I'm off to the Centre for Global Development today for a discussion of the risks of China slowing on Latin America by the Latin American Shadow Financial Regulatory Committee, or CLAAF in its Spanish acronym. The CLAAF is a blue ribbon group of academics, former central bankers and finance ministers from the region which meet periodically to discuss current financial sector challenges. At the conclusion of their meetings, committee members typically release a statement summarizing their deliberations and points of agreement.
The latest statement focuses on the risks to Latin America from a slowing of Chinese growth. The committee believes that the build-up of credit expansion, in part through "shadow banks," together with excessive investments in some sectors, particularly housing and real estate development, could lead to a slowdown in China's GDP growth (sound familiar?). Such a slowdown would have an impact on the region through four channels:
- first, commodity prices, which were a key driver of growth for Latin America over the past decade, could soften with negative effects on fiscal balances in the region, and a reduction or reversal of capital flows;
- second, a slowdown in China may lead to a general re-pricing of risk in emerging markets with capital moving from Latin America;
- third, Chinese foreign direct investment — an increasingly important source of capital for Latin America over the past decade — might fall; and
- fourth, inter-bank linkages could be a source of contagion as Chinese banks with branches or subsidiaries drain liquidity from the region.
In response to these threats, the CLAAF recommends that countries in the region conduct credible, transparent stress tests of financial, fiscal and external vulnerabilities in a coordinated manner with the support of the International Financial Institutions, particularly the International Monetary Fund (IMF). At the same time, in light of the risks identified, the committee believes that the IMF's capacity to act as a true international lender of last resort should be strengthened. Absent effective measures in this regard, individual countries should, it is argued, "build or maintain adequate external liquidity cushions, commensurate with these risks."
Countries can either build reserves by borrowing (taking on foreign exchange risk), which might be hard to do in the scenarios envisioned and in the context of Federal Reserve tapering, or through reserve accumulation. Countries can augment reserves, meanwhile, by reducing domestic absorption (consumption, investment and government spending). In the end, this means reducing imports relative to exports. But what one country can do, not all countries can do. And, if the advice is appropriate for Latin America, it would be equally applicable to Asia, emerging Europe, and other regions. Accordingly, if all countries tried to accumulate reserves, the result could be a shortfall in global aggregate demand as countries simultaneously reduce consumption, investment and government spending.
This was the situation in the 1930s. At that time, country after country tried to generate trade surpluses by raising tariffs to reduce imports. Of course if countries can't export, their incomes and eventually imports will fall; the result was an insufficiency of global aggregate demand. This was the conjuncture that the IMF was designed to prevent.
So, here's the rub: the failure to make meaningful progress on IMF governance reforms could lead inadvertently to a situation in which actions that might be rational from the perspective of individual countries could be collectively irrational. In the current conjuncture, with China slowing, the Eurozone at risk of sliding into a Japanese-style deflation trap, and the U.S. and other advanced economies flirting with secular stagnation, the real cost of U.S. inaction could be much higher than more political gridlock in Congress.