Global Financial Crisis Requires a Responsive Multilateral Framework

2009-03-10T09:00:00.000-07:00

The recent financial market turmoil has proved beyond doubt that the present multilateral financial system is extremely vulnerable, and that the global economy needs a more responsive architecture. There is need for a comprehensive multilateral framework in dealing with such crises, and at the same time, such framework should provide maximum space for the national governments to pursue policies in their own national interest, minimizing of course the scope for the altruistic nationalistic instincts. The time is now ripe for nations at least from the G-20 to work towards such a framework, in order to mitigate the impact of adverse shocks.

The undercurrent of the bank failures and asset price bubble bursting have roots in the kind of nexus that has been built around financial innovations and the leverage that has been placed on the investment banks on stretching their balance sheets. In the guise of hedging risk and profiting out of it, the financial engineers have built sizeable innovative exotic instruments which have engulfed both real as well as financial sector. The stocks, bonds, and currency markets often spill over into other markets such real estate through financial innovations, that affect the balance sheets of the financial institutions. The World faces a much larger risk than ever before, more than the Great depression of 1930s, as asset markets are more integrated with significant cross correlations.

Financial innovations have led to excessive risk taking by institutions such as hedge funds and private equity. Leveraged “buy outs” and private equity fuelled by cheap credit and excess liquidity had encouraged excessive risk taking. Look at the amount of speculative funds raised from Japan with a very low interest rate, which was invested in high yielding assets of Europe or Asia, what is call ‘Yen Carry’ trade. When the yen appreciates these investors had a kill. You had buyers in oil when the future prices rose over $150 a barrel, and now that prices have fallen below $40 a barrel, creating huge losses on those oil portfolios. So also the emerging market stocks such as India which gave such high return until recently has now bottomed out. How will you address such wide gyrations in asset prices and capital flows in the absence of a comprehensive multilateral framework ?

The world economy would adjust to a lower level of equilibrium, and the asset price inflation would correct itself, which are inescapable. But this should not be at the cost of losing the financial institutions and market, and Governments must prevent bank failures and corporate bankruptcy, and most importantly the job and output losses. Governments and their central banks must work towards ensuring the development of soundly managed and adequately capitalized banking system that can safely and efficiently intermediate between savers and investors. International standards such as New Basel Capital Accord (also known as Basel II) are there, but these have to be tailored to specific country circumstances. Capital adequacy ratio has to be constructed in the light of the individual circumstances of the countries’ banking system and their asset characteristics and market volatility.

There is need for stronger institutional arrangements at discouraging all forms of speculation in the financial markets and excessive risk taking. The national policy framework should also minimize the potential hazard of the private sector, requiring stable macroeconomic policy and encouraging productive investment in the real economy. Governments should promote investment climate that will generate right incentives for private investments, attracting foreign direct investments into productive sector, and by proactively designing policies to private investments and by reducing business uncertainty.

The global investors rely so much on confidence factors in a national economy. The trends towards internationalization of firms and markets is irreversible, so the financial systems has to remain prepared with contingency policy framework and the wherewithal to deal with the eventualities of a speculative attack or a systemic financial as well as banking crisis.

High capital mobility and volatility arising out of liberalized financial markets have created a number of new issues for the policy makers. Macroeconomic divergence in major economies create movements in speculative capital flows looking for arbitrage opportunities, that have destabilizing impact on asset prices. The multilateral framework should address the issues arising out of high capital mobility. The proposal for the introduction of a nominal “Tobin-type tax” on short-term capital flows needs consideration. A tax on short term cross border flows would not only discourage speculative elements in international finance and erratic financial volatility.

H K Pradhan's Blog

Global Financial Crisis Requires a Responsive Multilateral Framework