By Simon Johnson
Most accounts of the ministerial meeting last weekend of the Group of 20 — 19 nations plus the European Union that represent the world’s wealthiest economies —implied that it continued to perform sterling service – heading off currency wars, keeping explicit protectionism under control and deftly managing the process of reforming governance at the International Monetary Fund.
Post-financial crisis, middle-income countries continue to rise in economic importance, and the recent shift in global leadership from the Group of 7 (the United States, Canada, Britain, Italy, France, Germany and Japan) to the G-20 is commonly supposed to accommodate the growing claims of “emerging markets” on the world stage.
This interpretation is correct as far as it goes, but it also misses the main story, which is that emerging markets have two primary goals that are increasingly at odds with each other. These goals – to hold large stocks of American dollars and to stave off a flow of capital from abroad – add up to wanting to retain the emerging markets’ recently achieved status of collective net creditors (i.e., being owed more than they owe). Unfortunately, this contributes to the serious vulnerability of the world economy as we head into the next credit cycle.
Emerging markets want to hold onto – or increase further – the vast stock of foreign exchange reserves that they have recently accumulated through current-account surpluses. In part these assets are a buffer against future shocks, but the countries now hold much more than they would need for purely precautionary purposes – China alone acknowledges holding around $2.5 trillion, much of which is presumably in American dollars.
Increasingly, emerging markets think about using the value of these reserves (or what they could buy with them) in a broader manner. They enjoy the status and power that comes with being a net creditor to the system – rather than a net debtor, as in the past (which involved periodic crises, loans with unpleasant conditions from the International Monetary Fund and having to be deferential to the United States when times were tough and so on).
They even begin to think about forming the basis for a new monetary arrangement that is less dependent on the dollar – since the 2008 financial crisis, both the Russians and Chinese have spoken in public about this objective, and it is shared in private by most policy-makers outside Europe and the United States.
The “reserve currency” status of the dollar means just that – private and public sector investors around the world hold their rainy-day funds in dollars. Traditionally, at least, this arrangement has been seen as a major economic advantage and source of political power for the United States.
Emerging markets want to discuss moving reserves into a basket of currencies, presumably involving some Chinese renminbi, Indian rupees, Russian rubles and Brazilian reals (the four Rs), among other currencies.
But this is where tension with the second goal enters the picture. Most emerging markets – including those with the four Rs – do not want to allow their currencies to appreciate, and they are also unwilling to take other measures (like cutting fiscal spending) that would be likely to hold back appreciation in some instances (Brazil, in particular, takes this stance). Instead they are imposing capital controls to prevent inflows.
The controls are unlikely to prove fully effective, but they do slow the appreciation for now – and they also send a very clear signal: Foreign investors will be treated at a differential disadvantage when the chips are down.
Ask an Indian executive whether she is thinking about investing in Brazil and the answer is an unequivocal yes. But ask whether she or her policy-making colleague would like to hold reserves in reals and the answer is also quite frank: no, thank you.
Emerging markets will continue to save for a very rainy day (or a bright unspecified future) – in dollars. They intervene to keep their exchange rates relatively depreciated and will try to run current-account surpluses for as long as they can. This behavior pushes down long-term interest rates in the United States, relative to what those would be otherwise.
And – here’s the kicker – very low interest rates in the United States contrast sharply in the minds of yield- and risk-seeking investors with the situation in Brazil, where you are now offered 11 percent interest rates.
In other words, the global credit machine in this part of its cycle takes savings from emerging markets, runs them through the United States, and – at the margin — plows them back into emerging markets. Dollars are bought up through central bank intervention and – you guessed it – funneled back into the United States. The Institute for International Finance, which represents global banks, just revised upward its estimate of capital flows into emerging markets this year.
This is exactly the kind of issue – inherently cross-border and very political – for which a structure like the G-20 is needed. But it will do nothing about these flows for three reasons:
1. The emerging markets want to save in this fashion, thinking they can dodge the consequences.
2. The United States needs to borrow, big time. Our politicians refuse even to think about the first-order causes of our recent fiscal disaster; they would rather just continue to borrow (at least as long as interest rates remain low).
3. The big banks like this approach. Their influence is in no way diminishing, and there is nothing about their recent track record that has diminished their appeal in the eyes of policy-makers (just this week, for example, the I.M.F. appointed a senior Goldman Sachs executive to head its high-profile European Department).
Accommodating emerging markets in global governance structures is appealing; their aspirations are legitimate, and the G7 looks outmoded. The profound instability of global financial structures and the broader “doom cycle” today is not the fault of emerging markets – the blame lies squarely with the United States and Western Europe, which have consistently failed to rein in their global megabanks. (For an 8-minute primer on the “doom cycle,” if you are not familiar with the concept, try this video.)
The argument that the global savings glut, largely from emerging markets, was a major driver of the 2008-9 crisis is tenuous at best. But there is no question of a dissonance within the current policy goals of emerging markets – and this is not helpful to financial stability moving forward. Most likely it helps feed – or otherwise becomes central to – the next financial frenzy. And there is nothing the G-20 can or will do about it.
An edited version of this post appeared this morning on the NYT’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.