Craig Eisele on …..

March 28, 2012

International financial system requires “drastic” reform

Filed under: Uncategorized — Mr. Craig @ 4:00 am

LONDON—The international financial system requires “drastic” reform if future crises are to be avoided, including more regional initiatives to tackle misaligned exchange rates and the wider use of capital controls, the head of a United Nations agency said.

The United Nations Conference on Trade and Development has long been critical of what it calls “financially driven globalization” and warned of its consequences ahead of the 2008 crisis.

Supachai Panitchpakdi, head of the United Nations Conference on Trade and Development, said capital flows don’t translate into real capital formation.

But as the agency prepares for the quadrennial gathering of its 194 government members in Qatar next month, its secretary-general believes many of the flaws in the functioning of the global economy that led to the crisis remain.

“If we do not do something more drastic with the international financial regime, then this will come back,” said Supachai Panitchpakdi in an interview Friday.

UNCTAD’s argument is that uncontrolled capital flows and associated financial speculation have led to the distortion of exchange rates and other key prices—including those for many commodities—which means that many countries aren’t able to pursue the economic policies that are right for sustainable growth.

Mr. Supachai’s comments come as a number of countries, including Brazil, are struggling to counter foreign-exchange moves they believe are damaging their economies. Brazil has recently introduced measures to slow the inflow of short-term portfolio investment, while the central bank has bought dollars in the local market to hold the currency above a level of 1.80 Brazilian reals to the dollar.

“Exchange-rate movements are still very much not really reflecting the flows of trade that we’re seeing,” Mr. Supachai said. “These distortions are no less damaging than tariff increases.”

Mr. Supachai also said that foreign-exchange trade of over $4 trillion daily didn’t appear to be related to any real investment.

“We see a huge amount of capital flows, but we do not see real capital formation,” he said, referring to the creation of capital or goods intended for investment or economic expansion. “Capital formation is not moving up in line with financial flows. There is no correlation.”

Mr. Supachai was deputy prime minister and commerce minister of Thailand from 1997 until 1999, and has first-hand experience of sharp movements in foreign exchange rates. The rapid depreciation of the Thai baht was one of the events that triggered a series of exchange rate and debt crises in Asia during 1997 and 1998.

“We saw in Asia during the 1990s that the misalignment of foreign-exchange rates can have devastating consequences, even more devastating than trade barriers,” Mr. Supachai said.

He believes that global policy makers should focus on maintaining real effective exchange rates at levels that reflect the relative competitiveness of economies. Under this scheme, a country that saw a sharp rise in unit labor costs would be allowed to depreciate its exchange rate to maintain its competitiveness, while one that saw a fall in unit labor costs would have to allow its exchange rate to strengthen.

Mr. Supachai said that this sort of flexibility should also be allowed within a currency union, such as the euro zone. He believes that it is essential for the health of the global economy that the euro zone survives but this can only happen if members are allowed to exit and re-join, and Greece should be the first to take that option.

Now on its second bailout, and in its fifth year of economic contraction, Greece may need to leave the euro zone, Mr. Supachai said.

“There may be a need for a temporary solution, to allow Greece the option of going out,” he said. “Greece must have the option of coming back in. That doesn’t mean the end of the euro zone, it would mean the opposite.”

Euro-zone members insist that once a country has made the decision to join the currency area, it’s irrevocable, since any doubts about that country’s commitment would affect financial stability.

But many economists believe that one of the underlying problems faced by countries like Greece is a loss of competitiveness since they joined the currency area, particularly relative to Germany.

Since consumer prices and wages rose more rapidly in Greece, Ireland, Portugal and others than they did in Germany, they experienced a de facto appreciation in their real exchange rates, leading to widening current account gaps and an increasing reliance on foreign funding.

Eventually, investors became unwilling to provide that funding, and those countries were forced to address their debt problems. As long as they remain inside the euro zone, they can only do that through austerity programs and what are known as “internal devaluations,” essentially cutting wages.

Mr. Supachai said countries will always make big mistakes in their economic policy, and a grouping such as the euro zone needs to be realistic about that fact, allowing countries to exit the block so that they can benefit from currency devaluation and growing exports.

Ever since exchange rates began to fluctuate after the dollar-anchored Bretton Woods system ended in 1971, it has proven difficult to get agreement among nations on whether their own or other currencies are fairly valued.

Some economists have suggested that the World Trade Organization, or a new and equivalent body, should perform that role, identifying exchange-rate misalignments just as the WTO highlights unfair tariff or other trade distorting measures.

A director general of the WTO from 2002 to 2005, Mr. Supachai doesn’t believe that is politically possible. Instead, he believes that a start should be made through regional initiatives, which could then be linked together.

“When countries get into difficulties, it’s usually related to competitors in the same region,” he said, adding that the currency misalignment is often relative to a currency from outside the region, and usually the U.S. dollar.

The model for this kind of regional arrangement is the Chiang Mai initiative, which was launched in 2000 but subsequently expanded to include the 10 members of the Association of Southeast Asian Nations, China, Japan and South Korea. It was intended to give individual members access to a large pool of foreign exchange reserves with which to intervene in the foreign exchange markets, and prevent a repeat of the currency crises of 1997 and 1998.

Mr. Supachai believes more of these regional mutual-assistance agreements—and especially one for Latin America—could help manage exchange rates globally, and lead to fewer misalignments.

“It would help to better manage the distortions,” he said.

The other tool that Mr. Supachai believes should be used more widely is controls on short-term capital flows. He argues that short-term capital flows can place an impossible burden on monetary policy in many developing economies, since any increase in interest rates to tackle high inflation immediately attracts capital flows that lead to an overly rapid appreciation in the exchange rate. “Capital flows are hurting countries so much,” he said. “Withholding taxes on short-term capital flows have proven quite useful.”

Mr. Supachai believes that for so long as the global economy is struggling to overcome the effects of the last financial crisis, it is unlikely to slip into another. But without radical reform of the international financial system, he believes that another crisis is inevitable soon after things return to “normal.”

“The crisis will come when it seems like business as usual,” he said. “When we are all patting each other on the back, that will be the beginning.”


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