Saturday, March 28, 2009

Global lender of last resort

Guillermo Calvo joins Dani Rodrik (and here) and Robert Mundell in calling for the setting up of a global lender of last resort, with capability to swiftly provide large enough sums of capital, to restore liquidity at times of crisis. All of them have argued that this institution should provide large enough liquidity facilities to protect emerging market economies from the risk of damaging sudden stops of capital inflows or delveraging as they have witnessed during the ongoing crisis and the East Asian currency crisis of the late nineties.

Deleveraging by financial institutions has devastated equity markets in emerging economies and deprived them of much needed private capital, the inflows of which fell from $928 billion in 2007 to $466 billion last year and is estimated to fall to $165 billion this year. The FIIs have fled to shore up the declining balance sheets of their beleaguered parent firms and the safety and liquidity of the American treasuries.

Just as Central Banks perform the role of lender of last resort to individual countries, there is need for a global lender of last resort to cushion economies, especially emerging and other smaller ones, from credit squeezes. This lender of last resort can even provide liquidity to private financial institutions and even entities in the shadow banking system.

Calvo argues that financial regulation without a global lender of last resort is meaningless as it still leaves the issue of credit supply during credit crunches unresolved. He proposes the creation of an Emerging Markets Fund (EMF), which would help stabilise their bond prices and insulate them from financial contagion. He also feels that such an international institution should be "endowed with considerably more firepower" than that presently available with the IMF. He argues that "liquidity crises requires that economies have rapid access to sums that are sufficient to meet short-term financial obligations, e.g., debt amortisations, and avoid a major collapse in aggregate demand".

Robert Mundell advocates a trillion dollar issue of Special Drawing Rights (SDRs), so as to provide public money to especially the smaller countries who do not have a lender of last resort. The amount 9.5 billion SDRs issued in 1970-72 would now be worth $270 billion.

Further, a global lender of last resort will reassure the emerging economies to undertake the fundamental structural reforms of their financial markets and discourage them from currency manipulations and accumulating massive surpluses.

Brad De Long, responding to Dani Rodrik's argument against strong trans-national financial regulatory institutions, says that since there are going to be sudden shocks to risk and duration tolerance on the part of global investors, we need a global institution to provide support for asset prices in an emergency — a global lender of last resort.

He writes that this institution should do two things, "First, it needs to be able to "print money" — to have its own liabilities be and be perceived to be the safest assets in the world so that when it borrows it calms markets by giving them more of the high-quality short-duration low-risk paper for which they suddenly have such a great craving. Second, it needs to know what it is buying—to have sufficient regulatory oversight and control over global finance to be able to limit the growth of potentially toxic assets beforehand and then to understand what prices it should offer when it does decide that it is time to support the market."

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