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Architecture of the International Financial System

Asia

The "Asian Currency Crisis" not only demonstrates the speed with which a strongly growing economy can falter, but more importantly, it has presaged a newly emerging environment of international governance through the actions and policies of the G8 governments, and the international institutions, primarily the IMF, which they support.

To review, 1997 saw severe currency depreciation and economic slowdown affect many of the "Asian Tiger" economies. The general causes of this downturn are threefold. Firstly, an overheated economy produced stock and property market "bubbles". Secondly, the policy of "pegging" exchange rates to the US dollar produced the illusion of risk free US$ borrowing by local firms. Lastly, inadequate financial sector regulation and credit assessment by financial institutions themselves, combined in many cases by "government directed" credit decisions, exacerbated the weakness in the economy.

In response to massive currency depreciation, mounting private sector debt and a general loss of confidence in their economies, South Korea, Thailand and Indonesia have requested and gained access to IMF resources totalling over US$ 100 billion. The central themes of these agreements are:

• Transparency of information (e.g. external debt levels, corporate sector leverage);
• Increased supervision of the financial sector;
• Liberalization of capital flows in an orderly manner (applying to all types of capital);
• Involvement of the private sector in debt relief and economic problem-solving;
• Strengthening multilateral institutions with "equitable" national representation;
• Greater "regional surveillance";
• Corruption-free government and public service.

These principles are consistent with the IMF's role in promoting a smoothly operating international monetary system (including stable exchange rates) in which cooperation between nations can overcome specific economic crises for the mutual benefit of all countries. Importantly, the principles of these reform packages illustrate an increasing trend towards diminished national sovereignty in the face of cooperative economic efforts. International aid is provided to nations who alone could not halt strong economic forces. However, these countries must also accept the international norms of economic policy. Comments and input on domestic economic conditions from other nations are specifically encouraged through "regional surveillance" and "multilateral institutions". Moreover, the IMF-supported reforms address very specific economic policy issues such as domestic product market structures, accounting standards and the conditions of the labour market, all of which were traditionally viewed as "domestic" affairs.

The IMF has thus altered its focus from an almost exclusive concern with macroeconomic stability in its recent past to an increasingly important goal of microeconomic policy reform. The G7 Finance Ministers and Central Bank Governors meeting in London earlier this year fully supported the tenets of this kind of domestic microeconomic reform as a way of achieving global economic stability. As representatives of the world's largest and most affluent economies, G8 leaders can be expected to support IMF led efforts to adopt policy measures similar to the standards in their own developed economies with which they are familiar. The leaders can also be expected to support the implicit leading influence of organizations such as the G8 in setting world economic policy.

Exchange Rate Management

Europe and the Euro

On January 1, 1999, the European Union will launch a new currency, the Euro, with all member states anticipated to join save the UK, Sweden, Denmark and Greece. This event is not only a significant step in on-going economic convergence and union between EU countries, but it also introduces a major new international currency. As such, its introduction has major long-term implications for both relations between EU and non-EU members, and between EU members themselves, at multilateral institutions such as the G8.

In order to qualify for Euro membership, the Maastricht treaty set out criterion which help foster the degree of economic convergence needed for a single currency area to work. The treaty requires a sustainable government financial position, price stability, normal fluctuation of currencies and interest rate convergence. On May 2, 1998, the European Council (composed of Heads of Government) will likely accept all 11 members.

While the current G8 Summit will likely not concentrate on the Euro currency issue, this institution will gain a greater role in discussing and setting global exchange rate policies. Once established, the ECB (European Central Bank) will focus on internal issues concerning integration and price stability. While there is some support within the EU for the ECB to adopt a goal of increased employment, it is likely the official primary mandate of price stability (per Article 105 of the Treaty) will be pursued, particularly with Dutchman Wim Duisenberg as the first ECB President. Moreover, with only a small percentage of EU trade being outside the Euro zone, the ECB may replicate the US Federal Reserve's "benign neglect" of exchange rates because of the relatively small importance of this issue. As the Euro gains credibility as a store of value, the uni-polar financial world dominated by the US dollar will evolve into a bi-polar world with both the US$ and Euro as strong international currencies.

As a result, multilateral negotiations will be required to address international currency stability. G8 participants may be forced to address exchange rate stability, given the likely concentration of the Fed and ECB on domestic price stability. Moreover, given the probable rise of the Euro as a second major international currency, actions long taken unilaterally by the United States will become the subject of multilateral discussions with the G8 Summit becoming a prime venue. Finally, be alert for power shifts within EU G8 member countries, as the politically independent and multinational ECB (or perhaps the EU as its "representative") rivals the importance of the UK, Germany, Italy and France as individual states in exchange rate policy discussions within this forum.

Document prepared by: Stephen Hudovernik
April 1998