Global Economic Governance:

Systemic Challenges, Institutional Responses, and the Role of the New Actors
Brussels (European Commission, Berlaymont Building, Hallstein Room)

17 February 2009

Global Imbalances and Global Governance

Philip R. Lane

CEPR wishes to thank the European Commission for its financial and organizational support for this meeting.
This document was prepared as part of “Politics, Economics and Global Governance: The European
Dimensions” (PEGGED), a Collaborative Project funded by the European Commission's Seventh Research
Framework Programme

The views expressed in this document are those of the author(s) and not those of the above-mentioned
institutions or of CEPR, which takes no institutional policy positions.
 Global Imbalances and Global Governance

Philip R. Lane
IIIS, Trinity College Dublin and CEPR
February 2009

Prepared for the Global Economic Governance: Systemic Challenges, Institutional Responses, and
the Role of the New Actors workshop in Brussels on February 17th 2009. Agustin Benetrix, Christiane
Hellmanzeik and Peter McQuade provided helpful research assistance. Email: plane@tcd.ie. Tel: +353 1
896 2259. Fax: +353 1 896 3939. Postal Address: The Sutherland Centre, Arts Block, Trinity College
Dublin, Dublin 2, Ireland.

1
1 Introduction

Figure 1 shows the evolution of global imbalances in recent years, plus the projections
for the 2009-2013 period. The general dynamics are well known: the United States has
been running the world’s largest current account de…cit, while current account surpluses
have been generated by Japan, emerging Asia and the oil exporters (with the relative
contributions of these groups varying over time). Although the aggregate current account
balance of the euro area has been small, this obscures a wide dispersion of current account
positions across the member countries, with the large German surplus o¤set by de…cits in
countries such as Spain, Portugal, Greece and Ireland. The IMF’s projections for 2009-2013
indicate a general contraction in current account imbalances, with the important exception
of emerging Asia.
Turning to net foreign asset positions, Figure 2 looks broadly similar to Figure 1, al-
though with some important modi…cations. First, the pattern of net valuation gains and
losses until 2007 has been stabilising for countries such as the United States, such that
the deterioration in its net foreign asset position has been less than the size of current
account de…cits. Second, Figure 2 shows that the dispersion of net foreign asset positions
is projected to widen over 2009-2013, despite the expected contraction in current account
balances. This re‡ects the reality that the projection for current account balances does not
anticipate widespread sign reversals in positions but just a dimunition of existing trends.
Moreover, it is not clear that the pattern for valuation e¤ects over 2009-2013 will neces-
sarily be stabilising. Indeed, Milesi-Ferretti (2009) estimates that the pattern of valuation
e¤ects during 2008 was destabilising, with the United States experiencing a major valu-
ation loss and some of the major surplus countries enjoying signi…cant valuation gains.
(The 2008 distribution of valuation gains re‡ects the skewed composition of international
balance sheets, with the ‘long equity, short debt’pro…le of the United States leaving it very
exposed to the global equity price declines during 2008.)

2
 Accordingly, there are several reasons to remain concerned about the scale of global
imbalances. First, global imbalances were surely a contributory factor to the origin of the
current global …nancial crisis (Portes 2009). While there remains considerable disagree-
ment about the appropriate weighting that should be attached to global imbalances in
developing a comprehensive explanation for the current crisis, it is important to further
improve our analytical understanding of the sources of global imbalances. Second, the on-
going persistence of global imbalances (in the current account and in the net foreign asset
position) continues to be a major risk factor for the world economy. Most obviously, the
risk of a disruptive dollar depreciation remains current, such that there is a clear policy
interest in continuing to focus on global imbalances.
Third, it important to consider new institutional arrangements that might help to avoid
the emergence of non-sustainable patterns in global imbalances in the future. Along one
dimension, it is plausible that the global tightening of regulations concerning the behaviour
of the …nancial sector may help to avoid the ampli…cation problem, by which capital in‡ows
into the United States contributed to increases in leverage and the explosion in securiti-
sations. Accordingly, there is some level of coherence between the global moves to reform
the …nancial sector and the debate concerning the role of governance reforms in redressing
global imbalances.
A second dimension concerns the impact of the monetary policies of the world’s leading
…nancial economies on the distribution of global imbalances. While the current account
is clearly not a policy target for central banks, the relevant issue is whether the major
central banks responded appropriately to shifts in asset prices that may be traced back to
global imbalances. Again, it is possible that the current crisis may prompt a recasting of
the intellectual framework that guides monetary policy decisions, extending to include a
greater appreciation of the role of international factors in driving domestic asset prices.
While these elements of global governance are important, I focus in this paper on how
reforms in the governance of the global …nancial system may alter the incentives facing

3
those emerging market economies that have opted to run large current account surpluses
over the last decade. These surpluses haven been accumulated in order to “self insure”
against the risks of disruptions in capital ‡ows to these economies. Although the emerging
markets have not been the only source of current account surpluses, we focus on this group
of countries since these surpluses may be intepreted as “globally ine¢ cient.” In contrast,
the large surpluses run by oil exporters in recent years conform to neoclassical predictions of
optimising behaviour in response to a terms of trade windfall. Similarly, the chronic current
account surpluses of Japan and Germany can be largely attributed to demographic patterns
and the declining share of these economies in global GDP.1 While “e¢ cient”current account
surpluses may still pose problems for the global system, the “ine¢ cient” surpluses run by
emerging market economies are arguably a more natural target for institutional reform.2
Although the epicenter of the global …nancial crisis has clearly been in the …nancial
systems of the advanced economies, the emerging markets have been substantially a¤ected
by the crisis. The latest indicators suggest a major slowdown in output and trade volumes
and a reversal in capital in‡ows to these economies. The decline in fundamentals is also
re‡ected in major shifts in asset prices, with a substantial depreciation of the currencies of
most emerging market economies (China excepted), a decline in stock market values and an
increase in foreign-currency bond spreads. These negative developments illustrate that the
“self insurance”model has not enabled emerging market economies to remain immune from
negative global developments and reinforce the urgency of developing a new institutional
framework to support a more stable pattern of capital ‡ows to emerging market economies.
1
See Lane (2008x) on the Japanese external position.
2
Here, I use “ine¢ cient” in the sense of departing from the current account balance that would be run
under an international …nancial system that has a superior institutional architecture.

4
2 Shifts in the External Balance Sheets of Emerging

Market Economies

The external risk pro…le of emerging market economies has undergone a radical shift since
the mid 1990s.3 Figure 3 shows the degree of international …nancial integration of the
major emerging market economies has trended upwards over time, where the IF I index is
the sum of foreign assets and foreign liabilities expressed as a ratio to GDP.4 As is analysed
by Lane and Milesi-Ferretti (2008a), the level of international …nancial integration remains
far below that exhibited by the major advanced economies. However, it is much higher
in terms of gross positions than was the case during previous crisis episodes in the 1980s
and 1990s. The scale of gross positions grew rapidly over the last …ve years, which was
mainly generated by an acceleration in gross capital ‡ows. In addition, rising global asset
values increased the scale of balance sheets relative to GDP. Accordingly, in terms of gross
cross-border positions, the emerging market economies were much more integrated into the
global …nancial system at the onset of the current global crisis.
As was noted in the previous section, the composition of the international investment
position of emerging market economies underwent a major shift. A major trend has been
the growing importance of FDI and portfolio equity as a source of …nance (Figure 4).
This has been a positive development in terms of risk pro…le, since the foreign investor
absorbs the risk of state-contingent returns on these positions. We can gain further insight
by inspecting the scale of the portfolio holdings by advanced-economy investors that are
located in the major emerging market economies. Figure 5 expresses these holdings in terms
of their weight in the total international portfolios of the major investor nations. We observe
3
The following material draws on Lane (2009).
4
In what follows, the group of major emerging market economies typically comprises the following
members of the G20: Argentina, Brazil, Mexico, India, Indonesia, China, Korea, South Africa, Saudi
Arabia and Turkey.

5
the increasing importance of emerging market destinations in portfolio equity assets, while
these countries are much less important in international portfolio debt holdings.
Figure 6 shows that the risk pro…le has been further improved by the rapid growth in
foreign-exchange reserves, which have increased from 5 percent of aggregate GDP in the
1980s to over 25 percent by 2007.5
Taken together, these trends have led to a striking shift in the international con…guration
of portfolios.6 Figure 7 shows that the major emerging market economies have shifted from
a position in 1995 in which these countries were both net debtors and net recipients of
equity investments to a pro…le in which a much larger negative net equity position is nearly
matched by a very large long position in foreign debt holdings. The mirror-image trend is
evident for the major advanced economies, which increased their long position in foreign
equity while also taking on a larger short position in foreign debt.
The transformation of the external …nancial pro…le of emerging market economies also
included a major reduction in net foreign liabilities (Figure 8). This was achieved by a
sustained period of running current account surpluses (Figure 9). While the long-term
allocative e¢ ciency of capital running “uphill” may be open to question, it should have
reduced the vulnerability of emerging market economies to capital ‡ow reversals, since the
net external position has been a historical predictor of the incidence of crises.
The impact of these shifts in external capital structure has been to transform the ag-
gregate foreign-currency position of emerging market economies. Lane and Shambaugh
(2008) have developed an index of the foreign-currency exposure that is embedded in a
given level of foreign assets and foreign liabilities. This F XAGG index has the range
( 1; 1) where a country that has only foreign-currency liabilities and zero foreign-currency
5
There is a rapidly-growing literature that seeks to explain the determinants of reserve accumulation.
The recent study by Obstfeld et al (2008) highlights …nancial development as a driver of external reserves,
in order to o¤er investors protection against the risk of a “double drain.” See also the recent analysis in
ECB (2009).
6
See also the analysis in Lane and Milesi-Ferretti (2007a).

6
assets would score the value 1, while a country with zero foreign-currency foreign liabili-
ties and all of its foreign assets denominated in foreign currencies would score the value 1.
Table 1 shows the F XAGG index has become much less negative for most major emerging
market economies and indeed is substantially positive for a number of countries. For this
latter group, the depreciation of the domestic currency would actually generate a positive
balance-sheet e¤ect, since the capital gain on its foreign-currency assets would exceed the
capital loss on its foreign-currency liabilities.
At one level, this general recon…guration may be viewed as involving a major risk trans-
fer from the emerging markets to investors in the advanced economies. In turn, this should
be welfare improving to the extent that investors in the higher-income economies with
more developed …nancial systems should be better equipped to manage risk. However, the
build up in large two-way gross positions also meant that failures in risk management and
illquidity problems in the advanced economies may be transmitted quickly to counterparts
in the emerging market economies.
However, while these steps have reduced the vulnerability to …nancial crises, each in-
volves signi…cant ine¢ ciencies. In particular, this strategy has been costly in terms of
foregone domestic absorption opportunities and in the potential for superior international
risk sharing arrangements. Moreover, it exerts substantial spillover e¤ects on the reserve-
issuing countries, through the impact of persistent trade surpluses and the o¢ cial-sector
demand for liquid securities. Finally, the adverse impact of the current crisis on emerging
market economies demonstrates that vulnerabilities remain, such that the self-insurance
approach has not provided complete insulation.

7
3 The Institutional Framework for Capital Flows be-

tween Advanced and Developing Economies

In relation to the medium-term goal of improving the structural foundations of the inter-
national …nancial system, the over-riding principle is to reduce the risks faced by emerging
market economies in engaging with the international …nancial system (Wolf 2009). In ad-
dition, in managing the residual risk, the goal is to develop mechanisms that reduce the
cost of insuring against such risks.
In general, the appropriate framework for thinking about medium-term reform is to
recognise that the emerging market economies su¤er from an incomplete level of interna-
tional …nancial integration. Unlike very low income countries, these economies are su¢ -
ciently integrated into the global …nancial system to be exposed to severe …nancial shocks.
However, at the same time, these countries are treated di¤erently by the global system in
comparison to the …nancial environment that faces the most advanced economies. Empiri-
cally, Calvo et al (2008) and Kose et al (2008) …nd that there is a threshold e¤ect in terms
of the relation between international …nancial integration and …nancial stability. The goal
for the emerging market economies is to pass this threshold and thereby attain a more ro-
bust form of …nancial integration. Importantly, as is emphasised by Kose et al (2008), the
…nancial integration threshold is a¤ected by key features of the domestic economy, includ-
ing the level of domestic …nancial development, the quality of institutions and governance,
macroeconomic policy discipline and trade integration. Accordingly, reaping the gains from
…nancial globalisation involves the same types of reforms that are also generally bene…cial
for domestic economic performance.
In relation to the domestic reform e¤orts of the emerging market economies, the recent
increase in the cost of external capital should induce an intensi…cation of e¤orts to develop
the domestic …nancial system. Domestic …nancial development is important for two rea-
sons. First, the improved domestic mobilisation of domestic savings reduces the importance

8
of external capital as a funding source. Second, a deeper …nancial system increases the span
of investable opportunities that are available to foreign investors. Financial development
should be broadly interpreted to encompass improvements in corporate governance and
the quality of the regulatory system. In particular, the current crisis has highlighted that
volume-based indices of …nancial development (such as the stock of outstanding securities)
are not good measures if the …nancial system is distorted by a poor regulatory environment.
It is also important to take into account that the empirical evidence indicates that
…nancial reform policies only promote …nancial development in environments in which pri-
vate property rights are secure from arbitrary political interference (Tressel and Detragiache
2008). Moreover, while the full impact of domestic …nancial reform only unfolds over the
medium term, the credible announcement of a programme of …nancial reforms should be
helpful even in the short term. While Figure ?? shows that the major emerging market
economies have made major progress in …nancial reform, a considerable gap remains for
several countries relative to a fully-liberalised domestic …nancial system (the maximum
score is 21 in the IMF index).
It should also be understood that domestic risk management extends beyond the …nan-
cial system to include social insurance programmes. In advanced economies, risk manage-
ment is provided by a combination of public and private systems. However, the degree of
social insurance for major personal risks (illness, unemployment) is much less adequate in
a number of emerging market economies, leading to a high degree of precautionary saving
by households. Accordingly, part of the reform agenda is to improve the adequacy of social
insurance, via welfare systems and the public funding of relevant goods and services. In
similar fashion, institutional reform extends beyond the regulation of the …nancial system.
A striking illustration is provided by Naughton (2006), who shows how the ambiguous
ownership status of many enterprises in China generates an extraordinarily high level of
corporate savings, due to lack of clarity over the appropriate distribution of dividend pay-
ments.

9
 In relation to domestic reforms that directly a¤ect the nature of international capital
‡ows, one key element is the development of local-currency debt markets. Burger and
Warnock (2006) investigate the determinants of success in promoting local-currency debt
markets and …nd that key drivers include the attainment of macroeconomic stability (low
in‡ation) and strong creditor protection. Indeed, these authors note that the requirements
for a thriving local-currency bond market are very similar to those for the development
of the domestic-currency banking system. Accordingly, reform e¤orts that are targeted
at improving the operation of debt …nancing in general can serve the dual purpose of
promoting both the bond market and the banking system.7
So far, local-currency debt markets have been dominated by locally-resident investors,
with relatively little participation by foreign investors. While participation by domestic
residents is a major achievement in itself, it is also desirable to enable e¤ective cross-border
capital ‡ows in local currency. To this end, it is important that the development of local-
currency debt markets is complemented by the development of the currency derivatives
market, in order to allow investors to separately trade currency risk and credit risk.
The role of derivatives markets in cross-border risk transfer is not well understood at
the empirical level, with many derivative trades simply redistributing risk across domes-
tic residents. However, the evidence from a recent national survey in Australia is quite
striking. The analysis of this survey by Becker and Fabbro (2006) shows that currency
hedging allowed Australian residents to transform the risk pro…le of the external balance
sheet. In particular, foreign-currency debt of AUS$428 billion at the end of March 2005
was greatly reduced to AUS$90 billion through derivatives contracts with overseas coun-
terparties. These international hedges meant that the aggregate foreign-currency exposure
of Australia turned from negative to positive. Accordingly, the Australian example illus-
7
Schmitz (2009) …nds that domestic …nancial reforms stimulates capital in‡ows for a sample of emerging
European economies. A striking feature of his work is that it is banking-sector reform that is especially
important in attracting in‡ows.

10
trates how foreign-currency debt can be transformed via currency derivatives into domestic-
currency debt from the perspective of domestic residents.8
In addition to the promotion of local-currency debt markets, there is also considerable
scope to improve risk sharing via other types of state-contingent instruments. For instance,
the idea of GDP-indexed bonds has received considerable attention (see Borensztein and
Mauro 2004 for a recent and comprehensive review). In a series of contributions, Caballero
and a set of collaborators have advocated other types of state-contingent instruments (see
Caballero and Cowan 2007 for an overview of this line of work). On the liabilities side, a
commodities exporter might issue debt with a coupon that is indexed to global commodity
prices. More broadly, emerging markets might tie yields to the high-risk spread in the US
corporate debt market. The virtue of these types of instruments is that the contingent
element in the return is a function of external conditions, such that it cannot be manip-
ulated by the issuer. This feature eliminates the moral hazard problem that generically
a¤ects state-contingent contracts. There is also scope for greater use of state-contingent
instruments on the asset side of the international balance sheet, since many of the risk
sharing bene…ts of state-contingent liabilities can be replicated by an appropriate portfolio
of assets. However, the limitation of an asset-based approach is that, all else equal, it
involves the leveraging of the international balance sheet.
A second key element is to further promote international equity …nancing. As indicated
earlier, the share of equity in the foreign liabilities of emerging markets has grown strongly
over the last decade. However, corporate governance and regulatory problems limit the
attractiveness of emerging-market stockmarkets for many investors (see, for example, the
evidence provided by Kho et al 2008). However, the evidence is that …nancial reform
is associated with an increase in the equity share in liabilities, such that investors do
8
This is not to under-estimate the regulatory and market design challenges in establishing a well-
functioning derivatives market. Again, the current crisis teaches us that poorly-functioning derivatives
markets can lead to non-fundamental volatility in the prices of the underlying assets.

11
respond to shifts in the institutional environment (Faria et al 2007). Similar factors also
apply in relation to foreign direct investment. In addition, there are restrictions in some
countries that limit the capacity of foreign investors to acquire controlling stakes in certain
sectors that are deemed to be strategically important. However, in the other direction, it
is possible that the level of subsidies and tax breaks o¤ered to foreign direct investors is
arguably excessive in a number of host countries, such that some shift away from foreign
direct investment could be desirable in some cases.
The importance of domestic institutional development extends beyond the …nancial
sector. In particular, a fundamental goal for emerging market economies is to copperfasten
stability in macroeconomic policies. In relation to …scal procyclicality, institutional reforms
can do much to improve the cyclical behaviour of …scal policy (Lane 2003). While there
remains considerable variation across countries, the capacity of countries such as Chile to
develop …scal processes that help to insulate the budget from the curse of procyclicality
has been impressive.
So far, we have discussed domestic reforms. An extension of this is to further pro-
mote regional …nancial integration. The empirical evidence is that gravity factors such as
distance and cultural linkages are in‡uential in international asset trade (Portes and Rey
2005, Lane and Milesi-Ferretti 2008b). In addition, there is a strongly positive correlation
between trade in goods and services and trade in assets. Accordingly, there is much scope
for regional levels of …nancial integration. In particular, regional capital ‡ows may be more
stable in character, in view of the underlying linkages between neighbouring economies and
the lower level of bilateral exchange rate volatility. Accordingly, it is desirable that regional
groups intensify e¤orts to cooperate in the design of common institutional standards for
…nancial market development and work to lift barriers to cross-border asset trade.
Turning to the international dimension of reform, there is considerable scope for the
international community to support a more stable system of international …nance for emerg-
ing market economies. The international …nancial institutions have a clear role to play in

12
terms of the provision of technical advice in the development of domestic …nancial systems.
For instance, in relation to local-currency debt markets, the World Bank’s GEMLOC pro-
gram seeks to build a common knowledge base concerning the operation of these markets.9
The IFIs could possibly do more in terms of issuing securities in the currencies of the
emerging market economies. Such issues have the potential to help to expand the depth
and liquidity of the domestic-currency bond markets, as well as allowing the international
…nancial institutions to make local-currency loans to clients in those markets. Such issuance
could be in speci…c currencies, such as the RMB-denominated bond issues by the Asian
Development Bank and the International Finance Corporation (the so-called Panda Bonds).
In addition, securities could be issued that are indexed to a basket of emerging market
currencies (see also the discussion in Wolf 2009). More generally, in view of the free riding
problem and other externalities that inhibit the creation of new securities markets, the IFIs
potentially have a central role in helping to develop the types of state-contingent securities
that may improve the risk pro…le of the external liabilities of emerging markets.
The current crisis has vividly illustrated how public sources of funding must be available
in the event of the breakdown of …nancial trade among private-sector counterparties. In
this respect, two major innovations stand out in terms of the expansion of public funding
for cross-border transactions. First, there has been the establishment of currency swap
arrangements among the world’s major central banks and also vis-a-vis selected emerging
market economies.10 As is discussed by Obstfeld et al (2009), the currency swaps with
emerging market economies have typically been with countries that have already very
high levels of reserves. Accordingly, the main function of the swaps has been to signal
the commitment of the participating central banks to ensure adequate foreign-currency
9
GEMLOC stands for Global Emerging Market Local Currency Bond Fund Program.
10
See McGuire (2009) for an illuminating analysis of the global dollar shortage that was created by
international banks seeking to obtain dollar funding for the very large dollar asset positions that expanded
rapidly in recent years.

13
liquidity for the countries in question.
Second, the IMF created the new Short-Term Liquidity Facility (SLF) that is available
to those member countries that have previously demonstrated strong fundamentals in terms
of sound policies, access to capital markets and sustainable debt burdens. Since it relies
on the track record of the applicant, the funds can be disbursed quickly and without
conditionality, such that the SLF has the potential to be helpful in tackling short-term
liquidity di¢ culties. Accordingly, the SLF represents a potentially useful expansion in the
range of instruments available to the IMF in dealing with liquidity problems. However, as
with any public liquidity facility, the SLF faces the stigma problem, by which a country
may be reluctant to tap these funds in fear of the negative signal that such a move would
send to the markets.
More generally, the disruption in private capital ‡ows reinforces the need for an ex-
pansion of the funding base for the IMF. In tandem with a redistribution of quotas, it is
appropriate that the largest emerging market economies join the advanced economies in
becoming substantial underwriters of the IMF’s balance sheet. A better-…nanced IMF that
stood ready to provide liquidity support would enable these economies to shed some of
their excess foreign-currency reserves and would be collectively more e¢ cient. Accordingly,
the principle of major IMF renewal should be a key governance target.
That said, it is unlikely that major IMF reform can be achieved in the short term. The
recent agreement to reallocate quotas in a limited fashion took a considerable period to
be negotiated and has not yet been rati…ed by all member countries. A major shift in the
distribution of voting power at the IMF requires leadership by those regions that are cur-
rently over-represented, with the obvious potential for the consolidation of representation
by member countries of the European Union.
The expansion of IMF resources need not wait for the completion of governance reform.
Already, Japan has o¤ered $100 billion in …nancing for the IMF, while other major surplus
economies may also be prepared to o¤er extra funding. Such funding sources should

14
be explored in tandem with accelerated e¤orts to engineer a more radical shift in quota
allocations.
The current crisis has also revealed a major analytical failure in under-estimating the
risks embedded in the rapid increase in …nancial balance sheets over 2002-2007. It is
important that the appropriate lessons from this episode be drawn and the IMF is best
positioned to conduct the research that analyses the sources of the crisis from a global
perspective. In turn, the IMF has a role to play in developing new analytical frameworks
to better understand international …nancial linkages and in establishing a common level
of understanding across the member countries. As is emphasised by Eichengreen (2008),
this is a prerequisite for enabling any substantive level of policy coordination. Indeed, the
2006-2007 multilateral consultation process on global imbalances can be understood in this
way, as a mechanism to improve mutual understanding of the policy goals of the di¤erent
participants and identify areas of potential analytical disagreement. While such initiatives
do not immediately translate into coordinated policy decisions, the central role of national
governments in policy delivery means that a new framework for global …nancial governance
must build linkages between national governments and the IMF, in addition to the functions
that can be addressed through supra-national institutions and purely inter-governmental
cooperative initiatives.
Improved analysis of global imbalances would be greatly facilitated by renewed e¤orts
to improve the collection of publicly-available high-quality data on international capital
‡ows and international investment positions. While data availability has improved with
initiatives such as the Coordinated Portfolio Investment Survey (CPIS), major data holes
remain. Indeed, measurement problems are growing in absolute scale, due to the rapid
growth in the volume of cross-border transactions and the pace of …nancial innovation. Lane
and Milesi-Ferretti (2009) have shown the extent of measurement problems in analysing
the US external position, while it is evident that there are substantial data problems in
understanding the international balance sheets of major emerging market economies. A

15
major target must be to improve the quality of data concerning capital ‡ows that are
intermediated through o¤shore …nancial centres, in view of the very limited data availability
for these entitites.
In addition to the roles played by the international …nancial institutions, there is also
room for a greater level of inter-governmental cooperation in regulating the global …nancial
system. Angeloni (2008) provides an interesting study of the relative merits of di¤erent
vehicles for international policy coordination. To a degree, the global debate mirrors the
shifting preferences within the European Union concerning the conditions under which it
is appropriate to delegate powers to a supranational organisation such as the European
Commission or the European Central Bank versus decisions that are better reserved for
inter-governmental negotiation.Most recently, the focus has been on coordinating reforms
of national regulatory systems through the activities of the Financial Stability Forum. In
relation to international capital ‡ows, one element in these reforms could be to achieve
a coordinated response to the treatment of foreign-currency claims by domestic …nancial
institutions. In particular, it is worth investigating whether there are regulatory barriers
that unncessarily deter …nancial institutions in the advanced economies from holding claims
that are denominated in the currencies of the emerging market economies (see also Portes
2009).
In addition to reform of the global …nancial institutions, there is also room for a greater
level of regional initiatives. The limits to the potential resources of the IMF and the
heterogeneity of IMF membership means that there is scope for additional resource pooling
at the regional level.11 Most obviously, the bilateral swap arrangements among ASEAN+3
countries under the Chiang Mai Initiative demonstrate the viability of securing liquidity
insurance that is additional to IMF resources.12 Moreover, the current crisis has also shown
11
See Irwin et al (2008) for a model of how diversity across countries limits the capacity of the IMF to
function as a credit union.
12
See Kohlscheen and Taylor (2008) for an analysis of the Chiang Mai bilateral swap arrangements. In
line with a risk pooling model, these authors …nd that bilateral swaps among participants are larger, the

16
a regional capability to quickly respond to the shift in international …nancial conditions.
For example, major increases in the scale of the agreed bilateral swaps between China
and Korea and between Japan and Korea were announced in December 2008. There is
also room for the regional development banks to provide additional …nancing in those cases
where private-sector credit markets have broken down.
Regional groupings may also be better placed in terms of continuous surveillance of
member country policies and in designing multi-dimensional forms of policy coordination,
by which regional integration in trade and factor mobility reinforces the incentives to co-
operate in terms of …nancial support.13 The European experience also suggests that there
may be scope for regional cooperation in the development of processes that help in ensuring
the sustainability of the public …nances (Lane 2008). While the scope for political inte-
gration clearly varies across regions and limits the transferability of institutional models
across regions, the general principle is to obtain those bene…ts from regional integration
that are feasible in each particular setting.
Finally, it is important to appreciate that a broad reform programme at the domestic
and international levels could lead to a major re-con…guration of the distribution of global
imbalances. In particular, the growing share of global GDP that is generated by emerging
market economies in combination with successful domestic …nancial development and ap-
propriate international …nancial reforms may lead to this group of countries seeking to be
a major net absorber of global capital ‡ows.14 If this scenario plays out, other potential
weaker the correlation in reserves between the pair of countries. However, these authors also highlight the
limitations of a regional approach to risk pooling: the correlation in reserves growth is much higher within
regions than across regions.
13
The Chiang Mai agreement among the ASEAN+3 (China, Japan, Korea) provides for short-term
currency swap facilities. This agreement demonstrates the ability of governments to agree on forms of
policy coordination even when the level of political integration is quite low. See Lane (2008) on the lessons
to be drawn from the European approach to economic integration.
14
Dollar and Kraay (2006) calibrate a model that projects current account de…cits for China on the order
of 5 percent of its GDP for a sustained 10-15 year period. While not approaching the size of the current US

17
borrowers will receive smaller net capital in‡ows and/or the level of global interest rates
will climb. For advanced economies seeking to save due to population ageing, this should
be a welcome development.

4 Conclusions

The self-insurance strategy adopted by many emerging market economies over the last
decade have been only partially successful in reducing exposure to international …nancial
shocks. However, the limited role of domestic-currency debt in the funding of external liabil-
ities means that the nature of international …nancial integration for the emerging market
economies remains quite di¤erent relative to the experience of the advanced economies.
Moreover, the self-insurance approach is collectively ine¢ cient in terms of the allocation
of resources within the emerging market economies and between the emerging markets
and the advanced economies. Moreover, the expansion in the gross scale of international
balance sheets means that the linkages between the emerging market economies and the
advanced economies have grown tighter, in terms of the exposure to breakdowns in the
normal operation of …nancial markets.
Accordingly, there is a busy reform agenda at the domestic, regional and global levels
in order to develop a …nancial system that improves the stability of external …nancing
for emerging market economies. The reforms that will bene…t the emerging markets are
also the reforms that should improve global economic performance and global …nancial
stability. Accordingly, improving the institutional framework that underpins international
capital ‡ows should be a priority for global reform e¤orts.
de…cit relative to world GDP, it would still be a substantial call on global savings. See also the discussion
in Lane and Schmukler (2007).

18
References

[1] Angeloni, Ignazio (2008), “Testing Times for Global Financial Governance,” Bruegel
Essay and Lecture Series.

[2] Borensztein, Eduardo and Paolo Mauro (2004), “The Case for GDP-Indexed Bonds,”
Economic Policy, 38, 165–216.

[3] Burger, John and Frank Warnock (2006), “Local Currency Bond Markets,”IMF Sta¤
Papers 53, 115-132.

[4] Caballero, Ricardo and Arvind Krishnamurthy (2009), “Global Imbalances and Fi-
nancial Fragility,”mimeo, MIT and Northwestern University.

[5] Caballero, Ricardo and Kevin Cowan (2007), “Financial Integration Without the
Volatility,”mimeo, MIT and Inter-American Development Bank.

[6] Caballero, Ricardo, Emmanuel Farhi and Pierre-Olivier Gourinchas (2008), “An Equi-
librium Model of ‘Global Imbalances’and Low Interest Rates,” American Economic
Review 98(1), 358-393.

[7] Calvo, Guillermo A., Leonardo Leiderman and Carmen Reinhart (1996), “Capital
Flows to Developing Countries in the 1990s: Causes and E¤ects,”Journal of Economic
Perspectives 10, 123-139.

[8] Calvo, Guillermo A., Alejandro Izquierdo and Luis-Fernando Mejía (2008), “Systemic
Sudden Stops: The Relevance Of Balance-Sheet E¤ects And Financial Integration,”
NBER Working Paper No. 14026.

[9] Dollar, David and Aart Kraay (2006), “Neither a Borrower Nor a Lender: Does China’s
Zero Net Foreign Asset Position Make Economic Sense?,” Journal of Monetary Eco-
nomics 53(5), 943-971.

19
[10] Eichengreen, Barry (2008), “Should There Be a Coordinated Response to the Problem
of Global Imbalances? Can There Be One?,” United Nations DESA Working Paper
No. 69.

[11] Eichengreen, Barry and Ricardo Hausmann (2005), Other People’s Money: Debt De-
nomination and Financial Instability in Emerging Market Economies, University of
Chicago Press.

[12] European Central Bank (2009), “Foreign Asset Accumulation by Authorities in Emerg-
ing Markets,” Monthly Bulletin (January), 73-85.

[13] Faria, Andre, Philip R. Lane, Paulo Mauro and Gian Maria Milesi-Ferretti (2007),
“The Shifting Composition of External Liabilities,” Journal of European Economic
Association 5 (2-3), 480-490.

[14] Felices, Guillermo and Bjorn-Erik Orskaug (2008), “Estimating the Determinants of
Capital Flows to Emerging Market Economies: A Maximum Likelihood Disequilibrium
Approach,”Bank of England Working Paper No. 354.

[15] Irwin, Gregor, Adrian Penalver, Chris Salmon and Ashley Taylor (2008), “Dealing with
Country Diversity: Challenges for the IMF Credit Union Model,” Bank of England
Working Paper No. 349.

[16] Kaminsky, Graciela, Carmen Reinhart and Carlos Végh (2003), “The Unholy Trinity
of Financial Contagion,”Journal of Economic Perspectives 17(4), 51-74.

[17] Kho, Bong-Chan, Rene Stulz and Frank Warnock (2008), “Financial Globalization,
Governance, and the Evolution of the Home Bias,” Journal of Accounting Research,
forthcoming.

20
[18] Kohlscheen, Emanuel and Mark P. Taylor (2008), “International Liquidity Swaps:
Is the Chiang Mai Initiative Pooling Reserves E¢ ciently?” International Journal of
Finance & Economics 13(4), 323 - 332.

[19] Kose, M. Ayhan, Eswar Prasad, Kenneth Rogo¤ and Shang-Jin Wei (2008), “Financial
Globalization: A Reappraisal,”IMF Sta¤ Papers, forthcoming.

[20] Krugman, Paul (2008), “The International Finance Multiplier,” mimeo, Princeton
University.

[21] Lane, Philip R. (2008), “The Macroeconomics of Financial Integration: A European

Perspective,”IIIS Discussion Paper No. 265.

[22] Lane, Philip R. (2009), “The Global Crisis and Capital Flows to Emerging Market
Economies,”mimeo, Trinity College Dublin.

[23] Lane, Philip R. and Gian Maria Milesi-Ferretti (2007a), “The External Wealth of
Nations Mark II,”Journal of International Economics 73, 223-250

[24] Lane, Philip R. and Gian Maria Milesi-Ferretti (2007b), “Europe and Global Imbal-
ances,”Economic Policy 22(51), 519-573.

[25] Lane, Philip R. and Gian Maria Milesi-Ferretti (2008a), “The Drivers of Financial
Globalization,”American Economic Review (Papers and Proceedings) 98(2), 327-332.

[26] Lane, Philip R. and Gian Maria Milesi-Ferretti (2008b), “International Investment
Patterns,”Review of Economics and Statistics 90(3), 538-549.

[27] Lane, Philip R. and Gian Maria Milesi-Ferretti (2009), “Where Did All the Borrowing
Go? A Forensic Analysis of the U.S. External Position,” Journal of Japanese and
International Economies, forthcoming.

21
[28] Lane, Philip R. and Sergio Schmukler (2007), “The Evolving Role of China and India
in the International Financial System,”Open Economies Review 18(4), 499-520.

[29] Lane, Philip R. and Jay Shambaugh (2008), “Financial Exchange Rates and Interna-
tional Currency Exposures,”American Economic Review, forthcoming.

[30] McGuire, Patrick and Nikola Tarashev (2008), “Bank Health and Lending to Emerging
Markets,”BIS Quarterly Review (December), 67-80.

[31] McGuire, Patrick (2009), “The US Dollar Shortage in International Banking,” BIS
Quarterly Review, forthcoming.

[32] Milesi-Ferretti, Gian Maria (2008), “Fundamentals at Odds? The US Current Account
De…cit and the Dollar,”Economic Notes 37(3), 259-281.

[33] Milesi-Ferretti, Gian Maria (2009), “A $2 Trillion Dollars Question,”VoxEU.

[34] Naughton, Barry (2006), “Top-Down Control: SASAC and the Persistence of State
Ownership in China,”mimeo, University of California at San Diego.

[35] Obstfeld, Maurice, Jay Shambaugh and Alan Taylor (2008), “Financial Stability, the
Trilemma, and International Reserves,”NBER Working Paper No. 14217.

[36] Obstfeld, Maurice, Jay Shambaugh and Alan Taylor (2009), “Financial Instability,
Reserves, and Central Bank Swap Lines in the Panic of 2008,” American Economic
Review (Papers and Proceedings), forthcoming.

[37] Portes, Richard (2009), “Global Imbalances,”mimeo, London Business School.

[38] Portes, Richard and Helene Rey (2005), “The Determinants of Cross-Border Equity
Flows,”Journal of International Economics 65, 269-296.

[39] Prasad, Eswar (2009), “India’s Approach to Capital Account Liberalizaton,”IZA Dis-
cussion Paper No. 3927.

22
[40] Reinhart, Carmen and Kenneth Rogo¤ (2004), “Serial Default And The “Paradox”Of
Rich To Poor Capital Flows,” American Economic Review (Papers and Proceedings)
94(2), 52-58.

[41] Reinhart, Carmen and Vincent Reinhart (2008), “Capital Flow Bonanzas: An Encom-
passing View of the Past and Present,”NBER Working Paper No. 14321.

[42] Schmitz, Martin (2009), “Financial Reforms and Capital Flows to Emerging Europe,”
IIIS Discussion Paper No. 278.

[43] Spilimbergo, Antonio, Steven Symansky, Olivier Blanchard and Carlo Cottarelli
(2008), “Fiscal Policy for the Crisis,”IMF Sta¤ Position Note No. 08/01.

[44] Tressel, Thierry and Enrica Detragiache (2008), “Do Financial Sector Reforms Lead
to Financial Development? Evidence from a New Dataset,” IMF Working Paper No
08/265.

[45] Wolf, Martin (2009), “Fixing Global Finance,”Yale University Press.

23
 Current Account Imbalances
WEO October 2008

1.5

0.5

0
1997 1999 2001 2003 2005 2007 2009 2011 2013

-0.5

-1

-1.5
United States
Euro Area
-2
Japan
Emerging Asia
Oil Exporters

Figure 1: Current Account Imbalances. Source: World Economic Outlook (October 2008).

24
 Net Foreign Asset Positions
WEO October 2008

1997
-1 1999 2001 2003 2005 2007 2009 2011 2013

-3

-5

-7
United States
-9 Euro Area
Japan
Emerging Asia
Oil Exporters

Figure 2: Net Foreign Asset Positions. Source: World Economic Outlook (October 2008).

25
 International Financial Integration (% of GDP)
140

120

100

80

60

40

20

0
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Figure 3: International Financial Integration Ratio. Note: Sum of foreign assets and
liabilities, expressed as a ratio to GDP. Group of major emerging market economies. Source:
Author’s calculations based on updated version of dataset compiled by Lane and Milesi-
Ferretti (2007a).

26
 Share of Equity Liabilities (% of total liabilities)

70

60

50

40

30

20

10

0
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Figure 4: Equity Share in Foreign Liabilities. Note: Group of major emerging market
economies. Source: Author’s calculations based on updated version of dataset compiled by
Lane and Milesi-Ferretti (2007a).

27
 EMs: Portfolio Shares
CPIS
10
Equity
9 Debt

1
2001 2002 2003 2004 2005 2006 2007
year

Figure 5: Portfolio Allocations to Major Emerging Markets. Note: Portfolio holdings of

major investor nations (US, UK, Euro Area, Japan) in major emerging markets (Argentina,
Brazil, Mexico, Turkey, South Africa, Russia, Saudi Arabia, India, Indonesia, China, Ko-
rea). Source: Author’s calculations based on IMF’s Coordinated Portfolio Investment
Survey.

28
 Foreign Exchange Reserves (% of GDP)

30

25

20

15

10

0
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Figure 6: Foreign Exchange Reserves. Note: Group of major emerging market economies.
Source: Author’s calculations based on updated version of dataset compiled by Lane and
Milesi-Ferretti (2007a).

29
 20

15

Advanced G17 10
(2007)
Advanced G17
(1995) 5
Net Debt
0
-20 -15 -10 -5 0 5 10 15 20 25
-5
Emerging G17
(1995)
-10

-15

-20

-25
Emerging G17
-30 (2007)

Net Equity
-35

Figure 7: Composition of External Balance Sheets. Note: Advanced G17 comprises US,
UK, Euro Area, Japan and Canada. Emerging G17 is group of major emerging market
economies. Source: Author’s calculations based on updated version of dataset compiled by
Lane and Milesi-Ferretti (2007a).

30
 Net Foreign Assets (% of GDP)

0
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
-5

-10

-15

-20

-25

Figure 8: Net Foreign Asset Position. Note: Group of major emerging market economies.
Source: Author’s calculations based on updated version of dataset compiled by Lane and
Milesi-Ferretti (2007a).

31
 Current Account (% of GDP)
5

0
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
-1

-2

-3

Figure 9: Current Account Balances. Note: Group of major emerging market economies.
Source: Author’s calculations based on data from International Monetary Fund.

32
 Table 1: International Currency Exposures

FXAGG

Arg. Brazil China India Indo. Korea Mexico Russia S.Arabia S.Africa Tur.

1995 -0.01 -0.13 0.15 -0.48 -0.56 0.00 -0.32 -0.02 0.59 0.02 -0.42
1996 0.01 -0.13 0.19 -0.42 -0.48 -0.05 -0.25 0.06 0.64 0.05 -0.38
1997 0.02 -0.17 0.26 -0.36 -0.55 -0.11 -0.20 0.13 0.58 0.10 -0.34
1998 -0.01 -0.24 0.31 -0.33 -0.52 -0.01 -0.22 0.01 0.48 0.20 -0.36
1999 0.02 -0.21 0.33 -0.27 -0.46 0.04 -0.20 0.06 0.48 0.27 -0.32
2000 0.02 -0.19 0.38 -0.21 -0.47 0.15 -0.15 0.17 0.54 0.31 -0.38
2001 -0.06 -0.17 0.37 -0.16 -0.46 0.15 -0.08 0.19 0.58 0.31 -0.34
2002 -0.08 -0.18 0.41 -0.07 -0.40 0.16 -0.09 0.24 0.63 0.29 -0.32
2003 -0.05 -0.12 0.43 0.03 -0.35 0.19 -0.09 0.22 0.66 0.33 -0.30
2004 -0.03 -0.05 0.43 0.07 -0.33 0.24 -0.06 0.23 0.72 0.34 -0.24

NETFX

Arg. Brazil China India Indo. Korea Mexico Russia S.Arabia S.Africa Tur.

1995 -0.01 -0.07 0.08 -0.22 -0.42 0.00 -0.19 -0.01 0.68 0.01 -0.32
1996 0.01 -0.06 0.10 -0.16 -0.38 -0.02 -0.27 0.05 0.66 0.03 -0.27
1997 0.02 -0.08 0.14 -0.15 -0.43 -0.06 -0.19 0.10 0.58 0.07 -0.25
1998 -0.01 -0.13 0.19 -0.13 -0.42 0.00 -0.19 0.01 0.50 0.16 -0.27
1999 0.02 -0.13 0.22 -0.11 -0.94 0.04 -0.17 0.08 0.58 0.26 -0.26
2000 0.02 -0.17 0.27 -0.09 -0.71 0.15 -0.14 0.36 0.59 0.48 -0.40
2001 -0.07 -0.14 0.26 -0.07 -0.57 0.13 -0.06 0.32 0.58 0.45 -0.36
2002 -0.10 -0.16 0.30 -0.03 -0.48 0.15 -0.07 0.37 0.67 0.37 -0.43
2003 -0.16 -0.11 0.32 0.01 -0.36 0.18 -0.06 0.34 0.69 0.47 -0.34
2004 -0.07 -0.06 0.34 0.04 -0.31 0.25 -0.05 0.35 0.76 0.43 -0.26

Note: F XAGG is scaled between (-1,1) and denotes the aggregate foreign currency exposure for

a given level of foreign assets and liabilities; N ET F X(= F XAGG IF I) is ratio of net foreign-

currency assets to GDP. Source: Author’s calculations based on dataset compiled by Lane and

Shambaugh (2008).

33