Comments on “Let Developing Nations Rule” from Yung Chul Park

Posted by on 26 January 2009

Dani Rodrik has proposed several important reforms for the stability and efficiency of the global financial system.

Tobin tax

The Tobin tax on spot foreign-exchange transactions is one such proposal that could help moderate the volatility of foreign exchange rates and generate substantial revenues for the development financing. 13 years ago, there was active interest in the Tobin tax, but it was ignored by most developed countries controlling international financial intermediation. Their opposition was motivated by political rather than technical reasons (ul Haq, Kaul and Grunberg, 1996). This time developing countries should join forces to persuade the rationale for and work with developed countries to introduce the tax.

The global financial crisis has also brought out the need for imposing capital controls as a means of mitigating the procyclicality of international lending. As Rodrik suggests, the IMF could be entrusted with the task of identifying control measures that are effective and universally enforceable. This change will require the IMF to develop a new framework of policy analysis different from the one based on inflation-targeting, free floating, and capital account liberalization.

Reserves

The adequate amount of reserves to be held in developing countries as a self-insurance against future crisis has always been a controversial issue. The Greenspan-Guidotti-Fischer (GGF) rule prescribes the holding of an amount of reserves equal to the country’s short-term foreign currency liabilities. In an emergency situation, the rule would allow a central bank to buy back all the short-term liabilities that investors liquidate.

The rule is flawed however as it excludes foreign equity investments, which display rather more violent cycles of speculation and liquidation than other short-term foreign liabilities. Adding foreign equity investments to short-term foreign liabilities would impose substantial burden on developing economies. For instance, if Korea had included foreign equity investments, it should have held more than $500 billion in foreign exchange reserves, almost 50 percent of its GDP in 2007. It is difficult to imagine a small country like Korea can hold such a large volume of reserves.

But suppose it does. Would it be enough to fend off a financial crisis?

Speculators chiefly operate by taking short positions on currency that they perceive as weak. If the market sentiment builds up and expectations are firmly held, speculators can hold short positions of any size. In effect, a speculative attack is a run on the reserves of the central bank. In order to reduce holdings of large amount of reserves in developing countries what is needed is lender of last resort ready to liquidity when needed.

The ongoing crisis has underscored the danger that once foreign investors lose confidence in and hence liquidate their investments in financial assets of developing economies, the maturity and currency mismatches can easily bring on a liquidity squeeze even at a sound bank, threaten its insolvency, and set off a run on the banking system.

But these problems arise from normal banking operations and hence are largely unavoidable; regulations are not the most effective of way of dealing with them. In fact, regulatory restrictions designed to minimize the incidence of the two mismatches are often ineffective and if carried out too far, could run the risk of limiting the ability of even well managed banks to take part in international financial intermediation.

Without the legal backing of a lender of last resort, financial institutions operating out of emerging economies will be at a competitive disadvantage vis-à-vis their counterparts from reserve currency countries. This is because the central banks of non-reserve countries will have to be ready to supply foreign currency liquidity when needed. Barring such readiness, domestic financial institutions will have to be severely restricted in international financial intermediation in order to preserve their soundness and stability.

In either case the costs of international financial intermediation in emerging economies will be higher than those in reserve currency countries. Since it is costly to hold large reserves, the policy authorities may choose to limit local banks in international financial intermediation. The restriction will impair competitiveness of local financial institutions and eventually drive them out of global financial intermediation.

Alleviate the mismatch problems

In order to alleviate the mismatch problems, emerging economies may consider other options such as securing swap lines from the central banks of reserve currency country. Swap borrowings entail interest costs. Another option open to these countries is to internationalize their currencies.

Recent experiences of the countries with internationalized currencies are not encouraging. Internationalization has not allowed them to borrow in their own currencies. The IMF can serve as a provider of the short term liquidity through the SLF, but it is not clear whether the IMF can be a lender of last resort. At present, the Federal Reserve is the only global lender of last resort. The EMU members, UK and Japan can borrow in their own currency, but they cannot assume the role of lender of last resort. The Federal Reserve has entered many currency swap arrangements with advanced and emerging economies. These swaps may have to be institutionalized to provide a stable source of liquidity. These swaps can also be supplemented by regional liquidity support systems such as CMI (Chiang Mai Initiative) on trade issues.

Trade policies

There is little one can disagree with Rodrik’s balanced approaches for reducing trade frictions between advanced and developing countries. But which institution is going to mediate the interests of developed and developing countries?

The G-20 leaders agreed last November to instruct their trade ministers to conclude the negotiations on the modalities of Doha Round before the end of 2008. Unfortunately, the trade ministers were not able to come to an agreement. If G-20 leaders cannot implement what they agreed to, there is the danger that the institution may become irrelevant one.

Yung Chul Park
Distinguished Professor
Division of International Studies, Korea University
 
Reference

ul Haq, Mahbub, Inge Kaul and Isabelle Grunberg, “The Tobin Tax: Coping with Financial Volatility”, Oxford University Press, 1996