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Conference Call Briefing: Bretton Woods II

Speakers: Benn Steil, Senior Fellow and Director of International Economics, Council on Foreign Relations, and Brad W. Setser, Fellow for Geoeconomics, Council on Foreign Relations
Presider: Sebastian Mallaby, Deputy Director of Studies, Director of The Maurice R. Greenberg Center for Geoeconomic Studies, and Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations
November 12, 2008
Council on Foreign Relations

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I'm Sebastian Mallaby.  I direct the Center for Geoeconomic Studies at the Council on Foreign Relations.  And with me I've got two of my colleagues from the Center for Geoeconomic Studies, Benn Steil and Brad Setser.

Before we get going, I just want to point out that the Council website, CFR.org, is launching a new feature on the crisis in the world economy on the home page I think at the end of this week, and we already have on the Center for Geoeconomics Web site -- which is cfr.org/cgs -- ongoing coverage of the financial crisis.

On the Bretton Woods conference, I think we can stipulate that the G-20 conference was conceived more for political reasons than because anyone had a clear idea of what should be done.  Gordon Brown, it seems to me, and Nicolas Sarkozy, both had domestic political motives to look active on the crisis, and they persuaded the Bush administration, which had figured out by now that opposing multilateral initiatives gets you into more trouble than it's worth, to say yes to the idea.  And so now we have on the agenda this November 15th, this Saturday, a G-20, or as the Europeans like to call it a Bretton Woods II, conference.  And the leaders have had three weeks or so to figure out what agenda to graft into the summit.

I think there are sort of four baskets of achievement that one could look at.  The first is just the mere fact of the summit; it's the first head-of-state G-20 meeting, which sets a pattern that might be built upon for a more inclusive form of multinational cooperation going beyond the G-8, which clearly does not reflect the distribution of power in the world.  So just the creation of a G-20 at a head-of-state level is the first achievement.

Then there will be three others, I think.  There will be more action on an immediate stimulus to build on the Chinese announcement and maybe beef up the less impressive announcements, for example, from Germany.  There will be, perhaps, language on financial supervision and regulation to try and make the financial system less crisis-prone.  And then, finally, there may be some language which alludes ever so vaguely to the question of global imbalances, the need for a stronger lender of last resort to deal with those imbalances, and which, of course, underpinned... was one of the causes behind the credit bubble that got us into this mess.

So I'm going to start by asking Brad a couple of questions on the stimulus, which is sort of bucket two.  First of all, Brad, do you think that the Chinese stimulus will deliver as much as the headline suggested?

BRAD SETSER:  I don't.  I think the headline looks to have been sort of arrived at by a desire to produce a very impressive number, and it actually isn't all going to be incremental new spending.  So in some sense, it's probably comparing apples and oranges to compare the very impressive $585 billion number, which is, you know, sort of -- well above 10 percent of China's current GDP, probably closer to 15 percent of China's current GDP, with the numbers coming out of the U.S. and Europe. Because the numbers coming out of U.S. and Europe will be true stimulus -- i.e., money that wasn't already planned to be spent -- whereas some of China's big headline number comes from counting money that was already in the budget and giving yourself credit for what you would already have done.  And a true stimulus is something above and beyond that, which is directed at trying to support activity during a downturn.

MALLABY:  Has anyone come up with a rough estimate of the breakdown between true stimulus and false stimulus?

SETSER:  I think everybody is struggling -- well, not everybody, but the group of economists who focus very heavily on China are all working through the estimates, and I think they're actually kind of frustrated because it is very hard from the government's announcement to know exactly what's new, exactly what was,  already was in the pipeline.  I guess the general consensus would be maybe somewhere up to a half,  maybe,  new money, but maybe -- probably less than that, but could be that high.

MALLABY:  So that would still be on the order of 5 percent or 7 percent of Chinese GDP; in other words --

SETSER:  Spread out over a couple of years, which is a significant stimulus.  But it's not quite as large as it initially seemed.

MALLABY:  And where else -- which other countries would you look to kick in more at this point?

SETSER:  Well, the obvious additional case is here, the U.S., you know, where the latest indicators suggest a very significant further deterioration in the pace of economic growth in the U.S.  And so I would expect that the U.S. would provide an additional stimulus.  It's a little hard for the Bush administration to make that commitment now unless it's committing to work with the Democratic Congress to get something passed before January 20th.  And I do think that, as you alluded to, the slowdown in Europe has been quite significant, and that there is a need for a more aggressive use of fiscal policy there, too.

MALLABY:  Do you think that there is a prospect that the balance of the stimuli across the world can be designed in a way that lessens, rather than increases, the balance of payments and imbalances that have been a problem?

SETSER:  In principle, yes.  And in order for that to happen, the -- you know, in some sense, you know, the world has changed over the past several days.  Oil prices have come down quite dramatically, so the surplus in the oil-exporting world has for all intents and purposes disappeared if oil prices stay at ($)60.  There will be a few countries with small surpluses, but most countries will be more or less at their budgets and not running big surpluses with oil at this level.

Some might be able to push spending above the current price of oil if they're willing to dip into their accumulated stock of savings, which wouldn't necessarily be a bad idea for a country like Saudi Arabia.  But the real key is the U.S. and China, and whether China implements--China, which has a surplus implements--a bigger stimulus and does more to support domestic demand inside China than the U.S. does.  And I think if China delivers a bigger push domestically than the U.S. does, than that would tend to push China's surplus down and tend to encourage the reduction in the U.S. deficit.

So I think it could be done.  I think it's very hard, though, to coordinate at that level between the U.S. and China.

MALLABY:  You don't think that the fact that the Chinese announced their stimulus a few days ahead of this G-20 conference was a sign that they were trying to fend off direct pressure on their exchange rate?  You know, if they can show that they can address the problem of China's current account surplus by having a stimulus, then they may be less pushed on the alternative way of addressing it, which would be through the exchange rate.

SETSER:  I'm sure that that was a significant concern.  And I'm actually -- you know, I think it was -- it's good that China stepped up and announced a large stimulus.  I think that is as important as continuing to allow the renminbi to appreciate.

China's actually in a really difficult spot on its exchange rate, and the U.S. is also in a difficult spot on China's exchange rate, for the following reason.  While the renminbi has stopped appreciating against the dollar, the dollar has now appreciated quite significantly against the euro.  And China, by the way, now trades more with Europe than the U.S..  And the dollar has also appreciated quite significantly against countries like Korea and some other emerging Asian economies, which are also important trading partners for China.

So over the past several months, China's currency and its broad exchange rate has actually appreciated by far more than it ever did when it was moving against the dollar.  But nonetheless, from the U.S. point of view, it's not helping that the pace of renminbi appreciation has slowed, basically stopped, and that the dollar is going up when the U.S. economy is slowing.

There's a very difficult political situation because China is under domestic political pressure to bring the renminbi down against the dollar to offset the dollar's appreciation, and the U.S. would like to see that the renminbi keep on appreciating against the dollar, and I don't think there's a way of squaring that.  So the fact that China decided that it needed to do something, that it needed to demonstrate that it was serious about stimulating its domestic economy and not simply focused on maintaining its export market share, is a very positive sign.

MALLABY:  Benn, let me come to you.  You've been thinking about the sort of financial oversight and regulation part of this conference agenda, the idea that by tweaking the way we manage the oversight of financial institutions, we might make a future crisis less likely.  Amongst the various ideas that have been floated in this -- in this basket -- which one strikes you as really fruitful for the G-20 summit to bless?

BENN STEIL:  There are two particular areas. I don't expect them to make enormous progress at this particular meeting, but it would be good to lay down some markers at this point.

The first is in the area of over-the-counter derivatives, which served as a transmission mechanism across borders for this crisis.  The way to look at the problem is by distinguishing between what I would call fail-safe regulations and safe-fail regulations.  Fail-safe regulations, which really encompasses most regulatory interventions, are designed to reduce the risk that institutions will make reckless lending and investment decisions.  And I think most of the new interventions we need to see in that area will come at the national level.

Having said that, there is a case for what I would call safe-fail approaches on the international level; that is, approaches that acknowledge that institutional failures will occur in the future, but interventions which are designed to make sure that those failures don't get transmitted across borders and produce a systemic crisis.  The so-called CDS market, the credit default swap markets, were a major vulnerability, and I think that needs to be addressed.

In the current crisis, you had firms like AIG and Lehman Brothers selling credit default swaps.  Ironically, they were insuring other market participants against default risk and they themselves defaulted, producing enormous problems in that particular market.  Had these instruments been traded on exchange -- or more specifically, had there been a central clearinghouse as you see on exchanges -- these problems would not have had such a massive ripple effect across borders.

The best counter example is the collapse of the large hedge fund Amaranth in 2006.  Many people were expecting that that would produce enormous problems in the financial markets, but in fact it didn't.  And the reason was that Amaranth's exposures were mainly in exchange-traded contracts, natural gas futures.  Amaranth's losses were absorbed by exchange clearinghouses and they were not transmitted to other market participants, precisely the opposite of what we saw in the case in particular of AIG and Lehman Brothers in the credit default swaps market.

So I think we need to see interventions that will push a lot of major OTC derivatives contracts either on exchange or on clearinghouses.  One way to do that would be to impose restrictions on the fungibility of contracts that are not centrally cleared; in other words, mechanisms to stop or discourage the transferability of contracts that are not centrally cleared.

The other area where I think we need to begin to lay down a marker is on reform of Basel II, the international capital adequacy regulations.  There were numerous flaws in Basel II; in particular, three areas.  They were pro-cyclical in their effect; in other words, we had banks holding too little capital in good times, as they were building up their asset base, and then when things turned bad, suddenly they were required to raise massive new capital at a time when it was very difficult, or indeed impossible for them to do so.

Second, it allowed for banks to use so-called value-at-risk models to produce their capital standards.  Those models were based on flawed assumptions going forward that themselves were based on historical data that turned out not to be useful.

And third, they were based on the role of ratings agencies, which turned out to have performed very poorly over the course of this particular crisis.

So Basel II needs a complete rethinking.

MALLABY:  Okay.  So two broad areas, the first being moving over-the-counter derivatives contracts, namely swaps -- instead of having them between banks and hedge funds and other financial institutions, they should all be routed through these central clearinghouses-- the idea being that Bank A does a lot of business with banks X/Y/Z and Bank A goes bust, X/Y/Z will have trouble too.  But if A did business with a clearinghouse and then X/Y/Z did business with a clearinghouse, X/Y/Z are fine because they still have their contract with the clearinghouse.

STEIL:  That's correct.  It would not stop banks from writing their own tailorized contracts.  But if there were limited fungibility on contracts that were not centrally cleared, it would short-circuit this transmission --

MALLABY:  What do you mean by the limited fungibility?

STEIL:  Well, for example, if Bank A writes a tailored contract that it sells to Bank B -- for example, a credit default swap -- these days that credit default swap can be sold on to someone else and passed around the global financial system.  Eventually, you arrive at a situation where nobody knows whose exposure is precisely what, and this is one of the dangers in these contracts.  If there were restrictions imposed on the fungibility or the transferability of contracts that weren't centrally cleared, it would tie the buyer of the contract to the seller, such that we wouldn't get to a situation where firms' exposures to each other were completely unknown.

MALLABY:  But this is a persuasive regulatory fix because you, as you say, prevent the failure of one institution causing problems for the other.  But is it something that the G-20 heads-of-state conference needs to get involved with?  Isn't it the case that a derivative exchange in London or Chicago or New York just decides by itself to start listing these contracts and inviting banks and people from all over the world to trade them. This is a reform that can be done unilaterally by a Chicago exchange?  You don't need government to get involved with that.

STEIL:  Well, in fact, the exchanges have been busy in this area.  Eurex launched credit default derivative contracts on exchange a few years ago.  The problem was that these contracts had already become very liquid off-exchange, and the banks that invented them had no incentive to see them transferred on-exchange where their margins would be dramatically lower.  So Eurex had no success in getting these contracts to move on-exchange.

So you do need regulatory intervention at least to impose incentives for these contracts to be traded, if not on-exchange then with a central clearinghouse.  Now, the G-20 per se does not have to become intimately involved in this issue.  I think it's sufficient for the U.S. and the EU to collaborate on this particular intervention because they account for the vast bulk of the OTC derivatives market.

MALLABY:  And the role of the government here would -- I mean, to get around this problem that in the past a derivative exchange like Eurex has tried to solve this problem, but it was just ignored because banks were making too much profit selling these contracts directly.

STEIL:  Correct.

MALLABY:  And the intervention that would change that calculus would be to say to the banks that are selling these contracts directly, you can do that, but the contracts can't then be sold on, as you said before.  Would that be sufficient to --

STEIL:  Yeah, they can be sold on if they are cleared through a central clearinghouse.  If they are not sold through a central clearinghouse, there at least, in my view, have to be disincentives -- major financial disincentives -  to selling them on.  That could be done in terms of, for example, capital adequacy requirements, but it'll probably require a more robust intervention.

MALLABY:  If we step back for a moment and go to sort of a bigger picture view of this, essentially, what this financial crisis is showing is that when we live in a world of very large global capital flows, floating exchange rates can cause crises because they float in either direction at high speeds.  If you are in Korea or Brazil and money that came in and, you know, caused a problem by inflating asset prices and threatening inflation in one period can leave just as fast and create the opposite problem in the second period.

So looking at this, then, do you think that there is a lesson for smaller economies that have this capital rushing in and out of their countries?  What should they do to insulate themselves against this kind of problem?

STEIL:  Well, I think we need to extend the concept of safe-fail approaches to the macroeconomic policies that countries pursue.  I think the clearest-cut case is Iceland, which as you know has faced national financial catastrophe.

Back in August of 2007, I had gone to Iceland with a co-author of mine -- Manuel Hinds, a former Salvadoran Finance minister -- and we had strongly urged them at the time to consider euro-izing the country unilaterally; that is, adopting the euro as their currency even without joining the European Union.  The mechanism for doing so would have been very simple.  At the time, Iceland had more than sufficient hard currency reserves -- that is, euros and dollars -- to buy up all the Icelandic krona in the country at the then-current exchange rate and they still would have had sufficient reserves in the central bank.

Now, that would not have stopped the three major Icelandic banks from overextending themselves, but it would have prevented outright national financial catastrophe because there wouldn't have been any meaningful risk of current account crisis.  That is, if Iceland had been entirely euro-ized, there would have been no trouble getting hard currency to cover its short-term debts, which, of course, has been the root of the problem in this particular crisis.

MALLABY:  Right, because in a lot of financial crises, whether you're thinking about the emerging market crises of 10 years ago or whether you're thinking about Iceland more recently, you get a financial sector that blows up and a currency that collapses in tandem, correct?  And that's just a double whammy that is particularly toxic.

STEIL:  Correct.  And you know, the big problem with these financial crises, which occur approximately once every five years, particularly for countries that are dependent on commodity exports, is that in a financial crisis a country needs international currency -- that is for all intents and purposes U.S. dollars and to a lesser extent euros.  You can only get dollars and euros from the United States and from the European Union.  You can't get them from the IMF, except if the United States and the European Union make them available.

So for smaller, developing countries -- and even rich, small, open economies like Iceland -- I think they need to take seriously the possibility of outright dollar-izing or euro-izing.  Now, that might sound like a radical alternative, but countries have done that.  El Salvador and Ecuador dollar-ized earlier in this decade, and that has served as a significant insulating mechanism for them in the current financial turmoil.  You look at how well Italy has fared in this crisis.  You can only imagine the disaster they'd be facing now had they still been using the euro.

MALLABY:  The lira.

STEIL:  The lira.  Oh, excuse me.  The lira.  (Laughs.)  Excuse me.  They would certainly have faced enormous capital outflows.  They would have experienced an enormous decline in their currency and massive imported inflation.  They experienced none of that.

MALLABY:  One last question for Brad before we open it up to questions from people on the call.

You know, Brad, we've been talking with Benn about , you know, one response to this problem of a mixture of huge global capital flows and floating currencies, and Benn has been talking about the option of getting rid of that floating currency by dollar-izing or euro-izing.  What about the other idea, which is to limit the capital flows?  Do you think that for some emerging economies that might make sense?

SETSER:  Well, I think there are different ways of limiting capital flows, and there are more draconian and less draconian ways of doing so.  But certainly any emerging economy that has been borrowing, whose banks have been borrowing heavily in dollars and euros, is taking a very large risk, particularly in a context where the IMF's resources are limited and there isn't a sort of cross-border equivalent to the deposit insurance system that makes it safe for domestic banks to take in short-term deposits and use it to lend long.  When an emerging market bank takes in a short-term loan in dollars or euros and uses it to lend long locally even if it's dollars and euros, it's taking a significant amount of rollover risk.  And those emerging economies that were financing big current account deficits with big cross-border bank inflows have been hit really quite hard in this crisis.

So I think for those countries, it doesn't have to be a formal capital control, but certainly a much tighter scrutiny and some limits on short-term, cross-border bank financing strikes me as a reasonable option.

MALLABY:  What about countries that had a current account surplus that is still hit because the -- you know, the gross position is different to the net position?  You can have a current account surplus and, you know, a savings surplus nationally, but there is still companies within your country that have a deficit -- they owe money, they owe dollars abroad, and they can be hit if those dollars aren't available.

SETSER:  You know, I mean, you are seeing that, and you've seen that most noticeably with a country like Russia, which -- whose private sector was a big borrower and a lot of that borrowing was done short-term.  And so Russia has a huge refinancing need next year.  And at the same time that Russia's private sector was borrowing from the rest of the world, Russia's government was a net lender to the rest of the world because of the high commodity surplus, the big inflows from high oil prices that have now gone away.

Suddenly there's two issues.  One is that Russia probably should have been paying more attention to the buildup of short-term foreign currency exposure inside its banking system. Even though that foreign currency exposure was fueling something of a boom until, it was leading to a buildup of risk.  Second -- and this has sort of been one of the disturbing aspects of the recent crisis -- is that you really would like an international financial system that would provide financing to emerging economies when they need it.  And right now a lot of commodity-exporting economies in some sense will need financing.

Now a country like Russia -- and Russia's a special case, because it's made its own policy errors -- can't get financing, but even better run countries can't get financing.  So countries are being hit with a dual shock.  On one level, their commodity export revenue is falling, and on another level their access to international capital markets is falling.  And I think that the disturbing aspect of the past several years to me is that we thought that correlation might have gone away, but it seems to remain that in good times emerging markets get too much money, and in bad times they get no money.

MALLABY:  And for this conference -- to tie it back to the conference agenda, is there a prescription that the G-20 ought to embrace in order to address this problem?

SETSER:  Well, I think a couple of things are -- should be a part of the agenda, although they're both very, very hard.  One is that I do think that the IMF's current resources are too small to allow it to play a meaningful role for helping the larger emerging economies -- Brazils, the Koreas, the Indias of the world -- manage the extreme volatility that we've seen in the scale of cross-border flows.  So if you don't have a bigger IMF, there will be too much self-insurance, too much of a reserve buildup, and that causes other kinds of problems.

And then I guess I'm a little bit at odds with Benn in the sense that I do think that one of the underlying causes of the current crisis were a series of countries with large current account surpluses that were pegging their currencies to the dollar and in the process financing the large household deficit in the U.S.  And while the current risk is that the households in the U.S. will stop borrowing too quickly, I think, long run, we need to reevaluate whether it makes sense for large emerging economies, countries like China, to have their currencies tightly pegged to the dollar, or whether those countries should allow their currencies to float.

STEIL:  I would point out, Sebastian, that the current international financial crisis will only reinforce the impression in countries like South Korea, like Russia, that in order to avoid crisis you need a big war chest, perhaps even a bigger war chest, of dollars.  So --

SETSER:  Yeah, global imbalances are a problem that's going to stay with us.

MALLABY:  Yes.  I mean, I think that's probably something that we can all agree on, that any country that's looked at the last few months and seen that, you know, even countries which were running a current account surplus, which had a domestic budget surplus, which had lots of financial reserves, could still be buffeted and threatened by this crisis, the response is going to be, "Gee, I need more insurance in the future, therefore I need more reserves in my central bank."  And as you say, those reserves will build up the imbalances.

And it's the role, potentially, of the G-20 process, it seems to me, to push back against that very natural reaction and say, well, we may need reserves and assistance to deal with big capital flows, but they don't have to be accumulated country by country in each central bank, which involves a lot of depreciation of reserve accumulation, a lot of capital tied up where it could be used perhaps more productively elsewhere, and perhaps we should centralize some of that saving in the IMF.

But let's go to questions from people on the call.  Perhaps the operator can manage that process.

OPERATOR:  We'll now open the floor for questions.  If you would like to ask a question, please press the star key followed by the 1 key on your touchtone phone now.  Questions will be taken in the order in which they are received.  If at any time you would like to remove yourself from the questioning queue, press star-2.  Once again, that's star-1 to ask a question.

We're currently holding for questions.

MALLABY:  If there is no question, I can ask another question.

OPERATOR:  We have a question now from Wen Chen with the Beijing Review.

MALLABY:  Go ahead.

QUESTIONER:  My question is, could you comment on the Obama administration's attitude towards a remodeling of the international financial system?

MALLABY:  Bradley, that's a good one for you.

SETSER:  Well, I don't think the Obama administration has been formed, yet alone adopted, decided on, its position towards international financial reform.  My guess is that the Obama administration, given the names that have been mentioned for Treasury secretary, would be more inclined than the current administration to think that the IMF and big reserve pools could play a constructive role in trying to limit some of the pressures that Sebastian describes.  For each country to build up excessive reserves is a form of excessive national self-insurance.

And my guess is that an Obama administration would be more inclined to accept deeper regulatory reforms at the national level than the Bush administration would be.  But I also suspect that an Obama administration wouldn't be willing to embrace a global regulator.  That's a step too far.

And then I think the Obama administration has already signaled that it is interested in a large fiscal stimulus.  So it would be quite willing to join in a global effort to use fiscal policy to try to limit the scale of the downturn.

And then I think finally that it's very clear or relatively clear that the Obama administration will probably embrace the G-20 process, that this process will continue and that there will be some value in maintaining a dialogue with the emerging world.

STEIL:  I agree with Brad.  I would just throw in one caveat, that if by some chance, instead of Larry Summers or Tim Geithner being appointed Treasury secretary, it were Paul Volcker, I think, we could expect a more skeptical view from the Treasury on the role of derivatives contracts, and perhaps more robust -- support for a more robust international mechanism for controlling their use.

MALLABY:  Is there another question?

OPERATOR:  Yes.

Our next question comes from Deb Riechmann with the Associated Press.

QUESTIONER:  Hi.

Could you address the issue of no one from Obama's camp going to be participating that greatly in the summit?  So you know, how much could really be done?

I mean, Bush is in a lame-duck position.  And you know, what are the political stakes for Bush?  And what could possibly get done without Obama?

MALLABY:  Benn, do you want to go ahead?

STEIL:  Yeah.

I agree.  Very little can get done without explicit support from President-elect Obama, which is why I expect the idea of a global fiscal stimulus to be the only one that will get any real traction at the summit.

This is precisely because we know that President-elect Obama supports a significant new stimulus initiative, and therefore the Bush administration will be able to lend its support to such an initiative without having to be concerned that the incoming administration will pull the rug out from under it.

OPERATOR:  Another question?

QUESTIONER:  Does he face any political risk by even hosting it?

STEIL:  Does who face political risk?  President Bush?

QUESTIONER:  Yes.

STEIL:  Well, without doubt, that -- if he expresses support for an initiative that the Obama -- incoming Obama administration -- will not support, he can rest assured that he will not get any traction whatsoever.  And therefore, in the -- the summit can't really be expected to accomplish anything major.  It can just lay down some markers for the future, some general statements of principle and perhaps, as I said, express support for a global stimulus package, particularly since that would allow each country, each member of the G-20, considerable flexibility in deciding what should be the primary elements of the stimulus, for example, certain types of spending or tax cut initiatives.

MALLABY:  But I think, you know, there are signs that all three of us have perhaps picked up from conversations with people in the administration that , you know, the way this will go is not to lay down specific action points, apart, as Benn points out, on the fiscal stimulus and the immediate response.  I think there, you know, there could be some specifics.

But the summit is really about creating the start of a process.  When you start a process, you tend to outline the things you want to look at in rather general, abstract terms.  And so what really matters is the fine print, and that will come later, at a time when the Obama administration has taken office.  This talk of a follow-up G-20 summit -- the French want to host it in February, I think.  Others have also tried to host it.  The Italians, the Japanese have put in a bid.  And so I don't think that this meeting this weekend is the be all and end all.

It's just starting a conversation.  And so in that sense, the risk of the Bush administration going out on some limb that is unappealing to the Obama team, is reduced.

OPERATOR:  Thank you.

(Name and affiliation inaudible.)

QUESTIONER:  Hi.  Thanks for taking my question.

I was wondering if you could talk a little bit about the appropriateness of the G-20 as a venue for this.  Is it too large or too small or just right essentially for managing this?

And as a follow-on from that, what do you feel the motivations of the U.S. were in using this venue?  I mean, is it more -- is it a recognition that they have to have a multilateral approach to this?  Or is it more in a sense of paying lip service to the international community?

Thanks.

MALLABY:  Brad, do you want to have a crack at that?

SETSER:  I mean, I think the G-20 is as good a grouping as any.  It was probably selected for the simple reason that it already existed.  There was already a group of 20 countries that were meeting at the central bank and finance minister level.

And if you wanted to have a meeting at the leaders level, you either had to create a new grouping, which would involve an enormous diplomatic nightmare.  Just picking who should get an invitation is an enormously time-consuming process.  Or you have to fall back on an established grouping.

So in that sense, I think, it is probably the best available group of countries.  The G-7 is too small.  The G-8 includes one emerging economy, Russia, but doesn't include a lot of the other big emerging economies that you need.  And there isn't anything in between the G-8 and the G-20 that brings the emerging economies and the U.S., Europe and Japan and Canada and Australia together.

So in that sense, I think, the G-20 is about right.  That said --

MALLABY:  Notwithstanding that, one should just concede that there are some obvious oddities.  For example, Argentina is part of it, but Switzerland and Spain are not part of the G-20.

SETSER:  Well, I'm not sure that the -- the big problem-- that any international grouping faces is trying to avoid overrepresentation of Europeans.  Because if you still do a listing of big economies, by size, the majority end up coming from Europe.

The oddities are that it was a group created to manage or to help discuss emerging market crises at the end of the 1990s.  So the set of countries that are represented tend to be the countries that were big players in the international financial system in the 1990s, and that grouping hasn't been updated to reflect changes that have happened since then.

Argentina's a case I think you can also make a case that, you know, given the depth of the crisis in the region between Russia and core Eurozone, that it's sort of strange that some -- a country like Poland isn't represented.  So there's plenty of oddities.

STEIL:  I strongly agree with Brad, although I would point out that, in terms of immediate action items, coordination between the U.S. and the EU is what's necessary.  There are already some worrying signs of competition between the two.

For example, the U.S. in particular -- the Federal Reserve moved faster than the EU in order -- in terms of bringing together the various parties in the CDS market -- the credit default swaps market -- in order to push trading on exchange or onto a central clearinghouse.

The EU then became very concerned that that clearinghouse, or those clearinghouses, would all be American.  And so the EU is now playing catch-up, trying to ensure that at least part of this market is serviced by EU-based clearinghouses, in order to ensure that EU regulation is part of the mix.

MALLABY:  Okay, another question?

STAFF:  Yes, our next question comes from Nestor Ikeda with Associated Press.

QUESTIONER:  Yes, this is Mr. Ikeda from the Associated Press, the Latin American division.  As you know, the G-20 is also made of emerging economies, and especially from Latin America, coming -- the presidents of Mexico, Brazil and Argentina.  All those countries, as you know, have faced great crisis in the past decade.  So my question is, what kind of voice would you expect from emerging economies in this meeting, especially those three from Latin America?

MALLABY:  Benn?

STEIL:  Well, there's no doubt that the Latin Americans are going to be among the most concerned about the present crisis, because it brings back deep and painful memories about the 1990s.  Having said that, I really don't expect them to get too much out of this particular summit.

You know, one item on the agenda is certainly going to be the IMF, and how large it should be.  And on the one hand, Latin American countries want to make sure that they have sufficient official support when they run into problems like they're currently facing.  On the other hand, none of them want to go back to the IMF.  So in this regard, I don't -- I think they're going to come away from this -- the summit -- rather disappointed.

MALLABY:  Okay.  Another question?

MODERATOR:  Yes.  And this question comes from Ruben Barrera with the Mexican news service.

QUESTIONER:  Yes, this is Ruben Barrera with the Mexican news agency Notimex.  I have a question in the same topic.  I mean, the fact that the U.S. for the first time in, you know, I don't know how long, they decide to include the emerging economies in discussing issues like this, a crisis like this.

And the question is, I mean, how much do you expect the U.S. and other developed countries -- how much attention do both put to the fact -- to any advice offered by countries like Mexico, South Africa or Brazil, who have proved their resilience in the face of the -- this crisis, and in some way had to maybe put on the spot these countries that -- a long time ago, they were showed to these countries as an example of what should -- what they should do.

And the other question is, do you expect any -- what -- I mean, what are the expectations of any joint declaration by this group once this meeting ends on Sunday?

MALLABY:  Brad, do you want to take a crack at that?

SETSER:  Sure.  I mean, the second question is the easier, which is that I expect the joint declaration to read something to the effect that "We met and we agreed to meet again, and we've agreed that we need a big fiscal stimulus globally, and each country will do its part, and we agree that we will discuss at our next meeting the following set of topics."  I think that's about all that can be expected.

I think your first question, though, is actually in some sense a quite interesting one.  I would actually say that the U.S. has been meeting regularly with emerging economies since the 1990s, the U.S. and Europe, through -- at the lower level through--the G-20 finance ministers process and the G-20 central bank deputies process.  So the unique aspect is they're meeting at a higher level, not that they are meeting.

But the other unique aspect is that emerging economies, particularly Latin economies, can quite rightly say that this is the first crisis -- international financial crisis in recent memory where no one believes the Latin country policy errors were the central cause of the crisis, and that they're dealing with the fallout of a crisis that emerged out of the financial sectors in the U.S. and Europe.

And the solution on the financial side likely, as Benn suggests, will be out of -- will focus most intensely on reregulating or changing the regulatory structure for large banks and broker dealers or former broker dealers in the U.S. and Europe.

But I think emerging economies can fairly say that just as when our financial sectors caused global trouble, the G-7 said that they had a reason to care that we did our job well -- that the G-7 said that the way emerging economies regulated their financial system had global implications -- I think emerging economies can now say that the way the U.S. and Europe regulate their financial institutions also has global implications that affect all of us, and therefore we're not going to drive the process; we should have some voice.  Our concerns should be heard.  We should have some ability to put pressure on the U.S. and Europe to make sure that they're doing their own job, which is regulating their own institutions well and limiting the risk of fallout.

And there's a second set of agenda items where the emerging economies are absolutely central, and that is the whole discussion around global imbalances and the size of the IMF.

STEIL:  Sebastian, can I jump in?

MALLABY:  Sure.  Sure.

STEIL:  I partly -- or I should say mostly agree with Brad.  But I would point out that so-called commodity currencies have been the hardest hit in this particular crisis, as they have always been in crises like these.  And I think that should deliver the same message to Latin America -- and I'm thinking particularly of two countries, Argentina and Brazil -- that they've gotten over the past several decades.  And that is that in order to shield your economies from being buffeted by wild capital inflows and outflows, you need to diversify your economies.  They are still too commodity dependent, and that's going to get them into problems in the future as well.

SETSER:  Although, Benn, China's getting buffeted by a major slowdown and low demand for global manufacturers, and China isn't commodity dependent.  I think this is a case where there is no safe harbor.

STEIL:  Yeah, but China's faring far better than Argentina and Brazil.

MALLABY:  Is there another question?

OPERATOR:  Yes.  We have a question from Clovis Rossi with Folha Sao Paulo.

QUESTIONER:  Yes, my question is about the fiscal package because of the financial communique of the G-20 meeting in Sao Paulo of finance ministers and the central bank governors of nation also -- not only fiscal policy, but -- and I will quote, "We affirmed our determination to take all necessary steps to foster non-inflationary growth, including through monetary and fiscal policy."  Will you believe that also a monetary policy and a movement such reducing interest rates, coordinating by emerging economies and which countries would be advisable -- (inaudible) -- right now?

MALLABY:  Benn?

STEIL:  Well, in terms of monetary policy, we have to be realistic about this, particularly in emerging markets.  There, what's feasible in terms of monetary policy is going to be driven by the actions of the Federal Reserve.  And to the extent that the Federal Reserve continues to loosen monetary policy, we can expect that to facilitate monetary loosening in emerging economies.

So although coordination in the abstract is a nice thing, I don't think it's strictly necessary.  I think as long as the Fed continues to push an accommodative monetary policy, for all intents and purposes, world monetary policy will be accommodative.

MALLABY:  Brad, do you want to come in on that?

SETSER:  One simple point, which is that the G-20 finance ministers meet with central bank governors so that they can release a communique which discusses monetary policy. I'm quite sure that the central banks would strongly oppose any mention of monetary policy at the leaders' level.  So I would not expect that language to be repeated.

MALLABY:  Okay.  Is there another question?

MODERATOR:  Yes, we have a question from Cesar Munoz with EFE.

QUESTIONER:  Yeah.  Thank you.  I have a question about the IMF, but I joined later, so I hope I'm not trying to ask something that you mentioned.  I  mean, there is all this talk about the IMF having a bigger role.  It hasn't really been defined.  And Strauss-Kahn last weekend said that he will ask for more money for the Fund.  I mean, is this possible?  Who will give the money?  And I mean, is that -- is there a willingness to do this in the international community?  Thank you.

MALLABY:  Brad, do you want to get that?

SETSER:  Sure.  Is it possible right now?  I think the answer to that is no.  Why?  Because the Bush administration more or less said that they weren't going to support efforts to expand the Fund's size.

Would it be possible through next year?  I think it is possible.  And you know, there's no doubt in my mind that the U.S. could come up with the resources needed to increase its contribution to the IMF.  But I think it is conceptually possible.

Then the question is, what role do you want the IMF to play in this crisis?  And there's sort of been two roles that have been proposed for the fund.  One is its sort of traditional role of providing conditional financing to countries that need to make important adjustments to their policies, whether letting their currencies depreciate to help them reduce their current account deficit or tightening fiscal policy.  And I think that set of countries would include a group of countries in Eastern Europe -- Hungary, the Ukraine already -- Pakistan outside of Eastern Europe, probably others--that need more traditional kind of IMF financing.  And that's what you're -we've-seen so far.

The IMF has also proposed a short-term liquidity facility, which is a new kind of financing, which is, you know, for three months, can be rolled over, but comes with no conditions, and presumably is for countries with stronger initial starting positions.

And that, I think, is an important new role, because it's a role which might reduce some of the stigma of going to the IMF and might make it possible for the IMF to play the role that Sebastian described as sort of common pool of reserves that reduces the incentive to have too many reserves at the national level.  But that process, that facility hasn't been used yet, and it's not clear that the IMF, as it is currently sized, has the ability to really provide the kind of resources that a large emerging economy would need.  And so that's why I think that there should be some discussion about how the IMF size can be increased.

In the interim, if the IMF size can't be increased, you can run through the IMF's existing resources and then countries can augment any IMF program with supplementary financing from their own resources.

MALLABY:  Brad, can you just talk a little bit about one alternative that's emerged, which is for strong central banks to provide swap loans or basically loans to central banks in countries that are distressed?  And particularly, I think there's a relationship like that between China and Indonesia.  Is that a sign of the world to come?

SETSER:  Well, I mean, there's also now a relationship between the U.S. and Mexico and Brazil and Korea and Singapore.  You know, there's... Central banks can be strong in different ways.  Right now, the world needs dollars, and the Fed can more or less create dollars, so, to the extent that the Fed is willing to accept emerging markets' currencies as collateral, it can provide access to dollars to central banks that need dollars to provide the "lender of last resort" function in their... in foreign currencies.

In addition, you know, it's a new world, where the U.S. isn't the only big source of dollars.  And China, Japan, Saudi Arabia all could potentially provide dollars, either alongside the IMF, alongside the U.S., or outside of the IMF, outside of any format that includes the U.S.

So far, I think China's been fairly reluctant and fairly conservative in its use of its reserves in that way, and I'm not sure that, say, with Indonesia, the Chinese would be willing to provide financing on significantly different terms than the IMF.  But that's a choice they would have to make.  They would have to make their own judgments about the risk of providing financing to Indonesia against the collateral of Indonesia's own currency.

MALLABY:  Benn?

STEIL:  I have nothing to add.

MALLABY:  Okay.  I think we have time for one last question.

STAFF:  Okay, we have a question from Patricia Milo (sp), with Estado.

QUESTIONER:  Hi.  My question is, do you think it's going to be possible to reconcile the positions of Europe, who has expressed the desire of stronger regulatory agency, and the U.S.?  And you said that one of the few issues that they will likely agree upon is a fiscal stimulus, but some big emerging countries such as Brazil and India, they don't have much room for fiscal expansion.  So how would that be --

MALLABY:  So on the regulatory competition question, Benn, do you want to comment?

STEIL:  Yeah.

Well, there's this idea, Sebastian, of having some form of international college of supervisors.  And I think that particular idea has legs.  There is a strong case for having, at the very least, much tighter international coordination to deal with what we could call systemically important international financial institutions.

Take a highly leveraged financial institution like Deutsche Bank.  If they were to get into trouble, it would be impossible for Germany to deal with that problem on their own.

They would have to intervene in tight coordination with other countries, including their EU partners and the United States.  And therefore it's exceptionally important to make sure that supervisors particularly in developed markets are intimately familiar with what Deutsche Bank is doing and what it's financial situation is, that they can share information and coordinate strategies.

So I think that particular idea has legs.

MALLABY:  Just to clarify, do you mean that Germany could not deal with a problem at Deutsche Bank, by itself, because it doesn't have enough money to do it?  Or what?

STEIL:  Absolutely, precisely.

MALLABY:  Deutsche Bank is too big.

STEIL:  Deutsche Bank it too large and too highly leveraged a financial institution.  And I'm not implying that Deutsche Bank is in such difficulty at present.  But it's an example of an exceptionally large financial institution domiciled in a country that would not have the resources to deal with the problem on its own.

MALLABY:  So we have banks that are both too big to fail and too big to save under the current rules that we have.  I guess that alone is a reason for the world leaders to get together.

STEIL:  Precisely.

To put it in the rubric that I presented at the start, that requires a fail safe strategy.  In other words, there are a group of about 30 systemically important international financial institutions, where their solvency is actually quite critical.  And that has to be dealt with on an international basis.

MALLABY:  Okay.

Well, thanks very much to Benn Steil and Brad Setser.  And I think we'll wrap up this Council on Foreign Relations call right here.

Thank you to everybody who participated.

.STX

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