Corporate Governance of the World's Financial

Corporate Governance of the World’s Financial System: Extend the Financial Regulation Franchise to Emerging Economies

Sergei Guriev Rector, New Economic School, Moscow

Aleh Tsyvinski Professor of Economics, Yale University; Professor, New Economic School, Moscow

The Quality of the Developed World’s Consider an example of Russia . In the last 10 years, Financial System and Global Imbalances Russia became a significantly larger economy that is also more integrated and reliant on the global financial system . Its income depends on a volatile There is a conventional view that global imbalanc- and risky stream of revenues from commodities . es—in which developed countries, in particular the Despite impressive development in the recent United States, are the net borrowers and emerging years, Russia’s financial markets are rudimentary markets, in particular China, are net lenders—are and do not offer long-term assets to households a symptom of inefficiency in the world financial and firms . Nor can they can adequately hedge their system, a potential cause of financial crises, and long-term and short-term risks . It is not surprising therefore need to be corrected through govern- that foreign assets are a popular means of savings ment or multilateral interventions . and insurance for Russians; the only viable alter- native is real estate, which is by definition illiquid However, many economists argue that the global and cannot hedge most of the risks . Households imbalances per se are not a symptom of ineffi- in Russia hold a large amount of foreign currency ciency .1 The argument in a nutshell is as follows: in dollars and euros . The government and private let us consider the case of two countries—a de- sector in Russia invest in long-term foreign assets veloped country (for example, the United States) that are not provided by local financial markets . and an emerging economy (for example, China) . As we argued above, the ability of markets in the For the purpose of this analysis, there are two key developed countries to provide high quality as- features of the emerging economy . First, there sets superior to those in other countries can ex- are more risks that firms and households are ex- posed to in the emerging market economy . The plain why developing countries accumulate for- shocks to the firms and households in such an eign assets . In other words, developed countries’ economy are typically larger . Higher uncertainty financial systems export the services of financial and volatility at the level of the households and assets to countries that need them but cannot pro- firms translate into a desire to save more for pre- duce them . The availability of these foreign assets cautionary purposes . Second, emerging capital is important from the welfare point of view as it and financial markets are much shallower than provides the necessary insurance and financial developed capital markets . Importantly, there are intermediation that are not available through the few, if any, domestic long-term assets and rela- domestic financial system . It is not surprising that tively few domestic safe shorter-term assets in the largest foreign reserves are held by developing which to channel these large precautionary sav- countries, such as China and Russia . ings . It is natural then that emerging economies would invest in the financial assets in developed Importantly, even small differences in the deep- economies . In other words, a key “export” of an ness of financial markets can generate very large 3 economy with a developed financial market to “imbalances” . The quality of the financial system emerging market consumers is the depth and so- in the developed world is a key determinant of the phistication of its financial system .2 flow of funds and the prices for U .S . assets . The

Think Tank 20: Macroeconomic Policy Interdependence and the G-20 60 very fact that U .S . dollar assets are still in high global financial system strongly benefits from demand even after several bankruptcies and near- extending a regulatory and oversight franchise to bankruptcies of major financial institutions as well these countries . Even though the vast majority of as an unprecedented peace-time expansion of gov- the global financial institutions are in the West, the ernment debt implies that the U .S . financial system new financial system should incorporate the in- and the dollar are still superior to competitors . But terests of emerging markets . The standard reason further deterioration of the financial system may for this is promotion of global welfare . Indeed, the destroy the “superior and unique” U .S . export— cross-border externalities of the West’s financial the long-term dollar-denominated assets . On the system on other countries should be internalized . contrary, if the U .S . manages to improve, even if In the post-crisis world, the large emerging econo- marginally, its financial regulation and macroeco- mies will remain important providers of capital to nomic policy, then global imbalances will be “ag- the OECD markets . These economies will continue gravated”—the inflow of capital to the U .S . will to grow faster than the G-7 countries and will feel grow with the respective current account deficit in the constraints of the underdeveloped financial the U .S . and current account surplus in China . system and the lack of safe and credible investment instruments . As the crisis re-confirmed the impor- Should we be worried about such a development? tance of reserves and stabilization funds, emerg- Probably not . The crisis did not happen because ing market countries will also resume building up of global imbalances per se . The crisis happened their sovereign funds . Conservative finance minis- because investors in Western financial institu- ters in countries, such as Russia, Chile and China, tions overestimated the quality of these institu- who argued for keeping higher reserves, are now tions . Therefore, the major task now is to improve viewed as heroes and will likely wield even greater the regulation of Western financial markets and influence in the aftermath of the crisis . institutions . The good news is that the global im- balances provide at least a partial solution to this As large investors in the G-7 financial system, the problem . developing countries will have a stake in enforcing investor protection in a broad sense and therefore Emerging Economies as Key Stakeholders improving the quality of regulation . This is simi- in the Developed World’s Financial System lar to the main principle of corporate governance: providers of finance should have a say on how their The two major determinants of the West’s com- resources are used . parative advantage in financial intermediation and financial asset creation are good economic policy But there is also another reason . Including and high quality of financial regulation . While emerging markets in regulating OECD financial there is now at least a beginning of a “peer review” markets is not only fair and good for developing process for macroeconomic policy with the Mu- countries, it is also good for investors in OECD tual Assessment Process4, there is much less inter- countries . The interests of the developing coun- national coordination in financial regulation . We tries that lack their own financial institutions are believe that the world should not miss an impor- aligned with those of all investors in the OECD tant opportunity here . financial markets . Hence, if emerging markets are given the effective participation in the design Who can monitor the quality of the developed and enforcement of new regulation, they can ef- countries’ financial systems? It is crucial to involve fectively promote investor interests . This is es- the largest non-OECD economies in the debate pecially important given that investors are not on financial regulation and in the design and sub- organized and are usually underrepresented in sequent enforcement of a new system of regulat- the debate . Thus, developing countries can help ing global financial markets and institutions . The resolve a collective action problem .

Think Tank 20: Macroeconomic Policy Interdependence and the G-20 61 Yet another important advantage of extending the References financial regulation franchise to developing coun- tries follows from their incentives to take into ac- Blanchard, Olivier, and Gian Maria Milesi-Ferrett, 2011 . “(Why) Should Current Account Balances Be Reduced?” IMF Staff Dis- count not only the benefits of stricter financial reg- cussion Note . ulation but also its costs . Being major stakeholders Doepke, Matthias and Martin Schneider, 2006 . “Inflation and the Re- in the Western financial system, they are interested distribution of Nominal Wealth ”. Journal of Political Economy, not only in preventing crises and bankruptcies of Vol . 114, No . 6, pp . 1069-1097 . individual institutions but also in the long-term Mendoza, Enrique, Vincenzo Quadrini, and Victor Rios-Rull, 2007 . “Financial Integration, Financial Deepness and Global Imbal- performance of assets . Therefore, it is in their in- ances ”. Journal of Political Economy, Vol . 117, No . 3, pp . 371-416 . terest not to throw away the baby with the bathwa- Caballero, Ricardo, Emmanuel Farhi, and Pierre-Olivier Gourinchas, ter; emerging markets have very strong incentives 2008 . “An Equilibrium Model of “Global Imbalances” and Low Interest Rates ”. American Economic Review, Vol . 98, No . 1, pp . to preserve the global financial system’s ability to 358–93 . innovate . The voters in the developed countries are looking for a culprit for the financial crisis, which Endnotes may create a temptation for the policymakers to over-regulate . On the other hand, those develop- 1 See Caballero, Farhi, and Gourinchas (2008) and Mendoza, ing countries, whose financial systems lag behind, Quadrini, and Rios-Rull (2007) 2 are important beneficiaries of financial innova- Blanchard and Milesi-Ferreti (2011) describe this situation as a “distortion” which developing countries should be willing to tion . For many of those countries, the stakes in correct . Certainly, all countries are interested in developing a promoting efficient financial intermediation and world-class financial system . However, it is unrealistic to expect that the major emerging markets will be able to catch up with the economic growth are much higher than the stakes West in terms of the quality of financial institutions . Also, as we in the developed countries; it is an issue of political argue below, even a small gap in efficiency of financial systems results in large imbalances . The other important consideration survival . While the OECD democracies can afford is that some countries may just have a substantial comparative a slower growth rate, for many emerging markets, advantage in financial intermediation (e .g . due to the Anglo- Saxon origin of the legal system) . This comparative advantage a growth slowdown also implies significant threats may determine these countries’ long-term export orientation in to political and social stability . exporting financial services . This is similar to the fact that resource- rich countries export resources and tropical countries export tropical agricultural products . Such a comparative advantage is not carved in stone . For example, the U .S . is “resource-rich” and has the most advanced technology in the oil and gas sector, being the largest producer of natural gas and one of the largest oil producers in the world, but it has no comparative advantage in these industries anymore . But it is difficult to imagine that the developing countries’ financial systems will close the gap with Western ones in any foreseeable future . 3 See Mendoza, Quadrini, and Rios-Rull (2007) 4 In this article, we focus on financial regulation . But the macroeconomic policy in the G7 countries is certainly a major concern . The unprecedented rise in the government expenditures during the crisis has resulted to an increase in debt that may prove unsustainable . This is no longer a domestic policy issue . As shown in Doepke and Schneider (2006), foreigners hold a large amount of the U .S . government debt and increased U .S . inflation constitutes a substantial tax on them . An increase in inflation redistributes wealth from the foreigners to the young, middle class households who hold mortgages . Politicians faced with an increased debt may be tempted to inflate instead of taking more unpopular measures such as decreasing government spending . The developing countries with their large reserves will lose the most from irresponsible macroeconomic policies in the West .

Think Tank 20: Macroeconomic Policy Interdependence and the G-20 62