India’s economy was one of the earliest to stage a turnaround after the global financial crisis.

The decisions taken in early 2008 to increase public-sector wages, forgive loans for farmers who had borrowed from the banks, and massively expand the rural-employment guarantee scheme assisted the economy before the global financial crisis unfolded in the last quarter of the year. Not surprisingly, India staged its recovery within two quarters of the crisis striking, as economic growth accelerated from 6.7 per cent in 2008–09 to 7.2 per cent in 2009–10 and 7.5 per cent in 2010–11. Most forecasts for 2011–12 predicted over 8 per cent growth. But the economy has shown significant signs of slowing down. With the economy growing at about 6.9 per cent in the second quarter of 2011, and the November estimates of industrial production showing over 5 per cent decline, it is now expected that the growth rate for 2011 may even fall below 7 per cent.

The moderation in India’s economic growth rate was not the only matter for concern in 2011. The economy possesses a number of structural imbalances, and no effective mechanisms have been put in place to correct them. The government has not been able to control fiscal deficits at the budgeted levels and it is now expected that the central government’s fiscal deficit will be about 5.5 per cent of GDP and the consolidated fiscal deficit around 8 per cent. With the annual losses of state electric utilities amounting to 1 per cent of GDP, the government’s overall fiscal situation is not much different than it was at the beginning of the decade. Providing for additional expenditure commitments in education, healthcare and food security will be a daunting challenge over the coming year — especially when combined with the political difficulty of phasing out ill-targeted subsidies and achieving fiscal consolidation in the medium term.

There are worries on the balance-of-payments and inflationary fronts as well. The virtual stagnation of the global economy has resulted in stagnating exports for India, and as crude oil prices remained elevated throughout 2011, a high growth in imports also continued. With exports even slowing in the services sector, India’s current account deficit is likely to touch 3 per cent of GDP. In normal times, this could have been managed with capital inflows, but, with foreign institutional investors shying away from India, financing a deficit of this order will pose problems. Not surprisingly, the value of the rupee plummeted by over 20 per cent in the last few weeks, and even with the Reserve Bank of India in possession of reserves surpassing US$300 billion, a significant depreciation of the rupee could not be prevented. In the next six months, India will have to repay foreign loans of over US$140 billion, but problems may arise if the lenders refuse to roll over the credit. In addition, the inflation rate for 2011 is likely to be close to 10 per cent, and the rupee’s falling value has not helped matters.

The major concern for 2012 is the government’s apparent inability to forge political consensus and enact reforms which could bring in FDI and institutional investment. The last few months have raised serious questions about the government’s ability to carry forward much-needed reforms. These issues of governance — teamed with the inability to phase out subsidies or achieve fiscal consolidation — and India’s ‘policy paralysis’ in several areas are serious cause for worry. But crisis is the mother of reform, and the difficult situation should force the Indian government to act. The government has an 18-month window to carry out reforms before electoral politics overtake policy making. Hopefully, it will muster enough support by forging consensus on important economic reform policies, remedy the structural imbalances and revive the economy to reach the trend growth rate of over 8 per cent.

M. Govinda Rao is Director at the National Institute of Public Finance and Policy, New Delhi, and a member of the Economic Advisory Council to the Indian Prime Minister.

This article is part of a special feature: 2011 in review and the year ahead.

1. The Eurozone crisis and prospects for India
2. India: The discipline of liberalisation
3. Incredible India? Complicated India

As Europe continues its desperate struggle to salvage the euro and monetary union, the spotlight of regional cooperation is shifting to Asia.

In December, European leaders retro-fitted the union with fiscal disciplines which impose binding limits on national budgets and borrowing. All but Britain opted in; the UK, Prime Minister David Cameron argued, was not prepared to yield such fiscal sovereignty. Lack of fiscal integration alongside commitment to a common currency was a serious design flaw in the original European enterprise. The new fiscal disciplines will allow more room for the European Central Bank to act as lender of the last resort to European borrowers. Whether these ‘architectural’ arrangements for European cooperation will be sufficient to save the euro will finally depend, of course, on how and whether they encourage the ‘substantial’ structural reforms and adjustments necessary to restore growth momentum in the deeply indebted southern European states.

Faced with shrinking economies and rising unemployment, and lacking exchange rate flexibility to restore price competitiveness in external markets, how can the sick economies of Europe get to grow again? Without the option of deeper currency depreciation, real wage cuts and structural reform are the only way to export-oriented growth — outside the OECD economies — in emerging markets like those in Asia.

As Shinji Takagi argues, the European mess has revealed just how inept Europe’s supra-national institutions were in dealing with a regional problem of the proportion that has emerged there. Inter-governmentalism — that is, a willingness to cede position and sovereignty through decision making in the collective interest — moved centre stage as the instrument of crisis management. French President Nicolas Sarkozy and German Chancellor Angela Merkel had to call the shots for the rest of Europe. France and Germany are providing critical leadership: despite over half a century of regional institution building, the huge Brussels bureaucracy proved little more than a paper tiger. The implications for Asian regional cooperation are profound.

In Asia, a central question is whether strong growth can be maintained despite continuing weakness in the developed world. Success in avoiding that scenario also depends on whether extensive structural reform is put in place to shape the expansion of Asian investment — so that it continues to roll out in ways that ensure it is productive and that economic growth does not run into the sand.

Asia does not need a huge supra-national bureaucracy, but it does need its own measure of inter-governmental cooperation to keep growth on track. It has the architectural frameworks, in APEC and the East Asian arrangements, to give this effect — if it is so minded.

On recent evidence, emerging market economies in Asia and elsewhere might have had some reason to think that there was ‘trend decoupling’ between their growth rates and those in the old G7 economies. But events of the past six months should have dispelled that illusion, as interdependence through expectations and market sentiment, as well as more directly through trade and finance, has ensured that problems in the industrial economies wreak their havoc and uncertainty around the rest of the world. De-coupling Asia from European growth clearly has its limits.

The Asian emerging market economies are, nonetheless, in a stronger position than their industrial country partners, with demographic dividends still to reap, much lower debt ratios, and economies that enjoy the benefit of powerful ‘catch up’ to the industrial-country frontier. The potential rate of growth in emerging economies remains high because the ‘convergence gap’ — the gap between productivity levels in industrial countries and developing economies — remains large even for economies like China and India. This hasn’t changed because the rest of the world has fallen into recession.

With these assets, what’s to stop emerging economies powering the global economy from its industrial-country malaise?

Wendy Dobson in this week’s lead essay suggests that Asia’s focus should be on ‘re-balancing’ and trade liberalisation. Expectations of Asia’s role, Dobson says, are growing much faster than Asia’s capacity to meet them.

In Asia too regional architecture is required for cooperative action. And Asian regional architecture still lacks tight and effective links to emerging global architecture around the G20 process.

‘Yet with some notable exceptions’, Dobson points out, ‘Asia’s focus remains on the architecture rather than the domestic and regional economic adjustments required to sustain growth momentum in the face of potentially serious external shocks from renewed European recession and near-stagnation in the United States’. On trade liberalisation, Dobson puts faith in the recent US Trans-Pacific Partnership (TPP) initiative.

Others would prefer broader regional and continuing global efforts, given that China has not been engaged in the TPP and due to other circumstances in the international economy.

Without Chinese engagement in what is putatively Asia’s primary trade liberalisation enterprise, the TPP is unlikely to give much strength to the heart of Asian integration nor to global trade.

Peter Drysdale is Editor of the East Asia Forum

1. Will Asia step up to the global challenges of 2012?
2. Regional cooperation and national sovereignty: Asia and the euro crisis
3. The East Asia Summit and regional financial cooperation

The slow resolution of the European debt crisis has evolved into a liquidity problem which threatens the global financial system.

And these long-drawn-out efforts to address the sovereign debt problems have heightened uncertainties about resolving the crisis and induced speculative activities, threatening the survival of many European banks. In an effort to contain financial disaster, central banks of the world’s major economies have taken a concerted emergency action to provide cheaper dollar funding to these troubled banks at the end of November 2011. Further, the President of the European Central Bank (ECB) recently pledged readiness to act more aggressively in averting a deeper financial crisis.

This serious threat of financial crisis is not new to the global economy. Triggered by different factors, the world has observed two similar crises within the last decade; the burst of the dotcom bubble in the early 2000s and the beginning phase of the global financial crisis through 2007 and 2008, which culminated in the bankruptcy of Lehman Brothers and the freezing up of global finance. In both cases, aggressive policy easing took place in the leading industrial economies, sending real interest rates to a very low level.

The current situation inEurope may still lead to a global economic slowdown if the debt problems are not resolved, propelling the global financial system into another deep crisis comparable to that of 2008. The policy reaction this time should not be much different from 2008. At the very least, the ECB and central banks should relieve pressure on banks and the financial sector by cutting interest rates further to ensure that affordable liquidity is available for the financial sector. As observed in both the burst of the dotcom bubble and the global financial crisis, such action would result in a low international interest rate environment.

Given the integrated global financial system, any such shock would have implications for small, open economies elsewhere. For emerging ASEAN economies (Indonesia, Malaysia, the Philippines and Thailand), the two episodes of internationally originated financial shocks in the past decade seem to have insignificant effects unless coupled with a global recession that pushed their domestic output down at the same time. To better understand the effects of adverse international financial shocks, however, it is useful to isolate these shocks and analyse their impact on the macroeconomic performance of these economies. This type of structural analysis typically suggests the shock’s effects on inflation and output tend to be largely similar and relatively small. An isolated negative shock in international interest rates would tip the ASEAN economies toward an environment with lower inflation and higher output volatility, albeit generally small in magnitude.

Although small, the impacts of purely international financial shocks on ASEAN economies tend to be long lasting, with implications for the management of future macroeconomic stability. It seems the larger the size of the international financial shock, the greater the consequences of maintaining future economic stability for ASEAN countries.

How should emerging ASEAN economies react to an isolated adverse international financial shock? Typically, to counter a drop in the international interest rates, a country may reduce its domestic interest rate. This discretionary policy action may counter the short-run inflation effects from the international financial shock, but would aggravate the short-run impact on the country’s output gap at the same time. Consequently, the country would end up facing greater volatility in its domestic output. In this way, the cure may worsen the illness. Discretionary monetary policy action may only be sensible when the global financial shock is accompanied by a global recession that also reduces domestic output at the same time. In this case, the cure will have the desired short-run impact of limiting the global shock’s effect on both domestic inflation and output.

Yet, confronted with the external shock’s long-lasting effects, the short-lived domestic interest rate shock will only work for containing short-run volatility implications and will leave domestic policy makers with a hanging problem of managing volatility in the medium to longer term. In this regard, efforts to manage the domestic economic implications of a single, large shock in the international financial system would entail not just a simple short-run policy response in emerging ASEAN countries, but more complicated adjustments to their overall economic structure.

To deal with the effect of an adverse international financial shock, individual authorities in emerging ASEAN economies should opt for policies which provide longer-term structural adjustment to their economy. To this end, emerging ASEAN authorities should support the current efforts to restructure the global financial system in order to reduce future risks of more volatility. In addition, the similar pattern of effects on emerging ASEAN countries highlights the need for enhanced policy coordination and cooperation among these countries to better deal with such disturbances.

Arief Ramayandi is an Economist at the Asian Development Bank. The views are solely of the author’s and do not necessarily reflect the views or policies of the Asian Development Bank.

1. ASEAN economies on the slide?
2. An Asian perspective on financial crises
3. An Asian response to international financial reforms

The global financial crisis forced East Asian nations to get serious about regional architecture.

As global trade entered a precarious decline during the height of the crisis in 2008–09, one of the obvious areas of focus for East Asia was trade regionalism, aimed at making East Asia a more efficient production network and, over time, a final market in its own right. At last, these initiatives are starting to bear fruit.

This year has seen significant progress in negotiations. This was revealed at the November ASEAN+3 summit which saw the heads of state agree to bureaucrat-level negotiations outlined earlier in the year.

Early indications that agreement on an East Asian trade area might finally be reached occurred in August at the 14th ASEAN Economic Ministers Plus Three (AEM+3) Meeting in Indonesia. The final communication welcomed a joint proposal by China and Japan, declared as the ‘Initiative on Speeding up the Establishment of an East Asia Free Trade Area (EAFTA) and Comprehensive Economic Partnership in East Asia (CEPEA)’.

Until this joint proposal the whole process had been held hostage by Sino–Japanese strategic rivalry. But the deadlock was broken by the worsening global economic situation and Washington’s bid to boost its flagging growth through exports, driving a return to Asia via the under-negotiation Trans-Pacific Partnership (TPP) agreement.

For China, the TPP is a potentially threatening arrangement, as its intellectual property and investment protection requirements will pose formidable barriers to joining. That’s if China was invited — which it has not been. And it seems this reality has been enough to shift China’s priorities towards reaching a regional trade agreement in East Asia, even if it means moving towards Japan’s position on issues of coverage and membership.

The outcome of all this is the joint proposal by China and Japan calling for the East Asian Free Trade Area to cover goods, services and investment — that is, an agreement which brings in Japan’s WTO-plus interests. Since the outset of negotiations on the EAFTA, Japan has focused on the investment-related issues (in contrast to tariff liberalisation). As Japan has few tariffs left to cut — and those that remain are in the politically-sensitive agricultural area — any EAFTA which focuses solely on tariff measures would be of little political interest to Japan.

Japan is also unwilling to enter into agreements with China that fail to address Japanese firms’ concerns about investing in the growing Chinese market. It is partly for this reason that the bilateral China–Japan FTA remains frozen. But outside the bilateral negotiations, and in the context of the EAFTA, China is now willing to discuss Japan’s wider set of economic interests. This year Japan and China have jointly sponsored setting up three working groups to deal with trade in goods, services and investment which will begin work in early 2012.

More importantly, the joint agreement is a promising step toward resolving long-standing disagreement over the grouping’s membership. While China had been adamant about the EAFTA being limited to ASEAN+3 members only (the ASEAN 10 plus Japan, South Korea and China), it appears that the final agreement will be expanded to include the ASEAN+6 grouping, adding Australia, New Zealand and India.

It is likely that these three countries would be brought into the new trade area via the so-called ‘ASEAN + +’ institutional mechanism. The framework is being negotiated at the ASEAN Plus Working Groups, and under consideration are rules of origin, tariff nomenclature, customs procedures and economic cooperation. These will feed into the working groups on trade, services and investment to provide a single template agreement.

Still, there remain hurdles. First, the terminology is not yet settled, with ‘EAFTA’ and ‘CEPEA’ still being bandied around. This suggests there do remain some tussles over membership — with China favouring an East Asia–Southeast Asia-only grouping. Second, while the Japanese and Chinese leaders have directed the bureaucrats to start negotiations, political leadership will be required to sign the agreement into force. However, the Heads of Government only enter the process next year, and in the meantime another flare up in Sino–Japanese relations could put everything back into deep freeze.

Notwithstanding those issues, the halting trend towards the realisation of an EAFTA is progressing. There will no doubt be more setbacks; but an EAFTA now seems more a question of when than if.

Joel Rathus is an EAF postdoctoral scholar and a regular contributor to the East Asia Forum.

1. A closer look at East Asia’s free trade agreements
2. The TPP, APEC and East Asian trade strategies
3. The de facto ‘free trade area’ in East Asia

The 2008 global financial crisis catalysed a long-overdue transformation in the oversight of global affairs, bringing large emerging Asian economies to the G20 table.

A transition in the role of Asian countries at the G20 — from cautious and sometimes defensive to visionary and exemplary — was expected to unfold slowly, possibly taking a decade or more. Yet the renewed threat to recovery arising from the self-created problems of the US and EU has created an urgent demand for Asian leadership in 2011.

As in 2008, the world is looking to the G20 to deal with the renewed threat of recession.

The US and EU are certainly not going to boost global demand. Asian and other emerging economies have some scope to stimulate domestic demand, but not nearly as much as in 2008. By the time G20 leaders met in France in November 2011, the short-term prospect was, at best, to avoid recession in the US and EU.

Such an outcome may be adequate for one year but risks the future of the G20. Continued stagnation of mature economies will accelerate the ongoing shift of economic power and influence towards emerging economies. Economies with growing shares of wealth and dynamism will be blamed for not doing more. But aggressive attempts to attribute blame to dynamic economies, China in particular, just makes it politically harder for these economies to implement reforms.

To avoid falling into a swamp of unproductive recrimination, the G20 needs to find a strategy to stimulate effective demand which all its members can support.

At a time of deficient global demand, substantial savings generated by emerging economies are locked up in excessive foreign exchange reserves alongside vast potential for investment in economic infrastructure. Much of the vast unmet demand for infrastructure is in the emerging economies of Asia, which are also the source of much of these savings.

Asian governments have recognised the costs and risks of continuing to accumulate reserves. Those risks include significant capital losses, ongoing blame for inadequate global growth, and the costs of prolonged weak global demand on their own economies.

Now is a good time to address a global financial market failure in order to reduce these growing risks. Bringing forward some badly needed investments in infrastructure could be a decisive circuit-breaker to spark sustained global recovery.

Asian governments can put the challenge of fixing the current massive market failure squarely on the G20 agenda. A concerted effort by all members of the G20 to gradually make better use of Asia’s huge accumulated savings will allow them to work constructively to solve a shared policy problem, rather than blaming each other for there being too little growth and too many exports.

Channelling more of Asia’s savings into productive investment in infrastructure will not happen quickly or easily. G20 leaders can challenge their officials, financial-sector managers, and international financial institutions to use their expertise to find creative ways to intermediate savings to finance more investment in infrastructure.

The Asian Development Bank (ADB) and other multilateral development banks can step up their roles. They can be sound borrowers of Asian savings; they can invest them in productive projects, including projects to improve connectivity among economies. Commercial banks can also do more in credit-worthy emerging economies.

There will be some risks. One or two governments may act irresponsibly and make a mess of some investments. But, with care, most investments in infrastructure will prove to be viable. There is a lot of international experience on designing public-private partnerships and shaping policies to set prices and contain project risks within acceptable limits. And the risk of some projects being less successful than expected is far less than the risks of prolonged recession.

An effort to create more effective demand for investment will need to be accompanied by ongoing efforts to cope with long-term problems of debt in mature economies and structural adjustment in emerging economies. These complementary efforts can restore confidence in the world economy.

In the meantime, G20 leaders might delay thinking about other significant global problems. Unfortunately, the window of opportunity to avoid disastrous climate change is closing fast, and the future of an open non-discriminatory WTO-based regime for international commerce is being undermined by misplaced faith in preferential trade deals.

It will take a long time to find consensus on how to contain, let alone resolve, such problems. In a voluntary process of cooperation like the G20, there will be no big breakthroughs in any one year. It will not be possible to deal with these big problems in sequence. A more prudent option is to start a discussion of these issues in a patient, non-confrontational manner.

Right now, the US and EU are both caught in a vicious circle of acrimony and repeated attempts to defer hard decisions. They cannot be expected to lead the consensus-building needed to deal more adequately with global warming or rescue the WTO. Nor can Asian governments rely on them to deal wisely with global issues, respecting differences and searching for consensus rather than confrontation.

At a time of weak global governance the challenge of leadership is being thrust on Asia sooner than it had hoped.

The agenda of Asian institutions for regional cooperation can move beyond preoccupation with local issues and trade negotiations to an outward-looking effort to address important matters which require global solutions. Forums like ASEAN+3 and the East Asia Summit can be used to consult on how Asia can use the G20 opportunity — an opportunity which may not be repeated — to defend, then reform, the international economic order in ways needed to complete their emergence from poverty.

Andrew Elek is a Research Associate at the Crawford School of Economics and Government, the Australian National University. 

This article was first published in the most recent edition of the East Asia Forum Quarterly, ‘Asia’s global impact’.

1. How can Asia help fix the global economy?
2. Asian leadership and the global economic crisis
3. Asia’s challenge: to rebuild the global economic order in a generation

The founding institution within the World Bank Group is the International Bank for Reconstruction and Development (IBRD).

The only part of the institution that was established by the 1944 Bretton Woods conference, the IBRD is the World Bank’s bank. Importantly, the IBRD is not an aid agency. It borrows on global capital markets — cheaply because of its triple-A credit rating — and passes on the funds, at these cheap but commercial rates, to its member developing countries. The International Development Agency (IDA) is the World Bank’s aid arm: it was created later, in 1960, and gets its funds from rich country tax-payers rather than the capital market.

The IBRD started small, but expanded rapidly in the seventies under President McNamara. There was another surge in the eighties as the Bank started to provide budget support or adjustment lending. But total commitments reached US$15 billion in the mid-eighties, and then stopped growing. The average for 2006-08 was about $13.5 billion.

Stagnant lending in nominal terms meant declining lending in real terms. In the context of a globalising world — with massive increases in everything from remittances to international capital flows and from exports to the size of developing country economies — it meant a less relevant and influential World Bank.

This in turn led to the widespread conclusion that the future of the World Bank was not as a bank. The World Bank, it was argued, needed to expand its role as an aid agency, a global problem-solver, or a multilateral think-tank (a knowledge bank), or some combination of all three.

But not as a bank. The World Bank’s banking role was seen as a legacy from the past rather than a priority for the future. In 2007, leading US development commentators Nancy Birdsall and Arvind Subramanian argued that the World Bank should become ‘a more reluctant lender to governments’. Jessica Einhorn, writing in Foreign Policy in 2006, went further, proposing that the IBRD should be shut down.

In the last few years, however, the World Bank has become not more but less reluctant to lend. Total IBRD lending catapulted from US$13.5 billion in 2007-08 to US$33 billion in 2008-09 and US$44 billion in 2009-10, before falling to US$27 billion in 2010-11.

Of course the World Bank always lends more in a crisis, as do all of the international financial institutions. Lending from the IMF and the Asian Development Bank, for example, is also up sharply. But the rapid expansion this time round can hardly be satisfactorily explained solely in terms of the global financial crisis. A comparison with the Asian financial crisis of the late nineties is telling. Then IBRD lending also went up but only from that historic average of US$15 billion to about US$22 billion for a couple of years before falling back to average levels. More tellingly, this comparatively small and temporary increase was all in quick disbursing budget support. Project lending, the IBRD’s traditional fare, in fact continued to decline throughout the Asian financial crisis, falling in 1999 to about US$7 billion — the lowest since the mid-seventies.

This time around is very different. Not only is the total increase much bigger (a tripling rather than a 50 per cent increase), but project lending has also gone up dramatically, from US$9 billion in 2007-08 to US$24 billion in 2009-10 and US$17 billion in 2010-11. This suggests a deeper role for the IBRD than simply the provision of liquidity.

What is going on? One obvious explanation is that the IBRD can lend more. It has recently benefited from a general capital increase, the first in over 20 years. The more capital reserves the IBRD has from its members, the more it can borrow and lend.  The developed countries have also encouraged the IBRD to lend as part of a global stimulus strategy.

And developing countries, this time round, are in a better position to borrow. Finding it more difficult to raise private capital, they have turned to the IBRD both for short-term cash and longer-term projects.

Another explanation are the reforms put in place by the World Bank to make it a more attractive source of funds. In the last few years, it has embarked on an effort to reduce transaction costs, as well as margins to borrowers. The World Bank has also shifted power in its governance structure from developed to developing countries.

Perhaps the ideological pendulum has also swung. In the 1990s, public-sector lending for infrastructure was seen as passé, and something which should be the domain of the private sector. No longer.

Another deep change is the adoption by the G20 of the IMF and World Bank. The G20 does not have its own secretariat, and the IMF and the World Bank end up doing a lot of the background work for it. A significant part of the G20’s deliberations are also addressed to multilateral issues. For example, the G20 has driven the recent governance reforms at the World Bank, and also the capital increase.

It is quite remarkable that these two institutions of the old world order, the World Bank and the IMF, the so-called Bretton Woods twins, should now be adopted by the emblematic institution of the new world order, the G20. This must give them a new energy, and a new legitimacy.

It remains to be seen if the recent increase in lending will be sustained. There are also risks. The big scale-up of lending under McNamara came at the cost of quality. But there is also a strong argument that a diminishing role as a borrowing and lending institution was making the World Bank much less relevant to its clients.  Yes, the World Bank has a number of other important functions, from aid agency to think tank, but so do the UN agencies. It is arguably its ability to combine its intellectual firepower with a lending role that gives the World Bank its unique character. From this perspective, the recent revival of the IBRD, the World Bank’s bank, is to be welcomed.

Stephen Howes is Director at the Development Policy Centre, Crawford School of Economics and Government, the Australian National University.

This article was originally published here at the Development Policy Blog.

1. Zai jian – Goodbye – See you again: A look back on China’s progress upon leaving the World Bank
2. Private Chinese firms don’t get bank loans? Think again
3. The removal of Muhammad Yunus from Grameen Bank

Asia is in a strong position to assert itself in global financial governance.

The remarkable growth of the economies in the region and their integration in global trade and finance bestow upon Asian states considerable potential clout in international forums and institutions. However, Asia’s current influence is not yet commensurate with its economic weight in the International Monetary Fund (IMF), arguably the premier institution in global finance.

Asia’s relationship with the IMF before the Asian financial crisis of 1997–1998 can be best characterised as cool, but not hostile. The main interaction between them was in the context of annual Article IV Consultations and the IMF’s advice on economic policies was broadly considered useful by Asian countries, although there was no imperative to follow it.

The picture changed dramatically after the crisis hit Asia and the mode of interaction changed from annual consultations to adjustment programs with the IMF. This new relationship between the IMF and Asia had a rocky start and the Asians became increasingly antagonistic towards the IMF. This hostility persisted for a number of years and well after the IMF programs themselves had ended.

The main reason for the breakdown in the relationship was Asian countries’ unhappiness with the macroeconomic and structural conditionality associated with the IMF’s programs that were negotiated with Thailand (August 1997), Indonesia (November 1997, August 1998) and Korea (December 1997). The conditionality contained in these programs was seen as overly harsh and intrusive and this soured the relationship. Asian countries were convinced that the IMF had misdiagnosed the problems they were facing and had imposed excessive and inappropriate conditionality on the financing it was providing. It is noteworthy that the IMF later acknowledged the mistakes it made, which presumably gave the Asian countries some degree of satisfaction.

There are now signs that the relationship is improving, as seen in the context of the global financial crisis in 2008–2009. While Asian countries made it perfectly clear that they would not again engage in adjustment programs of any type with the IMF, there was Asian support for the IMF in its borrowing arrangements and in quota increases, from which Asian countries stood most to benefit.

Historically, Asia has had a less prominent position in the governance of the IMF than either Europe or the United States. Despite periodic review, the adjustment of quotas and voting shares for member countries has lagged far behind changes in relative economic position, which has operated to the disadvantage of the fast-growing countries of East Asia, in particular. There was a concerted effort over the last decade to redress this discrepancy and this effort has produced significant results. The combined quotas of ASEAN+3 represent 15.7 per cent of total quotas and their votes comprise 15.2 per cent of total votes. If ASEAN+3 voted as a bloc, it could now exercise a veto over decisions requiring the supermajority of 85 per cent, much as the US can do acting by itself.

Furthermore, it is worth noting that the ASEAN+6 countries — including Australia, New Zealand and India — collectively command almost 20 per cent of quotas and 19.2 per cent of votes. Although Asian representatives are now becoming more assertive, when the chips are down, some Asian countries have still been reticent in pushing a unified Asian agenda in the IMF.

The process of selecting the managing director of the IMF is a case in point. Asian governments are sometimes frustrated that the United States and European countries have a ‘lock’ on the positions of the president of the World Bank and the managing director of the IMF — an informal arrangement referred to as the ‘convention’. This convention should be broken and these appointments should go to the best-qualified candidates. Because regional diversity is an important consideration, a non-European will sometimes be the best candidate in the case of the IMF and a non-American will sometimes be the best candidate in the case of the World Bank. This does not necessarily mean that the managing director must be Asian, but Asia has a strong claim to this position as the world’s fastest-growing region with large lending commitments to the IMF.

Yet Asian officials have not competed with much determination for this position and, unless they do, Asian governments cannot legitimately complain about the convention. Not since 1999 has there been a formally declared Asian candidate for the managing director post. During the round in June 2011, several Asian names were mentioned for the position but none was nominated.

Asian countries’ reservations about the IMF have led ASEAN+3 to develop regional arrangements, principally the Chiang Mai Initiative Multilateralisation (CMIM) and the ASEAN+3 Macroeconomic Research Office (AMRO) for crisis financing and economic surveillance. These arrangements change the international financial architecture for the region in important ways. Yet despite the hopes of some, they cannot be relied upon alone to provide financial stability; instead, they will have to work with the IMF for the time being.

Asia’s role in the IMF to date has been limited. Given the size and strength of Asia in the global economy, it is evident that the region ‘punches below its weight’. This is partly the result of a conscious choice by Asian countries to keep the IMF at arm’s length, reflecting bitter memories of the IMF’s role in the Asian financial crisis. But it is also due to the fact that, at least until recently, Asia has not pushed to have a larger say in global financial circles, but has chosen instead to develop its own regional arrangements and institutions. But playing its rightful role in the IMF need not detract from regional arrangements. The global and regional institutions can easily work together in a complementary way.

Mohsin Khan is a Senior Fellow at the Peterson Institute for International Economics and was formerly Director of the Middle East and Central Asia Department at the International Monetary Fund (IMF).

This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Asia’s global impact‘.

1. China’s role in global and regional governance architecture
2. Asia’s global responsibilities: Delivering through global and regional arrangements
3. Reshaping global economic governance and the role of Asia in the G20

The Indian Finance Minister Pranab Mukherjee’s remarks at the launch of the World Bank Development Committee meeting recently expressed the concerns of emerging economies about the European debt crisis.

If not managed with an iron hand, the crisis will have a contagion effect and lead to a double-dip recession in the world economy. Emerging markets like China and India coped with the collapse of Lehman Brothers, as the right policy stimulants were present along with booming domestic demand. But a double-dip recession could have more serious implications on investment, growth and employment in emerging markets.

A double dip recession may be more worrying than the 2008 global financial crisis (GFC) due to the economic situation in key countries: China’s growth is showing signs of slowing; India is sacrificing growth to fight inflation; US markets are weak due to efforts in debt-reduction and reduced government spending; and Japan is experiencing negative growth, resulting in an overall drop in investor and consumer confidence. If a second recession takes full effect, emerging countries like India will be affected. The initial symptoms are already evident in stock markets, where share values and wealth are eroding.

Why the present crisis?

The Eurozone debt crisis was partly caused by sustained budget deficits and high government debt without structural reforms to improve productivity growth in European countries such as Greece, Ireland, Portugal and Spain. The GFC shook investors’ confidence in the ability of these governments to manage the economy, and they dumped government bonds. More significantly, investors deserted these troubled European countries during the GFC.

After the Euro was introduced as the common currency in 1999, investors found it very attractive to buy assets in these countries. The huge capital inflow created the high current account deficit in addition to a high fiscal deficit. The simultaneous twin deficits were manageable as long as there were huge capital inflows, but the sudden end to capital inflows and the dumping of government bonds created the present debt crisis.

The Euro was created to unify the European market and to create better investment opportunities. But the EU failed to stamp authority in these countries to follow structural reforms and tight fiscal discipline. Though 17 countries have the Euro as a common currency, each country has its own political dynamics and pursues socio-economic reforms in its own interest. As such, the present danger to Europe is the Euro itself.

To rescue Greece, Ireland and Portugal, a coordinated effort led by rich European countries like Germany and the Netherlands, and the G20 countries, is urgently required. This will help investors regain confidence, preventing a banking collapse in Europe. In this context, the offer of G20 countries, including emerging markets, to assist international financial institutions is a welcome step. In times of crisis, stressed economies often need funds to stabilise domestic demand and financial markets. This adds pressure to bank funds whose capital is already depleting fast in managing the debt crisis in Europe. Though in the near future multilateral financial institutions and developed countries (along with emerging markets) may bail out the Eurozone countries, the long-term plan should be to help these economies achieve growth with structural reforms and liberalisation.

Impact on emerging markets, including India

European banks have higher exposure than banks in emerging markets, the US and Japan put together. If European banks collapse due to exposure to countries such as Greece, Ireland and Portugal, the supply of foreign credit to emerging markets will dry up. That will put pressure on investment spending in emerging markets — already struggling with high capital costs due to tight monetary policies — impacting investment, growth and employment. Early warning signs, such as low investor confidence and falling consumer demand across the board, signal a crisis at India’s doorstep which it cannot completely avoid. So it is imperative that emerging markets, including India, look inward and boost domestic demand to compensate for the shrinking world market.

Europe is one of India’s largest trading partners. Austerity measures in European countries and falling consumer expenditure may affect Indian exports, especially in services. Though China is India’s largest trading partner, it mostly imports raw materials for manufactured goods produced for the rest of the world, now facing recession. So, the Eurozone crisis does not bode well for Indian exports. The Indian stock market has already fallen substantially, and if European banks become insolvent capital may return, leading to a sharp depreciation of the rupee, which is already in turmoil. Given increased intra-industry trade, and the import intensity of Indian exports, a rising rupee would hurt industries both within and outside the country.

But in every crisis is opportunity. Indian policymakers need to maintain domestic demand and work towards gaining investors’ confidence. The government must explore export markets like Africa and the ASEAN countries, and continue to reduce dependence on Europe and the US. Special tax incentives for exporters to Europe and the US may help them retain their competitiveness in these markets. Some of the pending reforms, whether they are FDI in retail, labour or financial and insurance sector reforms, need to be pushed ahead to maintain growth and investment. It is time to show that India is a safe haven for investment, and to do this bold governance reforms are needed to improve the overall competitiveness of the Indian economy.

Pravakar Sahoo is Associate Professor at the Institute of Economic Growth, and Visiting Researcher at the East-West Center. An Earlier version of this article was first published in Business Line, 10^th October 2011. 

1. The global financial crisis and short-run prospects for India
2. India: Confronting the Global Financial Crisis
3. India: Turning Crisis into Opportunity?

Since the Asian financial crisis of 1997–98, the countries of East Asia have, in aggregate, run huge annual current account surpluses.

The counterparts of these surpluses, including Europe and the US, have been correspondingly huge current account deficits. This process has continued for over a decade and a half, and huge stocks of debt have accumulated. Much of this is US government debt owed to the central banks of the East Asian countries. About half of it is held by China. It is expected that the debt will eventually be repaid and this implies that the surpluses must eventually turn into deficits, and vice versa. Indefinite accumulation of debt is unsustainable.

Current account imbalances are not necessarily a problem. They reflect what international economists call international inter-temporal trade. One country (the surplus country) is exchanging current goods and services for financial assets, which are claims on goods and services in the future. The other country (the deficit country) is doing the reverse. Mutual gains from trade arise from these transactions because the initial circumstances of the countries involved are not the same. For some countries it makes sense to save more now, because they have a younger working age population, for example, in order to consume or invest more later. For others, the reverse applies. In this respect, inter-temporal trade is not fundamentally different from contemporaneous trade in goods and services. But basic differences do exist. The time dimension can mean that the individuals obliged to repay a debt may not be the same as those who incurred it. So the outcomes chosen by this generation of Americans, for example, can create an unwelcome problem for the next generation.

Many observers regard the present global imbalances as unsustainable, even in the short run. First, East Asian countries may be unwilling to continue to accumulate US debt and even wish to reduce the stock they hold. Second, the US may be unwilling to allow this accumulation of indebtedness to continue and seek to reduce the stock of debt they currently owe. The two are not mutually exclusive and could happen at the same time. They both rest on the fear that the burden of debt servicing might suddenly become intolerable for the debtors, notably the US, meaning an unexpectedly rapid adjustment becomes necessary.

East Asia’s current account surpluses may have to decline, and even turn into deficits, very quickly. This must happen eventually — the question is when. It might not be a problem if it happens ‘gradually and predictably’. But if it happens ‘soon’, at an unexpectedly rapid rate, there may be a serious adjustment problem involved. If the problem is anticipated it might be possible to avoid the large-scale unemployment and other social costs that would otherwise result. But these events are uncertain, and ‘growth rebalancing’ is essentially a problem of risk management.

From the perspective of the East Asian countries, the interest in growth rebalancing is motivated by two concerns. First, there is the possibility that current account surpluses (positive flows) will turn into deficits (negative flows) quickly, leading to social disruption and other adjustment costs. Second, there is the fear that the stock of debt owed to them may become so high that it becomes impossible to repay. The first concern is more immediate.

Especially since the Asian financial crisis, the countries of Asia and the Pacific have, to varying extents, focused their production towards exports and away from their domestic markets. But if the current account surpluses are to be reduced significantly, or even reversed, then resources must be reallocated towards production for the domestic market to avoid massive unemployment. For the deficit countries the problem is exactly the reverse. The policy imperative is similar in both cases: avoid the disruption — especially large-scale unemployment — resulting from having to adjust too rapidly.

The issue is not really whether such growth rebalancing will occur, but when, at what rate and by what means. In the current global environment Asia is vulnerable to such an adjustment problem arising at short notice. Some ‘rebalancing’ now — away from reliance on external demand and towards domestic demand — can reduce this vulnerability by reducing Asia’s export dependence.

A simple model of the global demand and supply of loanable funds can be used to bring out a key feature of the adjustment options. Suppose the deficit countries, principally the US, wish to reduce their current account deficits. Is it better for the US to make the adjustment itself or attempt to induce Asia to adjust by reducing its surplus? If the US adjusts, its excess demand for funds declines, the level of its current account deficit declines and world interest rates fall. If Asia contracts its excess supply of funds, the same combination of current account balances may result, but with an increase in world interest rates.

Given the huge level of its stock of debt, the US has a strong interest in low world interest rates. It should therefore do the adjusting itself and not be berating Asia to reduce its current account surpluses.

Peter Warr is John Crawford Professor of Agricultural Economics and Head of the Arndt-Corden Department of Economics in the Crawford School of Economics and Government at ANU.

1. The burden of US debt
2. How should G20 help global rebalancing?
3. Asian Development Bank and the invention of a new Asian growth paradigm

In East Asia, as elsewhere in the world, the risks that we continue to face in recovery from the global financial crisis, economically and politically, are a consequence not only of failure in national governance but also in the architecture of international governance, including regional architecture.

Failures that frustrated a coherent East Asian and international response to the big problems of the day (including payments imbalances, financial market reform, trade and exchange rate issues) in their global context.

The global financial crisis and the emergence of the Group of 20 (G20) has changed this dramatically and gives the G20′s Asian members the opportunity, at least, to assume a new role and their proper responsibilities in managing the world economic order. The ten-nation Association of Southeast Asian Nations (ASEAN) is still the fulcrum of Asian cooperation arrangements, including Asia Pacific Economic Cooperation (APEC), the ASEAN Regional Forum (ARF), ASEAN+3 (the 3 being Japan, China and Korea) and the newly expanded East Asian Summit (EAS). But with the rise of the bigger powers in Asia and the emergence of the G20 this seems likely to change. There is a new and immense fluidity in the shape of regional architecture despite the recent initiative to include the US and Russia in the EAS dialogues. The rise of Asia suggests that the time is right for Asian leadership. But what are the prospects for a coherent approach from Asia to the crisis in the international economy today? And can Asia step up to exercise the responsibilities the rest of the world now increasingly expects it to do?

In this week’s lead, Wendy Dobson sees the emergence of Asian leadership in global affairs as a slow and gradual process. ASEAN, which has been at the core of Asian institutional arrangements, hasn’t the strength to do what is needed now. So ‘will the region continue to cede the leadership of the world trading system to the United States and Europe, as it has through much of the post-war period? Or will it use its increasing economic weight to shape the world order by, say, helping to conclude the Doha Round, forging a new approach in the WTO post-Doha or building a Pacific-wide free trade area?’

It makes little sense for Asia to rely too heavily on Europe and the United States for leadership at the global level given their internal troubles that will distract them and cause defensive policies for the foreseeable future.

The scale of Asia’s impact on the global economy means that the need to mobilise regional efforts to deliver on Asia’s global responsibilities — in the financial and macro-economy, in trade policy (which the collapse of Doha makes a more urgent priority) and on climate change — is a task that is more and more pressing and one that needs to be managed more actively through regional institutions.

Getting this right in practice may be more complicated than it appears in principle. It will require decisions about which regional arrangements provide the most effective link between regional and global cooperation. Many of the initiatives will sensibly require strengthening East Asian arrangements (at least within ASEAN+6 which includes the +3 and India, Australia and New Zealand), perhaps via enhanced financial cooperation through finance ministry and finance agency involvement (the Asian Financial Stability Dialogue AFSD, for example). Others will benefit from participation of a broader Asia Pacific group.

Getting the connection between regional and global arrangements right will require careful attention to scheduling regional meetings and initiatives so that they can both make useful input into, and be reinforced by, the efforts in global cooperation. Success will depend heavily upon the logistical detail. There needs to be much careful thought given to this question. The legitimacy of the G20 will depend on how the interests and views of non-G20 members are brought to the G20 process. Structuring the timing of Asia’s regional meetings around the G20 to give the regional non-G20 members input and ownership of initiatives is an important start. The implication is that, while ASEAN provides a critical modus operandi for regional initiatives, the agenda and schedule for regional arrangements, if regional institutions are to remain relevant, needs also and essentially to be driven from elsewhere.

Dobson reckons that in Asia it is likely that efforts could be made to use scarce leadership resources better in the continuing variable geometry in which the broadest membership of East Asian arrangements meets to discuss strategic issues. With time and experience it might also engage in setting and monitoring goals and targets if such goals and targets were adopted, similar to the G20′s emerging role at the global level. Crises will require managers, though, and are likely to require a steering committee of the largest economies. That suggests a group of the large players, perhaps the six Asia members of the G20 (including Australia) working with North America might emerge as the leading players. How ASEAN remains relevant is another issue.

Meanwhile Asia has a great deal at stake in fronting up with recovery and growth strategies that support G20 efforts to deal with the collapse in global economic confidence.

Peter Drsydale

1. East Asia’s response to the global economic crisis
2. East Asia and the global financial crisis
3. Asia’s uncertain path to global economic leadership