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International Reserve System:
Is it Feasible?


by
Sze Peng Wang
 

 

During the last decade, the world saw some of the most severe economic shocks and crises since The Great Depression of the late 1920’s.  The crises of Mexico in 1994, Russia in 1995, Asian countries in 1997 and even recently in Latin America in 2000 have shown us that the economic shocks have a very drastic and crippling effect on the stricken countries.  Rapid capital outflow; firms and banks overwhelm by bad debts; inability to provide loans; bank closures due to sudden capital losses and devaluation of the home currency, all have struck the affected countries simultaneously that their central banks did not have enough sufficient reserves to protect themselves.  The realization of the poor central bank’s regulation, also aided by the fact that markets throughout the world are now interlinked, quickly caused panic and similar shocks to spread to neighboring countries and even regions.  An international organization, which controls a form of reserve system, could have been the lender of last resort for these sickened countries in their time of need.

A working example of a reserve structure for banks would be the Federal Reserve System currently being used by the United States.  This consists of 12 regional Federal Reserve Banks that is coordinated under one main Board of Governors.  The main roles of the Fed is to issue new currency, administer discount loans to banks, examine the management of local banks and their financial status and provide a system of standardized banking regulations for banks to follow.  Lastly, but most importantly, the Fed acts as a lender of last resort to banks facing financial collapse.[1]  This not only provides stability for consumers but also protects the integrity of the American banking system and prevents bank-runs. A more suitable version for the world would be the European Central Bank, which consists of a executive board and the central bank governors from the 11 Euro nations and is based on the Fed system.  What is most appealing about this version is its independence from political control.  This is so because its charter can only be changed by legislation, where the Maastricht Treaty would have to be altered and have a unanimous agreement from all the signatories of the treaty.[2]


[1] Federal Reserve Bank, Boston 2002, http://www.bos.frb.org

[2] Frederic Mishkin, The economics of Money, Banking, and Financial Markets (New York, 2002), 383

 

Currently there are two international financial institutions which sought of undertake this role, the International Monetary Fund and the World Bank.  The goals of the World Bank are for long term development in countries to reduce poverty by improving a countries investment climate and training its people.[1]  The IMF was establish to promote international monetary cooperation, exchange stability, to foster economic growth with high levels of employment, and to provide temporary financial assistance to countries to help ease balance of payments adjustment.  Both organisations can provide immediate funds to stabilize countries economic crises[2] but their aims are for the long-term health of the economy and not the immediate soothing of shocks with financial remedies.  Their solutions tend to very painful for the citizens of the countries affected and do not take into consideration their present sufferings.


[1] World Bank home page, 2002, <http://www.worldbank.org>

[2] IMF, “About the IMF”, < http://www.imf.org/external/about.htm>

 

Ideally an international reserve organization would be like a “United Nations” for the world’s central banks.  It will be an organisation where central bankers can meet to plan common goals or policies to help stabilise the volatile world economy.  Most importantly it is a place where the central banks would store a required reserve ratio of funds from their own country, in order to form a common pool of funds.  This pool of funds can in turn be used for emergency situations.  Where countries faced a financial crisis and their central banks have no more means to solve their problems.  This organisation can then provide immediate assistance to the affected country to try and damper the crisis.  This will buy some time for the stricken country to hopefully solve its economic woes.  However there must be stringent controls as to how much, the number of times a country can borrow the funds and a time period to do so.  This organization should simultaneously work with others like the IMF and World Bank to help the affected country. 

Ideally an international reserve organization would be like a “United Nations” for the world’s central banks.  It will be an organisation where central bankers can meet to plan common goals or policies to help stabilise the volatile world economy.  Most importantly it is a place where the central banks would store a required reserve ratio of funds from their own country, in order to form a common pool of funds.  This pool of funds can in turn be used for emergency situations.  Where countries faced a financial crisis and their central banks have no more means to solve their problems.  This organisation can then provide immediate assistance to the affected country to try and damper the crisis.  This will buy some time for the stricken country to hopefully solve its economic woes.  However there must be stringent controls as to how much, the number of times a country can borrow the funds and a time period to do so.  This organization should simultaneously work with others like the IMF and World Bank to help the affected country. 

 

A second problem is international banking and specifically who should control them.  With the tremendous growth in international trade and multinational corporations for the past 40 years, banks have also evolved to meet the demands of these customers.  A firm or an individual investing in a foreign country would most likely prefer to deal with their own country’s bank branches in that foreign land than with the indigenous ones.  Agency offices, where lending and transfer of funds within a foreign country is possible, but it cannot accept the deposits of the local people.  This type of bank is normally not under the same regulations that apply to full service banks.  Only a foreign subsidiary bank can be scrutinises by the host country. 

Eurodollar deposits are another form of international banking. These are created when deposits in accounts in the US are transferred to a bank outside the US and kept in dollars.  These are considered “offshore” deposits and are not subjected to such regulations like reserve requirements.[1]  The problem here is who has jurisdiction over these types of banks.  The hosts or the original country? This brings us back to the same problems discussed in the previous paragraph, which are different regulatory methods.  An international reserve organisation would have to worry about this, as the above aspects will also affect the host’s countries economies.


[1] Mishkin, 264-267

 

An example of where an international reserve system would have been useful would have been the Asian economic crisis of 1997.  In the early months of that year, several major firms in Thailand and South Korea declared bankruptcy and defaulted on their foreign debts.  Local financial institutions had lent heavily to these firms begun to experience severe financial difficulties.  In the case of Thailand, their central bank had to loan out $8 billion to prop them up.  Both domestic and foreign creditors experienced substantial losses despite the efforts.  An air of general uncertainty sound fell on the financial markets of Thailand and South Korea, eventually leading to substantial declines in their securities markets.  In Thailand’s case, with the failure of one of their major financial firms, led to a successful speculative attack, that led the central bank to float the Baht downwards.  These speculative attacks soon spread to neighbouring countries and soon Asia was experiencing a full fledge economic crisis.  In additional to the currency crisis, several of the Asian stock markets begun to crash also.  A vicious cycle had started.[1]


[1] Mishkin, 206-207

 

There were several problems here that could have been address to damper the crisis.  An IMF working paper published in August 1998 showed that the most important factor was the speed and magnitude in the turnover of capital flows to the affected countries.  The financial crisis adversely affected investments flowing in, almost stopping suddenly, while the capital outflow tremendous speed.  Simultaneously, commercial bank loans to Asia deteriorated from $55billion net inflow in 1996 to a $21 billion net outflow in 1997.  Many Asian firms as a result could not continue to fund their projects and also were unable to pay off their indebtedness.  Concurrently local banks, that used to lend indiscriminately under government directives, now were reluctant to lend and contributed to a serious credit crunch.[1] Another remark was while these Asian countries managed to place a basic banking infrastructure, operating efficiency had been low due to direct government lending, low supervision, lack of transparency among the corporate sector and other things.


[1] Jorge A. Chan Lau / Zhaohui Chen, “Financial Crisis and Credit Crunch as a Result of Inefficient Financial Intermediation.”, IMF Working Paper, August 1998 http://www.imf.org/external/pubs/ft/wp/wp98127.pdf

 

In order to solve the curb the crisis, banks should have been willing to lend.  However most of them probably did not have enough reserves to risk it.  This is where the central banks should have stepped in to provide the banks with cover to undertake the lending.  An international reserve system could have provided the countries with further cover.  This would help bring confidence to investors that the governments would be able to rectify the problems and probably not have caused such a dramatic capital run.  A key thing that was missing in the Asian crisis was credibility or the lack of one.  A known international organization that will be willing to stand next to the central banks during the crisis; would have gone a long way in promoting both domestic and foreign confidence.

However not everyone agreed to this view.  An article written by Charles Calomiris in the Cato Journal, believed that the IMF bailouts provided in Mexico and Asia were counterproductive.  He believed that the IMF could have best contributed by not insulating domestic or foreign creditors from loss.  He wrote, “The more that developing countries are forced to handle their own financial insolvencies, and the more foreign investors are forced to bear the costs of their investment decisions, the more developing countries will be attracted by benefits of true liberalization.”[1]  Yet, he believed that the IMF and World Bank had several times been successful in helping to identify and give credibility to regimes that are honestly pursuing the path of reform.  The author wrote, “In my view, their expressions of support for these regimes have been more important than the funds they have contributed in support of those reforms.”[2] This highlights the same point I made in the previous paragraph that an international organization, which can give moral support and investor confidence, is what is really needed.

[1] Charles W. Calomiris, “THE IMF'S IMPRUDENT ROLE AS LENDER OF LAST RESORT”, The Cato Journal, 1998 http://www.cato.org/pubs/journal/cj17n3-11.html, Ch. 7

[2] Calomis, Ch. 7

 

Nevertheless, with any idea there are the pros and the cons.  There are several pros that support the creation of an international reserve system.  Firstly, such an organization could provide an immediate aid package, which could help stabilize any economy that seems on the brink of a financial crisis.  It could help the central banks of the affected countries to place a “band-aid” temporarily to buy some time, while allowing them to access the situation and come up with an appropriate solution.  Also the citizens would not have to suffer as greatly, and their plight would not impair or bias the central bank’s decision.  This would not solve the economic problems, as the causes would have been from the fundamentals of their economies.  Yet this will provide a buffer period in order for the IMF and World Bank to come in and conduct proper reforms for the country, and not some short-term solutions.

Secondly, the organization can be like a “Lender of Last Resort” for the central banks of the world.  If the central banks are not capable of providing emergency funds for their consumer banks, the organization can step in to provide emergency relief.  This could prevent bank-runs and the lost of investor confidence.  The latter is most crucial, as sudden capital outflows have shown to further infuriate financial crisis.  Such aid packages would allow the local banks to provide loans and prevent a credit crunch, which is not advisable during a crisis. 

Thirdly, an international reserve system would mean that the world’s central banks would have to agree on some mandate.  This mandate would have to be agreed upon and recognized by all members.  This would lead to a basis of an international standard for banking roles and regulation. It would help to remove confusion and mistrust of foreigners banking overseas.  This is very important especially nowadays with the increased international trade and investments, where having a standard set of regulations would ease the burden of many contract negotiations.  Also making it easier to transfer funds from one country to another.  Also another pro, related to the previous one, is that having the backing of an international organization would improve investors’ confidence in developing nations, as they will have the confidence in investing as they thrust the local banking system.     

 

In a world, where financial markets are integrated and linked by computers, financial stability is of the utmost importance.  The organization would provide the world central banks with a body to communicate and share ideas on how to ensure the steadiness and soundness of the world’s economies.  In a time, where one country’s economic policies will affect its surrounding neighbors, it would allow the nations to brace themselves for any spread of financial crisis and maybe even provide aid for its neighbors.

There are, on the other hand, several problems in the way of forming an international reserve system.  Firstly someone has to provide fair and unbiased leadership for the organization, which will guide the nations with solid advice not lined with political agendas.  Many of the Third World nations would not want a governing body dominated by the industrialized countries, as they might feel their interests are not factored in policy decisions.  While simultaneously, industrialized countries might feel that Third world nations should not be in charge, due to the fact that they won’t be contributing a large majority of the funding and lack appropriate experience and knowledge.

The past decade has seen the growth of regional trade blocs, like NAFTA, ASEAN and EU.  Within these trade blocs, free trade and liberalization policies have occurred.  Unfortunately, these tend to be for member states only, and outsiders still might face trade barriers.  So the idea of free trade is in the minds of most countries, but many still lack the drive and will to carry it out.  Therefore an international reserve system might see regional trading blocs uniting and using their single voice to support policies to benefit themselves and not consider the rest of the world.  For instance the member countries the industrialized countries might not be so readily to give aid to the Third world nations if their own industries might suffer as a result.

 

Also for an international reserve system to work, the organization will need some funds to work with.  Ideally every country would have to provide an equal amount of funds per year, like a yearly fee.  However for everyone to contribute equally would be asking a lot since most countries are at different stages in their economies.  Logically countries should contribute a percentage proportional to their size of their GDP.  The bigger it is, the more they will contribute.  However, this would be unfair to the developed countries, which have worked hard to get where they are.  Countries might not want to see their hard-earn reserves used for solving other countries’ problems, which they had no part in causing.

Another problem is deciding what course of action is needed to help a country during any financial crisis.  Because of its volatility and unpredictability, there are no written procedures to follow.  Deciding how much aid to give and duration of the aid period are some problems that might be faced.  Also, there must be a way of ensuring that the funds given as aid are use properly and not placed into some official’s coffers.   The new financial institutions also posed another predicament for the international reserve system.  Securities markets, mutual funds, hedge funds, venture capitalists and other new forms of money making methods also played a an important part in the creation of the world’s financial crises.  However, with the ideas of economic liberalization, controlling them would go against this theory.  Not too mention the impossibility and futility of doing so.  Other problems like international bank subsidiaries and Euro banks where already mentioned previously

Overall, despite the numerous difficulties that will arise in the creation of a world reserve system, I still believe it is an essential tool in the stability of the world’s economy.  It will also help to aid in increasing the confidence of many developing countries’ economies, attract trade and provide a basis for which to standardize the banking procedures of the world. 

 

List of References:

1)      Asli Demirgüç-Kunt and Enrica Detragiache, “The Determinants of Banking Crises: Evidence from Developed and Developing Countries”, May 1997 http://www.worldbank.org/html/dec/Publications/

Workpapers/WPS1800series/wps1828/wps1828.pdf

2)      Benton E. Gup, Bank Failures in The Major Trading Countries of The World (London : Quorum Books, 1998)

3)      Charles W. Calomiris, “THE IMF'S IMPRUDENT ROLE AS LENDER OF LAST RESORT”, The Cato Journal, 1998 http://www.cato.org/pubs/journal/cj17n3-11.html

4)      Ethan B. Kapsten, Governing the Global Economy (Cambridge: Harvard University Press, 1994).

5)      Federal Reserves Bank, Boston web site, http://www.bos.frb.org

6)      Frederic S.Mishkin, The economics of Money, Banking and Financial Markets (New York : World Student Series, 2003)

7)      Jorge A. Chan Lau / Zhaohui Chen, “Financial Crisis and Credit Crunch as a Result of Inefficient Financial Intermediation.”, IMF Working Paper, August 1998 http://www.imf.org/external/pubs/ft/wp/wp98127.pdf or http://www.imf.org/external/pubs/CAT/longres.cfm?sk=2738.0

8)      IMF web site, http://www.imf.org

9)      The Asian Crises, http://faculty.washington.edu/karyiu/Asia/papers/index.htm

10)  Works in International Monetary Fund-Financial Medic to the World?, ed.  Lawrence J. McQuillan and Peter C. Montgomery (Stanford: Hoover University Press, 1999)

11)  World Bank web site, http://www.worldbank.org

 

 

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