Industry Talk 2010
The 2008/09 Credit Crisis: An Asian Regulator's Perspective

CSC-IBF Lecture on "The 2008/09 Credit Crisis: An Asian Regulator’s Perspective” Global Imbalance and Global Financial Architecture

The Institute of Banking and Finance and Civil Service College co-organized an industry lecture entitled The 2008/09 Credit Crisis: An Asian Regulator's Perspective featuring Datuk Andrew Sheng, Chief Adviser to the China Banking Regulatory Commission and Board Member of the Qatar Financial Centre Regulatory Authority and Sime Darby Berhad, Malaysia.

Post-Crisis Re-balancing of Economic Power and Growth

Datuk Sheng noted that in the post-crisis period, most economies were on either of two growth tracks - emerging economies were experiencing higher growth while advanced economies were experiencing lower growth rates due to deleveraging. He opined that the financial markets were reading too much into the recent economic recovery, which was more likely to be a technical recovery. This was expected, given the amount of financial stimulus that had been pumped into the system. A lot of recent debate revolved around whether need a 2nd stimulus package was needed to ‘keep the engine going’. Protectionism was also on the rise, and this was manifested in, for example, the pressure on China to appreciate the exchange rate.

Asian Crisis (97-98) vs Current Crisis (07-09)

There were a lot of similarities between the Asian financial crisis and the current crisis. For example, both crises involved excessive liquidity, large capital flows, carry trades and asset bubbles. Both crises had excessive leverage, excessive financial liberalization as well as lack of transparency and understanding of complex instruments. However, there was one main difference – back then, the West told Asia to raise interest rates and cut fiscal expenditure, but this time, Western governments did the opposite and increased fiscal stimulus.

Failures in the Financial Crisis

Datuk Sheng remarked that financial crises were attributable to a failure to recognize that micro behavior has macro effects, and macro decisions impact on micro behavior. He highlighted four specific failures in a financial crisis:

Datuk Sheng highlighted that in academia, economics wanted to be scientific, but adopted unrealistic assumptions about human behavior. In government, there was one global market but financial institutions were regulated under national laws. He also observed that many global banks were bigger than most regulators and were regulated by a minimum of 4 different regulators. Large multinational financial institutiosn could be regulated by a few hundred regulators, larger than most regulators.

As the US dollar was still the dominant reserve currency, the US enjoyed “exorbitant privileges”. As banker to the world, it earned higher spreads on recycling inflows from emerging markets. The US was not just the commercial banker, but also the investment banker to the world. In a way, not much had changed from colonial times. The current account deficit grew, financed by lower interest rates, which further encouraged financial engineering, which further drove speculation and leverage. The cycle ended when the Fed started raising interest rates too late in 2006.

Datuk Sheng remarked that the current crisis was an ‘Asian supply chain crisis” and a “network crisis”, which resulted from having 2 currency standards, the US dollar and the Japanese yen. During the crisis, volatility put huge stresses on the system and when a financial hub had a crisis, the whole network followed. For example, when the two largest hubs (London and New York) had a crisis and one of the largest prime brokers (Lehman Brothers) failed, then the whole supply chain was affected which led to the stoppage of global credit.

Global Mega-trends

Datuk Sheng outlined several global mega-trends:

Datuk Sheng observed three major issues – trade, jobs and global warming. Two crises were taking place simultaneously – the short-term financial crisis, and the long-term crisis which was global warming. He commented that the upcoming G20 meeting in Korea was important because it would be the first opportunity to have a more workable representative global governance model, but with the G20 fragmenting despite verbal agreement, he felt that a double-dip recession was likely.

Triffin Dilemma

He noted that the US was confronted with the “Triffin Dilemma”. As banker to the rest of the world, the US needed to print money and run a current account deficit. However as the rest of the world began to grow faster than the US, this became an unsustainable situation which unbalanced when the US started raising interest rates. The political economy had no will to stop false prosperity from bubbles and loose monetary policy. US failed to confront the Triffin Dilemma and overstretched itself. Although the household sector was blamed for the financial crisis, the real problem was in fact an over-leveraged financial system.

Datuk Sheng disagreed that the Fed’s low interest rate policy did not contribute to the global financial crisis. Other ‘high priests’ of finance such as Mervyn King have admitted that capital flows have risks.

Structural Problem of Global Financial Architecture

He commented that the present global financial architecture depended on the US maintaining fiscal and monetary discipline, but the “reverse Triffin” effect was causing bubbles in emerging markets through the zero-interest rate policy. Growing imbalances will lead to financial crises, asset bubbles and rising protectionism.

He noted that Western responses differed through the crises. For example, in 1997/98, the EU insisted on IMF solving the Asian crisis, yet they didn’t ask the IMF to solve the Greek problem Recently. He also observed that during the Asian crisis, Japan wanted to create an “Asian IMF”, but the US said that they should go to the IMF. But now, the US and Europe wanted to create their own fund.
Global Imbalances and the Effects

He further highlighted 3 main global imbalances – current account balances, foreign exchange reserves and national savings rate. He noted the trend of decreasing interest rate policies in the US, Europe and UK led to a common ailment - the ‘global erosion of monetary policy’, which created debt and equity bubbles.

In the post-crisis era, emerging markets were confronted with a policy dilemma. The build-up on emerging markets’ large foreign reserves, and the increase of US net liability to foreigners beyond 25% was not sustainable. He said that large capital flows (resulting from the dollar, yen and sterling carry trades) were causing bubbles in emerging markets. He commented that none of the emerging markets could tighten monetary policy without attracting huge capital flows, which posed a big dilemma.

One question was whether a stable or depreciating US dollar was good for long-term stability. If so, then the current US dollar reserve system should continue. If not, what model and how? A few scenarios had been proposed, e.g. Euro as the leading reserve currency, and a dual-reserve currency system (comprising US dollar and Euro). Depreciation of the US dollar will mean losers for the largest holders of USD foreign exchange reserves, such as China, Japan, UK, etc.

Datuk Sheng felt that current situation was untenable, a ‘collective action trap with no hard budget constraint’. In an environment of low interest rates, it was possible to postpone current payments to tomorrow and the cost to future generations. The US needed to have self discipline in exchange for its “exorbitant privilege”, since it could “tax” other stakeholders. Without US self discipline, the system is unstable and will lead to protectionism and fragmentation.

Will an International Currency Work?

Datuk Sheng cited Paul Volcker’s suggestion that “a global economy needs a global currency”, but this would necessitate a global central bank policy, global regulatory policy and a global fiscal policy. He commented that the huge fiscal deposits post-global financial crisis 2008 showed that a global fiscal policy is also necessary to overcome a global shock.

Role for the IMF in New Architecture

Datuk Sheng remarked that in the past, the IMF (along with the World Bank and BIS) had more of a surveillance function, rather than a lending or clearing function. He noted that the IMF’s current resources were too low relative to needs for global liquidity, as the total reserves of the 3 institutions were about US$1 billion, which was not even close to the capitalization of the largest financial markets.

He opined that it was probably easier to build a Regional Reserve System before building a Global Reserve System. He questioned having three dominant trading currencies, i.e. US dollar, Euro and Yen / Yuan or some Asian currencies, highlighting Governor Zhou’s suggestion to use the IMF’s Special Drawing Rights, a currency basket comprising of US dollars, Euros, yen and sterling, as an international reserve currency.

Datuk Sheng commented that Asia may be forced to move towards regionalism for self-protection. Post-Asian crisis, Asia was already on foreign exchange self-insurance and that it was already on an uncoordinated regional float. Much depended on the future of the Asian Global supply chain and China-Japan-ASEAN co-operation, and building on the Chiang Mai Initiative.

In conclusion, he suggested that Asia needed to begin building blocks for strong regional bargaining power in the global architecture, and push towards a common voice on the global platform.