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Tuesday, February 24, 2009

Did China Help to Create the Financial Crisis?

Was bad advice to developing countries partly responsible for the financial crisis? According to this, the answer is yes:

How China helped create the macroeconomic backdrop for financial crisis, by Moritz Schularick, Economist's Forum: Over the past decade, China and other emerging markets accumulated foreign currency reserves to insure against the economic and political vagaries of financial globalisation. They were wise to do so. Countries with larger reserves are weathering the storm relatively better than those who have bought less insurance.

Although purchasing insurance policy might have been sensible from the perspective of each country, collectively these currency interventions prepared the ground for the global crisis. Emerging markets, most notably China, helped to create the macroeconomic backdrop for the current financial crisis by subsidising interest rates and consumption in the US. ...

[After] the Asian crisis... Emerging markets heeded Martin Feldstein’s advice and took out an insurance policy against the vagaries of financial globalisation. By running current account surpluses, intervening in foreign exchange markets and building up currency reserves, Asian and other emerging economies were sustaining export led growth and buying insurance against future financial instability.

These policies turned developing markets into net capital exporters to the developed world, mainly to the US. ... Yet the accumulation of large war chests of foreign reserves through currency intervention carried negative externalities.

The arrangement opened a Pandora’s Box of financial distortions that eventually came to haunt the global economy. The glut of savings from emerging markets has been a key factor in the decline in US and global real-long term interest rates, despite the parallel decline in US savings.

Lower interest rates in turn have enabled American households to increase consumption levels and worsened the imbalance between savings and investment. And because foreign savings were predominantly channeled through government (or central bank) hands into safe assets such as treasuries, private investors turned elsewhere to look for higher yields. This ... unleashed the ingenuity of financial engineers who developed new financial products for the low interest rate world, such as securitised debt instruments.

This is not to say that reserve accumulation was the only cause for the current crisis. Yet the core issue remained the Chinese willingness to fund America’s consumption and borrowing habit. Without this support, interest rates in the US would almost certainly have been substantially higher, acting as a circuit breaker for the developing debt-consumption bubble.

Beijing and others cannot be blamed for reckless lending into the housing bubble or leverage in western financial institutions, but it is clear that a vast amount of capital was flowing from a developing country ... to one of the richest economies in the world. ...

From the perspective of emerging markets, the academic debate as to whether reserve levels have grown excessive has been answered almost overnight in the current crisis.  It is clear to policy makers from Buenos Aires to Budapest and Beijing that one can’t have too many reserves in a world of volatile capital flows. ... Have we therefore come to a crossroads for financial globalisation...? After the dust has settled, members of the economics profession will have to think hard about what the right policy advice ... should be. ...

The liquidity coming into the US from Asia and other sources such as the oil producing countries was a factor in the crisis, as were low interest rates under Greenspan, but the availability of large amounts of liquidity on easy terms in and of itself is not enough for problems to develop. How the liquidity is used is the important factor, and if the proper regulatory safeguards are absent, the liquidity may not be used very wisely (as we now know all too well).

With the proper regulatory apparatus in place, or with financial instruments that truly disperse and reduce risk as promised, the reserve balance insurance polices pursued by developing countries do not have to lead to a financial crisis. Distortions are one thing, a crisis is something else and the mere existence of distortions does not lead, by necessity, to a meltdown of the financial system. I am not arguing that no distortions existed, but the crisis was not a necessary consequence of those distortions. The article notes that "Beijing and others cannot be blamed for reckless lending into the housing bubble or leverage in western financial institutions," and I agree. With the proper regulatory framework in place, the crisis need not have happened, and I can't see how the absence of effective regulatory safeguards is the fault of the polices pursued by countries anxious to protect themselves from a repeat of the Asian crisis.

    Posted by on Tuesday, February 24, 2009 at 06:39 PM in China, Economics, Financial System | Permalink  TrackBack (0)  Comments (34)

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