The Politics of Appropriate Policy Responses by G-8 and Others for Stabilising the World EconomyBackground for Presentation at Policy Network: Global Economic Imbalances - A Need for Global Governance beyond the G-8?

Professor Stephany Griffith-Jones Email: s.griffith-jones@ids.ac.ukWebsite: www.stephanygj.netTel: 0044 (0) 1273 305819

I. The nature of the challenges for world stability and sustained growth

A. Global Imbalances

B. Increased growth of unregulated financial institutions (e.g. hedge funds) and instruments (derivatives)

II. What can be done? By the G8? By others?

A. To avoid threats of economic slowdown and of costly financial crises

B. To mitigate potential effects on poorer countries and peoples of slowdowns or crises.

A. Global Imbalances

1. Scale of US Deficit

2. US Current Account deficit far larger than Chinese surpluses with US. China has deficits with rest of Asia. Importance of OPEC surpluses

2005(millions of dollars)

China 160,818

OPEC countries 257,057

OPEC Countries + Russia

340,221

3. US increasingly becoming a net debtor: by 2004, US holding of foreign assets (US$10 trillion) far lower than foreign holding of US assets, US$12.5 trillion (d’Arista and Griffith-Jones, 2006)

4. Risk: non-insignificant probability that, in the foreseeable future, there could be a disorderly and costly global economic adjustment. This would be damaging for world economy and especially developing countries

5. Negative impact on developing countries could be both via trade and financial channels and possible perverse interactions; the latter two could be through highly leveraged institutions (HLIs) and derivatives instruments, where positions have grown exponentially (see below)

6. Risks could be via abrupt financing of the US current account deficita. By private actors (role usually under-estimated)b. By Central Banks

• East Asia, especially China• OPEC countries

B. Exponential Growth and opaqueness of unregulated financial institutions (like hedge funds) and instruments (derivatives)1. For example, since 1999, hedge fund assets under

management grew more than five-fold and are estimated to total $US1.6 trillion (FSF, 2007). In the last four years, share managed in Europe doubled to 24%

2. It is estimated that hedge funds accounted for 45% of trading in emerging market bonds, 58% in credit derivatives

3. They play, via derivatives, a major role in the “carry trade” amongst developed economies e.g. Japan, but also increasingly in developing countries e.g. Brazil, Chile

Table 2

National Amounts over-the-counter

outstanding of derivatives (US$ trillion)

Source: B.I.S.

Dec 2004 Dec 2006

Total 257 415

Foreign Exchange 29 40

Table 3

4. Derivatives largely unregulated, as much of it done off-shore (though usually linked to G-8 financial centres) and opaque

5. Rapid innovations and complexity of products may imply excessive risk taking. This could lead to far greater uncertainty, potential large reduction of systemic liquidity in times of stress (Trichet, 2007) and thus systemic risk. True globally, for G-8 and for developing economies

II. What can be done? By G-8? By others?

A. To avoid threats of sharp economic slowdown and financial crises

1. Imbalances Key role for US to decrease its current

account deficit G-8 wrong forum to discuss China, as this

major country not a member Chinese appreciation could make US

deficits more difficult to fund

1. Imbalances cont. If China floated and liberalised capital account,

Yuan could actually weaken Key that Europe further increases its growth, as

US slows down Further changes to reduce deflationary bias of

the Growth and Stability Pact AVOID tightening of European monetary policy Developing countries, with tight monetary policy,

to be less stringent Promote study of major reforms of global reserve

system to make it more stable and more equitable as well as reflecting new realities

2. Unregulated Financial Actors and instruments

Increased transparency of hedge funds and derivatives essential (as Germany and Financial Stability Forum , May, 2007 pointed out)

Transparency of key variables (size, distribution and concentration of risks) essential first step as Trichet 2007 points out

Regulation to reduce systemic risks globally and in countries (including developing) essential. New challenge: avoid speculation impact on macro-economic variables not linked to fundamentals, by financial actors

Regulation needs to be comprehensive, including of off-shore centres and of all transactions. Poses political and technical problems but doable. Need for political will and research

2. Unregulated Financial Actors (cont)

New challenges linked to direct and indirect risk. For example, indirect implies risks from indirect market liquidity effects from liquidation of positions or insufficient funding liquidity to meet margin calls by actors like hedge funds (FSF 2007 Report)

Key role for G-8 where most major financial centres are and with links to off-shore centres

B. To mitigate potential effects on poorer countries and people

1. Risk of possible slowdown or crisis may not unfortunately be avoided

2. Need to mitigate risk of negative impacts Encouraging further borrowing by developing

countries in local currencies. Both through own financial markets or with support of World Bank and regional development banks

Support developing countries borrowing in GDP-linked bonds. This could be encouraged by developed countries setting an example and/or by support of WB and RDBs

Could be attractive for Islamic investors, given GDP linked bonds seem particularly compatible with Sharia law .Example of sukuk financing for infrastructure, including in Germany

2. To mitigate potential effects on poorer countries and people (cont.) Local currency and GDP-linked bonds reduce risk of crises,

default and facilitate counter-cyclical policies Allow developing countries to curb excessive short-term

capital inflows Expand IMFs contingent lending against external shocks

(such as slowdown of world economy). Implies sufficient non-conditionality IMF lending available for terms of trade shocks; automatic and sufficient access for emerging economies hit by contagion, if they have good performance in IMF Article IV

consultations

Essential to make global economic governance more democratic and representative as pre-condition to achieve global economic management that is effective and legitimate. Seems to imply clear need to broaden G-8