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Trade and Development Report 2011: Post-crisis policy challenges in the world economy - Overview

Report by UNCTAD, 2011

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The Trade and Development Report 2011 focuses on the post-crisis policy challenges in the world economy. It concludes that the recovery is slowing down and that the "two-speed recovery" in developed and developing countries is mainly the result of wide differences in domestic demand. It shows that post-crisis reforms are progressing slowly, and addresses the main regulatory reforms that should take place in relation to financial markets. To diminish the effect of fnancialization of commodity markets based on herd behaviour, the TDR proposes measures to increase transparency in physical and derivatives markets. Finally, to decrease the disparity between macroeconomic fundamentals and foreign exchange markets, the report recommends a system of rules based management floating at a multilateral level - this would greatly improve international financial stability.

OVERVIEW


U n i t e d n at i o n s C o n f e r e n C e o n t r a d e a n d d e v e l o p m e n t


TRADE AND DEVELOPMENT
REPORT, 2011






UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT


Geneva


TRADE AND DEVELOPMENT
REPORT, 2011


OVERVIEW


UNITED NATIONS
New York and Geneva, 2011




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togetherwithareferencetothedocumentnumber.
Acopyofthepublicationcontainingthequotationor
reprintshouldbesenttotheUNCTADsecretariat.


• TheOverviewcontainedherein is also issued as
partof theTrade and Development Report, 2011
(UNCTAD/TDR/2011,salesnumberE.11.II.D.3).


Note


UNCTAD/TDR/2011 (Overview)




OVERVIEW


Economic integration and interdependence in the world today
have reached an unprecedented level. As a result, the globalized
economy cannot function for the benefit of all without international
solidarity and cooperation. This was highlighted by the global
financial and economic crisis that followed the collapse of big
financial institutions, and it has underlined the need for developing
approaches to new forms of global collaboration. The G-20, which
has become a leading forum for international economic cooperation,
successfully coordinated an immediate policy response to the crisis,
or “Great Recession” as it is now called. Coordinated monetary
policy easing by leading central banks marked the first step, with
most members of the G-20 launching large fiscal stimulus packages
as well as emergency support programmes to restore financial
stability. The aggregate impact of these measures stopped the
economic freefall and won policymakers an important first round
in battling the crisis. However, despite intense discussions, little
progress, if any, has been achieved in major areas that were also of
concern to the G-20. These include financial regulation, inter alia
for tackling problems related to the “financialization” of markets
for many primary commodities, and, even more importantly, reform
of the international monetary system for curbing volatile short-term
capital flows that are driven mainly by currency speculation.


Meanwhile, global economic recovery has entered a renewed phase
of fragility because a process of self-sustaining growth through
private spending and employment is not assured, especially in
developed countries. Many of these countries have shifted their
fiscal policy stance from stimulus to retrenchment, which risks
leading to prolonged stagnation, or even to a contraction of their
economies. Given the lack of growth in employment and wages
in Europe, Japan and the United States, their policies should aim
at continued stimulation of their economies instead of trying to
“regain the confidence of the financial markets” by prematurely
cutting government spending. The main global risk is that wages




2


and mass incomes might not increase sufficiently to feed a
sustainable and globally balanced process of growth based on
domestic demand. This indicates that the risk of higher inflation
resulting from rising commodity prices is very small. Only very few
countries that have strong growth and overshooting wage dynamics
face inflation risks.


The recovery of commodity prices has helped developing countries
maintain their growth momentum, but these prices are prone
to considerable volatility as they are strongly influenced by the
speculative activities of market participants motivated by purely
financial considerations. And although growth in a number of large
developing countries has come to rely more on domestic drivers
than on exports, it remains vulnerable to adverse developments in
the international financial system. In particular, these countries are
exposed to short-term capital flows, which tend to exert an upward
pressure on their currencies and damage their export industries.
Thus developing countries are also facing considerable downside
risks, and should aim at maintaining stable macroeconomic
conditions domestically and containing external disruptions. As
they progress along successful development paths, they need to
make their voices better heard in the global debate on a new design
of the international monetary and financial system.


The world economy is still struggling to recover from the worst
recession since the Great Depression. Courageous, globally
coordinated countercyclical policies succeeded in rescuing
economies from the brink of collapse. Nevertheless, policymakers
cannot afford to waste the opportunity for a more fundamental
reorientation of policies and institutions. Strict regulation of the
financial sector, orienting it more towards investment in fixed capital,
is key to greater stability of the global economy and to its return
to a sustainable growth path. This requires increased coherence
between the multilateral trading system and the international
monetary system. At the national and regional levels, there is a
strong case for a reorientation of fiscal policy that takes into account
the requirements of the overall macroeconomic situation rather
than focusing exclusively on balancing budgets or on achieving
rigid public deficit targets. However, unless there is a reversal of
the current trend of diminished income expectations of the average
household and a return to policies that emphasize the importance
of mass income growth as the basis for sustainable and balanced
development in rich and poor countries alike, all other attempts
to regain growth momentum will be in vain.




3


Recovery of the world economy is slowing down,
with strong downside risks


Thepace of global recovery has been slowingdown in 2011.
GlobalGDPisexpectedtogrowby3.1percent,followinganincrease
of3.9percentin2010.Inmanydevelopedcountries,theslowdownmay
evenbeaccentuatedinthecourseoftheyearasaresultofgovernment
policiesaimedat reducingpublicbudgetdeficitsorcurrent-account
deficits.Inmostdevelopingcountries,growthdynamicsarestillmuch
stronger,drivenmainlybydomesticdemand.


Astheinitialimpulsesfrominventorycyclesandfiscalstimulus
programmeshavegraduallydisappeared sincemid-2010, theyhave
revealedafundamentalweaknessintherecoveryprocessindeveloped
economies.Privatedemandaloneisnotstrongenoughtomaintainthe
momentumofrecovery;domesticconsumptionremainsweakowing
topersistentlyhighunemploymentandsloworstagnantwagegrowth.
Moreover,household indebtedness in severalcountriescontinues to
be high, and banks are reluctant to provide newfinancing. In this
situation,theshifttowardsfiscalandmonetarytighteningriskscreating
aprolongedperiodofmediocregrowth,ifnotoutrightcontraction,in
developedeconomies.


In theUnitedStates, recoveryhasbeenstalling,with thepace
of growthwell belowwhat is needed tomake a significant dent in
unemployment.Eventhesecondroundofquantitativeeasinghasfailed
totranslateintoincreasedcreditfordomesticeconomicactivities,as
domesticdemandhasremainedsubduedduetostagnatingwagesand
employment.Withlittlescopetolowerinterestratesfurther–astheyare
alreadyathistoricallylowlevels–andfiscalstimuluswaning,aquick
returntoasatisfactorygrowthtrajectoryishighlyunlikely.InJapan,
recoveryhasbeendelayedbytheimpactofunprecedentedsupply-chain




4


andenergydisruptionsdue to themassiveearthquakeand tsunami in
March.IntheEuropeanUnion,growthissettoremainbelow2percent
in2011,althoughwithsignificantvariationsamongmembercountries.
InGermanyarevivalofexports(particularlytoAsia)andinvestment,
togetherwith risingpublic expenditures, resulted in a strong increase
ineconomicactivityin2010andearly2011,but,asinotherdeveloped
economies,massincomeremainsveryweak,asdoesdomesticdemand.


Withtheunresolvedeurocrisis,thereappearanceofseveredebt
marketstressinthesecondquarterof2011andtheprospectofausterity
measuresspreadingacrossEurope,thereisahighriskthattheeurozone
willcontinuetoactasasignificantdragonglobalrecovery.Austerity
measures,asthemainmeansoftacklingtheeurocrisiswithoutregard
for regional domestic demand growth,may backfire badly.Crisis-
hitcountriesintheeuroareaarelabouringunderextremelyadverse
conditions.Theyneedlowinterestratesandarevivalofgrowth,but
instead,theirgrowthdynamicsareweakandmarketinterestrateson
publicdebtareprohibitivelyhigh.


Relatively fast growth in developing countries
has relied more on domestic demand


Growthratesindevelopingcountriesarelikelytoremainmuch
higher–atalmost6.5percent–thaninthedevelopedcountries.In
manydevelopingcountries,growthhasbeendrivenmorebydomestic
demandthanbyexports.Emergingmarketeconomies(e.g.Brazil,India,
SouthAfricaandTurkey,amongtheG-20members)havehadtodeal
with themajor challengeof short-termcapital inflows, attractedby
higherinterestratesthatreflecthigherinflationratesortightmonetary
policies.These inflows have been exerting enormous appreciation
pressureontheirdomesticcurrencies,andtendtoweakentheirexport
sectorsandwidentheircurrent-accountdeficits.InBrazil,thecentral
bankintervenedheavilyinthecurrencymarket,butatthesametimeit
alsoincreaseditspolicyinterestratefurther,eventhoughitwasalready




5


ataveryhighlevelinrealterms,andthefiscalstancewastightened.
ThecentralbankoftheRussianFederationhadasimilarresponse.


Expansionhas remainedstrong inalldevelopingregions,with
theexceptionofNorthAfricaandsomecountriesinWestAsia,where
political unrest has adversely affected investment and tourism, and
thusalsogrowth.East,SouthandSouth-EastAsiacontinuetorecord
thehighestGDPgrowthrates,althoughthereisa tendencytowards
some slowdown, reflecting supply-chain effects from Japan, tighter
monetaryconditionsandweakdemandinsomemajorexportmarkets,
notablyJapanandtheUnitedStates.InChina,thecontributionofnet
exportstoGDPgrowthhasdeclined,andfixedinvestmentandprivate
consumptionarenowthetwomajorgrowthfactors.Wagegrowthin
ChinaisanimportantelementinreducingtherelianceoftheChinese
economyonexports,and thus thefullparticipationof labour in the
country’sproductivitygainsiscontributingeffectivelytoarebalancing
ofglobaldemand.


InLatinAmericaandtheCaribbean,expansioncontinuestobe
robust.WhiletheBrazilianeconomyisslowingdown,Argentinaand
mostAndeancountriesaresettorecordanotheryearofrapidgrowth.
InMexico andmost of the smallCentralAmerican andCaribbean
economies,growthwillbemuchmoremodest,mainlyowingtotheir
dependenceon exports to theUnitedStates. Sub-SaharanAfrica is
likelytokeepgrowingatthesamerapidpaceasin2010.Asaresult
ofterms-of-tradegains,investmentininfrastructureandexpansionary
fiscalpoliciesshouldpromoteeconomicgrowthinthesubregion,and
rapiddevelopmentoftheservicessectorwillprovidefurtherimpetus.
However,GDPgrowth rates in sub-SaharanAfrica are unlikely to
contributetosignificantpovertyreductioninthenearfuture,aseconomic
improvementsoftenfailtotrickledowntotheentirepopulation.


Inthetransitioneconomies,althoughgrowthratesareunlikely
toequalthatofthedeveloping-countryaverage,theyhavereturnedto
theirpre-crisistrend,andshouldincreaseconsiderablyfasterthanthose
ofdevelopedcountries.




6


Recovery of international trade and price volatility
in commodity markets


Internationaltradeinbothgoodsandservicesreboundedsharply
in2010,afterhavingregistereditssteepestfallsincetheSecondWorld
War.Thevolumeofinternationaltradeisexpectedtoreturntoasingle-
digitgrowth rate in2011, from14percent in2010,particularly in
developedeconomies.Commoditypricesrecoveredveryearlyinthe
cycleandhavebeenexhibitinghighvolatility,owing largely to the
greaterpresenceoffinancialinvestorsincommoditymarkets.


AlthoughtheUNCTADindexforfoodpricesinFebruary2011
exceededthelevelsreachedduringthefoodcrisisof2007–2008,the
foodsecuritysituationappearstobelesscriticalthanatthattime,owing
totherelativelylowpricesofriceandagoodharvestforgraincrops
inAfricain2010.Moreover,mostfood-exportingcountriesrefrained
fromimposingexportrestrictions,whichhadbeenasignificantfactor
inthefoodcrisisof2007–2008.Nevertheless,theriseinfoodpricesin
2010–2011couldhaveaseriousimpactonfoodsecurity,madeworse
bythethreatoffamineinEastAfrica.Itisagainaddingtoextreme
poverty,asthefoodimportbillofthelow-income,food-deficitcountries
isexpectedtoincreaseby27percentin2011.Therefore,government
measurestoalleviatetheimpactonthepoorestareneeded.


Tosomeextent,risingcommoditypricesarealreadycontributing
totheslowdownofoverallactivityintheconsumercountries,because
highpricesarereducingpurchasingpoweratatimewhenhousehold
incomesarebeinghitbyhighunemployment,slowwagegrowthand
thedebtdeleveragingprocess,particularlyindevelopedcountries.If
highercommoditypricesleadtoawidespreadtighteningofmonetary
policyworldwide,thiscouldbecomeamajorthreattotherecovery.
TheEuropeanCentralBank, for example, continues to take its cue
fromheadline inflation, and has embarked onmonetary tightening
sinceApril2011.However, inviewof theenormous labourmarket
slack in theUnitedStates andEurope,where evennominalwages
arebarelygrowing,theriskofhighercommoditypricestriggeringan




7


inflationary spiral are negligible. Thus a restrictive monetary policy is
not an appropriate measure against high commodity prices, which are
primarily the result of external factors, mostly related to supply-side
shocks and to the impact of financial markets.


Similarly, in emerging market economies, headline inflation
is related less to overheating than to the fact that food and energy
prices have a much greater weight in the consumer price indices of
poorer countries compared with the developed countries. Under these
circumstances, monetary tightening in the absence of overheating would
appear to be largely misplaced, since second-round effects in most cases
have been limited.


Slow wage growth is endangering the recovery


Wage income is the main driver of domestic demand in developed
and emerging market economies. Therefore, wage growth is essential
to recovery and sustainable growth. However, in most developed
countries, the chances of wage growth contributing significantly to,
or leading, the recovery are slim. Worse still, in addition to the risks
inherent in premature fiscal consolidation, there is a heightened threat in
many countries that downward pressure on wages may be accentuated,
which would further dampen private consumption expenditure. In many
developing and emerging market economies, particularly China, the
recovery has been driven by rising wages and social transfers, with a
concomitant expansion of domestic demand. However, as developed
countries remain important export destinations, subdued growth in those
markets, combined with upward pressures on developing countries’
currencies, poses the risk of pressures for relative wage compression
in developing countries as well.


Wage growth that is falling short of productivity growth implies
that domestic demand is growing at a slower rate than potential supply.
The emerging gap can be temporarily filled by relying on external
demand or by stimulating domestic demand through credit easing and




8


raisingofassetprices.Theglobalcrisishasshownthatneithersolution
issustainable.Thesimultaneouspursuitofexport-ledgrowthstrategies
bymanycountriesimpliesaracetothebottomwithregardtowages,and
hasadeflationarybias.Moreover,ifonecountrysucceedsingenerating
a tradesurplus, this implies that therewillbe tradedeficits inother
countries,causingtradeimbalancesandforeignindebtedness.If,on
theotherhand,overspendingisenticedbyeasycreditandhigherasset
prices,asintheUnitedStatesbeforethecrisis,thebubblewillburstat
somepoint,withseriousconsequencesforboththefinancialandreal
economy.Therefore,itisimportantthatmeasuresbetakentohaltand
reversetheunsustainabletrendsinincomedistribution.


The case for an incomes policy


Giventheimportanceofconsumptionforboostingglobaldemand,
incomespoliciesinthebiggesteconomiescouldcontributesignificantly
toabalancedexpansion,especiallywhentheglobalrecoveryisstill
fragile.Anessentialelementofsuchapolicyistheadjustmentofreal
wagesinlinewithproductivity,sothatdomesticconsumptioncanrise
inlinewithsupply.Thiswouldalsohelppreventanincreaseinunit
labourcosts,andthuskeepthemaindomesticsourceofinflationunder
control.Monetarypolicycouldthenreduceitsfocusonpricestability
andpaygreaterattentiontosecuringlow-costfinanceforinvestmentin
realproductivecapacity,whichinturnwouldcreatenewemployment
opportunities.Wagesrisingataratethatcorrespondsapproximatelyto
therateofproductivitygrowth,augmentedbyatargetrateofinflation,
isthebestanchorforinflationexpectations.


The current problems in the eurozone are largely the result of
divergingwageincreasesinthememberStates.Sincethecreationof
theeurozone,wageshaverisenfasterthanproductivityandtheofficial
inflationtargetoftheEuropeanCentralBankinsomememberStates,
andmuchlessinothers,causingconsiderableshiftsincompetitiveness.
Unliketheemergingmarketeconomiesinsimilarcrisissituationsinthe
past,thecountriesintheeurozonethathavelostcompetitivenessand




9


nowfaceseriousdebtproblemsdonothavetheoptionofdevaluingtheir
currencies.Therefore,inadditiontoincometransfers,anexplicitpolicy
ofincreasingwagesinthesurpluscountries,particularlyinGermany,
toreducetheproblemsoffallingcompetitivenessinthemorecrisis-hit
countriesisacrucialpartofthesolution.


A brief “Keynesian moment”


AftermanyyearsofcallsforareducedroleoftheStateineconomic
management,many governments in both developed and emerging
market economies launched large stabilization packages to restore
aggregatedemand,andintervenedintherescueofthefinancialsector.
Beforethecrisis,expansionaryfiscalpolicieswereoftenconsidered
ineffective,onthegroundsthatanyincreaseinthepublicsectordeficit
would be compensated by a concomitant downward adjustment in
privateexpenditure.Butastheimpactofmonetarypolicywaslimited
duringthecrisis,theorthodoxconcernwithbalancedbudgetsorshort-
termfiscal targetscametobeignored,andgovernmentswereagain
viewedas“buyersandborrowersoflastresort”.


However,recentdevelopmentsinfiscalandmonetarypolicyin
many economies, and the recommendations ofmajor international
institutions such as the InternationalMonetaryFund (IMF) and the
OrganisationforEconomicCo-operationandDevelopment(OECD),
suggest that recognition of the need for fiscal stimulus during the
crisishasnotbeenfollowedupbyamoreprofoundrethinkingofthe
principlesofmacroeconomicpolicy.In2011,manygovernmentshave
againreversedtheirpolicyorientationfromoneoffiscalexpansionto
fiscaltightening,andothersareplanningtodoso.Thisisofparticular
concernsince,inmostdevelopedeconomiesthatwereseverelyhitbythe
financialcrisis,theprivatesectorhasnotyetcompletedthedeleveraging
processwherebynon-financialagentstrytoreducetheirindebtednessand
bankstrytorestoretheircapitalratios.Insuchadebt-deflationprocess,
evenifmonetaryeasingandlowinterestratesweretobecontinued,they
couldnotbeexpectedtohaveamajorstimulatingeffect.




10


Thosewhosupportfiscaltighteningarguethatitisindispensable
forrestoringtheconfidenceoffinancialmarkets,whichisperceived
as key to economic recovery.This is despite the almost universal
recognitionthatthecrisiswastheresultoffinancialmarketfailurein
thefirstplace.Itsuggeststhatlittlehasbeenlearnedaboutplacingtoo
much confidence in the judgement offinancialmarket participants,
including rating agencies, concerning themacroeconomic situation
and the appropriateness ofmacroeconomic policies. In light of the
irresponsiblebehaviourofmanyprivatefinancialmarketactorsinthe
run-uptothecrisis,andcostlygovernmentinterventiontopreventthe
collapseofthefinancialsystem,itissurprisingthatalargesegment
of public opinion andmany policymakers are once again putting
theirtrustinthosesameinstitutionstojudgewhatconstitutescorrect
macroeconomicmanagementandsoundpublicfinances.


The strong fiscal impact of the crisis


Thegrowingpublic debt has not been the result of imprudent
fiscalpolicies.Beforethecrisis,between2002and2007–2008,ona
global scalefiscalbalanceshad improved significantly,mainly as a
resultof strong increases inpublic revenuesboth in absolute terms
andasapercentageofGDP.Thiswasaby-productofabroad-based
acceleration of output growth, and, inmany primary-commodity-
exportingcountries,itwasalsoaresultofthepriceboomininternational
commoditymarkets.Inaddition,therewasawidespreaddeclineinthe
shareofinterestpaymentsinpublicexpenditure,largelyduetolower
realinterestrates.Hence,manycountrieshadsubstantialfiscalspace
whenthecrisisoccurred.


The crisis caused a significant deterioration in public sector
accounts as automatic stabilizers operated,which reduced revenues
andincreasedexpenditure,andfiscalstimuluspackageswerelaunched,




11


manyofthemunprecedentedinsize.Inmanydevelopingcountries,
fiscalaccountswerealsostronglyaffectedbyasharpdropincommodity
pricesandhigherinterestratespreadsonthepublicdebt.Inseveral
developed countries the deterioration of fiscal balances reflected
publicbailoutsofailingfinancialinstitutions,whichtoalargeextent
impliedaconversionofprivate intopublicdebt. In2008and2009,
governmentexpenditureasashareofGDPincreasedinallregions,
whilegovernmentrevenuesdeclined.Thisdeclinewasparticularlysteep
intheAfrican,WestAsianandtransitioneconomiesthatrelyheavilyon
theproceedsofprimarycommodityexportsfortheirfiscalrevenues,
anditwasmoremoderateinmosteconomiesofEastandSouthAsia,
andLatinAmerica.


In developed countries, strongfiscal stimulusmeasureswere
particularlycriticaltocounterbalancesharplyshrinkingprivatedemand,
since even extremely expansionarymonetarymeasureswere not
particularlyeffectiveinanenvironmentofmassiveprivatedeleveraging.
TheUnitedStatesimplementedthelargeststimuluspackage,bothin
nominal termsandas apercentageofGDP, followedby Japanand
Germany.Inthedevelopedcountries,about40percentoftheannounced
fiscal stimulus took the formof taxcuts. Inseveraldevelopingand
transitioneconomies,thesizeofthestimuluspackagesasashareof
GDPexceeded thatofdevelopedeconomies,and therewasamuch
greateremphasisonincreasedspendingthanontaxcuts.


The countercyclical policies and the recession led to a sudden
jumpinthepublic-debt-to-GDPratioindevelopedcountries.Bythe
endof2010thatratiohadrisentowellabove60percent,surpassing
the previous peak of 1998. In developing and emergingmarket
economies, the ratio increased onlymoderately following a steep
reductioninthepreviousyears,sothatitisnowmuchlowerthanthat
ofdevelopedcountries.However,therearesubstantialvariationsamong
thedevelopingcountries,andanumberoflow-incomecountriesare
stillindebtdistress.




12


Fiscal space is not a static variable


As current budget deficits and the stock of public debt have
risen sharply in several countries, there is awidespreadperception
thatthespaceforcontinuedfiscalstimulusisalready–orwillsoon
be – exhausted, especially in developed countries.There is also a
perceptionthatinanumberofcountriesdebtratioshavereached,or
areapproaching,alevelbeyondwhichfiscalsolvencyisatrisk.


However,fiscalspaceisalargelyendogenousvariable.Aproactive
fiscalpolicywillaffectthefiscalbalancebyalteringthemacroeconomic
situationthroughits impactonprivatesector incomesandthetaxes
perceived from those incomes. From a dynamicmacroeconomic
perspective,anappropriateexpansionaryfiscalpolicycanboostdemand
whenprivatedemandhasbeenparalysedduetouncertaintyaboutfuture
incomeprospectsandanunwillingnessorinabilityonthepartofprivate
consumersandinvestorstoincurdebt.


In such a situation, a restrictivefiscal policy aimed at budget
consolidationorreducingthepublicdebtisunlikelytosucceed,because
anationaleconomydoesnotfunctioninthesamewayasanindividual
firmorhousehold.Thelattermaybeabletoincreasesavingsbycutting
back spendingbecause sucha cutbackdoesnot affect its revenues.
However,fiscalretrenchment,owingtoitsnegativeimpactonaggregate
demandandthetaxbase,willleadtolowerfiscalrevenuesandtherefore
hamperfiscalconsolidation.Sincecurrentexpenditurecanbedifficult
to adjust (because it is composedmainlyofwages and entitlement
programmes),fiscalretrenchmentusuallyentailslargecutsinpublic
investment.This reduction in growth-promotingpublic expenditure
mayleadtoafallinthepresentvalueoffuturegovernmentrevenues
thatislargerthanthefiscalsavingsobtainedbytheretrenchment.The
outcomecouldbeanimprovementintheimmediatecashflowofthe
government,butwithnegativeconsequencesforlong-termfiscaland
debtsustainability.Moreover,makingbalancedbudgetsorlowpublic
debt anend in itself canbedetrimental to achievingothergoalsof




13


economicpolicy, namelyhigh employment and socially acceptable
incomedistribution.


The failure to consider these dynamic effectswaswhat led to
disappointingoutcomes formany countries that implementedfiscal
tighteningaspartofIMF-supportedprogrammesduringthe1990sand
2000s.Incountrieswherefiscaltighteningwasexpectedtoreducethe
budgetdeficit,thatdeficitactuallybecameworse,oftensizeably,dueto
fallingGDP.InIndonesiainthelate1990s,forexample,aGDPgrowth
rateof5percentwas forecast,but in factoutputshrunkby13per
cent; inThailand, insteadof theexpected3.5percentGDPgrowth
therewasa10.5percentcontraction.Othercountriessharedsimilar
experiences.Thereasonforwhatappearstohavebeenasystematic
miscalculation, leading “inevitably tofiscal under-performance”, as
the IMF’s IndependentEvaluationOfficeput it,wasoveroptimistic
assumptionsaboutthe“crowdingin”ofprivateinvestment.


Anotheroftenneglectedaspectoffiscalspaceisthatthewayin
whichthepublicsectorspendsandtaxesisnotneutral;changesindifferent
types of revenue or expenditure generate differentmacroeconomic
outcomes.Inprinciple,anincreaseinspendingoninfrastructure,social
transfers or targeted subsidies for private investors tends to bemore
effective for stimulating the economy than tax cuts, because it leads
directly to increased purchases and demand.On the other hand,
disposableincomesfromreducedtaxpaymentsarelikelytobespent
onlypartially.Thisisparticularlytruewhentheprivatesectorishighly
indebted,sinceitwouldthenusepartofthetaxproceedsforrepaying
outstandingdebtsratherthanforconsumptionandinvestment.Increased
socialspendingtosupportlow-incomegroupsseemstobearationalway
topromoterecovery,asitpreventstheirconsumptionfromfallingduring
acrisisandpovertyfromrising.Iftaxcutsarethepreferredinstrument,
reductionsofsalesandvalueaddedtaxesaswellasincometaxcuts
forthelowerincomegroupsthathaveahigherpropensitytospendare
generallymoreeffectiveinraisingdemandandnationalincomethan
taxcutsforthehigherincomegroups.




14


Determinants of public debt


Highandrisingpublicdebtratiosareclearlyalegitimatepolitical
concern, but like fiscal space, public deficit and debt limits are
difficulttodefine,sincetheyhavestronginterrelationshipswithother
macroeconomicvariables.Therefore,anyattempttoidentifyacritical
levelof“sustainable”debtisadifficulttask.Governments’economic
policies anddebt strategies have to take into account their specific
circumstancesandsocialneedsaswellastheirexternalrelationships.


Empirical evidence shows that, even thoughfiscaldeficits and
public debt constitute a relatively highproportionofGDP in some
partsoftheworldtoday–especiallyinsomedevelopedcountries–in
manycountriestheyarenotlargebyhistoricalstandards.Moreover,it
isnotonlytheabsolutestockofdebtthatmattersforthesustainability
ofthepublicdebt,buttherelationshipbetweenthatstockandsome
otherkeyvariables.Thesevariablesinclude,inadditiontotheprimary
fiscalbalance,theaverageinterestratetobepaidontheoutstanding
debt,thegrowthrateoftheeconomyandtheexchangerate.Thelatter
stronglyinfluencesnotonlythedomesticvalueoftheforeign-currency-
denominated debt, but also the demand for domestically produced
goods.


Therefore,unsustainablepublicdebtpositionsarenotalwaysthe
outcomeofexpansionary–orirresponsible–fiscalpolicies.Primary
deficitscausedbydiscretionaryfiscalpolicieshaveevenbeenfound
tocontributelesstohigherdebtratiosthanslower(ornegative)GDP
growthandbankingandcurrencycrises.Conversely,evenifgovernment
budgets are in primarydeficit, the public-debt-to-GDP ratio canbe
reduced, provided thenominal interest rate onpublic debt is lower
thanthegrowthrateofGDP.Thus,monetarypolicyplaysanimportant
role in determining the sustainability of the public debt.However,
countriesthathaveforeign-currency-denominateddebt,orthatdonot
havecontrolovertheirownmonetarypolicy,mayexperiencesudden
surgesinborrowingcostsduringeconomiccrisespreciselywhentheir
abilitytopayislimited.Indevelopingcountries,empiricalevidence




15


showsthatcontractionaryeffortshavenotbeenparticularlysuccessful,
andthat,normally,debtsustainabilityhasbeenachievedbypromoting
higherratesofeconomicgrowth.


Theresponse toacrisisshoulddependon itscause. Ifacrisis
originatesfromtheburstingofanassetbubble,amorerationalresponse
would be financial reform, and even quite the opposite of fiscal
retrenchment,namelycountercyclicalpoliciestoabsorbprivatesector
deleveragingsoastoreducethemacroeconomicslumpcreatedbyasset
deflation.Ifthecrisisoriginatesfromoverexposuretoforeigncreditors
andexcessiveappreciationofthedomesticcurrency,theappropriate
responseatthenationallevelmightbetoimprovethedebtstructure,as
wellasintroducepoliciesaimedatavoidingmisalignmentsofthereal
exchangerateandimposingcontrolsoncapitalinflows.


Financial deregulation opened the door to
excessive risk taking


The recent sharp increase in public sector deficits and public
indebtednessistheresultofagravecrisisinthefinancialsystemfollowing
awaveoffinancialliberalization,ledbytheso-called“Anglo-Saxon”
economies. It is, therefore, somewhat ironic that thefinancial agents
thatcausedthecrisisshouldhavebecomethejudgesofthesuitabilityof
publicpoliciesadoptedtocontainitsdamage.Financialliberalizationand
deregulationwasbasedonawidespreadbeliefinthegreaterefficiency
ofmarketforces,anditledtothecreationofincreasinglysophisticated
financialinstruments.Deregulationwasinpartaresponsetopressure
fromcompetitiveforcesinthefinancialsector,butitwasalsopartofa
generalizedtrendtowardslessgovernmentinterventionintheeconomy.
Newfinancialinstrumentsandcontinuedliberalizationinthefinancial
system allowed speculative activities to expand significantly, so
thatgamblingbecamean important and, at timesdominant, feature
offinancial activities.This became a source of instability inmany
economies,andindeed,intheentireinternationaleconomicsystem.By
contrast,itisdifficulttofindanynewfinancialinstrumentsthathave




16


contributedtoincreasingtheefficiencyoffinancialintermediationfor
thebenefitoflong-terminvestmentinrealproductivecapacity.


Evenwhenfinancialderegulationandcurrent-accountliberaliza-
tion resulted in an increasing number of financial crises in both
developed anddeveloping countries, the strongbelief thatmarkets
arethebest judgesofefficientfactorallocationledpolicymakersto
continuewithfinancialderegulation.Ittooktheglobalfinancialcrisis
tofinallyforceaseriousdebateaboutthenecessityforfundamental
reformstopreventsimilarcrisesinthefuture.Widespreadconsensus
that deregulationwasoneof themain factors leading to theglobal
financialandeconomiccrisis ledtocallsforstrengtheningfinancial
regulationandsupervision.


Markets are important, but financial
markets work differently


Financialmarkets do not function in the sameway as typical
marketsforgoodsandservices.Whileentrepreneursparticipatingin
goodsmarketsareconcernedwiththecreationofnewrealassetsthat
have thepotential to improveproductivityand increaseall incomes
in the future, financialmarket participants are primarily concerned
withtheeffectiveuseofinformationadvantagesconcerningexisting
assets.Ingoodsmarkets,pricediscoveryisbasedoninformationfrom
amultitude of independent agentswho act according to their own
individualpreferences,andopportunitiesforprofitarisefromindividual
pioneeringactionsbasedontheprivate,circumstantialinformationof
themarketparticipants.Bycontrast, infinancialmarkets,especially
thoseforassetswhichfall in thesamebroadriskcategory(suchas
equities,emerging-marketcurrencies,andmorerecently,commodities
andtheirderivatives),pricediscoveryisbasedoninformationrelatedto
afew,commonlyobservableevents,orevenonmathematicalmodels
thatmainlyusepast–ratherthanonlycurrent–informationformaking
priceforecasts.




17


Thefatalflawinthefunctioningoffinancialmarketsliesinthefact
thatthemostprofitableactivitiesareoftenderivedfromherdbehaviour
(i.e.followingthetrendforsometimeanddisinvestingjustbeforethe
restofthecrowddoes).Actingagainstthemajority,evenifjustifiedby
accurateinformationaboutfundamentals,mayresultinlargelosses.Thus,
whenevermarketparticipants“discover”thatpricetrendsindifferent
marketsprovideanopportunityfor“dynamicarbitrage”(i.e.investment
intheprobabilityofacontinuationoftheexistingtrend),andallbeton
thesameoutcome,suchasrisingpricesofrealestate,equitiesorother
assets,sincethesameinformationisavailabletoallmarketparticipants,
thereisastrongtendencyforherdbehaviour.Asaresult,theherdacquires
themarketpowertomovethosepricesinthedesireddirection.


This iswhy prices in financial and “financialized”markets
sometimes tend to overshoot,which gives rise towrongprices for
extendedperiodsoftime.Asherdingdominatesthescene,nosingle
participantquestionswhethertheunderlyinginformationiscorrector
canberationallyrelatedtoeventsanddevelopmentsintherealeconomy.
Thisphenomenonhasbeenobservednotonlyinsecuritiesmarketsand
marketsforfinancialderivatives,butalsoincurrencyandcommodity
futuresmarkets.Thusfinancialmarketsthemselveshavecreatedmost
ofthe“fattail”risksthathaveledtotheircollapseinfinancialcrises.
Uncertaintyabouttheappropriatevaluesofbankassetsduringsuch
bubblescanbecomesohighthatnocapitalrequirementorliquidity
buffercanabsorbthesubsequentshock,sothatgovernmentshaveto
stepinwithrescuepackages.


Re-regulation of financial markets is indispensable


Oversome150yearsofbankinghistory,animplicitaccordhad
emergedthatintimesofcrises,governments,orcentralbanksservingas
“lenderoflastresort”,wouldprovidethenecessarysupporttoprevent
thecollapseofindividualfinancialinstitutionsandoftheoverallsystem.
Inreturntheseinstitutionsweresubjecttogovernmentregulationand
supervision.Therehadalwaysbeenariskthateventsintherealeconomy,




18


such as failure of a large debtor or a generalized recession, could
generatedifficultiesinthefinancialsector.Thisbecameparticularly
evidentduringtheGreatDepressionofthe1930s,asaconsequenceof
which lender-of-last-resort functionswere institutionalized, together
withdepositinsuranceaimedatpreventingbankruns.


However,with the trend towards deregulation of thefinancial
systemover thepast threedecades, thesituationhasbeenreversed:
today,thefinancialsectorhasincreasinglybecomeasourceofinstability
fortherealsector.Atthesametime,officialsupportforthissectorhas
becomemore frequentand involvesever larger injectionsofpublic
money.Financialmarketswerederegulated,despitefrequentfailuresof
thosemarkets.Therefore,toprotecttherealsectoroftheeconomyfrom
thenegativespillovereffectsthatareendogenouslygeneratedinthe
financialmarketitself,aconsiderabledegreeofofficialre-regulationis
neededwhichwouldre-establishaproperbalancebetweengovernment
protectionofthefinancialsectorandgovernmentregulationoffinancial
institutions.


Becausefinancialmarketsaresolittleunderstood,anunresolved
issue is the systematic underestimation of risks that arisewhen all
participantsinacertainsegmentofthefinancialmarketmoveinthe
samedirectionthroughherdbehaviour.Thiscanresultinso-called“tail
risks”,which,althoughoccurringveryrarely,whentheydooccur,the
consequencescanbecatastrophic.Themarketscanonlybestabilized
iftheynolongerhavethepowertomovepricesinthewrongdirection
or to overshoot the fair value by awidemargin.Thus, systematic
interventionbygovernmentsshouldbecomealegitimatetooltocorrect
marketfailures.


The deregulation of financialmarkets has also allowed an
increasedconcentrationofbankingactivitiesinasmallnumberofvery
biginstitutions,aswellasashiftinbankfunding,fromarelianceon
depositstoagreaterrelianceoncapitalmarkets,andfromlendingto
trading.Moreover,ithaspavedthewayforthedevelopmentofalargely
unregulated “shadowfinancial system”, particularly in developed




19


economies.Byearly2008,theliabilitiesofthatsystemwerealmost
twicethoseofthetraditionalbankingsector.Byabsorbingmanyofthe
newlycreatedfinancecompaniesormoneymarketfunds,orbycreating
theirownonesundertheumbrellaofbankholdingcompanies,banks
outsourcedalargesegmentoftheircreditintermediationfunctionsto
associatedcompaniesintheshadowsystem.Somepartsofthissystem
(e.g.moneymarketfunds)playedthesameroleasthatofbanksbut
withvirtuallynoregulation,andthevolumeofactivitiesofsuchgroups
hasalwaysbeenbackedbytoolittlecapital.


Muchof the systemic risk in thefinancial systemhas derived
from the systemically important financial institutions. Proposals to
address this “too-big-to-fail” problemhave concentrated, so far, on
additionalcapitalrequirementsandimprovedsupervisionratherthan
onrestructuring.Amorecomprehensiveapproachshouldalsoinclude
aspecialresolutionprocedureincaseofcrises,whichshouldnotplace
aburdenongovernmentresources,andtheintroductionofsizecaps,
whichmaybeabsoluteorrelativetoGDP.


Towards a restructuring of the banking system


Astheproblemofmispricingisasystemicfeatureoffinancial
markets,regulationshouldfocusonthesystem,ratherthanonbehaviour
insidethesystem,withaviewtoensuringthatthesystemasawhole
betterservesrealproductiveinvestmentandgrowthintherealeconomy.
Aclear separationofdeposit-taking institutions from those that are
engagedininvestmentbankingactivitiescouldhelppreventgambling
bycommercialbanks.Thiswouldalsoreduce thesizeand increase
thediversityofbankinginstitutions.Publiclyownedbankscouldplay
amore important role, not only for developmentfinance purposes,
butalsoasanelementofdiversityandstability.Thesekindsofbanks
haveturnedouttobemoreresilientduringcrises,andtheyhavepartly
compensatedforthecreditcrunchintheprivatesystemcausedbythe
recentcrisis.Theymayalsohelppromotecompetitioninsituationsof
oligopolisticprivatebankingstructures.




20


Asthelatestfinancialcrisiswasgeneratedintheprivatefinancial
sector,manyoftheargumentsrepeatedlyadvancedoverthepastfew
decadesagainstpubliclyownedbankshavefurtherlostcredibility.When
thecrisisstruck,largebanksinEuropeandtheUnitedStateswereable
tosurviveonlybecausetheybenefitedfrompublicfundsandguarantees.
While during the boomperiod private institutions and individuals
enjoyedlargeprofitsandbonuses,governments–orthetaxpayers–have
hadtobearthedownsideriskduringslumps.Thereforethepointthat
onlypubliclyownedbanksenjoyanadvantagethroughtheiraccessto
publicresourceshasbeenprovenwrong.Moreover,thefactthatthese
institutionsarepublicentitiesreducestheirincentivetoengageinherd
behaviour,exaggeratedriskexposureandmaximizationofreturns.


Growing financial speculation in
primary commodity markets


Commoditypriceshavedisplayedconsiderablevolatilityoverthe
pastdecade.Thecommoditypriceboombetween2002and2008was
themostpronouncedinseveraldecades–inmagnitude,durationand
breadth.Thesubsequentpricedecline following theeruptionof the
currentglobalcrisisinmid-2008wasnotablebothforitssharpnessand
forthenumberofcommoditiesaffected.Sincemid-2009,andespecially
sincethesummerof2010,globalcommoditypriceshavebeenrising
again,thoughtherewassomeflatteningoutinthefirsthalfof2011.


Someobservers consider broad-based changes in fundamental
supplyanddemandrelationshipsasthesoledriversofrecentcommodity
price development.However, analyses are increasingly supporting
the view that these fluctuations have also been influenced by the
growing participation of financial investors in commodity trading
forpurelyfinancialmotives–aphenomenonoftenreferredtoasthe
“financializationofcommoditytrading”.


While participation of financial actors in commoditymarkets
isgenerally recognizedasanormal featureof themarket,acrucial




21


question is thesizeof thefinancialflowsand that theydriveprices
away fromfundamentalsand/or increase theirvolatility. Ingeneral,
theirparticipationcouldbeeconomicallybeneficialbymakingmarkets
deeperandhelpingtoaccommodatethehedgingneedsofcommercial
usersandreducetheirhedgingcosts,buttheirherdbehaviourdestroys
thesebenefits.Financialinvestorssuchasindexfundsdonotpromote
liquidityinmarkets,whichwouldbringdiversitytothosemarkets;most
ofthemfollowthesamestrategybygoinglonginthestrongbeliefthat
pricesonthosemarketswillcontinuetoriseintheforeseeablefuture.
Suchfinancializationofcommoditymarketshascausedthosemarkets
to follow less the logicof a typicalgoodsmarket andmore thatof
financialmarketswhereherdbehaviouroftendominates.


Herdingincommoditymarketscanbeirrational,basedonwhat
maybecalled“pseudo-signals”suchasinformationrelatedtoother
assetmarkets and the use of inflexible trading strategies, including
momentuminvestmentorpositivefeedbackstrategies.Suchstrategies
assumethatpricedevelopmentsofthepastcarryinformationonfuture
pricemovements,givingrise,forexampletotrendchasing.Thisresults
inbuyingafterpricesriseandsellingafterpricesfall,independently
ofanychangesinfundamentals.


Butherdbehaviourcanalsobefullyrational.Information-based
herding,forexample,referstoimitationwhentradersbelievethatthey
cangleaninformationbyobservingthebehaviourofotheragents.In
otherwords,investorsconvergeintheirbehaviourbecausetheyignore
theirprivateinformationsignals.Position-takingbasedonlyonother
peoples’previousactionswillleadtopricechangeswithoutanynew
informationbeingintroducedtothemarket.Asequenceofsuchactions
causesasnowballeffect,whichwilleventuallyleadtoself-sustaining
assetpricebubbles.Informationalherdingismostlikelytooccurin
relativelyopaquemarkets,suchasincommoditytrading.




22


Correlated movements on equity, commodity
and currency markets


Identifyingtheextenttowhichfinancialinvestmenthasaffectedthe
levelandvolatilityofcommoditypricesischallengingduetothelimited
transparencyandlevelofdisaggregationofexistingdata.However,there
isevidencetosupporttheviewthatfinancialinvestorshaveaffectedprice
dynamicsintheshortterm.Onesuchpieceofevidenceconcernsthe
roleofdramaticchangesinfinancialpositionsintheoilmarketbetween
FebruaryandMay2011.Anotherrelatestostrongcorrelationsbetween
commoditypricemovementsanddevelopmentsonequityandcurrency
markets,whichareknowntohavebeenexposedtospeculation.


A comparison of commodity and equity price developments
overvariousbusinesscyclesshowsthatthosepricesusedtomovein
oppositedirectionsduringtheearlyupswingsofpreviouscycles.In
contrast,therehasbeenaremarkablesynchronizationofthoseprice
movementsinthemostrecentcycle.Thisincreasedsynchronizationis
surprisingbecauseoftheverylowlevelofcapacityutilizationinthe
wakeofthe“GreatRecession”of2008and2009,whichmeantvery
lowdemandforcommodities.Despitethis,commoditypricesincreased
evenbeforetherecoverybeganinthesecondquarterof2009andkept
growinginthetwosubsequentyears,partlyduetorisingdemandin
emergingeconomiesbutalsotoalargeextentbecauseofpurelyfinancial
operations.Consequently,twoyearslatermonetarypolicyhasreacted,
even though there is still avery low levelofcapacityutilization in
developedeconomies.Thispointstoanotherworryingaspectofthe
impactoffinancializationthathassofarbeenunderestimated,namely
itscapacitytoinflictdamageontherealeconomyasaresultofsending
thewrongsignalsformacroeconomicmanagement.


Measures in response to commodity price instability


Short-termemergencymeasuresareneededtopreventormitigate
thenegativeimpactofadversecommoditypricedevelopments.Atthe
sametimeitisnecessarytodevisewaysofimprovingthefunctioning




23


ofcommodityderivativesmarketstoenablethosetradingvenuesto
betterfulfiltheirroleofprovidingreliablepricesignalstocommodity
producersandconsumers,oratleastpreventthemfromsendingthe
wrongsignals.


In light of the vital role of information in commodity price
developments,asetoffourpolicyresponsestoimprovethefunctioning
ofthosemarketsshouldbeconsidered,especiallyforfoodandenergy
commodities.First, thereshouldbegreater transparencyinphysical
marketsthroughtheprovisionofmoretimelyandaccurateinformation
aboutcommodities,suchassparecapacityandglobalstockholdingsfor
oil,andforagriculturalcommodities,areasunderplantation,expected
harvests, stocks and short-termdemand forecast.Thiswould allow
commercialmarketparticipantstomoreeasilyassesscurrentandfuture
fundamentalsupplyanddemandrelationships.Second,thereneedsto
beabetterflowofandaccesstoinformationincommodityderivatives
markets,especiallyregardingposition-takingbydifferentcategoriesof
marketparticipants.Thiswouldfurtherimprovemarkettransparency.
Inparticular,measuresdesignedtoensurereportingrequirementsfor
tradingonEuropeanexchanges,similar to thoseenforcedinUnited
States exchanges, would considerably improve transparency of
tradinganddiscourageregulatorymigration.Third,tighterregulation
offinancialmarketparticipants,suchassettingpositionlimits,could
reducefinancialinvestors’impactsoncommoditymarkets.Proprietary
tradingbyfinancialinstitutionsthatareinvolvedinhedgingtransactions
oftheirclientscouldbeprohibitedbecauseofconflictsofinterest.This
requiresfindingtherightbalancebetweenadoptingoverlyrestrictive
regulation,whichwouldimpairtherisk-transferfunctionsofcommodity
exchanges,andoverlylaxregulation,whichwouldequallyimpairthe
basicfunctionsoftheexchanges.


Fourth,market surveillance authorities could bemandated to
intervenedirectlyinexchangetradingonanoccasionalbasisbybuying
orsellingderivativescontractswithaviewtoavertingpricecollapses
ortodeflatingpricebubbles.Suchinterventioncouldbeconsidereda
measureoflastresorttoaddresstheoccurrenceofspeculativebubbles




24


ifreformsaimedatachievinggreatermarkettransparencyandtighter
marketregulationwereeithernotinplaceorprovedineffective.While
most of the triggermechanismcould be rules-based, and therefore
predictable,suchinterventionwouldnecessarilyhavesomejudgemental
components.However,doubtshavesometimesbeenraisedaboutthe
abilityofmarketauthoritiesorgovernmentagenciestounderstandand
followthemarket.Theseareunfounded,becausethereisnoreasonwhy
theirunderstandingshouldbeanydifferentfromthatofothermarket
participants;inmarketsthatarepronetoherdbehaviour,theyallhave
accesstosimilarinformation.Moreover,contrarytotheothermarket
participants,aninterveningauthoritywouldhavenoincentivetoengage
inanyformofherdbehaviour.Rather,itcouldbreaktheinformational
cascadesthatunderlieherdbehaviourbyannouncingwhenitconsiders
pricestobefaroutoflinewithfundamentals.


Exchange rates have become disconnected from
macroeconomic fundamentals


The current debate on reform of the internationalmonetary
systemhasbeendealingmainlywithsymptomsratherthanwiththe
mainproblems.Thestrongincreaseinforeignexchangereserves,the
stillhegemonicroleofthedollaranddestabilizingshort-termcapital
inflowsaremainlyduetoseriousdefectsintheglobalexchangerate
regime.Foreignexchangemarketsareunderthedominantinfluenceof
financialmarketbehaviourthatisdisconnectedfrommacroeconomic
fundamentals.Thisisasourceofcurrent-accountimbalances,distortions
in international factor allocation and additional uncertainty for all
participantsininternationaltrade.


EvenafterthebreakdownoftheBrettonWoodssystemandthe
adoptionofwidespreadexchangeratefloatingin1973,international
economic policy-making has often assumed that it ismainly real
shocks, rather thanmonetaryshocks, thatneed tobe tackledby the
international system.However, after several decades of experience




25


it has become clear that monetary shocks, particularly in a system of
flexible exchange rates, are much more significant and harmful. Whereas
the international exchange of goods and services is subject to the rules
and disciplines of the multilateral trading system, the absence of an
international monetary system allows individual countries autonomy
in their exchange rate policies, even when such policies have adverse
impacts on the global economy by creating financial booms and busts
and distortions in international trade.


Exchange rate developments that diverge from those that would be
warranted on the basis of fundamentals can be attributed to two major
factors: either significant cross-country differences in the evolution of
unit labour costs in the context of a regime where nominal exchange
rates are not flexible enough, or excessive short-term capital inflows
that lead to an appreciation of an overly flexible nominal exchange
rate. In a situation where unit labour costs vary among countries,
because of differences in the growth of wages relative to productivity,
exchange rate adjustments are necessary to prevent the build-up of trade
imbalances arising from a shift in competitiveness among countries.
Not all current-account disequilibria are due to misaligned exchange
rates. However, deviations of the real exchange rate from fundamentals,
especially if persisting over long periods, have a major impact on the
international competitiveness of producers, particularly of manufacturers
of any country, and thus on the pattern of international trade and trade
balances.


On the other hand, deviations of exchange rates from what
would be warranted by economic fundamentals can also arise from
the impact of private short-term capital flows that are attracted by
positive interest rate differentials. In such cases, the exchange rate of a
country with higher interest rates – reflecting a higher rate of inflation
or tight monetary policy – appreciates, although the macroeconomic
conditions would require a depreciation. Once the underlying interest
rate differential narrows or disappears completely, or in a situation of
crisis, the earlier appreciation is typically followed by an overshooting
currency depreciation that is again out of line with fundamentals.




26


Redesigning the exchange rate system


In the current non-system, individual countries have tried to
find temporaryandpragmatic solutions to theproblemsofover-or
undervaluation.Onesolutionisunilateralinterventioninthecurrency
markets,evenonadailybasis;anotheriscapitalcontrolsorthetaxation
of inflows of hotmoney.All of thesemeasures are justified in an
environmentwherethereisstillabeliefthat,inprinciple,“themarket”
isabletofindtherightexchangerates.However,theydonotsolvethe
mosturgentproblem,thatofapplyingthe“categoricalimperative”of
internationalexchangebyfindingtheinternationalvalueofthecurrency
ofonecountrywhichallitstradingpartnerscanaccept.


Abetterdesignoftheglobalexchangeratesystemhastoensure
thatprivatefinancialactors,whosebehaviourisoftendrivenbypurely
speculativeconsiderationsandherding,donotexertexcessiveinfluence
onthedeterminationofexchangerates,andthusonthecompetitiveness
ofproducersofdifferentcountriesininternationaltrade.Governments
and central banks need to take the initiative by targeting exchange
ratesandensuringthatdeviationsfromthosetargetsareminimaland
temporary.


Asystemofexchangeratemanagementthathelpspreventtrade
distortionsandservesasasourceofstabilityininternationalfinancial
relationswould need to include rules that provide: (a) sufficient
stabilityoftherealexchangerate(themostcomprehensivemeasureof
competitiveness)toenhanceinternationaltradeandfacilitatedecision-
makingonfixedinvestmentinthetradablesector,and(b)sufficient
flexibility of the exchange rate to accommodate differences in the
developmentofinterestratesacrosscountries.


Rules-based managed floating to curb speculation


Greaterstabilityoftherealexchangeratecouldbeachievedbya
systemofrules-basedmanagedfloating.Inprinciple,sucharegimemay
beregardedasadynamicversionoftheBrettonWoodssystem,which




27


wasbasedontheruleoffixedbutadjustablenominalexchangerates.
LiketheBrettonWoodssystem,itwouldaimatavoidingfundamental
balance-of-paymentsdisequilibria;butunlikethatsystem,itwouldrely
oncontinuousadjustmentsofthenominalexchangeratealongapath
basedonpurchasingpowerparity(PPP)oruncoveredinterestrateparity
(UIP).Inordertoachievegreaterstabilityoftherealexchangerate,the
nominalexchangeratewouldbeadjustedaccordingtodivergencesin
theevolutionofconsumerpricesorunitlabourcostsinthefirstcase,
ortodifferencesinshort-terminterestratesinthesecond.


Exchangeratemanagementbasedonsuchasystemwouldremove
theincentivesforspeculationofthecarry-tradetype.Thus,short-term
capitalmovementsthathavenolinkageswithtradeorrealinvestment,
butareentirelymotivatedbyexpectationsofprofitsfrominterestrate
arbitrageacrosscurrenciesandsubsequentexchangerateappreciation
ofthetargetcurrency,woulddisappear.


Overthemediumterm,astrategyofmanagedfloatingbasedona
UIPruleisnotverydifferentfromastrategythattargetstheexchange
ratebasedonaPPPpath.InaUIP-basedsystem,thenominalexchange
ratewould depreciatewhenever a positive interest rate differential
arose, andwould thus cancel any gain that could be had from the
interestratedifferential.Ithastheadvantageofdirectlydealingwith
financialmarkets.ThesemarketsaremoresensitivetoUIPdeviations
thangoodsmarkets,whichreacttoPPPdeviations.TheUIPrulealso
hastheadvantagethatUIPcanbeidentifiedatveryshortnotice,andon
thebasisofofficialinterestratesratherthanstatisticalmeasurements.
However,itmaybedifficulttoapplyinsituationsofverylargeinterest
rate differentials, because the required adjustments of the nominal
exchangeratewouldcausesignificantincreasesinimportpricesand
asharpriseinthedomesticcurrencyvalueoftheexternalprivateand
publicdebt.Inthiscase,applyingthePPPrulebasedonunitlabourcost
mightbethemoreappropriatesolution.Underthisrule,thenominal
exchangeratewouldbedepreciatedbyanamountdeterminedbythe
differential in unit labour costs, thereby neutralizing its impact on
internationalcompetitiveness.




28


The concrete terms of a systemof rules-based exchange rate
managementwouldneedtobediscussedandelaboratedfurther.The
problemofhowtodeterminethelevelandallowablerangeofnominal
exchangeratechangesattheoutsetwouldhavetoberesolved.This
wouldrequireadetailedinvestigationintothepurchasingpowerofall
currencies.Countriescouldalsoapproachthestartingexchangerateof
suchasystembymakingdiscreteparityadjustmentsbeforeengaging
intherules-basedmanagedfloatingstrategy.


The need for symmetric intervention


In a systemof rules-basedmanagedfloating along these lines,
centralbankswouldgainadegreeoffreedominsettingdomesticshort-
terminterestratesinlinewithdomesticmacroeconomicobjectives.At
thesametime,itsimplementationwouldbeconsiderablyfacilitatedifthe
policytocontrolinflationweretorelymainlyonanincomespolicythat
aimstocheckinflationarypressuresinsteadofonamonetarypolicy.


Tosomeextent,rules-basedmanagedfloatingcanbepracticed
asaunilateralexchangeratestrategy. Ifacountry is facedwith the
problemofshort-termcapitalinflowsgeneratingappreciationpressure
on its currency, this strategy could be appliedwithout quantitative
limitations,andwithoutentailingoperatingcostsforitscentralbank.
However,whenfacedwiththeproblemofcapitaloutflows,thereare
limitstotheextentofcentralbankintervention,which,intheabsence
of appropriate support from international financial institutions, are
determinedbytheamountofitsforeignexchangereserves.Inthiscase,
symmetricinterventionbyoneormorecountrieswhosecurrenciestend
toappreciateasacounterparttothefirstcountry’scurrencydepreciation
pressurewillbenecessarytomakethesystemwork.Therefore,thenext
bestsolutionwouldbetheapplicationofthesystemthroughbilateral
agreementsorasakeyelementofregionalmonetarycooperation.The
greatestbenefitforinternationalfinancialstabilitywouldresultfrom
therulesformanagedfloatingbeingappliedmultilaterallyaspartof
globalfinancialgovernance.




29


Towards greater efficiency of international
goods markets


The principle of rules-basedmanagedfloating should not be
contentious,althoughtheconcretetermsanddetailsneedtobeworked
out.Itwouldmaketheinternationalmarketsforgoodsandservicesmore
efficientbypreventing internationalfinancialmarkets fromcreating
seriousdistortionsininternationaltraderelations.Itacknowledgesthat
financialmarketsdonotfunctioninthesamewayasgoodsmarkets,and
arethereforemorepronetoherdbehaviourthatcanleadtoover-and
undershootingofthefairvalueofcurrencies.Thefrequentargument
thatgovernmentscannotknowthecorrectvalueofacurrencybetter
thanmarketshasbeenrefutedbytheperformanceoffinancialmarkets,
whichhaveconsistentlyfailedtofindtherightvalues.


Inanycase, if currencyappreciationasa resultof speculative
capitalflowscouldbeavoidedbythesysteminthefirstplace,therisk
of a speculative attack that could subsequently lead todepreciation
pressurewouldbemuchsmaller.Thiswouldalsoreducetheneedfor
centralbankstoaccumulateforeignexchangereservesforprecautionary
reasons,andthereforetheneedforsymmetricalinterventionaltogether.
Nevertheless,shouldsuchasituationarise,theuseofcapitalcontrols
asasupplementarymeasureshouldbewelcomedbytheinternational
communityasanotherlineofdefence,sincepredictableexchangerates
areatleastasimportantforthefunctioningoftheinternationaltrading
systemasmultilaterallyagreedtraderules.


Thereformagendain thewakeof theglobalfinancialcrisis is
far frombeingcompleted. Ithasadvancedslowly,andmuchof the
enthusiasmforreformhaswaned.Thereisaveryrealriskofnewcrises
erupting,and,inahighlyintegratedandexcessivelyfinancializedworld
economy,suchcriseswouldnotbelimitedtospecificsegmentsofthe
financialsystemortospecificcountriesorregions.Evenifacrisishas
itsoriginindevelopedcountriesandtheircomplexfinancialmarkets,
developing countries and emergingmarket economieswill also be
affected,asevidencedbythelatestcrisis.TheG-20hasrecognizedthis




30


fact,butactionsbytheG-20alonearenotenough.Theworldeconomy
asawholeisfacedwithseriousandfundamentalchallenges,suchas
eliminatingpovertyandthetransitiontomoreclimate-friendlypatterns
ofproductionandconsumption.Totacklethesechallengessuccessfully,
alltheothercountriesintheworldneedtoparticipate,soonerorlater,
in the process offinding solutions.These include creating a stable
macroeconomicenvironmentthatencouragesanappropriatelevelof
investmentinfixedcapital,whichisneededforsupportingthenecessary
structuralchange.Thereforeitremainsimperativefortheinternational
communityanditsinstitutionstoaddresstheunfinishedelementsinthe
globalreformagendamorevigorouslythanhasbeendonesofar.


SupachaiPanitchpakdi
Secretary-GeneralofUNCTAD




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