Global Finance

B minus

June 2014

The Global Governance Report Card grades international performance in addressing today's most daunting challenges. It seeks to inspire innovative and effective responses from global and U.S. policymakers to address them.

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Subject

  • Average

    Managing Financial Crises

    While the global economy continued its tepid recovery from the 2008 financial crisis, emerging markets stumbled. Globally, in 2013 the economy grew by 3 percent [PDF]. The IMF revised its 2013 predictions for emerging markets downward by 0.5 of a percentage point to 5.0 percent, pointing to their insufficient capacity to cope with increased financial volatility, among other factors. The slowdown in emerging markets led many to warn against relying on the “BRICS” to fuel the global economy. However, the eurozone crisis overshadowed these concerns for much of the year, as international and EU institutions, along with national officials, were concentrated on containing sovereign debt crises and encouraging growth in the region. Despite renewed attention, their cooperation on eurozone debt crises in 2013 was limited.

    The turmoil in March over how to address a banking crisis in Cyprus highlighted continued disagreement on crisis response among the members of the troika—comprising the European Central Bank, European Commission, and IMF. When the island nation sought funding from the troika, the IMF and Germany provoked a fierce political backlash and undermined trust in deposit safety by demanding that Cyprus impose a tax on bank deposits. Though the troika and Cypriot government eventually restructured the bailout deal to avoid taxing smaller deposits, the final deal was criticized as self-defeating. Furthermore, the Cypriot government’s introduction of capital controls, which were still in place at the end of 2013, endangered the future of the common currency. The crisis revealed a general unraveling of European cooperation and a lack of a coherent strategic direction for the continent.

    European solidarity appeared to disintegrate further throughout the year, as the EU’s most prosperous members pushed to reduce their budget contributions and the United Kingdom planned a referendum on EU membership itself. This prompted the ratings agency Standard & Poor’s to lower the region’s credit rating due to the overall negative economic outlook. On the other hand, the ECB took decisive action to cut interest rates in an effort to stimulate growth, and ECB President Mario Draghi’s announcement of the Bank’s commitment to “do whatever it takes” served to calm markets. Meanwhile, a commitment to a 2014 asset-quality review and stress test to promote the health of the region’s banks advanced progress toward a banking union. In addition, preparations continued [PDF] for a Single Supervisory Mechanism (SSM), which will allow the ECB, rather than national authorities, to directly supervise 130 of the eurozone’s largest banks. Overall, although this institutional progress was significant, it failed to provide a convincing roadmap for political and economic union. Significant differences remain among members about the terms for recapitalization or resolving troubled banks, as well as on a permanent European bailout fund that could react more rapidly and decisively to unfolding crises. The prospects on these and other critical reforms, including a euro-wide deposit insurance scheme and resolution mechanism for winding down major banks that fail, appeared uncertain. For, they will require not only continued leadership from the ECB but also deeper commitment from member nations to a banking union.

    For its part, the IMF announced [PDF] in April 2013 that it was reexamining its strategy for—and involvement in—sovereign debt restructurings. The announcement followed the Fund’s thorough ex post evaluation of Greece [PDF], which acknowledged the need for improved cooperation within the troika and for IMF analysts to approach official economic data from national authorities more judiciously when assessing sustainability. The Fund also noted that it was seeking to revise procedures for evaluating countries’ debt burdens, with the aim of reducing political pressure to downplay economic problems in the Fund’s sustainability assessments (which IMF shareholders sometimes exert to avoid debt restructuring). This proposal generated intense debate and criticism, mostly from the major shareholders who are reluctant to see their authority to negotiate solutions to sovereign crises compromised. Still, this stocktaking has catalyzed needed discussion on how to mitigate the weaknesses of the current system.

  • Average

    Coordinating Macroeconomic Policies and Exchange Rates

    In 2013, coordination of macroeconomic policies was mixed. The 2013 G20 annual meeting in St. Petersburg—which provides the best opportunity for leaders from the world’s major economies to design a cohesive approach to manage the international economy—achieved little. The summit’s economic agenda was overshadowed by tension between Russia and the United States over how to respond to Syria’s civil war. The rambling communiqué from the summit outlined various points of agreement among the world’s twenty largest economies—such as the need for debt reduction, as well as structural reforms to boost growth and employment—but did not provide concrete action plans to deliver on these objectives. Debates over the utility of austerity measures versus growth stimulus (such as quantitative easing) remained contentious, with no progress toward a coordinated agenda. The weak outcome appeared to confirm criticisms that the G20 is losing steam, and “falling into a bureaucratic morass.”

    On the other hand, in February, the G20 demonstrated the vital role it can play in helping countries reach and communicate joint positions on macroeconomic policies, to the benefit of international financial stability. Gathering in Moscow that month, G20 finance chiefs jointly signaled that a Japanese decision to loosen monetary policy did not qualify as an attempt to target (and thus manipulate) its exchange rate. The united front reassured markets that leaders would not be drawn into a vicious cycle of competitive devaluations. Even after the Japanese yen’s value dropped by 19 percent against the dollar, G20 members withheld criticism for the sake of global economic stability. The G20’s success in calming fears of a currency war in the near-term was notable, but it proved unable to bring members together to hold discussions on ensuring long-term foreign exchange rate alignment. Further currency depreciation in emerging economies and slower growth in China only increased the urgency of this issue.

    In 2013, the IMF carried out its first biennial review [PDF] of countries’ economic policies as part of the Mutual Assessment Process (MAP)—a collaborative effort [PDF] between the IMF and G20 to monitor and support countries’ implementation of international commitments set forth in the G20 Pittsburgh Declaration. The report noted [PDF] that China’s external surplus had fallen from 10 percent to 2 percent between 2008 and 2013. Still, the IMF found that nine countries had made little progress toward addressing internal and external imbalances and concluded that economic performance had been disappointing compared to 2011 projections. Though much heralded, the MAP agenda has expanded to include too many issues to operate effectively and has thus far failed to generate [PDF] positive momentum on the more contentious global financial challenges.

    Other bright spots included a decrease in China’s currency manipulation and progress on global trade. Since 2010, the United States has used the G20 to pressure China to allow its currency to fluctuate according to “market-determined exchange rates,” and in 2013 China continued to loosen control over its exchange rate. By December 2013, the yuan’s value had appreciated to 6.07 against the dollar, its highest value since 1993. This contributed to the drastic decline in China’s current account surplus, as the IMF biennial review documented.

    Finally, in St. Petersburg, countries extended their commitment to refrain from protectionist measures until 2016 (though adherence to the pledge has varied in countries like Brazil, Russia, and Argentina). And remarkably, the World Trade Organization achieved a modest breakthrough in December. After many combative negotiations over the Doha Round, 160 countries agreed to measures that will simplify customs procedures and cut the costs of international trade. As the first significant movement in global trade liberalization at the WTO, this was a welcome step, despite including more limited agreements than those sought in the Doha round. The growing number of plurilateral negotiations now underway, however, suggests that significant developments in trade liberalization may increasingly originate outside universal negotiating forums. The two most significant negotiations now underway—the Trans Pacific Partnership and Transatlantic Trade and Investment Partnership—promise to further challenge the centrality and relevance of the WTO.

  • Average

    Regulating Financial Institutions, Bank Capital, and Liquidity

    Throughout the year, international organizations and major economies continued to work toward mitigating risks in the global banking system that caused the 2008 financial crisis, but they postponed essential discussions on issues like regulating shadow banking. Meanwhile, implementation of some important initiatives flagged.

    By August, twenty-five of the twenty-seven jurisdictions that agreed to the Basel III framework had issued final rules [PDF] to implement the revised capital regulations. The set of updated banking regulations was one of the most critical reforms since 2008. It will require banks to hold more than triple the amount of capital as previously, and to limit their leverage ratios. The remaining two countries (Turkey and Indonesia) were in the process of finalizing the rules. Still, harmonized implementation of Basel III promises to prove challenging as the approaches of the United States and Europe diverged in several areas.

    In addition, the Basel Committee on Bank Supervision (BCBS) released a revised leverage framework [PDF] and stricter disclosure requirements for consultation in June 2013. The revision’s centerpiece was an updated formula for calculating a bank’s leverage ratio. However, in response to criticism by industry, the BCBS was prepared to dilute the rules by December, which would potentially undermine the original intent of the leverage ratio.

    For its part, the Financial Stability Board acquired official status as its own legal entity under Swiss law in January 2013. In the following months, the FSB continued to update its list of global SIFIs, whose collapse could threaten the world economy, and published a draft methodology to help governments craft procedures to wind down these sprawling financial institutions if they become distressed, rather than bail them out. In July 2013, it also added nine insurance firms to this list of too-big-to-fail institutions, so that regulators account for how integrated insurers have become in the global financial system.

    Nevertheless, the FSB faced the challenge of pursuing an ambitious, expanding mandate with modest resources, and it drew criticism for its opaque decision-making processes. In particular, the board still elected not to release information about the formulation of its work program, which continued to grow. In 2013, for example, the FSB launched an initiative to propose options for repairing or replacing financial benchmarks such as LIBOR (the London Interbank Offered Rate), which requires broader reforms beyond the July 2013 transfer of control from the British Bankers Association to the NYSE/Euronext (since the latter body too could benefit from manipulating the rate).

    Meanwhile, member state progress in meeting other commitments was patchy. One FSB review concluded that most national jurisdictions lack requirements for SIFIs to submit resolution plans. Furthermore, as a September FSB report concluded, countries need to redouble efforts [PDF] to agree to procedures for winding down “too-big-to-fail” financial institutions that span multiple jurisdictions. At the same time, commitments to harmonizing accounting standards stalled [PDF] during the year. Another important proposed reform to separate banks’ traditional lending operations from risky speculative trading lost momentum in 2013 after the original 2012 proposal was watered down.

    Finally, at the G20 summit in St. Petersburg, the world’s leading economies merely postponed discussions to agree on details over regulation of the shadow banking system, including hedge funds, private equity, and money market funds. Individual countries continued to hesitate to act independently, for fear of disadvantaging their own banks. Therefore, delaying multilateral negotiations about oversight and regulation of this crucial sector allowed risks to the global financial system to persist. And despite the FSB’s recommendations [PDF] for G20 action regarding SIFIs, countries made no progress in St. Petersburg on this issue, further underscoring the G20’s diminishing effectiveness.

  • Good

    Supporting Development

    During the year, the United Nations, in consultation with international financial institutions and bilateral donors, worked to define a new international framework to advance human development after the Millennium Development Goals (MDGs) expire in 2015.

    In May 2013 a high-level panel of twenty-seven world leaders appointed by UN secretary-general Ban Ki-moon released a final report on the post-2015 development agenda. The document offered a set of development goals for 2030, geared to accelerate five “transformative shifts:” ending extreme poverty, focusing on sustainable development, emphasizing inclusive growth, supporting accountable and effective governance, and forging more innovative ways to coordinate global cooperation. Despite its lack of official standing, the report generated significant attention, though reviews were mixed. It inspired both praise for its practical recommendations and criticism for not paying greater attention to economic inequality.

    Meanwhile, the world recorded some notable successes in achieving the current MDGs. The 2013 MDG Report [PDF] noted major gains in improving health and reducing poverty and suggested that the positive trends in development (exemplified by the achievement of halving global poverty since 1990—two years ahead of schedule) was holding steady. Development aid from advanced economies, after slipping by 4 percent in 2012, was expected to rebound in 2013. Still, the report concluded that urgent action was needed to achieve all the MDG targets by 2015, particularly in the lagging areas of education, environmental sustainability, and maternal health.

    At the World Bank, President Jim Yong Kim spearheaded an internal reorganization designed to respond to pressing organizational and bureaucratic challenges. The proposal sought to rearrange teams to eliminate internal barriers between regions and projects, and help improve cooperation among experts that work on similar issues. The reorganization also included a new methodology to help officials deploy Bank resources where they will have the greatest impact. It is too soon to tell how effective the reorganization will be as it is unclear whether the addition of new practices and partnerships will be accompanied by the removal of material and procedural redundancies throughout the organization.

    Lastly, the BRICS continued discussions on the design of their development bank—a lending body that will mainly oversee infrastructure projects in member countries. At the annual BRICS summit in Durban, South Africa, the five countries formally agreed to create the bank, with a tentative launch date in 2015. Many, however, expressed skepticism that the project will ever be fully realized. Relations between members remained fractious, and crucial questions, such as how responsibilities for funding and governance will be allocated, particularly with respect to China’s role, have not been settled.

  • Poor

    Reforming Governance of International Financial Institutions

    Progress in updating the governance structures of international financial institutions (IFIs) proceeded at a snail’s pace throughout the year. The failure to update IFIs to adequately reflect the growing weight of emerging economies left traditional industrialized countries overrepresented [PDF] within the IMF and World Bank, increasingly jeopardizing the legitimacy of these institutions (a view expressed [PDF] by no less than IMF managing director Christine Lagarde).

    The IMF undertook a review of its quota formula, which is the basis for deciding each member country’s voting power and access to the institution’s financial resources. The review was completed in January 2013. The executive board was scheduled to make decisions based on this review in early 2014, but this has been postponed until January 2015 because of U.S. delays in approving quota reform. But even if the reforms move forward in 2015, their impact will be limited, as they will merely shift 6 percent of quota shares from over-represented to under-represented countries, and shift another 6 percent to emerging market and developing countries. This is inadequate given the significant growth in emerging economies that remain substantially underrepresented.

    The broader reform package, intended to integrate emerging markets by increasing their presence on the executive board and doubling IMF quotas to raise their contributions, remained stalled at year’s end, despite G20 pledges to implement the change by 2012. European countries did not approve the executive board changes, and the quota reforms must be approved by the U.S. Congress because the country maintains effective veto power over changes to quota formulas. Assurances that the United States need not contribute new money (since the additional funds would be shifted from existing U.S. commitments) and would not see its influence in the IMF decline proved unable to elicit progress. The U.S. Congress did not hold a vote on reform legislation, as the issue became enmeshed in partisan budgetary squabbles.

    For its part, the World Bank, which completed [PDF] a rebalancing [PDF] of shares in 2012, has launched a reorganization to remove bureaucratic roadblocks. The institution focused on this effort during the year rather than reforming its structure to better incorporate major emerging economies, awaiting progress at the IMF before moving forward. More positively, the Financial Stability Board (FSB), which coordinates regulatory cooperation among major economies, finally earned official status as a legal entity. This shift entrenches the FSB as a pillar of a more inclusive global financial system that includes new economic powerhouses. However, the FSB’s inclusivity was no substitute for IMF governance reform as its power is significantly more limited than the IMF.

    The failure to implement comprehensive, meaningful reforms to global financial institutions undermines the confidence of emerging market governments in today’s global financial architecture. Ultimately, it may drive them to build alternative structures outside existing frameworks. Indeed, some recent initiatives indicated that they were already trying to do so. For example, the BRICS (Brazil, Russia, India, China, and South Africa) announced a push to establish an independent $100 billion fund to address short-term liquidity problems in their economies and continued to call for a new BRICS development bank. Despite doubts that these initiatives will proceed, the proposals lay out parallel institutions: The former would compete with the IMF, the latter, with the World Bank.

Leader

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Financial Stability Board

U.S. Federal Reserve

Gold Star

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China

Most Improved

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Ireland

Japan

laggard

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Group of Twenty

Truant

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U.S. Congress

Detention

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Argentina

Class Evaluation

The Financial Stability Board (FSB), which coordinates among the financial authorities of the world’s largest economies, demonstrated leadership in 2013 by continuing to provide critical recommendations and data to marshal support for reforms that reinforce the health of the financial system.

In particular, following up on their effort to address the difficult issue of “too-big-to-fail” financial institutions, the FSB continued to push for implementation [PDF] of guidelines on how to wind down major institutions if they fail (Key Attributes of Effective Resolution Mechanisms [PDF]). The group delivered a report on the progress of G20 countries’ implementation, and the G20 recommitted to the effort in St. Petersburg. The FSB also released a draft assessment methodology to assess compliance with the Key Attributes and encourage the construction of credible resolution regimes. In addition, the FSB identified nine globally important insurers that, along with the world’s largest banks, will be subject to certain conditions in order to minimize costs to the financial system in the event of failure. These initiatives represented important efforts to update regulatory frameworks for the twenty-first century, as more complex financial instruments increasingly pose risks to insurance firms, which are in turn increasingly integrated into the global financial system. The FSB also continued the daunting task of monitoring implementation of past national commitments, publishing these results in numerous reports throughout the year. Finally, the body’s recommendations [PDF] for regulating the shadow banking sector provided a roadmap for G20 commitments at the leaders’ summit in St. Petersburg.

The U.S. Federal Reserve joined the FSB at the top of the class for continuing to help the U.S. and the global economy recover from the 2007-08 financial crisis by effectively managing its five-year-long policy of quantitative easing. The 2013 version of this policy—referred to as QE3—saw the government purchase $85 billion in bonds every month to buttress the economy. With growing evidence that labor markets were healing and growth strengthening, the Federal Reserve’s Open Market Committee (FOMC) announced a reduction in the massive asset purchase program in December 2013, lowering it to $75 billion a month. To be sure, initial communication missteps around “tapering” caused considerable confusion, but by the end of 2013, the FOMC had clarified its QE exit strategy, and newly appointed Chairperson Janet Yellen had declared her commitment to continuing to increase the transparency of the FOMC’s deliberations and the activities of the Federal Reserve.

China received a gold star for taking a number of laudable steps during the year, again earning the country praise despite a mixed record on addressing structural imbalances and exchange rate management [PDF]. Primarily, in response to signs that its economy was beginning to cool, Chinese authorities in July launched a mini stimulus to boost growth. By September, the economy appeared to have “found its feet.” Moreover, it continued, in fits and starts, to loosen control over its currency, allowing the renminbi (RMB) to fluctuate more closely to market rates, which is critical for rebalancing the nation’s current account surplus. By December, the RMB had reached its strongest value against the dollar—6.07—since 1993, when the exchange rate policies began. Finally, a series of market liberalization steps, ranging from relaxing some foreign investment restrictions to expanding the access of foreign firms to the Chinese stock exchange, signaled the Chinese leadership’s interest in enticing foreign capital.

Still, by the end of 2013, the growth trend had clearly slowed and underlying financial vulnerabilities—continued dominance of state-owned enterprises, massive imbalances, the expansion of the shadow banking system, and high provincial and local debt levels, among others—were generating significant concern. Chinese leaders were clearly cognizant of the need to rebalance the economy (in particular by increasing domestic consumption) and to rein in shadow banking. In response, they launched a comprehensive plan to reform the economy by 2020 to mitigate these risks. Navigating the tension between promoting growth and ameliorating risk is inherently difficult, but China was awarded a gold star for its prudent recognition of the challenges facing its economy and for taking incremental steps to begin to address these.

Ireland earned the status of most improved for becoming the first of the countries bailed out by the troika (the European Commission, European Central Bank, and the IMF) to exit its aid program, valued at $114 billion. The move came after a March 2013 sale of ten-year bonds raised enough financing to cover Ireland’s estimated borrowing needs. Still, with unemployment at 12.8 percent and property prices still falling outside Dublin, Ireland’s economy has a long way to go before it returns to pre-crisis levels.

Alongside Ireland as most improved, Japan merits mention for taking decisive action to spur economic growth after decades of stagnation. Throughout 2013, the Japanese government sought to implement Prime Minister Shinzo Abe’s economic package, referred to as Abenomics, which aims to jolt the economy out of its deflationary malaise. First, Abe announced a $116 billion short-term stimulus package. Meanwhile, the Central Bank of Japan launched an effort mirroring the U.S. Fed’s quantitative easing, which included doubling its holdings of Japanese government bonds and doubling the average remaining maturity of bonds that it purchases. While it is too soon to judge the ultimate success of the program, the government’s resolve to take action was promising.

More negatively, the G20 appeared to lose steam during the year, earning that forum the designation of laggard. The G20 summit in St. Petersburg in September produced a bland communiqué lacking concrete steps to further implement vital economic reforms and encourage the rebalancing of economies needed for durable global growth. For example, members reiterated the importance of mitigating “spillover” consequences of domestic policies (like quantitative easing) on the global economy, but specified no actions countries should take to address the issue.

Meanwhile, the United States Congress was assigned the label of truant for endangering the full faith and credit of the United States and risking a default during a September 2013 partisan budget battle. Moreover, Congress also prevented progress on reforms to international financial institutions committed to in 2010 by failing to include increased IMF funding in a spending bill despite pressure from the Obama administration to do so throughout 2013. Without U.S. approval of the 2010 reforms, emerging market powers must continue to wait for reform of voting shares and the composition of the Fund’s board.

Argentina landed in detention after receiving an official censure from the International Monetary Fund (IMF) for government manipulation of economic data. Though Argentina apparently softened its stance and began to cooperate with the IMF by the end of 2013, the credibility of its pledges to continue dialogue remained uncertain. An ongoing legal battle with its creditors further undermined its attempts to regain access to international bond markets. The government also continued to report that inflation stood at only 10 percent while independent experts estimated that it was closer to 25 percent. Moreover, a lack of transparency over apparent policy changes to allow the Argentinean peso to depreciate by 33 percent in 2013 threatened to worsen the country’s economic woes. Furthermore, by the end of the year, Argentina’s reserves had dropped by 30 percent—to their lowest level since 2006.

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Introduction

In 2013, five years after the collapse of Lehman Brothers and the onset of the global financial crisis, the global economic recovery continued to strengthen, which stood as a testament to international cooperation to avert a devastating depression reminiscent of 1929. Overall, the world economy grew by an estimated 3 percent [PDF] in 2013, but this masked unused capacity and high unemployment, in addition to persistent systemic risk. 2013 was a particularly turbulent year for emerging markets and the euro area. Emerging economies generally logged lower growth rates than had been forecast, dragged down by a reversal of capital flows, while debt crises and regulatory battles further delayed recovery in the eurozone.

To support the global economy, countries and multilateral organizations continued to display respectable levels of cooperation in 2013, though some collaborative efforts faded compared to recent years. In the eurozone, there was limited progress toward stronger financial governance, including setting up a banking union. The Group of Twenty (G20)—a group of major economies—merely laid out points of agreement without including concrete steps to boost growth, mitigate remaining risks in the global financial system, or address contentious debates over austerity versus growth plans. G20 leaders did pledge to extend a ban on protectionist measures but a number of emerging markets still took increased protectionist measures. Early in the year, G20 finance chiefs also jointly reassured markets that they would refrain from competitive devaluations in response to Japanese monetary easing, which could otherwise have sparked a currency war. Countries also achieved a modest breakthrough in global trade negotiations after years of deadlock, though this paled in comparison to the aspirations of the Doha Development Round. Lastly, international cooperation on global development improved, as donors expanded official development assistance moderately after two years of contraction and the United Nations-led discussions to draft a post-2015 development agenda advanced.

Efforts to implement reforms agreed multilaterally in the wake of the 2008 financial crisis proceeded unevenly, and some rules were diluted. By August, for example, most countries had enacted legislation to require banks to comply with Basel III capital requirements by the 2015 deadline, but European banks balked at adopting a revised leverage formula intended to complement these new requirements. Momentum to apply the leverage formula subsequently waned.

Meanwhile, the Financial Stability Board (FSB) , which G20 leaders established in 2009 as a replacement for the Financial Stability Forum to coordinate the harmonization of financial rules among regulators from major economies’ and international financial institutions, continued to provide policymakers with useful recommendations and monitor countries’ progress on past commitments. Its findings revealed important regulatory gaps. The FSB found that many jurisdictions lacked adequate plans to confront the failure of a major bank and would thus be tempted to provide taxpayer-funded bailouts, as they did in 2008-2009. Additionally, national initiatives to separate banks’ traditional lending activities from risky speculative trading were weakened somewhat and leaders avoided discussions about regulating the shadow banking sector (which refers to nonbank entities that are not subject to regulations on banks but engage in the “core-banking function” of issuing loans with money from other savers).

More problematically, existing institutions continued to struggle with local financial crises. The incoherent response of the IMF and European institutions to a March crisis in Cyprus drew scathing criticism from economists and Cypriots alike for the initial proposal of a tax on all bank deposits in the country, including on small savings accounts. This controversy overshadowed other successes such as Ireland’s exit from its bailout program and Portugal’s efforts to regain market access.

Finally, governance reforms to international financial institutions remained stalled as the year drew to a close, with dim prospects for immediate progress, thanks to opposition in the U.S. Congress. This inertia threatened to further weaken the legitimacy of the international economic architecture in the eyes of emerging powers. Furthermore, although the U.S. Federal Reserve’s policy of quantitative easing reinforced economic growth both in the United States and abroad, congressional budget battles during 2013 raised the specter of a U.S. default on its debt, undermining confidence in U.S. global leadership and threatening to destabilize the global economy.

This review identifies six major areas for improvement. First, the G20 should reenergize its efforts to reduce global imbalances through improved national economic policy coordination. Second, U.S. policymakers should concentrate on setting aside partisan political battles and developing sound fiscal and monetary policy for the long-term. Third, China should confront structural weaknesses in its economy. Fourth, the IMF and the World Bank should continue efforts to integrate emerging economies into decision-making processes. Fifth, the European Union should persist with governance reforms that will strengthen economic integration and ensure the long-term financial health of the eurozone. Finally, in response to capital market volatility, emerging economies should avoid short-term fixes and implement policies that will strengthen their resilience.

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Background

Financial markets are more open and complex than ever before. This brings benefits, but also leads to volatility—as reflected in the repeated financial crises over the past two decades. In the wake of the most recent major crisis, which reached a peak of intensity in September 2008, leaders from around the world made two main pledges. First, they would coordinate economic stimulus to keep the global economy afloat and put in place policies to promote strong, sustainable growth. Second, they would overhaul the global financial architecture to prevent a similar crisis in the future. By 2010, the first pledge had been more or less fulfilled—though global growth has since slowed and problems remain, especially in Europe, and with respect to global imbalances. Overhauling financial regulation has proved to be a harder challenge.

The major institutions of today’s global financial architecture date back to the 1940s. After the crash of 1929, the Great Depression of the 1930s, and the devastation of World War II, world leaders gathered in 1944 to establish a new financial architecture that would protect the world economy from currency swings and help rebuild war-torn Europe. The foundation of the Bretton Woods system was a new monetary order based on a fixed exchange rate: the major currencies were pegged to the dollar and the dollar was pegged to the gold standard. Two new multilateral institutions were created to manage the new global financial order: the International Monetary Fund was primarily mandated to “ensure the stability of the international monetary system,” while the International Bank for Reconstruction and Development (today part of the World Bank Group) was established to support reconstruction and development projects, initially in Europe.

This foundation cracked in the early 1970s. The fixed exchange rate system collapsed under the pressure of U.S. inflation, which eroded U.S. competitiveness, leading to a current account deficit and a flood of dollars into other states. Once foreign holdings of dollars greatly exceeded U.S. holdings of gold, the United States was unable to stand by its promise to exchange gold for dollars at the fixed rate, and the gold-dollar peg ceased to be credible; the Bretton Woods regime thus gave way to a new era of floating exchange rates. As a result, with global capital flows increasing, foreign exchange trading began to expand rapidly. Meanwhile, the advent of affordable computing made it possible to price and trade financial derivatives, adding to the complexity of markets. With the collapse of communism, globalization increased the reach of large financial firms, creating an even larger and more sophisticated financial system along with unprecedented growth and global imbalances. Governments struggled to adapt the global financial architecture to address these changes. After the U.S. housing market bubble collapsed in 2007, exposing the risks of over-leveraged banks and poorly-regulated activity, the global financial system plunged into turmoil. Soon after, a sovereign debt crisis rocked the European Union and revealed the shaky foundations of the euro, the currency now used by eighteen of the EU’s twenty-seven members.

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Class Evaluation

The Financial Stability Board (FSB), which coordinates among the financial authorities of the world’s largest economies, demonstrated leadership in 2013 by continuing to provide critical recommendations and data to marshal support for reforms that reinforce the health of the financial system. In particular, following up on their effort to address the difficult issue of “too-big-to-fail” financial institutions, the FSB continued to push for implementation [PDF] of guidelines on how to wind down major institutions if they fail (Key Attributes of Effective Resolution Mechanisms [PDF]). The group delivered a report on the progress of G20 countries’ implementation, and the G20 recommitted to the effort in St. Petersburg. The FSB also released a draft assessment methodology to assess compliance with the Key Attributes and encourage the construction of credible resolution regimes. In addition, the FSB identified nine globally important insurers that, along with the world’s largest banks, will be subject to certain conditions in order to minimize costs to the financial system in the event of failure. These initiatives represented important efforts to update regulatory frameworks for the twenty-first century, as more complex financial instruments increasingly pose risks to insurance firms, which are in turn increasingly integrated into the global financial system. The FSB also continued the daunting task of monitoring implementation of past national commitments, publishing these results in numerous reports throughout the year. Finally, the body’s recommendations [PDF] for regulating the shadow banking sector provided a roadmap for G20 commitments at the leaders’ summit in St. Petersburg.

The U.S. Federal Reserve joined the FSB at the top of the class for continuing to help the U.S. and the global economy recover from the 2007-08 financial crisis by effectively managing its five-year-long policy of quantitative easing. The 2013 version of this policy—referred to as QE3—saw the government purchase $85 billion in bonds every month to buttress the economy. With growing evidence that labor markets were healing and growth strengthening, the Federal Reserve’s Open Market Committee (FOMC) announced a reduction in the massive asset purchase program in December 2013, lowering it to $75 billion a month. To be sure, initial communication missteps around “tapering” caused considerable confusion, but by the end of 2013, the FOMC had clarified its QE exit strategy, and newly appointed Chairperson Janet Yellen had declared her commitment to continuing to increase the transparency of the FOMC’s deliberations and the activities of the Federal Reserve.

China received a gold star for taking a number of laudable steps during the year, again earning the country praise despite a mixed record on addressing structural imbalances and exchange rate management [PDF]. Primarily, in response to signs that its economy was beginning to cool, Chinese authorities in July launched a mini stimulus to boost growth. By September, the economy appeared to have “found its feet.” Moreover, it continued, in fits and starts, to loosen control over its currency, allowing the renminbi (RMB) to fluctuate more closely to market rates, which is critical for rebalancing the nation’s current account surplus. By December, the RMB had reached its strongest value against the dollar—6.07—since 1993, when the exchange rate policies began. Finally, a series of market liberalization steps, ranging from relaxing some foreign investment restrictions to expanding the access of foreign firms to the Chinese stock exchange, signaled the Chinese leadership’s interest in enticing foreign capital.

Still, by the end of 2013, the growth trend had clearly slowed and underlying financial vulnerabilities—continued dominance of state-owned enterprises, massive imbalances, the expansion of the shadow banking system, and high provincial and local debt levels, among others—were generating significant concern. Chinese leaders were clearly cognizant of the need to rebalance the economy (in particular by increasing domestic consumption) and to rein in shadow banking. In response, they launched a comprehensive plan to reform the economy by 2020 to mitigate these risks. Navigating the tension between promoting growth and ameliorating risk is inherently difficult, but China was awarded a gold star for its prudent recognition of the challenges facing its economy and for taking incremental steps to begin to address these.

Ireland earned the status of most improved for becoming the first of the countries bailed out by the troika (the European Commission, European Central Bank, and the IMF) to exit its aid program, valued at $114 billion. The move came after a March 2013 sale of ten-year bonds raised enough financing to cover Ireland’s estimated borrowing needs. Still, with unemployment at 12.8 percent and property prices still falling outside Dublin, Ireland’s economy has a long way to go before it returns to pre-crisis levels.

Alongside Ireland as most improved, Japan merits mention for taking decisive action to spur economic growth after decades of stagnation. Throughout 2013, the Japanese government sought to implement Prime Minister Shinzo Abe’s economic package, referred to as Abenomics, which aims to jolt the economy out of its deflationary malaise. First, Abe announced a $116 billion short-term stimulus package. Meanwhile, the Central Bank of Japan launched an effort mirroring the U.S. Fed’s quantitative easing, which included doubling its holdings of Japanese government bonds and doubling the average remaining maturity of bonds that it purchases. While it is too soon to judge the ultimate success of the program, the government’s resolve to take action was promising.

More negatively, the G20 appeared to lose steam during the year, earning that forum the designation of laggard. The G20 summit in St. Petersburg in September produced a bland communiqué lacking concrete steps to further implement vital economic reforms and encourage the rebalancing of economies needed for durable global growth. For example, members reiterated the importance of mitigating “spillover” consequences of domestic policies (like quantitative easing) on the global economy, but specified no actions countries should take to address the issue.

Meanwhile, the United States Congress was assigned the label of truant for endangering the full faith and credit of the United States and risking a default during a September 2013 partisan budget battle. Moreover, Congress also prevented progress on reforms to international financial institutions committed to in 2010 by failing to include increased IMF funding in a spending bill despite pressure from the Obama administration to do so throughout 2013. Without U.S. approval of the 2010 reforms, emerging market powers must continue to wait for reform of voting shares and the composition of the Fund’s board.

Argentina landed in detention after receiving an official censure from the International Monetary Fund (IMF) for government manipulation of economic data. Though Argentina apparently softened its stance and began to cooperate with the IMF by the end of 2013, the credibility of its pledges to continue dialogue remained uncertain. An ongoing legal battle with its creditors further undermined its attempts to regain access to international bond markets. The government also continued to report that inflation stood at only 10 percent while independent experts estimated that it was closer to 25 percent. Moreover, a lack of transparency over apparent policy changes to allow the Argentinean peso to depreciate by 33 percent in 2013 threatened to worsen the country’s economic woes. Furthermore, by the end of the year, Argentina’s reserves had dropped by 30 percent—to their lowest level since 2006.

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U.S. Performance & Leadership

B

The United States economy continued to show signs of recovery from the 2008 financial crisis, and implementation of post-2008 reforms proceeded. Consumer confidence and stock markets rallied to new highs, and unemployment reached a new low [PDF] of 6.7 percent, pointing to positive future growth. On the other hand, some systemic risks remained unaddressed and Congress failed to agree on a path for long-term fiscal sustainability. Although the fiscal deficit fell to 3 percent of GDP, brinksmanship with respect to the debt ceiling and the resulting political crisis sent chills through the global economy. Negotiations succeeded in averting a potential debt default but long-term fiscal issues remained unresolved.

The economic expansion can be partially attributed to the U.S. Federal Reserve’s ongoing monetary policy of quantitative easing—that is, the injection of new money into the economy through the purchase of treasury and mortgage securities, while holding interest rates at zero to spur spending. In addition, the Fed has used “forward guidance”—clear statements about its willingness to maintain easy monetary conditions for a considerable period—to keep interest rates low. After economic growth surpassed analyst expectations in the third quarter, the Fed announced in December 2013 that it would slow the pace of its quantitative easing program (i.e., its pace of asset purchases). Though markets tended to react with volatility to the prospect of tapering in mid-2013, the Fed was able to minimize disruption in the domestic and global market in December thanks to the overall improved state of the economy, and a carefully worded announcement. Underscoring the increasing health of the economy, the government housing finance agencies, Fannie Mae and Freddie Mac, which had required a $188 billion bailout from taxpayers after investment in risky loans went sour in 2007-2008, had earned enough profits to repay almost $150 billion to the U.S. Treasury by September.

Furthermore, U.S. agencies continued to make progress on implementing regulatory reforms. In December 2013, the five agencies drafting the Volcker rule, which aims to limit the extent to which insured depository institutions and affiliates can engage in risky short-term proprietary trading or invest in hedge or private equity funds, resolved their disagreements and approved a final rule. As the Dodd-Frank Wall Street Reform and Consumer Protection Act [PDF] of 2010 had initially set a July 2012 deadline for the rule, its release at the end of the year was overdue. The rule imposed limits on hedging that were stricter than expected and that promise to reduce the probability of and contagion from massive shocks such as JPMorgan’s $6 billion loss on bad derivatives (though the rule was still far more lenient than originally intended due to compromises made during the 2010 negotiations). It also mandated executives to “attest in writing” that their companies are complying with the regulation, which should ensure greater accountability.

On the other hand, some systemic risks appeared to persist. In particular, regulators continued to design plans for winding down systematically important financial institutions (SIFIs—or banks that are “too big to fail”) in case they became insolvent, but increasing consolidation in the financial sector raised questions as to whether these new regulations were adequate. By September 2013, the combined assets of the four largest banks in the United States amounted to almost half of U.S. gross domestic product (GDP), suggesting that the economy would struggle to weather the collapse of one or more of them. That same month, the market share of Fannie Mae and Freddie Mac in the U.S. mortgage market stood at 90 percent, while reforms to both agencies needed to reduce government exposure to future downturns in the housing market continued to elude lawmakers.

Moreover, bitter partisan rancor over the national debt jeopardized U.S. recovery. Congress battled over raising the U.S. debt ceiling, culminating in a sixteen-day government shutdown and the threat of the United States defaulting on its debt. Christine Lagarde, managing director of the IMF, warned that gridlock in the U.S. political system could undermine the global economy. Echoing her admonishment, the U.S. Treasury declared that a U.S. default on its debt obligations would have “catastrophic" global consequences. Congress cobbled together a last-minute agreement, but the Fitch Ratings Agency still placed the United States on a negative watch list (indicating that a downgrade was being considered) following the crisis. Acute fiscal uncertainty, coupled with continued tight spending controls and the across-the-board budget cuts of the sequester, dragged down GDP growth by an estimated 0.3 percentage points, although a year-end budget accord and increased revenues indicated that near-term budget deficits may fall [PDF] to the historic norm of 3 percent of GDP.

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Managing Financial Crises

Average

While the global economy continued its tepid recovery from the 2008 financial crisis, emerging markets stumbled. Globally, in 2013 the economy grew by 3 percent [PDF]. The IMF revised its 2013 predictions for emerging markets downward by 0.5 of a percentage point to 5.0 percent, pointing to their insufficient capacity to cope with increased financial volatility, among other factors. The slowdown in emerging markets led many to warn against relying on the “BRICS” to fuel the global economy. However, the eurozone crisis overshadowed these concerns for much of the year, as international and EU institutions, along with national officials, were concentrated on containing sovereign debt crises and encouraging growth in the region. Despite renewed attention, their cooperation on eurozone debt crises in 2013 was limited.

The turmoil in March over how to address a banking crisis in Cyprus highlighted continued disagreement on crisis response among the members of the troika—comprising the European Central Bank, European Commission, and IMF. When the island nation sought funding from the troika, the IMF and Germany provoked a fierce political backlash and undermined trust in deposit safety by demanding that Cyprus impose a tax on bank deposits. Though the troika and Cypriot government eventually restructured the bailout deal to avoid taxing smaller deposits, the final deal was criticized as self-defeating. Furthermore, the Cypriot government’s introduction of capital controls, which were still in place at the end of 2013, endangered the future of the common currency. The crisis revealed a general unraveling of European cooperation and a lack of a coherent strategic direction for the continent.

European solidarity appeared to disintegrate further throughout the year, as the EU’s most prosperous members pushed to reduce their budget contributions and the United Kingdom planned a referendum on EU membership itself. This prompted the ratings agency Standard & Poor’s to lower the region’s credit rating due to the overall negative economic outlook. On the other hand, the ECB took decisive action to cut interest rates in an effort to stimulate growth, and ECB President Mario Draghi’s announcement of the Bank’s commitment to “do whatever it takes” served to calm markets. Meanwhile, a commitment to a 2014 asset-quality review and stress test to promote the health of the region’s banks advanced progress toward a banking union. In addition, preparations continued [PDF] for a Single Supervisory Mechanism (SSM), which will allow the ECB, rather than national authorities, to directly supervise 130 of the eurozone’s largest banks. Overall, although this institutional progress was significant, it failed to provide a convincing roadmap for political and economic union. Significant differences remain among members about the terms for recapitalization or resolving troubled banks, as well as on a permanent European bailout fund that could react more rapidly and decisively to unfolding crises. The prospects on these and other critical reforms, including a euro-wide deposit insurance scheme and resolution mechanism for winding down major banks that fail, appeared uncertain. For, they will require not only continued leadership from the ECB but also deeper commitment from member nations to a banking union.

For its part, the IMF announced [PDF] in April 2013 that it was reexamining its strategy for—and involvement in—sovereign debt restructurings. The announcement followed the Fund’s thorough ex post evaluation of Greece [PDF], which acknowledged the need for improved cooperation within the troika and for IMF analysts to approach official economic data from national authorities more judiciously when assessing sustainability. The Fund also noted that it was seeking to revise procedures for evaluating countries’ debt burdens, with the aim of reducing political pressure to downplay economic problems in the Fund’s sustainability assessments (which IMF shareholders sometimes exert to avoid debt restructuring). This proposal generated intense debate and criticism, mostly from the major shareholders who are reluctant to see their authority to negotiate solutions to sovereign crises compromised. Still, this stocktaking has catalyzed needed discussion on how to mitigate the weaknesses of the current system.

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Coordinating Macroeconomic Policies And Exchange Rates

Average

In 2013, coordination of macroeconomic policies was mixed. The 2013 G20 annual meeting in St. Petersburg—which provides the best opportunity for leaders from the world’s major economies to design a cohesive approach to manage the international economy—achieved little. The summit’s economic agenda was overshadowed by tension between Russia and the United States over how to respond to Syria’s civil war. The rambling communiqué from the summit outlined various points of agreement among the world’s twenty largest economies—such as the need for debt reduction, as well as structural reforms to boost growth and employment—but did not provide concrete action plans to deliver on these objectives. Debates over the utility of austerity measures versus growth stimulus (such as quantitative easing) remained contentious, with no progress toward a coordinated agenda. The weak outcome appeared to confirm criticisms that the G20 is losing steam, and “falling into a bureaucratic morass.”

On the other hand, in February, the G20 demonstrated the vital role it can play in helping countries reach and communicate joint positions on macroeconomic policies, to the benefit of international financial stability. Gathering in Moscow that month, G20 finance chiefs jointly signaled that a Japanese decision to loosen monetary policy did not qualify as an attempt to target (and thus manipulate) its exchange rate. The united front reassured markets that leaders would not be drawn into a vicious cycle of competitive devaluations. Even after the Japanese yen’s value dropped by 19 percent against the dollar, G20 members withheld criticism for the sake of global economic stability. The G20’s success in calming fears of a currency war in the near-term was notable, but it proved unable to bring members together to hold discussions on ensuring long-term foreign exchange rate alignment. Further currency depreciation in emerging economies and slower growth in China only increased the urgency of this issue.

In 2013, the IMF carried out its first biennial review [PDF] of countries’ economic policies as part of the Mutual Assessment Process (MAP)—a collaborative effort [PDF] between the IMF and G20 to monitor and support countries’ implementation of international commitments set forth in the G20 Pittsburgh Declaration. The report noted [PDF] that China’s external surplus had fallen from 10 percent to 2 percent between 2008 and 2013. Still, the IMF found that nine countries had made little progress toward addressing internal and external imbalances and concluded that economic performance had been disappointing compared to 2011 projections. Though much heralded, the MAP agenda has expanded to include too many issues to operate effectively and has thus far failed to generate [PDF] positive momentum on the more contentious global financial challenges.

Other bright spots included a decrease in China’s currency manipulation and progress on global trade. Since 2010, the United States has used the G20 to pressure China to allow its currency to fluctuate according to “market-determined exchange rates,” and in 2013 China continued to loosen control over its exchange rate. By December 2013, the yuan’s value had appreciated to 6.07 against the dollar, its highest value since 1993. This contributed to the drastic decline in China’s current account surplus, as the IMF biennial review documented.

Finally, in St. Petersburg, countries extended their commitment to refrain from protectionist measures until 2016 (though adherence to the pledge has varied in countries like Brazil, Russia, and Argentina). And remarkably, the World Trade Organization achieved a modest breakthrough in December. After many combative negotiations over the Doha Round, 160 countries agreed to measures that will simplify customs procedures and cut the costs of international trade. As the first significant movement in global trade liberalization at the WTO, this was a welcome step, despite including more limited agreements than those sought in the Doha round. The growing number of plurilateral negotiations now underway, however, suggests that significant developments in trade liberalization may increasingly originate outside universal negotiating forums. The two most significant negotiations now underway—the Trans Pacific Partnership and Transatlantic Trade and Investment Partnership—promise to further challenge the centrality and relevance of the WTO.

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Regulating Financial Institutions, Bank Capital, And Liquidity

Average

Throughout the year, international organizations and major economies continued to work toward mitigating risks in the global banking system that caused the 2008 financial crisis, but they postponed essential discussions on issues like regulating shadow banking. Meanwhile, implementation of some important initiatives flagged.

By August, twenty-five of the twenty-seven jurisdictions that agreed to the Basel III framework had issued final rules [PDF] to implement the revised capital regulations. The set of updated banking regulations was one of the most critical reforms since 2008. It will require banks to hold more than triple the amount of capital as previously, and to limit their leverage ratios. The remaining two countries (Turkey and Indonesia) were in the process of finalizing the rules. Still, harmonized implementation of Basel III promises to prove challenging as the approaches of the United States and Europe diverged in several areas.

In addition, the Basel Committee on Bank Supervision (BCBS) released a revised leverage framework [PDF] and stricter disclosure requirements for consultation in June 2013. The revision’s centerpiece was an updated formula for calculating a bank’s leverage ratio. However, in response to criticism by industry, the BCBS was prepared to dilute the rules by December, which would potentially undermine the original intent of the leverage ratio.

For its part, the Financial Stability Board acquired official status as its own legal entity under Swiss law in January 2013. In the following months, the FSB continued to update its list of global SIFIs, whose collapse could threaten the world economy, and published a draft methodology to help governments craft procedures to wind down these sprawling financial institutions if they become distressed, rather than bail them out. In July 2013, it also added nine insurance firms to this list of too-big-to-fail institutions, so that regulators account for how integrated insurers have become in the global financial system.

Nevertheless, the FSB faced the challenge of pursuing an ambitious, expanding mandate with modest resources, and it drew criticism for its opaque decision-making processes. In particular, the board still elected not to release information about the formulation of its work program, which continued to grow. In 2013, for example, the FSB launched an initiative to propose options for repairing or replacing financial benchmarks such as LIBOR (the London Interbank Offered Rate), which requires broader reforms beyond the July 2013 transfer of control from the British Bankers Association to the NYSE/Euronext (since the latter body too could benefit from manipulating the rate).

Meanwhile, member state progress in meeting other commitments was patchy. One FSB review concluded that most national jurisdictions lack requirements for SIFIs to submit resolution plans. Furthermore, as a September FSB report concluded, countries need to redouble efforts [PDF] to agree to procedures for winding down “too-big-to-fail” financial institutions that span multiple jurisdictions. At the same time, commitments to harmonizing accounting standards stalled [PDF] during the year. Another important proposed reform to separate banks’ traditional lending operations from risky speculative trading lost momentum in 2013 after the original 2012 proposal was watered down.

Finally, at the G20 summit in St. Petersburg, the world’s leading economies merely postponed discussions to agree on details over regulation of the shadow banking system, including hedge funds, private equity, and money market funds. Individual countries continued to hesitate to act independently, for fear of disadvantaging their own banks. Therefore, delaying multilateral negotiations about oversight and regulation of this crucial sector allowed risks to the global financial system to persist. And despite the FSB’s recommendations [PDF] for G20 action regarding SIFIs, countries made no progress in St. Petersburg on this issue, further underscoring the G20’s diminishing effectiveness.

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Supporting Development

Good

During the year, the United Nations, in consultation with international financial institutions and bilateral donors, worked to define a new international framework to advance human development after the Millennium Development Goals (MDGs) expire in 2015.

In May 2013 a high-level panel of twenty-seven world leaders appointed by UN secretary-general Ban Ki-moon released a final report on the post-2015 development agenda. The document offered a set of development goals for 2030, geared to accelerate five “transformative shifts:” ending extreme poverty, focusing on sustainable development, emphasizing inclusive growth, supporting accountable and effective governance, and forging more innovative ways to coordinate global cooperation. Despite its lack of official standing, the report generated significant attention, though reviews were mixed. It inspired both praise for its practical recommendations and criticism for not paying greater attention to economic inequality.

Meanwhile, the world recorded some notable successes in achieving the current MDGs. The 2013 MDG Report [PDF] noted major gains in improving health and reducing poverty and suggested that the positive trends in development (exemplified by the achievement of halving global poverty since 1990—two years ahead of schedule) was holding steady. Development aid from advanced economies, after slipping by 4 percent in 2012, was expected to rebound in 2013. Still, the report concluded that urgent action was needed to achieve all the MDG targets by 2015, particularly in the lagging areas of education, environmental sustainability, and maternal health.

At the World Bank, President Jim Yong Kim spearheaded an internal reorganization designed to respond to pressing organizational and bureaucratic challenges. The proposal sought to rearrange teams to eliminate internal barriers between regions and projects, and help improve cooperation among experts that work on similar issues. The reorganization also included a new methodology to help officials deploy Bank resources where they will have the greatest impact. It is too soon to tell how effective the reorganization will be as it is unclear whether the addition of new practices and partnerships will be accompanied by the removal of material and procedural redundancies throughout the organization.

Lastly, the BRICS continued discussions on the design of their development bank—a lending body that will mainly oversee infrastructure projects in member countries. At the annual BRICS summit in Durban, South Africa, the five countries formally agreed to create the bank, with a tentative launch date in 2015. Many, however, expressed skepticism that the project will ever be fully realized. Relations between members remained fractious, and crucial questions, such as how responsibilities for funding and governance will be allocated, particularly with respect to China’s role, have not been settled.

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Reforming Governance Of International Financial Institutions

Poor

Progress in updating the governance structures of international financial institutions (IFIs) proceeded at a snail’s pace throughout the year. The failure to update IFIs to adequately reflect the growing weight of emerging economies left traditional industrialized countries overrepresented [PDF] within the IMF and World Bank, increasingly jeopardizing the legitimacy of these institutions (a view expressed [PDF] by no less than IMF managing director Christine Lagarde).

The IMF undertook a review of its quota formula, which is the basis for deciding each member country’s voting power and access to the institution’s financial resources. The review was completed in January 2013. The executive board was scheduled to make decisions based on this review in early 2014, but this has been postponed until January 2015 because of U.S. delays in approving quota reform. But even if the reforms move forward in 2015, their impact will be limited, as they will merely shift 6 percent of quota shares from over-represented to under-represented countries, and shift another 6 percent to emerging market and developing countries. This is inadequate given the significant growth in emerging economies that remain substantially underrepresented.

The broader reform package, intended to integrate emerging markets by increasing their presence on the executive board and doubling IMF quotas to raise their contributions, remained stalled at year’s end, despite G20 pledges to implement the change by 2012. European countries did not approve the executive board changes, and the quota reforms must be approved by the U.S. Congress because the country maintains effective veto power over changes to quota formulas. Assurances that the United States need not contribute new money (since the additional funds would be shifted from existing U.S. commitments) and would not see its influence in the IMF decline proved unable to elicit progress. The U.S. Congress did not hold a vote on reform legislation, as the issue became enmeshed in partisan budgetary squabbles.

For its part, the World Bank, which completed [PDF] a rebalancing [PDF] of shares in 2012, has launched a reorganization to remove bureaucratic roadblocks. The institution focused on this effort during the year rather than reforming its structure to better incorporate major emerging economies, awaiting progress at the IMF before moving forward. More positively, the Financial Stability Board (FSB), which coordinates regulatory cooperation among major economies, finally earned official status as a legal entity. This shift entrenches the FSB as a pillar of a more inclusive global financial system that includes new economic powerhouses. However, the FSB’s inclusivity was no substitute for IMF governance reform as its power is significantly more limited than the IMF.

The failure to implement comprehensive, meaningful reforms to global financial institutions undermines the confidence of emerging market governments in today’s global financial architecture. Ultimately, it may drive them to build alternative structures outside existing frameworks. Indeed, some recent initiatives indicated that they were already trying to do so. For example, the BRICS (Brazil, Russia, India, China, and South Africa) announced a push to establish an independent $100 billion fund to address short-term liquidity problems in their economies and continued to call for a new BRICS development bank. Despite doubts that these initiatives will proceed, the proposals lay out parallel institutions: The former would compete with the IMF, the latter, with the World Bank.

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Areas for Improvement

Global financial governance requires improvements in six major areas:

  • Five years after the 2008 financial crisis began, destabilizing global economic imbalances persist. The Mutual Assessment Process (MAP), which was launched by the G20 in 2009 as a mechanism to enhance economic policy coordination among G20 member states, has underperformed. Current account imbalances between deficit and surplus countries—and the risks these pose to financial stability—have narrowed somewhat since 2008, but largely as a result of falling global demand [PDF] and this decrease remains insufficient. The G20 should redirect the MAP to focus on the body’s core financial priorities, and reform the process’s deliberative procedures to ensure that a desire for consensus does not discourage member states from discussing the most divisive issues.

  • The U.S. Congress and Obama administration should strive to avoid political bickering that diminishes confidence in the United States and leads to irresponsible fiscal policies. The rancorous debates undermine the stability of global markets. U.S. policymakers should instead cooperate to identify strategic budgetary reductions while enhancing the prospects for long-term economic growth. Meanwhile, the Federal Reserve should maintain its focused yet flexible approach to monetary policy and adjust the tapering of its bond-buying program according to domestic and global market conditions. During the transition to tighter monetary policy, the Fed should continue to concentrate on increasing transparency.

  • China’s domestic imbalances could threaten the stability of the global economy. China should therefore continue to reform its economic policies to address these imbalances, especially the growth of the shadow banking system. Meanwhile, China’s leaders should continue to push for greater oversight of unregulated lenders, starting with the enforcement of new regulations and guidelines circulated in December 2013. Further movement toward currency liberalization is appropriate as China still retains the tools to intervene in currency markets [PDF] to keep the RMB at an artificially low rate. A fast-growing economy such as China should ideally be running a modest deficit after years of running large current-account surpluses.

  • The failure of IMF members to implement the governance and quota reforms approved by the IMF Board of Governors in 2010 by the October 2012 deadline represents a significant step back. Europe remains overrepresented at the Fund, which undercuts the legitimacy of the institution, as does the U.S.-Europe grand bargain of appointing the heads of the IMF and World Bank. Emerging economies should be integrated into international financial decision-making structures. In turn, emerging powers should also step up their contributions to stabilizing world economic order to ensure that these institutions continue to securely anchor the international monetary system.

  • The European Union should continue pushing forward with financial governance reforms that foster economic and political integration and reduce fragmentation. The top priorities should be ensuring that the Single Supervisory Mechanism is fully operational, securing consensus among member states on the scope of the Single Resolution Mechanism, and establishing the Single Resolution Fund. Moving supervision and support for banks to the supranational level and delineating clear lines of authority is necessary for the economic recovery and long-term stability of the eurozone.

  • The trade balances and currencies of emerging markets were buffeted by capital outflows and falling commodity prices in 2013. Emerging markets, especially Brazil, South Africa, India, Turkey, and Indonesia—the so called fragile five— should prepare themselves for market conditions that could further undermine their growth prospects. Eventual normalization of monetary conditions in industrialized countries, most notably the United States, will exert further downward pressure on their exchange rates. Structural reforms to increase productivity will be a more effective buffer than short-term, inefficient fixes, like raising interest rates, hoarding international reserves, and regional currency swap arrangements. Longer-term reforms to enhance productivity in growing industries would enhance the resilience of emerging markets.

Credits

Produced by the Council on Foreign Relations and Threespot

  • Executive Producer: Stewart Patrick
  • Web Producer: Andrei Henry
  • Producer / Writer: Farah Faisal Thaler
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