The problem with the world having only a single reserve currency came to the fore during the crisis as many countries faced dollar liquidity problems as a consequence of swift deleveraging by foreign creditors and foreign investors. Paradoxically, even as the US economy was in a downturn, the dollar strengthened as a result of flight to safety, said Subbaro while speaking on Frontier Issues on the Global Agenda Emerging Economy Perspective on the occasion of the 60th anniversary celebrations of Central Bank of Sri Lanka, in Colombo on Tuesday.
Based on the experience of the crisis, several reform proposals have been put forward to address the problems arising from a single reserve currency, he hinted.
One is to have a menu of alternative reserve currencies. But this cannot happen by fiat. To be a serious contender as an alternative, a currency has to fulfil some exacting criteria. It has to be fully convertible and its exchange rate should be determined by market fundamentals and it should acquire a significant share in world trade, he said.
The currency issuing country should have liquid, open and large financial markets and also the policy credibility to inspire the confidence of potential investors. In short, the exorbitant privilege of a reserve currency comes with an exorbitant responsibility, he explained.
Subbarao also drew attention to the fact that managing currency tensions will require a shared understanding on keeping exchange rates aligned to economic fundamentals, and an agreement that currency interventions should be resorted to not as an instrument of trade policy but only to manage disruptions to macroeconomic stability.
However, he was vociferous about the fact that currency appreciation is not the only problem arising from the ultra loose monetary policy of advanced economies. Speculative flows on the lookout for quick returns can potentially lead to asset price build up. The assurance of advanced economies to keep interest rates exceptionally low for an extended period has also possibly triggered financialisation of commodities leading to a paradoxical situation of hardening of commodity prices even as advanced economies continue to face demand recession.
EMEs have been hit by hardened commodity prices through inflationary pressures, and in the case of net commodity importers, also through wider current account deficits, he said.
Managing capital flows should not be treated as an exclusive problem of EMEs. In as much as lumpy and volatile flows are a spillover from policy choices of advanced economies, the burden of adjustment has to be shared, suggested Subbarao.
How this burden has to be measured and shared raises both intellectual and practical policy challenges. Our current theory of external sector management draws from an outdated regime of fixed exchange rates and limited capital flows when the task was largely limited to managing the current account of the balance of payments. What we now need is a theory that reflects the changed situation of flexible exchange rates and large and volatile capital flows. The intellectual challenge is to build such a theory that encompasses both current and capital accounts and one that gives a better understanding of what type of capital controls work and in what situations, Subbarao said.
The practical challenge in these matter is that once such a theory is accepted, there is a need to reach a shared understanding on two specific aspects: first, to what extent are advanced economies responsible for the cross border spillover impact of their domestic policies, and second, what is the framework of rules that should govern currency interventions in the face of volatile capital flows.