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Draft: Not for quotation. Comments welcome.

Learning from the Global Economic Crisis: Toward a New East Asian Model?1

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Introduction/background 1.1 Soon after the Asian crisis

Two of the most remarkable events in Asia with respect to the recent global financial crisis were: first, how it could have happened since we had labored hard at fixing the roots of the Asian financial crisis; and, second, how could it happen so soon after the Asian crisis. The answer to the first question is that this time it came from another direction. While we were focused on controlling our foreign indebtedness and our fiscal deficits to remove the causes of the Asian financial crisis 10 years ago and the Latin American debt crisis 25 years ago, this time it was our credits (not debts, mind you) and investments abroad that had an immediate hit on our economies. Of course, it became much deeper because our export markets contracted due to losses of our export markets. The second question is answered when one remembers that there had been mini-crises all the last 25 years since the increase in financial liberalization. As a side effect of increased global financial integration, the interaction among financial markets had increased across borders. There had been general misgivings about the rapid expansion of credit over international markets but the exact channel had not been described so it was difficult to design preventive mechanisms. By almost all accounts this was the worst financial crisis since the Great Depression because of the depth and breadth of its effects. It affected several of the most economically and financially important countries. By of February 2009, the United Kingdom, Japan, and the United States have suffered absolute declines of -0.50%, 11%, and -1.5%, respectively, in their gross domestic product. And China’s rapid growth rate will decelerate to 6.5% from a high of 11% at one tine. Other countries have suffered similar if not worse fortunes. There are indications that things will get worse before they get better. For a crisis of such depth, length and breadth we may have to go back to the 1930’s to look for close parallels.

1.2 New roots When the crisis finally arrived it came from the general direction that had been broadly anticipated but in a specific form that had not been visualized. The global financial system had had been a reflection of the general form of its domestic
By Cayetano Paderanga, Jr., Visiting Professor, Kobe University and Professor, University of the Philippines. The author would like to thank the participants of the Kyoto Conference on the New East Asian Model, February 28, 2010.
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equivalents. The two main components were the financial intermediaries like banks and insurance and financial markets. Because of its role in previous domestic financial crises, financial intermediaries had always been closely regulated by domestic rules. In recent years, the Basel Committee in Switzerland had formulated an evolving set of international standards that acted as an informal system regulated by business practice and domestic regulators to put more order in the global banking system. However, financial markets had previously been more loosely regulated based on the belief that market participants were higher-value, more sophisticated investors. The main regulators of the financial markets were the securities and exchange commission of each country. Their main objectives were the prevention of fraud and to maintain an orderly market. Prevention of systemic failures was not an explicit function of these watchdogs. Greenspan admitted in an interview that he underestimated the risky lending (i.e. subprime credits) on the broader economy (Davies, 2007). In postcrisis interviews he has also observed that he may have overestimated the selfcorrecting ability of the financial markets. In this context, several weaknesses appear from hindsight. These are discussed in detail in the section on possible responses by individual countries and regions as a whole. 1.3 Causes of vulnerability

Subsequent analysis of the crisis and its origins indicate that some areas of the international of domestic and international financial systems were vulnerable to the enormous expansion of essentially un-hedged credit risks. Perversely, some of the system’s prudential features facilitated this dangerous buildup. One of the root causes may have been the over-consumption of developed economies especially the United States, capitalizing on the cost competitiveness of newly emerging economies like China and India. This combination of mature economies, efficient production by new producers and the increasing integration of global product markets became apparent about a quarter of a century ago, manifested by the tremendous growth in trade volumes in the last decades of the 20th century. As the flow of goods from these newly-industrializing economies accelerated, it caused a continuing flow of funds trade deficit to surplus countries. Figure 1: US BOP By Components (in US$ Billions)

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200
Balance on Income

Balance on Services

0

-200
in US$ Billions Current Account Balance Unilateral Current Transfers, Net

-400

-600

Balance on Goods

-800

-1,000
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: US Federal Reserve Board (US Fed)

The other major cause of the crisis, easy monetary policy, may be described as the other side of the overconsumption coin. However, overconsumption is discussed separately because it implies a structural imbalance that needs to be addressed above and beyond the tightening of monetary policies once recovery is achieved. It implies a radical rearrangement of world trade if rapid global growth is to continue in an orderly manner. Whereas we saw a one-way flow of goods during the last twenty-five years, we need a more multi-directional pattern of trade and a more varied distribution. Further, the timeline indicates that the large deficits persisted even during periods when monetary policies were less relaxed although the two broad threads clearly coincided in the most rapid buildup of the last decade. The global crisis clearly goes beyond the subprime credit crisis.

Figure 2: World Exports Value, 1980- 2007 (in US$ billions)

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16,000 14,000 12,000 10,000

25

20

Levels (FOB in US$ billions)

15

Annual Growth Rate (%)

10 8,000 5 6,000 4,000 2,000 0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

0

-5

-10

Source: International Monetary Fund (IMF)

Figure 3: World Imports Value, 1980- 2007 (in US$ billions)

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16,000 14,000 12,000
Levels (CIF in US$ Billions)

25

20

15

Annual Growth Rate (%)

10,000 10 8,000 5 6,000 4,000 2,000 0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

0

-5

-10

Source: IMF Figure 4: World Merchandise Trade, 1948- 2008
50

40
Merchandise Exports Merchandise Imports
Annual Growth Rate (%)

30

20

10

0

-10
1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008

Source: World Trade Organization The production and trade imbalance created a re-cycling problem for the main exporters that needed either currency realignment or a remedial capital flow from surplus countries. To maintain their cost competitiveness, surplus economies chose the latter, shipping several trillion dollars of funds to purchase earning assets from deficit countries. While we use China to illustrate how the process took hold, this

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phenomenon came out of a strategy rooted in development lessons of the last halfcentury and was part of a major push for economic growth by emerging economies.

Figure 5: BOP Deficit/Surplus as % of GDP for Selected Economies
12 10 8 6
as % of GDP US India China Japan

4 2 0 -2 -4 -6 -8
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: IMF

Figure 6: China’s Foreign Exchange Reserves (in US$ Billions) and Exchange Rate (Chinese Yuan/US$)

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2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0
1980:01 1983:05 1986:09 1990:01 1993:05 1996:09 2000:01 2003:05 2006:09 Foreign Exchange Reserve (in US$ Billions) Chinese Yuan/ US$ (monthly average)

10 9 8 7 6 5 4 3 2 1 0
Yuan/ US$

Source: IMF For the United States, the supplier of the de facto global currency, this was masked by the need to produce a moderate balance of payments deficit in order to supply liquidity needed by the rapidly expanding volume of world trade. This cover was extended when the collapse of the socialist economies created several new capitalist economies with central banks that loaded up in foreign exchange reserves to support their entry into the world trading system. Figure 7: Daily Global Foreign Exchange Turnover, By Major Markets (in US$ Billions)

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1,600 1,400 1,200 1,000 800 600 400 200 0
1989 1992 1995 1998 2001 2004 2007

(in US$ Billions)

United Kingdom Japan Hong Kong SAR

United States Switzerland Singapore

Source: Bank for International Settlements These flows of cheap goods and funds had two salient results in the recipient countries. First, the inflow of cheap goods reduced their inflations rates, strengthening their currencies and, thereby, harming their manufacturing sectors. Second, the flow of funds inflated asset prices and reduced the return on investments. When the dot-com bubble burst in 2000, the low-inflation environment allowed the central banks, led by the US Federal Reserve, to reduce interest rates to avoid recession, further enhancing the asset price bubble and aggravating the already low returns on investments, inciting a frantic search for higher-yielding alternative investments. They found the solution in subprime credits and inflation hedges like minerals and agricultural commodities. Subprime credits became the centerpiece of a (financial) market-wide effort to stem the decline in investment returns and to extend the reach of the financial markets to the rest of the world. This unlocked a huge reservoir of capital that spawned a spiral of financial activity. This was facilitated by financial innovations allowing the securitization of subprime mortgage loans into collateralized debt obligations (CDO’s) and the “originate and distribute” business model of selling these assets. In 1999, the United States repealed the insulating restrictions between banking and other financial services like insurance, increasing the size of the financial market and the market players at the same time that it allowed the increased exposure of banks to the volatility of the financial markets. 2.2 Business rationality and market myopia Among the puzzles of the crisis is how regulators could have missed the signals and how they could have allowed the problem to get so large. One of the reasons is that

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the crisis started in the financial markets rather than among banks. It was “market liquidity” that froze when the rapidly dropping asset prices caused funds to flee financial markets, rather than “funding liquidity” with banks running out of funds as depositors withdrew their funds. Among the main factors identified in the market freeze are new financial structures called structured investment vehicles (SIV's) that made substantial use of financial innovations including collateralized debt obligations (CDO's). Structured investment vehicles were handy financial structures to exploit the availability of funds provided by the recycling of funds from surplus economies and to avoid the low investment returns (and parallel asset bubbles) in the face of growing liquidity. These were set up to mop up market liquidity by issuing short-term instruments and turn around to buy higheryielding longer-term notes, part of a practice known as the carry trade. This type of operation carried the inherent danger posed by “a term mismatch” where short-term borrowings finance long-term assets. If short-term rates were to suddenly rise, these activities could result in substantial losses. Using short-term fund sources also created uncertainty about the stability of the financing. The activities of SIV’s were facilitated by the increasing availability of securitized subprime credit instruments (CDO’s) essentially based on homebuilding loans that were supported by the Federal National Mortgage Association (FNMA, hence Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, hence Freddie Mac). The presence of a vigorous secondary market allowed the tranching of these securities, producing highly-rated instruments that allowed the market to attain much higher volumes of financing. Figure 8: Global Issuance of Mortgage- Backed Bonds (in US$ Billions)

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Source: Fitzgerald, V. The Global Financial Crisis & Developing Economies. University of Oxford. 22 September 2008.

Unfortunately, increasing profits by using these instruments was too tempting and the market expanded, among others, by re-securitizing these securities a few more times. As the original loans were packaged and repackaged through increasing levels of securitization, their underlying credit weakness became submerged and the market forgot how poor the credit basis was. This phenomenon was facilitated by a financial institution meant to strengthen the credit process: credit rating. Credit rating is one of the main pillars of modern financial markets, acting as an instrument for controlling risk. To control risky taking by investment and credit managers, provide more information for investment and credit decisions, and protect the public, Securities and Exchange Commissions (SEC’s) require that public issues of bonds and other credit instruments be rated by accredited credit rating agencies (CRA’s). To encourage prudent lending and portfolio decisions, central banks have increasingly implemented the Basel accords that require risk weighting for banks’ risk (earning) assets. Risk-weighted assets are used to compute the minimum amount of capital to support bank lending in order to minimize the chances of bank failure due to unexpected losses (i.e. over and above the allowance for bad debt losses). The SEC requirement ensures that investors unable to afford their own individual credit investigation efforts have enough information to guide their investment and lending decisions. Since the issuance of debt to the general public has tremendously raised the amount at risk, credit rating has become armor against wholesale losses by investors in the financial markets. The central bank rule is meant to ensure that banks are insulated against failure and, therefore, safe counterparties in the credit business. If individual banks cannot survive loan defaults, then they also create trouble for the next bank in the chain of lenders and that bank to the next bank and so on. This kind of systemic failure is minimized as risk weighting and capital cover allow the banks and other lending entities to absorb unexpected losses at their turn, thereby stopping the contagion mentioned above. Credit rating (and other risk mitigating methods) failed to prevent the financial meltdown. In fact, some features of the credit rating system --- coupled with other innovations like the securitization of subprime mortgages and deregulation (e.g. repeal of Glass-Steagall) that allowed the fusion of the banking and financial services industries --- may have allowed the underestimation of risk and even amplified the overall danger, individually for lenders and collectively for the market as a whole. The rating process typically involves assessing the issuer of the instrument. In the case of the collateralized debt obligations (CDO’s) where debt servicing ultimately rests with the

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original borrowers (i.e. the mortgagors of the properties) of the underlying contracts, the rating would focus on the issuers of the bonds (perhaps real estate investment trusts or REITs) or the guarantor. By slicing CDO’s into varying tranches of seniority, REITS and similar funds are able to issue instruments rated AAA even though based on underlying subprime instruments. When the issuers are highly rated or the issue is guaranteed by highly-rated entities (like Lehman Brothers), the assets are carried at higher value (risk weights are low). Given the high interest rates that subprime credits carried, these instruments were very attractive to investors. Conveniently forgotten was the fact that the mortgagors ability to service the underlying debt questionable or very sensitive to market shifts such as changes in interest rates. When interest rates rose, the original mortgagors started defaulting and even AAA rated paper were not protected by the tranche feature. The credit rating process became an unwitting facilitator of risk magnification because it lent a (falsely) reassuring tone to what were essentially risky instruments. Guidelines for pension funds, investment and similar committees include rules that investments “must be AAA rated” or “must be investment grade,” etc. Disciplined boards were lulled into believing that they had done their fiduciary responsibilities for prudent investing. Moral hazard similar to the loss of market discipline if deposit insurance (especially if subsidized) is too high arose. Because the instruments were credit rated, decision makers become careless in ensuring that default risks were minimized. Unknown to most participants in the financial markets, a dangerous mixture of highly combustible risk was building up. Paradoxically, the comfort provided by high credit ratings may have abetted this hazard. Reassured by credit ratings risk managers, credit committees and similar bodies contentedly allowed investment managers to continue investing in these instruments. Business rationality and market myopia were combining into a highly dangerous recipe for disaster. The beginning of the end came when the extraordinary demand for dollars finally came to an end. The large balance of payments deficit finally translated into a weakening the US dollar. Around this time, increased militancy by OPEC also led to rising oil prices and, connected to this, increasing prices of minerals and other commodities. Accelerating inflation induced central banks to raise interest rates, resulting in rapidly declining asset values, especially houses. Declining house prices exposed the inherent inconsistency in subprime credits --- the borrowers could not afford to service their debts especially with higher interest rates --- and the defaults started. The resulting asset losses squeezed the credit markets in a crisis of market liquidity. When the credit markets froze, the absence of operating capital and short-term funds led to higher interest costs and shutdowns in the real economy, leading to losses, layoffs and the general economic slowdown. 3.0 How the crisis evolved

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In early 2008 Paul Krugman of Princeton University said that “$1 trillion of losses on mortgage securities [will be] showing up somewhere.” (That turned out to be a gross underestimate with recent subsequent estimates being in the 3-4 trillion dollar range). He also said that the financial impact “looks like a combination of 1990 and 2001, and probably bigger than both combined” and continued that “if the recession started in January 2008, then that would mean that July 2010 is the first month we have anything that feels like a recovery” and he “wouldn’t be surprised if it goes longer than that.” In mid-2008, Professor Nouriel Roubini of the New York University wrote in his Global EconoMonitor, “The worst is ahead of us rather than behind us in terms of the housing recession and its economic and financial implications.” The numbers have since gone in the general direction they had pointed out. The US economy has since declined by 0.9% in 2008, UK has grown minimally by 1.1%, and Japan has contracted by 0.6%. The housing markets in the United States, United Kingdom and Spain fell precipitously. At one point about 20 million people, accounting for about a fourth of US homes, were saddled with paying for more than their houses are worth. House prices continued to decline and the US housing sector and its impact on consumer spending weighed heavily on the economy. Tighter credit conditions added to these woes. Lenders undertook a mass freezing of home-equity credit lines. Continued risk aversion by lenders was heightened by rising delinquency rates in auto loans and credit card payments. The delinquency rate on indirect auto loans – which buyers get from dealers themselves – and credit card delinquencies rose to their highest levels in several decades. Various business and consumer confidence indices declined drastically.

Figure 9: Housing Price Trends for Selected Countries
40 30
US Annual Growth Rate (in %) Japan UK

20 10 0 -10 -20 -30
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

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Source: S&P, Japan Real Estate Institute, and UK Land Registry

These dire numbers have been repeated in various ways in other developed countries that served as major export markets for the Philippines. 4.0 How it reached the Philippines and other emerging economies

Impact on the Philippines Many people wonder what and how much the impact of the US recession on us has been. Most developing nations rely on America as their largest export market, not only for goods, but also for services. US companies have investments and subsidiaries in Asian countries, which provide employment and spur growth in investments. US investors have also included emerging market stocks in their portfolios to diversify; some invest in riskier assets in Asia for higher potential returns. Volumes of domestic assets are held by US investors, and the reverse is also true. These interrelationships make a lot of countries vulnerable to the US economic situation. A lot of discussion has been on the degree of “decoupling”, or whether other economies have reduced their dependence on the US economy to such an extent that the adverse impacts of downturns in the latter are diminished. This concept is not new. When the US went through a recession in 2001, China’s growth only fell by less than a percentage point to grow at 7.3%, as strong domestic demand helped cushion the huge decline in exports. In 2007, Asian countries enjoyed healthy growth while the US housing sector slumped and the sub-prime mortgage crisis exploded. Local currencies strengthened against a weakening US dollar, while stock markets rallied. There are two views. One says that we are still much affected by the US recession, and developing nations have not decoupled from US. As the recent declines in the stock indices of Asian countries show, the sub-prime mortgage crisis has had spillover effects on markets outside the US. US investors fled from risky assets to safer ones, and the sell-off led to declines in Asian stock markets. The drastic reductions in exports of export-oriented Asian countries also confirm this. And financial markets all over the world, including Asian institutions that do not have substantial exposures to soured CDOs and mortgage-backed assets, have been strongly affected by movements in developed economies.

Figure 10: Monthly Export Growth Rate for China & Japan, 1999:01 – 2009:01

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60 50 40 30 20 10 0 -10 -20 -30
1999:01 2000:01 2001:01 2002:01 2003:01 2004:01 2005:01 2006:01 2007:01 2008:01

China Japan

Source: IMF

The other view says that we are somehow insulated from the impact of the US recession. Some private forecasters share this view. According to some quarters, forecasted growth of emerging markets in Asia, though slower than their previous year’s, are more than twice that of developed countries. This conjectured insulation is puzzling in an era of globalization. Economies of developed and developing nations would have more interrelationships with each other. Then again, globalization and decoupling may not be totally opposite each other. The two forces can co-exist. In the past, emerging economies were more coupled with developed countries, especially the US, and less with the rest of the world. Now emerging countries have become more globalized – that is, they have expanded their relationships to other economies, especially with neighboring countries. This is certainly true of Asia. Globalization has played a hand in allowing economies to decouple from the US in at least two ways: One, globalization has resulted in stronger trade relationships among Asian countries. In the Philippines, the current share of exports to the US has declined from 30% to less than 20% since 2000. Demand from other neighboring countries helped offset the decline in exports resulting from sluggish US consumer demand. Also, China has become a rising force in the region’s trading activities. BCA Research reports that emerging markets, as a group, now export more to China than to the United States. At the same time, the internal growth of China is now hoped to minimize its dependence

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on exports to the US. This partly explains the expectation of Chinese growth around 6% despite a deep slide in exports.

Figure 11: Major Export Partner, 2007 Figure 1: Major Export Partner, 2007
ROW 24.2% USA 17.0%

ASEAN 15.9% China 11.4%

European Union 17.0%

Japan 14.5%

Source: BSP

Two, globalization has helped support the growth of the middle-class. With the growth of industries, higher production and income generation have led to strong consumer spending. This supports the growth of inter-regional trade. More important, it also illustrates that growth in Asian countries are slowly becoming internally driven by domestic consumers In turn, increased purchasing power helps spur investments and capital growth, as businesses rise to meet domestic demand. For the Philippines, although the US remains our biggest trading partner, the decline in our export dependence suggests that we are, to a small extent, decoupled from the US. The same may be said for other emerging markets. Although we unable to fully quantify its effects, we can expect it to continue, especially with the growth of large countries such as China and India. The future degree of this decoupling may ultimately determine how we and other emerging markets will respond to future shocks coming from other parts of the world. Figure 12: Philippine Economic Growth, 1998:Q1 to 2008:Q4

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12 10 8
Annual Growth Rate (%)

6 4 2
GDP GNP

0 -2 -4
1998:1 1999:3 2001:1 2002:3 2004:1 2005:3 2007:1 2008:3

Source: NSCB The impact on the Philippines has gone through five channels: First, through the impact on confidence and purchasing power because of the asset losses of higherspending levels of the population, magnified by the losses suffered by banks. Second, through the added losses to the investing public as portfolio investments flowed out leading to lower asset values in the country, and in turn leading to much more difficult mobilization of investment resources in the equity and credit markets; Third, through the difficulty of raising direct investment capital (FDI) in the developed markets over (to persist over the next few years); Fourth, through the impact on exports as our overseas markets contract (October as large as negative 37%); and, finally, through the feared impact on OFW deployment with the resulting adverse effect on the main engine of Philippine economic growth, OFW remittances. This last impact is still developing and will have to be monitored. Figure 13: Monthly Merchandise Trade Growth, 1998- 2009

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60

40

Annual Growth Rate (%)

20

0

-20

-40
Exports Imports

-60
1998:01 1999:02 2000:03 2001:04 2002:05 2003:06 2004:07 2005:08 2006:09 2007:10 2008:11

Source: NSCB Figure 14: Philippine Composite Index, 1998- 2009
4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0
1998:01 1999:02 2000:03 2001:04 2002:05 2003:06 2004:07 2005:08 2006:09 2007:10 2008:11

Source: BSP Figure 15: OFW Remittances and Deployed OFWs, 2004:01- 2008:12

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OFW Remittances
Deplo yed OFW and Salary Remittances o f OFWs (in M illion US$ )
1,500,000 150,000

1,400,000 125,000 1,300,000 100,000 1,200,000 75,000 1,100,000

1,000,000

50,000

Deployed OFW (R)

Remittances (L)

Source: BSP

Figure 16: Balance of Payments, 2004- 2008
Balance of Payments
Levels o f Current A cco unt, Capital and Financial A cco unt, BOP Cash Po sitio n
2,500 2,000 1,500 1,000 500 0 -500 -1,000 -1,500 -2,000 -2,500 -3,000 -1000 -1500 1500 1000 500 0 -500 2500 2000

KA (L)

CA (L)

BOP (R)

Source: BSP

Figure 17: Consumer Price Index, 2004- 2008

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Consumer Price Index
Co nsumer P rice index (2000=1 and Inflatio n Rates (%) 00)
180 160 140 10 120 100 80 60 4 40 20 0 2 0 8 6 14 12

Consumer Price Indes

Headline Inflation

Core Inflation

Source: BSP Figure 18: NG Cash Operations 2004- 2008
NG Cash Operations
Levels o f Natio nal Go vernment Revenue, Expenditures and Overall Cash po sitio n (in M illio n peso s)
160 140 150 120 100 80 60 40 0 20 0 -50 50 100 200

Cash Position

Revenue

Expenditures

Source: BSP

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Lessons learned: some initial issues Who’s afraid of global markets?

There are two aspects of the lessons from the global crisis. The first part deals with the changes to the domestic and global financial architecture that need to be introduced in the wake of the crisis. That is taken up in another paper and will is discussed only briefly here. The second aspect deals with the changes in the trade in production patterns to address the causes of the crisis. 19

5.1

Implications for international finance

One group of reforms is related to the financial architecture that appears to have fallen behind the evolution of the financial markets in the past few decades. 5.1.1 Financial innovation: Credit instruments ---

First would be modifications in supervision and regulation of structured credit including structured investment vehicles (SIV’s) and collateralized debt obligations (CDO’s) that have extended the tremendously enhanced the power of loan securitization. Among the issues that need to be addressed is the separation of origination and residual accountability present in recent financial innovations, the moral hazard aspects these represent, and the safeguard mechanisms and transparency rules needed to address these issues. 5.1.2 Credit rating --The distribution and acceptance of new the credit instruments mentioned above was greatly facilitated by the credit rating industry. Current proposals use two approaches: first, remove any use of credit rating from regulatory requirements, reducing role of the industry; and second, of government oversight of the industry. However, it also raises serious questions since governments are bond-issuers themselves.

5.1.3 Financial architecture, Supervision and regulation ---Exercise more supervision and regulation over the financial sector including, among others, credit rating, cross-border supervision and monitoring as against harmonization and surveillance, and the scope of financial operations across industries effectively reintroducing some of the Glass-Steagall restrictions. 5.1.4 Lender of last resort A final consideration relates to the possibility of a lender of last resort that would serve to support financial institutions and countries during periods of acute market stress. Among these proposals is to enhance the size and role of special drawing rights (SDR’s) within the International Monetary Fund.

5.2

Implications for production and trade

One of the manifestations of the current global economic crisis in the Philippines has been the sudden and drastic drop in exports. As our main export markets – US, Japan,

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Europe -- contracted, so have their imports. Unfortunately, those included the semiconductors, wire harnesses, and other products that have been our main exports. The impact of the crisis on Philippine exports has been devastating. In October, merchandise exports contracted by 14.8% compared to the same month in 2007, in November by 11.4% and in December by a staggering 40.3% compared to the same month in 2007. The contraction in exports is fundamentally intertwined with the origins of the global crisis. In the last few decades, a growing volume of trade has manifested the increasing specialization and economies of scale and scope in production. These have brought down costs of production as markets expanded beyond the domestic economy, leading to an increasing variety of goods at lower prices. Reflecting this, global finance has also grown tremendously. This is the result of the increasing integration in global markets. Countries specialized in industries where they enjoyed comparative advantage and had access to good quality products at lower prices. Unfortunately, the imbalance was not confined to specific industries but even to the overall macroeconomy (imbalance between countries’ exports and imports), creating a recycling problem. How the surplus could be sent back to developed countries (to avoid currency appreciation). The recycling of funds, coupled with lower policy interest rates in developed economies, triggered the asset and credit bubbles that became the fuel of the financial crisis. With recovery, the trading system may be reshaped. Recovery by the developed economies will not end the problem. Bringing their trade and balance of payments to long-run equilibrium is required. Developed markets will have to cut down on their imports or increase exports significantly. Developed economy restructuring has serious implications for exporting countries. The one-way surge of goods from emerging economies to developed markets will slow down. That is, the long-term fix essentially implies that traditional export markets will no longer be able to import at the same volume and growth rate.

6.0

Prospects for trade redirection and production restructuring

Diagram 1 below shows how particularly complicated a redirection of trade and production would be. It shows a tri-polar trade flow where manufactured products are shipped from the East Asia to the United States; arms and other manufactured products from the US to the Middle East; and, finally, oil from the Middle East to East Asia. It also indicates the instability the temporary equilibrium attained during the past few decades. A successful Middle East effort, for example, would cripple the balance among the three zones. The basic contradiction was that East Asia was overproducing 21

and the USA-EC zone was over-consuming ordinary goods. The US and some European countries had specialized in arms production and this was being absorbed by the Middle East whose function was completing the loop. Still, the triangle was unstable in that the USA-EC zone was consuming far above the volume warranted by its production capabilities. This was masked by, first, the world’s need for international liquidity as trade expanded rapidly after the 1970’s and, later, by the need for currency reserves as East European countries became capitalistic, market-oriented economies. But this clearly could not last indefinitely. 6.1 What the US-EC Zone has to do

Now that the limits of Western overconsumption have been reached a new arrangement has to be reached. If somehow peace in the Middle East is achieved, the adjustment has to be deeper and more abrupt. This realization puts some element of urgency into the adjustment process of the other two global zones. For this zone, there are two imperatives. First, over the long run it needs to reduce its dependence on the arms industry, shifting into other industries that are still consistent with its resources and its level of development. Second, in the medium term it has to develop alternative industries even now just to address its huge imbalance in its current account. The United States has already signified its push into high technology industries anchored on its front-line position in science and technology and its extensive research and development infrastructure anchored on world-class universities and research centers. A parallel direction is into energy-related industries, expecting a shift away from petroleum-fuels into alternative energy sources. Efforts in both directions imply a significant amount of physical investment as well as investment and restructuring in education and other human resource enhancement. Both efforts will take time and complex effort 6.2 The task for East Asian Economies: Towards a New East Asian Model

The most immediate implication of recovery from the global crisis is arriving at new sustainable equilibrium arrangements. We have already noted that there is an immediate need to move to a sustainable balance even if the Middle East keeps on importing arms, providing the USA-EC zone with financing to partial financing of its imports from the East Asian zone. The USA-EC zone’s imports still have to be curtailed to achieve a sustainable balance. This has two extensions for East-Asia: first, how does it finance its imports of oil as the US-EC reduces its imports and, second, how does it solve its resulting over production. East Asian in turn has two alternatives. First, it can reduce its dependence on Middle Eastern oil and, second, it can start selling to each other, depending on the internal gains from intra-regional trade to finance its 22

continuing demand for oil. It can, of course, do both simultaneously. But both will also take some time to take hold and have substantial impact. Changes in trade pattern within East Asia and implications The need redirecting trade (export) flows from the external to internal East Asian markets requires facilitating mechanisms within the region that have to be enhanced within a rather short period. Among these would be product and rules harmonization, dispute settlement issues, and investment facilitation to help joint ventures and crossborder business relationships, among others. While difficult and complicated, these changes are amenable to government policy and action. With intensive discussion and cooperation among countries, this could be achieved within the medium-term. More difficult is the industrial restructuring by the change in trade direction. East Asian countries will now be engaging different countries from before (i.e. themselves instead of USA-EC). Therefore, the pattern of comparative advantage between them and their new trading partners may be0 drastically different from the original countries. More specifically, whereas before they were selling to developed economies with relatively high wage structures, now they will be trading with countries with roughly equal wage structures. The task of developing markets and trading partners is now more complicated. This may some time to develop. In response to the change in trade patterns, the industrial structure within the region will also change. Some of the old industries exporting to the USA-EC zone may now decline considerably or be completely replaced by newer industries more attuned to internal regional trade. This may require tremendous investment in physical capital and infrastructure and transition costs. Attendant changes in supporting facilities like financial and social infrastructure also have transition costs. The political costs can be quite high if done on a compressed way. Longer adjustment time allows easier transition. This all implies that achieving industrial restructuring will be complicated in the medium term. The international financial infrastructure is a very important enabling framework to trade patterns. While intra-regional East Asian trade can be handled by traditional international finance institutions in the West, unique characteristics of the region may be able to facilitate intra-regional trade more efficiently. The cultural, business practice and legal institutions may become more alike as more trade develops and may be more convergent with use by the new trading partners. Ultimately cost will determine the most advantageous financial infrastructure for the regions internal trade. A closer integration of financial markets within the region may bring intra-regional financial transaction costs down. A comprehensive and purposeful program of financial

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integration by governments within the region may be continuing advantage to the region’s economies over the long run. Finally, attendant changes in social, labor, and professional legislation, administrative support mechanisms, tax laws and other legal institutions will need at least harmonization for mutual trust in trade and investments to develop. Cultural attitudes and social practices must, at least, not be conflicting or counterproductive although this may develop gradually as business and social interaction proceeds.

6.3

Going forward

The tasks involved in moving towards a new East Asian model, outlined in broad form above, are difficult and complicated. It requires political and economic will and deliberate and focused government attention as well as commitment by the general public. But East Asian economies have proven themselves equal to seemingly insurmountable tasks before. With dedication and political will, economies around the region can prevail. In sum, recovering from the crisis also provides an opportunity to leap forward. It just needs marshaling resources at key points for maximum support to, ultimately, productive capacity and industrial strength. With broadly supportive and integrated infrastructure systems coupled with a strong bureaucracy, good governance and intense effort as well as good will and cooperation among countries in the region will go far ahead. But these countries do have to start working it out now.

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Figure 1: Global Trade Triangle, 1974-2003

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References

Borio, C (2008): “The financial turmoil of 2007: a preliminary assessment and some policy considerations”, BIS Working Papers No 251 March). Cohen, Ben and Eli Remolona, (2008). “The unfolding turmoil of 2007-2008: lessons and responses,” Bank for International Settlements, August. Mishkin, Frederic S. (2006). The Next Great Globalization. (Princeton, NY: Princeton University Press). Obstfeld, Maurice and Alan M. Taylor (2004). Global Capital Markets: Integration, Crisis, and Growth. (New York, NY: Cambridge University Press). Sugihara, Kaoro (2010). “Asia in Global Trade Imbalances: The International Context of An East Asian Community” Paper presented in the First Joint International Workshop of the JSPS Asian Core Program Asian Connections: Southeast Asian Model for Co-existence in the 21st Century, Center for Southeast Asian Studies, Kyoto University, February 26-27, 2010.

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REFERENCES Paderanga, Cayetano Jr. (2009). “Learning from the Global Crisis,” Discussion Paper # 2009-02, University of the Philippines School of Economics, April.

Davies, Ann (2007) “Greenspan: I misjudged subprime lending crisis,” in Siydney Morning Herald. September 18.

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Appendix Figure 1: Global Trade Triangle, 1974-1985.

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