Monday 05 Jun 2023
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This article first appeared in Forum, The Edge Malaysia Weekly on March 20, 2023 - March 26, 2023

It has been one crisis after another, ever since financial liberalisation took off. There was the Latin American debt crisis of the 1980s. Then, the Asian financial crisis engulfed our own region, causing huge convulsions. That was followed by currency crashes in Russia, Brazil and Argentina. Soon after, the tech stock frenzy ended in a debacle of monstrous proportions. Then came the mother of all commodity price booms, followed by a bust. In 2007, the US housing boom also ended in a crash, culminating a year later in the worst global financial crisis since the 1930s.

Right now, we have smaller banks in the US and elsewhere under pressure as a result of the collapse of Silicon Valley Bank (SVB) and that’s triggering sharp corrections in other banks. Just a few months ago, the UK pension funds came within a few hours of collapsing, saved in the nick of time by regulatory intervention. While it does not look as if the current stresses will trigger another global crisis anytime soon, they are a warning to us that deep-rooted flaws in the global financial system remain unresolved. If nothing is done, another stomach-churning crisis may well be just a matter of time.

The current instability can be contained but there will still be damage

Following the collapse of SVB, fears of bank runs and other collateral damage induced sharp falls in the prices of risky assets all over the world. Swift action by US regulators appears to have prevented a downward spiral. We were also lucky in that SVB had unique vulnerabilities that are not prevalent elsewhere: its clientele was dominated by start-ups and tech-industry affiliates, making it highly undiversified, unlike conventional financial institutions. With interest rates rising and liquidity conditions tightening, cheap funding for tech companies virtually ended. SVB’s clients were forced to draw down their deposits to survive, depriving SVB of liquidity. The same monetary tightening had also caused losses in SVB’s bond portfolio, which meant that, adjusted for the unrealised losses in that portfolio, SVB’s capital base had eroded. SVB’s deposit portfolio was also severely underinsured: out of its deposits of US$173 billion, just US$8 billion were covered by the Federal Deposit Insurance Corporation’s scheme. Finally, there was some degree of herd behaviour in how SVB’s tech clients rushed to withdraw their deposits simultaneously and rapidly, giving the SVB and regulators little time to prepare.

Another reason why we have stability (at least temporarily) in financial markets is because investors are deluding themselves by betting that the US Federal Reserve and other central banks will pivot away from sizeable rate increases. That won’t happen unless the current stresses escalate into an outright crisis — and that is not likely. The Fed may well pause rate hikes briefly in order not to aggravate nervousness in financial markets. But, with core inflation still running at an uncomfortable pace and the real economy proving resilient, the Fed will resume rate hikes of at least 25 basis points each in succeeding months. More salient is the fact that over the medium term, there are underlying upward pressures on inflation in the global economy. That means that interest rates will still remain higher for longer.

So, while a broader financial crisis has been averted, this is not the end of the story:

•     More tight money means more stresses: SVB’s collapse was just one consequence of tighter monetary conditions that we will all have to live with for a long time. The UK pension funds’ near death was just one example of how the long period of easy money had led to poor financial decisions. As central banks continue to raise rates and cut back on their quantitative easing, more such incidents are likely in our view. No doubt, further skeletons will be exposed in the closets of banks or other corporations. In the current mood of fear and nervousness, more turbulence can be expected, which Asian markets will not be immune to.

•     Tech sector slowdown will persist: SVB’s collapse will hurt funding for the embattled US tech sector, already reeling from higher borrowing costs and difficulties in reversing the pandemic-induced overexpansion. Slower capital spending in this sector will hurt demand for Asian exports of key info-tech components.

In short, financial markets may well regain some of their balance in coming days but we should nevertheless expect a period of nervousness and volatility. However, if there are more financial accidents, then we could see wilder movements in Asian bonds, equities and currencies. 

Is the global financial system a help or a hindrance?

Even if we are likely to avoid an outright crisis, it is time we asked ourselves whether the current structure of the global financial system is fit for purpose. Ultimately, global finance exists to serve the interests of the common man. If instead, finance becomes a source of frequent crises which damage the livelihoods of ordinary folk while enriching a small minority, then it is not playing its role well and there is a need for change.

What are the features of global finance today, and do the pluses offset the minuses? 

The financial system, comprising banks, capital markets, asset managers, intermediaries and related institutions, helps to support economic activity by mobilising capital from savers and allocating that capital to the most efficient use. For the first 30 years of the post-war period, finance was heavily regulated. In the 1960s, domestic banking activity was gradually deregulated. Then from the late 1970s, developed countries began to open up their capital accounts, to allow more cross-border capital flows. By the late 1980s, emerging economies also began to follow suit.

The rationale for easing restrictions on cross-country capital flows was to allow capital surplus countries to export their excess savings and earn a good return while capital-short economies could utilise the funds flowing in to accelerate economic growth. Indeed, the deregulation of portfolio capital flows — that is, trading in bonds, equities and other financial securities — has helped fundraising in many parts of the world. We could also argue that subjecting policymakers to the discipline of financial markets made for better macroeconomic management. Central banks have become more rigorous in managing inflation. Finance ministers are more conscious that poor fiscal policies would invite punishment in bond and currency markets — as the short-lived administration of former UK prime minister Liz Truss found out last year.

However, the trouble is that this benefit comes with many questionable side effects as well. Overall, the current architecture of the global financial system has many unwelcome characteristics:

•     There has been an explosion of capital flowing across borders whose value today is multiples of the value of trade in goods and services. That would be fine if not for the fact these flows are highly volatile. When capital flows abruptly and in large scale into or out of the bond, equity and currency markets of emerging economies, they produce outsized increases and falls in values because these markets lack breadth and depth. Such large flows have proved to be greatly destabilising. For example, in 2013, when global investors realised that the Fed would tighten monetary policy ahead of expectations, there was a rush to the exits. Massive outflows clobbered currencies in India, Indonesia and other emerging economies, creating a crisis of confidence. As outlined in our opening paragraph, all too often such volatility leads to crises that have caused immense suffering.

•     There seem to be too many shock amplifiers rather than shock absorbers built into the financial system. In some cases, a small shock such as the unanticipated devaluation of the baht in July 1997 can trigger downward spirals in financial markets, with devastating effects. Less dramatically but still damagingly, derivative instruments meant to help hedge against downside risks are used for speculative purposes and often lead to major financial shocks.

•     Every now and then, financial markets tend to be subject to frenzies of speculation that produce bubbles, which eventually burst with terrible consequences. Banking supervisors and other regulators have consistently failed to quell this risk. Efforts to regulate seem to eventually be watered down as vested interests in the financial sector are able to use their political clout to telling effect. For example, it is now being reported that the weakening of regulatory rules in the US in 2018 under the Trump administration was partially responsible for the SVB collapse.

•     Another troubling characteristic is that central banks, which have a disproportionate influence on the world economy, such as the Fed and the People’s Bank of China, conduct policy with only their economies in mind and do not prioritise the potential fallout elsewhere. While they may consider the impact their policies have on emerging economies, this is not the highest priority. Unfortunately, the result is that such monetary policy decisions cause emerging economies to suffer terrible consequences, as we experienced during the 2013 taper tantrums. The view of the big and powerful countries is that emerging economies should learn to deal with this, for example, by allowing their currencies to float more freely. But this is unworkable for most emerging economies, which cannot manage the consequences of volatile currencies on their economies. 

•     Finally, instead of painlessly facilitating capital flows from rich to poor countries, we have the perverse outcome of huge amounts of savings from Asia being exported to rich countries, principally the US.

Reform is needed but it will not happen

Even in periods when there was a consensus in favour of reforming the global financial architecture, such as just after the 2008 global financial crisis, achieving a consensus has been difficult. The G20 was formed to facilitate such improvements. It has done some good work but struggled to move the needle on the big questions.

Today, this is even more the case because of the increased geopolitical frictions that bedevil relations between the US and China, two key players in the global financial system. In fact, finance has become a major arena for that big power tussle. The US and its allies have used powerful financial sanctions to punish Russia for the invasion of Ukraine. That has made China ever more conscious of its vulnerability to US sanctions given the preponderant role of the US dollar in the global financial system. The danger is that each side will devote its energies to weaponising finance rather than working together to reform the system for the better.

Conclusion: If no one will help us, we will have to help ourselves

Southeast Asian economies must find ways to insulate themselves against a more turbulent financial environment. One way is to build strong domestic buffers such as highly capitalised banking sectors and reinforce strict regulation on the financial sector. Another way is to ensure that fiscal and monetary policies are credible and do not invite speculation. A final way is to find ways to throw sand into the wheels of speculation through various forms of controls on foreign exchange trading and speculation. In the longer term, efforts must be made to create regional institutions that can help individual countries stand up to the titans of global finance. That might mean reviving the idea of an Asian Monetary Fund, difficult though that may sound right now.

Manu Bhaskaran is CEO of Centennial Asia Advisors

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