Quest for global 'rules of the game'
by Claudio Borio
The dollar’s dominance in the international monetary and financial system is indisputable, even though it not quite a monopoly. Its role has not declined much over the past decade or so, despite the waning US share of world output, which is now down to only one quarter.
The dollar’s gravitational pull, in turn, has a deep influence on the denomination of countries’ assets and liabilities and, hence, also on foreign exchange reserve composition, as it determines a portfolio’s sensitivity to exchange rate fluctuations.
There is a clear positive relationship across countries between these shares and the degree to which currencies co-move with the dollar. The dollar is involved in around 90% of all foreign exchange transactions and accounts for some 60% of official reserves as well as debts and assets outside the US.
It has a similar weight as a gravitational force for other currencies, and only a slightly smaller one as the currency of choice in the denomination of trade. The euro is a distant second, with weights ranging between one fifth and one third, and has a more regional character (see charts, below).
This dominant role, coupled with the depth and breadth of US financial markets, underpins the well-documented asymmetric influence of US monetary and financial conditions on the rest of the world. US asset prices, such as bond yields, tend to lead those in other economies. Furthermore, US monetary policy tends to have an influence on monetary policy elsewhere, over and above domestic conditions.
Two related concerns
One currency’s international dominance gives rise to two related concerns. The first is that the ‘asymmetries’ involved may exacerbate the tension between the interests of the dominant country, on the one hand, and those of the system as a whole, on the other. That is, the country appears to project its influence on the rest of the world, which cannot in any sense insulate itself.
The other, more central, problem could be called the Achilles heel of the international monetary and financial system: it does not have an effective anchor for monetary and financial stability. The system is thus unable to prevent the build-up and unwinding of hugely damaging financial imbalances through outsize financial cycles – circumstances reflecting what has been called excess financial ‘elasticity’.
More pluralism does not seem the answer to the main problem. True, it may impose greater discipline on the dominant country. Greater choice must surely help. But more pluralism, per se, does not address the absence of a global anchor.
Take the IMF's special drawing right as an example. Even if the SDR was placed at the system’s centre, what would anchor the SDR? Short of creating a supranational central bank that operated in SDR, this would require an explicit link to national monetary policies; otherwise, the SDR would simply remain an additional instrument with but a limited impact on global financial conditions, at least in tranquil times.
We should note, for instance, that the European currency unit acted as a common reference for exchange rate adjustments in the European Monetary System, the forerunner of economic and monetary union, although even then the system was far from symmetrical, with the D-mark playing the main anchor role.
Solutions to the possible destabilising effects of the present international constellation need to focus less on addressing current account imbalances and more on financial imbalances. That is, they need to focus more on gross capital flows (and the corresponding stocks) than on net flows (see chart below). In any case, gross capital flows dwarf current account balances.
Net flows are the tip of the iceberg. A focus on current accounts could be counterproductive. In particular, one should beware of recommending expansion in surplus countries exhibiting signs of financial imbalances. This is what happened in Japan in the late 1980s, contributing to the subsequent crisis. More recently, the international community encouraged China’s post-2008 credit-fuelled expansion – an expansion that lies at the heart of some of the debt challenges the country is now facing.
As these examples indicate, strong credit booms, including some of the most disruptive ones, have also occurred in current account surplus countries. Further back in history, the experience of the US ahead of the great depression is a famous example.
One further element of a solution is the requirement for stronger anchors for domestic regimes and their interaction. There is scope to improve international crisis management arrangements. But an ounce of prevention is worth a pound of cure. And, while putting one’s house in order is essential, it is not enough; there’s a need to put the global village in order.
Domestically, this means more systematic tackling of financial booms and busts through monetary, prudential and fiscal policies, strongly supported by structural policies.
The key is to have policies that are more symmetrical over booms and busts, mitigating these extremes without the risk of running out of policy room for manoeuvre. This means better internalising the possible international repercussions of national policies (including those reverberating back to the originating country).
The international community could envisage three possible sets of action for a more stable international system, ranked on a scale of increasing ambition.
At a minimum, enlightened self-interest, based on a thorough exchange of information, should be feasible. This would mean that, when setting domestic policies, countries would individually seek to take international repercussions more systematically into account. Large jurisdictions that are home to international currencies have a special responsibility. Going one step further, co-operation could extend to occasional joint decisions, on both interest rates and foreign exchange intervention, beyond the well-honed responses seen during crises. The third, most ambitious possibility would be to develop and implement new global rules of the game that would help instil greater discipline in national policies.
Based on this analysis, the international community is still a long way from finding adequate solutions. Progress has been substantial in the prudential domain. But much more is needed regarding monetary regimes. Even at the national level, it is difficult to incorporate systematically financial stability considerations, which are generally left to prudential policy. These problems are compounded at the international level.
The preconditions for progress are consensus on diagnosis, which would put financial imbalances at the heart of the problem, as well as a strong sense of urgency and shared responsibility internationally. At present, neither precondition is met.
Claudio Borio is Head of the Monetary and Economic Department at the Bank for International Settlements. This is an abridged version of the author's introductory speech at the Swiss National Bank-IMF conference 'Towards a system of multiple reserve currencies' in Zurich on 10 May. Back