The ongoing global financial and economic crisis has been gaining in momentum and virulence for well over a year. During this period reams have been written in newspapers, magazines, scholarly journals, blogs and websites. A few books have also hit the stands. The overwhelming bulk of the analytical commentary has been by Western pundits on this fundamentally West-centred crisis. Although the crisis has also hit Asia hard, especially after September 2008, there are as yet very few good assessments by Asian scholars. A shining exception is the work of Andrew Sheng, who delivered a superb K B Lall Memorial Lecture on this topic last Saturday in Delhi (see www.icrier.org). Sheng is a Malaysian Chinese, with degrees in economics and accounting, who spent the first 14 years of his professional career in the Malaysian central bank before proceeding to the World Bank in 1989 to conduct and supervise policy-relevant research on financial markets and crises for a few years (that’s when I got to know him). From 1993 to 1998 he was the deputy head of the Hong Kong Monetary Authority and then went on to chair the Hong Kong Securities and Futures Commission for the next seven years. Since 2005 he has combined professorial duties at the University of Malaysia with convening an international advisory panel to China’s Banking Regulatory Commission. In the field of financial economics I can think of no other Asian who combines serious policy experience with academic rigour so effectively.
So what does Andrew have to say on the global crisis? Plenty. Although not a cricketer by either heritage or inclination, Andrew has a penchant for dealing in fours. Thus, for example, he sees the present crisis as a product of “four historical mega-trends”. The first was the post-Cold War (and post-trade liberalization) integration of the Asian labour forces into the world economy, which flooded Western markets with cheap goods and kept inflation low. The second was Japan’s 1990s’ monetary policy loosening in response to its prolonged asset bubble deflation, which took yen interest rates near zero and spawned the famous “carry trade”, a key element of subsequent bubbles elsewhere, including the mid-1990s’ East Asian financial crisis. Third was the flood of physicists and engineers (a flood swelled by the collapse of the Soviet empire) who propagated quantitative models across the West’s financial industry to assess returns, create complex derivatives and manage risk. Of course, most of these models, based on typical, bell-shaped “normal” distributions for random variables, failed to account for the “long tail, black swan risk” that destroyed Western finance. The last was the mega-trend of global deregulation, of trade, capital controls and financial regulation, which swept across Western finance and paved the way for subsequent excesses.
In essence, as Sheng puts it, “these mega-trends were four arbitrages that created converging globalization—wage arbitrage, financial arbitrage, knowledge arbitrage and regulatory arbitrage”. The mega-trends welded national markets into a networked, global financial market, but without the steadying influence of any global regulator. The “four arbitrages also led to four excesses that were the hallmark of the present crisis-excess liquidity, excess leverage, excess complexity and excess greed.”
Sheng provides a wealth of information on the financial dimensions of the crisis. For example, he estimates that financial sector leverage rose from 108 per cent of world GDP in 1980 to over 400 per cent by 2007. And the notional value of financial derivatives soared to nearly $600 trillion by end 2007, or about 11 times global GDP! This mind-boggling inverted pyramid of financial “assets”, rested (more accurately, teetered) on the fragile foundation of largely sub-prime mortgage lending in the US. As he explains, four elements of financial innovation and deregulation combined to spawn the sea of toxic assets “at the root of the current crisis”. First, plain home mortgages were securitized into mortgage-backed securities, bundled, tranched and sold, often as AAA paper. Second, accounting and regulatory standards were diluted to allow moving these securities “off balance sheet” into unregulated “special investment vehicles” (SIVs) that were free of capital adequacy requirements. Leverage exploded: at end 2007 the five largest US investment banks had equity capital of $200 billion, balance sheet assets of $ 4.3 trillion (leverage of 21 times) and off balance-sheet liabilities of $17.8 trillion entailing additional leverage of nearly 90 times! Third, insurance companies (notably AIG) and newly created “credit default swaps” were used to enhance the credit quality of weak assets. Fourth, credit rating agencies willingly rated such assets AAA for a fee.
Sheng offers valuable insight into how the system-destroying potential of the Lehman bankruptcy might have been under-estimated by the regulators because of the “gross and net effects of derivative accounting: If you had a swap of say $100 million with Lehman, you would not have to book the gross liability of $100 million. Using market calculations of risks, your exposure would be roughly $2.4 million. But if Lehman defaulted, your loss would be $100 million…” On September 15, 2008 Lehman was allowed to topple into bankruptcy…and brought down the house of derivative cards.
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Sheng is not sanguine about the West’s progress thus far in resolving the crisis. He argues that bank restructuring after a crisis requires four major steps: “diagnosis, damage control, loss allocation and changing the incentive structure…” In summary, he feels the diagnosis has been ad hoc and faulty. With the financial crisis still spreading into the real sector, the damage control phase is far from over. Loss allocation has been imperfect since Western authorities seem to “have accepted the fact that the public will pay for the mistakes of the few”. There has been no healthy change in the incentive structure: “frugal savers are blamed for creating the surplus liquidity, the bad bankers and speculators are being bailed out and their losses will not only be paid by Main Street, but all future savings world-wide…”
Andrew Sheng ends with “six fundamental points” to ponder over the future of global finance. First, while crisis may be the natural outcome of human excesses, the window of opportunity for reform is short. Second, finance is a derivative (of the real sector) that carries leverage and risks. Because of inherent instability, finance has to be well-regulated. Third, finance should serve the real economy and not the other way round. Hence the need for greater policy focus on promoting a strong real sector. Fourth, the whole philosophy of financial regulation needs rethinking. Fifth, financial innovation should not get ahead of practice and reality. In the present crisis most investors, bankers and regulators simply didn’t understand the massive risks and leverages embedded in allegedly AAA securities. Finally, central bankers must integrate the implications of monetary policy for financial stability into their analysis and actions.
This piece is an appetizer. Now read the full lecture at the website.
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal