GLOBAL IMBALANCES AND THEIR IMPACTS ON
EMERGING MARKET ECONOMIES: ISSUES AND CHALLENGES
Denpasar-Bali, November 16-17, 2006
Banking and Financial Policies
Tun Ismail Ali Professor of Monetary and Financial Economics
University of Malaya and Tsinghua University
How should a small open economy respond to the growing global imbalances?
The conventional wisdom is to have strong macro-economic fundamentals, a
flexible exchange rate and a robust financial system with good supervision.
This note argues that in an interconnected world through trade, finance and
investments, we are all hostages to consequences of policy mistakes of each
other, but the larger economies have the luxury of size, while smaller economies
are bound to suffer more volatile shocks. Hence, the correct banking and
financial policy is to be as lowly leveraged as possible and to strengthen
domestic financial intermediation in order to reduce excessive reliance on foreign
Global Imbalances – the Question of Size
In his keynote address, Andrew Crockett (2006) has done a wonderful job of
surveying all the relevant issues regarding the global imbalances, which has
become something of a blame game. Global imbalances in terms of the trade
deficit or the growing size of net international position is thought to be
unsustainable, and therefore there is a desire for those in deficit to ask the
surplus countries to correct these imbalances before sudden adjustments or
protectionism becomes a global political issue, if not a massive recession.
In broad terms, my understanding of the US imbalance is that roughly 40% each
of the 2006 deficit would be accounted for by the China + Japanese current
account surpluses as one bloc, the oil producing countries as the second bloc
and the rest of the world is broadly in balance or slight surplus, accounting for
roughly 20% of the surplus with the US.
The views expressed in this note are solely those of the author.
The political pressure is on those with the large surpluses to make the necessary
adjustments. I shall first focus my comments on the need for adjustment by the
larger countries, before concentrating on the adjustment by the smaller
A current focus is whether exchange rate adjustments would impact on this
imbalance. So far, the evidence suggests that fairly large swings in the Euro-
dollar and the Yen-dollar rates over the last 30 years do not seem to have
impacted the broad direction of the US trade deficit with either Europe or Japan.
Both seem to run fairly stable surpluses with the US, whereas the growth in the
US deficit seems to have been with the rest of the world, particularly China and
the oil bloc. But as Andrew Crockett also has shown, China runs a large deficit
with her other trading partners.
Hence, the structural issue needs to be looked at. The Global Imbalance reflects
a fundamental shift in global comparative advantage. In the last quarter of a
century, the developing countries have emerged as the global supply chain in
terms of manufacturing and natural resources for the consumption of the
developed countries, which are shifting up the value chain from manufacturing to
services. This is not a bad thing.
Similarly, as the population giants of China and India become the global
manufacturing and IT services supply chain and begin to move out of poverty
and low income, their demand for commodities and energy has reversed the
long-term slide in terms of trade against the natural resource producers. Overall,
everyone seems to be the winner, except that the global imbalance is larger and
the poor are poorer in relative terms.
One needs to ask why the surplus savings of the emerging markets are placed in
the developed markets. Both the Dooley-Folkerts-Landau-Garber (2004) [total
equity return swap] and the Hausmann-Sturzenegger (2006) [dark matter]
arguments, highlighted by Andrew Crockett, are extensions of the comparative
advantage story. The US has a formidable comparative advantage in
entrepreneurship and financial markets, so it is natural for the surplus countries
to use its services and to invest in the US. Of course, if the US continues to
expend its comparative advantage or seigniorage and relies on continuous
inflows to finance its deficits, this is in the long run unsustainable.
However, the interesting issue is the breakdown of the structural deficits or
surpluses by sector. The US deficits are caused by deterioration in household
savings and in the fiscal situation, offset by surpluses in the corporate sector.
The Chinese surplus is caused by a broadly stable household savings picture, an
improving fiscal position and rising surpluses in the corporate sector. The latter
improvements are due to rising productivity gains in the corporate sector, plus
improvements in tax collection.
From both the East Asian and oil bloc perspective, it is true that in both regions,
the quality of financial intermediation is not up to the intermediation of domestic
savings into domestic investments. Hence, one needs to ask whether
improvements in domestic financial intermediation will solve this problem. My
conclusion is that it will partly solve the issue, but not wholly, because the US still
plays a major role as the leading consumer of last resort and also the leading
entrepreneur/investment banker to the world. Because EMCs (including Japan)
do not have the expertise to manage their financial intermediation well, they use
the markets of US and Europe/London to intermediate their long-term savings.
The US alone earns a huge spread in financial services to finance its deficit.
This comparative advantage should be emphasized, rather than to think that the
US can reverse its long-term trend in outsourcing manufacturing to the rest of the
world in order to cure its fiscal and current account deficits.
Moreover, if we focus only on the trade side of global imbalances, we are likely to
lead to a wrong conclusion, which is that the surplus countries should increase
their domestic consumption to reduce that imbalance. There is already growing
consumption in the developing markets, since one can question whether all the
investments are rightly classified as investments or should be labeled as
consumption due to leakages in the investment process.
Since there are already grave doubts that the world’s natural resources can
sustain the present rate of depletion, I do not believe that asking China and India
to consume like the average American can be a long-term solution to any global
trade imbalance. Indeed, there are two imbalances that are even more politically
and strategically more important than the trade equation.
The first is the growing imbalance between the rich and the poor due less to
globalization than to a naive version of total free market paradigm. The second is
the damage to the ecology and environmental sustainability due to the blind push
for faster GDP growth. There are already signs in many parts of the world, not
least China, where policy shifts are happening to try to get to grips with these two
The immediate policy consequence is that domestic government expenditure on
alleviating rural poverty and environmental clean-ups + energy/natural resource
saving will and should increase dramatically.
We all have a vested interest in reducing social inequality, which is the breeding
ground for terrorism and social instability. But no one is willing to focus on how to
strengthen the capacity of EMCs to strengthen their intermediation process,
particularly to plan, design and manage huge social infrastructure investments.
For example, there are huge social infrastructure projects that must be
implemented in education, basic amenities, health, transport and environmental
protection that are urgently needed throughout EMCs.
At the ground level, there are simply not enough well designed projects to put
into effect. The private sector is more than willing to put Build-Operate-Transfer
or Public-Private-Partnership projects in place, but the capacity of many EMC
civil services is already stretched to the limit. Since the Asian crisis, the need to
get fiscal deficits into balance and various conditionality that resulted in under-
investment in civil service training and pay have actually weakened the capacity
of EMC civil service to plan, design and manage these projects. Priority has
been given to the debate of appropriate domestic policies, rather than
unfashionable and boring task of institution building and capacity to implement
policy with good outcomes.
It is ironic that at a time of great need for institutional strengthening in the EMCs,
the IFI development agencies have shifted their own staff skills towards more
macro-economic policies, rather than the boring aspects of public sector project
planning and management. Speaking as someone who has worked at the World
Bank, I note how the tremendous strength in project management and skills of
the 1980s are now a shadow of its former capacity. By focusing more on the
symptoms of corruption and less on institution-building, the capacity of the
development agencies to lend or grant aid is constrained as EMC officials are
now unwilling to even sign and approve much needed projects, for fear of being
accused of corruption and favoritism. It is no wonder that EMCs find it easier to
go to market sources for funding rather than calling on the very agencies that
could help them in their work.
In sum, the global imbalance is a governance issue, not just a question of larger
economies managing their own financial and fiscal positions to avoid growing
deficits, but also the capacity of the surplus economies to manage their surpluses
and correct their own internal imbalances.
This leads to the second part of the imbalance story – what are the appropriate
banking and financial policies for the smaller economies, in the event the global
trade imbalance leads to sudden shocks? There are two forms of possible
shocks – a sudden export slowdown, as the US cut back its imports or a rise in
interest rates which leads to a reversal of capital flows. The first is likely to slow
global growth and the second could be another Asian-crisis type of shock.
The conventional wisdom on emerging markets as recipients of global savings
has been turned upside down. Many emerging markets are no longer short of
domestic or access to foreign capital. Certainly, the larger economies of China
and East Asia have become net exporters of capital. A fundamental reason for
this export of capital is the lack of domestic capacity to efficient intermediate such
savings. Accordingly, the need to build strong domestic financial systems to
improve the intermediation process is more important than ever. There are two
fundamental areas where domestic intermediation should be improved.
The first is deep and liquid bond markets. Deep and liquid bond markets are vital
for several reasons. Primarily, bond markets help reduce the maturity mismatch
that plague banking systems. Secondly, they enable central banks to conduct
open market operations more efficiently. Thirdly, they provide long-term
instruments for savings by pension and retirement funds. Finally, they provide
long-term funding for social and infrastructure fixed investments necessary for all
However, for reasons that are mainly of bureaucratic inertia and rivalry,
successful bond markets are taking longer and more complex to nuture than
initially realized (Sheng, 2006). There must be greater political will and
coordination to make these markets happen. Foreign consultants can bring the
technical expertise, but making the project work takes local knowledge and great
domestic political and bureaucratic push in execution, since bond markets cut
across much bureaucratic turf and involve major legal changes as well as the
need for a benchmark yield curve.
The second area of financial policy is beginning to receive more policy attention,
not least because of the Nobel Prize award this year to Muhammad Yunus for his
pioneering work in microfinance. However, the real issue in East Asia is that the
restructuring of the banking system since the Asian crisis has made the system
much more profit oriented, inclined towards safer consumer finance, as well as
risk adverse. In short, they have virtually ignored the SME sector, particularly in
the rural areas.
The larger enterprises have better access to banks, trade credit and even stock
markets. But the SME sector is generally starved of bank credit and has relied
more on informal finance. In Indonesia, Bank Rakyat Indonesia had a good rural
credit programme that could be the model to be extended internationally, but this
was affected by the Asian crisis.
I am inclined to believe that in building strong domestic financial systems to
protect against external shocks, one has to go back to basics. By basics, I mean
the need for the financial system to reach the masses. In developed markets
that are already urban, this is not a problem. In emerging markets where the
rural masses do not have access to modern finance, there is a huge market need.
The financial institutions that are able to bridge that gap will be big winners and
policy makers and academics should pay more attention on building the
necessary infrastructure for the market to respond to that demand.
Finally, on the question of appropriate banking and financial policies for emerging
markets, I have always maintained that modern corporate finance principles can
be applied to national economies (Sheng and Cho, 2002). There should be a
national risk management assessment that looks into the vulnerabilities of the
domestic economy, by sectors, in order to detect which sector would be most
vulnerable to shocks. Sectoral balance sheets are now being built globally and
this is a priority for emerging markets. My own research is now focused on
building a framework for that analysis.
What would be more important, once the national balance sheet by sector is
constructed, is to examine the incentive structure in the economy, in terms of
fiscal policies, deposit insurance or other policy distortions, that could lead to
In sum, with the best will in the world, I do not believe that we can predict how
the global imbalance will unwind and with what ferocity. The global imbalances
are already a given, and the rest of the world would have to adjust to them. We
all hope for a soft landing, but the risks of sharp shifts in savings and investments
cannot be ruled out. The larger economies would be pre-occupied in bilateral or
regional debates over exchange rates, trade policies and other negotiations.
The smaller economies could do better to focus on strengthening their own
financial systems against further shocks. This is easier to achieve by relying on
deep capital markets rather than on external funding. This is a governance and
institutional story, rather than a matter of policies. Getting the right institutions
built to address the internal imbalances are the necessary conditions for
addressing global imbalances.
14 November 2006
Andrew Crockett, The Portrait of Global Imbalances: From Theoretical to
Practical Perspectives, Keynote Paper, Bank Indonesia Conference on Global
Imbalances, Bali, November 2006.
Michael P. Dooley, David Folkerts-Landau and Peter M. Garber, The US Current
Account Deficit and Economic Development: Collateral for a Total Return Swap,
NBER Working Paper No. 10727, August 2004.
Hausmann, Ricardo and Federico Sturzenegger, Global Imbalances or Bad
Accounting? The Missing Dark Matter in the Wealth of Nations, CID Working
Paper No. 124, January 2006 (Revised September 2006).
Andrew Sheng, Building National and Regional Financial Markets: The East
Asian Experience, Emerging Markets Forum, Jakarta, September 2006.
Andrew Sheng and Yoon Je Cho, Risk Management and Stable Financial
Structures for LDC Inc, in G. Caprio, P. Honohan and D. Vittas (eds), Financial
Sector Policy for Developing Countries: A Reader, World Bank/Oxford University