|Brics leaders announce the establishment of their new development bank in July|
It was never meant to be this way. Chastened in the post-Lehman climate and by misadventures in the Middle East, Barack Obama’s presidency was hailed as an historic opportunity to moderate US unilateralism and boost global governance, from foreign policy to economic. As the shift in the centre of financial gravity in favour of emerging markets took root, hopes in 2008 snowballed that the governance of the international financial system – from capital-market regulation to the monetary system – would reflect the newfound clout of developing markets.
Meanwhile, the IMF’s flexibility in lending policies and shift from unbridled free market dogma, combined with the G20’s dethroning of the G7 as the principal forum for global economic co-operation, all boosted the spirit of multilateralism.
Fast-forward to late 2014: international trade negotiations remain on a knife edge, Russia is reeling from the ill effects of western sanctions, and the Brics are making concerted attempts to diversify away from the dollar and the Bretton Woods’ institutions. Meanwhile, efforts to reform the IMF, from quotas to its leadership process, have collapsed, with the blame falling squarely upon a fiscally conservative US House of Representatives, ideologically unwedded to multilateralism.
Six years after the collapse of the global economy that triggered unprecedented co-ordination between world leaders, fears of competitive exchange-rate devaluations, via FX interventions or over-zealous monetary easing, and trade skirmishes, continue to cast a shadow over the demand-deficit-ridden global economy.
And yet multilateral institutions are unable to breathe life into monetary coordination at an inflection point for the global economy, despite a cyclical rebound in growth. Europe continues to export deflation. Hopes of a spirited US recovery to power exporting nations remain dashed. Current account surplus nations, such as Germany, China and Japan, are either unwilling or unable to boost aggregate demand. And emerging markets remain hostage to Fed-induced capital cycles.
Joseph Joyce, professor of international economics at Wellesley College, and a keen observer of globalization, says: “The Bric nations are seeing a breakdown of US domestic policy. They want to develop their own institutions so they have their options and shape events. At present, they are not calling for the IMF to be shunned. They are being cautious, and not burning the bridges.”
International institutions remain hopelessly unrepresentative. The Bric nations account for 20% of global output but represent just 10.3% of the IMF quota while Europe is allocated 27.5% with an 18% share of global GDP. The US maintains its power of veto.
For proponents that fear economic coordination is fragmenting as emerging economies assert a muscular posture on the international stage, the establishment of the New Development Bank (NDA) in July, by Brazil, Russia, India, China, South Africa (Brics) is the watershed for a new order. Joyce adds: “The principal forum for global economic discussions, IMF and G20, are proving ineffective and losing relevance. If a lot of emerging markets move to different arrangements, it carries with it the risk of a crisis if global co-ordination breaks down.”
The NDA’s mission statement mimics the existing Bretton Woods’ institutions, the World Bank and IMF, which were set up after the Second World War, boasting strong US leadership, to stabilize the global monetary system. At present, the NDA’s arsenal is modest but a precedent has been established. The five countries aim to provide loans for capital programmes, principally infrastructure, with a current maximum allowable capital of $100 billion, while boosting monetary stability, through the establishment of a $100 billion central bank swap loan, the Contingent Reserve Arrangement (CRA).
|The problem is the rest of the world must find dollars to buy energy, conduct trade settlement and service dollar debts|
The bank is to be based in Shanghai, and the Brics will contribute to the CRA according to their respective size, underscoring China’s clout. The presidency will rotate, starting with India, while Beijing will not assume formal leadership until 2021. Other developing countries, from low- to middle-income, will also be able to contribute capital and apply for funding but their voting shares will be capped so as not to dilute the founders.
Russian president Vladimir Putin, with characteristic fanfare, articulated the NDA’s grand ambition in July. “The international monetary system … depends a lot on the US dollar, or, to be precise, on the monetary and financial policy of the US authorities. The Brics countries want to change this.” Thanks to Russia’s misadventures in Ukraine, and subsequent western sanctions, Putin has helped to de-dollarize the country’s economy – but for all the wrong reasons.
Rogério Studart, the World Bank’s executive director for Brazil and eight other Latin American countries, who was involved in discussions in the NDA’s establishment, says it will serve as a conduit for capital financing for cross-border infrastructure. As a result, the NDA will “complement existing multilateral institutions, boost the efficiency of domestic savings and develop capital markets”, including the potential issuance of 30-year bonds in local currencies after a credit rating is established in two years, he says.
The World Bank-like features of the NDA are a climax to a decade-long trend of western-backed development banks grappling for relevance in middle-income countries, amid a backlash against the bureaucracy and conditions attached to lending. What’s more, the growth of national and regional development banks, such as Corporación Andina de Fomento for Latin America, and intra-EM trade and portfolio flows, such as Exim Bank of China in Africa, have out-competed traditional western lenders.
Turning the screw
The timing of the Brics bank’s establishment, however, is symbolic as the Russia crisis has thrown into sharp relief the allure of intra-Brics co-operation, says Richard Batley, economist at Lombard Street Research. “The ability of western governments to manipulate globalized markets to turn the screw on individual countries will not be lost on others that fear they may be a future target,” he says. “To an economist the significance of 1914 is that it was the high water mark of the world’s first attempt at globalization. World trade as a percentage of GDP would not be as large again until around 1970. Even without invoking the calamitous events of the early 20th century, the deteriorating economic relationship with Russia introduces a similar fault into today’s globalization, with the potential to swallow more countries as it gradually grows in size. Not all turning points are crises.”
| A lot of trends are not going well for globalization, from trade, Russia sanctions, the balkanization of banking, to exchange-rate manipulations to the failure to pass IMF reform|
This might be an over-statement but it shines a light on the backlash to the western-centric structure of global capital markets. Put simply, the push for greater emerging market co-ordination stems from the inherent fault lines in the international economy, which central banks have declined to fix – or even address. Specifically, the dollar’s status as the principal global reserve currency, as John Maynard Keynes himself warned, and Robert Triffin more than 50 years ago, means the international monetary system is structurally flawed given the inevitable conflict between domestic (US) and global policy aims.
The latest manifestation of this has taken root over the past one and a half years. Emerging market current account deficit nations, in particular, from India, Turkey to South Africa, were forced to engage in pro-cyclical monetary tightening to stabilize besieged currencies, and correct imbalances, amid foreign outflows as the US Federal Reserve presses ahead with its tapering programme. In short, the negative spillover effects of US monetary policy, with the Fed maintaining its resolutely domestic focus, has been laid bare: countries, with strong fundamentals and weak, have been assaulted by Fed-induced hot money inflows and outflows. Market tremors, triggered from one hawkish utterance from Fed chair Janet Yellen alone have the potential to reverberate from Sao Paulo to Johannesburg, causing billion-dollar losses in global stock and bond markets, and a drop in EM output.
Given the dollar’s status as the global reserve currency, making the Fed the de facto global central bank, an improvement in the US trade balance naturally results in fewer dollars sloshing overseas, explains Charles Gave of Gavekal Dragonomics. “Those emerging markets faced a Hobson’s choice: they could try to fill the funding gap by engaging in a fire sale of assets (including foreign exchange reserves), or reduce their deficits by killing demand (and thus imports) through bruising interest rate hikes. Not surprisingly, most of them took the latter route. As a result, their financial markets and currencies collapsed.”
He adds: “The problem is that the rest of the world must find dollars to buy energy, conduct trade settlement and service dollar debts. Those who are short of dollars can in theory get a swap from the Fed, or at least a renminbi swap from the People’s Bank of China, which allows them to settle their trade with China. Practically speaking, most big emerging economies have not sought out such arrangements (or they were not offered) and so they instead stuck with the conventional approach of suppressing domestic demand.”
Meanwhile, domestic policy measures to fix the holes in global finance won’t work thanks to the economic policy conundrum known as the impossible trinity – the challenge of managing exchange rates, allowing the free movement of capital and boasting an independent monetary policy all at the same time.
Only two of these conditions are said to be possible. Strong portfolio flows heap on inflationary pressures, and interest rate increases, in response, risk sucking in yet more overseas credit.
Capital controls are a contentious form of financial protectionism and typically fail to ward off flows. Meanwhile, the frenetic growth and complexity of global financial industry suggests high-yield emerging markets, from Asia to Latin America, will be perennially vulnerable to hot-money boom and bust cycles even in economies that seek to address this conundrum with fully-floating exchange rates, says George Magnus, a veteran EM observer and economic advisor to UBS.
Heeding the lessons of the 1997 crisis, some emerging Asian nations, led by China, have relied on a combination of managed exchange rates, current account surpluses and large foreign exchange reserves in the absence of an international central bank to provide emergency liquidity. This bid to self-insure against a liquidity or foreign-exchange crisis, through a stockpile of low-yielding dollar reserves and a trade surplus, comes with a litany of costs. This includes domestic financial imbalances (an inefficient use of domestic savings and excess liquidity), a reduction in aggregate global demand, unless the US runs a big current account deficit, and causes trade tensions given fixed exchange rates. Meanwhile, other emerging markets, such as Brazil, South Africa and India, have opted for a mix of relatively liberal capital accounts and currency regimes in a bid to achieve a degree of monetary autonomy but remain hostage to the Fed.
Grand plans post-Lehman to address these flaws in international finance have failed to gain traction due to political hurdles. These include the People’s Bank of China governor Zhou Xiaochuan’s call to transform the IMF’s Special Drawing Rights into a truly global reserve currency, the IMF’s now long-forgotten bid in 2009 to become a de-facto global central bank by pooling foreign exchange reserves, and former US Treasury secretary Timothy Geithner’s suggestions for current account targets to stop Sino-American trade imbalances.
|Russia’s president Vladimir Putin says the Brics bank will change the international monetary system’s dependence on US policy|
As emerging markets wake up to the perils of importing US monetary policy, and the structural dependence on the dollar, even the first baby-step of reforming the international system has stalled: reform of the IMF’s quota and the US/European rotation of leadership of the World Bank and the IMF.
Frustrated by the western-centric global order, emerging market policymakers, in particular in South Africa and India last year, engaged in discussions with other Bric economies about the prospect of coordinated interventions in the foreign exchange market but to no avail.
The NDA then is a statement of the Brics’ intent to generate an “international liquidity backstop” to combat future crises, isolate the IMF and, ultimately, signal a shift in the US-led global monetary order, says Peter Attard Montalto, emerging market economist at Nomura.
Morris Goldstein, senior fellow at the Washington-based think-tank the Peterson Institute for International Economics, and a former senior IMF official, adds: “A lot of trends are not going well for globalization, from trade, Russia sanctions, the balkanization of banking, to exchange rate manipulations to the failure to pass IMF reform. The emerging markets are pressing ahead with their own flawed arrangements.”
Nevertheless, the NDA’s detractors can, for now, rest easy as the budding institution lacks teeth. The irony, says Benn Steil, senior fellow at the Council on Foreign Relations, is that the entire paid-in capital stock of the NDA will be in US dollars, while just 10% of World Bank’s capital at inception was denominated in the dollar, which means it will be “even more dependent on the dollar than the Bretton Woods’ institutions”.
The CRA, the stabilization fund of the NDA, designed to provide liquidity in a crisis, replicates the same flawed structure as the so-called Chang Mai Initiative Multilateralization (CMIM), a post-Asia crisis attempt to establish a regional safety net for short-term balance-of-payments and liquidity crises. The $240 billion foreign-exchange pool, established in 2000 by the Association of South-East Asian Nations plus China, Japan and South Korea, has largely failed to boost market confidence in the provision of emergency liquidity.
Instead, bilateral swap lines between the Fed, China and/or Japan and a given emerging-market central bank have proved more effective, says Steil.
Isn't it ironic…
Even if they are accessed, the CMIM and the CRA share the same irony: only 30% of a member’s quota is accessible without the prior agreement of an IMF programme. This has deterred applicants, highlighting how the NDA fails, in practice, to mark a shift, or improve upon, the existing international financial architecture. In addition, this structure reflects Brics’ leaders acceptance of the IMF’s market clout, resources and economic surveillance, says Goldstein at Peterson.
In any case, the $100 billion CRA lacks the requisite firepower. It represents just 1% of China’s reserves, 80% of India’s budget deficit for the 2013-14 fiscal year, while Brazil’s last bailout in 2002 was for a cool $30.4 billion, notes Steil, though at the margin the CRA could prove helpful for South Africa.
|A breakdown in co-ordination raises the risks |
of dangerous policy errors
Nevertheless, hawkish observers fear the prospect of conditionality-lite lending from the NDA, either for capital projects or emergency liquidity assistance, could one day freeze out the IMF and World Bank, and cause countries to postpone pro-market structural reforms in favour of a statist model, rolling back on globalization.
Montalto at Nomura adds: “As emerging markets are offered more options apart from IMF and World Bank funds, which comes with conditions, markets might see the provision of ‘free’ money – though probably with political conditions – as a form of moral hazard, ignoring the economic problems at hand.”
The Bank of the South, or Banco del Sur, serves as a cautionary tale. Backed by leaders of seven South American countries in 2007, it was designed to serve as “a new financial architecture for the south”, according to Rodrigo Cabezas, Venezuela’s former economy minister at the time.
Brazil’s former president Lula da Silva in 2007 stated its mission statement more succinctly: “Developing nations must create their own mechanisms of finance instead of suffering under those of the IMF and the World Bank, which are institutions of rich nations.”
The bank, though legally established, is dead in the water amid a rift over voting shares, capital commitments and Brazil’s pragmatic push for the institution to be exposed to market discipline against Bolivarian idealists led by Venezuela, now chastened post-Chavez and post-oil price boom. Ecuador even pushed for the inclusion of a regional monetary fund and a single currency within the purview of the Banco del Sur, underscoring emerging-market delusions of monetary grandeur in a dollar-based world.
Will the NDA – rather than signalling enhanced economic co-operation among emerging markets to craft a new form of monetary governance – mimic the aborted Bank of the South, which failed even to taken on the existing Latin American development banks, such as BNDES and CAF? Only time will tell but the early signs – the limited capitalization of the institution, the divergent political economies of the founders and the lack of originality in its design – bode ill for the institution.
Dissatisfaction with the US’s central role in the global monetary system is a feature, not a bug, of the global financial landscape, and not reserved to the Bric nations. In July, the same month as the Brics summit that gave the green light to the NDA, France and Germany lashed out at the large US fines imposed on European lenders which broke no domestic laws but fell foul of US sanctions on so-called rogue states. Also that month, the US Supreme Court’s ruling on Argentina’s default highlighted the US’s legal reach over the rules of finance, from foreign banks that deal in dollars to sovereign debt restructuring norms.
Attempts to boost intra-Brics cooperation on the international stage, judged by current plans, won’t materially weaken the existing financial architecture in the near- to medium-term. But faith in the integrity of the international financial system, and a global safety net of sorts, would speed up the shift to open capital accounts and freely-floating exchange rates in emerging markets, generating new sources of demand for a disinflation- and debt-ravaged west seeking new export markets.
The NDA is no game-changer but the west dismisses the economic and political drivers for greater intra-Brics co-ordination at its peril. As Magnus at UBS warns: a push to establish a rival IMF could balkanize markets.
“There is a battle of ideas when it comes to global governance – state-orientated emerging-market actors that seek stability in financial markets versus the US laissez-fair model – and a political desire for more control in international financial arrangements.
"However, global economic discussions and the introduction of new policy tools should be done within the IMF, which has the mandate to stabilize financial globalization. A breakdown in co-ordination raises the risks of dangerous policy errors.”