Monetary and Financial Policies in the

1

• Monetary and Financial Policies in the
• Asian Network Economy
• Tuesday, 18 April 2006
• Kuala Lumpur Convention Centre
• by
• Datuk Seri Panglima Andrew L.T. Sheng
• Tun Ismail Ali Professor of Monetary and
  Financial Economics
• Faculty of Economics and Administration
• University of Malaya

2
Contents

• Introduction
• Network Concept
• Asian Supply Chain
• Asian Financial Network
• Node Stability vs Network Stability
• Dollar as Standard
• Concluding Remarks

3
The Changing Landscape

• Since Berlin Wall in 1989, over three billion
  workers and consumers have joined the market
  economy. Brazil, Russia, India and China (BRIC)
  are expected to become larger than G6 in less
  than 40 years.
• Information and communication technology is
  growing at Internet speed. 1.02 trillion Internet
  users (15.7 of world population) pushing spread
  of knowledge and global market.
• Liberalization of trade and finance, innovation
  and globalization have resulted in large trade
  and capital flows. Global trade in physical
  goods and services reached US11 trillion in
  2004, but trading in foreign exchange amounted to
  US 1.9 trillion daily.

4
Markets as Networks

• A financial system, like all structures, is as
  strong as its weakest link Alan Greenspan,
  December 1997
• The Asian crisis was a large-scale example of a
  cascading financial failure, a natural
  consequence of connectedness and
  interdependency..
• - Albert-Laszlo Barabasi, Linked How
  Everything is Connected to Everything Else and
  What It Means for Business, Science, and Everyday
  Life, Plume Books, May 2003

5
Six degrees of Separation Network Theory

• A network is a set of interconnected nodes.
• Nodes do not connect with each other at random -
  preferential attachment
• Hubs and clusters are efficient because of
  network externality.
• Preferential attachment and network externalities
  together explain winner-take-all situation
  common to networks.
• Networks are scale-free and not static, because
  of continual each competition or cooperation
  between hubs.
• Since markets are by their nature competitive,
  they adapt and evolve around their environment.

6
Network Characteristics

• Metcalfs Law - the "value" or "power" of a
  network increases in proportion to the square of
  the number of nodes on the network

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Barabasi Networks follow Power Laws
8
Network Topology determines efficiency vs
robustness
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Network Altruistism Principle

• Rich get richer characteristic of networks is
  inherently unstable.
• Network Altruistic Principle where dominant hub
  helps the others maintains stability.
• The more you share knowledge, the more you gain
  knowledge
• The more you share wealth, the more you gain
  wealth
• The more you share power, the more you gain
  power.

10
Asian Supply Chain Network

• Information technology, automation, innovation
  and competition have converged to the degree that
  manufacturing has become more flexible, with
  higher quality standards and greater
  responsiveness to consumer needs.
• IT has driven globalization through its networks,
  so that the global is increasingly operating as
  one global net where ideas, capital and products
  flow with less and less concerns for geographical
  borders.
• Through the World Wide Web, manufacturers are
  able to source production, restructure
  operations and delivery system to serve global
  customers.

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Asian Supply Network Flying Geese

• 1950-60s Japan first to industrialize
• 1960-70s As costs rise, industries move to NIEs
  (Korea, Taiwan, Hong Kong, Singapore)
• 1970-80s ASEAN began to industrialize and also
  benefit from US IT investments
• 1990s China begins to become global supply
  chain hub, after the Asian crisis, because of
  cheap labour and attraction of large domestic
  market.
• India becomes IT service outsourcing hub

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Intra-Asian Trade is Growing(Trade Flows as a
percent of Total Asian Trade, 2004)
Source David Roland-Holst, Mar 2006
13
Asias Growth and Its Sources, 2005-2025 ()
Note TFP means total factor productivity Source
Asian Development Bank
14
Great Gains in Real Income if Liberalization(
change from baseline in 2025)
Source Asian Development Bank
15
Great Gains in Real Exports( change from
baseline in 2025)
Source Asian Development Bank
16
Asian Financial Network

• The distinctive feature of Asian network economy
  is that the financial network relied primarily on
  the domestic banking channel Japanese supply
  chain, whilst capital market developments were
  driven largely by non-Asian supply of FDI and
  foreign FPI US supply chain.
• The result was an imbalanced growth strategy that
  was vulnerable to sharp withdrawals of capital
  flows, which culminated in the Asian crisis.

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Asian Financial Crisis

• Since US ultimate and dominant consumer, ideally
  there should be one market, one currency standard
• But Asia had two standards dollar and yen
• When yen strong, Japanese FDI and exports shift
  to Asian production
• When yen weak, reverse process occurred.
• Pre-Asian crisis, US200 bn flowed into Asia
• Post-crisis, US160 bn flowed out.
• Asia had a bank run without a dollar lender of
  last resort.

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Traditional Financial Stability vs Network
Perspective

• Sound Macro-economic policies and management
• Build deep, transparent and liquid markets that
  strengthen institutions and reduce system risk
• Enhance supervisory skills, focusing on good
  regulation, surveillance, prevention and exit
  management
• Build efficient and robust property rights
  infrastructures and
• Strengthen framework for governance and
  transparency at all levels.

19
Schinasi (IMF Sep 2005)Framework for
Maintaining Financial Stability
20
Inter-connected crises

• 1995/97 Thai companies depended heavily on trade
  credit from Japanese manufacturers as well as
  bank borrowing. Yen weakening decline in
  Nikkei in 1997 caused Japanese banks to cut back
  FX loans, leading to sharp cutback in trade
  credit at same time, exacerbating credit squeeze
• In 1997, offshore Korean banks bought Brazilian
  and Russian bonds because yields were higher than
  their cost of funds. Unwinding in 1998 caused
  contagion to Russian and Brazilian markets
• 9/11 NY telephone networks (thought to be
  independent) all wired through one exchange

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Three Possible Network solutions to shocks

• Immunization strengthening each node and link
  so that that the whole network is robust
• Prevention surveillance, stress-testing,
  sanction and payoffs to ensure that members of
  network avoid opportunistic behaviour and look
  to collective welfare
• Isolation or Bail-in breaking the links would
  isolate the damage. Pull the Plug. What
  Malaysia did with exchange control!

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Dollar as Standard, US as Dominant Hub

• US dollar is dominant global network standard
  with power-law characteristics
• 4 of world population, 30 of GDP and 50 of
  world market capitalization, plus 60 of world
  financial transactions
• US is major banker to world in 1950 and has
  become venture capitalist with high returns on
  its FDI and FPI

23
Global Imbalances Growing AVERAGE CURRENT
ACCOUNT BALANCES IN USBn
Source IMF
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US External Position - from world banker to
venture capitalist

• US went from net creditor position (10 of GDP in
  1952) to net debt position (-26 of GDP) by 2003
• End 2004, US net external debt (with FDI at
  market value) was US2.5 trillion or 22 of US
  GDP. Foreign assets of US10 trn (85 of GDP),
  liabilities of US12.5 trn (107)
• 70 of US foreign assets are in FX, but all
  liabilities in US. 10 US depreciation
  transfers 5.9 of US GDP to US.
• Over period 1952-2003, average real rate of
  return on asset (5.72) higher than average real
  rate of return on liabilities (3.61), averaged
  2.11.

Source Gourinchas and Rey, Sept 2005
25
Global Assets Under Management (US trillion end
2003)

• International Banking Assets (BIS data)
  23.6
• International debt securities 14.6
• Insurance companies 13.5
• Pension Funds 15.0
• Investment Companies 14.0
• Hedge Funds 0.8
• Other Institutional Investors 3.4
• Total 84.9
• Memo OTC Derivative Contracts (notional)
  270.1
• Source BIS, IMF

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The Bretton Woods Architecture

• International Monetary Fund, total quota
  (capital) of SDR213 bn (USD306 bn), 184 members
  (2005 data)
• World Bank (International Bank for Reconstruction
  and Development), capital US38.6 bn, assets
  US222 bn
• Other development banks, ADB, African Development
  Bank, EBRD, Inter-American Development Bank etc
• Bank for International Settlements (BIS), owned
  by member central banks, equity of US14.9 bn and
  US260.5 bn assets
• Total asset size of these institutions (US790
  bn) is trivial (0.9) compared with size of
  global financial assets of US84.9 trn.

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Reform of IMF - Mervyn King Feb 2006

• IMF no longer can play role of lender of last
  resort (70 of IMF outstanding loans were to 3
  countries)
• Since IMF resources too small, then its roles are
  to -
• Forum for discussion of global risks
• Independent ruthless truth-telling
• Monitor international balance sheets, look at ERR
  choices, and encourage countries to maintain
  global stability through higher transparency.
• Focus on balance sheets, not just flows.

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Dollar Standard and Spare Tires

• Before the crisis broke, there was little reason
  to question the three decades of phenomenally
  solid East Asian economic growth, largely
  financed through the banking system. The rapidly
  expanding economies and bank credit growth kept
  the ratio of NPLs to total bank assets low. The
  failure to have backup forms of intermediation
  was of little consequence. The lack of a spare
  tire is of no concern if you do not get a flat.
  East Asia had no spare tires.
• But you cannot be leading banker and also leading
  consumer.
• Alan Greenspan, October 1999

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Why do Asians Hold More FX Reserves?

• Asians now have US 2 trillion in FX reserves.
• Asian FX reserves are 10 times larger than
  combined reserves of G7.
• In the absence of Lender of last Resort, Asia now
  has a spare tire.
• Asia may be fast becoming the dollar spare tire.

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Implications for Small Open Economies

• In world of changing configurations, variable
  geometry and flexibility better way of survival.
• Network problems require cooperative solutions.
  Emerging Markets and Asian countries should have
  seat at head table.
• We cannot be complacent that status quo will
  continue. US will adjust sooner or later.
• Closed-door protectionism is worst strategy.
• Four possible options on way forward.

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Four Possible Ways Forward

• Continue with Dollar Standard - evidence of Asia
  moving away from dollar bloc
• Increase use of Euro - requires Euro bloc
  agreement
• Work on Asian currency bloc - current lack of
  leadership and statesmanship in this area
• Free floating and pull the plug if shocks get too
  large. Muddling through.

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Concluding Thoughts

• Move from Linear, Segmented thinking to Matrix,
  Inter-Connected approach to global markets.
• In Interdependent world, greater mutual
  understanding and cooperation is necessary
• Since markets have structure, understanding
  topology helps in market reforms
• Tun Ismail legacy We must have clear thinking
  in fast changing and confusing world.

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• Thank you
• Questions to as_at_andrewsheng.net