On 27 October, European leaders announced an ‘emergency three-pronged’ deal to save the Eurozone from what seemed to be sure collapse from the burden of Italian and Greek debt. The prescription – a 50 per cent write-off of the Greek debt by private banks, boosting the bail-out fund European Financial Stability Facility (EFSF) from 440 billion to 1 trillion Euros, and a recapitalisation of banks through new fund-raising – sent a wave of relief through global markets, both developed and emerging.
Unfortunately, the foundation of the euro – currency unity without political or fiscal union – has already been shaken, and the most recent deal is just more proof that a high price is being paid for its preservation. As the G20 leaders meet this week to try and stave off Europe’s projected financial annihilation, the key question will be: can they think creatively and strategically to establish a robust and fair economic governance framework?
Governance in any financial system is based on four main pillars: managing and mitigating systemic risk, setting an orderly dismantling when required, establishing prudential rules and regulations, and protecting and upholding stakeholders’ interests.
So far, the European leaders have failed on all four counts. First, systemic risk has taken centre-stage, at the cost of the three other governance measures. For instance, the recent deal only has measures to avoid a systemic default of Greece. It is based on the erroneous premise that the collateral damage of the crisis – the default of multiple banks and countries – will not only prevent banks from functioning but will also catalyse the onset of an economic depression. The fear of this possibility, however remote, has made European leaders consider only one solution: the ‘rewind and replay’ of bailouts.
Instead, good governance dictates that the risk be contained. That means ring-fencing and recapitalising banks instead of countries. Germany and France should have bailed out the banks and let the countries default. Governments and multilateral institutions should act as backstops, and not become lenders of first resort, as is the case with the EFSF bail-out fund. This way gives capitalism a chance to work – both in boom and bust times.
Second, none of the solutions so far have suggested the orderly dismantling of Greek debt as an option. Most visibly, the German and French banks are at stake. But under the mechanics of financial interdependence lies a craving for saving the European identity – the value of which cannot be measured in numbers. This is masking the more pragmatic solution: that the breakaway of Greece, or even Italy, from the euro may just allow these countries to bounce back with competitive devalued currencies quicker than if they are forced to pay off loans for years to come. Excess wages (from euro benchmarks of yore) would evaporate and productivity improvement would push further gains. This requires strong political leadership that can manage and transform the knee-jerk will of the people for long-term benefits.
Third, to rebuild confidence with the rest of the world, the standards for Prevention of Money Laundering Act and Know Your Customer must be uniform, and coupled with a framework that eliminates global arbitrage in tax and regulatory mechanisms. The current perception that emerging market regulations are inferior is an unfair assessment, given that these countries have held up well in the global financial crisis. Similarly, arbitrage opportunities distort investment and business transactions giving unfair advantage to multi-national, rich businesses most of whom are from western countries.
Finally, in the current discussion, stakeholder interests have included only European banks and nations; included nowhere was the emerging world, for which capital has dried up. The owners of capital, largely from western private equity and institutional sources, claim a rightful pull-back from emerging markets given the uncertainty and risk-aversion of investors. Capital is required not only for investing in much-needed infrastructure in emerging markets but is also equally important for western countries that channelise the high capital returns for funding innovation and hi-tech industries. So the pull-back is irrational, and an unfortunate result of the narrow definition of the stakeholders for this crisis.
This brings us to the larger question of protecting the interest of stakeholders – the rules of engagement in the financial world must be inclusive and equitable. Who really has a stake in saving Europe? And would the G20 and the IMF take the same measures if India was in crisis? Or China or Indonesia or Brazil? Lessons from the 1997 Asian financial crisis tell us otherwise. The IMF process forced many individuals in those nations to lose their wealth, many banks to accept write-downs, and many countries to devalue their currency. The prognosis stated that the excess was caused by the plough-back of savings and surpluses into their own economies, and the solution proposed was to keep capital offshore (read: the US government and banks). Ironically, the short-termism of this solution led to the funding of the excesses in the form of subprime mortgages in the west, eventually leading to the global financial crisis in 2008.
But 2011 is different from 1997. The developing world wields sizable influence in global growth now. The $40 billion Asian financial crisis seems insignificant compared to the trillion-dollar European crisis. The GDP of the US and Europe are expected to grow at less 1 per cent in the foreseeable future. The growth of the emerging world is essential for global GDP growth, and to pull the west out of recession. Thus, to make the framework equitable, new formulae for crisis-saving mechanisms must be introduced so that there is a certainty of how rules that apply to developed countries apply to the developing ones as well. The BRIC nations are more likely to actively participate in saving Europe if they know that they can avail of a similar bail-out.
Perhaps, the guiding formulae can be based on the capitalisation of banks instead of sovereigns. Or it can be based on trade, specifically a promise of imports, such as chemical products from Greece. Or it can be driven by investments into competitive sectors such as the tourism industry of Greece or the manufacturing industry in Italy, rather than investing into a currency. The long-termism in the solution is captured in the old adage – give a man a fish and you feed him today, teach a man to fish and you feed him for a lifetime.
The other incentives for the rest of the world to participate can begin with the harmonisation of rules for anti-money laundering, standardizing ‘Know Your Customer’ norms, correcting pricing inequalities such as premiums for oil, and removing curbs on hi-tech for clean energy or defense.
India, as a net importer of capital, is looking for stability and the reduction in volatility; it is not in its interest for the world to move into risk-aversion and freeze mode. Since financial regulation, IMF reform and global governance make up three of six G20 agenda items, India could use those sessions to advocate for a more harmonised, equitable governance environment. Specifically, when at Cannes, Indian prime minister Singh will ask for the voluntary sharing of tax information and the rationalisation of the financial transaction tax – both of which play into his domestic concerns.
If the G20 keeps the status quo and finds solace in unimaginative approaches, it will be their biggest failure. The developed world needs capital and trade relationships with the developing world, and the developing world wants harmonised rules for global governance. Thus, there are opportunities to work together. If this is truly a world crisis, and genuinely has the risk of leading the world into depression, then to think that a contrived capital-intensive bail-out for a few a countries will work, or that a fraction of the world’s population who live relat
ively rich lifestyles will get buy-in from the rest of the world, is irrational – much like the global governance framework that exists today.
Akshay Mathur is the Head of Research at Gateway House: Indian Council on Global Relations, Mumbai.
K.N. Vaidyanathan is the Senior Geoeconomics Fellow at Gateway House: Indian Council on Global Relations, and the former executive director, Securities & Exchange Board of India.