Global Trends by Martin Khor

Monday 13 April 2009

Re-regulating the financial markets

The global economic crisis was partly caused by de-regulation of the financial markets.  What should be done to re-regulate finance and restore economic development was the subject of an interesting conference in Beijing last week.

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The global financial crisis and what to do to tame the financial sector so that it serves development needs was the subject of an interesting conference in Beijing last week. 

The meeting on “Re-regulating global finance in the light of the global crisis” was organized by IDEAS (International Development Economics Associates) and Tsinghua University.   

The closing panel on new directions in regulation brought out the views of a good range of policy makers, international organizations and scholars.

Mr. Y.V. Reddy, former Governor of India’s Central Bank, said that many of the important Central Bankers were aware of and had warned about the risks of imbalances and excessive liquidity since 2005.  However, the financial markets’ response was that the markets should be left to their own to fix the prices and to correct themselves, so the authorities should not interfere.  Many central bankers bought this argument, and thus there was no policy action.

Secondly, central bankers had the feeling that the risks were widely dispersed, although they did not know where the risks lay. By and large they believed the banks were well regulated and did not pose a risk, while hedge funds may be involved in risky activity, but there was no problem with the system overall. 

One major factor for the crisis was that there was a “comprehensive regulatory capture” in some important countries. In the excessive expansion of the finance sector and the excessive profits, the links between finance and governments became very clear.  The media and market analysts became part of the capture.  The model promoted was self regulation.  This led to a vicious circle of less and less regulation. 

Reddy said that with the crisis, new directions in regulation are needed.  So far this is discussed mainly as a technical response to the crisis. Whether the old model will be diluted depends on the extent to which the regulatory capture will be diluted.

On “financial innovation”, it is important to distinguish between what kinds of innovation are bad and risky and what are good. On macroeconomic policy, it is important for developing countries to have the space to undertake counter-cyclical policy. To do so, a developing country has to have autonomy of finance policy and to decide on how open a capital account (in which there are autonomous capital flows) to have.

Reddy added that there should be a policy on financial conglomerates.  If institutions are allowed to become too large, they are seen to be “too big to fail”, and this allows them to behave in a irresponsible manner. The conclusion is that institutions that are too big to fail should not be allowed.

Prof. Yu Yong Ding, director of the Institute of World Economy at the Chinese Academy of Social Sciences said that the crisis is a turning point in globalization, and the next 10 years will be different from the past 20 years.

China faces two big issues.  One is the slowdown of the economy, with huge unemployment.  It had exposed the limits of the present growth strategy which has been driven by exports and a high investment rate (amounting to 43% of GNP).  The economy now faces over-capacity.

The second is how to handle the country’s vast foreign reserves, much of which is in US treasury bills that earn little returns and that faces the danger of falling value if the US dollar depreciates.  This had led to the Chinese premier asking the United States for assurance for the safety of China’s reserves and to the proposal by the Central Bank to set up a new global reserves system.

Dr. Jomo Sundram, United Nations Assistant General for economic and social affairs, said the UN should play a central role in addressing the crisis because of its universal membership and legitimacy, but asked whether it would be allowed by the big powers to lead.  It was important to ensure that a debate on regulation is not just on financial stability but also about the development and equity aspects of finance.

Dr. Yilmaz Akyuz., former chief economist at UNCTAD, said that Asia had been hit by a third cycle of surge-and-withdrawal of capital flows. There was a surge of capital inflows after 2002.  During that boom many Asian countries’ central bankers and governments had various responses, including liberalizing inflows to capital markets, and intervening through market operations to avoid swings in their currency levels, and liberalizing resident’s capital outflows to relieve the pressure of excessive inflows. 

These responses allowed freer capital flows rather than regulate them, and Asia became more integrated into the world financial system than before their 1990s crisis. There were greater capital inflows, greater foreign presence in the countries’ financial sector, and increased foreign assets in the countries’ institutions’ portfolios.  They were thus more  vulnerable when the bubble burst.  The foreign inflows reversed, while it is difficult to get the outflows by residents in good times to return in bad times.

Akyuz urged developing countries to think again on the issue of national regulation of capital flows.  While there should be advocacy for global mechanisms, these are not substitutes for sound domestic policies on capital flows and exchange rates.

Arturo O’Connell, board member of Argentina’s Central Bank, said that at the international level, there is still no agreement on how good are capital flows to developing countries. It is important to defend the case for governments to be able to have exchange controls of different kinds.  The aim should be to avoid incoming speculative flows and also to be able to have controls on outflows (for example which Iceland is now imposing, or that Argentina has had since 2002).

On stronger financial regulations, O’Connell said there is a lot of lip service about the failure of financial markets and that something should be done. The basic rationale of such proposals is that the financial sector has not worked in the interests of the whole economy, there are repeated market failures with spillover effects  State intervention is very crucial to manage the system.  O’Connell said that besides lip service, it remains to be seen how far the needed strong regulations will be put in place.

Like Reddy, he warned about “regulatory capture”, citing an article by a prominent former IMF senior official who charged that the finance industry had captured the US government, and that we have to break the financial oligarchy that is blocking reform. 

Prof. Prabhat Patnaik, vice-chairman of the Kerala State Planning Board and a university academic in India, said that finance can accentuate booms and slumps through creating bubbles and the bursting of the bubbles. In a slump, if there is an external prop, the slump can be made less severe. There was such a prop (the opening up of colonial territories) prior to World War I and after World War II (with Keynesian demand management arising from pressures from labour) but not during the 1930s slump which is why there as such an acute depression.

In the present crisis, there is no external prop.  There should thus be state intervention to take on international finance capital, said Patnaik One way is for each country to undertake fiscal policies, but the better way is for coordinated action among states, for example coordinated expansion of expenditure of major countries in the areas of welfare, wages and social security.