillonallduepayments,whetherprivateorpublic;anautomaticstayoncreditorlitigation;temporaryexchange-rateandcapitalcontrols;theprovisionofdebtor-in-possessionandinterimfinancingforvitalcurrentaccounttransactions;and,eventually,debtrestructuringandrelief.

establishingsuchastatutorysolutionfordebtrestructuringhasmetwithconsiderableresistance.butitscoreadvantageispreciselythat,ifsuccessfullyestablished,itpromotesasetofregulationsandpracticesthatembodylong-termobjectivesandprinciplesoverandaboveparticularinterests.buildingmomentumonallthreefrontswouldappeartobeaconstructiveapproachtoforgingaconsensusoneffectivedebtrestructuring.

Restating the case for additional official development assistance

oneofthelimitationsofthecurrentinternationalfinancialsystemisitsrelativeinabilitytoprovidethedesired levelsof internationalfinancefordevelopmentandfor long-terminvestments.AsdiscussedextensivelyinpreviousTrade and Development Reports,domesticresources(bothprivateandpublic)willremainthemostrelevantsourcesoflong-terminvestmentinmostdevelopingcountries.However,internationalfinancing–especiallyofalongertermnature–canplayanimportantrolewhendomesticfinanceislimitedorismissingaltogetherinkeyareas.Abasicchallengeisthat,whileinternationalpublicfinancecanbeundulyinfluencedbypoliticalcalculations,privateinternationalfinancialmarketstendtounderinvestinkeyprojectsindevelopingcountries,becausetheseareoftenassociatedwithlengthygestationperiods,significantexternalitiesandcomplementaritiesacrossinterrelatedinvestments,aswellasuncertaintyabouteventualoutcomes,orbecausetheylacktheinformationaboutthespecialneedsofSMesorstart-ups.

Theresultingdisconnectbetweenprivateandsocialratesofreturnisalong-standingpolicychallengeatalllevelsofdevelopment,andnecessitatesgreaterStateinvolvementtoprovidetherightkindoffinance,particularlyfordevelopmentpurposes.Mostsuccessfulbiginvestmentpusheshavemanagedtoeffectivelymixpublicandprivateinitiativesinsomewayoranother,andsoinaverybasicsense,alldevelopmentfinanceisblended.Thebigissuesarewhoisdoingtheblending,howandtowhatend?

official development assistance (oDA) continues to play a critical role in resourcemobilization,particularlyforthepoorerandmorevulnerabledevelopingcountries,includingthroughbudgetsupport.Thisformoffinancingtendstobemorestablethanotherformsofexternalcapital,andwhiletheempiricalevidenceremainsambiguous,successfulprojectswithlarge-scaleoDAindicatethatitcanplayacatalyticrole

XVI

ingrowthanddevelopment.However,thetrendsinoDAarenotencouraging:eventhoughithasincreasedinthepastdecade,andinabsolutetermshasreachedrecordlevels,itwas,onaverage,just0.29percentofdonorGNiin2014−wellbelowthedesiredandcommittedlevelof0.7percentofGNiandevenlowerthanintheearly1990s.Moreover,partlyasaresultofeffortstoachievetheMillenniumDevelopmentGoals,oDAhasbeenfocusingincreasinglyonthesocialsectors,andonlyasmallanddecliningshare(lessthan40percentofthetotal)hasbeendirectedtowardseconomicinfrastructuredevelopment,productivesectorsandrelatedservices.

Cooperationamongstdevelopingcountriesisgrowing.South-Southdevelopmentassistanceincreasedtoaccountforaround10percent,orhigher(dependingonwhichmeasurementsareused)oftotaldevelopmentcooperationin2011.TheseflowsarealsotypicallymoreorientedtowardsinfrastructuredevelopmentandeconomicactivitiescomparedwithtraditionalNorth-Southflows,althoughtheyinvolveagreaterdegreeoftiedandbilateralaid.

overall,however,thescaleofcurrentofficialflowsremainswellshortofwhatisneeded,andeven,asshouldbethecase,ifdonorcountriesweretomeettheoDAtargetof0.7percentoftheirGNi,itwouldstillbeinsufficienttofillinfrastructureandotherfinancinggaps.Suchchallengesarecompoundedbytheneedtofinanceglobalpublicgoodsrelatedtoclimatechangemitigationandadaptation.Forinstance,between2010and2012,$35billionwasmobilizedforthatpurpose.Thisiswellbelowthe$100billionayearby2020pledgedundertheCopenhagenAccord.Moreover,mostoftheseresourceshavealsobeencountedasoDA,meaningthattheydonotclearlyconsistof“additional”financing.

inthiscontext,theideaof“blendedfinance”isbeingmootedasawayfordevelopmentassistancetobeusedtoleverageprivatecapital.However,discussionsappeartoignorethelonghistoryofblendedfinance,andhavethereforeavoidedaskingthequestions,“bywhom,howandforwhatpurposes?”Theinternationalcommunityneedstoexplorefurtherhowtheseprocesseswouldworkinpractice,takingintoaccountthepossiblepitfallsalongside theiradvantages.oDAisalreadyamixtureofgrantsand(subsidized) loans,withashifttowardsthelatterinrecentyears.TheoeCDreportsthattheamountof“aid”providedasloansdoubledfrom$9billionin2006to$18billionby2013.Animmediateconcernisthatsuchaidshouldnotresultinrisksbeingtransferredfromtheprivatetothepublicsector.

Public-private partnerships

Recently,andinthewakeofheightenedfinancialization,theideaofleveragingpublicresourcesforlong-termfinancinghasbeenlinkedspecificallytopublic-privatepartnerships(PPPs).

Theuse ofPPPshas increased sharply in developing countries over recent decades, and is beingstronglypromotedinthepost-2015contextamidhopesthatharnessingtheprivatesectorwillhelpmultiplymillionsofdollarsintobillionsandeventrillions.However,whilePPPshaveshownsomesuccessesinsomecountriesandactivities,themostneedyareasandservicestendtobeneglected,suchasinleastdevelopedcountriesorinwaterservices.Moreover,evenwherePPPshavegrowninnumber,thehistoricalexperienceinmanysettingssuggeststheydonotsucceedincreating“additional”financeinarealeconomicsense;indeed,theirusestilltendstobejustanaccountingexercisetogetprojectdebtoffthegovernmentbudget.evenincountriesorregionswithalonghistoryofPPPs,governmentsfrequentlyprovidethelion’sshareoffinance.Particularcautionisneededinassessingthelong-termfiscalcoststogovernments,asthescaleofobligationsandliabilitiesthatgovernmentshaveincurredthroughtheuseofPPPshasoftenbeenmuchgreaterthananticipated.

Where international investors have been involved as partners in thePPP, contingent liabilities ofgovernmentsmaybe related to exchange-rate volatility ormacroeconomic shocks; other liabilities canoccurbecauseofoveroptimisticexpectationsofconsumerdemand,orhigher-than-expectedoperatingcosts

XVII

thatthreatenthesurvivalofaproject.evenifaprojectgoesaccordingtoplan,thefiscalburdenduringtheentirelifespanoftheproject,asopposedtojusttheconstructionphase,haspromptedsomegovernmentstoreviewallPPPsandissuenewguidelines.Somegovernmentsinsistontheuseofaccrualaccountingthatmakesexplicitallcontingentandfutureliabilities,ratherthanjusttheshort-termexposureduringtheconstructionphase.inothercases,unsatisfactoryoutcomeswithPPPshaveresultedinsomeschemesbeingabandonedearlyandnotrevived.Morethan180citiesandcommunitiesin35countrieshavetakenbackcontroloftheirwaterservices,forexample,evenincitiesthathavebeeninternationallyrenownedfortheirPPP-basedwatersupplyprojects.

Blending the new with the old: Sovereign wealth funds and development banks

Amajorchallengeforlong-terminvestmentsourcesrelatestoproductiveactivitiesthatarepotentiallyprofitablebutwhichprivateinvestorsavoidbecauseofmarketfailures.Suchclassicalmarketfailuresmaybebestaddressedbyspecializedpublicfinancialinstitutions.

onesuchinstitutionisthesovereignwealthfund(SWF).Thesespecialpurposevehiclesareownedbynationalorregionalauthoritieswithlargeamountsofforeignassetstoinvestratherthanholdasinternationalreserves.SWFsaregainingincreasingattention,notonlybecauseoftheimmensescaleoftheircombinedassets(currentlyestimatedatsome$7trillion),butalsobecausemorethan40developingandtransitioneconomiesownalmost$6trillionofthoseassets.Fundholdingsarehighlyconcentrated,withalmost90percentoftotaldeveloping-countryfundsbeingheldbyjust7countries,butevenintheremainingcountries,whereassetvaluesarerelativelysmall,theamountsarestillsufficientlylargetomakeadevelopmentimpact.Atpresent,however,onlyinrelativelyrarecasesareSWFsdesignateddirectlytoinvestindevelopment-orientedactivities;mostofthemmakethesameportfoliodecisionsastraditionalprivateinvestors.

Thisisnotthecasefordevelopmentbanks,whicharedesignedspecificallytocompensatefortheshort-termismofprivatecapitalflowsandmarkets.Theyhaveaclearmandatetosupportdevelopment-orientedprojects,andfortheirfundingbasetheycanseeklow-cost,long-termcapitalfrominternationalmarkets.Suchbankscanprovidelow-incomecountrieswithloansfordevelopmentprojectsatsubsidizedinterestrates;theirconcessionallendingrepresentsabout30percentoftheirtotalloanportfolios.Theyalsoplayanimportantcountercyclicalrole,providingprojectfinancetofillthegapsleftwhenprivatelenderswithdrawduringtimesofdownturnorcrisis.

However,despitetheirimportantrole,withoutfurthercapitalinjections,thetraditionalmultilateralandregionaldevelopmentbankscanmakeonlyalimitedcontributiontowardsessentialdevelopmentfinanceneeds,giventheirsmallloancapacity.South-Southcooperationishelpingtofillthegapthroughsubregionaldevelopmentbanksthathaveemergedinthedevelopingworld.Thesecanbesignificantplayers:inlatinAmerica, for instance, loansapprovedby theAndeanDevelopmentCorporationstoodat$12billion in2014,roughlythesameamountasthetotalloansoftheinter-AmericanDevelopmentbank.Someofthenewdeveloping-countryregionalbanksplantobeactivefarbeyondtheirregion,suchasthenewAsianinfrastructureinvestmentbankestablishedin2014,whichincludesdevelopinganddevelopedcountriesfromoutsideAsiaasfoundingmembers.Somenationalbanksaresimilarlyshowingawillingnesstoinvestattheregionalorinternationallevel,providingexternalfinanceaspartoftheiroperations.in2014,thestockofloansdisbursedbytheChinaDevelopmentbank,theexportandimportbankofChinaandbrazil’snationalbankforeconomicandsocialdevelopment(knownbyitsacronymasbNDeS)totalled$1,762billion,ormorethan5timestheWorldbank’stotaloutstandingloansof$328billion.Thusthelandscapeofdevelopmentbankingischangingconsiderably,bothinresponsetonewinvestmentneedsandasareflectionofthewidertrendofSouth-Southcooperationandglobalengagement.

insummary,thereremainsacriticalneedforgovernmentsupportforlong-termdevelopmentfinance,atboththeinternationalanddomesticlevels.Thisneedhasnotbeenmet,evenbytheemergenceofinnovative

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MukhisaKituyi Secretary-GeneralofUNCTAD

mechanismsforharnessingfinanceorbyoDA.inpartthisrelatestotheintrinsiccharacteristicsofsomeoftheactivitiesthatneedtobefinanced:infrastructuredevelopmentwillalwaysinvolvelarge,long-termandlumpyfinancingneeds;SMeSandstart-upswillalwayspresentmoreriskthanmanyotherborrowers;andmarketswillneverfinancepositivesocialexternalitiesthatcannotbecapturedbytheprofitmechanism.Howeveritalsoreflectsthecurrentstateoftheglobaleconomy,inwhich,ironically,privateinvestorsappearwillingtoacceptverylowreturnsongovernmentbondsratherthanassumetheriskofinvestinginprivateproductiveenterprises.

Current Trends and Challenges in the World Economy 1

1. Global growth

Followingthe2008–2009financialcrisisandthereboundin2010,theglobaleconomyhasbeengrowingatanaverageannualrateof2.5percent.Growth is expected to remain at around the samelevelin2015(table1.1).Thiswillresultfromaslightacceleration of growth in developed economies,amoderate deceleration in developing economiesandacontractionofgrossdomesticproduct(GDP)in transition economies.Therefore, global outputgrowthwillremainsignificantlybelowthe4percentratepostedinthepre-crisisyears.

Developedcountries are expected togrowataround1.9percentin2015comparedwith1.6percentin2014.TheeurozoneandJapan,inparticular,areexperiencingamoderateaccelerationofgrowth,althoughfromverylowratesin2014.Developingcountriesasawholewillcontinuetoexpandatarateofmorethan4percent,mainlyowingtotheresil-ienceofmostcountriesintheAsianregion.However,otherregionsareexperiencingasignificantslowdownduetolowercommoditypricesandcapitaloutflows,whichhavepromptedtightermacroeconomicpoliciesinsomecountries.Theworsthitbyallthesedevelop-mentsarelatinAmerica,thetransitioneconomies

andWestAsia,whiletheAfricansubregionspresentamoremixedpicture.

in developed countries, recent improvementsineconomicactivity reflectapick-upofdomesticdemand, owing togreater household consumptionandtoalessstringentfiscalstance.Theincreaseinhouseholdconsumptionislargelyduetolowerenergyprices and improvements in some labourmarkets,withlowerunemploymentratesincountriessuchasGermany,Japan,theUnitedKingdomandtheUnitedStates.Monetarypoliciesremainexpansionary,withverylowinterestratesinalldevelopedregionsand“quantitativeeasing”(Qe)programmesintheeuro-zoneandJapan.

ineurope,theQeprogrammeoftheeuropeanCentralbank(eCb)helpedtofurtherreduceyieldsonsovereigndebt,butsofarthishashadlittleimpactoncreditflowsto theprivatesector.Nevertheless,householddeleveraginghasalreadyeasedinrecentmonths, fiscal austerity has beenmoderated orslightlyreversed,andrealwageshaveimprovedonaccountofthefallincommodityprices.However,fragilitiespersist:inmanycountrieshigherratesofemploymenthavenotbeenmatchedbybetterqualityjobs,andsomebanksare showingsignsofweak-ness,whiledownsideriskshaveincreasedwiththe

Chapter I

CURRENT TRENDS AND ChALLENGES IN ThE wORLD ECONOMy

A. Recent trends in the world economy

Trade and Development Report, 20152

Table 1.1

wORLD OUTPUT GROwTh, 2007–2015(Annual percentage change)

Region/country 2007 2008 2009 2010 2011 2012 2013 2014 2015 a

world 4.0 1.5 -2.1 4.1 2.8 2.2 2.4 2.5 2.5

Developed countries 2.5 0.1 -3.7 2.6 1.5 1.1 1.3 1.6 1.9of which:

Japan 2.2 -1.0 -5.5 4.7 -0.5 1.7 1.6 -0.1 0.9United States 1.8 -0.3 -2.8 2.5 1.6 2.3 2.2 2.4 2.3European Union (EU-28) 3.0 0.5 -4.4 2.1 1.8 -0.5 0.1 1.3 1.7of which:

Eurozoneb 3.0 0.5 -4.5 2.0 1.8 -0.8 -0.4 0.8 1.5France 2.4 0.2 -2.9 2.0 2.1 0.2 0.7 0.2 1.2Germany 3.3 1.1 -5.6 4.1 3.6 0.4 0.1 1.6 1.5Italy 1.5 -1.0 -5.5 1.7 0.6 -2.8 -1.7 -0.4 0.7

United Kingdom 2.6 -0.3 -4.3 1.9 1.6 0.7 1.7 3.0 2.3EU member States after 2004 6.2 3.5 -3.5 2.0 3.1 0.6 1.2 2.6 3.0

South-East Europe and CIS 8.7 5.4 -6.6 4.7 4.6 3.3 2.0 0.9 -2.6South-East Europec 6.2 5.8 -1.8 1.5 1.7 -0.6 2.4 0.7 1.5CIS, incl. Georgia 8.9 5.3 -6.8 4.9 4.7 3.5 2.0 0.9 -2.8of which:

Russian Federation 8.5 5.2 -7.8 4.5 4.3 3.4 1.3 0.6 -3.5

Developing countries 8.0 5.3 2.6 7.8 5.8 4.7 4.8 4.5 4.1Africa 6.1 5.5 3.0 5.1 0.9 5.1 3.8 3.4 3.2

North Africa, excl. Sudan 4.8 6.2 2.9 4.1 -6.8 8.9 1.0 1.3 2.0Sub-Saharan Africa, excl. South Africa 7.4 6.1 5.3 6.7 4.6 4.3 6.0 5.4 4.3South Africa 5.4 3.2 -1.5 3.0 3.2 2.2 2.2 1.5 1.9

Latin America and the Caribbean 5.6 3.6 -1.6 5.8 4.7 3.2 2.8 1.4 0.8Caribbean 7.1 2.5 -1.0 2.7 1.9 2.0 2.7 3.0 3.3Central America, excl. Mexico 7.0 3.9 -0.3 3.7 5.2 5.0 4.3 4.2 3.7Mexico 3.2 1.4 -4.7 5.2 3.9 4.0 1.4 2.1 2.1South America 6.6 4.8 -0.2 6.5 5.2 2.8 3.3 0.8 -0.2of which:

Brazil 6.0 5.0 -0.2 7.6 3.9 1.8 2.7 0.1 -1.5Asia 9.2 5.9 4.1 8.8 6.9 5.1 5.6 5.6 5.2

East Asia 11.1 7.0 6.0 9.5 7.6 6.0 6.3 6.3 5.7of which:

China 14.2 9.6 9.2 10.4 9.3 7.7 7.7 7.4 6.9South Asia 9.1 5.1 4.8 9.0 5.5 3.0 5.2 6.2 6.7of which:

India 10.1 6.2 5.0 11.0 6.2 4.4 6.4 7.1 7.5South-East Asia 6.7 4.2 1.6 8.1 4.7 5.8 4.9 4.3 3.9West Asia 5.5 4.6 -1.0 6.7 7.5 4.0 4.1 3.3 2.5

Oceania 4.1 2.1 1.0 3.5 4.4 3.2 2.8 3.3 5.3

Source: UNCTAD secretariat calculations, based on United Nations, Department of Economic and Social Affairs (UN-DESA), National Accounts Main Aggregates database, and World Economic Situation and Prospects (WESP): Update as of mid-2015; ECLAC, 2015; Organisation for Economic Co-operation and Development (OECD), 2015; International Monetary Fund (IMF), World Economic Outlook, April 2015; Economist Intelligence Unit, EIU CountryData database; JP Morgan, Global Data Watch; and national sources.

Note: Calculations for country aggregates are based on GDP at constant 2005 dollars.a Forecasts.b Excluding Lithuania.c Albania, Bosnia and Herzegovina, Montenegro, Serbia and the former Yugoslav Republic of Macedonia.

Current Trends and Challenges in the World Economy 3

uncertaintyoverthesustainabilityofdebtinGreece.ThelatterrepresentsthemostimmediatethreattothesovereigndebtyieldsofPortugal,Spainandothereuropean countrieswhich had recently started torecoverfromthedepthsofthecrisis(seebox1.1).

in Japan, following the recession in 2014,economicactivity is starting to improve,aidedbyconsumerandinvestmentspending.lowerenergypriceswillhaveapositiveinfluenceonthebalanceoftradeandonconsumptionexpenditure,aswillexportstotheUnitedStateswhichroseinthefirstmonthsof2015.TheUnitedStatesisexpectedtocontinueitspost-crisisgrowthtrajectorywitha2−2.5percentgrowthrate,whichisbelowpreviousrecoveriesbutallowssteadyjobcreation.Fiscalausterityiseasingatthefederalandstatelevels,andresidentialinvest-mentisrecoveringfromalowbase.However,withscantevidenceofnominalwageincreases,thereareconcernsthathouseholds’balancesheetswillremainfragile.eveniftheexpectedverygradualincreasesinthepolicyinterestratedonotrepresentasignificanttighteningofmonetaryconditions,theyhavealreadyimpactedinternationalcapitalmovementsandledtoadollarappreciation.ThisinturnmayresultinnetexportshavinganegativeimpactonGDPgrowth.

GrowthinAustraliaandespeciallyinCanadais slowingdownon account of their deterioratingtermsoftradeandlowerinvestmentsintheextrac-tive industries. Fiscal austerity policies inCanadahave also affected its economic activity, althoughhigher exports to theUnitedStatesmay attenuatetheirnegativeimpact.

economic trends in developing economieshavefollowedadifferentpatternsincethecrisis.inresponse to the initial shock in 2008−2009,manyofthemappliedambitiouscountercyclicalpolicies,including increased fiscal spending and incomespolicymeasuresthatweresustainedlongenoughtoencourageacontinuingriseofhouseholdexpenditureand,byextension,privateinvestment.Someofthesecountries are now scaling back or even reversingtheirpolicystimuliastheyfacecapitaloutflowsorlowerexportprices.bycontrast,foroilimporters,therecentimprovementsintheirtermsoftradeenlargetheroomformanoeuvre.

Amongthosemostaffectedbylowercommodityprices and capital outflows have been the transi-tioneconomies,whoseGDPisexpectedtodecline

in 2015. in theRussian Federation andUkraine,balance-of-paymentsproblemswereaggravatedbypoliticalconflicts.Steepcurrencydepreciationandinflationdampeneddomesticdemandanddeepenedeconomicrecession.Thisinturnaffectedneighbour-ingcountriesforwhichtheRussianFederationisamajormarketandsourceofremittances.

inlatinAmericaandtheCaribbean,theeco-nomicslowdownwhichstartedin2011isforecasttocontinue,withanestimatedgrowthrateoflessthan1percentin2015.inparticular,SouthAmericaandMexicohavecontinuedtoexperiencelossesintheirtermsoftradeandreversalsofportfolioinvestmentinflowssincethesecondhalfof2014.lowerexportpriceshaveaffectedtaxreceiptsandhavealsoledtotheparalysisofseveralinvestmentprojects,particu-larlysomelinkedtooilexploitationandmining,andtoafallingrossfixedcapitalformation.Governmentshavegenerallysoughttosustainrealwagesandkeepunemployment in check despite the slowdownofeconomicgrowth.Asaresult,privateconsumptionis still themain engine of growth for the region,thoughitsrateofexpansionwaslessdynamicin2014andearly2015(eClAC,2015).Themorestringentexternalenvironment,andinsomecasestheinabilitytomaintaincountercyclicalpoliciesandcreditexpan-sionresultedinlesssupportivepoliciesinthefirstmonthsof2015,andevenausteritymeasuresinthecaseofbrazil.bycontrast,mostCentralAmericanandCaribbean countries benefited from lower oilpricesandwerealsolessvulnerabletospeculativecapitaloutflows.ThelinkagesoftheirmanufacturingsectorwithUnitedStatesmarkets,togetherwiththeincreaseinremittancesfromabroad,shouldcontrib-utetosignificantgrowthofthesesubregions,whichislikelytobewellabovetheregionalaverage.

ThepictureintheAfricanregionisalsovaried.inthelastdecade,growthinsub-Saharancountrieshasbeenmostlydrivenbyrisingprivateconsump-tion and infrastructure spending, linked inmanycountriestocommodityproduction,withapositiveimpactmainlyontheconstructionandservicesec-tors.Recently, however, some large oil-exportingcountriessuchasAngolaandNigeriahaveannouncedcutsinpublicspending,notablycapitalinvestmentandsubsidies.TheNigeriannairahasbeensubjecttospeculativeattacksthatledtotheadoptionoftightermonetaryandfiscalpolicies,whichwillhaveafurthernegative impact ongrowthprospects.Meanwhile,growthinmosteastAfricancountries,whoseterms

Trade and Development Report, 20154

Box 1.1

ThE EURO zONE CRISIS, A CASE OF Déjà VU

Theeurozonecrisisresemblesearlierbalance-of-paymentscrisesindevelopingcountriesintermsoftheoriginsandpolicyresponses;butitalsorevealssomespecificandinpartuniqueproblemsinthedesignofeurozonerules,institutionsandadjustmentmechanisms.

Theoriginsoftheeurozonecrisisdonotreflectfiscalmismanagement,butratherlieinmacroeconomicimbalancesgeneratedbyexcessiveforeigncapitalinflowsintotheso-calledperipherycountriesoftheeurozone,aswashighlightedinTDR 2011.essentially,intheyearspriortothe2008globalfinancialcrisis,therecyclingthroughthebankingsystemofthegrowingsurplusesintheeurozonecentretotheperiphery(andwhichinpartwereduetotheasymmetricimpactonrelativepricesoftradedgoodsinthecoreandperipheryfollowingtheintroductionofacommoncurrency),helpedfinanceamassivesurgeinprivatesectorconsumptionandhousinginvestmentinthelatter,athistoricallylowinterestrates,butattheexpenseofgrowingfinancialfragilities.However,therewerenomajorpolicyreactionsoneithersidetostoprisingimbalances.Astheslowdownintheeurozonepersistedafter2010,capitalflightforceddeficitcountriestocutdomesticspendingtobringitinlinewithdomesticincomes.Thisresultedinasevererecessionaryadjustmentand,ultimately,ariseofpublicsectordebt.

The traditional response to balance-of-payments crises is to devaluate the currency.butwithin theeurozone,nominaldevaluationisnotanoption.Therefore,policiesinthedeficitcountriessoughtaninternal devaluation throughwage compression and reducedgovernment spending, butwithout anyadjustmentonthepartofthesurpluscountriesthroughfasterwageincreasesandamoreexpansionaryfiscalstance.However,suchanapproachtoachievingarealdepreciationislikelytoinvolvehigheconomicandsocialcostsand,eveniffeasible,wouldtakeconsiderabletime,especiallywhentheproductivitygapwithtradepartnersishighandinflationisverylow.Moreover,deflationarypoliciesdampendomesticconsumption and investment, adding tounemployment and increasing thedebt burden. in addition,decliningpricesandfallingdomesticactivityreducetaxrevenues,forcinggovernmentstoseekliquidityfromexternalsourcesinordertoservicetheirdebtintheshortterm.

lackingtheinstitutionalarrangementstoprovidefinancialassistance,theeurozonedesignedaseriesofbilateralloansin2010,coupledwithiMFassistancetoGreecetoenablethatcountrytocopewithitsdebtrepayments.Thissavedtheoriginalprivatecreditorsfromincurringmajorlosses,despitetheirirresponsiblelendingpractices.bailingincreditorswasruledoutasanoptionuntilmajorlenders(orbondholders)hadremovedsubstantialportionsoftheirtroubledassetsfromthebalancesheet.Thoseassetswereacquiredbysupranationalbodies(suchastheSecuritiesMarketsProgrammeestablishedbytheeCbin2010,thecoordinatedlendingbytheeurozonecountriestoGreeceandtheeurozonerescueprogrammesforPortugalandireland)orbyotherfinancialinstitutionsinthecountriesinvolved(suchasitalianandSpanishbanks,whichincreasedtheirholdingsofnationalgovernmentdebt).TheSpanishandPortuguesegovernmentsalsoborrowedfromeuropeanfundsinordertorecapitalizesomeoftheirdomesticbanks,makinggoodthelossescausedbybubble-inducedlending.

Fromlate2009, lending toperipheraleurozonecountries (Greece, ireland,PortugalandSpain)wassuddenlyreversedas“core”eurozonebankssoughttoreducetheirexposurewithoutincurringsignificantlosses(seechart).ThefirstrestructuringofGreece’sexternaldebtwasonlyimplementedinMarch2012,whileavoluntarydebtbuybackwasintroducedinDecemberofthatsameyear.

eventually, the eurozone established a numberof funds– initially theeuropeanFinancialStabilityFacilityinJune2010,whichwaslaterabsorbedbytheeuropeanStabilityMechanismin2012–inordertoprovidefinancialassistancenotonlytoGreece,butalsotoirelandandPortugal.Suchassistancewas,however,oftenattachedtounrealisticgrowthpredictionsandcamewithexcessivepolicyconditionalities,insomecaseswithiMFinvolvement,whichneitherallowedforameasuredrecoverynorfacilitatedaclean-upoftheprivatesector’sbalancesheets.Meanwhile,governmentdebtroseinalltheperipherycountries,withsovereignyieldsmovingupwardsuntiltheannouncementbytheeCbofitsoutrightMonetaryTransaction(oMT)Programme.TheimmediateeffectofoMTinreducinginterestspreadsonsovereigndebtshowedthatrelianceonalenderoflastresortismuchmoreeffectiveforcreatingconfidenceinfinancialmarketsthanfiscalausterity.

Subduedgrowthinthe2010s,causedbyasetofrestrictivepoliciessimilartothoseimplementedinemergingmarket economies in the 1980s and1990s, clearly demands a change in the approach toresolvingfinancialcrisestriggeredbyprivateandpublicdebtdenominatedincurrenciesoverwhich

Current Trends and Challenges in the World Economy 5

domesticmonetaryauthoritieshavenocontrol;allthemoresoasthesolvencyofforeigncreditorsmaybeatrisk.Adifferentdistributionofthecostsofadjustments,sharednotonlybythedomesticsectorbutalsobyexternalcreditorsthroughbail-ins,couldprovidetheconditionsforafasterandmoresustainablerecovery.Thisalternativeresolutionproposalisnotjustamatterofcounterfactualthinking,butcandrawonactualexperiencessuchasthatoficeland.

inresponsetothedramaticfinancialcrisisinicelandin2008,theiMFprovideda$2.1billionconditionalloanaimedpartlyatstabilizingthedomesticcurrency,supplementedbyadditionalloansfromtheNordiccountries.iceland’scentralbank,withstrongiMFsupport,introduced“capitalflowmanagement”tostopcapitalflightandboostexporters’repatriationofforeignexchange.inaddition,theGovernmentletitsbankscollapseratherthanbebailedoutbytaxpayers.inshort,itpartiallynationalizedthebigbanks,andtransferredtheirforeignassetsandliabilitiestoinsolvent“old”banksandtheirdomesticassetsandliabilitiestosolvent“new”banks.italsoprovidedaguaranteefordepositsinthenewbanks.implicitly,itdeclinedtoprotectdepositors inbranchesoficelandicbanksabroad.Thenewbankscontinuedtofulfil basic domestic banking functions. in parallel, theGovernment set up a “WelfareWatch” taskforce,comprisedofrepresentativesfromawiderangeofstakeholdersandoperatingatarm’slengthfromtheMinistryofWelfare.Separately,itestablishedadebtor’sombudsmantofacilitatehouseholddebtrestructuring,asasizeablenumberofhouseholdswereintrouble,withtheirmortgagedebtworthmuchmorethanthesharplydepreciatedpricesoftheirhouses.lastly,theGovernmentchangedthetaxcodesoastoshiftmoreoftheburdenonhigherincomegroupsandreduceitonlowerincomegroups.

Capitalcontrolsiniceland–whichwerelimitedtocapitalaccounttransactionsaftertheinitialcrash– coupledwith timelybail-ins of foreign creditorswere a key component of the recovery strategy.TheGovernmentandtheiMFconsidereditmoreimportanttopreventafurtherdeclineinthevalueofthecurrencyandtosharethecostsmoreequitablybetweennon-residentcapitalownersandicelandictaxpayersthantosafeguardtheliberalcommitmenttofreedomofchoiceandthepropertyrightsofcapital.inadditiontocapitalcontrolsandtherejectionofbailoutsforforeigninvestors,inordertoprovideafaster,moresustainableandbroad-basedrecovery,thereisanongoingneedforamixofcountercyclicalpoliciesthatprotecttheweakestgroupsofthedomesticeconomytogetherwithmeasuresaimingtosolvelingeringindebtednessobstaclesandtorevitalizeproductivecredit(suchasdifferentiatingoldloansandnewloans,whichwouldbepayableinfull).

Box 1.1 (concluded)

ExPOSURE OF “CORE” EUROzONE bANkS TO SELECTED PERIPhERAL EUROzONE COUNTRIES, 2006 Q1–2014 Q4

(Billions of dollars)

Source: UNCTAD secretariat calculations, based on BIS, Consolidated Banking Statistics database.Note: Exposure of “core” eurozone banks reflects the consolidated claims of Austrian, Belgian, French, German

and Dutch banks vis-à-vis the selected countries on an ultimate risk basis. This indicator excludes “other potential exposures” consisting of derivatives, credit commitments and guarantees extended.

0

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2006 2007 2008 2009 2010 2011 2012 2013 2014

Ireland Spain Greece (right scale) Portugal (right scale)

Trade and Development Report, 20156

oftradehaveimproved,isexpectedtocontinueata relatively fast pace.by contrast,WestAfricancountriesarelikelytocontinuetosufferfromthecon-sequencesoftheebolaepidemic.economicgrowthisforecasttoremainsubduedinSouthAfricaduetosupply-sideconstraintsintheenergysector,coupledwithrestrictivefiscalandmonetarypolicies.Addedtothis,thoughthewidespreadfallincommoditypricesoverthepastyearwillhaveamixedimpactonthetermsoftradeofnetoilimporters,itmayalsodelayinvestmentspendingandprojects,particularlythoserelatingtotheextractiveindustriesandconstructionsectors.Finally,conflictsandsecurityconcernswillhaveanimpactonnationalincomesinanumberofeconomiesthroughoutthecontinent.

Asinpreviousyears,Asiaisthemostdynamicregion,andisestimatedtoaccountforalmosthalfoftotalglobalgrowthin2015.Theprojectedgrowthrateforeast,SouthandSouth-eastAsiacombinedis between5.5 and6per cent in2015.Growth isbeingdrivenessentiallybydomesticdemand,withan increasing contribution of consumption, bothpublicandprivate.Hence,eventhoughinvestmentrateshavebeenveryhighincomparisonwithotherregions (and should remain so, given the region’sinfrastructureneeds),mostAsiancountries(particu-larlyChina)seemtoberebalancingthestructureoftheirdemand.inthepastfewyears,thecontributionofdomesticdemandtogrowthhasexceededthatofnetexports,andtheshareofconsumption(privateandpublic)inGDPhastendedtoincrease.However,the bursting of the stockmarket bubble inChinahascreatedeconomicuncertainty,asitcouldaffectdomesticdemand.Nevertheless,thegrowthofprivateconsumptionisessentiallybasedonrisingincomesratherthanoncreditoranappreciationofassetval-ues,whichshouldensuresustainability.Furthermore,expansionaryfiscalandmonetarypoliciesseemsettocompensateforthesenegativeshocks.Meanwhile,loweroilpriceshaveeasedcurrentaccountdeficitsinseveralcountries,suchasindiaandPakistan,andtheformereconomyisforecasttoexpandbymorethan7percent.inWestAsia,Turkeyalsobenefitedfromloweroilprices,butmostoftheoil-exportingeconomiesinthesubregionfacedeterioratingtermsoftrade.inaddition,militaryconflictshavereducedgrowthprospectsinpartsofthissubregion.

2. International trade

(a) Goods

like global economic activity, internationaltrade remains subdued.between 2012 and 2014,therateofgrowthofworldmerchandisetrade(byvolume) oscillated between 2 and 2.6 per cent(table1.2).Thesegrowthratesaresignificantlybelowtheaverageannualrateof7.2percentrecordeddur-ingthe2003–2007pre-crisisperiod.in2014,worldmerchandise trade at current prices grew at evenlowerrates(only0.3percent,toreach$19trillion)1duetothesignificantfallinthepricesofmajorcom-modities.Preliminaryestimatesfor2015indicatethatmerchandisetradevolumecouldgrowatarateclosetothatofglobaloutput.Thisremainslargelyinsuf-ficienttoprovide,byitself,asignificantstimulustoeconomicgrowth.

Aggregatefigureshide somediversity acrosscountries and products. in developed countries,trade – especially imports – accelerated in 2014,albeitfromalowbase.Positive(althoughslow)GDPgrowthratesintheeuropeanUnion(eU)andJapanhelpedboosttheirimportvolumesbyaround2.8percent in 2014.but because imports of theeU-28hadcontractedduringthetwopreviousyears,realimportsstillremainedbelowtheirlevelof2011attheendof2014.intheUnitedStates,importsrosefaster,by4.7percent,partlyduetodollarapprecia-tion.Allthesefactors,combinedwiththefactthatimportvolumegrowthindevelopingandtransitioneconomiescontinuedtofallshortofthatachievedinearlieryears,madedevelopedcountriesthecountrygroupwiththehighestannualgrowthofimportsforthefirsttimesincethelate1990s.

Dataforthefirstfivemonthsof2015indicatethat growth inworldmerchandise trade in 2015maybeslightlyweakerthanin2014.Duringthesefivemonths,thevolumeofinternationaltradegrewby a year-on-year average of less than2 per cent(chart1.1).Amongthedevelopedcountries,importgrowthintheeUshowedsignsofdeceleration,whileitsexportscontinuedtopickup.inaddition,bilateralmonthlytradereceiptsindicatethateUexportstotheUnitedStateskept increasingonaccountof faster

Current Trends and Challenges in the World Economy 7

Table 1.2

ExPORT AND IMPORT VOLUMES OF GOODS, SELECTED REGIONS AND COUNTRIES, 2011–2014(Annual percentage change)

Volume of exports Volume of imports

Region/country 2011 2012 2013 2014 2011 2012 2013 2014

world 5.1 2.0 2.6 2.3 5.4 2.0 2.3 2.3Developed countries 4.8 0.6 1.4 2.0 3.3 -0.4 -0.3 3.2of which:

Japan -0.6 -1.0 -1.9 0.6 4.2 3.8 0.5 2.8United States 7.3 3.9 2.6 3.1 3.8 2.8 0.8 4.7European Union 5.4 -0.1 1.7 1.5 2.6 -2.5 -0.9 2.8

Transition economies 1.8 0.7 1.8 0.2 15.9 5.6 -0.8 -8.5of which:

CIS 1.6 0.8 1.1 0.1 16.8 6.4 -1.4 -9.8Developing countries 6.2 4.0 4.2 2.9 7.9 5.1 6.1 2.0

Africa -7.2 5.5 -2.0 -3.6 4.2 13.2 5.2 3.3Sub-Saharan Africa 0.1 0.2 2.0 -0.9 9.9 8.2 7.5 2.8

Latin America and the Caribbean 4.6 3.2 2.1 2.4 9.7 3.3 4.0 0.6East Asia 8.7 4.7 6.6 4.7 7.8 3.5 8.3 2.7of which:

China 8.8 6.2 7.7 6.8 8.8 3.6 9.9 3.9South Asia 9.4 -7.0 2.7 4.8 5.4 3.8 -0.6 4.4of which:

India 14.9 -1.8 8.5 3.2 9.6 5.9 -0.2 3.2South-East Asia 7.8 1.4 4.3 3.4 9.5 5.2 3.8 1.0West Asia 8.3 9.6 3.1 0.3 8.4 9.2 9.6 0.2

Source: UNCTAD secretariat calculations, based on UNCTADstat.

Chart 1.1

wORLD TRADE by VOLUME, jANUARy 2005–MAy 2015(Index numbers, 2005 = 100)

Source: UNCTAD secretariat calculations, based on the CPB Netherlands Bureau of Economic Policy Analysis, World Trade database.Note: Emerging market economies are those of the source, excluding Central and Eastern Europe. Line in dashes corresponds to

the January 2002−December 2007 trend.

World Developed economies Emerging market economies

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outputgrowthinthelattercountryandtheapprecia-tionof thedollar.Meanwhile,europe’sexports toChinashowedsomeresilience.intheUnitedStates,importscontinuetoincreaseatafasterratethanitsexports,whichareshowingsignsofaslightdecel-eration,whileJapan’sexportsarealso recovering.exportsfromemergingmarketeconomiesplungedinearly2015beforerebounding,partlyowingtoagradualoutputrecoveryindevelopingAsia.

Moregenerally,thegrowthofexportsbyvol-ume in emergingmarket economieshas remainedbelowtheirpre-crisistrendbyasubstantialmargin,withtheshortfallevenincreasingduringthefirsthalfof2015 (chart1.1).This ispartlydue to sluggishimportdemandgrowthfortheirgoodsindevelopedcountries, in spiteof the slight acceleration in thelatter’sgrowthofimportsin2014.AsdiscussedinsomedetailinTDR 2013,thisposesachallengetotheemergingmarketeconomiesthataimtoreverttoexport-orientedgrowthpolicyusedbeforethecrisis.

Regarding the transition economies, exportswerevirtuallystagnant in2014,while importvol-umesplungedby8.5percentandfurthercontractedinearly2015,mostlyonaccountofeconomicandfinancialdifficultiesintheRussianFederationandUkraine.indevelopingcountries,mosttradefigurespointedtoableakerpicturethanthepreviousyears.inparticular,Africa’srealexportsshowedacontrac-tionasaresultofshrinkingoilexportsinlibyaandtoalesserextentinsomeothermajoroil-exportingsub-Saharancountries.Notably,Nigeria’soilexportstotheUnitedStatesstoppedcompletelyin2014,astheshalerevolutioninthelattercountryreduceditsneedforoilimports.NigeriawasthereforeforcedtoreorientitsexportstowardsChina,india,JapanandtheRepublicofKorea.otherAfricanoilexportersmayfollowNigeria’sexample.2Meanwhile,SouthAfrica’sexportstoeast,SouthandSouth-eastAsia–comprisinglargelyprimarycommodities–fellby13.4percentin2014.bycontrast,exportreceiptsfrommanufacturedproductsofseveralAfricancoun-triesregisteredsignificantgrowth–inparticularthosewithclosetradingconnectionstoeurope,likesomeNorthAfricancountriessuchasMoroccoandTunisia.

inlatinAmericaand theCaribbean, interna-tional trademeasured incurrentvaluespracticallyground to a halt, largely due to the fall in exportunit values.Weaker demand fromChina and the

slowdown of intraregional trade affectedmostlySouthAmericancountries.inparticular,theirexports,especiallymachinery and transport equipment,were strongly affectedby adeclineof importsbybrazil,thelargestregionaleconomy.indeed,SouthAmericanexports tobrazil fellby7.9percent in2014.Plungingpricesoftwoofitskeyexports,ironoreandsoybeans,pushedbrazil’stradebalanceintonegativeterritory,despiteasignificantreductionofitsimports.ThiscontrastswithMexico,whoseexportstotheUnitedStatesincreasedsignificantly.inaddi-tion,Mexicanautoexports tomost regionsof theworld,inparticularAsia,increasedmarkedly,withtheexceptionofexportstoeurope,whichdeclined.

inWestAsia, oil-exporting economies facedadverse terms of trade, which sharply reducedtheirexportreceipts,butalsotheirimportdemand–despite someof themhaving large internationalreserves.Armed conflicts in several countries ofthe subregion further affected intraregional trade,withspillovereffectsinsomeNorthAfricancoun-tries’ exports, including fromegypt.Meanwhile,Turkishexportreceiptsincreasedbycloseto4percentin2014,fallingshortoftheGovernment’star-get.This disappointing resultwasdue to politicalandeconomicturmoil,whichtookaheavytollonTurkey’sexportstoiraqandtheRussianFederation.Nevertheless,loweroilpriceseasedcurrentaccountdeficitsinTurkeyandinotheroil-importingecono-miesofthesubregion.

ineastAsia,thegrowthrateoftrade,byvol-ume,wasunusuallylowfortheregion,atlessthan4percentin2014.Toalargeextent,thisreflectstheslowdownofChina’sinternationaltrade.itsexports,byvolume,grewby6.8percentin2014,whichwasaslowerratethanthatofitsGDP.Meanwhile,thegrowthofChina’s imports byvolumedeceleratedevenmore,to3.9percent.Asaresult,developingand transition economieswhich export primarycommoditiesexperiencedasignificantslowdownindemandfromChinain2014.bycontrast,developingcountries’exportstoChinathatarerelatedtomanu-facturingsupplychains,withthefinishedproductsultimatelyendingupindevelopedeconomies,faredbetter.in2014,China’sexportstotheeurozoneandtheUnitedStates saw a rebound from the declin-ingand sometimesnegativegrowth rates thathadoccurredbetween2010and2013,buttheydidnotreturntotheirpre-crisisdynamism.

Current Trends and Challenges in the World Economy 9

inSouth-eastAsia,exportgrowthbyvolumealsodecelerated,to3.4percentin2014,whileimportgrowthslowedevenfurtherto1percent;boththeserateswere lower than the subregional economicgrowthrate.indonesiahasbeenconsistentlyrunningmonthlytradesurplusessincelate2014untilmid-2015,asitsimportbilldecreasedmorethanitsexportreceiptsinthecontextofsignificantcurrencydepre-ciation.SouthAsiantradedepartsfromthedownwardtrends registered in all other developing-countrygroups.Within this group, the islamicRepublicofiranregisteredasignificantriseinitsoilexportvolumes in2014,although they remained roughlyhalfofwhattheyhadbeenpriortothestrengtheningofeconomicsanctions in2011.Meanwhile,buoy-ant garment sectors supported exports (mainly todeveloped economies) frombangladesh, themostpopulousoftheleastdevelopedcountries(lDCs),andfrompost-conflictSrilanka.bycontrast,india’sexportgrowth(byvolume)sloweddownfrom8.5percentin2013to3.2percentin2014.

overall,globaltradehasdisplayedlittledyna-mism.Themoderate trade growthmainly reflectsan improvement inNorth-North trade,with onlylimitedpositiveeffectsonexportsfromdevelopingtodevelopedcountries.

(b) Services

Tradeinservicesmaintaineditsgrowth,toreach$4.9 trillion in 2014− a year-on-year increase of5.1percent(atcurrentprices),whichwashigherthanthegrowthofmerchandisetrade.Transportservicesgrewby2.7percentwhiletravelandgoods-relatedservicesincreasedby6and2.8percentrespectively.Transportandtourismrepresent55percentofser-vicesexportsfromdevelopingcountriesand62percent fromlDCs, comparedwithonly39per centfromdevelopedeconomies.3

International tourismremainsthelargestcom-ponent of trade in services,with export earningstotalling$1.4trillionin2014.Touristarrivalscon-tinuetoberobust:theyincreasedby4.3percentin2014(similarto2012and2013),reaching1.1billionarrivals.Receiptsearnedfrominternationalvisitorsgrew3.7percentinrealterms(takingintoaccountexchange-ratefluctuationsandinflation).Preliminarydataconfirmthistendencyfor2015:duringthefirst

fourmonthsof2015,touristarrivalsgrew4percentyear-on-year,whileinternationalairtravelreserva-tionswere forecast toexpandbyabout5percentinMay–August2015(WorldTourismorganization(UNWTo),2015aand2015b).

At the regional level, the europeanUnionremainstheworld’smostvisitedregion,andalsoaverydynamicone,asthegrowthintouristarrivalsaccelerated to 4.9 per cent, comparedwith 3 percentand4percentin2012and2013respectively.Growth of tourist arrivalsmore than doubled inNorthAmericato9.2percentin2014.bycontrast,touristarrivalsfellinthetransitioneconomiesduetotheconflictinUkraineandtheslowdownoftheRussianeconomy.Allotherregionsandsubregionsregisteredpositive growth rates in 2014, althoughdemandweakened inAfrica after years of solidgrowth,affectedmainlybytheebolaepidemic.

in2015,preliminarydatabyregionshowposi-tivefigureseverywhereexceptinAfrica.inparticular,touristactivitiesexpandedrapidlyinNorthandSouthAmerica,theCaribbeanandoceaniaduringthefirstfourmonthsof2015.Theyalsoreboundedby7percentinthetransitioneconomiesaftershrinkinglastyear.by contrast, inAfrica limiteddata currentlyavailableforJanuary−April2015pointtoa6percentdecline,duetorecenthealthorsecurityconcernsinanumberofcountries(UNWTo,2015a).

Regardinginternational transport services–thesecond largest category of commercial services –preliminary estimates indicate that the volumeofworldseaborneshipmentsexpandedby3.4percentin2014−thesamerateasin2013.4Drycargoship-ments,whichaccountedforovertwothirdsoftotalcargoshipments,increasedby5percent,mainlyonaccountofthecontinuedrapidexpansionofglobaliron ore volumes.Thiswas partly driven by sus-tained import demand fromChina.Containerizedtradeexpandedby5.6percentwhile tanker tradecontractedby1.6percent.

Developingcountriescontinuedtobethemainsource and destination for international seabornetrade:intermsofloading,theyaccountedfor60percent ofworld tonnage in 2014, a figure that hasremainedratherflatoverthepastdecade.Theircon-tributiontounloadingcontinuedtogrow,reachinganestimated61percentoftheworldtotalin2014.

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Theexpandingproductionof shaleoil in theUnitedStatesandthedropinoilpricessinceJune2014haveaffectedshippingandseabornetrade,par-ticularlytankertrade.Asmentionedabove,theformerhasalteredthedestinationofAfricanoil,agrowingshareofwhichisreorientingfromtheUnitedStatestoAsia.inaddition,loweroilpriceshavecontributed

to lower fueland transportcosts; for instance, the380-centistokebunkerprices inRotterdam fell by46 per cent (ClarksonResearch Services, 2015).lower fuelcosts reducedshipoperators’expendi-turesandtheratespaidbyshippers,whichinturnis expected to stimulate the demand formaritimetransportservicesandincreaseseabornecargo.

B. Recent developments in commodity markets

Commoditymarketswitnessedturbulenttimesin2014andthefirsthalfof2015.Mostcommoditypricesfellsignificantlyduring thecourseof2014,continuing the downward trend from their peaksof2011−2012.Themostdramatic fallwas thatofcrudeoilpricessincemid-2014(chart1.2),whichhadwidespread influence.All commoditygroups,except for tropicalbeverages,5 sawaveragepricesdeclinein2014(table1.3),withthepaceacceleratingincomparisonwith2013forthosecommoditygroupswhosedemandismorecloselylinkedtoglobaleco-nomic activity, such asminerals, ores andmetals,agricultural rawmaterials and oil.Nevertheless,onaverage,in2014anduptoJune2015commod-itypriceshavebeenhigherthantheaverageofthe2003–2008priceboom.

Themainreasonfortherecentfallinmostcom-moditypriceshasbeenanabundantsupply,astheinvestmentresponsetothepriceboomofthe2000shassignificantlyincreasedproductionoverthepastfew years.The resulting tendency towards over-supplyhasbeenreinforcedbyweakeningdemandduetosluggishgrowthintheworldeconomymoregenerally,andtherecentslowdowninanumberoflargedevelopingeconomiesinparticular.Apartfromsupplyanddemandfundamentals,thefinancializa-tionofcommoditymarketscontinued to influencepricedevelopments,asfinancialinvestorshavebeenreducingtheircommoditypositionsinconjunctionwiththedownturninpricesandreturnsfromcom-modityderivatives.Anotherimportantfactorinthe

commoditypricedeclinehasbeenthestrongappre-ciationofthedollaroverthepastyear.

1. Evolution of main commodity prices

Themarketforcrudeoiltooktheleadincom-modity price developments in 2014.After havingremainedatarelativelystablelevelsinceApril2011,with oscillationswithin a $100−$120band, crudeoil prices plummeted in the second half of 2014.For example, thepriceofbrent crude fell fromamonthlyaverageof$112inJune2014toalowof$48inJanuary2015.Thisdeclineof56.7percentpushedthepriceofcrudeoiltoitslowestlevelsince2009(UNCTADstat).

Theplungeinoilpriceswasmainlycausedbygreaterglobalproduction,particularlyof shaleoilintheUnitedStates.in2014,globaloilproductionincreasedby2.3percent,whileintheUnitedStatesitgrewby15.9percent.indeed,intheshortperiodbetween2011and2014,UnitedStatesoilproduc-tionincreasedby50.6percent,reachinglevelsnotachievedsincetheearly1970s(bP,2015).Thisledtosignificantincreasesininventories.SubstantiallyhigheroilproductionintheUnitedStatescontributedtotherelativestabilityofoilpricesbetween2011andmid-2014,asitcompensatedforproductiondisrup-tionsinotherproducingcountries(TDR 2014).When

Current Trends and Challenges in the World Economy 11

thesedisruptionsbecamelessofaproblemandtheoversupplymore evident, prices started to fall inmid-2014.However, the price decline acceleratedaftertheNovembermeetingoftheorganizationofthePetroleumexportingCountries(oPeC)whereitwasdecidednot tochangeproductionquotas,adecisionupheldatthesubsequentmeetingofoPeCin June2015.Thishasbeenwidely interpretedasanattemptbyoPeCtodefenditsmarketshareandtoundercuthighercostproducers,suchasshaleoil,tarsandsanddeepwateroilproducers,soastodrivethemoutofthemarket.

Asaresultofthelowerprices,anumberofoil-producing companies announced investment cuts,whichshouldresultinadownwardsupplyadjustment(iMF,2015).inJuly2015,thenumberofoilrigsintheUnitedStateshadfallenby60percentcomparedwithoctober2014, to reach their lowest count inaboutfiveyears(eiA,2015).Followingexpectationsthatthedeclineininvestmentwouldquicklytranslateintolowersupplies(seebelow),thepriceofbrentcrudeincreasedfromunder$50inJanuary2015andstabilizedataround$65betweenendAprilandendJune.6However,itfellagainattheendofJuneandinJuly.Thisispartlyattributabletotheresilienceofshaleoilproducers,whomanagedtoincreasepro-ductivityandreducecosts.7TheUnitedStatesenergyinformationAdministration (eiA, 2015) estimatesthatinthefirsthalfoftheyearcrudeoilproductionintheUnitedStatesincreasedby0.3millionbarrelsperday,upfromtheaverageproductionofthefourthquarterof2014.Nevertheless,theeiAnotesadeclineinonshoreproductionsinceApril2015.TheJulyfallinpriceswasalsorelatedtoexpectationsofanagree-mentwiththeislamicRepublicofiranonitsnuclearprogramme,whichwas reached on 14 July.Theconsequenteventualliftingofsanctionswillmeananadditionalsourceofoilenteringinternationaloilmarkets,whichwouldexertdownwardpressureonanalreadyoversuppliedmarket.However,thetimingofthisreturnofiranianoilwilldependonthetimerequiredtorehabilitatethatcountry’soilproductionand transport facilities.Meanwhile, by June2015SaudiArabiahadincreaseditsowncrudeoiloutputtorecordlevels.8

overall,internationalcrudeoilmarketspresentanewlandscape,withtheincreasingimportanceofproduction in theUnitedStates and an abandon-mentofoPeC’sprice-targetingpolicy.Aslongasthispersists,theUnitedStatescouldreplaceSaudi

Chart 1.2

MONThLy COMMODITy PRICE INDICES by COMMODITy GROUP, jAN. 2002–jUNE 2015

(Index numbers, 2002 = 100)

Source: UNCTAD secretariat calculations, based on UNCTADstat.Note: All commodities exclude crude oil. Crude oil price is the

average of Brent, Dubai and West Texas Intermediate, equally weighted. Index numbers are based on prices in current dollars, unless otherwise specified.

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Trade and Development Report, 201512

Table 1.3

wORLD PRIMARy COMMODITy PRICES, 2009–2015(Percentage change over previous year, unless otherwise indicated)

Commodity groups 2009 2010 2011 2012 2013 2014 2015 a

2014–2015 versus

2003–2008 b

All commodities c -16.9 20.4 17.9 -8.3 -6.7 -6.1 -13.1 36.9All commodities (in SDRs) c -14.5 21.7 14.1 -5.5 -6.0 -6.1 -5.9 39.1All food -8.5 7.4 17.8 -1.4 -7.4 -4.1 -12.2 51.1

Food and tropical beverages -5.4 5.6 16.5 -0.4 -6.7 -3.8 -11.7 54.2Tropical beverages 1.9 17.5 26.8 -21.5 -18.3 23.5 -7.5 60.7

Coffee -6.9 27.3 42.9 -25.7 -23.6 29.9 -14.8 66.7Cocoa 11.9 8.5 -4.9 -19.7 2.0 25.6 -2.3 66.3Tea 16.5 -1.0 11.4 0.8 -23.9 -10.4 28.5 17.3

Food -6.0 4.4 15.4 2.0 -5.7 -5.9 -12.1 53.6Sugar 41.8 17.3 22.2 -17.1 -17.9 -3.9 -19.6 54.3Beef -1.2 27.5 20.0 2.6 -2.3 22.1 -6.4 92.2Maize -24.4 13.2 50.1 2.6 -12.1 -22.2 -14.2 40.1Wheat -31.4 3.3 35.1 -0.1 -1.9 -6.1 -18.7 32.6Rice -15.8 -11.5 5.9 5.1 -10.6 -17.8 -7.6 20.6Bananas 0.7 3.7 10.8 0.9 -5.9 0.6 4.8 54.4

Vegetable oilseeds and oils -28.4 22.7 27.2 -7.6 -12.6 -5.8 -16.0 30.2Soybeans -16.6 3.1 20.2 9.4 -7.9 -9.7 -18.2 37.2

Agricultural raw materials -17.5 38.3 28.1 -23.0 -7.4 -9.9 -11.2 22.8Hides and skins -30.0 60.5 14.0 1.4 13.9 16.5 -8.2 58.4Cotton -12.2 65.3 47.5 -41.8 1.5 -8.8 -14.5 26.9Tobacco 18.0 1.8 3.8 -3.9 6.3 9.1 -0.4 65.7Rubber -27.0 90.3 32.0 -30.5 -16.7 -30.0 -10.0 6.1Tropical logs -20.6 1.8 13.4 -7.1 2.6 0.4 -16.0 21.4

Minerals, ores and metals -30.3 41.3 14.7 -14.1 -5.1 -8.5 -15.8 19.5

Aluminium -35.3 30.5 10.4 -15.8 -8.6 1.1 -4.3 -14.0Phosphate rock -64.8 1.1 50.3 0.5 -20.3 -25.6 4.3 15.4Iron ore -48.7 82.4 15.0 -23.4 5.3 -28.4 -37.4 5.4Tin -26.7 50.4 28.0 -19.2 5.7 -1.8 -22.4 94.4Copper -26.3 47.0 17.1 -9.9 -7.8 -6.4 -13.5 35.0Nickel -30.6 48.9 5.0 -23.4 -14.3 12.3 -18.9 -21.5Lead -17.7 25.0 11.8 -14.2 3.9 -2.2 -10.4 45.6Zinc -11.7 30.5 1.5 -11.2 -1.9 13.2 -1.1 10.9Gold 11.6 26.1 27.8 6.4 -15.4 -10.3 -4.8 120.5

Crude oild -36.3 28.0 31.4 1.0 -0.9 -7.5 -41.7 41.1

Memo item:Manufacturese -5.6 1.9 10.3 -2.2 4.0 -1.8 .. ..

Source: UNCTAD secretariat calculations, based on UNCTADstat; and United Nations Statistics Division (UNSD), Monthly Bulletin of Statistics, various issues.

Note: In current dollars unless otherwise specified.a Percentage change between the average for the period January to June 2015 and the average for 2014.b Percentage change between the 2003–2008 average and the 2014–2015 average.c Excluding crude oil. SDRs = special drawing rights.d Average of Brent, Dubai and West Texas Intermediate, equally weighted.e Unit value of exports of manufactured goods of developed countries.

Current Trends and Challenges in the World Economy 13

Arabiaasthekeyswingproducer.Thiswouldmeanthatwhenpricesfalltoverylowlevels,investmentandproduction in theUnitedStates couldbe cut,pushingpricesup;andoncepricesreachedacertainlevel,UnitedStatesoilproductioncouldrise,therebyexertingadownwardpressureonprices.indeed,asignificant characteristic of shale oil drilling is itsflexibility.Asaresult,therewouldbeanuppercaponoilpriceswhichwoulddependonthebreak-evenpriceofprofitabilityforshaleoilproducers.However,thereappearstobelittleagreementonwhatthatpriceis.9insum,itisnotlikelythatpriceswillapproach$100perbarrelanytimesoon.Asshaleoilproductionhasashortlifespan,thiswilldependonhowlongtheshaleoilboomlasts.However,thereisconsider-ableuncertaintyastowhenshaleoilproductionwillreachitspeak.

on the demand side, expectations of lowereconomicgrowthalsoplayedaroleinthecollapseof oil prices. indeed, specialized agenciesmadecontinuousdownwardadjustments to theirprojec-tionsfordemandgrowth.in2014,globaloildemandgrewbyamere0.8percent,downfromanaveragegrowth of 1.1 per cent during the previous threeyears.Non-oeCDcountries accounted for all thedemandgrowth,at2.7percent,withoildemandinChinaincreasingby3.3percent,butthesewerelowerrates thantheaveragesfor theprevious three-yearperiod,of3.3percentand4.8percentrespectively.bycontrast,oildemandinoeCDcountriesdeclinedby1.2percent(bP,2015).

Adeclineincrudeoilpriceshasaninfluenceonthepricedevelopmentsofothercommodities.itleadstoareductioninproductioncosts,forinstancethrough lower transport costs, or to lower ferti-lizer prices in the case of agricultural production.Thereisalsoalinkthroughthebiofuelchannel,asdepressedoilpricesmakebiofuelslesscompetitiveas an energy source and can reduce demand forfood crops.However, someother factors can alsoinfluence biofuel production, particularly officialmandates.Anotherchannelthroughwhichoilpricesinfluenceothercommoditypricesisfinancialization,asoilpricesarea largecomponentofcommodityprice indices (see below).Nevertheless, prices inagriculturalmarketshavebeenmainlydeterminedbytheirownsupplysituation,whichisaffectedinparticularbymeteorologicalconditions.inthecaseof food commodities, bumper harvests, thanks togoodweather,andamplelevelsofinventories,were

thekeyfactorscontributingtothecontinuedfallincerealandsoybeanpricesin2014andearly2015.However,thosepricessawareversalinJuneandJuly2015duetoadverseweatherconditionsintheUnitedStates,whichaffectedplanting.Wheatprices alsoroseinJuneduetotheadverseimpactsoftherainsonharvestingintheUnitedStatesandtodryweatherinotherproducingareasintheworld.Uncertaintiesalso arose concerning the potential effects of theelNiñophenomenon.10Thesugarmarketwasalsocharacterizedbyoversupplyanddecliningprices,asproduction in2014exceeded consumption for thefifthconsecutiveseason(oeCD-FAo,2015).

Pricedevelopments in the tropical beveragesmarketsin2014andearly2015weremoreerratic.Pricesofcoffeeandcocoaroseinthefirsthalfof2014asaresultofunfavourablecropconditionsforcoffeeinbrazil and for cocoa inWestAfrican countries.Theyfelllaterintheyearfollowingimprovementsinthoseconditions.Cocoapricesincreasedinthesecondquarterof2015duetoashortfallinGhana’sharvest.

in the agricultural raw materialsmarkets,plentiful supplywas amajor issue.Global cottonproductionexceededconsumption,andexcessstockspushedpricesdownwards.AnnouncementsbyChinathatimportquotasweretobereducedandtheendof its inventory policy also had an influence onprices.Naturalrubberpricesexperiencedasubstan-tialdecreaseof30percentin2014resultingfromoversupplyandhighstocks.Weakdemandforcottonandnaturalrubberisalsorelatedtotheslumpinoilprices.Thisleadstolowerpricesofsyntheticrubberandsyntheticfibres,puttingdownwardpressureonthepricesofnaturalrubberandcotton.

Minerals, ores and metalsmarketsalsoexperi-encedasupplyglut.Themainexampleisironore,theoversupplyofwhichledtoapricereductionof28.4percentin2014(table1.3).Aluminium,nickelandzincperformedrelativelybetter,recordingpriceincreasesin2014.Fornickel,thiswasrelatedtotheexport ban of unprocessed ores in indonesia; foraluminiumandzincpriceincreasesweretheresultof production cuts.However, these rising pricessawa reversal aftermid-2014.11 Sluggishdemandstemming from subdued global economic growthhasplayedarole,asmetalpricestendtobestronglylinkedtotheevolutionofglobalindustrialproduc-tion.inparticular,prospectsforgrowthofdemandformetalsinChinawilldependonthebalancebetween

Trade and Development Report, 201514

high investment in infrastructure andurbanizationthatwillstillbeneededinthecomingyears,ontheone hand, and its transition towards an economywithanexpandingshareofdemandforservices,onthe other.12However, this has generally translatedintoreducedconsumptiongrowthratesratherthandecliningdemand.Moreover,sincethecurrentlevelsofconsumptionaregreater than in thepast, lowergrowthratesmaystillmeansubstantialamountsofadditionaldemandformetals.Therearealsosomeexceptions; for instance, consumption of copperincreasedbyaround15percentin2014.Sincethemarket for thismetal appeared to bebalanced, orevenindeficit,thesharppricedropin2014“looksoverdonecomparedtothefundamentals”(AieCe,2015).Thiscanmostprobablybeattributedtofinan-cialfactors(seebelow).Thedeclineingoldpricesisalsostronglylinkedtofinancialfactorsandmonetarypolicy:expectationsofanincreaseininterestratesintheUnitedStatesaswellastheappreciationofthedollartendtoreducedemandforgoldasasafehaven.

2. Thecontinuinginfluenceoffinancialfactors

Commoditypricescontinuetobeinfluencedbythecloselinkagesbetweencommodityandfinancialmarkets, as further discussed in the annex to thischapter.These linkagesmaybe illustrated by therecentmovementsinoilprices.Theirdeclineduringthesecondhalfof2014wasaccompaniedbyamuchmorerapiddropinthenetlongpositionsofmoneymanagers, suchashedge funds,which is likely tohaveacceleratedthefall(chart1.3).Similarly, therebound in the price ofWestTexas intermediate(WTi)crudeoilfromasix-yearlowof$44perbar-rel inMarch2015to$61inearlyMaywaspartlystokedbyasubstantialincreaseinthenetlongposi-tionsofmoneymanagerswho,bettingthatlowoilpriceswouldrapidlyreducesupply,doubledtheirnetlongpositionsbetweenmid-MarchandearlyMayontheNewYorkMercantileexchange(NYMeX);thiswas accompanied by similarmovements onthe intercontinentalexchange (iCe). in July, theystrongly reduced their positions, having realizedthatboththecutsinoilsupplyandtheglobaleco-nomicrecoverywereprovingtobelessrapidthananticipated,whichmadepricesplungeconsiderablyonceagain.

Theuseofcommoditiesascollateralconstitutesanother linkagebetween commodity andfinancialmarkets.Apositivedifferentialbetweendomesticandforeigninterestratesprovidesanincentivetoborrowmoneyoninternationalfinancialmarketsusinglettersofcreditfromdomesticbankstoimportcommodi-ties.Theacquiredphysicalcommodityisplacedinawarehouse,whiletheborrowedmoneyisinvestedinhigh-yieldingdomesticassetssuchasrealestateorfinancialproducts(TangandZhu,2015).

Copperhasprobablybeenthecommoditymostfrequentlyusedforthistypeofcarrytrade,andtheresultingincreaseddemandforphysicalcopperhashelpedboostthepriceofthismetal.Takingtheexam-pleofChina,theworld’sleadingconsumerofcopper,Zhangandbalding(2015)findthatcopperinventoryinShanghaigrewfrom4percentofglobalstocksin2009to38percentin2014,andthatduringthesameperiodtheinterestratedifferentialbetweenChinaandtherestoftheworldaveraged358basispoints.Morerecently, however, the decline inChina’s interestratesledtoanunwindingofsuchcoppercarrytrade.

Chart 1.3

MONEy MANAGER POSITIONS AND CRUDE OIL PRICES, MARCh 2014–jULy 2015

Source: UNCTAD secretariat calculations, based on Thomson Reuters datastream.

Note: The data shown refer to WTI and positions on NYMEX.

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Current Trends and Challenges in the World Economy 15

Accordingtomediareports,theresultingdeclineincopperpriceswasacceleratedbythesubstantialnetshort copper positions that hedge funds had builtup inparallelwithnet longequitypositions.ThiswasbasedonexpectationsthatslowergrowthoftheChineseeconomywouldcauseadeclineincopperprices,while a subsequent looseningofmonetarypolicywouldboostequitymarketvaluations.13butinJuly2015, thehedgefundsneededtobuybacktheirbearishbetsinordertomeetrisingmargincallsfromChina’sequitymarkets,whichexperiencedasharpdecline.

Furthermore, the strong appreciation of thedollarcontributessignificantlytofallingcommodityprices.Typically,ascommoditypricesaredenomi-natedindollars,theytendtobeinverselyrelatedtothedollarexchangerate.Thisfactorinfluencespricesbothonthephysicalmarketsandthroughthefinan-cializationchannel.ontheonehand,asthedollarappreciates commodities becomemore expensiveinnon-dollarareas,puttingdownwardpressureondemand.Similarly,withanappreciatingdollar,pro-ducersinnon-dollarareaswhonormallyreceivetheirrevenuesindollarsbutpayformostoftheircostsinlocalcurrencyhaveanincentivetoincreasesupply.Forexample,brazilianfarmershaveincreasedtheirproductionofcoffeeandsugarasaresultofthedepre-ciationoftheircurrency,thereal,againstthedollar.14ontheotherhand,ahighervalueofthedollarmayprovidemoreincentivestoincreasefinancialinvest-mentindollarsintheforeign-exchangemarkettothedetrimentofinvestmentincommoditymarkets.Forexample,fornon-oilcommodities,pricedeclinesarenotsopronouncedinspecialdrawingrights(SDRs),andineurostheyhaveevenincreasedinparallelwiththeappreciationofthedollar(chart1.2).15

3. Impact and prospects

Theimpactoflowercommoditypricesondif-ferentcountriesvariesaccordingtotheirproductionandtradestructure.Developingcountries(andalsosomedevelopedcountries)thatarehighlydependentontheirexportsofcommoditiestendtobethemostadverselyaffected.TheseincludemostlycountriesinAfrica, latinAmerica, theCommonwealth ofindependentStates(CiS)andWestAsia.Decliningcommodity prices frequently translate into lower

termsoftrade,pressuresonthecurrentaccountbal-anceandthefiscalaccounts,andeventuallyleadtoaslowdownofeconomicgrowth.Somecountrieswhichhavewell-functioningcommoditystabilizationfunds,such asChilewith copper, orwhichhavehealthylevelsofforeign-exchangereserves,suchastheoil-exporting countries inWestAsia,may havemorepolicyspacetobuffertheseimpactsbetterthanothers.

inanycase,thereversaloftheupwardtrendincommoditypricesisanewreminderofthechallengesfacedbydevelopingcountriesthatdependononlyafewcommodities,astheyareexposedtoboomandbustcyclesresultingfrompricechanges.Therefore,toachieveandmaintainsustainedgrowth,itiscrucialfor them to implementpolicies that facilitate eco-nomicdiversificationandstructuralchange.ontheotherhand,asthecommoditypricedeclineamountstoatransferofincomefromcommodity-producingtocommodity-importingcountries,thecountriesthatbenefitthemostaremanydevelopedcountriesandsomeemergingmarketeconomies, suchasChina.To the extent that lower prices for commodity-consuming countries could help global economicrecovery, and particularly recovery in developedcountrieswhichhavebeendraggingdowngrowthinthepastfewyears,thenetglobaleffectcouldbepositive,thoughunevenlydistributed.However,allthis remains unclear, and largely depends on thedurationofthepricedownturn.

Prospects for commodity prices are highlyuncertain.Thereversaloftheirrisingtrend,whichtookplacearound2011,hasbeenwidelyconsideredtomark theendof theupwardphaseof the com-moditysupercycle.ifthisisindeedthecase,thencommodityprices16couldcontinuetofallforquitesome time.However, there is another possibility.Until2014,mostofthepricecorrectionstookplacebyway of increasing supply, while commoditydemandwasgrowingathealthylevels.onlyin2014andearly2015diddemandshowsomesignsofeas-ing,butneverthelessregisteredpositivegrowthratesformostcommodities.Thisslowdownindemandisrelatedtodisappointingeconomicgrowthinmanycommodity-consumingareas.However,thecurrentlowerlevelsofcommoditypricesarealreadyleadingtosomedownwardadjustmentsof investmentandproductioncapacities.This isparticularly thecaseformineralsandmetals.Forexample,worldwide,non-ferrousmetalsexplorationbudgetsfellby26percentin2014,afteranevensharperreductionin2013

Trade and Development Report, 201516

(SNlMetals&Mining,2015). Thisshouldresultinlowerproductioninthemediumterm.

ifgrowthoftheglobaleconomy−mainlydevel-oped countries−manages to return to reasonablelevels,andthelowerpricesstimulatedemand,thiscouldmaintaindemandgrowthdespiteadecliningsupply outlook.Muchwill also dependondevel-opments inChina.Moreover, other emerging anddevelopingcountriesmayintensifytheircommodityconsumptionastheyentermoreadvancedphasesin

theirdevelopment.inthiscase,itisquitepossiblethat,afterashort-termcorrection,commoditypricescouldincreaseagaininafewyears’time.However,theyareunlikelytogrowasrapidlyastheydidinthefirstdecadeofthe2000s.Thiswouldimplythatthelevelofcommoditypricesislikelytostayatahigherplateauthanatthebeginningofthemillen-nium.Moreover, as long as commoditymarketsremainfinancialized,pricevolatilitycouldbehigherandpricechangesmorepronouncedthanwarrantedbysupplyanddemandfundamentals.

C. Stagnation: Secular or temporary?

Theobservationthatthegrowthtrajectoriesofmany developed countries have remained at sub-stantiallylowerlevelsthanbeforethecrisis,despiteseveral years of accommodativemonetary policy,somewhatimprovedfinancialconditionsandsomerelaxationoffiscalconsolidation,hascreatedasenseofa“newnormal”thatnowdefinesthefutureevolu-tionofincomesindevelopedcountries.

The concern is that the crisis that erupted in2008may have had a long-lasting effect on thegrowth potential of these economies (oulton andSebastiá-barriel,2013).Thiscouldbeforavarietyofreasons.oneisthatafinancialcrisisofthismag-nitudehasnecessarilyaffectedthebalancesheetsofawiderangeofeconomicactors−includingprivateandpublicagents,financialandnon-financialsectors−andithasgeneratedsignificantspareproductioncapacities.Normally, these negative impacts areeventually overcome, although itmay take sev-eralyears,especiallyintheabsenceofappropriatecountercyclicalpolicies.However,thistimethereisaconcernthattheabnormallyprolongedperiodoflowinvestmentandhighunemploymentwillbecomeself-sustainingbecauseoftheirlastingrepercussionsintermsofreducedproductioncapacitiesandproduc-tivity.Prolongedunemploymentleadstotheerosionofskillsandspecializationamongsomesegmentsoftheworkforce;andwithinsufficientinvestment,the

diffusionofnewtechnologieslargelyembodiedinplantandequipmentmayalsobeaffected.

Another impact of the crisismay bemoresubtle:totheextentthatitbroughttoasuddenendanextraordinaryperiodofcreditexpansionthathadsupportedassetbubblesandartificiallyboostedcon-sumptionandgrowth,itmayhavereleasedanumberofunderlyingfactorsthattendtohampergrowthinthelongterm.Thesepre-existinglong-termfactors,andnotthefinancialcrisisperse,wouldbethetruecauseofprotractedslowgrowth.Andratherthanacyclical downturn, developed economies couldbeenteringintoaperiodof“secularstagnation”.

Thishasrevived thedebateon thedriversofeconomicgrowthdatingbacktoclassicaleconomistssuch asAdamSmith,DavidRicardo, JohnStuartMillandKarlMarx,whichreceivedafurthertwistin“thesecularstagnationthesis”presentedinthelate1930sbyAlvinHansen.The thesis refers to“sickrecoverieswhich die in their infancy anddepres-sionswhichfeedonthemselvesandleaveahardandseemingly immovable core of unemployment”. inhisoriginalanalysis,Hansenstressedtheproblemsof“inadequateprivateinvestmentoutlets”(Hansen,1939: 4)17 in the context of declining populationgrowth,therelativeineffectivenessofmonetarypol-icy,andtechnologicalchangethatfailedtostimulate

Current Trends and Challenges in the World Economy 17

substantial capital disbursement.All these factorswereeventuallyreversedinthepost-warperiod,notleastbecauseofmassivepublicintervention−includ-ingdeficitspending−whichwasapossiblesolutionproposedbyHansenhimself.However,thesluggishrecoveryfromthe2008crisis,inwhichitispossibletoidentifytracesofthoseverysameelements,hasledtoareappearanceof“stagnationist”analysesinthepublicdebate.

Themodern twist on the “secular stagna-tionhypothesis”suggeststhat,sincethecrisis, thetraditionalmacroeconomic toolkit, and especiallymonetarypolicy,haslostmuchofitseffectiveness.Withthedeleveragingprocessesafterthecrisis,andnominalinterestratesalreadyclosetozero,monetaryexpansionhasnot translated into increasingcredittofinanceprivatesectorexpenditures;insteadithasbeendirectedtoinvestmentinfinancialassets.Highlevelsofindebtednessthatadverselyaffectinvest-mentdemandhavebeenidentifiedasanexplanationforthesluggishgrowthratesindevelopedcountries,whichwould also affect future performance.Koo(2014)emphasizesthatthedeteriorationinthebal-ancesheetsoftheprivatesectoraftertheburstingofadebt-financedbubblehasconstrainedtheabilitytofosterproductiveinvestment.loandRogoff(2015)blame sluggish growth performance on the con-tractionaryfiscalstanceadoptedbyhighlyindebtedgovernmentswhohavepursuedsustainedprimarybudget surpluses inorder to reducepublic indebt-edness,eventhoughalternativepolicieshavebeenavailable.Asafurtherexplanationofsecularstagna-tion,Summers(2014aand2014b)notesthelimitedspaceforfurthermonetaryeasing−giventhatthezerolowerboundratehasalreadybeenreached−inparticularsinceitsmaintransmissionchanneltorealactivity(affectingassetpricesandrelativeyieldsoffinancialproducts)hashadonlyindirecteffectsoneconomicagents’propensitytoinvest.

intheacademicdebateonthesecularstagna-tionhypothesis,agreementhasyettobereachedonwhetherinfactsecularstagnationexists,andifso,whichareits long-termorstructuraldeterminants.Some hold that the deceleration of growth hasbeendue to a combinationof supply-side factors.Accordingtothem,thesizeofthelabourforcehasdiminished due to developed countries’ shrinkingandageingpopulations,andahypothesizedreducedspeedof technological innovation is holdingbackproductivitygrowth.Gordon (2012), inparticular,

stressesthedifferentkindsoftechnologicalinnova-tionswhichwereadoptedatafasterspeedinthelastfourdecadesthanpreviousbreakthroughtechnicaladvances (such as the steam engine, combustionengineorelectricity),withanemphasisonshort-livedcapitalequipment.Fromamorepolicy-orientedper-spective,Dabla-Norrisetal.(2015)havelistedpolicydistortions as factors in developed countries thathavehinderedproductivitygrowthoverthepastfewdecades,particularlyintheagriculturalandservicessectors.Theauthorsarguefortheneedforstructuralreformmeasurestoreduceproductmarketrigidities.Also,especiallyinmostseverelycrisis-hitcountriesineurope,somegovernmentshavetakenmeasurestoincreasetheflexibilityoflabourmarketsandtoreducesocialbenefits,aimedataddressing“supply-sideconstraints”inordertoboostcompetitiveness,whilemaintainingcontractionaryfiscalpoliciesforprolongedperiods.

other observers argue that secular stagna-tionreflectsadecade-longtendencyof inadequateaggregatedemandgrowth.Theyattributethemajorcauseofsecularstagnationtothelackofgrowthoflabourincomes.Fromthisperspective,thedeclineinthewageshareindevelopedcountriesbyabout10percentagepointssincethe1980shasconsider-ably constrained income-based consumer demandwithattendantadverseeffectsonprivateinvestment(TDR 2012).Theseadversedemandeffectsresultingfromworseningfunctionalincomedistributionhavebeen reinforcedbywideninggaps in the distribu-tionofpersonalincome,astheshareintotalincomeof the richest households has strongly increased,and these households tend to spend less and savemoreoftheirincomesthanotherhouseholds.Thesetrendshavebeenstrengthenedbypoliciesthatseektoaddressthedemandshortfallessentiallythroughmonetaryexpansion.However,insteadofinducingfirmstoinvestinproductiveactivities,suchapolicyhas resulted infirms investing infinancial assets,whichspursassetpricebubblesandworsenswealthdistribution,withoutaddressingincomestagnationforthemajorityofthepopulation.

The related policy debate has beenmainlyconcernedwithwhether private investment andaggregate demand growth can be best spurredby supply-side-oriented structural reforms or bydemand-side-orientedfiscal and incomes policies.The former approach is based on the belief thatproductandlabourmarketsthatarenotsufficiently

Trade and Development Report, 201518

flexiblediscourageenterprisesfromincreasingtheirfixed investments.18However, to the extent thatsecularstagnationresultsmainlyfromweakdemand,suchapolicyapproachwill tend toworsen ratherthan resolve theproblem.Analternativeapproachgivesaprominentroletoincomespolicy(e.g.mini-mumwagelegislation,reinforcementofcollectivebargaining institutionsandsocial transfers)and topublicexpendituretoaddressweaknessesbothonthedemandandthesupplysides.19Thisisobviouslythecaseforpublicinvestmentininfrastructure.

Koo(2014)stressesthatanexpansionaryfiscalpolicyinacontextofhighprivateindebtednessneednotbedetrimental;onthecontrary,asalsodiscussedinTDR 2011,thepositivemultipliereffectsofgov-ernment spending in a stagnating or recessionaryeconomywould increaseoutputand tax revenues,andconsequentlystabilizetheratioofpublicdebttoGDP.Thiskindofpublicinvestmentcomplementsprivateinvestmentandtendsto“crowdin”thelatter.

Moreover, a progressive incomes policy in-creases demand, as it strengthens the purchasingpower of social segmentswith a high propensitytoconsume.Thisinturncreatesoutletsforprivateinvestment,withmultiple benefits: higherwageincomesandimprovementsinformalemploymentreduce thefinancial pressure on pension schemesandallowhouseholdstoincreasetheirconsumptionspendingwithoutaddingtohouseholddebt(Palley,

2015).Andhigherlevelsofactivityandemploymentare known to foster productivity aswell, creatingvirtuous circles of demand and supply expansion(McCombieetal.,2002).Thus,fiscalexpansionandincomegrowthwillincreaseoutputandatthesametimeacceleratepotentialoutputgrowth,therebyani-matingavirtuousfeedbackrelationshipthatlaysthebasisforfuturesustained,non-inflationarygrowth.international coordinationwouldmultiply theseinvigorating effectswhile preserving balance-of-paymentssustainability(onaranandGalanis,2012;TDR 2013).

Theimplicationsofthisdebatefordevelopingcountriesaresignificant(Mayer,2015).Aprotractedperiodofstagnationindevelopedcountrieswouldweakendemandforexportsfromdevelopingcoun-tries,affectingbothoutputgrowthandproductivity,andeventuallygeneratebalance-of-paymentsprob-lemsintheselattercountries.Furthermore,thechoiceofmonetaryexpansionasthemaininstrumentforfos-teringdemand,coupledwithprevailingunregulatedcapitalmovements,generatesvolatilefinancialflowstoemergingeconomiesofmagnitudesthatarewellabovethelatters’absorptivecapacities.Unlessdevel-opingcountriesareabletoapplymacroeconomicandprudentialpolicies tochecksuchfinancialshocks,theywillenterintoasequenceofassetpricebubblesanddebt-fuelledconsumptionsprees.Thesubsequentfinancialcollapseandeconomicretrenchmentcouldeventuallyleadtosecularstagnationworldwide.

Notes

1 DatafromUNCTADstatasonJuly2015. 2 Financial Times,“Victimofshalerevolution,Nigeria

stopsexportingoiltoUS”,2october2014. 3 SeealsoUNCTAD News,“in2014,worldmerchan-

diseexportsgrewby0.6%,whiletradeinservicesrecordeda4.2%globalincrease”,14April2015.

4 Unlessotherwisespecified,dataonseabornetradearefromUNCTAD,2015.

5 Thepricesoftropicalbeveragesincreasedsharplyinearly2014, thenstabilizedup tooctober2014onlytofallinthefirstmonthsof2015.Therefore,since2011,pricesforthisgrouphaveexperiencedanoveralldownwardtrend.

6 in fact oil priceswere quite volatile in the firstquarterof2015.Thiswasmostlikelyrelatedtotheuncertaintyabouthowfartheycouldfall.

Current Trends and Challenges in the World Economy 19

7 bloomberg, “U.S. oil drillers add rigs for secondstraightweek”,10July2015.

8 SeeFinancial Times,“iran’sreturntooilmarkettoweighoncrudeprices”,14July2015;andFinancial Times,“SaudiArabia’scrudeoiloutputhits10.6mb/drecordinJune”,13July2015.

9 See,forinstance,Forbes,“U.S.oilproductionfore-castscontinuetoincrease”,7May2015.

10 See,forinstance,Financial Times,“Grainpricesriseastightersupplylooms”,30June2015;Financial Times,“elNiñohitsAsianandAfricancerealpro-duction”,9July2015.

11 Thispricedeclinewasduetoincreasedproductionofaluminiumandzinc inChinaandan increasedsupplyofnickelfromthePhilippines,aswellashighinventorylevelsofnickel(AieCe,2015).

12 Chinaaccountsformorethanhalfofworldmetalsdemand(Worldbank,2015).

13 Financial Times, “Chinese funddoubles downoncopper short”, 12May 2015;Financial Times,“Copperbenefitsfromequitymargincalls”,29June2015;Financial Times, “China’s low rates sounddeath knell for copper carry trade”, 3 July 2015;Financial Times, “Copper hit by China equityswings”, 6 July 2015. it is also noteworthy that

goingshortoncopperandlongonChineseequitieswas one ofGoldman Sachs’ six top trade ideasfor 2014 (see: http://www.businessinsider.com/goldman-sachs-top-trades-for-2014-2013-12?op=1).

14 See,forinstance,Financial Times,“Weakbrazilianrealdragsdowncoffeeandsugar”,30March2015.

15 Areplicationofthisexercisefordifferentrepresenta-tivecommodities,suchasoil,copper,wheatorcoffee,alsoconfirms that thedeclines inpricesarenotsopronouncedinSDRsoreurosasthedollarappreciates.

16 Thisdiscussiondoesnotrefertooil,asitsprospectsin the current production environment have beendiscussedearlier.

17 Seebackhouseandboianovsky(2015)forareviewoftheoriginanddevelopmentofthesecularstagna-tionthesis.

18 on the contrary, it has been found thatmeasuresaimedatincreasinglabourmarketflexibilityactuallylowerlabourproductivity(VergeerandKleinknecht,2010;PessoaandvanReenen,2013).

19 SeeMukhisa Kituyi (2015). Statement by theSecretary-GeneralofUNCTADfor the thirty-firstmeetingoftheinternationalMonetaryandFinancialCommittee.18April.Availableathttps://www.imf.org/external/spring/2015/imfc/index.asp.

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backhouseReandboianovskyM(2015).Secularstag-nation:The history of amacroeconomic heresy.blanquilecture, 19thAnnualConference of theeuropean Society for theHistory of economicThought,Rome,14−16May.

bP(2015).Statistical Review of World Energy 2015.britishPetroleum,london.

ClarksonResearch Services (2015). ShippingReviewandoutlook.Spring.ClarksonResearchServiceslimited,london.

Dabla-Norrise,GuoS,HaksarV,KimM,KochharK,WisemanK andZdzienicka,A (2015).The newnormal:Asector-levelperspectiveonproductivitytrendsinadvancedeconomies.StaffDiscussionNoteNo.15/03,iMF,Washington,DC.

eClAC(2015).Estudio Económico de América Latina y el Caribe.Santiago,Chile.

eiA(2015).Short-Term Energy Outlook.Washington,DC,UnitedStatesenergyinformationAdministration.July.

GordonRJ(2012).isUSeconomicgrowthover?Falteringinnovation confronts the six headwinds.WorkingPaperNo. 18315,Nationalbureau ofeconomicResearch,Cambridge,MA.

HansenAH (1939). economic progress and decliningpopulation growth.American Economic Review,29(1):1−15.

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iMF(2015).Commoditymarketdevelopmentsandfore-casts,withafocusoninvestmentinaneraoflowoilprices.SpecialfeatureinWorld Economic Outlook,April,Washington,DC.

KooRC(2014).balancesheetrecessionisthereasonforsecularstagnation.in:baldwinRandTeulingsC,eds.Secular Stagnation: Facts, Causes and Cures.london,VoxeUebook,CePRPress.

lo S andRogoffK (2015). Secular stagnation, debtoverhangandotherrationalesforsluggishgrowth,six years on.Working PaperNo. 482,bank forinternationalSettlements,basel.

MayerJ(2015).HowcouldtheSouthrespondtosecularstagnationintheNorth?PresentedattheworkshoponeconomicStagnationandDeflation:ChallengesforJapaninComparativePerspective,SchooloforientalandAfricanStudies(SoAS),london,3−4July.

McCombieJSl,PugnoMandSorob(2002).Productivity Growth and Economic Performance: Essays on Verdoorn’s Law.london,PalgraveMacmillan.

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PalleyTi (2015). inequality, the financial crisis andstagnation:Competingstoriesandwhytheymatter.WorkingPaperNo. 151,Macroeconomic PolicyinstituteattheHansböcklerFoundation,Düsseldorf.

PessoaJPandvanReenenJ(2013).TheUKproductiv-ityandjobspuzzle:Doestheanswerlieinlabourmarketflexibility?SpecialPaperNo.31,CenterforeconomicPerformance,london

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VergeerRandKleinknechtA(2010).Theimpactoflabormarketderegulationonproductivity:Apaneldataanalysisof19oeCDcountries(1960-2004).Journal of Post Keynesian Economics,33(2):371−408.

Worldbank(2015).Commodity Markets Outlook.July.Available at: http://siteresources.worldbank.org/iNTPRoSPeCTS/Resources/334934-1304428586133/GeP2015c_commodity_Jul2015.pdf.

ZhangMandbaldingC (2015).Carry tradedynamicsundercapitalcontrols:ThecaseofChina.Availableathttp://ssrn.com/abstract=2623794.

Have Commodity Markets De-Financialized? 21

Financializationofcommoditymarketsreferstotheobservationthatcommoditieshavebecomeanassetclassforportfolioinvestors,justlikeequitiesandbonds.While thedebateonfinancialization isongoing,asignificantbodyofanalysissuggeststhatcommoditypricedynamicshavechangedsubstan-tiallysincetheearly2000s,andthatthesechangeshave been associatedwith a sizeable increase infinancialinvestors’positionsoncommoditymarkets,aswellaswithchangesinthecompositionofthesepositions(TDRs 2009and2011;UNCTAD,2011).

Regardingfinancial positions on commoditymarkets,evidencefortheperiodsince2006showsthat total commodity assets undermanagement(AUM) increased dramatically prior to the globalfinancial crisis and during the period 2009–2011.Theyreachedapeakofalmost$450billioninthefirsthalfof2011anddeclinedfromalevelthatwasstill over $420 billion in January 2013, to about$270billioninMay2015.Whilethisisasizeabledrop,thelevelofAUMisstillclosetoitspre-crisispeakofmid-2008(chart1.A.1).

The fall in overallAUMpositions betweenearly2013andmid-2015isthecombinationoftwoelements.First is thesharpdecline inpositionsofexchange-tradedcommodityproducts,suchasfuturesandoptions contractsheldbyhedge funds,whichslumpedbyalmost40percentbetweenJanuaryandJune2013.Thisisalsotheperiodspanningthethirdroundof quantitative easing by theUnitedStatesFederalReserve,whichwasadoptedinSeptember2012, and the announcement in June 2013 that a“tapering”oftheFederalReserve’squantitativeeas-ingpolicycouldbeginlaterthatyear.Thelastquarterof2012alsomarksthetimewhentheS&P500equity

marketindexstartedtorally,risingbeyonditspre-viouspeaks,whichmayhavebeensupportedbyare-composition of financial portfolios away fromcommodities towards equities. Second, therewasanequallysharpdeclineinpassiveindexinvestmentpositionsinthesecondhalfof2014,followedbyabottomingoutofthesepositionsatalevelofroughly$70billionduringthefirsthalfof2015.Giventhatenergyproductshaveasizeableweightinmostcom-modityindexes,thismovementwasassociatedwiththatoftheoilpriceandprobablyreflectedcontinuousgrowthofoilsuppliesinthecontextoftepidglobaldemandgrowthandthedecisionbyoPeCnottocutoutputtostemthepricedecline.1

itisalsonoteworthythatsincemid-2011,posi-tionsinexchange-tradedcommodityproductshavealmostcontinuouslyexceededthoseincommodityindexswaps,oftenbyasignificantmargin.Thismayindicate that commodities are now seenmore asopportunisticshort-terminvestmentsratherthanaslong-terminvestmentsaswaslikelythecasebeforetheonsetofthefinancialcrisisin2008whenindexinvestmentsaccountedformostofAUM.indeed,theprofitabilityofindexinvestmentsmainlyreliesontheabsenceofaclosecorrelationwiththatofotherfinan-cialassets.butitalsodependsonatrendincreaseinthespotpricesofcommodities,suchasthroughrapidgrowthincountrieswithsizeablecommodityconsumption,and/ora situationofbackwardation,i.e.adownwardslopingfuturescurvewhereindexinvestorsexperiencepositiverollyieldsandrealizeaprofitontheirpositionsevenwhenspotpricesdonotrise(TDRs 2009 and 2011).2Arapidriseincom-modityspotpricesaccompaniedthestrongincreaseinindexinvestmentpositionsbetween2006andtheonset of the crisis inmid-2008.Commodity spot

Annex to chapter I

HAvE COMMODITy MARkETS DE-FINANCIAlIzED?

Trade and Development Report, 201522

pricesalsostronglyincreasedbetweenmid-2009andmid-2011,wheneconomicgrowthinlargedevelop-ingcountries,especiallyChina,continuedunabated.Sincethen,however,developing-countrygrowthhasdeclined,commoditieshaveproved tobestronglycorrelatedwithotherassetclasses(seebelow),andcommoditypriceshavefallen.Thischangeoffor-tuneshascausedindexinvestorstosuffersignificantnegativerollyields,andprobablyexplainsmostofthedecline incommodity index investmentssince2011,andespeciallytheaccelerationofthisdeclineduringthesecondhalfof2014.3

Another factor that is likely to have causedthe decline inAUM, and especially that of indexinvestments, is the increased correlation betweencommoditiesandotherfinancialassets.Thesecor-relationsweretrendingupwardsbetweentheearly2000sand2008,andwereparticularlypronouncedduringtheperiod2008–2013.Whilethecorrelationbetween returns on commodities and otherfinan-cial assets declined between aboutmid-2013 and

mid-2014, thecorrelationwithequitymarketshasstabilizedroughlyatpre-crisislevelsandthatwiththedollarhasgoneupagainsincethebeginningof2015(seechart1.A.2).ThelattermaymainlyreflectstabilizationofthedollarexchangerateamidfadingexpectationsofanimminentincreaseininterestratesbytheUnitedStatesFederalReservethathaddrivenitsappreciationbetweenmid-2014andearly2015.

The increased correlations between com-modities and other financial assets that started inthe early 2000s andwere accentuated during theperiod2008–2013maybeattributedtothechangeincommodityfutures’pricedynamics.AsdiscussedindetailinTDRs 2009and2011,therearemainlytwoeconomicmechanismsthatunderliethefinan-cializationofcommoditymarkets.4First,accordingtothetheoryofrisk-sharing,financialinvestorsthattakelongpositionsoncommoditymarketsprovideliquidity,accommodatehedgingneedsandimprove

Chart 1.A.1

COMMODITy ASSETS UNDER MANAGEMENT, APRIL 2006–MAy 2015

(Billions of dollars)

Source: UNCTAD secretariat calculations, based on Barclays Research.

Chart 1.A.2

CORRELATIONS bETwEEN COMMODITy INDExES, EQUITy INDExES AND ThE DOLLAR ExChANGE RATE, 2000–2015

Source: UNCTAD secretariat calculations, based on Thomson Reuters datastream.

Note: The data reflect one-year rolling correlations of returns on the respective indexes on a daily basis.

0

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450

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2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Commodity index swaps

Exchange traded commodity productsCommodity medium-term notes

Total (right scale)

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S&P GSCI excess return index and dollar exchange rate indexS&P GSCI excess return index and S&P 500 indexS&P GSCI non-energy excess return index and S&P 500 index

2015

Have Commodity Markets De-Financialized? 23

risk-sharing.However,theybasetheirtradingstrat-egiesontheirownneeds,whicharedeterminedonthefinancialmarkets.Thismeansthattheytendtobuildandunwindpositionsoncommoditymarketsaccordingtopricedevelopmentsorchangesinper-ceivedriskonotherassetmarkets.Whentheydoso,forexamplewhentheyneedcashtohonourmargincallsonequitymarkets,theyconsumeliquidityandadverselyaffectrisk-sharingoncommoditymarkets.5

Second, financial investors tend to trade inresponse to information signals emanating fromfinancialmarkets, thereby introducing “noise” incommodity trading (i.e. trading unrelated to fun-damentals).Suchnoise trading is reinforcedwhenfinancialinvestors’expectationsdifferamongthem,whichmakes them engage in speculative tradingagainst each other. it is also reinforcedwhen themostprofitableactivitiesarisefromherdbehaviour(i.e.whenmarketparticipantsfollowthepricetrendforsometimeanddisinvest justbeforetherestofthecrowddoes),andwhenactingagainstthemajor-ity,evenif justifiedbyaccurateinformationaboutfundamentals,may result in large losses.Mostimportantly,marketparticipantsinterestedinphysicalcommoditiesoftenacton incomplete information6onglobaldemandandsupplyshocks,aswellasonchanges in inventories,whichoften lack transpar-ency.Therefore, theycannotdifferentiatebetweenpricesthatmoveduetofinancialinvestors’tradingortochangesinfundamentals.Thiscausesthe“herd”toacquiremarketpowerandmovepricesinthedesireddirection,whichtendstomakethemovershoot.

The increased correlation between commod-ityandotherfinancialmarketshasunderminedtheviewthatcommodityinvestmentisasuitableport-foliodiversificationstrategy.Thisviewwasbasedon evidence for the period 1959–2004 indicatingthatcommodity investmentofferedreturnssimilarto thosefromotherassetclassesbuthada lowornegative correlationwith returns fromequity andbondmarkets (Gorton andRouwenhorst, 2004).Thisfindingreceivedconsiderablemediacoverage,and is usually considered as having provided theintellectualunderpinning for the investmentboomincommodityderivatives,andespeciallyof indexinvestment positions for diversification purposes.Followinganupdateofthisanalysis,ithasrecentlybeenarguedthatthediversificationcharacteristicsofcommodityinvestmentsarestillpresent,andthatthefinancializationhypothesiswasnevervalid,mainly

for two reasons (bhardwajet al.,2015).First, theauthorsarguethatthecompositionofopeninterestoncommoditiesmarketshasremainedrelativelystabledespitethedoublingofthatinterestbetween2004and2014.Theybasethisobservationonanaggregationofpositionsin27commodities.However,thisaggrega-tionmaywellhaveintroducedabias.evidenceforoil,whichisthemosttradedcommodityandwhosepricemovementsarewidelyacknowledgedashav-ing considerable impacts onprices of agriculturalcommodities(chart1.A.3),indicatesthattheshareofswaptraders(whoareusuallyconsideredaproxyfor index investors) sizeably increased between

Chart 1.A.3

ThE COMPOSITION OF TOTAL OPEN INTEREST IN wTI CRUDE OIL ON NyMEx,

by TRADER CATEGORy, 2006–2015(Per cent)

Source: UNCTAD secretariat calculations, based on the United States Commodity Futures Trading Commission (CFTC), Commitment of Traders Reports.

Note: The CFTC provides disaggregated data on long and short positions for commercial users, swap dealers, money managers and other reportables, as well as spread positions of the latter three categories. Total open interest is the sum of all these positions and the positions of non-reportables. Following Bhardwaj et al. (2015), the data shown reports each category’s total gross position (long plus short plus twice the spread position) as a share of twice the open interest.

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13/06/2006 24/06/2008 06/07/2010 17/07/2012 29/07/2014

Commercial usersSwap tradersMoney managersOther reportablesNon reportables

21/07/2015

Trade and Development Report, 201524

mid-2008andearly2010,afterwhichitembarkedonadeclineuntilend2014,andthattheshareofmoneymanagers(suchashedgefunds)hasincreasedsincemid-2012.Thechartalsoshowsthattheshareofotherreportablesspikedwhenoilpricesmovedparticularlysharply(i.e.in2008andbetweenthethirdquarterof2014andthefirstquarterof2015),andthattheshareofcommercialusers(includingproducers,merchantsandusers)sharplydroppedin2007–2008and,fol-lowing a rebound, has trended downwards since2010.Hence,thereislittleevidencetosuggeststablemarketsharesofdifferentcategoriesofmarketusers.What ismore, it is difficult to clearly slotmarketparticipantsintothesecategories,asindividualtrad-ersmaynotalwaysadoptthesametradingstrategy.inparticular,thelinebetweencommercialusersandfinancial investors has been increasingly blurred,partly because trading houses have progressivelyengaged infinancial activities (for further discus-sion,seeUnitedNations,2013:boxii.2).Thisissueraisesmoregeneralqueries as tohowmeaningfultheevidencecitedbybhardwajetal.(2015)couldactuallybe,evenifitwereunbiased.7

Asecondargumentagainstthefinancializationhypothesisholdsthattheincreaseinreturncorrela-tionsbetweencommoditiesandotherassetclasses

wasmerelyatemporaryphenomenonrelatedtothefinancialcrisis(bhardwajetal.,2015).However,asshownabove,andalsoarguedinTDR 2011,thecrisis-relatedtemporarilystrongincreaseincorrelationscanlargelybeattributedtosuccessiveroundsofmonetaryeasingbytheUnitedStatesFederalReserve,whichaccentuatedthecross-marketcorrelationsandaddedasecondshifttotheonethathadoccurredalreadyintheearly2000s.AccordinglyasnotedbyUNCTAD(TDR 2011: 132–133), “a tightening ofmonetaryconditions [in theUnited States]wouldmerelyhaveeliminatedthesourceofthesecondshiftinthecross-marketcorrelations,butitisunlikelytohaveeliminatedthefinancializationofcommoditymarketsaltogether and brought cross-market correlationsbacktowheretheywereattheendofthe1990s”.

Takentogether,thereisnoreasontopresumethattheeconomicmechanismsthathavedriventhefinancialization of commoditymarkets, andmadethesemarkets followmore the logic of financialmarkets than thatof a typicalgoodsmarket,havedisappeared.Nordoestheempiricalevidencerelatedtofinancialinvestmentincommoditymarketsorthedevelopmentofreturncorrelationsacrossdifferentassetmarketssuggestthatcommoditymarketshavede-financialized.

Notes

1 Theevidencealsoshowstherewasasteadyincreasein commoditymedium-termnotes (i.e. corporatedebt financing instruments collateralized throughcommodities). Thismay at least partly reflectincreaseddebtexposureintheenergysectorwherethedebtburdenincreasedfrom$1trillionin2006to$2.5trillionin2014(Domanskietal.,2015).Theissuersofthesenotesgenerallyhedgetheirliabilitiesbytakinglongpositionsinthefuturesmarkets.Thefindingthatthepricesoftheunderlyingcommoditiesincreasewhensuchnotesareissued,anddecreaseon their terminationdate(Hendersonetal., forth-coming)suggeststhatthesenotesareadeterminantofcommoditypricevolatilitywhichisunrelatedtochangesinmarketfundamentals.

2 Thehedgingpressuretheoryconsiderssuchasitua-tionofbackwardation“normal”,becausecommodityproducersneed tooffer apremium to speculatorsforthemtoassumethepriceriskinhedgingopera-tions.Thissituationisalsoakeycharacteristicofthe traditionalpartial segmentationofcommodityfuturesmarketsfromthebroaderfinancialmarkets,duetothefactthatcommodityconsumersareoftenunwilling to engage in direct hedging operationswithindividualproducers.Thisisbecauseconsum-ersfacerisksonmultiplecommodities,andarenotprepared toassume thefixedcostsofhedgingonmultiplecommoditymarkets.However, empiricalevidence strongly suggests that commoditymar-kets are not always in backwardation, and hence

Have Commodity Markets De-Financialized? 25

capturingphasesofbackwardationiscrucialfortheprofitabilityofcommodityindexinvestments(basuandMiffre,2013).

3 Forexample,thevalueoftheS&P’sTotalReturnCommodityindexinApril2013stoodatonly90percentofitsvaluein2011,beforedecliningtobarely50percentbythebeginningof2015;thiswasfol-lowedbya slight reboundduring thefirsthalfof2015.The total return on a commodity futurescontractisthesumofchangesinthespotprice,theroll yield and the collateral yield.Given that thelevelofthelatterisafunctionofinterestrates,itisnotsurprisingthatperiodsofquantitativeeasingarecharacterizedbylowyieldsontotalreturnindices.Theexcessreturnindicesusedinchart1.A.2includeonlythefirsttwotypesofreturn,butnotthecollateralyield.

4 Athirdmechanismemphasizesthetheoryofstor-age. it holds that inventorymust rise if financialinvestors drive futures prices upwards, as suchpriceincreasesgiverisetoaconvenienceyieldforphysicalcommodityholdingsandinducemorecom-modityholdings,which in turn reduce thesupplyavailableforimmediateconsumptionandincreasespotprices.Theconvenienceyielddependsonthecostsofwarehousingandfinancing,andisthereforestrongly affectedby the level of nominal interestrates.AsdiscussedinTDR 2009,thisviewassumesthatphysicalmarketsareperfectlytransparentand

thatinformationoninventoryholdingsisfullyavail-ableworldwide,whichisgenerallynotthecase.

5 Thedirectimpactoffinancialinvestmentoncom-moditypricesrelatedtothetheoryofrisk-sharinghasoftenbeenexaminedon thebasisofGrangercausality tests spanning long timeperiods.Thesetestsusuallyfindlittleevidenceofadirectimpactoffinancialinvestmentoncommodityprices(Sandersandirwin,2011).However,thisidentificationstrat-egy assumes that financial-market signalsmakefinancialinvestorsactcontrarytocommodity-marketsignalsandconsumeliquidityallthetime.Thisisnot the case, especially inperiodswhenfinancialinvestors’risk-returnprofilesonotherassetmarketscausetheirtradingbehaviouroncommoditymarketstoaddliquidityandimproverisk-sharing.Asaresult,Grangercausalitytestsonspecificsub-periodstendtofindmoreevidenceofsuchdirectpriceimpactsoffinancialinvestors(Mayer,2012).

6 indeed,theveryfunctionofcentralizedcommodityexchangesistoaggregatedispersedinformationandfacilitatepricediscovery.

7 Regardingtheseauthors’argumentthatindexinvest-mentisstillavalidportfoliodiversificationstrategy,itisworthnotingthatbhardwajis“aresearcheratSummerHaven,a$1.4bncommodityfundmanagerwhereProf.Rouwenhorst is also a partner” (see,Financial Times,“investment:revaluingcommodi-ties”,4June2015).

References

basuDandMiffreJ(2013).Capturingtheriskpremiumofcommodityfutures:Theroleofhedgingpressure.Journal of Banking and Finance,37(7):2652–2664.

bhardwajG,GortonGandRouwenhorstKG(2015).Factsand fantasies about commodity futures ten yearslater.WorkingPaperNo.21243,NationalbureauofeconomicResearch,(NbeR),Cambridge,MA.

DomanskiD,KearnsJ,lombardiMandShinHS(2015).oilanddebt.BIS Quarterly Review,March,basel:55–65.

GortonGandRouwenhorstKG(2004).Factsandfantasiesaboutcommodityfutures.WorkingPaperNo.0595,NbeR,Cambridge,MA.

HendersonbJ, PearsonND andWang l (forthcom-ing). New evidence on the financialization ofcommoditymarkets.Review of Financial Studies.Available at: http://rfs.oxfordjournals.org/content/early/2014/12/25/rfs.hhu091.short?rss=1.

Mayer J (2012).The growingfinancialisation of com-moditymarkets:Divergencesbetweenindexinves-torsandmoneymanagers.Journal of Development Studies,48(6):751–767.

SandersDandirwinS(2011).Theimpactofindexfundsincommodityfuturesmarkets:Asystemsapproach.Journal of Alternative Investments,14(1):40–49.

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UNCTAD (2011).Price Formation in Financialized Commodity Markets: The Role of Information.NewYorkandGeneva,UnitedNations.

UNCTAD(TDR 2009).Trade and Development Report, 2009. Responding to the Global Crisis: Climate Change Mitigation and Development.UnitedNationspublica-tion.SalesNo.e.09.ii.D.16,NewYorkandGeneva.

UNCTAD(TDR 2011).Trade and Development Report, 2011. Post-crisis Policy Challenges in the World Economy.UnitedNations publication. SalesNo.e.11.ii.D.3,NewYorkandGeneva.

UnitedNations (2013).World Economic Situation and Prospects 2013.UnitedNationspublication.SalesNo.e.13.ii.C.2,NewYork.

Financialization and Its Macroeconomic Discontents 27

Thegrowinginfluenceoffinancialmarketsandinstitutions,knownas“financialization”,affectshowwealthisproducedanddistributed(UNCTAD,2011).Consequently,theincreasingintegrationofdevelop-ingandtransitioneconomies(DTes)intotheglobalfinancialsystem,andtheaccelerationofcapitalflowsintothesecountriessincetheturnofthemillennium,havefuelleddiscussionaboutthelinksbetweenopen-ness,financialdeepeningandeconomicdevelopment.increasingfinancialintegrationhasthepotentialtoenhance access to externalfinancing for develop-ment.However, this chapter argues that there hasbeenonlyaweaklinkbetweentheintegrationofmostDTesintoglobalfinancialmarketsandtheirlong-termdevelopment.Thislinkhasexperiencedfurtherstrainsinrecentyearsduetooverabundantliquiditygeneratedbycentralbanksindevelopedcountries.WhileseveralDTeshaveexhibitedstronggrowthandcurrentaccountsurpluses(orlowerdeficits)overthepastdecade,accumulating,inaggregate,consid-erableexternalreserveassets,theirgreateropennesstoincreasinglylargeandvolatileinternationalcapitalflows,especiallyshort-termspeculativeflows,hasexposedthemtotherisksoffinancialboom-and-bustcycles.1Thischapterdetailstheimplicationsofsuchrisksfromamacroeconomicperspective.

FinancialflowstoDTesintheperiodsincethe2008–2009 crisis reflect a previously established

pattern ofmacroeconomic drivers that started toemergeinmanycountriesbeginninginthe1980s:a long-termdeteriorationin theglobalwageshareandreducedpublicsectorspendinginthedevelopedeconomies,whichhavecontributedtothedampen-ingofglobaldemand.Globalgrowthhasbeenbasedmainly on expanding financial liquidity and thegenerationofcreditandassetbooms.Afterthecrisis,developed-country policies of quantitative easing,coupled,afterabriefexpansionary interlude,withfiscal austerity, have largely perpetuated this pat-tern.2ThepromiseofhigherreturnsoninvestmentsinDTes,andperceptionsthattheyposedlowerrisksthan before,made them an attractive alternativeforinternationalinvestors.However,anincreasingproportionoftheresultingfinancialflowsintothesecountrieshastendedtobeshort-termorofamorespeculativenature,andtheyarealreadyexhibitingthetypeofvolatilityreminiscentofconditionsthatprecededfinancialcrisesinanumberofDTesinthe1980sand1990s.

ThischapterfirstconsidersfinancializationinDTesatanaggregatelevel,andhighlightstherela-tionship between capital flows and factor incomepayments,andtheresultingpressuresontradebal-ances.ThehigheraggregateratesofreturnonDTes’liabilitiesrelative to thoseearnedonDTes’assetsareaninsufficientlyacknowledgedandpotentially

Chapter II

FINANCIALIzATION AND ITS MACROECONOMIC DISCONTENTS

A. Introduction

Trade and Development Report, 201528

problematicaspectof these relationships.existingpatterns point to unsustainable trends for the cur-rentaccount, therefore leading togreaterfinancialfragility.Moreover, in thecurrentcontextofslug-gishrecoveryfromthecrisis,whichrequiresstrongcontributionstoglobaldemand,especiallybysurpluscountries,thepressuretomitigatetheeffectofnetfactorincomelossesonthecurrentaccountiscoun-terproductiveforglobalwelfare.

This chapter then discusses the implicationsof financialization for domesticmacroeconomicpolicy.itarguesthatexcessivefinancialflowsalterpricesandinfluencepolicyinwaysthatcompromisethe potential for sustainable growth and develop-ment.With fully open capital accounts,monetaryauthoritiesbecomemoreexposedtothepressuresandexpectationsofexternalfinance.inparticular,largecapitalinflowsgeneratepressuresforexchange-rateappreciation,whichisexacerbatedbyawidespreadcommitmenttomaintainingextremelylowratesofinflationasagoalinitself.Thereachoffiscalpolicyissimilarlylimitedbyacompulsiontomaintainafinance-friendlypublicpolicystance,whichdiscour-agespolicyinterventiononboththeexpenditureandrevenue sides.The result is a tendency towards adeflationarymacroeconomicenvironment,coupledwithstructuralfragilitiesinthesystemsoffinanceandproductiveinvestment.Allof thisdiscouragesboththegrowthofrobustaggregatedemandandthedeepeningofproductivecapacity.

Theexpectedrepercussionsofthesefragilitiesondomesticaggregatedemandare thendiscussedbyreviewingthehistoryofseveralfinancialcrisesintermsthatlinksurgesinspeculativefinancewithprivatesectorrisk-takingandsubsequentpublicsec-torlosses.Thoselossesareincurredasgovernments

eventuallyanduniversallyassumetherisksandcostsgeneratedbyprivatespeculationandproductionfail-ures.Abroader,stylizedframeworkthenjuxtaposesdomesticandexternalsourcesofeconomicgrowth,emphasizinghowpastconditionsparallelthosethatprevailtoday.

Thechapterconcludeswithadiscussionofanumberofpolicyresponsesthatdevelopingcountriescouldconsiderinthelightofthesefragilities.Suchresponseswould aimatbettermanagingfinancial-ization and itsmacroeconomic effects, aswell asstrengtheningthelinkbetweenfiscalandmonetarypolicies and development goals. Strong domesticfinancialregulationneedstobeatthecoreofeffortstoharnessthebenefitsofinternationalfinance.insteadof relying on narrowly conceived inflation targetsandhighinterestratestomanagecapitalinflowsandthe balance of payments, a judicious combinationofcapitalcontrolsandexchangeratemanagement,includingby influencing theamountandcomposi-tionofcapitalinflows,wouldhelpmaintainaccesstoproductiveexternalfinancewhilealsoencouragingdomesticinvestment.Proactivefiscalandindustrialpoliciesarealsoessentialforgeneratingthestructuresandcircumstancesthatsupportdomesticproductivitygrowthandtheexpansionofaggregatedemand.Giventhe extent offinancialization and the large size ofglobalcapitalflows,however,macroeconomicman-agementatthenationallevelmustbesupplementedbyglobalmeasuresthatdiscouragetheproliferationof speculativefinancialflows.Further support canbeprovidedattheregionallevelbymeansofmoresubstantialmechanismsforcreditsupportandsharedreservefunds.Policycoordinationshouldalsoextendtodomesticmacroeconomicmanagement.Andsuchmeasureshaveagreaterchanceofsuccessiftheyareimplementedregionallyand,ultimately,globally.

Financialization and Its Macroeconomic Discontents 29

1. Liquidity expansions before and after the crisis

inadequateglobaldemandisaprimaryproblemresulting fromtheGreatRecession thathasyet toberesolved.inpart,thisreflectsanongoingfailuretore-linkfinancetosustainableincomegenerationandspending.intherun-uptothefinancialcrisisof2008–2009, effectivedemand inmajor economieswasnot supportedbya sustainedgrowthofwageincome,whichisthemainfactordrivinghouseholddemand,nor,inmostcases,wasitsupportedbyrisingpublicsectorspending.Fromthe1990s,fiscalstanceswereeithermoderatingorbeingsubjecttodownwardadjustments inmost of themajor economies.TheexceptionwastheUnitedStatesbetween2001and2004,whereextraordinaryfiscalinjectionhelpedlifttheeconomyafterthedot-comcrash.intheabsenceofthesetwomaindrivers,GDPgrowthwasbasedonliquiditycreation,initiallybymonetaryauthoritiesandthenbyprivatefinancialinstitutions(seechapteriii).insomeofthemajoreconomies,thissucceededin boosting demand through asset appreciationsandborrowing,leadingtoconsumptionboomsandprivateinvestmentbubbles.Thecounterpartdriverin other economieswas net export demand.Thishazardousconfigurationoffinanceanddemandwasvery different from the process of credit creationthatsustainsproductionandemploymentgeneration.

likewise,intherecoveryfromthe2008–2009crisis, the failure to reverse the long-term dete-riorationof thewageshare,whichbegan inmanycountriesinthe1980s,wascompoundedbyageneralshifttofiscalausteritybymostdevelopedeconomiesafterthebriefexpansionaryepisodeof2009–2010.Thisleftrecoveryalmostexclusivelydependenton

renewed liquidity expansion.However, there aresome important differences between the pre- andpost-crisisperiodsthathelpexplaintherecentcon-figurationofgrowthandfinancialpositionsacrosstheglobaleconomy.

Thefirst andmost obvious difference is thepost-crisis rise of public sector deficits in devel-oped economies, an inevitable analogue of theunprecedentedbalancesheetadjustmentsofbanks,businessesandhouseholds.Theseconddifferenceisthatthistimeliquiditycreationhasbeenengineeredbycentralbanks,unlikeduringthepre-crisisperiodwhen themain trigger for liquidity creationwasexcessive leveraging by the private (and shadow)banking sector.3A thirddifference, a consequenceofthefirsttwo,isthatliquidityexpansionhasbeenchannelled through financial sectors as portfolioassets, including in developing countries, and isthereforemostlydetachedfromtherealeconomy.4

Thelatterbecameapparentintheriseofcross-assetcorrelationsamongglobalequities,commoditymarketsandcurrenciesintheearly2000s(TDR 2011,UNCTAD2012a). Portfolio allocations betweenequityandcurrencymarketsreflectedmostlyrisk-on/risk-off perceptions,while perceived benefitsfromdiversification drove commodity investmentand reduced the linkbetweenassetpricesand theperformanceoftheunderlyingrealassets,especiallybetweenmid-2008andmid-2013.Thiscontributedtoanoticeableriseinvolatilityacrossallmarkets.Since2013,fundamentalshavebeenmoresignificantinexplainingpricemovementsformostprimarycom-modities(seechapteri).inthiscontext,thechangingdegreesofimportanceofdriversofpriceformationinreal,financialandforeign-exchangemarketshaveconsiderablyundermined the abilityof policies to

B. The challenges of global liquidity expansion

Trade and Development Report, 201530

influence real economic performance ormitigateexternalshocks.

As far asDTes are concerned, their perfor-mance,both in thepre- and immediatepost-crisisperiods,hasgenerallybeencharacterizedbyacom-binationofsupportivedomesticdemandandexportbuoyancy.Asagroup,theyhavealsoenjoyedgreaterdomesticfinancialstabilitythandevelopedcountries,despiteincreasedliberalizationoffinancialflowsandopeningup thathasallowedagreaterpresenceofforeignbanksandinvestorsintheirdomesticmarkets.However,globalfinancialization in theabsenceofsufficient regulationofdomesticfinancialmarketshasleftDTesmoreexposedtotheconsequencesofboom-and-bust cycles of capital inflows, as notedinearlierTDRs andotherstudies(Akyüz,2008and2011).exposuretoanyshockemanatingfromexter-nalfinancialcyclescouldquicklyerodethestrengthofdomesticdemandinseveralDTes,withpotentialrepercussionsforthestabilityoftheglobaleconomy.

inChina,wheremonetarypolicysterilizationandreserveaccumulationhavelargelymoderatedtheimpactofcapitalinflows,overindebtednessinsectorslinkedtotheconstructionboomisbecomingagrow-ingconcern forpolicymakers (Chandrasekhar andGhosh,2015;Magnus,2014).5Althoughaslowdownofinvestmentcanbeexpected,ifthiscoincideswitha sharpdecline inhousingconstructionand infra-structurebuilding,itcouldcontributetoareversalof the large short-term and equity capital inflows(as detailedbelow). inotherDTes, sociallymoreinclusivepolicieshaveplayedarelativelyeffectiveroleinsupportingdomesticdemandbyimplementingcountercyclicalfiscalmeasures,advancingstrategicplansforexportdiversificationawayfromprimarycommodities (with limited success), socializinggains fromcommodityextraction,andmoderatingtheeffectsofexcessivecapital inflowsviareserveaccumulationordifferentformsofcapitalcontrols.Nevertheless,thereremainsastrongpossibilitythatthescopeandimpactofsuchpolicymeasurescouldbeinsufficienttocountertheconsiderablesizeandconsequent influence of global financialmarkets.indeed,the“tapertantrum”of2013,whichgeneratedsubstantialshockstoperformanceanddeflationarypolicy reactions in several developing countries,couldprovea (mild)harbingerofpossible capitalreversalstocome(Neely,2014;UNCTAD,2014).ThelandscapemaybemorechallenginginDTesthat

havenotimplementedanycountervailingpoliciestomanagefinancialization.

2. The rise and aggregate risks of capitalinflowstoDTEs

ComprehensiverecordsofexternalflowsandstocksforalargenumberofDTesconfirmthattheirexposuretoexternalsourcesoffinancinghascontinuedtorise(Chandrasekhar,2007;Gallagher,2015).6Grossannualdebtflows(netflowsplusdebt repayments)toDTesreachednearly$1trillionin2013.This isaboutfivetimesmorethanin2002,thelastsignifi-canttroughafterthesequenceoffinancialcrisesinthelate1990sandthedot-comcrashin2001,whengrossdebtflowstoDTesamountedto$204billion.itshouldbenotedthatarisingshareofgrossannualdebtflowsisonaccountofdebtrepayments,whichgrewproportionallytothevolumeofaccumulatedliabilitiesovertime.However,therewasalsoahugeriseinnetdebtflows(i.e.grossinwardflowsminusrepayments),from$3.5billionin2002to$535bil-lionin2013.NetequityinflowsintoDTes,which,according to theWorldbank’s International Debt Statistics2015,compriseportfolioequityaswellasdirectinvestment,rosemorethanfourfoldduringthatperiod,from$152billionto$637billion(chart2.1).

These increases of external flows toDTesdo not seem so staggering considering that theseeconomiesexperiencedaperiodofnearlyuninter-rupted rapid economic growth after 2003, despitebeing affected to varying degrees by the globalfinancialcrisis.Comparisonsofthesameflowvari-ablesnotedaboveasapercentofaggregategrossnationalincome(GNi)arecapturedinchart2.1.bythismeasure,therewasaconsiderableriseofgrossandnetdebtflowsfrom2002to2007,resumingagainin2010.Particularlyforgrossflows,thepatternissimilartotheboomcycleofthe1990s,thoughnotasdramaticasthatofthe1970swhichledtothedebtcrisesoftheearly1980s.Netequityinflowsasapercent ofGNi experiencedfluctuations aswell, butfromaconsistentlyhigherlevelfromthemid-1990sonwards.AsaproportionofGNi,bothsourcesofexternalinflowstoDTestogether(debtandequity)increasedfrom2.8percentin2002to5percentin2013,afterhavingreachedtwohistoricalrecordsof6.6percentin2007and6.2percentin2010.

Financialization and Its Macroeconomic Discontents 31

TheseaggregatepatternsarenotuniquetothelargerDTes,whichhaverelativelymoredevelopedfinancialandcapitalmarkets.lower-incomeDTes7mayhaveabsorbedaconsiderablysmallervolumeofcapitalflows,buttheirpatternsaresimilartothoseofthegroupasawhole,showingaclearrisefrom2002 to2013,withpeaks in2007and2010.AsaproportionofGNi,both sourcesofexternalflowstothissubgroupofDTestogether(debtandequity)increasedfrom2.5percentin2002to5.1percentin2013,afterhavingreachedahistoricalrecordof7.7percentin2007.

Relativetoearlierperiods,from2003onwardsmostDTesexperiencedstronggrowthandcurrentaccountsurplusesorlowerdeficits,suggestingthatfinancingneedsfordevelopmentmaynothavebeenthemain driver of the boom in capital inflows.8Rather,“push”factorslikemonetaryconditionsandriskperceptionsofdeveloped-countryinvestors,intandemwith stockmarket appreciations inDTes,mayhavebeenthedominantdrivers(see TDR 2013,chap.iiiforadetailedeconometricexercise).NotunrelatedisthefactthatDTesasawhole,particularly

thelargereconomiesofthisgroup,accumulatedcon-siderableamountsofexternalreserveassetsduringthisperiod(chart2.2).9Underthesecircumstances,reserveaccumulationprimarilyreflectsanexcessofinflowsover the amounts thatwould normally beconsistentwithdomestic spendingand investmentpatterns.by2013,over40percentofthereservesheldbyDTeswere“borrowed”,inthesenseofnotderivingfromacurrentaccountsurplus,butratherset aside fromcapital inflows (Akyüz, 2014: 11).While policymakers often see reserve accumula-tionasaprecautionarymeasure,therearelimitstothisstrategy.Giventhelevelsofinflowsandreserveaccumulation,animportantquestioniswhetherthesepatterns are consistentwithfinancial stability andsustainedglobaldemand.

When considering the balance of payments,the focus is often on trade deficits and surpluses,on the assumption that net factor incomes10willsimplyreflectaneutralpatternofcapitalflows.butthe determination and implications of the factorincomebalance involve a fewcomplexities.First,factorincomesdependonthevolumeofassetsand

Chart 2.1

FOREIGN CAPITAL INFLOwS INTO DEVELOPING AND TRANSITION ECONOMIES By COMPONENTS, 1970–2013

(Billions of dollars and percentage of GNI)

Source: UNCTAD secretariat calculations, based on World Bank, International Debt Statistics (IDS) database.

0

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llion

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Trade and Development Report, 201532

liabilities,aswellasontheirratesofreturn.inturn,assetsandliabilitiesareaccumulatedfromtheout-wardandinwardflowsrespectively.Second,acurrentaccountsurplus,bydefinition,equalsanetoutflowof funds on the “capital and financial account”(hereafter referred to as the “capital account”).11Conversely,acurrentaccountdeficitwillequalnet inflowsof capital.but thisdoesnotmean that aneconomywillreceivepreciselytheamountofgrossinflowsthatmatchthecurrentaccountdeficit,orhavegrossoutflowsthatexactlyequalthecurrentaccountsurplus.Rather,inflowsandoutflowsarepartlytheautonomousresultofinvestors’perceptions,leadingtomismatchesbetweenfinanceandtherealeconomy.Asnotedabove,capital inflowsinexcessofthoserequired to finance a current account deficit endupasresidents’privatecapitaloutflowsorreserveaccumulationbyacentralbank.likewise,surpluscountrieswhich,inadditiontotheirearnedforeign

exchangefromtrade,receivelargeamountsofprivateinflowsendupaccumulating“borrowed”reserves.

Taking into consideration that rates of returnpaid to foreign investors are usually greater thanthoseobtainedbyprivateresidentsorcentralbanksofdevelopingcountries,theendresultisthatthebal-anceoffactorincomesoftenmayhaveatendencytoworsenthecurrentaccount.12Forexample,risingnet(positive)investmentpositionsofsurplusDTescould eventually coexistwith decliningnet factorincomes.These disadvantages aremagnified forDTeswithprolongedcurrentaccountdeficits,wherethe accumulated reserves aremostly “borrowed”.Thus,withworseningnetfactorincomeimbalancesandtradedeficits,theseDTeswillfacegrowingnetliabilitypositions.ifdeficitDTesdonotsucceedinimprovingtheirtradeperformance,theymustdependoncapitalinflowstofulfiltheirexternalobligations.byimplication, theseareextremelyfragile“Ponzifinance”schemes,wherecurrentliabilitiescanonlybemetbygreaterborrowing,andanysmallchangeincircumstancesorsentiment,internalorexternal,candestabilizeboththefinancialsystemandmacro-economicconditions(Minsky,2008).

DTesgenerallyaimatimprovingtradeperfor-manceforavarietyofreasonsrelatedtogrowth,andtechnicalprogress,amongothers.buttheprospectsof ever larger net factor payment outflowsdue totheaccumulationofinheritedliabilitiesandunequalratesofreturnmayintensifythesearchforeconomicstrategiestoincreasenetexports,includingbyreduc-ingimports.13

in sum, the empirical evidence reveals thatfinancializationisassociatedwithacontinuingriseofglobalcapitalflowstoDTes.14Furthermore,DTesfaceunevenratesof returnon theirassets relativetotheirliabilities.Fromaglobalperspective,thesepatternscombinedmaybeproblematicinwaysthathave not been sufficiently acknowledged. First,economiesmayfindthemselvesinasituationwhereadeteriorationintheirfactorincomesaccountleadstoincreasingliabilitiesonPonzi-finance-typeterms.Second, in the current circumstances of sluggishrecovery from the crisis,when efforts need to bemadetoboostglobaldemand,especiallybysurpluscountries, the aimof achieving trade surpluses inordertomitigatenetfactorincomelossescreatesacontractionarybias.

Chart 2.2

FOREIGN RESERVE STOCkS IN DEVELOPING AND TRANSITION ECONOMIES, 1970–2013

(Percentage of GNI)

Source: UNCTAD secretariat calculations, based on World Bank, IDS database.

a The major economies excluded are Argentina, Brazil, China, India, Mexico, South Africa and Turkey. Also excluded are Algeria, Egypt, Libya, Morocco and Tunisia. The Russian Federation is not in the IDS sample.

0

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1970 1975 1980 1985 1990 1995 2000 2005 2010

Total for developing and transition economies

Developing and transition economies excluding major economiesa

2013

Financialization and Its Macroeconomic Discontents 33

3. Greaterfinancialintegrationandincreasinglyunstablecapitalflows

Mainstreamviewsonfinancialintegrationstressthatitwillbebeneficialforbothinvestorsandrecipi-entcountries,providedthat it takesplacewithina“sound”macroeconomicframework.RecommendedpoliciesforDTesincludereducinggovernmentinter-vention(creatingacorrespondinglybiggerroleforfinancialinstitutionssuchasprivatebanksandpen-sionfunds)andincreasingcompetitionandstructuralreforms in product and labourmarkets (Caruana,2011;Milkeninstitute,2014a;oeCD,2011).

bycontrast,theanalysishereadoptsabroaderandmore critical approach to financialization byemphasizinghowbothpushandpull factorshaveinfluencedthere-emergenceofrisksforDTessincethefinancial crisis.These greater risks stem fromexternalaswellasdomesticconditions.externalcon-ditionsincludeexcessivegloballiquidity,drivenmostrecentlybyquantitativeeasingindevelopedcountriesthatwasinsufficientlymatchedbyanexpansionofdemandbecauseoffiscalausterity.15WithinDTes,risks have tended to stem frommacro-financialpolicies thatdisregard the importanceofdomesticfinancialregulationandunderestimatethepotentiallydeleteriouseffectsofspeculativebubbles.Thereforethis section stresses the composition of portfolioflowsasaguidetoanassessmentofpotentialrisks.16

During the course of the past 10 years, theweightofprivate,non-guaranteed,short-termspecu-lativeflowshasincreasedsignificantlyintheexternalportfoliosofmanyofthelargerDTes(chart2.3)aswellasforalltheDTestakentogether,excludingthecountriesillustratedindividually.17Chart2.3tracespatternsofmorespeculativecapitalinflowsrelativeto total inflows as a share ofGNi; the differenceincludesmostly long-termor publicly-guaranteedloanstopublicsectorinstitutionsandforeigndirectinvestment(FDi).Admittedly,therearesignificantdifferencesintermsofinitialconditions,behaviourandotherfactorsamongsuchavariedgroupofcoun-tries.Chandrasekhar(2015),forexample,stressestheinfluenceofpreviousandrecentfinancialcrisesonthedirectionofcountries’policyresponses.Acaseinpointisindonesia,wherere-regulationandcapitalcontrols in the aftermath of the 1997–1998Asianfinancialcrisishelpexplainwhycapitalinflowsdid

notrecoveruntilwellintothemid-2000s.AnothercaseisthatofArgentina,wheretheamountofnetcapitalflowsremainedmoderateafterthe2001–2002crisis.18other authors, such asGallagher (2015),proposeamappingofcross-borderfinancialregula-tionsinthewakeofthe2008–2009financialcrisis,highlightingthecasesofbrazil,Peru,theRepublicofKoreaandThailand,whichimplementedsecond-andthird-generationmeasures,price-basedcontrolsandforeign-exchangeregulationsrespectively.

observations on diversity notwithstanding,thesetofcountriespresentedinchart2.3showsaconsiderablylargeproportionoftypicallyunstableor unreliable flows in the total, strongly drivingupswingsanddownswings,which, in somecases,havebeendramatic.Withinperiodsofoneor twoyears,inalmostalloftheseeconomiesthesizeofnetinflowshasvariedbymorethan5percentofGNiineitherdirection,apparentlydrivenbyfluctuationsinthecombinationofprivate,non-publicly-guaranteeddebt,short-termdebtandportfolioequity(i.e.unsta-ble)flows.insomecountriessuchasSouthAfricaandTurkey(aswellasUkraineuntilthecrisisof2013),suchunstableflowsrepresentalmostthetotalityofinflows,which,combined,canadduptofairlysig-nificantproportionsofmorethan6percentofGNi.Theseflowsareevenlargerforothercountriessuchasindia,MalaysiaandThailand.Amongtheselectedsample, onlyChina, indonesia andMexico reflectsituationswheremostoftheinflowsmaynotbeofashort-termorunstablenature.Thiscanbeexplained,atleastpartly,bythegreaterroleofregulationinthetwoformercountries.

Thesepatternsrepresentincreasingvulnerabili-tiesforDTes,notonlybecauseoftheirsizerelativetoGNi,butinparticularbecauseofthefactthatsomemarkets, such as stockmarkets, foreign-exchangemarketsandinsomecasesevenrealestatemarkets,operateinspheresrelativelybeyondthereachofpublicpolicy.Thesemarketsaretypicallyunstableandhighlycorrelatedwith one another,which exacerbates thepotentialfordestabilizingco-movements.Andwhileitmaybedifficult tomeasure the sizeof foreign-exchangemarketsfromtheperspectiveofasingleeconomy,domesticcapitalizationmeasuresofstockmarketsaretelling:forthissampleofDTespresentedinchart2.3,domesticcapitalizationisgenerallycon-siderable,insomecasesgreaterthan100percentofGDP(Akyüz,2014;Milkeninstitute,2014b).

Trade and Development Report, 201534

Chart 2.3

COMPOSITION OF CAPITAL FLOwS, SELECTED DEVELOPING AND TRANSITION ECONOMIES, 2002–2013

(Percentage of GNI)

Source: UNCTAD secretariat calculations, based on World Bank, IDS database.

Net portfolio equity inflowsShort-term net debt inflows Long-term, private non-guaranteed net debt inflows

Total net inflows

-10-8-6-4-202468

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2002 2004 2006 2008 2010 2012

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2

4

6

8

10

2002 2004 2006 2008 2010 2012

Indonesia

2013

-4

-2

0

2

4

6

8

10

2002 2004 2006 2008 2010 2012

China

2013

-4

-2

0

2

4

6

8

10

12

14 Turkey

2002 2004 2006 2008 2010 2012 2013-4

-2

0

2

4

6

8

10

2002 2004 2006 2008 2010 2012

Other DTEs

2013

-10

-5

0

5

10

15

20

25

30

2002 2004 2006 2008 2010 2012

Malaysia

2013

Financialization and Its Macroeconomic Discontents 35

inmanycountriesand in theDTesubgroup,the gapbetween the total and the combination ofunstableflowsincludesFDiandnon-portfolioequityinflows (chart 2.3). FDi in productive activities,especiallyinindustrialsectorsthatunderpindevel-opment,canpositivelycontributetodevelopment.19ThisisparticularlythecasewhenFDiintheformofgreenfieldinvestmentsisappropriatelyabsorbedatthenationallevel.However,FDidatainaggregateshouldbeinterpretedwithcaution.Forexample,theclassificationofFDitypicallyreferstothesizeoftheownershipstake(10percentormore,accordingtotheiMF),andnottotheliquidityoftheinvestment.indeed,financial innovation and the deepening offinancialmarkets canmake largeownership stakesmore apparentwithout significant changes in theliquidityofinvestments.Anotherexampleisthefactthat real estate, a highly liquid andvolatile sector,attractedthemostgreenfieldFDiin2014,andofthetop20recipients,allbut4weredevelopingcountries.20

Furthermore,thepotentialmagnitudeoffactorincomepayments related toFDineeds tobe con-sidered. in 2014, the value of globalFDi incomeexceededthatofallFDiinflows.21economiesthataremajor recipients of FDimay experience thesortsofbalance-of-paymentsinstabilitiesdiscussedabove,sincemaintainingasustainablegrowthpathrequires generating sufficient foreign exchange tocoverexternalpayments,particularlyinthecontextoflargeprofitoutflows(TDR 1999).ifFDiinflowsweretoslowdown,theproblemofcoveringevenamodestrepatriationofprofitscouldquicklybecome

acute, especiallywhen a large proportion of FDiinflows consists of reinvested earnings andmaybehavemorelikeportfolioflowsthanlong-termflows(Kregel,2014b).22

Thispictureofunstablecapitalflowsechoestheexperienceofmanydevelopingcountriesinthelate1980sandthe1990s(asdiscussedbelow).Althoughthecombinedshareofprivate,short-termandequitycapitalflowsasapercentageofGNiisnowlargerthanitwasinthosetwodecades,atthetime,manydevelopingcountriesstartedtorelyonsuchformsoffinancing,sincedebtmarketsremainedvirtuallydryafterthedebtcrisisthateruptedin1982.SinghandWeisse(1998),inacriticalanalysisoftheinteractionsbetweenspeculativecapitalflowsandstockmarketsindevelopingcountries,concluded that theresult-antvolatility,likelihoodofmacro-financialshocks,misallocationof resources, and severe disruptionstolong-termdevelopmentgoalscalledintoquestiontheargumentthatdevelopingcountriesshouldturntostockmarketsasawayofmobilizingresourcesforsustainabledevelopment.

Combiningthesepointsonvolatilityarisingfromthestructureofglobalcapitalflowswiththeaggre-gatefragilitiesstemmingfromcountries’balanceofpayments,thissectionarguesthattheexpansionofunstable,short-termandspeculativeflowspresentsachallengeforusingsuchexternalfinanceinwaysthatcouldenhancedevelopment.Thenextsectiontakesupthequestionofthechallengesandopportunitiesfordomesticmacroeconomicmanagement.

C. The macroeconomic costs of financialization

1. Effectsofunfetteredfinancialintegration on prices and policy

inadditiontothemacro-financialrisksidenti-fiedabove,unstablefinancialflows toDTeshaveeffectsonkeyprices,suchasexchangerates,andatthesametimetheyconstrainmonetaryandfiscalpoli-cies.So-called “balance-of-payments-constrained”

growthframeworksprovideabasisforunderstandingthemyriadconnectionsandlinesofcausalitybetweenexternalflowsandeconomicgrowth.Theyarebasedontheinsightthattoachievesustainedgrowthitisnecessarytobalanceimportsandnetfactorincomepaymentswithexportsinasustainablemanner.23Forinstance, the sizeof the current accountdeficit orexternaldebtrelativetodomesticincomecanlimitpathwaystostablegrowth.Policymakersmaychange

Trade and Development Report, 201536

coursebyeitherreducingdomesticexpenditure,andthusimports,orsupportinginvestmentsthattriggerfasteroutputgrowth,suchasbyincreasingexports(Moreno-brid, 1998).Alternatively, according tothis approach, conditions in internationalfinancialmarketscandeterminetheextentofforeignfinanc-ingavailable,whichinturnaffectsimportsandfixedinvestments,eventuallydeterminingthetradebalanceandthegrowthtrajectory(barbosa-Filho,2001).

These relationships are perhapsmost imme-diatelyapparentintermsofhowfinancialflows,incombinationwithmonetarypolicyreactions,affectprices.influencingtherealexchangeratetomaintaincompetitiveness and encourage the production oftradablesrepresentsachallengeforpolicymakersinDTes.excessivenominalexchangeratedepreciationwilltendtoexacerbatedomesticpriceinflationduetothehighercostofimportedcapitalandconsump-tiongoods.Conversely,excessivenominalexchangerateappreciation,whennotsufficientlycompensatedbylowerdomesticinflation,maycreateatendencytowards realexchangerateappreciation thathasaprolongedeffectonthecurrentaccount.Navigatingwithintheseconstraintsisdifficultforcentralbankpolicyindevelopingcountries.

interventionsintheforeign-exchangemarkettoavoidanappreciationofthedomesticcurrencyleadtomonetaryexpansion,whichcentralbanksusuallytry to sterilizeby sellinggovernment securities inmoneymarkets.However,theseoperationsmaynotnecessarilyresultininterestratesthatarestableandconsistentwithrealdemand;generally,theinterestratetendstoovershootandisfollowedbyadrasticfall.Ahigherinterestrateexertsfurtherupwardpres-sureontheexchangerateasforeigninvestorsrespondbyengagingininterestratearbitrage.evenassumingthatexchange-ratemanagementandreserveaccumu-lationmaybehelpfulinthecontextofcapitalinflows,often, this policy is not symmetrical.Authoritiesusuallyhavegreater difficulty copingwith capitalreversals.Usingalargeamountofreservestomeetdemand for foreign currency can risk eventuallyemptyingthecoffers.24Usually,moneymarketopera-tionsaimedatraisingtheinterestrateareactivated.

independentlyofwhether the central bank isengagedinexplicitexchange-ratemanagement,ifthebehaviourofthecentralbankisdrivenbyanarrowinflationtargetrule,therewillbeatendencytowardsnominal appreciation (for further explanation, see

barbosa-Filho,2012).inflation-targetingframeworkstypicallytendtoconformtonarrowmonetaristideasabouttheexistenceofanexogenoussupplyofmoneyanditsimpactoninflation.Thus,followingsurgesofcapitalinflows,monetaryauthoritiesmayconsideritcriticaltoavertaninflationaryspiralresultingfromtheincreaseinmoneysupply.butcapitaloutflowsleadingtoexchange-ratedepreciationscanalsotrig-gerinflationarypressuresviathepass-througheffectsofimportprices.inthecontextofinflation-targeting,independentlyofthesourceofinflationarypressures,thecriticalinstrumenttotametheinflationrateistheinterestrate,whichoftenbringswithitpressurefornominalappreciation.ifthiseffectisstrongerthanthepresumedeffect of reducing the inflation rate,areal-exchange-rateappreciationfollows,withthepotentialofacurrencycrisisifthecurrentaccountdeterioratessignificantly.Asamatteroffact,highinterestrateshaveperverseeffectsonpriceforma-tion, as producers tend to pass on the higher costofborrowingbyraisingprices(lavoie,2001).Thedestabilizingeffectofspeculativecapitalmovementsonnominalexchangerates,combinedwithinflationtargetingregimesthataimathighinterestrates,maynotonlycreatebalance-of-paymentsproblemsintheshortrun,resultingfromanovershootingandsucces-sivecorrectionsofinterestrates;itmay,inthelongrun,alsotranslateintoslowergrowth,becauserealexchangeratestendtoremainappreciatedinordertoavertfinancialshocks,effectivelydamagingthecurrentaccount(FrenkelandRapetti,2009).

Chart 2.4 illustrates some of thementionedinteractionsbetween capitalflows, exchange ratesandshort-termpolicy rates for thesamecountriesshown in chart 2.3. in some cases, the suggestedinfluencesofexternalcapitalonthemacroeconomicenvironmentseemunambiguous.increasesincapi-tal inflows in excessofwhat is needed tofinancerealdemand tend toexertupwardpressureon theexchange rate.This influencemay bemagnifiedduringcommoditypriceboomsfornetcommodityexporters.brazil,Malaysia,Ukraine and to someextentindiaappeartoberepresentativeofthesepat-terns,whileChinaisanexception,astheauthoritieshavemanagedasteadyappreciationoftheexchangerate.FortheentiregroupofDTes,therelationshipholdsquitewelldespitethehighlevelofaggregation.inother cases (e.g.SouthAfricaandTurkey), thecorrelationappliesonlyforselectiveyears,whileinThailandthevariationsintheexchangerateseemtobeinfluencedbythepaceofcapitalinflowsoverthe

Financialization and Its Macroeconomic Discontents 37

Chart 2.4

NET CAPITAL INFLOwS, NOMINAL ExChANGE RATES AND NOMINAL INTEREST RATES IN SElECTED DEvElOPINg AND TRANSITION ECONOMIES, 2002–2013

Source: UNCTAD secretariat calculations, based on World Bank, IDS database; IMF, World Economic Outlook, April 2015; and IMF, International Financial Statistics database.

Total net inflows (percentages of GNI) Short-term interest rate (per cent)Exchange rate ($ per local currency, 2000 = 1) (right scale)

0.0

0.5

1.0

1.5

-10

0

10

20

2002 2004 2006 2008 2010 2012

Indonesia

20130.0

0.5

1.0

1.5

0

5

10

15

20

2002 2004 2006 2008 2010 2012

Malaysia

20130.0

0.5

1.0

1.5

0

5

10

15

2002 2004 2006 2008 2010 2012

India

2013

0.0

0.5

1.0

1.5

0

5

10

15

2002 2004 2006 2008 2010 2012

South Africa

20130.0

0.5

1.0

1.5

-5

0

5

10

15

2002 2004 2006 2008 2010 2012

Thailand

20130.0

0.5

1.0

1.5

0

5

10

15

2002 2004 2006 2008 2010 2012

Mexico

2013

0.0

0.5

1.0

1.5

0

10

20

30

40

2002 2004 2006 2008 2010 2012

Ukraine

20130.0

0.5

1.0

1.5

0

5

10

15

2002 2004 2006 2008 2010 2012

Other DTEs

20130.0

0.5

1.0

1.5

-10

0

10

20

30

40

2002 2004 2006 2008 2010 2012

Turkey

2013

0.0

0.5

1.0

1.5

0

10

20

30

40

2002 2004 2006 2008 2010 2012

Brazil

20130.0

0.5

1.0

1.5

0

5

10

15

2002 2004 2006 2008 2010 2012

China

20130.0

0.5

1.0

1.5

-10

0

10

20

30

40

2002 2004 2006 2008 2010 2012

Argentina

2013

Trade and Development Report, 201538

mediumterm,withcentralbankinterventionactingovertheshortterm.Argentinashowsasteadycurrencydepreciationinnominalterms,resultingnotfromcapi-talmovements(whichremainedsubdued),butratherreflectingitsinflationrateandproactiveexchange-ratemanagement.inthesemoreambiguouscases,itseemsthatotherdrivers,includingsomedegreeofproactivepolicymanagement,maybethecauseofexchangeratefluctuations.indonesia,asnotedearlier,hasforseveralyearsmaintainedvaryingregimesofexchange-ratemanagement,whiletheresumptionofcapitalinflowsseemstohaverespondedtothecommodityboomthatstartedin2003–2004.

Typically,thecorrelationsbetweencapitalflowsand exchange-rate cycles aremorepronounced intheshortterm.indeed,drasticcapitalflowreversalsoccurred inmid-2013 inmany of the economiesdiscussedherefollowingtheannouncementbytheUnitedStatesFederalReservethatitwouldreducethepaceofquantitativeeasing.Sharpdepreciationsfollowed, and in some economies it took specificmonetary policy responses to halt the turnaround.Fearsthatinstabilitiesofthiskind,andperhapsofagreatermagnitude,willemergefollowingatighteningofUnitedStatesmonetarypolicyarejustifiableinviewofsuchexperiences.Someshort-termmonetarypolicyresponsestochangesincapitalflowsarediscernibleintheannualflowsshowninchart2.4,wheredecelera-tionsinthepaceofcapital inflowsarefollowedbyinterestrateincreases–apatternthatisoftenquicklyreversed.inthesecases,interestratefluctuationscanbesharpfromoneyeartothenext.Thisvolatilitymayhavedamagingeffectsonfinancialstabilityandontheenvironmentforproductivelong-terminvest-ment.Whatismore,becausehighinterestratesareoftennotsufficientlyeffective,ormayevenhamperefforts to control inflation, a resulting tendencytowardsappreciationoftherealexchangeratewillhavelastingeffectsonthecurrentaccount.

Tosumup,itappearsthat,forthemostpart,theeconomiesshowninchart2.4,aswellasmanyothers,havebeenadverselyaffectedbytheglobalizationoffinanceasaresultofperverseeffectsonexchangerates,andvolatileandoftenhigh interest rates. insomecountries,somedegreeofcapitalcontrolsmayhavehelpedmitigatetheseeffects(Gallagher2015;ostryetal.2010).

exchangerates, thebalanceofpaymentsandmonetarypolicyarethemostfrequentlydiscussedaspects of themacroeconomic consequences of

financialflows.However,financializationalsomayexert general deflationary pressures on nationaleconomies,partlyasaresultoftheconstraintsthatopencapitalaccountsimposeonfiscalpolicy(PatnaikandRawal,2005;Patnaik2006).25Asnotedabove,inanenvironmentcharacterizedbyfreeandtypicallyunstablefinancialflows,policymakerscedecontroloverthedomesticinterestrate,withtheresultthattheratethatprevailsisgenerallyhigherthanwhatwouldbeappropriatetosupportdomesticcapitalformation,dampeningeconomicactivityandloweringGDP.inaddition,financializationandopencapitalaccountsexertmacroeconomicpressuresthattendtorestrictfiscalpolicy.interventionistpoliciesandexpansion-aryfiscalstances,nomatterhowimportanttheyarefordevelopment,maybeaconcernforinternationalfinance.Whetherthesesentimentsstemfromafearofunsustainabledebtaccumulationorinflation,ora desire to expand the scope for private investorsbylimitingthereachofthepublicsector,orsimplyfrom resistance to a proactive role for the publicsector,theresulttendstobethesame:policymakersbecomeapprehensivethatgovernmentspendingmaydrivefinanceaway(Krugman,2000;Patnaik,2006).Recent debates about fiscal austerity and growthreflectboththisconcernandtheprevalenceoftheideathatpublicdeficitsanddebtareunequivocallybadforgrowth,evenwhentheempiricalevidenceshowsotherwise (Herndon et al., 2013).26on therevenueside,taxreceiptsmaydeclinefortworelatedreasons:first,duetolowerlevelsofeconomicactivityassociatedwithweakerpublicstances;andsecondduetoongoingpressurestoofferinternationalinves-torsfavourabletaxrateslesttheymoveelsewhere.Theupshotislessgovernmentactivity,whichdirectlyreducesnationalincomeasaresultoflimitedgovern-mentspending,butalsoindirectlylowersproductivecapacitybyrestrictingthetypesofpublicinvestmentsinphysicalandhumancapital thatsupportprivateinvestmentandproductivitygrowth.

Furthermore,opennessofthecapitalaccount,bystronglyalteringrelativepricesanddemandpat-terns,mayhavelongertermeffectsaswell,includingby creatingdeindustrializationpressures inDTes.Giventhisrisk,itisimportanttoconsidertheinter-actionbetween,andsequencingof,liberalizationofthecapitalandcurrentaccounts.Thishasbeen,inparticular,theexperienceinpartsoflatinAmericaandsub-SaharanAfrica(datingbacktothelate1970sinsomecountries),wherecapitalaccountderegula-tion,which initially led tomassive capital inflowsand currency appreciations, tookplace at the same

Financialization and Its Macroeconomic Discontents 39

timeas increasedopenness to trade.Thelowercostandgreatervarietyof industrial imports constitutedagainforconsumersandasourceofimportedinputsintoproduction;buttheyalsodepressedtherelativepricesoftradablegoodsandservices(bothimportedand exported), squeezing domestic profitmarginsandwages,andloweringdomesticinvestmentandemployment.

Recentempiricalevidenceshowshow,inecono-mieswithlessdevelopedmanufacturingindustries,these conditions can hollow out local capacities(TDR 2003;Rodrik, 2015).27This hasmeant lostopportunities for growth and for an expansion ofhigherqualityemployment,sinceindustrialgrowthisessentialforboth.indeed,insuchcases,therehasbeenanincreaseinofteninformal,lowerproductivityservicesectorjobs.

Thus,financializationandopencapitalaccounts,and the higher interest rates they often require tomaintain stability, compromise domestic invest-mentand theabilityofgovernments tosupport it,independentlyofwhether any inflowsoroutflowshavetakenplace(PatnaikandRawal,2005;Kregel,2014c).When inflowsor outflowsdo occur, theycanhavedeleteriouseffectsonindustrializationanddevelopmentinvariousways.Asdiscussedabove,capitalinflowsexertpressuresforrealexchangerateappreciationandelevatetheprimacyofshort-termreturnsinspeculativemarketsoverlong-termproj-ectsthatraiseproductivecapacity(Patnaik,2003).Thismakesitmoredifficulttoconductthetypeofstructurallytransformativeinvestmentsrequiredfordevelopment.on the other hand, sudden stops orcapitalflowreversalscanturndeflationarytendenciesintocontractionarycrises,resultinginsubstantialrealeconomicandhumancostsandrelegatingfiscalpolicytoservicingdebtratherthansupportingdevelopment.ThenextsectionusestherecenthistoryoffinancialcrisesinDTesasaguidetodeterminingtheconse-quencesofsuchoverexposuretospeculativefinance.

2. Learning from the past: Public sector financesandeconomicdevelopmentafterfinancialcrises

As discussed above, financial liberalizationandderegulationprovideanopeningforasurgeofcapitalflowsaswellasdomesticlending,addingtothelikelihoodofbubblesinstockmarketsandreal

estatemarkets.Such large inflowsareoftenmagni-fiedbythewayfiscalandmonetarypoliciesadapttoinvestors’ expectations.The consequent build-up infinancialfragility,drivenbylargelyprivatespeculationandrisk-taking,isoftenswiftlyunwoundbyacrisis,withsubstantialnegativerealeffectsandasharpriseinpublicdebt.Table2.1listscountriesandthedatesof their currency, sovereigndebt or banking crises,groupedbythefourwavesoffinancialcrisesidentified:variousdebtcrisesinthe1980s,theMexicancrisisin1994–1995anditsso-calledtequilaeffects,theAsianfinancialcrisisin1997–1998,anditsrippleeffectsoncountriesoutside theAsian region.28 it isnotacompletelistofallofthefinancialcrisesthatoccurredduring these periods, but rather a representativesampledictatedbydataavailabilityandcorethemes.

Almostallofthesecrisisepisodeslisted(31outof33)wereprecededbya“capitalflowbonanza”,definedasanunusuallylargenegativesurgeinthecurrentaccountbalance.29Similarly,domesticcreditboomsprecededcrisisnearly75percentofthetime(24 out of the 33 episodes listed). in the table,minimumrealpercapitaGDPgrowthreferstotheminimumgrowthratewithinfouryearsofthestartof thecrisis(includingthecrisisyear, recordedastheearliestyearthatanyofthethreetypesofcrisesbegan,andisreferredtoastime T).itsintentistomakeinferences,howeverrough,about theoutputlosses resulting from these crises.The last twocolumnsindicatethecostsofthefinancialcrisesintermsofthegrowingpublicdebt,bothtodomesticand external creditors.Comparing public debt asashareofGDPtheyearbeforethefinancialcrisisbegins(T-1) relativetotwoyearsafter(T+2)fortheentiregroupofcrises listed, themedian (average)increase in total gross central government debt is85.9 (124.3)per cent,while themedian (average)increaseinexternalgovernmentdebtis42(60.5)percent.interestingly,althoughfiscalmismanagementisafrequentrefraininmainstreamaccountsoffinan-cialcrises, it is typically thepublicfieldingof theprivatebust,andallthecostsassociatedwithit(e.g.nationalizingprivatedebt,recapitalizingbanks,andtheimpactofcurrencydevaluationonthevalueofforeigncurrencyliabilities),thatrunuppublicdebt.

(a) Lessons of the 1980s

ThelatinAmericandebt crisesof the1980scaughtmany investors and analysts by surprise.30Theworld had notwitnessed amajor financial

Trade and Development Report, 201540

Table 2.1

PERIODS OF FINANCIAL CRISES, CAPITAL FLOwS AND PUbLIC DEbT

Country

Currency crisis (year)

Sovereign debt crisis

(default year)

Banking crisis

(starting year)

Capital flow

bonanza

Domestic credit boom

Minimum annual real per capita

GDP growth

Change in total gross public debt as a share

of GDP

Change in gross external

public debt as a share

of GDP

(Per cent)

Debtcrisesofthe1980sArgentina 1981 1982 1980 x -7.1 417.7 53.4Chile 1982 1983 1981 x x -11.7 161.7 106.9Mexico 1982 1982 1981 x x -6.1 95.7 117.9Uruguay 1983 1983 1981 x x -10.9 378.5 302.9Colombia 1985 1982 x x -1.3 71.1 35.2Ecuador 1982 1982 1982 x -2.9 60.5 16.0Paraguay 1984 1982 x -5.9 78.7 35.5Turkey 1982 x x 1.2 83.1 32.7Venezuela (Bolivarian Rep. of) 1984 1982 x -6.3 95.2 62.1Brazil 1983 x x -5.6 12.7 39.7Peru 1981 1983 x x -12.5 127.6 73.4Philippines 1983 1983 1983 x x -9.8 n.a. 34.2Argentina 1987 1989 x -8.8 111.4 87.7Peru 1988 x x -14.2 146.8 68.7Venezuela (Bolivarian Rep. of) 1989 x x -10.9 43.9 8.8Brazil 1990 x -5.9 191.1 32.1Group median -6.7 95.7 46.6

Tequila crisisMexico 1995 1994 x x -7.6 26.4 47.0Argentina 1995 x x -4.1 14.5 41.3Group median -5.9 20.5 44.2

AsianfinancialcrisisIndonesia 1998 1999 1997 x x -14.4 246.0 100.9Republic of Korea 1998 1997 x x -6.4 278.8 65.3Malaysia 1998 1997 x x -9.6 7.1 38.1Philippines 1998 1997 x x -2.7 10.4 42.5Thailand 1998 1997 x x -11.5 597.7 28.0Group median -9.6 246.0 42.5

Ripple effects from theAsianfinancialcrisisColombia 1998 x x -5.8 117.5 20.8Ecuador 1999 1999 1998 x x -6.6 49.9 28.9Russian Federation 1998 1998 1998 x -5.1 39.5 96.4Ukraine 1998 1998 1998 x 70.0 n.a.Brazil 1999 x -1.2 -15.2 46.1Turkey 2001 2000 x x -7.1 144.4 35.1Argentina 2002 2001 2001 x x -11.7 208.1 149.9Paraguay 2002 -2.0 -3.3 18.5Uruguay 2002 2002 2002 x x -7.8 88.6 60.7Venezuela (Bolivarian Rep. of) 2002 x x -10.5 22.5 10.1Group median -6.2 60.0 35.1

Note: Country and crisis listings: Countries are listed in order of earliest crisis year of the three types of crises listed, referred to as time T, and then alphabetically; source for dates of the currency, debt and banking crises is Laeven and Valencia, 2008.

Capital flow bonanza: An “x” indicates that a capital flow bonanza occurred within any one of three years preceding the earliest crisis date; source: Reinhart and Reinhart, 2008.

Domestic credit boom: An “x” indicates that a domestic credit boom was identified preceding time T in one of three sources: Arean et al., 2015; Elekdog and Wu, 2011, or Takáts and Uper, 2013.

Minimum real per capita GDP growth: This refers to the lowest annual growth rate within four years of the beginning of the crisis (i.e. the range is time T to (T+3)); source: World Bank, World Development Indicators database.

Public debt: Total gross central government debt includes both domestic and external debt. Total gross external government debt includes all external debt owed to both the public and private sectors. Percentage changes are based on UNCTAD secretariat calculations; source: Reinhart and Rogoff, 2010a, except for data on Ukraine, which is from de Bolle et al., 2006, and percentage changes are based on UNCTAD secretariat calculations of the change between (T-1) and (T+2).

Financialization and Its Macroeconomic Discontents 41

crisissincethe1930s,commoditypriceswerehighandrealinterestrateslow.Flushwithpetrodollars,manydeveloped-countrybanksprovidedfinancingto(mostlyprivate)borrowersindevelopingecono-miesasanalternative to the lacklustre investmentopportunitiesathome.Thefactthattheloanswereoverseenbybanks (andnot basedonbonds)wassupposedtoenhanceinformationandoversight,add-ingtothegeneralsenseofconfidenceandoptimismthatprevailed (Reinhart andRogoff,2009).Manydevelopingcountriesusedthesefundstocopewithoilpriceshocks,maintaininggrowthinthefaceofmountingbalance-of-paymentsconstraints;evenoilexportersborrowedheavily,drawninbyinternationallenderseagertoextendloans(Palma,2003).Atthepolicylevel,anumberoflatinAmericancountriesintroducedfinancialderegulationandtradeliberali-zationinthe1970s,especiallythoseintheSoutherncone(Argentina,ChileandUruguay).

beginningin1979,therewasaseriesofglobaleconomicshocksinvolvingrealinterestratehikes.ThesewereaconsequenceofUnitedStateseffortstotameinflation,intensifiedrecessionindevelopedcountriesandafallinnon-oilcommodityprices.Asa result,optimismswiftlygaveway topanic.Thecut-off in lending,balance-of-paymentscrisesanddevaluationsthatensuedledtoacascadeofdefaults(see table2.1 forapartial list). in response to thealarmingspectreofwidespreadbankruptcies,latinAmericangovernmentsnationalizedwhathadbeenlargelyprivatedebt,withrenegotiationandservicingorchestrated by internationalfinancial institutionsontheconditionofimplementingstabilizationandstructuraladjustmentprogrammes(Díaz-Alejandro,1985;Younger,1993;Damilletal.,2013).

lookingbackatthisperiod,therewereseveralreasonstobecriticalofdomesticpolicychoices,suchas liberalizing domesticfinancialmarketswithoutimplementingadequateoversight,orunderestimatingthedeleteriouseffectsofreal-exchange-rateapprecia-tioninthecontextoftradeliberalization.butDTes’domestic policies and economic structures variedmuchmore than critics typically emphasized. Forinstance, someGovernments had relatively inter-ventionistmodelsofeconomicgovernance(e.g.asinbrazil),whileothersengagedinmorefreemarketreforms,includingfinancialliberalization(e.g.asinArgentina,ChileandUruguay).Athirdsethadopencapitalaccountsbutimposedlimitsonprivatesectoraccesstoexternalfinance(e.g.asinMexicoandthe

bolivarianRepublicofVenezuela)(Díaz-Alejandro,1984).Whatthesecountriesdidsharewerethesameexternaleconomicconditionsthatgeneratedcapitalflowbonanzasintheyearsleadinguptothecrisis,aconsequentbuild-upoffinancialfragility,andtheinevitablecrashthatfollowedontheheelsofcom-mon economic shocks (Stiglitz, 2003).31 explicitandimplicitpublicguaranteesofprivatedebtthentransformedthecrisesintosovereigndebtproblems.

Predictably,giventhedominanteconomicpara-digmoftheera,earlyeconomicmodelsthatgrewoutoftheexperiencesofthe1980sdebtcrisesfocusedprimarilyonthechallengesof“fiscalsustainability”,andhowfiscaldeficitsandexpansionarypolicies,forinstance,madeeconomiesvulnerabletospeculativeattacksinthecontextofeffectivelyfixedexchangerateregimes(e.g.Krugman,1979;obstfeld,1994).Accordingly,governmentmisstepscouldgeneratealossofinvestorconfidence,inducingaself-fulfillingprophecyasinvestorfearswouldfuelthecurrencydepreciationthathadsparkedtheiruneaseinthefirstplace(Krugman,2014).Theconventionalwisdomthat emerged emphasized getting a country’s fis-calhouse inorder,and lettingmarketsdo the rest(Calvo,2005).Thisperspectivewasalso reflectedinthepolicyprescriptionsassociatedwithstructuraladjustment,whichaccordedprioritytoservicingdebtandrequiredliberalizationandprivatization.

(b) The return of capital flows to Latin America

in1989,MexicosignedontotheUnitedStatesGovernment’sbradyPlan,whichwasdesigned tofurtherencouragefreemarketreformsandeasedebtburdensbyconvertinggovernmentdebtintobondscollateralized byUnited StatesTreasury bills.Anumberofothercountriessweptupinthe1980sdebtcrisissoonfollowedMexico’sexample.Thismarksthebeginning,particularlyinlatinAmerica,oftheerawheretheWashingtonConsensusoneconomicpolicydominatedmuchof the thinkingonhowtomanageglobalintegrationandthedomesticeconomy,includingstrongcommitmentstofinancialliberaliza-tionandprivatization (Damill et al., 2013).Thesereformsanddebtrestructuringseasedconcernoverfiscaldebt,allegedastobethekeypolicymistakeof the1980s,andreopenedaccess to internationalcapitalfordebtorcountries.

Trade and Development Report, 201542

Attracted by relatively high rates of return,and reassuredbydomesticpolicy reformsand theprospectofasatisfactoryconclusionofthenegotia-tionsontheNorthAmericanFreeTradeAgreement(NAFTA),portfolio investorsherded intoMexico,driving booms in domestic credit (helped by theprivatizationofcommercialbanks)andstockprices,butthisdidlittletoboostrealGDPgrowth(Grabel,1996). in1994,an increase in interest rates in theUnitedStates, aswell as a series of destabilizingpoliticalevents,endedthecapitalflowbonanzaandnecessitatedthedrawingdownofreservesinorderto finance the substantial current account deficit(Moreno-bridandRos,2004).internationalinves-tors became concerned thatMexico’s exchangerate,whichwas essentially pegged to theUnitedStatesdollar,washeadedfordevaluation.Astheseself-fulfillingcrisestypicallywork,theconsequentcapital outflows induced the currency crisis thatinvestors had feared. in the lead-up to the crisis,Mexico’sincreasingrelianceondollar-denominateddebtinstrumentscalledtesobonosintroducedaddi-tional risks, stoking investors’ fear of default andcrisis (lustig, 1995).TheClintonAdministrationhelpedsecureaquickbailout thatgavepriority tobond repayment and furthered neoliberal reforms(FitzGerald,1996;Grabel,1996).

TheMexicancrisiscreateddevaluationpressureamonganumberofotheremergingmarketsaswor-riedinvestorsre-evaluatedriskinthecontextoffixedexchangerates(theso-called“tequilaeffect”).ThestrongestimpactwasfeltinArgentina.inearly1991,Argentinahadestablishedacurrencyboard,whichmaintainedafixedpegofitscurrencytotheUnitedStatesdollarandestablishedthatthemonetarybasewouldbeentirelycoveredbyinternationalreserves(an arrangement that persisted to 2001,when thecrisisthattheschemehelpedtobuildfinallyerupted).Whiletheregimewaseffectiveatcurbinghighinfla-tion,theliberalizationoftradeandfinanceledtoanappreciationof the real exchange rate, increasingcurrentaccountdeficitsandexternaldebt(Damilletal.,2013).WhentheMexicancrisisstruck,Argentinaalso faced sudden capital outflows,mainly fromresidents’depositsindomesticbanks.ThepressureonArgentina’sbanksprovedtoostrong,forcingthegovernmenttonegotiateabailoutagreementwiththeiMFin1995.iMFsupport,whichwasconditionalon theGovernment tightening its fiscal policy byincreasingtaxes,openedthewayforsignificantfor-eignfinancingofgovernmentdebt(Calcagno,1997;

boughton,2012).brazilavoidedasimilarfatelargelybyraisingshort-terminterestrates,whichintroducedotherfragilities(i.e.persistentlyhighinterestrates,includingonpublicdebt)thatrendereditsusceptibletocrisislaterinthedecade(Palma,2011).

Thoughlimitedinscopeandrelativelyshort-lived,thesecriseschallengedsomeoftheconventionalwisdomon thedetermining rolesof fundamentalsandliberalization,aswellasthereputationofsomeofthe“starstudents”thathadfollowedthispolicyadvice (boughton, 2012: 487–488).Thereweresomeeffortstosuggestthelackofdomesticsavingsasaninsufficientlyrecognizedvulnerability,butthespectacularsaverscaughtupintheAsianfinancialcrisis a couple of years later quickly underminedthatlineofreasoning(Calvo,2005).Amoreendur-ingalternativeexplanation,forwhatwouldbecomea commonneoliberal “exceptionalism” story, laidthe blame for the crisis squarely on theMexicanGovernmentforeconomicmismanagement,politicaloverreachandcorruption(Grabel,2006).echoesofthisreasoningwouldreappeartotryandexplaintheAsianfinancialcrisis.

(c) The Asian financial crisis and beyond

iftheMexicancrisiscaughtmanybysurprise,theAsianfinancialcrisiscameasaveritableshock.Mostoftheregion’smacroeconomicfundamentalsseemed indisputably sound: growth and savingsrateswerehigh,andsincefiscalpolicywasgener-ally conservative,most borrowingwasprivate. in1996,theyearbeforethecrisishit,currentaccountdeficitsinMalaysiaandThailandwereonthelargeside,32andtheregion’soverallgrowthhaddeclinedslightly,butnoneofthisreallyjustifiedtheextremealarmandconsequentdislocation thatwouldsoonfollow(Krugman,1999).

Aswithothercrises,thepathwaytotheAsianfinancial crisis beganwithfinancial liberalization,bothonthecapitalaccountandindomesticfinancialmarkets(Montes,1998).Thesereformswerepartlyinresponsetopressurefromdomesticfirmsandbanks,whichwereeagertoaccesslowerinterestloansinglobalcapitalmarketsforinvestmentsathome;andlargeinstitutional investorsindevelopedcountrieswere happy to oblige (Wade, 1998). South-eastAsian governments caved in to the pressure, and,in some cases, had developed vested interests in

Financialization and Its Macroeconomic Discontents 43

allowingpropertybubblestogrow(Wade,2004).33The practical resultwaswidespread expansion ofprivatelending,muchofwhichwaslinkedtoshort-term,hard-currency-denominateddebt instruments(Grabel, 1999).At the same time, capital inflowswere associatedwith higher rates of inflation andrealexchangerateappreciation,leadingtoalossofinternational competitiveness andworsening cur-rent accounts (Chandrasekhar andGhosh, 2013).Thesechangesdroveevenmoreinvestors into therealestateandstockmarketbubbles,especiallyinSouth-eastAsia.Withgrowing signsofweaknessinThailand’s assetmarkets by 1995, and globalcapitalstartingtoshiftawayfromemergingmarketsastheUnitedStatesFederalReserveraisedinterestratesinMarch1997,investorsbecameincreasinglyworriedthatThailand’speggedexchangeratewouldnothold(Wade,1998).TheThaicentralbank,afterunsuccessfullyusingitsreservestodefendthebahtagainstspeculativeattacks,finallyletthecurrencyfloatinJuly1997.Thebaht’sconsequentdepreciationspookedinvestors,settingoffcontagionfirsttoneigh-bouringeconomies inSouth-eastAsia (indonesia,Malaysia and thePhilippines), and then toHongKong (China), theRepublic ofKorea andTaiwanProvinceofChina.34TheiMFswiftlymovedintohelpcontainthecrisis,pushinganagendathathassincebeencriticizedforpossiblyworseningthecon-tagionanddeepeningthecrisis(RadeletandSachs,2000),aswellasover-reachinginitsimpositionofmarket-orientedstructuralreforms(Crottyandlee,2004;Stiglitz2002).

outsideAsia,theRussianFederationwasnextto be pulled into a crisis. Soon after liberalizingfinance and allowingmore foreign participationin its stock andpublic bondmarkets, theRussianFederationfacedanincreasinglywidespreadreversalofcapitalflowstoemergingmarkets–initiallyledintheRussianFederation’scasebytheexitofinvestorsfrombrazilandtheRepublicofKoreainresponsetotheAsianfinancialcrisis(PintoandUlatov,2010).Declining commodity prices further compromisedtheabilityof theRussianFederation todefend itsfixed exchange rate, resulting in devaluation anddefaultin1998.Thelargeprivatesectorlosses(bothdomesticallyandamonginternationalinvestors)gen-eratedbytheRussiancrisisinducedasuddenstopofcapitalflowstolatinAmerica,whichmanifestedasaseriesoffinancialcrisesandlowgrowththatcametobedubbedthe“losthalf-decade”of1998–2002(TDR 1999;CalvoandTalvi,2005).

TheexperiencesofArgentinaandbrazilillus-trate these dynamics and their linkswith vulner-abilitiesestablishedinpriorcrises.brazil’ssystemof publicfinancingwas severelyweakened by itseffortstoweatherthetequilacrisis,whereinadditiontoraisinginterestrates,abankingsectorrestructur-ingloadedtheGovernmentwith lotsofadditionaldebt.Theeconomicslowdownandveryhighinter-estpaymentscausedbrazil’sinternalfiscaldebttosoarbetween1994and1998,withinterestonpublicdomesticdebtamountingto3.4percentofGDPin1994and7.3percentofGDPin1998(TDR 1999;SainzandCalcagno,1999).35Defendingthecurrencypeginlightofthesuddenstopincapitalinflowsandinsufficientreservesbecamequicklyuntenable,andcurrencycrisisanddevaluationensuedinearly1999.inArgentina,with unsustainable exchange rates,anyeconomicgrowthincreaseditstradedeficit,butthelackofgrowthledtoafiscaldeficit:neitherofthesedeficitswasconsistentwiththeconvertibilityregime.Thiscontradictioncouldbecircumventedaslongasexternalfinancingkeptflowing.However,when that stopped, toughfiscalausterityand iMFassistancecouldnotpreventaneconomicimplosion,arunondepositsandapartialdefaultonpublicdebt(Calcagno,2003;CalvoandTalvi,2005;Damilletal.2013;Grabel,2006).RealaverageannualpercapitaGDPgrowthinArgentinasankto-4.2percentdur-ingthelosthalf-decade,whiletheaverageforlatinAmericaasawholewas0.2percent.36

(d) Public sector finances in the context of financial liberalization and systemic risk

Thisbriefreviewclearlysuggeststhatthelikeli-hoodoffinancialcrisesincreasedasDTesliberalizedtheircapitalaccountsanddomesticfinancialmarkets,whichledinitiallytosurgesincapital inflowsandthen to the sudden stops or reversals that almostalwaysensue.37Andalthoughcapitalflowbonanzasincreasedintandemwithfreemarketpolicystancesindevelopingcountries, they continued tobe sig-nificantly driven by circumstances external to theeconomiesthathostedthem,suchaschangesinglob-alcommoditypricesorinUnitedStatesinterestrates,or by the psychological and economic contagioneffects of crises elsewhere.These external forcesinteractwithdomesticmacropolicyandstructureinwaysthatraiseoverallfragilityandrisk.butdomesticfactorsareonlysignificantwhentheyexistwithina larger global financial system characterized by

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toomuchliquidityandnotenoughmacroprudentialregulation,ridingonwavesofoptimism,excessiveprivaterisk-takingandover-borrowingthatprecedetheinevitablecrash–adynamicthatisendemictothefinancialsystemitself(Minsky,1992).

Thelargelyprivaterisk-takingassociatedwithfinancialliberalizationthenbecomesapublicdebtproblem.Themost proximate reasons involve theexplicit and implicit guarantees that governmentsprovide on private liabilities and the nationaliza-tionofbadprivatedebts.butafinancialcrisisalsosystematicallyreducespublicrevenuesandwealththroughtheeffectsofexchange-ratedepreciationonpublicassetsandliabilities,increasesinrealinterestrates,declinesinrealoutput,andtheadditionalbor-rowingrequiredtodealwiththecostsofthecrisis(debolleetal.,2006).Althoughsovereigndefaultsareacommonfeatureoffinancialcrises inDTes,contrarytothecommonrhetoricarounddevelopmentmacroeconomics,inthecasesanalysed,largepublicdebtismostoftenaconsequence,notacause.

even among countries such asArgentina,Mexico and theRussianFederation,where publicdebtwasidentifiedasamajorsourceofthefinan-cialfragilitythatpushedtheireconomiesintocrisisinthe1990s,thereisampleroomforqualification.Table2.2takesacloserlookatpublicdebtforthesethreecountriesintheirrespectivepre-andpost-crisisyears.ReferencelevelreferstopublicdebtasashareofGDPthreeyearspriortothecrisisdate(T-3),and

pre-crisisgrowthtothepercentageincreaseinthatleveloverthethreeyearsleadinguptothecrisis.bywayofcomparison,thegrowthinpublicdebtafterthe crisis presented in table 2.1 is repeated here.Total and external public debt as a share ofGDPforMexicowasactuallyon thedeclinebefore thecrisis,whilethepre-crisisdebtlevelsoftheRussianFederationandArgentinacertainlydidnotportendthecrisesthatfollowed.However,thesefiguresdonotcapturehow the structureofdebtmakesDTegovernmentsmorevulnerablethantheirdebtlevelssuggest(e.g.theextentofforeign-exchange-linkedliabilitiesandshort-termmaturities).eventhen,thereareargumentstobemadeabouttherespectiverolesoffiscalprofligacyversushavingtobendtotherulesofglobalfinancialmarkets.

3. Looming losses: Fiscal stance, macro policy and aggregate demand

This chapter shows that exposure to unregu-latedandlargefinancialflowsaltersmacroeconomicdevelopmentsinwaysthatcanleadtoaslowdownofGDPgrowthaswellasunstableinternaldynam-icsmarkedbysuddenshiftsofincomeandwealthbetween themain sectors (private, public andexternal).Aconvenientwaytomaptheseshiftsandtheirrelationshipwitheconomicgrowthisbyusingthe“demandstances”framework(seeGodleyandCripps, 1983;Godley andMcCarthy, 1998; and

Table 2.2

FINANCIAL CRISIS AND PUbLIC DEbT IN MExICO, ThE RUSSIAN FEDERATION AND ARGENTINA (Per cent)

Total gross public debt as a share of GDP

Total gross external public debt as a share of GDP

Country (crisis date)Reference

levelPre-crisis

growthPost-crisis

growthReference

levelPre-crisis

growthPost-crisis

growth

Mexico (1994) 42.6 -29.2 26.4 37.3 -10.7 47.0Russian Federation (1998) 30.2 34.1 39.5 31.0 4.0 96.4Argentina (2001) 37.6 19.8 208.1 47.9 6.2 149.9

Source: UNCTAD secretariat calculations, based on data from Reinhart and Rogoff, 2010a. Note: Time T refers to the crisis year in parentheses. The columns refer to the following: Reference level is debt as a share of GDP at (T-3); Pre-crisis growth refers to the percentage change between (T-3) and (T-1); Post-crisis growth refers to the percentage change between (T-1) and (T+3).

Financialization and Its Macroeconomic Discontents 45

Taylor,2001and2006).ThisframeworkreassertstheKeynesianprinciplethatsustainedgrowthrequirescontinuouslyincreasinginjections(which,insimplemacroeconomic terms, includeprivate investment,governmentexpenditureandexports)intotheflowofincome.Theseinjections,inturn,requireasteadygrowthofleakages(measuredbythepropensitytosave,thetaxrateandtheimportpropensity),whichover time ensurefinancial stability, as credit risesalongthecircularflowofincome.ThusGDPgrowthcanbeexplainedasthegrowth,alongstablenorms,of injections relative to leakages; theseeventuallydeterminefinancialtransfersbetweenthemainsec-tors.Suchratiosofinjectionstoleakagesaretermedstancesandprovideameasurebothofdemanddriversandfinancialbalances.38

Therefore, ausefulway to assess changes inbehaviouristotracethepatternsofthethreestances(fiscal,privateandexternal)alongthepathofgrowth.eachofthethreestancescanbeobservedrelativetoGDPinordertoseewhichcomponentsofaggregatedemandarecontractionaryandwhichprovidestimu-lustotheeconomy.Weakerfiscalstances(declinesingovernmentexpenditurerelativetothetaxrate),weakerprivatestances(declinesininvestmentrela-tivetothesavingspropensity),andweakerexternalstances (declines in exports relative to the importpropensity)adverselyaffectthegrowthpathandmaygeneratefinancialimbalancesthatincreasefinancialinstability.

Applyingthisframeworktothecrisesdiscussedintheprevioussectionandlistedintable2.1,wefindthatintwothirdsofthesecases,theleadingsourceofdemandshiftedawayfromthedomesticstances(pri-vateandgovernment)beforethecrisis,andtowardstheexternalstanceafterthecrisis.39Thisreflectsatendency,post-crisis,forexternalaccountstogointosurpluswhiledomesticsourcesofdemandtaperoff.Structuraltrendsandcyclicaleffectsjointlycomeintoplay.Currentaccountliberalizationpriortoacrisis,alongwithfinancial inflows and strong exchangerates,allowanexpansionofdomesticdemandwithsubstantial import leakages.After a crisis,wagecompression and lower profits, alongwith fiscalcontractionandinterestratehikestoattractcapitalinflows,weaken private sector stances and lowerimports.Strongerexternalstancesmostlyderivefromadecline indomesticdemandand theconsequentswiftreductionofimports.Regardingthedomesticsectors,thetriggersareashifttowardsdeleveraging

of households (higher saving propensities) and acontractionofgovernmentexpenditurewhenauster-ityisapplied(particularlyafterprivatesectorlossesaretransferredtothepublicsectorandfiscalimbal-ancesgrowasaresult).Further,depreciationoftheexchangeratecanfrequentlymaketheforeignsectortheleadingsourceofeffectivedemandwithoutanysubstantialincreaseinrealexportcapacity.

TwoadditionalconsiderationsservetohighlighttheusefulnessoftheframeworkdescribedabovetotracedemanddriversinsomeDTesafterthecrisis:(i)thebufferroleplayedbycommodityexportrev-enues, and (ii) changingviewson countercyclicalfiscalpolicyamongDTes.Risingcommodityprices(atrendnowinreversal)havesustained–attimesnarrowly – private sector profitability, preservingoptimisminthefaceofongoingfinancialvolatility.inaddition,whengrowthacrosstheSouthdeceleratedin2009duetoacontractionofexportstotheNorthandthesuddenstopofcapital inflows,countercyclicalpolicyresponsesmadearecoverypossiblein2010(GrabelandGallagher,2015).Despitetheseephem-eralreversalsoncountercyclicalpolicyconventions,powerfulfinancialmarketinstitutionsmaintaintheirbiased,short-termperspectivewhichhangson theimportanceoffinancialratings(seealsochapteriV).Apolicyaversiontoprovidingastrongfiscalstimulushasbeentherule.Fiscalorthodoxyandanexcessiverelianceonmonetarypolicyhavegeneratedfinancialfragilityandexchange-rateinstabilityinmajordevel-oping economies (Akyüz, 2013).Susceptibility tofinancialpressuresisheightenedeitherwhenpublicsectorsincurdebtdirectlyor,asismorefrequentlythecase,circuitouslywhenincreasedliquiditygener-atesprivatesectordebtthatisultimatelytakenonbythepublicsector.interestpaymentsondebt,whetherpublicorprivate,furtherdampendomesticstances.

To summarize, themost important elementsthat were present in previous crises andwhichpersisttodayare:opencapitalaccounts;hotmoneycyclesworsenedbymonetaryexpansion indevel-oped countries and a consequent rise in externaland internaldebt (inparticular short-termdebt);ashiftawayfromdeepeningindustrialdevelopment;andconstraintsonusingfiscalpolicyasa toolforstructural transformationand industrialexpansion,asmonetarypolicycontinuestopromotethedefla-tionarytrendsfavouredbyglobalfinancialinvestors.Verybroadly,thesefeaturesapplytomanycountriestodaytovaryingdegrees,dependingontheirfinancial

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flows,stocksofdebt,andmovementsinexchangeratesandinterestrates.Clearly,themostvulnerable

economiesare thosewheredomesticactivitiesarehighlyconcentratedinonlyafewsectors.

The analysis in this chapter has focused onthe reshapingof globalfinancialmarkets, leadingtotheGreatRecessionanditsaftermathtothepre-sentday.Theextraordinarygrowthofunregulatedglobal financialmarkets, in tandemwithweakerdomesticregulationinmostDTes,hasexacerbatedthe vulnerabilities of these countries, rather thanproviding increased financing for developmentneeds (discussed in chapterVi of thisReport).The chapter has stressed that excessive privatecapital inflows, particularly those of an unstableor speculative nature, affect the configuration ofnet factorpayments, exchange rates, interest ratesandotherprices,andinfluencemonetaryandfiscalpolicystancesinperverseways.WhenDTesfacethethreatofsuddenstopsorcapitalflowreversalsasconditionsinglobalmarketschange,theresultscanbeevenworse. it isclear from thediscussionthatunderthesecircumstances,policymakers’searchfor alternatives to ensuremore stableoutcomes isbecomingincreasinglychallenging.

A significantlymore stablemacroeconomicenvironmentfordevelopmentisimplausiblewithoutcollectiveeffortstoreformtheinternationalmonetaryandfinancialarchitecture,thesubjectofchapteriii.Nevertheless,thereareanumberofoptionsthatstillremainwithinthepurviewofnationalpolicy.Tobeclear,noneoftheproposedrecommendationscallfordelinkingfromtheglobaleconomyintermsofeithertradeorfinance,butratherforbettermanagingthelinkstopromotedevelopment.

onesetofcriticalpolicychoicesrestsontheabilitytoinfluencetheexchangerate.Whileavoid-ing“cornersolutions”,suchasfixedexchangeratesor fully liberalized exchange rates, some sort ofmanagedfloatremainsanattractiveoption(Ghosh,

2007;Damilletal.,2013).Themanagementoftheexchange rate (as described by these authors andothers)withaviewtoguidingitsevolutionasatoolfordevelopmententailscombinationsofmonetarypolicy, central bankoperations and incomespoli-cies.Howthisisachievedinpracticedependsontheparticularcircumstancesineachcountry,includingtheirinstitutionaldiversityandtheirbalancesheets.40

Asdiscussedabove,guiding theevolutionoftherealexchangerateinanenvironmentoflargeandderegulatedglobalfinance,andaglobalexchangesystem dominated by a few reserve currencies,willbeextremelydifficultwithoutsomedegreeofmanagement of the capital account.The possibleuseofcapitalcontrolsasatoolfordevelopmentandfinancialstabilityhasgainedgreateracceptabilitybymanygovernmentsandinternationalorganizationsinrecentyears.indeed,UNCTADhasbeenalong-standingadvocateofsuchapolicy:intheearly1990s,itsuggestedthatDTesshouldconsidermeasuresthat“discouragecapitalflowsthatwerenotrelatedtorealinvestmentor to trade transactionsbutweremoti-vatedbyshort-termgains”(UNCTAD,2012b:50).Theseandcomplementaryrecommendationsaimedat restoring stability and averting systemic crisesare evenmore relevant in today’s context, as alsoevidencedbydevelopedcountriesseverelyhitbytheGreatRecessionanditsaftermath.Again,thecircum-stancesandscopeforactiondifferfromcountrytocountry,asdoesthedegreeofregionalcoordinationrequiredtoensuresuccess.

inanefforttoavoidthecurrencyandinterestrateriskshistoricallyassociatedwithexternaldebt,DTes have also shiftedmore of their borrowingfromdebtdenominatedinforeigncurrenciestoonedenominated in domestic currency.41 but not all

D. Concluding policy discussion

Financialization and Its Macroeconomic Discontents 47

developingcountriescanattractinternationalinves-torstodomesticsecuritiesmarkets.Andevenwhentheydo,thereistheadditionalriskthatlargersharesofdebt, regardlessofcurrencydenomination,willbe held bymore internationallymobile investors.Recent evidence bears out thiswarning: greaterforeignparticipationindomesticcurrencysovereignbondmarketshasbeenassociatedwithheightenedvolatilityasaresultofincreasedexposuretoglobalfinancialshocks(ebekeandKyobe,2015).

AsimilarlymixedresultisseeninthegrowthofinternationalreservesamongDTes.Thebuild-upofreservesisinprinciplemostlyprecautionary,inthesensethatitisexpectedtoguardagainstahostofillsintroducedbylargeandspeculativeinternationalcapitalinflowsandthenegativeeconomicandsocialconsequencesoftheirsometimessuddenorsubstan-tial departure. Precautionary reserve buffers alsohedgeagainstthelossofpolicyautonomythatoftenaccompaniesiMF-typebailoutsoragainstpressurestoprovidethemacropolicyconditionspreferredbyinternationalfinancialinvestors(Grabel,2006).butevenifreserveaccumulationdoesoffersomeprotec-tion,providingsomepolicyspacetocountrieswhosecurrenciesareunderattack,thereisanopportunitycosttotyingupdevelopmentresourcesinthisman-ner.Furthermore,whenpolicymakerstrytocountercapitalflowreversalsthroughtheuseofreserves,theyoftenendupresortingtocomplementarymeasures,suchasinterestrateincreases,asthestockofreservesdeclines.Thesepolicyresponsesultimatelyweakentheeconomyanderodeconfidenceevenfurther.Asnoted above, such trade-offs pose a challenge tocentralbankpolicy.

in considering policy options, central banksinDTesshouldcarefullyevaluatetheimplicationsof narrowly applied inflation-targeting regimes.Pressingtoohardtoachieveinflationratesdeemeddesirablemoreoftenindeveloped-countrycontextscould easily lead to high interest rates and appre-ciation of the real exchange rate, both ofwhichdiscourageproductiveinvestmentandhencedevel-opment.Still,thewidespread(formalandinformal)adoptionofinflationtargetingbysomedevelopingcountries’ central banks reflects real apprehensionover anyhint of inflation, given their histories ofhigh inflation.butprobablymore important is thewidespreadbeliefthatinflationtargetingregimesgivemorecredibilitytothecentralbanksthatimplementthem,loweringexpectationsofinflationandenabling

higheremploymentratesforagivenlevelofinflation.However,theempiricalevidencedoesnotsupportthecredibilityargument(epstein,2007).indeed,stablepriceformationprocessesandsustainedincreasesofhigh-quality employment in a developing countrycontextarecomplexgoalsthatrequireattentiontotheoverallstabilityofcreditandfinancialflows.

butcentralbankscandomorethanonlymain-tainpricestabilityorcompetitiveexchangeratestosupport development, as attestedby the historicalrecord.AftertheSecondWorldWar,centralbanksineuropeandJapanusedinterestrateceilings,sub-sidizedcreditsandcreditallocationpoliciestoguidereconstruction and facilitate industrial upgrading(epstein,2015).Similarpolicieswerefollowedbythenewlyindustrializingcountriesinthesecondhalfofthetwentiethcentury,wherecentralbanksprovidedkeysupporttodevelopmentbanksandtheirgovern-ments’fiscalpolicies(Amsden,2001;TDR 2013).Pricestabilitygoalscanstillhelpguidethesetypesof policy choices, aswhen targeted or subsidizedcredit encourages productivity and employmentgrowthratherthanactivitiesthatgenerateinflation-arypressures(epsteinandYeldan,2009),orwhenincomes policies ensure thatwage growth tracksproductivitygrowth.

However,asevidencedbythefailuresofdevel-opedeconomiestofullyemergefromtherecentcrisis,monetarypolicyaloneisnotsufficient.Proactivefis-calandindustrialpoliciesareessentialforgeneratingthestructuresandconditionsthatsupportdomesticproductivitygrowthandtheexpansionofaggregatedemand.Maintainingstrongandstablefiscalstancescanhelpincreaseproductionandincomes,generatehigh-quality employment, and encourage amoreegalitarian distribution of income (which exerts afurtherpositiveeffectonaggregatedemand).Policiesthatensurethatwageincomesincreaseconcomitantlywithproductivitygrowthenhancethesemechanisms.byextension,tradepolicyalsoneedstobealignedwith domestic goals and policies for productivityandwagegrowth,includinginglobal,regionalandbilateraltradenegotiations(seeTDR 2014).

Thesecircumstanceshighlighttheneedformoreeffective international policy coordination.Giventhe sheer size of global capital flows, individualcountries’managementmeasures, such as capitalcontrols, exchange ratemanagement, centralbankpolicyconsistentwithstrategicdevelopmentneeds,

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andatighterregulationofdomesticfinancialsystems,maynotbeenough.Domesticpolicyoptionsshouldbesupplementedbyglobalandregionalmeasuresthatdiscouragetheproliferationofspeculativefinancialflows. in addition,more substantialmechanismscouldbeestablished forcredit supportandsharedreserve funds at the regional level.At the sametime,implementingcountercyclicalmacroeconomicpolicies,improvingincomedistributionandextend-ingfiscal space for development purposes have a

significantlygreaterchanceofsuccesswhenappliedalsobypartnercountries,andeffectively,theworldatlarge.indeed,domesticpolicystimuli,whenappliedbyonlyafewcountries,areconsiderablyweakenedwhentheinertiaofmacropolicyorthodoxiesprevailsinpartnercountries.42Suchconditionscanevenyieldperverseeffectsifglobalinvestorsandinternationalfinancialinstitutionsrespondinwaysthatgenerategreatervolatilityanduncertainty.Theseaspectsarediscussedfurtherinthenextchapter.

Notes

1 Althoughmiddle-incomecountriestendtobemoreintegrated into the global economy, and as such,seeminglymoreexposedtotheeffectsoffinanciali-zation, themagnitudesofcapitalflowsrelative toGDPandtheirmacroeconomiceffectsdiscussedinthischapterapplytoallDTes(seesectionb.2formoredetail.)

2 Amongagroupof26developedcountries,allbut4(France,Japan,SwedenandSwitzerland)hadcon-tractionaryfiscalstancesrelativetotheir long-runtrendbetweenthesecondquarterof2010andthefourthquarterof2013(TDR 2014,chart2.1).

3 SeeChandrasekhar(2007)forananalysisoffactorsthatledtoanexplosionofgloballiquiditycreationbyprivateagentsafterthe1997Asiancrisis,whichwastransmittedtodevelopingcountriesthroughtheoperationsofhedge-funds,foreigndirectinvestmentintheformofportfolioequityandincreasedmergersandacquisitions.

4 Thinktanksprovidinganalyticalinsightsforinter-nationalinvestorstrumpetedthepotentiallyattrac-tive returns of developing economies. See, forexample,Accenture,2012;blackRock,2011;CreditSuisse, 2011;economist intelligenceUnit, 2011;UbS,2012;andAhmedandZlate,2013,foramorerigorous analysis of factors determining the rela-tiveattractivenessof emergingmarket economiesas investment destinations. (The latter study alsoevaluatestheinfluenceoftheunconventionalmon-etarypolicyoftheUnitedStatesasafactorinthecompositionofflows,alargeproportionofwhichareportfolioallocations.)

5 The crash inChina’s stockmarket in June–July2015,and theGovernment’s responses to it,echotheseworries(Bloomberg Business,“ChinastocksplungeasStatesupportfailstoreviveconfidence”,8July2015).

6 TheWorldbank’sInternational Debt Statistics 2015containsrecordsof125countries,ofwhich121areDTesaccordingtotheUnitedNationsclassification.Unlessotherwisespecified,theempiricaldiscussionreferstothisgroupof121DTes.elsewhereinthechapterthetermDTesreferstoalldevelopingandtransitioneconomies.

7 These are identified as all the 121DTesminusAlgeria,Argentina,brazil,China, egypt, india,Mexico,Morocco,SouthAfrica,TunisiaandTurkey.

8 ThereareafewexceptionsamongDTeswherecur-rentaccountdeficitsinthe2000sweresignificantlylargerthanthoseinthe1990s,including,mostnota-bly,india,SouthAfricaandTurkey.

9 even countries with a current account surplusobtainedadditionalfinancingtomanagetheirport-folios,increasetheirassetaccumulationbuffersinviewofuncertainties,andcopewithintertemporalinconsistencies (since expected expenditures aredecidedinadvanceofearnedincome),orevenforfinancialspeculationpurposes.

10 Thecurrentaccountisthesumofthetradebalanceandthebalanceontransfersandnetfactorincomes.Net factor incomes are primarily the earnings onoutwardinvestmentsandloanslesspaymentsmadetoforeigninvestorsandcreditors.Remittanceflowsfromresidentsworkingabroadarealsoaccounted

Financialization and Its Macroeconomic Discontents 49

asfactor incomesandforsomeDTes(e.g. india,MexicoandthePhilippines)thesizeofsuchflowsissubstantial.

11 Anystatisticalerrorsbetween thecurrentand thecapitalandfinancialaccountsinthebalanceofpay-mentsarecapturedbythe“neterrorsandomissions”category;thisitemisusedtopreservetheaccountingprincipleofequalitybetweenthecurrentaccountandthecapitalandfinancialaccounts.

12 ThediscussionthatfollowsdrawsfromtheanalyticalframeworkdevelopedbyKregel,2014a.

13 intheory,thesituationforsurpluscountriesexposedto unfettered capital flowswould present similarchallenges.eventheycouldfacedecliningtrendsinnetfactorincomes,andthereforedownwardpressureontheircurrentaccounts.Asidefromotherfactorsdrivingtheirexportsuccesses,theprospectsoffall-ingnetfactor incomesmightgeneratepressure tocompensatebyaimingatevergreatertradesurpluses.

14 Whiletheaggregateperspectivetakeninthissec-tion is critical for pinpointing themacrofinancialimplicationsofcapitalflowsinthecurrentcontext,thedetailedanalysisbelowshedsadifferentlightbydistinguishingbetweenmoreunstableandspecula-tiveshort-termflowsandthosethatarelongertermandmorelikelytobebetterlinkedtodevelopmentneeds.

15 Thisconfigurationofpoliciesisfound,forinstance,in theUnitedStates, theeurozoneand theUnitedKingdom,andonlypartiallyinJapanwherequan-titative easingwas accompaniedby somedegreeoffiscalrelaxation.SeeTDR 2014foranextensiveanalysis.

16 Thisperspectiveisinlinewithrecentstudiessuchas those byGallagher (2015),Kaltenbrunner andKaracimen (forthcoming), Kaltenbrunner andPanceira(2014)andPowell(2013).

17 Some countries of similar relevance, such as theRussianFederation,arenotincludedduetothelackofdetaileddataintheWorldbank’sInternational Debt Statistics.

18 Thespikeinprivatecapitalinflowsrecordedin2005is in fact theway theWorldbank recorded debtrelief.

19 ForadiscussionaboutchannelingFDiforthegoodofdevelopment,seethejointUNCTAD/ilovolumeonindustrialpolicy(Salazar-Xirinachsetal.,2014).

20 SeeFinancial Times,“RealestateandChinadomi-nateFDiflows”,4June2015.

21 UNCTAD,2015:18,tablei.5.22 between2011and2013,netFDiinflowstoDTes

consistedof,onaverage,reinvestedearnings(45percent)andintra-firmloans(22percent);theremain-ing33percentconsistedofequity,includingmerg-ersandacquisitions(UNCTAD,World Investment Reportdatabase).

23 Forarecentreview,seeThirlwall,2011.

24 SeePatnaik(2007)forananalyticalexposéofthelimitedeffectivenessofprecautionaryholdingsofforeign-exchange reserves; and alsoTorijaZane(2015),with special reference to central banks inlatinAmerica.

25 Forformalderivationsofthepointsmadehere,seePatnaikandRawal,2005;andPatnaik,2006.

26 Herndon et al. (2013) replicate and empiricallychallengeReinhartandRogoff(2010band2010c),whosewritingshavebeenwidelyused tosupportfiscalausterityargumentsbasedonthestylizedfind-ingthatpublicdebtexceeding90percentofGDPreducesgrowth.Herndonetal.(2013)concludethatReinhart’sandRogoff’sselectiveexclusionofdata,codingerrorsandinappropriateweightingofsum-marystatisticsunderlietheresultonpublicdebtandgrowth.Whentheseerrorsarecorrected,theresultsshowthatthegrowthconsequencesofpublicdebtvaryandtheeffectsaremodest.

27 inlatinAmerica,thecontextofovervaluedexchangerates,expandingdomesticdemandandamoreopentraderegime,“ledtoincreasedimportsandagrow-ingcurrent-accountdeficit,whichwasfinancedbyforeigninvestorswhowereattractedbythepromiseofhigherreturns.However,thecreativeprocessoftechnologicalprogressandrestructuringremainedtobecarriedout,andthemacroeconomicenviron-mentofhigh interest rates, strongexchange ratesandvolatile capitalflowsdid little to support thenewinvestmentrequiredforsuchatransformation.Thuspolicyreformswereunsuccessfulbecausethe‘creative’elementinthe‘destruction’processfailedtobringaboutrealtransformationoftheproductivestructurethroughhigherinvestmentandtechnologi-calchange”(TDR 2003:145–146).

28 These ripple effects are grouped separately fromtheAsianfinancial crisis in order to differentiatebetween the regional contagionof that crisis andhowthesecostsmanifestedinotheremergingmarketeconomies.

29 Thesedataandtheterm“capitalflowbonanza”arefromReinhartandReinhart(2008),whonotethat,althoughabettermeasurewouldbereserveaccu-mulationlessthecurrentaccountbalance,thelongertimeseriesandgreaterconsistencyofdataonthecurrentaccountmakethisasatisfactorysubstitute.

30 ThissectionlimitsthediscussiontolatinAmerica.Many other developing countrieswere swept upinthesamecycleoffinancialcrises,butthelatinAmerican experience is emblematic of the largereconomicforcesatwork.

31 evenbrazil,whichhadcapitalcontrolsanddidnotexperiencemuchcapitalflight,sufferedbecauseofthegeneralsuspensionoflendingtolatinAmerica(Díaz-Alejandro,1984).

32 As a share ofGDP, the current account deficitsofThailandandMalaysia thatyearwere-8.1and

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-4.4 per cent respectively (iMF,World Economic Outlook database,october2014).

33 Wade considers theRepublic ofKorea a differ-entcaseonthegroundsthatthereitwasmoretheindustrialconglomeratesthathadlinkswithfinancethroughtheiraccesstocheapforeigncapital,ratherthanvestedinterestsinproperty.

34 TaiwanProvinceofChinaandHongKong(China)successfullyfendedoffspeculativeattacks,buttheRepublicofKoreawasmuchmoreexposedbecauseofshort-termdebt.

35 by contrast, government spending on goods andservicesasashareofGDProsefrom19.2percentin1994to20.6percentin1998,withthebulkoftheriseoccurringin1995(whenitincreasedto21percent) as a result of a one-timepositive shock ofinflation-related adjustmentofwages and salaries(UNCTADstat).

36 Source:Worldbank,World Development Indicatorsdatabase.

37 See alsoDemirgüç-Kunt andDetragiache,1998;ReinhartandReinhart,2008;andWeller,2001.

38 inmathematicalterms,themainaccountingidentitydefinesGDPasthesumofconsumption(C),privateinvestment (i), government expenditure (G) andexports(X)minusimports(M).Simpleassumptionsallowspecifyingthetaxrate(t)andthesavingsandimportpropensities,sandmrespectively,as:

T=t·GDP;S=s·GDP;M=m·GDP, whereTstandsfortotaltaxrevenueandSforprivate

savings.Arrangementsoftheseequationsaroundtheaccountingidentityyieldtheexpression:

GDP=(G+i+X)/(t+s+m),oralternatively: GDP=wt·(G/t)+ws·(i/s)+wm·(X/m) wherewt,ws andwm are theweights of each of

the leakages (tax, savings and import propensi-ties, respectively).This equation establishes thatgrowthofGDPdependsonthegrowthofthethreevariables,G/t,i/sandX/m;definedasfiscalstance,private stance and external sector stance, respec-tively, amplifiedby the strengthof the respectivemultipliers, given thementionedweights, in themacroeconomic context.To avoid complicatingthepresentationwithderivationofthesteadystateconditions,itissufficienttonotethatthesestancesreflectfinancialconditionsaswell,wherealargernumeratorthanthedenominatorpointstowardsanetborrowingposition.Thus,asteadypathofsustainedgrowthandfinancialstabilityrequiresthatnoneofthesestancesgrowataproportionally fasterpacethantheothersforaprolongedperiodoftime.

39 Theexternalaccountbecametheleadingdriverin40percentofthesecases,andbecamesignificantlymoreimportantinanother27percentofcases.

40 SeeFrenkelandTaylor(2006)foradiscussionofthevaryingcircumstancesandchallenges thatareassociatedwithmanagingtheexhangeratetosupportdevelopment.

41 DatafromtheWorldbank(2013) indicate thatattheendof2012theshareofnon-residentholdingsinlocalDTedebtmarketswas26.6percent,andthatitwasashighas40percentinsomeeconomies(citedinAkyüz,2014:20).

42 SeeTDR 2013, annex to chap. i,where a globalmodel simulation provides empirical illustrationofthefactthatpoliciesbasedonimprovedlabourincome and supportivefiscal policy yieldweakerresults,evenifstillpositive,whenpartnercountriestakeanoppositestanceandprofitinatypical“free-rider”manner.

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Systemic Challenges in the International Monetary System 55

The tensions and troubles in today’s globaleconomyemergefromtheinteractionbetweenweakeffectivedemandandpersistentfinancialinstability.Theglobalfinancialcrisisin2008wasareminderof the economic and social damage that such aninteraction can generate.Muchof the subsequentreform effort has concentrated on repairing bankbalancesheets,strengtheningregulatoryframeworksand improving the resilience of financial institu-tionstoshocksthroughactionsatthenationalandinternationallevels.Thisisanongoingprocess(seechapteriVofthisReport).butthesuccessofsucheffortsiscloselyrelatedtoglob-almacroeconomicforceswhosecurrentweakness stemspartlyfromthemalfunctioningoftheexistinginternationalmonetarysystem(iMS).

Themain functionof theiMS is to contribute towardsglobal macroeconomic andfinancialstabilitybymaintain-ing stable exchange rates, ensuring sustainablecurrent account positions, providing an adequateamountofinternationalliquidityandenablingorderlyadjustmentstoexternalshocks.Theerosionandeven-tualbreakdownofthesystemalongallthesefronts

contributedtotheaccumulationofglobalmacroeco-nomicandfinancialimbalanceswhichfacilitatedthebuild-upofunstablefinancialmarketconditionsthateventuallytriggeredthecrisis(e.g.UnitedNations,2009;Kregel,2010;DorrucciandMcKay,2011;seealsoTDR 2010).

Theglobalspreadofthecrisisfromitsoriginsinthefinancialmarketsofdevelopedcountries,aswell as those countries’ subsequent approaches tocrisismanagement, have revealed the inadequacyof existing global safety nets to dealwith large

adverse shocks.The crisis hasalsorevealedthetendencyofthecurrentiMStocreatesubstantialinstability in the provision ofinternational liquidity1 and itsinability to provide sufficientsupporttotherecoveryofglobalaggregate demand.Moreover,ongoing financial instabilityraisesquestionsabouthowsup-portivetheglobalenvironment

will be for attaining theSustainableDevelopmentGoals(SDGs)thatarecurrentlythesubjectofdebateonthePost-2015DevelopmentAgenda.Allthesefac-torspointtotheneedformorefundamentalreformoftheiMS.

Chapter III

SySTEMIC ChALLENGES IN ThE INTERNATIONAL MONETARy SySTEM

A. Introduction

The current IMS creates substantial instability in the provision of international liquidity and is unable to adequately support global economic recovery.

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Thischapterexamines theweaknessesof thecurrent iMS, and proposes some elements for itsreform.itfocusesonthreefundamentalchallengescommonlyperceivedasconfrontinganyiMS(see,forexample,UnitedNations,2009;ertenandocampo,2012),andexamineshowthesechallengesandtheresponsestothemhavechangedovertime.itsuggeststhatthereformsaimedataddressingtheinadequaciesofthecurrentiMSexposedbytheglobaleconomicandfinancialcrisishavebeentimidatbest.

Thethreefundamentalchallengesare:

• First, regulating the provisionof internationalliquidity.Traditionally,privateandpublicagentsofdifferentcountrieshavewillinglyacceptedoneorseveralnationalcurrenciestouseasaunitofaccount,asameansofpaymentsorasastoreofvalueintheirinternationaleconomicandfinancialactivities.Thedollarhas,predominantly,servedthese purposes since the end of the SecondWorldWar,but thishasbeenassociatedwithlargeswingsintheavailabilityofinternationalliquidity and in exchange rates. Furthermorefinancialglobalizationandtheincreasingroleofprivatefinancialintermediariesintheprovisionofinternationalliquidityhavecompoundedthecomplexityofthischallenge.

• Second,providingaccesstoshort-termliquid-ity formanaging shocks.2The internationalMonetaryFund(iMF)wasdesignedtoprovidesuchfinanceinordertopreventcountriesfromresorting to a combination of trade restric-tions and competitive currency devaluations.However, developing countries have increas-ingly shunned iMF assistance, especiallyfollowing theAsian crisis in 1997–1998, infavourofaccumulatinglargeforeign-exchangereservesasaformofself-insuranceandafirstlineofdefenceagainstexternalshocks.

• Third, ensuring amore equitable sharing oftheburdenofcurrentaccountadjustment.3Theasymmetric adjustment process implied by

curtailedspendinginthedeficitcountrieswith-outoffsettingspendingincreasesinthesurpluscountries represents the so-called “contrac-tionarybias”oftheiMS.Thishasparticularlyundesirableimpactsonglobalmacroeconomicdynamismwhenglobaloutputgrowthisalreadyanaemic,asiscurrentlythecase.

Thischaptersuggeststhattheincreasedroleofshort-termprivateinternationalcapitalintheprovi-sionofinternationalliquidityhascausedboom-bustcycles,andhasleddevelopingcountriestoaccumu-latelargeamountsofforeignexchangereservesinspiteoftheinequitythattheassociatedtransferofresourcestoreserve-currencycountriesimplies.initscurrentform,theiMSwillcontinuetogeneratebothinstabilityandinequity,andforcedevelopingcountriestoadjusttotheeffectsofpoliciesbeyondtheirowncontrol.

Thechapterdoesnotprovideacomprehensiveblueprintforreform.Rather,itfocusesonthemajordifficultiesinmeetingthethreechallengesdescribedabove,anddiscussesvariousproposalsaswellastheconditionsrequiredtoimplementthoseproposals.

Thechapterisorganizedasfollows.Sectionboffersahistoricalaccountofthewayinwhichsuc-cessiveformsoftheiMShaveaddressedthethreechallengesmentionedabove.italsoexamineshowthepost-brettonWoods era has accentuated thesechallenges.onthebasisofthisanalysis,sectionCevaluatesanumberofproposalsforacomprehensivereformoftheexistingiMSthatwouldleadtoanew,centrallyadministerediMS,aswellassomemoreincrementalchangeswhichmightbeeasiertoimple-ment.Thediscussionofsuchincrementalchangesincludesproactivemeasuresthatdevelopingcoun-triescouldtaketobetterattaintheirdevelopmentalgoals.Thewaysinwhichgreaterregionalmonetarycooperation could help dealwith the contraction-arybiasoftheiMSandprovidesteppingstonesformorecomprehensivereformsinthefuturearealsodiscussed.SectionDsummarizesthemainconclu-sionsandsetsoutapolicyagenda.

Systemic Challenges in the International Monetary System 57

Anyinternationalmonetarysystemwillfacethethreechallengesnotedabove.Theprevailingglobaleconomicandinstitutionalsituationdetermineshowthesechallengesmanifestthemselves,aswellasthenatureandeffectivenessof the responses to them.Thisisthefocusofthissection.

1. The gold standard and the Bretton Woods system

Theclassicalgoldstandard,whichlastedfromaround 1880 to the beginning of the FirstWorldWar, supposedlymanaged these three challengesby linking the provisionof global liquidity to thephysical availability of gold, andmaking pricesadjusttochangesinthedomesticstockofgoldthatresulted frommovements on the current account.However, itsactualfunctioningdidnotdependonthe automaticworking of the“pricespecieflow”mechanismthat was designed to ensuresymmetricadjustment;rather,itdependedonthedominantroleplayedbytheUnitedKingdomas themajor source of globalcapital flows at that time andthe entrepot forworld trade,andthereforebythesetofcom-mercial,financialandpoliticalnetworkscentredontheCityoflondon(seeTriffin,1961;deCecco,1974;Panic,1992;andeichengreen,1992).Thisenabledaperiodofrelativeeconomicstabilityintheglobaleconomy,alongwithlargecross-borderflowsofcapital(andpeople)andexpandingtradeflows.However,stabilitywasconcentratedincountriesthatcametoconstitute

the“core”oftheworldeconomy.ContinuouscapitalflowsfromtheUnitedKingdomensuredthatsomecountries,suchastheUnitedStates,couldrunlargecurrentaccountdeficitsforprolongedperiods,whiledeveloping countrieswith current account deficitsexperiencedmuchgreatervolatilityofcapitalflowsandmore damaging adjustment because surpluscountriesdidnotfeelthepressuretoadjust.Thesys-temcollapsedontheeveoftheFirstWorldWar,bywhichtimeitwasevidentthatthemajoreconomies− andparticularly theUnitedKingdom−hadnotadheredtotherulesandhadexpandedtheirdomesticmonetarybasefarbeyondwhatwasjustifiedbytheirgoldholdings.

efforts to re-establishgold standard arrange-mentsaftertheFirstWorldWarconfrontedthedualproblemsof higher nominal prices resulting fromwartimeinflationandtheshiftingpositionsofcredi-torsanddebtors.ThisaffectedtheabilityoftheUnitedKingdomtotakeonthemantleofglobaleconomic

leadership.Withtheburdenofadjustment falling heavily onthedeficit countries, includingtheUnitedKingdom, this sys-temprovedtobeimpossibletomaintain.TheUnitedKingdommoved to themassively over-valued pre-war exchange-rateparityin1925,andwaseventu-allyforcedtoexitfromthegoldexchange standard in 1931. italsomeantthatthesurpluscoun-

triesprovidednoexpansionaryimpulsetotheworldeconomythatcouldhaveoffset thecontractionarymeasures that the other countrieswere obliged toadoptasaresultofthedeclineintheirgoldstocks.Thecombinationofthesefactorshadahugecontrac-tionaryeffectontheworldeconomythatcontributed

B. The international monetary system: Main challenges and evolving responses

The Bretton Woods conference aimed at a system that would prevent the restrictive trade practices and competitive devaluations of the interwar period.

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totheGreatDepression,leadingtosharppricefallsandthethreatofdebtdeflation(eichengreen,1992).

insteadofengaginginexpansionarymacroeco-nomicpoliciesinacoordinatedway,manycountriesrespondedtothisbyabandoningthegold-exchangestandardanddevaluingtheircurrenciesinanefforttoboostnetexports,andbyresortingtoprotectionistmeasurestorestrictimports.However,onecountry’sadditionalexportsareanothercountry’sadditionalimports.Thus theneteffectof suchabeggar-thy-neighbourpolicywasheightenedvolatilityofboththeexchangerateandoutput,whichdepressedinterna-tionaltradeandexacerbatedthefallinglobaldemand.

Finding an international system thatwouldpreventtherestrictivetradepracticesandcompeti-tivedevaluationsoftheinterwarperiodwasakeyobjectiveofthebrettonWoodsConferencein1944.Conferenceparticipantsalsosoughttoeliminategoldasthemonetarybaseanddeterminantofexchangerates,anddiscussedwhetherandhowtheburdenofadjustmentshouldbesharedmoreequallybetweensurplusanddeficitcountries.

As is well known, the post-war iMS thatemergedfromthebrettonWoodsConferencelargelyfollowedthewishesofthedominantcreditorcoun-try,theUnitedStates.itsmainfeaturewasagridoffixedexchangeratesbetweenthedollarandallothercurrencies,combinedwiththepossibilityforcentralbankstoconvertdollarsintogoldatafixedparityof$35perounce.Theexchange-rateparitiescouldbechangedonlyincasesoffundamentaldisequilibrium,therebypreventingthecompetitivedevaluationsthattook place during the interwar period.However,thisalsoimpliedthatadjustmentthroughprices(i.e.exchange-ratechanges)rarelyoccurred,4takingplaceinsteadthroughchangesinquantities(i.e.changesindomesticdemand).

The system also sought to limit the size ofexternal imbalances, and thus theneed for capitalflowstofinanceexternaldeficits.ThiswasachievedbyprovidingloanstodeficitcountriesoutofnationalcurrenciescontributedtothenewlyestablishediMFbyitsmembers,subjecttoconditionsdeterminedbythe iMF’sboardofGovernors.However,becausetheseconditionswouldonlyapplytodeficitcoun-triesrequestingassistance,andbecauseiMFloanstodeficitcountrieswereaccompaniedbystrictpolicyconditionalities,includingrequirementsforcurrency

devaluationandmonetaryandfiscalcontraction,thesystemexhibitedacontractionarybiasatoddswiththe original intention of the architects ofbrettonWoods.

bytheearly1960s, thestockofforeign-helddollars started to exceed the value of theUnitedStates’goldholdingsintermsofitsdeclaredparityof$35perounce.Thisgaverisetowhatisknownasthe“Triffindilemma”:shouldtheUnitedStatesnolongerprovidedollarstoothercountries,globaltradeandincomewouldriskstagnation,butifitcontinuedlubricating tradeandgrowth throughanunlimitedprovisionofdollars,confidenceinitscommitmenttoconvertthedollarsintogoldatthefixedpricewouldbe eroded.one attempted solution to theTriffindilemmawas thecreationofanartificialcurrencyknown asSpecialDrawingRights (SDRs),whichhasgivencentralbanks the right toobtaindollarsorotherinternationallywidelyusedcurrenciesfromtheiMFwithoutconditionsattached.TheseSDRswereintendedtobeusedbycountriestosupporttheirexpandingtradeandpaymentswithoutrequiringthecreationofadditionaldollars.butwhentheseunitsfinallybecameavailableinJanuary1970,thisreformprovedtobetoolittle,toolate.

2. The post-Bretton Woods era

TheUnitedStates unilaterally suspended theconvertibilityofthedollarintogoldon15August1971.ThebrettonWoodssystemoffixedexchangeratesfinallycollapsedin1973,andflexibleexchangeratesbecamethenorm,withtheiMF’sArticlesofAgreementamendedtolegitimizefloatingexchangerates.5Atthesametime,theiMFwascalleduponto “exercise firm surveillance over the exchangeratepoliciesofmembers”withaviewtopreventingcompetitivedepreciationsandsustainedundervalua-tion,whilemakingtheadjustmentmechanismmoresymmetrical.

inadditiontotheabandonmentofdollarcon-vertibilityintogoldandtheadoptionofwidespreadfloating, the other core characteristic of the post-brettonWoods era is a change in themodalitiesunderwhichliquidityisprovided.Thegrowingroleofoftenshort-termprivateinternationalcapitalflowsasacomplementtoliquiditysuppliedthroughcurrentaccountdeficitsoftheUnitedStateshasimpliedthat

Systemic Challenges in the International Monetary System 59

theprovisionofgloballiquidityisnolongerlimitedtowhatmaybecalled“officialliquidity”,i.e.“thefund-ingthatisunconditionallyavailabletosettleclaimsthroughmonetaryauthorities”(biS,2011:4).officialliquiditycanbemobilizedfromaccumulatedforeign-exchangereserves,fromswaplinesbetweencentralbanks,andfromtheiMFthroughSDRallocationsorloanagreements.itcanbeandhasincreasinglybeenaugmentedby“privateliquidity”resultingfromcross-border operations of financial institutions,suchasbanks,andnon-financial institutions,suchasenterprisesthatprovidecross-bordercreditsand/or foreign-currency-denominated loans.6This haseffectivelymeant themergingof the internationalmonetaryandfinancialsystems.

Thecombinationoffloatingexchangeratesandthegradualliberalizationandincreasingroleofinter-nationalcapitalflowsinthepro-visionofinternationalliquiditywasexpectedtoreducethepres-sureondeficitcountriestomakeadjustmentsthroughchangesinquantities(i.e.reduceddomesticdemand),givinggreaterweightinstead to adjustment throughprices(i.e.exchangeratechang-es),includingthroughcurrencyappreciation by surplus coun-tries.Thiswasconsideredparticularlyimportantinthecontextofsubstantiallygreaterinternationalcapi-talflowsfollowingthesharpincreaseinoilprices.itwasalsoexpectedthatthesemarket-friendlymecha-nismswoulddiscouragecountriesfromaccumulat-ingever-increasingofficialreserves,whileaccordingeachcountrythenecessaryautonomytopursueitsdomesticmacroeconomicpolicygoals.

However, contrary to these expectations, thepost-brettonWoods era has seen recurrent andsignificant exchange-rate swings, large paymentsimbalancesandgrowingreserveholdings.Moreover,thenewelementsoftheiMShavefailedtoremovethecontractionarybiasassociatedwith thegreaterpressureondeficitthanonsurpluscountriestoadjustpaymentsimbalances,andtheliberalizationofinter-nationalcapitalflowshasintroducednewformsofinstabilityassociatedwiththeinherentvolatilityandprocyclicalityofprivatecapitalflows.

Priortotheglobalfinancialcrisisthatbeganin2008,bankloansconstitutedthebulkofdollarcredit.

european banks (mainly fromFrance,Germany,SwitzerlandandtheUnitedKingdom)accountedforonethirdoftheglobaldollarbankingmarket,astheysearchedfor(supposedly)safeassetswithminimumcapitalrequirements,suchastheasset-basedsecuri-tiesissuedbyUnitedStatesbanks(borioetal.,2014).Thismayalsoindicatethattheroleofeuropeanbanksinfinancingthepre-crisiscreditboomintheUnitedStatesexceededthatrelatedtodevelopingcountries’accumulation of foreign exchange reserves in theformofUnitedStatesTreasury securities, despitethese countries’ often large trade surpluses. Sincethecrisis,bycontrast,mostof thesedollarcreditshavebeenintheformofbondsissuedbyfirmsandgovernmentsotherthanthoseoftheUnitedStates.A recent evaluation byMcCauley et al. (2015)estimates that the dollar credit to non-financialborrowers outside theUnited States, comprising

outstanding bank loans andbonds,amountedto$8trillioninmid-2014,equivalentto13percentofglobaloutputexcludingthatoftheUnitedStates.7Thisamountofoffshoredollarcreditconsiderably exceeds its euroandyencounterparts that total$2.5 trillion and $0.6 trillionrespectively.Another notablefeatureistheconsiderablyfaster

expansionofdollarcredittoborrowersoutsidetheUnitedStatesrelativetothatofdomesticcredit,bothbetween2005andtheonsetofthefinancialcrisis,aswellassince2009.

Thereareseveralconsequencesofthissurgeofprivatelycreatedgloballiquidity.First,theprovisionofinternationalliquidityhasbecomeprocyclicalandunstableasprivatecapitalflowsaresubjecttoglobalfinancialcyclesdrivenbypushfactors,suchasfinan-cialinvestors’searchforhigheryields,theircapacitytoleverage,andadvancedcountries’monetarypolicydecisions.The share of total private internationalcapitalthatflowstoanindividualcountryisinflu-encedbythatcountry’spullfactors,suchasitsgrowthexpectationsandexternalfinancingneeds,aswellasbytheopennessofitscapitalaccount(e.g.Rey,2013;Ghoshetal.,2014).inboomperiods,privateliquiditycreationwillaugmentofficialliquidity.incrisisperi-ods,bycontrast,financialinvestors’riskappetiteandcapacitytoleveragetendtodeclinecausingaslumpintheavailabilityofprivateinternationalliquidity.Thisprocyclicalityofprivatecapitalflowsposesthe

Short-term private international capital flows have assumed a growing role in the provision of international liquidity, and make it procyclical and unstable. ...

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riskthatwhencountriesfacethemostsevereliquid-ityshortages,theprovisionofinternationalliquidityshrinks,leavingmainlyitsofficialcomponentintact.

Second, the increased provision of privateliquidityimpliesthatcountrieswithcurrentaccountdeficits can avoid adjustment as long as they canaccess sufficient private lending.but this is oftenattheexpenseofaggravatingprocyclicalpressuresanddisconnectingexchange-ratemovements fromunderlying fundamentals.Unless capital inflowsarecontainedorcentralbanksinterveneincurrencymarketstopreventthecapitalinflowsfromcausinganappreciationoftheircurrency,therearenoeco-nomicorinstitutionalmechanismsthatwouldlimitthisself-reinforcingprocessleadingtogrowingtradedeficitsandcapitalinflows,otherthantheconfidenceofglobalfinancialmarketsinthesustainabilityoftheprocess–whicheventuallyvanishes.

Third,grosscapitalflowsaremorerelevantthannetflows(ordevelopmentsinthequanti-tiesandpricesoftradedgoodsandservices)inexplainingbal-ance-of-payments crises.Theyalsoaffectcurrentaccountbal-ances, since large gross assetandliabilitypositionsgeneratesignificantinvestmentincomeflows.Theirnetimpactonthecurrentaccounttendstobenegativefordevel-opingcountries,owingnotonlytofinancialliabilitiesbeing,ingeneral,largerthanassets,butalsotothedifferencebetweentheinterestratespaidandearned.

Moreover, ifgrossinflowsstopsuddenlyandgrossoutflowssurgesimultaneously,acountrywillexperienceanadverseshockintermsofnetcapitalflows,whichisequivalenttoadeteriorationofthecurrentaccount in termsofcausingexchange ratechanges.Thesechangescanbeparticularlydamag-ingiftherearelargecurrencymismatchesinbalancesheets; and sharpdeclines in the exchange rate inturncanresultinincreaseddebtservicingdifficul-tiesanddefaults.Thiswillbethecase,inparticular,when suchbalance-sheetmismatchesoccur in theprivatesectorforwhichforeign-exchangereservescannotbereadilymobilizedtocompensateforliquid-ityshortages.

Sincethe1970s,therehasbeenasequenceoffinancialcrisesinemergingmarketeconomiesthat

werecloselylinkedtosuddenchangesinthedirec-tionof private capitalflows (see chapter ii).Thisexperience led financially integrated developingcountriestoaccumulateofficialliquidityintheformofforeign-exchangereservesfortworeasons:first,asaformofself-insuranceinordertocompensateforeventualliquidityshortagesarisingfromasud-denstopandreversalofcapitalflows;andsecond,asaby-productofinterventioninforeign-exchangemarkets designed to avoid currency appreciationresultingfromcapitalinflowsthatareunrelatedtothefinancing of imports.Thismeans that reserveaccumulationcantoalargeextentbeconsideredapolicymeasureaimedatmitigatingadverseeffectsonthedomesticeconomyemanatingfromprocycli-calinternationalcapitalflows.

Arelatedobjectiveofthisstrategyistoavoidrelianceon the iMF in crisis situations, given the

severe macroeconomic con-tractioncaused,toasignificantextent,bypolicyconditionalityattachedtoiMFloans.Suchcon-ditionalityisoftenbasedonaninappropriateassessmentoftheunderlyingproblem,asalsorec-ognizedbytheiMFitself(TDRs 2001and2011;iMF,2011a).

Theaccumulationofforeign-exchangereservescan also reflect non-precautionarymotives, suchasacountry’schoiceofexchange-rateregimeandspecificmacroeconomicstrategies.Thishasplayedan important role for those countries that supportdomesticgrowththroughnetexportpromotionandrelyoninterventiononforeign-exchangemarketstomaintainexternalcompetitiveness.Suchexport-ledgrowthstrategieshavesometimesresultedinlargecurrentaccountsurpluses.

Thetotalholdingsofforeign-exchangereserveshavegrownsharplysincethebeginningofthemil-lennium,amountingtoalmost$12trillionin2014(chart3.1).Developingcountriesaccountedformostoftheincrease,whichwasparticularlylargeinChina.in2014,Chinaheldaboutonethirdoftheworld’stotalforeign-exchangereservesandroughly45percentofthoseofdevelopingcountries.8

These reserve stocks have sometimes beenjudged“excessive”basedonconventionalmeasures,such as the levels needed to counter fluctuations

... In response, developing countries are seeking to accumulate sizeable foreign-exchange reserves for self-insurance. ...

Systemic Challenges in the International Monetary System 61

inexportearningsortorollovershort-term(uptoone year) external debt (the so-called “Guidotti-Greenspan” prescription of reserve adequacy).However,empiricalestimatessuggestthatfinancialopenness,desiredexchange-ratestabilityandthesizeofthedomesticbankingsystemareadditionalconsid-erationsindeterminingtheadequacyofreserves.incrisissituations,policymakersattemptingtoavoidormitigatecurrencydepreciationmayneedtocountera large and suddenwithdrawal of liquid domesticdeposits(i.e.“suddencapitalflight”)inadditiontostemmingdepreciationpressurefromsuddenstopsand reversals of foreign financial inflows.Thisimplies that a determination of reserve adequacydiffers by the type of economy.9 For financiallyintegrateddevelopingeconomies,reserveadequacymaybedeterminedbytheGuidotti-Greenspanrule,aswellasbythesizeofbroadmoneyasapotentialsourceofcapitalflightby residents.Forcountriessuch asmany least developed countries (lDCs),whicharelessintegratedinglobalfinancialmarkets,the traditional trade-related rules remainpracticalstartingpointsbeyondwhichcountry-specific fac-tors determine precise assessments. in developed

economies,reserveadequacywilldependonwhethertheyhavereadyaccess toothersourcesofofficialinternational liquidity for these purposes (such asthrough standing foreign currency swap arrange-mentsamongcentralbanks,asdiscussedinthenextsection).otherwise,theyneedtorelyonreservestolowertheriskstobankandnon-bankbalancesheetsresultingfromshortagesindollarliquidityandrelateddysfunctioningof their foreign-exchangemarkets,aswellastocontainadverseeffectsoncesuchsitu-ationsoccur (for furtherdetails, see, for example,iMF,2015b).

Thelargesizeofcountries’foreign-exchangereserveshasgivenrisetoanewformoftheTriffindilemma.Theoriginal dilemmawas linked to thesize of official dollar reserves and the confidenceoftheirholdersthattheUnitedStatescouldconverttheseholdingsintogoldatthefixedprice.Thenewformof the dilemma refers to the combinationoftwomechanisms:first,thepersistentaccumulationofforeign-exchangereservesisassociatedwiththecontinuedpurchaseofsupposedlysafeassetsintheformofgovernmentsecuritiesinthereserve-currency

Chart 3.1

FOREIGN ExChANGE hOLDINGS OF SELECTED COUNTRy GROUPS, by CURRENCy DENOMINATION, 1995–2014

(Billions of current dollars)

Source: UNCTAD secretariat calculations, based on IMF, 2015a.Note: Since data for the composition of China’s foreign-exchange reserves are not publicly available, in the chart those reserves

have been allocated for the entire period based on estimates for 2014 (Financial Times, 15 April 2014), with about two-thirds in dollars, a quarter in euros, and the rest in other currencies.

0

2 000

4 000

6 000

8 000

10 000

12 000

1995 2000 2005 2010

Emerging and developing economies – unallocated reserves

Emerging and developing economies – other currencies

Emerging and developing economies – euros

Emerging and developing economies – dollars

Developed economies – unallocated reserves

Developed economies – other currencies

Developed economies – euros

2014

Developed economies – dollars

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countries; and second, this requires confidence oftheholdersoftheseforeign-exchangereservesthatTreasurysecuritiesandreservecurrencieswillnotdepreciate,asthiswouldimplyadeclineinthepur-chasingpoweroftheirreserves(AgliettaandCoudert,2014).10inthemediumtolongrun,thestatusofthedollarasthemaininternationalcurrencywillpartlydependonthefuturefiscalpoliciesandperformanceoftheUnitedStatesandothersignificanteconomies(eichengreen,2011),andpartlyontheavailabilityofalternativesthatcouldchallengeitsrole.

Suchalternativesarenotyetevident.TheglobalfinancialcrisisthatbeganintheUnitedStatesin2008mayhavebeenexpectedtoseriouslychallengethedollar’sinternationalrole.11Yetthedollar’spredomi-nance as an international currency remains intact,and has, if anything, actuallystrengthenedsincetheonsetofthe crisis (e.g. Prasad, 2013).There has beennodiscerniblediversification away from theuseofthedollarintheinvoicingofinternationaltrade(GoldbergandTille,2008;Auboin,2012).12Moreover,ithasmaintaineditsdominanceinforeign-exchangemarkets,asitcontinuestobeusedinover85percentofforeign-exchangetransactionsworldwide,eitheron both sides of the transactions or in exchangesbetweenthedollarandothercurrencies(biS,2014;Goldberg,2011).13Thedollaralsocontinuestobethecentralcurrencyintheexchange-ratearrangementsofmanycountries,andisstilldominant incentralbanks’ foreign-exchange reserves, accounting forroughlytwothirdsoftheirreportedcompositionin

bothdevelopedanddevelopingcountries(chart3.1).Moreover,thedollarremainsthemajorcurrencyusedininternationalcapitalmarkets.

Tosumup,thissectionsuggeststhatthecurrentdollarstandardisbothunstableandinequitable.Thecombinationofwidespreadfloatingandthesizeableroleofprivateinternationalcapitalflowsintheprovi-sionofinternationalliquidity,withmacroeconomicpolicieslargelybasedonnationalpriorities,hasbeenaccompaniedbywideswingsintheavailabilityofinternationalliquidityandtheaccumulationofoftenwide external imbalanceswhose adjustment hasgenerally occurred through crisis.Hence, the cur-rentsystemhasfailedtoprovideareasonablelevelof globalmacroeconomic and financial stability.Financially integrated developing countries have

chosentoaddressthisshortcom-ingthroughtheaccumulationofsubstantial foreign-exchangereserves, in spite of the asso-ciated transfer of resourcesto reserve-currency countriesthatmakes the system highlyinequitable.14Theaccumulationof large external imbalances– frequently associatedwith

volatilecapitalflows–andtheirdisorderlyunwind-ingpointtotheneedforimposinglimitsonthesizeofsuchimbalances.Theyalsosuggesttheneedforgloballymoreefficient formsof foreign-currency-denominatedliquidityprovision,especiallyincrisissituations,tocomplement−andeventuallyreplace−largeholdingsofforeign-exchangereservesheldforprecautionarypurposes.Theseaspectsareexaminedinthenextsection.

... However, the associated resource transfers to reserve-currency countries make the IMS highly inequitable.

Systemic Challenges in the International Monetary System 63

Themany existing proposals for reformingthe iMSgenerally exhibit an inverse relationshipbetween comprehensiveness and feasibility.ThisisparticularlytrueofproposalsthataimtotaketheiMSbacktoamorerules-basedandmultilaterallycoordinated systemdesigned to address all of thethreechallengesmentionedintheintroduction.Mostoftheseproposalshavealonghistory,andsurfaceperiodicallyaftereverymajorinternationalfinancialcrisis.Thisisnotsurprising.indeed,theyserveasabenchmarkformoreincrementalbutfeasiblereformmeasures thatmay achieve consensus in the nearterm.Arelatedquestioniswhetherthecurrentunsat-isfactoryglobaleconomicsituationwillimprovethechances of political acceptance of comprehensivereformsandproducethehighdegreeofmultilateralagreementandmacroeconomicpolicycoordinationtheywouldnecessitate.

Thissectionstartsbydiscussingsomeofthesecomprehensiveproposals.itthenfocusesonasecondcategoryoflessambitiousproposals,butwhichcouldbemoreeasilyimplemented.Thissecondcategorygenerally considers reformswhich, in addition toincreasingthesupplyofsafeassets,andespeciallythe availability of official liquidity duringperiodsof crisis, should aim at curbing the role of short-termprivatecapitalflowsinprovidinginternationalliquidity.Thiswould reduce both the demand forforeign-exchange reserves and the accumulationofunsustainablecurrentaccountimbalances.Suchreformsalsoseemwell-suitedtobecombinedwithmeasures designed to increase the contributionofsurpluscountriestoadjustment.Variouspossibilitiesattheregionalleveloracrossgroupsofcountries,suchasliquidityprovision,policysurveillanceandmechanismsforthesharingoftheburdenofadjust-ment,arealsoconsidered.Adoptingsuchmeasuresat the regional or interregional levelmay be an

improvement on the current system that subjectsdevelopingcountriestodisorderlyadjustmentpres-sureandrequiresthemtoholdlargeforeignexchangereserves, thereby exposing them to the system’sinequity.Theseproposalsforgreaterregionalmon-etaryintegrationamongdevelopingcountriesmightbemorepoliticallyfeasibleatthepresentjuncturethancomprehensiveglobalreforms,whilealsopre-paringthegroundforglobalreformsinthefuture.

Thissectiondoesnotaimatprovidingablue-printforanewiMS;rather,itexamineshowfeaturesofexistingproposalsaddressthethreeeternalchal-lengesofaniMS.italsodiscusseswhatconditionswouldneedtobemetinorderfortheseproposalstobeimplementedsoastolaythefoundationsforglobalmacroeconomicandfinancialstability.

1. Creating a new global monetary order

Proposalsforanewglobalmonetaryorderoftenemphasizetheneedforaworldcurrency,andusu-allystartfromthepremisethatthemanagedfloatingregimeofthepost-brettonWoodserahasnotliveduptoexpectations.extremeexchangerategyrationshave been identified as amajor systemic defect,posingaconstantthreattothesmoothexpansionofglobaltradeandincomes(Mundell,2012).

Creatingaworldcurrencyisseenbysome(e.g.Mundell, 2012) as following a natural sequence,from establishing target zones for the threemainreserve currencies, followed by amulti-currencymonetaryunionwhichwouldlockinexchangerates,fix an inflation target, establish a jointmonetarypolicycommitteeandcreateanarrangementforthe

C. Reforming the international monetary system

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coordinationoffiscalpolicies,toaworldcurrencyinitiallyrepresentingaweightedbasketofthethreemain currencies, but gradually extended to othercountries.15lin(2013)haspresentedanalternativeproposalforaworldcurrency,wherebythesupplyof the newly created globalcurrencywould be governedby an international treaty andaugmented according to somewell-defined rule. itwould becombined with a system offixed,butadjustable,exchangeratesbetweentheglobalcurren-cy and all national currencies.Whilerecognizingthatsimilarproposalshavehadlimited traction in thepast, their supporters arguethatboththeincreasedfrequencyofcurrencycrisesandthedecliningweightoftheUnitedStatesintheworldeconomycouldconvincecountriesthatsuchareconstructediMSwouldbeintheirowninterestsaswellasintheinterestofglobaleconomicstability(Mundell,2012).

Theadverseeffectsofexchange-ratemisalign-mentsontradeflowshavealsogivenrisetoproposalsformultilateral exchange-rate coordination. Suchproposalsmaysimplymarkasteptowardsaworldcurrency(i.e.thefirststageintheschemeadvancedbyMundell).buttotheextentthatsuchaspirationsseemdifficulttofulfil,searchingforanappropriatesystemofexchange-ratemanagementconstitutesareformagendainitself.16Thisisparticularlytrueifexchange-ratepolicycoordinationfollowsrulesthatpreventtheaccumulationoflargeexternaldeficitsresultingfrom cross-country price andcostdifferentials.Thus,themainobjectivewould be to designan exchange-rate system thataimsatstablerealexchangeratesandglobalmacro-economicstability(TDRs 2009and 2011).

Focusinginternationalpolicycoordinationonexchange-ratemanagementhassomeadvantages.Forexample,itcanrelyoncountries’obligationsunderArticleiVoftheiMF’sArticlesofAgreementtocol-laboratewithaviewto“assuringorderlyexchangearrangements” and “promoting a stable systemofexchange rates”.Moreover,multilaterally agreedexchange rateswould provide a consistent set ofmultilaterallyagreedexternalpositionsofindividual

countries. indeed, the few instances of effectiveinternationalpolicycoordinationhavebeenmostlyassociatedwithcorrectingexchange-ratemisalign-ments,suchasthroughthePlazaAgreementandthelouvreAccordinthe1980s.However,anycoordi-

nationofexchange-ratepolicieswill invariably facesignificantproblemsindefiningthecriteriatobeusedbothtosettheinitialtargetratesandtochangethem,in identifying the causes thatunderlieanywidedivergenceofactualfromtargetedrates,andindeterminingwhether targets

shouldbeadjusted.17inaddition,thereisalsoten-sionbetweenthelossofpolicyautonomytowhichpolicymakerswouldneedtoagree,andthedegreeof policy coordination required tomaintain theexchangerateswithinabandthatprovidesreasonableexchange-ratestability.Theabsenceofregulationsoninternationalcapitalmovementswouldmakesuchcoordinationdifficult ifnot impossible.Moreover,thecurrentsimultaneousattemptsbymanycentralbankstoengineercurrencydepreciationssuggestthattheexchangerateremainsamajorpolicytoolusedpredominantlytosupportnationaleconomicinterests.

Thedryingupofprivateliquidityduringfinan-cialcrisesandconstraintsontherapidprovisionofofficialliquidityforemergencyfinancehaveledtorenewedinterestinmovingtowardsamorediversi-

fiediMS.Thiswouldentailthecurrent dollar standard beingreplaced by amulti-currencysystem,witharangeofinterna-tionalcurrencies–suchas thedollar, the euro, the renminbiand possibly other currencyunits–playingamoreimportantrole. Some observers believe

suchasystemwouldofferseveraladvantages(see,forexample,Farhietal.,2011;lee,2014)intermsofmore elastic liquidity provisioning and easingtheTriffindilemma.Theysuggestitwouldprovidealternativesforcountriestodiversifytheirforeign-exchange reserves, exert greater discipline on thepoliciesofthereserve-currencycountriesandpreventtheirissuersfromabusingthesupposedexorbitantprivilegeofissuingareservecurrencytobolsternar-rownationalinterestsoverbroaderglobalinterests.inaddition,rejectingtheideaofnetworkexternali-tiesintheuseofjustoneinternationalcurrency,a

There is an inverse relation-ship between comprehensive and feasible reforms.

New multilateral arrange-ments remain the long-term objective of any comprehen-sive reform.

Systemic Challenges in the International Monetary System 65

multi-currencysystemmaybeeconomicallymoreefficient,becauseusingmultiplecurrencieswouldbettermatcheconomictransactionsbetweencurrencyblocks,resultinginsavingsontransactioncosts.Aspointedoutbysomeauthors,historyhasseenmanyepisodesofcoexistinginternationalcurrencies(e.g.eichengreen,2005).

others havenoted that any central bank thatissuesaninternationalcurrencytakesdecisionsbasedsolely on national concerns, rather than concernsrelated to the needs of the international paymentssystemandtheworldeconomy.Thisproblemalsoexistsinamulti-currencysystem.Moreover,thesup-poseddiscipliningeffectfromcurrencycompetitioncanoccuronlyifthereisclosesubstitutability.butifthisisthecase,thereistheriskofabruptand substantial exchange-ratechanges,notonlyinthetransi-tionperiod,whencentralbankswilldiversifytheirreserveport-folios,butalsooncesuchasys-temhasbeenestablished.Thisisbecauseamulti-currencysys-temwouldincreasetheriskthat,whenconfrontedbyorinantic-ipationofanyeventthatmightadverselyaffectthevalue of their portfolios, reserve-currency holderswouldtrytorapidlyconverttheirholdingsfromonecurrencyintoanotheraheadofotherholders.Thisconversioncouldbeinterpretedbytheotherholdersassignallinganimminentcrisisandcausethemtorapidly convert their ownportfolios aswell.Theoverallresultwouldbesubstantialvolatilityintheexchangeratesofthereserve-currencycountries.

inaddition toquerying the systemic stabilityofamultipolarmonetarysystem,therewouldbethequestionofwhichcurrencieswouldcombinewiththedollar.Marketforcesplayanimportantroleintheincreaseduseofacurrencyasaninternationalcurrency,thoughpolicymakershaveattimestriedtofoster,orhinder,theuseoftheircountry’scurrencyinsuchaway(Roosa,1982).18Morerecently,andespeciallyuntil thebeginningof theeurocrisis in2011,theeuroappearedtobeaseriouschallengertothedollar’sdominantpositionasaninternationalcurrency.Thischallengewasbasedontheeconomicsizeoftheeuroarea,whichiscomparabletothatoftheUnitedStates,aswellastheamountofitsglobalexports.Moreover,theeuroareahaswell-developed

financialmarketswithbanksthatoperateinternation-ally.ontheotherhand,whiletheeuroareapossessesanample stockofgovernmentdebt securities, theeuroisbackedbyaheterogeneousgroupofcoun-triesthatareunitedbyalooselystructuredfederalarrangement,andthereisnohomogeneousmarketforgovernmentdebtsecurities.Moreover,theStabilityandGrowthPactandtheexclusivefocusoftheman-dateoftheeuropeanCentralbank(eCb)onpricestability hindermember States fromundertakingthe kindof expansionarymacroeconomicpoliciesthatreserve-currencycountriesmightneedtooffsettheadverseoutputandemploymenteffectsarisingfrom the current account deficits associatedwithothercountries’demandsforsafeassetsintheform

ofgovernment securities.Thispresents a serious challenge,especiallybecauseofthecurrentlackofeconomicdynamismintheeuroarea.

Agreaterinternationalroleoftherenminbiseemstobealog-icalcorollarytoChina’sgrowingweight in theworld economy.Since 2009, renminbi interna-tionalization has been active-

lypromotedbytheChineseGovernment,partlyinreactiontotheslowpaceofAsianregionalfinancialcooperationandtheinternationalcommunity’sappar-entlackofinterestinreformingtheiMS,aswellastoavoidsignificantcapitallossesintheircountry’sforeign-exchangereserves(Yu,2014).19Moreover,China isstarting toreap theassociatedbenefitsoftherenminbi’sinternationalization,includinglowertransactioncostsintradeandareducedneedforaccu-mulatingadditionalforeign-exchangereserves.itisworthnotinginthiscontext,thatinitsquinquennialSDRreviewscheduledtotakeplaceinlate2015,theiMFboardofGovernorswillconsiderincludingtherenminbiinthecurrencybasketthatformstheSDR.Thiswillrequireanevaluationofwhethertheren-minbiisbeingsufficientlywidelyused,andwheth-eritis“freelyusable”(Zhou,2015;iMF,2011b).

Nevertheless,itiswidelybelievedthatpromot-ing renminbi internationalizationwhile avoidingan undue increase inChina’s exposure to finan-cial instabilityfaceschallenges. itwill require therelaxationofforeign-exchangecontrolsandfurtherdomesticfinancialmarketreform,promotingcapi-tal account convertibility,20 greater exchange-rate

The drying up of private liquidity during crises and constraints on the rapid provision of official liquidity for emergency finance have renewed interest in a more diversified IMS.

Trade and Development Report, 201566

flexibility,marketdeterminationofinterestratesandthecommercializationofbanks,aswellaseffectivelyaddressinghighcorporateandlocal-governmentdebt(eichengreen,2011;Yu,2014).21Thus,whilerenmin-biinternationalizationisalongprocess,therecanbelittledoubtthatthecontinuingincreaseintheweightofChinaintheglobaleconomyispushinginthisdirection.22

Given that introducing aglobalcurrencymaybeaprojectfortheverylongterm,andthatthemove towardsamulti-cur-rencysystemmaynotimproveglobalfinancialstability,andinanycaseitwouldbeagradualand time-consumingprocess, theproposal to givetheSDRamoreprominentroleintheiMS,initiallydiscussedinthe1960s,hasreceivednewimpetus.TheideaofreplacingthedollarwiththeSDRastheglobalinternationalcurrencyhasbeenpromoted,inparticular,bytheGovernorofthePeople’sbankofChina(Zhou,2009),byaUnitedNationscommission(UnitedNations,2009)andalsobyanumberofaca-demics(e.g.Kenen,2010a;ocampo,2011and2014).

Similartoadvocatesofamulti-currencysystem,proponentsofanSDR-basedsystemalsoarguethatthiswouldimposeagreaterdegreeofpolicydisci-plineontheUnitedStates,thushelpingtopromoteglobalmacroeconomicstability.DependingonhowSDRswouldbeissued,anSDR-basedsystemwouldalsocurbtheneedforreserveaccumulationforself-insurancepurposes,thushelpingtocutthecostofholdingborrowedreserves,andreduce the current system’sbias in favour of the reserve-currencycountry.Whatismore,an SDR-based systemwouldaddresstheTriffindilemma.itwould delink the provision ofofficial international liquidityfromanynationalissuer,andthecreationofarealalternativetonationalcurrenciesasreserveassetswouldallaytheconcernsofholdersoflargeforeign-exchangereservesaboutmaintainingthepurchasingpoweroftheirreserves.Also,sinceSDRsarebasedonacurrencybasket,23diversifica-tionoutofdollar-denominatedassetswouldentailmuchsmallerexchange-ratefluctuationsthanamovetowardsamulti-currencysystem,therebyminimizingthethreattointernationalfinancialstability.

ontheotherhand,movingtowardsanSDR-based iMS involves several technical and institu-tional challenges, including howSDRswould beissued, how the diversification away fromdollar-denominatedreserveassetswouldbemanaged,andhow the required institutional changeswould be

handled(UnitedNations,2009;ocampo, 2011; anderten andocampo, 2012).24 in order tosupport the sustained expan-sion of international transac-tions,theiMFwouldneedtobeempoweredtoissueSDRsmorefrequently thanunder the cur-rent regularfive-year reviews,wherebySDRsareallocatedto

meetlong-termglobalneedstosupplementexistingreserveassets.MoreregularallocationsaccordingtomemberStates’quotascouldbedone,ascurrently,basedonestimationsofglobaldemandforreserves(iMF,2011a),butmaking themmuch larger25andmorefrequent,orbyallocatingtodevelopingcoun-triesalargersharethantheirquotas.26Moreover,toavoidusingSDRallocationsasasubstituteforneed-edadjustmentwhileensuringtheavailabilityofoffi-cialliquidityasaformofemergencyfinanceintimesofcrisis,theiMFcouldbeempoweredtoissueSDRsinacountercyclicalway,suchasbyincreasingallo-cationsattimesofglobalfinancialstressandpartlywithdrawingsuchallocationsoncefinancialcondi-tionsnormalize.27However,giventhatthedemandforofficialliquidityforcrisis-relatedemergencyfinancemainlyemanatesfromdevelopingcountriesandthattheiMF’squotasystemisheavilyskewedinfavourof

developedcountries,thiswouldrequireasubstantialrevisionofquotas.inthelightofcontinuingdelaysintheimplementationofthequotareformin2010,whichawaitsratificationbytheUnitedStatesCongress,thisisunlikelytohappeninthenearfuture.28

To further reduce exchange-rate volatilitythatmightoccurbymovingoutofofficialdollar-denominatedreserveassetsintoSDR-denominatedreserves, the diversification could bemanagedthroughaso-called“substitutionaccount”,assug-gestedinthedebateoniMSreformduringthe1970s.ThiswouldbeundertheauspicesoftheiMFandusedbymemberStates’centralbanksandgovernmentstodepositsomeoralloftheirdollarreserves,obtaining

A greater international role of the renminbi is a logical corollary to China’s growing global economic weight in the long run.

Despite all its deficiencies, the dollar standard is likely to remain for the foreseeable future.

Systemic Challenges in the International Monetary System 67

inexchangeclaimsdenominatedinSDRs.29Movingtowards an SDR-based iMSwould also involveeliminating theFund’s distinctionbetween its so-calledgeneralresources,whichhavebeenbasedonmemberStates’ national currencies, and theSDRaccounts.SinceanySDRrepresentsapotentialclaimonsomecurrency,anSDRmustbeunderwrittenbythecentralbanksthatissuethecurrenciesincludedinthebasketthatmakeuptheSDR.However,noneoftheunderwritingcentralbankscandeterminethecurrencyonwhichtheSDRholder’sclaimwillbeexercised.Thislossofcontrolovermoneycreationcouldwellbedifficultforanycentralbanktoaccept.

enlarging the international roleofSDRsandchangingtherulesfortheirissuancetomeetmoreflexibly theeconomicneedsofmembercountries,insteadofreflectingtheexistingquotas,wouldbeamajorreform.inthelightofcontinuingdelaysintheimplementationofacomparativelymarginaladjust-ment,suchasquotaredistribution,movingtowardsanSDR-basedsystemposeseconomicandpoliticalchallengesthatmaymakeitdifficulttoimplement.

2. Reforming the dollar standard

betweentheearly1990sandtheearly2000s,anumberofdevelopingcountriesexperiencedboom-bustcyclesofprivateinternationalcapitalflowsthatprecipitatedaseriesofbalance-of-paymentscrisesinthesecountries,asdiscussedinchapterii.TheAsianfinancialcrisisin1997–1998,inparticular,triggeredadebateonwhatsystemofglobalgovernancewascompatiblewithflexibleexchangeratesandlarge-scaleprivatecapitalflows,andwhat role the iMFshouldplayinsuchasystem(TDR 2001).Giventhatproposalsdesignedtoregulateandstabilizeinterna-tionalcapitalflowsweresummarilydismissedfromtheoutset, theoutcomeof thisdebateemphasizednationalpolicymeasuresthatprovidedself-defencemechanismscombinedwiththecreationofprecau-tionary“pre-crisis”lendingfacilitiesattheiMF.

Sincecapitalflowslargelyrespondtoconditionsindeveloped-countrymarkets,effectiveself-defencemechanisms in developing countries havemainlyfocused on the accumulation of foreign-exchangereserves.The new approach to iMF lendingwasdesignedtoreducethevulnerabilityofmembersto

thecontagioneffectsfromcapitalaccountcrisesinothercountriesthroughostensibly“soundpolicies”.The iMFmadeavailablepre-committedcredits tocountriesmeetingpre-establishedeligibilitycriteriatobridgeany liquidityshortage thatmight remainevenafterusingacountry’sreserves.ThiswasontheconditionthatpotentialrecipientsofsuchiMFfinancingwouldcommittomaintainingpoliciesthatprivatecapitalmarketswouldinterpretasacredibledefence against a crisis of confidence.However,thecreationofnewloanfacilitiesfor thispurposehashadonlyverylimitedsuccess.Forexample,theContingentCreditline(CCl)createdbytheiMFin1999remainedunuseduntilitwassuspendedinNovember2003,becausepotentialusersfearedthatrequestingaCCl loancould signal an impendingdifficultythatmarketparticipantshadnotdetected,andmight therefore cause private capital inflowsto bewithdrawn rather than increased. Similarlythe Flexible Credit line (FCl) adopted by theiMFin2009hasbeenusedbyonlythreecountries(Colombia,MexicoandPoland),despitelessstrin-genteligibilityrequirements.Anadditionalfacility,thePrecautionary andliquidityline (Pll),wascreated for countries that have soundpolicies butare ineligible for theFClbecause of certain vul-nerabilities – but only two countries (the formerYugoslavRepublic ofMacedonia andMorocco)haveusedit(iMF,2015cand2015d).30Asaresult,otherinstrumentshaveemergedfortheprovisionofofficialliquidityduringtimesofmarketstress,suchascurrencyswaparrangements.

(a) Central bank foreign-currency swap arrangements

Central bank foreign currency swap arrange-ments have begun to play a crucial role in theprovisionofemergencyliquidity.WhentheimplosionoftheUnitedStatesfinancialmarketseventuallyledtotheglobalfinancialcrisisin2007–2008,interbankfundingbegandryingupbeyondUnitedStatesfinan-cialmarkets,andcreatedanacuteglobalshortageofdollarliquidity.31TheUnitedStatesFederalReservecoulduseitsordinaryfacilitiestoprovideliquiditytoUnitedStatesbanks,butcouldnotdosoforthemultinationalbanks,manyofwhicharebasedinotherdevelopedcountries,andwhich,priortothecrisis,had relied on cheap dollar funding through theiroperationsintheUnitedStates.Thus,inDecember2007 theUnited States Federal Reserve started

Trade and Development Report, 201568

to engage in currency swap arrangementswith anumberof foreigncentralbanks. inasense, thesearrangementsweretheinternationalextensionsoftheunconventionaldomesticmonetarypolicymeasuresthatmanymajorcentralbanksadoptedatthetime,withthecrucialdifferencethattheinternationalswaparrange-ments were undertaken in acoordinatedway.

Centralbankcurrencyswapsarearrangementsbetween twoormorecentralbankstoenablea central bank in one countrytoprovideforeign-currencyliquiditytobanksinitsjurisdictionintheeventofasuddenshortageofsuchliquidity.Given thedominant roleof thedollar inglobalinterbankmarkets,andthefactthatmostlocalforeign-currencyloansaredenominatedindollars,theUnitedStatesFederalReservehasbeenoneofthepartiesinvolvedinmanyofthesearrangements.

Addressingtheseliquidityproblemsbyusingforeign currency swap arrangements andmakingtheUnitedStatesFederalReservethedefactointer-national lender of last resort relied on threemainpremises.First,centralbankscanactswiftly;second,theyfacevirtuallynolimitontheirmoney-creatingcapacities;andthird,theprovisionofinternationalliquiditythroughswaparrangementswiththecentralbankthatissuesthecurrencyinwhichtheliquidityshortageoccursdoesnot cause any exchange-rateeffects. if, on the other hand,foreigncentralbankssell theirowncurrenciestobuy,forexam-pledollarsonthespotmarket,the requiredmassive scale ofthetransactionwillexertstrongdownwardpressureontheircur-rencies.Thiswill complicate,ratherthanfacilitate,thesecur-ingoftherequiredfundingfortheircommercialbanks,aswellascreatingupwardpressureonthedollar,whichmaydestabilizeUnitedStatesfinancialmarkets.

Moreover,manycentralbanks,includingthosefromdevelopingcountriesthathadaccumulatedsub-stantialreserves,werereluctanttousealargeamountof their dollar-denominated assets tomeet dollarliquidityproblems.Theywereconcernedthattheirreserveswouldproveinsufficienttoresolveliquidity

problems if theystarted toexperiencecapitalout-flows,andthatusingtoomuchoftheirreserveswouldinsteadfuelmarketuncertaintyandaccentuate thedollarshortage.indeed,accordingtosomeestimates,thedollarreservesofmanycentralbanksattheonset

oftheglobalfinancialcrisisweresmaller than the amounts theysubsequentlyborrowedthroughthe swap arrangements.Thustheir reservesalonewouldnothavebeen sufficient to reducefunding pressure on financialinstitutions and improve thefunctioning of interbank lend-

ingandcreditmarketsduringtimesofmarketstress(obstfeldetal.,2009).32Moreover,theUnitedStatesFederalReservewasconsciousofthefactthatamas-sivesellingofTreasurysecuritiesbyforeigncentralbankswaslikelytoaddtofinancialturmoilinUnitedStatesfinancialmarkets.

According to someobservers (e.g.Allen andMoessner, 2010;bordo et al., 2014), the counter-parts involved in these swap arrangements (mostnotablytheeCb)werechosenbecauseoftheirsizeandthepotentialspillovereffectsthatseriousbank-ingcrisesintheirjurisdictionscouldhaveonglobalfinancialmarkets.33Fromthisperspective,theswaplinesextendedbytheUnitedStatesFederalReserverepresentacaseofsuccessfulcooperationbetweencentralbanksinaddressingglobalconcerns.others(e.g.AizenmanandPasricha,2010;Prasad,2013),on

theotherhand,arguethatcoop-erationmerely stemmed fromcoinciding interests under thespecialcircumstancesthatpre-vailedatthetime,andthatthechosen countries had bankingsystemswith a sizeable stockofliabilitiesowedtotheUnitedStates’bankingsystem,aswellasagoodsovereigncredithis-

tory.ThismightbetakentomeanthatextendingtheswaparrangementswasintheinterestoftheUnitedStates,andservedsimplytocontrolasituationthatmayhave posed a systemic risk to that country’sbankingsystem.

ThePeople’sbankofChina(PboC)didnotrequestaswaparrangementwiththeUnitedStatesFederalReserve because it had access to a verysubstantialamountofdollar reserves,whichsome

Central bank foreign currency swaps now play a crucial role in providing emergency liquidity …

… but swap arrangements extended by developed-country central banks mainly cater to developed-country needs.

Systemic Challenges in the International Monetary System 69

estimatetohavetotalled$3.8trillion,orroughlyonethirdoftheworld’stotal,inApril2014(Aizenmanetal.,2015).Moreover,Chinesebanksarefundedmainlyfromdomesticsources,withfewinternationaloperations thatwould require dollar-denominatedliquidity.

instead,thePboCitselfestablishedcurrencyswaparrangementswithawiderangeofothercentralbanks,mostlyfromdevelopingcountries.34but it is generallybelievedthatthemainobjectiveof these arrangements has notbeentoaddresstheproblemofliquidityshortages,butrathertofostertheinternationalizationoftherenminbibyincreasingtheshareofChina’stradeinvoicedandsettledinrenminbi(PboC,2012:68),perhapswithaviewtoerodingthenet-workexternalitiesthathavehelpedmaintainthedol-lar’spredominantroleasaninternationalinvoicingandsettlementcurrency.35Theselongertermobjec-tivesof thecurrencyswaparrangementsextendedbythePboCarealsoreflectedintheirdurationofthreeyearswiththepossibilityofrenewal,aswellastheirdenominationinrenminbiwhichdiffers,forexample,fromthePboC’sswaparrangementsundertheChiangMaiinitiativeMultilateralizationthataredenominatedindollarsandservetostrengthenthedefencesofmemberStatesduringfinancialcrises,asdiscussedbelow.

ofparticularinterestinthecontextofthischap-termaybethePboC’scurrencyswaparrangementwithArgentinasignedinJuly2014,whichenablesArgentina’scentralbanktoexchangetherenminbiitreceives(againstArgentinepesos)throughtheswapinto other currencies, includ-ing dollars, if necessary.ThisamountstoaddingrenminbitoArgentina’s foreign-exchangereservesasiftheyweredollars.These “vouchers” for dollarsthus free upArgentina’s actu-al foreign-exchange reservesfor its immediateneeds.36 inasense,thisswaparrangementenablesArgentinatotapintoChina’sverysizeabledollarreservesforitsownforeignexchangeliquidityrequirements.Whilethesearrangementsmayclosely resemble foreign-currencyloans,theynonethelesscanhelpdealwith

episodesofcapitalflowvolatilityandstabilizetheforeignexchangemarketintimesofstress.37

othercurrencyswapnetworkshavesprungupinvolving thecentralbankofamajoreconomy inaspecificregionandanumberofcentralbanksinsmallerneighbouringcountries.Forinstance,someeuropean countries that are notmembers of theeuroarea(suchasDenmark,Hungary,Polandand

Sweden)which suffered fromeuro liquidity shortages bene-fited from swap arrangementswiththeeCb,whiletheSwissNationalbank extended swaparrangements to theeCb andtothecentralbanksofHungaryand Poland thatwere suffer-ingfromliquidityshortagesinSwiss francs. inAsia, China

andJapanestablishedarrangementswithindonesiaandtheRepublicofKorea,aswellaswithanum-berofothercountries.Whatismore,theseregion-alnetworkshavebeenusednotonlyforregionallydominantcentralbankstoprovideliquidityintheircurrencies,butalsotoredistributedollarstocentralbanksthatcouldnotgetdirectaccesstodollarliquid-ity through theUnitedStatesFederalReserve.AnexampleistheswaparrangementbetweenthebankofJapanandtheReservebankofindia.38butsuchswaplineshavebeenmuchsmallerinsizeandulti-matelytemporary,andatpresenttheydonotofferadequateemergencyfinancetothosecountriesthatarelikelytoneeditthemost.

AlloftheswaplinesestablishedbytheUnitedStates FederalReserve in 2007–2008 expired, asscheduled,inFebruary2010.butthearrangementswithfivecentralbanks(i.e.thebankofCanada,the

bankofengland, thebankofJapan, theeCband theSwissNationalbank)weremadeper-manentinoctober2013.Giventhat these central banks estab-lishedtemporaryswaparrange-mentswitheachotherin2011,when the euro crisis began tothreatenthefunctioningofglob-

alfinancialmarkets,lenderscouldaccessemergen-cyliquidityinthesesixinternationalcurrencies.Asaresult,centralbankswaparrangementshavenowbecomepartoftheiMS,andfinancethebulkoflend-er-of-last-resortliquidityprovisionsofforeigncentral

The lack of decisive reform continues to encourage developing countries to accumulate more reserves …

… but this implies serious risks for those countries themselves and for the global economy.

Trade and Development Report, 201570

banks,whiletheUnitedStatesFederalReservehasbecomethedefactointernationallenderoflastresort.

A systemic question related to central bankcurrency swaps concerns their relationshipwiththe existing internationalmonetary and financialarrangements. Since swaps can potentially cre-ate unlimited amounts of international liquidity, acomprehensivenetworkthatgivesautomaticaccesstoofficial international liquiditycouldobviate theneedforself-insuranceintheformoflargeforeign-exchangeholdings.However,thusfar,currencyswaparrangements have been limited to countries thathave a clearly perceived self-interest inmaintain-ing access to liquidity in the partner country, andtherefore a permanent institutional framework forsuchswapsisunlikelytoemerge.indeed,sincethehighdegreeofflexibilityanddiscretionthatallowrapidliquidityprovisionatrelativelylowtransaction

costsarethekeycharacteristicsofcentralbankswaparrangements,theirverylogicpreventsbroaderinsti-tutionalization(Destais,2014;Sgard,2015).

Anadditionalsystemicquestioniswhethercen-tralbankcurrencyswapshavereducedthedesireofdevelopingcountriestoaccumulatelargestockpilesofforeign-exchangereserves.Totheextentthatswaplinesarerapidlyavailableattimesofmarketstress,central banks can reduce other liquidity buffers,includingtheirreserveholdings.ontheotherhand,large reserve stocksmay be required to reduce alendingcentralbank’ssovereigncreditriskandmakeswaplinesaccessible.Andonlythecombinationofsecureswaplinesandlargereservesmaycontributeto crisispreventionby instillingconfidence in thefinancialmarkets of a country’s liquidity and sol-vency.Moreover,foreign-currency-denominateddebthasincreasinglybeenaccumulatedbynon-financialactors,suchascorporationsandhouseholds,andcen-tralbanksmaybelegallypreventedfromextendingtheborrowedforeigncurrencytothem.Perhapsmostimportantly,evidencesuggeststhat,despitetheaccu-mulationofsignificantforeign-exchangereservesbysomedevelopingcountries,inmostcountriesthesearestillmodestcomparedwiththeincreaseintheirexternalliabilities,andtoomodesttoeffectivelyavertthreatstofinancialinstability(chart3.2).Allofthis,andespeciallythefearofexclusion,willcontinuetoencouragecountriestoaccumulatemorereserves.

(b) Addressing the contractionary bias of asymmetric adjustment

Todate,insufficienteffortshavebeenmadetoeffectivelyaddresstheiMS’contractionarybiasbymakingsurpluscountriescontribute(more)toglobaladjustment, rather than leavingvirtually theentireburdenofadjustmenttodeficitcountries.39

Nevertheless,anumberofconcreteideashavebeenproposed as to howcountrieswith a currentaccount surplus could bemade to adjust.Theseproposals envisage such adjustment taking placeeither in an automatic or coordinatedmanner, butalwaysensuringthatglobaladjustment iscompat-iblewithmaintainingglobal aggregatedemand ata level sufficient to provide full employment andsupport the national development strategies ofdevelopingcountries.Forexample,countriesmightinterveneincurrencymarkets, limitor taxsurplus

Chart 3.2

CROSS-BORDER lIABIlITIES AND FOREIgN-ExCHANgE RESERvES

OF SELECTED DEVELOPING COuNTRIES, 2005–2013

(Billions of current dollars)

Source: UNCTAD secretariat calculations, based on IMF, International Financial Statistics database.

Note: The country sample on which the reported data are based comprises: Argentina, Brazil, Chile, Colombia, Costa Rica, the Dominican Republic, Ecuador, Egypt, El Salvador, Guatemala, India, Indonesia, Jamaica, Jordan, Malaysia, Mexico, Morocco, Pakistan, Panama, Peru, the Republic of Korea, South Africa, Thailand, Tunisia, Turkey, Uruguay and the Bolivarian Republic of Venezuela.

0

1 000

2 000

3 000

4 000

5 000

6 000

7 000

8 000

9 000

10 000

2005 2006 2007 2008 2009 2010 2011 2012 2013

Total non-gold reservesInternational investment position: liabilities

Systemic Challenges in the International Monetary System 71

countries’ holdings of foreign assets (particularlyTreasurysecurities), symmetrically limit the shareinGDPof countries’ current account surpluses ordeficits, or receive authorization from theWorldTradeorganization (WTo) toimposetariffsorotherformsoftraderetaliationonexportsfromsurpluscountries(forareview,seeWilliamson,2011).buttherearearangeofunresolvedques-tions:whowoulddeterminethatacountry’ssurplussituationisunacceptable,whatwouldtriggeraction,howwoulditbedeterminedthattheactionisproportionateand,perhapsmostimportantly,whatwouldinducepower-fulsurplusnationstoagree?

The iMS’ contractionary bias could also beaddressed throughmore appropriate iMF surveil-lancethroughitsArticleiVconsultations.However,itiswellknownthattheiMFexertsitssurveillancefunctioninanasymmetricway,asitcanmeaning-fullyinfluencenationalpoliciesonlywhenacountryformallyrequestsfinancialsupportandthusbecomessubjecttoiMFconditionality.Thus,iMFdirectivesonlyaffectdeficitcountriesbuthavelittleleverageoversurpluscountries.Moreover,globalsurveillanceprocedureshavefailedtopreventcurrencyturmoiland several international financial crises, particu-larlytheglobalcrisisthatbeganin2008.TheiMF’sinabilitytoforestallfinancialcrisesandtodealwiththem,oncetheyoccur,hasoftenbeenduetoitsinap-propriateassessmentoftheunderlyingcauses.Thisispartlyattributabletoitsasymmetricsurveillance.TheiMFconsidersitnecessarytofocusitssurveil-lancemoreonriskspreadingandspillovers,aswellasonlinkagesbetweenfinancialandmacroeconomicforces. it alsoconsiders it important to streamlineitsmultilateral surveillancemessages, such as bydeliveringmorecandidandpracticaladvicetosys-temically importanteconomies,andremovinganydoubtsabouttheinstitution’seven-handedness(iMF,2014).Whiletheseareworthyintentions,thereisnoindicationthatitwillgobeyondthetraditional“nam-ingandshaming”ofsurpluscountries.40

effective international policy coordinationwouldbetheoptimalwaytoaddresstheiMS’con-tractionarybias,butthisappearstobeverydifficulttoimplement.ThelimitedsuccessoftheG-7,andlater theG-20, in this regard, aswell asmuchoftheinitialcausesandpersistenceoftheeurocrisis,

maybepartlyattributedtodivergingviewsamongpolicymakers as to the correct approach to adoptfortacklingthecrisis.Theyalsodifferontheextent(andsometimeseventhedirection)oftheimpactof

policies, especiallyfiscal poli-cies (TDRs 2010, 2012).Withsuchdisagreement,decisionsontheappropriatenatureofpolicycoordination andmonitoringmechanismsbecomemoredif-ficult.However,itisevidentthattheabsenceofsuchcoordination

intensifiesthecontractionarypressuresafflictingtheglobaleconomy.

Tosumup,thestepstakenbytheinternationalcommunitytoreformtheiMShavebeeninsufficientforaddressingtheshortcomingsofthecurrentdollarstandard.of specificconcern todevelopingcoun-tries is that theprovisionof international liquidityremains subject to the boom-bust cycles of short-term private international capital flows, and thatcentral bank foreign currency swap arrangementsarenoteffectivedisincentivestotheaccumulationofforeign-exchangereservesforprecautionarypur-poses.Moreover,theshortcomingsofinternationalpolicycoordinationhavefailedtoaddresstheprob-lemofanunequalsharingoftheburdenofadjustmentamongdeficitandsurpluscountries.

3. Strengthening regional and interregional cooperation

Since comprehensive reform of the iMS isnot on the immediate agenda, and themeasurestakenbytheinternationalcommunitytoaddresstheshortcomingsofthecurrentdollarstandardremainunsatisfactory,developingcountriesneedtoconsiderwhattheycoulddoforthemselves.oneimportantstrategywhichindividualcountriescouldconsiderpursuing is to use capital accountmanagement asa regular instrument forpreventing theboom-bustcyclesof international capitalflows fromexertingpressureonexchangeratesanddestabilizingfinancialmarkets(TDR 2014).

There are alsoways of dealingwith somespecific concerns through bilateral, regional andother group-based arrangements that provide

Implementing effective inter-national policy coordination has proved difficult.

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some additional access to liquidity both in gen-eralandalsoasemergencyfinancewhenrequired.Recentdevelopmentsinregionalandinterregionalmonetary arrangements havefocusedincreasinglyonalleviat-ingadverseimpactsofexternalfinancialshockswithaviewtosecuringmacroeconomic andfinancial stabilitywithin thegroup.This can be done in anumber ofways: establishingpaymentssystemsthatdampenthe volatility of cross-borderprivate capital flows and pro-moteintra-grouptradewithoutusingthedollar,reservepoolingthatmakesavailableshort-termfinancetofacilitateexternaladjustment,andexchange-ratepolicycoordinationthatpreventsthe accumulation of intraregional imbalances orfacilitatestheiradjustment.41

Regional payment systemswhich reduce thenumberandvalueoftransactionsthatneedtobecar-riedoutinforeigncurrenciesareonewaytomitigateexchangerateuncertaintyandrisk.Theycanalsohelptopromoteinterregionaltradebycuttingthetransac-tioncoststhroughtheuseofdomesticcurrenciesinsuchtraderatherthanhavingtochangecurrencies(often several times)against a third, international,currency.

Amongdeveloping countries,latinAmericahas pioneered the implementation of such pay-mentmechanisms.42 in 1965, thelatinAmericanintegrationAssociation (lAiA) established the“reciprocal credit and pay-mentagreement”(CPCR−theacronymforitsSpanishname)among themember countries’centralbanks.ithasfunctionedasaclearinghouseandashort-termcreditmechanismfortradetransactions,which includes aclearanceperiodoffourmonths(with central banks assumingtheriskofdelayedpayments)andnetsettlementindollars thereafter. itwas used a great deal duringthe1970sand1980sat timeswhenaccess todol-lar financingwas extremely difficult.At its peak,during thelatinAmericandebtcrisis,80percentof intraregional tradewas channelled through thisarrangement.However, changes in international

financial conditions in the early 1990smeant thatitwasmorebeneficialtoprepayimports,effective-lydiscouragingtheuseof thisfacility.Thispartly

explainsthesubsequentmarkeddeclineinthevolumeoftransac-tionssettledthroughthelAiA,whichfelltobarely5percentofintraregional trade (UNCTAD,2011).Similarly,in1969CentralAmerican countries foundedtheCentralAmericanMonetaryStabilizationFund in order tofinance balance-of-paymentsimbalances, but its operationswere suspended in the mid-

1980s followingwidespread payment difficultiesbytheparticipatingcentralbanks(seeTDR 2007).

Variousgroupsof countrieshave instituted anumber of innovative payment systems since the2008 crisis years.one of the simplest, thelocalCurrencyPayment System (Sistema dePagos enMonedaslocales,SMl),wasestablishedbetweenArgentinaandbrazilin2008forbilateraltrade.itenablestransactionsbetweenexportersandimport-ersinthetwocountriesinlocalcurrencieswithouttheintermediationofthedollar,aswouldotherwisehavebeentheusualpractice.TheSMlisparticu-larlyusefulforsmallandmedium-sizedenterprises,asitobviatestheirneedtoaccessforeignexchangemarkets,which added significantly to their costsbecausetheirlowvolumeoftransactionsistypicallyassociatedwithhigherperunitcosts.initially,onlyasmallnumberoftransactionstookplacewithalowtotalvalue,butusepickedupquickly,andby2013

almost10,000brazilianexportoperations(Argentineimports)had been carried out throughSMl.Argentine exporters tobrazilhavenotbeenusingthesystemtothesameextent,partlybecauseofthearbitragebenefitstothemofretainingincomeindollars.Thesystemaccountsforonly3percentoftotalbilateral

trade,butstillclearlybenefitssmallerfirms,almostthreequarters ofwhich reportedusing the systemmultiple times.Uruguayhas recently signedSMlagreementswithbrazil(in2014)andArgentina(in2015),creatingthebasisforamultilateralsystemthatcouldbejoinedbytheothercountriesoftheCommonMarketoftheSouth(Mercosur).

Since comprehensive reforms are not on the immediate agenda and the measures taken by the international community remain unsatisfactory …

… developing countries need to consider what they could do for themselves at the regional level.

Systemic Challenges in the International Monetary System 73

Amore complexmechanism established in2010 is the Unitary System of local PaymentsCompensation (SistemaUnitariodeCompensaciónRegional, SUCRe),which is based on a “virtual”regionalcurrency.43Thecountriesparticipatinginthisarrangementarebolivia(PlurinationalStateof),Cuba,ecuador,Nicaragua,Uruguay and thebolivarianRepublicofVenezuela.liketheSMl,SUCReaimstoavoidtheuseofthethird-partycurrency,thedollar,fortransactionswithintheregion.italsoenablesdelayedsettlements of payments (unlikeSMlwhere trans-actionsaremostlysettledwithin24hours).itsusehasincreasedrapidly:withinfouryearsofitsinceptionitaccountedforaround24percentof total intra-grouptransactions (PerezCaldenteyet al., 2014). like the SMl,membersoftheSUCReusethemechanismtovaryingdegrees,reflecting their different economic structures andsize.ThebolivarianRepublicofVenezuelahasusedthesystemthemost,withtheSUCReaccountingfor93percentofitstotalintraregionalimportsin2012.incontrast,ecuadorhasuseditforonly7percentoftransactionsandCubaforabout10percentofexports.

easing electronic payments and creating amoremodern systemof interregional transactionswastheaimofanotherpaymentmechanisminlatinAmericaknownastheregionalinterlinkedpaymentsystemor“SistemadeinterconexióndePagos”(SiP).introducedbeforetheeconomicandfinancialcrisis,thismechanismbeganwithelSalvador(2007)andthengainedadditionalmembersasthecrisisunfolded,includingGuatemala, Honduras, Nicaragua, theDominicanRepublicandCostaRica.ThismechanismisbroaderthantheSMlandSUCRe,andcomprisesallkindsoftransactionsapartfromthoseinvolvingtrade,includingremittances.itaimstoofferacheap,rapidandsafeplatformfortransfersandsettlementsbetweenfirms,financialinstitutionsandcentralbanksofmembercountries.Alloperationsarecentralizedthroughoneinstitutionaladministrator(currentlytheDominicanRepublic),whichisresponsibleforrealtimegrosssettlementofpositions.Asaresult,itisestimatedthatthecostofregionaltradetransactionshasfallensignificantly(PerezCaldenteyetal.,2014;FritzandMühlich,2014).

Regionalmechanismsarealsoemergingtohelpmeetdevelopingcountries’medium-andshort-term

needsforinternationalcapital,thuspotentiallycon-tributingtostrengtheningtheirresiliencetoexternalshocks.Providingcountercyclicalfinancehaslongbeen recognized as one of the critical pillars ofregionalfinancialcooperationandintegration.

AnexampleofsuchamechanismistheChiangMai initiative (CMi) launched by theASeAN+3economies44inMay2000.itisasystemofbilater-al swap arrangements designed to provide liquid-ity support tomembers experiencing short-term

balance-of-paymentsproblems.The CMi has been replacedby theChiangMai initiativeMultilateralization (CMiM),whichisamultilateralreserve-poolingandswaparrangement.TheCMiMbecameeffectiveinMarch2010withaninitialsizeof$120billion,whichwasdou-

bledto$240billionin2012.itisdesignedtosup-plementtheexistinginternationalfinancialarrange-mentsforaddressingbalance-of-paymentsandshort-term liquidity difficulties in the region.There arealso plans to create aCMiMPrecautionaryline,whichwilloperateinparallelwiththeCMiMmech-anism,nowrenamedtheStabilityFacility.45inaddi-tion,anASeAN+3MacroeconomicResearchoffice(AMRo)wasestablishedinApril2011asaninde-pendentregionalsurveillanceunitthatanalysesandmonitorstheregionaleconomiesandsupportsCMiMdecision-making.46

However, neither the CMi nor the CMiMhaveemergedasmajoralternatives to the iMFordeveloped-country sources for helping to resolvemembers’ balance-of-payments problems. indeed,theywerenotusedatallduringthe2008–2009crisis,andhavebeenonlyrarelyusedsincethen.Tobeginwith,theamountofdollarliquiditythatcanbedrawnfromtheCMiMappearstobetoosmalltoconstituteacredibledefenceagainstreversalsofinternationalcapitalflows.Moresignificantly,amemberthatseekstodrawmorethanacertainshareofthemaximumswap amount that it can obtainmust have a loanagreementwiththeiMFandsubmittoiMFcondi-tionality.47However,oncetheCMiMPrecautionarylineandregionalsurveillancebytheMacroeconomicResearchofficebecomefullyoperational,thelinkwithiMFconditionalitycouldbereduced,makingthesefundsmoreattractive.butthenitisimportanttoensurethatthearrangementdoesnotattachsimilar

Developing countries could proactively build on existing regional and interregional monetary arrangements.

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conditionalitiestoitsloansasthoseimposedbytheiMF,whichcoulddetercountriesfromusingit.

establishingswaparrangementsbetweenregion-almonetaryinstitutionsandacentralbankissuinganinternationalcurrencycouldsignificantlyincreasetheamountofliquiditysupportavailabletomembersofregionalarrangements.48 in theASeANregion, theCMiMwouldbewellsuitedtotakeonthisroleasitsmembersincludebothChinaandJapan,whichhavealreadyparticipated in bilateral swap arrangementswith countries in the region.Suchlinkedswaparrangementswould,inprinciple,needtopro-videaccesstounlimitedamountsofliquiditytobefullyeffective.ithasbeensuggestedthatrelat-edmoral hazard issues couldberesolvedbyassociatingsuchaccesswiththeprequalificationprocessof the iMF’sFClandPll facilities.Thus, prequali-fiedcountrieswouldaccesstheiMFfacilitiesasafirstlineofdefence,andsubsequentlytheywouldhaveaccesstounlimitedswapsshouldamassiveliquiditywithdrawaloccur(ParkandWyplosz,2014).WhilethisproposalraisesmanyconcernsassociatedwithiMFlending,asmentionedearlier,itdeservesfur-therdebate,especiallyifappropriatereformofiMFgovernanceandsurveillanceisundertaken.

latinAmericahasalongerhistoryofregionalarrangementsinvolvingmutualcreditsupportamongcountries.ThelatinAmericanReserve Fund (orFlAR−theacronymforitsSpanishname)estab-lished in 1978 is a liquidity-sharingmechanismbetweenmediumand small-sizedmembers (FritzandMühlich,2014).itslendingvolumedependsonthepaid-incapitalofitsmembersandonthetypeofcredit−whetheritistofinancebalanceofpayments,liquidityshortages,orothertypesofcontingencies−withanupperlimitoftwoandahalftimesthepaid-incapitalforbalance-of-paymentsproblems.However,itsdisbursementcapacity is relativelysmall,sinceit has a paid-in capital of only $3.6 billion,withindividual contributions ranging from $328 to$656million.Nevertheless,thevotingmechanismsfordecision-makinghavecreatedasenseofowner-shipamongitsmembercountries.49Thisisreflectedinitspositionasafavouredcreditorandazerodefaultratewithahighercreditratingthanthatoftheindi-vidualcountriesthemselves,eveninthecontextof

sovereigndefaults.ithasarecordofspeedyresponsestoloanrequests,withnoconditionalityattachedtoitsassistance.largermembercountriesstilltendtoviewitasacomplementarymechanismtootherliquidity-sharingarrangementssuchasiMFsupport,butsomecountriessuchasecuadorhaveborrowedmorefromFlARthanfromtheiMF(FritzandMühlich,2014:10).Prospectsfor itsenlargement to includeothermajorregionalplayerssuchasArgentina,brazilandMexicogiverisetoconcernsrelatedtoitsvotingandsurveillancemechanism(seeTitelmanetal.,2014),

similartothemoralhazardcon-cernswithrespecttotheCMiM,asmentionedearlier.

Similarly to FlAR, theArabMonetary Fund (AMF)providesemergencybalance-of-paymentsfinancingthattailorsits lending conditions to eachbeneficiary’ssituation.Thecon-ditionsaregenerallylessstrict

thanthoseoftheiMF.TheAMFstartedoperationsin 1977with 22WestAsian andAfrican coun-tries.Giventhatitstotalsubscribedcapitalisabout$1.8billion,whichisevensmallerthanthatofFlAR,itusuallycomplementsiMFloans(forfurtherdiscus-sion,seeTDR 2007;andFritzandMühlich,2014).

one recent proposal goes a step further andbuilds onKeynes’ idea of establishing a clearinghousethatwouldfacilitatetradeandotherinterna-tionalpaymentsusingdebitsandcreditsdenominatedinanotionalunitofaccount(Kregel,2015).50Theunitofaccountwouldhavefixedconversionratestonationalcurrenciesbutmaynotbe traded.Creditswiththeclearinghousecouldbeusedonlytooffsetdebitsbybuyingimports.Countrieswithacurrentaccount surpluswouldhavean incentive to spendtheircreditsasthesewouldlapseifnotusedwithina specified period of time.This provisionwouldbothhelpsupportglobaldemandandleadtoamoreequitablesharingoftheburdenofadjustment.51inparticular,thetaxorinterestchargesoncreditanddebitbalanceswould limitpayment imbalances inasymmetricmanner,andmultilaterallynegotiatedexchange-ratechangeswouldenabletheadjustmentof imbalanceswhentheir limitsarebreached.Thecollectedchargescouldbeusedasadditionalcreditstosupporttheclearingaccountsofdevelopingcoun-tries.As an additional feature, a country’s capitalflowscouldbelimitedbyitscurrentaccountposition

Regional arrangements have suffered from institutional shortcomings and, especially, limited size, which could be overcome by linking them to global facilities.

Systemic Challenges in the International Monetary System 75

and capital outflows in the formof foreigndirectinvestmentsorportfolioinvestmentswouldbalanceoutforeigncreditsinthesamewayasimports.Therewouldbenoneedforforeign-exchangereserves,andnotional exchange rateswith the accounting unitcould be adjusted to support development policy.Such clearing houses could be established on aregionalbasis, buildingonexisting swaparrange-ments.Thiswould allowdeveloping countries topursuetheirdevelopmenttrajectorieswithoutrelyingonreformoftheinternationalmonetaryandfinancialarchitecture,particularlyastheirconcernshavenotbeen adequately taken into account indiscussionson reform.As argued byKregel (2015: 21), forthesecountries, “thebasic advantageof theclear-ingunion schemes is that there is noneed for aninternationalreservecurrency,nomarketexchangeratesorexchangeratevolatility,andnoparitytobedefended.”

A problem affecting regional arrangementsis that all theirmembersmaybe subject to exter-nal shocks simultaneously.This problem clearlyunderlines the need for such arrangements to beof a certainminimumsize.links to interregionalswaparrangementswouldbeparticularlyusefulinthisrespect.Anotherpossibilitymightbethecrea-tionofacommonfundwithaperiodicincreaseofpaid-in capital,wherebya regional clearingunionorreservepoolcouldincreaseitsliquidityprovisioncapabilities by borrowing on its own.This couldevenbeaneffectivetoolforpreventingintraregionalcontagionintheeventofexternalshockswithdif-ferentintensitiesorvaryingtimelags.Moreover,ina heterogeneous international community, strongregionalinitiativescancombinewithglobal,regionalandnationalinstitutionstocreateabettergovernancesystemthananarrangementbasedsolelyonglobalfinancialinstitutions.

Theshortcomingsof theiMShavebeen thesubjectof intensedebatefordecades,but thenewglobal economic environment has altered somechallengesandbroughtinnewconcerns.Thechal-lenge of providing an adequate level of interna-tionalliquidity,whichwasattheheartof thedebateon reform-ingtheiMSduringthebrettonWoodsperiod,haslostmuchofits relevance. Private interna-tionalcapitalflowshaveattimescomplemented,butmoreoftendwarfed, official internationalliquidity.Theboom-bustcyclesassociatedwithsomeofthepri-vate flows indicate the needforpayingmuchmoreattentiontothechallengeofensuringapredictableandorderlysupplyofofficialinternationalliquidity,andespeciallyofshort-term

financerequiredtocompensateforsuddenliquidityshortages.

efforts to reform the iMScan take the formof eitherwholesale changes to global arrange-

mentsandagreementsormorepiecemeal and less ambitiousreformsof thedollarstandard.Suchchoicesgenerallyinvolvetrade-offsbetweencomprehen-sivenessandfeasibility,asillus-trated in chart 3.3,where thepre-crisis dollar standardmayserve as a benchmark.52 Thechartpresents the threefunda-mental challenges confronting

an iMSmentioned in the introduction,alongwiththose that feature in themore recent debate. Forexample,thecrisisexposedthetendencyofthedollar

D. Conclusions and policy agenda: Merits and drawbacks of current reform proposals

The evolving global economy poses new challenges to reform aimed at providing stable and secure emergency finance and redressing the IMS’ inequity and contraction-ary bias.

Trade and Development Report, 201576

standard to create excessive external imbalances,poseriskstoexchange-ratestabilityandmakecoun-trieshighlyvulnerabletotheboom-and-bustcyclesthat characterize international capital flows,withadditionalchallenges tomonetarypolicy indevel-opingcountries.Thisimpliesalowerrankingofthecurrent,ascomparedwiththepre-crisis,dollarstand-ard,asthecrisishasheightenedtheneedforforeign-exchangeholdings,sharpenedthesystem’sinequitybias,reduceddomesticpolicyspaceandsloweddowneconomicrecovery.

Newmultilateral arrangements are the onlyreformsthatwouldeffectivelyresolvethesystem’sbiases, both in terms of inequity and asymmetry.Thus,sucharrangementsshouldremainthelong-termobjectiveofanycomprehensivereformagenda.butas longaspolicymaking isdominatedbynationalinterestsandthereisnosupranationalinstitutionwitheffectiveenforcementmechanisms,suchasaglobalcentral bank, or aworldfinancial authority, thereislittleprospectforaglobalcurrency.Anddespiteall its evident advantages, effectiveglobalmacro-economic policy cooperation has been observedonly in situationsof acute crises,when countries’national interests coincided and disputes over thecorrecteconomicmodel,aswellasthedirectionand

sizeofpolicyeffectsandtheassociatedmonitoringandcommitmentmechanisms,couldbeovercome.Thistrade-offbetweendesirabilityandfeasibilityisparticularlypronouncedatpresent,when the tran-sition fromweak economic recovery to sustainedglobalgrowthwouldgreatlybenefitfromcoordinatedexpansionarypolicies.

it is also doubtful whether, at the presentjuncture, itwould be possible to implement theinstitutional changes required formoving towardsanSDR-basedsystem.Andwhilemovingtowardsamultipolarmonetary systemmight bebeneficialin terms of amore flexible provision of officialinternationalliquidity,itwouldprobablyposeriskstoexchange-ratestability.Alternativeinternationalcurrenciessuchas theeuroand the renminbimayassumeincreasinglyimportantrolesfortradeinvoic-ingandsettlinginternationaltransactions.However,theirroleasreserveassetsisunlikelytosubstantiallyincreaseintheforeseeablefuture,asthecrisisintheeuroareapersistsandtheinternationalizationoftherenminbiisprovingtobeaprolongedprocess.

The various foreign currency swap arrange-mentscreatedbycentralbanksfromvariouscountriescanofferapotentiallypowerful tool toensure the

Chart 3.3

FEATURES OF ThE CURRENT DOLLAR STANDARD AND ALTERNATIVE REFORM PROPOSALS

Source: UNCTAD secretariat.

Current dollar standard

World currency

Multi-currency system

Global network of central bank foreign currency swap arrangements

Regional monetary integration

SDR

Pre-crisis dollar standard

Supporting(more) symmetric

adjustment

Facilitating recoveryfrom 2008–2009

crisis

Maintaining purchasing power of

foreign-exchange reserves

Supportingexchange-rate

stability

Enabling orderly adjustment to external shocks through predictable and orderly supply of official international liquidity

Efficient provision of official international liquidity through

network effects

Reducing need forforeign-exchange

reserves

Respectingdomestic policy

space

Ease ofimplementation ofreform proposals

Systemic Challenges in the International Monetary System 77

predictableandorderlyprovisionofofficialinterna-tionalliquidity.Currently,thegreaterproportionoftheseswapscaterstodeveloped-countryneeds,whilesuchswapsinvolvingdevelopingcountriesarestillrelativelylimited.

As long as attempts to strengthen financialregulation and improve the resilience offinancialsystems remain largely ineffective in addressingglobalrisksandleveragefactorsthatdriveboom-bustcyclesininternationalcapitalflows,anddevelopingcountriescontinuetobediscouragedfromadoptingcapital-accountmanagement policies as ordinarypolicytools,theonlycollectiveinsurancemechanismavailableto them isfinancial assistancefrom the iMF.However, iMFassistance often implies theadoptionofprocyclicalpoliciesduringcrisisperiods,andmanycountries are choosing,moregenerally, to avoid the condi-tionsattachedtoiMF-supportedprogrammes.Hence,involvingthe iMF in iMS reform thatmeets theneedsofdevelopingcountrieswillrequirepriorreformofiMFgovern-ance,policyorientationandsurveillancemechanisms.

Thesedifficultiesinthedesignandimplementa-tionofthevariousreformproposalshavereinforcedtheperceptionthatself-insuranceintheformoflargeforeign-exchangeholdingsisaneffectivestrategyfordevelopingcountriestofosterexchange-ratestabilityandensurethepredictableandorderlyavailabilityofemergencyfinance.However, encouraging devel-oping countries to takeon still larger holdings offoreign-exchangereserveswouldimplyseriousrisks,notonlyforthosecountriesthemselvesbutalsofortheglobaleconomyasawhole.Foreign-exchangereservesthatareaccumulatedthroughborrowingininternationalcreditmarketsoronthebasisofport-foliocapitalinflowscanfurtherincreasecountries’vulnerability to capital flow reversals and globalfinancial instability.Moreover, the costs involvedinholdingreservesborrowedininternationalcreditmarketswill also increase the current system’sinequity.Anotherpossiblesolutionisforthecoun-tries to try and achieve current account surpluses.However,giventhemanyquestionsassociatedwiththepotentialforexport-ledgrowthstrategiesinthepost-crisiseconomicenvironment(TDR 2013),this

optionwouldprobablyinducedevelopingcountriestoaimforexchange-ratedepreciation,whichcouldjeopardize the sustainabilityof their external debtand risk triggering a currencywar.Moreover, theincreaseintheiMS’contractionarybiasassociatedwithwidespread attempts to accumulate foreignexchangereserveswouldhavetheeffectoffurtherholdingbackalreadyweakglobaldemandandeco-nomicrecovery.

Apreferredoptionfordevelopingcountriesmaybetoproactivelybuildonaseriesofregionalandinterregionalinitiativesdesignedtofosterregional

macroeconomic and financialstability, reduce the need forforeign-exchange accumula-tion, and strengthen resilienceand capabilities to dealwithbalance-of-payments crises.While regional arrangementshavesufferedfromsomeinstitu-tionalshortcomings,thegreatestproblemprobablyistheirlimitedsize.Thiscouldbeovercomebyestablishingzonesofmonetarycooperationattheregionallevel,

whichwould include both clearing arrangementsandsystemsofemergencyfinancethatcouldabsorba significant number of such shocks, and therebyreduce the need for self-insurance.An additionalpossibilitycouldbetolinkregionalarrangementstoglobalfacilities,suchastheiMFortocentralbankswaparrangementsthatincludeacentralbankwhichissuesaninternationalcurrency(TDR 2007;AgliettaandCoudert,2014).Sofar,proposalsforcooperationwiththeiMF(e.g.Volz,2012;iMF,2013)havenotincludedanybindingrulesorguidelines,andlittleseemstohavebeenachievedoncoordinationwithextra-regional swap arrangements.Themodalitiesforcoordinationneed tobeclarifiedbeforeanewcrisishitssothattherewillbeareadyresponsewhenneeded,andduplicationandsubstitutionofresourcesfromvarioussourcesareminimized.

Thereformproposalsdiscussedinthischapteraredifficulttoseparatefromthosedesignedtoavoid,oratleastmitigate,instabilityofthefinancialsys-tem.indeed,theproposalsdiscussedinthischapterarecomplementaryto,andshouldnotbeseenasasubstitute for, the equallynecessary reformof theregulatoryandsupervisoryarchitectureofthefinan-cialsystem.Thisisthetopicofthenextchapter.

Involving the IMF in IMS reform that meets the needs of developing countries requires prior reform of IMF governance, policy orientation and surveillance mechanisms.

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1 Thenotionof“internationalliquidity”hasevolvedovertime.Traditionally,itreferredtothegoldandforeign-currency assets that a country’s centralbankcouldreadilyaccess.Thisnotion isstill rel-evantforthosecountriesthatdirectlycontroltheirresidents’ international transactions andmanageexchangerates.bycontrast,forcountrieswithfloat-ingexchangerates,andwhereresidentscanfreelyengage in international transactions, internationalliquidityalsoincludesthegoldandforeign-currencyassetsandcreditstowhichtheirresidentshaveaccess.

2 Thepurposeofprovidingshort-termfinance is toprevent countries that faceproblems in accessinginternationalliquidityduringcrisesfromdefaultingontheirforeignobligationsorbeingforcedtoadoptdrastic “adjustment”measures. it is not aimed atmanagingproblemsassociatedwithsovereigndebtissues,which are addressed in chapterV of thisReport.

3 itshouldbenotedthattheissuesofexternalimbal-ances and their adjustment in the context of theiMSarebasedonaconceptofbalance-of-paymentsequilibrium,wherebyacountry’scurrentaccountis,onaverage,balancedovertime.Thisdoesnottakeintoaccountthefactthatdevelopingcountries,andespecially the least developed among them,mayhavecurrentaccountdeficitsforaprotractedperiodof timeasa resultof theirneed to import capitalgoodsandfinanceinvestmentprojects.ideally,therelatedfinancing requirements should bemet bylong-termdevelopmentfinance,whichisthefocusofchapterViofthisReport.

4 indeed,whiletherewereseveralcasesofcurrencydevaluationbydevelopingcountriesoverthisperiodtocompensateforhigherinflationrates,thedevalu-ationof theFrench franc followedby theUnitedKingdom’s pound sterling in the 1960s signifiedgrowingproblemswiththissystemandpresageditseventualdemise.

5 Moreprecisely,countrieswereallowed tochoosetheirexchangeratesystemaslongastheyavoided“currencymanipulation”,eventhoughthenotionofcurrencymanipulationwasneverdefined.

6 indeed,asnotedbythethenGovernorofthebankofitaly:“Thereisnoofficialinstitutioncapableofsupplying the internationalpayments systemwiththeliquidityrequiredforfurtherexpansionoftrade.This functionhas been takenover by the privatebankingsystem,andprimarilyby theU.S.banks,throughoperationscarriedoutbytheirbranchesathomeandabroad”(Carli,1976:8).

7 TheamountofdollarcreditoutsidetheUnitedStatesincreasesto$9trillionifnon-bankfinancialborrow-ersareincluded,suchastheGermanstateagencyKreditanstaltfürWiederaufbauwhichinmid-2014heldadebtof$100billion.

8 ThesenumbersareUNCTADsecretariatcalculationsbasedondatafromtheiMF’sInternational Financial Statisticsdatabase.

9 itshouldbenotedthatreserveadequacydiffersfromtheconceptofanoptimallevelofreserves.Thelatterbalancesthebenefitsfromreserveholdingsintermsofavoidedpotentiallossesinoutputandconsump-tion from sudden liquidity shortages against theopportunitycostsofholdingreserves,suchasimpliedresource transfers to reserve-currency countries.Theresultingoptimallevelisstronglydeterminedby country-specific, and often time-varying, riskattitudes.

10 ThisnewformoftheTriffindilemmaalsoraisesthequestionastotheextenttowhichtheinternationalroleofthedollarcontinuestoconfereconomicben-efitsontheUnitedStates,whichhasbeenamatterofdebate.oneargument is that suchdemand fordollarreservespushesupthevalueofthedollarandtherebyslowsdownoutputandemploymentgrowthintheUnitedStates,especiallyinthecountry’strad-ablesector,andthat italsoaffectsfiscalrevenues(Pettis,2013;Galbraith,2014).However,theUnitedStatescansettleitscurrentaccountandfiscaldeficitsby printingmoney, and is therefore less vulner-abletoforeignshocks,whileothercountriesmustadjusttoitsmacroeconomicpolicies.inaddition,areserve-currencycountryusuallyearnsinvestmentincomebecauseyieldsonitsforeignassetsusuallyexceedthoseonitsforeignliabilities.Accordingto

Notes

Systemic Challenges in the International Monetary System 79

GourinchasandRey(2007),thesebenefitsexceed$30billioneachyearfortheUnitedStates.

11 Foracriticalassessmentofthelinkbetweentheroleofthedollarasaninternationalcurrency,thelargecurrentaccountdeficitoftheUnitedStatespriortothecrisis,andthewayinwhichthecrisisunfolded,see,forexample,Pettis,2013;andTDR 2009.

12 Nevertheless, tradefinance is theone areawheretheinternationalizationoftherenminbihasbecomeparticularlyvisible.in2013,itemergedasthesec-ondmost used currency for settling cross-borderpaymentsintrade,attainingashareofalmost9percent(eCb,2014:32).

13 Theeuroisusedinroughlyonethirdofallforeignexchange transactions, down from39per cent in2010,andtheyen’ssharehasoscillatedaround20percent.Theremaindercomprisesabasketofcur-renciesfromdevelopedanddevelopingcountries,thecompositionofwhichisnotfurtherdisaggregatedbythedatasources.itshouldbepointedoutthatthesumofthepercentageshareswillnecessarilyexceed100percentsincemanytransactions involve twocurrencies.

14 However, the cost of holding foreign-exchangereservesneeds tobeweighedagainst thepossiblemacroeconomiccostsresultingfromexchange-rateappreciationthatwouldoccurintheabsenceofcur-rencymarketintervention(seeTDR 2009:124–125).

15 For technical details of these three stages, seeMundell, 2012. For lessons from the experienceswiththeconstructionandfunctioningoftheeuropeanMonetarySystemandtheeuropeanMonetaryUnion,seeTDR 2007.

16 Forsuchaproposal,albeitlimitedtotheeuropeanUnion, Japan and theUnitedStates, seeCooper,2006.

17 Forexample,rules-basedmanagedfloatingtarget-ingastablerealexchangeratemaybedesignedtoimmediatelycompensateforemergingpriceandcostdifferentialsthroughcommensurateadjustmentsofthenominalexchangerate,therebypreventingthebuild-upoflargecurrentaccountimbalances.insuchasetting,interventionsinforeign-exchangemarketswould be of crucial importance for adjusting thenominalexchangerate.Whilemanyofthetechnicalproblemsassociatedwith thisproposalhavebeenaddressed(e.g.bofinger,2011),theconcretetermsforsuchaschemerequirefurtherdiscussion.

18 AccordingtooneaccountofGermany’sandJapan’sstrategies, the Japanese authorities resisted theinternationalizationoftheyenuntilthemid-1970stosafeguardtheircountry’sdevelopmentmodelthatrequiredminimizingspilloversfrominternationaltodomesticfinancialmarkets,andtopreventupwardpressureontheexchangerate(eichengreen,2011:44–45).butfromabout1975onwards,theystartedtofacilitatetheinternationalizationoftheyen(see

alsoMatsukawa,1982).However, the removalofrestrictionsondomesticandinternationalfinancialtransactionsdidnotproducetheexpectedresult,asitledJapanesecorporationstoaccessinternationalbondmarketswhiledomesticbanksreplacedtheircorporateclientswith realestatedevelopers, trig-geringamassiveboomandbustcycleinrealestate.Germanymaintained restrictions on purchases ofmoneymarketinstrumentsbynon-residentsinordertobeabletoaddressinflationfearsbyraisinginterestrateswithouttriggeringappreciationpressure,whichwould have jeopardized the country’s export-ledgrowthmodel(seealsoRieke,1982).

19 China’s policymakers have adopted a gradualapproachtotheinternationalizationoftherenminbi,withaninitialfocusonitsuseasasettlementandinvestmentcurrency,tobefollowedbyitsuseasareserveasset.Aschemelaunchedin2009toencour-ageimportpaymentsinrenminbihasledtoarapidincreaseinrenminbiusefortradesettlementandthecreationofrenminbioffshoremarkets(firstinHongKong(China)andthenSingapore,TaiwanProvinceofChinaandsomeeuropeancountries).Moreover,theintroductionofrenminbiqualifiedforeigninsti-tutionalinvestorshasboosteditsuseasastoreofvalue.Theestablishmentofforeigncurrencyswaparrangements(furtherdiscussedbelow)hasfurtheredthepossibilityofholdingtherenminbiasareservecurrencyincertaincontexts.

20 SeeZhou (2015) for a brief review of both thehistory ofChina’smove towards capital accountconvertibility and the respective reformsplannedtobelaunchedin2015.Zhoualsoarguesthatoneof the lessonsof theglobalfinancialcrisis is thatcapitalaccountconvertibilityshouldnolongermean“fullyandfreelyconvertible”currencies.Rather,itshouldimplyretaininganumberofcapitalaccountmanagementinstruments,suchasmacroprudentialmeasuresthathelpmanageexcessiveforeigndebtintheprivatesectorandsignificantcurrencymis-matches aswell as capital controls on short-termspeculativecapitalflows.

21 SomeobserversarguethatChinamayfacesimilarproblemstothoseencounteredbyJapan:thefailureoftheyentoemergeasaninternationalcurrencyinthe1970sand1980swasduenotonlytothereluc-tanceofJapanesepolicymakerstointernationalizetheyen,butalsotothefactthattheyenhadnotfirstestablisheditselfasaregionalcurrency(Park,2010;lee,2014).

22 Forafurtherdiscussionofthewiderangeofissuesinvolved in internationalizing the renminbi, see,forexample,theJournal of Chinese Economic and Business Studies,May2013–aspecialissuededi-catedtothistopic.

23 TheSDRiscurrentlycomposedofabasketoffourcurrencies−thedollar,theeuro,thepoundsterling

Trade and Development Report, 201580

andtheyen−whichcurrentlyaccountfor41.9,37.4,11.3and9.4percentofthetotalbasketrespectively.

24 TheneedtodevelopprivateuseofSDRsisoftenmentionedasanadditionalchallenge(Mateosylagoetal.,2009).However,aspointedoutbyocampo(2014),anSDR-basediMScouldbecombinedwithamulti-currencysystemwheretheSDRwouldbetheglobalreserveassetwhilenationalorregionalcurrencies could continue to be used in privatetransactions.However,movingtowardssuchamixedsystemwouldstill requiresubstantial institutionalchanges.

25 ThelastSDRallocationwhichtookplacein2009comprisedtheallocationof21.4billionSDRsthathadalreadybeenapprovedin1997andanewallo-cationof161.2billionSDRs(equivalent toabout$250 billion). Since the allocationwas based oniMFquotas,morethanhalfofthesefundswenttodevelopedcountries.TheseallocationsbroughtthestockoftotaloutstandingSDRstoroughly5percentofglobalnon-dollarreserves.Moreover,thealloca-tionsin2009fellconsiderablyshortoftheestimatedamountrequiredtomaintainastablesupplyofglobalreserveassets,whicharangeofstudiesestimatedat $200–$300 billion annually. For comparisonsofseveralsuchestimates,seeertenandocampo,2012:15.

26 inasense,thiswouldbeakintocreatingadevel-opment link inSDRallocations, as suggested byUNCTAD (1965).However, the potential use ofSDRs as an instrument of development financeshouldbeclearlydistinguishedfromtheirpotentiallyenhancedmonetaryfunctionsemphasizedhere.

27 Technically, this could be done in either of twoways(ocampo,2011:22):byallowingtheiMF“tocreateSDRsinalmostunlimitedamountinthefaceofamajorglobaldisturbance”orbytreatingSDRsthattheiMFhadpreviouslyallocatedbutcountrieshaveleftunusedasdeposits−or“excessreserves”−whichtheinstitutioncouldlendtocountriesinneed.

28 itshouldbenotedthattheagreedquotarevisionisrelativelysmall,sothatevenafteritsimplementa-tion, quotaswould still not reflect the increasedsharesofdevelopingcountriesintheglobaleconomy(ocampo,2011:23–24).

29 in the1970s, thedebatestalledbecauseofa lackofagreementastohowtheexchange-rateriskandpotentially ensuing losses should be distributedamongmemberStates.Calculationsofhypotheti-callossesduringtheperiod1995–2008suggestthatthesewouldhavebeensmallrelativetothesizeoftheUnitedStateseconomy,andwouldnot impairadoptingasimilarschemetoday(Kenen,2010b).

30 Foradetaileddiscussionofthesefacilities,see,forexample,MarinoandVolz,2012.

31 Themechanismsdiscussedhere concern the cur-rencyandmaturitymismatchesingrossinternational

capitalflows.Thefactthatthedollarplaysakeyroleinresolvingemergingproblemshastodowithitspositionasthedominantinternationalcurrency,andthisisnotdirectlyrelatedtothelargedeficitrecordedintheUnitedStates’currentaccountin2007–2008.indeed,atthesametime,similarliquidityshortagesneededtobeaddressedintermsoftheeuro,withtheeurozoneasawholerecordingabasicallybalancedcurrentaccountposition,andintermsoftheJapaneseyenandtheSwissfranc,withJapanandSwitzerlandrecordingsubstantialcurrentaccountsurpluses.

32 The country-specific account ofAizenman et al.(2011),forexample,indicatesthat,despiteusingalargeshareofitssizeableforeign-exchangereserves,theRepublicofKoreawasabletostabilizeitsfinan-cialmarkets inoctober2008onlyafter thebankofKoreaenteredintoswaparrangementsfirstwiththeUnitedStatesFederalReserveandthenwiththebankofJapanandthePeople’sbankofChina.

33 AttheirpeakinDecember2008,outstandingswaplinestotalledover$580billionandinvolved14for-eigncentralbanks,withtheeCbaloneaccountingfor about fourfifthsof this amount (FlemingandKlagge, 2010; bourgeon, 2015). The group ofcountriescoveredbythesearrangementsincludedfourdevelopingcountries,namelybrazil,Mexico,theRepublicofKoreaandSingapore,butbrazilandSingaporeneverdrewontheirswaps(bordoetal.,2014;bourgeon,2015).

34 ThePboC’s swap arrangementswithdeveloped-countrycentralbanks,suchas theSwissNationalbank, haveoften served to developoffshore ren-minbimarkets(SNb,2014).TheyenableimportersinthecountryofthePboC’spartnercentralbank,aswellasinthatcountry’sneighbouringregions,toeasilyobtain renminbi-denominated funds if theywishtosettletransactionsinrenminbi.Assuch,theirmainpurposehasbeentoprovideliquidityincasethereisashortageoftradefinanceandtolubricatetheemergingoffshorerenminbimoneymarkets.

35 According to an empirical analysis byGarcia-HerreroandXia(2015),thechoiceofcountrieswasinfluencedbythepartnercountry’seconomicsizeandgeographicalproximity,aswellasby itssizeofexportstoChinaanditssigningofafreetradeagreementwithChina.

36 SeeWendeP, “Por el swap conChina, elbCRAincorporóyuanesalasreservas”,Ambito Financiero,31october2014,availableat:http://www.ambito.com/diario/noticia.asp?id=765312. in october2014,thePboCconcludedasimilararrangementwith the central bank of theRussian Federation(seePboC, “Centralbanks ofChina andRussiasigned bilateral local currency swap agreement”,available at: http://www.pbc.gov.cn/publish/eng-lish/955/2014/20141015162604364930184/20141015162604364930184_.html). Contrary to the

Systemic Challenges in the International Monetary System 81

arrangementswithcentralbanksofothercountriessuchasChile (seehttp://www.pbc.gov.cn/publish/english/955/2015/20150528095203205835709/20150528095203205835709_.html), this arrange-ment is designed not only to facilitate “bilateraltrade anddirect investment”, but also topromote“economicdevelopmentinthetwocountries”.

37 China hasmade similar arrangementswith thebolivarianRepublicofVenezuela,whereby loansthatextendoverseveralyearsareinitiallydepositedinthelatter’sforeign-exchangereservesbutaregrad-uallyusedfordevelopmentprojects,especially intheoilsector.otherChineseloanstothebolivarianRepublicofVenezuelamayalsoboost the latter’sreserves,astheirrepaymentwillbeintheformofoilandfuel(seeReuters,“ChinatolendVenezuela$10billionincomingmonths”,19March2015,avail-ableat:http://www.reuters.com/article/2015/03/19/us-venezuela-china-idUSKbN0MF2AD20150319).

38 Foradetailedaccountoftheseregionalnetworks,seeAllenandMoessner,2010.

39 For a recentproposal thatbuildson theplan thatKeynespresentedtothebrettonWoodsconferencein 1944, seeDavidson, 2007. For other sugges-tionsas tohowKeynes’ initialproposalmightbeemployedtoday,seeMateosylagoetal.,2009,andUnitedNations,2009.

40 Moreambitiousapproacheshavecalledforamend-ingArticleiVoftheiMF’sArticlesofAgreementtointroduce an obligation formemberStates to geartheir domestic policies to achievingboth domesticandglobalstability(PalaisRoyalinitiative,2011),orgivingtheiMFtherighttoidentifyrequiredmeasuresfor globally coherentmacroeconomic policies andmonitorprogress(King,2011).SuchmeasureswouldobviouslyneedtobebackedbysignificantreformoftheiMF’sgovernanceandbychangesinitsapproachestosurveillanceandmacroeconomicprocesses.

41 Foracomprehensivereviewofregionalmonetaryandfinancial arrangements, seeUNCTAD,2011;andFritzandMühlich,2014.

42 Amongthemacroeconomiccoordinationandmon-etaryintegrationmechanismsinAfrica,whicharenotpeggedtotheeuroandsupportedbytheFrenchTreasury,onlytheCommonMonetaryArea(CMA)isoperational.Thisarrangementbetweenlesotho,Namibia,SouthAfricaandSwazilandconstitutesanintegratedfinancialmarketwithinwhichthereisafreeflowoffundsandaccessbymemberstoeachother’scapitalmarkets (TDR 2007; andFritzandMühlich,2014).

43 TheSUCReisanartificialunitofvaluealongthelinesoftheSDR.itiscalculatedfromabasketofcurrenciesoftheparticipatingcountries,weightedaccordingtotheireconomicsize.

44 ASeAN+3includesthemembersoftheAssociationof SoutheastAsianNations (bruneiDarussalam,

Cambodia,indonesia,thelaoPeople’sDemocraticRepublic,Malaysia,Myanmar, the Philippines,Singapore,Thailand andVietNam), plusChina(includingHongKong (China)), Japan and theRepublicofKorea.

45 See https://www.boj.or.jp/en/announcements/release_2014/rel140717a.pdf.

46 For details, seeAMRo’swebsite at: http://www.amro-asia.org/.

47 Themaximumamountisdeterminedbyapurchas-ingmultipleappliedtoamember’scontributiontotheCMiM,where the country-specificmultiplesrangebetween0.5 (forChina and Japan) and5.0(for a number of smallmember economies). Forexample,itisroughly$34billionforChina,$38bil-lionforJapanandabout$23billionforeachofthemajorASeANeconomies(indonesia,Malaysia,thePhilippines,SingaporeandThailand).TheshareofthisamountthatcanbedrawnwithoutaniMFlinkhasbeenincreasedinsteps,fromaninitial10percenttothecurrent30percent,andthereareplanstoincreaseitfurtherto40percent.ThisrequirementhasremainedinplacesincetheCMi’sinceptioninorder toaddressmoralhazard,which isseenasaproblemduetothecontinuedlackofregionalsur-veillancethatwouldhavesufficientpoliticalauthor-ity,andinsufficienthumanandfinancialresources(Rheeetal.,2013;Shimizu,2013).Fordetailsonthe 2014 amendment of theCMiM, see: https://www.boj.or.jp/en/announcements/release_2014/rel140717a.pdf.

48 The swap arrangement envisaged as part of thebRiCSContingencyReserveArrangement (afterits creatorsbrazil, theRussianFederation, india,ChinaandSouthAfrica),which,asofMay2015,wasscheduledtostartoperatingbytheendof2015,would be interregional in character.However, itwouldnotincludeacentralbankissuinganinter-national currency, though thismay change overtime,with the renminbiassumingan increasinglyimportantroleasaninternationalcurrency.butwithagreedinitialresourcesof$100billion,itwillremainsignificantlysmallerthaneventheCMiM,andittoowouldincludeaniMFlinkforwithdrawalsexceed-ing30per cent of amember country’s limit. Forfurther details, see: http://brics6.itamaraty.gov.br/media2/press-releases/220-treaty-for-the-establish-ment-of-a-brics-contingent-reserve-arrangement-fortaleza-july-15.

49 eachmemberhasonevote,withdecisionsrequiringa75percentapprovalformostoftheagreements,and80percentrequirementforspecialagreementssuchascapitalaugmentation.

50 HistoricalprecedentsofsuchregionalclearinghousesincludetheeuropeanPaymentsUnion(ePU),whichexisted during the period 1950–1958, aswell astosomeextentthelAiA.Asimilarmechanismis

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includedintheSUCReinitiativelaunchedin2009,thoughitisnotyetoperational(forfurtherdiscus-sion,seeUNCTAD,2011).

51 it is possible that intraregional imbalanceswouldresult from certain development strategieswhichcouldbe taken into consideration by themember

countrieswhendesigningamechanismtoaddressthose imbalances, such as if a country acts as aregionalengineofgrowth.

52 it shouldbeemphasized that theobjectiveof thischartispurelyillustrative,anddoesnotreflectpre-cisenumericalevidence.

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YuY(2014).Howfarcanrenminbiinternationalizationgo?WorkingPaperNo. 461,AsianDevelopment

bank institute,Tokyo.Available at: http://www.adbi.org/working-paper/2014/02/13/6136.how.far.can.renminbi.internationalization.go.

ZhouX (2009).Reformof the internationalMonetarySystem.essaypostedonthewebsiteofthePeople’sbank ofChina, 9April: http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178.

ZhouX (2015). internationalMonetary andFinancialCommitteeStatement.Washington,DC,internationalMonetaryFund,18April.Availableat:http://www.imf.org/external/spring/2015/imfc/statement/eng/chn.pdf.

Financial Regulatory Reform after the Crisis 87

in the aftermath of the 2008−2009 globalfinancialcrisis,politicalleadersacknowledgedthattherewereseriousshortcomingsinthewayfinancialmarketsandinstitutionshadbeenregulated.Thiswasamplydemonstratedbythefailureoflargeprivatebankstomanagerisk,theuncheckedexpansionofashadowbankingsystemandtheexcessiverewardschemes common throughout the entire financialsector.initially,theyshowedawillingnessforfun-damentalreformofthesystemaimedatmakingitmorestable,lesspronetocrisesandmoreresilienttoshocks,aswellastoorientitmoretowardssup-portingtherealeconomyandeconomicdevelopment.Theyalsorecognizedtheneedtoaccommodatetheinterestsandconcernsofthelargerdevelopingecono-miesinthedesignofanysubsequentreformagenda.Thusinlate2008,theG8wasreplacedbytheG20,which includes the largerdevelopingcountries,asthemostrelevantforumforinternationalcoordina-tionanddecision-making.SomeofthesecountrieswerealsogivenmembershipintheFinancialStabilityboard(FSb),whichsucceededtheFinancialStabilityForum(FSF)tocoordinatetheactivitiesofvariousfinancialstandard-settingbodiesandtotakechargeofmonitoringimplementationofthefinancialreformsagreedbytheG20countries.

ThereformprogrammecoordinatedbytheFSbaimed at strengthening prudential regulation and

theoversightandsupervisorycapacitiesoffinancialauthorities.However, today, sevenyears since theeruptionoftheglobalcrisis,ithasbecomeclearthat,apartfromsomepartialimprovements,ithasbeenunabletoeffecttherequiredchanges.Theexistingfinancialstructuresstilllackadequateinstrumentstoreducethevolatilityofcapitalflows,preventsystemiccrisesandensurethatfinanceisavailableforsmallandmedium-sizedenterprises(SMes)andinnova-tion.Reformsintroducedafterthe2008−2009crisishave takenonly a limited account of someof thespecificneedsofdevelopingcountries.

Thischapterdiscussessomekeyfinancialreformsagreedattheinternationallevelandwhichareintheprocessofbeingimplementedbynationalauthorities,and assesses their possible impacts, particularly indevelopingcountries.Sectionb,whichexaminesthenewbaselcapitalrequirementsaimedatstrengthen-ingbanks, shows that they still rely excessively onnarrowlydefinedprudentialrulesasthebestapproachto banking regulation.The section also examinesa number of initiatives to reform thefinancial sys-tem indeveloped countries.SectionC studies theshadowbankingsystemandtheproposedmeasurestomitigaterisksarisingfromthisformoffinancialintermediation.SectionDassessesotherimportantissuesforfinancialregulation,suchastheexcessiveuseoftheratingsofcreditratingagencies(CRAs),

Chapter IV

FINANCIAL REGULATORy REFORM AFTER ThE CRISIS

A. Introduction

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thechallengesarisingfromthegrowingpresenceofforeignbanksindevelopingcountries,andtheneedtoaddressthevulnerabilitiesarisingfromspeculativeinternationalcapitalflows.Sectionearguesforthe

needforamoreambitiousreformagenda,includingthenecessaryseparationorring-fencingofsomebankactivities.italsodiscussestheregulatoryelementsofamoredevelopment-orientedfinancialsystem.

B. Post-crisis financial reform and prudential regulation

over the past 40 years, the financial sectorhasexpandedsignificantlyandinternationalcapitalmobility, in particular, has soared following suc-cessivewaves offinancial innovation andmarketderegulation.Globalliquidityandtheallocationofglobal fundinghavebecome influencedmore andmorebycreditconditionsinmajorfinancialcentres,bytheoperationsoftheinternationallyactivebanks,andbytheactivitiesofawiderangeofassetmanage-mentcompaniesandotherinstitutionalinvestors.

Financialderegulationincludedtheprogressiverelaxationofquantitycontrolsandotherrestrictionsonbanks,suchascapsoninterestratesorlimitsontheabilitytoengageinactivitiesother than traditional lending.one aspect of such deregula-tionwastheretreatfromdirectgovernmentinterventioninthefinancial sector and the ero-sionof instruments to achievedevelopment targets. in theirplace,alight-handedregulatoryapproach based on prudentialrules(i.e.requiredcapitalizationandliquidityratios)gainedprominence.Thecentraltenet of this approachwas that banks should beallowedtofreelyallocatecreditorengageinmarket-basedactivitiesprovidedtheyholdsufficientcapitaltocopewithunexpectedlosses.Marketcompetitionwassupposedtoensuretherightfundingforprofit-ableinvestments,andthereforeahighsocialreturn.

Sincetheirintroductionin1988,baselcapitaladequacy requirements have become an impor-tant reference for prudential policies, not only in

countries represented on thebaselCommittee onbankingSupervision (bCbS)−originallya smallnumberofdevelopedcountries−butalsoinalargenumberofdevelopingcountries,eventhoughtheywerenotpartytotheformulationprocess,andeventhoughtheguidelineswerenotconceivedwiththeirfinancialsystemsinmind.1ThebaselAccordsseektopreventinternationallyactivebanksfrombuildingbusinessvolumewithoutadequatecapitalbacking.Theyalsoaimtoremovetheincentiveforindividualjurisdictionstoimposelessdemandingrequirementsonthebanksinordertoattractbusiness.Thebaselrulesreflectedthebeliefthatmarketsandfinancialentitieswere capable of self-discipline, and that

prudent behaviour by a bankwas integral to its reputationalcapital.Assuch,marketforceswereexpectedtopreventbanksfromtakingexcessiverisks.

Theglobalfinancialcrisisof 2008−2009,whichwas byfar theworst since the 1930s,revealedtheseriousshortcom-ings of financial deregulation

andoftheconceptualframeworkbasedonacom-mitmenttofreemarketsandself-regulation(TDRs 2009 and2011).The narrow focus of prudentialregulationbasedoncapitalrequirementsforbanksfailed topreventwidespread turmoil in late2008.indeed,manyoftheworld’slargestbanksthatfullymetthebaseliistandardsin2008werecrippledbythesubprimecrisisanditsramifications,promptingvery expensive bailout packages by governmentsthatresultedinsignificantincreasesinpublicdebtandhighsocialcosts.

The global financial crisis of 2008−2009 revealed the shortcomings of the concep-tual framework based on a commitment to free financial markets and self-regulation.

Financial Regulatory Reform after the Crisis 89

inthepost-crisisreformprocess,aconsensusseemedtoemergethatinstabilitywasglobal,andthatinternationalcooperationneededtobestrengthened(TDRs 2009and2011;Haldane,2014).Theinterna-tionalreformagendaunderFSbguidancedelivereda number of initiatives, including the basel iiiAccords,specificprovisionsforthe“globallysystemicimportantbanks”andrecommendationstoimprove oversight of shadowbankingactivities.2

G20 countries agreed toprogressively introduce thenew standards in their regula-toryframeworks.However,thesourcesofsystemicrisk,thatis,theriskthatadefault,liquiditysqueezeorcrisisonagivenmarketwouldspreadtoothermarketsandeventuallydevelopintoafull-fledgedcrisis,arelikelytopersist,andthefragilitiesthatcontributedtotheglobalcrisisremainaseriousconcern.Thissectioncriticallyexaminesthespiritofthereformprocess,highlightingitsmainweaknessesandthechallengestheyarecreatingfordevelopingcountries.

1. The new Basel III Accords

ThebaselAccordsofferthemostcomprehen-siveregulatoryframeworkforthebankingindustry.3However,theyhavebeeninadequate,inseveralways,toensureastrengthenedfinancialsystem.Crucially,capitaladequacyruleshavenotpreventedhighlever-agenorpromotedmuchportfoliodiversification,andtheyhaveaddedtothealreadyprocyclicalnatureofthebankingbusiness,asnotedbyseveralanalyses(e.g.Slovik,2012).

in reaction to the crisis and to the increasedscrutinyitwasfacing,thebaselCommitteeagreedtoprovideanewregulatoryscheme“tostrengthentheresilienceofbanksandtheglobalbankingsystem”(bCbS,2011).Thepackageofreforms,announcedinoctober2010,knownasbaseliii,includesnewcapitaladequacyrulesandanumberofliquiditypro-visions.inaccordancewiththeagreedtimetable,G20countrieshavebeenintroducingthenewstandardssince2013,andhavetargetedfullimplementationoftheframeworkby1January2019.

With respect to capital rules, basel iii hasimproved the quality of the capital that banks arerequired to hold to better absorb potential losses.CommonequityandretainedearningshavebecomethepredominantformofTier1 capital,asthenewframework has eliminated the possibility to use

preferredstockanddebt-equityhybridstoboostcorecapital.

in addition,basel iii hasintroduced higher levels ofcapitalcomparedwithitsprede-cessor,baselii.Theminimumlevel for total capital require-ments remained at 8 per centofrisk-weightedassets,buttheproportion accounted for by

commonequityTier1was raised from2percentto4.5percentoftherisk-weightedassets.baseliiialso requires banks to hold “capital conservationbuffers”ofanamountequaltoatleast2.5percentoftherisk-weightedassets,alsointheformofcommonequityTier1capital,tobemadeavailableintimesof stress.Whenbuffers aredrawndownas lossesareincurred,banksarerequiredtorebuildthembyreducingdiscretionarydistributionsofearningsandexecutivebonuses.Takentogether,thesemeasureshavebroughtthetotalcommonequityrequirementsto7percentofrisk-weightedassets.Thenewframe-work alsogivesnational authorities thediscretionto request banks to uniformly adjust upwards thecapitalconservationbuffersbuilttocopewithstresssituations,when,intheirjudgement,creditgrowthresultsinanunacceptablebuild-upofsystemicrisk.Thiscountercyclicalbufferisimposedwithinarangeof0−2.5percentandalsoshouldbemetwithcom-monequity.

Another feature ofbasel iii is the introduc-tion of a non-risk-based leverage ratio, based onaminimumTier1capitalofat least3percentoftotalassets.Forthecalculationoftheleverageratio,banks’exposuresmustcoveron-balance-sheetitemssuchassecuritiesfinancingtransactions,aswellasoff-balance-sheetitemssuchasderivativesandlet-tersofcredits.

Finally,theproposedliquidityprovisionsinthebasel iii package include liquidity coverage ratio(lCR)andnetstablefundingratio(NSFR)require-ments.ThelCR aims to ensure that banks havesufficientshort-termliquiditytodealwithsituations

Many of the world’s largest banks that fully met the Basel standards were crippled by the subprime crisis, prompting very expensive bailout packages by governments.

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ofstresslastinguptoonemonth.TheNSFRaimstohelpbanksdealwithliquidityissues,butithasatimehorizonofoneyear,focusingonthematuritystructureofabank’sassetsandliabilities.Thatis,itencouragesbankstoholdmorestablefunding(forinstancefromdeposits)aswellasmoreliquidassets(bCbS,2014aandb).Althoughportrayedasagreatleap forwardwhen compared to its predecessor,baselii,thesereformsareunlikelytomakebanksmoreresilient.

Since basel iii has not changed the risk-weightingframework,corecapitalhastobemeasured,aspreviously,againstrisk-weightedassets.Thismeansthat in thecalculationof theassets thathave tobebacked by the bank’s capital,onlyassetsdeemed tobeveryriskyareaccountedattheirfullvalue,while those consideredto be safer are considered atonlyaproportionoftheirvalue.This increases the incentiveto invest in low-risk-weightedassets that can be leveragedmuchmore than risky assets.4Atthemacroeconomiclevel,therisk-based approachmayhaveadverseconsequencesforemploymentandeconomicgrowth,becauseitdiscriminatesagainstSMes.Sincethesefirmsareperceivedtoposegreaterrisksthanbigfirms,bankswouldbereluctanttoextendcreditlinestothem(Moosaandburns,2013)whenchoos-ingaportfolioskewedtowardsassetswithlow-riskweights.Moreover,baseliiidoesnotquestiontherelianceonexternalratingsbyCRAsortheuseofbanks’ internal riskmodels to calibrate the risk-weights.5 it isnotclearwhy thebaselCommitteestillseesvalueinCRAs’ratingswhentheFSbitselfstatedthat“itisparticularlypressingtoremoveorreplacesuchreferences[i.e.toexternalcreditratings]wheretheyleadtomechanisticresponsesbymarketparticipants”(FSb,2010).

by retaining the system of adjustable riskweights,baseliiihasnotaddressedtheprocyclical-ityofbaselii.Whendefaultrisksareperceivedtobelow,whichislikelyduringperiodsofeconomicexpansion – as in the 2003−2007 growth period– credit ratings are upgraded, therebymoving theassets towards a lower risk category for capitalrequirements.This causes a reductionof requiredcapitalforthesameassetportfolio,therebyallowing

higherleveragingduringtheexpansionaryphaseofthecycle.Conversely,capitalrequirementsincreasesuddenlywhentheexpansionendsandbanks’assetsareperceivedtobemorerisky.Further,thebaseliiireformsfailtoaddressoneofthemorecontroversialcomponentsofpreviousbaselrules:banksarestillallowed tocalculate their regulatorycapital them-selvesasanalternativetotheuseofexternalcreditratings,whichmeansthattwodifferentbanks,eachusingtheirowninternalriskmodels,oftenendupwithdifferentcapitalneedsforsimilarassetportfo-lios.6Perhapsmostfundamentally,thebaselnormscontinuetorely,implicitly,onlargebanks’effectiveself-monitoring,ratherthanonexternalsupervision,basedontheassumptionthat“marketdiscipline”will

ensure responsible behaviourby financial agents.Yet thisassumptionisnowrecognizedtobeflawedandunrealistic.

Under the risk-weightedframework, institutions haveaccumulated an excessive lev-el of leverage. between theenforcementof thebasel risk-weighted capital requirementsin1992(baseli)andtheglobal

economicandfinancialcrisisin2008−2009,banks’ratio of total capital tounweighted assets steadilydeclined.Forexample,inasampleoflargeinterna-tionalbanks,theratiofellfrom4.8percenttolessthan 3 per cent between 1993 and 2008 (ingves,2014).7Thebaseliiileverageratio,supposedtoserveasabackstoptotherisk-basedcapitalrequirement,will improve thecapitalbaseonlymarginally.Setatonly3percentofunweightedassets,capitalmaybesignificantlybelowthelevelnecessarytoensurebanksareminimallypositionedtowithstandamajorshock(AdmatiandHellwig,2013).8

2. The proposed framework for systemically important banks

large, internationally active banks contrib-uted significantly to the global financial crisis of2008−2009.Their presence in different nationaljurisdictionsandtheircross-bordertradingactivitiesfacilitatedthespilloverofthecrisistovariouscoun-tries.Giventheirsize,complexity,cross-jurisdictional

Basel III introduced higher levels of capital requirements but retained the risk-weighted system and the reliance on credit ratings agencies, thus failing to prevent high lever-age and procyclicality.

Financial Regulatory Reform after the Crisis 91

presenceandinterconnectedness,theselargebankshave createdglobal systemic risks and challengesforregulators.

Their complex and intertwined operations,whicharedifficulttotrackbyfinancialregulators,andevenbythebanks’ownseniormanagers,arefarfromtransparent.Thesebankshavebecomesolargethatfinancialexpertsandpolicymakersconsiderthem“toobigtofail”,meaningthatlettingthemcollapsewouldcauseunbearabledamagetotheentireinter-nationalfinancialsystem.Thefiscalcostsentailedinbailingthemoutincaseofinsolvencywouldbeexorbitant,andwouldrequireahighlevelofinter-nationalcoordination,whichisdifficulttoachieve.

Theirinternationalexpansionandthelargesizeof their balance sheets are difficult to explain onefficiencygrounds(biS,2010a).instead,evidencesuggeststhatsuchexpansionwasfacilitatedbyanunderestimationofrisk,whichmighthavedistortedtheir incentives.The “too-big-to-fail” label givessuchbanksacompetitiveadvantagebasedontheirassumption that if they suffer huge losses fromengaginginriskybehaviour,theywillberescuedbythegovernment.inaddition,itgivesthemaccesstocheaperfundingsources,astheyareseenaslesslike-lytodefault.Anothercompetitiveadvantagearisesfromthefactthat,underthebaselframework,largebankscanchoose themostconvenientapproachesforcapitaldetermination.Theyhavetheresourcestousetheirownriskmodels,whichgivesthemflex-ibility to determine their capital requirements andholdlesscapitalrelativetosmallerbanksthatonlyhavethemeanstoadoptthesimplerapproachesforcapitaldetermination.

Atthenationallevel,theexpansionoftheactivi-tiesoflargebankshasbeenamajorreasonbehindbankingconcentration,especiallybetween1998and2007.inthepost-2008periodthistrendhasstoppedoverall,although ina fewcountries, including theUnitedStates, it continues, partly reflecting post-crisisgovernment-sponsoredmergers(chart4.1).

Since theglobalcrisis,systemicrisksassoci-atedwithlargebankshavebeenamajorconcern.AUnitedNationsReportrecommendedsubjectinglargefinancial institutions to additional capital require-ments(UnitedNations,2009).italsoproposedtheadoptionbygovernmentsofstronganti-trustpoliciesto discourage banks fromgrowing too big.other

bodieshave suggested similar regulatorychanges.Forexample,theG20,atitsWashingtonSummitinNovember2008,recommendedareviewofthescopeoffinancial regulations to ensure that all systemi-callyimportantfinancialinstitutionsareadequatelyregulated.Ayearlater,theG20Summitinlondonfurtherproposedthatcomplexfinancialinstitutionsbesubject tospecialoversight,andthatregulatorsbegivenaccesstorelevantinformationonfinancialinstitutions,marketsandinstrumentsinordertobeabletodetectpossiblefailuresorsituationsofstressthatposesystemicrisks.

Since 2011, the FSb has identified globalsystemically important banks (G-Sibs) using amethodology developed by thebaselCommittee(bCbS,2011).9ThelatestupdateofNovember2014identifies 30 suchbanks (all of them fromdevel-opedcountries,exceptthreefromChina),whichareexpectedtobuildagreaterlossabsorptioncapacityaswellastohavecrisismanagementgroups,cross-border cooperation agreements and disaster plans

Chart 4.1

ASSETS OF ThE FIVE LARGEST bANkS AS A PROPORTION OF TOTAL ASSETS OF ThE bANkING SECTOR IN

SELECTED ECONOMIES, 1998–2011(Per cent)

Source: Bankscope, Bureau van Dijk.

201020

30

40

50

60

70

80

90

100

1998 2000 2002 2004 2006 2008 2011

Eurozone JapanUnited Kingdom United States

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(knownas“livingwills”).in2014,theFSbpresentedproposalstoenhancetheloss-absorbingcapacityofG-Sibsinresolution,accordingtowhichthesebankswouldfacecapitalsurcharges,leadingtototalcapitalrequirementsequalto16−20percentoftheirrisk-weightedassets.Thisismeanttoallowanorderlyresolution thatminimizes anyimpactonfinancialstabilityandensuresthecontinuityofcriticalfunctions.10

However,eventhesepro-posalsmay be insufficient toaddress the “too-big-to-fail”issue. First, the fact that loss-absorbingcapacityiscalculatedusing riskweights creates anopportunity for exercising considerable discretioninmeetingtherequirements.Second,itisnotclearwhethernationalregulatorswillcooperatewithouta globally agreedbank resolution regime; indeed,withoutsucharegime,therecouldevenbealocal-asset-seizingfrenzy todefendnational interests incaseofbankruptcy.

3. The prudential framework and developing countries

Sincetheirintroductionin1988,baselguide-lines on capital requirements have become asignificant reference for regulators throughout theworld.More than100 countries have adopted thebaseliguidelinesforcapitalrequirements(barthetal.,2006),andallthedevelopingcountriesthatareG20members,butalsoalargenumberofnon-members,haveimplementedthebaseliirequire-ments.Althoughmostofthesecountries adopted thebasel ii“standardizedapproach”,someofthenon-membersoftheG20(e.g. bahrain,Malaysia andThailand)alsoimplementedthemorecomplexinternalratings-basedapproach,allowinglargebankstodeterminecapitalrequirementsonthebasisofaself-assessmentofrisk.AccordingtotheFSb’sassessment of implementation of the regulatoryreformsinNovember2014,allthemajordeveloping

economies that are FSbmembers have alreadybecomefullycompliantwiththenewbaseliiicapitaladequacyrules.11AmongotherdevelopingeconomiesthatarenotFSbmembers,adherencetobaseliiihasbeenratherweak(biS,2014and2015).12Table4.1summarizesthedegreeofimplementationofbaselii

andiiiindevelopingcountriesbyregion.

Theadoptionofthebaseliicapitalrequirementsbyalargenumberofdevelopingcountries,and the steps they have takento complywith the basel iiiarrangementsissomewhatpuz-zling.Afterall,implementationof thebasel recommendations

isvoluntary,andthebaselCommitteedoesnotpos-sess any formal supranational supervisory author-ity.Moreover,manydevelopingcountries thatareadoptingbaselstandardswerenotevenpartytotheformulationprocess.indeed,baselguidelineswerenot conceivedwithdeveloping countries inmind;theywereconceivedforcountrieshostinglargeandcomplex,internationallyactivefinancialinstitutionswiththepurposeofharmonizingnationalregulations(Powell,2004).

Nonetheless, therearevarious reasons for thepartialadoptionofbaselrulesbydevelopingcountries.Sincetheirintroduction,baselprincipleshavecometoberegardedbypolicymakersastheglobalsealofapprovalforthequalityofcountries’bankingsupervi-sionsystems.Manydevelopingcountries“imported”regulatorycredibilityasaresultofofficialandmarketpressures,especiallythoseeconomieswhoseregula-toryframeworkscameunderscrutinyfollowingthe

financialcrisesofthelate1990sandearly2000s(Walter,2008).inaddition,somelargedevelop-ing countrieswhich joined theG20cameunderfurtherpressuretoimplementbaselregulations.All theG20 countries, includ-ing the developing-countrymembers, agreed to allow theFinancial SectorAssessmentProgram (FSAP)13 to conduct

ananalysisoftheirdomesticfinancialsector−whichincludesanassessmentoftheirobservanceofbaselguidelines−aswellastoacceptpeerreviewsoftheirsupervisoryframeworks(Walter,2015).

Given their size, complexity, cross-jurisdictional presence and interconnectedness, large banks have created global systemic risks and challenges for regulators.

Basel guidelines were con-ceived for countries hosting large and internationally active financial institutions; they do not consider devel-oping countries’ needs.

Financial Regulatory Reform after the Crisis 93

implementation of the newbasel iii capitalrequirements by themajor developing economiesmaynothavebeenparticularlydifficultbecause,ingeneral, their banking systems had higher capitallevelsbeforetheglobalcrisisthanthosestipulatedinbaseliii.14However,thispictureisnotuniform.inindia,forinstance,publicbanks,whichaccountfor 62 per cent of indian bank loans,will find itdifficult tomeet thebaseliiicapitalrequirementsbetweennowand2019(Moody’s,2014).Thedegreeofcompliancevariesmuchmoreforbaseliii’snewliquidityrequirements.AnFSbsurveyindicatesthatArgentina,brazil,indonesiaandMexicoarebehindothercountriessuchasChinaandSouthAfrica intheirextentofcompliance(FSb,2014a).AccordingtoarecentassessmentbyFitch(2015),smallerbanksinMexicowillstruggletomeettheliquiditycoverage

ratio,andwillfaceanevenbiggerchallengewhenthenetstablefundingratiorequirementsareeventuallyadoptedbytheircountry’sregulators.

DevelopingcountriesotherthantheG20mem-bersappeartobefacingamuchgreaterchallengeinmeetingbaselrequirements.Acriticalchallengeisthelevelofcomplexityofbaselrules,particularlythenewrulesunderbaseliii,whichnotonlyrequiresophisticatedtechnicalcapabilitiesfortheirimple-mentationbutarealsoresourceintensive(HaldaneandMadouros, 2012). FSAP reports on countriesfromdifferentdevelopingregionsindicateagenerallackofcompliancewithbaselstandardsduetocriti-calcapacitygaps.Theseinclude,overall,insufficientandpoorlytrainedstaffwhoalsolacktheexperienceto perform regulatory and supervisory functions

Table 4.1

bASEL IMPLEMENTATION IN DEVELOPING AND TRANSITION ECONOMIES

Basel II Basel III

Total economies surveyed

Capital requirements (Standardized

approach)

Capital requirements

(Internal ratings based approach)

Leverage ratio

Liquidity coverage

ratio

(Per cent) (Per cent)

Region (whole sample)

Africa 30 27 10 13 13East, South and South-East Asia 17 82 59 47 29Latin America and the Caribbean 21 38 23 14 24Transition economies from Europe and Asia 11 73 9 18 18West Asia 9 100 33 33 33

Region (excluding BCBS members)

Africa 29 23 7 10 10East, South and South-East Asia 11 27 13 0 7Latin America and the Caribbean 18 16 7 7 3Transition economies from Europe and Asia 10 23 3 7 3West Asia 7 23 3 3 3

Source: UNCTAD secretariat calculations, based on BIS, 2014 and 2015.Note: The data cover the following economies, by region: Africa: Angola, Benin, Botswana, Burkina Faso, Côte d’Ivoire, Democratic

Republic of the Congo, Egypt, the Gambia, Ghana, Guinea, Guinea-Bissau, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Morocco, Mozambique, Namibia, Niger, Nigeria, Senegal, South Africa, Togo, Tunisia, Uganda, United Republic of Tanzania, Zambia and Zimbabwe; East, South and South-East Asia: Bangladesh, Bhutan, China, Hong kong (China), India, Indonesia, Malaysia, Mauritius, Nepal, Pakistan, the Philippines, Republic of korea, Singapore, Sri Lanka, Taiwan, Province of China, Thailand and Viet Nam; Latin America and the Caribbean: Argentina, Belize, Bolivia (Plurinational State of), Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, Trinidad and Tobago, Uruguay; Transition economies from Europe and Asia: Albania, Armenia, Belarus, Bosnia and Herzegovina, Georgia, Kyrgyzstan, Montenegro, Republic of Moldova, the Russian Federation, Serbia and the former Yugoslav Republic of Macedonia; and West Asia: Bahrain, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia, Turkey, United Arab Emirates (countries in bold are members of the Basel Committee).

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satisfactorily.Thesegapsbecomeevenmorecriti-calwithrespecttotheverycomplexbaseliiirules.

Thereareothersignificantconcernsrelatedtotheimplementationofbaseliii.TheadoptionoftheNSFR,which aims at reducing thematuritymis-matchesbetweenbanks’assetsandfundingsources,may have adverse consequences for developingcountries,asbanksinthoseeconomiesaremainlyfundedthrough(short-term)deposits.Assuch,therequirementforastrictmatchbetweenmaturitiesofassetsandliabilitiesmayreducebanks’abilitiestosupplylong-termcredit.Anotherchallengehastodowith the implementationofcountercyclicalcapitalbuffers.economiesatearlystagesoffinancialdevel-opmentmayexperiencerapidcreditgrowthwhichtriggers the buffermechanism, even though theremaynotbeabuild-upofsystemicrisks(DrehmannandTsatsaronis,2014).

Amoregeneralconcernisthatbaselregulationshaveincreasinglyfocused(withoutmuchsuccess)onanarrowviewoffinancialstabilityat theexpenseof regulations geared towardsthe realization of growth andequity objectives.Relianceonrisk-weightingforcapitaldeter-mination,whether through thestandardized approach or themorecomplexmethods,islikelyto result in credit rationing tosectors thatneedsupportfromadevelopmentperspective.ThebaselguidelinesforcreditriskmeasurementmayincreasethecapitalrequirementsforfinancingSMes(whicharegenerallyviewedaspresentinghigherrisks)andforlong-termprojects,whilemakinglendingcheapertolargerfirms,includinginternationalcompaniesthatareusuallyawardedhigherratingsbyexternalCRAs.

Therefore, it seems that, despite developingcountries’ greater representation on internationalforums,thereformsundertakenfollowingtheglobalfinancialcrisisdonotseemtoaddressanumberoftheirconcerns.Thefocusonnarrowlydefinedpru-dential reformsmaybe inadequate for preventingfuturecrises.Theyarealsocomplexanddifficulttoimplementinmanydevelopingcountries,andindeed,theirimplementationmayposeobstaclestoeconomicdevelopment.

4. Some attempts to ring-fence banking operations

in parallel to the adoption of the regulatoryreformscoordinatedbytheFSbattheinternationallevel,manydevelopedcountriesdraftednewnationallegislationtoaddresssystemicrisksintheirfinancialsystems.of all the reformproposals triggeredbythefinancialcrisis,themostfar-reachingarethosecontainingprovisionsto“ring-fence”financialactivi-ties,whichgobeyondtheprudentialapproachofthebaselframework.

Thebasicargumentforring-fencingisthatinsu-latingdepositors’assets fromriskybankactivitieswouldlimittheprobabilityofabankrunincaseofinsolvencyresultingfrom“casino”investmentdeci-sions.Suchseparationwouldalsofacilitateresolutionofabankinggroupindifficultyandwouldreducethelikelihoodorthenecessityofgovernmentinter-ventiontosavebanksthathaverunintotroubleasaresultoftheirhigh-risktradingactivities.Ahistorical

precedent is theUnitedStatesGlassSteagallAct,whichpro-hibitedcommercialbankswithprivileged deposit insurancefromengaginginmarketactivi-ties,whileexcludinginvestmentbanksfromacceptingdeposits.Thatreform,whichwaspartoftheNewDealof1933,regulatedthe functioning of theUnitedStates financial system for aperiodofover65yearsuntilthe

FinancialServicesModernizationActof1999liftedrestrictionsonbanks.

TheUnited States did not reintroduce deepbankreorganizationmeasuresafterthe2008−2009financialcrisis,butoptedinsteadforarulerestrictingsomeoftheactivitiesofbanks.Amongitsvariousprovisions, theDodd-FrankWall Street ReformandConsumerProtectionActof2010includedtheVolckerRule,whichprohibitstwotypesofactivities.First,abankingentityunderUnitedStatesjurisdic-tionisnotallowedtoengageinproprietarytrading.Thismeansthatbankscannotbuyorsellsecuritiesfortheirownaccount.15Second,theRuleprohibitsbanksfromsponsoring,acquiringorretaininganownershipinterestinhedgefundsandprivateequityfunds.

Despite developing countries’ greater representation on international forums, the reforms undertaken seem to neglect a number of their concerns.

Financial Regulatory Reform after the Crisis 95

inlate2013,theUnitedKingdomintroducedlegislationonbankingreformbasedontheso-calledVickersReport.Unlike in theUnited States, thereformdid not focus on prohibiting banks’ riskyactivitiesbutonring-fencingdeposit-takinginstitu-tions.Assuch,itwasdecidedthatretailbankinghadtobesetapartfrominvestmentbankinginaseparatelycapital-izedsubsidiary.Theaimsofthereformwere to help insulatedomestic retail banks fromexternal financial shocks andfacilitateresolutionoftroubledbanks should the need arise(FSb,2014b).Therecommen-dationsoftheVickersReportwerearesponsetotheworryingfact,fromtheUnitedKingdomperspective,thattheinternationalexposureofthatcountry’sbank-ingsectorwasmanytimeslargerthanthedomesticeconomymeasuredbyitsGDP.oneoftheaimsofring-fencingwas to protect domestically orientedbankingfromwhatevermighthappeninthegloballyorientedactivities(Wolf,2014).16Thering-fencingappliedonlytolargefinancialgroupsholdingcoredepositsofover£25billion.

TheeuropeanCommission (eC) also exam-ined the possibility of structural reform of theeuropeanUnion’sfinancial system.based on therecommendations of itsHigh-levelexpertGrouponbankStructuralReform(theso-calledliikanenCommission),theeCsubmitteddraftregulations,acorepropos-alofwhichwasthatproprietarytradingandotherhigh-risktrad-ingactivitiesshouldbeassignedaseparatelegalentityfromtherest of a bank’s businesses. ifthe reform is enacted, itwillbe restricted to banks holdingassetslargerthan30billioneuros,anditwillapplynotonlytodeposit-takingbanks,butalsototheirpar-entcompaniesandsubsidiaries.FranceandGermanyhavealreadyintroducedrulespartiallybasedontherecommendationsoftheliikanenCommission.

ThestructuralmeasuresproposedbytheUnitedStates,theUnitedKingdomandtheeuropeanUnionaim to lower the probability of bank failure andits systemic implications by reducing the risk fordepositsassociatedwithbanks’interconnectedness(Viñalsetal.,2013).Apossiblewaytorestructure

thefinancialsectorwouldbetoestablishafirewallbetweenbankstakingdepositsandthoseengagedinbroker-dealeractivities.However,ring-fencinginitia-tives–justlikeproposalstoraiseminimumcapitalrequirements–facestrongresistancefromthebank-ingindustrylobby.indeed,noneofthering-fencing

rules discussed above is fullyinplaceyet.implementationoftheVolckerRule in theUnitedStateshasbeenpostponedsev-eraltimes,andafurtherdelayto21July2016setbyUnitedStatesregulators is being considered.intheUnitedKingdom,regula-tors expect to finalize rules in

2016,withbanksfullycomplyingby2019,butthereisconsiderableresistancefromthesector.

itisstillunclearwhetherthesemeasureswillbeabletoinhibitfurtherexpansionoflargebanksandmakeiteasierforgovernmentauthoritiestomanageorcontrolthem.Pressuresfromsomefinancialactorshavemadetheproposedregulationsmuchmorecom-plexthantheyneededtobe.exceptions,loosedefi-nitions and supervisory judgements couldweakentheoutcomesof thereforms.in theUnitedStates,thereareimportantexceptionstotheprohibitionofproprietarytradingandothertradingactivities.Theexceptionsincludepermissiontoengageinhedgingactivitiestomitigaterisks,proprietarytradinginvolv-ingUnited StatesGovernment debt instruments

andmarket-making.The lackof a precise definition of pro-prietary trading enables banksto determine for themselveswhichtradingactivitiesareper-mitted,andwhicharenot.Anddespite reforms inFrance andGermany, the intention seemstobetomaintaintheuniversal

bankingmodel, althoughnational supervisorswillhavethediscretiontoseparatecertainactivitiesfromcorebanking,butonlywhentheyjudgeafinancialinstitution’ssolvencytobeunderthreat.

Therefore,itremainstobeseentowhatextentthevariousregulatoryandstructuralreformmeasureswill be sufficiently effective in reducing the com-plexityandinterconnectednessoflargebankssoastomakethemsafer,andwhethertheywilldiscour-agethesebanksfrombecomingevenlarger,orhelpreverselong-termtrendsinbankingconcentration.

Ring-fencing bank activities would limit the probability of a bank run in case of losses from “casino” investment decisions…

… and facilitate the resolu-tion of a banking group in difficulty, thus reducing the likelihood of expensive gov-ernment bailouts.

Trade and Development Report, 201596

1. The emergence and principal features of the shadow banking system

After the 2008–2009 global financial crisis,largebanksreducedsomeoftheirlendingactivitiestorepairtheirbalancesheetsandadapttotighterregula-tions.Asaresult,banks’credittotheprivatesectorindevelopedcountrieshaswitnessedadownwardtrend.

Despite this movement, total global debtexpandedby$57 trillionbetween2007and2014,which increased the ratio of global debt toGDPby 17 percentage points to 286 per cent ofGDP(McKinsey,2015).Thegrowthinborrowingoccurredprincipallyoutsidethetraditionalregulatedbankingsystem.indevelopedcountries,formsofnon-bankfinance,suchascorporatebondsandcreditissuedbynon-bankinstitutions,havesoaredsincetheglobalcrisis.Meanwhile,bankmanagershavecontinuedtomoveactivitiesofftheirbalancesheets,afterpack-agingtheloansintosecuritiestosellinthemarkets.Althoughsecuritizationhasdeclinedinimportancecomparedwiththepre-crisisperiod,itremainssig-nificant:in2014,32percentofthestockofhouseholddebt (mainlymortgages and credit card loans) indevelopedcountrieswassecuritized,against36percentin2007(McKinsey,2015).

The shift in credit intermediation from thebankingtothenon-bankingsectorreflectsthelargerroleoftheassetmanagementindustry(iMF,2015).Thisindustryiscomposedofinstitutionalinvestors,including insurers, and investment funds such ashedgefundsandmutualfunds,aswellasoff-balancesheet entities such as special purpose entities, allofwhichbuyandsellsecuritiesandotherfinancialassets.17Financingviacapitalmarketsinvolvesboth“directfinance”mechanisms,inwhichinvestorsbearallthecreditrisk,andtheso-calledshadowbanking

system.bothcomplement(butalsocompetewith)traditional banking, and are alternative sources offundingforrealeconomicactivity.Shadowbanking,however,posesanumberofthreatstofinancialstabil-ity,asitperformsthesamefunctionsastraditionalbankingwithoutappropriateregulation.

in the shadow banking system credit inter-mediation takes placewith less transparency thantraditional banking.Agents in that system takedeposits (just as banks do) or accept deposit-likeinvestments,extendcreditandperformmaturityandliquiditytransformation,oftenrelyingonleveragingtechniques to increase profitability.They convertshort-term liabilities, such as deposit-like sharesinmoneymarketmutual funds (MMMFs), into awiderangeoflong-termassets−fromgovernmentsecurities to bonds issued bymeans of complexsecuritization techniques. Financial companiesperforming bank-like intermediation face fewerrestrictionsontheirsizeandleverage,butlackaccessto explicit liquidity guarantees.Thismakes theshadowbankingsysteminherentlyfragile.

Theroleoftheshadowbankingsysteminthe2008financial crisis iswell known, andhas beendocumented and analysed in previousUNCTADreports(e.g.TDRs 2009 and 2011).TheG20andtheFSbhaveidentifiedanumberofproblemswiththatsystem,whichcontributetoglobalfinancialfragility.However,notnearlyenoughhasbeendoneintermsofregulationoftheshadowbankingsystem.Clearly,moreambitiousreformsareneeded.

Shadowbankingistheoutcomeofderegulationofthefinancialsystemoverthepastfourdecades.Thismarket-basedsystemdevelopedmainlyintheso-calledAnglo-Saxoncountries,andthenexpandedtomostoftheothercountries,includingthedevel-oping ones. in the process, institutional investors(includinginsurancecompanies,pensionfundsand

C. The rise of the shadow banking system

Financial Regulatory Reform after the Crisis 97

mutualfunds)becamemajorparticipantsinglobalfinancialmarkets,andthesizeoftheirassetsundermanagement rapidly caught upwith those of thebanking system. Subsequently,most institutionsturned to specialist assetmanagers to help theminvest,whichdrovegrowthinequitymarketsdur-ingthe1980sandinthehedgefundsindustryinthe1990s. Direct investment byinstitutionalinvestorsprovideda stable and reliable sourceoffunding for borrowers and theopportunity for investors tohold a diversified portfolio offinancialassets.

Thedevelopmentofinno-vative forms ofmarket inter-mediation allowedmany assetmanagers(suchashedgefunds)andbroker-dealers(oftenbelongingtofinancialcon-glomerates) to expand investments by leveragingwithin thefinancial systemandfundingassetpur-chaseswith theirdebt.Asa significantproportionofthedebtissuedbyintermediarieswasshortterm,thefinancial companiesperformedmaturity trans-formation.inthetraditionalbankingsystem,inter-mediationbetweendepositorsandborrowersoccursinasingleentity.bycontrast,thecreditintermedia-tionprocessperformedbytheshadowbankingsys-temcaninvolvenotjustone,butawebofspecial-izedfinancialinstitutionsthatchannelfundingfromlenderstoinvestorsthroughmultiplemarket-basedtransactionsandlendingvehicles.

Asimpleexamplefacilitatesanunderstandingofthebasicfunctioningoftheshadowbankingsys-tem.ThetypicallenderinthecreditintermediationchainisahouseholdinvestingitscashholdingsinsharesofanMMMFinsearchofahigheryieldthantheonetypicallyofferedbyadepositinacommercialbank.18Thelendermayalsobeatreasurerofalargecompanyseekingtoinvestavailablecashinadiffer-entformthanbankdeposits,whichinmostcountriesarenot insuredfor largesums.Thefinalborrowerintheshadowbankingsystemisanyentityissuingsecurities(i.e.agovernmentorprivatecorporation)tofunditsexpendituresorinvestments.itcanalsobeahouseholdifitsloansordebts(e.g.mortgageorcreditcarddebt)arepackagedintosecuritiesbybanksorspecializedfinancialinstitutions.Securitizedbonds(includingstructuredsecurities)areinfactakeycomponentoftheshadowbankingsystem.The

cash resources fromMMMFs and companies areinvestedinshort-termdebtsecurities(i.e.commer-cialpaperandgovernmentbillsoranydebtabouttoreachmaturity)andinshort-term(oftenoneday)repurchaseagreements(repos).Reposareaformofsecured lendingbackedby collateral, so that theyseem safer than non-insured bank deposits (see

box4.1).investmentsinbillsorcommercialpaperdonotcarrysignificantmaturityrisk,astheshort-term funding ismatchedwith short-term investments.but the liquid resources pro-vided through reposoften endupbeingusedbytheborrowerfor the outright purchase of along-term security or anotherasset in such away that thesystemperformsmaturitytrans-

formation, similar towhat banks do but in a lesstransparentway.Thebroker-dealermayindeedusethefundsitraisesthroughrepostopurchasehigh-qualitysecurities,whichitthenusesascollateralforthetransaction.19Hedgefundsaretypicallyengagedinreposandotherkindsofshort-termborrowingforleveragedinvesting.

Shadowbankingisgrowingstronglyindevel-oping economies, although the steps involved inthechainsofcreditintermediationtendtobesim-pler.Thatsaid,itcanstillposesystemicrisks,bothdirectly,asitsimportanceinthetotalfinancialsystemgrows,andindirectlythroughitsinterlinkageswiththeregulatedbankingsystem(Ghoshetal.,2012).

2. How big is shadow banking?

Theperimeterof theshadowbankingsystemanditsoverallsizearecurrentlyunderdebate.TheFSb, engaged since 2011 in a global project tomonitor andmeasure shadowbanking, originallydefineditas“creditintermediationactivitiesinvolv-ing entities outside the regular banking system”(FSb, 2014c). Following this definition, the sizeofthesystemisdeterminedbythevolumeoftotalfinancialassetsofnon-bankfinancialintermediaries,excludinginsurancecompanies,pensionfundsandpublicfinancial institutions (which are regulated).Many judged this definition as being too broad.

In the shadow banking system, credit intermediation takes place with less trans-parency and regulation and higher leverage than tradi-tional banking.

Trade and Development Report, 201598

Box 4.1

REPOS: ThE CORE TRANSACTION OF ThE ShADOw bANkING SySTEM

A repurchase agreement (or repo) is an acquisition of funds through the sale of securities,with asimultaneousagreementbythesellertorepurchasethem−orsubstantiallysimilarones−atalaterdate,oftenovernight.Theborrowerpaysinterestataratenegotiatedwiththelender,andretainstheriskandreturnonthatcollateral,sothattheroleofthesecurityinvolvedinthetransactionisonlytoprovidecollateraltothelender.Reposarethereforeameansofsecuredlendingofshort-termfunds.inpractice,however,asizeableportionofthefundsusedremainsinreposforrelativelylongperiods,asthedailycontractsarerolledover.inthatsense,reposareadeposit-likefundingsourcefortheborrower.Meanwhile,theownersofthefundscantreatthemvirtuallyasdemanddeposits,astheyhavereadyaccesstothecash,shouldtheneedarise,bynotrenewingorrollingovertherepo.

Reposareattractivetocorporatetreasurersandotherholdersoflargecashbalancesbecausetheycanearnasecuredmarketrateofreturnuntiltheyareusedforpayments.inaddition,reposmayseemsaferthanbankdeposits,whicharenotprotectedbydepositinsuranceforlargeamounts.Repos,alongwithcommercialpaper,arealsoatypicalinvestmentproductforMMMFs,whoseshareholdersarealsoultimatelendersintheshadowbankingsystem.

Theborrowerintherepotransactionmayusethecashtofinancealongpositionintheassetinvolvedinthecollateral,inamountsandatpricesthatreflectthesecurityprovidedtothelender(iCMA,2015).broker-dealersalsofrequentlyarrangereverserepos inorder toborrowthesecuritieswithwhich toengageinarepo;bymatchingarepoandareverserepotransaction,theymayprofitbythedifferenceininterestrates.Dealersalsousereverserepostoacquiresecuritiestomakeashortsale.

Theadvantageforborrowersthroughrepos,includingcommercialbanksandbroker-dealers,isthattheyarenotrequiredtoholdreservesagainstfundsobtainedthroughtherepos.aAnotheradvantageistheflexibilityinrecordingthesetransactionsinthebooks,atleastforfirmsoperatingintheUnitedStatesundertheGenerallyAcceptedAccountingPrinciples(GAAP).Forinstance,somelenderschoosetorecordtheirownershipofsecuritiesratherthantheirownershipofrepos,whichmaybeconsideredabetterriskandthuslesscostlyintermsofcapitalrequirements.Forborrowers,assetssoldinreposmayberemoved(temporarily)fromthebalancesheets,therebydisguisingthetrueleveloftheleverage(iCMA,2015).b

Thebankruptcy“safeharbour”forreposhasbeenasignificantfactorcontributingtothegrowthofshadowbanking(GortonandMetrick,2009).intheUnitedStates,reposareexemptfromcorebankruptcyrulessuchastheautomaticstayondebtcollectionunderChapter11oftheUnitedStatesbankruptcyCode.UnderNewYorklaw(themainjurisdictionforUnitedStatesrepos),apartytoarepocontractisallowedtounilaterallyenforcetheterminationprovisionsoftheagreementasaresultofabankruptcyfilingbytheotherpartybysellingthecollateraltorecoverthedeposit.Withoutthisprotection,apartytoarepocontractwouldbeadebtorinbankruptcyproceedings(GortonandMetrick,2009).cineurope,therepotransferslegaltitletocollateralfromthesellertothebuyerbymeansofanoutrightsale.Thereforeinmajorfinancialcentres,forlargedepositors,reposcanactassubstitutesforinsureddemanddeposits.

it encompasses non-leveraged activities by fundmanagersthatadministerinvestmentsonbehalfoftheirclients,whobeargainsandlossesdirectly,sothatthereisnointermediationperse.inresponsetothis,theFSbstartedreportingonanarrowermeasure,filteringoutnon-bankfinancialactivitiesthathavenodirectconnectionwithcreditintermediation(e.g.the

transactionsofnon-leveragedequityfunds)orthatareprudentiallyconsolidatedintobankinggroups(e.g.securitizedproductsheldbybanksandassetsfromthebroker-dealeractivitiesoftheuniversalbanks).

TheiMFhasproposedmeasuringthevolumeof the “non-core” liabilities of both banks and

Financial Regulatory Reform after the Crisis 99

An interesting featureof repos is that thecollateralpostedbyaclient to itsbrokermaybeusedascollateralalsoby thebroker for itsownpurposeswithanunrelated thirdparty.Thesamecollateralcanthereforesupportmultipletransactions.indeed,brokersmayrehypothecatetheassetsreceivedascollateral,forinstancefromahedgefund,togainaccesstothemoneytheylendtoitscustomer.Theclientthatborrowedthemoney(thehedgefund)canuseitsincreasedassetsforanewrepotransaction.Thedealerusesthesecuritytoraisemorefunds,andsoon,ad infinitum (SinghandAitken,2010).Unlimitedleveragehaspracticalconstraints.Marketparticipantstendtoapplyhaircuts(apercentagediscount)tothecollateralinarepoinordertocalculateitspurchaseprice.Applyinghaircutsisequivalenttoaskingforanovercollateralization.Theadjustmentisintendedtotakeaccountoftheunexpectedlossesthatonepartytotherepotrademightfaceinbuying(orselling)thesecuritiesiftheotherpartydefaults.Haircutslimittheleverage.Forinstance,ahedgefundfinancingitsassetpositionthrougharepo(andusingthepurchasedassetascollateral)willneedtobuypartofitspositionwithitsownresources.Aninfinitemultiplierwouldalsocomeupagainstthecreditlimitsimposedbyfinancialinstitutionsontheircounterpartiesand,ifapplied,againstlimitsduetoregulatoryconstraints.

AccordingtotheinternationalCapitalMarketAssociation(iCMA),therearelargerepomarketsineurope,theUnitedStates,latinAmericaandJapan,aswellasrapidlyemerging(althoughstillrelativelysmall)repomarketsinChinaandanumberofAfricancountries.outstandingrepocontractsintheeuropeanrepomarkettotalledanestimated5.5trillioneurosinDecember2014,butthisestimateisnotcomprehensiveasitonlyincludesthemostactiveparticipantsintheeuropeanrepomarket(iCMA,2015).TheFederalReservebankofNewYorkreportedthattheoutstandingrepobusinessofprimarydealers(whomayaccountforasmuchas90percentoftheUnitedStatesmarket)amountedtoalmost$5trillionin2014.TheiCMACentreatReadingUniversityhassuggestedthat,althoughtheglobalmarketforreposhascontractedsince2007,itmayhaveamountedto15trillioneurosin2012.GortonandMetrick(2009)suggestanamountuptothreetimeslargerfortheUnitedStates.

a iftheyarebanks,theleverageratiomayapply,dependingontheaccountingrulesofthejurisdictionswheretheyarebased.

b ThefirmsoftenuseloopholesspecifictotheUnitedStatesGAAP.inordertoensurethatthebalancesheetmakesclearwhichassetshavebeensoldinrepos,theinternationalFinancialReportingStandards(iFRS)requiresthatsecuritiesagainstarepobereclassifiedfrom“investments”to“collateral”andbalancedbya“collateralizedborrowing”liability.

c According toMorrisonet al. (2014), evidence shows that exemptions from thebankruptcyCode’snormaloperationforreposdistortthecapitalstructuredecisionsoffinancialfirmsbysubsidizingshort-termfinancingattheexpenseofother,saferdebtchannels,includinglongertermfinancing.Whenfinancialfirmsprefervolatileshort-termdebttomorestablelong-termdebt,they(andmarketsgenerally)aremorelikelytoexperiencea“run”intheeventofamarketshock,suchasthedownturninhousingpriceswitnessedduringtheglobalfinancialcrisis.

Box 4.1 (concluded)

non-bankfinancialinstitutionstoestimatethesizeoftheshadowbankingsystem(iMF,2014).Non-coreliabilities are all the funding sources of financialfirms thatdiffer frombankdeposits.According tothis definition,which includes all non-traditionalfinancial intermediation, securitization is alsopartof shadow banking, regardless ofwhether it is

conducted directly onbalance sheet by a bankorindirectly through a special purpose entity (SPe).TheiMFhasalsosuggestedanarrowermeasureofshadowbankingwhichexcludesinterbankdebt.

based on theFSb’s broadmeasure, shadowbanking activity has expanded significantly since

Trade and Development Report, 2015100

2002, particularly in developed economies, and,notably,itcontinuedrisingafterthefinancialcrisis.itsoverallsizeintermsofassetswasanestimated$75.2trillion,oraboutonefourthoftotalfinancialintermediationworldwideattheendof2013,asharprisefrom$67trillionin2011and$71trillionin2012.ThelargestshadowbankingsystemsarelocatedintheUnitedStates,theeurozoneandtheUnitedKingdom(chart4.2),butshadowbankingintermediationhasbeenalsoexpandinginafewdevelopingcountriessuchasChina(seebox4.2).

other forms of shadowbanking exhibited asimilar growth trend until 2007, but the patternchangedafterthecrisis,whenitstagnatedordeclined,accordingtoiMFmeasures.20Themainreasonforthis,bothintheUnitedStatesandintheeurozone,wassluggishactivityamongissuersofasset-backedsecuritiesandafallincommercialbankdebtissu-ance.MMMFs’shares,whichalsoshrankafterthecrisis, furthercontributedto thedropin totalnon-coreliabilities.incontrast,FSbestimatespointtoapick-upofshadowbankingactivityafterthemild

Chart 4.2

SIzE OF SHADOw BANkINg By DIFFERENT MEASuRES, 2001–2013(Trillions of dollars)

Source: Harutyunyan et al., 2015; and FSB, 2014c.

0

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2001 2003 2005 2007 2009 2011 2013

A. Eurozone

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2001 2003 2005 2007 2009 2011 2013

B. Japan

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2001 2003 2005 2007 2009 2011 2013

C. United Kingdom

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2001 2003 2005 2007 2009 2011 2013

D. United States

FSB (broad measure) FSB (narrow measure) IMF (broad measure) IMF (narrow measure)

Financial Regulatory Reform after the Crisis 101

Box 4.2

ShADOw bANkING IN ChINA

inChina, theriseofashadowbankingsystemisquiterecent,asbankshavecompletelydominatedthecreditsystemsincethemarketreformsofthelate1970s.evenasrecentlyastheendof2008,bankloansrepresentedalmost90percentofoutstandingcreditinChina(elliottetal.,2015;elliottandYan,2013).Reformsinthecountry’sfinanceandbankingsectorsoverthe1990sand2000s(okazaki,2007;Kruger,2013)resultedingreatersophisticationoffinancialinstrumentsandalsomadeitmorepossibletoavoidregulatorycontrols.

ShadowlendinginChinatakesplacethroughawiderangeofentitiesinvolvingfivemainsourcesoffinancing:wealthmanagementproducts,entrustedloans,trustloans,financingcompaniesandinformalloans.Manyshadowbankingactivitiesarespecificallydesignedtocircumventbankingregulations,andcanthereforebeinterpretedasformsofinternalregulatoryarbitrage(ChandrasekharandGhosh,2015).Forexample,despitecapsonlendingvolumesofbanksandlimitsonloanstopotentiallyriskyborrowers(suchaslocalgovernmentfinancingvehicles,realestatedevelopers,coalminersandshipbuilders),thoseloansactuallycontinuedtoincrease,becausetheywereroutedthroughshadowlending.

Wealthmanagementproducts(WMPs)provideareturnbasedontheperformanceoftheunderlyingassets(asingleloanorapoolofloans),typicallyhigherthanbankdepositratestowhichmonetaryauthoritiesapplycaps,therebyenablinginterestrateliberalization“bystealth”(Kruger,2013).Theyarepromotedaslow-riskinstruments,andasignificantnumberofthemofferguaranteedreturns(iMF,2014).entrustedloansare inter-company loans inwhichonefirmservesas theultimate lender and records the loanassetonitsbalancesheet,whilebanksactasintermediariesandcollectfees.Fundsofentrustedloanstypicallyflowintoassetssuchaspropertyandstocks,andtheyareapotentialrisktofinancialstabilitysincetheygenerateanewroundofcreditandincreaseleverage.Thereareotherchannelsthroughwhichnon-financialfirmsoffercredittooneanother,suchascorporatediscountingofbankacceptancebills,whichcanalsobeusedtoaddtoleverage(eliottetal.,2015).

Guaranteecompanies,originallycreatedtohelpSMesobtainaccesstobankloans,chargeprospectiveborrowersafee,andinexchangeserveasaguarantortoabank,pledgingtopayforanylossesintheeventofadefault.ineffect,the“creditguarantee”companysellsinsurancetothebankforariskyloan,withtheborrowerhavingtotakeonthepremium.likeanyinsurancescheme,thisarrangementmayberiskyiftherisksarecorrelatedbetweenborrowers.Finally,otherformsofintermediationconsistofinformallendingbyindividualmoneylenders(suchaspawnshopsandkerblenders)tohouseholdsandsmallbusinesses.

independentestimatesoftheextentofshadowbankinginChinavarywildlyfromalowof8−22percentofGDPtoahighofasmuchas70percentofGDPin2013(ChandrasekharandGhosh,2015).AccordingtotheiMF(2014),socialfinancingthroughshadowbankinghadrisento35percentofGDPbyearly2014,anditisexpandingattwicetherateofbankcredits.ThevalueoftotalassetsofWMPsaccountedfor25percentofGDP,havinggrownby50percentsinceearly2013,andthreefoldsinceearly2011.Underthebroadestdefinitionsofshadowbanking,China’sshadowbankingsectorremainsmuchsmallerrelativetothesizeofitsGDPthanthoseoftheUnitedStates(150percent),theUnitedKingdom(378percent)andmanycountriesoftheeurozone.

Aspartoftheireffortstocurbtherisksassociatedwiththeinformalfinancialsector,theChineseauthoritiesintroducedinsuranceforbankdepositsofupto500,000renminbiperdepositorperbankinApril2015,coveringbothindividualsandbusinesses.Thisshouldmakethedistinctionbetweenbankdepositsandunprotectedwealthmanagementproductsclearer,butthereisstilllikelytobeintensepoliticalpressuretostepinandrescueunprotectedinvestorswhensuchschemesfail(eiU,2015).officialshavefrequentlystatedthattheGovernmentwillnotbackshadowbankingtransactionsundertakenbybanks,althoughtheissueiscomplex,sincebankownershipinChinaisheldbytheGovernmentintheformofshares.

Trade and Development Report, 2015102

dropin2008,reflectinggrowthinthevolumesinter-mediatedbyinvestmentfundsandpositivevaluationeffectsfollowingtherecoveryofassetpricesfromtheirlowvaluesin2008−2009.

However,thesizeofshadowbankingtendstobegrosslyunderestimated,asmostmeasuresexcludetheshadowbankingentitiesdomiciledinmanyoffshorefinancialcentres,ortaxhavens.TheFSbrecognizedthatincorporatingdatafromtheseoffshorecentres,whicharenon-FSbmemberjurisdictions,wouldhelpfillgapsinthecurrentglobalmonitoringexercise.Suchgapsmaybelarge,asfinancialentitiesmovesizeableportionsoftheirshadowactivitiestooffshorecentrestoavoidregulationsintheirhomecountries.

3. Risks associated with shadow banking

The specialization of each institution partici-patinginthechainofintermediationoftheshadowbanking system allows borrowers and lenders toavoidcreditspreadsandotherfeeschargedbytra-ditionalbanks.inthatsense,shadowbankingmaybringefficiencygainsfromspecializationwithlowercostsforclientsandhealthycompetitionforbanks.it has been argued that securitization enables themobilization of illiquid assets,thus broadening the range ofpotentiallenders,andthatstruc-turedfinancetechniquescanbeused to tailor the distributionofriskandreturns tobetterfitthe needs of ultimate inves-tors (iMF, 2014). However,activitiesthatresemblebanking,particularlybytakingdeposits,create specific financial risks.Unlikebanks,towhichauthori-tiesapplycapitalrequirementsandotherrules,thetransactionsintheshadowbankingsystemarenotregulatedandlackexplicitpublicsectorcreditguaranteesoraccesstocentralbankliquiditybackstops.Problemsintheintermediationchaincanthereforetriggerasystemiccrisisinthewholefinancialsystem.

Since the2008crisis, various featuresof theshadowbanking systemhave been highlighted ashighlyproblematicforfinancialstability.Aleading

concern is the quality of somefinancial productstradedinthatsystem.Someoftheloanspackagedintosecuritiestobesoldinthemarket(i.e.asset-backedsecurities)haveoftenbeenpoorlyunderwritten,withissuersnotrecordingtherisksintheirbalancesheets,andinsteadtransferringthemtothebuyers(Covalet al., 2008).21As the 2008 crisis has shown, the“originateanddistributemodel”carriesmoralhazard.banksarelikelytobemorecarefulinevaluatingriskwhentheyplantokeepaloanontheirbooks,whilesecuritizationmayleadtoweakenedlendingstand-ardsandadeteriorationofcreditquality.Aparticularconcernrelatestocomplexsecuritizationstructures(e.g.collateralizeddebtobligations),forwhichrisksareparticularlydifficulttoassess.

A second concern, directly related tomacro-economicstability,isthatshadowbankingishighlyprocyclical.Whenassetprices arehigh, thevalueofthecollateralforreposincreases,enablingmoreleverage.Shadowbankingthereforecontributes toassetpricebubbles(Pozsaretal.,2013),andalsotoacreditcrunchwhenafinancialcyclecomestoanabruptend.Sometypesofcollateralusedfortransac-tionsmayevenbecomeunacceptableduringperiodsofturmoil.

indeed,athirdconcernisthatshadowbankingisparticularlypronetorisksofclients’suddenand

massivewithdrawals of fundsoriginating frommarket-basedtransactions instead of froma run on deposits. indeed, thepanicof2007−2008originatedinasecuritizedbankrun(areporun)drivenbythewithdrawalofrepurchaseagreements(GortonandMetrick,2009).Uncertaintyastotherealvalueoftheassetsservingascollateralledtomas-sive redemptions on the repomarket.

A fourth concern relates to contagion effectsfromrunsontheshadowbankingsystemtotherestofthefinancialsystem.onemechanismofcontagionisthroughassetprices.intheeventofarunontheshadowbankingsystem,massivesalesofassetsmayhave repercussions forpricesoffinancialand realassets and a direct impact on themark-to-marketvaluationofsecuritiesinthebooksofthetraditionalbanks.Asecondmechanismofcontagionrelatesto

Shadow banking may bring efficiency gains from specialization, with lower costs for clients and healthy competition for banks, but many of its features are highly problematic for financial stability.

Financial Regulatory Reform after the Crisis 103

thefactthatbanksalsofundactivitiesinthewhole-salemarket,where illiquidity caused by shadowbankingactivitiesmayinducethebankstoengageinrapiddeleveraging.Thiscanleadtoafurtherfallinpricesandcreatenegativefeedbackloops.Suchspillovers also take place internationally. Finally,sincebanksandinsurancecompaniesprovideshadowentitieswith back-up liquidity lines and implicitguaranteestospecialpurposevehicles,incidentsinshadowbankingmaydirectlyaffecttraditionalinter-mediaries(Greeneandbroomfield,2014).

4. Insufficientreforms

itissurprisingthat,sofar,regulatoryreformshave paid relatively little attention to themanyentities and activities of shadowbanking. indeed,focusingmainlyonreforming the regulatedfinan-cialsectormayevenbeinducingalargemigrationof banking activities towards the shadowbankingsystem,ashintedearlier(seealsoiMF,2014).

AttheG20SeoulSummitinNovember2010,leaders requested theFSb to develop recommen-dations to strengthen oversight and regulation ofshadowbanking activities.22 in response, theFSbdevelopedaframeworkforconductingannualmoni-toringexercisestoidentifyentitiesandactivitiesincredit intermediation and assessglobal trends andrisksposedby theshadowbankingsystem.23FSbrecommendationstoimprovethemarketinfrastruc-tureandtheresilienceofinstitutionsarenowunderconsiderationbynationalauthorities.Theyaddressanumberofidentifiedconcerns,includingaheavyrelianceonshort-termwholesalefundingforsomeintermediaries,weakenedlendingstandardsduetosomesecuritizedassetsandstructuredproducts,anda general lackof transparency that hides growingamounts of leverage andmaturitymismatches, aswellastheultimatebeareroftheassociatedrisks.

The proposed reforms cover four areas (dis-cussed below), and some countries have alreadyadoptednewregulations.

(i) in order tomitigate risks in banks’ interac-tionswith shadowbankingentities, therearerecommendations to set risk-sensitive capitalrequirementsforbanks’investmentsinequity

fundsandaproposedsupervisoryframeworkformeasuring and controlling banks’ largeexposures,includingtoshadowbankingactivi-ties.CountriesthataremembersofthebaselCommitteehaveagreedtofullyimplementtheframeworkby2019.

(ii) inordertolimitmassiveandsuddenredemp-tions, the followingmeasures are proposed:limittheuseofconstantnetassetvaluetoallowthesharepricesofthosefundstofluctuateinlinewiththemarketvalueofthefunds’assets,impose capital buffers, require redemptionrestrictions,establishliquidityandmaturityport-foliorequirements,andrequirestresstesting.24

(iii)in order to improve transparency in securiti-zation, it is recommended that risk retentionrequirements be included for entities spon-soring securities, and that banks and otherfinancialsponsorsofsecuritizationtransactionsberequiredtoretainpartoftheloansontheirbooks.ThelatterwasapprovedbytheUnitedStatesin2014.

(iv)Regarding repoagreements, inoctober2014theFSbpublishedaregulatoryframeworkforsecurities financing transactions in order tolimitexcessiveleverageaswellasmaturityandliquiditymismatchedexposures.itconsistsofminimumqualitativestandardsformethodolo-giesusedbymarketparticipants thatprovidesecuritiesfinancingtocalculatehaircutsonthecollateralreceived,andnumericalhaircutfloorsthatwillapplytonon-centrallyclearedrepos,inwhichfinancingagainstcollateralotherthangovernment securities is provided to entitiesotherthanbanksandbroker-dealers.

Additionalworkonothershadowbankingenti-tiesisalsounderwaywithintheFSbinordertolisttheentitiesthatcouldbecovered,maptheexistingregulatoryandsupervisoryregimesinplace,identifygapsinthoseregimes,andsuggestadditionalpru-dentialmeasuresforthoseentities,wherenecessary.

Theaimoftheseregulatoryreformproposalsistotransformshadowbankingintoaresilientmarket-based system of financing.However,while theyaddressparticularrisks,theproposedactionsappearto be insufficient to dealwith the system’s inher-entsystemicrisks.Amajorchallengetoregulatory

Trade and Development Report, 2015104

reform of the shadow banking system is how toensureappropriateoversightandminimizeriskstofinancial stabilitywhile not inhibiting sustainablenon-bankfinancing conduits that donot pose sig-nificant risks, particularlywhere shadowbankingfillsagap.

inthecaseofsecuritization,thebalancesheetcapitalretentionrequirementsoflessthan5percentseemarbitraryandsmall;investorsmaystillconfuseMMMFswithdepositsandbesusceptibletopanics.Forrepos,theproposedhaircutsareonlyforbilateraltransactions, leaving open the possibility of largerehypothecation(andleverage)incentrallyclearedmarkets.TheFSbevendroppedtheminimumhair-cutsrequirementonreposwithgovernmentbondsthatithadinitiallysuggestedtomakerepo-supportedleveragemoreexpensive(FSb,2012).inaddition,theFSbmonitoringexerciseisnotcomprehensive,asdatacollectionfromoffshorefinancialcentresislacking.

Measures suchasafinancial transactions tax(FTT)applied to repos,whichwouldsignificantlyreduceleverageintheshadowbankingsystem,are

missingfromtheFSbreformagenda,andhavebeenfiercelyopposedbymostmarketparticipants(includ-ingcentralbanks).25otherambitiousreformsmoreconsistentwithamarket-basedapproachhavebeensuggested,buttheyhavenotreceivedproperconsid-eration.Forinstance,GortonandMetrick(2009)haveproposedprinciplesforregulationofshadowbankingentitiesbasedonthepremisethatanykindofbankingshouldbebroughtundertheregulatoryumbrella.onthispremise,regulatorswouldhavetoprovidestrictguidelinesonwhatkindsofcollateralmaybeusedforreposandonminimumhaircuts(tolimitleverag-ingandreducerehypothecation).Totallyunregulatedreposmaystillbeauthorized,butauthoritieswouldhavetomakeitclearthatthebuyeroftherepowillnotreceivespecialbankruptcyprotection.

Tosumup,despitesomemovestowardstight-ening rules relating to specific activities, shadowbanking remains largely unregulated, probablybecauseofthepressuretoavoidimpactsonthepriceoffinancialservicesorontheprofitabilityoffinancialinstitutions.Thismeansthatthesystemicrisksaris-ingfromtheverynatureofshadowbankingcouldcontinuetoposeathreattoglobalfinancialstability.

D. Other important issues in financial regulation

Theglobalfinancialcrisisraisedunprecedentedconcernsaboutthegovernanceoffinancialinstitu-tionsandthelackoftransparencyofinformationinfinancialmarkets.Thelistofdistortedincentivesattherootof thecrisis is long,butat thetopof thatlistare the roleofcredit ratings in regulations forriskassessment(discussedbelow)and,ofparticularimportancefordevelopingcountries,theabsenceofinternationalmacroprudential regulations to tamespeculativeinternationalcapitalmovements.inthiscontext,foreignbankswithbranchesandsubsidiar-iesindevelopingcountriesareimportantchannelsfortransmittingglobalfinancialspilloverstotheseeconomies, and therefore pose specific regulatorychallenges.

1. Credit rating agencies: The need for more than a code of conduct

Creditratingagencies(CRAs)areafundamen-talinstitutionoftoday’sfinancialmarkets.26byratinglargecorporateborrowers,sovereignbonds,munici-palbonds,collateralizeddebtobligationsandotherfinancial instruments,CRAs provide prospectiveinvestorswithguidanceontheborrower’screditwor-thiness.Theroleofratingsistoprovideinvestorswithinformationandopinionsonwhetherabondissuermayrenegeonitscommitments.Theratingservicescatertobothnon-specialistbondholders(e.g.thegen-eralpublicandsmallfinancialfirms)andspecialist

Financial Regulatory Reform after the Crisis 105

investors(i.e.financialintermediariessuchasbanks,insurancecompaniesandpensionfunds).Theyhelptheformerbyprovidingthenecessaryinformationtoassessthecreditworthinessofborrowers;andtheycan help the latter obtain information concerningunfamiliarbondmarketsornewlendingactivities.

TheactivitiesofCRAs,asexpressedthroughnewsaboutratings,haveanimpactonassetalloca-tion, as ratings contribute to the determinationoftheinterestrate−orprice−theborrowermustpayforobtainingfinancing. Reliance on creditratingshasincreasedovertimewiththedevelopmentoffinan-cial markets and the use ofratingsinregulations,standardsandinvestmentguidelines,bothatthenationalandinternationallevels,asevidencedbytheirfre-quentreferencestoCRAs’ratings.Theyconstituteakeycomponentofregulatoryriskmeasurement,andcanbeused to determine capital requirements forbankinginstitutions.Theyalsoinfluencedecisionsonwhether the ratedassets canbeusedas collat-eral,anddeterminebenchmarksforassetmanagers’strategies.Thebaseliicapitaladequacyframeworkallowsbankstoconsiderexternalcreditassessmentsoftheborrower‒orthespecificsecuritiesissuedbytheborrower‒forthedeterminationofriskweightfor the banks’ exposures.Another example is thereliance bymany central banks onCRAs’ assess-ments of thefinancial instruments they accept foropenmarketoperations,bothascollateral and foroutrightpurchase.

However,thewideuseofCRAratingshasnowcometoberecognizedasathreattofinancialstabilityandasourceofsystemicrisk.

The2008−2009globalfinancialcrisisservedasareminderofanumberofseriousproblemsintheratingsindustry.itbecameclearthatmanyratings,such as those relating to subprime collateralizeddebt obligations and other securities − includingfromgovernments−hadbeen artificially inflated.Thiswasrelatedtothebusinessmodelsoftheratingagencies,which contain serious conflicts of inter-est:essentially,ratingagenciesarepaidbytheveryissuerswhosesecuritiestheyarerating.27overratingdebts and underestimating the default risk allowstheissuertoattractinvestors.“buy-side”investors

mayhave incentives to accept inflated ratings, asthisincreasestheirflexibilityinmakinginvestmentdecisions and reduces the amountof capital tobemaintained against their investments.This alsoexplainswhyinstitutionsbuyoverpricedsecurities(Calomiris,2009).

The overreliance onCRAs’ assessments ofstructured financial products contributed signifi-cantly to the 2007−2008 subprime crisis, aswell

documented, for instance bythe iMF (2010).However, thedebate considerably pre-datesthe 2008 global crisis, whenCRAsclearlyperformedbadlyinmeasuring the risk of sub-primedebts.Theywereheavilycriticized for their role in the1997Asianfinancialcrisisandthe 2001 dot-com bubble for

havingbeenslowtoanticipatethesecrises,andthenforhavingabruptlydowngradedthedebtors.

Downgrades in ratings have triggered largesell-offs of securities as a consequence ofmarketparticipantsadjustingtoregulationsandinvestmentpolicies (“cliffeffects”).Thehighvolatility in theeuropean sovereign debtmarket in 2011 after anumberofratingdowngradesisanexampleofthelinkagesbetweendowngradesandthepricesofdebtinstruments.Conversely, ratingupgrades can con-tributetomechanisticpurchasesofassetsin“goodtimes”,which can fuelfinancial bubbles.AnothermajorconcernwithCRAsisrelatedtodeficienciesin their credit assessment process.An additionalsourceofunease is thatCRAs’ ratings,whicharebasedonsubjectivecriteriaratherthanoneconomicfundamentalsfordeterminingsovereigndebtsustain-ability,exerciseastronginfluenceonmarkets,issuersofsecuritiesandpolicymakers(seealsobox4.3).

overrelianceonratingshasthereforebecomeaconcernforinternationalregulatoryauthorities.TheFSbpublisheditsPrinciples for Reducing Reliance on Credit Rating Agency Ratings in2010,whichwereendorsedbytheG20.ThegoaloftheprinciplesistoreducetheuseofCRAs,andtoprovideincentivesfor improving independentcredit riskassessmentsandduediligencecapabilities.Memberjurisdictionshavecommittedtopresentingatimelineandspecificactions for implementing changes in the regula-tions.Atthesametime,theFSbhassuggestedthat

In assessing sovereign debt sustainability, credit rating agencies follow ideological prejudices rather than economic fundamentals.

Trade and Development Report, 2015106

Box 4.3

bIASING INFLUENCES ON CRAs’ RATINGS OF SOVEREIGN DEbT

Ratingsofsovereigndebtorsinvolveconsiderablejudgementaboutcountryfactors,includingeconomicprospects,politicalriskandthestructuralfeaturesoftheeconomy.CRAsprovidelittleguidanceastohowtheyassignrelativeweightstoeachfactor,thoughtheydoprovideinformationonwhatvariablestheyconsiderindeterminingsovereignratings.broadlyspeaking,theeconomicvariablesaimatmeasuringthecreditworthinessofaneconomybyassessingthecountry’sexternalpositionanditsabilitytoserviceitsexternalobligations,aswellastheinfluenceofexternaldevelopments.CRAs’assessmentsappear tobebasedonabiasagainstmostkindsofgovernment intervention. inaddition,theyoftenassociatelabourmarket“rigidities”withoutputunderperformance,andahighdegreeofcentralbankindependenceashavingapositiveimpactondebtsustainability(Krugman,2013).

Sovereignratingsofthethreemajorratingagenciesarestronglycorrelated(seetable),possiblysignallingaverylowdegreeofcompetitionintheCRAmarket.Atthesametime,theirratingsaresignificantlycorrelatedwith indicators thatmeasure theextent towhich theeconomicenvironment is“business-friendly”,regardlessofwhatimpactthismighthaveondebtdynamics.

Aneconometricmodel,basedonapooledsampleoftheaveragevalueofthe“bigThree’s”sovereignratings of 51 developing countries for the period2005−2015,indicatesacloselinearfit(R2of44percent) between those ratings and the followingvariables estimated by theHeritage Foundation:“labour freedom”, “fiscal freedom”, “businessfreedom” and “financial freedom” (chart 4b.1A).However,thesevariablesappeartohavebarelyanyrelationtothecountries’fundamentals,whichwoulddeterminetheirabilitytoservicetheirsovereigndebt.

For instance, “financial freedom” is considereda measure of independence from governmentcontrol and “interference” in thefinancial sector.Consequently, an ideal banking and financeenvironmentisbelievedtobeonewherethereisaminimumlevelofgovernmentintervention,creditisallocatedonmarketterms,andthegovernmentdoes

notownfinancialinstitutions.Also,insuchanenvironment,banksarefreetoextendcredit,acceptdepositsandconductoperationsinforeigncurrencies,andforeignfinancialinstitutionscanoperatefreelyandaretreatedinthesamewayasdomesticinstitutions.The“labourfreedom”indexisaquantitativemeasurethatconsidersvariousaspectsofthelegalandregulatoryframeworkofacountry’slabourmarket,includingregulationsconcerningminimumwagesand layoffs, severance requirements,measurable regulatoryrestraintsonhiringandhoursworked.“Fiscalfreedom”isameasureofthetaxburdenimposedbythegovernment,basedonacombinationofthetopmarginaltaxratesonindividualandcorporateincomes,andthetotaltaxburdenasapercentageofGDP.Finally,“businessfreedom”referstotheabilitytostart,operateandclosedownabusiness(HeritageFoundation,2015).

bycontrast,theeconometricestimatesshowamuchweakercorrelation(R2of16percent)whenCRAs’ratingsareregressedonthefourmostrelevantvariablesusedinthestandardmacroeconomicliteraturetoassessdebtdynamics(chart4b.1b).Thosevariablesare:theleveloftheprimarybudgetsurplus,thegovernment-debt-to-GDPratio,economicgrowthandthecurrentaccountbalance.

TheseestimatesshowthatCRAs’sovereignratingsarebasedmuchmoreonsubjectiveassessmentsandprejudices(forinstance,thatgovernmentinterventionreducesgrowthandefficiency)thanonthe“fundamental”variablesrelatedtodebtsustainability.

ThereisastrongriskthatalternativeapproachestocreditassessmentmightreproducethesameflawsoftheunderlyingCRAmodels.indeed,otherCRAs,includingtheChinesefirm,Dagong,haveproducedjudgementssimilartothoseofthe“bigThree”:Moody’s,StandardandPoor’sandFitch(chart4b.2).Thissuggestseitherthatotherparticipantsbasetheirjudgmentsonsimilarmodels,orthatthe“bigThree”aremarketmakersintheratingsindustry.Assuch,thereistheaddedconcernthatinternalcreditriskassessmentsmadebyriskdepartmentsofinvestors’institutionsalsodeliverratingswithsimilarflaws.

CORRELATION bETwEEN SOVEREIGN RATINGS OF ThE “bIG ThREE”, jANUARy 1990 TO MARCh 2015

Fitch Moody’s

Standard and

Poor’s

Fitch 1 0.955 0.970Moody’s 1 0.956Standard and Poor’s 1

Source: UNCTAD secretariat calculations, based on Thomson Reuters Eikon database.

Note: The sample includes 129 issuers. The number of observations are: Fitch vs. Moody’s: 17,908; Fitch vs. Standard and Poor’s: 18,317; and Moody’s vs. Standard and Poor’s: 23,258.

Financial Regulatory Reform after the Crisis 107

Chart 4B.1

SOVEREIGN RATINGS OF DEVELOPING COUNTRIES, ACTUAL AND FITTED VALUES, 2005–2015

(Average of the ratings of the “Big Three”)

Source: UNCTAD secretariat calculations, based on Bloomberg and Heritage Foundation databases; and IMF, World Economic Outlook, 2015.

Note: Countries covered are those for which data were available from all the selected CRAs. Country ratings have been converted into numerical order, ranging from 0 (defaulted security) to 20 (highest rating). For chart A, fitted values correspond to the best possible prediction of the average rating based on a linear regression against four variables taken from the Heritage Foundation Index of Economic Freedom: “labour freedom”, “fiscal freedom”, “business freedom” and “financial freedom”. For chart B, fitted values are the best possible prediction of the average rating based on a linear regression against four macroeconomic variables: budgetary primary surplus, ratio of public debt to GDP, current account balance and GDP growth rate.

Chart 4B.2

CORRELATION bETwEEN COUNTRy RATINGS OF SELECTED CRAs

Source: UNCTAD secretariat calculations, based on Standard and Poor’s; and Dagong. Note: Country ratings have been converted into numerical order, ranging from 0 (defaulted security) to 20 (highest rating). Countries

covered are those for which data were available from both CRAs. Data are as on July 2015.

Act

ual r

atin

gs

Fitted values predicted by ideological variables

45O Correlation = 0.66

Act

ual r

atin

gs

Fitted values predicted by fundamental variables

45O Correlation = 0.40

A. Actual vs. fitted values predicted by ideological variables

B. Actual vs. fitted values predicted by fundamental variables

02468

101214161820

0 2 4 6 8 10 12 14 16 18 2002468

101214161820

0 2 4 6 8 10 12 14 16 18 20

R² = 0.8643

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18 20

Dag

ong

Glo

bal C

redi

t Rat

ings

Standard and Poor’s

Box 4.3 (concluded)

Trade and Development Report, 2015108

referencestoCRAratingsberemovedorreplacedoncealternativeprovisionsinlawsandregulationshavebeenidentifiedandcanbesafelyimplemented.

Regulatoryeffortshavealso sought toestab-lish a codeof conduct forCRAs.A report by theinternationalorganizationofSecuritiesCommissions(ioSCo,2015) focusesonthequalityandintegrityoftheratingprocess,avoidanceofconflictsofinter-est, transparency, timeliness of ratings disclosuresandconfidentialinformation.Regionalandnationalregulatorshavethediscretiontoadoptmorestrin-gent regulations forCRAs. For example, in theUnitedStates, theDodd-FrankAct has attemptedto address problems relating toCRA ratings byrequiringthatbanksnolongerusethoseratingsintheirriskassessmentsforthepurposeofdetermin-ing capital requirements.RecenteuropeanUnionregulationsrequiregreaterdisclosureofinformationonstructuredfinancialproductsandonthefeesthatCRAs charge their clients (eC, 2013 and 2014).Nevertheless, the pace of regulatory change hasbeenslow.

Creditratingagenciesarestillofrelevanceforthefinancialsector,despitetheirdisastrouslyinac-curate ratings assessments prior tomajor crises.Followingwidespread recognition that the con-centrationof the sector in the three biggest inter-nationalCRAs has created anuncompetitiveenvironment,andthatitisthereforenecessarytoreduce theirpower, therehavebeen different suggestions formore substantial changes.TheoeCDhighlightedtheneedtocurb conflicts of interest, anissuethatCRAscouldaddress,forinstancebymovingfroman“issuer pays” to a “subscriberpays”businessmodel(oeCD,2009).butthisnewmodelwould require some kind of public sectorinvolvementtoavoidfree-riderissues.othershavesuggestedmoreradicalmeasures,suchascompletelyeliminating the use of ratings for regulatory pur-poses(Portes,2008),ortransformingtheCRAsintopublicinstitutions,sincetheyprovideapublicgood(AgliettaandRigot,2009).Also,bankscouldpayfeestoapublicentitythatassignsratersforgradingsecurities.Alternatively,bankscouldreverttowhathas historically been one of theirmost importanttasks,namelyassessingthecreditworthinessofthe

potentialborrowersandtheeconomicviabilityoftheprojectstheyintendtofinance(Schumpeter,1939;brender,1980).

Policymakersshouldbemadeawareofthecur-rentflawsintheconstructionofriskmeasures,andaconceptualframeworkforanalternativeapproachshould be designed.Alternative sources of creditassessmentshouldavoidrepeatingthesamekindsofmistakesthatledCRAstounderestimaterisk.

2. The negative impacts of speculative internationalcapitalflows

Anothermajorconcernaboutthenewfinancialreformsisthevirtualabsenceofconcreteinternationalregulationstotamespeculative,short-terminterna-tionalcapitalflows.overthepastfewdecades,manycountrieshaveexperiencedstrongmacroeconomicandfinancialvolatilityasaresultofcapitalinflowsdrivingexchangeratesawayfromfundamentalsfol-lowedbycapitalreversalstriggeredbychangesininternationalmonetaryconditions(TDRs 2009and2011).Someproposalsthatcouldhaveaddressedthisissue,suchasaninternationalagreementforataxoninternationalcurrency transactions,havebeendis-

cussedatapolicylevel,buthavereceivedlittlepoliticalsupportfromdevelopedcountriessofar.

Risks related to interna-tionalcapitalflowsarenotonlyaconcernfordevelopedcountriesand for the larger developingeconomies that are viewed asemergingmarkets.increasingly,manymiddle-andlow-income

countriesthatareconsidered“frontiermarkets”mayalsohavetocopewithvolatilecapitalflows.Theirgrowing reliance on international capitalmarketsto raisefinance,whichwasmadepossibleby lowinternational interest rates and investors’ growingappetiteforrisk,makesthemvulnerabletosuddenreversalsofforeigncapital.itwassuchreversalsthattriggeredseveralfinancialcrisesinlargedevelopingcountriesinthelate1990s.

Capital accountmanagement to regulate theamount and composition of foreign capital flows

Financial reforms have not included concrete international regulation to tame speculative cross-border capital flows.

Financial Regulatory Reform after the Crisis 109

canhelpmitigatesuchrisks.brazil,indonesiaandtheRepublic ofKorea, amongothers, have intro-ducedmeasurestoreduceexcessivecapitalinflowswithreasonabledegreesofsuccess.Further,notalldevelopingcountrieshavepromotedrapidinterna-tionalfinancialintegration.Whilesomehavesoughttoenhancetheirintegrationintotheglobalfinancialsystem, favoured the installation of foreignbanksandstartedissuingcommercialexternaldebt,othershavepreferreddelayingsuchintegration.ethiopia,for instance, has not resorted to easily availableforeigncapital,andhasimposedrestrictionsonthecapitalaccountinitsbalanceofpayments.Foreignbanks are not allowed to operate in that country.Thisstrategydoesnotimpedethedevelopmentofadomesticfinancialsystemtoservetheneedsofthereal economybecause of a strategy for long-termcreditprovisionthroughitsdevelopmentbank,alongwith considerable funding fromprivate domesticbanks(Alemu,2014).Asaresult,itsfinancialsystemisabletochannelfundstoprioritysectors,includingmanufacturingandinfrastructure.

3. Foreign bank presence in developing countries

Arelatedissuehasbeenthegrowingcommer-cialpresenceofforeign-ownedbanksindevelopingcountries.This trend started in the late1990sandcontinuedwith full force in the newmillenniumuntiltheglobalfinancialcrisis.initially,inthe1990s,privatizationofState-ownedbankswasanimportantfactorinthegrowingpresenceofforeignbanksindevelopingcountries.Subsequently,jointownershipwithlocalprivatebanksandfullyownedsubsidiariesgainedimportance.

Accordingtoonerecentestimate, thecurrentshareofforeignbanksinthetotalnumberofbanksaverages24percentinoeCDcountriesandaround40percentindevelopingcountries(ClaessensandvanHoren,2014).between1995and2009,foreignbanksasapercentageofthetotalnumberofbanksdoubled insuchcountries,anda largemajorityofthemare fromdeveloped economies (buch et al.,2014).Moreover,thisproportionistypicallyhigherinpoorerandsmallercountriesthaninthemajordevel-opingeconomies, reaching in somecases100percent.Amongthemajordevelopingcountries,there

areconsiderablevariationsinforeignbankpresence.TheRepublicofKorea,whichhadnoforeignbanksbefore it joined theoeCD in 1996, has seen thefastestincreaseintheirpresenceoverthepasttwodecades, though theirshare in the totalnumberofbanksinthecountryisstilllowerthantheaverageforothermajordevelopingcountries.China,indiaandSouthAfrica also have a lower foreign bankpresence thanother developing countries, both intermsofthenumberofbanksandtheirsharesintotalbankingassets.

inadditiontojointownershipwithlocalpart-ners,foreignbankshaveenteredhostcountriesbyestablishingbranchofficesorfullsubsidiaries, theformerbeingthemoretypicalpatterninAsianandAfricancountries,andthe latter inlatinAmerica.Foreignbranches take the formofunincorporatedbanksorbankofficeslocatedinaforeigncountry.Theyareintegralpartsoftheirparentbank,andnotindependentlegalentitieswithseparateaccountsandcapitalbases.Theycannotincurliabilitiesandownassets in theirown right; their liabilities representrealclaimsontheirparentbank.Theyprovideglob-ally fundeddomestic credits.by contrast, foreignsubsidiaries are stand-alone legal entities createdunderthelawofthehostcountry.Theyhaveseparateaccountsandcapitalbasesfromthoseoftheirparentcompanyandarefinanciallyindependent.Theyhaveto complywith thehost country’s regulationsandsupervision,andarecoveredbythehostcountry’sdepositinsuranceschemes.

Muchhasbeenwrittenon thepros andconsofforeignbanksindevelopingcountries.onebodyofliteraturesuggeststhatforeignbanksmaybringefficiencygains, improve competitiveness, reduceintermediationcostsandgeneratepositivespilloversto local banks in developing countries, and alsoenhancetheirresiliencetoexternalfinancialshocks.

However,theirpresencemightalsocreatechal-lenges.Forexample,foreignbanksoftencherry-pickthebestcreditorsanddepositors,leavingsmallerandmarginalcustomers,includingSMes,tobeservedbylocalbanks.Moreover,foreignbankstendtofocusmoreonlucrativeactivitieswheretheyhaveacom-petitiveedge,notablyintradefinancing,anareainwhichtheyenjoyacostadvantageoverlocalbanksin being able to confirm letters of credit throughtheirheadoffices; and their internationalfinancialintermediation,ratherthandomesticintermediation,

Trade and Development Report, 2015110

often attracts the best customers in need of suchservices.Theyarealsobetterable tobenefit fromregulatoryarbitragebyshiftingoperationsbackandforth between the home and host countries.Theycaneasilyavoidthecostoflegalreservesbymov-inglargedepositstooffshoreaccounts,whichalsoenablesthemtoofferhigherinterestrates.Sincelocalbankscannoteasilyavoidthesecosts,theymayfacecompetitivedisadvantages.

Moreover, foreign banksintermediate between interna-tional financial markets anddomesticborrowersmuchmoreeasily than local banks, fund-inglocal lendingfromabroad,including through their parentbanks.Duringtherecentsurgein capital flows to developingcountries, foreign banks have been extensivelyengaged in intermediations resemblingcarry-tradeoperations,benefitingfromlargeinterest-ratearbi-tragemarginsbetweenreserve-issuingcountriesanddevelopingcountriesaswellascurrencyapprecia-tionsinthelatter,asdiscussedinchaptersiiandiii.

Since the global financial crisis, it has beenincreasingly recognized that the large presence offoreign banks in developing countries could haveimplicationsforfinancialvolatility(Fiechteretal.,2011). indeed,becauseof theirclose internationallinkages,foreignbanksinsuchcountriesactascon-duitsofexpansionaryandcontractionary impulsesfromglobalfinancial cycles, particularlywith thegrowing liberalization of international financialflows.Thus,whenglobal liquidity and risk appe-titearefavourable,foreignbankscancontributetothe build-upof excessive credit; andwhenglobalfinancialconditionsbecometight, thesebankscanintensifytheirdestabilizinganddeflationaryimpactonhostcountries,transmittingcreditcrunchesfromhometohostcountries,ratherthaninsulatingdomes-ticcreditmarketsfrominternationalfinancialshocks.Theshiftof internationalbanks fromcross-bordertolocallendingimpliesthatattimesofstressinthehomecountry,deleveragingbyparentbankscouldresultincreditcontractioninhostcountries.

ThiswasseeninAsiaduringtheeurozonecrisis,wherelendingbylocalsubsidiariesandbrancheswasasubstantialpartofoveralleuropeanbankclaims(AiyarandJain-Chandra,2012;HeandMcCauley,

2013). Several other studies have also found thatforeignsubsidiariescutlendingmorethandomesti-callyownedbanksduringtheglobalcrisis(ClaessensandvanHoren,2014;ChenandWu,2014).Thiswasparticularlytruewheretheyfundedalargeproportionoftheirlendingfromabroadratherthanfromlocaldeposits(CetorelliandGoldberg,2011).Attheheightofthecrisisin2008,inbrazilandChina,thegrowthofforeignbankcreditlaggedbehindthatofdomestic

banks,and“foreignbanksinone[emergingmarketeconomy]…withdrewearlierthandomesticbanksfromtheinterbankmar-ket”(biS,2010b).DuringboththeAsiancrisisin1997andthecrisis in developed countriesin 2008, foreign bankswereslower thandomesticbanks toadjusttheirlendingtochanges

inhost-countrymonetarypolicy,therebyimpairingitseffectiveness(JeonandWu,2013and2014).

Recentexperiencesuggeststhatlocalsubsidi-ariesofforeign-ownedinternationalbanksmaynotactasstabilizersofinterestrateshockstodevelop-ingeconomies’localbondmarkets.Duringthebondmarketcollapsein2008,ratherthanincreasingtheirexposuretooffsettheimpactoftheexitofforeigninvestors, thesebanks joined them, reducing theirholdingsoflocalgovernmentbondsandscalingbacktheirmarket-makingactivity(Turner,2012).

otherchallengesarisingfromthepresenceofforeignbanksrelatetothestructureofthebankingsystem.Suchbanksmaybesystemicallyimportantinthehostcountry,eventhoughtheiractivitiesmayrepresent only a small proportion of their globalbusiness.This creates regulatory difficulties forhostsupervisors,especiallywhenthereisalackofhome-hostcountrycoordinationinthesupervisionofthetransnationalbanks’activities.Thisbecomesaparticularlyseriousissuewhenhostsupervisorshavetodealwithresolutionproblemsarisingfromcross-borderfailures.oneresponsetothesechallengeshasbeentoensurethatforeignbanksareeffectivelyregu-latedbythehost-country’ssupervisors.Anotherisforthehostcountrytorequireforeignbanks’branchestoholdtheirowncapital,assomecountrieshavedone.othermeasures(introducedinMexico,forexample)imposehighercapitalrequirementsonforeignbanksortransferlimitsonrevenuesandassetpurchasesbyabanktoitsparentcompany(FSb,2014b).

Foreign banks in developing countries act as conduits of expansionary and contractionary impulses from global financial cycles.

Financial Regulatory Reform after the Crisis 111

Reformsof the internationalfinancial systemhavecertainlynotgone farenough toenable it toforestallshocksandmakeitmoreresilient.Currentregulatorypracticesandproposedreformsseemtobedesignedtopreserve–withsomefinetuning–theexistingsystemratherthantotransformit.Thenewbaselrules,whicharesupposedtomakebankssafer,still rely on risk-weighting for capital calculationand,moreregrettably,maybebasedonthecontinuedbeliefthatprivateinstitutionscanbythemselves–or throughCRAassessments – properly establishthelevelofcapitaltowithstandunexpectedlosses.Furthermore, thoserulesdonotaddressinasatis-factorymannerconcernsaboutmoralhazard,whichhasbecomea significant issuewith regard to systematicallyimportant institutions. Thoseinstitutionswouldstillhave tobebailedouttoavoidpossiblecontagion effects, and so the“marketdiscipline”thatunder-liesthebaselnormsisunlikelytowork.Meanwhile,theshadowbankingsystemremainsalmostcompletely unregulated.Withrespecttothering-fencinginitiativestakeninanum-berofjurisdictions,thenewrulesareyettobefullyadopted,andinanycasemaynotbeeffective,astherestrictionshavebeendilutedwithahostofexemp-tions,suchasthoseappliedtotheVolkerRule’sbanonproprietarytradingintheUnitedStates.

Partoftheslowprogressonreformshasbeendue to powerful interests linked to the financialindustrysystematicallyopposingmoreandstrongerregulations − and also to ideological obstacles.Theviewthatafreelyoperatingprivatesectorwillfindtheoptimalwaytoallocatefinancialresourcesremains deep-seated in national and internationalpolicycircles.

Sincethevariousrecentattemptsatre-regulationof finance have not brought about fundamentalchanges in the financial system, the factors thatcontributed to financial crises continue to pose aconstantthreattostabilityandgrowth.Thesystemcontinues to rely on the interaction of too-big-to-failfinancial institutionswithveryvolatilecapitalmarkets,remainshighlyleveraged,andwouldstillrequirelargepublicbailoutsincaseofacrisis.

ThebaselAccordsareneithersufficienttobringaboutfinancialstabilitynortoensurethatfinancialinstitutionswillpursuesocialanddevelopmentgoals.Therefore,theimplementationofbaselrulesshould

notbethemainfocusorprior-ity in improving the financialsystemfordevelopingcountries.onemajor shortcomingof theincentivestructurescreatedbyregulatorypracticesandderegu-lation in the financial sectorhas been the homogenizationof financial institutions andthe proliferation of “universalbanks”, which perform both

retailandmarketactivities.Whenallbanks,regard-less of their purpose andownership structure, aregovernedbyasimilar regulatoryframework,suchasthebaselrulesthatwereoriginallydesignedforinternationallyactivebanks,theyhaveincentivestoadoptsimilarbehaviourpatterns.

in the past decade, in particular, banks col-lectivelyresortedtohigh-riskoperationsthatwerepotentiallymore profitable, incorporating broker-dealers’activitiesandinvestorpracticesresemblingthoseofhedgefundsundertakenbylargeproprietarytrading desks (Haldane, 2009).As a result,manycooperative development banks, and even publicbanks, endedupbehaving likecommercialbanks,

E. Fixing finance: The need for a more positive agenda

Slow progress on reforms has been partly due to systematic opposition to more and stronger regulations by powerful interests in the financial industry.

Trade and Development Report, 2015112

eventhoughtheirsolemotivationwasnotintendedtobeprofitability,butrathertoensurecertainkindsoffinancinginparticularcontexts.

This tendency towards homogenization hasledtosimilarportfoliosandexposures.ineurope,many banks became involved in risky activitiesthat had little to dowith theircore business, and recordedsignificanttradinglossesinthe2008−2009crisis(Ayadi,2010).However, some institutions,such as cooperative and sav-ingsbanksinGermany,whichdid not conform to universalbankingmodels,withstoodthecrisis, and therefore did notrequirepublicbailouts(CePS,2010).AndthelargecooperativeFrenchbank,CréditMutuel,provedtobethebestnationalperformerinthestresstestexercisecoordinatedbytheeuropeanbankingAuthorityin2014.28

The concerns related to homogenization areequallyrelevantforallcountries,althoughtherearesomeadditionalissuesfordevelopingcountries.Thelackofdiversitymeansthatthereisaninsufficientvariety of institutions to cater to different needs,especiallytotherequirementsandinterestsofsmallproducersand thosewhootherwise lackaccess toformalfinance (Ghosh, 2012). it follows that theregulatoryregimeshouldrecognizetheimportanceof differences and regulate financial institutionsaccording to their functions.Thus, the rules thatapply to commercial banks orinvestment banks should notbe the same as those appliedtodevelopmentbanks,savingsbanksandcooperativebanks.

Clearly,amoreambitiousreform agenda is necessary iffinanceistobecomelessfragileandvolatile,andbet-terservetheneedsoftherealeconomyandsociety.ongoingeffortstostrengthenprudentialregulationalonewillnotsuffice;alsonecessaryarestructuralreformsthatfocusbothonfinancialstabilityandonsocial and development objectives. Such reformsshouldincludetherequirementofastrictseparationofretailandinvestmentbanking.Suchring-fencingdoesnotmeanthatlargeprivatefinancialinstitutionswillnolongerbeabletodecidewhatactivitiesthey

shouldengagein,butrather,thateachactivityshouldbeinstitutionallyseparatedintodifferentlegalentitiesandsubjecttospecificregulations.

Structuralreformsshouldalsobringtheshadowbanking system under the regulatory umbrella,whileallowingit toretain its intermediationfunc-

tions.Moneymarketmutualfunds(ortheirequivalent)couldbecome“narrowsavingsbanks”,as suggested by Gorton andMetrick (2010).Accordingly,entitieswishing to offer bank-ing services, such as transac-tion accounts,withdrawals ondemand at par and assurancesofmaintainingthevalueoftheaccount,shouldbereorganized

asspecial-purposebanks,withappropriatepruden-tial regulation and supervision. in exchange, suchentitiesshouldhaveaccesstocentralbanklender-of-last-resort facilities.Alternatively, those fundsmayofferaccountsthatprovidehigherinterestratesthandeposits,butwithafluctuatingvaluereflectingthemarketvalueoftheassetportfolio,butofcoursewithnoaccesstopublicguarantees.Withregardtosecuritization,onlyspecificentities(whatGortonandMetrickterm“narrowfundingbanks”)withcharters,capitalrequirementsandstrictoversightshouldbeallowedtobuyasset-backedsecurities,whileotherinstitutionsshouldbeforbiddentodoso.Finalinves-tors,insteadofbuyingsecuritizedassets,wouldbuytheliabilitiesofthesenarrowbanks.Theregulatorshouldalsodeterminethecriteriafornarrowfunding

banks’portfoliosanddeterminetheamountofminimumcapitaltheywouldneedtooperate.

However, ring-fencingalonewill not ensure that thefinancial systemwill allocateenoughresourcestomeetbroad

developmentgoals.Asrisksinvolvedindevelopmentfinancearebeyondtheacceptancelimitsofcommer-cialbanks,theStateshouldemployvarioustoolstohelpshapeamorediversifiedsystem,bothintermsofitsinstitutionsandfunctions.

AsisdiscussedfurtherinchapterVi,thechan-nellingoffinancialresourcesforsociallyproductivepurposes requires some amount ofState interven-tion.This could include public incentives,when

A more ambitious reform agenda is necessary to make the financial system less fragile and volatile, and to ensure it better serves the needs of the real economy and society.

Shadow banking entities, like any kind of banking, should be brought under the regulatory umbrella.

Financial Regulatory Reform after the Crisis 113

profitabilitydoesnotspontaneouslyattracttheprivatesector.italsonecessitatesabroaderroleforcentralbanks (TDR2011).beyond their focus onfightinginflation,theyshouldbeabletointerveneintheprovi-sionandorientationofcredit,astheydidfordecadesinmanysuccessfulindustrializedcountriesineuropebutalsoineastAsia,andstilldoinanumberofdevelop-ingcountries(TDR 2013).Attheveryleast,regula-tionshouldnotdiscouragethefinancingoflong-terminvestments,innovationandSMesjustbecausetheymayappeartobemoreriskyfromanarrow,prudentialpointofview.Financingtheseactivitiesandagentsisessentialforaneconomy’sgrowthanddevelopment,which also improves the overall quality of banks’assets,whereasalackofgrowthwouldresultintheaccumulationofnon-performingassets.

The goals of a regulatory framework shouldthereforebemoreambitiousthanensuringstabilitybasedonrigidprudentialnorms;regulationsshouldalsoencouragetheproliferationofdifferenttypesoffinancialproductsandorganizationsforcateringtothedifferentneedsoftherealeconomy(KregelandTonveronachi,2014).

inconclusion,amorepositivereformagendaisneeded toestablishacloser linkbetweenfinan-cialsystemsand therealeconomy.This iscriticalfor ensuring sustainable economicgrowth and forsupportingtheglobalaspirationsreflectedinthepost-2015DevelopmentAgenda and its accompanyingSustainableDevelopmentGoals.

Notes

1 ThebCbSwas designed as a forum for regularcooperation on banking supervisorymatters, butitsmembershiporiginallywasconfined tocentralbankrepresentativesofonly13countries:belgium,Canada,France,Germany,italy,Japan,luxembourg,theNetherlands,Spain,Sweden,Switzerland, theUnitedKingdomandtheUnitedStates.FollowingaproposalbytheG20inNovember2008,fullmem-bershipwasextendedtorepresentativesofthecen-tralbanksofArgentina,brazil,China,HongKong(China), india, indonesia, theRepublic ofKorea,Mexico, theRussian Federation, SaudiArabia,Singapore,SouthAfricaandTurkey.

2 otherimportantinitiativescoordinatedbytheFSbinclude the development of principles for soundexecutive compensation practices; the over-the-counterderivativesmarket reform,which aimsatgivingmore transparency to regulate such trans-actions; and the implementation of theGlobal Legal Entity Identifier System,whosepurposeistouniquelyidentifylegalentitiesinvolvedinfinancialtransactions.

3 itshouldbenotedthatbaseliandiiAccordssoughttoestablishalevelplayingfieldforinternationallyactivebanks,whilebaseliiiaimedatimprovingtheresilienceofbanksinthefaceoftheglobalcrisis.

4 Forinstance,beforethesubprimecrisis,thecalcula-tionofregulatorycapitalonthebasisofrisk-weightedassets encouraged the accumulation by banks oftriple-Atranchesofthestructuredmortgage-backedsecurities.

5 Thebaselframeworkgivesamenuofoptionsforminimumcapitalrequirementsforcreditrisk:(i)theStandardizedApproach,which involves changingriskweightsbasedonassessmentsmadeperiodicallybyratingagencies;(ii)thesimplifiedStandardizedApproachquite similar tobasel i towhichfixedweights are assigned aswell; (iii) the internal-Ratings-based approach (iRb),which is basedonbanks’ownriskassessmentmodelsforcapitaldetermination;and(iv)theadvancediRbapproach(A-iRb),which is alsobasedonbanks’own riskassessmentmodels for capital determination, butdifferingfromtheiRbapproachinthatitusesthelossgivendefaultastheinputvariableinsteadoftheprobabilityofdefault.

6 ThesedisparitiesareconfirmedbystudiesconductedbythebCbS(2013).

7 The prevailing economic orthodoxy claimed thatlowercapitalrequirementsreducethecostoffinan-cialservices,andthatbankscansafelymanagetheiraffairsfromanarrowcapitalbase.

Trade and Development Report, 2015114

8 AlessandriandHaldane(2009)suggestthatbanks’capitalshouldbeatleast20−30percentoftheirtotalunweightedassets.

9 inoctober2012,thebaselCommittee,acknowledg-ingthatproblemsassociatedwiththe“too-big-too-fail”banksdidnotapplyonly to the largeglobalbanks,issuedasetofprinciplesontheassessmentmethodologyandthehigherlossabsorbencyrequire-ment fordomestic systemically important banks(D-Sibs).

10 Adoptionoftheserulesisscheduledfor2019.11 in terms of liquidity requirements,China, india,

SouthAfricaandTurkeywereexpectedtohavefinalrulesinforceasofJanuary2015,whileArgentina,brazil, indonesiaandMexicohadpublisheddraftregulations.

12 A survey by thebiS (2014) shows that only afewcountries,suchasbelarus,Colombia,Kenya,liberia,Pakistan,Peru,Qatar,theformerYugoslavRepublicofMacedoniaandZimbabwe,arepartiallyincorporatingthenewguidelinesintotheirregulatoryframeworks.

13 TheFSAPs are prepared jointly by the iMF andWorldbank for developing and emerging econo-mies,andbytheiMFalonefordevelopedcountries.

14 TheWorldbank,which assesses the effects ofreformsjointlywiththeFSb,reportsthatthecapitaland leverage ratios of banks in somedevelopingcountries are higher than those required underbaseliii(Worldbank,2013).

15 Proprietary trading refers to a bank’s trading ofstocks,bondsandotherfinancialinstrumentswithitsownresources,asopposedtotradingonbehalfofclients,soastomakeaprofitforitself.

16 Ring-fencedactivitieshavetobelegally,financiallyandoperationallyindependentfromtherestofthefinancialgroup(FSb,2014a:7).

17 Aspecialpurposeentity,orspecialpurposevehicle(SPV),isalegalentitythathasbeensetupforaspe-cific,limitedpurposebyanotherentity−thespon-soringfirm,typicallyabank.AnessentialfeatureofanSPVisthatitis“bankruptcyremote”meaningthatitcannotbecomelegallybankrupt(GortonandSouleles,2005).SPVsareoftendomiciled inoff-shorefinancialcentresinordertoengageinfinancialactivities in amore favourable tax environment.FinancialinstitutionsalsomakeuseofSPVstotakeadvantageoflessrestrictiveregulationsrelatingtotheir activities.banks, in particular, use them toraiseTiericapitalinthelowertaxjurisdictionsofoffshorefinancialcentres.SPVsarealsosetupbynon-bankfinancialinstitutionstotakeadvantageofmoreliberalnettingrulesthanprevailintheirhomecountries, thereby allowing them to reduce theircapitalrequirements(FSF,2000).

18 Thesharesofmoneymarketfundsareredeemableatpar,andarethereforewidely(thoughsometimes

erroneously) regarded as being as safe as bankdeposits.

19 Thebroker-dealermaynotholddirectlythehigh-quality assets it needs for the repo funding, butmaygetitthroughasecuritieslendingoperation(aswapbetweentwosecurities).Throughthesecuri-ties lending transaction, a third party (usually aninstitutionalinvestorsuchasaninsurancecompanyorapensionfund)lendshigh-qualitysecuritiestothebroker-dealer,asawayto“enhance”theyieldoftheportfolio,andreceivesascollateralhigh-yieldsecurities.Asthesedealsoccursimultaneously,thebroker-dealergetsthefundingtopurchasetheriskyasset. if the returnon thehigh-yieldasset ishighenough, the broker-dealerwill be able to pay theinterestratesoftherepoandofthesecuritieslending,andstillmakeaprofit.Foradiscussiononsecuritieslending,seePozsarandSingh,2011;andAdrianetal.,2013.

20 SeeHarutyunyanetal.(2015).21 Whattriggeredthe2008globalcrisiswaspreciselya

seriesofdefaultsoncollateralizeddebtobligations,aparticulartypeofstructureddebtassembledfromsubprimemortgages.inthecaseofthesestructuredsecurities,eventhe“senior”tranches,expectedtobe saferbecause theyhadfirst priority to receivecashflowsfromultimateborrowersandhadtripleAratingsbythemaincreditratingagencies,hadtobewrittenoffbyfinalinvestors(seeTDRs 2009 and 2011).

22 beforetheFSbreceiveditsmandatefromtheG20,theUnited States’Dodd-FrankAct of July 2010addressedissuesrelatedtoshadowbanking.TheeCsetupaparallelprocess,publishingagreenpaperin2012anditsownactionplanin2013(eC,2012).

23 SeeFSb,2012and2014c.24 For example, in July 2014 the United States

Securities and exchange Commission adoptedamendmentstotherulesthatgovernMMMFs,tobeimplementedby2016.Theserequireafloatingnetassetvalueforprimefundswithinstitutionalinves-tors.Forfundswithonlyretail investors, thenewrulesincludeliquidityfeesandredemptiongatestomanageredemptionpressures,enhanceddiversifica-tion,disclosureandstresstestingrequirements,aswellasupdatedreporting.

25 ThedraftdirectiveforFTTimplementationissuedbytheeCin2011causedanuproaramongsomemarket participants, andwas eventually droppedin2013.Financialinstitutionsdeclaredthattheini-tiativewouldhurtthecompetitivenessofeuropeanbanking,increasefinancialinstabilitybymakingriskmanagementmoreexpensiveandreduceinvestmentinfast-growingcompanies(Gabor,2014).

26 Although there is a plethora ofCRAs across theglobe−morethan70,accordingtotheiMF(2010)−theglobalmarketisdominatedbythe“bigThree”:

Financial Regulatory Reform after the Crisis 115

Standard&Poor’sandMoody’s,withmarketsharesestimated at 40 per cent each, andFitchwith anestimatedmarket shareof15percent (Schroeter,2011).

27 excludingthoseofsovereigndebtors.

28 The2014stresstestwascarriedoutincooperationwiththeeuropeanSystemicRiskboard,theeCandtheeuropeanCentralbank,aswellascompetentauthorities from all relevant national jurisdictionsacrosstheeuropeanUnionplusNorway(ebA,2014).

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PozsarZandSinghM(2011).Thenonbank-banknexusand the shadowbanking system.WorkingPaper11/289,iMF,Washington,DC.

PozsarZ,AdrianT,AshcraftA andboeskyH (2013).Shadowbanking.Economic Policy Review,19(2). FederalReservebankofNewYork,NY.

SchroeterUG(2011).Creditratingsandcreditratingagen-cies, in:CaprioG,ed,Encyclopedia of Financial Globalization,elsevier.

Schumpeter JA (1939).Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process.NewYork,Torontoandlondon,McGraw-Hill.

SinghMandAitkenJ(2010).The(sizable)roleofrehy-pothecationintheshadowbankingsystem.WorkingPaper10/172,iMF,Washington,DC.

SlovikP(2012).Systemicallyimportantbanksandcapitalregulationchallenges.oeCDeconomicsDepartmentWorkingPaperno.916,oeCDPublishing,Paris.

TurnerP (2012).Weatheringfinancial crisis:DomesticbondmarketsineMes.biSPapers63,biS,basel.

UNCTAD(TDR 2009).Trade and Development Report, 2009. Responding to the Global Crisis: Climate Change Mitigation and Development.UnitedNationspublication.SalesNo.e.09.ii.D.16,NewYorkandGeneva.

UNCTAD(TDR 2011).Trade and Development Report, 2011. Post-crisis Policy Challenges in the World Economy.UnitedNations publication. SalesNo.e.11.ii.D.3,NewYorkandGeneva.

UNCTAD(TDR 2013).Trade and Development Report, 2013. Adjusting to the Changing Dynamics of the World Economy.UnitedNationspublication.SalesNo.e.13.ii.D.3,NewYorkandGeneva.

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UnitedNations (2009).Report of theCommission ofexperts of the President of theUnitedNationsGeneralAssemblyonReformsoftheinternationalMonetaryandFinancialSystem.NewYork.

VinãlsJ,PazarbasiogluC,SurtiJ,NarainA,erbenovaMandChowJ(2013).Creatingasaferfinancialsystem:Will theVolcker,Vickers, andliikanen structuralmeasures help?StaffDiscussionNotesNo. 13/4,iMF,Washington,DC.

WalterAW (2008).Governing Finance: East Asia’s Adoption of International Standards. ithaca,NY,CornellUniversityPress.

WalterAW(2015).emergingcountriesandbaseliii:Whyisengagementstilllow?New Thinking and the New G20 Series,PaperNo.4,Centre for internationalGovernanceinnovation,Waterloo,ontario.

WolfM(2014).The Shifts and the Shocks: What We’ve Learned − and Have Still to Learn −from the Financial Crisis.london,PenguinPress.

Worldbank (2013). implementing post-crisis financialregulatoryreforms:Whatdoes itmeanforemerg-ingmarket and developing economies and howtheWorldbankGroupcanhelp.Washington,DC,Available at: http://siteresources.worldbank.org/FiNANCiAlSeCToR/Resources/eMDes_note.pdf.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 119

The preceding chapters analysed themajorweaknessesintheexistinginternationalmonetaryandfinancialsystem,whichlimititsabilitytopromoteandmaintainglobal economic stability.They alsoconstraintheeffortsofpolicymakers,indevelopedand developing countries alike, to achievemoreinclusiveandsustainablegrowthpaths.Atthemac-roeconomic level, thecurrentsystemhas failed tosubstantially reducevolatility infinancialmarketsandtocorrectpersistentglobalimbalances.inaddi-tiontotheoftenhighsocialandeconomiccoststoindividualcountries,thishasalsoledtothecontinuedaccumulationoflargeexternaldebts.Atthemicro-economiclevel,asdiscussedinthepreviouschapter,regulationhasfailedtocurbthehighrisk-takingandprocyclical behaviour of variousfinancial institu-tions,whichwasattherootofthe2008−2009globalfinancialcrisis.Thustheriskoffuturefinancialanddebtcrisespersists.

This chapter addresses a long-standing defi-ciency in the internationalmonetary andfinancialsystem,namelythelackofaneffectivemechanismtobettermanageexternaldebtcrises.itpaysparticularattention to sovereigndebt, since, as discussed inchapterii,evenwhenfinancialcrisesoriginateintheprivatesector,asisoftenthecase,theyusuallyresultinpublicoverindebtednessandaprolongedperiodofeconomicandsocialdistress.1

intherun-upstothelasteightmajorcrisesinemerging economies (beginningwithMexico in

1994,followedbyThailand,indonesia,theRepublicofKorea, theRussianFederation,brazil,Turkey,andfinally,Argentinain2001),sovereigndebtwasa problem only in four economies −Argentina,brazil,MexicoandtheRussianFederation.butinalmostalltheseinstances,sovereigndebtincreasedabruptlywiththecrisis.Severalfactorscontributedtothisincrease.inmostoftheseeconomies,amajorshareof private debt, bothdomestic and external,wassocializedthroughgovernmentbailouts.Publicfundswere also used for recapitalizing insolventbanksandassuming thecostsofdevaluations thatotherwisewouldhavehadtobebornebytheprivatefinancialandnon-financialsectors.And,followingthesecrises,fiscalrevenueswerelowerandinterestratesonthepublicdebtrose.MuchthesamepatternwasrepeatedmorerecentlyinirelandandSpaindur-ingtheeurozonecrisis.

Thenextsectionofthischapterprovidesabriefintroduction to the challenges raised by externalsovereigndebt.Thisisfollowedbyanoverviewofrecentaggregateandregionaltrendsindevelopingcountries’ external debt volumes and composition(sectionC).SectionDsummarizesbasiccharacteris-ticsofexistingfinancialanddebtcrisesindevelopingeconomies, in general, and examines historicalapproachestosovereigndebtresolution,inparticu-lar.Sectioneanalysescurrentproposalsforreformofthepresent,fragmentedsystemofsovereigndebtresolution.

Chapter V

ExTERNAL DEbT AND DEbT CRISES: GROwING VULNERAbILITIES AND NEw ChALLENGES

A. Introduction

Trade and Development Report, 2015120

externaldebtisnotaprobleminitself;indeed,debt instruments are an important element of anyfinancingstrategy.butitcanbecomeaproblemwhenthe foreign borrowing is unrelated to productiveinvestment,orwhenanetdebtorcountryishitbyasevereshocktoitskeymacroeconomicvariables.Underthesecircumstances,theclaimsonthedebtorcanquicklyexceeditscapacitytogeneratetherequiredresourcestoserviceitsdebts.iftheseclaimsarenotmatchedbynewcreditinflows(or by higher interest receiptsfrom investments abroad) ser-vicing the external debt amounts to a transfer ofresourcestotherestoftheworld,which,ifsignifi-cant, reducesdomestic spending andgrowth, thusfurthercompromisingitsabilitytomakepaymentswhentheyfalldue.

High external debt has diverse causes andvariedimpactsindifferentgroupsofeconomies.inmostlow-incomecountries,itistheresultofchroniccurrentaccountdeficits,primarilyreflectinglimitedexportcapacitiesandhighdependenceon importsfor both consumption and investment purposes.Thebulkofdirectdebt-generatingcapitalflowstothese economies has come fromofficial sources.bycontrast,alargeproportionoftheexternaldebtofmiddle-incomecountrieshascomefromprivatecreditors since themid-1970s as a result of theirgreater integration into the international financialsystem,whichgivesthemeasieraccesstointerna-tionalfinancialmarkets.

Thesustainabilityofsuchanexternaldebtbur-dendependsontherelationshipbetweenthegrowthofdomesticincomeandexportearnings,ontheonehand,andtheaverageinterestrateandmaturityofthedebtstockontheother.Thus,totheextentthatforeign

capital inflows are used for expandingproductioncapacities–directlyorindirectlythroughimprovedinfrastructure, especially in the tradable sector –they contribute to boosting the domestic incomeand export earnings required to service that debt.However, external debt has increasingly resulted

fromprivatecapitalinflowsthatwerelargelyunrelatedtocurrentneedsforthefinancingoftradeand investment.And as theirvolume has frequently beenverylargecomparedtothesizeoftherecipienteconomies,suchflowshaveledtoassetbubbles,

currency overvaluation, superfluous imports andmacroeconomic instability, thereby increasing theriskofdefaults.Theyalsoexposethoseeconomiestothevagariesofinternationalcapitalmarkets,astheyfacilitateorevenencouragethebuild-upofexternaldebtduringtheexpansionaryphaseofthefinancialcycle,butmayeasilytriggeradebtcrisiswhenthereisasuddenstoporreversalofthosecapitalflows.

in addition to these basicmacroeconomicrelationships, the sustainability of external debtalsodependsonitsstructureandcomposition.Thecommonly used definition of gross external debt,including in thischapter,adopts the residencecri-terion,whichconsistsofnon-residentclaimsontheresourcesofthedebtoreconomy.Specifically,grossexternal debt here corresponds to the outstandingamountof“liabilitiesthatrequirepayment(s)ofprin-cipaland/orinterestbythedebtoratsomepoint(s)inthefuture,andthatareowedtonon-residentsbyresidentsofaneconomy”(TFFS,2013:5).otherpos-siblecriteriatoqualifydebtaseither“domestic”or“external”arewhetheritisdenominatedindomesticorforeigncurrency,thejurisdictionunderwhichdebtisissuedandwherealegaldisputewillbesettledincaseofadefault.

B. Sustainability of external debt: Main issues

External debt instruments are important elements of any financing strategy…

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 121

Whenmost external debt consisted of loans,as opposed to bonds, the residence, currency andjurisdiction criteria tended to coincide: the lenderwasanon-residentandtheloanwasissuedinafor-eigncurrencyunderforeignlaw.Thishaschangedsignificantly since the early 1990s.over the pasttwodecades, increases in thestockofoutstandingdebthavebeenaccompaniedbyaprocessofdisin-termediation (i.e. a shift in debt instruments fromsyndicated bank loans tomore liquid bonddebt).Sincebondsissuedinlocalcurrencyandunderlocallawmaybeheldbyforeigninvestors,andconversely,sovereigndebt denominated in a foreign currencymaybeheldbyresidents,asignificantshareofdebtcouldbeconsidered“external”undersomecriteriaand“domestic”underothers.

Theamountofdebtissuedinforeign-denominatedcurrencies could significantly affect debt sustain-ability.This is because, in order to service suchdebt,thedebtormustnotonlygeneratetherequiredincome,but alsoobtain thecorresponding foreignexchange.Thisdependsonthestateofacountry’sbalanceofpayments.However, theremaybeatrade-offbetweenthecon-ditions needed for extractingtradesurpluses,ontheonehand,andthosedeterminingdebtors’profits(orprimarysurplusesinthecaseofgovernments)ontheother.Forinstance,domesticcurrencydevaluationsandrecessionaryadjustmentpoliciesmightbeneededtoimproveexportperformanceandreduceimports,buttheywillalsohavetheeffectofincreasingtherealvalueoftheforeign-denominateddebtandreducingthedebtor’sincome.

inmostlyhigherincomedevelopingcountries,arecenttrendhasbeenashiftinthedenominationofdebtfromforeigntolocalcurrency.Thishasbeenmadepossiblelargelyasaresultofastrongexpansionofgloballiquidityandconcomitantsurgesofcapitalinflows into these economies, reflecting lenders’willingness to assume the exchange-rate risk andoperateunderlocaljurisdictions.butinthiscase,theresidencecriterionisrelevantfordebtsustainability,because investments in local bonds and securitiesbynon-residentsmakedomesticdebtmarketsmoreliquid.Moreover,growingnon-residentparticipationinthesemarketsalsomeanslessstabilityofholdingsrelative to participation by domestic institutional

investors,asthelatterareusuallysubjecttoregula-tionsthatobligethemtoholdagivenpercentageoftheirassets in localdebt instruments.bycontrast,when non-resident creditors liquidate their local-currency-denominateddebt,theyarelikelytoconverttheproceeds intoforeigncurrenciesandrepatriatetheirearnings.

Finally,thejurisdictionofdebtissuanceaffectsdebt sustainability, since itdefines the rulesunderwhich anydisputesbetweendebtors and creditorsare negotiated, in particular the extent towhichnon-cooperativecreditorswillbeallowedtodisruptagreementsondebtresolutionbetweendebtorStatesandamajorityoftheirprivatecreditors.Moregener-ally,wheredevelopingcountries’externaldebthasmostlybeenissuedunderforeignjurisdictionsasasupplementaryguaranteeforinvestorsthataredis-trustfulofthejudicialsystemofthedebtorcountry,thishasthepotentialtocomplicatecrisissituations,since the debtor economymay have to contendwithmultiple jurisdictions and legal frameworks.

inaddition,countriesthathavesignedinternationalinvestmentagreements, including thoseprovidinginvestor-Statedisputesettlementmechanisms,maybesuedinarbitrationtribunalssuchastheinternationalCentrefor Settlement of investmentDisputes(iCSiD)ortheUnited

NationsCommission on internationalTradelaw(UNCiTRAl).The nature of such arbitration hastendedtobeadhoc,andmostlybiasedinfavourofinvestorclaimants.Moreover,itisgenerallybasedonaprivatecommerciallogic,withoutconsiderationforthelong-termsocialandeconomicimpactsonthedebtoreconomyasawhole(VanHarten,2007;seealsoTDR 2014).

Sovereigndebtdeservesspecialattentionforanumberofreasons.insomeinstances,governmentsmay encounter difficulties in servicing the exter-naldebtstheyhaveincurredtofinancetheirpublicexpenditures.intimesofeasyandcheapaccesstocredit,theymayunderestimatetheriskoftheirexpo-sure to the volatility of the internationalfinancialsystemandtofinancialshocksarisingfrommone-tarypolicychangesabroad.inmanyotherinstances,however,theinitialcauseofasovereigndebtcrisisistheimprudentbehaviourofprivateagents,onboththeborrowers’andthecreditors’sides.inprinciple,

… but external debt can become a problem if foreign borrowing is unrelated to productive investment.

Trade and Development Report, 2015122

privatedebtors’defaultsontheirexternaldebtfallundertheinsolvencylawofthejurisdictionwherethedebtwas incurred.This legal framework typi-callyprovidesforacertaindegreeofdebtorprotec-tionanddebtrestructuring(withorwithoutapartialdebtwrite-off),orfortheliquidationofadebtor’sassetsincaseofbankruptcy.butwhenawaveofprivatedefaultsthreatenstodisruptthefinancialsystem,thepublicsectoroftenassumestheprivatedebt,espe-ciallythatoflargebanks,andasa consequence becomes over-indebteditself(seechapteriiofthisReport).

However,sovereigndebtproblemsarenotsub-jecttothelegislationthatgovernsprivatedefaults.Theythereforenecessitatespecifictreatment,notleastbecausegovernmentsandpublicadministrationsaretaskedwiththeroleofprovidingpublicgoodsthroughappropriatemacro- andmicroeconomic policiesdesignedtoachievelong-termdevelopmentobjectives.Therefore,anyimpedimenttofulfillingthesedutiesduetodebtoverhangortoconditionalitiesassociatedwithsupporttodebtrestructuringwouldhavesignificantsocial,economicandpolitical impacts.Thisraisesthequestionofhowbesttoapproachsovereigndebtrestructuringsinanincreasinglyglobalizedeconomy.

Concernaboutthelackofaresolutionmecha-nismforexternalsovereigndebtisnotnew.2Sincetheearly1980sUNCTAD’sTrade and Development Reportshaverepeatedlyarguedforreplacingcreditor-led,adhocandarbitrarydebtworkoutmechanisms,bothforofficialandcommercialdebt,withstatutory

mechanisms that would per-mitanimpartialassessmentofa country’sdebt situation, andpromotefairburden-sharingandarestorationofdebtsustainabil-ity.TDR 1986stated:“Thelackofawell-articulated, impartialframework for resolving inter-nationaldebtproblemscreatesa considerable danger… that

international debtorswill suffer theworst of bothpossibleworlds:theymayexperiencethefinancialandeconomicstigmaofbeingjudgeddefactobank-rupt…Atthesametime,theyarelargelywithoutthebenefitsofreceivingthefinancialreliefandfinancialreorganizationthatwouldaccompanyade jurebank-ruptcyhandledinamannersimilartochapter11oftheUnitedStatesbankruptcyCode”.Aswithotherneeded reformsof the internationalmonetary andfinancialsystem,theremaybeatrade-offbetweendesirabilityandfeasibility,atleastintheshortterm.Consequently,arangeofoptionstodealwithsover-eigndebtproblemsneedstobeconsidered.

Sovereign debt crises are often caused by private agents’ imprudent behaviour, on both the borrowers’ and the creditors’ sides.

C. Trends in the volume and composition of external debt

1. Evolution of external debt in developing and transition economies

Measuredinnominalterms(andfollowingtheresidence criterion explained above), the externaldebtofdevelopingcountriesandtransitionecono-mieshasdisplayedarisinglong-termtrend.WiththeexceptionofAfrica,whichremainedalessattractivemarket for private investors andgreatly benefitedfromdebtreductionprogrammes,allotherregions

exhibitedasignificantlyhigherdebtstockin2013thaninthe1990s(chart5.1).Thiswasnotasteadytrend,however:latinAmericaandSouth-eastAsia– the twodeveloping regionsmost integrated intothe internationalfinancial system–had relativelystableexternaldebtlevelsbetween1997−1998and2006−2007.Thiswas the resultof theirowndebtcrises in the secondhalfof the1990s,whichcre-atedatemporaryrestrictionontheiraccesstonewprivateforeigncredit.butitwasalsopartlyduetotheirsubsequenteffortstoreducetheirdependenceon

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 123

Chart 5.1

ExTERNAL DEbT, SELECTED COUNTRy gROuPS AND CHINA, 1980–2013

(Billions of current dollars)

Source: UNCTAD secretariat calculations, based on World Bank, World Development Indicators database; and national sources.

Note: Aggregates are based on countries for which a full set of data were available since 1980 (except for the transition economies where the cut-off date was 1993). Africa comprises Algeria, Benin, Botswana, Burkina Faso, Burundi, Cameroon, Central African Republic, Chad, Comoros, the Congo, Côte d'Ivoire, the Demo-cratic Republic of the Congo, Djibouti, Egypt, Ethiopia, Gabon, the Gambia, Ghana, Guinea, Guinea-Bissau, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Mauritania, Mauritius, Morocco, Niger, Nigeria, Rwanda, Sao Tome and Principe, Senegal, Seychelles, Sierra Leone, Somalia, Sudan, Swaziland, Togo, Tunisia, Uganda, the United Republic of Tanzania, Zambia and Zimbabwe. Latin America and the Caribbean comprises Argentina, Belize, Bolivia (Plurinational State of), Brazil, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Grenada, Guatemala, Guyana, Haiti, Hondu-ras, Jamaica, Mexico, Nicaragua, Panama, Peru, Saint Vincent and the Grenadines and Venezuela (Bolivarian Republic of). South-East Asia comprises Indonesia, Lao People's Democratic Republic, Malaysia, Myanmar, the Philippines and Thailand. South Asia comprises Bangla-desh, India, Iran (Islamic Republic of), Maldives, Nepal, Pakistan and Sri Lanka. West Asia comprises Jordan, Lebanon, Syrian Arab Republic, Turkey and Yemen. Transition economies comprise Albania, Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Republic of Moldova, the Russian Federation, Serbia, Tajikistan, the former Yugoslav Republic of Macedonia, Turkmenistan, Ukraine and Uzbekistan.

0

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2013

capitalinflowsbyavoidingrecurrentcurrentaccountdeficits,orevengeneratingsignificantsurpluses.inthisregard,theybenefitedfromtherealdevaluationoftheircurrenciesduringtheircrisesand,insomecases,fromgainsintheirtermsoftradeafter2003.Sincethe2008globalfinancialcrisis,however,thestockoftheirexternaldebthasbeenrisingagain,insomecasesdramatically,asaresultofbothworsen-ingcurrentaccountsandrenewedinflowsofforeigncapitaldrivenbyexpansionarymonetarypoliciesindevelopedcountries.

The ratio of external debt to gross nationalincome(GNi),declinedatvaryingratesinalldevel-opingregionsfromthelate1990suntilthe2008crisis(chart5.2),thankstofavourablemacroeconomiccir-cumstancesandrobusteconomicgrowth.ThebiggestreductioninthatratiooccurredinAfrica,whereitfell,onaverage,frommorethan100percentin1994tobelow20percentin2013.inadditiontogrowthaccelerationinthe2000s,thisregionbenefitedmorethananyotherfromofficialdebtreliefprogrammes.However,after2008thistrendcametoahalt,withtheratioofdebtstocktoGNirisingslightlyagain.inthetransitioneconomies,externaldebtstockshavegraduallyincreasedfromtheirlowbaseoftheearly1990storeachabout60percentofGNiin2013iftheRussianFederationisexcluded,andonly15percentofGNiifitisincluded.

This overall reduction in the relative size ofexternaldebts,combinedwithoverallfallinginterestratesonexternaldebtsincethelate1990s,largelyexplainsthediminishingweightofinterestpaymentsasa shareofexports inalldeveloping regions. inAfrica,thissharefellfrom13percent,onaverage,duringthe1980stoaround1percentin2012−2013,inSouth-eastAsiaandSouthAsiaitfellfrom11percenttolessthan2percent,inWestAsia,from18percentto6percent,andinlatinAmerica,from28percentto6percentoverthesameperiod(chart5.3).

As a result, developing countries, includingemerging economies, faced the global financialcrisiswith relatively strong public sector balancesheetsandhistoricallylowlevelsofexternaldebt,whichhelped them, initially, to recoverwell fromthisshock.Theyalsobecameattractivedestinationsfor capital in search of higher returns than thoseavailable in thedevelopedeconomies.Thisappar-entmacroeconomic robustness and stability,was,

Trade and Development Report, 2015124

2. Public and private borrowing and lending

The relative share of external debt owed bypublic andprivate debtors has an important bear-ingondebtsustainability.3Historically,publicdebtconstitutedthebulkofexternaldebtindevelopingcountries.in2000,forinstance,itsshareinlong-termexternaldebtstocksofalldevelopingcountrieswas72percent,butby2013,thissharehaddeclinedtonearlyhalfofthetotalstocks(chart5.4).

Chart 5.3

INTEREST PAyMENTS ON ExTERNAL DEbT AS A PROPORTION OF ExPORTS, SELECTED COuNTRy gROuPS AND CHINA, 1980–2013

(Per cent)

Source: UNCTAD secretariat calculations, based on World Bank, World Development Indicators database.

Note: Regional aggregates refer to the same countries as in chart 5.1, except for Djibouti, Ethiopia, Guinea, Guinea-Bissau, Guyana, Haiti, Iran (Islamic Republic of), Lao People's Democratic Republic, Lebanon, Paraguay, the Russian Federation, Sao Tome and Principe, Somalia, Syrian Arab Republic, Thailand, the United Republic of Tanzania and Yemen, for which data were not available.

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Chart 5.2

ExTERNAL DEbT STOCk AS A PROPORTION OF GNI, SELECTED COUNTRy GROUPS

AND CHINA, 1980–2013(Per cent)

Source: UNCTAD secretariat calculations, based on UNCTADstat; World Bank, World Development Indicators database; and national sources.

Note: See chart 5.1. Regional aggregates refer to the same countries as in chart 5.1, except for Ethiopia and Yemen, for which GNI data were not available.

however,short-lived:recentepisodesofturmoilininternationalfinancialmarkets–triggeredbyexpec-tationsofawindingdownofquantitativeeasingintheUnitedStatesandofanormalizationofinterestratesthere–haveadverselyaffectedemergingeconomies(UNCTAD,2014).Moregenerally,therecentexces-sive increase in liquidity in internationalfinancialmarketsthatremainslargelyunrelatedtolong-termdevelopmentfinance,combinedwithrisingforeign-currency-denominatedprivatesector indebtedness,hasincreaseddevelopingcountries’exposuretothevolatilityofinternationalfinancialmarkets.

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External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 125

Chart 5.4

ExTERNAl DEBT By TyPE OF DEBTOR, SElECTED COuNTRy gROuPS AND CHINA, 1980–2013(Per cent of GNI)

Source: UNCTAD secretariat calculations, based on UNCTADstat; and World Bank, World Development Indicators database.Note: Regional aggregates refer to the same countries as in chart 5.1, except for Ethiopia, the Russian Federation and Yemen, for

which data were not available. The chart shows total external debt to be larger than the sum of public and private debtors, because external debt is not always fully disaggregated by public and private debtors.

Total Public debtors Private debtors

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Trade and Development Report, 2015126

externalprivatedebt,ontheotherhand,washistoricallyquitelimited.Thusitattractedlittleatten-tionfromoversightbodies.Moreover,thosebodiestended tobe influencedby freemarketadvocates,whoopposedgovernment intervention ingrowingprivateexternalliabilitiesonthegroundsthatsuchliabilities resulted from the actions of so-called“rationalagents”withrespecttoprivatesavingandinvestmentdecisions,andthereforewouldnotleadtofinancialdistress.However,experience,particularlyintheaftermathoftheglobalfinancialcrisis,whenhighexternalprivatedebtbecameamaindriverofpublicsectordebtcrises,haschallengedthevalidityofsuchanargument.4

Policymakersshouldthereforenotbetoocom-placentabouttheoveralllowerlevelsofpublicdebtinmanydevelopingeconomies;rather,theyshouldbewaryof thesignificant risks tofinancial stabil-ityassociatedwith the increasing ratiosofprivateexternaldebttoGNi(chart5.4).Thisincludesrisinglevelsofprivateexternalborrowingbynon-financialcorporations, primarily for purposes of financialoperationsviatheoffshoreissuanceofdebtsecuritiesoverthepastfewyears(Avdjievetal.,2014).Thisiscompoundedbyexchange-raterisksandthedangerofsuddenreversalsofcapitalflows,forexampleinthewakeofanormalizationofUnitedStatesinter-estrates,and/orvolatilecommodityprices.Hence,arapidexpansionofprivateexternaldebtcouldbefollowedbydebtcrisesandarapidincreaseofpublicexternaldebts.indeed,followingthelatinAmericandebtcrisisinthe1980s,alargeshareoftheexternaldebtowedbytheprivatesectorwastransferredtothepublicsector.Similarly,duringthebuild-upto theAsianfinancialcrisisof1997,asignificantproportionofthedebtincurredintheregionwasintheformofbankloanstoprivateborrowersthatweredefactonationalizedaftertheonsetofthecrisis.

Thestructureofexternaldebthasalsoevolvedsignificantlyon thecreditors’ side. inmostdevel-opingcountries,untilthe1970s,andsometimesinsubsequentdecades,alargeproportionoflong-termexternaldebtwasowedtoofficialcreditorsmostlyonabilateralbasis.Thiswasthecase,inparticular,fordevelopingcountrieswhoseeconomiclinkswiththeirformermetropolitancentreshadremainedstrongandforthelessdevelopedcountriestowhichcommercialbankswerereluctanttolend.intheearly1970s,inalldevelopingregionsotherthanlatinAmerica,exter-naldebtowedtoofficialcreditorsoutpacedthatowed

toprivatecreditors.intheperiod1970−1972,67percentofAfricanexternaldebtwasowedtobilateralormultilateralofficialcreditors;inWestAsiathissharewas92percent,climbingto93percentinSouthAsia.bycontrast,70percentoflatinAmericandebtandalmosthalfthatofSouth-eastAsiawascontractedwithprivatecreditors(chart5.5).inrecentyears,theshare of official debt in developing and emergingeconomieshas remainedbelow20percentof thetotalexternaldebt.

Throughout the 1970s, developing countries’external debt rose sharply (mainly on account oflatinAmerican borrowers).Their total long-termexternaldebt increased fromabout13per centoftheircombinedGNiin1970to21percentin1980,dueprimarilytoasurgeintheirdebtowedtoprivatecreditors,from6percentto13percentoftheirGNi.Capitalaccountliberalizationandcommercialbanks’effortsto“recycle”petrodollarsplayedanimportantroleinthisdevelopment.itwasfurtherfacilitatedbylegislationindevelopedeconomiestostrengthenandclarifycreditors’rightsincaseofforeignsovereigndefaults,suchastheUnitedStatesForeignSovereignimmunitiesActof1976andtheStateimmunityAct1978of theUnitedKingdom(bulowandRogoff,1990).

WhiletheFederalReserveinterest-rateshockintheUnitedStatesandsubsequentdebtcrisesindevel-opingcountriesvirtuallystoppednewprivatecapitalflowstotheseeconomies,privatedebtkeptincreas-ingasapercentageofGNiuntil1987duetolow(ornegative)outputgrowthandsharpdevaluationsinthecrisis-hiteconomies.officialdebt–bothbilateralandmultilateral–asashareoftheirGNialsoroserapidly,mostlyduetotheinterventionsofofficialcreditorstoavoidmassivedefaults.Asaresult,between1979and1987,developingcountries’externaldebtowed toofficialbilateralandmultilateralcreditorsincreasedfrom8to19percentoftheirGNi.

After 1987, the stock of debt owed by bor-rowersindevelopingcountriestoprivatecreditorsdeclinedfromitspeakof24percentoftheirGNiin1987to9percentin2011.Thisoveralldeclinewaspunctuatedbyanumberofboomandbustepisodesinseverallargedevelopingeconomies,whichledtonewfinancialcrisesandwerereflectedintemporarybutsharpincreasesintheexternaldebtowedtotheprivatesector (reaching19percentofdevelopingcountries’GNiinthelate1990s).externaldebtowed

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 127

Chart 5.5

lONg-TERM ExTERNAl DEBT By TyPE OF CREDITOR, SElECTED COuNTRy gROuPS AND CHINA, 1970–2013

(Per cent of GNI)

Source: UNCTAD secretariat calculations, based on UNCTADstat; and World Bank, International Debt Statistics database.Note: Aggregates are based on countries for which a full set of data were available since 1980 (except for the transition economies

where the cut-off date was 1993). Africa comprises Algeria, Benin, Botswana, Burkina Faso, Burundi, Cameroon, Central African Republic, Chad, Comoros, the Congo, Côte d'Ivoire, the Democratic Republic of the Congo, Djibouti, Egypt, Gabon, the Gambia, Ghana, Guinea, Guinea-Bissau, Kenya, Lesotho, Madagascar, Malawi, Mauritania, Mauritius, Morocco, Niger, Nigeria, Rwanda, Senegal, Seychelles, Sierra Leone, Sudan, Togo, Tunisia, Uganda, Zambia and Zimbabwe. Latin America and the Caribbean comprises Argentina, Belize, Bolivia (Plurinational State of), Brazil, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Guyana, Honduras, Jamaica, Mexico, Nicaragua, Panama, Peru, Saint Vincent and the Grenadines, and Venezuela (Bolivarian Republic of). South-East Asia comprises Indonesia, Malaysia, the Philippines and Thailand. South Asia comprises Bangladesh, India, Nepal, Pakistan and Sri Lanka. West Asia comprises Jordan, Leba-non and Turkey. Transition economies comprise Albania, Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Republic of Moldova, Tajikistan, the former Yugoslav Republic of Macedonia, Turkmenistan, Ukraine and Uzbekistan. Data refer to all disbursed and outstanding debt at year-end.

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Trade and Development Report, 2015128

Chart 5.6

lONg-TERM ExTERNAl DEBT OwED TO PRIvATE CREDITORS, By TyPE OF DEBT, SElECTED COuNTRy gROuPS AND CHINA, 1970–2013

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Source: See chart 5.5.Note: See chart 5.5.

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External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 129

toofficialcreditorsdeclinedmoresteadily,duepartlytodebtreliefforthepoorercountries,andpartlytothedeliberatepolicybymiddle-incomecountriesoflimitingtheirrecoursetomultilateralfinancing.

Theaccumulationofquasi-acceptedarrearsondebtservice–includingtheiMF’spolicyof“lendingintoarrears”–plusthefactthatlargeprivatebanksinthefinancialcentreshadbecomesolidenoughtobeabletosustainsellingtheirportfolioofloansatadiscount,ledtheGovernmentoftheUnitedStatestoadoptthe1989bradyPlan.Thiswasanimplicitrec-ognitionthattroubleddebtorscouldnotfullyservicetheirdebtsandrestoregrowthatthesametime,thuspavingthewayfornegotiationsbetweenthecreditorbanksanddebtornationstoshifttheprimaryfocusfromdebt rescheduling todebt relief.Mostbradyrestructuringsincludedtheexchangeofbankloansforbonds,ofeitherequalfacevaluebutwithafixedandbelow-market rateof interest,ora lesser facevalue.Theplanthusinitiatedaprocessof“financialdisintermediation”,thatis,ofmoredirectborrowingfromthecapitalmarketsviabondsinsteadofbor-rowingfromcommercialbanks.Thishasbeenonanacceleratingtrendeversince(chart5.6).Whilethischangeinfinancinginstrumentshasrendereddevel-opingcountries’debtmoreliquid,ithasalsoresultedinmorecomplexdebtrenegotiationswithamyriadofbondholders,inadditiontoincreasingdevelopingcountries’exposuretohigherriskexternaldebt.

3. Currency-related issues

Thecurrencyinwhichexternaldebtisdenomi-natedsignificantlyaffectsdebtsustainability.Debtdenominatedinforeigncurrencyismoreriskythanonedenominatedindomesticcurrency,becauseincaseofcurrencydevaluation,theburdenofthefor-merkindofdebtindomesticcurrencytermswouldimmediatelyincrease,sometimesverysignificantly.Moregenerally,evenwithoutdevaluation,debtorswouldonlybeabletorepaytheirexternaldebtiftheygeneratedenoughrevenue(and,inthecaseofgovern-ments,iftheyrealizedalargeenoughprimarybudgetsurplus)andiftheeconomyasawholeachievedatradesurplus.However,itmaybedifficulttomeetbothconditionssimultaneously.Higherprivateandpublic revenues require output growth that gener-allyisnotpossiblewithoutexpandingimports,but

this affects the ability to generate a trade surplus.Conversely,deflationaryadjustmentwithadeclineinimportsasawaytorapidlyachieveatradesurplusmakesitverydifficulttoachievefiscalprimarysur-pluses,andprivatedebtorsmaybecomeinsolvent.This trade-off between trade and fiscal balancesisanother factor thatexplainswhysovereigndebtdenominatedinforeigncurrencytendstobelesssus-tainablethanthatdenominatedindomesticcurrency.

importantly,debtorsfacingsolvencyorliquidityproblemsvis-à-visforeigncurrencyliabilitiescannotrelyonthesupportofadomesticlenderoflastresort(e.g.nationalcentralbanks);andevensolventdebtorsmaybeforcedtosuspendtheirdebtrepaymentsiftheyareunabletoobtainenoughhardcurrencyduetobalance-of-paymentsrestrictionsthatarebeyondtheir control.by contrast, debt in local currencyreduces the risk of a currencymismatchbetweendebt,ontheonehand,andassetsandrevenuesontheother,andtheexchange-rateriskrestswiththecreditors.Moreover,withthiskindofdebtitispos-sibleforthenationalcentralbanktostepinwhenanemergencysituationarises.

Consequently,agrowingnumberofdevelopingeconomieshavebeenshiftingtowardslocal-currency-denominateddebt.Nevertheless, thedrawbacksofforeign-currency-denominateddebtremainarelevantissuefor themaswell,sincea largeproportionoftheirgrossexternaldebtisstillintheformofbankloansandofficialdebt,andisthusdenominatedinforeign currency.This is particularly the case inpoorer developing countrieswith small domesticdebtmarkets,aheavydependenceonofficiallend-ingandlowcreditratings,butalsoinsomelargermiddle-incomedevelopingcountriesandtransitioneconomies. For instance, in 2013, the share ofexternaldebtdenominatedinforeigncurrency,was95percentinArgentina,93percentinTurkey,80percentinindia,74percentintheRussianFederation,70percentintheRepublicofKoreaand64percentinMexico.5Among the developing and emergingmarket economies that aremembers of theG20(andforwhichdataareavailable),onlySouthAfricahadalargershareofexternaldebtdenominatedindomestic rather than foreign currency (i.e. 55 percentofitsgrossexternaldebtposition).eventhoughthesefigures represent relatively lowpercentagesofGNi, the risk remains that external debt couldgrowsignificantlyintheeventofdomesticcurrencydepreciations.

Trade and Development Report, 2015130

As a result of the considerable advantagesassociatedwithdebtindomesticcurrency,developedcountrieswhosecurrencyisacceptedininternationalpaymentsandforconstitutinginternationalreserves,andwhichhavethepossibilityofissuingbondsandloans in their own currency, tend to incur largeramountsofexternaldebt,includingindifficulttimes.For instance, between 2003 and 2013, the grossexternal debt of theUnitedStates increased from60percentofGNitoalmost100percent.between2001−2003and2013,thisratiorosefrom31to55percentinJapan,from113percentto144percentinGermanyandfrom114percentto194percentinFrance.lastbutnotleast,intheUnitedKingdom,itrosefrom198percentin1999to354percentin2013.6Animportantcounterparttothesesignificantincreases in external debt in developed countriesis theaccumulationof foreign reserveholdings inmanydevelopingcountriessincethelate1990s.Thiscreatesanavenueforsomeofthesecountries–par-ticularlythoserunningacurrentaccountdeficit–toaccumulatedebtatalowcost.

4. The jurisdiction for debt issuance

The jurisdictionunderwhich a debt contractisissuedisrelevantincaseofadefault,becauseitdefinesthecourtsandthelegislationunderwhichtheprocessofdebtrestructuringisultimatelydecided.Schumacheretal.(2014)notethatinrecentyears,

almost 50per cent of sovereigndefaults involvedlegal disputes abroad, comparedwith just 5 percent in the1980s;and75percentof these litiga-tionsinvolveddistresseddebtfunds,alsoknownas“vulturefunds”.

Formerly,therewasaclosematchbetweentheplaceofissuance,thejurisdictionforthedebt, theresidenceoftheultimateholderand,toalesserextent,the currency denomination of the debt.However,somerecentindicationssuggestthatmoreandmoreinternational investors are entering domestic debtmarketsofdevelopingcountries,andthatdomesticinvestors often hold bonds issued in internationalmarkets(Panizza,2008).Suchinformation,whichiscriticalforidentifyingexternaldebtthroughtheresi-denceofthecreditor,issometimesdifficulttoobtain.

looking at all the outstanding public bonds(irrespective of the residence of the creditors andthecurrencyofdenomination),recentdatashowthatthemajorityofthesehavebeenissuedindomesticmarkets.insomedevelopingsubregions,suchaseastandSouthAsia,thepercentageofdomesticpublicbondissuancehasbeenashighas theaveragefordevelopedeconomies.inthetransitioneconomies,inlatinAmericaandtheCaribbean,andinWestAsia,28,28and32percent,respectively,ofoutstandingpublic bonds at the beginningofMay2015wereissuedinforeignmarkets(andnormallyunderforeignjurisdictions).7Thisleavesroomforvulturefundstopursueholdoutlitigationsinforeignjurisdictionsinfuturedebtrestructurings.

D. External debt resolution

Giventhefrequentoccurrenceandcontinuingvulnerability of the globalized and financializedeconomy todebt crises,national and internationalpolicymakersrequiremoreappropriateinstrumentstohandle such crises in away thatwillminimizetheircosts.inprinciple,debtresolutionmechanismsshouldhelpprevent the threatoffinancialordebt

criseswhencountriesexperiencedifficultiesinmeet-ingtheirexternalobligations,pre-emptingthekindofsuddencollapseofmarketconfidencewhichcanhavecatastrophiclong-termconsequencesforthedebtoreconomy.but debt resolutionmechanisms shouldalsoaimatafairdistributionoftheburdenofdebtrestructuringsbetweendebtorsandcreditorsoncea

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 131

crisisdoeserupt.Finally,theyshouldrespectnationalsovereigntyandpreservedomesticpolicyspacewithaviewtoenablingadebtoreconomytogrow,achieveimproveddebtsustainabilityanddesignandimple-ment itsowndevelopment strategies.This sectionsummarizesthemaincharacteristicsofexternaldebtcrises,followedbyananalysisofthehistoricalevolu-tionofsovereigndebtproblems,and,inparticular,approachestoresolvingthem.

1. External debt crises: A recurrent problem

Whilethestructuralcausesofdevelopingcoun-tries’debtcrisesvary,recentcriseshavebeenclose-lylinkedtotherapidliberalizationoffinancialmar-kets,theirinherentinstabilitiesandthe“globalfinan-cialcycles”thesehaveproduced(UNCTAD,2014).Generally,debtcrisesoccuratspecificjuncturesinfinancialcycles.Theystartwhenasignificantnum-ber of debtors (or some largeones) areno longerabletoservicedebtaccumulatedduringanexpan-sionaryphase.Asaresult,riskperceptionshiftsfromoverconfidencetoextremeunease,leadingtoliquid-ity shortages, asset price col-lapsesandaneconomicdown-turn.eventualassetliquidationsfurtherdepressassetprices, inparticularpricesofthoseassetsthatweretheprimaryobjectofspeculation during the boomperiodandservedasaguaran-tee for thedebt.Thisnotonlycausesthebankruptcyofhighlyindebtedagents,butalsoaffectsmoreprudentagentswhowouldbesolventinnormaltimes.onceadebtcrisisoccurs,a potentially long process of financial consolida-tionmusttakeplacebeforetheeconomycanbegintorecover,lendingcanresumeandaneventualexitfromthecrisiscanbeachieved.

Thespecificitiesofexternaldebt,discussedintheprecedingsectionsofthischapter,tendtoincreasethevulnerabilitiesassociatedwithfinancialcycles.Thegreateropennessofmanydevelopingeconomiestopoorlyregulatedinternationalfinancialmarketsislargelyresponsibleforthebuild-upoftheirexternaldebt and their concomitant exposure tohigh risks

ofmacroeconomic instability. in theory, opennesstocapitalflowscanhaveacountercyclicaleffectbyallowingdevelopingcountriestoborrowduringeco-nomicslowdownsandrepayduringexpansions.butthiswouldrequirecapitalflowstorespondpassivelytodemandfromdevelopingcountries,andforthemtobeusedeffectivelyforcountercyclicalpurposes.inreality,“push”factorsinthedevelopedeconomies,such as theirmonetary policies, risk perceptionsandtheleveragecyclesoftheirbanks,areoftenthedrivingforces(o’Connell,2014).indeed,allmajorwavesofcapitalflowstodevelopingcountriessincethemid-1970shavebeenpromptedbyexpansion-arymonetarypoliciesaimedatmitigatingeconomicrecessionsinthemajordevelopedcountries(Akyüz,2012).Withlimitedcreditdemandandlowinterestrates in their ownmarkets, financial institutionsfromdeveloped countries have channelledpart oftheircredittodevelopingoremergingeconomiesinsearchofhigheryields(TDR 2014).Theseflowshavefrequentlyexceededtheamountthatmostdevelopingcountriescoulduseproductively(Haldane,2011).

Very large capital inflows entering relativelysmalleconomieshavethustendedtogeneratedomes-tic credit booms, strong asset price increases andcurrency appreciations.Theyhave also facilitated

sizeable imports of consumergoodsand services, leading tocurrent account deficits andoverindebtedness, particularlyintheprivatesector.Wheneco-nomicconditionsandriskper-ceptionindevelopedcountrieschangeorindebteddevelopingcountries experience repay-mentdifficulties,capitalmove-ments can reverse suddenlyandtriggerexternaldebtcrises.

Steepcurrencydepreciations increase thevalueofexternal debt in the domestic currency, resultingin insolvency for thoseagentswhose incomesaremainlydenominatedindomesticcurrencyandwhoseexternalliabilitiesarenotmatchedbyexternalassets.Widespread bankruptcies, affecting not only therealeconomybutalsothefinancialsector,typicallypromptcentralbankinterventionstotrytocontainthe crisis, including through bailouts, emergencyfinancingandcountercyclicalmeasures.Asaresult,external debt crises are often also public sectorcrises.evenwhere governments themselves havenotengagedinextensiveforeignborrowingduring

Recent external debt crises have been closely linked to the rapid liberalization of financial markets and to the global financial cycles they produce.

Trade and Development Report, 2015132

theboomperiod,theyarefrequentlyforcedtoabsorbbadprivatedebts.

Privateexternaldebtdefaultsdonotposeaspe-cificprobleminthemselves:solongasthedebtdoesnotaffectthewidereconomyinasystematicmanner,managingprivate defaults only requiresapplyingtheprivatecommerciallawinthejurisdictionwherethedebtwas issued.by contrast,sovereign external debt prob-lemspresentparticularfeaturesthat,incaseofadefault,requirespecific arrangements toman-age them.Thesystemic issuesraised by sovereign debt anddefault,andthelegalaswellaseconomicchallengestheypose,arediscussedintheremainingsectionsofthischapter.

2. Sovereign debt issues in historical perspective 8

insomerespects,sovereigndebtorsaremorevulnerablethanprivatedebtors:unlikeprivatedebt-ors,iftheyareunabletoservicetheirdebtbytheduedate,theycannotseektheprotectionofbankruptcylawsforrestructuringordelayingtheirrepayments.inanotherrespect,theyarelessvulnerablethanprivatedebtors,becausecreditorscannotseizemostpublicassetsinpaymentforadefaulteddebt.infact,mostoftheseassetsarelocatedinthesovereign’sjuris-dictionandprotectedbydomesticlaws.Thosethatarelocatedabroadbenefitfromsovereignimmunityclausesthatlimitthekindsofassetsaforeigntribu-nalcanconfiscate.onlyassetslinkedtocommercialactivitiescanbeseized,andnottheonesrelatedtotheintrinsicroleofaState,whichincludeinterna-tionalreserves.Asaconsequence,themainwayofresolvingsovereigndebtissueshashistoricallybeenthroughrenegotiationbetweendebtorgovernmentsandtheircreditors,broadlyfollowingaprivate-lawparadigm.

Hence,throughoutthenineteenthcentury,debtrestructuringswere a bilateralmatter, dealtwithexclusively between the debtor and the creditor.Crisis resolutionwasnot always swift or smooth,

butmutualself-interesthelpedthepartiestoreachagreement. in general, domestic currency devalu-ationwas not an option, since debt instrumentsfrequently included gold clauses,which obligedthedebtorState tomakepayments ingold,or the

equivalent thereof. Creditors,on the other hand,were in aweak bargaining position at atimewhentherespectforsov-ereign immunitywas strongerthanitistoday,andtheylackedan effectivemeans to coordi-nate their claims. even aftertheformationofsupportstruc-tures, such as theCorporationofForeignbondholders(intheUnitedKingdom),andlaterthe

Foreignbondholders’ProtectiveCouncil,theyfre-quently lacked government support (eichengreenandPortes,1986;Feldmann,1991;Adamson,2002).Moreover,legalenforcementwasvirtuallyimpossi-bleforthem,sincesovereignimmunitiesweremorestrictlyobservedthantheyaretoday,andeffective-lyprotectedStatesagainstsuchenforcement,ifnotagainst legalproceedings. international arbitrationwasrare,ingeneral,andevenmoresoforsovereigndebt,whilemilitaryinterventionandgunboatdiplo-macyremainedtheexception.9Debtrestructuringsthusfollowedaprivate-lawparadigm,characterizedby horizontal dialogues between relatively equalparties,andtheydidnotrequiretheinterventionofinternational institutions representing somewiderpublicinterest.

ThischangedaftertheFirstWorldWar,whensovereigndebtissuesacquiredanewdynamicinthecontextofGermandefaultsonreparationpayments,thewidereconomicimpactoftheFirstWorldWaronothereconomiesand,moregenerally,thedetri-mentaleffectsofanincreasinglyfragileinternationalmonetarysystem.Multilateraleffortstopreventsov-ereigndebtcrises,andtosolvethesewheretheyhadalreadyoccurred,playedanimportantrolethrough-out thisperiodinelevatingdebtsustainabilityandresolution to the levelofan internationalconcern,and in raising international awarenessof thepub-licinterestsatstakeinsovereigndebtnegotiations.TheUnitedStatestooktheleadindesigningwaystosettleGermany’sFirstWorldWarreparationdebtwithoutriskingthelatter’stotaleconomiccollapseandpoliticaldisintegration,throughthe1924DawesPlananditssuccessor,the1929YoungPlan.other

Even when governments have not engaged in foreign borrowing during the boom period, they are frequently forced to absorb bad private debts. Thus, external debt crises are often also public sector crises.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 133

multilateral attempts to dealwith sovereign debtproblemsweremadebytheleagueofNations.Theleaguedidnothavefundstoprovidefinancialsup-portfortroubleddebtorStates,butitscrutinizedthedevelopmentofcontractualprovisionsusedforsov-ereignbonds,advisedmemberStatesoneconomicreform, andmonitored the implementation of itsrecommendationswiththeaimofhelpingindebtedStatesregainaccesstocapitalmarkets(Myers,1945;FlorezandDecorzant,2012). itevenestablishedaCommitteefor internationalloanContracts,whichsystematicallyinvestigatedsov-ereigndebtissuesbetween1935and1939.Atthesametime,thePermanentCourtofinternationalJusticehelpedFrenchcreditorsto enforce contractual rights torepaymentingoldbybrazilandSerbia(Waibel,2011).overall,andwhilesovereigndebtrestruc-turingslargelymaintainedtheirconsensualandhorizontalstruc-tureofnegotiationsbetweendebtorStatesandcredi-tors’committees,theneedfordebtorStatestoquicklyreturntocapitalmarketsseemstohavebeengener-allyrecognized,notleastinthewakeoftheGreatDepression and themany sovereign defaults thisentailed(lindertandMorton,1989;Feldmann,1991;ReinhartandRogoff,2009).

With the emergence of the brettonWoodsSystemafter theSecondWorldWar, a new inter-national economic order emerged,which had agreatercapacitytodealwithsovereigndebtproblems,althoughthesebecamemuchlessfrequentthroughoutthebrettonWoods period.While some countries,suchastheUnitedKingdomandtheUnitedStates,reflatedtheirwayoutoftheirmostlydomesticdebt(Grossman1988),10otherdebtrestructuringsbecameaconcernforinternationallaw.Mostfamously,the1953londonAgreement (seebox5.1) to restruc-ture theGerman external debt−both official andprivate− from the interwar periodunderlined theimportanceof substantial debt relief, not only fortheeconomicprosperityofthedebtorcountryanditseconomicpartners,butalso forglobalpoliticalstabilityandpeace.

Fordevelopingandemergingeconomiesrequir-ingarestructuringoftheirbilateralofficialdebt,theParisClubhasprovidedafairlycomprehensiveforumfornegotiationssincethemid-1950s(Cosio-Pascal,

2008).However,overmanyyears,therestructuringsachieved through this institution seemed to giveprecedencetorepaymentstocreditorsratherthantodebtrelief(eskridge,1985).

Thus,onthewhole,theprivate-lawparadigmstill prevailed, although a global public concernfordebtsustainabilitywasnowmorerecognizablethanat the turnof thecentury.Within this frame-work, the bargaining power of debtors and cred-itors shifted in favour of the latter. laws such

as theUnited States ForeignSovereign immunitiesAct of1976,theUnitedKingdomStateimmunityActof1978andothersimilar acts passed bymostcountries inWestern europeended the concept of abso-lute sovereign immunity.Thismeantthatagovernmentwhoseactivitieswereconsideredtobe“commercial” and not intrin-

sictotheStatewasnotentitledtoclaimsovereignimmunityandcouldbesubjecttolitigationinforeigncourts.11Thesechangesbecameparticularlyrelevantwiththereturnofsovereigndebtcrisesintheear-ly1980s,afteralmost30crisis-freeyears(ReinhartandRogoff,2009).

3. Emergence of a fragmented resolution system for external sovereign debt

The1989bradyPlanwasbasedonrecognitionthatasustainablesolutiontodebtoverhangindevel-opingcountrieswouldrequiredebtrestructuringandrelief.Tothisend,itinitiatedashiftfromsyndicatedbank loans to disintermediated bondfinancing ofexternaldebt.

bytheendofthe1980s,renewedconcernsondebtsustainabilityalsoledtheParisClub(seebelow)toincorporatespecialtreatmentforthedebtofpoorcountries owed to official creditors.The “Torontoterms”approvedin1988granted,forthefirsttime,debtreliefofupto33percentofnon-oDAcreditreceivedbypoorcountries.Thelevelsofdebtcancel-lationweresubsequentlyincreasedwiththe“londonterms”in1991,the“Naplesterms”in1994andthe“Cologneterms”in1999,to50,67and90percent,

Since the 1970s, the bargaining power in debt restructuring has shifted in favour of the creditors, both private and official.

Trade and Development Report, 2015134

Box 5.1

ThE LONDON AGREEMENT ON GERMAN ExTERNAL DEbT

ThelondonAgreementbetweentheFederalRepublicofGermany(FRG)anditsthencreditors,concludedinlondonon27February1953,wasadebtreliefagreement.itwasindispensablefortherebuildingoftheWestGermaneconomysoonaftertheSecondWorldWar,andwasamajorfactorcontributingtothatcountry’sso-called“post-wareconomicmiracle”.

Theagreementcoveredboththepre-andpost-SecondWorldWarGermandebt.Justover20billiondeutschemarkofthisdebt,includinginterest,stemmedfromloanstakenpriorto1939topayreparationsagreedaftertheFirstWorldWar;theremainderofjustover16billiondeutschemarkrepresentedUnitedStatesreconstructionloansaftertheSecondWorldWar.WhilethenegotiationstookplaceonlywiththeFRG,theycoveredtheentireGermandebtwithWesterndebtorsthattheFRGhadinheritedinfullaftertheendoftheSecondWorldWar.UnderthelondonAgreement,WestGermandebtwascutbyjustover60percent(includinginterestpayments)to14.5billiondeutschemark.

ThelondonAgreementneedstobeunderstoodinthecontextofthewiderUnitedStatespolicyconcerningWesteuropeanreconstructionafter1945.Alreadyinoctober1950,theWesternAlliessignedadeclarationontheGermandebtprobleminwhich“thethreecountriesagreethattheplanincludeanappropriatesatisfactionofdemandstowardsGermanysothatitsimplementationdoesnotjeopardizethefinancialsituationoftheGermaneconomythroughunwantedrepercussionsnorhasanexcessiveeffectonitspotentialcurrencyreserves.ThefirstthreecountriesareconvincedthattheGermanfederalGovernmentsharestheirviewandthattherestorationofGermansolvabilityincludesanadequatesolutionfortheGermandebtwhichtakesGermany’seconomicproblemsintoaccountandmakessurethatnegotiationsarefairtoallparticipants”(citedinToussaint,2006).SubstantialdebtcancellationforWestGermanyrankedhighintheWesternAllies’prioritiesforpost-warreconstructionasameanstoensurethecountry’sfutureeconomicandpoliticalstabilityanditsfirmintegrationintotheemergingblocofanti-SovietColdWarallies.beyondthesepoliticalconsiderations,theeconomiclogicunderlyingtheagreementisinsharpcontrasttotheausterityconditionalitiesthatcharacterizecontemporaryapproachestodebtrestructuring,suchasforGreece.Apartfromdebtcancellationperse, this isevident in thespecificmeasuresandarrangementsincludedinthelondonAgreement:

• Debt servicing and trade:TheagreementlimitedtheamountofexportrevenuesthattheFRGcouldspendondebtservicingto5percentofthetotalinanyoneyear.Thisismarkedlylowerthanthepercentagesallowedfordeveloping-countrydebtservicingsincethe1980s,whichhaverangedbetween8and20percentofexportrevenues.inaddition,debtpaymentwaslinkedtotradesurpluses,andcouldbepostponedifthecountryranatradedeficit,sothattherewasnoneedforittoresorttonewsourcesofborrowing,thusavoidingthecreationofapotentiallyviciouscircleofdebtaccumulation.Atthesametime,thisalsoensuredthatitwasinthecreditornations’intereststoincreasetheirdemandforGermanexports.

• Interest rates and currency denomination:interestratesontheFRG’sdebtrangedbetween0and3percent,againsubstantiallylowerthanaverageinterestratesondebtincurredbytoday’sdevelopingcountries.importantly,thedebtcouldbepaidindeutschemarkratherthaninanycreditorcurrency,thusfreeingthatcountryfromtheneedtouseitsforeignexportearningsfordebtrepayments.

• Comprehensiveness of debt restructuring:ThelondonAgreementbroughttogetherthevastmajorityoftheFRG’screditorsaroundasingletable,includingofficialandprivatecreditors.Thisensuredequaltreatmentofcreditorsaswellasswiftdecision-makingthatprovidedaclear,comprehensiveandlong-termplanfordebtrepayment.TherewasnopossibilityforprivatecreditorstooptoutofthearrangementwithaviewtospeculatingonGermandebtandobligingthecountrytoengageinlongprocessesofrenegotiationandlitigation.

• Renegotiation option:ThelondonAgreementexplicitlyincludedtheoptionfortheFRGtosuspenddebtservicingandseekrenegotiatedtermsintheeventofanysubstantialchangestoitssituation.

Theagreementwasthusclearlyinformedbyaneconomicrationalebasedontheviewthatsafeguardingandpromotingthefuturegrowthpotentialofthedebtoreconomywasessentialforenablingittoserviceitsdebt.expansionaryeconomicpolicies,activelysupportedbythecreditors,werethepreconditionfordebtrepayment.GiventheFRG’sremarkablesuccesswithpost-warreconstruction,arguablythelondonAgreementprovidesaconstructivetemplatefortoday’screditors,bothprivateandofficial.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 135

respectively.12The ParisClub also extended thepossibility of debt relief to non-HiPCdevelopingcountries,onacase-by-casebasis,underthe“evianterms”in2003(ParisClub,2015).

Furthermore,regardingthemultilateralofficialdebt of poor countries, in 1996 the iMF and theWorldbank launched theHeavily indebtedPoorCountries (HiPC) initiative,whichwas enhancedin 1999.Under this initiative, poor countries thatbore a very high debt burdenwere offeredmultilateral debtrelief and access to credit onconcessional terms. in addi-tion, the iMF progressivelyliberalizeditslendingpracticesby introducinga“lending intoarrears” policy for States thatwereinarrearsonpaymentstotheirprivatecreditors,providedtheywereinvolvedinbonafidenegotiationswiththeircreditors.Hence,specifictoolsweregraduallyintroducedtohandlesovereignexternaldebtdistresswithbilateralormultilateralcreditors,andinvolvedcase-by-casenegotiationsbetweenofficialcounterparts.

by contrast, the series of emergingmarketcrises,which began inMexico in 1994, elicitedtraditionalpolicyresponsesfromthesesameinsti-tutions.Theirnew lendingwasconditionalon therecipient’scommitmentstoausterity,theadoptionof“appropriate”macroeconomicpoliciesandstructuralreforms.Sincetheseofficialcreditswereusedlargelytopreventcountriesdefaultingontheirdebtstopri-vatecreditors, theydidnotmitigate thecountries’economicslowdownordiminishtheirdebtburden;rather,theyappearedtoberescuingthecreditors.Thehighcostofthesepolicyresponsesintermsoflostoutputandexcessiveconstraintsonnationalpolicyspacegeneratedwidespreaddissatisfactionwithsov-ereigndebtresolutionmechanisms,leadingtheiMFtoproposethecreationofasovereigndebtresolutionmechanism(SDRM)fordebtheldbyprivateinves-tors.Followingthefailureofthisinitiative–whichwasrejectednotonlybyprivatecreditors,butalsobytheGovernmentsoftheUnitedStatesandsomeemergingmarketeconomies–privateexternaldebtissueshaveremainedtheprerogativeofcommercialcourtsanddirectdebtor-creditornegotiations.

These developments have given rise to afragmentedsovereigndebtresolutionsystem,withdifferent procedures for handlingdiverse kindsofexternal sovereign debt (bilateral andmultilateraldebt,bankloansandexternalbonds)whendifficultiesarise(UNCTAD,2015).TheParisClubprovidesthemainnegotiatingforumforrestructuringtheofficial bilateral debt of its creditormemberStates.Thisgroupiscomprisedof19developedcountriesthatarethemajorprovidersofofficialcredittodeveloping

countries.Negotiations,whichcovermedium- and long-termdebt, including export creditswhose terms exceedone year,normally take place after thedebtor government has agreedtoan iMFloanand itsassoci-ated conditionality, althougha few exceptions have beenacceptedrecently.Negotiationsresultin“agreedminutes”whichincludethegeneraltermsofdebt

restructuring.Thisisfollowedbybilateralagreementswitheachparticipatinggovernmentthatmaypresentsomedifferences,aslongastheyfollowthegeneralguidelines.TheParisClubhassought toestablisha framework for debt restructuring by seeking“comparability of treatment”,whereby the debtorgovernment commits to seeking similar treatmentfromother official creditors that are notmembersof the ParisClub, and also from foreign privatecreditors.13Domesticdebtandmultilateraldebtareexcludedfromthisrequirement.

Multilateral institutions play a key role insovereigndebtresolution,despitethefactthatmulti-lateral debtshavegenerallybeenexemptedfromdebtrestructuringorrelief.TheinvolvementoftheiMF,theWorldbankandmultilateraldevelopmentbankstypically consistsofprovidingexceptionalfinanc-ingwhenvoluntaryprivatesourcesdryuporarenolongeravailable.incompensation,theseinstitutionshave benefited from the status of preferred credi-tor.Theirfinancinghasgenerallybeenconditionaluponstrictandcomprehensivepolicyrequirements,originally intended to ensure that countrieswouldbeabletocorrecttheirimbalancesandrepaytheirloans.14Therefore,securingacreditagreementwiththeseinstitutions(andparticularlywiththeiMF)hasbeenapreconditionfornegotiatingdebtrestructuring

The current fragmented sovereign debt resolution system applies different procedures to handling diverse kinds of external sovereign debt.

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orreliefwithothercreditors,astheassociatedcon-ditionalityhasbeenviewedasacommitmentfromthedebtorcountrytoaddressthecausesofitsdebtproblems.

Themain exception to the rule that exemptsmultilateraldebt fromrestructuringorahaircut isthe debt owed by poor countries,mainly throughtheHiPC initiative launched in 1996, broadenedin 1999, and deepened through theMultilateralDebtReliefinitiative(MDRi)in2005.TheoriginalHiPCinitiativewasaimedatprovidingthepoorestcountrieswithanexitfromtherepeateddebtreschedulingpro-cess. itwas designed to coor-dinate the efforts of involvedcreditors through broad andequitable participation,mostprominently by multilateralinstitutionsandParisCluboffi-cialcreditors,butalsobynon-Paris Club bilateral officialcreditorsandcommerciallend-ers.15Subsequentiterationsthathaveextendedreliefinvariousways,havebeenlinkedtocountryperformance.Theyhave also developed amore systematic approachto the quantitative evaluation of debt sustainabil-itythroughtheformulationofthresholdvaluesforstandarddebtindicatorsbasedonhistoricalexperi-ence,andtheinclusionofanadjustmentforexternalshocks.Subsequenteffortstorefinethisevaluationmethodology have been tried, but continue to bedoggedbycriticismaboutthelackoftransparencyintheunderlyingassumptionsofwhatconstitute“good”or“bad”policiesandtheinstitutionalarrangements,aswellaspersistentproblemsindifferentiatingeffec-tivelybetweenliquidityandsolvencycharacteristicsofimpendingdebtcrises(ocampoetal.,2007).

Hence,overalldebtrestructuringwithofficialcreditors followsapre-establishedprocedurewithlittle roomfornegotiation.Thiscontrastswith thetreatmentofsovereigndebtwithprivatecreditors,which consists of bank loans and external bonds.Bank loansaresubjecttonegotiationsatthelondonClub,aninformalgroupofinternationalcommercialbanksestablishedin1976.Whenasovereigndebtorrequests debt restructuring, a bank advisory com-mittee (bAC) is createdwithin thelondonClubprocessandchairedbyaleadbank−generallytheonewith the largest exposure –whosemain task

is to coordinate the creditors’ bargainingposition.ThebACeventuallyreachesanagreementwiththedebtor government and seeks to convince all thebankcreditors(eventhosethatarenotmembersofthebAC)tosignon.SincethelondonClubdoesnotestablishbindingresolutionsorhavedefinedvotingprocedures, agreements have sometimes requiredlong negotiations, and free-riders have posed arecurrentproblem.Althoughthenegotiationprocessallowsconsiderableflexibilitywithintheprivate-lawparadigm,ithasmaintainedsomelinkswithnegotia-tionsonofficialbilateralandmultilateraldebt.For

instance,reachingacreditagree-mentwiththeiMFisadefactorequirement for a governmentthatisseekingtorestructureitsdebtwiththelondonClub,andreciprocally, avoiding arrearsinpaymentswithprivatebanksisausualconditionforsigningan agreement with the iMF.Regarding Paris Club agree-ments, commercial banks arenormallyasked tooffer“com-parable treatment” (i.e. debt

relief)tothatofferedbyofficialcreditors.Thislatterapproachhasrepeatedlybeencriticizedforitslackoftransparencyabouttheunderlyingmethodologyfordeterminingcomparabilityaswellasforitslackofenforceability(UNCTAD,2015).

The substantial shift from syndicated bankloanstoexternal bondfinancingoverthepasttwodecadeshassignificantlyincreasedthecomplexityof debt restructuring.Thousands of bondholderswithdiverseinterestscanfacedivergentregulatoryconstraints,andbondseriescanbeissuedindiffer-ent jurisdictions.Usually, an informal negotiationtakesplaceincommitteeswheredifferentgroupsofbondholders are represented.16Thedebtor countryeventually proposes bond swapswith lower facevalues,longermaturitiesand/orlowerinterestrates.otherbasiccharacteristicsofthebondsmayalsobealtered:newbondsmaybedenominatedinadifferentcurrency,besubjecttoadifferentjurisdiction,andincorporate newclauses, such as collective actionclauses(CACs).bondholdersthenvotefororagainstacceptingtheswaps.iftheoldbondsincludedCACs,aqualifiedmajoritymaymakethevotebindingonallbondholders.ifnosuchCACsareincluded,ortherequiredmajorityisnotobtainedthroughvoting,creditorsthathavenotacceptedtheswap(“holdout

The substantial shift from syndicated bank loans to external bond financing over the past two decades has significantly increased the complexity of debt restructuring.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 137

bondholders”or“holdouts”)mayseekbettertermsorevenfullrepaymentthroughlitigation.

Debtorscantrytoobtainwideracceptanceoftheirproposalbypromoting“exitconsents”,throughwhichbondholderswhoaccepttheswapareaskedtovotetoalterthenon-repaymentterms of old bonds tomakethem less liquid and attractiveto holdouts. They can alsoestablishminimum participa-tion thresholds,meaning thattheir restructuring offer onlyholdsifaminimumnumberofbondholders accept it. in thiscase, creditorswishing to endamoratorium and start receiving a paymentmaytry to convinceother creditors to accept the deal.However,manybondholdersmayalsoprefertoselltheir bonds at a discount in the secondarymarketratherthanwaitfortheconclusionofthenegotiationprocess.increasingly,conventionalbondholdersarebeingreplacedbyspecializedinvestorsnotinterestedinreachingasettlement,butseekingtoobtainfullpaymentthroughlitigation(includingtheso-called“vulture funds”).As discussed further below, thishas become themost serious challenge for debtrestructuring.

4. Aninefficientandunbalancedapproach to debt resolution

(a) Too little, too late

Anearlydiagnosisthatdetermines,inparticular,whetheracountryisfacingaliquidityorsolvencycrisisisessentialfortheorderlymanagementofadebtproblem.Thepresentfragmentedschemehas proved inefficient in pro-viding such early diagnoses,and has tended to delay oftenurgently required swift andcomprehensiveactiontopreventadebtcrisisfromspirallingoutofcontrol.

itappears,underthecurrentsystem,thatneitherdebtorgovernmentsnorcreditorshaveanincentive

torecognizeasituationofoverindebtednessandtakeearly and comprehensive action (buchheit et al.,2013).Fordebtorgovernments,amajordisincentiveis the likelihood thatdeclaringadebtmoratoriumwill have a self-fulfilling effect by triggering aneconomiccrisis.Furthermore,defaulting“tooearly”

maybeviewedbycreditorsasa strategic (avoidable) defaultaimedatloweringdebtservicingcosts.Governmentsmaywantto avoid the consequent repu-tational costs −whichwouldresultinloweraccesstocredit−thatmayoutweighthebenefits.Therefore,theymaypostponeaneededdefaultuntilitbecomes

clearly“unavoidable”soasnottoraisedoubtsabouttheir good faith andwillingness to pay. Finally,governmentsquitefrequentlyfailtofullyperceivetheincreasingrisks,andonlyreactwhencriseshavealreadystarted.

Creditors also have an interest in delayingexplicitrecognitionofasolvencycrisis,asopposedtoamereliquiditycrisis,since,incaseofasolvencyproblem, no creditors can expect to recover theirloans in full (except, to some extent,multilateralinstitutionswith preferred creditor status). Privatelenders therefore tend to initiallyminimize theextentofthedebtproblems.Thiscanreceiveofficialendorsement froman initialdiagnosisby the iMFwhichagreesemergencysupport(ashashappenedinallthemajordebtcrisessincethe1980s),andfore-castsarapidrecoveryfollowingtheimplementationof adjustment policies.Those forecasts in generalhavebeen toooptimistic (iMF,2003b;TDR 2011,chap. iii), but have provided the rationale for the“liquidityproblem”hypothesis.Asaconsequence,debtorgovernmentshavereceivedcreditfromofficial

sources,whileprivatecreditorshave been reluctant to renewcreditlinesandhaveoptedforimmediate repayment. oneimplication has been the so-called“revolvingdoor”process,withofficialcreditfundsbeingused to repay debts to privateagents, instead of supportingthe real economy and helpingto restoregrowth.Precisely to

avoidsuchinefficientuseofexceptionalfinancing,the iMF’sArticlesofAgreement includea rule to

The present scheme of debt resolution has tended to delay the swift and compre-hensive action needed to prevent a debt crisis from spiralling out of control.

Since solvency crises were treated as liquidity crises, official credit extended to indebted governments was used to repay debt to private agents, instead of helping to restore growth.

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theeffect that“amembermaynotuse theFund’sgeneralresourcestomeetalargeorsustainedoutflowof capital”(ArticleVi). Since the 1980s, this rulehasbeenoverlookedrepeatedlyinthemanagingofsovereigndebtcrises.

(b) Asymmetric and procyclical resolution processes

Unlikeprivatefirms,indebtedStatescannotgobankrupt.Ultimately,debtresolutionprocessesneedtofocusonadebtoreconomy’sabilitytorecoverasquicklyaspossibleandonminimizingsocial,politi-cal and economic adjustmentcosts.Thisrequiresasupportiveinternational framework thatallows the debtor country toconductcountercyclicalpolicieswhichwillenableittorestoreitsdebtservicingcapacitythroughinvestment, output and exportgrowth,ratherthanimportcon-traction.Nationalpolicyshouldalso ensure that government debt can be reducedby increasingpublic revenue rather than reducingexpenditure.

Thecurrentinternationalfinancialandmonetarysystemislackinginthisregard,andischaracterizedbyacontractionarybias.This isevidencedby theiMF’s“stand-byagreements”(SbAs)underwhichstandard associated credits typically include therequirementforfiscalandmonetaryausteritymeas-uresbasedon the“absorptionapproach”.Suchanapproachisbasedontheviewthatcurrentaccountdeficitsand theresultingexternaldebt result fromalevelof“absorption”(i.e.domesticconsumptionandinvestment)inexcessoftotaloutput(MussaandSavastano,1999).

A new form of conditionality imposed bysubsequent iMF lendingprogrammes, in additiontoconventionalmacroeconomicadjustments,istherequirementforstructuralreforms.intheirvariousmanifestations,thesehavecontinuedtofocusoncon-tractionarymeasures,aswellasonageneralroll-backofStateinterventionineconomicandfinancialareasthroughfar-reachingliberalizationandprivatizationpolicies.besidesmacroeconomic adjustment andstructural reforms, a third core component of theiMF-supported programmes has been to secure a

sustainableflowofforeignfinancing.Consequently,theseprogrammesusuallyalsoincludetherequire-mentfortherecipienteconomytoremaincurrentongovernmentdebtserviceandtoeliminateanydebtarrearsaccumulatedprior toprogrammeapproval.Hence, rather than involvingprivatecreditors inadebtrestructuringprocess,theiMFhasincludedtheservicingofprivatedebtamongitsusualconditions.

Arguably,suchconditionalitieshavedonelittle,ifanything,topromotedebtsustainabilitythroughgrowth, and havemostly been counterproductive.TheiMFhasprogressivelyacknowledgedmistakesinitspolicyconditionalitiesundercrisisconditions.it

nowarguesthatfiscalausterityduringrecessionsismorecostlythanwas previously assumed,because fiscalmultipliers arehigher, the assumption of atrade-off between public andprivatedemandisquestionable,andpublicspendingcutsarenotautomatically offset by higherprivatedemand(iMF,2012).it

hasalsorecognizedthatitsstrictconditionalityandacumbersomeprocessfordeliveringcreditsupportwere inappropriate for preventing or addressingexternal debt crises triggered by gyrations in thecapital account.Consequently, it has created newcreditlineswithlowerconditionalitythatwouldpro-videa“precautionarylineofdefense”formembersthatmightsufferfromcontagioneffects(iMF,1997and2004;ocampo,2015).17However,sofaritsnewcreditlineshavenotbeenusedmuch,18anddonotaddresstheneedsofthemostvulnerablecountries,includingthosehitbyanexternaldebtcrisis(TDR 2001).

(c) The rise of non-cooperative creditor litigation

The rapid rise of bondfinancing in externaldebtmarketsfollowingthebradyPlanwaswidelyexpected tostabilizeexternaldebt throughmarketdiscipline,coupledwithsufficientlegalguaranteesforcreditors.Thus,forinstance,enforcementclausescontaining awaiver of sovereign immunitywereincluded in bond contracts.Asmentioned earlier(see subsectionD.2) under a number of jurisdic-tions, sovereigns couldno longer claim immunityforwhatwasdeemedtobecommercialactivity.in

Debt resolution processes should focus on economic recovery and on minimizing adjustment costs. …

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 139

addition,in2004theNewYorklegislatureopenednewopportunitiesfortheso-called“vulturefunds”whenitgreatlyrestrictedthescopeoftheChampertyDoctrinewhichforbidspurchasingadebtwiththesolepurposeoffuturelitigation.19

inthiscontextofstrengthenedcreditorrights,vulturefundshaveflourished.Theirstrategyconsistsofbuyingdefaultedbondsatasignificantdiscountonlytoaggressivelysuegovernmentsthereafterforrepaymentoftheirdebtsatfacevalueplusinterest,arrearsandlitigationcosts,withgainsofbetween300and2,000percent.20AccordingtoSchumacheretal.(2014),suchholdoutlitigationhasbecomeacommonandincreasingpracticeindebtrestructurings,fromonlyabout5percentinthe1980stoalmost50 per cent in 2010, and thetotalvolumeofprincipalunderlitigationreached$3billion in2010.between1976and2010,therewereabout120lawsuitsbycommercial creditors (against26 defaulting Governments)in theUnited States and theUnitedKingdomalone,thetwojurisdictionswheremostsovereignbondsareissued.Thistrendhassincecontinued,withsuitsbeingfiledagainstecuador21andGreece,amongothers.22

Holdoutlitigationhasbeenparticularlydisrup-tiveinthecontextofmultilateraldebtreliefeffortstoreducetheexternaldebtburdenofheavilyindebtedpoorcountries.23inpractice,suchlitigationhassig-nificantlyerodedthelimitedfiscalspacecreatedbydebtrelieftoalleviatepovertyandfostereconomicdevelopmentinthesecountries.Atleast18heavilyindebtedpoorcountrieshavebeenthreatenedwithor subjected to legal actions by these commercialcreditorssince1999,leadingtoanestimatednumberofmore than 50 lawsuits of the kind described.24For example, in a case againstZambia,Donegalinternational, a vulture fund based in thebritishVirginislands,havingboughtdebtinstrumentsfor$3.28million, sued the debtor for their nominalvalueof$55million.TheHighCourtofJusticeofenglandandWales,withnotablepoliticalandmoraldisapproval, ruled that theGovernmentmust paythevulture fund$15.4million,which represented65percentofwhatZambiahadsavedindebtreliefdeliveredthroughtheMDRiin2006.25inreaction,theUnitedKingdompassed legislationpreventing

claimsagainstheavilyindebtedpoorcountriesthatexceedtheamountwhichaholdoutcreditorwouldhavereceivedhaditacceptedtherestructuring.26

Actionbyvulturefundshighlightstheconflictbetweenapurelyprivate-lawparadigmthatseekstoenforcecontractsatanycostandthelogicofpubliclawwhichissupposedtotakeintoaccountthewidereconomicandsocialconsequencesoflegalactions.Courtshavegenerallyendorsedholdouts’views,evenattheexpenseofsovereigndebtsustainabilityandtheinterestsnotonlyofthedebtorcountry,butalsoofbondholderswillingtoreachaviableagreement.Themainargumentisthatthemajorityofcooperative

creditorsmust not be allowedtomodifythefinancialtermsofothercreditorcontracts,unlessspecific contractual clausesallow this possibility.UnitedStatescourtshaveconsistentlyruled that, in the absence ofcontractual clauses providingformajorityvoting, the“sanc-tity of contracts” prevails, sothatunanimityamongcreditorsisrequiredtomakearestructur-

ing agreementbindingon every creditor.27DebtorStates’invocationofastateofnecessityhasmostlybeen rejectedbycourtsaround theworld,be theynationalcourtsorarbitrationtribunalsactingwithinan investor-State dispute settlementmechanism(iSDS).28

inrarecases,courtshavetakenintoaccountdebtsustainabilityconcerns.Dependingonthepotentialglobaleffectsoftherestructuringatstake,inafewcasescourtsintheUnitedStateshaveacknowledgedthattherecanbealegitimateinterestindebtrestruc-turings on the grounds of safeguarding financialstability.29inotherjurisdictions,courtshavegivenbroaderrecognitiontotheprincipleofdebtsustain-ability, by granting immunity to debt repudiationaimed at safeguarding the basic human rights ofcitizensinthedebtorStates.30However,thesecaseshavenothadanywiderimpact,andhavebeenover-shadowedmorerecentlybythewell-knownrulinginthecaseofNML Capital, Ltd. et al. v. The Republic of Argentina that has been strongly supportive oftheholdouts.

Thiscasehighlightstwomajorfactorsthatfacili-tateholdoutlitigationandthreatendebtsustainability.

… However, such processes are characterized by a contractionary bias through the conditionality attached to lending programmes by the IMF and other official sources.

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Thefirstistheso-called“forumshopping”,thatreferstotheabilityofholdoutcreditorstoshoparoundforfavourablejudges.Thus,Argentina’screditorsfoundsympathetic judges not onlyin theUnited States, but alsoat theGermanConstitutionalCourt,31 theSupremeCourt oftheUnitedKingdom,32andtheiCSiD tribunal,33 aswell as ajudge inGhana.34The secondfactorarisesfromtheverywideinterpretationofthepari passuclause that iswidely used insovereigndebtcontracts.Accordingtoaconventionalreading,itspurposeistoensurethatnopriorityrankingisestablishedforunsecuredcreditors(buchheitandPam,2004).bycontrast,thesittingjudgeinthecaseofNML Capital, Ltd. et al. v. The Republic of Argentina,following an earlierbelgian case,35 interpreted thepari passu clause as anobligationbyArgentina tomake rateablepayments toNMleach time itpaysitsrestructuredbondholders.36Morespecifically,theDistrictCourt’sinjunctionsforbidanyfinancialinter-mediariesfromcollaboratingwithArgentinainpayingexchangebondholdersunlesstheyarenotifiedthattheholdoutshavereceivedrateablepayment.

This ruling threatensdebt sustainability in atleastthreeways.First,itmakesfuturedebtrestruc-turingsmuchmoredifficultthantheyalreadyarebystrengtheningcreditors’incentivesnottoconsenttodebtrestructuringagreements.Notonlycancredi-torsnowexpecttohavemoreleveragetoseekfullrepayment,butthoseagreeingtoadebtrestructuringcannolongerbesurethattheywillactuallybepaid.Second,giventheglobalscopeofthemanyfinancialintermediaries involved in this case, the judgmentpotentially has universal reach.Third, the rulingfocusesexclusivelyoncreditors’rightsanddisregardsanywidersocio-economicimplicationsofrequesting rateable paymentsfromthedebtorcountry,totheextent of risking anArgentinedebt default and, in any case,severelyunderminingitsfutureaccesstoexternalfinancing,andthusitsgrowthprospects.

beyondArgentina, holdout creditors alsohavecomplicatedrecentGreekdebtrestructurings.Normally,holdoutlitigationislimitedtodebtissued

under foreign lawwhich the debtor State cannotmodifyunilaterally.in2012,undertheauspicesoftheeuropeanFinancial Stability Facility,Greece

restructured$206billionofitsdebt by offering bondholdersnewbondswith a 75per centhaircut, lower interest ratesandlongermaturities.Thenewbondswereacceptedby97percentofthecreditors.bondsgov-ernedbyGreek lawwerealsosubjecttoanex-postlegislativeintroductionofaCACtofacili-

taterestructuringofthedebtportfolio.Justbeforethehaircuttookplace,vulturefundsboughtGreekbondsissuedunderUnitedKingdomlegislationthatdidnotallowGreecetoactivatetheCACs.Amonthafterthecompletion of the haircut, theGreekGovernmentdecidedtopay435millioneurostoinvestorswhohad refused to participate in the restructuring. inJune and July2013, theGreekGovernmentmadetwoadditionalandhigherpayments,of790millioneurosand540millioneuros,respectively,toholdoutcreditors.

(d) The role of contingent liabilities in sovereign debt

Finally,abriefmentioniswarrantedofanotherrecent and growing area of concern, namely theproblem of contingent liabilities of a sovereignandtheirtreatmentinprocessesofdebtrestructur-ing (seebuchheit andGulati, 2013).Contingentsovereign liabilities refermostly to third-partydebt guarantees, granted either explicitly througha formal undertaking, or implicitly through infor-malorsemi-formalarrangementsthatsignaltothe

creditorthesovereign’saware-ness and implicit approval ofa transaction.Another, evenless formally acknowledgedformof contingent liability ofasovereignarisesfromitsroleas lender of last resort duringdebtcrises.Asalreadypointedout,giventhecharacteristicsofrecentdeveloping-countrydebtcrises,thereisarelativelyhigh

probabilitythat,intheeventofsuchacrisisstartingintheprivatesectorofaneconomy,atleastpartofprivatelyoweddebtwillbedefacto“nationalized”.

Holdout litigation and recent rulings that forbid govern-ments to pay the restructured debt make debt restructurings more difficult than they already are. …

…Such rulings show a total disregard for the sovereignty of the debtor, for third-parties’ interests and for the socio-economic impacts they might have on a debtor economy.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 141

Third-party debt guarantees are, almost bydefinition, kept off the public balance sheetsprecisely because they constitute liabilities thatare contingent on the primary debtors’ ability toservice the debt.At the same time, this practicekeeps the sovereign State’s official debt ratioslow, thus facilitating continued access to futureborrowings,inparticularwhereasovereignalreadyhashighlevelsofindebtedness,atleastasviewedby market participants. Preliminary evidencesuggeststhat,sincethe2008−2009globalfinancialcrises, sovereigncontingent liabilitieshavegrown

significantly, althoughmostly inWesterneurope(buchheitetal.,2013).

Howsuchgrowingcontingentliabilitiesmightbeincludedinsovereigndebtrestructuringsiscur-rently unclear, since there is hardly any relevantprecedence.WhilesovereignStatesmighttemporar-ilybenefitfromthenoveltyofthisissueandthelackofestablishedways toaddress it in thecontextofrestructurings,inthelongerrunignoringcontingentliabilitieswillproveverycostly,notonlytosovereignStatesbuttoallpartiestoadebtrestructuring.

Since the global financial crisis, there hasbeengrowing recognitionof theneed to facilitatesovereign debt restructuring. Such concerns arenotnew.However, in theyearsprior to2008, thedominantviewwasthatthemorecostlyasovereigndebtdefault,thelesslikelyitwouldbetooccur(seebuchheitetal.,2013).Accordingtothisview,anyreductionin thecostsofdefaultwoulddiscouragegovernments frompaying their debts and encour-age over-borrowing, thereby increasingperceivedcreditorrisksandreducingaccesstoforeigncredit.instead, as argued above, recent experience hasshownthatthemorelikelyscenarioisnotthatgov-ernmentsmayrestructuretheirdebtstooeasily,but,onthecontrary,thattheywilldelaynecessarydebtrestructurings.

Thissectionanalysesexistingproposalsforamoreeffectiveapproachtosovereigndebtrestruc-turing,andtheextenttowhichtheywouldfacilitatesuccessfulandcomprehensivesovereigndebtresolu-tionwhilealsoremainingpoliticallyfeasible.Therearebroadlythreetypesofapproachestosovereigndebtrestructuringmechanisms(SDRMs):amarket-basedapproachthatfocusesonlegalimprovementsto the existing contractual system; a semi-institu-tional approach that advocates theuseof soft-lawinternationalprinciplestohelpinformandguidea

restructuringprocess;andastatutoryapproachthataims toestablish internationallybinding rulesandproceduresonsovereigndebtrestructuring.Alegallybindingmultilateraltreatyistheultimateobjectiveofthisapproach.

These proposals differ on a number of keyaspects of sovereign debt restructuring, such aswhichtypesofdebtshouldbeincluded,thedegreeofcoordinationandcentralizationofSDRMs,howpar-ticipatoryandtransparenttheseshouldbe,whetherornotSDRMsshouldincludeadjudicationpossibilitiesincaseswherenovoluntaryagreementisreached,andhowconsistentoutcomeshavetobeacrossdebtrestructurings.

1. Contractual or market-based approaches

Anumberofprominentproposalstofacilitatesovereign debt restructuring seek tomaintain theintegrity of existingmarket-based approaches byclarifying and strengthening their legal underpin-nings, in particular by improvingCACs in bondcontracts (iMF, 2014).other approaches include

E. Alternative mechanisms for debt restructuring37

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contingentpaymentprovisions,clarificationof thepari passu(equaltreatmentofbondholders)provi-sion,inparticularfollowingtheongoingArgentinecase,andmechanismstolimitcreditorparticipationinrestructuringsbyaddressingtheissueofsovereigncreditdefaultswaps.ContingentpaymentprovisionsarenotprimarilyconcernedwiththeSDRMitself;instead,theywouldallowfuturepaymentsbysov-ereigndebtorstobemadecontingentonobservableeconomicconditions,forexamplethroughtheuseofGDP-indexedbondsorcontingent-convertiblebonds.

Themain advantage of suchmarket-basedapproaches is that debt restructurings remainvol-untary and, at least potentially, consensual.Theyalsoopen theway togradual reform, in the sensethatwidespreaduseof such contractual proposalsmighthelptopromotedebtsus-tainability, reduce uncertaintyaboutoutcomesandpreparetheground formore far-reachingreforms.

This said, thecaseof theCACs also highlights majorlimitations.As the exampleofGreecehasshown,convention-al, single-seriesCACs,whichrequiretheconsentofaqualifiedmajorityofbondholdersofeverysingleissue,caneasilybedisabledbyholdoutcreditorswhobuyablockingminority.AggregatedCACs,whichrequirea twofold qualifiedmajority− that of the holdersofeachbondissueaswellasof theholdersofallcoveredbondissues−canreduce,butnoteliminate,theriskofsuchbehaviour.Yet,eventhebest,single-limbCACsthatdonotrequirevotingbybondissuecannotguaranteethatholdoutswillnotfindwaystoblocktherequiredconsent(GalvisandSaad,2004).

TheseCACsrequiretheparticipationof75percent of all covered categories of outstanding debt.Whileitmightbedifficultevenforverylargeinves-tors to acquire a blockingminority, the operationof such clauses –which are yet to stand the testof practice – requires that all creditors be offeredidentical conditions under the restructuring agree-ment,regardlessoftheconditionsoftheiroldbonds.Without this, therewould be a high risk that therestructuring is achieved at the expense of somebondseries.However,thisconditionprovidesabasisfor inter-creditor discrimination.one-size-fits-all

restructuringagreementswillnecessarilydisadvan-tagethosewhoenjoyedbetterconditionsbeforetherestructuringthanthemajority,suchascreditorshold-inginstrumentswithlongmaturities.intheend,eventhird-generationsingle-limbCACsremainstructur-allydeficient(bohoslavskyandGoldmann,2015).

ApurelycontractualapproachfocusedonCACssuffersfromanumberofadditionallimitations.TheintroductionofcertainCACsmightrequirelegisla-tiveamendments in some jurisdictions inorder toprotectthemagainststandardtermreviewsbycourts.Manylegalordersprotectcontractualpartiesagainstboilerplate termsusedbyonepartywhichundulycompromisetherightsofanotherparty.legislationwouldhavetodeterminethatcertainCACsdonotfallintothiscategory.Moreover,CACsonlyapply

to bond debt; if the debtorState has significant outstand-ingmultilateral, bilateral orbankdebts,theywillbeoflit-tle help.Coordination amongdifferent categories of credi-tors and the riskof free-riderstaking advantage of a lack ofsuchcoordinationhasbeenanongoing concern. CACs alsoadopt a very narrowapproachto sovereigndebt issues.They

donotpreventcrises,nordotheyprovidethetoolsnecessaryforexitingthem,orinterimfinancingdur-ingdebtrestructuring(KruegerandHagan,2005).Furthermore,CACsdonotguarantee that theout-comeof negotiations –whichwill dependon therelativebargainingpowersof theparties–willbeconsistentwithadurablesolutionbasedonareturntogrowth.

2. Need for internationally accepted principlesforSDRMs

Thisapproachaims,inprinciple,ataninterna-tionallyacceptedsolutionforSDRMs,andthusatahigherdegreeoftheircoordination,andpossiblycentralization, than themarket-based contractualapproach.Unlikethestatutoryapproach(seebelow),itfocusesonsoft-lawprinciplesorguidelines,drawnfrom international public law.GeneralAssemblyresolutionsonexternaldebtanddevelopmenthave

Market-based instruments such as collective action clauses may improve debt restructuring, but they do not prevent crises, nor do they provide the tools necessary for exiting them.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 143

repeatedlycalledforconsiderationofsuchenhancedapproachestoSDRMsbasedonexistingframeworksandprinciples,withthebroadparticipationofcredi-torsanddebtors.38Anexampleofsuchprinciplesistobefoundin UNCTAD’s roadmap andguideforsovereigndebtwork-outs(UNCTAD,2015).

Generallyspeaking,asoft-law approachmight define anumber of principles to guidesovereign debt restructuringsand address the challenges todebtsustainability.Suchgeneralprinciplesoflawusuallyrefertounwrittenrulesofbehaviourorcustomarypractices.Theyshouldberecognizedinmostdomesticlegalsystems,andtheyshouldbeapplicableinthecontextofexistinginter-nationallaw.ThefollowingarethecoreprinciplesunderdiscussionforSDRMs:

• Sovereignty,which establishes the right ofgovernmentstosetpoliciesandregulatetheirinternalaffairs independently,and implementtheminthepublicinterest.Thisisafundamen-talprincipleunderpinninganydomesticlegalsystem, and remains the basis for economicand political interactions at the internationallevel.TheconditionsunderwhichinternationalbodiesmayadoptdecisionsaffectingStatesorindividualsisanongoingdebate.

• Legitimacy,whichreferstothebasicjustifica-tionofagovernment’sauthorityoveritscitizens(or of an international or supranational bodyoveritsmembers)andtheproceduresbywhichthatauthority iscreated,exercisedandmain-tained.inthecontextofSDRMs,thisprincipleisunderstoodtorefertosuchrequirementsascomprehensiveness, inclusiveness, predict-ability andownership. it broadly reflects theideathatSDRMsneedtotakeintoaccountandrectify the trendofStatesbeing lessand lessprotectedby sovereign immunities andmoreandmore subject to thedecisionsof interna-tionalorganizationsandotherstructuressuchascreditorcommittees.

• Impartiality,whichreferstotheabsenceofbias.Assuch,itfosterstheacceptanceofdecisionsbygeneratingorreconfirmingtrustinactorsand

institutions.itiscloselyrelatedtotheprincipleoflegitimacy.inthecontextofsovereigndebtworkouts, the principle of impartiality refers

to institutions involved in debtworkouts, and includes theirfinancial situation, the choiceandactionsoftheirpersonnelandtheinformationattheirdisposal.Thefundamentalideaisthatsov-ereign debtworkouts require aneutralperspective,inparticularwithregardtodebtsustainabilityassessmentsanddecisionsaboutrestructuringterms.

• Transparency,whichhas twodimensions ofparticularrelevanceforsovereigndebtwork-outs:datatransparencyondebtorandcreditorpositions, projections underlying proposedrestructurings and any indicator used in thecontextofdebtrestructurings;andinstitutionaltransparencysoastoavoidthebackroomnatureofsomepastdebtworkoutnegotiations.

• Good faith,whichencompassesbasicrequire-mentsoffairness,honestyandtrustworthiness,and iswidelyacceptedasageneralprincipleof law.Good faith implies that the legal andeconomicoutcomesofsovereigndebtworkoutsmeetlegitimateexpectations.Assuchithasaparticularlyimportantimpactonallproceduralelementsofadebtworkout−fromastandstillon payments, through a stay on litigation torestrainingholdouts.

• Sustainability,whichconsidersthatsovereigndebtissustainableifitcanbeservicedwithoutseriously impairing the social and economicdevelopmentofsociety.ineconomicterms,thismeansthatonlysustainedandinclusivegrowthcreates the conditions for servicing externaldebtinthelongrun,andthatconditionalitiesfor the restructuring of sovereign debtmustnot undermine growth-enhancing dynamics.Sustainabilityconstitutesan(atleastemerging)generalprincipleoflaw.inthecourseofthelastfewdecades,theconceptofsustainabilityhasspreadfromenvironmentalregulationtootherpolicyfields, including political economy. itnowcharacterizeslargesegmentsofdomesticpolicy,andhas received recognition inmanyinternationalforumsandresolutions.

Basic principles to guide sovereign debt restructuring and recover debt sustainabil-ity can be incorporated into domestic legal systems and be applied in the context of international law.

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Box 5.2

bELGIAN LEGISLATION RELATING TO VULTURE FUND ACTIVITIES

inJuly2015,thebelgianparliamentoverwhelminglyadoptedabill“tocombatvulturefundactivities”.Attheheartofthenewlawistheintroductionofaceilingfortheamounttheso-calledvulturefundscanreclaimfromgovernmentbondsboughtathighlydiscountedpricesinsecondarybondmarketsfromeconomiesclosetodefault.Thelawallowsbelgianjudgestostopvulturefundsfromclaimingrepaymentabovethediscountedmarketpriceitpaidforgovernmentbonds,forexampleatoriginalfacevalue.

it followsearlierbelgian legislation, adopted inMarch2013, toprevent creditors’ seizureof fundsearmarkedfordevelopment(Art36,loirelativeàlaCoopérationauDéveloppement).Morespecifically,the new legislation targeting vulture funds provides a legal framework to prevent non-cooperativebondholderstaking“illegitimateadvantage”,whichisdefinedasamanifestdisproportionbetweentheamountclaimedbyacreditorandthenotionalfacevalueofthedebt.Asignificantmeritofthislegislationisthatitdefinesessentialcharacteristicsofvulturefundsandthecontextsinwhichtheiractionsarenotacceptable.Underthelaw’sprovisions,onceacreditor’s“illegitimateadvantage”hasbeenestablished,basedontheabovedefinition,abelgiancourtcandenyanyorderofpaymentthatwouldgivethecreditoranillegitimateadvantageifatleastoneofthefollowingcriteriaismet:(i)thedebtbuy-backtookplacewhenthesovereigndebtorwasinsolventorindefault,orwheninsolvencyordefaultwereimminent;(ii)thecreditor’slegalheadquartersareinarecognizedtaxhaven;(iii)thecreditorhasatrackrecordofusinglitigationtoobtainrepaymentofrepurchaseddebts;(iv)thesovereigndebtorhastakenpartindebt restructuring that thecreditor refused; (v) thecreditorhas takenadvantageof the sovereigndebtor’sdebtdistresstoobtainaclearlyunbalanceddebtsettlementinthecreditor’sfavour;and(vi)fullreimbursementbythedebtorhasadversesocio-economicimpactsand/ornegativelyaffectsthedebtoreconomy’spublicfinances.

Thelawclearlyundercutsanyincentivefornon-cooperativecreditors,holdoutbondholdersandvulturefundstostartlitigationinbelgium,andmakesbelgiumapioneeringovernmenteffortstocurtailtheactivitiesofsuchfunds.Thisisparticularlysignificant,asbelgiumishometoeuroclear,oneoftheworld’slargestclearinghousesforglobalfinancialtransactions.Forexample,underthenewlaw,earlierdemandsbyNMlCapital,ltd.tofreezeArgentineaccountsinbelgiuminthecontextofitsholdoutlitigationintheUnitedStatesagainstArgentina,wouldnolongerbeallowed,sinceabelgianjudgecanrefusetoabidebylegaldecisionsmadeinotherjurisdictions.

TheonlyothernationalinitiativerelatingtovulturefundstohavepassedthetestofaparliamentaryvoteistheUnitedKingdomDebtReliefAct(DevelopingCountries)of2010,whichpreventsvulturefundsfromgainingmassiveprofitsfromdebtrestructuringindevelopingeconomies.othernationallegislativeinitiativestothiseffect,andwithaparticularfocusondeveloping-countrydebt,havebeenproposedinseveraleuropeancountriesandintheUnitedStates,butsofartheyhavenotbeenenacted.TheUnitedKingdomDebtReliefActislessstringentandcomprehensivethanthenewbelgianlegislationinanumberofrespects:itislimitedspecificallytotheheavilyindebtedpoorcountries.Also,ithaslessstringentcapsonprofitsthatcanbemadefromdebtdistressinsucheconomiesbylinkingthosecapstothe“relevantproportion”ofanydebtreliefobtainedundertheHiPCinitiative’sformula(usuallybetween67and90percent).Creditorsthatreachacompromiseagreementrelatingtoclaimsforqualifyingdebtsareexemptfromthisautomaticdebtreductionsystem.overalltherefore,thislegislationislimitedtoaddressing“disproportionate”profitsbyvulturefundsratherthancurbingtheiractivitiesperse.bycontrast,thebelgianlawexplicitlytakesaccountofthewidersocio-economicimpactsofvulturefundactivitiesandoftheirpotentialillegitimacy.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 145

Proponents of such an approach based onsemi-institutional, general principles have devel-opedarangeofsuggestionsonhowtostructuretheinstitutionalaspectsofpromotinggeneralprinciplesorguidelinesforsovereigndebtrestructuring.oneviewisthatrestructuringnegotiationswillcontinuetotakeplaceinestablishedforumsoronanadhocbasis, butwill be supervised and coordinated byanewindependentbody,suchasasovereigndebtforum (a private organization) or a debtworkoutinstitute(endorsedthroughamultilateralprocess).39Asecond,butcomplementary,viewhighlights theusefulnessofsemi-institutionalizingSDRMsatthelevel of adjudicationor arbitration, but falls shortofanapproachbasedonamultilateraltreaty.Thisincludesmainly thepromotionanduseofspecificrulesandprocedures,orapplicationsofthegeneralprinciples,acrossadhocarbitrationprocesses.

onewayofpromotingtheapplicationofgeneralorsoft-lawprinciplesforSDRMsisthroughdomes-ticlegislation,suchastheUnitedKingdom’sDebtRelief(DevelopingCountries)Actof2010,totackleproblemsarisingfromnon-cooperativebondholderlitigation.Similarly,thebelgianparliamenthasonlyveryrecently(inJuly2015)passedalaw“inrelationtothefightagainsttheactivitiesofvulturefunds”,40whichisintendedtocurtailharmfulspeculationbysuchfunds(box5.2).Thisavenueofworkingthroughnationallegislationcouldbeparticularlyeffectiveifcoreprincipleswereadoptedinthosejurisdictionsinwhosecurrenciesmostdebtiscurrentlyissued.Anobviouslimitationis,ofcourse,thedangerofalackofuniformity,coordinationandconsistencyacrossdifferentjurisdictions,aswellasthepossibilitythatonlyveryfewStateswillpursuethiscourse.

overall,asemi-institutionalizedapproachbasedonsoftlawbutalsorootedininternationalpubliclawisclearlyafurthersteptowardsamorepermanent,less fragmented,more transparent andpredictableframework for SDRMs. it has the advantage ofbuilding,forthemostpart,onexistingmechanismsofnegotiationandrestructuring.Moreover,itcouldbescaledupinthefutureifitattractsenoughpar-ties.However,themainlimitationofthecontractualapproachappliestothisapproachaswell,iftoalesserdegree:theprinciplesarenotbinding,andthereisnoguaranteethatacriticalmassofpartieswillbewill-ingtomakemorepermanentcommitmentstotheseprinciples.Thisproblemcanonlybesolvedthroughafull-fledgedmultilateralandstatutoryapproach.

3. Statutory approaches to multilateral debt restructuring

inSeptember2014,theUnitedNationsGeneralAssemblypassedResolution68/304thatcalledfortheestablishmentofa“multilaterallegalframeworkfor sovereign debt restructuring processes”.Thisrepresents a first possible step towards the finaloption,namelyaninternationalformalandstatutoryapproachtoestablishbindingregulationsforallpar-tiesthroughamultilateralprocess.Thisiscertainlythemost far-reaching proposal for sovereign debtresolution,aswellasthemostchallenging.

Advocatesofmultilateraldebtworkoutproce-duresoftendrawattentiontotheasymmetrybetweenstrongnationalbankruptcylaws,asanintegralpartofahealthymarketeconomy,andtheabsenceofanycounterparttodealwithsovereigndebtrestructuring.Giventheuniqueroleofsovereignactorswithrespecttoeconomic,legalandpoliticaloutcomes,anysuchproceduresshouldmeettwoobjectives.First, theyshouldhelppreventfinancialmeltdownincountriesfacingdifficultiesservicingtheirexternalobligations.Suchameltdownoftenresults ina lossofmarketconfidence,currencycollapseanddrasticinterestratehikesthatinflictseriousdamageonpublicandpri-vatebalancesheetsandleadtolargelossesinoutputandemployment,nottomentionasharpincreaseinpoverty.Second,theyshouldprovidemechanismstofacilitateanequitablerestructuringofdebtthatcannolongerbeservicedaccordingtotheoriginalcontract.Meetingthesegoalsimpliestheapplicationofafewsimpleprinciples:

(a) Allowingatemporarystandstill,regardlessofwhetherdebtispublicorprivate,andwhethertheservicingdifficultiesareduetosolvencyorliquidityproblems(adistinctionwhichisnotalwaysclear-cut).inordertoavoidconflictsofinterest,thestandstillshouldbedecidedunilat-erallybythedebtorcountryandsanctionedbyanindependentpanel,ratherthanbyaninstitu-tion(e.g.theiMF)whichisitselfalsoacreditor.Sucha sanction shouldprovideanautomaticstayoncreditorlitigation.

(b) Standstillsshouldbeaccompaniedbyexchangecontrols,includingthesuspensionofconvert-ibilityforforeigncurrencydepositsandotherassetsheldbybothresidentsandnon-residents.

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(c) Debtor-in-possessionfinancingshouldbepro-vided, automatically granting seniority statustodebtcontractedafter the impositionof thestandstill.TheiMFshouldlendintoarrearsforfinancingimportsandothervitalcurrentaccounttransactions.

(d) enablingdebtrestructuring,includingrolloversandwrite-offs,basedonnegotiationsbetweenthedebtorandcreditors,andfacilitatedbytheintroductionofautomaticrolloverandCACsindebtcontracts.

Therearecurrentlytwomainsetsofproposalsforaformalstatutoryapproachthatcouldachievetheseobjectives.Thefirstoftheseforeseesthedevel-opment,insomeformorother,ofasovereigndebtrestructuringfacilityunder theauspicesoftheiMF.Thiswouldrequire an amendment to theiMF’sArticles ofAgreement.A second set of suggestionsemphasizestheneedforamorepermanentand impartial inter-national institution, not itselfinvolved in sovereign lending,and favours the establishmentof an independent tribunal,whether housed in existingcourts (such as thePermanentCourt ofArbitration or theinternationalCourt of Justice)ornewlyestablishedinitsownright.ineithercase,anyfixedinstitutionalbasewouldneedtobeestablishedthroughamultilateraltreaty(ortherelevantmodificationofanexistingtreaty).

The essential feature sharedby all proposalsforastatutoryapproachtosovereigndebtrestructur-ingis,however,thatlegaldecision-makingindebtrestructuringcaseswouldbegovernedbyabodyofinternational lawagreed in advanceaspart of theinternationaldebtworkoutmechanism.Also,thecorepurposeofanysovereigndebtrestructuringfacilityortribunalwouldbetoprovidetransparent,predictable,fairandeffectivedebtresolution,withitsdecisionsbindingonallpartiesaswellasuniversallyenforce-able,regardlessofjurisdiction.

Clearly,establishingsuchastatutorysolutionfordebtrestructuringwouldbeextremelychalleng-ing,aswellasaratherlengthyprocess,fromtreaty

negotiationtoeventualratification.Tobeeffective,astatutoryapproachwouldneedacriticalnumberof signatories to its underlyingmultilateral treaty.inparticular,itwouldneedtotakeonboardthoseeconomiesunderwhose jurisdictionmostexternaldebtiscurrentlyissued.Thisisboundtobedifficult,and therearealso likely tobe legitimateconcernsaboutthenatureofthepowerstobevestedinsuchan international tribunal or iMF facility, andhowthepowerfulinstitutionalintereststhatmayalreadyexistormaydevelopwithinsuchanentitywillbegoverned.

Themainandveryimportantadvantageofsuchamultilateralstatutoryapproachisthat,ifsuccessful-lyestablished,itwouldpromoteasetofregulationsand practices that embody long-term objectives

and principles – such as sus-tainable development, equityand fairness of outcomes, andtransparencyofprocess–overand above particular interests.Giventhedeep-seatedproblemsoflackofaccountability,partial-ityandanabsenceoflegitimacythatcharacterizemanyexistingdebtrestructuringmechanisms,as well as their fragmenta-tion, themere provision of astable and clear institutionalframework for sovereign debtrestructuringcouldhelprenderdebt resolutionmore effective

andoutcomestobecomemorepredictablethroughthe promotionof consistency in judging cases. inadditiontotheobviousmacroeconomicbenefitsfromearlydiagnosesofsovereigndebtproblemsandtheimplementationofswiftactiontowardstheirresolu-tion,theimportanceofahighdegreeoflegitimacyofawell-functioningSDRMwithglobalreach–andwhich has been establishedwith the active par-ticipationof allmemberStates andother relevantstakeholders–cannotbeemphasizedenough.

it goeswithout saying that the approachessurveyedhereneednotbemutuallyexclusive.itisperfectlypossibletopursueimprovementsinexist-ing contractual approaches,while also promotingnationallegalprojectsandsoft-lawprinciplesforsov-ereigndebtresolution,andsimultaneouslypushingforlongertermplansforamorepermanent,legallybindingandinstitutionalsolution.

A multilateral legal framework for debt restructuring should allow temporary standstill, stay of litigation, exchange controls and lending into arrears to prevent a financial meltdown in countries facing a debt over-hang, and allow them to reach a debt restructuring agreement that helps restore growth and debt sustainability.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 147

Recurrent external debt crises are likely toremainamajorchallengetoglobalfinancialgovern-ance.Asshownabove,amajordriverofthisgrowingindebtednessisthepushfactoroffast-risingfinancialcapitalinflowsinthecontextofrapidandexcessiveglobalexpansionofliquidity.Moreover,theconcomi-tantgrowthofoftencomplexandopaquefinancialanddebtinstruments,alongwithsubstantialchangesin the structure and composition of developing-country external debt, have rendered their debthighlyvulnerable to thevagariesofprivatefinan-cialmarkets,inparticular,andinthepresentglobaleconomy,moregenerally.even for the larger andmoreadvanceddevelopingeconomies,itisnotcleartowhatextenttheyarepreparedtofacethemanifoldchallengesstemmingfromamuchhighermarketriskexposureoftheirexternaldebts,afragmentedandadhocsystemofdebtrestructuringmechanismsandanoveralleconomicandinstitutionalenvironmentthat

introduces a recessionary bias tomacroeconomicadjustmentprocesses.

Therefore,thepersistentvulnerabilitiesandchal-lengesposedbyinternationalfinancialmarketsmakeitallthemoreimportanttoensurethatthedebateaboutenhanceddebtrestructuringmechanismsistakenseri-ously.Thedifferent approaches to this issue reflectwidevariationsintheunderstandingofaneconomy’sfunctioning andneeds, as discussed in this chapter,whichmaynotbeeasilyreconcilable.Consequently,itmightbeprudenttoadoptagradualapproachtochangeinthisarea,proceedingfromthemoreminimalisttomorefar-reachingproposals.Whatseemsclearisthat,despite obviousdifficulties in political consensus-building, a comprehensive, predictable, equitableandconsistentframeworkforeffectiveandefficientsovereigndebtrestructuringisindispensableandwillbetothelong-termbenefitofsovereigndebtorsaswellasthegreatmajorityoftheircreditors.

F. Conclusions

Notes

1 Thoughotherestimatesvary,accordingtoFurceriandZdzienicka(2011)oftheiMF,suchcrisescanreduceoutputgrowthby5to10percentagepoints.Moreover,theauthorsfoundthatafter8yearsoutputremainsbysome10percentbelowthecountrypre-crisistrend.

2 See,forexample,TDR 1986,annextochap.Vi;TDR 1998,chap.iV;TDR 2008,chap.Vi;Radelet,1999;iMF,2001.

3 in thisdocument, “publicdebt” includespubliclyguaranteed private debt, and “private debt” onlyrefers to non-publicly-guaranteed private debt,following the classifications in theWorldbank’sinternationalDebtStatistics.

4 ThecasesofSpainandtheUnitedStatesprovideagoodillustrationofthisphenomenon.in2007,theexternaldebtheldbytheprivatesector(excludingdebtrelatedtodeposit-takingcorporationsanddirect

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investment)represented50percentofGNiinSpainand48percentintheUnitedStates.Afterasharpdeleveragingprocess,itfellto31percentinSpainandto34percentintheUnitedStates.Meanwhile,generalgovernmentexternaldebtincreasedfrom20to42percentinSpainandfrom18to34percentintheUnitedStates.

5 Source:World bank,Quarterly External Debt Statistics – Special Data Dissemination Standard (QEDS–SDDS)database.

6 Source:Worldbank,QeDS–SDDSdatabase. 7 Source:UNCTADsecretariatcalculations,basedon

ThomsonReuters’EIKONdebtstructureanalysingtool.

8 ThissubsectionpartlydrawsfrombohoslavskyandGoldmann,2015.

9 ThemostnoteworthywastheinvasionofMexicobyFrance after the government ofbenito Juárezsuspended interest payments on its external debtin1861.AnotherwastheblockadeofVenezuelanportsbythefleetsofGermany,italyandtheUnitedKingdom in 1902−1903 to force theVenezuelanGovernmenttopayitsforeigndebttotheirnation-als.ThispromptedtheDrago-PorterConventionof1907,whichestablishedtheuniversalprinciplethatStatesmaynotuseforceinordertocollectclaimsarisingfromthesovereigndebtofaStateheldbytheirnationals(benedek,2007).

10 TheUnitedKingdomalsosuspendedtheconvert-ibilityofthepound;thisforceditsforeigncreditorstousetheresourcesobtainedfromUnitedKingdomdebt repayments in purchases of goods or assetswithinthepoundarea.

11 See also the decision,Republic ofArgentina v.Weltover,inc.,1992, underwhichissuingbondswasconsidereda“commercialactivity”.

12 inalltheseschemes,creditorscouldchoosebetweena“debtreductionoption”,whichappliedtheappro-priate debt cancellation rates and rescheduled theremaining debt, includingoDAcredits, or otheroptionsthatreducedthedebtburdenbyextendingtherepaymentperiodandreducinginterestrates.

13 For instance, theParisClubobligedPakistanandUkrainetoobtainalevelofdebtrelieffromprivatecreditorsequivalenttotheClub’sconcessions.

14 Conditionality(especiallythatinvolvingstructuralreforms)bytheiMFandWorldbankhas,infact,followedsomeadditionalgoals,suchasredefiningnational development choices according to credi-tors’viewsandinterests(Akyüz,2005).SomeiMFreportshaveacknowledgedthatthereare“legitimateconcernsthatinmanyinstancesstructuralcondition-alitymayhavegonebeyondwhat canbe justifiedinrelationtotheintendedpurposeofconditionalityin safeguardingFund resources” (iMF, 2001: 27).Moreover, a report by the independentevaluationofficeoftheiMFstressesthat“thecrisisshouldnot

be used as an opportunity to seek a long agendaof reformswith detailed timetables just becauseleverageishigh,eventhoughsuchreformsmaybebeneficial to long-runeconomicefficiency”(iMF,2003a:50).

15 Successinassociatingcommercialcreditorshasbeenlimited,andsomeofthemhaveinitiatedlitigationagainstHiPCstoobtainfulldebtrepayment.

16 intheGreekdebtrestructuringof2012,forinstance,commercialbanksholdingGreekbondswererep-resentedby the instituteof internationalFinance,whosemembers includebanks, insurancecompa-nies,assetmanagers,sovereignwealthfunds,pen-sionfunds,centralbanksanddevelopmentbanks.

17 in 1997, the iMF launched the SupplementalReservesFacilitytohelpcountriescopewith“largeshort-termfinancingneedresultingfromasuddenanddisruptivelossofmarketconfidencereflectedinpressureonthecapitalaccountandthemember’sreserves”(iMF,1997).Subsequently,countriesmeet-ing pre-established eligibility criteria could haverapidaccesstoshort-termprecautionarycreditlines.TheContingentCreditlinewasmadeavailablein1999,followedbytheReserveAugmentationlinein2006andtheShort-termliquidityFacility(SlF)in2008,immediatelyafterthecollapseoflehmanbrothers.As potential users did not apply to thisprecautionaryfinancing,theiMFhadtoproposenewcreditlinestofinallyreceiveanumberofrequests:the FlexibleCredit line (FCl) in 2009 and thePrecautionaryCreditline (PCl) in 2010−withlargeraccess, longerrepaymentperiodsandmoreflexibility,andwithoutex-postconditionality.

18 Colombia,Mexico and Poland applied for theiMF’sFCl,andtheformerYugoslavRepublicofMacedoniaandMoroccofortheiMF’sPCl.

19 The new legislation did not totally override theChamberty principle, but added a “safe harbour”provisionforlitigationclaimswheretheaggregatepurchasepricewasatleast$500,000.

20 SeeAfricanDevelopmentbankwebsiteat:http://www.afdb.org/en/topics-and-sectors/initiatives-partnerships/african-legal-support-facility/vulture-funds-in-the-sovereign-debt-context (accessed on10August2015).

21 GMO Trust v. The Republic of Ecuador,(1:14-cv-09844),UnitedStatesDistrictCourtfortheSouthernDistrictCourtofNewYork(settledinApril2015).

22 See, for example, european Court of Justice,Fahnenbrock et al. v. Greece,C-226/13etal.,judg-mentpending;Poštová banka, a.s. and Istrokapital SE v. Hellenic Republic,iCSiDCaseNo.ARb/13/8.

23 See the reportonvulture fundsandhumanrightsoftheUNindependentexpertonForeignDebtandHumanRights,A/HRC/14/21, 2010, available at:http://www2.ohchr.org/english/bodies/hrcouncil/docs/14session/A.HRC.14.21_AeV.pdf.

External Debt and Debt Crises: Growing Vulnerabilities and New Challenges 149

24 Affected countries are:Angola, burkina Faso,Cameroon,theCongo,Côted’ivoire,theDemocraticRepublicoftheCongo,ethiopia,Honduras,liberia,Madagascar,Mozambique,Niger, SaoTome andPrincipe,Sierraleone,Sudan,theUnitedRepublicofTanzania,UgandaandZambia.

25 Donegal International Ltd. v. Zambia,HighCourtofJustice(englandandWales),[2007]eWHC197(Comm.).

26 UnitedKingdomDebtRelief(DevelopingCountries)Act2010.

27 SeeAllied Bank International v. Banco Credito Agricola de Cartago, United States Court ofAppeals,2dCir.,March18,1985(757F.2d516);Pravin Banker Associates v. Banco Popular del Peru,109F.3d850,854(2dCir.1997);Elliot Associates v. Banco de la Nación and the Republic of Peru,12F.Supp.2d328(S.D.N.Y.1998).

28 See, for example, Federal Constitutional Court(Germany),cases2bvM1-5/03,1,2/06,decisionof8May2007,bVerfGe118,124.ForiCSiDcases,seeWaibel,2007a.

29 SupremeCourtofNewYork,Crédit francais, S.A. v. Sociedad financiera de comercio, C.A., 128Misc.2d564(1985);EM Ltd. v. Argentina,Summaryorder,05-1525-cv, 13May2005 (obiter dictum lackingprecedentialvalue).

30 See,forexample,thecaseconcerningjudicialimmu-nityforArgentinainitaliancourts(CorteSupremadiCassazione,SezioniUniteCivile,21April2005),and the holdout litigation cases beforeArgentinecourts (Juzgado Nacional en lo ContenciosoAdministrativoFederalN°1,12october2006).

31 FederalConstitutionalCourt,Case2bvM1/03etal.,decisionof8May2007.

32 NMlCapitallimited (Appellant) v.Republic ofArgentina(Respondent)[2011]UKSC31.

33 Abaclat v. Argentine Republic,iCSiDCaseARb/07/5,DecisiononJurisdictionandAdmissibility,14August

2011;seealsoGallagher2011;andWaibel,2007b.onthequestionas towhethersovereigndebtcanbe regarded as direct investment, seeFedax v. Venezuela,iCSiDCaseARb/96/3;Československa obchodní banka v. Slovak Republic, iCSiDCaseARb/97/4;however,seealsotherestrictiveviewofthetribunalinPoštová banka, a.s. and Istrokapital SE v. Hellenic Republic,iCSiDCaseNo.ARb/13/8.

34 Cf.iTloSCaseNo.20,ARA Libertad(Argentina v. Ghana),orderof15December2012.TheiTloSorderedthereleaseofanArgentinevesselseques-teredbytheGhanaianauthorities.

35 Elliott Associates, brussels Court ofAppeals,8thChamber,GeneralDocket2000/QR/92,26Sep-tember2000.

36 NML Capital, Ltd. v. Republic of Argentina,No.08Civ.6978(TPG),UnitedStatesDistrictCourtfortheSouthernDistrictofNewYork,orderof23February2012: “WhenevertheRepublicpaysanyamountdueunder[…]the[exchangebonds]…theRepublicshallconcurrentlyorinadvancemakea‘RatablePayment’toPlaintiffs.[…]Such‘RatablePayment’shallbeanamountequaltothe‘PaymentPercentage’multipliedby the total amount currently due to [Plaintiffs].Such ‘Payment Percentage’ shall be the fractioncalculatedbydividingtheamountactuallypaidorwhichtheRepublicintendstopayunderthetermsoftheexchangebondsbythetotalamountthendueunderthetermsofsuchexchangebonds.”

37 Thissectionpartlydrawsonlienauo,institutionaloptionsforDebtRestructuring,backgroundPaperfortheUNGAAdHocCommitteeonSovereignDebtRestructuring,Reviseddraft21April2015.

38 SeeGeneralAssemblyresolutions64/191,65/144,66/189,67/198,68/20268/304.

39 Forthelatterproposals,seeUNCTAD,2015.40 See:www.dekamer.be/kvvcr/showpage.cfm?section

=/flwb&language=fr&cfm=/site/wwwcfm/flwb/flwbn.cfm?legislist=legisnr&dossieriD=1057.

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KruegerAandHaganS(2005).Sovereignworkouts:AniMFperspective.Chicago Journal of International Law,6:214−215.

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Long-Term International Finance for Development: Challenges and Possibilities 153

Aconcernthathasemergedrepeatedlyintheprevious chapters is the apparent inability of thecurrent globalmonetary andfinancial systems tomake available long-termfinance for growth anddevelopment.This chapter considers someof thepossiblestrategiesforensuringtheprovisionofsuchfinance.Thefocusisonthefinancingofproductivecapitalformation,includingforinfrastructure,whichhelps,directlyand indirectly, toaccelerategrowthandstructuralchange.Thiseffectivelyrequireschal-lenging the rationale underlying private financialflowsthataredrivenbyshort-termprofitsandrents,and strengtheningmechanisms formobilizingandallocating both domestic and external finance forvaluecreationanddevelopmentoveralongertimehorizon.Whiledomesticresources(bothprivateandpublic)arelikelytoremainthemostimportant(TDRs 2008 and2013), internationalfinance canplay animportantrolewhendomesticfundingisnotavail-ableorisinsufficient,particularlywhenacountryisinneedofforeignexchangetoimportcapitalgoodsandproductioninputsbeyondwhatitearnsthroughitsexportsofgoodsandservices.

itiswellknownthatprivatefinancialmarketscannotbereliedupontofullyfundlong-terminvest-mentprojects.Thisisbecauseassociatedinvestmentstypicallyinvolvelongergestationperiodsandentailgreaterriskanduncertaintyabouteventualoutcomes,

evenwhiletheycreatesignificantpositiveexternali-tiesfortherestoftheeconomyandcomplementaryinvestmentprojects.These factorsgeneratediffer-encesbetweenprivateprofitabilityandsocialreturnsonsuchinvestment.itisalsorecognizedthatprivatefinancialmarkets,lefttothemselves,seldomdirectfinance to such classes of borrowers as small andmedium-sizedenterprises(SMes)orstart-ups,ortoactivitieswhosereturnsarenotimmediatelyevidentand cannot be readily calculated.This negativelyaffects activities that could be crucial for futuregrowthandwhichcouldproduceconsiderablesocialbenefits,suchasinnovation,technologicalprogressand environmental protection.These features areequally characteristic of global financialmarkets.Thus, greater financial integration of developingcountrieshasnotdeliveredonexpectationsofeasieraccesstothekindoflong-termfinancingneededtoboostgrowthanddevelopment.Consequently,thereappearstobeaneedforStateactiontoensuretheprovisionofbothexternalanddomesticlong-termfinanceforthesepurposes.

ThenatureofsuchStateinvolvementcanvaryaccording to the types of activities that are to befunded.Financingforpurelypublicgoodsnecessarilyrequiresappropriatepublicdomesticrevenues,andinthecontextofexternalfinancingthisismostlikelytobesupportedbyofficialdevelopmentassistance

Chapter VI

lONg-TERM INTERNATIONAl FINANCE FOR DEVELOPMENT: ChALLENGES AND POSSIbILITIES

A. Introduction

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(oDA)orotherformsofdevelopmentcooperation.inthecaseofmeritgoodsandservices,aswellasother activitieswith large positive externalities, amixofpublicandprivatearrangementsisconceiv-able,typicallyinvolvingsomedegreeofexplicitorimplicitgovernmentsubsidies,whichinturnwouldrequireeitherinternalorexternalresources,usuallychannelledthroughthepubliccoffers.Recentinitia-tivesbasedonpublic-privatepartnerships(PPPs)areonepossibleresponse.Finally,there are some activities thatgeneratechangesinproductivestructures and are potentiallyprofitable(suchassomekindsof infrastructure investment),whichareneverthelessavoidedbyprivateinvestorsbecauseofuncertainties associatedwithlumpyinvestmentrequirementswith large initial costs, longgestationperiodsandassociatedrisks.Thesecallforagreaterrolebyfinancialinsti-tutionsthatarespecificallygearedtomakingsuchlong-terminvestments,suchasdevelopmentbanks.

inthischapter,eachofthesetypesofexternalfinancingforlong-termdevelopmentisconsideredinturn.insectionb,itisarguedthat,whileofficialfinancinghasincreasedinthepastdecade,itisstill

well belowdesired levels, and there remain someconcernsaboutitseffectivenessandconditionalitiessometimesincorporatedinoDA.Asaresult,somedeveloping countries seeking long-term externalfinancefordevelopmentpurposeshaveresortedtootherarrangements,mostnotablythroughagreateremphasisonprogrammesandprojectsthatinvolvePPPs, as examined in sectionC.However,whiletheseprovideopportunitiestoinvolveprivatefirms

in infrastructure investment,there are also risks associatedwiththem,particularlyintermsof fiscal costs,which can bemuch greater than anticipatedandmayextendoveraverylongtimehorizon.SectionDexam-inestheroleofsovereignwealthfunds. Some of them controlsignificant amounts of capital,andcouldconceivablyplayanimportant role in providing

somelong-termdevelopmentfinance;but,thusfar,theirinvolvementinthisareahasbeenextremelylim-ited.Sectioneanalysestheuseofnational,regionalandinterregionaldevelopmentbanks,whichremainaneffectiveoptionformobilizinglong-termfinance.Recentnewinitiativesinthisareaareencouraging,butwillneedtobescaledupsubstantiallytomeetcurrentandfuturedevelopmentgoals.

Financing productive capital formation requires challenging the rationale underlying private financial flows that are driven by short-term profits and rents.

B. Financing through official cooperation

official development financing refers toexpenditures directed at strengthening produc-tive capacities, promoting structural change andenhancingsocialwell-beinginrecipientcountries.itdoesnotincludehumanitarianormilitaryaidofvarious types. it involves the provision of eithergrantsor loans,whichcanbedeliveredbilaterallyorchannelledthroughmultilateralagenciesandnon-governmentalorganizations(NGos).Grantsdonotrequirerepayment,whereasloansareextendedwithsome element of subsidybutmust be repaid, and

thereforeimplyareturntothedonorinsomeform.Thisdistinctionisimportanttonote,becausediffer-entformsofdevelopment-relatedexpenditureshavedifferenteffectsoncountries’debt-servicingcapaci-ties,andthereforetheuseofloansthatarepartofdevelopmentassistanceshouldgeneratetheincomeneededtorepaythedebt.

officialfinancinghastraditionallybeenseenasaflowfromdevelopedcountriestothedevelopingones, particularly the poorest countries.However,

Long-Term International Finance for Development: Challenges and Possibilities 155

recent trends indicate the growing importance ofemergingdevelopingcountriesasdonors,althoughtheyprovidedifferentformsofdevelopmentcoopera-tionandassistancethanthemoretraditionaldonors.

1. Officialdevelopmentassistancefromdeveloped countries

What is currentlyknownasofficial develop-mentassistance is a subsetofexternalofficial aidprovided by developed to developing countries.TheneedforestablishingastableflowofoDAwasalreadydebatedinthe1950sand1960s.NegotiationswithintheUnitedNationssystemeventuallyledtodevelopedcountriescommittingtoanannualtransferofatleast0.7percentoftheirgrossnationalincome(GNi)asforeignaidtodevelopingcountries.1

Followingaperiodofdeclineandstagnationinthe1990s,registeredoDAflowstodevelopingcoun-triesincreasedsignificantlyinthe2000s(chart6.1A).NetdisbursementsbymembersoftheDevelopmentAssistanceCommittee(DAC)oftheorganisationfor

economicCo-operationandDevelopment(oeCD)rose from$89 billion in 2002 to $134 billion in2014(inconstant2013dollarterms)−a51percentincrease,thoughanamountslightlybelowtherecordlevelsin2010and2013.However,thisstillrepresentsonly0.29percentoftheirGNi,whichisfarshortoftheircommittedtargetof0.7percentofGNiandislowerthanthesharesintheearly1990s.2Moreover,thispercentagehasbeenonadecliningtrendsince2010,bothfortotaloDAandforoDAtotheleastdeveloped countries (lDCs) (chart 6.1b).AroundonethirdofoDAhasbeendirectedtowardslDCs,where,onaverage,itaccountsforover70percentof external financing (UnitedNations, 2014a). inconstantdollarterms,itmorethandoubledbetween2000and2010,butithasbeenfallinginrecentyears.indeed,bilateralaidtolDCsdeclinedby16percentin2014(oeCD,2015).Moreover,spendingplansbymajordonorssuggestthatthereisunlikelytobeasignificantgrowthofoDAflowsin themediumterm(oeCD,2014a).

Agrowing proportion ofoeCD-DACassis-tancehasbeendirectedtothesocialsector–partlyasaconsequenceof theefforts towardsachievingtheMillenniumDevelopmentGoals.oDA to this

Chart 6.1

ODA PROVIDED by DAC COUNTRIES, 1990–2014

Source: UNCTAD secretariat calculations, based on OECD.stat database.

0

20

40

60

80

100

120

140

160

1990 1995 2000 2005 2010

A. At constant prices(Billions of 2013 dollars)

20140.00

0.05

0.10

0.15

0.20

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0.30

0.35

1990 1995 2000 2005 2010

B. As a share of DAC countries’ GNI at current prices (Per cent)

Total ODA ODA excluding debt relief ODA to LDCs

2014

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sector increasedby117per cent (in constant dol-lars)between2000and2008.AsimilarincreasewasrecordedforoDAtoeconomicinfrastructureandtheservices sector,while aid to theproduction sectorregisteredasmallerincreaseof78percent.Viewedfrom another perspective, the share ofoDAori-entedtothesocialsectorintotaldevelopmentalaid3increasedfromlessthan50percentinthe1990stoover60percentin2008,andhasremainedrelativelystablesincethen.Conversely,theshareofoDAflowstoeconomicinfrastructureandtheservicessector,aswellastotheproductionsectors,declined(chart6.2).

The effectiveness of oDA4 in supportingdevelopmentvaries considerablydependingon itsmodalities,whether it consists of grants or loans,whether it isdeliveredbilaterallyor throughmul-tilateralagenciesandwhether it takes the formofbudgetsupport(notearmarkedforanyspecificpur-pose)orprojectfinancing.Donorcountriesgenerallypreferprojectfinancingthroughbilateralproceduresbecausetheycanbettercontroltheuseofthefunds,

includingbytyingtheirdeliverytotheprocurementofgoodsandservicesproducedby thecompaniesofthedonorcountry.ithasbeenestimatedthattiedaidraisesthecostofgoodsandservices,andreducesthe potential for local development.5Multilateralaidandbudgetsupportareingeneralbetteroptionsfor recipients because they reduce the possibilityofdonorpreferencesexertingdistortinginfluences,andthereforeincreasetheownershipofaidbytherecipient country.Theymay alsohelp to improvepredictability,coherence,transparencyandaccount-ability of aid (UNCTAD, 2006).Multilateral aidrepresented39percentoftotaloDAin2011−2012(oeCD,2014b).Also,aidprovidedonamulti-yearbasisismorepredictablefortherecipient;whenitisunpredictableandvolatile,thevalueofaidcanfallbyasmuchas15−20percent.6

besides themodality ofoDA, the nature ofsome of its components also influences its effec-tiveness.indeed,someoftheflowsincludedintheoeCD-DACdefinitionprovideonlylimiteddevelop-mentaid.Forinstance,formanyyearssomecreditdeliveredatmarketinterestratescouldberegisteredasoDAeventhoughitdidnotreallyreflectadonoreffort,justbecausethereferenceinterestrateof10percentwasexcessivelyhigh.othercomponentsofoDAdonotimplyatransferofresourcestodevelopingcountries,suchasin-donorexpenditures,includingtechnical assistance, administrative costs, costs ofeducatingforeignstudentsandcostsofhostingrefu-gees(CharnozandSeverino,2015).Moreover,debtreliefisincludedasasignificantelementofoDA,evenincaseswhereithaslittleornoimpactintermsofnetfinancialflows(seechart6.1A).Someloansmight evenbe counted twice asoDA:when theyare delivered, and againwhen they are cancelled.AccordingtoActionAid(2005),in2003only39percentofoDAwas“realaid”.7

oeCD-DAChas responded to this criticismbydistinguishingbetween totaloDAandcountryprogrammableaid(CPA),alsoknownascoreaid.CPAexcludesfrombilateraloDAthoseactivitiesthatareinherentlyunpredictable(suchashumanitarianaidanddebtrelief),thatdonotinvolvecross-borderflows,andthatarenotpartofagreementsbetweengovernments (oeCD, 2014a). it is estimated thatbetween2009and2013CPAaccountedfor57percentofgrossbilateraloDA.However, totaloDAremainedthetargetinDACcountries’commitments.Furthermore, inDecember 2014 theoeCD-DAC

Chart 6.2

COMPOSITION OF DEVELOPMENTAL ODA By MAIN CATEgORIES, 1990–2013

(Per cent)

Source: UNCTAD secretariat calculations, based on OECD.stat database.

0

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30

40

50

60

70

80

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100

1990–1995

1996–2000

2001–2005

2006–2008

2009–2010

2011–2013

Production sectorsEconomic infrastructure and servicesSocial infrastructure and services

Long-Term International Finance for Development: Challenges and Possibilities 157

High-levelMeetingdecidedtorevisethedefinitionandmeasurementofoDAinorderto“modernize”it(oeCD,2014c).ThemainchangerelatestothewayinwhichconcessionalloansarereportedasoDA.

Since the turn of themillennium, the inter-national community has progressively focusedonimprovingthewayaidisdelivered.ThisindicatesagrowingrecognitionthatitisnotonlythevolumeofoDAthatmatters;thequalityofoDAisalsocriticalformaximizing itsdevelopment impact.8Thishasledtothedevelopmentofanumberofprinciplesforimprovingaideffectiveness,includingownershipofnationaldevelopmentstrategies,alignmentofdonorstothosestrategies,harmonizationamongdonors,afocusonresults,mutualaccountabilityandtranspar-ency.ithasalsoresultedinperiodicassessmentsoftheevolutionofoDA.Anassessmentofdevelopmenteffectivenessmadein2010indicatedthattherehadbeenveryslowprogressinmeetingmostofthetar-getssetintheParisDeclaration(UNCTAD,2011a).ThebusanPartnershipagreementin2011resultedin the establishmentof theGlobalPartnership foreffectiveDevelopmentCo-operation,which helditsfirstHigh-levelMeetinginMexicoin2014.Theassessmentofprogressonaideffectivenesspreparedforthismeetingshowedthattheresultsweremixed(oeCDandUNDP,2014).

2. Developmentcooperationamongdeveloping countries

Apotentially important new trend in globaldevelopmentassistanceisthegrowingsignificanceof developing-country donors.According to theUnited Nations (2014b), in2011 the total valueofSouth-South cooperation was esti-matedatbetween$16.1billionand$19billion,anditsshareintotal development cooperationwas10percentin2011,upfrom6.7percentin2006.However,thismaywellbeanunderesti-mate, especially as definitionsofdevelopmentassistancevary,and there are no systematic and comparable dataacross countries. Formany developing countries,developmentcooperationiscloselylinkedtotrade

andinvestmentrelationships,anditisoftenhardtodistinguishbetweenpublicandprivatecomponents(Zhou,2010).

one study has suggested that South-Southfinancialassistancerepresentedaround15percentofDACrealaidin2008,withthelargestdeveloping-countrydonorsthatyearbeingSaudiArabia,China,thebolivarianRepublicofVenezuela,theRepublicofKorea,Turkeyandindia, though inotheryearsbrazilhasalsobeenasignificantdonor(TheRealityofAidManagement Committee, 2010). Sincethen,theamountoffinancialassistancehasgrownsubstantially,ledbyChina.itshouldbenotedthatnotallofthisfinancialassistancewouldqualifyasoDAinthesenseusedbyDACmembers.Financialassistance fromnon-DACcountries has taken theformofgrants,concessionalloans,non-concessionalloansanddebtrelief.Themixoffinancialassistancevaries from country to country, but loans are thepredominantform.

officialChinesesourcesexplicitlydistinguishbetween three categories of financial assistance:grants, interest-free loans and concessional loans.Thefirsttwoarefundeddirectlybythegovernmentexchequer,while the third is fundedby theeximbankofChina (seesectione).A largeproportionis tied aid,which requires that at least half thepurchasesmadeunder the assistance programmesbe forChinese goods, and, in several cases, forChineselabouraswell.Nevertheless,sinceasub-stantial proportion of suchChinese assistance isdirectedtowardsinfrastructuredevelopment,itcancontributesignificantly to transformingproductivecapacitiesoverthemediumandlongterm.Wolfetal.(2013)estimatethat,duringtheperiod2001−2011,latinAmericareceivedthelargestamountofsuch

Chineseassistance(muchofitforamulti-countryprogrammeoriented to natural resources),followed byAfrica (amix ofnatural resource and infra-structure programmes), SouthAsia (infrastructure andfinan-cialaidforbudgetarysupport)and South-eastAsia (mostlyinfrastructure).

indianfinancial assistance takes the formofcredit,concessionalloansandgrants.ithasbeenusedtofinanceinfrastructuredevelopment(e.g.railway

A potentially important new trend in global development assistance is the growing significance of developing-country donors.

Trade and Development Report, 2015158

reconstructioninAngola),thepurchaseofagriculturalmachineryandequipment,developmentofinforma-tion and communications technologies (iCTs), thesettingupofprocessingcompanies(cashewnutsintheUnitedRepublicofTanzania)andforhealthandhumanitarianpurposes.Mostofitisprovidedbytheindiaexport-importbank.TheRepublicofKoreaandSaudiArabiaprovidegrantsandconcessionalloans.Assistancebytheformersupportshealth,iCT,educationandagriculture.ThroughthePetroaméricaProject launched in2005, thebolivarianRepublicofVenezuela has been providing oil under veryfavourablefinancial conditions tolatinAmericanandCaribbeancountries(TDR 2007).AnumberofWestAsiancountriesprovideassistancetoproduc-tivesectors(e.g.transportation,telecommunications,energyandagriculture).Mostoftheirfundingcomesfrom their financeministries and a small portionfromtheSaudiFundforDevelopment,inadditiontoassistanceprovidedthroughmultilateralchannels.Turkey’sassistancetakestheformofgrants,exportcreditsandloanstosupporttheeducationandhealthsectors, and the development ofwater resources,infrastructure, agriculture and culture (Kragelund,2008).

brazilcanbesingledoutasthecountryinwhichco-financingisthemostprevalentformofassistance,delivered trilaterallywith the involvement of itsowngovernmentagency,ahostgovernmentagencyandadeveloped-countrydonor (Kragelund,2008;UNCTAD,2010); it has targeted in particular theagriculture,education,healthandfisheriessectors,aswellasreconstruction(Gottschalketal.,2011).Also, its national development bankhas providedanincreasingnumberofloans,particularlyforlargeinfrastructureprojectsinAfricaandlatinAmerica.

3. Challengesofofficialcooperation

Proponentsof increasedaidagree that,whileitisnotapanaceaorengineofgrowth,itcanworkasacatalystfordevelopment,forexamplebysup-portinginfrastructuredevelopment.Scepticsofaid,ontheotherhand,pointtovariousdownsiderisks,suchaslimitedabsorptivecapacitiesofsomerecipi-entcountries,Dutch-diseaseeffects,crowdingoutofothersourcesoffinance,reductionoffiscaleffortsand corruption.However, someof these concerns

areoftenexaggerated (UNCTAD,2006), andoth-erscanberesolvedbyproperaidmanagementandmacroeconomicpolicies,aswellasthroughappro-priateproceduresforaccountabilityandmonitoring.Theconditionalitiesassociatedwithaidareclearlyimportantinthisrespect,andcanhaveeitherpositiveornegativeeffectsdependingupontheirtermsandhowtheyareimplemented.

SincetheMonterreyConsensusof2002,whichemphasizedtheneedforincreasingoDAasapre-conditionforachievingtheMillenniumDevelopmentGoals, therehavebeensomeimprovements in themanagementofaidflows.Theseincludeeffortstountieaid,reportingofoDAinnationalbudgetsofrecipient countries and the use of country admin-istrativesystemsinthemanagementofaid-fundedprogrammesandprojects(UnitedNations,2014b).Forinstance,in2012,79percentofDACbilateraloDAwasreportedasuntied,upfromabout50percent at the start of themillennium (oeCD andUNDP, 2014).9However, “conditions attached tooDA remain too numerous and detailed in somecases,(and)proceduresremaincomplexandinsuf-ficientlyflexible”.Moreover, fragmentationof aidremains high, and is increasing,with emergingdonorsandactors,whichposessignificantcoordina-tionchallenges(UnitedNations,2014b:8).Mostofall,despiterecentincreases,thistypeoflong-termdevelopmentfinancingstillremainswellbelowbothcommitmentsandrequirements.

Animportantareaofofficialfinancingthathasremainedrelativelyneglectedrelatestothefinanc-ingofprogrammesforglobalpublicgoods.Thisisparticularlyevident in theareasofclimatechangemitigation and adaptation.Major global agree-mentsonclimatechangehavestressedtheneedforclimatefinancetobe“newandadditional”.UndertheCopenhagenAccord, developed countries col-lectivelycommitted toprovide“fast start”financeofabout$30billionfortheperiod2010–2012,withabalancedallocationbetweenadaptationandmiti-gation.Theyalsocommitted to thegoalof jointlymobilizing$100billionayearby2020toaddresstheneedsofdevelopingcountries(UNFCCC,2009).An assessment of fast-start finance between2010and2012foundthat$35millionwasmobilizedinthisperiod.However,80percentoftheseresourceswereestimatedtohavealsobeencountedasoDA(Nakhoodaetal.,2013).Pledgesmadebydonorstomobilize$10.2billion(UNFCCC,2014)representan

Long-Term International Finance for Development: Challenges and Possibilities 159

importantsteptooperationalizingtheUnitedNationsGreenClimateFund,althoughtheyonlyamounttoabout10percentofthecommittedtargetfor2020.

Sincethereappearstobenoproperdefinitionofwhat“newandadditional”means,noranyinter-nationally agreeddefinitionofclimate finance and how it istobedelivered,“muchclimatefinance is currently sourcedfromexistingaidcommitmentsandflowsthroughadecentral-ized system dominated by alarge number of bilateral aidagenciesandaseriesofmulti-lateralfunds”(Pickeringetal.,2015:149).Thereforemuchoftheclimatefinancehasnotbeenadditional,andhas alsomade the aid fragmentationproblemmore complex. Further, the aid provided thus farhasbeenmainlydirectedtomitigationefforts,whichdisproportionatelybenefitmiddle-incomedevelopingcountries.Financingforadaptationpurposes,whichis crucial for the poorest countries, remains inad-equate (UN-DeSA,2015;Nakhoodaetal.,2013).Thismakesastrongcaseforagreaterfocusonofficialfinancingbytherichercountries–andothercountriesinapositiontodoso–forclimatechangemitigationandadaptationinthepoorercountries.

inrecognitionoftherelativelysmallamountofofficialfinancingthatiscurrentlyavailable,thereareongoingdiscussionsonthepotentialuseof“blendedfinance”, inwhichoDAwouldbeused to“lever-age”private capital for long-term investment.Forexample,oDAcouldprovidesubsidiesonloansandequityinvestments,orguaranteestoprivateinvestorsor for co-financing arrange-ments.Thisapproachofusingaidasalevertoattractprivatefinance is already part of theexternalassistanceprogrammesofseveraldevelopingcountries,includingChina,asnotedabove.itisalsonowbeingencouragedbyotherdonors,andisstronglypromotedbyinter-nationalorganizationssuchastheWorldbankandtheoeCD.10

inasense,sincedevelopment-orientedinvest-ment necessarily generates externalities and com-plementaritiesbetweenthepublicandprivatesec-tors,andeffectiveinvestmentfinancemixespublic

andprivate initiatives, all developmentfinance isblended;thegreaterissueistoaddresswhoisdoingtheblending,howandtowhatend.Suchinitiativesmayhaveadvantagesintermsofincreasingresourcemobilization,11 but also have some drawbacks,as highlighted in recent research.12 in particular,

they risk allowingoDAflowsto reinforce the inequalitiesthat privatemarkets generatein termsof geographical, sec-toralandinstitutionalcoverage.Aidthatislinkedtoexpandinginvestmentbytheprivatesectorismorelikelytogotomiddle-income countries and bypass

the low-income countries. Furthermore, there istypicallyinadequatesupportforSMesindevelopingcountries.ManyattemptstoutilizeoDAtosupportprivate investment do not adequately capture thediversityintheprivatesector;forexample,theydonotalwaystakeintoaccountthedifferencebetweendevelopment-oriented spending to support smallfarmerswith input purchases and investments indevelopingcountriesbytransnationalcorporations(TNCs) that are simply seeking better returns. inaddition,where thebenefits accrue toTNCs fromthedonorcountries,bypassingdeveloping-countryfirms,thereistheriskthat,increasingly,aidwillbetiedtothedeliveryofgoodsandservicesofdonorcountries’companies.

inviewof thesedrawbacks, the internationalcommunity should consider further exploring thefunctioningofthesemechanismsandtheirpotentialdevelopment impactbeforemakingpolicy recom-mendations in this regard.There should be an ex

ante evaluation to ensure thattheadditionalinvestmentfundswill support companies thatwouldnototherwiseinvestforthestatedpurposesandactivi-ties,andtoascertainthatthosecompanies donot have accesstoanyotherfunds.Theimpacts

on poverty reduction and development should beclearlydemonstrable.Moreover,theopportunitycostofusingoDAtoattractprivatefinancemaybetoohigh.instead,itmightbepreferabletodirecttheoDAflowstowardsbuildingtheproductiveprivatesectorofdevelopingcountriesbysupportingtheirdomesticSMesandsmallholderfarmers.itisalsoimportantto prevent such aid frombecoming amechanism

Despite recent increases, ODA still remains well below both commitments and requirements.

The opportunity cost of using ODA to leverage private finance may be too high.

Trade and Development Report, 2015160

fortransferringrisksfromtheprivatetothepublicsector,withthelatterpayingincaseoffailureofaproject butwith potential profitsmainly reverting

totheprivatesector.Finally,thefundsleveragedinthismannershouldbebasedonthesameprinciplesofeffectivenessasrelatetooDAingeneral.

APPPisacontractbetweenagovernmentanda private company underwhich the private com-panyfinances, builds and operates some elementof a servicewhichwas traditionally considered agovernment domain.13 in some forms ofPPP, theprivatecompanyeven“owns”theunderlyingassetsneededtoprovidetheserviceforaperiodoftime.Thecompanyispaidoveranumberofyears,eitherthroughchargespaiddirectlybyusers,orbypay-ments from thepublicauthority,oracombinationofboth.Sincetheprivatepartnerisnotnecessarilyaforeigninvestor,anddoesnotnecessarilyobtainfinancing fromexternal sources, PPPs themselvesdo not only represent a vehicle for internationalfinancing.indeed,asillustratedbelow,severallargecountries frequently have sizeable domesticfirmsthatareabletoimplementlarge-scaleinvestmentininfrastructureandoperatethePPPs.

PPPshavebeenusedwidelyindevelopedanddevelopingcountriesoverthepast20years,andarecurrentlyseeingarevivalofinterestinthecontextofnegotiationsonfinancefordevelopmentandtheSustainableDevelopmentGoals.There are hopesthat“harnessing”theprivatesectorinthiswaycanhelpmultiplymillionsofdollars intobillions,andbillionsintotrillions.

PPPsmay appear to be effective in termsofgeneratingandimplementinginfrastructureprojectswhenpublicbudgetsareconstrained,andtherearecertainlysomesuccessstoriesinthisregard.ifprop-erlymanaged,theycanalsoimprovetheefficiencyofthepublicservicethroughthetechnicalexpertiseprovided by the private sector (eClAC, 2015).However, there is also evidence ofmany pitfalls

andunexpectedfiscal andother costs, and rarely,ifever, is theirperformanceproperlycomparedtootheravailablemechanismssuchastraditionalpub-licprocurementanddeliverysystems.Theevidenceacross decades and countries suggests that publicsectorfinancewillstillhavetodotheheavylifting.AcautiousapproachisneededifPPPsaretodelivertheexpecteddevelopmentbenefitsandtoavoid,orminimize,thepotentialcostssuchpartnershipscangenerate(ieG,2014).

1. Scale, scope and use of PPPs

in 2013, PPP funding for infrastructure pro-jects in developing countries amounted to about$159billion,having recoveredafter theeconomicandfinancialcrisisin2008−2009butfallingsharplyfromapeakin2012.14evenwiththerecentdownturn,theuseofPPPshasincreasedmarkedlysincetheirintroduction in the1980s (chart6.3A), recoveringfrom setbacks following thelatinAmerican andAsiancrises,aswellasenronandothercorporatescandalswhich affected even those countries thathadpreviouslybeensuccessfulinattractingcapital(Worldbank,2009).Theiruseindevelopedcountrieshasalsoshownabroadoverallincrease,andagainreflectssensitivitytoexternalshocksandthebroadereconomiccycle.However, ineurope,thevalueofPPPswasaround13billioneurosin2012,thelow-estinatleast10years.Theserecenttrendspointtothechallengesthatlieahead.Neverhasthecostofdebtbeen lowerandyet it is increasinglydifficulttofinancenewinfrastructureinvestment,especially

C. Public-private partnerships for development

Long-Term International Finance for Development: Challenges and Possibilities 161

whenequitycommitment isa requirement (Helm,2010).

PPPinvestmenthasbeenconcentratedinrela-tivelyfewcountriesandsectors.Almost60percentofthetotalprivateparticipationinprojectsrecordedin developing countrieswas inChina,brazil, theRussianFederation, india,MexicoandTurkey (byorderofmagnitude).ThisisanindicationthatPPPinvestorsarenotdissimilarfromotherinstitutionalinvestors,preferringlargeanddynamicmarketstothemorevulnerableeconomieswherefinancingneedsaregreatest.ofthedevelopingregions,latinAmericahastraditionallyhostedthelargestshareofPPPsandstillaccountedfor45percentofthetotalin2013.only10percentofthetotalwenttoAfrica,althoughinsub-SaharanAfricainvestmentshavebeensteadilyrising(primarilybecauseofinvestmentsintelecoms).

Also,PPPinvestmentshavebeenconcentratedinrelativelyfewsectors,withtelecomsaccounting

for37percentofthetotal,or$58billion,in2013,andenergyfor37percentofthetotal,or$59bil-lion (chart 6.3b).Water and sanitation are amongthemost needed infrastructure services to relievehumansuffering,andyettheyaretheleastlikelytobefinancedthroughthismethod,havingreceivedamere$3.5billionin2013(seealsoUNCTAD,2013).indeed,mostcommercialinteresthasbeendirectedtoiCTsandenergy-relatedactivities,whilesociallychallengingsectorsattractedalmostnoprivateactiv-ity(AiCD,2010).PPPsalsoappearmorelikelytoemergeinbrownfieldprojects(changingownershipofassetsthatalreadyexist)thanincompletelynewgreenfieldprojectsorriskytransformativeactivitiessuchasthoserelatedtoclimatechange(WeF,2014).

Unsurprisingly,therefore,thegrowthintheuseofPPPshas not relievedState responsibilities forinvestment in infrastructure development, and thepublicsector’scontributioncontinues tobeessen-tial,especiallyattimesofuncertainty.estimatesof

Chart 6.3

PRIvATE SECTOR PARTICIPATION IN INFRASTRuCTuRE, 1985–2013(Billions of current dollars)

Source: UNCTAD secretariat calculations, based on World Bank, Private Participation in Infrastructure Project Database (as on July 2015).

Note: Country groups in chart A are those of the source. Investments refer to the year of implementation.

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East Asia and PacificEurope and Central AsiaLatin America and the CaribbeanMiddle East and North AfricaSouth AsiaSub-Saharan Africa

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EnergyTelecomTransportWater and sewerage

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theshareofpublicinvestmentininfrastructurevaryfromanywherebetween75percentand90percent(estache,2010;briceño-Garmendiaetal.,2008;Hall,2015).evenintheeuropeanUnion,PPPs,onaverage,contributeaverysmallsharetototalinfrastructureinvestment,withsomecountriesdecidingnottousePPPsatall(chart6.4).indevelopingcountries,gov-ernmentsfinancedaround70percentofinfrastructureinvestmentduring theperiod2000−2005, rising to90percentforthelowestincomecountries.15Toalargeextent,thisreflectstheverynatureofinfrastruc-ture.AstheWorldbank(2009:78)hasnoted,“manygovernments see the private sector as a solution.However,privatefinancing,whileofferingadditionalresources,doesnotchangethefundamentalsofinfra-structureprovision:customersortaxpayers(domesticorforeign)mustultimatelypayfortheinvestments,andcost-coveringtariffs(andwell-targetedsubsidies)remainthecentre-pieceofallsustainableinfrastruc-tureprovision,publicorprivate.”

As a result, evenwith PPPs, public financeremainscritical.ofthetotalinvestmentindeveloping

countriesbroadlydescribedby theWorldbankasPPPs,publicdebtandequityaccountedfor67percentandprivatedebtandequityaccountedfortheremaining(Mandri-Perrott,2014).Moreover,thesedata relate only to the phase before projects areoperational, afterwhich contingent liabilities andotherchargesgenerallyaddconsiderablytothetotalpubliccosts.

Historically,privateparticipationininfrastruc-turehasbeendominatedbylargeTNCsdomiciledinoeCDcountries(oeCD/NePAD,2005),especiallyforlarge-sizedprojects.DatafromtheWorldbankPPiDatabasefortheperiod2010−2014suggestthatforeignactorsarestillasignificantpresenceinmanydevelopingcountries,accountingforaround58percentofPPPinvestmentsinMexicoand35percentinChina(calculatedastheshareofinvestmentswitheitherfullorpartialforeignsponsorship).oneimpli-cationofthisfordevelopingcountriesisthatitaddssomeof the risks associatedwith private externalfinancing discussed in previous chapters, in addi-tiontotheotheraspectsofinfrastructureprovision.Projectsmaybefinancedthroughinternationallend-ing,involvingforeigncurrencyexposureforbothdebtrepaymentsanddividends,whilethereturns(profits,if thereareany)areintheweaker, localcurrency.Suddenexchangerateshockscandramaticallyaffectprofitability,aswasexperiencedinlatinAmericaandSouth-eastAsiaduringthe1990s,which“helpstoexplainthediminishedenthusiasmforsuchprojectsonthepartoftheinternationalinvestmentcommu-nity” (oeCD/NePAD,2005: 171).16Therefore, insomecountries, thecurrencyrisksofPPPprojectsarebornebythehostgovernment.However,duringtheperiod2010−2014,forfourofthesixdevelop-ing and transition economies that account for thelargestshareofPPPs,thePPidatabasesuggeststhatdomestic firms aremore significant than foreignones.inindia,81percentofprojectshaddomesticsponsorship only, inChina the sharewas around60percent,inTurkeyitwas55percentandinbrazil39percent(comparedwith14percentattributedtoforeignfirmsactingalone).17inparticular,domesticsponsorshipappearstobelinkedwithsmallersizedprojects,butitistooearlytotellwhetherthisisapermanentchangeinfinancingsourcesoracyclicalone related to the post-crisis environment. in anycase,iffundsareborrowedinternationally,foreign-exchangeconcernsremainthesameregardlessofthenationalityofprojectpartners.

Chart 6.4

INFRASTRUCTURE SECTOR FINANCING IN ThE EUROPEAN UNION,

by CATEGORy, 2009–2011(Per cent of GDP)

Source: European Investment Bank, 2012.

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Government CorporatePPP Other

Long-Term International Finance for Development: Challenges and Possibilities 163

SomeofthelargercompaniesinvolvedinPPPsarequasi-publicmonopoliesintheirhomecountries;othersshareculturalorlinguisticlinkswiththehostlocation.18This concentrationmeans that govern-mentsnegotiatingthetermsofprivateparticipationinPPPsdonotnecessarilydealwithanumberofcompetingatomistic suppliers.For example, theretend to be nomore than two or three bidders intransporttenders(estacheandSerebrisky,2004),andcompetitioncanbefurtherlimitedbymulti-stagebid-dingprocesses,wherebyacompanyisselectedinthefirstroundwithouthavingtospecifycontractdetailsuntilthesecondroundfromwhichcompetitorshavebeenremoved.Furthermore,agovernmentmaybedealingwithacorporateentitywithmarketpowercomparabletoorevengreaterthanitsown(oeCD/NePAD,2005).Notonlycanthiscreateimbalancewhenthetermsofcontractsareagreedupon,itcanalsoaffectconflictresolutionifthingsgowrong,asthepartner companiesmaybe large andpowerfulenoughto“takeontheregulators”incaseofconflict(Shaoul,2009).19

2. Assessing the contributions and costs of PPPs

one of themost common reasons for gov-ernments to choose PPPs over their own directinvestmentandprocurementisthattheyareexpectedtobringadditionalfinance,beyondwhatgovernmentscanprovide.Howevertheresultsareatbestambigu-ous.Someobservershavearguedthatadditionalityismorelikelytooccurindevelopingcountriesthanindevelopedones(Winchetal.,2012),especiallyifcapitalisraisedfromoutsidethecountry.butafterreviewingtheWorldbank’sdecade-longexperienceofsupportingPPPsintransition,developingandleastdeveloped countries, the independentevaluationGroup(ieG)concludedthat“contrarytointuition,PPPsgenerallydonotprovideadditionalresourcestothepublicsector”(ieG,2014:6).ifPPPsweremoreefficientthanthepublicsectorandcouldoffsettheirhigherfinancingcosts,theycouldprovideaddition-alityinthesenseofcreatingsavings.However,theresults in termsof improved efficiencyhavebeenmixed.

Moreover, theexperienceindevelopedcoun-triesisthatthebenefitsofadditionalitycanonlybe

realizedunder very specific conditions. in reality,somemaybeaformof“pseudo-additionalityfacili-tatedbyaccountingrules”(Winchetal.,2012:15),wherebyPPPsbecomeameansofavoidingadmin-istrative (as opposed tomacroeconomic or real)constraints,suchasfiscalresponsibilityrequirements.implementingprojectswithoff-budgetfinancefromthe private sector is oneway to avoid such con-straints.However, insofar as there areotherfiscalcostsemergingovertimethathavetobeincludedinthebudget,suchassubsidiesorotherincentivesthatmustbeprovidedatalaterdate,eventhisaccounting“advantage”maybe–andtypicallyis–short-lived.

AnotherargumentinfavourofPPPsrelatestotheirgreaterefficiencyandabilitytodeliverbettervalueformoney.Accordingtomeasuresofbusinessperformanceduringtheconstructionphase,mostofthePPPssupportedbytheWorldbankweresuccess-fulinthesenseofbeingcompletedontimeorwithinbudget,with62percentof thosereviewedbytheieGratedsatisfactoryorbetter.However,broadermeasures that indicate longer term sustainabilityoverthelifetimeofaprojectarenotestimated.outof128projectsstudied,only10recordedresultsofservicequality,8recordedresults intermsofeffi-ciency,and1reportedfiscalresults.improvedaccesstoservicesforthepoorcouldbeconfirmedinonlyabout10percentofcases(ieG,2014).owingtothescarcityofdata, it isdifficult todrawconclusionsabouttheimpactofPPPsonend-users.

ithasbeennotedthatPPPsaregenerallymorecostlythantraditionalprocurementorprovisionofservices through thepublic sector if onlybecausegovernmentscanborrowmorecheaplythanthepri-vatesector.20AnoeCDsurveyofthe18countrieswithsufficientinformationtoreportonthepercentageofPPPs’contributiontopublicinfrastructurefoundthat,“thereislittleinformationtoassessempiricallywhetherPPPsoutperformTiP[traditionalinfrastruc-tureprocurement]projectsoverthelifetimeoftheproject.Thiscontrastsstronglywith thepurportedmotivationofgoingthePPProute,namelythemaxi-mizationofwhole-of-lifevalueformoney”(burgerandHawkesworth,2013:69).

Therearealsorelativelylittledataonthedevel-opmentimpactofPPPs.TheirperformanceovertimetendstobegreatlyaffectedbythefactthatmorethanhalfofallPPPcontractshavebeenrenegotiated,onaverage every twoyears (ieG, 2014).New terms

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havetypicallyfavouredtheconcessionaire,withtar-iffsrising,feesfallingorobligationsbeingpostponed,thusagainaddingpotentially to theburdenon thegovernmentpartnertoensurethatanadequateserviceisprovided(inquality,priceandcoverage).ThisisnotlimitedonlytoWorldbank-supportedprojects;theoeCDsurveyofmembercountriesusingPPPsfoundthatwhencontractrenegotiationstookplaceattherequestoftheprivatepartner,therewasahighprobabilitythatthegovernmentlostvalueformoneycomparedwith the originallynegotiatedcontract(burgerandHawkesworth,2013).

AllthishasmeantthatthescaleofobligationsandliabilitiesthatgovernmentshaveincurredthroughtheuseofPPPshasbeensurprisinglyhigh,andthusmeritsgreaterattention.liabilitiesmaybeexplicitorimplicit,contractualornon-contractual.Someareevidentfromtheoutset.Forexample,inChina,foreigninvestorsusuallyrequestaguaranteedfixedorminimumreturn;intheRepublicofKorea,theofferofaguaranteedminimumrevenueplayedasignificantroleinattractingprivatecapital,butalsocausedmoralhazardproblems(Winchetal.,2012).other liabilitiesmay emerge over time,which ispotentiallyabigproblemforgovernments,giventhatprojectshavealifespanof30yearsormore.

Forthe128PPPsinitssample,theWorldbankconcludedthatitwasnotpossibletoshowhowmuchriskwasbeingbornebytheprivateorpublicpart-nersbecause“downstreamcontingentliabilitiesarerarelyquantifiedattheprojectlevel”(ieG,2014:40).Thisispartlyduetoalackofstandardizedfinancialreporting,whichmakesitdifficultforbothinvestorsandgovernmentstojudgetherisksinvolvedinPPPprojects.ChinahassharplyreducedtheuseofPPPsbecausetheywerefoundtobecreatingliabilitiesthatweredifficulttomanageatlocallevels;followingapeakofupto6percentofgovernmentexpenditureand0.8percentofgrossdomesticproduct(GDP)duringtheperiod1995−1997,theyhavefallenswiftly(Ahmad et al., 2014).brazil introduced exposurelimitsforstateandlocalgovernmentsandsomestateshavealreadyreachedthelimit,promptingcallsforfederalassistance.

Thiscouldbean issuenotonlyforcountriesthatarenewtoPPPs,butalsoforthosecountrieswith

PPPsalreadyinplace.AnoeCDsurveyfoundthatmost countries rely onmedium-term affordabilitywhenmakingadecisionaboutwhethertousePPPsortraditionalinfrastructureprocurement.However,thelongertermviewcanbeverydifferent,andgovern-mentsneedtobudgetthefullcapitalcostsupfront(burgerandHawkesworth,2013).evenifthecostofaprojectisexpectedtobefullycoveredbyusercharges,ratherthanthroughgovernmentrevenues,plannersneedtobeawareofthefiscalimplications

inthefutureif,forsomereason,paymentbyusersdoesnotworkout, for example if demand islowerthananticipated,orifcon-sumersareunwillingorunabletopay.oncefuturegovernmentcommitmentsarereportedoverthe lifetime of a project, thiscan significantly increase theactualfiscalcost.intheUnited

Kingdom,forexample,concernsaboutthescaleoftheunitarypaymentstheGovernmentisrequiredtopayeachyear(around£9billionperannumforthenext fewdecades) prompted theUnitedKingdomTreasurytoreviewallPPPsandissuenewguidelines.

Governmentliabilitiescanariseinvariousways,whetherfromformalcommitmentsthroughcontractsorinformally,stemmingfromthesimplefactthatgov-ernmentsaretheprovidersoflastresort.Whenthingsgowrong,thefiscalcostscanbehigh,asexemplifiedbyinfrastructure-relatedexperiencesinMexico.intheearly1990s,Mexicoinitiatedanambitiousroad-buildingprogrammeinvolvingmorethan50PPPs(concessions)tobuildandmanage5,500kmoftollroads.Theconcessionswerehighlyleveraged,withloansprovidedatfloatingratesbylocalbanks,whichwereownedbysub-nationalgovernmentsandwereunderpressuretosupporttheprojectthroughlend-ing.Usertollswereexpectedtoprovidetherevenuesthatwouldnotonlyrepaythedebt,butalsoprovidetheprivatepartners’profits.However,costsprovedtobehigherandtrafficvolumeslowerthanantici-pated,interestratesroseovertime,andthebankingsystemabsorbedtheincreasedliabilities.Thesystemhadalreadybeenstrugglingwhenamacroeconomicshockmademattersworse.TheFederalGovernmentsteppedin,eventhoughtherewerenoexplicitguar-anteescompellingittodoso.itrestructuredtheentireroadprogramme,bailingoutconcessionaires,takingover25ofthem,andassumingcloseto$8billionindebt(ehrhardtandirwin,2004).

The scale of obligations and liabilities that governments have incurred through the use of PPPs has often been much larger than anticipated.

Long-Term International Finance for Development: Challenges and Possibilities 165

inseveralcountries,unsatisfactoryoutcomesofPPPprojectsmeantthatsomeschemesweregivenupearly.Specificallywithregardtowater,morethan180citiesandcommunitiesin35countrieshavetakenbackcontroloftheirwaterservicesinthelast15years(WaterJustice,2014).Such“re-municipalizations”haveoccurred for threemain reasons:widespreadproblems affectingwater privatization, seeminglyindependentofthecountryorregulatoryregime;theequalorgreaterefficiencyofpublicwaterservicesandlowerpricesthatcanbeachievedwhendividendsorprofitsdonotneedtobepaidtoprivateoperators;andthecomparativeadvantageofthepublicsectorinprovidingforhumanwelfareandrealizingsocialandenvironmentalobjectives(lobinaandHall,2013).

3. Policy implications

PPPsmayremainausefulsourceoflong-termfinancingfordevelopment,giventhepaucityofotherexternalresources,particularlyifrealandperceivedfiscalconstraintspersist,whichpreventgovernmentsfromdirectly undertaking public procurement forlong-termdevelopmentneeds.However,itisimpor-tantforgovernmentstofullyunderstandthevariousconsequencesandramificationsofsuchmechanisms,andbemindfulof thepotential costs andbenefitsovertheentirelifeofaprojectsoasnottoexperienceunpleasantfiscalshockssubsequently.

Tobeginwith,thisrequireseffortstoimprovetransparencyandaccountabilityinPPPs,includingstandardizingtheprocessforcoveringandreportingonpublic transactions,and, inparticular,adoptingaccrualaccountingsystemsthatconsiderlong-terminvestmentsandliabilities.evenwhentherearenoexplicitguaranteesbygovernments,itislikelytheywillhavetoassumeasignificantshareofliabilities.Aparticularconcernisthatmanycountriesstilldonothavethebasicaccountingsystemsneeded.ironically,thosecountriesthatmayhavethehighesthopesforPPPsmaybetheoneswiththeleastcapacitytoman-agethemproperly.

it is also necessary to improve the decision-makingprocesseswithrespecttoPPPs.Asamecha-nismforensuringlong-terminvestmentswithsocialgoals,PPPsmaynot be appropriate in all circum-stances.Therefore,aproperassessmentneedstobeconductedbeforetheyareselectedinpreferencetoothermeansofprovidingpublicgoodsandservices.Thisalsoinvolvesbetterpre-projectplanning,carefulcomparisonwithothermeanssuchasprocurement,improved transparencywith respect to contractualterms−includingrenegotiationsandoptionsforexitorbreakingofcontracts−aswellasidentifyingandquantifyingthefiscalimplications.itfurtherrequiresthatgovernmentsdisclosedocumentsandinforma-tionrelatingtoPPPsandtheircontractstoencouragehonestandtransparentprocessesthatarealsosociallyaccountable.itmayalsobeusefultocreateaforumforthesharingofexperiencesandexpertise,andbuildnetworksofdevelopingcountriesforthispurpose.

Manynationalgovernmentsorregionalauthori-ties that have been accumulating large amountsof foreign assets in recent years have establishedsovereignwealthfunds(SWFs)asamoreprofitablewaytousesuchassetsinsteadoffurtherincreasingtheirinternationalreserves.Thetotalvalueofthesepublicassetscurrentlystandsatmorethan$7tril-lion.This has raised hopes in somequarters that

SWFs could complement the existing sources ofdevelopmentfinance, particularly sincemore than40ofthe52SWFsestablishedsince2000arebasedindevelopingcountriesand32ofthemholdmorethan $10 billion in assets.Their total assetswereestimated to be nearly $6 trillion inMarch 2015(SWF institute, 2015), 87per centofwhichwerefundsfromSWFsinonlysevendevelopingcountries

D. Can sovereign wealth funds make a difference?

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(China,Kuwait,Qatar,theRepublicofKorea,SaudiArabia,SingaporeandtheUnitedArabemirates).

Apartfromthefundsheldformacroeconomicstabilization purposes only (which therefore holdswiftlydeployable,highly liquid instruments suchas government bonds or cash),many SWFs aremandatedtobuildupcapitalreservesforfuturegen-erations,andcanthereforeconsiderdeployingtheirremainingfundsforequityand“alternativeinvest-ments”thatareilliquidandlongterm.Someareevenexplicitlyexpected to supportnationalor regionaldevelopmentthroughinvestmentsininfrastructure.SWFstypicallyhavemorefreedomintheirchoiceof asset classes comparedwithmore risk-aversefundsoperatedbycentralbanks,pensionfundsandotherfunds.HintsofportfoliochoicescanbegleanedfromexamplesofrecentdecisionsbyvariousSWFs:theNorwegianGovernment’s SWF recentlymadeaclimate-change-relatedpledgetoexitglobalequi-tiesincoal,Singapore’sTemasekhasinvestmentsinnationalandregionalinfrastructure,andtheFundforProductiveindustrialRevolutioninthePlurinationalStateofboliviahasinvestmentsinmedical,cementandfoodindustries,amongothers.

inpractice,fewSWFstakeadvantageofthisfreedomtoinvestinwaysthatwouldsupportdevel-opingcountries’long-terminvestmentneeds.Rather,their investment decisionsmirror those of private

marketplayers,favouringsomecountries(e.g.China,theUnitedKingdomandtheUnitedStates)andwhattheydeemtobelow-riskandshort-termmarketsec-tors (inderst andSteward,2014; iPeandStirling,2013).AndwhilemorethanhalfofallSWFsinvestsomeresourcesininfrastructure(typicallyinenergy,transportandtelecommunications),theseinvestmentsareagainmostlyindevelopedcountries(inderstandSteward,2014).

SWFs’decision-makingprocessesarenotwellknown,asfewer thanhalfdisclosedetailsof theiractivities(bauer,2015).Somefundsareconstrainedbytheirlegalstructures.Forexample,severalfunds,suchasthebotswanaPulafund,arenotallowedtoinvestdomestically,butothershavemandatesthatallowinvestingbothdomesticallyandininfrastruc-ture.Technical assistancemayhelp boost projectmanagement capabilities in developing countries,thus responding to criticism that someSWFs areunwillingtoinvestinthosecountriesbecausetherearetoofewlarge-scaleprojectstoattractthem.Somemechanismsforriskmitigationmayhelp,suchaspre-projectappraisalsorcontingentguarantees.However,sincethedeclaredaimofSWFsistypicallytosavefor their country so that future generationsmaybenefitfromtoday’s(possiblywindfall)successes,this necessarily requires an emphasis on low-riskinvestments thatyieldpositive returns,whether insocialorfinancialterms.

1. Distinctivefeaturesofdevelopmentbanks

Multilateral development banks have playedandcancontinuetoplayacrucialroleasprovidersoflong-termfinancingthatisnotdeliveredbyprivatelenders.21Typically, transformative developmentrequires,amongotherthings,large-scaleprojectsoflongmaturity,whichinvolverisksthatprivatebanks

areunwillingtoassume,especiallywhentheirownliabilitiesareshortterminnature.inaddition,manylarge-scaleprojectsgeneratepositiveexternalities,andthereforesocialreturnsthatarebiggerthanpri-vatereturns.Developmentbanks(bothnationalandmultilateral) are specifically designed to compen-satefortheseshortcomingsofprivatecapitalflowsandmarkets.Theyhaveaclearmandatetosupportdevelopment-orientedprojectsthattypicallyrequirelong-termfinanceandafundingbasewhoseliabilities

E. Development banks: Their evolution and potential for supporting development

Long-Term International Finance for Development: Challenges and Possibilities 167

arepredominantlylongtermandthusalignedwiththeirmandate.Their capital is, for themost part,ownedbyhighly rated sovereigns,whichpermitsthebankstoborrowlongterminfinancialmarketsatrelativelylowcosts.22inadditiontotheirprovisionoflong-termfinance,developmentbanksactas“marketmakers”bycreatingandprovidingfinancinginstruments that better spreadrisks, both between creditorsand borrowers and over time,includingthroughco-financingwithprivateinvestors.

Development banks canalsohelptoovercomesomeofthe informational deficienciesfacingtheprivatesectorbyassistinginthescreening,evaluationandmonitoringofprojects.Unlikeprivatebanks, development banks tend to have in-housetechnical andmanagerial expertisewhich allowsthemtoparticipateindecisionsinvolvingchoiceoftechnology,scaleandlocation.Thisreinforcestheirabilitytoleverageresources,astheycanattractotherlenders that donot have the same technical capa-bilitiestoassessaproject’sviabilityandpotential.Developmentbanks,therefore,haveuniquefeaturesthatgivethemastrongcomparativeadvantageoverprivate financial institutions, including the toolstomitigate specific risks that the private sector isunwillingto takeon,andtheability toexploit thecomplementaritiesbetween themand theirprivatepartnerseffectively(buiterandFries,2002).

Thesebanksaregenerallymandatedtoprovidecreditontermsthatrenderindustrialandinfrastruc-turalinvestmentviable.Theyprovideworkingcapitalandfinanceforlong-terminvestments,sometimesintheformofequity.Tosafeguardtheirinvestments,theyoftencloselymonitortheactivitiesofthefirmstowhichtheylend,sometimesnominatingdirectorstotheboardsofthosefirms.

Nationaldevelopmentbankshavelongpredatedmultinational banks. inGermany, for example, inthe nineteenth and twentieth centuriesGermanGrossbanken or universal banks became heavilyinvolved inmaturity transformation. Since suchactivitiessometimesresultedinthesebanksexperi-encingilliquiditysituations,theyrequiredconstantand reliable access to last-resort lending by theReichsbank,orcentralbank.ithasbeenarguedthat

this represented “a clear case of planned institu-tionbuilding”, tofinance the necessary long-terminvestments.The universal bankswere private,limited liability, joint stock banks, but theywerealso instruments of theState, actingon its behalf

inreturnforlarge-scaleliquid-ity support (DeCecco 2005:355). Following theGermanexperience, togetherwith theexperience of themain-banksystem in Japan that financedexport-led industrial expan-sion with support from anddirectionbythebankofJapanandtheJapaneseGovernment,manydevelopingcountrieshavechosentoestablishstand-alone

developmentfinanceinstitutionsexpresslygearedtospecificfinancingobjectives(Chandrasekhar,2014).

Morethanhalfofthedevelopmentfinanceinsti-tutionsinthedevelopingworldarerelativelysmall,withassetsoflessthan$10billion.However,about5percentaremega-bankswithassetsgreaterthan$100billion, including institutions like theChinaDevelopmentbank (CDb)and theNationalbankforeconomicandSocialDevelopment(bNDeS)ofbrazil(Chandrasekhar,2014).

Clearly, internationalormultilateraldevelop-mentbankscanplayevenmoresignificantrolesifthey also assist in reducing developing countries’foreign-exchange gaps, and if they provide loansatevenlowerinterestratesbecauseoftheirgreaterability to access global capitalmarkets.As notedabove, these financing gaps arise because of thepublicnatureofsomeinvestmentprojects,thelim-itedfinancingcapacityofnational(andsub-national)governments to undertake large projects, and theprivatesector’sunwillingnesstoundertakelong-term,large-scaleprojectswhichtheyperceiveastoorisky.Sincepublicinvestment,bynature,typicallydoesnotgeneratedirectfinancialreturnsoninvestment,butonlyindirectandlong-termreturnsintermsofhighergrowth,fromwhichdebtservicecaneventuallybepaid,thiscanbe,andtypicallyis,amajorobstacletocommercialfinancing.

oneareainwhichfinancinggapsremainhugeis infrastructure, with an estimated current gapgreaterthan$1trillion(bhattacharyaandRomani,2013).AswasevidentinsectionC,eveninnovative

Development banks have a clear mandate to support development-oriented projects that typically require long-term finance and a funding base whose liabilities are predominantly long term.

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mechanisms tomeet this gap throughPPPs havethusfarbeeninadequate,andfurthermore,theyhavetendedtoinvolveverysubstantialfiscalcosts.ithasbeenestimatedthatinordertomeetthegrowthanddevelopmentneedsofdevelopingcountries, infra-structurespendingwouldhavetoincreasefrom3percent to 6−8 per cent of developing-countryGDP.However,privatesectorinfrastructureinvestmentisnotonlyrelativelysmall,butalsoveryconcentratedin the energy, transport and iCT sectors (estache,2010).Thelackofprivatesectorinvolvementispar-ticularlymarkedforregionalinfrastructureprojectsduetothecomplexityoftheregulatoryframeworkforcross-borderprojectsandthepoliticalrisksinvolved.Multilateraldevelopmentbanks,especiallyregionalones,canplayaleadingroleinprovidingfinanceforregionalinfrastructuredevelopment,sincetheycantacklecollectiveactionandcoordinationproblemsdue to their internationalor regionalnature,accu-mulatedknowledgeandaccesstodifferentfinancingandimplementationinstruments.

international development banks canprovidelow-income countrieswith loans for developmentprojectsat subsidized interest rates. in2013, theirconcessionallendingamountedtoalmost$20billion,whichrepresented30.4percentoftheir total loanportfolios.23inaddition,bothnationalandmultilat-eraldevelopmentbankscanplaycountercyclicalroles,providingproject finance to fill in gapswhen private lenders reducecredit during recessions andcrises (ocampo et al., 2007).Theymayalsobeabletosustainorevenincreaselendingduringeconomicshocks,suchassharpchangesincommoditypricesornatural disasters.This in turncan help a country sustain itslevelofincomeandeconomicactivity,aswellasitscapacitytoimportaftersuchashock.Thiswasevi-dentduringtheglobalfinancialcrisis,forexample,when lendingbyboth theCDbandbNDeSwassufficientlylargetooffsetsomeofthelikelydeclinesininvestmentduringthecrisis(Ferraz,2012).Someregional banks such as theeuropean investmentbank (eib) have the explicitmandate to providecountercyclical lending,24whichdemonstrates thatinternational/regionaldevelopmentbanks,alongwiththeirnationalcounterparts,candirectlyhelpsupportincomeandemploymentaspartoftheirpolicygoals.

2. The changing landscape of development banks

overmorethanhalfacentury,theWorldbankand various regional development banks such astheAsianDevelopmentbank (ADb), theAfricanDevelopmentbank (AfDb), the inter-AmericanDevelopmentbank (iADb),eib and the islamicDevelopmentbank(iDb),haveplayedavitalroleinfinancinglong-termprojectsaroundtheworld.Theyhavehelpedtofillsomefinancinggaps,especiallyinlarge-scaleinfrastructureprojects,and,morerecently,insocialandenvironmentalprojects.Despitetheirpresence,however,giventherelativelymodestsizeoftheirloans,theyhavebeenabletoonlyslightlyreducethesegaps.25

other subregional development banks havealsopartiallycoveredthesefinancingneeds.inthelatinAmerican and theCaribbean region, theseinclude theCentralAmericanbank foreconomicintegration, theCaribbeanDevelopmentbankandtheAndeanDevelopmentCorporation(CorporaciónAndina de Fomento, or CAF). The latter, nowknownastheDevelopmentbankoflatinAmerica,was createdwith amandate to promote sustaina-bledevelopmentandregionalintegrationamongits

foundingmembercountries,thePlurinational State ofbolivia,Colombia, ecuador, Peru andthebolivarianRepublicofVene-zuela.Membership has beengradually expanded since thebank’screationtoincludemostlatinAmericanandCaribbeancountries, aswell as PortugalandSpain.The bank supportsthe strengthening of itsmem-bers’nationalproductivesectors,

particularlythedevelopmentofvalue-addedproductsandservices,aswellasjobcreationandthepromo-tionofaccesstosocialservices,includingeducation,health,waterandsanitation.in2013,loanapprovalsbytheCAFsurpassed$12billion,whichwasasimilaramounttothetotalloansoftheiADb.26AlthoughtheCAFisownedmostlybydevelopingcountries,thebankhasafairlylargecapitalbase,which,togetherwiththeexcellentrecordofrepaymentonitsloans,hascontributedtoitsinvestmentgradestatusfromtheinternationalratingagencies−aratingthatishigherthan that ofmost latinAmerican countries. The

In recent years, some national development banks have become increasingly significant international players, providing external financing as part of their international operations.

Long-Term International Finance for Development: Challenges and Possibilities 169

bank’sclearandfocusedmandate,leanmanagementstructure,rigorouseconomicevaluationofprojects,rapid approval process and loans grantedwithoutconditionalityhelptoexplainitssuccessandconsist-entlyhighcreditrating(Griffith-Jonesetal.,2008).

inAfrica, theAfDb is an important sourceof external long-term finance.Africa also has alargenumberof subregionalbanks, including: theeastAfricanDevelopmentbank,theWestAfricanDevelopment bank, the CentralAfrican StatesDevelopmentbank,theeasternandSouthernAfricanTradeandDevelopmentbank,commonlyknownasthePreferentialTradeAreabank(orPTAbank)andtheDevelopmentbankofSouthernAfrica(whollyowned bySouthAfrica but serving theSouthernAfricanDevelopmentCommunity,withafocusonlargeinfrastructureprojects).However,thesebankshave limited capacity to providefinance for largedevelopment-orientedprojectsonascalethatmeetstheneedsoftheirrespectivesubregions.27Thismaybe explained by their small capital base, and bythefactthatmostoftheirshareholdersarethebor-rowing countries themselves,which have limitedfinancial resources to expand these banks’ capitalbasessubstantially.inAsia,theADbplaysamajorrole in financing long-termprojects, including ininfrastructure,asthereisalackofsubregionalbanks.

in recent years, some national developmentbankshavebecomeincreasinglysignificantinterna-tionalplayers,providingexternalfinancingaspartof their international operations.Themost activeinternationallendershavebeenChinaDevelopmentbank(CDb),theexportandimportbankofChina(Chinaeximbank),brazil’sbNDeSandtheGermanDevelopmentbank,Kreditanstalt Für Wiederaufbau(KfW).Theinternationaloperationsofthesemajordevelopmentbanksaccountforasignificantpropor-tionoftheirtotalassetsandloans,whichcanbequitelarge(chart6.5).

TheCDbandChinaeximbankaretwoofthethree“policy”banksthatChinacreatedin1994tosupportspecificdevelopmentgoalssetbytheChineseGovernment.TheCDb is a primary provider oflong-termfinance for infrastructure projects, suchasrailways,roadsandtelecommunications,andforlarge-scaleinvestmentsinbasicandheavyindustries,suchaspetrochemicals.Chinaeximbank’smandateistosupportChina’sexportsandimportsofmechani-calandelectronicproducts,equipmentandhigh-tech

products,aswellasoverseasinvestmentsofChinesecompanies.ThebankalsoactsasthefinancingarmofChina’sinternationalcooperationprogrammesbyprovidingconcessionallendingabroad(Poon,2014;Chinaeximbank,2014).

Since the early2000s, bothof theseChinesebanks have been active providers of internationalfinance to developing countries.Their loans havesupportedChina’s “going out” strategy as part ofits new role as an emerging superpower on theglobalstage.Recentinitiativesincludetheirplannedcontributionsto thenew“SilkRoad”strategythatinvolveslargeinfrastructureinvestmentsacrossAsia,alongwithcontinuingfinancinginAfrica,AsiaandlatinAmerica through South-South cooperationagreements.

in 2014, theCDb’s foreign currency loanstotalled$267billion,accountingforabout22percentofitsentireloanportfolio.Theygenerallysupportinfrastructuredevelopment indifferentdevelopingcountries,while facilitatingChina’s access to raw

Chart 6.5

TOTAL ASSETS AND LOANS, SELECTED NATIONAL DEVELOPMENT bANkS, 2014

(Billions of dollars)

Source: Banks’ annual reports.

0

200

400

600

800

1 000

1 200

1 400

1 600

1 800

BNDES CDB China’s EximBank

KfW

Total assets Total loans

Trade and Development Report, 2015170

materialsat lower transportationcosts.28Thebankalsoprovidesfinancingthroughothermechanisms,suchastheChina-AfricaDevelopmentFund(CADFund),towhichthebankwasthesoleproviderofcapital funds in its phases i and ii. in 2014, theCADFundcommitted$3.1billionof investmentsin80projectsinarangeofareas,includingregionalaviation,ports,electricity,pharmaceuticalsandvehi-cleassembly(CDb,2014).

TogetherwiththeCDb,ChinaeximbankhasstronglysupportedChina’sstrategicpartnershipwithotherdevelopingcountries.ithasmadepreferentialloancommitmentstodifferentcountriesandregions,includingAfrica,AsiaandthePacific,CentralandeasterneuropeandtheCaribbean(Chinaeximbank,2014). in2014, itsactualexport seller’screditdis-bursementsreached$287.8billion,ofwhich15.2percentwasspentonoverseasconstructioncontractsand7.9percentonoverseasinvestmentprojects.Recently,thebankhasprovidedsupportto“thedevelopmentofhigh-speedrailway,expresswayandregionalaviationnetworks(the‘ThreeNetworks’)inAfrica”throughloans(partoftheseconcessional)andotherassistancemechanisms(Chinaeximbank,2014:9).

inadditiontotheseChinesenationaldevelop-mentbanksthathaveaninternationalreach,anotherprominent national development bank isbrazil’sbNDeS,which has been providingfinancing fordevelopment,bothnationallyandabroad,inrecentyears.Createdin1952withaninitialfocusonfinanc-ingdomesticinfrastructuredevelopmentaspartofthecountry’sstrategyofmodernizationandindustriali-zation,itsubsequentlybroadeneditsfocustofosterbrazil’scapitalgoodsindustryandotherindustrialsectors.Sincethe1990s,ithasalsobeenprovidingfinancingtoexportingsectors.inthe2000s,thebankexpandeditsinternationaloperations,reflectingthewillingnessofbrazil’sGovernmenttoplayagreaterroleontheinternationalstage.Thisnewstrategyhasincludedsupportingregionaleconomic integrationandthereforeinvestmentpromotioninneighbouringcountries,aswellasstrengtheningbrazil’seconomiclinkswithfast-growingdevelopingregions,particu-larlyAfrica.Thebank’sloanshavealsobolsteredtheinternationalizationoflargebraziliancorporations.

in2014,14percentofthebank’stotalloanport-foliowasinforeigncurrency.SincebNDeSfiguresamong the largest national development banks intheworld,withatotalloanportfolioof$245billion

in 2014 (chart 6.5), its provision of foreign loansis significant, especially for smaller countries thatlack funding for large-scaledevelopmentprojects.inSouthAmerica,forinstance,thebankhasplayeda very important development-supporting role bylendingtosmallcountriessuchasecuadoraswellaslargeronessuchasArgentina,tofinanceeconomicinfrastructure. inAfrica, it has extended loans tolargenationalconstructioncompanies investing ininfrastructureandotherprojects.

An example of a national development bankfromadevelopedcountryisKfW.ithasbeenplayinganincreasinglyimportantroleinternationallyasthelendingarmofGermany’sdevelopmentcooperationprogrammes.itpromotesdevelopmentprogrammesinalldevelopingregions.Attheendof2014,itsloanportfoliototalled$536billion(chart6.5),and10percentofitsbusinesspromotionactivitieswererelatedtodevelopmentprogrammesaround theworld. itsmandateistoimprovelivingconditionsinGermany,europeandaroundtheworldsustainably,suchasbypromotingclimate-friendlyeconomicdevelopment,includingindevelopingcountries.itsprojectsincludepowersupplylinesinindia,asolarthermalpowerplantinChileandsustainablehousingconstructioninAfrica(KfW,2014).Partsofthesefinancingpro-grammesarelinkedtothebank’sparticipationinavarietyofclimateprotectioninitiatives,suchastheinitiativeforClimateandenvironmentalProtectionandtheinternationalClimateinitiative.ithasalsocreatedaClimateinsuranceFundaimedatsupport-inglocalinsuranceandreinsurancecompanies,anditisexpectedtocontributetothenewUnitedNationsGreenClimateFund (GCF) forclimateprotectionandadaptation.inaddition,theGermanGovernmentchannelsfundsthroughthisbankfortheprovisionof grants and highly concessional loans tolDCs(KfW,2014).

3. Thepotentialfinancingroleof South-led multilateral banks

Asystemofdevelopmentbanksthatprovidesinternationalfinancingtosupportgrowthanddevel-opmentshouldincludeSouth-ledmultilateralbanks,alongsidemultilateral, regional and subregionalbanksandnationalbankswithinternationalopera-tions.Recent initiatives todesignand setup such

Long-Term International Finance for Development: Challenges and Possibilities 171

banksareaimedataddressingtheshortageoflong-termcapitalforinvestmentincrucialinfrastructuralareas and capital-intensive industries essential fordevelopment.These initiatives include the newlycreatedNewDevelopmentbank(NDb)setupbythegroupofcountriesknownasthebRiCS(brazil,theRussianFederation,india,ChinaandSouthAfrica),theAsianinfrastructureinvestmentbank(Aiib)andthebankoftheSouth.Thedecisionstocreatetheseinstitutionsarepartlymotivatedbythedisillusion-mentofdevelopingcountrieswith thegovernancestructures,patternsoflendingandtheconditionali-tiesassociatedwithlendingbythebrettonWoodsinstitutions and by some of the leading regionaldevelopmentbanks.

TheNDbwasestablishedatthebRiCSFortalezaSummitofJuly2014,withthespecificmandatefor“mobilizingresourcesforinfrastructureandsustaina-bledevelopmentprojectsinbRiCSandotheremergingand developing economies” (bRiCS, 2014, para-graph11).Thisfocusisclearlyjustifiedinthelightofthelargeunmetneedsintheseareas, as highlighted above. ithas been establishedwith aninitialauthorizedcapitalof$100billion(andasubscribedcapitalof$50billion).Accordingtothedeclaration of theViibRiCSSummit in July 2015 inUfa(RussianFederation),theNDbisexpectedtostartapprovingitsfirst investmentprojectsat thebeginningof2016(bRiCS,2015a).Thequalityofitsloanstoinfrastructureandotherprojectsshouldbeanimportantprioritysoastomaximizethedevel-opmentimpactsofsuchprojectsandminimizerisksofdefault.Moreover,theabilitytomakeprofitswillhelpthebankexpanditscapitalbase,andthereforeincreaseitslendinginthefuture.

intermsofgeographicalcoverage,itwouldbeimportantfortheNDbtohaveabalancedportfolioofloansthatincludebothmiddle-andlow-incomecountries, since thismixwould generate benefitsofgeographicaldiversificationandmake thebankmorecreditworthy.inordertolendtolow-incomecountries, thereisacasetobemadeforincludinga subsidy element,making loans to this group ofcountriesconcessional.Thecreationofatrustfund,fundedbydevelopedcountries,couldsupportsuchloans(Griffith-Jones,2014).

TheAsian infrastructure investment bankwas established inoctober 2014 inbeijing,with33foundingmembersfromwithintheAsianregionand 17 (including several developed countries)fromoutside the region; an additional seven pro-spectivemembers have yet to sign on.29Most ofthebank’sauthorizedcapitalstockof$100billionwillbecontributedbyChina.inordertoreflecttheregionalcharacteroftheAiib,itsregionalmemberswillbethemajorityshareholders,holdingapproxi-mately75percentofshares.Thebank’screationisaresponseto therecognitionof theimportanceofinfrastructure to thedevelopmentofAsia, and theneedforsignificantadditional long-termfinancingforbuildinginfrastructureintheregion.WhiletheADbestimatesAsia’sinfrastructurefinancingneedstobearound$720billionperannumovertheperiod2010−2020,itsownannualloanapprovalamountsto only $13billion (Junio, 2014).TheAiib aimstofinancebothnationalandregionalinfrastructureprojects.Thelattershouldaimtosupporttradeandfurtherdevelopmentoftheregion’sproductionnet-

works.Themainfundingmech-anismwillbethroughtheissu-ingof bonds, both in regionalandglobalmarkets.

inlatinAmerica,thebankoftheSouth(bancodelSur)isasubregionalentitywhosefound-ingmember countries are allfromSouthAmerica:Argentina,thePlurinationalStateofboli-

via,brazil, ecuador, Paraguay,Uruguay and thebolivarianRepublic ofVenezuela.established in2009withapromisedinitialcapitalof$20billion,itaimstopromoteeconomicdevelopmentandregionalintegrationintheSouthAmericansubregion.

Noneofthesethreebanksisinoperationyet,buttheyarepromisingsignsofarenewedinterestbothindevelopmentbanksandintheneedtofinanceinfrastructure creation for social and economicdevelopment.Theyalsoadd toanenvironmentofhealthycompetitionwithotherdevelopmentbanks;forexample,partlyasaresponsetothesedevelop-ments, theWorldbankhas decided to stepup itspresence in theareaof infrastructuredevelopmentbysettingupaGlobalinfrastructureFacility(GiF),which it defines as “a global open platform thatwill facilitate the preparation and structuring ofcomplex infrastructure PPPs tomobilise private

A system of development banks that provides inter-national financing to support growth and development should include South-led multilateral banks.

Trade and Development Report, 2015172

sector and institutional investor capital.”30This isanambitiousstep,giventheWorldbank’srelativelylimitedspendingon infrastructuredevelopmentsofar−about$24billionin2014,upfrom$16.7bil-lionin201331−anditsmixedrecordonsocialandenvironmentalstandards.Nevertheless,itpointstothepossiblecatalyticrolethesenewinstitutionsmayplayinchangingboththeconditionsandtheapproachofexistingmultilateralfinancinginstitutions.Further,theycouldbecomeadrivingforceforcollaborationinanetworkofdevelopmentbanks,creatingsynergiesandcomplementaritiesamongthem.

inthisnetwork,thenewSouth-ledbankscouldworkcloselywithnationaldevelopmentbanks,par-ticularlyfromthebRiCScountries,suchasbrazil’sbNDeS,theDevelopmentbankofSouthernAfricaandChina’sCDb,aswasproposedattheViibRiCSSummit in July 2015 (seebRiCS, 2015b).Whilemultilateralbanksmayhavegreaterexpertiseintheengineeringandfinancingaspectsofloans,nationaldevelopment bankshavegreater local knowledge,therebyhelpingreduceasymmetriesofinformationatthenationallevel.

ThesenewSouth-ledbanks are expectednotonly to supplement the amount of financing for

long-term investments that are on offer globally,but also to better serve the interests of economicdevelopment,alongwithgreaterconcernforsustain-abilityandinclusiveness,thanmultilateralbanksthataredominatedbydevelopedcountries.Thiswoulddependonseveralfactors.oneisthedegreetowhichtheemergenceofthesebanksisabletosignificantlyaltertheglobalfinancialarchitecture,andperhaps,therefore,thebehaviouroftheinstitutionsthatcur-rentlydominateit.Anotherrelatestowhethertheywoulddifferintheirlendingpracticesfromtheestab-lishedinstitutions−notjustincreasingthequantityof financing for long-termdevelopment, but alsochangingitsqualitytofocusmoreoninclusiveandsustainable economic transformation.Thus,whilegreater diversity in the internationalfinancial andmonetary landscape is certainlywelcome, and theadditionalresourcesthatthesenewinstitutionspro-videcanhaveasignificantpositiveimpactintermsofgeneratingmorelong-termfinancingfordevelop-ment,itdoesnotnecessarilyfollowthattherewillbemajorchangesinthetermsandconditionsofsuchfinancing.Forthistohappen,governmentsandcivilsociety indevelopingcountrieswillneed toplacegreateremphasisonmonitoringthefundingpatterns,termsandconditionsinthelendingactivitiesofthenewdevelopmentbanks.

inaworldeconomyinundatedwithliquidity,themainobstacle tofinancingdevelopment isnotthelackoffinancingcapacity.Rather,thequestionis how tomove resources fromhighly leveragedinstitutionswith short-termfinancial horizons toeconomicagentswishingtofinancelong-terminvest-mentprojectsthatgeneratelargepositiveexternalitiesandthereforeencourageadditionalinvestment.Thisreport stresses that this cannot be ensured simplythroughtheworkingsofmarketmechanisms,eithernationally or internationally.This is because pri-vate financial institutions are naturally driven byaprofitmotive,wherebyduringaboom,theytendtoproducetoomuchcreditanddebt,whileduringa bust, credit ceases and a debt deflation sets in.

Asaconsequence,andlefttoitself,privatefinancefinds it difficult to incorporate social or develop-ment benefits in its calculations.Where there areexternalities,aswithpublicgoods,privatefinanceisinsufficientforsocialneeds.inaddition,privatefinancehastendedtobegeographicallyconcentratedinhighandmiddle-incomecountriesandinsectorsinwhichprofitabilityismoreassured,ratherthaninriskyprojectsorprojectswithlonggestationperiodsthatmaybemorenecessaryforindustrializationanddevelopment.Withincountries,privatefinancetendsto provide lessfinancing toSMes, to sectors thatarecharacterizedbydifferentformsofrisksuchasagriculture,toprojectswithbulkyupfrontinvestmentrequirementssuchaseconomicinfrastructureandto

F. Conclusions

Long-Term International Finance for Development: Challenges and Possibilities 173

necessarysocialinvestmentsinhealth,sanitationandeducation,amongothers.Yetsufficientspendinginalloftheseareasisclearlyessentialforasustainedandinclusivedevelopmentprocess.

Therefore,ensuringfinanc-ing for development requiresspecialized agents andmecha-nisms designed specificallyfor this purpose, inwhich therole playedby the public sec-tor iscrucial.Thischapterhasreviewed themost importantpotentialsourcesofinternationalfinancethat,hav-ingsomedegreeofpublicinvolvement,maybeusedfordevelopmentfinance.Relatedmechanismsmayresultdirectlyfrompublicspending,aswithoDAandotherformsofcooperation,mayinvolvechangingthetermsofprofitabilityandtheincentivesavailabletoprivateinvestorstoconsiderexternalities,aswithPPPs,ormayemergefrompublicinstitutions,suchasdevelopmentbankssetupforthispurpose,whichareeffectivelyunderwrittenbythegovernment.

oDA remains the only existingmechanismwhose central aim is to redistribute incomeat thegloballevel.Despiteitspotential,theamountofoDAhasremainedfarshortofbothneedsandexpecta-tion.inthepastfewyears,therehasbeenprogressregarding both the amount of assistance providedandeffortstoimproveitseffectiveness.inaddition,South-South cooperation has been significantlyincreasing.However,mostoDAstillreflectsflowsfromdevelopedcountries todevelopingcountries,and closing the gap between the current level ofsuchoDA(0.29percentofGNiofdevelopedcoun-tries)andthecommittedlevelof0.7percentremainsoftheutmostimportanceforsustainingdevel-opmentstrategies,particularlyinlDCs.inthiscontext,thereisanincreasingfocusinthedebateonfinancingfordevelopmentonthepotentialuseofoDAtocatalyseadditional resourcemobiliza-tion, both public and private.However,theuseofpublicaidforleveragingprivatefinanceshouldbeconsideredwithcaution,toavoidtheriskofprivat-izingbenefitsandsocializinglosses.TheopportunitycostofusingoDAforthispurposemaybetoohigh.

This chapter has also shown that, despitetheir recent popularity, experiencewithPPPs hasbeenmixedandratherlimitedintermsofgenerat-ingadditionalprivate investment indesiredareas.

Aswithother blendedfinanceinstruments,PPPsmay“lowerinvestment specific risks andincentivize additional privatesectorfinanceacrosskeydevel-opmentsectors”(AddisAbabaActionAgenda of the Thirdinternational Conference onFinancing forDevelopment in

2015).However,thescaleofobligationsandliabili-tiesthatgovernmentshaveincurredthroughtheuseofPPPshasoftenbeenmuchlargerthananticipatedand, therefore, thefiscal costs haveoftenbeen sohigh as to suggest that governments could havemoreeffectivelyandefficientlyengaged inpublicinvestmentintheseareasdirectly.Therefore,thereisaneedtoimprovepre-projectplanningprocesses,increasetransparencyandaccountabilityandidentifyfiscalimplicationsforthedurationofsuchprojects.

Finally,multilateralandregionaldevelopmentbanks that are dedicated to the special challengesinherentininfrastructurecouldplayagreaterrole,delivering technical assistance aswell asfinance.indeed,existingandnewdevelopmentbankshaveaprimaryroleasprovidersoflong-termfinancing,vis-à-vis privatefinancial institutions. Since theyhave a clearmandate to support developmentallyorientedprojectsandafundingbasewhoseliabilitiesare predominantly long term, aswell as in-housetechnicalexpertisethatallowsthemtoparticipateindecisions involving choices related to technology,

scale and location, they haveuniquefeatures thatgive themastrongcomparativeadvantageover private financial institu-tions.internationaldevelopmentbankscan,inaddition,playanimportant countercyclical rolethroughtheirprovisionofcrisisfinancing to individual coun-tries,inresponsetoaneconomicshock (e.g. commodity-pricerelated) or a natural disaster,

which canhelp sustain levels of income and eco-nomic activity and the capacity to import duringdownswings.

Private finance finds it difficult to incorporate social or development benefits in its calculations …

… therefore, ensuring finance for development requires specialized agents and mecha nisms designed specifi-cally for this purpose, in which the role played by the public sector is crucial.

Trade and Development Report, 2015174

1 A target of official flows equivalent to 0.75 percentofeachdevelopedcountry’sGNPwasinitiallyadoptedat thesecondconferenceofUNCTADinNewDelhi in 1968.This proposalwas acceptedbymost, but not all, developed countries.Afterfurthernegotiations,thisinitiativewasapprovedbytheUnitedNationsGeneralAssemblyofoctober1970, although the targetwas lowered to 0.7 percentofGNP.ThiscommitmentwasendorsedbythemembersofoeCD-DAC,whichdefinedoDAas“thoseexternalfinancialflowswhichareprovidedbyofficialagencies,havethepromotionofeconomicdevelopmentandwelfareofdevelopingcountriesasitsmainobjective,andareconcessionalincharacter.”

2 onlyfivemembersexceededthetargetof0.7percent of GNi: Denmark, luxembourg, Norway,SwedenandtheUnitedKingdom(oeCD,2015).

3 DevelopmentaloDAincludessocialinfrastructureandservices,economicinfrastructureandservicesandproductionsectors,whichin2013representedabout63percentoftotalregisteredoDA.

4 Forempiricalevidenceontherelationshipbetweenaidandgrowth,seeTDR 2008andUNCTAD,2006.Formorerecentreviewsontheliteraturerelatingtothis,seeAlonso,2012;edwards,2014;GlennieandSumner, 2014;Morrissey, 2015;Qian, 2014; andQuibria,2014.

5 Suchcostsincreaseby15–30percent,onaverage,andbyasmuchas40percentormoreforfoodaid(DiiS,2009).

6 onaidpredictability,seeoeCDat:http://www.oecd.org/dac/aid-architecture/(accessed21July2015).

7 Theremaining61percentwas“phantomaid”−aidwhichwasnottargetedforpovertyreduction,orwasdouble-countedasdebtrelief,overpricedandinef-fectivetechnicalassistance,tiedtothepurchaseofgoodsandservicesfromthedonorcountry,poorlycoordinated andwith high transaction costs, toounpredictabletobeusefultotherecipient,spentonimmigration-relatedcosts in thedonorcountryorspentonexcessiveadministrationcosts.

8 evidence of this can be found in the high-levelforumsonaideffectivenessheldinRome(2003),Paris(2005),Accra(2008)andbusan(2011).

9 evenwiththerecordedincreasesinformal,untiedaid,somepartofitmaystillbe“defacto”tied.Thismaybeduetodonorregulations,lackoflocalcapac-ity,difficultiesforlocalandregionalcontractorstocompeteinternationally,unequalaccesstoinforma-tion,potential riskaversionon thepartofdonorsandpressureforspeedyimplementation(UNCTAD,2011b).

10 Similarly, theAddisAbabaActionAgendaof theThird internationalConference onFinancing forDevelopment(13–16July2015)stressesinitspara-graph54:“Animportantuseofinternationalpublicfinance, includingoDA, is to catalyse additionalresourcemobilization fromother sources, publicandprivate.itcansupportimprovedtaxcollectionandhelpstrengthendomesticenablingenvironmentsandbuild essentialpublic services. it canalsobeusedtounlockadditionalfinancethroughblendedorpooledfinancingandriskmitigation,notablyforinfrastructure and other investments that supportprivatesectordevelopment.”

11 However,“evaluatingblendedprojectsisnoteasyanditcanbedifficulttodemonstratekeysuccessfactors,suchasadditionality,transparencyandaccountabil-ityandtoprovideevidenceofdevelopmentimpact”(UNCTAD,World Investment Report 2014:169).

12 See for instance,Griffiths et al. (2014),UKAidNetwork(2015),Concord(2014),ActionAid(2014),brettonWoods Project (2012), eurodad (2012),ActionAid,eurodad andoxfam (2015),eurodad(2013),KwakkenbonsandRomero(2013).

13 Definitions of PPPs vary considerably, reflectingdifferentinstitutionalarrangementsandconceptualunderstandings, but they nonetheless sharemanysimilarities.intheirsimplestform,PPPs“refertoarrangementswheretheprivatesectorsuppliesinfra-structureassetsandservicesthattraditionallyhavebeenprovidedbythegovernment”(iMF,2006:1).Suchadefinitioncanencompassexistingassetsandtheacquisitionofnewones,anduser-paysservices,or free-to-user systemswheregovernments pay aunitarychargetotheprovider.otherdefinitionsfocusonriskandhowitisintendedtobeallocatedbetweenthepublicandprivatepartners.Forexample,one

Notes

Long-Term International Finance for Development: Challenges and Possibilities 175

definitionstatesthatPPPsare“anagreementbetweenthe government andoneormoreprivate partners(whichmay include the operators andfinancers)accordingtowhichtheprivatepartnersdelivertheserviceinsuchamannerthattheservicedeliveryobjectivesofthegovernmentarealignedwiththeprofitobjectivesoftheprivatepartnersandwheretheeffectivenessofthealignmentdependsonasuffi-cienttransferofrisktotheprivatepartners”(oeCD,2008:17).inpractice,muchofthecurrentdebateconcernstheperceivedimbalanceofriskbetweenpublic andprivate partners; in particular that thepublicsectorcarriestoomuchrisk,especiallyinthelong-termoperationalphasesofaprojectasopposedtothefirstcoupleofyearsduringwhichconstructiontakesplace.

14 Mostofthedatausedinthissectionaredrawnfromthe Private Participation in infrastructure (PPi)Database, produced jointly by the infrastructurePolicy Unit of theWorld bank’s SustainableDevelopment Network and the Public-PrivateinfrastructureAdvisoryFacility(PPiAF),whichisamulti-donortrustfund.Thedatabaserecordscontrac-tualarrangementsrelatedtoinfrastructureprojectsinlow-andmiddle-incomecountries(asclassifiedbytheWorldbank),inwhichprivatepartnersassumesomedegreeofoperatingriskthroughownership,financeoroperationalactivities.itfocusesonsectorswithadegreeofmonopolisticoroligopolisticchar-acteristics, including energy, telecommunications,transport andwater. Such “private participation”should not be equatedwith private investment ininfrastructure.First, it doesnotnecessarilycorre-spondtorealinvestment,asitalsoincludesmanage-mentand leasecontracts,concessionprojectsanddivestitures;second,recordedinvestmentreferstowhatwascommitted(notnecessarilymade)forthewholeproject;and third,whenprojectcompaniesareownedbybothpublicandprivateparties, thedatabasepresents the investment by both parties,notbyprivateinvestorsalone.

15 SeeWorldbank(2009).Notableexceptionsweremiddle-incomecountries,andtheiCTandtelecomssector, where private sector financewasmoreforthcoming.

16 Forexample,theFrenchcompany,Suez,pulledoutofawaterconcessioninArgentinaafterthepesofellsteeplyin2002andtheauthoritiesdidnotagreetoincreasechargestooffsetthedevaluation.largelyasaresultofthedevaluation,therewere28proceedingsagainstArgentinaundertheinternationalConventionforSettlementofinvestmentDisputes(iCSiD)byearly2004(oeCD/NePAD,2005).

17 TheothertwocountriesareMexicoandtheRussianFederation.

18 ofthetopfivedevelopingcountrieshostingPPPs,Spain and theUnitedStates together account for

almost30percentofprojectswithuniquelyforeignsponsorship,potentiallyreflectinglanguageorprox-imityfactors.

19 on thechallenges that thismaypose tocompeti-tionpolicies,seehttp://unctad.org/en/Pages/DiTC/Competitionlaw/ResearchPartnership/Contact4114.aspx.

20 AreviewbytheUnitedKingdom’sNationalAuditoffice(2015)foundthatprivatefinancedealswerechargedaninterestratethatwasdoublethatofallgovernmentborrowing.Thistrendhasbeenconsist-entovertime:in2010Infrastructure UKestimatesthatthecostofcapitalforpublicfundingwas3.9percent,comparedwithcostsofupto6.9percentforfirmsoperatinginregulatedmarkets(e.g.privatizedwaterorelectricityutilities)and10.9percentforfirmsinunregulatedmarkets(e.g.concessionsforuser-payservices).

21 This has been reaffirmed in theAddisAbabaActionAgenda,which states in its paragraph75:“Developmentbankscanplayaparticularlyimpor-tantroleinalleviatingconstraintsonfinancingdevel-opment,includingqualityinfrastructureinvestment.”

22 RegionaldevelopmentbankswithexcellentrecordsofcreditrecoverycanhaveevenbetterratingsthantheStatesthatownthem.

23 This refers to the totalmultilateral lending bytheWorldbank, theAfricanDevelopmentbank(AfDb),theAsianDevelopmentbank(ADb),theinter-AmericanDevelopmentbank(iADb)andtheeuropeanbankforReconstructionandDevelopment(ebRD).

24 Sincetheglobalcrisis,theeibhasplayedastrongcountercyclical role to help sustain income andinvestment levels acrosseurope and protect theregion’s infrastructure and productive capacityfrom the effects of the deep economic downturn.Thebank’sprovisionoffinanceisenlargedbyitsleveragingandbycombiningresourcesfromothersourcesoffinancing(e.g.theeuropeanUnionbudgetandtheprivatesector),whichimpliesalargemul-tiplier effect (http://www.eib.org/about/index.htm,accessed9March2015).

25 in2014,grossdisbursementsbyeib($78billion)and theWorldbank($44billion)werebyfar themostsignificant,comparedtoiDbandADb(about$10billion)andAfDb(almost$5billion),asnotedinthebanks’annualreports.

26 SeeCAFFactsheet2014at:www.caf.com.27 ThetotalassetsoftheDevelopmentbankofSouthern

Africaamountedto$6billionasofend-March2014.ThoseoftheWestAfricanDevelopmentbank,PTAbank,CentralAfricanStatesDevelopmentbankandeastAfricanDevelopmentbankwere $3billion,$2.5billion,$0.5billionand$0.2billion, respec-tively,asofDecember2013,asnotedinthebanks’annualreports.

Trade and Development Report, 2015176

28 Forexample,someforeignprojectstheCDbcur-rentlysupportsincludethelasbambasCopperMineinPeru,towhichithascommitted$3.5billion(anddisbursed$2.6billionbytheendof2014),acoal-firedpowerplantinbali,indonesia,towhichithascommitted$473million(anddisbursed$367mil-lion),andtheupgradingoftheMansa-luwinguRoad

inZambia,towhichithascommitted$175million(anddisbursed$65million)(CDb,2014).

29 Seehttp://www.aiibank.org/.30 Seehttp://www.worldbank.org/en/programs/global

-infrastructure-facility.31 See http://www.worldbank.org/en/news/press-

release/2014/07/18/world-bank-group-infrastructure-spending-increases-to-24-billion.

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Selected UNCTAD Publications 181

trade and development report, 2014 UnitedNationspublication,salesno.e.14.ii.D.4Global governance and policy space for development iSbN978-92-1-112877-2

Chapter i RecentTrendsintheWorldeconomyChapter ii TowardsaSustainedeconomicRecovery:ReviewofPolicyoptionsChapter iii PolicySpaceandGlobalGovernance:issuesatStakeChapter iV PolicySpaceandtheoriginsoftheMultilateraleconomicSystemChapter V TradeandindustrialPoliciesinanevolvingGlobalGovernanceRegimeChapter Vi internationalFinanceandPolicySpace Annex: DobilateralinvestmentTreatiesAttractFDiFlowstoDevelopingeconomies?ChapterVii FiscalSpaceforStabilityandDevelopment:ContemporaryChallenges

trade and development report, 2013 UnitedNationspublication,salesno.e.13.ii.D.3Adjusting to the changing dynamics of the world economy iSbN978-92-1-112867-3

Chapter i CurrentTrendsandChallengesintheWorldeconomy Annex: AlternativeScenariosfortheWorldeconomyChapter ii TowardsMorebalancedGrowth:AGreaterRoleforDomesticDemandin

DevelopmentStrategies Annex: ShiftingGrowthStrategies:MainimplicationsandChallengesChapter iii FinancingtheRealeconomy

trade and development report, 2012 UnitedNationspublication,salesno.e.12.ii.D.6Policies for inclusive and balanced growth iSbN978-92-1-112846-8

Chapter i CurrentTrendsandChallengesintheWorldeconomyChapter ii incomeinequality:TheMainissuesChapter iii evolutionofincomeinequality:DifferentTimePerspectivesandDimensionsChapter iV ChangesinGlobalizationandTechnologyandtheirimpactsonNationalincomeinequalityChapter V TheRoleofFiscalPolicyinincomeDistributionChapter Vi TheeconomicsandPoliticsofinequalityReconsidered

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Switzerland(http://unctad.org)

Selected UNCTAD Publications

Trade and Development Report, 2015182

trade and development report, 2011 UnitedNationspublication,salesno.e.11.ii.D.3Post-crisis policy challenges in the world economy iSbN978-92-1-112822-2

Chapter i CurrentTrendsandissuesintheWorldeconomyChapter ii FiscalAspectsoftheFinancialCrisisanditsimpactonPublicDebtChapter iii FiscalSpace,DebtSustainabilityandeconomicGrowthChapter iV FinancialRe-RegulationandRestructuringChapter V FinancializedCommodityMarkets:RecentDevelopmentsandPolicyissues Annex: ReformofCommodityDerivativesMarketRegulationsChapter Vi TheGlobalMonetaryorderandtheinternationalTradingSystem

trade and development report, 2010 UnitedNationspublication,salesno.e.10.ii.D.3Employment, globalization and development iSbN978-92-1-112807-9

Chapter i AftertheGlobalCrisis:AnUnevenandFragileRecovery Annex: CreditDefaultSwapsChapter ii PotentialemploymenteffectsofaGlobalRebalancing Annex: SimulationoftheTradeandemploymenteffectsofGlobalRebalancing:

ATechnicalNoteChapter iii MacroeconomicAspectsofJobCreationandUnemploymentChapter iV StructuralChangeandemploymentCreationinDevelopingCountriesChapter V RevisingthePolicyFrameworkforSustainedGrowth,employmentCreationand

PovertyReduction

trade and development report, 2009 UnitedNationspublication,salesno.e.09.ii.D.16Responding to the global crisis iSbN978-92-1-112776-8Climate change mitigation and development

Chapter i TheimpactoftheGlobalCrisisandtheShort-termPolicyResponse Annex: TheGlobalRecessionCompoundstheFoodCrisisChapter ii TheFinancializationofCommodityMarketsChapter iii learningfromtheCrisis:PoliciesforSaferandSounderFinancialSystemsChapter iV ReformoftheinternationalMonetaryandFinancialSystemChapter V ClimateChangeMitigationandDevelopment

trade and development report, 2008 UnitedNationspublication,salesno.e.08.ii.D.21Commodity prices, capital flows and the financing of investment iSbN978-92-1-112752-2

Chapter i CurrentTrendsandissuesintheWorldeconomy AnnextabletochapteriChapter ii CommodityPriceHikesandinstabilityChapter iii internationalCapitalFlows,Current-AccountbalancesandDevelopmentFinance

Annex: econometricAnalysesofDeterminantsofexpansionaryandContractionaryCurrent-accountReversals

Chapter iV DomesticSourcesofFinanceandinvestmentinProductiveCapacityChapter V officialDevelopmentAssistancefortheMDGsandeconomicGrowth Annex: DetailsoneconometricStudiesChapter Vi CurrentissuesRelatedtotheexternalDebtofDevelopingCountries

Selected UNCTAD Publications 183

trade and development report, 2007 UnitedNationspublication,salesno.e.07.ii.D.11Regional cooperation for development iSbN978-92-1-112721-8

Chapter i CurrentissuesintheWorldeconomy StatisticalannextochapteriChapter ii Globalization,RegionalizationandtheDevelopmentChallengeChapter iii The“NewRegionalism”andNorth-SouthTradeAgreementsChapter iV RegionalCooperationandTradeintegrationAmongDevelopingCountriesChapter V RegionalFinancialandMonetaryCooperation Annex1 TheSouthernAfricanDevelopmentCommunity Annex2 TheGulfCooperationCouncilChapterVi RegionalCooperationinTradelogistics,energyandindustrialPolicy

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trade and development report, 1981–2011 UnitedNationspublication,salesno.e.12.ii.D.5Three Decades of Thinking Development iSbN978-92-1-112845-1

Part One TradeandDevelopmentReport,1981–2011:ThreeDecadesofThinkingDevelopment 1. introduction 2. interdependence 3. Macroeconomicsandfinance 4. Globaleconomicgovernance 5. Developmentstrategies:assessmentsandrecommendations 6. outlook

Part Two PanelDiscussionon“ThinkingDevelopment:ThreeDecadesoftheTrade and Development Report” openingstatement byAnthonyMothaeMaruping originsandevolvingideasoftheTDR introductoryremarksbyRichardKozul-Wright StatementbyRubensRicupero StatementbyYιlmazAkyüz TheTDRapproachtodevelopmentstrategies introductoryremarksbyTaffereTesfachew StatementbyJayatiGhosh StatementbyRolphvanderHoeven StatementbyFaizelismail Themacroeconomicreasoninginthe TDR introductoryremarksbyCharlesGore StatementbyAnthonyP.Thirlwall StatementbyCarlosFortin StatementbyHeinerFlassbeck evolvingissuesininternationaleconomicgovernance introductoryremarksbyAndrewCornford StatementbyJomoKwameSundaram StatementbyArturoo’Connell Thewayforward ClosingremarksbyAlfredoCalcagno Summaryofthedebate

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Trade and Development Report, 2015184

rethinking development strategies after UnitedNationspublication,salesno.e.15.ii.D.9the Financial Crisis iSbN978-92-1-112894-9Volume I: Making the Case for Policy Spaceeditedby AlfredoCalcagno,SebastianDullien,AlejandroMárquez-Velázquez,NicolasMaystreandJanPriewe

Introduction AlfredoCalcagnoRethinking Development Strategies after the Global Financial CrisisJanPrieweSeven Strategies for Development in ComparisonericHelleinerRestoring the Development Dimension of Bretton WoodsVeerayoothKanchoochatThe Middle-Income Trap and East Asian Miracle LessonsRobertH.WadeThe Role of Industrial Policy in Developing CountriesRobertoFrenkelandMartínRapettiThe Real Exchange Rate as a Target of Macroeconomic PolicyRachelDenaeThrasherandKevinP.GallagherDefending Development Sovereignty: The Case for Industrial Policy and Financial Regulation in the Trading Regime

the Financial and economic Crisis of 2008-2009 UnitedNationspublication,salesno.e.11.ii.D.11and developing Countries iSbN978-92-1-112818-5editedbySebastianDullien,DetlefJ.Kotte,AlejandroMárquezandJanPriewe

Introduction

the Crisis – transmission, impact and special FeaturesJanPrieweWhat Went Wrong? Alternative Interpretations of the Global Financial CrisisDanielaMagalhãesPratesandMarcosAntonioMacedoCintraThe Emerging-market Economies in the Face of the Global Financial CrisisJörgMayerThe Financialization of Commodity Markets and Commodity Price VolatilitySebastianDullienRisk Factors in International Financial Crises: Early Lessons from the 2008-2009 Turmoil

the Crisis – Country and regional studieslaikeYangandCorneliusHuizengaChina’s Economy in the Global Economic Crisis: Impact and Policy ResponsesAbhijitSenGuptaSustaining Growth in a Period of Global Downturn: The Case of IndiaAndréNassifBrazil and India in the Global Economic Crisis: Immediate Impacts and Economic Policy ResponsesPatrickN.osakweAfrica and the Global Financial and Economic Crisis: Impacts, Responses and Opportunities

Selected UNCTAD Publications 185

Thesepublicationsmaybeobtainedfrombookstoresanddistributorsthroughouttheworld.ConsultyourbookstoreortheUnitedPublicationsSalesandMarketingoffice,300e42ndStreet,9thFloor,iN-919JNewYork,NY10017,UnitedStates;tel.:+12129638302,fax:+12129633489,e-mail:publications@un.org,https://unp.un.org.

the global economic Crisis: UnitedNationspublication,salesno.e.09.ii.D.4systemic Failures and multilateral remedies iSbN978-92-1-112765-2Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation

Chapter i AcrisisforetoldChapter ii Financialregulation:fightingtoday’scrisistodayChapter iii ManagingthefinancializationofcommodityfuturestradingChapter iV exchangerateregimesandmonetarycooperationChapter V Towardsacoherentefforttoovercomethesystemiccrisis

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looking Forward – policy agendaAlejandroMárquezThe Report of the Stiglitz Commission: A Summary and CommentRicardoFfrench-DavisReforming Macroeconomic Policies in Emerging Economies: From Procyclical to Countercyclical ApproachesJürgenZattlerA Possible New Role for Special Drawing Rights In and Beyond the Global Monetary SystemDetlefJ.KotteThe Financial and Economic Crisis and Global Economic Governance

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Trade and Development Report, 2015186

regional monetary Cooperation and growth-enhancing policies: the new challenges for latin america and the CaribbeanUnitedNationspublication,UNCTAD/GDS/2010/1

Chapter i WhatWentWrong?AnAnalysisofGrowthandMacroeconomicPricesinlatinAmerica

Chapter ii RegionalMonetaryCooperationforGrowth-enhancingPolicies

Chapter iii RegionalPaymentSystemsandtheSUCReinitiative

Chapter iV PolicyConclusions

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price Formation in Financialized Commodity markets: the role of informationUnitedNationspublication,UNCTAD/GDS/2011/1

1. MotivationofthisStudy

2. PriceFormationinCommodityMarkets

3. RecentevolutionofPricesandFundamentals

4. FinancializationofCommodityPriceFormation

5. FieldSurvey

6. PolicyConsiderationsandRecommendations

7. Conclusions

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Thesepublicationsareavailableonthewebsiteat:http://unctad.org.CopiesmaybeobtainedfromthePublicationsAssistant,MacroeconomicandDevelopmentPoliciesbranch,DivisiononGlobalizationandDevelopmentStrategies,UnitedNationsConference onTrade andDevelopment (UNCTAD), Palais desNations,CH-1211Geneva 10,Switzerland;e-mail:gdsinfo@unctad.org.

Selected UNCTAD Publications 187

UNCTAD Discussion Papersareavailableonthewebsiteat:http://unctad.org.CopiesofUNCTAD Discussion Papersmaybeobtained fromthePublicationsAssistant,MacroeconomicandDevelopmentPoliciesbranch,DivisiononGlobalizationandDevelopmentStrategies,UnitedNationsConferenceonTradeandDevelopment(UNCTAD),PalaisdesNations,CH-1211Geneva10,Switzerland;e-mail:gdsinfo@unctad.org.

unCtad discussion papers

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No.222 July2015 UlrichHoffmann Cangreengrowthreallyworkandwhatarethetrue(socio-)economicsofclimatechange?

No.221 May2015 ericHelleiner internationalpolicycoordinationfordevelopment:TheforgottenlegacyofbrettonWoods

No.220 May2015 MartinFalkandevaHagsten

e-commercetrendsandimpactsacrosseurope

No.219 March2015 PiergiuseppeFortunato,CarlosRazoandKasperVrolijk

operationalizingtheproductspace:Aroadmaptoexportdiversification

No.218 Dec.2014 DanielPoon China’sdevelopmenttrajectory:AstrategicopeningforindustrialpolicyintheSouth

No.217 Nov.2014 YılmazAkyüz internationalizationoffinanceandchangingvulnerabilitiesinemerginganddevelopingeconomies

No.216 April2014 AndrewCornford Macroprudentialregulation:Potentialimplicationsforrulesforcross-borderbanking

No.215 March2014 StephanyGriffith-Jones AbRiCSdevelopmentbank:Adreamcomingtrue?No.214 Dec.2013 JörgMayer Towardsmorebalancedgrowthstrategiesindeveloping

countries:issuesrelatedtomarketsize,tradebalancesandpurchasingpower

No.213 Nov.2013 ShigehisaKasahara TheAsiandevelopmentalStateandtheFlyingGeeseparadigmNo.212 Nov.2013 VladimirFilimonov,

Davidbicchetti,NicolasMaystreandDidierSornette

Quantificationofthehighlevelofendogeneityandofstructuralregimeshiftsincommoditymarkets

No.211 oct.2013 AndréNassif,CarmemFeijóandelianeAraújo

Structuralchangeandeconomicdevelopment:isbrazilcatchinguporfallingbehind?

No.210 Dec.2012 GiovanniAndreaCorniaandbrunoMartorano

Developmentpoliciesandincomeinequalityinselecteddevelopingregions,1980–2010

No.209 Nov.2012 AlessandroMissaleandemanuelebacchiocchi

Multilateralindexedloansanddebtsustainability

No.208 oct.2012 DavidbicchettiandNicolasMaystre

Thesynchronizedandlong-lastingstructuralchangeoncommoditymarkets:evidencefromhighfrequencydata

No.207 July2012 AmeliaU.Santos-Paulino

Trade,incomedistributionandpovertyindevelopingcountries:Asurvey

No.206 Dec.2011 AndréNassif,CarmemFeijóandelianeAraújo

Thelong-term“optimal”realexchangerateandthecurrencyovervaluationtrendinopenemergingeconomies:Thecaseofbrazil

No.205 Dec.2011 UlrichHoffmann Somereflectionsonclimatechange,greengrowthillusionsanddevelopmentspace

No.204 oct.2011 Peterbofinger ThescopeforforeignexchangemarketinterventionsNo.203 Sep.2011 Javierlindenboim,

DamiánKennedyandJuanM.Graña

Shareoflabourcompensationandaggregatedemanddiscussionstowardsagrowthstrategy

No.202 June2011 PilarFajarnes Anoverviewofmajorsourcesofdataandanalysesrelatingtophysicalfundamentalsininternationalcommoditymarkets

No.201 Feb.2011 UlrichHoffmann Assuringfoodsecurityindevelopingcountriesunderthechallengesofclimatechange:Keytradeanddevelopmentissuesofafundamentaltransformationofagriculture

No.200 Sep.2010 JörgMayer Globalrebalancing:effectsontradeflowsandemployment

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Trade and Development Report, 2015

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