Global SwinG StateS workinG PaPer 2012

Global SwinG StateS and the Financial order
JoSePh Quinlan

Global Swing States and the Financial Order
Global Swing States Working Paper November 2012

Joseph Quinlan1

1 Joseph Quinlan is a seasoned Wall Street analyst and expert on global capital flows and international finance. He is the author, co-author, or contributor to more than 25 books on global trade and finance. He lectures at various universities around the world and serves as a non-resident fellow at the German Marshal Fund of the United States in Washington, DC.

he aftershocks from the financial crisis of 2008 have produced cracks in the global financial architecture and triggered calls for a re-examination of the U.S.-led international monetary system.1 The crisis has shattered trust in the standard-bearers of the postwar financial system: the United States and Europe, along with Western-backed multilateral financial institutions like the International Monetary Fund (IMF) and the World Bank. Yet whether or not the financial crisis significantly alters the global financial system remains to be seen. Four years after the collapse of Lehman Brothers, Wall Street and the United States remain at the center of the global financial universe. The global appeal of the U.S. dollar has become stronger, not weaker. Meanwhile, developing countries — despite holding over $9 trillion in international reserves in early 2012 — have failed to effectively use their financial firepower to stave off a cyclical economic slowdown or begin a fundamental remaking of the global financial order in their image. All four “global swing states” — Brazil, India, Indonesia, and Turkey — have seen their real economic growth slow over the past year and are therefore disinclined, at this juncture, to push for a wholesale overhaul of the global financial architecture out of fear of the uncertainty such a move would trigger. In general, the remaking of the global financial architecture has been more evolutionary than revolutionary. The financial crisis has elevated the Group of 20 (G20) and its member states, including Brazil, India, Indonesia, and Turkey. Their involvement in not only the G20 but also the newly created Financial Stability Board gives the global swing states — in theory — a greater say in the future of international financial governance. In reality, however, the extent to which the four
1 Ben Rooney, “IMF calls for dollar alternative,” CNNMoney. com, February 10, 2011, markets/dollar/index.htm.


nations will affect and reshape the future financial architecture is still uncertain. Surrendering to the Markets The global swing states were swept up in the financial deregulation movement of the 1980s and 1990s, when nation after nation surrendered to the markets by dismantling capital controls and regulatory barriers designed to impede crossborder investment flows. Brazil, India, Indonesia, and Turkey all took part, at various speeds, in the global wave of capital liberalization. In developing countries, privatization, liberalization of trade and investment, and securitization of finance replaced nationalism and expropriation. Rapid advances in technology helped facilitate this process, allowing information and capital to flow across borders at lightning speeds. Global investing came of age, with many money managers in New York and London eager to sink capital into the highrisk, high-reward emerging markets of the four swing states. Accordingly, the equity, bond, and currency markets of Brazil, India, Indonesia, and Turkey became more open to foreign capital flows, deepening their economic and financial integration with the global economy. As part of this process, the capitalization of Brazil’s stock market rose more than 20-fold between 1990 and 2000. The market capitalization of Turkey and India roughly quadrupled over the same period, with that of Indonesia also experiencing a sharp rise. Most of the free-market policies adopted by the four countries were unilateral, although some of the structural adjustments of the 1990s were a response to conditions imposed by the IMF following various emerging-market crises (India in 19911992, Brazil in 1997, and Indonesia in 1997-1998). Each successive crisis bound the global swing states closer to international rules, standards, and

The remaking of the global financial architecture has been more evolutionary than revolutionary.

Global Swing States and the Financial Order


norms laid out by Washington or inspired by the Washington Consensus.2 However, each passing crisis also raised serious questions about the effectiveness and stability of the existing financial system. During the 1990s, developing countries, including the global swing states, became progressively more inclined to blame financial instability on Western-led financial markets and Western-dominated institutions like the IMF. The Asian financial crisis was a turning point: Many developing countries vowed never again to be caught short of capital and therefore exposed to the gyrations of Wall Street and the harsh prescriptions of the IMF. To that end, many of these nations, including the global swing states, made the massive accumulation of foreign exchange reserves a central tenet of their monetary policies. Between 1997 and 2007, Indonesia’s reserves increased from $17 billion to $55 billion; Turkey’s, from $18 billion to $73 billion; Brazil’s, from $50 billion to $180 billion; and India’s, from $25 billion to $267 billion.3 Awash with cash, many developing countries, including Brazil and Indonesia, paid off their IMF loans early and made it very clear that they did not plan to borrow from the IMF again. The desire for greater financial autonomy also led Brazil and Indonesia to create sovereign wealth funds, which are essentially massive emergency funds for use in times of financial instability. The establishment of regional financial institutions and mechanisms in Asia and Latin America added
2 John Williamson, “The Washington Consensus as Policy Prescription for Development” (World Bank, January 12, 2004), Table 1, williamson0204.pdf. The Washington Consensus included policies such as fiscal discipline, financial liberalization, trade liberalization, and openness to external investments. 3 Valentina Pasquali, “Foreign Exchange Reserves, 2002-2011,” Global Finance, June 2011, html#axzz2A9O2pKhl.

During the 1990s, developing countries, including the global swing states, became progressively more inclined to blame financial instability on Western-led financial markets and Westerndominated institutions.

another protective layer against financial volatility. In 2000, ten Southeast Asian countries, Japan, China, and South Korea launched the Chiang Mai Initiative, a regional currency swap arrangement. This initiative has insulated its members from the vagaries of global financial flows. Latin American countries have also pursued regional financial arrangements, but on a less aggressive scale because of lukewarm support from Brazil. When the Financial Plumbing Exploded Massive reserve levels helped to insulate developing countries in general, and the global swing states in particular, from the economic crisis of late 2008, a seminal moment for the postwar financial architecture. The financial tsunami that swept over Wall Street in September 2008 laid waste to venerable institutions like Lehman Brothers and battered the reputations of Goldman Sachs and other financial stalwarts. The crisis also undermined the capacity and credibility of the world’s financial architects — the United States and Europe. After living beyond their means and amassing mountains of debt, the world’s two largest economies suffered the consequences. Financial institutions created by the West at the end of World War II lost their legitimacy and credibility. Against this backdrop, the Group of 7 industrialized countries — which had successfully kept the G20 from gaining too much power after the Asian Financial Crisis — yielded to reality and accepted the G20 as the world’s new financial steering committee. As part of this revised financial order, members of the G20 also became members of the Basel Committee and the new Financial Stability Board, the successor to the Financial Stability Forum. In addition, the International Organization of Securities Commissions — charged with developing and promoting globally consistent standards of regulation, oversight, and enforcement in securities markets — invited Brazil and India to


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join its Technical Committee, and the Committee of Payment and Settlements Systems expanded its membership to include the two nations. The IMF pledged to raise the representation of all four global swing states in return for increased funding commitments. Yet while Russia and China have fixed seats on the IMF board of directors, Brazil and India still do not. And despite claims of “far-reaching reforms,” the governance of the IMF and the World Bank remains firmly in the hands of Europe and the United States. Both institutions recently changed leadership, with the IMF opting, as expected, for a European and the top job at the World Bank going to an American. In terms of voting shares at the IMF and number of seats on the executive board, Europe is universally thought to be over-represented. Unsurprisingly, Brazil, India, Indonesia, and Turkey all seek to garner more seats and votes. The financial crises of the past few years have elevated the IMF as the standard-bearer of the existing financial order. The re-empowerment of the IMF as a first responder largely reflects the G20’s decision to bolster the capabilities and finances of the IMF during a time of financial turmoil, with Brazil and India, for instance, each committing to purchase $10 billion in IMF bonds. The developing countries, in other words, have played an instrumental role in adding to the IMF’s financial firepower, which has increased by more than $500 billion over the past few years. However, developing countries’ support of the IMF brings new expectations for greater influence and sway over future global governance. At the London G20 meeting, for instance, Indonesia successfully lobbied for the devolution of a proportion of new IMF commitments to the Asian Development Bank, allowing the regional bank to dole out capital in a more flexible and timely fashion to regional nations

in need. Other regional banks have followed suit to draw on the new IMF funds. Secretary of the Treasury Timothy Geithner has framed the Financial Stability Board as a potential “fourth pillar”4 of global economic governance, but its potential remains unrealized because the body lacks any substantive legal or formal power and remains largely a coordinating mechanism with limited resources. Of the global swing states, Brazil and India each have three seats on the board (as do Russia and China), whereas Turkey and Indonesia each have one representative. As at the IMF, European nations have a disproportionate share of votes at the Financial Stability Board. Still a U.S. Dollar-Based World An instructive way to examine how much the world financial order has changed since the crisis — and the new role of the global swing states within it — is to analyze the role of the U.S. dollar, the longtime anchor of the financial system. Ever since representatives from the United States, the United Kingdom, and 42 other nations met at Bretton Woods, New Hampshire, to hammer out a new international monetary agreement in 1944, the U.S. dollar has dominated global trade and finance. And although the financial crisis of 2008 harmed the economic credibility of the United States and severely damaged the reputation of Wall Street, the world remains tethered to the U.S. currency. Of the allocated global reserve holdings of central banks in the first quarter of 2012, roughly 64 percent were held in U.S. dollars. The euro ranked a distant second, at 26 percent.5 A number of factors undergird the current dollarcentric world and make overturning it difficult.
4 Timothy Geithner, “Press Briefing at G20 Meeting” (Pittsburgh Convention Center, Pittsburgh, September 24, 2009). 5 “International Financial Statistics” (International Monetary Fund, 2011), Appendix I, ar/2012/eng/pdf/a1.pdf.

Despite claims of “farreaching reforms,” the governance of the IMF and the World Bank remains firmly in the hands of Europe and the United States.

Global Swing States and the Financial Order


To change the future monetary order, the global swing states would have to line up behind China.

One factor is the United States’ capital markets, among the deepest, largest, and most innovative in the world. This gives the U.S. dollar a built-in competitive advantage relative to other currencies — or, as some say, the power of incumbency. The United States remains at the core of global capital markets: Not only is it a global leader in terms of total bank deposits, government debt securities, corporate debt, and equities, but it is also at the forefront of financial innovation and expansion of financial services. Another factor supporting the U.S. dollar is that global trade remains predominantly denominated in the United States’ currency. Despite the declining U.S. share of global trade over the past half-century and the fact that some countries, including Brazil and Indonesia, have begun to invoice their trade with China in each other’s currency, the U.S. dollar is still used in roughly 85 percent of all foreign exchange transactions.6 This widespread global use gives the U.S. dollar more staying power than many observers recognize. Key commodities like petroleum, wheat, and iron ore continue to be invoiced in U.S. dollars. Although Middle Eastern countries have complained over the steady decline in the value of their U.S. dollar holdings, they have no other currency option. The status quo in the Middle East depends on oil priced in U.S. dollars and dollarpegged currencies. This decades-old arrangement in the Middle East will continue in exchange for U.S. military services and protection. Furthermore, in the Middle East and globally, the European debt crisis has greatly undermined confidence in the euro as a reserve currency. The dominance of the U.S. dollar also reflects the fact that the United States possesses the largest, most productive and most resilient economy in the
6 Barry Eichengreen, “Why the Dollar’s Reign Is Near an End,” The Wall Street Journal, March 1, 2011.

world. Although deeply in debt and confronting a so-called “fiscal cliff ” by the end of the year, the U.S. economy has emerged in the past 12 months as one of the strongest relative to its competitors. The United States remains among the largest trading nations in the world, a magnet for foreign direct investment and a safe haven for global investors unnerved by Europe’s ongoing financial problems and political strife in the Middle East. All of these factors support the continuation of a dollar-centric world. However, other currencies could still gain importance in the years ahead, although the likelihood of this depends on developments and policies in the United States, Europe, China, and elsewhere. At worst, the U.S. dollar will remain first among equals for the next decade or so. In general, substitutes for the U.S. dollar are few, with none of the global swing states remotely positioned to have a world reserve currency any time soon. Of the global swing states, Brazil has called most vocally for a shift to a multicurrency world, although neither it nor any of the other swing states can singularly move the world in that direction. Working in tandem, the global swing states could potentially accelerate the move toward a more multicurrency world by invoicing more of their trade in non-dollar-denominated assets, aggressively diversifying their international reserves and compelling other developing countries to do the same. All have taken these steps in the past few years, but their uncoordinated and incremental policies lack an overarching strategic vision and, as a consequence, have not produced a new global monetary order. To change the future monetary order, the global swing states would have to line up behind China and encourage and support Beijing in making the renminbi a serious competitor to the U.S. dollar. Such support for China’s efforts to alter the dollar-


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based global system would strengthen China’s economic influence in Asia and around the world. However, there is little likelihood that India would enthusiastically sign up for that task — and only slightly greater likelihood that Indonesia would — given that China is an economic and geostrategic competitor to both countries. China’s rising economic power has, however, enticed both Brazil and Indonesia to support less-threatening moves like the greater internationalization of the renminbi. The increased use of China’s currency in day-to-day, cross-border activities amounts to a step toward greater currency convertibility in China.7 Indonesia, for instance, has agreed to hold more renminbi as part of its international reserves. Brazil, meanwhile, has agreed to price bilateral trade with China in local currency, a move that will further underpin the globalization of the renminbi. Yet in order for China’s currency to challenge the reign of the U.S. dollar, China must modernize and open its financial sector, allowing the development of efficient money and capital markets. At the moment, China’s banking sector is more closed than open. Much has been made of the fact that the Chinese financial sector weathered the financial crisis rather well. This is accurate but is due less to any inherent strength and more to the fact that China’s banking sector remains relatively walled off from the rest of the world — circumstances that hardly augur well for the convertibility of the renminbi any time soon. China appears to be in no hurry to see the world move away from the dollar-based system of the past 60 years. The same goes for the global swing states. They have proven reluctant to upend the dollar7 Cedric Muhammad, “China’s Yuan Internationalization: Made in Africa, Not Hong Kong,” Forbes (October 16, 2012), chinas-yuan-internationalization-made-in-africa-not-hongkong/.

centric monetary system because back-to-back financial crises — first in the United States and now in Europe — have left them craving monetary stability, not radical change. Global Swing States and the Financial Architecture None of the global swing states — in isolation — have the finances or economic weight to project their goals and objectives on the rest of the world. That said, they have become more active and vocal in pushing for reform of the global financial architecture. Brazil has been among the loudest in haranguing the United States and Europe over the past few years for wreaking financial chaos on the rest of the world. It has also been the most outspoken about “currency wars” — the country’s dissatisfaction with the U.S. Federal Reserve’s ultra-loose monetary policy, viewed by Brazil as a deliberate strategy to debase U.S. currency in order to gain a global competitive advantage in trade. To counter this perceived strategy, Brazil has become a key proponent of capital controls and has even helped trigger a rethinking of their use and effectiveness at the IMF. Brazil’s participation in regional financial arrangements has been more tepid. It is not a member of the Latin American Reserve Fund or the Bank of the South. Acting more alone than in concert with others in the region, Brazil has doled out regional aid via its National Bank of Economic and Social Development. Brazil is also one of the largest contributors to the International Development Bank and is at the forefront of efforts to resurrect the Agreement on Reciprocal Payments and Credits, which helps promote intraregional trade through guaranteed capital from central banks. In trade, Brazil has begun to denominate its commerce with Argentina and China in local currency, not U.S. dollars.

Brazil has become a key proponent of capital controls and has even helped trigger a rethinking of their use and effectiveness at the IMF.

Global Swing States and the Financial Order


To ensure that the global swing states continue as responsible stakeholders in the current financial order, the United States and Europe must — in the very near future — get their economic and financial houses in order.

India’s global financial involvement has increased over the past few years, although the nation remains more of a passive participant than a key driver. This reflects a number of factors. First, India remains a relatively poor nation, with a relatively closed economy; cross-border trade and finance is not as important to India as it is to the other global swing states. Second, India remains outside the Chiang Mai Initiative and is therefore more of an outsider when it comes to the financial integration of Asia. Finally, the financial strength of China inhibits India’s potential to become a significant financial player in Asia. India’s relatively scarce resources also play into these circumstances. However, India is a significant contributor to the Asian Development Bank and has increased its development assistance in South Asia and Africa. Unlike India, Indonesia is deeply embedded in the growing financial architecture of Asia. It was a key supporter of transforming the Chiang Mai Initiative into a multilateral currency pool, a step that has further deepened and expanded the financial regionalization of Asia. Many observers believe that the transformation of the Chiang Mai Initiative positions Asia to create its own regional monetary authority. Meanwhile, at the London G20 summit, Indonesia tabled a proposal to make the Asian Development Bank responsible for a portion of the new commitments to the IMF. Indonesia’s central bank has been keen to buy renminbidenominated bonds issued in China, a process that helps Indonesia diversify its U.S. dollar holdings. Currency swap lines between Indonesia and China have also grown thicker over the past few years. Turkey, like India, is more passive than reactive when it comes to reform of the global financial architecture. Being so close to the European financial crisis, it has cooled somewhat on the idea of joining the European Union; if anything, Turkey will take a more wait-and-see approach as the crisis unfolds. The more the crisis simmers,

the less ambitious Turkey will be about joining a floundering Western economic entity. How to Keep the Global Swing States as Financial Stakeholders To ensure that the global swing states continue as responsible stakeholders in the current financial order, the United States and Europe must — in the very near future — get their economic and financial houses in order. This is the first step toward rebuilding confidence in the worldwide financial system that both sides of the Atlantic have traditionally anchored. Macroeconomic stability and a medium-term plan to reduce European and U.S. sovereign debt remain open issues and continue to drain confidence in the current financial architecture. For the United States, the urgent challenge is to reduce the federal budget deficit to more manageable levels and trim the nation’s dependence on foreign capital and oil. For Europe, fiscal restraint, along with measures that create a more flexible and competitive labor market, are key elements of a long-term economic growth strategy. The longer the West waits to confront a crisis of confidence in its banking and financial institutions, the greater the risk of larger fissures in the global financial system. Since the financial crisis struck in 2008, financial sector reform in the United States, the United Kingdom, Germany, and many other parts of Europe has been more chaotic than coherent, with each party pursuing different mandates with nominal regard for the larger global impact. This has done little to engender confidence among the global swing states. Likewise, the Libor scandal, in which numerous banks have been accused of rigging or manipulating the key benchmark that sets global interest rates; the massive trading loss at JP Morgan Chase due to a rogue trader; and other similar instances have corroded faith in global financial markets. This leaves the global swing states caught uncomfortably


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between the existing — yet less than effective — financial order and the creation of a new financial architecture with its attendant uncertainty. Another task for the United States and Europe is to continue to widen and deepen the participation of global swing states in existing multilateral institutions, such as the IMF and the World Bank. This means paying more than just lip service to the global swing states when it comes to their demands for a greater say in these institutions. Brazil, India, Indonesia, and Turkey are unlikely to become long-term stakeholders of the financial architecture until they are granted more voting rights and have a legitimate voice when it comes to selecting leaders at the IMF and World Bank. Concurrently, it is important that both institutions work closely and in a complementary way with regional financial organizations in Asia and Latin America. The United States and Europe should realize that as the global swing states become less confident in and comfortable with the IMF and the World Bank, their attention and energy will likely turn toward more regional arrangements, potentially

undercutting the effectiveness of traditional financial institutions. In the end, the post-crisis financial architecture remains a work in progress. The financial crisis was a catalyst for change, but the process remains incremental. The pace of change, in part, will reflect the collective desires and objectives of the global swing states. Presently, these four nations remain concerned by elements of the existing financial order. However, they are not keen to see a complete overhaul of the existing structure. Change will occur incrementally, which will give the United States and Europe valuable time to engage the global swing states in crafting a more inclusive financial architecture, one fully supported by developed and developing countries alike. The alternative — for the global swing states to go their own way, eschewing international arrangements for more regional arrangements — holds less appeal for the United States and Europe and would do more damage to the global financial system and economy.

Global Swing States and the Financial Order


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