Reforming the financial system: Why the West should include the rest

Posted by on 27 January 2009

Reforming the system of financial regulations will be at the top of the agenda for the policymakers in developed countries. We argue that it is crucial to involve the largest non-OECD economies in the debate on financial regulation and in the design and subsequent enforcement of the new system of regulating global financial markets.

The global financial system strongly benefits from extending a regulatory and oversight franchise to these countries. The main reason is that after the crisis subsides, the large emerging economies will remain important providers of capital to the OECD’s markets. As large investors in the G7 financial system they will have a stake to enforce investor protection and therefore improve the quality of regulation.

Nominally, the debate on reforming global financial system already involves developing countries. For example, the recent G20 meeting prominently featured the opinions of such countries. Yet, in practice developing countries have little say or influence in the existing international financial institutions. The Financial Stability Forum is yet to include non-OECD countries. It is of course reasonable to ask why it is important to include poorer countries when the vast majority of financial institutions are in the West. Why should the new financial system incorporate the interests of BRIC countries?

A standard reason is that of growing importance of the BRIC countries in the world economy. We argue that the second, equally important argument is that such countries crucially rely on the well-functioning G7/global financial system and therefore have a large stake in ensuring that this system operates well. BRIC countries lack their own developed financial systems and have to rely on the G7’s markets and are consequently large providers of funds. Our point is that including BRIC is not only fair and good for BRIC – it is good for investors in OECD countries as well. The interests of the emerging markets—that lack their own financial institutions—will coincide with those of investors. Hence, if the emerging markets are given the effective participation in design and enforcement of new regulation, they can effectively lobby the investors’ interests. This is especially important given that investors are not organized and are usually underrepresented in the debate.

Consider an example of Russia. In the last 10 years it became a significantly larger economy that is also more integrated and more reliant on the global financial system. Its income depends on a volatile and risky stream of revenues from commodities. Its financial markets are rudimentary and neither the households nor firms can adequately hedge their long-term and often even short term risks. It is not surprising that foreign assets are a popular means of savings and insurance for Russians. The households hold a large amount of foreign currency in dollars and euros. The government and firms invest in the long-term foreign assets that are not provided by the local financial markets. Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas argued that the ability of the markets in the developed countries to provide high quality assets superior to those in other countries can explain why the developing countries accumulate foreign assets. In other words, the developed financial system in the West exports the services of the financial assets to the countries that need them but cannot produce them. The availability of the foreign assets is important from the welfare point as it provides necessary insurance and financial intermediation not available through domestic financial system. It is not surprising that largest foreign reserves are held by developing countries (including China and Russia).

The crisis brought a temporary pullback in the amount of funds saved in the assets of developed markets as the reserves are used to support the currencies or to prop the economy. Once the crisis subsidies, the savings of the developing economies will return. The BRIC economies will grow faster than the G7 countries and will necessarily feel the constraints of the underdeveloped financial system and the lack of safe and credible investment instruments. Moreover, the crisis re-confirmed the convictions in the importance of reserves. Once the growth returns, BRIC countries will resume piling up reserves and stabilization funds. Conservative finance ministers in countries such as Russia or Chile who argued for keeping higher reserves are now viewed as heroes of the current crisis and will likely wield much larger influence in the aftermath of the crisis.

We argued that the well functioning global financial system is of paramount importance for the large developing countries. This is the main reason that they have an important stake in ensuring its smooth operation especially guarding credibility and the flow of innovations. The first part of credibility is effective regulation of financial markets. A foreigner from a country such as Russia used to  unequivocally trust the Western financial markets – at least compared to the domestic one. This conviction was first shaken by a stream of the corporate scandals in the US starting with Enron. Now, after the Madoff affair, Merrill Lynch paying bonuses just before the government bailout, and the overall inadequacy of the regulators the belief in the infallibility and superiority of the Anglo-Saxon financial system is shattered. The other part of credibility is that the governments in the developed economies will continue to conduct responsible economic policy. Now, the taxpayers and voters in the US and Europe require that drastic measures have to be undertaken to save national economies. We already see the unprecedented rise in the government expenditures and a push for increased government involvement in the economy. The rest of the world worries that the rescue measures will lead to unsustainable debt and to high inflation in the medium term. Recent research by Matthias Doeppke and Martin Schneider shows that foreigners hold a large amount of the US government debt and that the increased US inflation constitutes a substantial tax on them. An increase in inflation redistributes wealth from the foreigners to the young, middle class households who hold mortgages. Politicians faced with an increased debt may be tempted to inflate instead of taking more unpopular measures such as decreasing government spending. The BRIC countries with their large reserves will lose the most from the failures in regulation and will have strong incentives to guard the credibility of the financial system.

The second essential element of the developed financial system is the ability to innovate. The voters in the developed and developing countries alike will be looking for the culprit of the financial crisis. It is important that the reformed financial regulations will not stifle creativity and innovations in finance. Would not involving the emerging markets result in counterproductive overregulation? In fact, the opposite will likely be true. The developing countries with their large risks, opaque regulatory systems, and underdeveloped domestic financial markets are important beneficiaries of the financial innovations. For many of those countries, stakes in promoting efficient financial intermediation – and therefore economic growth – are much higher that in the developed countries. The latter can afford a slower growth rate, but for many emerging markets, a growth slowdown also implies significant political and social instability.  

When the developed countries reform the financial system it is of essence not to think about their own parochial interests. The reformers should remember that a functioning system of the financial markets is equally important for the developing countries. Moreover, it is not just fair to involve the developing countries. It is in the interest of investors in the developed countries to make sure the developing countries become the watchdogs for the West’s financial institutions.

Sergei Guriev is Morgan Stanley Professor of Economics and Rector at the New Economic School in Moscow.

Aleh Tsyvinski is a Professor of Economics at Yale University and New Economic School.


Ricardo Caballero <> ,

Emmanuel Farhi, <> ,

Pierre-Olivier Gourinchas <> , "An Equilibrium Model of Global Imbalances and Low Interest Rates," American Economic Review, March 2008 

Matthias Doepke and Martin Schneider “Inflation and the Redistribution of Nominal Wealth” <> , Journal of Political Economy, December 2006.