By Brahima Sangafowa Coulibaly and Eswar Prasad
Undoubtedly, the economic recovery from the COVID-19 pandemic will dominate the agenda for the G20 Summit in Rome in late October. The summit also presents an opportunity to lay the foundation for a more robust and resilient global financial system. The creation of a new global liquidity insurance mechanism (GLIM) would expand the financial safety net to encompass a larger share of the world’s population.
To fill this important gap of systematic provision of foreign exchange liquidity to a broader set of countries, the G20 should initiate the groundwork to set up an insurance pool—the GLIM—with the following design features.
Each country would pay a modest entry fee, depending on its economic size to provide an initial capital base for the GLIM. The country would then pay an annual premium depending on the level of insurance desired. The premium could on average be about 3 percent of the face value of the insurance policy (e.g., $3 billion in annual premiums for $100 billion of insurance). This is comparable to the current quasi-fiscal cost of reserve accumulation through sterilized intervention, so the premium would be calibrated to cost no more than the implicit cost of self-insurance through accumulation of foreign exchange reserves.
Premiums, which would also depend on the quality of a country’s policies, would be based on simple and transparent rules. For instance, a current account deficit larger than 2 percent of a country’s GDP triggers a higher premium. Other criteria for determining premiums could include budget deficits, public debt, and external debt (all relative to GDP). There would be higher premiums for a country that chose to run large budget deficits or that accumulated large amounts of debt. In the interest of simplicity, there would be no country-specific adjustments—such as adjusting the budget deficit for business cycle conditions.
The premiums would increase in a nonlinear fashion with the persistence and levels of weak policies. A country running large budget deficits in successive years would pay rising premiums. Countries that have demonstrated policy discipline would pay discounted premiums. The initial contribution and the annual premiums would be invested in government bonds of the United States, Euro zone, United Kingdom, Japan, and China. In return, the central banks of those countries would be obliged to backstop the pool’s lines of credit in the event of a global crisis.
The pool can also be directly backstopped by SDRs, in effect making the IMF an additional guarantor for a portion of the credit lines in the event of a catastrophic global shock.
The insurance payout would be in the form of a credit line open for one year, rather than an outright grant, with the interest rate based on the yields on short-term government securities in the countries backstopping the insurance pool.
The country would not be able to buy additional insurance until there was a full repayment of the initial draw, in the same hard currency of the original loan, from the insurance pool. Thus, the insurance would only be suitable for liquidity crises. An economy beset by a solvency crisis would have to go to the IMF for traditional borrowing with ex-post conditionality, with any funds drawn through the GLIM (and not yet paid back) becoming folded into such an arrangement.
The crux of the proposal is that it broadens and depoliticizes access to foreign liquidity in the event of a major global shock by institutionalizing ex-ante currency swap arrangements. This mechanism is simple and could easily be managed by an institution such as the Bank for International Settlements.
The scheme would be a transparent, rules-based mechanism to strengthen the power of moral suasion to get a country to adopt sound policies. There is no specific stigma associated with the premium levels as they are based on country variables that are all public knowledge. To encourage broad participation, the G-20 could make participation in this pool a condition for continued membership in a body such as the Financial Stability Board. No country would be forced to buy insurance, but would have to pay the basic membership fee to be part of the pool.
Our proposal would reduce the incentives for EMDEs to self-insure through costly and inefficient reserve accumulation, alleviate pressures on IMF resources, and promote global financial stability. The GLIM offers a bold yet practical solution to bolster the global financial safety net.
Further information:
Policy Brief (PDF): https://www.t20italy.org/wp-content/uploads/2021/09/PBTF9-2.pdf
About the Authors
Brahima Sangafowa Coulibaly is vice president and director of the Global Economy and Development program at Brookings after previously serving as director of the program’s Africa Growth Initiative. He joined Brookings in April 2017 after nearly a decade and half at the Board of Governors of the Federal Reserve System where he was most recently chief economist and head of the emerging market and developing economies group. In that capacity, he oversaw the institution’s work on emerging markets and developing economies, provided intellectual leadership on economic and financial issues facing these economies, and often represented the Federal Reserve in international meetings and working groups on relevant topics.
Coulibaly has also taught economics and international finance at Georgetown University, the Darden Graduate School of Business at the University of Virginia, and the University of Michigan. He has published widely in top-tier academic journals on various topics in international finance, macroeconomics, economic development, monetary economics, and trade. He speaks regularly to the national and international media on these issues. His research has featured in numerous prominent media outlets, including the Wall Street Journal, the Financial Times, Project Syndicate, and the New York Times.
Eswar Prasad is the Tolani Senior Professor of Trade Policy and Professor of Economics at Cornell University. He is also a Senior Fellow at the Brookings Institution, where he holds the New Century Chair in International Economics, and a Research Associate at the National Bureau of Economic Research. He was previously chief of the Financial Studies Division in the IMF’s Research Department and, before that, was the head of the IMF’s China Division.
Prasad’s latest book is The Future of Money: How the Digital Revolution is Transforming Currencies and Finance (Harvard University Press, 2021). He is also the author of Gaining Currency: The Rise of the Renminbi (Oxford, 2016) and The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance (Princeton, 2014). Prasad has testified before the Senate Finance Committee, the House of Representatives Committee on Financial Services, and the U.S.-China Economic and Security Review Commission. He is the creator of the Brookings-Financial Times world economy index (TIGER: Tracking Indices for the Global Economic Recovery). His op-ed articles have appeared in the Financial Times, Foreign Policy, Harvard Business Review, International Herald Tribune, New York Times, Wall Street Journal, and Washington Post.
Notes
- ¹ See https://www.imf.org/external/np/pp/eng/2014/012714a.pdf, January 2014.
- ² The insurance scheme proposed here is not relevant for the major reserve currency economies, which are covered by institutionalized bilateral swap lines that can cover their foreign currency liquidity needs.
- ³ If this scheme was later extended to cover smaller and less developed economies, the entry fee could be reduced or even waived as the insurance pool would presumably have built up reserves by that time.
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4 Countries with weak policies would be charged higher-than-average premiums. This would match their correspondingly higher costs of self-insurance through reserve accumulation; their sterilized intervention costs would be higher than average as they would typically face wider spreads on government (or central bank) bonds relative to the interest earned on reserves.
References
- Coulibaly, B. and E. Prasad, “The International Monetary and Financial System: How to fit it for purpose?”, in Reimagining the Global economy: Building back better in a post-COVID-19 world, Brookings Institution, 2020
- Prasad, E., The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance, Princeton, NJ, Princeton University Press,2014
