September 30, 2013 3:12:52 am
Emerging economies should not be regulated in terms meant for advanced ones
The collapse of Lehman Brothers in September 2008 sent Western financial markets into the deepest freeze,and their economies into the severest recession,since the Great Depression. The ultimate cause of the global financial crisis is usually traced to the gradual dismantling of the post-war financial regulatory structure. The current crisis is leading to another comprehensive overhaul of financial regulation. In this context,there are problems that are unique to emerging market economies (EMEs).
There is a danger that the scarce savings in EMEs will be pulled away from investment necessary to sustain current levels of high growth to cover non-existent risks. BASEL III constitutes a double whammy for countries like India. It could constrain the rapid credit growth necessary to sustain high growth. On the other hand,it could aggravate the runaway structural fiscal deficit of a government that would need to cough up a substantial chunk of the additional capital by virtue of its large ownership of the banking sector. The cost of capital is already high in EMEs. The enhanced capital requirements of BASEL III are almost guaranteed to keep it high in the foreseeable future. But why should EMEs be pushed towards a regulatory framework calibrated to risks in advanced market economies (AME)?
There is no good reason to suppose EME financial systems will remain where they are presently. Tighter regulation could keep shadow banking in check. Alternatively,if some EMEs see benefits in the development of innovative shadow banking,they could move towards lighter regulation and migrate to AME-type financial systems.
Financial panics are invariably preceded by escalating leverage. The primary drivers of leverage in AMEs and EMEs are,however,strikingly different. The recent galloping leverage in AMEs was an attempt to increase returns on capital through increased trading of claims on real economy assets. This led to a rapid expansion of financial assets as a proportion of GDP. High credit growth in EMEs like India was primarily due to high rates of investment and growth. Global production has long been migrating to these countries on account of rapid productivity shifts. Their economies are consequently far less financialised. With deposit insurance and the central bank discount window in place,deposit-based banking is no longer susceptible to financial panics and bank runs,as long as capital is calibrated to cover asset quality deterioration in business downturns. Unsurprisingly,although they were affected by sudden stops from abroad,financial intermediation in EMEs held up while the Western financial system froze.
EME financial systems were already more tightly regulated than the proposed norms. Their central banks did not hesitate to prick asset bubbles. Regulators were wary of opaque structured products. Their boring banking could never afford the outsized compensations that encouraged excessive risk-taking in AMEs. Banks were not allowed to become interconnected with shadow banking. So EMEs found it easy to sign on to the reforms. To the extent the Western financial system became safer,they stood to gain. Although they are net savers,much of their own financial intermediation is routed through the international banking system,where they park excess savings. A shock in AME financial systems was automatically transmitted to EMEs through sudden stops and attendant currency crises. In the past,these stops had usually been of their own making,triggered by poor macro-economic management. But this time,it was on account of lax financial regulation in advanced economies.
The impact of the ongoing financial regulatory reforms on EMEs has also been relatively benign. Despite the general decline in cross-border claims on financial assets among advanced economies,especially in Europe,capital flows to EMEs are back to pre-crisis highs. This is perhaps because capital flows to EMEs are more through FDI by transnational companies (TNCs) than through banking channels. TNCs did not lose access to capital markets even at the height of the financial crisis. Indeed,capital flows to EMEs appear to be more effected by monetary policies in advanced economies.
Both prior to and following the global financial crisis,the chief concerns of EMEs about their financial systems remained developmental rather than regulatory: increasing financial savings to accelerate growth and development,notwithstanding recent uphill capital flows from EMEs to AMEs. This is arguably a temporary phenomenon,which will change as the global economy rebalances.
While financial regulatory reforms are expected to be implemented across all jurisdictions,their immediate impact would be felt most in the relatively lightly regulated AMEs,rather than in the more tightly regulated EMEs. The impact of the new BASEL III banking capital adequacy norms,however,will be almost equal across both AMEs and EMEs.
While the rationale for tightening capital adequacy norms for the banking sector in AMEs is self-evident,the case for EMEs migrating immediately from BASEL II to BASEL III norms is not. Avoiding arbitrage is the argument put forward for common norms. This alone is not very convincing because any capital migrating to a more regulated environment would incur additional costs,as regulation is
a proxy tax.
The writer is secretary,Prime Ministers Economic Advisory Council. Views are personal