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About the project

The International Economy program aims to explain developments in the international economy, and influence policy. It does so by undertaking independent analytical research.

The International Economy program contributes to the Lowy Institute’s core publications: policy briefs and policy analyses. For example, the program contributed the Lowy Institute Paper, John Edwards’ Beyond the Boom, which argued that Australia’s transition away from the commodities boom will be quite smooth.


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Short-term capital flows to emerging economies

Emerging markets are under pressure from events in the global economy, including the normalisation of American monetary policy, the strengthening of the US dollar, and President Donald Trump’s trade war. Heightened risk perception is causing substantial outflows of foreign capital from the emerging economies. Australia’s region, however, seems to be coping without drama.

But the surges and retreats of foreign capital flows pose the question: how could they be made less volatile and thus more beneficial? 

For decades, conventional wisdom has urged emerging economies to integrate their financial sectors more closely with advanced economies and adopt freely floating exchange rates. This was expected to provide additional funding, raising investment and growth. A freely floating exchange rate was supposed to remain stable, fostering steady capital flows. 

When this worked out disastrously (for example, the 1998 Asian crisis), the standard assessment was that the fault lay with the recipient countries, which had not followed the prescription closely enough: “Should try harder”. 

But the evidence is accumulating that short-term flows are intrinsically volatile, with surges and retreats reflecting changes of mood (“risk-on”, then “risk-off”) in the investing economies.

The latest Bank for International Settlements annual economic report provides details on one important component of the flow: foreign investment that comes via managed portfolio funds which buy emerging-economy bonds and equities on behalf of foreign savers.

Source: Bank for International Settlements

It was a nervous year in 2015, with net outflows, especially in the second half of the year. By 2017 foreign portfolio investors had their mojo back, helped by the “push” factor of low returns at home and a weak US dollar. Now the flow has turned negative again.

The recipient countries in our region have, for the main part, learned to live with these fluctuations. Their exchange rates are flexible (if not quite floating freely). The graph below shows that the exchange rates of emerging markets (red line, with a rise denoting a depreciation of the currency) didn’t fluctuate as much as the euro (blue) or the yen (yellow). 

Source: Bank for International Settlements

In our region, exchange rates have depreciated, but roughly in line with the global appreciation of the US dollar. The renminbi, rupee, and rupiah have fallen less than 10% over recent months – not much different from the weakening Australian dollar. 

This may, however, conceal underlying stresses. These countries routinely use their substantial foreign exchange reserves to smooth their exchange rates. This is not costless: they are holding low-return foreign assets, waiting for the moment when these will be used to support the exchange rate for fear of overshoot. 

Moreover, their macro policies are constrained by the threat of outflow. These countries have learned that they have to keep their budget and external deficits on a tight leash. Perhaps this discipline is useful, but it certainly diminishes the benefits of international capital flows in meeting the local savings shortfall: they can’t draw too deeply on this fickle source.

How can these flows be made more stable and thus more useful?

Conventional wisdom says that when these emerging economies are able to fund their deficits with local-currency-denominated bonds, the foreign flows will be more stable because the foreigners know that the debtor country can always pay back debt issued in its own currency. This, however, was always a misguided argument. Foreigners who have lent in local currency still have a compelling reason to flee in response to exchange rate concerns, as they don’t want to be paid back in depreciated currency.

Source: Bank for International Settlements

Thus, in practice, local-currency debt yields move more than dollar-denominated yields when risk-aversion rises. The red line in this graph shows how the yield margin on emerging-economy local-currency debt (the difference between yield on this debt and US dollar–denominated debt) widened during the outflow period 2015–16, compared with the margin on dollar-denominated debt (the yellow and blue lines).

What are the lessons? 

First, developing domestic bond and equity markets will encourage local saving and intermediation, which is a good thing. But this doesn’t solve the problem of volatile capital flows. 

Second, it makes sense to manage fragile exchange rates in emerging economies rather than allow a pure free-float. But that doesn’t mean over-managing. If the exchange rate and bond yields are allowed to move significantly when outflows occur, this would impose an appropriate penalty on fickle foreigners who routinely flee like lemmings whenever sentiment changes. 

Other measures might discourage the fair-weather investors: transaction taxes, minimum holding periods, tight macro-prudential rules and effective imposition of income taxes. 

None of this fits the conventional wisdom of encouraging seamless financial integration. But if such measures discourage some of the flighty foreign investors, so much the better. Better still if the foreign funds come in the form of foreign direct investment or stable company-to-company loans.


The US is moving quickly to follow through on Trump’s threats to further escalate his trade war with China (now is as good a time as any to say that the trade war has officially started).

Last week the US imposed tariffs on US$34 billion worth of Chinese imports, with another US$16 billion to be hit shortly, and China is responding in kind. Now the administration has released a list of a further US$200 billion worth of Chinese goods that it proposes to hit with higher tariffs, as part of Trump’s threat to double-down in response to Chinese retaliation.

There is real concern Trump’s bullying tactics are only strengthening the hand of those in China who want greater national self-reliance.

If Beijing continues to fight back, Trump has indicated he is willing to cover all Chinese imports, worth roughly US$500 billion in additional tariffs.

Trump’s escalations would quickly turn a needless but miniscule negative shock into a much more significant macroeconomic one. His actions provide an unfortunately vivid example of precisely why tit-for-tat protectionism is such a dangerous route to go down (although Trump is on the verge of escalating things far more rapidly than most probably imagined).

The initial set of tariffs on US$50 billion worth of goods in both directions will do unnecessary but very little damage in the scheme of things. The gross value of those exports equates to only 0.4% of China’s GDP and about 0.25% of America’s respectively. If things stopped there, the overall macroeconomic effects would perhaps be perceptible but ultimately of not much significance.

The effect of tariffs on US$500 billion worth of Chinese imports will obviously be much bigger. How big is difficult to say.

For one, Trump hasn’t specified the tariff increase. If we assume it would be the 10% he is proposing for the next US$200 billion, together with 25% on the initial US$50 billion, that would make the weighted average tariff increase about 11.5%. Sizeable, but much less than the 45% across-the-board tariffs he originally threatened on the campaign trail.

Much harder to gauge is how China would retaliate. US exports to China only amount to about US$130 billion, so China won’t be able to mirror Trump even on his next US$200 billion batch. But they have other options to make up the difference, including simply applying a higher tariff rate and aggressively deploying regulatory levers to arbitrarily harass US firms exporting to China (for example, delaying customs approvals) or those operating in China (for example, increased audits and inspections).

Devaluing the renminbi is a theoretical option, but would be far too risky given the danger of prompting renewed capital outflows (although the RMB would indeed need to weaken on the fundamentals).

In the short-term, the costs will be magnified by the disruption to global supply chains, the incredible uncertainty being generated, and the fear that things will only get worse. Firms would significantly delay or even curtail important investment decisions, as are already starting to do so.

Overall, the impact would be a significant negative shock for both economies (with flow-on effects for the global economy). Though not likely to be recession-inducing, the costs would be large, needless, and could easily escalate further, including with mounting risks of a more globalised trade war.

There is still some scope to make a deal before all this comes to pass (perhaps a face-saving or time-buying deal). But the space to manoeuvre is rapidly shrinking.

As my colleague John Edwards has pointed out (US–China trade: joke’s over), it is not clear what the Trump administration wants that China would realistically give. China might be willing to sweeten the deal it offered earlier, by agreeing to further increase the forced purchase of US goods, and maybe by moving faster on certain liberalising measures.

But Trump’s maximum pressure tactics look more likely to prove highly counterproductive. Xi Jinping presents himself as a strong leader and cannot be seen to be giving in to such blatant foreign bullying (especially given China’s historical sensitivities).

Nor will China budge on core US demands to dismantle its industrial policies. In fact, there is instead real concern Trump’s bullying tactics are only strengthening the hand of those in China who want greater national self-reliance and believe in a more statist approach – to the detriment of those pro-market reformers the US should instead be trying to bolster.

US-China trade: joke’s over

Once entertaining, the Trump administration is becoming unfunny. In less than a week the trade dispute between China and the US has escalated to cover what will quite likely be the entirety of US goods exports to China, and the greater part, if not the whole, of Chinese goods exports to the US.

On Friday, the US finalised additional tariffs on $50 billion of imports from China. The following day, China announced corresponding tariff increases on $50 billion of imports from the US. This week, US President Donald Trump has threatened tariffs on at least another $200 billion, and perhaps $400 billion, of imports from China.

The US imports approximately $500 billion of goods from China per year. China imports $130 billion of goods from the US, so it is already running out of imports to penalise, and is looking for other ways to respond. For Australia, which sends a third of its exports to China, this is no longer even faintly amusing.

We could more clearly see the endgame here if US motives were less obscure.

The first round of the new US tariffs on China, and the first round of China’s countermeasures, will not go into effect until 6 July. The US and China will probably resume negotiations between now and then, perhaps postponing the actual operation of the trade penalties, or limiting their escalation. But it is not at all obvious what a negotiated solution would look like.

Nor is it obvious that the Trump administration is seeking something China can actually deliver. China is no doubt prepared to import more from the US, and perhaps a lot more. It has already offered to do so, without stopping or even slowing the tariff penalties.

The White House says it wants an end to the “forced transfer” of US commercial technologies to China as the price of participating in the China market. That, surely, is to some extent negotiable. So there is likely also room for China to offer up more liberal access to its financial services market, and some parts of its communications and energy industries.

But what is not negotiable for China is relinquishing the ambition of becoming a global leader in advanced technology industries. That is central to its economic progress as Chinese wages rise, the workforce begins to contract, and its labour-intensive manufacturing moves to other countries.

Nor is China likely to publicly accept US instruction on how rapidly and to what extent it introduces more private business competition into areas now controlled by state-owned industries; although there, too, American pressure will be welcomed by many Chinese policymakers.

We could more clearly see the endgame here if US motives were less obscure. If it was the bilateral deficit alone, the dispute would not have come this far. It is possible for China to reduce its bilateral surplus with the US by purchasing more from it and less from other countries.

But the economic arithmetic tells us it is not possible to reduce the US trade deficit with the rest of the world unless the US saves more or invests less. By sharply increasing US fiscal deficits, the Trump administration has reduced saving. A bigger trade deficit will result.

The Trump administration might have found it easier to focus on China if it had not also initiated ongoing trade disputes with Europe, Japan, Canada, and Mexico, all of which are hotly contested and far from being resolved. The US is in trade rows with all of its major trading partners, all at the same time.

The cost of these escalating disputes to the world economy has so far been contained. In a very useful research piece published on Tuesday, CPB Netherlands Bureau for Economic Policy Analysis economists find that, if carried through, the macroeconomic impact of higher US steel and aluminium tariffs, and the equivalent response by Europe, on global growth will be very insignificant.

The trade contest between the US and China is much more consequential because the range of goods covered is much wider, and the tariffs impositions are generally higher. Even so, the modelled losses are not large.

Adding the further $50 billion of tariffs on goods that the US and China have now announced against one another to the reciprocal steel and aluminium tariffs mainly between the US and other advanced economies would see 2030 GDP in the US down by only 0.3% and in China down by only 1.3% from the levels it would otherwise attain.

If the trade conflict continues beyond these announced measures and countermeasures, the impact begins to be very serious indeed. These are all minimum numbers. They do not and cannot take into account the impact of uncertainty on business investment, the cost of disrupting and then replacing supply chains, and the probability of trade conflict engendering political responses that shake the foundations on which global trade and investment are built.

Some of that menace is now evident in volatile financial markets and the sharp declines in affected stocks, such as Boeing and Caterpillar. Much more will be evident between now and 6 July.

Global profit shifting

Australia’s proposed corporate tax cuts aim to attract footloose global capital by offering an internationally competitive tax rate.

Much of the global tax debate, however, focuses on increasing rather than reducing company tax. Specifically, the aim is to discourage companies from shifting profits to tax havens where they pay little or no tax.

New analysis by academic researchers Thomas Tørsløv, Ludvig Wier, and Gabriel Zucman adds compelling data to the case for stronger internationally coordinated action to address this profit shifting.

The broad narrative is familiar, and the tax-avoidance techniques are well known: transfer pricing; intra-company loans; and locating intangible assets (trademarks and intellectual property) in tax havens. From time to time, accidental leaks, such as the Panama Papers, provide detailed insights. But neither the companies nor the tax havens have much interest in providing enough transparency to allow an accurate assessment of the magnitude of profit shifting.

In recent years, however, better data is becoming available thanks to the base erosion and profits shifting (BEPS) project run the Organisation for Economic Cooperation and Development, work by the International Monetary Fund to improve balance of payments data, and work by the statistical office of the European Union. Financial transactions have two sides: when one party provides transparency, it can shed light the other side of the transaction.

This new data provided the basis for the paper’s revealing forensic analysis. In particular, macro-level data on foreign entities provides detail on company income, including in tax havens.

Company output (which makes up more than half of GDP) comprises profits and wages. The ratio of profits to wages can vary with capital intensity and other factors, but when this ratio is abnormally high, it is a strong indicator that profits have been inflated by transfers from associated companies in other countries.

In normal circumstances, profits tend to be around one third of wages. Local companies in Ireland, a notable tax-shifting destination, match this typical ratio. But foreign-owned companies in Ireland record a ratio of around 800% – a sure sign of massive profit shifting into Ireland to benefit from the extremely low tax rate on company profits. 

Source: Tørsløv, Wier, and Zucman: The missing profits of nations

For Ireland, the transfers are around 100 billion euros annually: so large that the national accounts are clearly distorted. In 2015 Ireland recorded a phenomenal GDP increase of more than 25%. 

More detailed US data demonstrates the growing prevalence of profit shifting by US companies over the past fifty years.

Source: Tørsløv, Wier & Zucman: The missing profits of nations

The authors estimate that at least 40% of multinationals’ profits earned outside their home country are shifted, with the extreme cases being companies with high levels of profit from intangibles and very little conventional capital, such as Google, Facebook, and Apple. The European Union is estimated to lose 20% of its company tax revenue, hence its special interest in requiring Ireland to impose more tax on foreign companies such as Apple.

This analysis suggests that Australia has the wrong priority in corporate tax reform. Of course, Australia participates in the BEPS process, and the Australian Tax Office works hard to address profit shifting (and not only by foreign multinationals, as its current dispute with BHP demonstrates).

But this paper argues that it is profit shifting, not profit competition between countries, that matters.

Keeping track of trade distortions

A tentative ceasefire has been declared in the US–China trade war, giving China time to make adjustments which might placate America. With the emphasis on the US–China bilateral trade balance, there is a good chance the main losers will be third countries: collateral damage in the conflict.

The easiest way for China to reduce its bilateral surplus with the US is to replace imports from third countries, such as Australia, with similar imports from America. Thus, Australian liquefied natural gas and Brazilian soybeans would be replaced by US sources.

China has the administrative means to do this easily, and the cost to it would be minor because these are widely traded, generic commodities. This comes as the the Financial Times reports a US move to demand long-term import deals with China, raising concern about the potential exclusion of fair competition from other countries.

One way that third countries could register a low-key protest against a distortion of the multilateral trade framework would be to track the development of trade in the relevant commodities, comparing past trends in China’s import sources with the new realities. The results of this analysis could be publicised, perhaps spurring other countries to add to the analysis: examining Europe’s aircraft exports, for example.

A further step would be to put this analysis on the agenda for the next G20 meeting.

The model for this initiative is the widely publicised compilation of trade protection measures during the 2007–08 global financial crisis, when there was a concern that countries would attempt to insulate themselves by erecting trade barriers. Whether or not this “naming and shaming” had a big impact is uncertain, but the outcome was clear enough: new protectionist measures were limited.

The Trump trade strategy is based on “divide and rule”, emphasising bilateral deals. Initiating this sort of analysis would be one way that Australia’s Department of Foreign Affairs and Trade could keep the focus on collateral damage to multilateral trade.

This would also send a signal to the Trump administration of the complicated consequences for allies, such as Australia, of picking fights with China.

The tide is turning against US financial regulation

This article was orginally published on 7 February and has been reposted following legislative change this week in the US. 

For most of the decade since the global financial crisis, financial regulation has been strengthened. Now the tide is turning in America. Reform has come up against the combined forces of Wall Street lobbying and Donald Trump’s deregulation agenda.

It is beyond dispute that the financial crisis revealed not only serious deficiencies in prudential regulations, but also systematic gaming of the regulations by European and US banks. Alan Greenspan’s view that the self-interest of financial sector management would discipline their actions proved hopelessly out of touch with reality.

The reform efforts have been coordinated at the international level by the Bank for International Settlements, rewriting the Basel rules that focus mainly on ensuring the banks have enough capital to absorb losses. Within this global framework, national regulators have flexibility to modify and add to these rules in order to suit local conditions. Randal Quarles, Trump’s appointee in charge of supervision on the Federal Reserve Board, has foreshadowed changes to the US regulatory framework – all favouring Wall Street.

The first proposed change will weaken what has proven to be one of the most effective post-2008 measures: the requirement that banks undergo a stress test to simulate the impact of an adverse shock, such as a big fall in GDP, on the balance sheets of individual banks. Stress tests in 2009 were, in fact, the key to restoring public confidence in the US banking system after the crisis.

Since then, however, the banks have complained that they don’t know what the simulation shocks will be in advance, so can’t prepare themselves properly. This might sound a bit like students asking to be told what their exam questions will be ahead of time. Banks can tweak their balance sheets so that they look good in the context of these specific shocks. Nevertheless, Vice Chairman Quarles seems ready to make the stress tests more “transparent”.

The loudest of the bank complaints relates to the “Volcker Rule”, even the watered-down version of which was finally agreed upon in 2013. Until 1999 the Glass-Steagall Act separated banking from other financial activities, such as insurance and investment banking. The logic is simple: in a crisis, the banking sector is protected not only by depositor insurance, but also by the understanding that if a substantial bank gets into trouble, it will inevitably be bailed out by the taxpayers to ensure there is no general loss of confidence in the financial system.

The implicit downside of this guarantee is that it may make bankers less diligent and more risk-prone (moral hazard), and it certainly means that taxpayers subsidise the full range of risky activities. Thus, even though an implicit guarantee is necessary, it should be confined to the part of the financial sector that is really vital – simple deposit-taking and lending, and the payments system. The taxpayer should not be guaranteeing banks’ own-account trading in financial and commodity markets or risk-prone activities, such as derivatives and securitisation.

Of course, this comprehensive coverage suits banks. For a start, the government guarantee means that they can borrow more cheaply. All sorts of arguments, of varying merit, have been put forward in opposition to the Volcker Rule. But the need for this kind of separation has been recognised universally, with the UK and Europe moving to ring-fence traditional banking services.

The most powerful argument in favour of such a separation relates to the diverse nature of finance. A good financial sector should:

  • provide funding even for risky ventures
  • provide risk-management (such as underwriting IPOs, derivatives and forward cover)
  • participate in the full range of financial markets
  • be innovative.

All this is desirable and necessary. But providing a government guarantee for banks carrying-out this full range of services not only puts the taxpayer at risk, but also alters the structure of the financial sector. Core banking should be a dull part of finance, run by conservative, risk-averse managers. Without an enforced separation, banks expand their activities into these more exciting activities and are then managed by hard-driving, risk-loving Masters of the Universe. Didn’t we learn this lesson in 2008?

This prospective weakening of the Volcker Rule will not cause an immediate collapse of the financial sector. Memories of 2008 are still fresh enough to constrain management and stiffen regulators’ spines. But the lessons of the 1930s bank failures lasted for more than half a century. The lessons of 2008 look like they have already been forgotten, or erased.


2018-02-07 16:30:00 +1100

All’s not fair in US–China trade stoush

As tense trade talks between the US and China continue, a growing chorus of US commentators seem to have concluded that, whatever their misgivings about President Donald Trump, he’s right in taking on China for its unfair trade and being an economic cheat (for instance, see here and here).

But what exactly is unfair in international economic relations anyway? As Australia’s Productivity Commission has said about anti-dumping duties, so-called fairness arguments for protection often “ignore the fairness of outcomes for anyone other than those who benefit”.

Getting this right is about more than semantics. It matters for designing the right policy responses to the economic, security, and geostrategic concerns that lie at the heart of the current tensions. Witness the confusion over how sanctions against ZTE are being handled today, as the US mixes up unclear objectives.

So, what of the various American complaints against China?

The easiest thing to judge is state-sponsored cybertheft of commercial trade secrets. This is clearly unfair – being illegal and blatantly coercive. The US is right to challenge this forcefully, and has been doing so for years.

America’s biggest grievance is about state-sponsored Chinese outward investment targeting high-end US technologies. America has said it wants China to drop its Made in China 2025 plan under which this investment occurs. China has indicated that this is the one thing that is non-negotiable.

What of the economics? At the most basic level, if China wants to subsidise such acquisitions (for example, with cheap loans from state-owned banks or other implicit subsidies), this is effectively just a welfare transfer from China to America. The US receives a premium over the market price for its assets (which can theoretically be used to finance additional investment and thus support US economic growth).

A counter to this basic logic is that high-tech industries are somehow different to the rest of the economy. But if the argument is about economics, then one must explain in what way these industries are so special that isn’t reflected in market valuations, and also exceeds the value of any Chinese subsidies (premiums) that might be paid on top. 

That isn’t obvious. Remember, things such as future growth potential, intellectual property, rents from uncompetitive market structures, and so on would all be part of any market valuation. The onus is thus on those who think ownership in these industries is special to make a concrete case.

Yet, if that case can even be established, then the US should presumably still take issue with any Chinese takeovers, regardless of whether there are subsidies involved or not. In fact, America should object especially if there are no subsidies involved, as it would mean its assets are being sold for even less than their real value.

A similar argument goes if security or geostrategic issues are the real concern – if it is so problematic for China to access or control certain technologies, then what does it matter if the acquisition was subsidised or not? Chinese subsidies are not the problem. They are either a gift or a distraction.

What about forced technology transfers? This is more complex. Complaints about specific policy measures relate to foreign investment restrictions (notably joint venture requirements) and technology-licensing rules that disadvantage foreigners. But the problem also extends to more nebulous informal state pressure on foreign firms to hand over technology in exchange for access to the lucrative Chinese market.

It’s worth recognising at the outset that there’s nothing wrong with China seeking to maximise the domestic economic benefits of foreign direct investment (FDI). The transfer of technology and know-how are fundamental to this, especially for developing economies. China’s surplus savings also means it has little need to attract foreign capital purely to finance investment. 

However, just because the policy goal is fair doesn’t mean the approaches used are fair also. Cybertheft is inherently unfair. Other Chinese measures, though, might be more justifiable. A timely recent study, for instance, shows that joint ventures have delivered much more sizeable productivity gains to the Chinese economy than wholly owned foreign investments.

But if China is breaking rules it agreed to at the World Trade Organisation, this ought to be challenged as part of upholding a rules-based system. That may be the case with some technology-licensing rules and informal state pressure to transfer technology. Equally though, the rules require the US to challenge this at the WTO, not unilaterally. Currently it is only doing so on the first issue.

Joint venture requirements and other FDI restrictions, however, don’t run afoul of any existing rules. Here the US complaint is about a lack of reciprocity – the US is currently open to Chinese investment but faces extensive restrictions in the other direction. A similar complaint is made about Chinese import tariffs, which remain higher on average than in the US.

Ironically, this is only unfair if you think like a mercantilist. After all, there is nothing altruistic about US openness. America is more open simply because it has traditionally seen this as being in its own national self-interest, following the basic insights of international economics. It is in America’s self-interest to have access to cheaper imports and lots of foreign capital, regardless of what others do.

Of course, also having greater access to foreign markets would be even better. That is something to negotiate, and tariff threats are perhaps one way to do it. However, any tariffs imposed will also be self-damaging. So it depends on whether the realistic gains are worth the cost.

In any case, imposing tariffs if you don’t get what you want would not be some kind of correction back to a fairer state of affairs. It would just be a more compromised kind of self-interest.

Will Argentina’s problems destabilise Asian economies?

Argentina has taken the politically drastic step of calling in the International Monetary Fund for help, and is clearly in deep trouble. What does this mean for other emerging economies, particularly those in our region?

IMF Managing Director Christine Lagarde meets Argentine Treasury Minister Nicolas Dujovne in Washington on 10 May.

At the centre of this enduring narrative is the fickle nature of international capital flows. In Asia, capital flooded in before the 1997 crisis and then surged out suddenly. Argentina is experiencing a variant of the same whipsaw.

Compare Argentina’s current plight with the lessons Asia took from the 1997 crisis. In Indonesia, a deep recession and spectacular exchange rate fall were needed to switch the current account from deficit to surplus, eliminating the need for foreign capital inflow for several years.

Since then, Indonesia has been careful to prevent the current account deficit from exceeding 3% of GDP: policy is routinely tightened to slow growth whenever this benchmark is approached.

The budget deficit is similarly held in tight check. Indonesia borrows overseas to fund its external deficit, but much of this borrowing is denominated in rupiah (foreigners hold around 40% of rupiah-denominated government bonds). 

Following the 1997 crisis, Asian countries have allowed their currencies to depreciate when necessary to retain external competitiveness. They have used periods of upward pressure on exchange rates to build up foreign exchange reserves and resist over-appreciation.

The deep post-crisis recession halted inflation in its tracks. Overall, the Asian crisis countries have been prepared to live more modestly since 1997, with growth around 5% rather than the 7% that was normal before the crisis.

Contrast this with Argentina. There was a searing crisis in 2001, but populist governments then frittered away the opportunity for reform. It is an economic aphorism that crises provide the opportunity for change. The inflation problem was addressed by fiddling the official statistics. Even since President Mauricio Macri’s market-friendly government took over late in 2015, the pace of reform has been sedate, constrained by politics. 

Macri began with a big depreciation and resolved foreign-debt disputes, which set the scene for a return to foreign borrowing. Foreigner lenders responded, perhaps too eagerly. The budget deficit was readily funded by borrowing overseas in dollars (rather than borrowing at home in local currency), including a headline-catching 100-year bond in 2017.

Source: IMF

While the nominal exchange rate was depreciating steadily (and more quickly recently), inflation has outpaced this decline, eroding international competitiveness. The IMF estimates that the peso is overvalued by 10–25%. Exports have fallen from 24% of GDP in 2005 to 9% now, and the current account deficit is 5% of GDP.

Source: IMF

Now the inflows that funded this external deficit have dried up. If a country can’t attract new foreign capital, has to repay existing foreign debt as it is due, and must cope with outflows from nervous residents, it needs ample foreign exchange. The central bank still has reserves, but not nearly enough.

Raising interest rates (which has been done, to 40%) is necessary but not sufficient. When the market thinks the exchange rate might fall further in the near future, no interest rate is high enough to offset this short-term expectation. Tweaking the budget still leaves the overall deficit at around 7% of GDP, with depreciation adding to government debt servicing. There is no painless way out.

Will this crisis trigger a wholesale retreat of foreign capital from all emerging economies?

Argentina’s problems will be high-profile, as it is the current chair of G20. Market participants can behave like lemmings, shifting overnight from glib over-optimism to deep pessimism, driven by algorithms rather than real-world analysis. And there are other economies (notably, Turkey) that are similarly vulnerable because sensible economics has been ignored.

But in our region, the lessons of 1997 have been fully absorbed and incorporated into economic conservatism.

“Normalising” America’s monetary policy might justify exchange rates fluttering a few per cent as emerging economies adjust. But it would be a serious indictment of financial-market efficiency and maturity if global investors can’t distinguish between the policy deficiencies which led to Argentina’s current predicament and the sensible macroeconomic policies which prevail in the emerging economies of Asia.

Banks misbehaving everywhere

The current Royal Commission into Australian finance is uncovering headline-grabbing malpractices which have scandalised the community. These deficiencies will prove costly to the sector’s wealth and reputation. Because Australian finance largely avoided the dramas and tribulations experienced in America and Europe during the 2008 crisis, these weaknesses may come as a surprise.

But they shouldn’t. Over the past decade, the financial sector overseas has accumulated somewhere between US$240 billion and $320 billion (yes, billion!) in fines for regulatory breaches. This huge sum is not retribution for causing the 2007–08 financial crisis: these are penalties for rigging markets, breaking sanctions, money laundering, mis-selling financial products, misreporting, misleading investors, trading scandals, and similar operational misconduct.

Bank of America heads the line-up, with $76 billion (representing more than half of its market capitalisation), followed by JPMorgan Chase with $44 billion (including fines originating in Bear Stearns, which JPMorgan took over during the crisis at the urging of the Federal Reserve). These penalties are not confined to US banks: Deutsche Bank paid $14 billion; Royal Bank of Scotland and Lloyds each paid around $25 billion; while Paribas and Credit Swiss each paid approximately $10 billion.

The enormity and ubiquity of the fines suggest that the sector is prone to misbehaviour. Why is this so?

Financial transactions are often complex, long-lasting, and surrounded by esoteric legal issues whose outcomes are delayed until sometime in the unforeseeable future. Financial markets are volatile, with asset prices and interest rates changing over the lifetime of a transaction.

The consequences of mistakes or malfeasance can be life-changing for depositors, borrowers, and pensioners. Many customers deal in financial markets so rarely that they are not well-versed in the dangers or precedents. Some know this, while others count on governments to protect them when things don’t work out.

Transactions often involve an agent or broker who purports to guide the uninitiated through the financial maze; but these agents have their own priorities which may not coincide with those of the customer. Competitive pressures are intense, encouraging administrative cutting of corners. Bonuses distort incentives and judgement.

In response to these characteristics, the sector is heavily regulated. The more red tape, the greater the likelihood of transgressions. Banks must be prudentially regulated to avoid bank runs and to ensure that the payments system is not misused for illegal activity, such as money laundering. Beyond these systemic issues, consumer protection provides the rationale for another thick layer of rules.

If everyone agreed on the appropriate degree of regulation, and this was incorporated in simple unambiguous rules, the challenge might be manageable. But there are inevitably conflicts of interest, misinterpretations, and arguments about bureaucratic compliance costs. The rule book contains ambiguities, leaving regulators unsure of how to react to apparent infringements.

The public, on the other hand, expects to be protected from the rapacious aspects of finance. When things turn out badly they look for someone else to blame.

Big fines have not done much to impose personal responsibility and accountability on individuals in top management and boards: instead, shareholders bear the cost. Bonuses have been paid and golden parachutes have protected departing management. Hardly anyone went to jail this time (in contrast to the aftermath of the 1980s US savings and loan crisis).

When things go wrong, there is the usual sorrowful public contrition, acceptance of responsibility (whatever that means), undertakings to reform, and unanimous affirmation that trust is at the heart of an effective financial system.

What more should be done? It would be unrealistic to assume that, with these fines, incompetence and bad behaviour have been eradicated and that gimlet-eyed management will hereafter prevent repetition. Rather, the lesson might be that this sort of behaviour is endemic in the financial system as currently structured.

Disaggregating and simplifying the structure of the sector would help, with a move back to a Glass-Steagall world where banks do simple deposit-taking and lending, and are managed by conservative (even boringly dull) bankers. Expecting the public at large to make good decisions about their long-term pension portfolios is unrealistic, and professional advice has too often shown itself to be self-interested. A publicly provided alternative along the lines of Australia’s Future Fund or Singapore’s centralised pension funds would provide a default option appropriate for most pension savers.

All the cutting-edge, exciting, and innovative activities would be separated in “buyer-beware” entities, quarantined from bank balance sheets. Market-making, investment banking, derivatives, commodity trading, high-frequency trading, risk management, and financial-product development would all take place in these overtly risky institutions, with the Masters of the Universe largely trading with each other. The casino-like aspects should be handled by those who understand that finance is a big gamble in which you may lose your shirt.

This would make the financial sector much smaller than it is at present, and the smart talent which is currently employed there might go elsewhere, doing something useful for society.

All this seems a long way from the Australian Royal Commission, which will likely leave the financial sector embarrassed and chastened, and a few institutions punished. While memories are fresh, management is likely to be more careful with compliance. But the structure seems unlikely to change.

Trump and “currency manipulation”

The central tenet of US President Donald Trump’s economic world view is that bilateral trade imbalances are bad for the deficit country. In this mindset, imbalances are believed to come about because the surplus country is cheating on its exchange rate to promote exports and restrict imports. Hence, Trump’s recent tweet:

One of the few things economists agree on is that bilateral trade balances aren’t a sensible macroeconomic target. If Trump bargains hard enough with China, he might be able to change the bilateral balance, but this will have little or no effect on America’s aggregate external balance – its current account.

A country’s current account equals the difference between its saving and its investment. There are many factors behind this simple national accounting identity, but America’s current account will change only when its savings/investment balance changes. The US needs to save more if it wants to reduce its external deficit. But Trump’s tax cut is taking government saving in the wrong direction, causing a larger current account deficit.

Misplaced as Trump’s bilateralist fetish may be, his concern about policy that results in undervalued exchange rates is shared by mainstream economists at the Peterson Institute in Washington, even if they disagree with almost every other aspect of Trump’s economic agenda.

Fred Bergsten and Joe Gagnon have been pounding away at the issue of “currency manipulation” for years. Until a decade ago, China was a perfect target, with a current account surplus close to 10% of GDP and spectacular growth driven by exports.

Now that China’s current account surplus is less than 3% of GDP, however, growth relies on investment rather than exports, and China’s intervention has been to shore-up the renminbi. So the targets have broadened to include Hong Kong, Israel, Macao, Norway, Singapore, Switzerland, Taiwan, and Thailand.

Bergsten and Gagnon are both smart economists, so their logic is more sophisticated than Trump’s. For a start, they focus on overall current account surpluses, ignoring bilateral balances. They recognise that not all current account surpluses are caused by foreign exchange intervention.

There are legitimate reasons why countries might want to run either deficits (such as Australia, so that we can invest more than we save) or surpluses (so that resource-based economies can accumulate foreign assets, preparing for later resource depletion). Others, such as Japan (with an average annual surplus of 3% of GDP) and Singapore (nearly 20%!) are excused because they are accumulating official foreign assets for future pension payments.

Germany, with its external surplus of nearly 10% of GDP, is excused because it membership of the eurozone means it has no control over its exchange rate. It’s also apparently acceptable to have a decade of accommodative monetary policy, where low – or even negative – interest rates keep the exchange rate depreciated. Switzerland, with negative interest rates, has a sustained current account surplus of 10% of GDP.

In short, in the Bergsten/Gagnon framework, you can run any imbalance you like provided you don’t actively intervene in foreign exchange markets.

In any case, the focus on exports and imports is too narrow. The external balance is driven by capital flows as well. Emerging economies are on the receiving end of volatile capital inflows, reflecting fickle sentiment in world financial markets rather than domestic factors.

Exchange rates in emerging economies are not well anchored and are subject to waves of optimism and pessimism. These economies have a legitimate interest in intervention to smooth their international competitiveness. When favourable terms of trade result in a current account surplus, it’s not exchange rate intervention which is causing the surplus: it’s the surplus causing the policy response of intervention.

Doctrine creates strange bedfellows. The free-market economists at Peterson find themselves advocating the same policies as a president who thinks running a complex, interconnected macroeconomy is the same as running a micro-level enterprise, deal by deal.

These misperceptions are apparent in two mistaken policies.

First, the US Treasury is obliged to report to Congress on foreign exchange policies, identifying trading partners with large current account surpluses, substantial foreign exchange intervention, and large bilateral surpluses with America. Currently no large trading partner offends on all three counts, so the unspecified penalties have not been triggered. But the threat remains.

Second, American trade agreements are now routinely accompanied by a side-letter requiring that the parties avoid intervention. The original Trans-Pacific Partnership negotiations included such a side-letter. The recent free trade agreement with South Korea includes one, even though South Korea went through a traumatic currency crisis in 2008 which not only included much-needed currency intervention by the Bank of Korea, but also was brought under control only through substantial intervention by the US Federal Reserve supporting the Korean Won.

The International Monetary Fund has, belatedly and reluctantly, come to accept that intervention may sometimes be the appropriate policy. These Congressional reports and side-letters reflect a mistaken mindset. 

Misunderstandings about “currency manipulation” are not the only danger here. Trump’s tweet sees the recent modest interest rate increases by the US Federal Reserve as part of his perceived exchange-rate problem. The Fed will have to maintain its full independence, ignoring such tweets as it normalises the stance of monetary policy.


Photo via Flickr user photosteve101