Monday, 23 February 2009

'Toxic' Assets, Contagion and the Financial Crisis

By Xavier Cirera

An interesting question regarding the spread of the current financial crisis is the extent to which banks in developing countries hold 'toxic' assets. This is critical to understanding the channels through which the crisis will spread to developing countries. It is already evident that there is a significant impact on developing countries from a reduction in demand in OECD countries (the trade channel). Recent news about a substantial decrease in exports from China is alarming. However, less clear is the impact through bank lending.

The bank lending channel depends on the bank asset position, which in turn may depend on whether the bank is foreign owned and the use of bank finance by domestic firms. Financial development in developing countries varies greatly between emerging markets and LDCs. One may think that the banking system in Latin America and Asia is clearly more exposed to the global banking crisis than financially underdeveloped banks in Sub-Saharan Africa. In addition, firms’ access to bank finance is very restricted in Sub-Saharan Africa and other LDCs. As a result, it may seem that LDCs are quite isolated from the financial channel of contagion since banks have a less vulnerable position and play a less important role in firms’ finance. Interestingly, so far there are no news reports about large bank collapses and rescues in LDCs.

However, greater isolation from the financial channel does not imply that the impact of the current crisis on GDP growth in LDCs will not be large. Some LDCs are already experiencing the drop in demand from OECD countries.

If you are interested in the issue of 'toxic' assets, do not miss the excellent note from my colleague Neil McCulloch on what to do about them.

Wednesday, 4 February 2009

On China Currency Manipulation and Multilateralism

By Xavier Cirera
One collateral impact of any financial crisis is the risk of raising protectionism. One clear example is the warning thrown by recently appointed US Secretary of State, Timothy Geithner, that China has been manipulating its currency, which increases the risk of creating a US-China trade row. The idea that the renminbi is undervalued is nothing new, and a large number of academic papers have tried to quantify this undervaluation. However, the tone of the US administration seems to have changed substantially with the new Obama team, and one wonders whether this change would have occurred in a context of economic stability. A bilateral trade dispute between the US and China would be bad news for the world economy, and could open the door to the indiscriminate use of protectionist measures by other countries.

The effect of government policies achieving currency undervaluation is similar to the impact of an import tariff or an export subsidy. Currency undervaluation has an impact on trade volumes and on the current account, since it generates cheaper exports and larger current account surpluses. Undoubtedly, an undervalued renminbi has a large impact on the US current account balance with China. However, what is less clear is the competitive impact of the undervaluation on US producers. The existing evidence is not clear about whether Chinese products compete directly with higher quality products from the US and EU countries. While there has been a significant overlap between exports from China and high-income countries, and significant quality upgrading in some areas, in general most Chinese exports are of lower quality and, therefore, do not compete directly. On the contrary, China is the main platform for outsourcing and assembling many products originated in the US and the EU. So despite the existing fear of ‘unfair’ Chinese competition in the US and the EU, any Chinese currency manipulation has larger direct competitive impacts on other Asian and middle income countries. Besides, if the Chinese currency is undervalued, it is likely to be undervalued with most currencies, not only the US dollar.

So why then so much bilateral focus US-China? Clearly, the emergence of a new super power creates tensions with the existing one, and history shows that transitions can be difficult and violent. However, the risk, in my view, is to marginalise developing countries from the new arising system of global governance and polarisation of power. Asian drivers should be the catalyst to change the rules of the game, and design a system of global governance where developing countries, not only India and China, are adequately represented, nominally and with de facto decision power in multilateral institutions. A good start could be the Chinese currency row. Developing countries are also affected by Chinese currency ‘manipulation’ and, therefore, this issue should be addressed at the multilateral level.