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The G-20 communique

November 17, 2008

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The G-20’s communiqué offered a surprisingly robust work program for regulatory reform. MIT’s Simon Johnson even worries that it may be too robust – and push banks to scale back their lending in a pro-cyclical way. I am a little less worried about this risk. I assume regulators recognize that a sensible macro-prudential regulatory framework requires raising capital charges in good times (to lean against the boom), not forcing banks to squeeze lending to conserve capital in bad times.

The G-20’s ability to reach agreement on a detailed work program on regulatory reform – just think, the US President has signed off on an effort to evaluate whether compensation practices in the financial sector contributed to excessive risk taking -- presumably reflects the groundwork done by the Financial Stability Forum. Many of the G-20’s proposals reflect reforms that key countries have already agreed on there.*

It also reflects another reality: agreement on regulatory changes only required a deal among the G-7 countries, not a deal between the G-7 and the emerging world. The big internationally-active banks are still primarily in the US, Europe and Japan – and are still regulated (and bailed out) by these countries. Emerging economies of course feel the impact of a fall in lending if the financial sector in the US and Europe is hobbled – so they aren’t just bystanders. They should want the US and European regulators to do their jobs effectively, so they aren’t sideswiped by a sudden fall in lending. And no doubt regulation in the emerging world is influenced by practices in the US and Europe. But most emerging market banks already held a bit more capital than US or European banks, as the emerging world didn’t bet on the notion that the fall in macroeconomic and financial volatility associated with the “Great Moderation” was permanent. The Great Moderation never really made it to most of the emerging world: they had a lot more recent experience with macroeconomic volatility.

The “regulatory” deal consequently hinged far more on the US and Europe than the emerging world. And they stepped up. I was struck by how robust the G-20 language describing the short-comings in the advanced economies financial systems was. The G-20 leaders:

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

But I was also struck my how quiet the G-20 was on the macroeconomic imbalances that facilitated the expansion of leverage in the US and Europe. Remember, the US had a low savings rate – and required inflows from the rest of the world. If those inflows had fallen off as US household debts – and the financial sector’s balance sheet leverage – increased, the US might not have dug itself into a hole. The communiqué language here was remarkably diplomatic. No mention was made of macroeconomic imbalances across countries – or misaligned exchange rates. The communique language remained very vague: "Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes." I consequently am surprised (or perhaps I should say less than impressed) that the White House believes that the G-20 reached "a common understanding of the root causes of the global crisis." Paulson was quite clear on Thursday that the macroeconomic imbalances the G-20 avoided mentioning had something to do with the current mess.

Paulson observed:

"If we only address particular regulatory issues – as critical as they are – without addressing the global imbalances that fueled recent excesses, we will have missed an opportunity to dramatically improve the foundation for global markets and economic vitality going forward. The pressure from global imbalances will simply build up again until it finds another outlet."

I agree.

The unwillingness of the G-20 to even mention the policies that led to large surpluses in the emerging world was noticeable. Part of the logic of meeting in the G-20 rather than the G-7 is a recognition that financial difficulties in the G-7 matter for the entire global economy. But part of the logic of the G-20 is that the G-7 isn’t the right group for addressing macroeconomic imbalances – or doing macro-economic coordination – as it leaves out the key surplus countries and adjustment ultimately requires policy changes in the surplus as well as the deficit countries (see Martin Wolf). If China (I assume) blocks any reference to misaligned ex change rates and the resulting reserve buildup as a source of the imbalances, it is hard to see how the G-20 can become a forum for helping to coordinate the policy changes needed to bring these imbalances down.

There is another area where the G-7 and the emerging world need to cooperate: the provision of crisis financing to cash-strapped emerging economies. The G-20 leaders statement recognized the need to reform the IMF – and didn’t rule out expanding its size "We should review the adequacy of the resources of the IMF, the World Bank Group and other multilateral development banks and stand ready to increase them where necessary").

That was a bit more than I was expecting. But it also falls short of what is needed.

Last week the US was indicating that it thought the IMF had all the resources it needs. Mark Landler reports:

"The White House, officials told The Times, does not support proposals for a giant increase in financing for the International Monetary Fund, which is lending money to Iceland, Hungary and Ukraine and recently set up a credit line for countries with liquidity shortages. Noting that the fund had $200 billion on hand to lend, another senior official said, “The I.M.F. seems quite well-funded.”"

I would be interested in seeing the underlying calculations that support that conclusion.

Consider the following:

The short-term external debt of the emerging world (per the BIS) is around $1.3 trillion – far more than the $200-250b the IMF can mobilize.

Korea started the crisis with about $250b in reserves. Brazil started the crisis with about $200b in reserves. Both now believe – I suspect – that they needed more reserves than they had to be in a position to protect themselves from the recent financial shock. A $200 billion reserve pool in the IMF is clearly too small to be able to substitute for large national reserves.

In the month of October alone, emerging Asian economies (setting China aside) spent at least $45b defending their currencies.** Russia spent another $45b – and that total likely leaves out a lot of commitment to the state banks. Brazil’s intervention was done through swaps so it didn’t show up as an outright fall in reserves. But -- according to

Otaviano Canuto, Brazil’s intervention in the spot market still topped $5b, and it did another $25b in currency swaps. That sums up to a $100 billion plus outflow from the emerging world. A $200 billion IMF couldn’t even cover than kind of global outflow for two months …

Allowing the emerging world to borrow more is in the self-interest of the US and Europe. The shortage of foreign exchange in the emerging world has already led to a strong rally in the dollar – a rally that will cut into US export growth at a time when the US needs exports. That rally is also creating pressure on China to devalue its currency against the dollar – something that would make Chinese products more competitive in the US market and hinder the needed adjustment in Sino-American trade.

If emerging borrowers all have to cut back because of concerns about a lack of financing that would be a further blow to global demand. That should worry Europe – and Germany. If Eastern Europe cannot borrow, Germany (and others) cannot export (Pettis’ argument about China also applies to surplus countries inside Europe).

And longer-term, the last thing the US and Europe should want is a world where the emerging world concludes that it only way it can integrate safely in the international financial system is by maintaining undervalued currencies and building up enormous reserves. Those policies just would perpetuate the imbalances that helped generate the current crisis. The Council on Foreign Relations’ Sebastian Mallaby writes:

"In the absence of a larger IMF, Brazil and its equivalents have two options. They can plan to rely on powerful central banks for emergency loans -- during this crisis, the U.S. Federal Reserve has provided $30 billion apiece to Brazil, South Korea, Singapore and Mexico. The problem is that financing from a central bank may come with political conditions. That might sound fine if the central bank is the Fed. But what if it’s the People’s Bank of China, which has more than enough reserves to play the IMF surrogacy game? A weak IMF could hand a powerful foreign policy tool to China.

The other option for countries such as Brazil is to self-insure -- to be a driver with an $80,000 bank account. Again, this is already beginning to happen: After the IMF imposed unpopular conditions on crisis countries a decade ago, many emerging economies built up their reserves to avoid repeating that experience. But this every-country-for-itself reserve accumulation is not only wasteful. The savings that pile up in central bank vaults will largely take the form of dollar bonds -- that is, lending to Americans. If the past few years are any guide, the resulting whoosh of capital into the United States will inflate the next bubble. "

Much as the US Treasury needs financing now, surely there is a better long-term use of the emerging world’s savings than lending huge sums to the US Treasury.

*The G-20 calls for expanding the membership of the Financial Stability Forum to include a broader set of emerging economies – not just Hong Kong and Singapore.

** My number is adjusted for valuation changes; the unadjusted fall in reserves topped $100 billion.

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