The financial crisis gives Asia a chance to strategically position itself in the new international financial architecture. Will Asia seize the opportunity?
This article is an excerpt from a paper that was originally published by Caijing magazine in China in December 2008. It also includes excerpts from the third KB Lall Memorial Lecture, given by the author Feb. 7 at the Indian Council for Research on International Economic Relations in New Delhi.
Future historians will compare the 2008 Great Global Credit Crisis with the 1930s' Great Depression, which set in motion World War II and changed the financial landscape for nearly 80 years. Similarly, the current crisis is likely to cause major changes in economic theory, philosophical outlook, and institutional structure.
This essay looks at three possible scenarios where China and East Asia could position themselves in the next decade. Because the success of economies hinges on governance, it is the quality of Chinese and Asian governance that will be severely tested in the coming years.
A Historical Inflection Point
Clearly, 2007-2008 marked an important turning point in the global market economy. Therefore, we must pose three significant questions.
First, does this mark the peak of global capitalism? One thing at least is certain: The crisis put a question mark on the American dream that every individual, through his own labor and creativity, can have all that he wants. This could be true for individual Americans, who number less than 5% of world population, account for 25% of global GDP, and annually consume global resources (through the current account deficit) equivalent to 6% of GDP.
The sad fact is that global resources and the environment cannot support the American dream for the average Chinese and Indian, who together number 37% of world population. The problems of global resources and the environment were not constraints to emerging markets during the Great Depression, but today's fast-growing countries, such as China and India, must address global warming and environmental sustainability not only for their own health, but for the world as a whole. Environmental issues could easily change the geopolitical landscape in the next decade and throw all current projections out of line.
Second, if India and China are both growing at more than 8% per year, while the United States, Europe, and Japan are growing at less than 2% per year, will the relative power between the mature economies and the emerging markets change dramatically?
Angus Maddison1 has projected that by 2018 China will have overtaken the U.S. as the largest economy in the world, with India as No. 3. By 2030, he has estimated that Asia (including Japan) will have accounted for 53% of world GDP, whereas the U.S. and Europe will have only accounted for 33%. If this is the case, the global financial architecture will be significantly different in the future than it is today.
Already by 2007, Asia accounted for 66.8% of world official reserves, 55% of world population, and 24.5% of world GDP, but only 16% of IMF quotas, equivalent to its voting power in the Bretton Woods institutions. My own crude calculations suggest that Asian financial markets will be the largest in the world within the next 10 years, assuming that financial deepening in Asia continues to improve and Asian currencies appreciate relative to the U.S. dollar and euro. This means that either one Asian currency or Asian currencies as a group will very likely play a role as a global reserve currency by that time.
Is Asia ready to play that role? Not by far. In the past, emerging markets were dependent on the advanced economies for markets and financing. Asia's surplus role has been too recent for that fact to sink in. Asia has had to put its excess savings in the West precisely because its own financial system is not ready to intermediate such savings. Its regulatory structure is still evolving, and Asian bureaucrats are neither internationally minded nor prepared psychologically to act in the international monetary order. In the past 10 years, the number of Asian bureaucrats in the Bretton Woods institutions has declined not just because of better career prospects at home, but also because they see little future for themselves in these institutions. There are very few think tanks in Asia dedicated to researching the international financial order.
The third question drawn from the present crisis reflects this parochialism: Is there a future for the international financial architecture? We have global markets but national mind-sets. So far, national responses to the crisis have been faster than regional or global responses. A major defect of the current international financial architecture is that even within Europe, initial reaction to the crisis was at the national level, rather than the global level. Everyone cared for their own banks. There was also insufficient coordination between the United States and Europe on the appropriate response regarding rescue efforts. This implies that we must strengthen domestic crisis management and response policies before we even begin to think about global policies.
One World, Three Paths
The financial crisis phase is passing, and the world has moved into the crisis management and resolution phase. The United States and Europe are doing whatever it takes to restore order. They have recapitalized banks, used fiscal policy to stimulate the economy, limited the foreclosure of mortgages, engaged in regulatory reforms, and have started to talk about the global architecture. Where do China and Asia fit in? I see three potential paths.
Although there are signs that there is some willingness to change, there is every chance that the status quo in the international financial order will continue. The reason is very simple. The vested powers in the majority shareholders in the G-7 countries will not want to let go of power, and the emerging markets are psychologically and institutionally not ready to share power. The 1944 Bretton Woods framework was essentially a trade-off between the opening up of global trade in exchange for finance for development under Pax Americana. There is currently little to trade off between the emerging markets and G-7 countries, because the surplus countries do not have anywhere other than the advanced markets to put their excess savings.
Under globalization, debt is the connectivity, but if power is unequal, the creditor is hostage to the debtor. In other words, I see relatively little change within the next five years to the present international monetary order. The advanced countries will ask the surplus economies to place more savings with the Bretton Woods institutions that will remain under the advanced countries' control. The IMF and World Bank will continue to lend to help emerging markets deal with problems stemming from their excessive reliance on external financing. The dollar and euro dominance will continue, and the balance between the two will depend on their respective geopolitical strengths. The IMF will be given more enforcement and surveillance powers, but its legitimacy to do so remains questionable until the quota structure is resolved.
The IMF quota issue, however, will not be resolved until the Europeans decide whether they should vote as one group or whether individual countries will still maintain huge voting power relative to emerging markets. For example, Belgium, which has a population of 10 million, has almost the same voting power (2.13%) as China, which has a population of 1.3 billion (2.94%), and as Brazil and Mexico, which have a combined population of 300 million people (2.61%).
Emerging markets would do well to get their own financial-stability infrastructure in place, namely a domestic Financial Stability Forum, comprising all the relevant players, including standard-setters and the private sector. Each member of the domestic FSF will need to understand the financial interconnectivity domestically and internationally. Hence, a strong global network must begin with strong and resilient domestic networks.
The Rise of Regional Markets
The second scenario, which would take 10 years to unfold, involves the creation of strong regional markets. Because Asia is being blamed for its surplus savings2, then Asia must accelerate the program of building strong regional markets to finance all the social infrastructure and environmental adjustments that Asia needs.
The global imbalance will shrink dramatically as the U.S. economy adjusts. The surplus of the emerging markets will also shrink, possibly faster than conventional wisdom would suggest. There are several reasons why this will occur. The first is that as real interest rates increase to reflect higher risks, world growth will slow down despite attempts to reflate growth. The second is that the current phase of deleveraging will continue as banks have to recapitalize; therefore, the level of capital flows, market turnover, and general volatility will decline in the medium term. The third is that the post-crisis shocks will lead to greater inward-looking policies, a higher level of regulation, and risk aversion in terms of investments. All this suggests that the emerging markets will adjust back to a basic balance more quickly than anticipated.
Under this scenario, those emerging markets that take the opportunity to strengthen their domestic financial systems, improve domestic corporate governance, develop their social infrastructure, and maintain social stability will be the major winners. Pension and mutual funds in advanced countries and surplus emerging markets will still have to park their savings in markets with high growth potential that offer stability in property rights.
But building strong domestic financial markets is easier said than done, and it will take time. This is because emerging markets can no longer simply replicate a wholesale banking model that has proven to be fragile. One of the side effects of the current crisis is that it has forced a complete rethinking of how emerging-market financial structure should be deepened to build in high levels of efficiency, robustness, and transparency, without incurring excessive levels of government intervention. In other words, it requires a complete overhaul of the current forms of domestic governance.
Here, strengthening of domestic markets is still key and a precondition to stronger global markets. But national strengthening is really a building block to regional strengthening, as economic geography still counts. South-South dialogue between emerging markets would increase because of lack of willingness of the present powers to change the status quo. Within Asia, there will be greater monetary and financial cooperation, not ruling out a regional currency arrangement. Ministries of finance, central banks, and financial regulators would meet regularly within each region and support deliberations at the global level. These regional discussions would form the basis for future regional cooperation.
It is possible that the G-7 countries may concede to some power-sharing in the Bretton Woods institutions in order to coordinate policies to address the global imbalance. This will certainly come in the form of greater pressure on exchange-rate revaluation for the emerging markets, particularly China. My view is that exchange rates matter less than real total factor productivity growth. As long as a country's total factor productivity is growing, changes in the nominal exchange rate should stably adjust to reflect such changes. For example, global imbalance will be adjusted partly through a gradual increase in Asian exchange rates as a bloc against the U.S. dollar and the euro.
Romance of the Three Regions?
If, as I expect, that regionalism will be the outcome of the current crisis, then within the next two decades, the global monetary and financial architecture will be radically different from what it is today. By then, there will be at least three global reserve currencies contending for hegemony.
Notice that I have not specified what the third reserve currency would be. Within Asia, it could be the Japanese yen, the Chinese renminbi, the Indian rupee, or even an Asian currency that includes large components of Korean, Middle Eastern, and ASEAN currencies. In Latin America, it could be the Brazilian real or Mexican peso that forms the core of the region's currencies. Given the complex politics in each region itself, it is not clear which and how these currency arrangements will emerge.
Nevertheless, because Asia remains a dynamic, fast-growing region, there is no doubt that for regional growth to be stable, some form of monetary cooperation and a regional financial market is inevitable. When it happens, diversified global portfolios will comprise a more equal distribution of assets at the geographical level, so that investors are not exposed excessively to only one or two major currencies, but at least three, if not four, global reserve currencies and related assets. The competition for resources in this more equal environment would offer better choice for investors globally.
Having studied financial crises almost all my life, I come to the conclusion that crisis is ultimately political in nature. Even if it erupts as a financial crisis, its resolution is inevitably political because the distribution of losses is highly arbitrary and controversial. Ultimately, all financial crises are crises of governance. Financial crises prove that financial engineering cannot create perpetual prosperity. It takes good governance--at the corporate, financial, and social level--to generate long-run sustainable stability. All crises have to be solved by governments, and if not satisfactorily, by the next government.
Finance must serve the real sector. The three key functions of financial sector are to protect property rights, reduce transaction costs, and have high transparency. These are Western concepts that were not understood well within the Asian experience. But Asians do have the advantage of being pragmatic and have deep historical and cultural wisdom to accept the facts of life and adjust accordingly. Asians have to recognize that we live in an interdependent world, and that we need to cooperate to live in an increasingly small and fragile planet. We have national rights, as well as global responsibilities. How we move forward will depend on all our fountains of patience and understanding to listen to other views and, hopefully, find the right way forward.
Andrew Sheng is adjunct professor at the Graduate School of Economics and Management, Tsinghua University, Beijing, and the University of Malaya, Kuala Lumpur. His book, From Asian to Global Financial Crisis: An Asian Regulator's View of Unfettered Finance in the 1990s and 2000s (Cambridge University Press), will be published in September.
Footnotes: 1 Angus Maddison, Contours of the World Economy, 1-2030AD, Oxford University Press, 2007. 2 There is a current tide of Western economists, led by Federal Reserve chairman Ben Bernanke, who blame the savings glut in East Asia for the excessive high liquidity that provided conditions for the asset bubble and subsequent deterioration in credit quality. See Ben Bernanke, "The Global Saving Glut and the U.S. Current Account Deficit," Remarks by the Governor of the Federal Reserve Board at the Sandridge Lecture, Virginia Association of Economics, Richmond, Va., March 10, 2005.