global liquidity insurance

Financial protection could easily be extended to include developing economies.

While the world is still grappling with the economic and social fallout from the Covid-19 pandemic, the upcoming G20 summit in Rome presents an important opportunity to lay the foundations for a more robust and resilient global financial system. To this end, we propose the creation of a new global liquidity insurance mechanism (GLIM) which would expand the financial safety net to encompass emerging market and developing economies (EMDEs).

During the pandemic, even solvent EMDEs faced severe liquidity crunches as tourism and export revenues dried up. They also encountered, to varying degrees, sudden stoppages in capital inflows, downward pressure on their exchange rates and widening interest rate spreads on their sovereign bonds. EMDEs have long been subject to such capital flow and exchange rate volatility, while their reliance on foreign currency funding remains a source of vulnerability.

The central banks of major advanced economy have established bilateral swap lines among themselves to gain access to foreign liquidity during periods of global shocks. There is no comparable arrangement available for most EMDEs. The International Monetary Fund (IMF) offers lines of credit with ex-ante conditionality, but take-up has been limited, perhaps because of the stigma. The International Monetary Fund’s (IMF) firepower has been enhanced by the new special drawing rights (SDR) allocation to the tune of $650bn, but the way SDRs are distributed does not directly benefit the EMDEs that most need the resources.

We believe that the G20 should initiate the groundwork to set up an insurance pool – the GLIM – to fill this important gap of systematic provision of foreign exchange (FX) liquidity for a broader set of countries.

How it works

The GLIM would be designed as follows: each country would pay a modest entry fee based on its economic size to provide an initial capital base. The country would then pay an annual premium depending on the level of insurance desired. The premium could be, on average, around 3% of the face value of the insurance policy (e.g. $3bn in annual premiums for $100bn of insurance). This is comparable to the current quasi-fiscal cost of reserve accumulation through sterilised intervention, so the premium is comparable to the implicit cost of self-insurance through accumulation of FX reserves.

Premiums would also be contingent on the quality of a country’s policies, based on simple and transparent rules. For example, a current account deficit larger than 2% of a country’s gross domestic product (GDP) triggers a higher premium. Other criteria for determining premiums could include budget deficits, as well as public and external debt (all relative to GDP). A country running large budget deficits in successive years would pay rising premiums. On the other hand, countries that demonstrate policy discipline would pay discounted premiums.

During the pandemic, even solvent emerging market and developing economies faced severe liquidity crunches 

The initial contribution and the annual premiums would be invested in government bonds of the US, the eurozone, the UK, Japan and China. In return, the central banks of those countries would be obliged to backstop the pool’s lines of credit during a global crisis. The pool can also be directly backstopped by SDRs, making the IMF an additional guarantor in the event of a catastrophic global shock.

The insurance payout would take 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 as the original loan – from the insurance pool. Thus, the insurance would only be suitable for liquidity crises, not for dealing with solvency problems.

Towards sound policy

Our proposal broadens and depoliticises access to foreign liquidity in the event of a major global shock by institutionalising ex-ante currency-swap arrangements. This mechanism is simple and could be managed by an institution such as the Bank for International Settlements.

The scheme would constitute 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 because they are based on country variables that are all public knowledge. To encourage broad take-up, the G20 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 strengthening the global financial safety net.

Brahima Coulibaly is vice-president, director and senior fellow, global economy and development, and Eswar Prasad is senior fellow, global economy and development, at the Brookings Institution. This is a summary of the policy brief Strengthening the global safety net by broadening systematic access to temporary foreign liquidity.


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