The credit crunch and developing countries: the lessons for financial regulation

26 November 2008 13:00 - 14:15 GMT+00
Public event

Speakers:

Prof. Avinash Persuad - Chairman, Intelligence Capital

Prof. Willem Buiter - Chair in European Political Economy, London School of Economics and Political Science

Chair:

Larry Elliott - Economics Editor, The Guardian

Description

The global financial crisis has now stretched across the world, a crisis which emerged in developed countries has already spread to the developing world. Forecasts of growth in developing countries have been downgraded significantly in recent weeks even from those made two months ago. questions linger as to how deep and for how long these difficulties will stretch, which countries will be most affected and what are the channels through which the contagion might work? What will this mean for long term efforts to promote growth and poverty reduction in developing countries? Must the credit crunch turn into a development crunch, or can this be avoided? And how should policy makers and development officials respond?

This meeting looked at what the financial crisis has taught us about financial regulation.

    1. Professor Avinash Persaud outlined five points discussing the macroeconomic implications of the financial crisis for developing countries:
      1. Overview of the international banking regulation system;
      2. Where it failed;
      3. Lessons learned;
      4. Solutions to the crisis;
      5. What this means for banking and developing countries.
    1. The Basel committee created international banking regulation designed for large, systematically developed financial sectors. The international banking regulations were built on three pillars:
      1. First pillar: minimum capital requirement addressing risk;
      2. Second pillar: supervisory discretion;
      3. Third pillar: market discipline to promote greater transparency.
  1. Developing countries try to adopt these standards because they believe they would otherwise be at a competitive disadvantage.

    1. All three pillars failed completely due to three flaws during a period of belief in the market as good and government as bad:
      1. Use of market prices of risk;
      2. Introduction of high and common standards; and
      3. Use of common external credit ratings.
    2. Avinash Persuad learned three key lessons from the financial crisis:
      1. National taxpayers matter: they have important implications for offshore banking;
      2. Funding matters: the problem is not about assets but about how they have been funded. There is a need to regulate leverage;
      3. Complexity is encouraged by banking regulation: for example, credit ratings led to the use of complex financial instruments which allow banks to improve the credit rating of their loans and so to hold less capital.
    3. Possible solutions:
      1. Bank regulators are conscious that a key source of the failure to address, and a source of tremendous leverage is market failure.
      2. Developing countries and emerging markets are on track to adopt government regulations but afraid of being outside the standard. These countries should be empowered so they realise they may have different standards.
      3. Cross-border banking is important in financing trade. National banking must support trade.
      4. Whilst economies benefit from greater exposure and greater trade, finance is a difficult cost of a liberal financial system and as a result, banking failures have been substantial.
      5. There is need to regulate in the right way.
    1. Professor Willem Buiter discussed developing countries and emerging markets in the context of how the financial system has collapsed, how to reconstruct it, and the implications all over the world.
      1. Global growth is expected to be below two percent next year after remaining around four percent in the past. This is a global recession and every country will suffer. Slower growth will feed protectionism and hurt poor textiles exporters with unfair pricing mechanisms. Willem Buiter expects an improvement in the terms of trade for commodity importers as a result of the collapse in commodity prices and poorer countries will benefit as food importers. However, he expects a highly uneven distribution of the effects of the crisis.
      2. Remittances are a major channel through which the financial crisis will affect emerging countries. This will hurt countries from Albania, Bosnia-Herzegovina, Moldova and Tajikistan to Pakistan, the Philippines and the countries bordering South Africa. 
      3. Financial aid flows will be affected due to fiscal stresses. The political choice between bailing out local factories in rich countries versus sending out aid overseas will often favour the domestic constituency. Collapsing financial flows will be disastrous for emerging markets relying on foreign money and foreign direct investment, but will only indirectly affect the poorest countries.
      4. Barriers against both legal and illegal workers will affect labour flows and remittances.
      5. Willem Buiter hopes for a slightly more robust model of financial sector development in the process of reconstructing after deconstructing the financial system. Developing a robust domestic banking system comes first.  Then comes developing domestic capital markets.  International financial integration comes last.  Subsidiaries of foreign banks should be independently capitalised.  Branches of foreign banks should not be welcome. Capital controls should be maintained where they exists and may have to be strengthened or re-introduced. It is time to rethink international finance, but must not lose confidence in market-oriented decentralized institutions. Political failure and market failure go hand in hand.
    2. A question and answer period followed the presentations:
      1. Prompted by questions regarding the reintroduction of capital controls and the creation of tax havens, Willem Buiter suggested that capital controls in deloping countries should be reinstated where necessary; capital market integration between London and Paris made a common currency desirable.  Despite the absence of a common currency, capital controls between the UK and Paris are undesirable (as well as against the EU Treaties) and in the Eurozone and indeed the EU at large he would prefer to see a common regulator for border-crossing financial institutions. Tax havens (defined not by low taxes but by bank secrecy promote criminality – they are pirates’ lairs. Further in discussing possible alternatives to capital controls, he emphasized that tax havens that create further bank secrecy should be put out of business.

                                                                   i.      Avinash Persuad expressed that countries building an economic model to become competitive at tax need to work on a different type of competitive advantage than tax havens. Also, capital controls intimidate governments and lead them to say they are not possible. He stressed that market innovation does not rule out government innovation.

      1. In response to a question of whether or not it is time to return to Keynes’s original ideas as regards Bancor ( a common world currency) and a global central bank, Willem Buiter stated that Keynes is economically sensible but politically unfeasible without proper institutions. Keynes cannot be applied on a global level to create a global central bank without a global government.

                                                                   i.      Larry Elliott then noted that, before the original Bretton Woods agreement was signed, America was a surplus country and now is a deficit country and suggested that perhaps China is the new America.

                                                                 ii.      Willem Buiter stated that the weak currency countries always has to intervene and do the adjusting, not the stronger one.

                                                                iii.      Avinash Persaud pointed out that when Keynes pushed his ideas forward Great Britain became a surplus country. He then proceeded to list what went wrong: savings investment imbalances led to surplus countries viewing this for liquidity instead of thinking for future generation; the US believes that they are at the mercy of China, and existence of helpful but unused policy levers.

      1. Avinash Persaud stated that banks’ lawyers understand regulations better than bankers. Believing that all assets must be treated the same is a false perception. A common set of bank regulations would not work. Risk sensitivity rather than risk capacities must be assessed, and banking regulation to increase diversity will improve liquidity. Commonality rules destroy credit markets in emerging countries. Credit unions have the capacity for taking on risks.
      2. Willem Buiter stated that resources are hoarded by banks to avoid further recourse to the state and banks would currently rather lie low than lend because the risks are too great. He expects to see a nationalisation of most of the banking sector in the US and the UK before it gets better.
      3. The discussants were requested to present an ambitious set of financial regulations that would be advantageous for developing countries. Willem Buiter emphasized that different rules are needed for different countries. The developed world may return to a post-depression form of highly regulated public utility banking and a more losely regulated ‘investment banking’ sector, a form of Glass Steagall on steroids.  In the regulated sector credit unions, co-operative banks and mutual banks would be likely to play a role, alongside publicly owned banks.  He emphasized that we must make sure not to regulate names rather than risks. In the more lightly regulated investment bank sector the reappearance of entities too big to fail can do huge damage. Limiting size is draconian but he is unsure how to stop businesses from becoming too big to fail. He stressed keeping it simple in domestic banking.
      4. Considering that capital controls will probably make an appearance, Willem Buiter hopes not to also see a return to formal dual exchange rates that will make arbitrage too easy . Informal dual exchange rates will no doubt emerge (black marketa), but inflation targeting will be no different or easier with capital controls than without, makes no difference.
      5. Avinash Persuad addressed a question about possible alternative frameworks to securitization to increase lending in developing countries. He first stated that lending does not need to increase at this point, but many models may be developed to reduce credit monitoring costs, improve lending and to address whether the poor have access to it.
      6. A member of the audience pointed out that although developed countries cannot afford to support primary education, etc. the current bailout packages prove unavailable funding is simply a lack of political will.
      7. When asked, which emerging market is better placed than others for recovery, Avinash Persuad emphasized that emerging markets ran surpluses, and will benefit from consumption but it will take time to rearrange the economies to move from imported good to domestic good consumption. Willem Buiter suspects India is likely to do better than China in the short-term because China is much more open and has a large surplus that will have nowhere to go, but in the long-term India is overregulated and more inward looking than China.
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