Sudip Bandyopadhyay’s Blog

Misaligned exchange rates are more often than not a prelude to trade friction. Yet so far, in spite of sporadic outbreaks of warlike political rhetoric between the US and China, currency misalignments between the world’s surplus savings countries and the world’s borrowers and spenders have not ended in disaster. Buy America provisions and bail-outs for bankrupt motor companies are less damag- ing than trade barriers of the kind erected by the Smoot-Hawley Act in the 1930s. Yet the reality, in this financial crisis, is that we have protectionism by the financial backdoor and may soon have it by the front door.

Until August 2007, liberalisation in global banking enhanced the efficiency of the financial system and facilitated trade in goods and services along with cross-border movements of capital. The huge advantage of such globalisation was that lenders no longer needed to be physically close to borrowers. Since the collapse of Lehman Brothers last September, trade credit has become scarce, causing international trade to implode. The impact has been quite as severe as any controls over imports, although a return of financial stability would mitigate the damage. A more lasting problem lies in foreignowned banks’ retreat from cross border activity. Capital and financial flows tend to display a homing instinct in a crisis. And this is now being reinforced by the regulatory response to the financial debacle. This financial de-globalisation is, as the Bank for International Settlements points out in its annual report , financial protectionism. By threatening to curtail crossborder capital movements, such regulation will shrink trade in goods and services and thus moderate growth and development.

Home countries, Iceland being the most obvious case in point, may not be able to honour obligations to depositors abroad if their banks are too big for their economies. There are plenty of countries that potentially fall into this category. New York-based economist Geoffrey Bell points out, for example, that Ireland’s bank liabilities are 954 per cent of GDP, while Switzerland’s are 644 per cent, which has led to suggestions that UBS and Credit Suisse should be forced to shrink. At the same time, host countries are less happy about having foreign-owned banks on their soil, especially in the form of branches supported only by capital back in the home country. Host country supervisors will thus demand that more business is done via locally incorporated, well capitalised subsidiaries.

Reducing institutions’ international reach will, says the BIS, come at the expense of economies of scale and scope. So a safer and more stable financial system may be a less efficient one. A more fundamental protectionist threat lies in global imbalances, which are at the root of the crisis. Excess savings in Asia, northern Europe and the petro-economies are deflationary. They have to be accommodated by someone else borrowing and spending if the world is to avoid a slump. In response to the global recession, the excess savers have loosened fiscal policy. But in Germany’s case this has been done with extreme reluctance. Japan has been more willing, but its public sector debt burden is such that it will probably want to tighten relatively soon. And China’s fiscal expansion has come more through increased investment than higher consumption, which fails to address the structural problem. The counterpart of a surplus of savings over investment is a current account surplus. It follows that the excess savers continue to expect others, and the US in particular, to provide a dumping ground for their exports. But why should the US do this at the cost of another debt binge and subsequent crash? Why, Americans will ask, should they burden their children with huge debts just to generate jobs in Germany, Japan and China?

The political pressure for curbs on imports is thus bound to increase. The only positive gloss that can be put on this is that it may take a dose of protectionism to shock the excess savers into structural change. But that smacks of burning down the house to roast the pig.