A neo-Westphalian international financial system?

Setser, Brad

In the late 1990s, private markets were widely assumed to have triumphed over the state. State firms were perceived to be a recipe for failure. Large financial flows overwhelmed and humbled small states. Countries that wanted to succeed had to embrace the policies favored by private capital. Daniel Yergin wrote in 1998, "While the public votes only every few years, the markets vote every minute.... National governments ... must increasingly heed the market's vote--as harsh as it sometimes can be." (1) The rating agencies that helped to determine a country's ability to access market financing were thought to be the superpowers of the post-Cold War era. (2) Michael Mandelbaum summarized the mood of the late 1990s well:

 Capitalism requires capital and the countries of the periphery
 looked to the core countries to supply it.... Attracting private
 capital required having the appropriate institutions and pursuing
 the appropriate policies. It required, that is, putting on the
 'golden straightjacket' in order to appear a worthy recipient of
 resources for investment ... (3)

Ten years after the financial crises in Asia, Russia and most of Latin America, talk of the triumph of private markets over the interventionist state seems far from the mark. Today's global economic system is marked both by increased trade--including greater trade in financial assets--and by a far larger state role in the financial markets. Martin Wolf, the Financial Times' influential columnist, recently wrote that "Globalization was supposed to mean the worldwide triumph of the market economy. Yet some of the most influential players are turning out to be states, not private actors." (4) The reassertion of the state in the marketplace has come not from an expansion of the state's regulatory role, but rather from the growing role governments--particularly governments in the emerging world--play in key global markets. Global financial order once again depends heavily on the financial decisions of large states, not just on swings in private market flows.

Stephen Weber and his colleagues have argued that the world's emerging powers prefer a "neo-Westphalian" global order that places a far higher premium on state sovereignty than full integration into existing "liberal" international institutions. (5) This new and still emerging global financial system can be considered neo-Westphalian in two senses. First, large states are again key actors in financial markets. While the total stock of privately held financial assets in the United States, Europe and Japan remains large relative to the stock of financial assets in government hands, the foreign assets of key emerging market governments are growing far faster than those of private intermediaries. The foreign portfolios of large emerging market states now exceed the foreign assets of even the largest private financial institutions. Foreign exchange traders believe that, through its sale of dollars for euros, the government of China influences the dollar's value against the euro. U.S. Department of Treasury traders believe that the government of China exercises more influence over the treasury and agency market than any actor other than the U.S. Federal Reserve. This should not be a surprise. The government of China now holds more dollar assets than the Federal Reserve. Ousmene Mandeng of Ashmore, a large fund manager, argues, "No market, not even the treasury market, is now deep enough to accommodate the unprecedented growth of emerging market reserves." (6)

Second, national governments have more financial firepower than do the multilateral institutions. The International Monetary Fund (IMF) now has roughly $250 billion available to lend, with few takers. At the end of June 2008, China held US$1800 billion at its central bank, with another US$500 billion or so in the hands of the state banks and in China's new sovereign wealth fund. Russia now has well over US$500 billion in its central bank. Saudi Arabia will, too, if oil remains above $100 a barrel. Through the increase in the dollar holdings of their central banks and sovereign funds, emerging market governments are likely to provide $1 trillion in financing to the United States in 2008. This dwarfs IMF lending to the emerging world in the 1990s. The largest IMF program topped out at around $30 billion. The Group of Seven (G-7) countries generally preferred to lend to troubled emerging economies in concert, often through the IMF. By contrast, today's emerging powers have financed the United States though a series of uncoordinated national decisions. No multilateral institutions that advocate for coordination on a level comparable to that of the G-7--let alone of the IMF--exist among today's new financial powers.

However, in one respect this new order is not Westphalian. The scale of the growth of foreign assets of key emerging economies implies that they increasingly interfere in--or at least influence--what might be termed the internal financial affairs of other sovereign states. In the process of securing their own financial independence, emerging market governments have built up assets on such a scale that they now can shape economic outcomes in the G-7 economies.

This paper has a simple aim: to highlight the gap between the rhetoric that celebrates market-led globalization and the reality of a larger state role in a host of financial markets. There are two parts to this examination. The first reviews the reasons for the increase in the financial power of key states in the emerging world. The second looks at how the rise in the foreign assets of the emerging world has influenced the G-7 countries, economically and--potentially--politically.

Of course, any comparison between the world of 1998 and the world of 2008 also highlights the danger of assuming that current trends will continue uninterrupted. Current expectations that smart private money needs to cozy up to governments with financial power may prove as short-lived as the triumphant claim that the market will trump the state. At the same time, the increase in the financial resources under the control of national governments is now too big to be viewed as a minor aberration in a historical narrative defined by a reduced government role in financial markets.

THE REASSERTION OF THE STATE AS AN ACTOR IN THE MARKET

The reassertion of the state in the market stems from two key trends: first, the intervention by emerging market governments in the foreign exchange market and the domestic policies adopted to support exchange rate management; second, the rise in commodity prices and ongoing government control over commodity revenue streams.

Asian Reserve Growth

After the Asian crises, the G-7 and the IMF concluded that soft pegs and other heavily managed exchange rates were incompatible with financial integration and large private capital flows. Unless a country wanted to give up its own currency--and any chance of exercising monetary autonomy by adopting a currency board or committing to join Europe--it needed to allow more exchange rate flexibility. However, the governments of most emerging markets did not draw the same conclusions. Rather than giving up on exchange rate management, many gave up on current account deficits. After the crises, most emerging economies were left with depreciated exchange rates, and many decided to intervene in order to maintain them. In the process, the emerging world soon began to accumulate large quantities of reserves, reducing its vulnerability in responding to the crises. (7)

[FIGURE 1 OMITTED]

Of course, the world's emerging economies are far too diverse to fit into a common template; no generalization fits all countries. Most European countries that were on track to join the European Union continue to run large--if not very large--current account deficits. Commodity-exporting emerging economies are as interested in protecting themselves against volatility in commodity prices as reversals in private capital flows. And then there is China.

The legacy of the Asian crises has unquestionably shaped China's policies. China's leaders clearly wanted to avoid the risk that they would need to turn to the IMF for financing. China's policies are also not a simple reflection of the crisis. China did not devalue the renminbi (RMB) during the Asian crises, yet its reserve growth over the past eight years dwarfs the reserve growth of the crisis countries. China's rapid reserve growth stems primarily from its policy--one shared by other emerging economies--of managing its currency against the dollar. The change in the dollar's trajectory in 2002 as well as China's decision to follow the dollar down had enormous consequences for China and other emerging economies and the world. The initial rise in Chinese reserve growth reflected a fall in capital outflows rather than a rise in China's current account surplus. The fall of the dollar led Chinese investors to stop betting against the RMB. (8) However, between the end of 2000 and the end of 2004, the RMB depreciated by close to 15 percent in real terms, according to the BIS index. By 2005, the depreciation of the RMB, combined with the policy steps China took in late 2003 and early 2004 to keep its economy from overheating, increased China's current account surplus. That surplus topped 10 percent of China's GDP in 2007--an unprecedented level for such a large economy In turn, the large surplus encouraged even greater private capital inflows and faster reserve growth.

[FIGURE 2 OMITTED]

The sums involved have become staggering. China's government likely added over US$800 billion to its foreign assets between June 2007 and June 2008. (9) That is more than the increase in the foreign assets of the world's oil exporting economies over the same time period. It is also more than the amount the world added to its reserves in 2003 or 2004--years that at the time seemed marked by unprecedented central bank intervention. As a result, China's government is almost certainly now the largest player in the treasury market, the largest player in the agency market and the largest player in the euro-dollar market, (10) It also has the potential to be among the largest players in the U.S. equity market. If China directed a quarter of its foreign asset growth into U.S. equities, the resulting $200 billion in purchases would equal the total foreign purchases of U.S. equities by all foreign investors--Gulf sovereign funds as well as private investors--in 2007. (11)

China's intervention in the foreign exchange market did more than make its central bank a major player in a host of other markets. Other governments' fear of allowing their currencies to appreciate against the RMB also led them to increase their intervention in the foreign exchange market. In 2004, University of California-Berkeley's Barry Eichengreen argued persuasively that a global financial order where emerging market central banks financed ever larger U.S. current account deficits through their dollar reserve growth was intrinsically unstable. (12) Financing the United States had the key characteristics of a public good: everyone would rather that someone else finance the United States' large deficit. Each individual central bank had an incentive to avoid the financial losses associated with the dollar's inevitable depreciation. However, Eichengreen's analysis neglected one key impediment to defecting from the cartel of central banks financing the United States. As long as China limited the RMB's appreciation, any country that allowed its currency to appreciate against the RMB paid a price. Take one prominent example: The 10 percent appreciation of the Indian rupee against the U.S. dollar in early 2007 contributed to a large percent increase in China's exports to India over the course of 2007. Over time, Asian emerging economies began to intervene more out of fear of their currency appreciating against China's, rather than from fear of a repeat of the crises of the 1990s.

[FIGURE 3 OMITTED]

China's commitment to exchange rate management also led the Chinese state to intervene actively in China's domestic markets, notably through the allocation of bank credit. The story here is not simple. On one hand, three of the four Chinese state banks are now listed on China's stock exchange and often have foreign minority partners. Indeed, their stock market capitalization now tops the stock market capitalization of large U.S. and European banks. On the other hand, the Chinese state continues to own the lion's share of the state banks. Bank profitability stems at least as much from the large government-mandated spread between the low cap on deposit interest rates and the floor on lending rates as from the banks' better evaluation of credit. (13) Above all, China has opted to rely on administrative limits on bank lending rather than on a flexible exchange rate and an independent monetary policy for domestic macroeconomic management. Starting in 2004, the government opted to ration low cost credit through administrative limits on bank lending rather than to raise interest rates to decrease inflation. The state banks have also faced pressure to buy central bank sterilization bills to help offset rapid reserve growth, and, more recently, they have apparently been asked to hold dollars to meet their rapidly rising reserve requirement. (14) Fixed prices, administrative controls and pressure on state banks to lend to the government--in this case the central bank--at low rates were supposed to be relics of state control to be cast aside for rapid growth, not an integral part of the management of the world's most dynamic economy

[FIGURE 4 OMITTED]

Commodity Revenues

Asian reserve growth and the growing presence of the state in international and domestic financial markets is only part of the story The enormous rise in oil prices has also increased the financial might of the emerging market state.

In the late 1990s, Daniel Yergin wrote, "Governments are getting out of business by disposing of what amounts to trillions of dollars worth of assets. Everything is going.... It is happening not only in the former Soviet Union, Eastern Europe and China but also in Western Europe, Asia, Latin America and the in the United States ... the objective is to move away from governmental control as a substitute for the market." (15) Yet Yergin's argument has not held for one industry that he knows well: the oil industry. The influence of large, state-owned national oil companies has increased while privately-owned international oil companies have struggled to find enough new reserves to make up for their existing production. Russia, which turned to international oil companies for help developing certain costly oil fields when it was financially strapped in the 1990s, has reasserted state control over many fields. National oil companies continue to have a monopoly on domestic oil production in the Gulf and many Latin economies, lad Mouawad wrote in the New York Times:

 As late as the 1970s, Western corporations controlled well over
 half of the world's oil production. These companies--Exxon Mobil,
 BE Royal Dutch Shell, Chevron, ConocoPhillips, Total of France and
 Eni of Italy--now produce just 13 percent. Today's ten largest
 holders of petroleum reserves are state-owned companies, like
 Russia's Gazprom and Iran's national oil company. (16)

Saudi Aramco has more than ten times the reserves that Exxon does. State-owned oil companies are a presence "downstream" as well. National oil companies dominate the energy business in China and India, in no small part because both countries continue to regulate domestic energy prices. Analysts now expect that the so-called the commanding heights of the global oil industry, and perhaps of the global energy industry, will be occupied by state firms for the foreseeable future.

The vast majority of oil export revenue--over 90 percent in the case of some Gulf countries and 85 percent for Russia--goes to the countries' national treasuries. (17) The surge in oil revenue allowed the oil-exporting states, many of which were in dire financial trouble in the 1990s, to increase domestic spending. However, many states remain wary of increasing spending too much. Gulf states inspired by Dubai often opted to use their surging oil revenues to finance large investment projects rather than large transfer payments. The mix between private investment and public investment varies. Most is government-sponsored, where state banks, state firms and private investment vehicles of the ruling families are usually among the key players in the domestic market. The form of the government's involvement in the economy has changed, but not its extent.

Governments of oil exporting economies primarily influence global markets by building up their foreign assets. In 2002, oil averaged around $25 a barrel and the oil exporting economies likely added less than US$50 billion to their foreign assets. In 2008, oil will average over $100 a barrel, and the oil exporting economies should add at least US$700 billion to their foreign assets. The six countries of the Gulf Cooperation Council will account for roughly half that increase. (18)

Oil exporters' purchases of foreign financial assets impact the market in much the same way as China's purchases. However, there is one key difference: China's government is investing borrowed money, while the oil exporters generally are not. China's purchases run a large current account surplus, although the export revenue does not flow to the government. First, China's government accumulates foreign exchange when it buys U.S. dollars from its export sector, paying with its domestic currency. Its central bank then sells sterilized bills or forces the banks to hold more money at the central bank in order to pull local currency out of circulation and avoid expanding the money supply. The overall result is that the government ends up borrowing China's domestic savings from its citizens, assuming the exchange rate risk and buying foreign assets. This process will likely produce financial losses for the government. In contrast, the rise in the foreign assets of the oil exporters stems almost entirely from surplus export revenues that are held offshore to limit domestic inflationary pressure. (19)

This is one reason why some of the oil exporters invest their government's assets fairly aggressively while, until recently, only one Asian economy--Singapore--took a similar approach. Norway transparently channels its oil surplus into an oil fund that invests in both bonds and equities. Abu Dhabi, Kuwait and Qatar channel their surpluses into secretive sovereign wealth funds that invest in real estate, private equity funds and hedge funds as well as bonds and public equities. The majority of the oil exporters' combined surplus is still managed by fairly conservative central banks, notably by the Central Bank of the Russian Federation and the Saudi Arabian Monetary Agency. lust as the rise in Asian reserves has led many Asian countries to either set up sovereign funds or allow their central bank to invest more like a sovereign fund, the rise in oil revenues is leading a broad range of oil exporting economies to consider investing in a larger range of assets. Russia will determine the investment strategy of its new and still small sovereign fund in the fall of 2008. The Saudis often talk of creating a large fund, although so far they have only handed US$5 billion over to the Public Investment Fund--an institution whose primary function is to hold the state's stake in large state firms. (20)

Sovereign funds that invest in the equity market and in individual firms are certainly not new. (21) There is a difference between a world where sovereign funds add somewhere between US$10 and $20 billion to their foreign assets and a world where they add US$200 billion, if not more, to their foreign assets. A spread of US$10 to $20 billion across a host of markets is not enough to have an enormous impact on the structure of the market. No sovereign fund commanded assets comparable to those of international institutions like the IMF. Two hundred billion dollars, by contrast, is big enough to matter, and it is possible that sovereign funds will soon exert a larger impact on a broad range of markets. Inflows into sovereign wealth funds remain far smaller than the increase in central bank reserves. Central banks added well over US$1 trillion dollars to their assets in 2007, far more than the roughly US$200 to $300 billion that flowed into sovereign funds in 2007. The year 2008 will not be dramatically different. Many large investment banks now expect that the enormous sums flowing into central banks will be redirected to sovereign funds. (22) If these forecasts are born out, sovereign funds collectively could soon own a significant share of the world's stock market capitalization. Reverse globalization, or the "uphill" flow of capital from the emerging world to the Group of Ten (G-10), could lead to reverse privatization.

ACTION, REACTION: EMERGING MARKET POLICIES NOW SHAPE G-10 MARKETS AND POLICIES

Earlier in this decade, Michael Mandelbaum wrote that "there was virtually no country that neither received nor hoped to receive capital from the New York financial community" (23) That statement no longer rings true. The New York financial community, like the U.S. economy, now relies on capital from the rest of the world. Rather than facilitating U.S. investment abroad and helping other countries tap into U.S. savings, the U.S. financial system now helps the United States tap into the savings of other countries. In many cases, though, these pools of savings are controlled by (often authoritarian) governments rather than private financial intermediaries. Wall Street firms that previously traveled the world trying to convince emerging market governments to sell their state assets to private investors in the United States and Europe are now trekking around the world trying to raise funds in the cash-rich states of the emerging world. Right now, it is--to use a bit of Wall Street slang--"Shanghai, Mumbai, Dubai or Good-bye." (24)

Until recently, it was possible to assume that the reserves held by emerging economies--typically either bank deposits in the dollar, euro or another G-10 currency or a government or supranational bond denominated in one of these currencies--had a limited impact on the world's key financial markets. The emerging economies themselves were small relative to the G-10 economies. Their reserves were small relative to their GDP. It was assumed, given the costs of holding reserves, that this would likely remain the case, especially considering that large, developed economies other than Japan generally did not hold large reserves.

These assumptions have not been born out. Between 2000 and 2007, the combined GDP of Brazil, Russia, India and China (Goldman Sach's BRICs) increased from a little over l0 percent of the combined GDP of the G-7 economies to a bit under 25 percent. Impressive as this growth is, it was dwarfed by the pace of increase in the BRICs' reserves, which rose from around US$250 billion in 2000 to over US$2.5 trillion in 2007. Indeed, counting the non-reserve foreign assets of the Saudi Monetary Agency, the emerging world's US$5.2 trillion in foreign exchange reserves at the end of 2007 topped the US$5.1 trillion in marketable treasuries outstanding, especially after taking account of the $750 billion of marketable treasuries held by the Federal Reserve.

As a result, the foreign portfolios of emerging market governments began to shape the key financial market prices in the United States and other industrial economies, notably by lowering interest rates. The US$1.5 trillion increase in the outstanding stock of marketable treasuries between 2000 and 2007 was far too small to absorb the US$4 trillion increase in emerging market reserves over that period. (25) It should not have been a surprise that housing, a sector that is heavily influenced by interest rates and insulated from foreign competition, boomed in many G-7 economies. (26) As a result, the composition of the U.S. economy changed. Back in 2006, Lawrence Lindsey, the head of the National Economic Council in the early part of the Bush administration, wrote:

 We are buying more tee shirts, shoes and appliances and living in
 larger homes than we otherwise would because of a Chinese
 government decision. We are producing fewer appliances and less
 agricultural output than the market would have us make as well,
 thanks to a decision by the Chinese government. (27)

Understandably, manufacturing workers were not pleased by this change, while Wall Street did not object to an expanded government role in U.S. markets. Emerging economies built their market power by buying assets from willing sellers at a market or above-market price--not, generally speaking, by restricting opportunities for private profit.

Central banks generally avoided the riskiest kinds of mortgage-backed securities. They initially bought large quantities of treasuries and, after 2005, large quantities of agency bonds issued by government-sponsored enterprises like Freddie Mac and Fannie Mae. At that time, U.S. regulators had placed limits on the expansion of the agencies' balance sheets so that central banks, by buying some of the existing stock of agency bonds, effectively freed U.S. money to invest in other securities. Moreover, by holding long-term interest rates on treasuries down even as short-term rates rose, central banks pushed investors who borrowed short and invested long either to get out of business or to take on more risk. (28) Most seem to have opted to take on more risk.

At the time, the explosive growth of private mortgage-backed securities was presented as evidence that innovative private markets could do things that the government sponsored and regulated agencies could not. However, it now seems that the rise in emerging market reserves and the fall in interest rates on long-term treasuries contributed to an unsustainable credit boom and surge in home prices. The recent crisis has prompted an increase in financial market intervention by the G-7 states. The Federal Reserve has stepped in to provide support not just to banks that raised funds from insured deposits, but also to securities firms that financed themselves by issuing securities in the capital market. (29) The scale of this support has been almost as staggering as increases in central bank reserves. Between the end of July 2007 and the end of July 2008, a $311 billion reduction in treasuries held by the Federal Reserve financed the provision of an equivalent amount of central bank credit to the financial sector. (30) The Federal Home Loan Banks supplied additional credit to many banks. The U.S. government also lifted the caps that had prevented the expansion of the agencies' portfolios and allowed them to securitize a broader range of mortgages. The effect was dramatic. In 2004, 2005 and 2006, the average annual increase in the stock of agency bonds was a little less than $300 billion; in the four quarters from June 2007 to June 2008, it was over $900 billion. (31) Richard Iley of BNP Paribas has called this the effective nationalization of the U.S. mortgage market.

When doubts rose over the financial health of Fannie Mae and Freddie Mac, the U.S. government increased the size of their treasury credit line--a symbolic step meant to assure the agencies' creditors--then obtained Congressional authority to inject additional capital into the agencies as needed and ultimately took effective control of both institutions. The entire business of using emerging market savings to finance borrowing by U.S. households now requires government support at each step of the process. Foreign central banks buy the dollars their citizens no longer want to hold and the dollars private investors want to invest in the emerging world. These central banks use their rising dollar reserves to buy U.S. bonds. They are willing to buy agency bonds because they believe that the U.S. government stands behind the agencies--not because of the quality of the agencies' balance sheets.

Further financial stress then led governments in the United States and Europe to take an even larger role. The U.S. government guaranteed money market funds as well as bank deposits and looks poised to become the "buyer of last resort" for distressed mortgages and mortgage-backed securities. Ireland guaranteed the liabilities of all its domestic banks. The governments of Belgium, the Netherlands and Luxembourg joined forces to take over a major financial institution. The lack of trust among large financial institutions has also led to a truly unprecedented extension of central bank credit and liquidity support. At the end of September 2008, the total dollar lending by the central banks in the United States and Europe to troubled financial institutions exceeded $1 trillion. (32)

One set of institutions has been conspicuous in its absence: multilateral financial institutions. The U.S. subprime crisis--and its fallout among European financial institutions that raised dollars to participate in the financing of the U.S. housing boom--has been managed in the first instance by the national authorities in the United States and Europe. They supplied liquidity to their respective financial sectors and stepped in to assure the flow of funds to the household sector. They financed their activities with funds borrowed not from the IMF, but rather with funds raised by selling bonds to emerging market governments. There has been little coordination between debtors and creditors in the crisis. Emerging markets bought U.S. bonds as a result of the ongoing commitment to managing their own exchange rates against the dollar, not as a result of a negotiated agreement with the United States. Nor did emerging market governments explicitly coordinate their lending to the United States. The People's Bank of China, the Saudi Arabian Monetary Agency and the Central Bank of the Russian Federation do not generally talk to each other or share much information with the IMF. However, as long as they all resisted pressure for their currencies to appreciate against the dollar, they all needed to buy large quantities of U.S. bonds.

Central bank purchases of safe assets continue to account for a larger portion of total official flows than sovereign funds investment in risky assets. In a context where all sovereign investors have more money; these investors--state enterprise as much as sovereign wealth funds--have been active in a number of markets. This, in turn, has led to more state involvement in the market--both through direct intervention and, for G-10 countries, through screening foreign investment from state-owned firms more closely than investment from private firms. Germany recently passed new legislation giving the German state greater ability to limit takeovers from firms outside the EU. Australia has used its existing regulatory authority to slow Chinese investment in its resource sector. The United States, torn between concerns over state control and the need for state funds from abroad to help salvage its own domestic financial sector, has clarified the process it uses to review foreign investment. Surplus countries, worried that they are attracting too much "hot" money and that their foreign assets are growing too fast, have also tightened restrictions on foreign inflows. A less liberal global investment regime is a natural response to the current perverse global flow of funds. Private capital over the past year has flowed to countries such as China and the Gulf states that have a long tradition of state control, large current surpluses and little need for private inflows. Conversely; state funds have flowed heavily into the United States, a country that has long been leery of state ownership. (33)

Will Financial Influence Produce Political Leverage?

The scale of the growth of the emerging world's reserves leaves little doubt that the United States' reliance on other governments for the financing it needs to sustain its still large external deficit has increased. Governments are not motivated solely by financial gain. Indeed, it is hard to see how the United States could have sustained its large recent deficits despite offering poor returns if its government creditors prioritized financial returns over support for their exports. The possibility that a state could use its financial assets to support its political goals can no longer be ruled out. Former Treasury Secretary Lawrence Summers wrote in the Financial Times on 25 August 2008:

 For all the disagreements over the past decades, there has been a
 shared premise behind international economic policy
 discussions--the goal of increased economic integration, the spread
 of market institutions and more rapid growth for all nations. While
 companies may compete, the premise has been that nations co-operate
 to build a stronger economy in the interests of all. It is no
 longer clear that this premise remains valid. Nations are
 increasingly preoccupied with their relative economic standing, not
 the living standards of citizens. Issues of strategic leverage and
 vulnerability now play a bigger role in economic policy
 discussions. (34)

Traditionally, the provision of a reserve currency has been considered a strategic advantage for the country supplying it. Foreign central banks provided a steady supply of low cost financing and, in times of stress, money has tended to flow into the reserve currency. The United States did not have to worry that a geostrategic shock could turn into a dollar crisis. However, leverage may shift once other countries accumulate more reserves than they need. Many central banks could slow the pace of their dollar purchases without putting their own financial stability at risk. Shifts in the composition of central banks' dollar holdings, such as selling agencies for treasuries, could create pressure in parts of the U.S. market even in the absence of outright dollar sales. The United States is potentially in a position where it needs central bank financing more than other countries need to add to their reserves. The asymmetries in the relationship no longer necessarily favor the United States. (35)

This is not the only way the enormous growth in the emerging markets reserves have changed the strategic landscape. Large reserve holdings have clearly increased the economic policy autonomy of emerging market states. By freeing countries from short-term financial constraints--including those that restrained their ability to pursue their political objectives--reserves have increased countries' strategic options. Ten years ago, the IMF's decision not to lend Russia US$5 billion left it no choice but to default. In the week after conflict broke out in Georgia, Russia lost between US$5 billion and US$10 billion of reserves without blinking an eye, as it still had over US$500 billion left. (36) Russia's ability to support Ossetian and Abkhazian independence reflects, in some sense, its current financial independence from the United States and Europe. Absent the surge in the financial assets of authoritarian states, it would be hard to talk of a new age of authoritarianism. (37)

The United States risks finding itself in the opposite position. Its ongoing need for financing from other governments could limit its policy options. If China opposed a U.S. policy course, it could stop buying treasuries for several weeks and see if the market reacted. Indeed, a rise in Sino-American tension could lead to a sell-off in the treasury market even in the absence of any move by China, as markets anticipate that China might scale back its treasury purchases. An outright interruption of the existing pattern of flows remains unlikely, as it would hurt the United States' creditors nearly as much as the United States itself, but it is no longer possible to dismiss the risk out of hand. (38) The cost of a U.S. policy course that a large state creditor opposes surely has risen.

CONCLUSION

For much of the post-war period, global integration was driven by a reduction in government intervention at the border. That is no longer the case. The enormous growth in China's exports has been spurred by an increase in China's intervention in the foreign exchange market as much as by a reduction in barriers to trade. The increased dispersion in the world's current account--with large deficits and larger surpluses alike--also stems in part from government intervention in the market. (39) For most of the last five years, private capital has wanted to finance deficits in the emerging world, not the large U.S. deficit. The famous "uphill" flow of capital from poor to rich is entirely the result of official capital flows. (40) Key emerging economies have not tried to use their potential financial leverage to seek policy change in the G-10 countries. Nonetheless, the United States is increasingly importing state-ownership, rather than exporting American-style financial capitalism--although to date the state ownership has come in a form that large U.S. financial market players find easy to swallow.

Financial globalization has not proved to be the same as financial Americanization. The state has not withered away Rather, the power of ratings agencies and multilateral institutions like the IMF--previously the enforcers of the market's golden straitjacket--has been reduced. The rise in the foreign assets of key emerging market governments has reduced their vulnerability to swings in private capital flows and provided the largest emerging states the ability to alter financial conditions in the G-10 economies by changing the composition of their own external investments. The precise way states will shape the allocation of capital going forward remains unknown. Absent a change as profound as the changes that followed the Asian crisis, states--especially emerging market states--will be key players in a host of global markets for years to come.

NOTES

(1) Daniel Yergin and Joseph Stanislaw, The Commanding Heights: the Battle Between Governments & the Marketplace That Is Remaking the Modern World (New York: Simon & Schuster, 1998), 371.

(2) Timothy Sinclair, The New Masters of Capital (Ithaca: Cornell University Press, 2005).

(3) Michael Mandelbaum, The Ideas that Conquered the World: Peace, Democracy and Free Markets in the Twenty-First Century (New York: Public Affairs, 2002), 386.

(4) Martin Wolf, "The Brave New World of State Capitalism," Financial Times 16 October 2007. http://www.ft.com/cms/s/0/d31c18ca-7c14-11dc-be7e-0000779fd2ac.html.

(5) Naazneed Barma, Ely Ratner and Steven Weber, "A World Without the West," National Interest, 1 July 2007 http://www.nationalinterest.org/Article.aspx?id=14798.

(6) Ousmene Maneng, (speech, Reforming Bretton Woods seminar, Rio de Janeiro: 27 August 2008).

(7) The zeal emerging markets have applied to reducing their financial vulnerability is something of a surprise. Back in 2003, the IMF's Ken Rogoff argued that few countries were able to escape from a cycle of defaults and crises. See Carmen M. Reinart, Kenneth S. Rogoff and Miguel A. Savastano, "Debt Intolerance," NBER Working Paper no. W9908, The National Bureau of Economic Research, http://ssrn.com/abstract=435482.

(8) Eswar Prasad and Shang-Jin Wei, "The Chinese Approach to Capital Inflows: Patterns and Possible Explanations," (International Monetary Fund Working Paper no. 05/79, April 2005).

(9) Between June 2007 and June 2008, the foreign assets of China's central bank, counting "other foreign assets" as well as foreign exchange reserves, increased by US$804 billion. That number was inflated by the rise in the value of China's existing holdings of euros. But it also excludes the funds China shifted to the China Investment Corporation, its sovereign wealth fund.

(10) Between June 2006 and June 2007, when China added an estimated US$416 billion to its foreign assets, the U.S. survey data indicates that China bought $100 billion of treasuries and $120 billion of agencies. It also likely bought about US$100 billion worth of euros, though no hard data exists on its euro purchases. No data of comparable quality (the "monthly" TIC data is known to undercount Chinese purchases) is available for the last 12 months--a period when China's total foreign asset growth likely topped US$800 billion.

(11) Brad Setser, "Impact of China Investment Corporation on the Management of China's Foreign Assets," Debating China's Exchange Rate Policy, ed. Morris Goldstein and Nicholas Lardy (Washington, D.C.: Peterson Institute, 2008), 201-18.

(12) Barry Eichengreen, "The Dollar and the New Bretton Woods System," (lecture, University of California, Berkeley, December 2004).

(13) The transfer of non-performing loans (NPLs) from the state banks to China's state-owned asset management companies also has increased the banks' profitability.

(14) Marvin Goodfriend and Eswar Prasad, "A Framework for Independent Monetary Policy in China" (International Monetary Fund working paper, March 2007).

(15) Yergin and Stanislaw, 13.

(16) Jad Mouawad, "As Oil Giants Lose Influence, Supply Drops," New York Times, 8 August 2008; for more information see "Really Big Oil," Economist 10 August 2006.

(17) Valerie Marcel, Oil Titans: National Oil Companies in the Middle East (London: Chatham House, 2006); Christian Gianella, "A golden rule for Russia? How a rule-based fiscal policy can allow a smooth adjustment to the new terms of trade" (OECD Economics Department Working Paper no. 537, OECD Publishing, 2007).

(18) The 40 million residents of the Gulf likely have US$1.5 trillion in official assets; the 1.3 billion residents of China only have US$2.4 trillion.

(19) Andrew Rozanov, "Sovereign Wealth Funds: Defining Liabilities" (report, State Street Global Advisors: May 2007). See also http://www.rgemonitor.com/blog/setser/176376.

(20) Andrew England, "Saudis launch $5.3bn fund," Financial Times, 29 April 2008.

(21) Kuwait's fund dates back to the 1950s while Abu Dhabi's fund dates to the 1970s. Kuwait bought large stakes in British Petroleum and Daimler in the 1970s. Abu Dhabi has, until recently, preferred to take smaller and less visible stakes.

(22) Stephen Jen, "A 25:30:45 Long-term Model Portfolio for SWFs," (report, Morgan Stanley Reference Global, 11 October 2007) and Alex Patelis, "More on SWFs" (report, Merrill Lynch Economic Analysis, 30 October 2007).

(23) Mandelbaum, 4.

(24) Andrew Ross Sorkin, "Dealbook: A Toast to Wall St. (Please Hold the Bubbles)," New York Times, 30 December 2007.

(25) By 2004, the fall in Asian currencies against the euro had created a glaring misalignment. It is no surprise that China's trade surplus with Europe has increased rapidly over the past few years. Some European economies--Spain, Ireland and the UK---experienced large housing booms and started to look remarkably similar to the U.S. economy. In 2006 and 2007, the EU's current account deteriorated far more than the U.S. current account.

(26) Some studies estimated that the $300 billion in central bank purchases of treasuries reduced U.S. interest rates by over 100 basis points in late 2003 and early 2004. Estimating the impact of central bank purchases has grown more complicated over time for two reasons: central bank demand shifted from treasuries to agencies, and a smaller share of total central bank purchases of treasuries and agencies appeared in the monthly TIC data. In many months, the increase in the custodial holdings of the New York Federal Reserve topped the recorded central bank purchases in the TIC data. The Treasury's annual survey has produced large upward revisions to total official holdings and large subsequent revisions to estimated official flows in the BEA's financial account data. Those revisions, however, come with a long lag--and the TIC data itself isn't revised. Studies based on the monthly TIC data tend consequently understate central banks influence on the market. See the 2007 Treasury Survey for a discussion of the reasons why the higher-frequency data understates central bank purchases. Warnock and Warnock and Moec and Frey discuss estimates of the impact of central bank purchases on U.S. rates. See Laure Frey and Gilles Moec in "US long-term yields and forex interventions by foreign central banks," (Banque de France Bulletin Digest, no. 137 May 2005), 19-32; see also Francis E. Warnock and Veronica Cacdac Warnock, "International Capital Flows and U.S. Interest Rates,"(International Finance Discussion Papers no. 840, Board of Governors of the Federal Reserve System, September 2005).

(27) Lawrence B. Lindsey, "Yuan Compromise?" Wall Street Journal, 6 April 2006.

(28) 78th Annual report of the Bank of International Settlements (June 2008).

(29) United States Senate Committee on Banking, Housing and Urban Affairs, 'Actions by the New York Fed in Response to Liquidity Pressures in Financial Markets," testimony of Timothy F. Geithner, President of the Federal Reserve Bank of New York, 110th Congress, 2nd Session, 3 April 2008, http://www.newyorkfed.org/newsevents/speeches/2008/gei080403.html.

(30) Factors affecting reserve balances, available on the Federal Reserve's website at http://www.federalreserve.gov/releases/h41/20080731/. In addition to the fall in "securities held outright" the Federal Reserves appears to have lent an additional $120 billion of securities to the private financial system through its new term facility.

(31) Richard Iley, "Going with the Flow," BNP Paribas Fixed Income, 14 January 2008.

(32) The Federal Reserve's balance sheet data for 1 October 2008 indicates that the Fed has provided around $1.25 trillion of credit and liquidity support to the world's institutions by lending Treasury securities.

(33) United States House Committee on Foreign Affairs, "The Rise of Sovereign Wealth Funds: Impact on US Foreign Policy and Economic Interests," testimony by Edwin Truman, 110th Congress, 2nd Session, 21 May 2008.

(34) Lawrence Summers, "The Global Consensus on Trade is Unraveling," Financial Times, 25 August 2008.

(35) Brad Setser, "Sovereign Wealth and Sovereign Power: the Strategic Consequences of American Indebtedness," Council Special Report 37, Council on Foreign Relations, September 2008.

(36) For Russia's reserves see: http://www.cbr.ru/eng/print.asp? file=/eng/statistics/credit_statistics/inter_res_08_e.htm.

(37) Chrystia Freeland, "The New Age of Authoritarianism," Financial Times, 11 August 2008; and Bill Keller, "Cold Friends, Wrapped in Mink and Medals," New York Times, 16 August 2008.

(38) A large creditor like China would gain financially by cutting the United States off now rather than waiting. The longer China holds its exchange rate down and builds up its dollar holdings, the bigger its ultimate loss. The key constraint China faces is that any reduction in its financing of the United States risks triggering a sharp U.S. downturn that would reduce Chinese exports.

(39) Alan Greenspan noted the increased dispersion of global current account balances in 2005; his explanation, though, focused on financial innovation, not state intervention. That is hard to square with the IMF's data on capital flows, which shows that that the official sector now accounts for the entire net financial outflow from the emerging world. That outflow persisted even after the subprime crisis dented confidence in U.S. financial innovation. See Alan Greenspan, "International Imbalances," (speech, Advancing Enterprise Conference, London, 2 December 2005).

(40) See Eswar Prasad, Raghuram Raian, and Arvind Subramanian, "Foreign Capital and Economic Growth," (International Monetary Fund research department, 11 August 2006). Ben Bernanke attributes this flow to a glut of savings in the emerging world. However, he did not note that the entire net capital outflow from the emerging world comes from the official sector. Ben S. Bernanke, "The Global Saving Glut and the US Current Account Deficit," (speech, Sandridge Lecture, Virginia Association of Economics, May 2005).