nUnambitious efforts initiated after the crisis have failed
nReport proposes the adoption of rules-based managed floating to curb excessive currency speculation and presents innovative measures for restructuring of national banking systems, a stricter regulation of financial markets, including for commodity derivatives
The new financial turmoil should be a wake up call for the international community and its institutions. It remains imperative to address the unfinished elements in the global financial reform agenda more vigorously than has been the case so far.
The Trade and Development Report 2011 (TDR 2011) released this week presents innovative policy proposals aimed at curbing financial speculation to prevent damages to the real economy. It also proposes measures to enable a more stable macroeconomic environment and investment in real productive capacity.
The TDR 2011, subtitled “Post-Crisis Policy Challenges in the World Economy”, examines currency, commodity and financial markets and shows that speculation and herding destabilizes prices moving them far beyond sustainable levels and have created themselves most of the systemic risks that have led to their collapse in financial crises.
Needed reform of the international monetary system
The Report addresses the problem posed by an international monetary system in which exchanges rates have become excessively volatile and actually disrupt the functioning of the real economy.
The TDR 2011 presents the rationale for, and outlines the functioning of, an exchange-rate system of rules-based managed floating against the background of recent experiences with global current-account imbalances that contributed to the build-up of the financial crisis and the post-crisis surge of carry-trade financial flows to emerging economies. As pointed out by UNCTAD Secretary-General Supachai Panitchpakdi in his overview to the TDR 2011, “Even after the breakdown of the Bretton Woods system and the adoption of widespread exchange rate floating in 1973, international economic policy making has often assumed that it is mainly real shocks, rather than monetary shocks, that need to be tackled by the international system. However, after several decades of experience it has become clear that monetary shocks, particularly in a system of flexible exchange rates, are much more significant and harmful.”
To avert such monetary shocks, the TDR 2011 discusses two approaches for the design of a rules-based managed floating currency regime. Such a system could be built on the adjustment of nominal exchange rates to inflation differentials or to interest rates differentials. The first principle addresses more directly the need to avoid imbalances in trade flows, while the second one is more directly related to limiting financial speculation of the kind of carry trade which typically leads to currency misalignment. However, both approaches tend to lead to similar outcomes.
Such a system would be able to achieve sufficient stability of the real exchange rate to enhance international trade and facilitate decision-making on fixed investment in the tradable sector; and it would be sufficiently flexible to accommodate differences in the development of interest rates across countries.
Rules-based managed floating can be practiced as a unilateral exchange rate strategy, or, with much larger scope for symmetric intervention in foreign-exchange markets, through bilateral or regional agreements. However, the greatest benefit for international financial stability would result if the rules for managed floating were applied at the multilateral level as part of global financial governance.
Addressing the financialisation of commodity markets
The Report, expanding on the study “Price Formation in Financialized Commodity Markets: The Role of Information”, which UNCTAD released on 5 June 2011, shows that financialization of commodity markets has encouraged herd behaviour and significantly affects the prices of such basic goods as food staples and energy as commodity market participants increasingly follow other financial market´s trading decisions. Uncertainty arising from gaps in information and transparency, combined with the effects of equity market developments on commodity prices, is central to this “intentional herding”. Expansionary monetary policies may have accentuated correlations between equity, currency and commodity market developments. But these correlations had already strongly increased when financial investors started long-scale commodity investment some ten years ago.
UNCTAD suggests a number of policy responses to improve commodity market functioning, increasing transparency in physical and derivatives markets, as well as internationally coordinated tighter regulation of financial investors – for instance, by imposing position limits or a transaction tax. The authors of the report also say that market surveillance authorities could be mandated to intervene directly in exchange trading on an occasional basis by buying or selling derivatives contracts with a view to averting price collapses or deflating price bubbles. Such intervention could be considered a measure of last resort to address the occurrence of speculative bubbles if reforms aimed at achieving greater market transparency and tighter market regulation were either not in place or proved ineffective.
Financial re-regulation and restructuring
Finally, the Report argues that financial deregulation has been one of the main factors leading to the global financial and economic crisis of 2008. It favoured the emergence of a large, unregulated and undercapitalized shadow banking system, while traditional banking shifted from reliance on deposits to financing from capital markets, and from lending to trading. The loss of diversity of the financial system and uniformity of agents´ behaviour fuelled destabilizing speculation, accentuated pro-cyclical trends and eventually led to systemic crises. The re-regulation of the financial system is necessary to prevent the repetition of these crises. However, the attempts made so far has been slow and inadequate to cover the shadow banking system and to cope with a highly concentrated financial sector that is dominated by a small number of gigantic institutions.
Regulation must be tighter with the “too-big-to-fail” institutions and incorporate a macro-prudential dimension, including anti-cyclical capital requirements and the recourse to capital controls for coping with volatile capital flows. However, even if the financial sector were to be better regulated, it would not automatically drive growth and employment or make credit accessible to small and medium-sized firms or the population at large. In addition to a better regulation, the financial sector needs to be restructured in order to reduce the risk of systemic crises and to improve its economic and social utility. Financial restructuring should aim at more diverse national financial systems, with a bigger role for public and cooperative institutions, a sizing down of giant institutions and a clear separation between the activities of investment and commercial banking.
The Report warns that some international agreements such as the General Agreement on Trade and Services (GATS), several bilateral trade agreements (BTA) and bilateral investment treaties (BITs) include provisions related to payments, transfers and financial services that may limit not only the application of capital controls, but also other measures aimed at re-regulating or restructuring financial systems. Such measures could be considered as infringing previous commitments on financial liberalization.