November 8, 2016

Sourabh Gupta

In September 2006, on the margins of the 61st U.N. General Assembly session in New York, the foreign ministers of the (then) BRIC nations held their first-ever meeting. Ten years later, the grouping – with South Africa now included – has established itself as a supple entente of independent-minded rising powers, organized as a mutual support network that is committed to assisting each other’s rise in the international economic order. The establishment of the New Development Bank (NDB) and the Contingent Reserve Arrangement (CRA) at the 6th Leaders Meeting in Fortaleza in July 2014, the announcement by the NDB of its first tranche of funding for green and sustainable projects for all five BRICS member states, and its successful issuance of a first green financial bond (denominated in renminbi), represent important steps towards the institutionalization of an economic agenda for the BRICS.

As China assumes the rotating chairpersonship and prepares to guide the grouping into its second decade of existence, the BRICS must graduate beyond its development finance orientation. It must gradually become the most important emerging market economy forum to discuss the overhaul of the international monetary system (IMS) – a system whose architecture has failed to keep pace with the dynamic changes in the shape and scale of cross-border finance.

In a reprise of the 1920s and 1930s, large short-term capital flows transmit economic upheaval across borders, and the monetary order is yet again failing to provide systemic liquidity management tools to cope with these episodes of extreme volatility. Likewise, even as the system is awash with liquidity, there is ironically a palpable shortage of the type of high-quality or safe assets (as a share of global GDP) that are widely used in cross-border transactions. While the dollar remains the system’s principal reserve asset, U.S. authorities display little sense of obligation and interest in mitigating capital flow volatility, short of an extreme systemic crisis. Promising ideas to expand the global financial safety net for emerging market economies – the International Monetary Fund (IMF)-centered multilateralization of currency swaps; U.S. Federal Reserve-central bank swap arrangements; cross-border collateralized lending arrangements, etc. – have each foundered on the Fed’s unwillingness to countenance any credit or legal risk. The Fed won’t engage in such operations for lack of guarantees that indemnify potential losses on swap transactions (besides, its mandate is domestic); the U.S. Treasury, on the other hand, will not allow such financial resources to flow to, or be provided by, the IMF.

The modernizing of the International Monetary Fund’s concessional financing facilities to adapt to today’s capital flow realities has not fared much better. With each passing year, the gap between its original mandate – temporary lending to enable countries to tide over illiquidity-driven balance of payments crises – and the tools at its disposal keeps widening.

The European Stability Mechanism (ESM) armed itself against this new breed of capital flow-induced balance of payments crises with a financial assistance toolkit that includes temporary loans for macroeconomic stabilization, very short-term precautionary credit lines, and the facility to make primary and secondary market purchases of debt securities, as well as to provide loans and guarantees for direct and indirect capitalization of banks. Yet the key shareholders continue to deny the IMF almost all these tools behind the façade of moral hazard and defer any discussion on loss-sharing frameworks. Moral hazard never did restrain the key shareholders though from intentionally subverting the IMF’s lending rules to provide Greece the largest Fund program ever relative to quota, setting a world record in terms of restructured debt volume and aggregate creditor losses during the Greek debt exchange, or turn a blind eye to Athens’ mockery of IMF seniority by defaulting on a loan payment while continuing to repay private bondholders.

Going forward, in the short-term, the BRICS countries should press the IMF to introduce a Very Short-Term Liquidity Line which can disburse the entire amount of approved access upfront (linked to an indicator of capacity to repay) to pre-qualified countries and with no ex post policy conditionality attached. The BRICS countries should concurrently convert, and enlarge, their Contingent Reserve Arrangement (CRA) into an Emerging Market Crisis Prevention Fund that is large enough to lean against sharp swings – and self-fulfilling market panics – in an emerging market index of targeted bond prices such as EMBI+. Doing so would alleviate system-wide financial threats without having to suffer the moral hazard of catering to the financing requirements of any single economy.

Over the medium-term, the BRICS countries should aim to institute a broadening of existing Special Drawing Rights (SDR) arrangements within the monetary system, making its issuance automatic and regular. They should also establish modalities to enable the Fund to guarantee SDR allocations to central banks on short notice or borrow on capital markets to fund its liquidity provision operations during periods of heightened market stress. Fund-provided guarantees of new sovereign debt issuance and automatic purchase of secondary market bonds of pre-qualified countries should also be contemplated, pending agreement among member states to recapitalize the Fund in the event of large capital losses.

As a recent entrant to the SDR club with a strong balance of payments position, the People’s Bank of China, for its part, should support the broader usage of the IMF’s “designation mechanism” by volunteering its readiness to freely swap renminbi for SDRs while bearing any depreciation risk on its own balance sheet. The risk of such losses is minimal. The value of the SDR and its interest rate, as a rule, has been more stable than the values and rates of its individual component currencies.

In the long-term, the BRICS countries must aim to return the IMF’s machinery for collaboration on global monetary problems to its formative Bretton Woods design as a non-politicized, technocratic – not shareholder-run – institution. Its crisis prevention operations should tilt in the direction of automaticity rather than discretion and conditionality, akin to a central bank discount window willing to extend a substantial volume of credit for acceptable collateral on short notice. The IMF’s single greatest intellectual failing at the time of its founding – the inability to factor in the role played by private capital movements – must also be remedied by amending its Articles of Agreement to grant the Fund explicit jurisdiction over members’ capital accounts, including over source country flows.

The promotion of international financial stability, like infrastructure development, is a global public good. The incessant delay by the Fund’s twin, the World Bank, to set up an infrastructure development fund had been a driving motive to create the Asian Infrastructure Investment Bank (AIIB). During China’s Hangzhou G20 chairpersonship, the International Financial Architecture (IFA) Working Group was restored after a hiatus of three years and produced useful designs on the IMF’s crisis resolution role. With the U.S. unwilling, or unable, to underwrite international financial stability in the post-bank-intermediated age of global finance, China’s BRICS chairpersonship should similarly create an IFA Working Group and task its finance ministers and central bank governors to report useful designs on the IMF’s crisis prevention and systemic liquidity management role to their Leaders Meeting in Xiamen in September 2017.