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Global financial safety net: A three tier approach


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  • 1. Policy Paper Global Financial Safety Net: A three tier approach By: Adriyanto Introduction For emerging economies, like Indonesia, the recent global financial crisis has given a lesson the quick spread of crisis despite their strong economic foundation and has had serious cost to economic growth. The sudden capital flow reversal along with liquidity crisis have resulted in unprecedented levels of market volatility, which have significantly affected the ability to meet liquidity needs, access to capital and cost of capital. Back to Asian financial crisis in 1997, weak financial regulation and economic fundamentals were associated with the triggers of crisis (Zhuang and Dowling, 2002). The recent crisis demonstrated that countries with stringent economic policies and economic fundamental could not escape from the impact of capital flight. This lesson has alerted emerging countries the need to strengthen their financial position in managing the impact of the sudden capital reversal. The weakened global demand has adversely affected emerging countries’ export performance; this situation was exacerbated by the huge capital outflow. Mitigating the severe currency depreciation, as a first step, countries relied on the international reserve as the first line of defense. However, the reserve has limitation to tackle the impact of capital flight and may end up with reserve drain. In response to weakening domestic currency, countries requested bilateral swap lines with other major central banks. Indonesia set up a swap line with China’s central bank during the peak of crisis. In addition, some International Financial Institutions (IFIs) MDB has key role in facilitating stand-by loan to help countries cope the financial volatility, such as Flexible Credit Loan (FCL) from IMF and Deferred Drawdown Option (DDO) from World Bank‘. Regional cooperation was also strengthened through setting up a crisis response facility. In South East Asian, the Chiang Mai Initiative Multilateralisation (CMIM), which is basically a 1 Indonesia officially agreed on US$5.5 billion of loans from Australia ($1 billion), World Bank ($2 billion) through DDO, ADB ($1 billion) and Japan (available as $1.5 billion-worth of guarantee on the yen-denominated bonds the government plans to sell — Samurai bonds).
  • 2. multilateral swap contract among ASEAN member economies, was one of the regional arrangement took place during the crisis. Against this background, the G—20 is seeking ways to strengthen the global financial structure by setting up a global financial safety net. It is imperative that countries facing financial shock need to resort a reliable resource for external financial safety nets to cushion the adverse impact of financial shock. Given the high cost of accumulating reserves, there needs to build up additional insurance as a global safety net, to prevent the recurrence of instability in currency markets. Several mechanisms are already present with their drawbacks, which particularly focus on balance of payment crisis. During the time of crisis, affected countries suffer from twin deficit, therefore the efforts to manage the crisis needs to address both balance of payment crisis and budget safety. Impact of Financial Crisis on Indonesia Despite the clear sign of crisis in the US and other developed countries, Indonesia, even until September 2008, was still in sound economic situation. The growth rate was recorded 6.1% (year on year). Although export declined, import of capital goods was still increasing, which suggests that some investment activities were still taking place. However, the fourth quarter of 2008, worrying signs were detected everywhere from financial sector to real sector of the economy. The impact of global crisis starts affecting Indonesian economy. Following is the impact of crisis on selected sectors: Impact on Trade. ‘ Total cxpoit value in January 2009 declined to 17.70% against to December 2008 and declined to 36% compared to January 2008. The deteriorating export performance was also followed by import which in January 2009 declined to 17.63% compared to December 2008 and reached to 44% ( month on month). Export to trade partners has dropped on a yearly basis: 41% to ASEAN, -16% to EU and -33% to Japan.
  • 3. Impact on capital flows During the last three months of 2008, a massive self—off of government bonds and Central bank certificates resulted in financial account of BOP in deficit. Net Portfolio investment turned into negative. In the 2"‘! quarter of 2008, capital inflow from portfolio investment was around US$ 4 billion, in the 4“' quarter; massive capital outflow took place, around of US$ 4.4 billion. During 2008, the Indonesia Stock Exchange (ISX) index also experienced massive fluctuations due to foreign investor worries (at the time, foreign investors accounted for almost 60% of total market capitalization in Jakarta). At the end of 2008, the ISX index recorded a 51.17% drop. Market capitalization for equity at the end of year fell by 46.42%. International reserve dropped to 15%. In July 2008, our reserve was recorded US$60,6 billion, and dropped to US$ 51,6 billion in December 2008. Impact on Currency and Bond yield The loss of appetite from investor has pushed down the government securities price. Rupiah’s depreciation against dollar reached 16.9% of its value and up to 2 March 2009 it had already depreciated almost 10% from its value at the beginning of the year which produced another blow for Indonesian financial shock. Given the situation, the investor demanded higher yields. The yield spread (Indonesia’s global bonds and US Treasury note) increased from 411 basis points at the end of September 2008 to 716 at the end of the year. After all, inflation for 2008 was recorded at 11.06% (year-on-year). This was the highest annual rate in the past three years (2006: 6.6% and 2007: 6.59%). Existing Global Financial Safety Net G20 paper about Global Financial safety net generally defines it as systems, tools, mechanism or arrangement which assists countries to cope with extemal shock that lead to sudden swing in capital flows and cause financial volatility, including liquidity crisis. Regardless the fonrr, the premier purpose of this facility is to provide financial bumper for countries facing financial crisis which particularly due to capital flight. In general, the existing facilities classified as global or regional financial safety net can be classified into three types: institutional, bilateral and regional arrangement. To help countries 3
  • 4. with very strong fundamentals, policies, and track records of policy implementation mitigate the adverse impact of financial crisis, IMF introduced Flexible Credit Line (FCL)2 in March 2009 as an effort to prevent recurrence of FX crisis in emerging markets. On the ground, many countries, especially Asian countries are reluctant to use this facility due to the stigma issue. Since its inception, three countries (Mexico, Poland and Colombia) have accessed FCL. The amount offered is 47 billion USD for Mexico, 21 billion USD for Poland, and 11 billion USD for Columbia. In addition to the stigma issue, the uncertainty of availability issue has been a concern for many emerging countries to benefit from FCL.3 Bilateral financial arrangement during the crisis was dominant during crisis and took place in the form of currency swap between central banks. Leaming from experience in Korea and Indonesia, the investor’s confidence critically needs to be maintained. The Chinese central bank’s currency swap and the US Federal Reserve's credit swap during the crisis times with Korea has calmed the market and sticcessfully absorbed the financial market volatility. The same thing happened in Indonesia, the $5.5 billion commitment from World Bank. ADB, Japan and Australia has improved market’s perception on Indonesia's economic soundness and signaled to mar. ket that Indonesia did not have problem. Given the nature of currency swap which does not guarantee the sustainability and availability, some countries still deem this facility is quite inaccessible. Aizenman, Jinjarak and Park (2010) show that there is only a limited scope for swaps to substitute for reserves. The selectivity of the swap lines indicates that only countries with significant trade and financial linkages can expect access to such ad hoc arrangements, on a case by case basis. Various country groups have set up regional financing arrangements, a sort of reserve pooling arrangements, to provide insurance to members facing external shocks. Such arrangements include the bilateral swap lines under the Chiang Mai Initiative in Asia and the Latin American Reserve Fund, EU Balance—of—Payments (BOP) Facility, and Arab Monetary Fund (AMF). The regional financial arrangement has demonstrated an important role in the crisis response in 2 FCL arrangements would be approved for countries meeting pre-set qualification criteria. Access under the FCL would be determined on a case-by-case basis. Disbursements under the FCL would not be phased or conditioned to policy understandings as is the case under a traditional Fund-supported program. This flexible access is justified by the very strong track records of countries that qualify for the FCL, which give confidence that their economic policies will remain strong. 3 FCL is open for a year and rollover of FCL may not be always warranted
  • 5. Eastern Europe. The €50bn EU Balance—of—Payments (BOP) Facility for Hungary, Latvia and Romania, have contributed to stabilizing market expectations and underpinning confidence in all three countries. The regional arrangement in Asia is the Chiang Mai Initiative Multilateralisation (CMIM) which comes into effect on the 24th of March 2010. The total size of the CMIM is USD 120 billion with the core objectives (i) to address balance of payment and short~term liquidity difficulties in the region. and (ii) to supplement the existing international financial arrangements, the CMIM will provide financial support through currency swap transactions among CMIM participants in times of liquidity need. Each CMIM participant is entitled, in accordance with the procedures and condi. ti. ons set out in the Agreement, to swap its local currency with the US Dollars for an amount up to its contribution multiplied by its purchasing multiplier. China, Japan and Korea contributed 80 per cent of the total CMIM’s contribution ten ASEAN members contribute the remaining 20 per cent. Currently, under this initiative member countries can access the first 20 per cent of maximum swap amount without an IMF program, while the remaining is conditional on adopting a Fund supported program. Review of Literature Countries have relied upon intemational reserve as fist line of defense to tackle the impact of financial shock. Over decades, developing economies in Asia have significantly building up reserve. Figure—l below shows a significant upward trend of reserve accumulation in Developing Asia. Figure-1: Ratio of Foreign Exchange reserve to GDP, Developing Asia, 1990-2008 o.4s 0.35 0.25 0.‘! 5 0.05 1 990 1 992 ‘I994 ‘I996 1998 2 D00 2002 2004 2006 2008
  • 6. Sources: Park and Estrada (2009) Developing Asia’s reserves—GDP ratio rose from 13.1% in 1990 to 21.9% in 2000 and further to 40.2% in 2008. The contribution of China is significant and the reserve build—up is a region-wide phenomenon. Table 1 lists the region’s top 10 reserve holders as of the end of 2008. Table 1: Developing Asia’s Top 10 Reserve Holders, 31 December 2008 N0- Country Stock of Foreign Exchange Reserves (billion US$) 1. China 1945 2. China, Taipei 292 3. India 247 4. Republic of Korea 200 5. Hong Kong 132 6. Singapore 174 7. Thailand 1 03 8- Malaysia 91 9. Indonesia 49 10. Philippines 33 Sources: Park and Estrada (2009) Noyer (2007) indicated world foreign exchange reserves have surged from US$ 2 trillion in 2001 to an unprecedented US$ 5 trillion in early 2007, and of this total, the share of emerging Asia has risen from US$ 600 billion to more than 2 trillion. Several drivers motivate the reserve accumulation (Noyer, 2007): Insuring against shocks Originally reserve accumulation in emerging economies was encouraged by crisis—insurance motives. During the 1990’s crisis, official reserves were quickly depleted, emerging economies rapidly rebuilt their foreign assets in order to contain further speculative attacks, and be able to better absorb the shocks of abrupt stops in capital inflows. The recent financial crisis has shown that official reserve is effective instrument, at the first stage, to cope with capital volatility, at least initially. A deterrent against speculative attacks
  • 7. It is argued that the probability of a speculative attack may be considerably lowered by the reserve accumulation policy. Despite the absence of agreement of the optimum level of foreign reserve, the experience of Asian crisis arguably indicates the speculator had attacked the financial market and deepens the financial shock. Foreign reserves as a policy tool for growth The current global imbalances may provide an explanation of export led growth strategies in Asian countries and other regions. By deliberately maintaining undervalued exchange rates, export surged while providing current deficit for dominant importing countries, such as in the US. In the literature, several general rules of thumbs require level of forex reserves as “three months of imports” rule. The “Greenspan—Guidotti” rule thus recommends that reserves should enable full coverage of total short-term extemal debt in order to be able to pay back that debt in event of sudden stops, when capital flight occurs or when foreign lenders do not roll-over their loans facility. Despite the importance of the strong availability of foreign reserve as the first line of defense, excessive accumulation may lead to some consequences, not only benefits but costs as well. The three major costs of reserve accumulation are inflation, fiscal costs, and higher interest rate (Park and Estrada, 2009). A central bank’s issuance of domestic currency to purchase foreign currency increases the monetary base, which in turn leads to inflation. In order to sterilize the inflationary impact of reserve accumulation, a central bank may issue bonds, i. e., domestic liabilities, in exchange for currency in circulation, withdrawing domestic liquidity in the process. However, sterilization may entail a fiscal burden if the interest rate a central bank pays on its outstanding bonds exceeds the interest rate it earns on its foreign reserve assets. Sustained accumulation will eventually lead to a higher interest rate since there is a limit to the general public’s desire for sterilization bonds. Moreover, excessive build up of reserves can harm growth. The reserves could be used to spend on higher retum activities such as infrastructure investment rather than being accumulated.
  • 8. Mechanism for Global Financial Safety Net International reserve is unarguably premier instrument for emerging countries to tackle the financial shock resulting from sudden capital reversal. The persistent and massive capital outflow would lead to dry up reserve and trigger economic crisis. Containing the possibility of further impact, affected countries need second tier of defense through bilateral swap, regional arrangement or IMF. Regardless the drawback of each channels, they still cater economies effectively and timely in response to crisis. Therefore, a regional arrangement using the three channels shall serve as the second tier of crisis defense for countries affected4. Since fiscal crisis accompanies BOP crisis, Multilateral Development Banks (MDBS) should be involved in providing assistance for fixing the fiscal crisis for developing countries. When possible, all regions set up regional arrangement as the second tier of defense against financial shock. The globalized economy has eased contagion effect spreading to other economies, even fundamentally strong economies. Experience in Europe indicates economies must work together to successfully tackle the impact of financial shock and existing regional arrangements can work together. Third tier is multi regional arrangement or global regional arrangement which can be a type of GFSN. The institutionalized global arrangement on financial cooperation would require other regional arrangement to come to assist when fund insufficiency occurs in another regional arrangement. In addition to relying upon IMF’s contribution, another regional arrangement can come to assist in supplying additional capital to close the gap. Principles in Global Financial Safety Net Coping with the impact of financial shock, various parallel measures must be taken, ranging from strengthening financial regulation to measures to safeguard market confidence. Several 4 Korean G20 paper on FSN proposes that countries experiencing problems, could pick the facility that best serves their specific needs. The IMF facilities, what is referred as global FSNs, are more effective when it comes to sufficiency of financing resources, but lack certainty and, are plagued by their perceived stigma. Regional pooling arrangements, a regional FSNs, are desirable stigma—free tools, but their financial resources can be quite limited in many cases. Finally, bilateral arrangements proved their effectiveness during the last global crisis. They don‘t carry much of a stigma and play well in terms of market perception, but countries can never be assured of access to the swaps because of their extremely ad-hoc and political nature.
  • 9. empirical studies demonstrated that capital flight has not only been motivated by profit motive or spread difference, as Vespignani(2008) argues that saving rate has been a trigger for capital flight in Latin American countries. Several studies demonstrated the various determinants of capital flight. Dooley (1989) argued that capital flight can be explained by differences in risk perception, this finding is supported by Alam and Quazi (2003) posit that political instability is the single most significant cause of capital flight from Bangladesh. Therefore, the financial safety net should have sufficient capital to meet countries’ request. This facility shall be able to send positive signal that countries concerned are still in sound situation and calm market during economic turbulence. The financial crisis has triggered balance of payment crisis which further caused a twin deficits. The weakened global demand and capital outflow cause current account deficit in many emerging economies. The illiquidity in the financial market caused rising financing cost, and govemment were forced to borrow or sell securities with higher yield due to market’s negative perspective. The widening budget deficit would induce higher interest rate in response to stimulate capital inflow and improve the current account. On the other hand, higher interest rate leads to higher capital cost and add more cost for real sector. This situation ultimately leads to slow economic growth. Therefore, in the time of crisis, it is necessary for countries to have financial buffer for addressing budget deficit. The facility under financial safety net should also address the stressed budget6. 5 Twin deficit hypothesizes that a large budget deficit leads to a large current account deficit. The theory argues as follows: Y = C + I + G + NX, where Y represents GDP, C is consumption, I is investment, G is government spending and NX represents net exports. Another equation defining GDP using alternative terms is Y = C + S + T, where Y is again GDP, S is savings, and T is taxes. This is because national income is also equal to output, and all individual income either goes to pay for consumption (C), to pay taxes (T), or becomes savings (S). Since Y = C + I + G + NX, and Y= C+S+ T, then C+l+G+NX= C+S+T, which simplifies to (S-1)+(T—G)= (X—M), If(T-G) is negative, we have a budget deficit. Now, assume an economy already at potential output, meaning Y is fixed. In this case, if the deficit increases, and savings remains the same, then this last equation implies that either investment (I) must fall or net exports ()(-M, or NX) must fall, causing a trade deficit. Hence, the twin deficits. 6 A fiscal crisis is, in general, a typical cause of classical balance of payment (BOP) crisis. It is expected that fiscal deficits have to be financed by issuing money. Fiscal deficits are expected to lead to easy monetary policy, inflation and, in turn, depreciation of the currency. The Greek fiscal crisis is also atypical classical BOP crisis. The consequences do not just arise in the event that the fiscal deficits are financed from printing of money. Domestic financing through issuance of government bonds and bills can have similar negative implications. Domestic bond financing can raise interest rates, crowd out private investment, and raise expectations about fiscal sustainability that impact private activity.
  • 10. To contain deepening crisis, robust corrective measures must be taken when negative signals have been spotted. Before the turbulence becomes more destructive, there needs to take preventive actions. This facility must serve crisis prevention and countries have flexibility to employ the money in response to preventive measures. This is obviously necessary that the safety net is not aimed to help countries to resolve the crisis but merely as facility to strengthen financial position in response to prevent crisis. The GFSN facility should only serve in the time of crisis. It must be ensured countries use the facility is on the verge of economic crisis. To avoid moral hazard, there needs to be a clear and measurable guidance about the criteria of crisis. Further, G20 paper on GFSN proposes this will only be available to Countries with sound policies, and only if the shock is external, the risk of creating moral hazard is limited. These conditions could potentially function as incentives for non-qualifying countries to implement prudential policies. The role of IMF can be enhanced to address the global financial shock. As to its role as the principal institution of global economic govemance positioned to help deal with the current economic and financial crisis, IMF should play more active role in global financial safety net system. Despite the stigma issue attaching with IMF, its role as global “FSN” is critical. Nevertheless, IMF has worked hard to eliminate the stigma issue by actively streamlining the conditionality of its loan facilities, such as FCL. Conclusion The recent financial crisis has taught important lesson that when global illiquidity occurs; even economies with strong fundamental would still be affected due to massive and persistent capital outflow. Tackling the destructive impact of capital outflow on domestic economy, many economies held a bilateral swap; accessed IMF’s FCL or asks for assistance from regional arrangement such as EU-BOP. Indonesia has arranged a bilateral swap with China Central Bank to strengthen its official reserve and complemented by stand-by type loan from the World Bank (DDO) and commitment from ADB, Japan and Australia. These measures have proved to enhance investor’s confidence. 10
  • 11. In the aftermath of recent financial crisis shock, G20 proposes a global financial safety net as an additional resource for tackling the impact of capital outflow. The discussion is still underway and many ideas have converged. As a second tier of defense, three channels were adopted; through bilateral swap, regional arrangement or IMF. Regardless the drawback of each channels, they still cater economies effectively and timely in response to crisis. Therefore, a regional arrangement using the three channels shall serve as the second tier of crisis defense for countries affected where Multilateral Development Banks (MDBS) could play their roles. In addition to relying upon IMF’s contribution, neighboring regional arrangement can come to assist in supplying additional capital to close the gap. In order GFSN can function effectively, the following principles are necessary: 0 Sufficient: The GFSN must have sufficient capital to meet the countries’ request in order to send positive signal that countries concerned are still in sound situation and calm market during economic turbulence. 0 Preventive measures: Before the financial turbulence becomes more destructive, there needs to take preventive actions. Countries can use this facility for this purpose. 0 Flexibility: Countries have flexibility to use the facility both for addressing bop crisis and budget deficit. 0 Clarity: The GFSN facility should only serve in the time of crisis. To avoid moral hazard, there needs to be a clear and measurable guidance about the criteria of crisis and accessibility of the facility. 11
  • 12. Reference Aizenman, Joshua, Jinjarak, Yothin and Park, Donghyun, 2010, International reserves and swap lines: substitutes or complements? , NBER Working Paper No. 15804, March 2010 Alam, [man and quazi, Rahim, 2003, Determinants of Capital Flight: an econometric case study of Bangladesh , intemational Review of Applied Economics, Volume 17, Issue 1 January 2003 , pages 85 - 103 Dooley, P. Michael, 1988, Capital Flight: A Response to Differences in Financial Risks, Staff Papers - International Monetary Fund, Vol. 35, No. 3 (Sep. , 1988), pp. 422-436 Noyer, Christian, 2007, Foreign Reserve Accumulation: Some Systemic Implications, Salzburg Global Seminar - October, 1st 2007, Bank of French, retrieved from http: //www. banque- france. fr/ gb/ instit/ telechar/ discours/ disc071001 . pdf. Park, Donghyun and Estrada. Gemma B. , 2009, Are Developing Asia’s Foreign Exchange Reserves Excessive? An Empirical Examination, ADB Economics, Working Paper Series, No. 170 [ August 2009 Vespignani, Joaquin, 2008 "Capital Flight, Saving Rate and the Golden Rule Level of Capital: Policy Recommendations for Latin American Countries”. The American Review of Political Economy. Volume 6, Number 2, December 2008. http: //www. arpejournal. com/ . Zhuang, J and J. Malcolm. D, 2002. Causes of the 1997 Asian Crisis: What can an early waming exercise can tell us? , ERD Working paper series, Asian Development Bank. 12