This op-ed was originally published by The European Financial Review.
Undoubtedly, the economic recovery from the COVID-19 pandemic will dominate the agenda for the G-20 Summit in Rome in late October. The summit also presents an opportunity to lay the foundation for a more robust and resilient global financial system. The creation of a new global liquidity insurance mechanism (GLIM) would expand the financial safety net to encompass a larger share of the world’s population.
To fill this important gap of systematic provision of foreign exchange liquidity to a broader set of countries, the G-20 should initiate the groundwork to set up an insurance pool—the GLIM—with the following design features.
Each country would pay a modest entry fee, depending on its economic size to provide an initial capital base for the GLIM. The country would then pay an annual premium depending on the level of insurance desired. The premium could on average be about 3 percent of the face value of the insurance policy (e.g., $3 billion in annual premiums for $100 billion of insurance). This is comparable to the current quasi-fiscal cost of reserve accumulation through sterilized intervention, so the premium would be calibrated to cost no more than the implicit cost of self-insurance through accumulation of foreign exchange reserves.
Premiums, which would also depend on the quality of a country’s policies, would be based on simple and transparent rules. For instance, a current account deficit larger than 2 percent of a country’s GDP triggers a higher premium. Other criteria for determining premiums could include budget deficits, public debt, and external debt (all relative to GDP). There would be higher premiums for a country that chose to run large budget deficits or that accumulated large amounts of debt. In the interest of simplicity, there would be no country-specific adjustments—such as adjusting the budget deficit for business cycle conditions.
The premiums would increase in a nonlinear fashion with the persistence and levels of weak policies. A country running large budget deficits in successive years would pay rising premiums. Countries that have demonstrated policy discipline would pay discounted premiums. The initial contribution and the annual premiums would be invested in government bonds of the United States, Euro zone, United Kingdom, Japan, and China. In return, the central banks of those countries would be obliged to backstop the pool’s lines of credit in the event of a global crisis.
The pool can also be directly backstopped by SDRs, in effect making the IMF an additional guarantor for a portion of the credit lines in the event of a catastrophic global shock.
The insurance payout would be in the form of a credit line open for one year, rather than an outright grant, with the interest rate based on the yields on short-term government securities in the countries backstopping the insurance pool.
The country would not be able to buy additional insurance until there was a full repayment of the initial draw, in the same hard currency of the original loan, from the insurance pool. Thus, the insurance would only be suitable for liquidity crises. An economy beset by a solvency crisis would have to go to the IMF for traditional borrowing with ex-post conditionality, with any funds drawn through the GLIM (and not yet paid back) becoming folded into such an arrangement.
The crux of the proposal is that it broadens and depoliticizes access to foreign liquidity in the event of a major global shock by institutionalizing ex-ante currency swap arrangements. This mechanism is simple and could easily be managed by an institution such as the Bank for International Settlements.
The scheme would be a transparent, rules-based mechanism to strengthen the power of moral suasion to get a country to adopt sound policies. There is no specific stigma associated with the premium levels as they are based on country variables that are all public knowledge. To encourage broad participation, the G-20 could make participation in this pool a condition for continued membership in a body such as the Financial Stability Board. No country would be forced to buy insurance, but would have to pay the basic membership fee to be part of the pool.
Our proposal would reduce the incentives for EMDEs to self-insure through costly and inefficient reserve accumulation, alleviate pressures on IMF resources, and promote global financial stability. The GLIM offers a bold yet practical solution to bolster the global financial safety net.