“Systemic Issues” -Background Document1
Prof. Jan Kregel,
Director, Monetary Policy and Financial Structure Program
Levy Economics Institute del Bard College
I. Policy Coherence in Trade and Finance as a Major Systemic Issue
The background discussions that led to the resolution calling for a UN Conference on Financing for
Development took place against the background of the Asian financial crisis. The role of the
international financial architecture in channeling financial resources to developing countries and in
particular changes that might be introduced into the international financial system to avoid the financial
crises of the 1990s was thus in the forefront of those discussions. The result was the chapter of the
Monterrey Consensus “Addressing Systemic Issues: enhancing the coherence and consistency of the
international monetary, financial and trading systems in support of development.” Paragraph 53 of the
Consensus noted that “important international efforts are underway to reform of the international
financial architecture… to enhance financing for development and poverty eradication," while paragraph
52 noted that “In order to complement national development efforts, we recognize the urgent need to
enhance coherence, governance, consistency of the international monetary, financial, and trading
system. To contribute to this end, we underline the importance of continuing to improve global
economic governance and strengthen the UN leadership role in promoting development. … Similarly, we
should encourage policy and programme coordination of international institutions and coherence at the
operational and international levels to meet the Millennium Declaration development goals of sustained
economic growth, poverty eradication, and sustainable development.” To this end paragraph 56
charged that “The multilateral financial institutions, in particular the IMF, need to continue to give high
priority to the identification and prevention of potential crises and to strengthening the underpinnings
of international financial stability. In this regard, we stress the need for the Fund to further strengthen
its surveillance activities of all economies, with particular attention to short-term capital flows and their
impact. We encourage the Fund to facilitate the timely detection of external vulnerability through welldesigned surveillance and early warning systems and to coordinate closely with relevant regional
institutions or organizations, including the UN regional commissions.” In paragraph 59 “Noting the
impact of financial crisis or risk of contagion in developing countries and countries with economies in
1
Prepared for Panel sobre Temas sistémicos, Consulta Regional Preparatoria de la Conferencia
Internacional de Seguimiento Sobre La Financiación Para El Desarrollo Encargada de Examinar la
Aplicación del Consenso de Monterrey, Santo Domingo, Republica Dominicana,12 de junio de 2008
transition, regardless of their size, we underline the need to ensure that the international financial
institutions, including the IMF, have a suitable array of financial facilities and resources to respond in a
timely and appropriate way in accordance with their policies.”
This chapter of the Consensus, dealing with systemic issues, most directly reflects the vaunted “holistic”
approach to the development process taken in Monterrey. Yet, as the existence of large international
trade imbalances, the breakdown of international financial markets and a looming global recession in
the presence of historic price spikes in primary commodity prices that are driving millions into food
insecurity suggests that it is the chapter in which the least progress has been made. Aside from
questions of competence and rivalry within the UN System itself (many of the issues are the prerogative
of independent multilateral governing boards, such as those of the Bretton Woods institutions), the
chapter itself reflects a basic lack of coherence and consistency in the approach to development finance
taken in the Consensus. The chapters prior to the discussion of systemic issues deal with a serial
identification of the various sources of development finance, each considered independently of the
others. For example, trade is discussed without reference to the impact of foreign direct investment;
debt is discussed without reference to the lending that brings it into existence, domestic governance
and corruption are discussed independently of the interests of foreign direct investors in attaining
market access in developing countries. Yet, the inter relations among these factors are precisely the
things that should be considered in an analysis of coherence and consistency in trade and finance.
Further, it brings the discussion dangerously close to the issue of the appropriate policies required to
allow additional financing to support economic development because it requires analysis of the
interactions between policies in trade, governance and finance.
Since Monterrey a number of factors have taken place that have brought these issues to the forefront of
discussion and challenge this decision to limit the discussion to finance for development rather than
financing of development policy. The first was the Millennium Declaration which occurred some two
years after the initial discussions that led to the Conference. The Declaration formulated objective,
measurable, time bound goals that were to be attained by 2015, leaving the Financing for Development
process to produce the $50 billion or so per annum that the was estimated to be required if they were
to be reached by 2015. This, of course, opened the discussion of the most efficient e ways in which the
finance was to be used to reach those goals. Indeed, to avoid formal discussion of the appropriate
policies their formulation was given to the Millennium Project, an initiative that was formally separate
from the UN secretariat. The Report of the Project did propose concrete development policies to
achieve the MDGs.
The second was the transformation of the five-year follow-up of the Millennium Declaration into the
2005 Global Summit, dealing with a review and proposals for reform of virtually all aspects of UN activity
in providing economic and political peace and security. One of the major changes was the recognition
that policies to support domestic employment should be part of the process of domestic resource
mobilization in developing countries, and more importantly the recognition that promoting domestic
employment was a goal on a par and a major positive factor in achieving the other Millennium
Development Goals.
Finally, the Outcome Document noted the need to incorporate the international development goals of
all the UN Conferences and Summits in the formulation of national development strategies that were
nationally owned and formulated. This brought to the forefront the importance of the discussion of the
coherence and consistency of the monetary, trade and financial systems to the forefront of the followup process, and brought that discussion a step closer to the discussion of the appropriate development
strategies to be included in the national development strategies. Thus, one of the most important
aspects of the follow up process must be to give appropriate attention to the questions of the
interaction between the various individual sources of financing for development called for in the chapter
on systemic issues.
II. Traditional Importance of Interdependence of Trade, Governance and Finance in Latin America
It is thus encouraging to see the background document prepared by the CEPAL Secretariat includes the
international financial system, trade, tax cooperation and monitoring mechanisms, as well as the issue
of climate change, among the issues to be discussed in this session on systemic issues for they have
frequently been overlooked in the implementation of the Consensus. It is doubly appropriate that this
discussion of systemic issues should take place in the regional follow-up meeting for Latin America and
the Caribbean since CEPAL was the first member of the UN system to highlight the importance of the
coherence of policy in the areas of trade and finance for the development process in Latin America. An
interest which lives on both in Santiago and was transmitted to Geneva when Raul Prebisch became
Secretary General of UNCTAD.
As an example, consider the fact that most of the primary commodities (aside from gold, silver and
cocoa) that came to dominate Latin American exports were not indigenous to the region, and thus were
not developed as exports as a result of any pre-existing natural comparative advantage. Rather they
were the result of the decisions taken by colonial investors (we now call then foreign direct investors) on
the basis of relative international rates of return. Neither was the decline of the northeast of Brazil the
result of the action of international commodity markets determining the most competitive location for
the production of rubber, but rather the result of the ability of the English to smuggle seeds of the
rubber tree out of Brazil to be planted in the Malay peninsula. Thus the composition of exports from the
region denoted by the term “primary commodity or monocommodity dependence” was not an historical
or geographical accident, nor the result of comparative advantage operating in competitive
international markets, but the result of the flows of international capital and political competition.
Indeed, Bulmer-Thomas has described the evolution of Latin American export trade as being determined
by a “commodity lottery”.
When Latin America moved to independence it was not so much in support of free trade and to
embrace international markets as to escape the Spanish monopoly of trade in the region. But, since
newly democratic governments were loath to substitute alternative taxes to replace those lose through
the reduction or elimination of tariffs and duties, the move to free trade brought about a structural
deficiency of fiscal resources that has continued to plague the region.
At the same time, as CEPAL economists such as Raul Prebisch and Celso Furtado made clear, the impact
of trade in financing development was closely linked to the structure of the international financial
system. While primary commodity exports provided financing for industrialization in parts of Latin
America and the possibility of meeting debt service on the imports of industrial goods from Great Britain
and the rest of Europe in the 19th century, this system could no longer be relied upon in the 20th century
as the region’s primary commodity exporters lost their ready markets in Great Britain and had to
compete with the similar primary commodity exports of the United States in international markets.
Thus, not only was the composition of trade important, but also the international environment – or
what we would now call the global division of labour. This was independent of the subsequent
recognition of the barrier to development that could be created by the diverse behavior of the relative
prices of primary commodities and industrial products.
It is now all but forgot that the importance to the US of the Caribbean shipping lanes in insuring
unencumbered trade routes from its East to West coast after the opening of the Panama Canal led to
the wholesale refinancing of Latin American debt to European lenders with lending from New York
banks, simply to avoid the use by European powers of sovereign debt default as an excuse for gunboat
diplomacy in the region. The US base in Guantanamo was part of this process , which included a
proposal for the annexation by the US of Santo Domingo and the rise of “gunboat diplomacy” .To ensure
prompt payment of debt service to US banks, the US State Department engineered the appointment of
US nationals as the Heads of the Customs services in many countries in the region to ensure that the
tariffs and duties were collected efficiently and that debt service had first claim on them. This of course
brought with it a diversion of trade flows and financial flows within the region. The dominance of
external financial commitments over domestic development needs has a long history in the region.
III. The Interaction of Trade and Financial Policy after “Desarollo Desde Dentro”
These historical references should be sufficient to make the point about the impossibility of separating
trade from financial flows, and both from the shape and structure of the international financial system,
and thus the need to consider the coherence of policy in all these areas. But, what about more recent
experience? The most obvious example is perhaps the consequences of the shift in trade policy from
one of closed domestic development to one based on open international trading systems that took
place in most Latin American countries in the 1990s.
The available evidence suggests that the opening of domestic markets, aside from having a direct impact
on the rate of sustainable growth, has also had an impact on the shape of external finance and its
influence on the development process. For example, UNCTAD’s 1999 Trade and Development Report
shows that in the 1970s the non-oil producing American region was able to grow at an average rate of
over 5 per cent per annum with a trade deficit of around 1 per cent of GDP, while in the 1990s an
average growth rate of only around 3 per cent could be attained with a slightly larger trade deficit.
Comparing trade performance in the 1970s with the 1990s, we find that in the former period exports
grew by nearly four percentage points faster than imports, while in the latter period the relation was the
gap was reversed and nearly a half percentage point larger. The obvious conclusion is that the average
growth rate compatible with equilibrium in the external accounts was reduced by around two
percentage points as a result of the more open trade policies. The less obvious, but perhaps more
important conclusion is that if growth is to be accelerated to the average of the 1970s, it will require
larger capital inflows to finance the larger external constraint, thus leading to an increasing build up of
external debt, completing the linkage between trade policy, financial and monetary systems and debt
accumulation.
Since attracting the required external financing has meant higher domestic interest rates there has been
a tendency towards overvaluation of the exchange rate at the same time as external balances
deteriorate. Thus, instead of the exchange rate being used as a stabilizer of the external position there is
a procyclical relation between the appreciating exchange rate and the deteriorating external balance. In
addition, the extremely tight domestic monetary conditions, which have been associated with the much
improved inflationary conditions in the region, has also had a negative impact on domestic investment.
As can be seen from the chart, the openness of the 1990s has certainly not been supporting domestic
investment.
On the other hand, these conditions have tended to support foreign investment. But, changes in trade
policy have changed its nature. In the early years of its existence CEPAL excelled in its analysis and
measurement of foreign direct investment in Latin America. This investment was primarily targeted at
production for the domestic market, given the high tariff barriers that were present under programmes
of domestically led industrialization. Once these barriers were lifted as many countries joined the
process of tariff reduction and removal of subsidies and local content rules in the creation of the WTO, it
became possible for foreign manufacturers to use developing countries as simple production sites,
exploiting cheap inputs or labour, but reducing to a minimum technology transfer and domestic market
support. Thus, one of the impacts of reduced domestic market protection was the reduction in domestic
research and development carried out by transnational companies. Exemplary is the impact reported by
Cimoli and Katz (2003: 387–411) that the 1974 launch of the new Taurus model by the Ford motor
company in Argentina required 300,000 hours of work by a team of 120 engineering specialists, while in
2000 Ford produced a model that was to be sold in all global markets – the “world car” with no
contribution from engineers in Argentina. Thus, the call for more production and export of high
technology goods cannot be separated from the decisions on the trading system and the financial
system.
The impact of opening has also been seen in the composition of exports and the ability of exports to
serve as a source of increasing domestic incomes. The chart below shows that Latin America increased
its share of manufactured exports by two percentage points between 1980 and 1997 while its share of
world manufacturing value added did not increase but in fact fell by over a percentage point. Closer
inspection shows that nearly all of the increase came in Mexico, where maquilladora production
dominates manufactured exports, and that most of the decline in the share of world value added was
also due to Mexico. The other major Latin American economies were relatively static over the period
despite the increased openness and the increased role of foreign direct investment.
Given this clear impact of trade policy macro performance, it would seem appropriate for the WTO and
the IMF to coordinate their policies, as suggested in the Consensus, rather than having the trade
conditionality imposed on Fund borrowers and the trade recommendations in Fund Surveillance being
taken independently of negotiations undertaken in the WTO.
IV. The Increased Importance of Trade and Financial Policy Coordination in the New Millennium
If there had ever been a doubt about the impact international finance on trade, the current conditions in
financial and commodity markets should remove it. With commodities now considered as an asset class
to be included in asset allocation models of portfolio investment, commodity prices are no longer
determined by the final use demand relative to available supply, but rather by the demand to hold them
and those willing to supply them without actually producing them. The attractiveness of commodities as
an investment is their presumed negative correlation with other asset classes such as equities. In
addition, the rise real return portfolios that seek returns in excess of inflation has brought another
source of demand for commodities based on their positive correlation with inflation rates. Finally, the
collapse of the dot com bubble and the mortgage market in the US has led speculative investors to look
upon commodities as speculative investments. This has brought a sharp increase in non-commercial
demand for commodities at a time when other factors such as drought and increasing demand from
developing countries has caused prices to tighten. However, in relative terms the increase in noncommercial demand has been far greater than the increase in commercial demand.
Since non-commercial buyers of commodities have no interest in using them, they do not participate in
the cash markets, but rather in the futures markets, rolling over contracts as they reach maturity. The
shift in pricing from commercial to non-commercial users can be seen in the behavior of futures prices.
The price of a long futures contract in equilibrium should not exceed the cost of buying the commodity
and storing it until the maturity date of the contract. If I buy a futures contract the seller guarantees that
he will supply the commodity at the maturity date at a price that must cover his costs – that is, the cost
of buying the commodity today and holding it until he has to deliver it to me. However, in futures
markets where producers dominate the market by selling futures contracts to lock in the sale price of
their output, Keynes has taught us that futures prices will generally be in “backwardation” – that is the
price of the future delivery contract will be below the spot or cash price. This is because producers will
dominate the market and their selling will drive down the price. Since the price of the future at maturity
must be the same as the spot or cash price at maturity (in either case the physical commodity has to be
delivered so there should be no price difference) this means the price of the future rises over the life of
the contract, creating a profit incentive for speculators to buy the futures contract from the producer.
Alternatively, if the future price is above the spot, then a contango occurs, representing a predominance
of speculative demands in the market. And this is precisely what has been the case in the oil market and
most hard and soft commodity markets over the last year. Such conditions make it more difficult for
producers to hedge their output, place an upward trend on prices as speculators bet on further
increases, and increases the volatility of commodity prices. The graph, from the OPEC Oil Review, shows
the relative positions of various futures contracts for different monthsin2007. When the earliest
contract to expire – the near month contract indicated by 1st FM has a price below the next longest
contract – 2nd FM, then a contango exists in the market, indicating the predominance of speculation in
the market..
The next graph shows the long positions held by non-commercial interests for the same period
compared to the price of sweet crude.
The next two graphs show the rise in over the counter and exchange traded commodities dertivative
contracts.
This is where climate change comes into the systemic issues rubric. In response to rising oil prices and an
attempt at biodiversity, there has been an attempt to substitute biofuels for petroleum. This has had a
marked impact on the prices of soft commodities. The accompanying charts show the increase in the
use of corn to produce ethanol.
But the impact has not only been on corn. The rise in the price of corn has shifted production away from
other cereals and oil seeds, such as soybeans and rise, which has produced a rise in their prices and
produced a knock on impact on other foodstuffs. For example, the rise in the price of soybeans has
brought a sharp increase in the reclamation of grazing lands and in virgin lands in Argentina and Brazil.
In Argentina this has led to a decline in grazing land available for beef production and the rise in the
price of soy for feed cattle to bankruptcy of many small beef farmers, leading to a decline in supply and
a rise in the price of beef. At the same time, irrespective of the impact of substitution of ethanol for
petroleum, the clearing of virgin lands in Brazil both increases pollution and reduces bio diversity. All of
these factors provide supply side impacts that reinforce the impact of financial speculators on price.
Of
course, this is not a problem for those who are invested in commodity index funds earning positive real
returns. The costs will be born by those who lose employment as a result of central bank responses to
rising prices in the form of tighter monetary policy or high fiscal surpluses. Further, the rise in food
prices has a direct impact on poverty since every increase in food prices increases the number of people
living in poverty.
Finally, as a result of these factors many Latin American countries are experiencing record trade
surpluses, accumulating large amounts of international reserves, much of which is the result of foreign
investment attracted to high returns in asset markets and real investments. However, these conditions
appear very similar to the commodity lottery that dominated exports in the 19th century. These price
improvements in a range of primary commodities have also brought an increase in the terms of trade.
Irrespective of the reasons for these changes in relative prices, the impact that they have had on export
performance is clear. This improved trade balance position has been accompanied by increased capital
inflows from international investors. The result has been a combination of current and capital account
surpluses that have brought rapidly increasing foreign exchange reserves and appreciating currencies.
The result is that the commodity lottery has thus struck virtually all the primary commodity exports of
Latin America in what is similar to what George Soros has described as a “reflexive” process, or more
commonly known as Ponzi process or a price bubble. Thus, financial market conditions are producing
real changes in the production and export structure of most Latin American countries – changes that are
not sustainable and will produce substantial disruption when they are reversed. In particular, the bubble
in commodity prices is reflected in what should be considered a bubble in real exchange rates
throughout the region. This is precisely the situation that the reform of the international financial
architecture and of the multilateral financial institutions were supposed to prevent.
The question is whether these factors can be dominated. US regulators have been hesitant to intervene
in markets to prevent unsustainable price bubbles – with the consequence that their collapse produce
substantial losses, as well as domestic recession that spreads to the global economy. The argument is
that it is easier to prevent a collapse of the markets than to stop a speculative bubble. This may be true
of the US, where the Fed can act as lender of last resort. It is not clear that the same is true of Latin
American countries. This is precisely the kind of case that the Consensus called upon the IMF to analyse
and foresee and to prepare remedies. But to do this it is necessary to look at the coherence and
consistency of IMF policies and of national policies. So far this has not been done. The follow up should
recognize that it is now time to take these problems of the linkage between trade, finance, debt and
climate change seriously.