By any reckoning, the global financial system is once again in turmoil. A couple of years ago, after the sub-prime fiasco, it was the US that was in trouble, and there were serious doubts about the future of the dollar as a reserve currency. Today, it is the euro, the currency of the European Union (EU), that is facing a crisis because of the acute fiscal problems of Greece and some other European countries.
In the wake of the US crisis, and now the so-called “Euro-mess”, there has been a lot of talk about an urgent need for financial and regulatory reforms. However, nothing much has happened. Presidents, prime ministers and finance ministers have met in various fora like G-20, OECD, the International Monetary Fund (IMF) and the World Bank, and expressed their grave concerns. However, except for rescue packages for individual countries in trouble, a global programme of action is still lacking.
In this context, it is useful to recall that this was also the case in the 1990s. The decade, in fact, saw many more financial crises than the previous five decades since the Great Depression. In addition to East Asia and Russia, other countries across the world, like Argentina, Brazil, Mexico and Turkey, were also badly affected.
As is the case now, exchange rates of major currencies like the dollar, the euro and the yen were highly volatile, and capital flows had become unstable and unpredictable. There were innumerable meetings among leading countries with the objective of setting stronger standards and codes, and putting in place a more sustainable exchange rate regime. But then, as now, nothing much happened — except “bailout” packages for the affected countries.
One major difference between the situation in the 1990s and the present one is that the most affected countries back then were developing nations and countries in Eastern Europe. Financial systems in industrialised countries, on the other hand, were generally considered to be safe. Today, barring nations like China and India, all major countries of the world are experiencing problems and calling for urgent global reforms.
Where do we go from here? It is important to recognise that, irrespective of what political leaders from different parts of the world say in their public speeches or communiqués, each country is likely to do what it considers to be best for itself. This is perhaps as it should be. In this background, the primary objective of global financial reforms should be to develop transparent “rules” of financial transactions among sovereign countries to promote international trade, commerce and capital flows. For the present, it may also be useful to concentrate on some “basics”, rather than trying to cover the whole field.
In view of constraints of space, let me just mention a few reforms that should be put in place as soon as possible.
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First and foremost, it is important to agree on a globally acceptable exchange rate system. At present, there is significant volatility in the exchange rates of major currencies, particularly the dollar, the euro and the yen. Different countries follow different systems, ranging from freely floating exchange rates to declared or secret crawling pegs, with or without a band. One possible approach is to have a “dual” exchange rate system — one for three or four major currencies (selected in terms of their percentage share in currency transactions), and one for the rest of the world. Exchange rates among the top three or four currencies may be “fixed” but adjustable by agreement to reflect major changes in global trade. For the rest, currencies may be “pegged” or “floating” as a particular country decides. A similar system needs to be put in place for countries in the eurozone, with appropriate variations for a Union of independent states.
Second, an upper limit should be fixed for permissible levels of both fiscal and current account deficits as percentage of GDP. If a country exceeds that level, it should come under surveillance and scrutiny of an international financial agency like IMF.
Third, banks that are too big to fail, and whose international assets and/or deposits are more than “X” per cent of total global assets/deposits, should remain banks. They should not be permitted to issue other kinds of securities, which effectively “create” money without adequate deposits. Their minimum reserves-to-deposit ratios may be fixed by global consensus.
Fourth, profits or capital gains of foreign institutional investments (FIIs) and reversible capital flows of less than one year should be taxed at the same rate as domestic corporate profits.
Fifth, investment banks should be just that — they should be free to advise and raise funds for their clients, but they should not be permitted to issue securities (backed by other institutions’ securities).
Finally, Articles of Agreement of Bretton Woods financial institutions —IMF and the World Bank — should be completely overhauled. IMF should have the primary responsibility for surveillance of agreed financial rules and procedures, and for issuing an annual report on compliance. It should also assume the role of a “rating agency” for stability and transparency of the financial system of its members. The World Bank, on the other hand, should go back to its original role as a guarantor of loans raised by member countries from commercial sources. Direct lending should be confined to the International Development Association, its soft-loan arm.
These are a few aspects of the global financial system that require urgent attention. There is plenty of room to add or make changes in the above list. What is needed now is to convene a Bretton Woods II with experts and representatives of major industrial and developing countries, and agree on a programme of action. Perhaps India and China, two emerging powers of the 21st century, could take a lead in developing a global consensus as early as feasible.
The author is chairman, Centre for Development Studies and former Reserve Bank of India Governor