Holes in the Global Financial Safety Net

One-third of the IMF’s funding will evaporate over the next two years as bilateral loans negotiated in 2012 start to expire. This is a major problem. In a global economy fraught within downside risks, the global financial safety net — essentially the resources provided by the IMF and other institutions reserved for fighting crises and preventing contagion — is too small, too unresponsive and too fragmented.

One-third of the IMF’s funding will evaporate over the next two years as bilateral loans negotiated in 2012 start to expire. This is a major problem. In a global economy fraught within downside risks, the global financial safety net — essentially the resources provided by the IMF and other institutions reserved for fighting crises and preventing contagion — is too small, too unresponsive and too fragmented.

The Chinese G20 presidency, which starts 1 December 2015, needs to fix this problem. There are a number of practical things the G20 can do to further IMF reform, improve institutional cooperation between the IMF and regional financing arrangements, and renegotiate the bilateral loans with the IMF that are about to expire.

The global financial safety net consists of the financial resources and institutional arrangements designated to provide emergency funding when a country is unable to meet external payments and cannot access markets. It provides a financial backstop for countries in trouble and helps prevent financial contagion spreading from one country to another. It also encourages countries to open their economies to trade and capital knowing that, should they get into trouble, assistance is available. With global risks tilted to the downside, the safety net is more important than ever.

Over the past 20 years, the safety net has dramatically increased in size and has fragmented in composition. In 2003, the safety net consisted solely of the IMF and the US$365 billion it held to fight crises. Today it is about seven times larger, at around US$2.75 trillion. A larger safety net makes sense since countries have greater exposure than ever before. However, this increased size has come at the cost of increased fragmentation. Today, the safety net consists of a multilateral component (the IMF, which now represents just 50 percent of the safety net), a regional component (the European Stability Mechanism (ESM), the Chiang Mai initiative, and the BRICS Bank), and a bilateral component (currency swap lines).

Although this safety net seems large, it is inadequate for several reasons. While total resources amount to US$2.75 trillion, only US$1.08 trillion is actually available to respond to a crisis. Much of the IMF’s funding is tied up in existing programs or it relies on bilateral loans, which are the IMF’s secondary line of defence. Taking only available resources into account means that the size of the ESM drops from US$500 billion to around US$369 billion and the BRICS Bank drops from US$100 billion to US$50 billion. Credit swap lines from the US Federal Reserve extended during the global financial crisis have also expired, with no guarantees of renewal.

Whether US$1.08 trillion is sufficient depends on the crisis. Greece, for example, represents only 0.25 percent of global GDP (PPP) but if the IMF had to shoulder the Greek bailout on its own (around US$279 billion since 2010), this would represent almost 70 percent of the IMF’s forward commitment capacity. A larger economy like Spain, which represents 1.5 percent of global GDP (PPP) and has US$670 billion of debt to refinance by 2020, would exhaust the IMF’s entire forward commitment capacity, as well as most of the ESM.

The fragmentation of the safety net also conceals its true size. For most countries, including Australia, the safety net consists entirely of IMF funding since they do not participate in any regional initiatives. Increased fragmentation also reduces the speed at which these institutional mechanisms can respond to a crisis. At a time of crisis and market panic, fragmentation means the global economy is dependent on reaching an ad hoc agreement between different institutional arrangements. Current regional arrangements are weak substitutes for the IMF.

There are practical things China, as G20 host in 2016, can do to help address these challenges. The G20’s inability to reform the IMF is the primary cause for this fragmentation. The G20 can work to obtain an outcome from the 2016 summit that underlines the importance of IMF quota reforms to ensure the IMF remains the linchpin for the global financial system.

Liberalisation of China’s capital account will also be pivotal to the yuan’s inclusion in the IMF’s Special Drawing Rights (SDR) basket and to China playing an increasing role in the global economy more generally. However, progress remains slow. In its G20 year, China can articulate a clear timetable for implementing the financial market and capital account reforms necessary for having the yuan included in the SDR more quickly.

While IMF reform is the long-term priority, the G20 can do more to improve cooperation between the IMF and regional arrangements. Currently, no overarching framework exists to facilitate this cooperation. In 2011, the G20 developed one page of high-level principles, which looked at this issue. This can provide a basis for developing detailed procedures on the rules, expectations, and safeguards that would govern how such cooperation would take place in the event of a crisis. South Korea put forwards this suggestion in 2012 and received broad support. The IMF as a practical step to help fine-tune the current flexible approach to cooperation has also canvassed it.

The expiration of US$380 billion of IMF bilateral funding over 2016 and 2017 introduces unacceptable systemic risk into the global economy. This requires an urgent response from the G20. These loans need to be renewed. By packaging this with these other initiatives, renewing these bilateral loans will be more palatable to the emerging market economies who, in return for their funding commitments, do not receive any additional voting power.

The G20 is not ready for the next crisis is republished with permission from East Asia Forum