Jaimini Bhagwati: Insurance or Reserves?

Only ready access to hard currency credit will dissuade Asian countries from stockpiling FX

In the blame game for the on-going economic downturn accusatory fingers have been pointed at the hard currency reserves accumulation of current account surplus developing countries. The investment of large FX balances in US Treasury and other G7 government securities was an enabling factor for the financial sector meltdown. However, calling it a causal factor would be equivalent to banks claiming that since they had mopped up extra-large amounts they had no alternative but to default on commitments to their creditors. It has also been commented that if the currencies of the trade surplus developing countries had been allowed to appreciate enough the trade surpluses would not have continued to balloon. This amounts to demanding that capital accounts of these countries should necessarily be fully convertible. On the contrary, in the development process capital accounts should be amongst the last elements to be opened up.

 

The apologists for the financial sector meltdown maintain that trade surplus developing countries should now increase domestic demand and stop accumulating FX reserves. Let us assume that Asian developing countries increase public spending towards making up for the shortfall in global private sector demand. Would that automatically lead to additional exports from developed countries? Developing countries in Asia are essentially exporting mass produced, lower value added items as compared to their developed country trading partners. The principal source of cost advantage for these low per capita income countries is their large reservoirs of underemployed labour and this competitive edge will not be eroded for some time.

In a recent issue The Economist has labelled Asian developing countries with huge trade surpluses as practitioners of “crass mercantilism”. This is oversimplification to the power of “n” where n is tending to infinity. The current patterns of international trade in goods and services are based on a delicate and intricate web of give and take on tariffs and other arrangements across countries. Unfortunately, the Doha Round of multilateral trade talks has not progressed as much as everyone would have wanted. And, on 26 March, 2009 the WTO issued a “Report to the Trade Policy Review Body (TPRB) from the Director-General on the Financial and Economic Crisis and Trade-Related Developments”. Annex I of this report lists the new “import and export restrictions, trade-related subsidies and trade remedy actions” taken by the USA, EC, China, India and other countries since September 2008.

In the context of protectionist action, the large bailout packages for the systemically important financial institutions in developed countries are subsidies for their entire financial industry. For example, significant amounts out of the bailout funds provided to AIG were passed on to its trading counterparts such as Goldman Sachs, Bank of America, Citigroup, Merrill Lynch and 20 European banks. These are leaders in the global financial services industry and they seek greater access to the financial sector in developing countries. It is surprising that some Indian economists have supported wider access for foreign financial firms in India without reciprocal treatment for our banks. Separately, the funding support provided to some of the world’s largest auto-companies is also a form of protectionism. At the same time, there is widespread and growing recognition of the inter-dependence across countries. It is worth noting that despite the multiple distortions in the global trading regime, opinion makers are not calling for balanced trade. Further, the London G20 Summit meeting communiqué reiterated that protectionist tendencies should be curbed.

In the light of their past experiences, Asian countries have resorted to self-insurance by building up large volumes of FX reserves. In today’s straightened economic circumstances when hard currency credit is limited this insurance has provided a much needed life-line. In contrast, the countries queuing up for IMF assistance are those that did not stock-up on adequate amounts of FX reserves namely Ukraine, Pakistan and Hungary, etc. However, even though self-insurance works it is expensive for the countries concerned in terms of the opportunity cost of potential growth foregone. Additionally, an overwhelming proportion of their FX reserves are invested in US Treasury securities and the US$ could depreciate significantly over the next five years. However, if developing countries are to be persuaded against holding large stocks of FX reserves they have to be sure that they will have ready access to hard currency credit at the time of the next global economic downturn.

The Economist has suggested that one way to encourage countries to stop stockpiling FX reserves is to set up group insurance, which would be managed by the IMF. That is, during times when economies are humming along premiums would be paid by participating governments and depending on the size of the policy and pre-agreed benchmarks on what constitutes an economic crisis the insurance agency would pay up. Clearly, putting such a group insurance scheme into practice would be an extremely long shot. Hence The Economist’s proposal that the IMF could provide group insurance and also carry out its customary role, as a policeman, to ensure that governments manage their finances prudently would not work. Ask anyone seeking life or auto insurance if they would like the insurance company to monitor the life style of its policy holders and if it is not satisfied hold up payment on a policy.

The London G20 Summit called “on the IMF to complete the next review of quotas by January 2011”. The IMF is also expected to use its new “Flexible Credit Line (FCL)” to address countries' balance of financing needs taking into account “withdrawal of external capital flows to the banking and corporate sectors”. Time will tell if the FCL will provide prompt relief to developing countries with little or no strings attached. It is possible that, as in the case of IMF’s quota reforms, it would again be a case of too little too late. Consequently, it would be preferable to set up a separate multilaterally owned insurance company since it would carry greater credibility. However, some weaker economies may not be able to afford the “market” based premiums this insurance firm would charge. In that case they should be enabled to borrow from the development banks for this purpose. Ideally, for better management diversification at senior levels such an insurance agency should be located in a developing country.

j.bhagwati@gmail.com

(The author is India’s Ambassador to the European Union, Belgium and Luxembourg. Views expressed are personal)