Daniel Christen and Nicola Shadbolt
Geoeconomic fragmentation is one of the greatest risks to the international monetary and financial system at present, particularly since Russia’s war of aggression against Ukraine. Fragmentation is likely to have wide-ranging implications for the global economy, including increasing the volatility of capital flows and exposing gaps in the global financial safety net (GFSN). In this post, we argue that increased take up of the IMF’s ‘precautionary facilities’ would reinforce the GFSN and help prepare it for these challenges. The IMF’s upcoming review of precautionary facilities is an opportune moment to find ways to reduce stigma and increase uptake.
What is the GFSN and is it big enough?
The GFSN consists of a set of financial instruments and institutions that act as insurance for countries facing sudden stops in capital flows. It includes countries’ foreign reserves, Regional Financing Arrangements (RFAs), central bank swap lines, and IMF lending.
It proved resilient to the Covid shock, albeit with the help of a large injection of liquidity from the Federal Reserve, and a fresh allocation of IMF Special Drawing Rights, which boosted global liquidity further.
However, there are three key emerging risks that may result in it proving too small relative to demand in future. First, it may be more challenging for major central banks to extend liquidity on a large scale to mitigate an unwarranted tightening in global financial conditions while domestic monetary policy is in a tightening cycle. Second, continued growth in external liabilities, especially those intermediated by the non-bank sector, could increase the likelihood and size of sudden stop episodes.
Third, geoeconomic fragmentation, caused by tensions over security, trade and investment, could increase economic volatility, thereby increasing demands on the GFSN. It could also weaken the safety net itself, if, for example, geopolitical splits jeopardise existing RFAs and swap lines.
Fragmentation could play out in different ways. Since the global financial crisis, cross-border investment and trade have been shrinking as a share of world GDP, a phenomenon referred to as ‘slowbalisation’, partly reflecting geopolitical tensions. Meanwhile, Covid led to calls to reduce economic dependence on geopolitical rivals. Most recently, increased emphasis on national security and political values in economic relations – particularly following the start of Russia’s war of aggression against Ukraine – risks fragmenting the global economy into blocs.
To see how this might impact the global economy, we explore an illustrative scenario in which the global economy splits into blocs based on the votes cast on the UN General Assembly Resolution condemning Russia’s invasion of Ukraine. The emergence of these blocs could entail restrictions on trade and financial flows across blocs. We identify around US$12 trillion of ‘cross-bloc’ financial liabilities – roughly 13% of global external liabilities (excluding intra euro-area liabilities) – which might be at risk of disruptive unwinds (Chart A).
Chart A: ‘Cross-bloc‘ financial liabilities
Sources: BIS International Banking Statistics, IMF Coordinated Portfolio Investment Survey and IMF Coordinated Direct Investment Survey.
Notes: Bloc 1 assets are those held by countries who condemned Russia’s invasion, and are located in Bloc 2, which includes all countries who abstained or voted against the UN resolution on Ukraine. The opposite is true for Bloc 2 assets.
Taken together, these emerging risks point to the need for countries to seek greater insurance.
How can we strengthen the GFSN efficiently?
The most efficient way for countries to insure themselves is through pooling resources globally. The IMF, with its near-universal membership and mandate to promote and protect global macroeconomic stability, is the obvious vehicle for this. Accumulating large reserve positions individually is costly for the holder and, collectively, for the global economy. It has been identified as one factor that has contributed to global current account imbalances, which can have significant negative spillover effects, as well as encouraging risky ‘search for yield’ behaviour, by compressing global yields.
IMF resources are limited, however, and so it is important they are used efficiently. An increase in their use on a precautionary basis is one way to do this.
Having access to a precautionary line means countries that face external risks, but have sound policy frameworks, are ‘pre-approved’ to draw on IMF resources, should a qualifying balance of payments need crystallise and provided they continue to maintain sound policies.
The country’s commitment to good policies, the Fund’s endorsement, and the access to IMF resources that accompany this, send a reassuring message to markets. The overall package incentivises sound policymaking, promoting economic and financial stability.
This, ultimately, helps prevent financial bumps in the road ending in crises – which create even greater financing needs (and might require conventional IMF lending, which comes with higher costs and more severe adjustment requirements), as well as damaging spillovers to the rest of the world.
Precautionary lending, a preventative approach rather than reactive one, is therefore a more efficient use of IMF resources. ‘A stitch in time saves nine’, as the proverb says.
Why haven’t more countries taken precautionary facilities in the past?
Uptake of precautionary facilities has been fairly limited. Since the Flexible Credit Line (FCL) and Precautionary and Liquidity Line (PLL) were created in 2009, only eight countries have used them. The Short-term Liquidity Line, created during the pandemic, has only had one user.
Our analysis shows that the limited use of precautionary facilities isn’t because there hasn’t been a need. Due to data constraints, we focus on the FCL, which is designed to provide additional tail-risk insurance to countries with very strong fundamentals and policy track records when faced with potential balance of payments (BoP) pressures.
Using a capital flows-at-risk framework, we use financial market data to identify episodes where countries face heightened risk of BoP pressures in the year ahead. We find that there have been a significant number of cases where countries have faced heightened risks, but did not take up an FCL programme, despite likely being ‘eligible’ (Chart B).
Chart B: Episodes where FCL ‘eligible’ countries faced heightened risk of future balance of payments pressures
Sources: Bloomberg Finance L.P., Eikon from Refinitiv, IMF International Financial Statistics, IMF World Economic Outlook and Bank calculations.
Notes: Periods of heightened BoP risk are defined as episodes where ‘capital-flows-at-risk’, defined as the 5th percentile of the distribution of non-resident capital flows (portfolio and other), is more negative than the average historical level of ‘capital-flows-at-risk’ when counties first took-up or augmented their FCL programme. The full distribution of capital flows is estimated for a group of 19 emerging markets using financial conditions indices as in Eguren-Martin et al. FCL ‘eligibility’ is determined using the methodology similar to that set out in Birdsall et al.
This might be because countries preferred to build up large reserves positions instead. Indeed, countries identified as having heightened risks of future BoP pressures that did not take up an FCL, had much higher average levels of reserves than those that had an FCL in place (Chart C). Excessive reserve accumulation comes with a cost though, both for the holder and the global economy.
Chart C: FCL ‘eligible’ countries’ foreign exchange reserves following a period where countries faced a heightened risk of future BoP pressures
Sources: Bloomberg Finance L.P., Eikon from Refinitiv, IMF International Financial Statistics, IMF World Economic Outlook and Bank calculations.
Notes: Level of reserves during periods of heightened risk as defined as in chart B. Eligibility also determined as in Chart B. Episodes included in the ‘FCL in place’ panel are where ‘eligible’ countries had an FCL in place or took one up within a year of facing heightened risk. Episodes included in the ‘No FCL in place’ panel are where ‘eligible’ countries did not have or take up an FCL.
Countries have also increased their access to other parts of the GFSN since the FCL was created in 2009. The total size of RFAs has expanded more than ten-fold and the estimated value of bilateral swap lines has almost doubled. Neither of these provide perfect substitutes for reserves or IMF support. RFAs are vulnerable to regional systemic shocks and remain largely untested. Access to swap lines is not universal or guaranteed.
Despite having access to other elements of the GFSN, our analysis suggests having an FCL in place helps protect against the realisation of capital outflows following a period where risks of future BoP pressures are heightened. On average, countries with FCLs tended to experience more positive capital flows following the period of heightened risk (Chart D), and were much less likely to experience significant outflows.
Chart D: Cumulative non-resident capital flows following a period where FCL ‘eligible’ countries faced heightened risk of BoP pressures
Sources: Bloomberg Finance L.P., Eikon from Refinitiv, IMF International Financial Statistics, IMF World Economic Outlook and Bank calculations.
Notes: Realised non-resident capital flows (portfolio plus other) following periods of heightened risk as defined as in Chart B. Eligibility also determined as in Chart B.
Given the realised benefits of FCL programs, and the downsides of other elements of the GFSN, why haven’t more countries come forward? Geographical patterns suggest historical experience with the IMF may be a factor. In our sample, South American countries tended to get an FCL following a period of heightened risk, while in Asia, no country has come forward for a programme (Chart E). This might relate to historical experience: some Asian countries felt they were treated unfairly by the IMF during the 1997–98 Asia crisis.
Chart E: Regional differences in FCL take-up following periods where countries faced heightened risk of future BoP pressures
Sources: Bloomberg Finance L.P., Eikon from Refinitiv, IMF International Financial Statistics, IMF World Economic Outlook and Bank calculations.
Note: Periods are defined as number of quarters where ‘FCL’ eligible countries faced a heightened risk of capital outflows (as defined in Chart A).
What could an increase in the uptake of precautionary facilities achieve now?
We estimate that around a fifth of countries that would likely qualify for an FCL or PLL wouldn’t currently have enough insurance – via reserves, swaps and RFAs – to absorb a moderate sudden stop shock. With a precautionary arrangement in place, nearly all would be able to absorb the shock.
Moreover, in a fragmented world, it is likely that a significantly larger number of qualifying countries would require access to precautionary facilities to withstand external shocks. This is because only a minority could rely on reserves alone, while smooth and timely access to RFAs and swaps, which make up, on average, around 10% of their insurance, might be jeopardised by fragmentation. Moreover, if these 30 countries faced a more ‘severe’ shock, with some larger economies facing large capital outflows, aggregate financing needs could rise by around 50%.
What does this mean for policy?
The IMF should look at ways to increase the uptake of its precautionary facilities, while ensuring they continue to incentivise sound macroeconomic policies. Not least because this commitment to sound policies combined with up-front access to additional resources when faced with elevated external risks, should ultimately reduce the actual use of IMF financing.
To increase uptake, it is important to consider ways to increase demand, including by addressing stigma. But it is also important to address concerns around their supply. This might include ensuring they are effectively resourced, as well as adopting a ‘risk-weighted’ accounting treatment on the IMF’s balance sheet, reflecting the fact that many precautionary facilities are often approved but not drawn on.
The upcoming IMF review of its precautionary facilities is a timely opportunity to do it. Risks from fragmentation mean the need for the IMF to provide robust and efficient insurance at the heart of the GFSN has never been more important.
Daniel Christen and Nicola Shadbolt work in the Bank’s International Directorate.
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