The financial crisis, the London Summit and Developing Countries

Another one that's actually from Rob, with me as proof-reader and editor.

On 2 April 2009, leaders from the G20 countries (19 of the world’s largest economies plus the European Union) and guest countries invited by the host Prime Minster Gordon Brown will meet in London to discuss the global economic slowdown.

Against the backdrop of worst economic crisis since the Second World War, central bank governors and Ministers of Finance will come together to discuss coordination of global economic policies needed to restore global economic health.

They will discuss what policies are required to stabilize the financial markets and actions needed to reform and strengthen the global financial and economic architecture to put the global economy back on track. So where should they start from?

Any reform of the prevailing economic and financial system should start with addressing the root causes of the current economic crisis.

As has been well-documented, and as I highlighted in an earlier post, the financial crisis started in America with excess liquidity in the money markets being invested in high risk financial instruments (Mortgage-backed securities) to earn higher returns in a low yield environment.

However, the crisis which began in America, has spread to the rest of the world and in doing so, it has exposed some deficiencies within the global economic and financial system that precipitated it.

Dr Yilmaz Akyuz (formely chief economist UNCTAD) in a presentation at the South Centre on 13 March 2009 identifies some of the key systemic defects in the current architecture that have created recurrent financial instability and crises in the monetary and financial systems.

According to the Dr Akyuz, there are three interdependent sources of international monetary and financial instability that any international reform should start by readdressing.

These are “(1) Policies in systemically important countries, including some of the larger emerging economies, (2) problems inherent to an international reserve system based on a national currency, and (3) unregulated financial and currency markets”.

The current economic crisis was partially created by unilateral macroeconomic, exchange rate and financial policies followed by strategically significant countries over the last decade or so.

Key macroeconomic policy pursued in the USA and within some parts of the European Union was markedly different to that pursued in the large emerging economies of Asia which focused on export oriented growth and reserve boosting policies after the Asian crisis in the late 1990s.

This created imbalances within the system that indirectly helped to trigger the crisis. The IMF which has the de jure obligation to carry out surveillance of macroeconomic policies and exchange rates had failed to impose any telling discipline over its non-borrowing member countries choosing instead to focus on lending to developing countries.

Paradoxically, policymakers within the advanced economies and emerging markets have been able to pursue diverging policies because the international reserve system is based on a single national currency (the dollar). Dr. Akyuz points out “this is a system which is inherently unstable because it depends on the reserve country running a current account deficit in order to fund world reserves”.

The system is negatively affected by the pro-cyclical behaviour of the financial markets and capital flows (which compels developing countries to hold large stocks of dollar reserves) and macroeconomic and exchange rate policy indiscipline in the systemically important countries.

Concerning the pro-cyclical behaviour of financial markets, Dr Akyuz suggests the establishment of an International Lender of Last Resort (ILOFLR).

However, as he points out “.. this is neither feasible nor desirable. It would not address the question of global financial instability and may even aggravate it further by encouraging imprudent lending and investment”.

He proposes more consideration be given to establishing a genuine international reserves system that is based on Special Drawing Rights. Such a system would have the advantage of costs being incurred only when used.

In the upcoming summits, one of the key topics of discussion will no doubt be the regulation and supervision of financial markets and capital flows. The current financial crisis is testament that financial markets cannot be left to self regulate.

It is evident from the current crisis that the adverse global spillovers arising from the financial sector in developed countries can be equally as damaging if not more damaging than those arising from trade policies, however, unlike trade, international financial activities are not subject to multilateral discipline.

In order to reform of the international financial and economic architecture governments will need to consider the introduction of new multilateral arrangements and mechanisms or strengthen existing ones to correct this deficiency.

To this end Dr Akyuz highlights three regulatory systems;

• A fully fledged system World Financial Authority (WFA);
• a selective approach in which international supervisory bodies for large trans-national banks and credit rating agencies would supervise and oversee that the agreed standards and rules were adhered to; and
• an eclectic approach which would expand the mandate and improve on the governance of existing bodies such as Financial Stability Forum, Bank of International Settlements, the Basle Committee on banking.

He points out the WFA and the selective approach would be constrained by complex issues of national sovereignty and the power of international regulatory bodies` vis-à-vis national regulators and as such would be resisted by developing countries.

For Developing Countries (DCs) the WFA and the selective approach also carry the added problem of one size fits all policies with uniform rules and regulations that would most likely be shaped by developed countries to meet the needs of their economies.

To make sure that any restructuring of the economic and financial architecture takes into account their needs, DCs will need to collectively develop an agenda on the reform of international financial markets, one which includes new modalities in reaching and implementing agreements on regulations, with a view to minimizing their vulnerability to external financial shocks.

For the upcoming G20 summit and the UN high–level conference on the financial crisis, Dr. Akyuz suggests DCs push forward an agenda that contains at least some of the following, without forgetting the long term systemic issues identified above:

• Eliminating pro-cyclical behaviour of international lenders to DCs;
• Increasing transparency and reporting for highly leveraged institution investing in DCs;
• Imposing regulation to eliminate pro-cyclical rating and bias against DCs borrowers/issuers and restrictions of their investment strategies to reduce the destabilising effects on exchange mechanisms;
• Recognising the rights of DCs to impose control over both inflows and outflows;
• Creating a statutory framework for temporary debtstandstills and capital flows in countries experiencing serious balance of payments problems; and
• Introducing an arbitration system for orderly and equitable restructuring and workout of sovereign debt for developing countries to both private and official creditors.

How much of this can be achieved is an open question. But if any genuine impact or resolution is going to arise from these processes then the needs of developing countries must also be taken into account. For as long the current imbalances remain the incentive to pursue unilateral policies will remain, further weakening an already shaky and unstable financial architecture.