Financial Stability Paper No. 36
By Edd Denbee, Carsten Jung and Francesco Paternò
Financial globalisation and the expansion in global capital flows bring a number of benefits — more efficient allocation of resources, improved risk sharing and more rapid technology transfer. But they can also increase the risk of financial crisis. In recent years, to reduce these risks to stability, countries have reformed financial regulation, enhanced frameworks for central bank liquidity provision and developed new elements, and increased the resources, of the global financial safety net (GFSN).
A comprehensive and effective GFSN can help prevent liquidity crises from escalating into solvency crises and local balance of payments crises from turning into systemic sudden stop crises. The traditional GFSN consisted of countries’ own foreign exchange reserves with the IMF acting as a backstop. But since the global financial crisis there have been a number of new arrangements added to the GFSN, in particular the expansion of swap lines between central banks and regional financing arrangements.
The new look GFSN is more fragmented than in the past, with multiple types of liquidity insurance and individual countries and regions having access to different size and types of financial safety nets. These new facilities provide many benefits, such as increasing the resources available to some countries and providing additional sources of economic surveillance. However, many facilities have yet to be drawn upon and variable coverage risks leaving some countries with inadequate access.
This paper consider the features, costs and benefits of each of the components of the GFSN and whether the overall size and distribution across countries and regions is likely to be sufficient for a plausible set of shocks.
We find that the components of the GFSN are not fully substitutable: different elements exhibit different levels of versatility, have been shown to be more or less effective depending upon the circumstances, have different cost profiles and have different implications for the functioning of the international monetary and financial system as a whole. We argue that while swap lines and RFAs can play an important role in the global financial safety net they are not a substitute for having a strong, well resourced, IMF at the centre of it.
By running a series of stress scenarios we find that for all but the most severe crisis scenarios, the current resources of the GFSN are likely to be sufficient. However, this finding relies upon the IMF’s overall level of resources (including both permanent and temporary) being maintained at their current level.
Our analysis also highlights that the aggregation of global resources can mask vulnerabilities at the country, and even regional, level. In other words, while the current safety net might be big enough in aggregate, there is a risk that, for large enough shocks, gaps in coverage could be revealed. Steps should be taken to ensure the different components of the safety net function effectively together to reduce the risk of gaps appearing.
Policymakers should consider measures which (i) reduce vulnerabilities in external balance sheets which leave countries exposed to volatility in cross-border capital flows and increase potential demands on the safety net; (ii) secure the availability of appropriate GFSN resources, including the IMF’s resource base; and (iii) make more efficient use of the current GFSN resources by ensuring the elements of the GFSN more effectively complement one another.