Sunday, October 26, 2014
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Learning from Lehman

HONG KONG – When the US investment bank Lehman Brothers collapsed five years ago, emerging-market economies did not hold many of the toxic financial assets – mainly American subprime mortgages – that fueled the subsequent global financial crisis. But they were deeply affected by the drop in world trade, which recorded a peak-to-trough decline of at least 15%, with trade finance also contracting sharply, owing to a shortage of dollar liquidity. Have policymakers responded appropriately since then?

Soon after the crisis erupted, the G-20 countries embraced massive stimulus packages, unconventional monetary policies in the advanced economies, and major institutional efforts, such as the Dodd-Frank financial-reform legislation in the United States and the Basel III initiative to strengthen banking standards. China’s ¥4 trillion stimulus package, unveiled in November 2008, restored confidence in global commodity markets. Led by strong Chinese growth, emerging markets stabilized.

Since 2009, quantitative easing (QE) by the US Federal Reserve has resulted in record-low interest rates around the world. But, while the resulting surge in capital flows to emerging markets stimulated economic growth, it also inflated asset bubbles.

Now, with the Fed publicly considering an end to its massive, open-ended purchases of long-term securities and foreign capital fleeing home from emerging markets, many fear that Asia’s economies could come crashing down, as they did in the late 1990’s. Leverage in some emerging markets’ household and corporate sectors has reached record levels. China’s annual economic growth has slowed to around 7.5%, while Indonesia and India – and, outside Asia, Brazil and South Africa – are experiencing sharp downward pressure on their exchange rates.

Moreover, there has been no major reform of the global financial architecture. China’s renminbi is internationalizing, but its share of global payments remains relatively small, with the dollar retaining its role as the world’s main reserve currency. And, while regulatory reform is progressing, its effectiveness in addressing the weaknesses exposed by the global financial crisis will depend not only on the new rules that emerge, but also on the consistency and quality of their implementation.

There has been commendable progress on the Basel 3 capital requirements for banks, with 25 of 27 Basel Committee members having issued final rules. Likewise, the impact of regulatory changes resulting from major legislation and policy directives in the United States, Europe, and the United Kingdom on banking, insurance, financial-transaction taxes, anti-money laundering, and cyber-space is likely to be substantial.

Although rules on shadow-banking have yet to be formulated, another problem exposed by the crisis has abated: America’s external deficit has shrunk to a much more manageable 2-3% of GDP, accompanied by drops in the surpluses run by Japan and China. Global trade rebalancing has arrived.

Still, fiscal conditions in the advanced economies remain unsustainable, with many OECD members’ debt levels hovering around 100% of GDP. Japan, which has one of the world’s highest debt/GDP ratios, currently well over 200%, is engaging in a risky experiment with further monetary stimulus to try to target 2% annual inflation. In many advanced economies, both monetary and fiscal policies have reached the limits of their effectiveness.

The key questions now are whether global economic growth is self-sustaining without QE, whether emerging markets’ output will continue to rise strongly, albeit at a slower pace, and whether current global financial-reform efforts will be sufficient to prevent another crisis in emerging markets.

Given the high degree of trade and financial globalization that now characterizes the world economy, there is no doubt that the slowdown in the advanced economies, which account for two-thirds of global GDP, will undermine emerging-country growth. Indeed, the threat to withdraw QE is already having an enormous impact on emerging economies’ asset markets. As real interest rates and risk premia begin to rise, the level of global trade and investment will decline.

In the coming years, emerging markets will most likely struggle with implementation of global financial regulatory standards, which apply mostly to more sophisticated financial markets. They will also confront a rapidly changing external environment and a growing need to manage capital flows more effectively, which will require much closer coordination between central banks and financial regulators.

Indeed, perhaps the most important lesson learned in the aftermath of the collapse of Lehman Brothers is that we can no longer afford to examine problems in terms of individual institutions and from regulatory “silos.” The global economy’s high degree of interconnectivity, interdependence, and complex feedback mechanisms imply that one weak hub can bring down the entire system.

In other words, the world needs a systemic approach to deal with systemic risks and system failures. Unfortunately, there may be little hope of strengthening global financial governance as long as implementation and enforcement of rules remain at the national level.

Like other emerging markets, China is committed to financial stability and playing its role in reforming the global financial system. China was one of the first countries to sign up to the Basel 3 standards, and further renminbi internationalization will be implemented in a prudent and pragmatic manner. Domestic financial reforms will focus on strengthening policy coordination and moving toward market-determined interest rates and exchange-rate flexibility.

All of these steps will contribute to sustainable domestic growth and a more stable global financial system. Other major emerging economies’ policymakers would be wise to act with the same purpose in mind.

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  1. CommentedJonathan Lam

    Gamesmith94134: Learn from Lehman
    Soon after the crisis erupted, the G-20 countries embraced massive stimulus packages, unconventional monetary policies in the advanced economies, and major institutional efforts, such as the Dodd-Frank financial-reform legislation in the United States and the Basel III initiative to strengthen banking standards. Have policymakers responded appropriately since then? Perhaps, it is not the major issue here on how monetary or fiscal policy would have change unemployment or growth. Since the heart of the processes are not remanding the affordability or re-creation for its consumers that the inequality is much polarized with the rich to the poor; and much of the wealth is tilted toward the rich. It was the paper changing hands and not grunting machines.
    BY creating the asset bubble in the emerging market nations, the developed nations has sustained marginal balance on the financial market through the fluidity of the capital expansion; but the import and export did not hold as the value on its currencies. It made the emerging market nations to inflate as the capital asset rose, more burdens to the cost to living and pricing to the commodity since there is no deflation to adjust or lesser growth. Monetary policy took the currencies like, Indonesia and India – and, outside Asia, Brazil and South Africa for a ride in term of its fluidity that overflows; since higher cost and lower profit margin cut productivities. In order to regain its equilibrium if the overflow condition, it shifted their liquid assets run off in the stock market and capital assets in America to raise profit margin, instead of manufacturing, it devalued its currencies in the trade off.
    However, such reversal can has negative effects if the overflow condition disrupted like tapering the QE by raising the interest rates on the shortening of the cash flow; or deflation on price or waves of labor disputes to meet the threshold of affordability in order to establish the newer consumers. In a word, there is no foundation on the new consumer and lesser sustainability to the higher cost and lower profit margin for the corporations. Eventually, the price will fall after the QE tapered and fluidity ended.
    “Indeed, the threat to withdraw QE is already having an enormous impact on emerging economies’ asset markets. As real interest rates and risk premia begin to rise, the level of global trade and investment will decline.” Many believe it will be the chokehold that drags on to the re-evaluation on all terms of the capital goods; and labor costs will rise to meet affordability, then unemployment will escalate since production and cost of living would have set its price that eliminates its consumer. Then, I would expect the devaluation of on all goods and taxation will fall eventually soon as the shrinkage of liquidity or fluidity of cash flow both in the developed nations and the emerging market nations.
    “Indeed, perhaps the most important lesson learned in the aftermath of the collapse of Lehman Brothers is that we can no longer afford to examine problems in terms of individual institutions and from regulatory “silos.” The global economy’s high degree of interconnectivity, interdependence, and complex feedback mechanisms imply that one weak hub can bring down the entire system.” If we must return to the reality of the growth matter or employment, we must realize the processes on the equilibrium that deflation incurs to adjust; consequently, consumer rises if the price is right, so is employment.
    Perhaps, we must reexamine the idiom, “You cannot force the cow to drink, if it does not bow”. Is it legal or not? Deals are made among traders. It may not sound like Libor in its synchronized way, but law is just like beauty is in the eye of its beholders. Or, does cow bow?At one point, the global recession will appear at all papers or any internal disruption like, Jaingxi is having Detroit syndrome, will China accept a 3-5% growth?
    May the Buddha bless you?

  2. Portrait of Pingfan Hong

    CommentedPingfan Hong

    "Unfortunately, there may be little hope of strengthening global financial governance as long as implementation and enforcement of rules remain at the national level.": it is difficult to construe this sentence. Rules can be set at international level, but their implementation and enforcement would always rely on national governments.

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