Off Balance

by Paul Blustein

  The Basel Committee finally unveiled Basel II in June 2004, under a new chairman, Jaime Caruana of Spain. One central element remained unchanged from Basel I — the eight percent figure for the minimum amount of capital a bank must maintain relative to its risk-weighted assets. Beyond that were significant differences in the rules, starting with the number of pages required to spell them out — 347 pages for Basel II, compared with 30 pages for Basel I. Big banks won the right to use their models to assess risks, but an alternative method was available for smaller banks that didn’t have in-house mathematicians: they could use a system that relied on the ratings issued by Moody’s, Standard & Poor’s and other credit ratings agencies. (For example, a loan to a Triple-A credit had a zero risk weighting, while a loan to a credit rated below B-minus had a 150 percent risk weighting.) Moreover, Basel II contained rules concerning matters that Basel I didn’t cover, including transparency and extra layers of protection against “operational risks” such as fraud by employees.

  Critics were legion — and prescient. Markus Leippold, a Swiss finance professor, wrote an article in Euromoney attacking Basel II for its reliance on VaR, which he said “gives people a misleading impression of precision and blinds them to the true underlying risks of their positions.”11 Disdain for the rules’ dependence on credit ratings was expressed in the magazine International Economy by financial analyst Christopher Whalen, who wrote: “The new Basel Accord proposes to use precisely those measures of risk and credit quality that caused such fiascos as Enron, WorldCom, and Parmalat, to name the most familiar.”12 Others bemoaned the “procyclical” nature of Basel II, referring to the likelihood that it would amplify both booms and busts, because it effectively required banks to maintain less capital when market conditions appeared benign and more capital when markets turned volatile.

  11 Markus Leippold (2004), “Don’t rely on VaR,” Euromoney, November.

  12 Christopher Whalen (2004), “Managing Risk: A Skeptic’s View of Basel II,” The International Economy 18, no. 4.

  The Basel Committee stuck to its guns. But then, events took a turn for the perverse — because European regulators acted with alacrity in setting a target date for implementing Basel II, while American regulators didn’t, even though a prominent US policy maker had led the Basel Committee during most of the deliberations leading to the agreement. The upshot of this disparity in policy was a mind-boggling manifestation of the law of unintended consequences.

  “Not a team player” is the term often used to describe Sheila Bair, the strong-willed chairwoman of the Federal Deposit Insurance Corporation (FDIC), and it applied in spades in the case of Basel II. In the fractured US financial regulatory system, with its multiplicity of agencies overseeing different types of banks, Bair was a much less powerful figure than her counterparts at the Fed. But she and others at the FDIC disagreed with the Fed about the merits of the new international rules; as she later put it in a memoir: “It made no sense to me to have a capital framework that let big banks essentially set their own capital requirements.”13 And she had no hesitation about using her clout and influence in Congress to impede Basel II’s progress, at least with regard to the US banking system. Bair insisted that the United States keep an extra layer of protection for its banks on top of the Basel II rules — a simple “leverage ratio” requiring each bank to maintain a minimum amount of capital as a percentage of assets, regardless of how risky its assets were. The haggling went on for so long that the Basel II rules remained unadopted in the United States — yet another case of the Americans effectively exempting themselves from global rules that applied to others.

  13 Sheila Bair (2012), Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, chapter 3, New York: Free Press.

  As a result — although, of course, nobody contemplated it — demand for dodgy mortgage securities was pumped up just as the US real estate market reached its bubbliest point in 2006-2007. The different rules applying to US and European banks helped create a voracious appetite for all the various sorts of toxic assets that subprime mortgage lenders and their Wall Street accomplices were generating. European banks, which were required to comply with Basel II, had powerful incentives to load up their balance sheets with the “safest” tranches of CDOs. They could enhance their profitability by using the magic of leverage, squeezing earnings from assets that might be 50 times the size of their capital, because as long as they bought assets deemed to be Triple A or “super senior,” they could claim that their thin capital cushions were adequate on a risk-adjusted basis as specified by Basel II. Meanwhile, American banks, which were required to comply with a leverage ratio but not with Basel II, had incentives to buy the securities that the Europeans shunned. Although they were obliged to maintain thicker capital cushions, they could hold much riskier assets.14

  14 I am indebted to Professor Charles Goodhart of the London School of Economics for this insight.

  None of this means that Bair or other opponents of Basel II were wrong to resist the new rules and insist on imposing the leverage ratio on US banks. As Bair argues, the leverage ratio may have “saved our bacon during the crisis.”15 The sobering point is the inability of regulators to grasp how their collective decisions were helping to fan the flames that would eventually conflagrate the financial system.

  15 Bair (2012), Bull by the Horns, chapter 3.

  Also fanning those flames were international economic phenomena of an entirely different variety.

  “Bretton Woods II”

  Majestic columns adorn the front entrance of the US Treasury building on Pennsylvania Avenue in Washington, DC, looming over a statue of Albert Gallatin, the fourth Treasury secretary. It is understandable that Jin Renqing, China’s finance minister, would assume he should use this entrance when he arrived on the evening of October 1, 2004 to attend a dinner of G7 finance ministers and central bank governors — the first time Chinese officials had been invited to a G7 gathering. Unfortunately, someone had mixed up the directions; Jin was supposed to use a different entrance, on 15th Street, and when Secret Service agents refused to admit him, an uproar ensued. Serious diplomatic repercussions were averted only when Treasury Secretary John Snow, alerted to the problem, authorized emergency measures so that Jin could be cleared to enter, and rushed to the front gate to welcome the Chinese minister personally. To the relief of Treasury officials, Jin calmed down, and the news media never found out about the indignity that had been inflicted on the Chinese.16

  16 This episode is recounted in John B. Taylor (2007), Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World, chapter 10, New York: W. W. Norton & Co.

  The happy ending notwithstanding, this episode signified a major fault in the international financial architecture — in particular, the increasingly anachronistic nature of the G7. Given the burgeoning size and importance of its economy, China deserved full membership in the club of the world’s economic powers. If Jin had been enjoying status as an equal when he arrived at the Treasury building, he presumably would not have reacted so huffily to the logistical snafu that he encountered. Instead, he was merely the recipient of an invitation to a club dinner as a guest. This was no way to treat a country whose cooperation was essential to help manage an economic development that was stirring an increasing amount of concern, head-scratching, debate and antagonism around the world.

  Financial globalization was working in unexpected — and arguably aberrant — ways, with capital flowing in unprecedented quantities from developing countries to advanced ones (China and the United States being the respective standouts). This wasn’t what economists had thought would happen when the big push got underway in the early 1990s to open capital markets worldwide. Liberalizing financial systems was supposed to help funnel excess savings from the world’s wealthiest countries into poorer but increasingly dynamic regions, as it had in the nineteenth century when capital from old Europe financed development in the frontier
areas of the United States, Canada, Australia and Latin America. But a different pattern was emerging in the early years of the twenty-first century. Emerging markets, especially those in Asia, were the ones with excess savings; they were accumulating hundreds of billions of dollars annually from the sale of exports to rich countries, especially the United States, and they were plowing much of their surplus greenbacks into US securities of all kinds — Treasury bonds being the most obvious, as well as the bonds issued by US government-sponsored enterprises such as Fannie Mae and Freddie Mac. For its part, the United States had a dearth of saving (the savings rate as a percentage of Americans’ disposable income fell to approximately zero by 2005, and hovered there for three years), and indeed the US economy depended on that inflow of foreign capital to help finance the purchase of autos, electronic devices, clothing, toys and other imported goods that Americans were buying from abroad. The resulting imbalances were most prominently reflected in the ever-widening US current account deficit, which by 2004 had surpassed US$600 billion, or nearly six percent of GDP, and continued to swell even further thereafter. Other factors also contributed, of course, including the rising cost of oil and other commodities, which meant countries such as Russia and Brazil were also amassing great stockpiles of dollars for investment in US securities.17

  17 Much of the historical background for this section can be found in Martin Wolf (2010), Fixing Global Finance, Baltimore: Johns Hopkins University Press; Stephen S. Cohen and J. Bradford DeLong (2010), The End of Influence: What Happens When Other Countries Have the Money, New York: Basic Books; and Steven Dunaway (2009), “Global Imbalances and the Financial Crisis,” Council on Foreign Relations Special Report No. 44, March.

  “Bretton Woods II” was the term often used to describe the workings of the global economy at that time. It reflected the belief that the United States and the world’s export powerhouses were enjoying a healthy co-dependency that could remain stable for many years, just like the monetary system established after World War II. The countries with large current account surpluses, after all, had ample incentives to continue supporting American spending habits. Their export industries were major job creators, and their governments took considerable comfort from the surpluses that those export industries were helping to generate. As noted earlier, these governments were determined to avoid any need for the IMF’s tender mercies. With memories of the crises of the 1990s still fresh and raw, they knew that their countries would be better protected against market meltdowns the more dollars their central banks could sock away.

  Here was privilege at its most exorbitant, and against the sanguine appraisal of Bretton Woods II was the fear that America’s profligacy would lead, eventually, to a day of reckoning, most likely in the form of a crash in the dollar and a worldwide dumping of US securities. Many economists, both in academic and policy-making circles, figured it was just a matter of time before foreigners would wake up to the fact that they were collectively overexposed to dollar risk. Of particular concern was how the United States was using the six percent of GDP that foreigners were effectively lending it. Trade deficits, and the associated borrowing from foreigners, may be desirable when foreign capital is used productively, in investments that generate sufficient returns to repay the lenders. But in the case of the United States in the early 2000s, return-generating investments such as factories and machinery were not high on the list of ways in which foreign capital was being used; on the contrary, consumption and residential housing, which had accounted for less than 70 percent of US GDP over the previous half century, rose to 76 percent of GDP by 2004.

  For all those reasons, Cassandras fretted copiously about a dollar collapse. With hindsight, they look foolish for having done so, given that the US currency ended up strengthening during much of the global financial crisis. But the Pollyannas were mistaken, too, in overlooking the problems that Bretton Woods II was engendering. The inflow of foreign capital helped make credit ridiculously easy in the United States, inflating the housing bubble more than it would have been otherwise. The same phenomenon was materializing in a number of other countries, including the United Kingdom, Spain and Ireland.

  Whether or not the imbalances themselves were economically dangerous, the Chinese role in them was becoming a source of rising tension between Washington and Beijing by the time of that G7 meeting in October 2004, primarily because of a central element in China’s economic policy — the cheapness of its currency.

  Unlike most countries, China did not allow international speculators and businesses to freely move the renminbi (RMB) in and out, so Beijing had been able to keep the exchange rate of its currency at RMB 8.28 per dollar since the mid-1990s. This had not aroused any concern for some years, during which imports remained more or less in line with exports. But starting in 2001, the nation embarked on an extraordinary export boom, partly because of China’s success in joining the WTO, which gave Chinese products protection against capricious tariffs and other trade barriers imposed by other countries. Beijing’s current account surpluses mounted accordingly, to more than seven percent of GDP in 2005 (a higher proportion of its economy than either Japan or Germany had ever achieved), while at the same time the country’s foreign exchange reserves rocketed toward the US$1 trillion mark. Instead of allowing its currency to appreciate, which would normally happen in a country with a huge surplus, China held it down, for obvious reasons: even a modest rise in the exchange rate might lead to large-scale unemployment in an export sector full of low-margin businesses — a huge worry for a regime whose legitimacy depended on its ability to generate jobs for millions of workers moving each year from rural areas to the industrialized coast.

  The predictable result was an outcry among US industries that were taking a beating from Chinese competition, leading indignant members of Congress to introduce a variety of bills. The most popular bill — it garnered 67 Senate supporters at one point — was one introduced by Senators Charles Schumer, a New York Democrat, and Lindsey Graham, a South Carolina Republican, which would impose 27.5 percent tariffs on Chinese goods, based on estimates by some analysts of the RMB’s undervaluation.

  Noisy though such bluster may have been, US options were extremely limited. Inducing China to bear the burden of adjustment for global imbalances was clearly going to be much more nettlesome than it had been in Japan’s case during previous decades. The US security umbrella, which had been such an important concern for the Japanese, was an irrelevancy to Beijing and, in any event, the WTO had banned the kinds of restraints that Tokyo had “voluntarily” imposed on its exports. Slapping tariffs on Chinese goods unilaterally would be an egregious violation of international trade rules, and would surely lead to economic warfare between Washington and Beijing — a nightmare scenario under almost any sensible estimation. The links binding the US and Chinese economies included a web of supply chains extending throughout Asia, where thousands of companies depended on selling components to China for assembly into finished products. A trade conflict that disrupted those supply chains would knock the entire regional economy — and probably the global economy as well — for a loop.

  The US Treasury even shrank from naming China a “manipulator” of its currency in the semi-annual reports the department was required to issue regarding the foreign exchange policies of US trading partners. While privately acknowledging that the RMB was obviously manipulated, Treasury officials feared that using such a politically explosive term would validate arguments for protectionist legislation and risk a trade war. They were able to avoid doing so thanks to a loophole in the law governing their reports. This law contained language identical to the IMF’s articles, targeting countries that manipulated exchange rates “to gain an unfair competitive advantage.” It was impossible to prove that Chinese policy makers were motivated by a desire for competitive advantage, Treasury officials insisted.

  Given all the downsides to unilateral action, using international institutions looked more appealing. The administration of Pres
ident George W. Bush closely studied the possibility of bringing a case against China’s currency policy at the WTO, where a tribunal might authorize the imposition of penalties, including punitive tariffs on Chinese exports. The trade body’s rules include provisions prohibiting countries from using “exchange action” to “frustrate the intent” of the agreements opening global markets, or using other subterfuge to “nullify or impair” the rights of another country under the WTO treaty. But the rules are murky, and have never been tested, and they clearly indicate that the WTO should defer to the IMF as the arbiter on exchange rate issues. Administration trade officials concluded that a case against China’s currency policy would be very hard to win unless the Fund took action first.

  Ah yes, the IMF: six decades had passed since the conferees at Bretton Woods had created it with the ostensible purpose of overseeing the international monetary system and preventing abuses such as beggar-thy-neighbour policies. What might the Fund do about global imbalances in general, and the Chinese currency issue in particular? That is the subject of chapters 4 and 5.

  This chapter, and the one that precedes it, have provided a broad historical overview of the institutions that govern the global financial system, with the aim of illuminating the major forces that have shaped and transformed the international financial architecture. As noted at the outset, two conditions prevailing after World War II eased the task of managing international economic institutions and fostering global financial stability. One was the immobility of capital across national borders; the near-total removal of that condition led to the creation of the Basel Committee and the FSF. The other condition was the ability of the United States to exert hegemonic influence in international economic affairs. The relaxation of that condition led to the creation of the G5 and G7; although American dominance made something of a comeback during the era of the “Committee to Save the World,” that phenomenon proved ephemeral.