Capital Flows

See CFR Senior Fellow and Renewing America Director Edward Alden's accompanying blog post here. Download the Chinese translation of this report [PDF]. Introduction China recently became the world's second-largest economy and has emerged as the world's largest exporter and second-largest destination for foreign direct investment (FDI). In the past two years, China alone has contributed 16 percent of global GDP growth. Yet despite its rapid economic rise, China lags in one important area: outbound foreign direct investment (OFDI). China's OFDI has grown rapidly, but it remains relatively low—lower even than that of Ireland and Singapore. Historically, the United States has garnered approximately 15 percent of total global OFDI flows, yet currently it receives only 2 percent of China's OFDI. President Barack Obama's meetings in February 2012 with Xi Jinping, China's vice president and soon-to-be leader, provide an opportunity to address this issue and establish an economic framework to help rebalance the global economy. Creating a positive economic framework will help mitigate the inevitable stresses on the U.S.-China relationship as leaders in both political parties sharpen their anti-China rhetoric during the 2012 U.S. election. China's outward investment has substantial room to grow, and the United States has the potential to capture a larger share of it—an outcome that would benefit the U.S. and Chinese economies and strengthen the bilateral economic relationship. China could be transformed into a large overseas investor, not just an exporter. At the core of that framework should be an unequivocal policy of fostering additional Chinese investment into the United States, so long as particular investments do not compromise U.S. national security interests. The Problem A number of hurdles to investment in the United States are internal to China. State-owned enterprises (SOEs) accounted for approximately 70 percent of China's global OFDI stock in 2009. Most SOEs are internally focused, risk-averse, and lack professional management capabilities to run complex international operations. SOEs also require government approval of specific overseas investments, a process in conflict with the frequent fast pace of bidding processes for companies. Outside of SOEs, many successful Chinese companies remain small. Their expansion plans are typically limited to neighboring cities or provinces, not distant continents. They have neither the wherewithal nor the desire to invest heavily in the United States. Equally significant are the perceived, and sometimes real, political backlash and regulatory risks associated with their investments in the United States. The struggle to operate within the legal, regulatory, and political systems is a mutual concern for China and the United States. Many Chinese executives and government officials remain frustrated by the political controversy or regulatory resistance engendered by a few investments. Conversations with Chinese executives frequently turn to the failed attempt by the Chinese National Offshore Oil Corporation (CNOOC) to acquire Unocal Oil Company or to Huawei's problems with the Committee on Foreign Investment in the United States (CFIUS), the U.S. government's interagency group that reviews investment on security grounds. Consequently, many Chinese executives believe the United States is unwelcoming of Chinese investment, even though the vast majority of Chinese investments in the United States have either been approved or have not required any approval. The Rationale for Chinese Investment in the United States Openness to foreign investment generally benefits the United States, generating high-paying jobs, facilitating investment in research and development (R&D), and strengthening the country's manufacturing base. President Obama recently stepped up efforts to attract foreign investment, expanding the Commerce Department's investment promotion arm and proposing other measures to encourage "insourcing." Given the slow pace of the economic recovery, the United States would benefit hugely from additional FDI. Critics argue that Chinese investment could compromise U.S. security interests and lead to job offshoring. While Chinese acquisition of certain U.S. companies in the defense or technology sectors would create national security concerns, the preponderance of potential Chinese investments in the United States would raise no such issues. Chinese investment would promote new economic activity and expose Chinese companies to Western standards of corporate governance, reporting, and accounting. More FDI would boost U.S. exports to China, as Chinese companies look to their U.S. operations to export back home. Moreover, the jobs created by additional Chinese investment in the United States would help generate greater American support for Chinese investment. Recommendations for U.S. Officials and Companies Clarify and amplify that it is U.S. policy to attract Chinese investment. President Obama has made strong statements about overall U.S. policy toward foreign investment. But to this point, no president, Republican or Democrat, has stated U.S. policy toward Chinese investment as clearly as Vice President Joseph Biden did in October 2011: "President Obama and I, we welcome, encourage and see nothing but positive benefit from direct investment in the United States from Chinese businesses and Chinese entities. It means jobs." President Obama should seize the opportunity with Vice President Xi to state clearly that the United States welcomes Chinese investment and that additional investment is in both countries' economic interest. Bust myths and perceived biases. The vast majority of Chinese investments in the United States do not require any regulatory approval, and a number of important recent deals with Chinese companies that do require it have been successfully approved by CFIUS in the initial thirty-day review period. For example, CNOOC, the same company that encountered opposition in its bid for Unocal in 2005, recently acquired minority interests in both the Eagle Ford Shale (in Texas) and Niobrara Shale (in Wyoming and Colorado) without any controversy. U.S. officials should continue to strictly scrutinize those few transactions that potentially harm U.S. national security. But most Chinese investments have not and should not raise real concerns. Senior U.S. officials should highlight the many successful investments Chinese companies have made during the Xi visit, countering the natural tendency to focus on the most problematic investments. Quantify CFIUS's results. The recent CFIUS annual report said that sixteen transactions involving Chinese firms were reviewed by CFIUS between 2008 and 2010, but did not say how many of these were approved. By showing the number of transactions that were approved, which presumably vastly outnumber problematic transactions, Chinese companies would have more confidence to invest. Remove impediments and irritants to FDI. Policymakers can remove impediments to Chinese investment through improvements in visa and tax policies and procedures. Chinese executives who pose neither a security threat nor a risk of staying in the country illegally still face delays and hassles obtaining visas. Tax policies, such as the Foreign Investment in Real Property Tax Act (FIRPTA), which was adopted in 1980 to curtail Japanese investment in U.S. farmland, now impede foreign investment in the U.S. real estate sector at a time when such investment is needed. Other U.S. laws intended to reduce tax avoidance by citizens and residents have created burdensome reporting requirements that deter foreign investment in the United States. The likelihood of a successful Bilateral Investment Treaty (BIT) agreement in the foreseeable future remains small because of divisions in both governments and because China would find it hard to commit to binding open investment principles. Nevertheless, China and the United States should continue to advance BIT negotiations. Encourage private sector support for Chinese investments. U.S. businesses operating in China can help their Chinese partners navigate complex regulations and allay fears of political backlash. For instance, IBM shepherded Lenovo through the regulatory and political process associated with the sale of its personal computer division in 2005. Other U.S. companies should do the same. Recommendations for Chinese Officials and Companies Further open China to U.S. investment. China, which continues to maintain strict equity caps and sectoral restrictions on inward FDI, should take dramatic steps to eliminate investment barriers. Such actions would benefit the Chinese economy and U.S. investors, and would also increase U.S. receptiveness towards Chinese investment. At the same time, the United States should resist temptation to pursue investment policy based on reciprocity, since inward investment on its own creates economic benefits for the United States. Know the market. Chinese companies also need to be prepared to become more "localized" in the United States. Japan's experience serves as an instructive example. Twenty-five years ago, Japanese investments were erroneously perceived as a threat to the United States. Today, Japanese investment is perceived positively as integral to the U.S. economy. Japanese companies invested in parts of the country that needed jobs, fostered and strengthened relations with local communities, worked with local officials, and partnered with U.S. companies, including through the establishment of joint ventures. Chinese companies can do the same. Conclusion Greater investment by China in the United States is not only a natural evolution in China's economic development; it also yields significant benefits to the economies and welfare of citizens of both countries. More than $1 trillion of FDI is projected to flow from China into the global economy by 2020. President Obama, by articulating the right policies and setting the right tone during the Xi visit, could help ensure that the United States receives a significant share of this investment—for both countries' benefit.

This page is part of the Global Governance Monitor. Scope of the Challenge For twenty-five years, globalization produced unprecedented levels of both economic growth and economic risk. Financial markets became more open, which allowed firms and governments to invest more freely. But as global finance grew bigger, it also grew more complex. Faster-flowing capital became more volatile and economic risk harder to track. Domestic regulators struggled to keep up with evolving financial practices, many of which they did not fully understand. To make matters worse, most national governments refused to cede regulatory authority to a global institution, limiting the extent of international oversight over global markets. International cooperation was based on a patchwork of ad hoc arrangements with limited scope and coercive power. This resulted in an explosion of systemic banking crises, with more than 120 [PDF] taking place between 1970 and 2007. By the spring of 2008, policymakers who were disheartened by the severe impact of these crises began expressing anxiety about the lack of effective regulation of the global financial system, which former U.S. treasury secretary Lawrence Summers said had generated "over one major crisis every three years." The subsequent 2008 financial crisis shook the entire system, plunging the world's developed markets into a recession. Since then, stimulus packages and bailouts have staved off a 1930s-like depression, but the ongoing crisis illustrates the need for a more comprehensive global finance regulatory regime. In 2010, the Group of Twenty (G20) and the International Monetary Fund (IMF) agreed on initial steps toward international regulatory reforms and liquidity support but the G20 has yet to live up to expectations. Fundamentally, two underlying weaknesses in the international financial regime remain. First, there are too many institutions and mechanisms—often with overlapping mandates but limited power. Second, despite this machinery of cooperation, building critical agreement often proves impossible. When states perceive a conflict with their immediate national interest, they repeatedly disagree on fundamental issues, hindering the prospects for cooperative regulation to truly reform the international system. Further crises loom large on the horizon. Strengths and Weaknesses Overall assessment: Improving, but with hiccups After the global financial system collapsed in 2008, policymakers around the world scrambled to respond. The Group of Twenty (G20) designated itself the world's premier forum for economic cooperation, but has struggled to implement necessary reforms. The International Monetary Fund (IMF) was also retooled to better reflect shifts in the global economy. Similarly, regulators from twenty-seven countries forged new rules, known as Basel III, in an effort to prevent similar crises in the future. But despite these efforts, mitigating financial risk and coordinating global economic policy remains a challenge. In 1944, world leaders gathered in Bretton Woods, New Hampshire, to craft a global financial regime based on fixed exchange rates. They hoped the regime would provide the financial stability needed to recover from the Great Depression and World War II. But by the 1970s, the postwar setup had become untenable. A key aspect of international economics is that countries cannot simultaneously have market autonomy, free capital movement, and fixed exchange rates. Once countries running a surplus refused to allow their currencies to appreciate, the United States decided it would rather unhinge the dollar from the gold standard than sacrifice its macroeconomic autonomy, ushering in a new era of floating exchange rates. This new regime produced tangible benefits, allowing major economies to combine national policy autonomy with open capital markets. (Emerging economies that valued stability could still peg their currencies to a major currency, though doing so often required large foreign-exchange reserves). Meanwhile, floating exchange rates stimulated the development of capital markets, opening new opportunities for countries—rich and poor alike—to run large deficits. In the 1970s, major international banks financed deficits in less-developed countries by recycling petrodollars. In the 1980s, surpluses in Germany and Japan financed the U.S. trade deficit—which rose to the then-high level of 3 percent of U.S. gross domestic product (GDP). During the last few decades of unprecedented economic growth and globalization, crises periodically interrupted the expansion of global finance, forcing the international community to develop mechanisms that could prevent or mitigate them. The IMF, and more recently the G20, provided a forum for world economic leaders to address these crises. Nevertheless, achieving consensus on effective collective responses has proven an enormous challenge. For its part, the IMF supplied emergency financing to troubled economies with a primary focus on developing countries, acting as a lender of last resort. In addition to financial assistance, the fund often worked to promote structural adjustment policies designed to reduce the state's economic role and expand free markets. However, with the 2008 global economic recession and subsequent eurozone crisis, the IMF assumed a newly active role in developed economies. However, even as the IMF became a central figure in crisis response, countries also resisted shifting too much power—especially regulatory power—to the fund and similar global institutions. Regulation remained national, though occasionally states coordinated their national regulations to avoid a race to the bottom. One such initiative was a new set of regulations proposed by the Basel Committee on Banking Supervision in September 2010. Known as Basel III, these regulations were created to stabilize national financial systems through strict liquidity controls and capital adequacy requirements. However, these regulations have been postponed twice thus far and are unlikely to be implemented before 2019, at the earliest. Aside from its inability to prevent financial crises, the global financial regime has also been slow to adjust to tectonic shifts in the international distribution of economic power, particularly with regard to the rise of China, India, and other emerging-market economies. In the wake of the 2008 crisis, the G20 emerged as the most promising forum for policy coordination between developed and developing states. Its membership included stalwarts of the Bretton Woods system alongside burgeoning economic heavyweights like China and India. While the G20 produced an initially strong response to the crisis, it has struggled to bolster its initial success with strong implementation and further agreements. Policy disagreements emerged between developed and developing countries, as well as among major developing economies, which have distinctive interests and outlooks. In particular, the United States Federal Reserve's policy of quantitative easing and questions regarding China's currency manipulation represent continued threats to international financial cooperation. The continuing eurozone crisis, and in particular the financial and political turmoil in Greece, Spain, Italy, and Cyprus overshadow efforts to solve the debt crisis. Japan's recent devaluation of the yen also led to fears of a currency wars between G20 countries. Instrumentally, there has been a long struggle to strengthen agreed-upon frameworks for financial regulations with a continually fragmenting international architecture of national and regional policies including a financial transaction tax in Europe, Dodd-Frank Act the United States, and Basel III requirements all being implemented to varying degrees. The World Bank and IMF have also attempted to enhance the role of developing nations in policymaking processes. Both institutions have endorsed voice and quota reforms aimed at increasing the voting power and influence of developing economies, though implementation remains limited. Indeed, recent efforts to reform shares in the international financial institutions have progressed slowly. Even if the changes had occurred, the voting share of traditional advanced economies would only decrease by 2.6 percent. With that said, the World Bank, which released an external review [PDF] in October 2009 with proposals for governance reforms, successfully increased voting shares for developing and transition countries across its various groups: The International Bank for Reconstruction and Development (IBRD) increased voting shares by just over 3 percent, while the International Finance Corporation (IFC) and the International Development Association (IDA) raised voting shares for developing states by approximately 6 percent. In sum, although the reform in favor of developing countries enjoys broad international support, proportional representation remains a distant goal. More often than not, however, advanced economies have not agreed on the right response to crises. Some believe that international institutions need more firepower to help tame global markets. Others worry provisions for crisis insurance would reduce incentives for investors and countries to avoid crises themselves. Some emerging economies, for their part, often trust in national self-help, building up large reserves, and in some cases limiting capital flows, rather than relying on global institutions. Coordinating macroeconomic policies and exchange rates: A weak system since 1973 One major shortcoming of the global financial architecture is the lack of a robust mechanism to allow the world's economies to coordinate their macroeconomic policies. This gap has become acute in recent years and encouraged massive structural imbalances leading some to question the future of the U.S. dollar as the primary global reserve currency. While the global financial crisis encouraged provisional efforts to rationalize currency exchanges, these have not been institutionalized. During the Bretton Woods system, the dollar's value was linked to gold and other currencies were pegged to the dollar—providing an international framework for monetary policy. But when Bretton Woods collapsed in 1971, no mechanism of multilateral coordination emerged to replace it. By 1973, the unprecedented buildup of foreign-exchange reserves by emerging-market economies led some countries to declare the emergence of a new Bretton Woods system marked by unilateral pegs to the dollar. The currency gap has become particularly acute in recent years, promoting massive structural imbalances between surplus and deficit countries. As a result, the United States, as an importer, consistently runs up current account deficits of $500 billion to $1 trillion while Asian commodity exporters rack up large surpluses. The current account surplus of China alone rose from $20.5 billion in 2000 to more than $190 billion in 2012. The most recent financial crisis fostered unprecedented levels of macroeconomic cooperation among the world's major economies. In the immediate aftermath of the crisis, many countries passed fiscal stimulus packages to foster economic growth. Subsequently, the Group of Twenty (G20) demonstrated its potential as an international focal point for macroeconomic coordination by embracing the Framework for Strong, Sustainable, and Balanced Growth [PDF] at its September 2009 summit in Pittsburgh. In adopting the framework, G20 members agreed to undertake close macroeconomic coordination, including of their macroeconomic and fiscal policies; harmonize the national stimulus plans and "exit" strategies; and correct longstanding imbalances between surplus and deficit countries, which had contributed to the crisis. To encourage progress on the framework—and permit G20 members to evaluate one another's progress in achieving their espoused goals—the G20 established the Mutual Assessment Process (MAP), in close coordination with the IMF. Thus far, the first three phases of MAP have been successfully completed. Before the June 2010 G20 Summit in Toronto, the IMF aggregated G20 nations economic policies, analyzed barriers to growth, and drafted "alternative policy scenarios" that would lead to further growth. In response, G20 nations launched a second stage of MAP to draft recommendations for international policy coordination, which were agreed upon during phase three in February 2011. The final stage, which began in April 2011, assessed member nations' progress and guided the action plan at the November 2011 Cannes G20 Summit. The resulting Action Plan for Growth and Jobs highlighted international consensus toward the importance of tackling international unemployment. Specifically, the plan includes the creation of a G20 task force on employment with a focus on youth employment. Presently, however, "available data [PDF] for seventeen countries suggest the overall youth employment situation remains critical." Beyond the G20, other international organizations like the Group of Eight (G8), the United Nations, and regional development banks provide venues for economic policy coordination. Still other institutions including the Organization for Economic Cooperation and Development (OECD), and the Bank for International Settlements (BIS) further cooperative action by providing governments with consultative forums, analytical support, and financial guidelines. Through dialogue in the aforementioned organizations, as well as through direct diplomacy, major economic powers have pursued monetary policy coordination. The United States Federal Reserve, Bank of England, European Central Bank, and People's Bank of China implemented a round of coordinated interest rate cuts in late 2008, though analysts doubt whether their success will tame investor jitters. In late 2008, the Federal Reserve also gave European banks unprecedented access to U.S. dollars to hedge against consumer withdrawals. Yet monetary policy is not only a cooperative tool—it also serves competitive purposes. Facing difficult economic conditions at home, states have used monetary policy to pursue national prerogatives. Issues of currency valuation have long caused tension between the United States and China, resulting in entrenched nationalist positions and lost opportunities for further macroeconomic alignment. The controversy has also caused bitterness among emerging economies like China and Brazil. Recently, the Japanese devaluation of the yen and French worries concerning the overvalued euro raised fears of competitive devaluations. In the G20 and elsewhere, these conflicting interests have become an impediment to meaningful action on financial reforms and overshadowed a recent meeting of bank governors finance ministers in Moscow. Discord arises not only from the repercussions of international competition, but also from fundamental disagreement on how to rebalance the system. The United States believes that policy changes in major creditor countries, such as the appreciation of the Chinese yuan, can address the world's imbalances without structural change. Competitors like China, however, advocate broader changes for the international financial architecture, including a shift away from dollar reserves. Monitoring and regulating financial standards and financial activity: Insufficient consensus to prevent further global crises Another major weakness of the global financial system is the lack of a coherent set of rules for monitoring, regulating, and standardizing financial activities, particularly at the cross-border activities of systematically significant actors. The current system entails an uneven patchwork of oversight efforts and entities, sometimes with overlapping mandates and jurisdictions. As a first step toward tackling this problem, the Basel Committee announced and a new set of Basel reforms for the banking sector. Known as Basel III[PDF], they aim to create a more coherent regulatory framework by increasing transparency in the financial markets, preventing diversion of resources, and tracking potentially excessive risks—with the intension of spotting rotten players (or practices) and quarantining them before they infect the entire system. Prior to any regime being installed, participants must agree that they want to limit excessive risk-taking in the first place—a difficult precondition to set. One school of thought holds that regulations give investors false comfort and thus leads them to pay too little attention to the risks of lending to a regulated institution. Others argue that regulation introduces distortions that lead to bad investment decisions. Financial policymakers first realized the need for more transparency and accountability in the mid-1970s. The first international banking crisis of the postwar era prompted the creation of the Basel Committee on Banking Supervision, which was charged with coordinating national banking supervisory policy. In the 1980s, the debt crisis revealed that many large international banks did not have the capital to absorb an outright default on their loans, leading to almost a decade of rescheduling—or revising repayment timeframes—to give the banks time to build up their capital. In an effort to avoid these crises, the Basel Committee adopted common standards for evaluating risk-weighted capital. After the Asian financial crisis, similar attention shifted to improving the quality of bank supervision in emerging economies. In 1997, the Basel Committee released its Core Principles for Effective Banking Supervision [PDF] and the IMF, in conjunction with the World Bank, began to systematically assess supervision in its macroeconomic health checks through the Financial Sector Assessment Program. The Basel Committee announced its newest round of banking regulations, Basel III, in September 2010 as a response to the economic crisis. A month later, at the 2010 Seoul Summit, the G20 endorsed the new rules, emphasizing their function in stabilizing market fluctuations and lowering the financial risk and fallout emanating from the failure of large banks. The rules require banks to hold higher levels of tier-one capital and establish countercyclical buffers to offset potential fluctuation. Unfortunately, banking regulation moves slowly and are subject to repeated delays with Basel III now not going into effect until 2019 [PDF]—allowing known systemic risks to exist unregulated. While important to the global regulatory regime, the sclerotic pace of and delays to implementation make the Basel III regulations an unwieldy tool for much-needed reform. Several similar arrangements emerged in the securities, insurance, corporate governance, accounting, and auditing sectors. Additionally, the Joint Forum of Financial Conglomerates and the Financial Stability Board (FSB) promote overall coordination and cooperation by regularly bringing together overseers of the global financial system. At the November 2011 Cannes Summit, the G20 strengthened the purview of the FSB, giving it legal standing and buttressing its financial institutions. The OECD and the World Bank have also pitched in, leading international discussions on corporate governance standards, insolvency, and bankruptcy. Nonetheless, obvious flaws remain in the global regulatory structure. Regulation remains overwhelmingly national or regional with weak, external verification and assessment mechanisms. No organization has the power to enforce compliance with agreed standards—or to sanction countries that fail to live up to global standards. Even recent systemic regulatory measures like the Basel III banking reforms are subject to national implementation, the extent of which will determine the speed and strength of its entry into force on the international level. For example, Russia is only now, in 2013, approaching achievement of the Basel II regulations. The acceptance of global standards will remain subordinate to the perceived competitive edge of national financial sectors. Additionally, important new financial players have fallen through the cracks. Central banks, finance ministries, and bank regulators, were surprised to discover the extent to which new actors in the shadow financial sector—which consists of unregulated special-investment vehicles and broker-dealers—had taken on the risks associated with subprime mortgages. There are increasing efforts to place these actors under new regulatory mechanisms—including EU restrictions on short selling, credit default swaps, and new taxes on financial transactions, as well as laws mandating greater transparency for hedge fund transactions and controls on executive compensation. Managing financial crises: Progressing, but overarching concerns remain Under the current global financial regime, the world has found itself vulnerable to severe financial crises but unable to manage them successfully. The International Monetary Fund(IMF) is ostensibly the premier fire-fighter in these circumstances and is charged with mitigating economic tensions in the aftermath of financial crisis. Even so, individual states have created their own dizzying array of bilateral and multilateral arrangements to help cushion against financial crises, as the eurozone crisis aptly demonstrates. Excessive volatility in financial flows has become a hallmark of the global economy. In some cases, countries suddenly lose access to market financing and find that they can no longer finance substantial deficits. Likewise, short-term financing for financial institutions can dry up equally fast—be they special-investment vehicles that have to roll over short-term asset-backed commercial paper, U.S. broker-dealers that rely on the repo market to obtain financing from money market funds, or European banks that rely on the wholesale market. At the start of the global economic crisis, the reliance of Iceland's banks on short-term borrowing in foreign currencies sent the country's entire economy into a tailspin once instability in European markets began. Meanwhile, financial contagion affects weak and strong investments alike. Losses in one portion of a portfolio may prompt a leveraged institution to sell other assets, pushing the price of healthy assets down. Once investors begin confusing sound investments with unsound ones, financial institutions can lose confidence in one another and the system upon which their short-term borrowing costs rely. To reduce this uncertainty, the IMF is the principle institution for managing financial crises. The IMF took on some of the functions of lender of last resort when currency crises swept the developing world in the 1990s. It created two emergency credit facilities, the Supplemental Reserve Facility of 1997, and the Contingent Credit Lines of 1999 to facilitate faster financing for governments and markets judged to already have relatively sound policies. When developed nations required assistance during the most recent financial crisis, the IMF was able to draw upon these facilities and past experience. Following the model from the the developing world's currency crises in the 1990s, the IMF created the Short-Term Liquidity Facility of 2008 to more rapidly inject capital into relatively stable financial systems. Again, in 2010, the IMF and the European Central Bank approved a package of $930 billion to provide stability to eurozone countries. In December 2011, the eurozone again sought IMF assistance to craft a new massive bailout fund of $260 billion, but when Britain refused to contribute, the combined IMF-EU bailout fund only set aside $200 billion. With that said, the IMF issues its loans with a variety of conditions, which often impose fiscal austerity on crisis-battered societies. While many in the developing world have long regarded the IMF as a tool for developed nations to control developing nations, the fund's eurozone bailouts have generated resentment in Europe, too. In fact, portions of European publics, in particular, demonize the IMF for its strict demands of austerity. Furthermore, IMF critics still question the discretionary nature of its interventions as the institution lacks clear standards for determining how much financing countries should receive. Some economists even argue that the existence of the IMF prompts governments and investors to pursue reckless policies because they know they can receive IMF loans if their investments fall through. Unlike domestic lenders of last resort, the IMF's lending capacity is limited by donor contributions contingent upon internal voting processes and the feasibility of issuing new Special Drawing Rights (SDRs). As one expert notes, "Neither the IMF nor the Bank for International Settlements nor any other international organization has the authority to create and extinguish reserve money." Past concerns with the IMF prompted a slew of new bilateral, regional, and multilateral institutions—including the Brady Bonds, the Chiang Mai Initiative, and the European Central Bank—all aiming to supply a troubled country with the foreign exchange currency it needs in a crisis. In the European case, a multinational currency—the euro—and its accompanying policy infrastructure enabled the EU to oversee regional crisis management with aid from the IMF. Thus far, the IMF has provided traditional conditional loans to Iceland (its first loan to a developed country since the 1970s), as well as to Hungary, Ukraine, Pakistan, Latvia, Romania, Ireland and Portugal. To quell fears that the post-2008 wave of lending would exhaust the IMF's resources, the G20 and a few emerging market economies agreed to expand the New Arrangements to Borrow, providing the IMF with up to $500 billion in supplementary financing in March 2011. The IMF's members also authorized a Special Drawing Rights allocation, which expanded the IMF's global pool of reserves by giving each member additional reserves in proportion to their contribution to the IMF. However, the IMF's spending on eurozone bailouts and countries' failure to match rhetorical commitments with cash, has caused the IMF to fall short of that target. At the 2012 spring meetings of the World Bank and International Monetary Fund (IMF), the world's finance ministers agreed to increase the IMF's lending power by $430 billion, but doubts remain whether it will be enough to contain the crisis. Supporting Development: Some progress, but still starving for aid and investment A final shortcoming of the current global architecture is the disproportionate effect financial crises have on development assistance to developing countries. Poor countries are vulnerable to negative spillover effects that culminate in rampant poverty, mass unemployment, and food shortages. Over the years, multilateral development agencies and the International Monetary Fund (IMF) have refashioned their policies to support financial sector stability and growth, and to encourage financial activity through incentive programs. However, the demand for aid in developing countries remains tangible. Multilateral efforts to address the needs of the developing world extend back to 1945, when the architects of the Bretton Woods system created the World Bank to support postwar reconstruction. Many capital controls were dismantled, and private capital markets emerged as an alternative source of long-term financing. But countries with rudimentary financial and banking infrastructure or unstable governments still struggled to attract private investment on any but the most onerous terms. Meanwhile, concerns that development failure might spillover into neighboring economies created a demand for multilateral development support. Subsequently, the World Bank increasingly focused on helping the world's poorest economies, and in 1960, it set up its International Development Association, or so-called soft loan window to finance developing countries. Today, the World Bank continues to make loans to middle-income countries with access to private markets. These loans are priced commercially so they provide the World Bank with a profit, part of which is used to subsidize concessional assistance to poorer countries. In addition to being a financial intermediary, the World Bank has become a center of knowledge: it disseminates lessons learned from its experience of maintaining programs in dozens of countries from a variety of programs including its Poverty Reduction Strategy Papers. Regional development banks have also undertaken similar objectives. States, too, offer bilateral official development assistance (ODA) from donor countries and have helped support development goals in poor countries. However, too often bilateral ODA suffers [PDF] from a lack of harmonization and host country-ownership. Despite boosting funding levels in recent years, the increased number of actors involved—from donor states to nongovernmental organizations and philanthropic foundations—has increasingly fragmented the sources of financing for development projects. Additionally, weak capacity and corruption in recipient states often lead to ineffective implementation and squandered resources. These challenges make it difficult to account for success on the ground. In recent years, the developing world gained another source of financing: government-backed firms from Europe, the Middle East and Asia. Such investment, together with renewed private investment in mines and oil fields driven by high commodity prices, pushed investments and loans to Africa from $9 billion in 2000 to $62 billion in 2008. These investors offered governments an opportunity to sidestep the transparency requirements, performance monitoring, and governance rules attached to loans from development banks or Western ministries. The G20 also formally introduced development as a key issue to its agenda in November 2011 (which the Group of Eight had previously included on its agenda). The final communiqué agreed not to tax or restrict food destined for the United Nations World Food Program, established a task force to address youth unemployment, and enumerated steps to increase global agricultural output. However, in 2009, development assistance from industrialized countries dropped for the first time since 1997. In sum, development efforts fall short of fulfilling commitments outlined at the 2005 World Summit. Domestic financial policies in low- and middle-income countries need to become more countercyclical and targeted [PDF] to address systemic vulnerabilities in their national financial markets. As noted above, development banks, the IMF, and new financial institutions will inevitably play a critical role to keep these economies from contracting as the global financial crisis runs its course. Financial Policy Issues Introduction: The United States has been a champion of free markets, the architect of the Bretton Woods system, and home to one of the world's leading financial capitals. Despite evolving from the world's leading lender to the world's largest borrower, the United States has been the major promoter of a liberalized global financial system. Many therefore saw the United States as the major culprit of the 2008 financial crisis (though others blamed the crisis on global sources). Does global finance need sweeping regulation? Yes: Crises arise, in part, due to a lack of regulatory oversight in markets. To prevent their occurrence, the world needs to devise and implement a set of monitoring and enforcement guidelines. After the financial crisis hit in 2008, the Financial Stability Forum—now the Financial Stability Board (FSB)—produced a blueprint [PDF] for global reform. In June 2010, leaders from the Group of Twenty (G20) pledged to pursue a "better regulated" financial system based on four pillars: (1) a strong regulatory framework; (2) effective supervision; (3) addressing the systemic problems involving important ally institutions; and (4) transparent international assessment and peer review. The FSB is monitoring implementation of G20 recommendations for increasing financial stability and assesses [PDF] that efforts are progressing. In September 2010, financial authorities from twenty-seven countries also forged new rules known as Basel III to require larger holdings of low-risk capital reserves, thereby reducing systemic risk. However, individual nations are responsible for implementation, and spotty compliance points to the inadequacy of currency regulations. At the June 2012 Los Cabos G20 Summit, little progress was made to boost compliance with Basel III regulations. In December 2012, it became clear that compliance with the agreed-to Basel III would be further delayed in the United States and Europe amid fears that its implementation might hinder growth. No: Few question the need for reform, but some caution against going too far. Excessive restrictions and government interference might slow economic recovery by suffocating creative market dynamism. If the government's hand reaches too deep, politicians and policymakers may be tempted to use regulations to pursue their own agendas, creating dangerous distortions in resource allocation. In sum, these critics argue that the painful recession should not make us forget the remarkable results of the past twenty-five years. Stifling financial innovation would be even more costly than the financial crisis. Others argue that instead of regulating institutions that are "too-big-to-fail," the system needs to be made safe for failure—allowing markets rather than regulators to discipline financial institutions. Still others worry that reforms may concentrate too much power in the hands of a few regulators, such as the Federal Reserve, without eliminating the risk of regulatory capture. Moreover, adding new mandates to existing institutions could draw energy and attention away from traditional duties. These voices consequently favor limiting the Federal Reserve's regulatory responsibilities. Should regulation come through a new global architecture? Yes: Despite calls from some analysts who argued as early as 1984 that global financial markets could not sustain itself in the long term, proponents have only now begun to rally support for a global financial governance regime. European leaders have been particularly vocal, with former European Central Bank president Jean-Claude Trichet urging increased vigilance and a three-pronged approach based on "macroeconomic discipline, monetary discipline, [and] market discipline." The deep impact of the 2008 financial crisis has persuaded some economists and policymakers to favor a comprehensive financial architecture that looks not only at banks and coordinating macroeconomic policies, but also at the shadow financial market, including enhanced regulation and transparency of investment banks and derivatives. Other analysts have added to the plea by pointing out that the current financial system is too big to be rescued by one national government, and needs a more robust governance body to offer viable rescue packages. No: Critics of a new Bretton Woods approach believe that the ills of global finance can in large part be cured at home. National policies, they argue, will do more to address the key problem of excessive bank leverage than new global rules. "It's worth remembering that after the last global crisis in 1997-98, there was lots of grand talk about a new international financial architecture," Sebastian Mallaby writes, but in the end, "the only important reforms were national ones." Looking at the aftermath of the Asian financial crisis, the Economist argues that huge foreign reserves, flexible exchange rates, and stronger banking systems proved more powerful than international initiatives in spurring economic recovery. Others, such as former U.S. treasury secretary Henry Paulson, believe that new, intrusive international rules will not only be useless, but also damaging, because they will inevitably rely on a one-size-fits-all approach. Moreover, a final group argues that, regardless of whether a theoretical global system would work, it will never see the light of day because countries will simply refuse to turn over real power to international regulators. Should there be more support for global rebalancing? Yes: Many analysts agree that a root cause of the latest financial crisis has been the global imbalances that have been accruing since the 1990s. As current account discrepancies between exporting and importing countries grow larger, the need for rebalancing solutions becomes more imperative. Supporters of global rebalancing efforts feel that larger structural changes need to occur to correct these imbalances. Surplus countries, particularly China and Germany, need to save less and stimulate domestic demand and the United States must save more and increase the role of exports in its economy.The trend of global trade balance corrections since 2008 relied on unsustainable large fiscal stimuli and has already reversed. No: Critics contend that a global correction is already under way and that the market naturally tends toward equilibrium. The 2008 financial crisis has driven global demand lower, contributing to a decline in the U.S. trade deficit, a higher savings rate among U.S. households, and a correction in the U.S. exchange rate. Moreover, if countries were to pursue coordinated policies to tackle global imbalances, the question of who would be tasked with spearheading these efforts remains unanswered. The Group of Twenty (G20) has not adequately addressed concerns, and the recent summit in Los Cabos, Mexico represents a continued failure in these efforts. Some also believe that the informal institution may also be too big to prescribe consensus-based global rebalancing policies. Recent Developments January 2014: Higher IMF growth forecast The IMF revised its 2014 global growth forecast upward in January by 0.1 percent to 3.7 percent. In a shift from recent years, stronger performances by advanced economies, rather than emerging markets, are fueling global growth. The modest growth rates predicted for much of the developing world may slow even further in response to improvements in the U.S. economy as tighter U.S. monetary policy could redirect capital flows toward the U.S. market. January 2014: Doha Round ends The moribund Doha Round trade round was finally brought to a close in Bali, Indonesia. The Bali deal focuses on "trade facilitation", addressing inefficiencies in customs procedures. The agreement, however, fails to settle many other long-standing points of contention among WTO member states, nor is it likely to shift the international trade landscape decisively in favour of multilateral agreements, away from increasing popular bilateral and plurilateral agreements. September 2013: G20 Summit The eighth G20 Summit was held in St. Petersburg, Russia, from September 5-6. Unfortunately, tensions over the international response to the conflict in Syria overshadowed meaningful progress on the economic agenda. The outcome document from the Summit did not outline concrete steps on more critical issues like remaining regulatory challenges, but did include an extended commitment to refrain from protectionist measures and points of agreement on addressing the challenge of tax havens. May 2013: Dow Jones at record high On May 7, the Dow Jones Industrial Average closed above 15,000 points for the first time. Quantitative easing from central banks, low interest rates, and recent positive figures related to unemployment and productivity has each contributed to this record high. It remains unclear whether this trend will continue or whether it characterizes the end of the global financial crisis. It does, however, represent a significant expansion of the index from 13,000 points immediately before the crisis began and a doubling of the index from its lowest point under 7,000 points in early 2009. April 2013: World Bank targets extreme poverty Global finance officials endorsed a World Bank target to end extreme poverty by 2030 at the Spring Meetings of the World Bank and International Monetary Fund. The goal is to have only 3 percent of the world's populations classified as being in "extreme" poverty (with average consumption below $1.25 per day) and creates poverty reduction strategies to serve the bottom 40 percent of the population of each country in the developing world. This goal was created against the backdrop of new statistics that suggest extreme poverty has been reduced to 21 percent in 2010 compared to 43 percent in 1990 and the recent discussions reflected concerns that climate change and environmental protection were essential to achieving its goal of reaching 3 percent by 2030. This effort will likely coincide with the United Nations' effort to create a post-2015 development framework to replace the Millennium Development Goals. March 2013: U.S. sequestration U.S. lawmakers failed to make a deal to prevent significant budget cuts to U.S. government discretionary spending. These cuts to defense programs, research, and education programs took place despite warnings that they would affect both domestic and international markets and slow growth in gross domestic product by half a percentage point. These cuts remain ongoing with their full force not expected to take hold until later in the year. February 2013: Currency wars A devaluation of the Japanese yen triggered fears of a currency war among developed and developing states in early February. Japan's new fiscal and monetary policies apparently targeted a lower exchange rate to reinvigorate a stagnant economy. This development coincided with a rapidly strengthening euro that put a six-month long recovery in jeopardy. The prospect of a currency war between members of the G20 led to fears of increased protectionism that would unravel the international financial architecture built in the aftermath of the financial crisis. These fears overshadowed February's G20 Finance Ministers and Central Bank Governors Meeting. At this meeting, however, the group made clear that they would not devalue their currency in search of improving their respective balances of trade. Options for Strengthening the Regime Introduction he 2007-2009 economic crisis, followed by the sovereign debt traumas in Europe, has triggered a variety of operational and normative challenges in both finance and economics. The United States and other major economies are being pressured to find effective strategies that remedy financial instability, through both measures at home and international cooperation. Strengthening multilateral mechanisms remains the foundation for responding to financial crises, but importance must also be placed on coordination of domestic policies, particularly among the top twenty industrialized nations. These recommendations reflect the views of Stewart M. Patrick, director of the International Institutions and Global Governance program. In the near term, the United States and its partners should pursue the following initiatives to ensure the global recovery is a success: Revitalize Group of Twenty (G20) action on global economic imbalances During the April 14-15, 2011, Group of Twenty (G20) meeting of finance ministers and bank governors in Washington, DC, the group agreed on a two step process to reduce persistently large imbalances between countries with current-account surpluses (notably China) and those with deficits (notably the United States). The plan also charged the International Monetary Fund with identifying factors that drive countries to accumulate massive surpluses or deficits. However, building unanimous consensus on the outcome of these independent assessments is notoriously difficult. The risk is that national politicians will despair of a multilateral solution and will resort to unilateral sanctions, as suggested by a bill in the U.S. Congress that would punish China for alleged currency manipulation. Because unilateral measures could result in retaliation and escalation, the United States and its partners must display leadership by affirmatively supporting the G20 process. Both China and the United States recognize that it is in their own interest to address imbalances, so an international understanding about benchmarks of progress should not be impossible. Unfortunately, G20 leaders made only limited progress on these issues due to heightened tension over the eurozone and their own economic concerns. Bolster IMF in fighting liquidity crises The United States should support France's proposal [PDF] to bolster the IMF's role in helping countries respond to liquidity crises. Stronger IMF responses to liquidity crises would decrease the motivation for vulnerable countries to stockpile excessive reserves as a precaution in case of a sudden capital outflow. An increasing number of emerging economies are practicing precautionary reserve accumulation—which contributes to macroeconomic imbalances and mispricing of financial risks. As the U.S. dollar is the currency of stockpiled reserves, widespread reserve accumulation drives up the value of the dollar, widening the U.S. current-account deficit. A larger IMF, and one that stood ready to lend rapidly and without excessive conditions, would reduce the incentive to unilaterally accumulate cash reserves. In effect, collective insurance would displace individual insurance. Implement IMF governance reform Leaders at the 2010 G20 Seoul summit agreed to increase the voting shares of emerging economies at the International Monetary Fund (IMF) by 6 percent, and give more seats to developing countries on the IMF Executive Board. However, these reforms missed the deadline for actual implementation, which was slated for October 2012. An additional challenge continues to be negotiations within Europe to decide which European nations will give up seats on the executive board to allow for emerging economies. The United States needs to continue to pressure its partners in the G20—especially those European countries hesitant to acquiesce—toward implementing these and future reforms. A timely increase in the voting shares of emerging economies will reinforce the sense of ownership that these countries feel toward the IMF. That, in turn, should encourage them to have faith in the IMF's ability to provide liquidity in a crisis, and should dampen the temptation to unilateral reserve accumulation. Provide assistance to support the European recovery Despite positive developments toward the end of 2012 alongside the eurozone's recently negotiated banking union, Europe's economy remains deeply troubled. Those countries that embarked upon fiscal austerity face low growth rates and grim forecasts. Further, any movement toward fiscal union has been postponed until the summer of 2013 while the European Union has been dealt the blow of a potential British withdrawal amid its fraught budget negotiations. With France's new Hollande government looking inwards (and asking for a loosening of the EU's foundational Stability and Growth Pact) and Germany's leadership no longer a driving force toward consensus due to upcoming elections, there is a tangible leadership vacuum. This was clear during the unfolding banking crisis in Cyprus that has huge ramifications for European investors but that has received a lackluster response from the EU and International Monetary Fund, who failed to craft a financial rescue package that would not affect depositors and launch damaging capital controls on Cypriot banks. While the worst may well have passed, the European economy remains an anchor in the international economy and remains in need of fiscal stimulus and a nudge toward pro-growth strategies. Improve regulatory standards to mitigate financial risks Experts and policymakers have placed much of the blame for the financial crisis on weak regulatory standards and inadequate supervision of sophisticated financial activities. Although progress has been made, particularly through the creation of the Financial Stability Oversight Council in the United States and the European Systemic Risk Board in Europe, the complexity and integrated nature of modern finance continues to pose unprecedented challenges. Responding to the crisis, the Financial Stability Board (FSB), formerly the Financial Stability Forum, has provided [PDF] a set of proposals to "restore confidence in the soundness of markets and institutions." Though the 2011 G20 Cannes Summit endowed the FSB with a "legal personality," its recommendations remain advisory, and have no legally binding enforcement mechanism. Beyond the aforementioned near-term steps, the United States should consider another set of important proposals:These recommendations reflect the views of Stewart M. Patrick, director of the International Institutions and Global Governance program. Implement Basel III regulations The recently released Basel III regulations require banks to hold higher levels of tier-one capital and develop countercyclical buffers to cushion against future financial turbulence. Implementation of the reforms requires national supervision and the willingness of individual financial institutions to adhere to the new standards. The established timeframe for banks to meet requirements, on some measures lasting until 2019, means that there will be plenty of opportunities for global progress on Basel III to slow or falter. The IMF has recently criticized the European Commission's efforts to implement Basel III regulations as "too weak" and "a disappointment." In addition, the approaches to national enforcement may be altered by local political and economic concerns, leading to an inconsistent application between countries over that period. To some extent, differences in implementation may be justified. But it is vital that legitimate differences in implementation of capital and regulatory standards do not open the way for a regulatory race to the bottom. Finance the developing world The economic recession that followed the global financial crisis had a serious effect on developing countries. Export demand collapsed, commodity prices fell, and the flow of both remittances and private capital shrank. The World Bank estimates that in the first year of the crisis alone, 130 to 155 million people fell into extreme poverty. The period 2009-2011 saw a sharp rebound for emerging economies, especially commodity exporters that took advantage of resurgent prices and red-hot demand in China. But the extremes of the recent cycle demonstrate the value of public-sector development banks that can lend in a countercyclical fashion. Thus, in addition to commitments to the IMF, the United States and its industrialized partners should continue its commitment to multilateral financing for development banks and encourage private sector investment flows.

Overview The recent rapid growth of the offshore renminbi market presents a puzzle for analysts of China's development strategy. By allowing renminbi to flow offshore uncontrolled before loosening government controls over internal financial markets, Chinese officials are straying from the normal sequence of steps toward currency internationalization. Why might that be? In this Center for Geoeconomic Studies Working Paper, produced in association with CFR's International Institutions and Global Governance program, Peter Garber seeks to answer that question by investigating what drives offshore renminbi markets and how they are evolving.

Overview The twentieth century saw the rise of the U.S. dollar, the German mark, and the Japanese yen as international currencies. Now the Chinese renminbi is on a similar course toward reserve currency status, but its path is deviating from those of its predecessors in both aim and intent. In this Center for Geoeconomic Studies Working Paper, produced in association with CFR’s International Institutions and Global Governance program, Professor Jeffrey Frankel explains how the renminbi’s ascent is without historical precedent and why China might be pursuing such an unorthodox strategy.

Overview Internationalization was a spontaneous outcome of the marketplace for the rest of the world’s major currencies, but China is breaking with history by making it official policy to steer the renminbi on a path toward reserve currency status. However, this managed internationalization occurs at a time when China’s financial development is still in a transitional phase featuring capital controls and other constraints on credit growth and allocation.  In this Center for Geoeconomic Studies Working Paper, produced in association with CFR’s International Institutions and Global Governance program, Robert McCauley explores the policy challenges facing Chinese authorities as their pursuit of an internationalized renminbi threatens to undermine the effectiveness of their domestic financial market controls.

Overview China is making swift strides toward internationalizing its currency, the renminbi, but it must be careful when sequencing these changes. Without the proper reforms, wide-open Chinese financial markets would be vulnerable to massive flows of foreign capital that could send China into the throes of financial crisis. In this Center for Geoeconomic Studies Working Paper, produced in association with CFR’s International Institutions and Global Governance program, Professor Takatoshi Ito examines the progress of the renminbi’s march toward international status and evaluates the possible paths forward.

Overview Financial crises in the 1930s and 1970s showed the world that economic instability results when demand for international liquidity allows a small number of countries to run up massive debts in their own currencies. Named for the economist who first described the scenario in the 1960s, this “Triffin Paradox” threatens the global financial system again today as demand for reserves has skyrocketed among emerging market economies. In this Center for Geoeconomic Studies Working Paper, produced in association with CFR’s International Institutions and Global Governance program, Professor Alan Taylor considers whether China might play a larger role in stabilizing the world economy by supplying a reserve asset of its own—an internationalized renminbi.