By Charles Abugre
With poverty and inequality increasingly of concern in countries rich and poor, we should together seize the opportunity to tackle financial secrecy – both to guard against the instability that threatens economic progress and to curtail the tax evasion and corruption that undermines our states and actions to reduce poverty.
As protesting citizens occupy financial centres across the rich world, in part inspired by the rights protests of the Arab Spring, the crisis has returned to threaten economic recovery. Observers in developing countries recognise the crisis well, as a classic financial liberalisation bust – but with a particular twist.
The phenomenon of the capital account liberalisation boom and bust is well established in development economics. In the late 1990s John Williamson – who coined the term, the ‘Washington consensus’ – demonstrated that every liberalisation period in developing countries had been followed by a bust. In most cases – though not all – a boom occurred in between.
The broad strokes of a ‘typical’ episode are these. First, the liberalisation allows domestic banks and companies to borrow and to sell equity more freely. As foreign capital flows in, this greater access to finance triggers an economic boom. The second systematic feature is that these financial flows are not converted into productive investment, but overwhelmingly into consumption and unproductive assets. The latter typically results in major bubbles in the property market and the stock market.
Eventually, some trigger event – not necessarily with any clear relationship to the economy in question – leads investors to re-evaluate their exposure, and to reduce it. The resulting reversal of flows means that banks are suddenly unable to roll over their foreign debts and in turn call in their own loans to domestic businesses. Some banks go bust, further reducing credit. Listed companies also see their share value drop sharply. The combination causes a major squeeze on company finances, resulting in bankruptcies, falling investment and a steep rise in unemployment.
Domestic investors, meanwhile, have often been lulled into a sense that ‘this time is different’ and are highly exposed to the local stock markets – as well as to the property bubble. Many citizens lose both investment value and their jobs.
The economic and social costs are great indeed. Inequality is often exacerbated, both in the boom and in the bust. The reversal of the money tide often reveals business activity in its wake that was foolhardy at best, blatantly fraudulent at worst. Ratings agencies and auditors raise the alarm, if at all, only after the fact.
How much of the last four paragraphs sound familiar? Asset bubbles and a credit-fuelled consumption boom, giving way to a bust that brings social unrest and a sustained period of economic depression?
The twist is this: that there was no formal capital account liberalisation preceding the global financial crisis. Instead, there was – well, let’s call it a shadow liberalisation.
Since at least the 1980s, regulatory arbitrage between jurisdictions combined with international regulatory coordination that was ineffective or simply not attempted. The resulting ‘shadow banking’ sector represented in effect a massive increase in the amount of leverage that banks and other financial institutions could obtain without regulatory restraint. It was highlighted at the time only by the BIS, but no great heed was taken by national regulators.
A paradigmatic example of the excessive leverage made possible is that of the Bear Stearns vehicle in the Dublin financial centre. Irish academic Jim Stewart documented after the parent company’s collapse that it had $112 of assets for each $1 of equity. Neither the Irish nor US regulator appears to have recognised beforehand a responsibility here, because local regulations were apparently being respected.
The absence of international coordination and information exchange was exploited right across the financial system, as banks and others ‘freed’ themselves more and more from the burden of state intervention – until the time came when their reliance on it was made plain. Both US Treasury Secretary Tim Geithner and Nobel economist Paul Krugman have placed substantial blame for the crisis on the run on the shadow banking system.
The same lack of financial transparency that made this possible also underpins a problem that persisted all the way through the boom, but is now recognised as much more of an affront to society. We refer, of course, to the tax evasion and avoidance that may cost developing countries $160 billion a year in lost revenues – and greater sums to OECD countries.
The same regulatory arbitrage gave rise to a race to provide the most opaque, least taxed jurisdiction for companies to shift profits made elsewhere. And a location to hide assets and income streams has wider appeal – not least to corrupt state officials, and to companies that rely on bribery to win contracts.
Financial secrecy undermines the Millennium Development Goals, agreed by policymakers around the world to drive human progress to 2015, in numerous ways. Most tangibly, the diversion of revenues means less spending on health and education, less investment in infrastructure, less protection of the poorest. More insidiously, secrecy erodes the social contract that underpins government accountability to deliver for citizens.
When the ‘Occupy’ protesters call for finance that serves people rather than vice versa, while the World Bank publishes a strident attack on the ‘Puppet Masters’ of illicit finance, it should be clear that we are seeing a powerful convergence.
For once, we really are all in it together. The G20 has a long way to go to meet its 2009 promise to end secrecy; but if it can find the courage to do so, it will be applauded each step of the way.
Charles Abugre is the Africa Regional Director of the United Nations Millennium Campaign (for the MDGs). These views should not be attributed to the United Nations.