De ocampo presentation 3rd singapore global dialogue sep 12 (2)

Centennial Asia Advisor’s Chairman Roberto De Ocampo was one of the invited speakers at the 3rd Singapore Global Dialogue.

Presentation of Dr. Roberto F. de Ocampo, OBE Former Philippine Finance Minister

Delivered at the 3rd Singapore Global Dialogue, Sept. 21, 2012Shangri-la Hotel, Singapore

“Is the World Economy Governable?”

It’s a Different World

When I accepted the invitation to speak in this 3rd Singapore Global Dialogue on the panel session, “Is the World Economy Governable?” my first reaction was why was this question being asked in the first place? I figured that this question is being considered because there is some sense that the world economy has become less than governable. The first clear reality that predicates the question is that when we speak of the world, the reality is that it’s a far different world now from what it was even as recently as five years ago.

To put things in perspective, one could say that the world economy was so much simpler and, thus, governable when the Bretton Woods agreements were established giving rise, among others to post-war global institutions and procedures to regulate the international monetary system. The Bretton Woods system achieved its objectives to stabilize exchange rates and enhance economic growth. It gave importance to world institutions that it established, particularly the International Monetary Fund and the International Bank for Reconstruction and Development better known as the World Bank.

The important element of the Bretton Woods was the obligation of

countries to adopt a monetary policy that maintained the exchange rate by tying their currencies to the US dollar. It was also characterized by the ability of IMF to provide immediate relief for countries with problems in balance of payments. The system generally worked as it helped establish a period of relative stability until 1971 when the USA abandoned fixed exchange rates.

A fundamental difference since Bretton Woods is the change in the balance of economic power (and perhaps along with it, political leverage). A new configuration in world economy emerged after a series of financial crises in recent years that affected the dominant economic powers, particularly the USA and the European Community. These crises also raised questions about the effectiveness of the Bretton Woods institutions, especially the IMF. The issue of world economy being governable has become more challenging.

These financial crises started in certain national economies, and quickly triggered impact of regional and global proportions. Among these were the Mexican peso crisis in 1994 that triggered the “tequila effect’ in South America; the collapse of Thailand’s baht in 1997 that sparked the Asian financial crisis; the sub prime mortgage crisis in the US in 2007 that set off a global economic recession; and, the government debt crisis in Greece in 2009 which contributed to the Euro zone financial crisis that is still ongoing.

Along side these crises there has developed a defining event in the world economy, namely the emergence of China as a dominant power. Its well documented economic growth has enhanced its global influence. Thus since the time of the Bretton Woods agreements world balance of power has gone from Cold War relationships between the USA and Russia, the collapse of Communism and the emergence of the USA as the world’s predominant world power, and now the rise of a new balance of power primarily between the USA and China. One can also make a case that there is a shifting of the world’s balance of power towards Asia, particularly with the rise of Emerging Economies most of whom are Asian and the ongoing weakness and turmoil of the Eurozone.

Another difference in the world economy involves not just the economic configuration, but the demand for governance to underpin the new structure. Bretton Woods provided the platform for the economic powers, particularly Western Europe and USA, to be the dominant players in world economy. They set the rules of the game, so to speak, thus proving true the golden rule: he who has the gold makes the rules.

But these rules, as they refer to the conduct of business in international finance

and economics, were broken by these very same dominant economies who made the rules, thus resulting in various financial scandals that rocked the world economy and giving rise to the issue of world governability. In short, if the rule makers themselves have broken the rules, who is in a position to enforce the rules on them or can they be relied upon to right themselves?

We have seen in the last decade or so notable instances when companies employed questionable accounting tricks, financial engineering, complicated risk metrics, and outright fraud in order to hide losses and inflate profits. There was

the Enron scandal in 2001, WorldCom which inflated its cash flow by some $3 billion, and posted positive performance when it really lost money, the Lehman Brothers collapse that triggered the still on-going financial and economic difficulties in the USA, the most recent Barclays scandal, and of course the nerve wracking seemingly intractable saga of the Eurozone.

Companies in the dominant economies were obsessed with hitting their profit and share value targets. They let their people on their merry way, far from the executive suites, manipulating fuzzy numbers and obscure financial transactions with total absence of oversight by their superiors. The result was financial collapse that triggered a global crisis

In reaction to these, the noted economist Paul Krugman once wrote that he thought banking should be made boring again. But in the years that followed the US Financial Services Modernization Act “banking became anything but boring. Wheeling and dealing flourished, and pay scales in finance shot up, drawing in many of the nation’s best and brightest young people. And we were assured that our supersized financial sector was the key to prosperity”. Instead, and as Krugman stated “finance turned into the monster that ate the world economy”.

Furthermore, the process of globalization has been instrumental in the shift of the balance of economic power. Globalization not only facilitated interaction among the new and old dominant or important players in the world economy through trade, capital and investment flows. More importantly, it facilitated the exchange of information, concepts and standards that these economies have come to acknowledge the critical value of governance for growth and development to be sustainable.

There was a lot of blame to pass around. The easy-money policies of the US Federal Reserve have been suggested to be a leading cause of the sub prime mortgage crisis. Another school of thought maintains that the reason people commit these financial shenanigans and a fraud is greed.

Whatever the reason, the near-collapse of the world financial system in 2008 and the global credit crisis that followed, the continuing Eurozone saga, and the shifting balance of economic power has given rise to widespread calls for changes in the regulatory system and the structure of decision making in international finance.

From G7 to G20 This realization of a new economic paradigm was not lost on the economies that

were dominant or principal players of the Bretton Woods era, namely the Group of Seven comprising of USA, UK, West Germany, Italy, Japan, France and Canada, and thus the G7 expanded to the G20.

The G20’s Group of Twenty Finance Ministers and Central Bank Governors has declared itself as the "premier forum for international economic cooperation" but it continues to suffer from "input" legitimacy due to its exclusive nature and lack of broader representation.

Some have observed that “The G-20 is a self-appointed group. Its composition is determined by the major countries and powers. It may be more representative than the G-7 or the G-8, in which only the richest countries are represented, but it is still arbitrary.”

A study by the Danish Institute for International Studies (2011) makes the following points:

• The claim by the G20 that its “economic weight and broad membership gives it a high degree of legitimacy” is not convincing. It permanently excludes 173 countries.

• This fact alone undercuts its claim to representational legitimacy.• In addition to this fundamental problem, the composition of the

membership of the G20 is problematic from a representational perspective because (i) the African region is grossly under-represented (South Africa is the only African member country) and (ii) low-income countries and small, open economies are completely absent

While the G20 has invited ‘representatives’ from underrepresented regions – such as Vietnam for ASEAN and Ethiopia and Malawi or the African Union – to participate as ad hoc ‘observers’ in G20 summits this tantamount to ‘concessions at the margins’. Representational legitimacy requires universal participation on equal terms, such as when all countries participate with voting power in proportion to their GDP.

Even a World Bank/ IMF paper critiqued that the G20 membership is based on no explicit criteria and includes several countries which are obviously not “systematically important” such as Argentina and Australia.

• Lacking explicit membership criteria, the G20 contains no mechanism for adjusting membership to reflect changing realities of the global economy.

• The G20 claim for being representative due to its high share of the world economy is misleading because its figures include the whole of the EU via the EU chair. Take out the non-G20 countries in the EU and the shares fall to 77% of world GDP, 60% world trade, and 62% of world population.

• There is also the further question of why the EU is privileged as a full member while representatives from two other regional organizations (African Union and ASEAN) are marginal invited guests, and why other regions (such as Latin America, Middle East) have slight or no representation.

Some say that it also suffers from "output" legitimacy, namely its

ability or lack of it to strengthen international cooperation and come up with effective solutions.

Among issues raised in this regard have been that: the results of reform processes started in the U.S., E.U. and several individual countries after the 2009 Pittsburgh Summit are very meager, or are too slow and come too late.

Examples cited are the Basel III Agreement which is still not finalized, 4 years after Lehman, the stress test for European banks that failed to recognise that the entire banking sector in Spain was insolvent, and in the US, after passing the Dodd/Frank-Act establishing new structure of supervisory system, stress tests were made but shortly thereafter J.P. Morgan Chase had to confess to a loss of USD2bn. The losses are now estimated at USD5.9bn.

All thse criticisms notwithstanding, I don’t think it is our intention to answer the question asked in this panel, “Is the World Economy Governable?” with a proposal for a supra “world government” with supreme exercise of political and economic authority. This is of course unrealistic.

What is realistic is “world governance”. This is a requisite for growth and development to be sustainable. But definitely, the G20 as a mechanism for world economic governance is still at this point a work in progress.

The G20, IMF and other international institutions must continue to

evolve with the changing configuration of the world economy. New economic centers or powers are emerging as others fade away. New economic parameters and balances in world economy develop. These institutions must continuously assess their mandates, objectives, and memberships lest they become an anachronism.

The development process is not static, and depending on how a crisis is handled an economy can come out of it stronger. Asia, including the Philippines, was not as adversely affected by the 2008 global financial crisis.

I recall that during my time as Chairman of the APEC Finance Ministries at the

onsent of the Asian Financial crisis Japan proposed a rescue fund that would operate like an Asian IMF, but calibrated according to the character and context of the regional economic crisis. The proposal was not implemented as dominant APEC member countries from the West objected to it, claiming that it would lead to moral hazard.

If a proposal to establish a regional kind of an IMF is deemed ineffective on the belief that it would create moral hazards, are the countries as rule makers any more credible when they are themselves the rule breakers? Is it time now to revisit the concept of an Asian IMF as part of a new world economic governance?

More broadly, isn’t it time to review the organizational configuration of the Bretton Woods institutions? For instance, under some protocol or understanding, the US gets to appoint the World Bank President and Europe the IMF Managing Director. Does this still reflect the current balance of power in a similar way that the current protocol reflects the balance during the establishment of the Bretton Woods agreements?

The Sum is Equal to its Parts The world economy is indeed different now. But as always, the sum can only

be equal to its parts. And the effectiveness of the sum, as it were, of a system of world economic governance can only be equal to the economic health and interactive harmony of its parts.

Perhaps the progressive improvement of G-20’s role in world economic governance could start, as some suggest, with a more explicit and transparent criteria of size and regional representation.

Furthermore, aside from the abovementioned issue concerning the appointment of its heads, consideration could also be given to the reconfiguration of the boards of World Bank and IMF. It has been suggested that instead of their current board structures where eight countries represent themselves whereas all others are grouped into multi-country constituencies, a more representative system be put in place dividing the world up into fewer main regions with more balanced representation and with voting shares more representative of the regions’ economic weight.

From the Asian perspective, the key is integration. As a member of the External Advisory and Review Board of the ADB’s 2010 publication, “Institutions for Regional Integration: Toward an Asian Economic Community”, we identified certain challenges to make this concept of integration viable. Quoting from this publication, the integration process creates the following challenges for policy maker:

1. Cementing recent gains: Although Asia’s economic growth has been rapid, recent achievements are fragile. The region’s beneficial openness to the rest of the world also has its downsides, not the least a vulnerability to external shocks. And while regional economic cooperation has progressed in recent years, existing obligations and commitments have yet to be implemented uniformly across Asia and the Pacific.

2.Broadening the process: Until recently, Asian economic integration has mostly focused on East Asia with ‘Factory Asia” being mainly an East Asian operation. While trade between South and East Asia, notably between India and China, is growing, not all parts of those regions, and not all sectors and activities, are equally involved.

3.Deepening integration: The next steps is regional integration involve moving from the integrated trade and production networks to more deeply integrated goods markets by lifting barriers to trade and competition, removing obstacles to interregional trade in services, allowing a freer movement of labor, and developing more resilient financial markets.

4.Ensuring the compatibility of regional and global integration: Since Asia is highly integrated globally well as regionally, it is crucial that measures to cement the region’s integration complement rather than jeopardize its links with the rest of the world.

Aside from this, it is still a reality that much of global governance depends on the situation of the most powerful countries. It would be particularly important for key parts, particularly regional aggrupations and the more dominant economies to bring themselves to a healthy economic state and a continuing harmonious relationship.

If, as they should, these leading economies, primarily the USA, the Eurozone, and China are to credibly take the head, certainly the USA has to put in the financial regulatory framework to correct a financial system still prone to unbridled capitalism’s excesses, the Eurozone has to face the reality that monetary union without a better semblance of fiscal union will result in continuing economic crisis firefighting, China must begin to increasingly show its ability to be a credible influential voice on the world economic stage.

From the geopolitical perspective, considering the inevitable balance of power and to some extent, rivalry between the US and China it would be important that the two do not misunderstand each others signals and intentions since, as always, when elephants battle, ants get trampled.Thank you.