Sign of the times: financial governance must reflect reality

As the global economy evolves, the institutions and conventions that govern it are struggling to keep up. Global Insight assesses the potential for change.

Jonathan Watson

In July this year United States’ authorities fined BNP Paribas $9bn for sanctions violations. Some argued that it was the dominance of the US dollar in international transactions that had put the US in the unique position of being able to take action over what were, in this case, reprehensible actions. As the balance of the global economy shifts, we need to ask: how much longer can this dominance be maintained?

The dollar remains far and away the most important currency for invoicing and settling international transactions, including imports and exports that never go anywhere near the US. South Korea and Thailand, for example, set the prices of more than 80 per cent of their trade in US dollars, even though only around 20 per cent of their exports go to US buyers. Seventy per cent of Australia’s exports are invoiced in US dollars, even though less than six per cent go to the US. All the main commodity exchanges give prices in dollars; oil is priced in dollars; and dollars are used in 85 per cent of all foreign exchange transactions across the world.

Dollars account for nearly half the world’s stock of international debt securities. They are also the form in which central banks hold more than 60 per cent of their foreign currency reserves; the euro accounts for just under a quarter of foreign currency reserves.

Data from the International Monetary Fund (IMF) suggests this percentage is not changing significantly over time. ‘It moves around a little bit, partly because of valuation, but in general it seems like the world wants about 60–65 per cent of central bank reserves in US dollars,’ says Marc Chandler, Head of Currency Strategy at US private bank Brown Brothers Harriman.

This situation is ‘more than a bit peculiar’, says US economist Barry Eichengreen in his book Exorbitant Privilege: The Rise and Fall of the Dollar. It made sense in the immediate aftermath of the Second World War, when the US accounted for more than half the economic output of the ‘Great Powers’. However, these days, China and Germany export more than the US, whose share of global exports is just 13 per cent. The US is the source of less than 20 per cent of foreign direct investment, down from nearly 85 per cent between 1945 and 1980.


‘The Bretton Woods twins need governance reform to gain legitimacy in the eyes of emerging markets and developing countries. Such reform has been promised by the high-income countries, but it hasn’t been delivered’


Barry Eichengreen
Professor of Economics, Berkeley

One recent shock to the system came in August 2011, when credit rating agency Standard & Poor’s (S&P) downgraded the US’s top-notch AAA credit rating for the first time ever. The company cut the long-term US rating by one notch to AA+ with a negative outlook, arguing that the country’s deficit reduction plan did not go far enough.

All this has helped to undermine faith in the dollar. Some outside the US are attempting to move away from it as a unit in which to invoice and settle trade, denominate commodity prices and conduct international financial transactions. However, most remain sceptical about the potential for completely replacing the dollar from candidates such as the euro, China’s renminbi, or the bookkeeping claims issued by the IMF, known as Special Drawing Rights (SDRs).

‘When the euro started, people thought that would replace the dollar, but it hasn’t happened,’ Chandler says. More recently, people have been saying it will be the renminbi, but there’s no sign of that taking place anytime soon either. ‘Some countries have put some renminbi in their reserves, but it’s way too small,’ he says. ‘You have to think about what China offers. Central banks want liquidity, but the Chinese bond market is not all that liquid. You can buy US Treasuries 24 hours a day – it’s much more difficult to do so for Chinese bonds. The dollar market is also very transparent. There are very few restrictions on capital movement.’

Chandler says one way in which the dollar might feasibly be replaced is through abdication. The US and other countries have already decided to make it more difficult for some Russian institutions to access the financial markets: what if the situation deteriorated to the point that the US decided not to allow other administrations to access the dollar market? That might force the rest of the world to find an alternative.

The dollar’s influence would also decline if a compelling alternative were to emerge. ‘What would it take to persuade you to switch to a different, non-QWERTY keyboard?’ Chandler asks. ‘It would have to be something that is substantially better than the one you have been using for years.’ A similar argument applies to switching from the dollar as a global reserve asset.

‘Moving away from a dollar-based global financial system presupposes the existence of alternatives,’ Eichengreen tells Global Insight. ‘The only conceivable alternatives that scale are the euro and the renminbi. The euro is troubled, while the renminbi is starting out far behind (in terms of market liquidity and so forth). I think there is progress, but it is painstaking.’

There will come a time when the US currency has a less dominant role, but no one really knows when that will be, adds Larry Christensen, a member at Miller & Chevalier and of the IBA International Trade and Customs Law Committee. ‘It’s rather like a stockbroker saying the market will go up, but if you ask them when, they will say they don’t know.’

The terrible twins?

It is not just the dollar’s dominance that seems outdated: increasingly the International Monetary Fund (IMF) and the World Bank appear skewed in favour of developed nations. For example, their leadership has been reserved for a European and an American respectively since their creation in 1946 under the terms of the Bretton Woods agreement.

‘The IMF and the World Bank are both based on World War Two post-war concepts,’ says Walter White, a partner at law firm McGuireWoods, who campaigned for Ngozi Okonjo-Iweala – now Nigeria’s finance minister – when she sought the presidency of the World Bank. ‘In today’s world, there is no justification for the tradition that the US appoints the president of the World Bank and the EU appoints the president of the IMF.’ The world’s economic centre of gravity is shifting. ‘If we’re going to have global institutions, they should be truly global and they should reflect the best talent that the world has to offer,’ he adds.


‘If we’re going to have global institutions, they should be truly global and they should reflect the best talent that the world has to offer’


Walter White
Partner, McGuireWoods

Voting in the IMF is based on a quota system, which is designed to mirror each country’s relative size in the world economy, as measured by its gross domestic product (GDP). The problem for many years has been that the GDP of developing countries like China, India, Brazil and South Africa has risen dramatically, without an increase in voting power. This means the voting power of BRICS countries (Brazil, Russia, India, China and South Africa) is disproportionately low. Even though they account for 24 per cent of the world economy, they have approximately 10 per cent of the voting power.

China’s GDP, for example, is ranked second in the world at $9.24tn, more than three-and-a-half times the GDP of the UK, yet it receives only 3.81 per cent of total votes in the IMF, compared to the UK’s 4.29 per cent. Even though reforms to increase the voting power of developing countries were approved in 2010, the US Congress has not approved them. They would reduce the voting power of the US from 17 per cent to 16.5 per cent.

‘As Asia, particularly China, India and Singapore, and to a lesser extent the Middle East, Nigeria, Brazil and South Africa take on greater weight and move from the “emerging” status to the “fully developed global economy” status – that is, move into the G20 – they’re entitled to have a voice,’ White says.

‘The Bretton Woods twins need governance reform to gain legitimacy in the eyes of emerging markets and developing countries,’ says Eichengreen. ‘Such reform has been promised by the high-income countries, but it hasn’t been delivered. In addition, the IMF needs more financial resources, while the [World] Bank needs more focus.’


‘Moving away from a dollar-based global financial system presupposes the existence of alternatives. The only conceivable alternatives that scale are the euro and the renminbi. The euro is troubled, while the renminbi is starting out far behind’


Barry Eichengreen
Professor of Economics, Berkeley

Then, of course, there are concerns about the ‘conditionalities’ imposed on borrower countries. These often focus on liberalisation (of trade, investment and the financial sector), deregulation and the privatisation of nationalised industries. ‘Often the conditionalities are attached without due regard for the borrower countries’ individual circumstances and the prescriptive recommendations by the World Bank and IMF fail to resolve the economic problems within the countries,’ says Ronny Mkhwanazi, Managing Director of Mkhwanazi Incorporated in South Africa and member of the IBA International Trade and Customs Law Committee.

Other concerns relate to: countries effectively losing the authority to govern their own economies when they accept IMF help; the types of development projects being funded; the World Bank’s role in the global climate change finance architecture; its apparently automatic preference for working with the private sector; and the way the IMF and World Bank shape development discourse through their research, training and publishing activities.

‘The World Bank and the IMF need to overhaul their modus operandi to remain relevant in today’s world,’ Mkhwanazi says. This could take the form of reviewing their membership participation, voting mechanisms, sympathetic ‘needs analysis’ engagement and a clearly defined ‘conditionalities methodology’ that would be driven by practical needs other than profit.

‘My respectful view, however, is that these institutions are deeply embedded by shareholder prerogatives, and the only way such radical changes could happen is through the creation of alternative institutions,’ he says.

‘There is no alternative’ (or is there?)

Do alternatives to the IMF and World Bank exist? There have been many attempts to create them over the years, but so far none have proved convincing.

The trauma of the 1997 Asian financial crisis, for example, spurred Asian nations into deeper regional cooperation. The most visible outcome of this was the Chiang Mai Initiative, which established a network of bilateral currency swap agreements among the region’s central banks. The arrangement was multilateralised in 2010 and relabelled as the Chiang Mai Initiative Multilateralization – a self-managed reserve pooling mechanism for its member economies. Yet it has never been used, not even in 2008, at the height of the global financial crisis.

In July this year, a deal was agreed in Brazil by the leaders of the five BRICS countries to create a new development bank and emergency reserve fund. The New Development Bank (NDB) will have its headquarters in Shanghai, China and operate much like the World Bank. With $50bn in initial capital, it will seek to finance infrastructure and development. The emergency reserve fund – Contingent Reserve Arrangement (CRA) – will operate much like the IMF. With $100bn in initial capital, it will be a source of financial assistance for member countries that are suffering financial difficulties.The first president will come from India, while Brazil will head the board of directors. The chairman of the board of governors will come from Russia, and there will be a regional base established in South Africa.

‘The creation of the NDB and the CRA is motivated by frustration with the pace of reform of the IMF and the World Bank to give a greater voice to the BRICS and other emerging and developing economies,’ says Mkhwanazi.

In the Fortaleza Declaration, which established the NDB and CRA, the BRICS declared that ‘international governance under its current structure and power configuration shows increasing signs of losing legitimacy and effectiveness’. It added: ‘the BRICS are an important force for incremental change and reform of current institutions toward more representative and equitable governance capable of generating more inclusive
global growth.’

‘This clearly serves as a caution to the Bretton Woods institutions that the status quo of unequal participation and distribution of resources is unsustainable,’ Mkhwanazi says. The BRICS represent 42 per cent of the world’s population. Total trade between them is $6.14tn – nearly 17 per cent of the world’s total. Taken together, they add up to the world’s largest market and their combined GDP has grown by more than 300 per cent in the last ten years.

However, there are doubts about the CRA. If one of the BRICS faces a crisis and wants to use the facility, will the other members agree to meet its needs? If there are any doubts about repayment, they may only be prepared to offer token amounts. One way around this might be to follow the IMF’s example of imposing conditions on the country that is doing the borrowing. But the imposition of conditions on financial assistance is often controversial and is one of the reasons why the BRICS set up their own mechanism in the first place.

Strangely, the treaty setting up the CRA requires countries who draw more than 30 per cent of their swaps (which allow monetary authorities to pump foreign currency into their home markets) to negotiate a programme with the IMF, suggesting that ultimately, it does not really offer that much of an alternative to the IMF. In addition, the BRICS’ commitments to the CRA are expressed in dollars. According to Eichengreen, all this means the CRA is little more than ‘empty symbolism’.

In addition, if the NDB and CRA are to be successful, they cannot just operate as a closed shop for the subscribing members. This would deprive them of an opportunity to create a sustainable and strategic alternative to the current IMF and World Bank-led developmental agenda, Mkhwanazi says.

He believes the BRICS ‘should devise ways in which they could allow other developing countries, particularly small and medium-sized ones, to buy into the NDB and the CRA on terms they can afford’. Arrangements should also be made for borrowing by developing countries on less onerous and more sympathetic conditions than the requirements of the IMF and World Bank.


‘The creation of the New Development Bank and the Contingent Reserve Arrangement is motivated by frustration with the pace of the reform of the IMF and the World Bank to give a great voice to the BRICS and other emerging and developing economies’


Ronny Mkhwanazi
Managing Director , Mkhwanazi Incorporated

Chandler agrees. In its present form, the NDB ‘is interesting, but it’s not going to go anywhere’, he says. ‘They basically reserve a monopoly for the BRICS. Countries have been looking for an alternative to the IMF ever since the Asian financial crisis of the late 1990s – is this going to be it? I doubt it.’

It’s possible that creating competitive conditions for lending will encourage the Bretton Woods twins to review their current participation requirements so that developing countries might have better access to finance. The BRICS countries could also use the existence of an alternative in the form of the NDB and CRA to negotiate larger voting shares for themselves.

Stephen Hine, Head of Responsible Investment Development at pressure group EIRIS, says it is inevitable that the BRICS will have a greater say in the evolution of the global financial system. However, he is not convinced that the new ‘BRICS bank’ is a positive step.

‘Arguably it would be better to reform the governance and operations of the existing mechanisms such as the International Finance Corporation [a member of the World Bank Group] and World Bank by opening them up to greater participation by BRICS and other emerging nations,’ he says. ‘For all the sometimes justified criticism levelled at the incumbent institutions, they have, in many ways, served the global economic system well.’

And like the IMF and the World Bank, the dollar position as reserve currency is likely to stick around for some time yet. In his recent book, The Dollar Trap, Eswar Prasad, Tolani Senior Professor of Trade Policy at Cornell University in the US,argues that far from losing its position as the world’s leading currency, the dollar has in fact strengthened its prominence in global finance since the onset of the global financial crisis. Financial assets denominated in US dollars, especially US government securities, are still the preferred destination for investors interested in the safekeeping of their investments.

‘The dollar will remain the dominant reserve currency for a long time to come, mostly for want of better alternatives,’ says Prasad. ‘In international finance, it turns out, everything is relative.’ In an imperfect world, the dollar still stands out as a paragon of strength – relatively speaking.


Jonathan Watson is a freelance journalist and can be contacted on jwatson1@gmail.com