Improving global financial cohesion: the importance of a coherent international economic and financial architecture

October 21, 2014 - nr.89
Summary

Conclusions and recommendations

The previous chapters present a picture of an international economic and financial system that has failed to keep up with changing circumstances. Despite the adjustments made over the years, the system is looking increasingly outdated. Global financial stability has been undermined by trends such as the sharp increase in the volume of financial flows, the interweaving of financial markets, the accumulation of wealth, the sometimes excessive growth in the volume of cash in circulation due to quantitative easing, and the impact of trade surpluses (as in China) caused by strict adherence to excessively low exchange rates for national currencies. If one also factors into the equation the rapid expansion in inn ovative financial services (many of which are difficult to control), the growing number of treaties and institutions and the rise of regional financing arrangements, it becomes clear that the challenges are going to be just as complex in the future.

Will further – primarily reactive – adjustments to the current system be adequate? Or would the world be better served by a completely redesigned international financial architecture that safeguards the interests of a larger group of countries?

The AIV believes that there is no need to redesign the international economic and financial system. Having said that, the current system is in need of a thorough review, with certain aspects of the system possibly being combined in the future in order to prevent a situation in which (justifiable) dissatisfaction about elements of the system leads to further fragmentation and the erosion of the system as a whole. Reforms along these lines certainly appear to be feasible. The AIV believes that the key to success lies in achieving intergovernmental agreements on adjustments to policies and management structures, and possibly also on the creation of a supranational umbrella organisation.

However, the sharp drop in confidence in the financial sector among politicians and the general public makes it more difficult to adopt a clearer political position on changes in the international economic and financial system. Despite the measures taken by many governments to rebuild confidence in national economic and financial systems (such as stricter regulation, more extensive bank supervision, calls for financial institutions to cut back on staff pay and bonuses, and even bank takeovers), public confidence in national financial systems has yet to be restored. If public confidence were to be regained, this would make it easier to secure support for the desired changes in the international economic and financial system. The AIV therefore looks forward to the publication of a new report by the Scientific Council for Government Policy (WRR) on the consequences of ‘financialisation’ in the Netherlands. The report is due to be published sometime in 2015.

In short, the AIV believes that the key problems are: (i) the lack of a coherent and widely accepted perspective on how global financial and economic stability should be achieved and sustainable economic growth should be fostered around the world; (ii) the absence of a clear, coherent and globally accepted agenda, including a list of higher and lesser priorities, a problem exacerbated by the precedence given to national interests; and (iii) an inadequate management structure, as reflected by the lack of effective and representative global supervisory mechanisms, among other things.

A problem that is specific to low-income countries is their relative lack of integration into the global economy. As a result, these countries did not feel the direct effects of the global crisis in 2008. However, they did notice the effects in later years, as a result of financial instability and violent fluctuations in capital flows around the world. Although the group of low-income countries as a whole witnessed a fivefold rise in the level of foreign direct investment within a 10-year period, there were nonetheless wide disparities among individual countries. There was no dramatic decline in the level of capital flows to these countries in the wake of the crisis, though they did become more volatile. Certain low-income countries even experienced a net outflow of capital, probably precipitated by the absence of markets and investment opportunities, tax motives and the risks of mismanagement. The external perception of their risk profile, which some commentators feel was overly pessimistic, also tended to check the inflow of capital. The AIV therefore believes that such countries would also benefit greatly from the adjustment of the international economic and financial system.

The answer to the question: ‘Are the smaller emerging economies and poorer countries adequately represented in the current financial system?’ is a wholehearted ‘no’. Underrepresentation is a problem that applies just as much to many other countries. Middle-income countries, for example, also feel let down by the current system. Multilateral institutions such as the IMF and the World Bank are more representative than informal consultative bodies such as the G20. At the end of the day, countries are formally members of these institutions and are represented in constituencies. This is in contrast to a body such as the G20, whose managerial and decision-making processes take place largely without their involvement.

The recommendations made below apply to all developing countries, including the group of low-income countries. They follow from the realisation that market forces in the financial system are not sufficiently geared towards achieving and maintaining stability:

  • capital flows tend to be procyclical;
  • credit is attracted by favourable risk-return ratios and to a lesser degree by the most socially desirable investment opportunities; and
  • technological advances lead to virtually uncontrollable growth in the volume and complexity of financial products, thereby triggering a rise in systemic risks and creating a need for constant adjustments to international regulations.

A number of the recommendations are concerned with making government interventions more powerful and more efficient, although the AIV accepts that this would entail certain counter-risks:

  • moral hazard, i.e. making it possible to run certain financial risks with impunity, in the knowledge that governments will come to one’s aid if necessary;
  • the improper use of resources, abuse and corruption; and
  • increasing complexity and administrative burdens, which could be limited by building expertise (or supporting that process).

Recommendations on global governance and representativeness

  • The government should support the formation of a Global Economic Coordination Council (GECC). A treaty-based organisation conceived along these lines would be better able to play the role that the G20 has arrogated for itself, and would have the same ability to focus its attention at any time on vital economic and financial issues that require leadership at the highest political level and transcend the institutional boundaries of the various international bodies.
     
  • The Netherlands should press for the FSB to be transformed into a global coordinating body, or in any event into a global policymaking institution for the entire international financial system, in which all countries are represented on a proportionate basis. The aim of transforming the FSB along these lines would be to develop a generally accepted standpoint on how monetary and financial policy could be harmonised (i.e. between the dollar and the euro) and to formulate an agenda for coherent adjustments to relevant parts of the architecture. National reforms would form part of this.
     
  • Since the adoption of the 1993 Vienna Declaration on Human Rights, it has been internationally recognised that human rights in a broad sense and the operation of the international economic and financial system are closely connected with each other. Partly for this reason, the issue of governance should figure more prominently in the post-2015 development agenda. Recognising the importance of financing this agenda, the Netherlands could propose and perhaps organise a new UN conference on ‘financing for development’, analogous to the conference that was held to discuss the funding of the Millennium Development Goals.
     
  • The Netherlands should continue to argue for SDRs to play a more important role, and for the dollar to play a less prominent role. Although it is difficult for SDRs to additionally serve as a monetary tool for financing development and although the current reserves are relatively limited, the issue of SDRs could benefit low-income countries by giving them access to more stable reserve currencies.
     
  • The Netherlands should continue to press for the rapid adjustment of voting rights in the principal elements of the financial system, such as the IMF and the World Bank. Western countries should free up more space for both emerging and recently emerged economies. If this does not happen, the IMF will lose its authority among these countries and international coordination will become more difficult. The Netherlands could set an example by agreeing to share its seat at the IMF.
     
  • The Netherlands should argue more vigorously for a universal debt work-out mechanism. The lack of a generally accepted debt relief mechanism is a major shortcoming in the international financial system. As the current crisis in Europe has demonstrated, it is not just low-income countries that would benefit from such a system. The West would, too. A debt work-out mechanism could take several forms.

Recommendations to improve financial stability

  • The Netherlands should use its influence in the FSB and the IMF to support initiatives leading to the prudent regulation of incoming capital flows, with the aim of preventing sharp fluctuations in such flows. It should ensure that the latitude available to low-income countries in particular to regulate incoming capital flows is not totally constrained by the liberalisation requirements in international treaties.
     
  • The Netherlands should also call for initiatives to regulate outgoing capital flows to a certain extent, again with the aim of preventing sharp fluctuations in such flows. Any regulations should apply worldwide, in the knowledge that this will enhance the stability of the system as a whole. This would benefit all countries, particularly the more vulnerable developing countries. Such regulations could help to reduce capital flight, although the latter is caused by a wide range of factors, many of which are difficult to control.
     
  • The Netherlands should use its relatively strong voice in the Basel Committee for Banking Supervision to back measures leading to a reduction in the systemic risks posed by very large private financial institutions.
     
  • The Netherlands should continue to contribute to the IMF’s counter-cyclical facilities as the last resort in mitigating wide fluctuations in capital flows to the most vulnerable developing countries. The facilities should not create a situation in which countries can take ill-advised credit risks with impunity.

Assistance with the development of domestic financial sectors

  • Recognising that the governments of developing countries are primarily responsible for the balanced composition of the banking industry in their countries, the Netherlands could pursue a dialogue with these governments calling for the objectives of the supervisory mechanism to be extended to include growth and job creation alongside the containment of inflation.
     
  • The Netherlands could use its position in multilateral development banks (such as the World Bank and regional development banks) to argue for these institutions to pay sufficient attention to the above aspects of the development of domestic financial sectors.
     
  • The Netherlands could offer expertise and financial support for the further development of supervisory mechanisms specifically geared to the situation in low-income countries, and also of innovative financial services such as mobile payment systems, the development of pension schemes, inclusive and gender-sensitive lending and cooperative forms of banking and insurance. In consultation with the big banks, a study could be conducted to see whether a new type of instrument such as a guarantee could help raise finance for low-income countries on the international markets, while taking corporate social responsibility and transparency requirements into account.

Coherence at home

It became clear, during the preparatory work for this report and the interviews with experts, that, both in the Netherlands and in other countries, opinions on the issues discussed in this report tend to diverge. Among the main reasons for this are the political and economic role played by the financial sector, and the complexity of the subject matter. Proper, constructive debate is undermined by incomplete information and lack of awareness of one another views.

For this reason, the AIV urges the government to initiate and facilitate a consultative structure that would provide a better platform for distributing and discussing such information. The government could invite as participants Dutch representatives involved with the aspects of the international financial architecture discussed in this report, as well as a number of their counterparts from the South and representatives of large Dutch banks and civil-society organisations that are well-informed but critical followers of the system. The government could also support further research into the position of low-income countries in the international financial system and could make proposals for improving their position. This could enhance the coherence of Dutch contributions to the international economic and financial system. Presenting the findings of such meetings and research in international forums might help to speed up the process of making the necessary adjustments to the system. Although the road ahead is long and arduous, the benefits could be substantial.
 

Advice request

Mr F. Korthals Altes
Chairman of the Advisory Council
on International Affairs
P.O. Box 20061
2500 EB The Hague


Date 27 August 2013
Re Request for advice
 

Dear Mr Korthals Altes,

I am writing to ask the Advisory Council on International Affairs (AIV) to prepare an advisory report on the coherence of the international economic and financial architecture.

Shifts in the global economic and political balance of power are putting pressure on the international economic and financial architecture. The recent financial crisis has demonstrated the need for stronger global governance in this area, but the increasing number of players complicates the decision-making process. Large, emerging countries like the BRICS are demanding greater influence and choosing to go their own way. National political interests dominate international decision-making, giving rise to the question of who represents the interests of developing countries in this evolving system.

The smaller emerging countries and the poorest countries are particularly vulnerable in the current global economic and financial landscape. In order to stay a part of the global economy, they have no choice but to remain highly dependent on external markets and financial flows. At the same time they need stability, protection from economic shocks, and the freedom to shape their own policy. The instability that has marked the system in recent years is, of course, unfavourable for all countries, but it is especially detrimental for the development of this group. Open markets, risk financing, stability funds and debt management schemes are vital to their prospects for growth and development. In the years ahead, the system of trade, investment and other types of private financing will only become more important to these countries, as the significance of traditional ODA declines. Three elements of the financial system are especially significant to development policy: the stability of financial markets, development financing through the international financial institutions, and the financing of global public goods.

Although they have major interests at stake, most developing countries do not always have a place at the table when it comes to making decisions about changing the international economic system. This is particularly true of low-income countries and developing economics that exhibit growth but are too small to be part of the BRICS group. Major innovations prompted by the recent crisis have, to some extent, passed them by. The emphasis on the interests of the large emerging countries in the current negotiations threatens to further marginalise the smaller developing countries.

The position of the smaller emerging economics and poorer countries in the international economic and financial system is thus a key element of a coherence policy for development. The Netherlands can spotlight this issue in international forums and identify common interests and possible new coalitions. This request for advice is particularly concerned with possible changes to the international financial system, as represented by institutions like the IMF, the World Bank, the FSB, the BIS, the Paris Club and the G20. There are three core questions that we would like you to address.

1. Are the smaller emerging economics and poorer countries sufficiently represented?

How are the smaller emerging economics and poorer countries represented in the leading institutions of the international financial system? In answering this question I would ask you to focus on the following issues: what is the significance of recent decisions regarding the IMF quota system? What influence has the rise of the large developing countries had? Does it make sense to distinguish between new organs like the G20 and FSB and older financial institutions like the IMF and BIS? Can a distinction be made between formal representation and the exercise of influence?

Following on from the previous question, how can these countries’ specific interests attract adequate attention, given the existing balance of power in the international system? Is their limited influence inevitable, or is there scope for better results? Options that could be considered include stronger representation of these countries in the international financial institutions, the further refinement of the G20 development agenda, the establishment of regional systems, and the concentration of the decision-making process within global institutions where these countries enjoy genuine representation.

2. What are the specific interests of this group?

The AIV could examine those specific interests of the smaller emerging economics and poorer countries which differ from those of the large countries. On that basis, do these countries need to adopt a specific position in the international financial system? How would this relate to the existing exceptional status of least developed countries, fragile states and small island states? What is the significance of the various institutions to the countries concerned? Are their interests focused on a limited number of institutions within the system? A distinction could be made between their importance for financial stability and their importance for development financing.

In answering this question I would ask you to distinguish between the various specific interests at play.

  • Has the group of smaller emerging economics and poorer countries become more vulnerable on account of their increasing dependence on private financing? If so, what factors contribute to that vulnerability? Is the extent of both legal and illegal capital outflow a specific problem for them? What is the international system’s importance for the financial system in the developing countries themselves? What is the influence of the economic and financial policy pursued by the large emerging countries? What impact does their role as financiers (and the conditions they set) have on the role of the international financial institutions?
     
  • Do these countries require greater policymaking freedom, especially considering that stricter international rules and standards could limit the scope of their development policy? Can the large and wealthier developing counties be asked to make a bigger contribution, possibly in the form of graduation?
     
  • How can the countries in question best capitalise on increasing commercial and capital flows? Should the resilience of the smaller emerging economics and poorer countries be bolstered by building capacity, strengthening good financial governance and creating an enabling environment? If so, what role could the World Bank and the regional development banks play in this regard?

3. How should Dutch coherence policy engage with the issues raised above?

What opportunities exist for Dutch involvement in this area, given the Netherlands’ relatively strong position in the international financial system? What coalitions could be effective in this regard? How can we best make use of Dutch financial expertise?

I look forward to receiving your advisory report.

Yours sincerely,
 

Lilianne Ploumen
Minister for Foreign Trade and Development Cooperation


 

Government reactions

Letter of 21 November 2014 from the Minister for Foreign Trade and Development Cooperation to the House of Representatives and Senate in response to advisory report no. 89 of the Advisory Council on International Affairs (AIV) on improving global financial cohesion

This letter contains my response to the advisory report produced by the Advisory Council on International Affairs (AIV) entitled ‘Improving Global Financial Cohesion’.

The AIV was asked to produce a report on the cohesion of the international economic and financial institutions. The request was prompted by shifts in the global economic and political balance of power and the resultant pressure being placed on the international economic and financial architecture. This has given rise to the question of who represents the interests of developing countries in this evolving system. It was against this background that the AIV was asked to address the following questions:

  1. Are the smaller emerging economies and poorer countries sufficiently represented?
  2. What are the specific interests of this group?
  3. How should Dutch coherence policy engage with the issues raised?

The AIV divided its recommendations into four categories:

  • global governance and representativeness;
  • improving financial stability;
  • assistance with the development of domestic financial sectors;
  • coherence at home.

Global governance and representativeness

  • The AIV recommends transforming the Financial Stability Board (FSB) into a global coordinating body in order to enhance global governance and representativeness. I believe that it would not be appropriate for the FSB to develop into a coordinating body, as it consists mainly of supervisory authorities and central bankers and as its object is to issue recommendations on financial legislation. It does this at the request of the G20, which gives it a clear mandate. However, I would like to point out that the FSB is already making serious efforts to improve the representation of emerging economies. For example, the FSB’s Chair, Mark Carney, has announced plans to review the FSB’s representation structure. I believe that explicit account should be taken in this connection of the role of emerging economies.
     
  • I endorse the recommendation that the Netherlands should continue, where possible, to press for the adjustment of voting rights at the IMF. The Netherlands has already contributed to this aim by sharing a seat with Belgium, ratifying the 14th general review of quotas, and urging the US to do the same in the near future. The IMF members agreed earlier this year that, if the US does not ratify the review of quotas this year (2014), the IMF would examine alternative options for strengthening the IMF’s quota system and governance at the beginning of next year. The Netherlands supports this approach. The representation structure at the IMF should reflect the real financial relations in the global economy.
     
  • The AIV would like to see Special Drawing Rights (SDRs) play a more important role and the dollar become less prominent so as to give developing countries better access to more stable reserve currencies. I agree that it is important for low-income countries to gain access to stable financial resources when this is needed. At present, however, there is no need to give SDRs a greater role.
     
  • As regards the recommendation to adopt a universal debt work-out mechanism, I would like to stress that the main problem is the absence of a debt restructuring mechanism for sovereign bonds. The Paris Club and the London Club already provide orderly and efficient mechanisms for restructuring public debt and private loans. The IMF is currently working on an improved debt restructuring mechanism for bonds, its main efforts being directed at strengthening the IMF’s policy framework and tightening up and clarifying contractual clauses in bonds. I attach great importance to good financial governance, including debt management. That is why I provide technical assistance, through the Debt Management Facilities at the World Bank, the IMF and UNCTAD, to promote responsible debt management practices and prevent countries from getting into difficulties.
     
  • I recognise the importance of the new UN conference on Financing for Development that is to be held in Addis Ababa in July 2015. I intend to play an active role in this conference, partly in my capacity as co-chair of the Global Partnership for Effective Development Co-operation. I will also raise a number of the AIV’s recommendations there.

Improving financial stability

  • I share the AIV’s conclusion that large incoming and outgoing capital flows can affect the macroeconomic stability of both emerging and low-income countries. I would like to reiterate the importance of good financial governance. Although emerging economies and low-income countries are responsible for their own financial management, the richer countries can easily help them by making use of the Debt Sustainability Framework. Moreover, the ability of emerging economies in particular to withstand the volatility of capital flows depends primarily on the stability, capitalisation and supervision of their financial sectors. The IMF, the FSB and the World Bank are helping them in this respect. The IMF surveillance framework monitors spillovers and imbalances around the world.
     
  • The AIV urges the Netherlands to encourage international institutions to back measures to reduce the systemic risks posed by very large private financial institutions. This is an area in which the Netherlands has already achieved results in the international arena. During the years after the financial crisis, the FSB and the Basel Committee on Banking Supervision (BCBS) launched an extensive package of policy measures for regulating systemically important institutions and addressing the ‘too-big-to-fail’ problem. The Netherlands continues to contribute to further action in these areas.

Development of domestic financial sectors

  • I fully agree with the AIV on the need to help developing countries develop their domestic financial sectors. The Netherlands is already very active in this field, in many cases in conjunction with multilateral development banks. Together with other donors, the Netherlands has funded the Financial Sector Reform and Strengthening Initiative (FIRST) since 2002. Under this demand-driven scheme, developing countries can make use of technical assistance from the World Bank and the IMF in setting up a system of legislation and institutions for the financial sector. The Netherlands is also one of the donors funding the World Bank’s Financial Inclusion Support Framework, which supports cohesive country strategies for improving access to financial services in a wide sense. The MASSIF Fund of the Dutch Entrepreneurial Development Bank (FMO) supports banks specialising in SMEs and microfinance and whose products include innovative financial services. The Netherlands is also involved in the development of new financial products. For example, it is a contributor both to The Currency Exchange Fund (TCX), which helps countries to mitigate exchange rate risks and risks stemming from interest-rate differentials in international transactions. The Netherlands also supports the Health Insurance Fund, which by introducing affordable insurance policies in various African countries helps people who were previously uninsured to gain access to medical services.

Coherence at home

  • I appreciate the AIV’s finding that opinions differ on how to improve global financial cohesion. This is inherent to the complexity of the issue. For this reason I do not intend to take up the AIV’s suggestion of initiating a new consultative structure. Many of the issues discussed above fall within the remit of the Ministry of Finance, with which my own ministry enjoys close and excellent links. I do, however, intend to further raise the standard of in-house financial and economic expertise at the Ministry of Foreign Affairs. In addition, Minister of Finance Jeroen Dijsselbloem and I are already in contact with experts working in the international financial architecture, and we intend to maintain these contacts in the future.

 

Press releases

INTERNATIONAL FINANCIAL ARCHITECTURE: RENOVATION OF IRRELEVANCE?

The AIV advocates rapid and thorough restructuring
 

The Hague, 11 September 2014

The international economic and financial architecture is not functioning properly and is in dire need of reform. In its most recent advisory report, ‘Improving Global Financial Cohesion’, the Advisory Council on International Affairs (AIV) concludes that the current system will become hopelessly outdated without rapid intervention. The AIV notes that the decision-making process is misaligned with the current geopolitical situation, that poor counties are barely represented, and that an adequate response is needed to the ever increasing intertwining of financial markets and international wealth accumulation.

The AIV argues that while the world needs financial and economic stability, the current international architecture, which is rooted in the Bretton Woods Agreement, will not allow it. Pressure on the system is increasing due to the combined effects of the aftermath of the crisis of 2008, the dynamics between financial markets and financial institutions, and growing global inequality. Further complicating the task of managing the system is an opaque accumulation of – partly overlapping – treaties and regulations.

A well-functioning financial system benefits not only the West, but also low-income countries. Because of their limited integration into the global economy, low-income countries were only partly affected by the crisis of 2008 and capital flows remained fairly constant. The continuation of the crisis has resulted in more volatile capital flows, which will have negative effects on their economic growth.

The AIV views the absence of a united approach to improving global financial and economic stability as the main problem. Despite international agreements, national interests continue to predominate, and arrangements within the G20 sometimes do more harm than good. Other reasons for concern are inadequate management structures and supervision.

In the AIV’s opinion there is no need for a new system, but the current one is in urgent need of being reworked. Once this has been completed, rightful expressions of discontent – such as the establishment of the new Development Bank by the BRICs– and a further breakdown and erosion of the system can be avoided.

The AIV recommends that more attention should be devoted to global governance and representativeness. This could be achieved by means of a new treaty body under the auspices of the UN (Global Economic Co-ordination Council) and reforms within the IMF, the World Bank and the Financial Stability Board. Furthermore, the AIV calls for an explicit focus on the financing of the post-2015 development agenda, for an active Dutch contribution to increase global financial stability and for the strengthening of financial sectors in low-income countries.

The changes that the AIV advocates are radical and in some cases time consuming. But opportunities also exist under the current system to enhance the position of low-income countries in the short term, including making better use of existing facilities such as funds aimed at negating the effects of financial instability.