Fixing the Financial Sector: Is the G20 Helping Developing Countries?

Added 25 Jun 2015
Article also published in Heinrich Boell Stiftung's G20 and BRICS Update E-Newsletter

The G20’s track record on financial sector reform is uninspiring, and its failure to tackle the major concerns of developing economies or make the global financial system less prone to crisis suggests it is time to start searching for a more effective and more legitimate successor. 

The following three graphs tell us three important things about changes to the financial sector since the global economic crisis. The first graph, from an excellent paper by Yilmaz Akyüz, chief economist of the intergovernmental think tank, the South Centre, shows that financial assets (that they own overseas) and liabilities (that foreigners own in their countries) of emerging and developing economies (EDEs) have grown rapidly in the past decade. This means, of course, that they are now “closely integrated” into “an inherently unstable international financial system”. 

This can offer benefits, of course, but Akyüz points out that the way this is happening is causing significant risks, with “almost all” developing countries now at risk of financial crisis. According to Akyüz there are now two types of developing countries. The first type looks familiar to students of previous financial crises. They have “bubbles in domestic credit and asset markets” and are heavily dependent on external financing – so changes in exchange rates, or in the opinion of international investors, can spell disaster.

The second type is new, and mostly affects East Asian countries that look – from the outside – as if they are safe. They have “strong external positions” – meaning that they are not so vulnerable to the “typical external financial crisis [where] an emerging economy finds its access to international financial markets interrupted and faces a sudden stop in capital inflows.” Instead, their own domestic financial markets have been the scene of increasing activity by foreign investors, meaning the crisis could arise from within – but be triggered by the actions of those foreign investors.

Emerging markets have tried to use the G20 as a venue to tackle this issue of their vulnerability to the financial, monetary and economic policies of rich countries. Initially, they had some success, forcing the IMF to change its tune and accept that capital controls can be a useful part of their policy toolkit, as they can be used to prevent sudden exits of capital, or to discourage the entry of risky capital in the first place. However, on bigger issues, such as the negative global impacts of rich country quantitative easing policies, developing countries have been regularly rebuffed at the G20, with communiqués only vaguely referring to the issue, and rich countries in effect refusing to alter their policies to reduce their impacts on emerging markets. Quantitative easing (QE) – which is basically akin to central banks printing new money – has helped keep interest rates low in the US and elsewhere, and increased the amount of capital that is looking for a higher return in other countries. This has helped direct capital towards emerging markets, which rightly point out that, as QE is reversed, the flows too reverse, causing potentially disastrous financial instability for those economies.  

The second graph shows how the effort to “end too big to fail banks” – a key G20 objective since 2012 – is not going so well. The graph comes from an IMF discussion note on bank size from May of last year and shows that the biggest banks have not shrunk much since the crisis, and that in major western economies the share of the banking sector accounted for by the biggest three banks (the ‘bank concentration ratio’) continues on an upward trend.

In fact, last September’s G20 Finance Ministers meeting revealed that, while the G20 has promoted the “stronger capital requirements for systemically important banks”, these were not in fact designed to prevent failure, but instead to guarantee “additional loss-absorbing capacity that would further protect taxpayers if these banks fail.” 

The third graph, also prepared by IMF staff, is perhaps the most dramatic. It shows how IMF researchers estimate that financial sector development past a certain point is likely to reduce a country’s level of economic growth. 

This is probably no surprise to most observers, who have witnessed the fragility of overly complex and interconnected financial sectors, and the economic consequences of the global financial crisis. However, this has not stopped the G20 from pursuing a strategy of encouraging such complexity in developing economies, particularly through its work on infrastructure financing where, through the World Bank and the OECD, it is vigorously promoting the development of infrastructure as an ‘asset class’. This entails a major effort to package infrastructure investment in a way that will allow financial markets to displace the state as the principle source of finance for infrastructure. This February, G20 Finance Ministers said they wanted “to facilitate longterm financing from institutional investors and to encourage market sources of finance, including securitization”. “To promote infrastructure as an asset class,” the Ministers say, they “will encourage an increasing role for new financial models including transparent assetbased financing structures”.

This is a worrying agenda for two reasons. First, it flies in the face of the historical evidence of how infrastructure has been successfully financed. A World Bank background paper for the G20 found that over the past decade in developing countries, “…private capital has contributed between 15 and 20 per cent of total investments in infrastructure”. This means of course, that public investment has been 80-85% of the total. This is despite the fact that many states that have fallen under the tutelage of the IFIs have often been robbed of fiscal space for public investment. 

Second, efforts to bend the arc of history to allow private investment to dominate infrastructure are likely to have serious side effects. To package infrastructure assets in a way that will be of interest to distant and riskaverse institutional investors such as pension funds (which, according to the OECD, had only 1% of their assets directly invested in infrastructure in 2013), projects will get larger, and the risks will have to be ‘mitigated’. Reading the OECD’s recent paper for the G20 on this issue reveals that this really means transferring the risks of private firms to the public sector, “by providing coverage for risks which are new and are not currently covered by financial actors, or are simply too costly for investors”. The state’s absorption of substantial risks for packages of public-private partnerships (PPPs) can exacerbate financial instability, as it did in the cases of Portugal and Spain, among others. 

In summary, the G20 has been unwilling to adopt the real concerns of developing countries about key issues: a) the negative impacts of rich country policies, such as quantitative easing; b) the ineffectiveness of the G20’s efforts to tackle major parts of the financial sector reform agenda, such as ending “too big to fail” banks; and c) its major push on infrastructure, which encourages developing countries to become more, not less, integrated into the fragile global financial system. 

One key underlying reason for the less than impressive report card that the G20 as a whole has earned is the undemocratic and ineffective governance structure of the G20 itself. Unlike the sensible proposal (made by the truly excellent report of the UN commission of experts on reform of the international monetary and financial system) for Global Economic Coordination Council at the UN, the G20 is hamstrung by its ad hoc nature, and the arbitrary process of selection of its member countries. It has no effective method of involving the 174 UN member states who are not part of the G20, and relies for implementation on bodies such as the Financial Stability Board (FSB), which itself has a deeply undemocratic governance structure. 

Last year, the FSB concluded a review of its governance structure, making very limited changes. On the critical issue of the exclusion of the vast majority of the world’s countries from the FSB, the institution agreed to give an extra seat on its governing council to the five lucky emerging markets that are already members of the FSB. This means that emerging market countries will now have ten seats out of 70 – the rest held by developed countries and international institutions – with all other developing countries remaining unrepresented. In effect, the key body trusted with reforming the financial sector is dominated by policy makers from major financial sectors – who themselves are subject to intensive lobbying by the financial industry in their countries. Is it therefore any wonder that it has achieved so little? 

In the short term, it is unlikely that the inadequacy of the G20 as a global coordination or policy setting body will lead to its demise. However, given the continued fragility of the global economic and financial system, and the continued possibility of another major financial crisis, policy makers ought to begin dusting off the UN expert report, and preparing the ground for a legitimate, effective, and transparent successor.