Bill Emmott - International Author & Adviser


A new global financial system?
Voice - 2009

These are challenging times, indeed. We can count ourselves fortunate that the vast financial crash of 2007-09, centred on America and Europe, has not caused a repeat of the Great Depression of the 1930s. Huge government rescue efforts, using fiscal and monetary tools to replace collapsing private demand and debt with public demand and debt have saved us from that fate. The recovery from this crisis will be slow and hard.

            In politics, there are many potential risks and uncertainties that could disrupt the recovery. Nevertheless, we are fortunate for a second reason: the basically good relations between America, Europe, China and Japan should reassure us that we ought to be able to navigate our way out of these economic difficulties without major political disruptions. Unlike in the 1930s, the world is not on the brink of war, nor is an old order of European empires collapsing around us. But we cannot take this political stability entirely for granted. Nor can we make forecasts about how things will turn out with any great confidence.

            What we can examine more closely, however, is the root cause of the crisis, and ask ourselves whether this crisis might now bring about substantial, even historic changes in international finance. This crisis had its origins in international finance, so it is natural to expect governments to seek changes in the way finance works. Moreover, in recent decades, every financial crisis that has had cross-border dimensions or implications has brought forth, as one of its side-effects, widespread calls for some sort of reform of the international financial or monetary system.

            Such calls have taken various forms, but have often featured suggestions that it is time for a "new Bretton Woods", referring to the American-led conference in Bretton Woods, New Hampshire in July 1944 that gave rise to the postwar monetary system and institutions. Less grandiosely but with similar intent have been calls for changes to "the international financial architecture".

            The global crisis that first became visible in August 2007 has proved to be no exception to this trend. Indeed, both France´s President Nicolas Sarkozy and Britain´s Prime Minister Gordon Brown have been heard to declare that a new Bretton Woods is imminent, perhaps taking the modern form of agreements and statements made by the Group of 20 (G20) countries, which first met at head of government level in Washington in November 2008 and then in London in April 2009.

The G20 itself is a symbol of change, since this wider body, taking in China, India and Brazil as well as many smaller middle-income and developing countries, is intended gradually to supersede the old Group of Seven (G7) structure which since the 1970s has convened the richest countries of the world as a sort of global steering committee. The G7 (now G8, with Russia) lives on but looks increasingly anachronistic. Even so, nothing that truly compares to the 1944 agreement has yet come even close to emerging either from the G20 or the old G8.

This talk of Bretton Woods or of new architecture, whatever that really means, appears to arise more from the desire of political leaders and their speech-writers to sound important and statesmanlike than any genuine substance. Nevertheless, there are reasons to believe that the current global crisis could prove different from its predecessors in the 1980s and 1990s and may eventually lead to substantial changes in the international financial system. The contention of this chapter is that this will occur not in a "big bang" as at Bretton Woods nor as the result of a new architectural blueprint but rather in a gradual but inexorable process, over a period of five to ten years. And it is likelier to emerge in the global currency system than in the banking system.

            Why? For a start, while previous crises—including the Third World debt crisis of the 1980s, the Mexican peso crisis of 1995, and the East Asian financial crisis of 1997-98—have had some cross-border characteristics and implications, notably for developing countries, the current financial collapse and sharp economic contraction have been truly global in their span, taking in rich countries and poorer ones alike. This is producing a strong sense that if the problem is shared, so too should be the solution.

 Secondly, the financial origins of this collapse can be connected directly with the freedom of capital to flow internationally, which came about thanks to the dismantling of exchange controls in the 1980s and 1990s, and with failings in efforts during the 1990s and the present decade to establish global standards in banking regulation and supervision. Thirdly, the boom that preceded this bust was associated with growing macroeconomic imbalances between surplus and deficit countries of precisely the sort that the Bretton Woods conference of 1944 set out to try to control in the postwar era. At last, this historical parallel may have some relevance. Connected with this, and finally, the boom and now the bust have also become associated with a longer-term shift in the balance of economic power around the world, as China and other big developing countries increase their weight in trade, in capital flows and in flows of official funds.

            The notion that some sort of power-shift might be under way was given added credence in March 2009 by a speech given by the governor of the People´s Bank of China, that country´s central bank. In his speech Zhou Xiaochuan attributed the present crisis in part to the dominant role being played in world currency trading and in particular in national foreign-exchange reserves by the US dollar.

            As China is now the holder of the world´s largest foreign-exchange reserves, totalling more than $2 trillion much of which is held in the form of US dollar securities, such statements seized many imaginations all round the world. Mr Zhou went so far as to propose that there should be an alternative reserve currency to the dollar, or rather a reserve asset: a greatly enlarged issuance of "Special Drawing Rights" by the International Monetary Fund, which are in practice not currency but means by which countries can hold their reserves in a basket of four major currencies (dollars, pounds, euros and yen). Might this mean that the dollar´s domination of the world financial system is coming to an end? Could there soon be a collapse of the dollar, bringing new shocks to the financial system and new damage to America, its economy and its political power? My answer is that the dollar is not the world´s main financial problem. That title belongs, in fact, to the Chinese currency, the renminbi. And it is for the renminbi and for China that the biggest changes are likely, not the dollar.

Understanding the financial and economic crisis

In order to be able to analyse how the current economic crisis might bring about changes in the international financial system, it is necessary to have a clear understanding both of the nature of this crisis and of the present state of the international financial system. So let us return to that question: why did the crisis occur?

            Understanding the economic crisis is not simple because several different forces and features overlap one another, both in the origins of the crisis and in its present state. The main forces and features can usefully be divided into four. Naturally, the first of those forces is the misbehaviour of financial institutions, principally in America and Western Europe.

            The financial crisis first became evident in August 2007 when BNP Paribas, a major French bank, suspended three funds because of losses on mortgage-backed securities related to so-called "sub-prime" lending in the American housing market. This produced a sudden re-evaluation by investors and financial institutions of both the value and the liquidity of mortgage-backed securities, and then of other complex derivatives and transactions related to them. Rising house prices in America, it transpired, had led to a big expansion in lending to uncreditworthy borrowers in that market; this trend had become combined with the creation by banks and investment banks of complex derivative securities based, ultimately, on the cash flow from these sub-prime and other mortgage payments.

            The appetite among investors for these mortgage-backed securities, and the commission income from creating them, encouraged banks to create yet more complex derivatives based on other underlying instruments. In pursuit of profit, banks that created these derivatives for distribution (the so-called "originate to distribute" model) nevertheless retained large holdings of the securities themselves generally in off-balance-sheet vehicles. As a result, securitisation, a development that during the 1990s had been praised for dispersing risk between financial institutions, turned out to have left it highly concentrated in some banks and investing institutions. Although the origins of this crisis are generally associated with American banks and with lending in the sub-prime mortgage market in particular, it is worth noting that in fact the biggest losses and debt write-offs have occurred in European banks, especially those in Germany and Switzerland. Banks in those countries became major investors in derivative securities of all kinds,

            Banks and other financial firms misbehave all the time, however. That is why every country has financial regulations and supervisory agencies. So, for this misbehaviour to have achieved such a huge, system-threatening scale, there must be a second force or factor: Flaws in national and international regulation and supervision of financial institutions.

            This concentration of risk was largely hidden from regulators and from financial institutions themselves. It was hidden from regulators because derivatives were permitted to be traded on "over-the-counter" markets rather than on exchanges subject to reporting and monitoring requirements, and because under the capital adequacy rules agreed internationally, banks were not required to hold capital against off-balance-sheet derivatives holdings. With hindsight, this was a colossal misjudgement by the financial regulators, all over the rich world. A few countries avoided these errors: Canada and Spain stand out for the stability of their banks and the strictness of their regulations. But they are exceptions: the rule is that regulatory flaws were widespread.

            Ironically, however, this lack of transparency from a regulatory point of view also afflicted market participants: none had more than a very partial view of the overall exposures and trading volumes in all these complex derivatives products, and so none was in a good position to assess the risks inherent in this activity. This has now become known as the "shadow banking system", a name that is apposite both because of the way in which it operated in the shadows of conventional finance and because of the way in which no one could really see what was going on in those shadows. Hence, in a system in which regulation was flawed and where participants lacked good information about what was going wrong, it proved possible for huge, risky exposures to build up without top managers or shareholders of banks realising what was going on.

            They did, however, need cheap money in order to build up those risky exposures. This was created by the combination of low inflation and loose monetary policies. Flawed regulation and risky behaviour by financial institutions might not have become systemically threatening had it not been for this third factor: ultra-cheap credit.

            This arose from two sources. Following the (largely transAtlantic) bursting of the dotcom or high-tech stockmarket bubble in 2001, and then the terrorist atrocity of September 11th 2001, America´s Federal Reserve Board cut its short-term interest rates sharply and then held them down. Other central banks followed suit, for while America suffered only a mild recession the world economy as a whole slowed markedly in 2002-03 to less than 3% growth in real GDP.

            This monetary easing, along with a recovery of confidence in the absence of further major terrorist attacks, helped revive growth. It appeared, however, to have no inflationary consequences, as measured by consumer and producer price indices, with the result that long-term interest rates, set by the market, also stayed low. This low inflation was widely attributed to the downward pressure on traded goods and services prices resulting from increased manufacturing and information-technology industries in China and India.

            A further factor in keeping bond yields—ie, long-term interest rates—low was the abundant capital outflows at first from Asian current-account surplus countries, including China, Japan, Malaysia and Singapore. Then, once an energy and commodity price boom had been sparked off there emerged further abundant capital flows from the Arabian Gulf and other oil and commodity exporting nations. Liquidity was thus cheap, because it was widely available; low yields meant that institutional investors became keen on finding alternative investments that promised higher yields; and amid the fastest four-year period of global economic growth for more than 40 years it became possible to believe that these circumstances were structural in nature rather than cyclical.

            These circumstances of abundant liquidity and rapid, widely shared global economic growth also brought about—and were facilitated by—a disparity in international trade and payments that was historically unprecedented. By 2006, the United States was running a current-account deficit of about 6% of GDP; the United Kingdom, Spain and some other large European economies were running deficits in the range of 3-5% of GDP. The counterparts to those deficits could be found all over the world: in Germany and the Netherlands, whose current-account surpluses reached 4-6% of GDP; in Japan, where the surplus hit 4.5% of GDP; and above all in China, where in 2007 the current-account surplus exceeded an extraordinary 10% of GDP—extraordinary, that is, for a by now large economy with a large population and a diverse industrial structure.

            The rise in crude oil prices to a peak of $150 a barrel in June/July 2008 produced much larger surpluses as shares of GDP in the Arab oil exporting countries, but those are relatively small economies dominated by a single resource. Many, though not all, of the current-account surplus countries responded to this period by accumulating foreign-exchange reserves chiefly as a means to manage the value of their currency against the dollar and euro, but also as insurance against future swings in capital flows of the sort that had been seen in the 1997-98 emerging-markets financial crisis that began in East Asia.

These four different elements came together to produce the vast bubble in credit, and accompanying rapid economic growth, that has now burst. According to the International Monetary Fund´s Financial Stability Report in April 2009, total losses at banks and other financial institutions all around the world are expected to exceed $4 trillion. World trade was forecast at the same time to contract by 9% in 2009, while the global economy as a whole was forecast to shrink by 1.3%, forecasts that have since been shown to be fairly accurate.

The 1944 solution: Bretton Woods, GATT, the IMF and the World Bank

Clearly, the problem has been severe and the economic situation dramatic, as was already outlined in the first chapter. But what should be done to prevent future crises? What might be done?

This taxonomy of the origins of the current financial crisis is necessary because different elements of this crisis and of its causes are likely to require different sorts of solutions, at national, regional and global level. Some elements, indeed, hold implications chiefly for national policy rather than the international financial system as such. Examples include the appropriate management of monetary policy and the correct management of official intervention in national banking systems. Such policies may benefit from international co-ordination and from the sharing of experiences across borders, but do not of themselves raise questions about the institutions and governance structures of international finance. Other elements, though, may indeed prove to have international implications.

To explore those possible implications it is, as previously stated, desirable to be clear about the evolution of the international financial and economic systems themselves. The Bretton Woods conference of 1944 took place in what turned out to be the closing years of the Second World War, and thus involved only America´s allies and not the ultimately defeated nations of Germany and Japan. It was thus a conference of victors, with agreement made easier by the clear pre-eminence among those victors of the United States.

Bretton Woods was also, though, a new system conceived by Britain and America, through the main intellectual and policy-making individuals on both sides, John Maynard Keynes and Harry Dexter White, as a solution to the economic and financial problems of the 1920s and 1930s. These were seen as: trade protectionism; the absence, following the post First World War demise of the gold standard, of any mechanism to deal with imbalances in international trade and capital flows; and the absence of international lending institutions to assist with payments crises or the financing of postwar reconstruction and development.

As a result, the 44 countries that gathered at Bretton Woods agreed to establish three new international institutions and to launch a new system to manage exchange rates. The three institutions were: the General Agreement on Tariffs and Trade (GATT), which was to begin the process of trade liberalisation between the richer countries; the International Monetary Fund (IMF), which had the task of monitoring international payments imbalances and making finance available when countries needed it in order to bring about adjustments; and the World Bank, whose initial task is best described by its official name as the International Bank for Reconstruction and Development. The new exchange rate system, which took several further steps before it became operational, consisted of the setting of fixed exchange rates against the US dollar, while the value of the dollar was itself fixed in terms of gold.

Space does not permit a full history of the evolution of this "Bretton Woods system" up to the present day. What does need to be said, however, is that of the three institutions, the role of one has become much stronger, the role of one much weaker, and that of the third considerably changed; and that, in 1971-73, the fixed-exchange rate system was abandoned at American instigation, to be replaced by largely (but not wholly) freely floating exchange rates. The abandonment of fixed exchange rates by the world´s major economies also led to the gradual dismantling by all of them during the next 10-15 years of their national "exchange controls" which had limited the free flow of capital. That dismantlement prepared the way for the internationalisation of finance and of financial institutions that we see today.

The Bretton Woods institution that has become much stronger since 1973 is the GATT. Its membership became wider and the trade liberalisation achieved under successive GATT rounds extended to more and more goods and services. A key moment in the development of the GATT was the arrival in 1987 at the institution´s Geneva headquarters of a memorandum from the government of China, proposing that talks be opened with a view to China´s eventual membership. This prospective widening of GATT to take in not just a large developing country but also one hitherto operated as a largely closed, command economy, contributed to an international decision to strengthen the GATT, converting it through new treaties into the World Trade Organisation (WTO) in 1995. This crucially, involved the setting up of a new disputes settlement mechanism akin to an international trade judiciary. By 2001, when China joined the WTO, the organisation had become arguably the most advanced example of international governance through the sharing of sovereignty.

The institution that became much weaker was the IMF, for the simple reason that its main function—policing payments imbalances—was no longer necessary or feasible, at least between the bigger economies, once fixed exchange rates had been abandoned. During the 1970s, 80s and 90s the IMF became in effect a supranational think-tank, albeit one controlled by its bigger national shareholders and thus unwilling to give offence, linked to an emergency lending facility for any developing and middle-income countries that ran into financial trouble. Such trouble did occur, especially during the Latin American debt crisis of the 1980s and the East Asian financial crisis of 1997-98, but this did not truly give the IMF a powerful or sustained role. The World Bank, meanwhile, was attaining a greater global prominence as a provider of long-term lending in developing countries, along with development advice.

The internationalisation of financial institutions might have been expected to give rise to the creation of another international agency, namely a global financial regulator or supervisor of some sort. It has not, because national governments and parliaments consider banks and other financial institutions to be crucial elements of domestic economies and domestic policy, and have so far refused to share sovereignty in this regard. They have been willing only to negotiate common rules for capital adequacy and some common arrangements for accounting standards, but have left the implementation and enforcement of those rules up to national parliaments and regulatory agencies.

The post-crisis international system

So what might change, as a result of this economic crisis? Might China´s proposal for a new reserve currency lead to the end of the dollar´s pre-eminent global role? Might the rise of new economic powers, led by China, lead to further changes in the Bretton Woods institutions, as influence and voting power in those institutions changes? Might the pressure of rising unemployment lead to a new wave of protectionism, forcing a rethink about the role and powers of the WTO? Might the global banking crisis give rise at last to a new global financial regulator?

            Although this economic crisis became manifest two-and-a-half years ago, its full extent and especially political effects are still unknown. Unemployment, in particular, is still rising in the developed countries and in many developing countries, and could eventually bring about new political forces and new policy proposals. Further financial instability could occur. So, in attempting to answer the questions above it is prudent also to acknowledge that the process that might lead to change remains in its early stages.

            The second important point to acknowledge is that the current international financial and economic system consists, as described above, of a set of multilateral, detailed rules for trade, policed by a strong organisation and judicial process, but of an arrangement for finance which is essentially one of co-ordination of national policies and national rules, with no supranational organisation or enforcement process. Thus, the question for trade is whether the global rules and governance system will remain intact, as national protectionist pressures mount; the question for finance is the opposite one, of whether there will be any move towards supranational rules and enforcement.

            On trade, the WTO system currently looks robust. Although at the November 2008 G20 meeting the leaders present pledged to avoid raising barriers to trade during the succeeding 12 months and then 17 of the 20 (according to World Bank research) proceeded to do just that by raising their own trade barriers, the protectionism that has occurred so far has either been in areas outside the WTO´s remit or has been consistent with WTO commitments. No threat has yet arisen to the survival of the WTO itself, and the G20 process itself provides some reassurance on that count: peer pressure at the meeting, plus "naming and shaming" of transgressors from G20 pledges in the media and by agencies like the World Bank should act as a constraint.

            On finance, the theoretical logic for a move towards global or regional regulation is strong. It was cross-border investment by cross-border financial institutions that led to this mess, and those institutions are hard for national regulators to monitor. Separate national regulators and rules also offer incentives for regulatory arbitrage and for the use of offshore havens to avoid stringent rules. In practice, however, the most powerful forces during this financial crisis are pulling in the opposite direction. It is national taxpayers´ money that is being used to rescue and recapitalise banks. That is giving national governments and parliaments a strong incentive to make financial regulations and structures more national in nature rather than more global.

            The likelier area for genuine change lies in the economic relationships between the big countries involved in and affected by this crisis, in other words in the macroeconomic imbalances between surplus and deficit countries. On the face of it, this topic also entails acknowledgement, in the international financial system, of the rising power of China and other emerging economies, and the declining power of the United States and Europe. This crisis could thus offer the chance for China and other emerging economies to reshape the international system in their own interest.

            Certainly, China and the other emerging economies deserve, by dint of the size of their economies, to have corresponding representation and voting power in the IMF and other international agencies. Voting rights were adjusted in 2008 and are now scheduled to be adjusted at least every five years. So, by 2013, China can expect to have increased its influence in IMF decision-making. However, as was outlined earlier in this article, the IMF is not any longer a powerful or important agency. China´s extra influence over it is as likely to lead to the IMF´s further weakening as to any revival in its role.

The next currency reform

The more important place to look is in currency arrangements, which returns us to the proposal made in March 2009 by China´s central bank governor, Zhou Xiaochuan, for a new "super-sovereign reserve currency", in the form of the IMF´s Special Drawing Rights. This sounded like a Chinese repudiation of the US dollar, made from the country´s new position of strength. Yet on closer examination it is actually a statement of weakness. For China is the anomaly in the international financial system, not the United States, nor the US dollar.

            In an international system of floating exchange rates, China is the only large economy whose currency is not fully convertible and whose exchange rate remains closely managed by the central bank. As a result of the effort to prevent capital inflows from leading to an appreciation of the Chinese currency, the Renminbi, the financial authorities there decided to buy dollars, thus building up more than $2 trillion in foreign-exchange reserves, chiefly held in low-yielding but safe American Treasury bonds. This currency policy was used as a means of domestic economic policy but it has created an international problem for China: the risk of a big fall in the US dollar causing large losses on its foreign-exchange reserves; and the danger that China´s huge current-account surplus becomes a cause celebre for protectionists around the world.

            Mr Zhou´s statement was a clever piece of politics: it diverted attention from China´s surpluses while also declaring China´s desire to be part of a multilateral, rules-based financial system, just as it is part of such a system for trade. But as a piece of economics, it was flawed. It suggested that the big currency change that lies ahead concerns the US dollar and its status as a reserve currency. Yet that status has no institutional form: it is just the result of independent decisions by governments around the world to hold the largest portion of their reserves in dollars.

A reserve currency is generally one that is considered to be liquid, one whose assets are safe from default, and one which is widely used in trade. The dollar´s continued relevance on those measures is a result of the weakness of the yen during Japan´s long economic stagnation since 1990 and of the relative novelty of the euro. But it also reflects the absence from international finance of the currency used by the world´s third largest economy and its second-largest exporter: the Renminbi.

            The big change that the world is awaiting, as a result of the shift in global economic power to Asia and other emerging economies, is the arrival of the Renminbi as an international currency. The difficult question to answer is whether this change will prove to have been accelerated or delayed by the global economic crisis. From 2005-08, China was gradually revaluing the Renminbi, perhaps as a prelude to full convertibility. That process has now stopped, thanks to the weakness of China´s export sector and to the worries of China´s political leadership about social unrest during the economic slowdown of 2008-09.

            Mr Zhou´s statement about the SDR as a reserve asset offers a possible trade-off, however, that might end up accelerating this process. In return for helping China to manage its foreign-exchange reserves through a swap into SDRs, a process could be agreed under which China would gradually move to convertibility and a freer float for its currency. Given that, in order to support domestic demand, China is now running a growing budget deficit and thus needs to expand its domestic government bond market, the liquidity provided by an internationalisation of its currency could turn out to be in China´s national economic interest.

            This process, if it happens at all, could take five years or more. Ultimately, the most important question concerns when, if at all, it will become clearly in China´s interest either to revalue the Renminbi or to move it to full floating or convertibility. The likely answer to that question is when China starts to suffer again from rapid inflation.

            The reason why inflation would change China´s interests on its currency, is that for as long as Chinese policy is dedicated to holding down the value of the Renminbi against the dollar, Chinese interest rates are in effect tied to American ones—which, thanks to the economic crisis, are ultra-low. That, combined with direct instructions to Chinese state-owned banks to increase their lending dramatically during 2009, have meant that monetary growth is extremely rapid and bubbles seem to be forming in the property and stock-markets. Soon, this is likely to feed through into consumer price inflation. But China cannot simply raise interest rates to control that monetary growth, as would be the case in America, Europe or Japan, for if it does so it will attract big inflows of capital, forcing it to absorb those inflows by buying more and more dollar assets, further expanding its foreign-exchange reserves. Such a policy is becoming more and more expensive and more and more risky.

            During 2010 this theory may well be tested. As the year began, inflation was creeping higher in China. At the same time, protectionist actions against cheap Chinese exports, in America, Europe and even India, were spreading. So the pressure to do something about the Renminbi was intensifying. The Chinese authorities´ normal way of responding to such pressure is to take rather gradual actions. But in the currency markets, gradual actions are hard to carry out, as they risk just attracting more capital inflows, speculating on the likelihood of further gradual appreciations of the Renminbi. So the chance is there of a sudden, surprise revaluation. It might even be accompanied by the announcement of a plan to make the currency fully convertible at some point in the next few years.

            That scenario may sound unlikely to many people. I would describe it as both optimistic and logical. For if there is one anomaly in the international financial system that the current economic crisis stands a chance of resolving, it is the status of the Chinese Renminbi.

            From now on, all eyes should be on the Chinese currency as representing the issue that promises to produce the most significant and substantial change as a result of this global economic crisis. Or, a dispute over the Chinese currency and the failure of this potential bargain between China and the rest of the world could represent the most important and worrying source of geopolitical tension resulting from this crisis. With America due to hold mid-term Congressional elections in 2010, there is no real room for doubt that if nothing has been done about China´s currency and if American unemployment continues to rise during that year, the politics of US-China relations and of international finance promise to become increasingly dangerous.


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