Frontier issues on the global agenda
Emerging economy perspective:
The speech made by Dr Duvvuri Subbarao Governor of the Reserve Bank
of India as part of the 60th anniversary oration series of the Central
Bank of Sri Lanka.
As institutions, central banks go back several centuries. The first
central bank, the Riksbank in Sweden, was established in 1668, nearly
350 years ago. The Bank of
England came shortly thereafter in 1694. By
the turn of the century in 1900, there were only 18 central banks.
Today, there are around 180 central banks, a tenfold increase in the
last one hundred years.
In relative terms, both the Reserve Bank of India (RBI) and the
Central Bank of Sri Lanka (CBSL) are young institutions. RBI was
established in 1935, and we celebrated our platinum jubilee last year.
Apart from relative youth, there are several other similarities
between our two institutions. Both of us have a wider mandate than is
typical of central banks.
In addition to maintaining price stability and macroeconomic
stability, we both have responsibilities for currency management, debt
management and external sector management. More importantly, we also
have an obligation to calibrate our policies to promote the
socio-economic development of our peoples.
And in the wake of the crisis, we face the common challenge of
managing our policies, particularly preserving financial stability, in
the face of globalization.
India and Sri Lanka are not just geographic neighbours; we have deep
social, cultural and economic links that go back several centuries. And
as we navigate an increasingly complex world, we face a number of
similar opportunities and challenges.
We are both fast growing emerging economies; we aspire to raise our
growth rates to double digits, and want to efficiently translate that
rapid growth into poverty reduction. We also have to manage our
‘inclusive growth’ strategies in the face of globalization.
Experience shows that globalization offers incredible opportunities
but also poses immense challenges. If the years before the global
financial crisis – the period of the so called ‘Great Moderation’ –
demonstrated the benefits of globalization, the devastating toll of the
crisis showed its costs.
As emerging market economies (EMEs), we cannot withdraw from
globalization. That is neither feasible nor advisable. We have to
confront globalization head on, but manage it in such a way that we
exploit the opportunities and mitigate its costs. Surely, we have our
concerns about the forces of globalization and how they might impact us.
Many of these issues are on the global agenda that the G-20 is
deliberating upon.
G-20
I attended a meeting of the G-20 Finance Ministers and Central Bank
Governors in Paris in mid-February 2011. Apart from the specific issues
on the agenda, what impresses me about the G-20 forum is its group
dynamics driven by two underlying convictions. First, that global
problems cannot be solved without global cooperation and that
uncoordinated responses will lead to worse outcomes for everyone, and
second, that solutions to global problems are sustainable only if they
reflect also the EME perspective.
I thought the way I can best add value to this series of orations is
to focus my remarks on the EME perspective on issues on the global
agenda.
Emerging market economies in the global context
Dr Duvvuri Subbarao |
Fifty years from now, when historians look for the defining features
of the first decade of the 21st century, they will probably mark the
rise of worldwide terrorism, the deepening of the internet culture and
the devastating global financial crisis. Whether the emergence of EMEs
as a group will rank pari passu with those others will depend on what
EMEs achieved in the last decade, but importantly also on how they
consolidate those gains in this decade and beyond.
Before I go on to specific issues, let me make a brief comment on
EMEs in the global context. The sift in the global balance of power in
favour of EMEs is by now a familiar story. Some broad trends will show
what a remarkable shift this has been.
Setting GDP at 100 in the base year of 2000, the following chart
shows the aggregate growth in the decade 2000-10. Against the aggregate
growth of 17 percent of advanced economies, emerging market and
developing countries (EMDCs) grew by 82 percent and BRICs (Brazil,
Russia, India, China) by a whopping 127 percent.
When we look at shares in global GDP, the growing dynamism of EMEs
becomes even more persuasive.
The share of advanced economies in the global GDP dropped from 80
percent in 2000 to 67 percent in 2010 with a mirror increase in the
share of EMDCs. Quite expectedly the share of BRICs increased more
impressively from 8 percent to 17 percent.
By all accounts, the world has recovered from the financial meltdown
and the follow on recession much sooner than we had feared at the depth
of the crisis. The recovery is all the more remarkable because global
income, trade and industrial production fell more sharply in the first
twelve months of this crisis than they did in the first twelve months of
the Great Depression.
In its latest World Economic Outlook (WEO – January 2011), the IMF
estimated global growth for 2010 of 5.0 percent, this marks a surprising
upward revision from its earlier projection of 4.8 percent made in
October 2010. EMEs, contributing nearly half of this growth, have
clearly been the engine of this recovery. EMEs have also been the motive
force behind the estimated expansion of world trade at 12 percent in
2010, an impressive reversal from shrinkage of 11 percent in 2009.
Two FAQs
This post-crisis scenario, marked by the faster recovery of EMEs,
throws up two frequently asked questions relating to EMEs in the global
context. The first is whether EMEs will be able to sustain global growth
at near pre-crisis levels even if advanced economies continue to
languish.
People who put this question, I believe, are doing so as a rhetoric –
to encourage analytical thinking rather than to solicit an affirmative
answer. Sure, multiple growth poles are a safety-net for the whole
world, but to expect EMEs, by themselves, to lift global growth to
former levels will be unrealistic. Note that EMDCs account for less than
half of world GDP even when measured at PPP valuations, and only about a
third of the world trade in goods and services.
The second question about EMEs in the global context relates to
decoupling. The decoupling hypothesis held that even if advanced
economies went into a downturn, EMEs would not be affected because of
their improved macroeconomic management, robust external reserves and
resilient financial sectors.
The crisis failed to validate the decoupling hypothesis as all EMEs
were affected, admittedly to different extents. What the crisis, in
fact, reinforced is that the economic prospects of advanced economies
and EMEs are interlinked through trade, finance and confidence channels.
Even as the decoupling hypothesis gained intellectual credence in the
pre-crisis years, it was never very persuasive in the face of
globalizaion. In fact, recent research within IMF shows that the
detrended aggregate output growth of EMEs has strong association with
the aggregate output growth of advanced economies, and that this
‘association’ has in fact increased over time, evidencing not only that
the coupling is strong but that it is getting stronger. Sure, in recent
years EMEs have been less affected by recessions in advanced economies
owing to improved policy framework, more effective macroeconomic
management and growing intra-EME trade. But over an entire cycle, the
economic prospects of EMEs remain firmly coupled with those of advanced
economies.
In an increasingly globalizing world, advanced economies and EMEs are
dependent on each other, and going forward, both have big challenges in
terms of sustaining growth, containing inflation and reducing
unemployment. By far the biggest challenge for EMEs will be to convert
high growth into poverty reduction. Against that backdrop, let me
proceed to look at some of the issues on the global agenda from the EME
perspective.
Global rebalancing
The first issue I want to address from the EME perspective is global
imbalances. No crisis as complex as the one we have gone through has a
simple or a single cause. We now have a fairly good idea of the multiple
causes of the crisis and almost everyone is agreed that one of the root
causes of the crisis is the build up of global imbalances. In as much as
global imbalances – no matter whether they were caused by a ‘consumption
binge’ in advanced economies or a ‘savings glut’ in EMEs – were the root
cause of the crisis, reducing imbalances is a necessary condition for
restoring global financial stability.
The post-crisis debate on global imbalances has three interrelated
facets. The first is the role of exchange rates in global rebalancing.
The second relates to capital flows into EMEs raising the familiar
challenge of managing the impossible trinity. And the third facet is the
framework for the adjustment process. Let me turn to these one by one.
Role of exchange rates
First, on the role of exchange rates - a prime lever for redressal of
external imbalances. Global rebalancing will require deficit economies
to save more and consume less.
They need to depend for growth more on external demand which calls
for a real depreciation of their currencies. The surplus economies will
need to mirror these efforts - save less and spend more, and shift from
external to domestic demand.
They need to let their currencies appreciate. The question boils down
to what can surplus countries do domestically to increase consumption
and what can deficit countries do domestically to increase savings. The
problem we have is that while the adjustment by deficit and surplus
economies has to be symmetric, the incentives they face are asymmetric.
Managing currency tensions will require a shared understanding on
keeping exchange rates aligned to economic fundamentals, and an
agreement that currency interventions should be resorted to not as an
instrument of trade policy but only to manage disruptions to
macroeconomic stability.
Capital flows
That takes me to the second facet of global imbalances - return of
lumpy and volatile capital flows. Since capital flows have become such
an emotive topic around the world in recent months, it is important
perhaps to recall a few realities.
First, that EMEs do need capital flows to augment their investible
resources, but such flows should meet two criteria: they should be
stable and be roughly equal to the economy’s absorptive capacity.
The second reality that we must remember is that capital flows are
triggered by both pull and push factors. The pull factors are the
promising growth prospects of EMEs, their declining trend rates of
inflation, capital account liberalization and improved governance.
The push factors are the easy monetary policies of advanced economies
which create the capital that flows into the EMEs. What this says is
that international capital flows comprise a structural component and a
cyclical component. It is the cyclical component that typically disrupts
the macroeconomic stability of EMEs.
That said, the multi-speed recovery around the world and the
consequent differential exit from accommodative monetary policy have
triggered speculative capital flows into EMEs.
The most high profile problem thrown up by capital flows, in excess
of a country’s absorptive capacity, is currency appreciation which
erodes export competitiveness.
Intervention in the forex market to prevent appreciation entails
costs. If the resultant liquidity is left unsterilized, it fuels
inflationary pressures. If the resultant liquidity is sterilized, it
puts upward pressure on interest rates which, apart from hurting
competitiveness, also encourages further flows.
Currency appreciation is not the only problem arising from the ultra
loose monetary policy of advanced economies. Speculative flows on the
lookout for quick returns can potentially lead to asset price build up.
The assurance of advanced economies to keep interest rates
‘exceptionally low’ for ‘an extended period’ has also possibly triggered
financialization of commodities leading to a paradoxical situation of
hardening of commodity prices even as advanced economies continue to
face demand recession.
EMEs have been hit by hardened commodity prices through inflationary
pressures, and in the case of net commodity importers, also through
wider current account deficits.
EMEs have dealt with the problem of excess flows in diverse ways
depending on their macroeconomic situation.
This has broadly taken one of several forms: controlling capital at
entry, taxing it on entry or intervention in the forex market.
Such measures would have attracted criticism in the past as they went
against the broad economic orthodoxy that market forces should not be
resisted. The crisis has changed the terms of that debate. It is now
broadly accepted that there could be circumstances in which capital
controls can be a legitimate component of the policy response to surges
in capital flows.
Managing capital flows should not be treated as an exclusive problem
of EMEs. In as much as lumpy and volatile flows are a spillover from
policy choices of advanced economies, the burden of adjustment has to be
shared. How this burden has to be measured and shared raises both
intellectual and practical policy challenges.
Our current theory of external sector management draws from an
outdated regime of fixed exchange rates and limited capital flows when
the task was largely limited to managing the current account of the
balance of payments. What we now need is a theory that reflects the
changed situation of flexible exchange rates and large and volatile
capital flows.
The intellectual challenge is to build such a theory that encompasses
both current and capital accounts and one that gives a better
understanding of what type of capital controls work and in what
situations. What is the practical challenge? The practical challenge is
that once we have such a theory, we need to reach a shared understanding
on two specific aspects: first, to what extent are advanced economies
responsible for the cross border spillover impact of their domestic
policies and second, what is the framework of rules that should govern
currency interventions in the face of volatile capital flows.
G-20 framework for global growth
The third facet under global imbalances is happily not actually a
problem but an approach to a solution. At the Pittsburgh Summit in 2009,
the G-20 committed itself to a new “framework of strong, sustainable and
balanced growth” as also on a “Mutual Assessment Process” (MAP) to
determine the degree to which G-20 macro policy actions are
‘collectively consistent’ when examined together.
The framework and its assessment should ensure that individual
actions of countries add up to a coherent path forward.
The framework essentially consists of identifying a few indicators
and the guidelines against which these indicators for each of the
countries will be assessed.
At the Paris meeting of the G-20 in mid-February, there was an
agreement on the broad indicators that will aid us to focus, through an
integrated two-step process, on those persistently large imbalances
which require policy action.
It was also agreed to decide on the guidelines for assessing the
indicators by the next meeting of the G-20 scheduled for April 2011.
The G-20 Mutual Assessment Process is a potentially promising
mechanism to facilitate timely identification of disruptive imbalances
and to ensure that preventive and corrective action is taken in time.
Needless to say, global cooperation is vital for the success of MAP.
Global reserve currency
The global crisis has revived the familiar concerns about the
robustness of the international monetary system, and in particular about
the global reserve currency and the provision of liquidity in times of
stress.
The system we now have is that the US dollar is the world’s reserve
currency by virtue of the dominant size of the US economy, its share in
global trade and the preponderant use of dollar in foreign trade and
foreign exchange transactions.
And as Barry Eichengreen tells us in his latest book on the story of
the dollar, the reserve currency status depends also on a host of
intangible factors such as strategic and military relationships, laws,
institutions and incumbency. In line with the Triffin paradox, the US
has met the obligation of an issuer of reserve currency by running
fiscal and external deficits while enjoying the ‘exorbitant privilege’
of not having to make the necessary adjustment to bridge the deficits.
With no pressure to reduce the deficit, a dominant economy can
potentially create imbalances at the global level as indeed happened in
the build up to the crisis.
An argument can be made that even in the context of a single reserve
currency, global imbalances are not inevitable. The US could not have
run persistent deficits had not the EMEs provided the demand side
impetus by accumulating reserve assets either for trade advantage or as
a measure of self-insurance against external shocks.
The problem with the world having only a single reserve currency came
to the fore during the crisis as many countries faced dollar liquidity
problems as a consequence of swift deleveraging by foreign creditors and
foreign investors. Paradoxically, even as the US economy was in a
downturn, the dollar strengthened as a result of flight to safety.
Based on the experience of the crisis, several reform proposals have
been put forward to address the problems arising from a single reserve
currency.
One is to have a menu of alternative reserve currencies. But this
cannot happen by fiat. To be a serious contender as an alternative, a
currency has to fulfill some exacting criteria. It has to be fully
convertible and its exchange rate should be determined by market
fundamentals; it should acquire a significant share in world trade; the
currency issuing country should have liquid, open and large financial
markets and also the policy credibility to inspire the confidence of
potential investors. In short, the exorbitant privilege of a reserve
currency comes with an exorbitant responsibility.
A second solution to a single reserve currency is to develop the SDR
as a reserve currency. This does not seem to be a feasible option. For
the SDR to be an effective reserve currency, it has to fulfil several
conditions: the SDR has to be accepted as a liability of the IMF, has to
be automatically acceptable as a medium of payment in cross-border
transactions, be freely tradeable and its price has to be determined by
forces of demand and supply.
A third suggested solution aims at reducing the need for
self-insurance and thereby the dependence on a reserve currency by
supporting a multilateral option of a prearranged line of credit that
can be easily and quickly accessed. Such a multilateral option is
necessary as a complement to self-insurance but it cannot be a
substitute; some measure of self-insurance will continue to be the first
line of defence.
None of the above solutions fully addresses the problems arising from
a single global reserve currency. What this underscores is that at the
global level we need to explore these and other options for protecting
ourselves from the vulnerabilities that we confront as a consequence of
a single reserve currency.
Protectionsim
In the post-crisis world, there may not actually be ‘deglobalization’
but the earlier orthodoxy that globalization is an unmixed blessing is
being increasingly challenged.
The rationale behind globalization was, and hopefully is, that even
as advanced countries may see some low end jobs being outsourced, they
will still benefit from globalization because for every low end job
gone, another high end job - that is more skill intensive, more
productive - will be created. If this does not happen rapidly enough or
visibly enough, protectionist pressures will arise, and rapidly become
vociferous and politically compelling.
Recent international developments mark an ‘ironic reversal’ in the
fears about globalization. Previously, it was the EMEs which feared that
integration into the world economy would lead to welfare loss at home.
Those fears have now given way to apprehensions in advanced economies
that globalization means losing jobs to cheap labour abroad.
There is concern in some quarters that even as open protectionism has
been resisted relatively well during the current crisis, opaque
protectionism has been on the rise. Opaque protectionism takes the form
of resorting to measures such as anti-dumping actions, safeguards,
preferential treatment of domestic firms in bailout packages and
discriminatory procurement practices. Experience shows that countries
resort to restrictive trade practices in areas not covered by
multilateral rules or by exploiting the lack of specificity in certain
rules.
To strengthen multilateral trade discipline, the need for a quick
conclusion of the Doha Round can hardly be overemphasized. In a world
with growing worries about the debt creating stimulus packages, a Doha
Round agreement should be welcomed as a non-debt creating stimulus to
the global economy.
The most familiar form of protectionism is trade protectionism
operationalized through tariffs and controls. There can be other forms
of protectionism as well.
Martin Wolf talks about what he calls ‘macroeconomic protectionism’
which is an attempt by a country to shift inadequate aggregate demand on
to its own output. The efforts of several countries around the world in
recent times to resist currency appreciation is a manifestation of
macroeconomic protectionism.
Another form of protectionism is ‘financial protectionism’. What is
financial protectionism? It is a situation where countries impose
controls increasingly not on capital inflows but on capital outflows. In
a recent op-ed piece in the Financial Times, Richard Dobbs and Michael
Spence argue that “the 30-year era of progressively cheaper capital is
nearing an end.
The global economy will soon have to cope with too little capital,
not too much.” Their thesis is that even as investment needs of EMEs,
especially in infrastructure will grow, global savings will not rise in
step because of several factors: ageing populations who will spend
rather than save, increased expenditure on adapting to climate change
and large economies like China rebalancing towards consumption rather
than saving.
This will make capital scarcer and raise long term interest rates for
corporates and consumers. The question is, will the savings constraint
be so large as to push countries into restricting capital outflows as a
defence against rising interest rates at home? If yes, we will have to
brace for financial protectionism in the years ahead.
The short point is that in the years ahead, the pressures for
protectionism will mount and protectionism will also take new forms.
Global welfare will be maximized when collectively we resist short-term
pressures and put our long-term interest ahead of narrow short-term
advantage.
Financial Sector Reforms
Received wisdom today is that financial deregulation shares the
honours with global imbalances as being the twin villains of the recent
crisis.
It should not be surprising therefore that vigorous reforms in the
financial sector are under way. The Basel III package finalized by the
Basel Committee on Banking Supervision (BCBS) has since been endorsed by
the G-20 at its Seoul Summit last November. Broadly, these reforms will
require banks to hold more and better quality capital and to carry more
liquid assets, limit their leverage and will mandate them to build up
capital buffers in good times that can be drawn down in periods of
stress.
Another crisis driven initiative has been to expand the erstwhile
Financial Stability Forum into a Financial Stability Board (FSB) by
giving representation to EMEs.
The FSB has been working on a number of initiatives including
managing the moral hazard associated with systemically important
financial institutions (SIFIs) through more stringent regulatory and
supervisory norms, principles to guide compensation of bank managements,
a single set of accounting standards and regulation of OTC derivatives,
credit rating agencies and hedge funds.
There are also several areas where substantial work needs to be done
including in improving resolution regimes for cross-border banks and
systemically important non-bank financial companies, addressing the
procyclicality of the financial system, and macro-prudential
surveillance. We also need an approach for extending the prudential
norms on the lines of Basel III to the shadow financial system which lay
at the heart of the recent financial crisis.
The financial sector reform agenda is driven by the need to prevent
the type of excesses in the financial sectors of the advanced economies
that led to the crisis. Even so, EMEs too will have to fall in line and
implement these reforms. Some of these reforms entailing higher capital
and capital buffers will make the financial sector safer, but they come
at a cost and pose implementation challenges. Let me expand on this a
little.
Both the Bank for International Settlements (BIS) and the IIF have
come out with some preliminary estimate of the macroeconomic impact of
the Basel III package.
The Basel Committee too is carrying out an extensive impact
assessment study. EMEs will need to supplement that with their own
self-assessments to more accurately determine the impact of the new
norms on their financial and monetary systems.
In all likelihood, EMEs will see the cost of credit going up at a
time of growing credit demand arising from strong growth, structural
transformation of the economy and financial deepening. The challenge for
EMEs will be to balance the tension between implementing Basel III and
keeping the cost of credit at an affordable level. In terms of capital,
banks in EMEs typically have higher capital ratios, and can be expected
to comfortably meet the higher Basel III capital requirements. However,
going forward, as credit expands and bank balance sheets grow, banks
will find it necessary to raise further capital to conform to the Basel
III requirement. Basel III also poses non-cost challenges.
For example, operation of countercyclical buffers will need
judgements to be made on the trajectory of the business cycle and on the
identification of the inflexion point. Wrong judgements can entail huge
costs in terms of foregone growth.
Many of these reforms on the anvil, including some elements of the
Basel III package, allow for national differentiation. Should EMEs,
keeping in view their national circumstances, decide to deviate from any
global standard or norm, the challenge for them will be to communicate
the rationale so that the market does not interpret the deviation as
regulatory looseness.
Realizing that the reform measures designed for the financial systems
of advanced economies will have different implications for EMEs, and
that the challenges facing the EMEs may be entirely different from those
facing the advanced economies, it was decided in the Seoul Summit of the
G20 to work towards making the financial regulatory reforms better
reflect the perspective of EMEs.
The FSB, the IMF and the World Bank have been tasked with working on
this agenda and report before the next Summit.
Let me now summarize. In my remarks today, I tried to give you an EME
perspective on some of the issues on the global agenda. I started off by
giving the big picture - the tectonic shift of global economic power
towards emerging economies.
EMEs, however, have not completely decoupled from the advanced
economies; their economic prospects remain linked to the prospects of
advanced economies.
Even as multiple growth poles are a better safety-net for the world,
we will be collectively better off if all segments of the world grow at
a sustainable pace.
I then went on to the issue of global rebalancing which needs to
address three inter-related issues: exchange rate flexibility, capital
controls and an agreement on a framework for strong, sustainable and
balanced growth. A prime source of vulnerabilities at the global level
is the single reserve currency and I emphasized the need for global
cooperation in finding a viable solution.
An important issue on the global agenda is protectionism and I talked
about why protectionist pressures may arise again and what new forms
protectionism might take in the years ahead.
Finally, I gave a brief status of the reforms in the financial sector
and emphasized the need for further work to study the implication of
these reforms for EMEs.
The common thread running through all the issues that I raised is the
need for global cooperation in solving our most pressing problems of
today. The crisis has taught us that no country can be an island and
that economic and financial disruptions anywhere can cause ripples, if
not waves, everywhere. The crisis also taught us that given the
deepening integration of countries into the global economic and
financial system, uncoordinated responses will lead to worse outcomes
for everyone. The global problems we are facing today are complex and
not amenable to easy solutions. Many of them require significant and
often painful adjustments at the national level, and in a world divided
by nation-states, there is no natural constituency for the global
economy.
At the same time, the global crisis has shown that the global economy
as an entity is more important than ever.
The global crisis has taken a devastating toll on global growth and
welfare. In their painstakingly researched book, ‘This Time is
Different: Eight Centuries of Financial Folly’, Kenneth Rogoff and
Carmen Reinhart show how over eight hundred years, all financial crises
can be traced to the same fundamental causes as if we learnt nothing
from one crisis to the next. Each time, experts have chimed that ‘this
time is different’ claiming that the old rules do not apply and the new
situation is dissimilar to the previous one. It will be too costly for
the world not to heed this lesson. We should cooperate not only to
firmly exit from the crisis, but also to ensure that in resolving this
crisis, we do not sow the seeds of the next crisis. |