In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. To ensure stable and sustainable growth, the international rules of the game need to be revisited.
It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have. Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle, Rajan stated.
According to him, emerging economies have to work to reduce vulnerabilities in their economies, to get to the point where, like Australia, they can allow exchange rate flexibility to do much of the adjustment for them to capital inflows. But the needed institutions take time to develop. In the meantime, the difficulty for emerging markets in absorbing large amounts of capital quickly and in a stable way should be seen as a constraint, much like the zero lower bound, rather than something that can be altered quickly. Even while resisting the temptation of absorbing flows, they will look to safety nets.
So another way to prevent a repeat of substantial reserve accumulation is to build stronger international safety nets. As the financial crisis suggested, this is not just an emerging economy concern. In a world where international liquidity can dry up quickly, the world needs bilateral, regional, and multilateral arrangements for liquidity. Multilateral arrangements are tried and tested, and are available more widely, and without some of the possible political pressures that could arise from bilateral and regional arrangements. Indeed swap arrangements can be channelled through multilateral institutions like the IMF instead of being conducted on a bilateral basis, so that the multilateral institution bears any (small) credit risk, and the source central bank does not have to justify the arrangements to its political authorities.
Perhaps equally valuable would be a liquidity line from the IMF, where countries are pre-qualified by the IMF and told (perhaps privately) how much of a line they would qualify for under current policy - with access limits revised every Article IV and any curtailment becoming effective 6 months later. Access to the line would get activated by the IMF Board in a situation of generalized liquidity shortage (as, for example, when policy tightening in source countries after an extended period of low rates causes investment managers to become risk averse). The IMF has suggested such arrangements in a discussion paper, and they should be explored because they allow countries access to liquidity without the stigma of approaching the Fund, and without the conditionality that accompanies most Fund arrangements.
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Clearly, the Fund's resources will be safe only if the situation is one of genuine temporary illiquidity rather than one where countries need significant reforms to regain market access. Equally clearly, access will vary across countries, and prolonged use after the liquidity emergency is declared over will necessitate an IMF program. Nevertheless, the twin proposals of the Global Stability Mechanism and Short-term Liquidity Line that the IMF Board has examined in the past deserve close examination for they come closest to genuinely helping offset reserve build-up.
Finally, it would be a useful exercise for the Fund, in a period of growing vulnerability to capital flow reversals, to identify those countries that do not have own, bilateral, regional, or multilateral liquidity arrangements to fall back on, and to work to improve their access to some safety net. The role of honest ex-ante marriage broker may be one that could prove to be immensely important when the interest rate environment changes.
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