"The rescue of leading US financial institutions by developing countries is a complete reversal of the 20th century history."
There is a delicious irony in the fact that Citibank, Merrill Lynch, and Morgan Stanley have sought equity capital from the sovereign wealth funds of Asian and Middle Eastern developing countries to repair the balance sheet damage inflicted by subprime mortgage securities. Stung by the lessons of the Asian Financial Crisis of ten years ago, central banks in the developing countries began defensive actions to accumulate foreign exchange reserves. This trend was accelerated by their newfound ability to buy technology and capital goods from the developed world, which in turn rapidly increased domestic growth and fueled commodity prices. Economies blessed with significant natural resources accumulated yet more dollars. The problem is their huge overflowing coffers contributed to a major misallocation of capital in recent years that is likely to continue.
During the past four years, the developing countries have run an aggregate current account surplus of nearly $2.5 trillion. In 2008 alone, the surplus will probably exceed $625 billion. These huge surpluses provided the global financial system with the excess liquidity which funded America’s burgeoning current account deficit and depressed bond yields four years ago. The decline of long term interest rates encouraged America’s residential property boom and spawned the reckless lending for subprime mortgages. This process of surplus savings in developing countries influencing financial behavior in industrial countries has now made a complete circle with Abu Dhabi, Singapore, and China rescuing Citibank, Merrill Lynch, and Morgan Stanley.
The rescue of leading US financial institutions by developing countries is a complete reversal of the 20th century history. In the past, financial crises often occurred in developing countries because of large interest rate hikes in the United States or a suspension of capital flows from the old industrial countries. When capital flows ceased, the developing country currency fell sharply, boosting interest rates and bankrupting highly leveraged local companies. Such crises occurred in Latin America during the early 1980’s, Mexico in 1994, East Asia during 1997-98, and Argentina during 2001.
America has two similarities with developing countries today. It has a large current account deficit which has been funded in part by selling mortgage-backed securities to foreign investors. The subprime lending boom had a third world flavor because it provided unprecedented amounts of credit to people with low incomes and low credit scores. Developing countries have become far more conservative as a result of the crises which occurred during the 1980’s and 1990’s. The great majority are now running current account surpluses. A few have truly large surpluses because of spectacular export success (China, Malaysia) or high commodity prices (Russia, Saudi Arabia).
The current business cycle will go down in the history books as one which confirmed that leadership in the global economy is now shifting from the old industrial countries to the emerging market countries. During 2007, the developing countries produced over 52% of global growth compared to 37% during the late 1990’s. China alone produced 17.8% of global GDP growth last year compared to 14.6% for the US economy. The developing countries’ share of total world output has risen from 18% in 1995 to 29% this year. The World Bank is forecasting the developing country economies will grow by 7.4% this year compared to 2.2% in the old industrial nations. As a result of their large current account surpluses, the developing countries also account for 75% of the world’s $6 trillion of foreign exchange reserves. In addition to these large reserves, they have sovereign wealth funds with assets of $2.5 trillion. There has been a huge expansion of developing country stock markets during the past decade as well. Their market capitalization now exceeds $17.8 trillion compared to $2.2 trillion in 2000. The capitalization of the US market is $17.5 trillion.
In the decade before 2005, the American consumer was the world economy’s growth locomotive. The US consumer accounted for over half of all global consumer spending. The balance of power is now shifting. In 2000 the consumer spending of the world’s 17 largest emerging market countries was equal to only 48% of US consumer spending. In 2007, it was equal to 65% of US spending. At current growth rates, the developing countries could exceed US consumer spending by 2015. This consumption boom is changing global trade patterns. America’s share of global imports has fallen from over 20% in 2000 to 14% last year. The import share of the developing countries has grown from 33% in 2000 to 40.6% last year.
The shift occurring in the global balance of power has so far had only a modest impact on global institutions and governance. The World Bank might appoint a prominent Chinese academic as its chief economist. After the East Asian financial crisis, the US promoted the creation of a G-20 forum for finance ministers of developing countries to meet with the finance ministers of the industrial countries. The G-7 expanded during the late 1990’s to include Russia but more needs to be done. The G-7 should no longer consist of four European countries, the US, Canada and Japan. There should be only one European representative. The remaining three slots should go to China, India, and one African country. There will be great protests from the Europeans at consolidating their position but the current membership of the G-7 no longer reflects the changing reality of the global economy. The G-7 must adapt or become irrelevant.