G20 Report: Stimulus and Regulation Compromise Needed

What started last year as a growing international credit crunch and, by September, a global banking crisis has now spread into the real economy. International trade, investment and economic growth are all contracting. A drastic curtailment of credit, collapsing global demand and a loss of trade finance is having a devastating economic effect on both the developed and developing worlds, especially those economies that are heavily dependent on exports.

Executive Summary and Recommendations

The world economy is falling into a deep recession. After more than a decade of robust economic expansion that has contributed to improve the living conditions of millions of people, the current crisis threatens to reverse this progress and set in train a backward process of ‘deglobalization’ in both the developed and developing worlds.

The London Summit on 2 April provides a critical moment to broker international agreements and solutions among governments representing 80 per cent of global GDP on how to halt this collapse. The summit must restore confidence in the positive potential of an integrated world economy. It must demonstrate a shared commitment to the actions required to halt the crisis. And, to secure this shared commitment, it must set in place a rule-based and inclusive framework of international economic and financial governance.

With these imperatives in mind, the contributions to this report point to a set of overarching priorities for the London Summit. The summit should have an ambitious, but manageable and focused agenda that commits G20 governments to immediate and concerted action to stop the crisis in the short term and sets out specific targets and deliverables that will have a positive systemic impact over the medium to long term.

A Focused Agenda:

The G20 is an informal governance mechanism with no experience in managing a crisis, and there is a limit to what it can accomplish. Since the first G20 leaders’ summit in November 2008, the ever-worsening economic outlook has burdened the G20 process with expectations that are far too high and and agenda that is too complex. The existing G20 agenda of long-term financial reform has become entangled with immediate concerns about orderly crisis resolution and about the impacts of the crisis on the development and environmental agendas.

The immediate challenge now for the London Summit is to focus the agenda and embrace concerted action to stop the crisis. However, it is clear that immediate action by G20 leaders to halt the deepening recession will need to rest upon a central political trade-off. Agreement across the major G20 countries on the importance of stimulating the world economy (championed by the United States, United Kingdom and Japan) will require that G20 leaders also make specific commitments to international financial regulatory reform (as France, Germany and the majority of other EU leaders have consistently argued). With this compromise in place, the summit must also commit to halt any rise in protectionism, which could prove devastating for the world economy and especially for the developing world.

G20 leaders should commit, therefore, to two sets of actions at the London Summit – first, those that will have an immediate effect on stemming the crisis and, second, those that will have a longer-term structural impact.

1. Leverage the crisis to achieve a sustained resumption of economic growth.
2. Immediately increase capacity for systemic crisis management.
3. Reject protectionism and promote open economies.

4. Improve the financial regulatory framework.
5. Fundamentally reform the governance of the international financial institutions.
6. Address global imbalances.

It will not be sufficient for G20 leaders to issue general declarations at the London Summit. To be credible, there needs to be detail. We offer this sort of detail in the synopsis of the report’s recommendations below.

Recommendations for Action:

1. Agree on a path to sustained resumption of economic growth
G20 leaders must articulate their conviction at the London Summit that stimulating economic growth with all appropriate policy tools is the first priority, and that sharing the burden will be essential to achieving this task.

  • Sending a unified message on this point is the only way to restore global confidence and show that the world economy is     once  again under ‘adult supervision’. G20 nations have already taken major, but differentiated stimulus approaches,   reflecting national policy priorities. The London Summit must commit G20 nations to using all policy tools to stimulate   further their national economies and create traction for the entire world economy.
  • Rather than recommending one-size-fits-all fiscal stimulus packages, the G20 needs come up with a clear plan for establishing   how countries are going to share the burden of the stimulus. Such a plan requires analysis of the key influences that   determine the actual fiscal position and anticipated future debt burden of each major country. Each national plan must be   cast  in a credible medium-term framework and offer the prospect of generating sustainable growth as well as having an   immediate  impact.
  • US expansionary fiscal and monetary policies are putting downward pressures on the dollar, meaning that Eurozone countries   and others are sharing the burden of US stimulus indirectly through the exchange rate. It is vital to avoid the emergence of   competitive devaluations in this context.
  • A sub-group of the G20 should be established to review the performance of the stimulus packages and recommend necessary adjustments.

2. Immediately increase systemic capacity for crisis management
International institutions must be in a position to provide support to countries in dire need of financial assistance. This can best be achieved if the G20 agrees to increase the IMF lending facilities.

  • Japan and the EU have each now offered major new credit lines to the IMF ($100 billion and €75 billion, respectively). The US and other G20 members, especially those with large foreign exchange reserves, should follow suit at the summit and commit to other multilateral initiatives. For example, the Federal Reserve and other central banks already have swap lines with some emerging markets, and the Chiang Mai Initiative makes swap lines available to Asian Countries.
  • As important as the amount of new lending available will be a commitment to reduce the stigma associated with IMF borrowing and make these sums more accessible to borrowers, in terms of total amount, conditionality and length of borrowing periods.

3. Reject protectionism and promote open markets
While increases in actual tariffs or other WTO-illegal actions remain low, protectionism is creeping in through non-tariff barriers as well as through measures devised to bail out specific sectors and industries. In order to withstand these growing protectionist pressures and preserve global cohesion, there are four steps which the London Summit could take that would be of immediate effect:

  • Formally commit to a collective 12-month freeze on new protectionist measures and a rolling back of existing measures. This includes those measures that are WTO-legal, such as raising applied tariffs to bound levels.
  • Define a plan to bind existing applied tariffs and make one or two bold proposals, such as removing trade and investment barriers in sectors such as clean technology products.
  • Commit to bring the Doha negotiations to a successful conclusion by the end of 2009 in order to support developing-world economies as well as the world economy. This must not be an empty gesture and should contain details of specific milestones for the remaining months of the year.
  • Empower the WTO and the IMF to monitor the rise of WTO-compatible protectionist measures and the impact of bailout programmes on trade and capital flows. It is vital to establish an international consultative group to discipline and make transparent the execution of support programmes to sensitive sectors, such as banks and automobile companies, and to minimize trade-distorting effects. G20 governments should commit to report immediately all changes in applied tariffs and subsidies to the WTO Secretariat, including all presumed WTO-legal measures under contingent protection, such as safeguards, countervailing duties, and antidumping initiations and sanctions. The WTO Secretariat should provide a written account as a background paper to future G20 summits.

The most effective way to defuse protectionist pressures is to reignite economic growth quickly. When governments and the public see the burden of delivering economic recovery policies as fairly shared across countries, this should reduce the political pressure for protectionist retaliation.

4. Improve the financial regulatory framework
Agreeing at the London Summit to improved supervision and rules for financial institutions and instruments will help restore confidence in the financial sector – provided that countries resolve the issue of ‘toxic assets’ – and also help secure concerted action to drive forward measures to reignite growth. It is essential, however, that the regulation is appropriate and correctly targeted. Rushed action could be counter-productive. Reforms should take account the substantial work already accomplished in international financial regulation, correct mistakes and fill gaps. The London Summit should commit to the following goals:

  • Commit to modifying the regulatory regime in order to reduce the pro-cyclicality of the financial industry. This could be done in a number of ways, whether through dynamic provisioning, changes in mark-to-market accounting policies, the creation of ‘regulatory accounting policies’, a clearer monitoring of the term structure of funding versus loans, and of overall leverage in the system, and changes to the Basel II implementation.
  • Incrementally converge national financial rules. A gradual harmonization of financial regulations across borders (for example, defining an ‘institutional investor’, the number of settlement days for a transaction, or on valuation or auditing standards) would improve the common vocabulary of financial players, investors and regulators. Harmonization could be applied as narrowly or as widely as its success merited. By working on an incremental basis, regulators could choose subjects on which they already had agreement at the outset. Also, a small group of countries could agree to test selected topics on a trial basis and other countries could join in as they saw the success of the project. As other subjects of common agreement are found, a directory of common practices or common standards could be adopted across countries, regulators and regulated entities.
  • Take rating agency ratings out of legislation and capital rules. Embedding of credit ratings in legislation and banking regulation has caused a dependence on a few suppliers, an inclination for financial market players to try to ‘game’ the outcome of the ratings, and an overdependence on these ratings by investors who should be doing more of their own analysis as well.
  • Enlarge the membership of the Basel Committee for Banking Supervision (BCBS). This should occur along the same lines as for the FSF so that all countries with significant financial services sectors are included. Support for and implementation of BCBS proposals are likely to be more rapid and more consistent if these countries are involved from the outset, though drafting and negotiation will become more unwieldy among a larger membership.
  • Commit to an effective clearing and settlement mechanism for credit derivatives and other structured investment vehicles (SIVs). This involves agreeing on common standards; standardization of contracts; an end to the over-the-counter market in credit derivatives; standardized margin requirements; and transparent price and volume data that are made publicly available.

5. Commit to fundamentally reform the governance of the international financial institutions
Strengthening the international financial institutions will help prevent future financial crises. The London Summit should commit to the following ideas:

  • Transform the Executive Board of the IMF into a world Economic Committee that is effective, high-level and inclusive. The Economic Committee would focus on issues of policy spillovers that have collective macroeconomic impact, and involve large allocations of Fund resources. It would set the Fund’s agenda.
  • The size of the IMF’s financing capacity needs to be at least doubled, and ideally, tripled so that it can make a credible long-term commitment to help the most vulnerable countries. However, a fairer representation within the IMF will be vital if there is to be widespread agreement on recapitalizing the IMF.
  • Collapse European representation in the IMF into a single chair or some other form of fundamental consolidation. As summit chair, the British government should take the lead in this process by volunteering at the London Summit to give up its single chair in the IMF as part of such a reform.
  • Increase the voting weight and representation of major emerging economies within IMF governance structures to reflect the realities of the new world economy.
  • Make the Financial Stability Forum (FSF) formally accountable to the G20. The FSF’s G7-centric membership has damaged its legitimacy, credibility and reputation, making its recent enlargement to all G20 members very welcome. The FSF should report and testify to the G20 ministers and their deputies, while giving the G20 a formal agenda-setting or directional mandate, allowing the G20 to set priorities and deadlines for FSF work.
  • Use the FSF for greater surveillance of market sectors. Improve the FSF’s understanding of how everyday credit practices and procedures relate to securitization, risk management techniques, credit rating agencies, the activities of hedge funds (and other non-bank institutions), and structured investment vehicles. The FSF needs greater powers to elicit testimonies and contributions from agencies such as the Federal Deposit Insurance Corporation, the Securities Investor Protection Corporation, the Securities and Exchange Commission, and the Department of Housing and Urban Development in the United States.
  • Use the FSF for systemic or macro-prudential supervision. Rather than creating a new body, FSF could perform this role. This could be accomplished by augmenting its strength, membership and authority. However, in order to avoid the continued proliferation of regulatory bodies, a precondition for the creation of any new regulator should be the closure of at least one, if not two others.

A focus on financial regulation and reform is insufficient to address some of the essential drivers of the financial crisis. To that end, the London Summit should agree to:

  • Ensure the continuation of IMF Multilateral Consultations on global imbalances. These confidential consultations bring together surplus and deficit countries to discuss policies, exchange information and coordinate actions – in order to promote the growth of the world economy and prevent the build-up of instabilities in the international monetary and financial system.
  • Set up a caucus on currency misalignments and for the promotion of monetary coordination. This group would include China, Japan, the Eurozone and the US, with two rotating seats for G20 countries with the largest accumulation of foreign exchange reserves. Members of the group will formally commit to exchange information and enhance cooperation among the three main trading blocs: America, Europe and Asia.

Overcoming the Challenges:

We are under no illusion. Many of these proposals are very challenging and will require G20 leaders to spend a great deal of political capital. Strong leadership will be critically important to spur the most reluctant leaders to action. The UK is chairing the London Summit and as such it needs to send a very strong signal about its commitment to reform. It is for this reason that this report contains the proposal that at the London Summit the UK should volunteer to give up its single chair in the IMF, which could then form part of an overall IMF reform agreement to streamline European representation.

G20 leaders need to communicate clearly to the public about the basis, rationale and sequencing of their actions in order to sustain popular support through what will be a protracted period of economic turmoil. When carrying out stabilization and stimulus policies, G20 leaders should also act transparently and be clear about the intentions of domestic policies so that they do not serve as a justification for future protectionist retaliation.

Authors: Paola Subacchi, Alexei Monsarrat, and Robin Niblett.  

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Related Experts: Monsarrat, Alexei