About the Author
Born in Henan province of China in 1945, Zheng Xinli is Deputy Director of the Committee for Economic Affairs of the Chinese People’s Political Consultative Conference (CPPCC) and Permanent Vice Chairman of the China Center for International Economic Exchanges (CCIEE). Concurrently, Zheng also serves as President of the Chinese Industrial Economic Association, and is a PhD supervisor at the Graduate School of Chinese Academy of Social Sciences.
After graduation from Beijing Institute of Iron and Steel Technology in 1969, Zheng Xinli first worked at Tangshan Metallurgical & Mining Corporation as a technician and then as Deputy Director of the General Office from 1970 to 1978. Zheng pursued his postgraduate study in industrial economics at the Graduate School of Chinese Academy of Social Sciences (CASS) from 1978 to 1981. With a Master’s degree in economics from CASS, Zheng has served successively at the Secretariat of the Central Committee of the Communist Party of China (CPC) as Investigator of the Economic Department and Deputy Director of the Economic Department from 1981 to 1987, at the State Information Center as Deputy Chief Economist from 1987 to 1990, at the State Planning Commission (SPC) as Deputy Director of the Policy Research Department, Director of the Policy Research Department, Deputy Secretary-General and Spokesperson of SPC from 1990 to 2000, and at the Policy Research Office of the CPC Central Committee as Vice Chairman from 2000 to 2009.
Zheng Xinli has authored many books, including On Containing Inflation and Expanding Domestic Demand; New Economic Growth; Reform：China’s Second Revolution; The Chinese Economy in the Early 21st Century, and Paths to New Industrialization.
Zheng Xinli is also editor-in-chief of Development Economics, The Handbook for Modern Policy Research, Chinese Economic Analysis 2009, World Economic Analysis 2009.
Zheng Xinli’s major papers include Transforming Economic Growth Pattern: The Fundamental Way to Address the Crisis’, Scientific Advancement and Transformation of Growth Pattern, Adjusting Income-distribution Structure, Reinforcing Expansion of Domestic Demand, Making Use of the Government and the Market Functions, Confronting the Crisis.
A financial crisis that originated in the U.S. in the latter half of 2008 has swept the world like a tsunami. What led to this crisis? Economic imbalance caused by international trade? Financial bubbles and over-use of leverage? Sovereign debt crisis? The answer is none of the above. Rather, the real reason is that the U.S., as the major reserve currency issuer in the world, has been misusing its sovereign credit for a long time and implementing a twin deficit policy to maintain its domestic over-consumption and government over-spending, which paved the way for the financial tsunami. Moreover, with their monopoly positions, American credit rating agencies covered up credit risk and misguided international capital flow, which led to the fall of the last defensive wall against financial risk.
To prevent a similar crisis in the future, the following approaches should be considered: ① strengthening overall regulations on financial industry, and rebuilding the firewall between banking system and capital market; ② breaking up global monopoly by credit rating agencies and establishing an objective and fair sovereign credit rating system; ③ enabling international financial institutions to regulate the world’s major reserve currency issuer; ④ establishing an international reserve currency system characterized by mutual competition and diversity. In addition, in order to ensure global safety and development, we should further expand international cooperation by 1) reinforcing monitoring and early-warning for global financial risk, 2) assessing and revealing deeply-indebted countries’ financial and credit risk, 3) managing financial risks through cooperation and mutual development between developed and developing countries, and 4) strengthening financial supports to green technology and economy.
The Financial Tsunami: Its Origins and Prevention
By Zheng Xinli
Since the second half of 2008, a financial crisis that came out of the blue in the U.S. has swept across the world like a tsunami. After more than two years of joint efforts by governments and international organizations, recovery is finally on the horizon. What does the crisis teach us? What is the origin of the crisis? What lessons can we learn so as to prevent a similar crisis from happening again and to ensure risk-free development of world economy? Questions like these deserve serious thinking by those who are concerned about the prospects of economic globalization and the future of world economy during the post-crisis period.
I. Misuse of sovereign credit by the world’s major reserve currency issuer accumulated huge momentum for the financial tsunami
After the crisis, economists from various countries have been summarizing its origins from different perspectives. Generally, there are three most popular arguments: ①developing countries’ excessively high exporting volume has led to the world economic imbalance; ② overuse of financial derivatives has resulted in financial bubbles and over-leveraged economy; ③ overexpansion of government debts has caused sovereign debt crisis. Through repeated dissemination by mainstream media from developed countries, these seemingly reasonable arguments have been regarded by many people as the origins of the crisis.
It seems true that these arguments do make sense either from the standpoint of certain countries and interest groups or from certain perspectives. However, they are absolutely not the root causes of the crisis.
With their advantages in labor and resources, developing countries have attracted capital and technologies to accelerate their economic growth as well as export growth. This is a result of the optimized allocation of factors of production at the global level. At the same time, developing countries have also expanded their import volume, providing developed countries with constant impetus in employment and economic growth. And this investment in developing countries from developed countries’ multinational corporations (MNCs) has in turn generated profit growth points for developing countries. These win-win economic activities are basic requirements of economic globalization, reflecting a historical trend in which various countries are developing together. Historically speaking, imbalanced development is absolute while equilibrium is relative. Since modern times, the UK and the U.S. had been major exporting countries with trade-surplus for a long time. Nowadays, the U.S. is still a leading exporter of service trade, while some other developed countries like Japan and Germany are still major exporters of technology-intensive and knowledge-intensive products. Therefore, it is totally unreasonable to argue that the origin of the world economic imbalance which led to the global financial crisis is developing countries’ export which is mainly characterized by labor-intensive and resource-intensive products.
The overuse of financial derivatives resulting in over-leveraged economy is one of the direct causes of the financial crisis. But what are the reasons of excessive financial derivatives? Why did investors from various countries rush to purchase highly-risky financial products such as credit default swap (CDS)? Why did the overflow of financial derivatives occur in the U.S. rather than in any other countries? After the Great Depression of the 1930s, the U.S. learned lessons and passed a series of Acts to reinforce financial regulation which， however, were later regarded as barriers to the development of financial market and thus were repealed in the 1980s. During the period when financial derivatives were overused, some insightful American economists and government officials once proposed suggestions of strengthening legislation in financial regulation, which， however, were denied once submitted to the U.S. Congress. Why did U.S. congressmen, those self-claimed “representatives of voters’ interests”, liberally allow the overuse of financial derivatives to happen? What are the driving factors? In a word, overuse of financial leverage is a superficial phenomenon with further and deeper reasons behind.
Overexpansion of government debts causing sovereign debt crisis is one of the reasons for the financial crisis. But again, it is not the fundamental one. There is reserved transmission of the pressure for easing monetary condition from fiscal deficit and government debt to currency issue. Once the ratio of fiscal deficit or government debt to a country’s financial income and GDP exceeds a certain level, the demand for currency issuance will increase. Under such situation, inflation will inevitably be the only option. For this reason, ratios mentioned above must be kept within an appropriate range. In order to meet its expenditure demand, the U.S. has been relying on its fiscal deficit and government debt for a long time. As a result, the fiscal deficit and government debt escalated tremendously during the crisis. By the end of 2009, the federal government deficit had reached USD 1.4 trillion, accounting for 10% of GDP; the government debt had reached USD 11.87 trillion, accounting for 83.4% of GDP, which is very high among developed countries. Such high ratios did not bring about inflation but low interest rates. This is benefited from its position as the world’s major reserve currency issuer, which has attracted the inflows of foreign capital and low-price commodities. It is apparently indicated that the heavy debt of the U.S. government only helped contribute to the formation of the financial tsunami either before or after the crisis. We can also see clearly that the sovereign debt crisis in Greece had limited impact on the global economy as it happened without the involvement of monetary policy. So the sovereign debt crisis is by no means the root of the crisis.
The fundamental reason for the financial tsunami therefore is that the U.S., the major reserve currency issuer in the world, has been misusing its sovereign credit for a long time, with twin deficit (current account deficit and budget deficit) policy to keep excessive domestic consumption and government expenditure, thus accumulating huge momentum to cause the financial tsunami. Moreover, American credit rating agencies took the advantage of their monopoly positions to cover up sovereign credit risk and shift the risk from debtors to creditors. As a result, international capital flow has been misled into high-risk regions, causing the fall of the last defensive wall against financial crisis.
Market economy is based on credit, and economic globalization has made sovereign credit become an important part of a nation’s competitiveness and economic strength. A good sovereign credit will provide significant impetus for economic growth by reducing the financing cost for governments and enterprises, and by attracting more foreign capital inflows. On the contrary, misuse of sovereign credit, especially by the world’s major reserve currency issuer is doomed to incur a domestic and global economic catastrophe as such an action would always embezzle other countries’ wealth, accumulate and spread financial risk.
As the U.S. is the country of origin for this crisis, it tells us once again that financial products supported by the sovereign credit must correspond with the size of the real economy. The overexpansion of fictitious economy has made the U.S. economy look like an inverted pyramid built on the beach. Before the crisis, the subprime mortgage added up to USD 2 trillion; above which the ordinary housing mortgage USD 12 trillion; further above the corporate bonds including collateralized debt obligation (CDO) and credit default swap (CDS) USD 62 trillion; on top of the pyramid lies USD 300 trillion of financial derivatives held by various American financial institutions (source: Bank for International Settlements). With a single structural problem, the top-heavy pyramid will collapse instantly. As the past capitalist economic crisis has found its root mainly in excess production capacity, during the era when the financial industry is well developed it is the financial products with unlimited supply supported by sovereign credit that becomes the origin of the current global economic crisis.
II. Fundamental approaches to prevent global financial crisis from happening again
With identification of the origin of the financial crisis, it is a historical responsibility shared by economists and governments from all over the world to explore fundamental approaches to prevent similar crisis from happening again.
1. To strengthen overall regulation on financial industry, and to rebuild the firewall between the banking system and the capital market.
In the post-crisis period, it has become a consensus among countries that regulation should be strengthened on various types of financial institutions including banks, equity markets, bond markets, insurance institutions, funds, investment institutions, mortgage institutions, etc, and especially on financial derivatives. Recently, the U.S. President Obama signed a financial regulation bill, which is a correct move based on lessons learned from the crisis. In addition to bringing all non-banking financial institutions into regulation, the firewall between the banking system and the capital market should be rebuilt. After the Great Depression of the 1930s, the U.S. learned lessons and passed series of Acts to prohibit banks from holding corporate equities, which effectively prevented corporate bankruptcy from transmitting into bank failure or further into overall economic collapse. However, such Acts were regarded as barriers to the pursuit of new liberalism and thus were repealed in the 1980s. In conclusion, historical and current experiences tell us that it is necessary to rebuild the firewall between the banking system and the capital market, which is vitally important for guarding banks’ safe operation and interest of resident savings.
2. To break up credit rating agencies’ global monopoly, and to establish an objective and fair sovereign credit rating system.
Conducting objective credit assessment for various countries and enterprises is an important approach to urging them to promote their credibility in terms of debt payment appropriately orienting capital flows and avoiding financial risks. Currently the credit rating industry is characterized by high level of monopoly for the world’s three major credit rating agencies are all in the U.S. Prior to the crisis, the U.S. sovereign credit was rated as AAA, the highest credit rank. Before its bankruptcy, Lehman Brothers was assigned an A+ rating, releasing an adverse credit indicator, which made many investors suffer a total loss. It has become an urgent affair in the post-crisis period to establish a new international credit rating system in which the credit rating criteria and methods must be renewed thoroughly. Based on the new liberalist economic theories, the original rating system focuses wrongly on the degree of privatization and the level of economic liberalization when rating a country’s credit. Such criteria and methods used in regard to a government’s debt capacity, GDP per capita, the position of a nation’s currency in the international reserve currency, could ironically give a higher score to the highly-indebted country than the net creditor country. According to calculation, this distorted credit rating system has actually helped 13 debtor countries with developed status quo reduce USD 67.5 billion of external debt financing cost per year and helped reduce USD 235.1 billion of overall external debt financing cost per year. Thus USD 675 billion and USD 2.351 trillion respectively in one decade. These amounts should have belonged to creditor countries’ interests paid by these debtor countries.
3. Financial operation of the world’s major reserve currency issuer should be supervised by international financial institutions.
Since the Bretton Woods system collapsed in the 1970s, currency issuance has been decoupled from gold reserve, USD as the world’s major reserve currency has found its base on U.S. sovereign credit. This has enabled the U.S. to shift its debt burden to other countries by USD depreciation. Between 1971 to 2010, USD depreciated by about 97.2% against gold, causing huge loss for those countries holding USD as reserve currency. It may take years to see the shrink of an USD asset holder’s wealth through USD depreciation, but it just took a second to see the vanish of USD securities in the stock markets during the crisis. This phenomenon shows that the financial security’s impact of the world’s major reserve currency issuer, can go beyond the borders and spread to every single USD asset holder including residents, enterprises and governments. Therefore, it is vitally necessary and reasonable to conduct international regulation over financial operations of the world’s major reserve currency issuer. We believe it is also fully feasible for international financial institutions to undertake such task. Experts from the EU and the IMF have proposed relevant ideas and suggestions which deserve further discussion to reach a consensus.
4. To establish an international reserve currency system characterized by mutual competition and diversity is the fundamental way to ensure the stability of the international financial system.
It is estimated that in the future the global reserve currency system may be constituted by three currencies, USD, EURO, and RMB competing, counterbalancing and communicating with each other. With the mechanism of competition and preferential selection, risky currency will be sold while stable currency will be purchased, hence governments of international reserve currency issuers will adopt stable monetary policies to maintain their sovereign credit. This is the fundamental way to defend against international financial risk and to prevent global financial crisis from happening again.
III. With an aim of realizing global safety and development, international cooperation should be further expanded.
The 21st century should be a century for peaceful development and a harmonious world. Realization of global economic sustainability, risk-free and green development calls for cooperation among various countries. The prerequisite for risk-free development is to maintain global financial stability. Therefore, with an aim of preventing financial risk and promoting risk-free development, we should further expand international cooperation. Through communication and negotiation at government and civil society levels, we should create a positive environment for international cooperation, in order to pursue and expand consensus to ease the conflict between economic globalization and country-based decision-making. Currently, we should reach consensus and expand cooperation in the following areas:
1. To strengthen monitoring and early warning of global financial risk.
Currently, information asymmetry is a tough issue in the process of global financial risk prevention. In terms of economic activities related to global financial safety, international financial institutions and economic research institutes should strengthen their information collection and analysis, reinforce monitoring and scientific prediction of potential financial risk, as well as guarantee to release risk warning reports in time. For domestic financial activities related to other countries’ financial safety, information transparency should be institutionalized. In particular, the world’s major reserve currency issuer should proactively submit information about its financial activities to international financial institutions and relevant countries. Focal monitoring and analysis should be conducted in those areas with high financial risk such as stock markets, bond markets, foreign exchange markets, and housing markets. Hedge funds’ speculative activities must be followed and monitored, and restricted appropriately.
2. To objectively assess and reveal highly indebted countries’ financial and credit risks.
With the increase of developing countries’ economic strength, credit and debt relation between developed and developing countries has been experiencing a great change. The U.S. became a net debtor country from a net creditor country in 1986. Foreign exchange reserves held by developing countries exceeded that held by developed countries for the first time in 2005. Top 15 countries in 2008 Global External Debt Ranking are all from developed countries. Major debtor countries’ credit risk and financial risk must be assessed objectively and revealed in time. Major debtor countries’ debt capacity variation must be monitored to ensure the safety of creditor countries’ financial assets. Major debtor countries should change their high consumption lifestyle relied upon indebtedness and strive to achieve the balance between budget and current account. They should also enhance their debt capacity, maintain currency stability, ensure the safety of domestic and foreign investors’ assets and maintain the country’s credibility.
3. To manage financial risks through cooperation and mutual development between developed and developing countries.
In recent decades, some developing countries which quickly turned into emerging industrialized countries, have made significant contributions to the global economic growth and set good examples for other developing countries to follow. More capital flow should be introduced into developing countries worldwide to release their huge potential demands in the process of industrialization and urbanization, to form new popular investment focuses and economic growth points, to add value and safety to financial assets in the process of development. According to the statistics, in 2008, 90% of international capital flew into developed countries, while only 10% of that flew into developing countries. This pattern has to be changed. Currently, developed countries’ infrastructural and industrial investments significantly slow down. Only by increasing input to developing countries and combining developed countries’ capital and technologies with developing countries’ labor and resources, can new demands be created to realize reciprocity and mutual development. Developing countries should be assisted to improve their hard and soft environments for investment. Facts should be admitted that emerging economies have become major creditor countries and their credit has been enhanced significantly. The unfair treatments toward them in terms of financing requirements as well as market economy status should be changed. The expansion of domestic market by developing countries especially emerging economies will further strengthen their capacity in importing goods and services from developed countries, which will eventually create more and more employment opportunities for developed countries. Shifting the major international capital flow from developed countries to developing countries will provide a platform for international capital to enhance its value-added capacity.
4. To strengthen financial supports for green technology and green economy.
Realizing green recovery and development against climate change is an ambition shared by all human beings. Financial supports to green technology and green economy should be strengthened. Clean energy and renewable energy should be actively developed to reduce environmental pollution and carbon emission. Currently, various governments have increased their financial inputs in this field, but it is far from enough for fulfilling the ambition. A profitable mechanism should be created to introduce financial capital to develop green economy and green technology. It is then necessary to combine fiscal policies with financial policies to attract more financial capital input by various means such as interest discount and equity investment as well as specific funds. The new energy investment plan announced by the U.S. government has reinforced people’s confidence. International cooperation in terms of scientific development and productions should be encouraged and expanded, to avoid low-efficient repetition of investment. We should make the best use of limited capital to let the green technology serve the human being.