Transcript
CHAIR
Welcome to session three of what's already been a very interesting day, and we look forward to another lively session this time round, and to excellent papers that have been prepared for this session – the first by Professor Philip Lane, who's professor of Political Economy in Trinity College at Dublin University, and also a fellow of Centre for Economic Policy Research in the UK. And he'll be presenting his paper on Cross-Border Financial Integration and Macro and Financial Economic Policy Issues, which is one whole set of important issues that we have to consider in the policy response to what's going on in Asia.
Bob Gregory will be looking at entirely different set of issues that relates closely to what's going on in Australia, looking forward at the policy issues that confront Australia through the commodity boom that we've enjoyed over the last decade or so. And he's written a paper on that subject jointly with Peter Sheehan, and Peter will come up later and join in the discussion when we open the thing up to questions.
So, Philip, welcome and we look forward to your presentation.
PROFESSOR PHILIP LANE
So I'd like to thank the organisers for inviting me. This is an area in recent years I've worked on in projects with the World Bank and the Asian Development Bank and also in New Zealand, last year and the year before. So it's nice to revisit this topic. So you might say, well, if you have a European based economist talking about these issues, why should we listen? So if you go back a number of years, there were a lot of Asia conferences which said what can we learn from the European integration process? You can learn a lot but probably the... just put an opposite sign on what you thought you'd learnt, before and, of course that applies even more so when it's an Irish economist. Irish economists used to be invited around the world to talk about how do you sustain really high growth rates? We're now invited around the world for other reasons, but it's also pleasure to... for exactly those reasons to come to an area of the world where you can talk about positive economic activity.
So the work I'm doing here really reflects the fact that my main research interest in the last 15 years has been about the process of financial globalisation. When you look at that, financial globalisation is not a uniform process. There's very different profiles around the world of how countries and regions approach cross-border finance. So this morning we heard a lot of issues to do with, essentially, the real side of Asian structural change; trade openness, natural resources, and so on, and demographics. All of those are very important but they do have a parallel side to that, which is how do real factors mapped into financial flows, who finances these activities, how are the risks allocated across different types of sectors and across borders. And many people concluded from the global financial crisis or TFC – people here say TFC; we don't say that in Europe, but the TFC is a... that Asia did relatively well.
My main point during this talk is Asia did do relatively well in the crisis, and it's important to take the appropriate lessons from that. But at the same time, in terms of the topic of this conference, which is structural change, this is not a permanent feature. The characteristics by which Asia was safe during a crisis are not necessarily characteristics that are going to persist. And I think those factors mean that there has to be a lot of strategising about the future here. And here... someone said this morning that it's not just about what Australia needs to know about emerging Asia; it's also what emerging Asia can learn from Australia, and this is an area in terms of coming up with macro financial policy frameworks. In many ways at... could well be a convergence by which emerging Asia, at least a good number of those countries, will be looking to adopt Australian type policy frameworks. At the same time, I wouldn't say that the Australia is necessarily... it's not good to be complacent, so I'll say a little bit about some of the risk factors facing Australia.
So the... dependent on how much you've read in this area, there are a number of key asymmetries in the way emerging Asia has approached cross-border finance. So we know after the 1990s Asia crisis, there was this move to become much more safe, run a long sequence of large current account surfaces so that countries that were big net debtors either became smaller net debtors or a number of countries became creditors – essentially a policy of aversion towards cross-border finance so that the levels of cross-border asset trade were way below what were seen in other advanced areas. You had this skewed pattern which is, on the asset side for emerging Asia, a lot of that were debt assets, especially official reserves. And on the liability side, did it switch away from debt financing, which had been prevalent before the Asia crisis towards equity financing, a lot of that taking the form of direct investment, also stock market investment. And I say on the asset side these debt assets were predominantly held in the form of official reserves.
So you might say, well, that kind of out gives you a lot of insulation; you avoid the risk of being on bank run or a debt run because you're avoiding debt financing and you're offloading the investor risk because with equity investment, the foreign investors, if there's a crisis, will take losses. And at the same time, though, remember Asia, throughout this period, is growing in terms of share of world GDP. So what's interesting is, even though a lot of those features you might say is making Asia safer, it's still the case that if you're issuing a lot of equity liabilities, you are part of the global financial system, and when global equity markets go into freefall at the end of 08, you're going to be affected. So, in other words, the only way to be totally safe is to totally cut yourself off; that is not the Asia strategy. It's a big price for a financial autarchy. Asia did not go that way and so, of course, there was in end of 08, early 09 quite a big impact on Asia. They got through this but it was quite a big impact on emerging Asia after crisis. I focused on the emerging Asia case; Australia and New Zealand are quite different from that in the sense of running significant current deficits but there are some similarities as well, which I'll come back to.
So in terms of some pictures here, I just want to go through some of the points that I've made. So what you see here is that emerging Asia... this is the sum of the key emerging Asian countries, according to the IMF classification and then Japan separately reported. Running these sequences of surpluses, four or 5% of GDP and then which have come down since the crisis, and one big question, is that a cyclical decline or whether it's going to re-emerge? And then Australia and New Zealand, I added them together, just to create a block; again, running deficits but, again, those deficits having narrowed after crisis but coming out again in 2012, again from the IMF data.
So in terms of the accumulated positions our countries' creditors or debtors, what you see is, if you go back before date of crisis to now, Australia and New Zealand have these persistent net liability positions but China's gone from being a net debtor to being a net creditor. India has been roughly stable; they haven't followed that route. Indonesia has come in from -58 to -34; Korea, -9, pretty stable, actually, there; Thailand from -50 to -8, and Japan is increasingly a big net creditor. So, by and large, emerging Asia plus Japan has followed that route of becoming safer by essentially, rather than borrowing
from the world, lending to the world.
In my work with [unclear] of Malaysia for the FDI math, we came up with this index called the IFI ratios; the ratio foreign assets plus liabilities to GDP. So it is an index of how much cross-border financial trade you do and therefore the typical European country there's an explosion before the crisis where ratio's 400%, 500% – not unusual. And countries like Australia and New Zealand have ratios that are behind the European levels but still relatively high, whereas if you look at India, it's only 70% of GDP, Indonesia 80% and even countries like Korea and China and Thailand are still well behind levels you might see in other parts of the... where there are similar income levels. So, in other words, there was a much more cautious approach to cross-border finance than in Europe.
And what's interesting, again, is this skew pattern; so this is the debt-equity ratio in assets. So, again, the typical risk country has a lot of equity assets to deal with foreign investment overseas. The institution investors buy a lot of foreign equities and Australia and New Zealand follow that pattern. So equities are more important than debt in terms of the asset position. So Australia is a rate of .7, New Zealand .9, whereas for China it's 15 in 06, it's come down to eight; Indonesia seven times more that assets in the equity assets before the crisis; Korea four times; Thailand 13 times. So, in other words, it's the process of outward equity investment. It has started – we know more about FDI and so on, but still, it's still very skewed; it's still predominantly debt assets, again, mostly foreign reserves.
On the liability side, what you see is, again, rich countries might have a lot of each and the mix is... for Australia and New Zealand it's basically very similar; so Australia, it's even – equity flows in, debt flows in. But for the emerging markets it's very skewed towards equities. So China is very averse to debt inflows, India is averse, even Korea is averse. So what you see is, is this for asymmetric pattern where these countries are trying to be safe by avoiding that inflows and encouraging equity inflows. And what that has meant is in terms of debt markets, these countries came right down; so in terms of loan, international loan shares of these countries, emerging Asia, okay too much before the Asia crisis, but that number came right down. This is a share of total global cross-border lending. It came down from 16% to about 4%. All of these countries... none of these countries are that big in global bond markets in terms of issuing international bonds.
But on the equity side emerging Asia rose from about 5% in 97 to about 12%. So, in other words, when you deal with a lot of equities and you grow very quickly, you going to become important in world portfolios. So emerging Asia, even though they were trying to become safer, which they were, were still very integrated into the global markets to the equity side, and same for FDI. I don't have a time series here but the IMF data indicate emerging Asia has been... is now pretty big in FDI positions. So, again, what that meant was, was when all markets were falling, emerging Asia, no matter how safe they were in terms of net positions, was going to be exposed.
So, so far I've talked about these cross-border positions, but it's important to analyse cross-border positions rather to domestic indicators, especially the size of domestic financial system, domestic financial imbalances and also the state of the public balance sheet. So what you saw again over this period was emerging Asia, if you like, deleveraging internally. So private domestic credit of GDP came down from 78% of GDP to 53% over that period. Japan was also shrinking in that sense, whereas Australia and New Zealand were a bit more like their European counterparts, with significant increases in credit over that period.
Again, in terms of debt ratios, in terms of... if you have more risk on the external balance sheet, you better make sure your government is safe and there, what you see is we know Australia has this low public debt ratio and we know New Zealand came down before the crisis, and again, with fiscal response to crisis, gone back up again. But some of these emerging markets like India, it is well known, are constrained on their financial strategies, is the need to fund all of this public debt; Indonesia has come right down, and so on.
So in terms of what are lessons; so, first of all, they're global lessons which is, if you like, these are more lessons for Europe and the US, saying, well, maybe we should become more Asian, maybe we shouldn't let your banking systems go wild. So the idea of having a very ultra liberal approach to financial that been firmly discredited by the crisis. It's been firmly discredited that very large external deficits are a good idea. Again, part of my work in the last year or two has been to show the costs of the current account reversal. So those countries in Europe with really big deficits before the crisis, the climb in domestic consumption in investment has been so big and so sudden that any idea that this is something you sweep up after the event, I think it's firmly rejected. We know, right now in Europe, if you're in financial crisis, the fiscal impact is going to get pretty big.
And then last point is it's not just about the net, which I mentioned already for Asia, the growth positions matter. So, again, in 08 when the US markets fell, you might say, well, who's going to suffer from that? It wasn't the Chinese Central bank because the problem was not in the treasury market – in fact, that treasury market improved – the problem was in the sub-prime and ABS markets, whereas the foreign investors in those markets were Europeans. So, even though Europeans did not have a net in balance vis-à-vis the US, because they had such a big gross position in the US, they were going to make big losses, and that's on the seeds of the European crisis. So, in other words, you really have to look behind the net; it's not enough to run a credit account surplus; you have to really make sure what you hold is safe to the extent that you can do that.
So, turning to what are the big issues for Asia now, which is, you might say, well, the emerging Asian strategy was vindicated by the crisis. However, that still runs into the problem; it's neither feasible nor optimal to maintain that pattern. The feasibility issue, if you like, there's all sorts of factors in there but a very simple one is the Asian strategy of trying to be a net lender to the advanced economies really relies on the advanced economies want to being a net debtor, vis-à-vis the emerging markets. So the extent, and in the last few years temporarily, private sector might have got over that behaviour but the governments and the advanced economies have been looking to borrow, so that pattern has persisted to some extent. But now, if you think to one of the big stories for the advanced economies is going to be deleveraging where, essentially, trying to pay down these high levels of debt, governments having to go to austerity and even more than that, a recognition that having this highly leveraged approach to finance is not a good idea means that if you're collectively the emerging Asia, you may want to think again about a strategy where you think at trying to hold a lot of debt assets is a good idea. And we know there's tons written on the opportunity costs of excessive reserve accumulation, the collective inefficiency of each country trying to self-insure. And, also, we know, increasingly on the real side, you move away from export orientated to domestic orientated growth strategies, having these dollar tracking currency regimes is clearly sub-optimal.
So if you put that together, what you're going to see is increasingly a move towards normalisation of the international financial activities of emerging Asia. The pattern in terms of structural change in international financial traders as countries get rich
er, as they build up domestic financial systems, there's a greater comfort level in terms of entering overseas equity markets, liberalising the freedom of the private sector to engage in foreign asset acquisition and foreign liability issuance. And what's interesting here – and again, this is really interesting – once that happens, it's going to be regional. All the data indicate that cross-border private sector finance is very much driven by gravity factors. If you go across borders, you tend to go to your trading partners; so if they are in Asia, the natural... for a natural counterpart to that is also to invest in Asia. This is especially true for foreign direct investment; it's strong also in banking. Bank loans are information intensive; you're much more likely to be... someone was talking this morning about Malaysian banks being maybe competitive, say, in some neighbouring countries; banking is going to be a regional activity; stock markets look like that as well; lesser for bonds but for those areas that will be true.
And there are some other factors which reinforce the fact that the international financial [unclear] become more regional. Clearly one reason these Asian central banks hold a lot of dollars is to try to stabilise their currencies against the dollar, but if they move away towards either having independent multi policies or pegged against the RMB, then if you move to more regional currency targets, trade weighted exchange rates, independent currency regimes, and so on, the rationale to hold dollars or Euros will go down a lot. And, again, the rationale to hold out local... regional currencies will go up. And, of course, through the ADB and other initiatives, building the infrastructure to support regional financial integration will help there.
So, in terms of structural change in Asia, as again mentioned this morning, an odd feature of Asia is so much of the money goes out of Asia and then comes back again. It's re-intermediated through the US financial system. This will be a big change, and it's a big change also that carries risk, especially in terms of cross-border debt. So, as I mentioned, one strategy here is just try and avoid it and that's been sustainable for... since the Asia crisis to minimise cross-border debt flows. But, again, as you liberalise, as your recognise that as a limit to how much equity financing might be desirable, this will happen. But, of course, this is risky; there's not doubt there's a big correlation between cross-border debt flows and enhanced crisis risk.
So it's a question how to manage that risk. So here, let me pre-advertise work that's going to come out next week; I'm part of this grandly titled group called a Committee on International Policy Reform, which is run out of DC, and next week this report is launched, which is a very detailed analysis of how to think about cross-border debt finance. And in order for the risk management to be effective, it's clear that there should be both international level reforms and domestic reforms.
So in terms of the domestic... the international reforms, there's a long list here, and one is very simply informational. As I mentioned earlier on, in order to understand the risk distribution, you really need to know what's going on, who's holding the risk in any given situation. And one of the projects right now is to improve information flows; it's amazing how little is known about the matrix of cross-border risk linkages. So there's this legal entity identifier project of the G20 – let's see if that goes anywhere – with the idea there is you build a... identify who are the ultimate investors in a given security and that should help me work out the matrix of risk. Again, the level of analysis of... going back to 08, the analysis of who is going to lose when the US sub-prime market went into shock was very lacking; there's just huge amount of uncertainty. And the uncertainty itself was a big part of the problem; and also improving surveillance. Clearly, with banking to the extent, it's not enough just for each national regulator to regulate its banks; the more cooperation there is internationally would be a good idea.
Again, if you want countries to move away from reserve accumulation, part of that is just moving away from trying to peg the exchange rate, but part of it is coming up with other ways to pool risk, an expanded role for the IMF, expand the China mine initiative and related ventures. There's some work coming out from various groups of authors pointing out this is not necessarily regional; it could be an alliance across the emerging markets; it could be the BRICS, and so on, could get together as well to some extent. And, again, one of the big issues, when you look at it, is having asset trade in Asian currencies; so one of the big risk factors in financial integration is if you have to borrow in a foreign currency. So the ability of China to borrow from foreign investors in its own currency would really form an anchor for the regional financial system. So that's a big structural change, which a lot has been written about.
So, again, in the end all that international reform is second level reform because, in the end, until a lot has changed, it remains the case that national governments are primarily responsible for the stability of their macro systems. So if you move towards a more integrated financial system, again, the lessons from the crisis, the lessons from Europe are you need to work at it. You need to work at macro prudential regulation of financial systems. The polite phrase now, instead of capital controls is capital management policies as it is the IMF and others are working a lot on when does that make sense? There's a big gain from a fact of monetary regimes and, again, this is where emerging Asia can learn a lot from the Australia and New Zealand experiences where the exchange rate is a shock absorber.
So that's a big one, but you can just solve all... manage all risks factors with a single instrument; so the other big message is how could you use fiscal policy to mitigate risk? So, again, there's a big revolution in analysis now about the rebirth of fiscal policy as a stabilisation policy, not just vis-a-vis the business cycle, but also vis-a-vis the financial cycle. So, in other words, if the private sector's taken on more balance sheet risks, then the counterpart has to be the government, trying to lean against the wind by running low public debts and using a whole range of fiscal instruments to manage that.
So let me just finish at that point, is to emphasise that Asia should not be complacent. The fact that the global financial crisis was a [unclear] roughly less than other areas does not imply that's a permanent feature of the world. So that's my number one... my main point here, is the factors that meant Asia could build those protection doesn't mean that's going to be permanently available to emerging Asia. So when you have a more liberal approach to financial inflows and outflows, my prediction is it's going to mean a lot of regional financial [unclear], which we haven't seen up to now. And from a policy point of view, if you want to make that safe, there are obvious agenda items there in terms of reform of the international system. But also at a domestic level these risks are there; the fact that the private sector takes on risks essentially mean that the public sector has to offset those as far as it can. So let me stop at that point.