After the Covid-19 pandemic and the outbreak of the war in Ukraine, the hike in goods prices early on and the rise in energy and food prices over time eventually fuelled an outburst of inflation in 2022, causing monetary policy to switch from accommodative to contractionary. The increasing long-term real interest rates have clouded the macroeconomic outlook (IMF 2022, 2023). Additionally, geopolitical tensions and the sanctions on Russia in response to the invasion are magnifying the risk of disengagement of the Western and Chinese economies and financial systems. These developments may have significant implications for the evolution of the international monetary landscape and the sustainability of sovereign debt. The fifth report in the Future of Banking series (Corsetti et al. 2023), part of the Banking Initiative from the IESE Business School, aims to shed light on the following key questions:
- Should the inherited policy model and institutional framework be changed to control inflation without endangering financial stability?
- Is policy coordination and cooperation among jurisdictions easier or more difficult?
- Will US sanctions on Russia jeopardise the international role of the US dollar?
- Is the renminbi a feasible alternative to the US dollar, US banks and SWIFT as a cross-border financial vehicle?
- To what extent has sovereign debt sustainability deteriorated after the large shocks that the international economy has endured?
- Should the EU reform its fiscal rules, and how?
- Are the sovereign debt restructuring mechanisms in place adequate, particularly in developing countries in which China is a major creditor?
Previous reports in the Future of Banking series (Bolton et al. 2019, Carletti et al. 2020, Bolton et al. 2021, Duffie et al. 2022) have analysed a number of core challenges to the financial system (both markets and institutions), including the need for a new regulatory environment, the consequences of the Covid-19 outbreak, the transformation of business models towards a net-zero carbon economy, and the impact of digitalisation. Following on from this agenda, the new report complements the early analyses by elaborating on how the pandemic and war have accelerated previous trends – specifically, the rise of protectionism, the regionalisation of finance, the decoupling of the West and China, and the accumulation of public debt. These trends in turn exacerbate conflicts between the different policy objectives of managing inflation, maintaining debt sustainability, and ensuring financial stability.
The report delivers three broad messages. The first is that both a stable fiscal outlook and a credible monetary policy are necessary to attack the inflation crisis, but achieving this task will be difficult without reconsidering how fiscal and monetary authorities can remain strong and independent while interacting with regulatory policy in addressing financial vulnerability. The second message is that although the ‘weaponisation’ of the dollar and the rise of China have created an opportunity to promote the international use of alternative reserve currencies, the emergence of these will be gradual unless geopolitical tensions between the US and China escalate significantly. The third message is that although debt remains sustainable in most countries, a subset of EU countries will need to undertake significantly more debt adjustment than is currently planned, and EU fiscal rules will have to be reformed in order to reconcile debt sustainability and stabilisation while preserving incentives for investment.
Macroeconomic outlook and stabilisation policies
The strong impact of the Covid-19 shock on sectors, relative prices, labour markets, and global supply chains has added extraordinary complexity to the policy challenge of maintaining employment, inflation, and financial stability – and this has been exacerbated by the war in Ukraine. While monetary and fiscal authorities are redressing the outburst of inflation in 2022 and pursuing the joint goal of keeping inflation expectations anchored and the fiscal outlook stable, the question arises of whether the current ‘policy model’, with independent monetary, fiscal, and regulatory authorities pursuing their own mandates without explicit coordination, is still appropriate ((Bianchi et al. 2020, Schoenmaker and Reichlin 2020).
There are strong arguments for amending and fixing the policy model but not to scrap it altogether. Both a stable fiscal outlook and a credible monetary policy are crucial for a satisfactory resolution of the current inflation crisis. In a high (private and public) debt environment, achieving these goals may prove challenging without addressing financial vulnerability (as shown in the recent turbulence across the Atlantic). It will be necessary to reassess the interactions between monetary, fiscal, and regulatory policies to ensure they work together effectively, while preserving their credibility. The overarching objective should be to reduce vulnerabilities to confidence crises and foster deleveraging at minimal economic and social costs. A basic strategy would see central banks backstopping government debt, with the treasury in turn ensuring that potential losses in the balance sheet of central banks do not undermine the credibility of monetary policy.
The new international monetary landscape
The ‘weaponisation’ of the dollar provides a window for contemplating the internationalisation of other currencies, such as the euro or renminbi. However, obvious alternatives to the dollar (other Western currencies, gold, barter, and cryptocurrencies, including stablecoins) have limited utility compared to the US currency. China is the first mover in the global race to develop a digital currency for cross-border transactions (with its e-CNY) and consolidate its currency as an alternative to the dollar, US banks and SWIFT. However, the dollar will retain its dominance for a long while – though it may face weakness ‘by a thousand cuts’, translating into a lengthy if gradual decline. A more disruptive case would arise if relations between the US and China were to collapse and both governments threatened to impose secondary sanctions on jurisdictions engaging with the other. In this scenario, countries would have to choose between doing business with the dollar or the renminbi, polarising the international monetary system. This would have very substantial costs for international trade and the stability of the international financial system.
The sustainability of sovereign debt
Despite higher debt and long-term real interest rates, debt remains sustainable in most advanced countries and emerging market economies. One reason is that the difference between expected interest rates and growth rates generally remains small. However, a subset of EU countries will need to undertake significantly more adjustment, over the medium term, than is currently planned. EU fiscal rules need reform to reconcile the sustainability of debt and stabilisation policy while preserving incentives for investment. In line with recent proposals from academics, think tanks and the IMF (Blanchard et al. 2021, Martin et al 2021, Medas and Balakrishnan 2022) reform initiated by the European Commission would give country-by-country debt sustainability analysis (DSA) a central role. This could represent a big step forward, provided that the key remaining challenge – the reduction of discretion and the prevention of potential abuse of DSAs – is addressed without a return to the mechanical rules of the past. The rise of China, and other non-Paris Club creditors, and the increase in the share of external debt owed to multilaterals is making crisis resolution in developing countries much harder (Chuku et al. 2023). Preserving or restoring debt sustainability in these countries requires expanding non-debt-creating financial support, bond contracts linked to climate risks and climate actions, and better coordination among official creditors, including China.
References
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