In the aftermath of the Asian financial crises ten years ago the international community recognised the importance of financial stability. Today new troubles infect the global financial system, leaving governments and financial analysts uncertain how to react. The media is full of the credit crunch, write-downs by private banks and dramatic price rises. There is discussion of how these incidents are spilling over across the economy in the U.S.A., Europe and elsewhere, with people losing their homes and jobs and struggling to provide meals for their families. Very little attention is given to the specific impacts in the world’s poorest countries. Yet global financial stability – like climate change – is a key global challenge and one that the current financial and regulatory system is ill-equipped to handle.
The sub-prime crisis that started in the U.S. and spread through contagion has shown that market-based solutions and conventional crisis management are completely insufficient. Central bankers and finance ministers have tried injecting liquidity, lowering interest rates, and even nationalising a bank. Yet regulators and central banks are largely playing catch up. In France a single trader caused a €5 billion loss to Société Générale by evading in-house systems. In Germany the scandal of hidden deposits in Liechtenstein exposed the tip of the tax havens scandal iceberg.
The crisis is not just due to individual misbehaviour. There are deep flaws in the international financial system. Finance has become an end in itself: to make money out of money in the shortest possible time. This speculation leads to instability and widens the gap between rich and poor. Recurrent crises are inevitable. We are very far from achieving what the world’s governments signed up to at the Monterrey Financing for Development conference in 2002. There they pledged to encourage “the orderly development of capital markets aimed at addressing development financing needs and foster productive investments”. They agreed, correctly, that this “requires a sound system of financial intermediation, transparent regulatory frameworks and effective supervisory mechanisms”. Finally they said they would introduce measures “that mitigate the impact of excessive volatility of short-term capital flows” and to strengthen “prudential regulations and supervision of all financial institutions, including highly leveraged institutions”.
The financial system is not only unstable, it is also unjust, resources are flowing from poorer to richer. Experts estimate that every year $500 - $800 billion leave Southern countries due to criminal activities, tax evasion, and corruption. This makes South-North financial flows several times higher than the average $90 billion annual aid flows, the $240 billion foreign direct investment to the South and the couple of hundreds of billions of dollars of remittances transferred from migrants.[i]
The International Monetary Fund is the main international public body responsibile for overseeing the financial system. Since the 1980s it has instead spearheaded the liberalisation and deregulation of financial markets in most developing economies. This has made these economies more vulnerable to external shocks and to capital flight. The IMF’s failed response to the Asian financial crisis has encouraged Asian countries and other emerging economies to accumulate huge reserves in order to prevent future crises. This diverts enormous sums of money from development needs.
Many proposals have been put forward for a fundamental reform of the international financial architecture to guarantee stricter regulation, more transparency and better control of capital. The implementation of such measures would be a win-win game for both the North and the South, generating productive and sustainable development-oriented economic growth. European governments – which committed at the Financing for Development Summit and under the Eighth Millennium Development Goal to develop a rule-based, predictable financial system – must play a leading role in promoting these reforms.
This paper addresses the major structural problems faced by developing countries under the existing global financial architecture. It points out how the financial sector lacks regulation and threatens development by facilitating capital flight and tax evasion, exposing developing countries to volatility in financial markets, and allowing unregulated actors such as hedge funds to exacerbate those risks through speculation.
The paper then underlines the failure of existing financial regulatory attempts by the IMF and other institutions. The last chapter points out that progress towards a just and stable global financial system will require vigilant advocacy at many levels and advances recommendations to build a stable and development-friendly financial system.
Among the recommendations, the report calls for the dramatic reform of the IMF’s structure and mandate and the strengthening of regional financial architecture and a stronger UN mandate to combat capital flight. It proposes regulatory measures to combat capital flight and speculative actors such as hedge funds and private equity funds and stresses the need for greater transparency.
The report finally calls on European governments’ to take up their responsibilities directly and in international financial institutions. The paper points out two particular regulatory measures in which the EU can play a leading role, namely on improving transparency of the accounting standards for Transnational corporations and on ensuring enhanced automatic disclosure of information through an expanded EU savings tax directive.
The Doha summit that will review the financing for development process in December 2008 will be a unique occasion to put these systemic issues at the forefront of the international agenda and should open the necessary political space to start taking concrete steps for a development-friendly reform of international finance and financial institutions.
[i] Annual average from 2003-2006 period, figures from the World Bank, Global Development Finance 2007 and illicit flows estimate from Raymond Baker.