Bahamas: Hyper Risks in the Status Quo of the Global Financial System

I give this paper with some difficulty today, understanding that in the balance, we are not accustomed to thinking that amongst our own, new ideas with profound global application are in any way possible. I say this because it is exactly the business I am in, which is to formulate new ideas applicable not only within our national limits, but also in the global international context. And, as a practical matter, I intend to use this occasion, as a sign of respect for your interest in ideas, to advance aspects of a new idea as a means of creating the baseline for debate.

Allow me to preface the above said in the flowing way: For myself, I do not worry in the least at our seeming mistrust of what is ‘home grown’, but I am often left to wonder about you gathered here - young people, constantly under training and varieties of career development initiatives – whether your own studied observations will win a respectful audience amongst your colleagues. I wonder whether you will break the cycle of the absence of professional intellectual collegiality in The Bahamas, whilst cultivating amongst yourselves a community of persons prepared to take ideas seriously.

Let me press this point: there must come a time when you are not merely prepared to live in the world, or to live under the practical benefits of ideas that have emerged elsewhere. At the same time, we cannot simply assert that what we think is valid. We must commit ourselves to the development of an intellectual basis for every aspect of our lives in these islands; as a meanings finally, of walking that last mile of independence, through an informed, critical, reflective independence of mind.

There was a time when ideas - particularly those touching the global financial system - was the preserve of intellectuals and scholars in the larger nations. However that has changed; largely because of technology, but more directly because of the business development and enterprise cultures in which the use, development and advances in technology have fostered a school of emerging nations - particularly India, China, Dubai and Estonia – which have revolutionized their commercial and manufacturing systems with profound effects on the world markets. Noticeably, absent from this emergent trend are the nations of the Caribbean; amongst whom - aside from the expansion of Bermudian banking into Asia - there is little sign of a sustainable emerging trend with an infrastructure capable of sustaining a growth trend attractive enough to draw the full notice of the world.

Let me explain this so I am not taken out of context: recently we have seen capital developments on Paradise Island in The Bahamas recently, (and in the region the new Sangster Airport at Jamaica, initiatives for software development in Barbados and new partnership in petroleum services provision in Trinidad) which may lead you to ask why I failed to include them as indicators of an emerging growth model. My answer is that such investments are good for The Bahamas and the regional jurisdictions respectively. And that in the case of The Bahamas, the previous and current administrations are to be commended for facilitating the PI investments mentioned before.

However, it does nothing to meet the criteria of an emerging market in the sense assigned to the nations mentioned earlier.

To put the matter technically, an emerging market is one in which international investors can find alternatives to traditional markets, and in which there is an agreed comparative advantage for global capital evidenced by significant, perhaps even unprecedented inflows of capital that places the jurisdiction or nation in a position – potentially - to monetize their infrastructural development needs to increase their comparative and competitive advantages.

Whilst it is true that China and India in particular are less ready in infrastructure terms than are Dubai and Estonia, their available labour, wages and rate of increase in wages and high productivity results in a general advantage, and in the case of India, science and math education extends comparatives to a competitive advantages.

Recently, in a lecture to the Society of Trusts and Estate Planners (STEP), I was at pains to show the practical implications of what I am saying.

I am not blaming the developers or the governments that have negotiated these deals. Rather, at this point, I merely draw the irony to your attention as a state of affairs.

This story is repeated in as many Caribbean jurisdictions, where we seem to be passive co-existents with investments into our countries. And it seems that we have no real plans to take a more proactive role, which would require that we behave in a serious manner, and that we should be prepared to take each other seriously as professionals. If we could envision that, and perhaps achieve some measure of it, the world now linked by technologies in a way that promotes intelligence as a strength may be able to offer us more than we may now imagine; particularly in respect of our potential contribution to the formation of a new international financial architecture. Before we can see the possibilities here, we must try to understand what is happening in the world’s financial system.

In September 1998 the Federal Reserve organized a rescue of Long-Term Capital Management, a very large and prominent hedge fund on the brink of failure. The Fed intervened because it was concerned about possible dire consequences for world financial markets if it allowed the hedge fund to fail. In point of fact, the spectre of the possibility of failure was tied to an old-world, out-dated view of the global financial system, and a clear mis-apprehension of the character of hedge fund investing.

This hubristic mis-apprehensions continues today, and influences many of the contretemps now facing participants in the world’s financial system. In that same year I wrote about the OECD initiative on harmful tax practices as being a mis-application of the professional attention of economist, since the real problems facing the global financial systems were (and are):

1. The Capital Account Crisis in the Emerging Market World
2. The lack of investment in infrastructure in emerging markets
3. The demographic shifts in the G21 nations, and its effect on global capital flows

A number of my colleagues at the National Bureau for Economic Research (NBER) took up these arguments, but this subject matter is largely unaddressed in the international economic literature; at least to a degree sufficient for the problems they are likely to pose.

If one observed the international financial system over the last four decades, the system was composed of two polarities in the accepted thinking:

1. A core, which has – because of its political advantages - the exorbitant privilege of issuing currency used as international reserves. Over the 40 year period, these jurisdictions have had a determinative effect on the world’s financial system and its support institutions such as the World Bank and the IMF.
2. A periphery, which is driven by export-led growth based on the maintenance of an undervalued exchange rate.

In the 1960s, the core was the United States and the periphery was Europe and Japan. Now, with the spread of emerging markets, the new periphery is Asia, but with the United States as the same old core as 40 years ago¹.

There are many conclusions to be drawn from the current international economic climate in respect of the maintenance of this structure. For instance, American consumerism drives this system, with the same tendency to live beyond its means. This has suggested to some Americans – particularly economic neo-conservatives - that the current pattern of international settlements can be maintained indefinitely. We all agree that they advance a unilateral foreign and military policy in world of multilateral dependencies². We may have overlooked is their commitment to a unilateral economic policy, even in systems of an integrated economic world in which the US is the largest net borrower in the global system³.

The argument – in part - is that The United States can continue running current account deficits because the emerging markets of Asia and Latin America are happy to accumulate dollars; even though this has changed significantly in the last decade with the introduction of the Euro. Some colleagues argue that: ‘There is no reason why the dollar must fall, since there is no need for balance of payments adjustment; in particular, the Asian countries will resist the appreciation of their currencies against the dollar.

But another argument suggests itself: that this image of a new Bretton Woods System confuses the incentives and rising opportunities perceived by individual countries under Bretton Woods with the challenges confronting groups of countries today. It imagines the existence of a cohesive bloc of countries called the periphery upon whom they can call to act in core country’s interests, or are able, willing and ready to act in their own collective interests. Whilst we have seen some measure of this collectivity recently in WTO and FTAA negotiations. Nothing so concrete as a small or peripheral nation strategy exits on any issue internationally.

I argue, to the contrary, that the countries of Asia constituting the new periphery are unlikely to be able to subordinate their individual interests to the collective interest⁴. And the underlying volatile growth rates in Asian nations will prove impossible as a prop for long term dollar values.

Coming Crises for Emerging Nations; Worse for those Below:
A greater understanding of the causes and nature of financial crises, as precursor to understanding how the current financial theology is likely to lead to further crisis will require an examination of the characteristics of crisis; particularly as they arise from the current global financial architecture based on the Bretton Woods (core/periphery model). While each episode of financial instability has had its own special characteristics, a number of common features stand out:

• They have typically been preceded by rapid financial deregulation; where there was currency instability marked by comparative undervalue; by liberalization of capital transactions in condition of macroeconomic volatility
• The above conditions lead to Banking crises as they are associated with excessive lending on certain categories of assets such as property and stocks, and with speculative bubbles, frequently following a large movement by banks into unfamiliar lending territory; spurred by the financial ‘bubble rush’ typical in emerging market economies. Such lending has often - as in China - but not always - as in Japan & San Francisco⁵ in the 1990s - taken place in the context of weak financial regulation and supervision, and if often marred by crony banking, where political insiders benefit at the cost of better more efficient proposals
• The events above are often preceded by increased capital inflows attracted by a combination of an interest, tax and labour rate differentials and relatively stable disequilibrium in exchange rates.
• Colleagues at the NBER assert that: "There is no known case in any country, developed or developing, of a large increase in liquidity in the banking sector resulting from capital inflows that did not lead to an over-extension of lending, a decline in the quality of assets and increased laxity in risk assessment".
• In particular situations – with the common characteristics entered here – large, swift inflows of capital generates affective currency appreciation complimented by a co-terminus deterioration of balances on the current account. And so again following colleagues at NBER, "When there are excessive capital inflows, the worsening of external balances and the weakening of the financial sector are often two sides of the same coin".

Two conclusions follow from these critical observations which are advanced by Chakravarthi Raghavan⁶:

• The pressure on banks to find alternative sources of business to increase returns, and the greater competition in the financial sector brought about by deregulation, have been an important cause of increased international financial instability
• Reversals of capital flows are often associated with a deterioration of macroeconomic conditions resulting from the effects of the inflows, rather than with shifts in policies, because by the time the risk factors have reared, it is too late. (emphasis is mine).

These observations represent the world picture which is the direct result of the 40 year old Bretton Woods model; that dominates the thinking of G7 governments and institutions. The model cannot account for the actual state of affairs in the global financial world; particularly as it relates to overseas investment of portfolio flows, which are markedly different in their character and career than foreign Direct Investment flows of capital.

I assert, that global financial stability is less influenced to day by the core/periphery model, and moreso by two factors already named above:

1. The demographic shifts or aging of G7 populations
2. The critical lack of readiness and capacity to absorb investment, because of a variety of infrastructural poverties.

Mexico and Brazil are key examples for observing the effects of a quick rise and quick fall scenario, characterized by an inability to absorb investment capital efficiently.

Additionally, most if not all major episodes of capital outflow influenced debt crisis in developing countries have been associated with rising international interest rates, which is the situation facing the world at the moment; and so yet another component of risk.

Constant Factors of Volatility:
In the emerging market or developing world – which is not the same thing, but often overlaps – the constant fact of volatility is not either FDI, portfolio investments, bank lending or the maturity of the flows. What may be observed is that in Asia, Latin America and elsewhere though they have gone through a full circle of bank loans, bonds, FDI and portfolio flows there is one constant factor, which is the volatility of flows into emerging market systems.
The experience of the post-Bretton Woods system shows that the nature of the borrower does not significantly alter the probability of a crisis. And financial sector competition, caused by deregulation, is as much a cause of increased financial instability as anything else.

Large capital inflows lead to an overextension in bank lending that is exposed when flows are reversed or have internal adverse macroeconomic effects – such as in sharply rising prices, resulting in instability or collapse of the banking system.
However, the main considerations for risk factors in emerging markets, which the dominant thinking on the global financial system has not addressed properly are a variety of poverties which plague nations of the Caribbean as well. They are primarily:

1. Failure of infrastructure
2. Poor fiscal management
3. Poor Institutional arrangements
4. Undisciplined Courts
5. Weak Professional organizations
6. Risky Capital Markets
7. Poor Education
8. Market Entry Red tape and costs
9. Poor tax collections & Corruption

I return then to the situation here in The Bahamas. If this nation and your sector of the economy must become what it can, you will have to become well-versed in these discussions and the particular characteristics of the global financial system. I say this on the basis that you are seeking or will seek to reverse the status quo in which you are not only unconnected to large investments in The Bahamas – even as you constitute the human capital of its financial sector – but seemingly disconnected.

If this is to be done, the ills which plague emerging markets and developing economies must be corrected. In particular, a support infrastructure for investment and investor protections - whether local or foreign - must be cultivated.

As is may constant refrain, professional associations and civil society – which is nothing more or less than an amalgam of professional and social organizations. A clear focus must be gotten on the direction of national development and the critical comparative and competitive advantages which are to be had in a Bahamas revitalized by a banking sector which does not wait on the sidelines to be hired into the front lines of the banking world.

I repeat my call for Bahamians to begin to take a strong position on developing a domestic banking platform based on Bahamian ownership of banks. I cite Bermuda as an example of a certain widely agreed competence in the financial services, beyond acting as back office specialists, which has culminated in the internationalization of its two major domestic banking institutions.

I caution however, the you must not merely assert you right to banking licenses, you must show your talent in such a way that no other conclusion can be drawn. One way of doing this is to do your current jobs at the highest standards. Second you must participate in your professional organization, and act fastidiously to prevent them becoming political in any way. Third, you develop a basis of respect and collegiality amongst yourselves; by pursuing research relevant to the developmental trajectory of banking and finance in The Bahamas; and not slavishly follow what other forces deem as important. Fourth, make your presence felt in the application of your skills in your immediate lives. I am shocked at the state of finances of professional organizations and even Churches in this nation, given that we claim to be first rate bankers, accountants, lawyers and financial analysts. Our failure in these regards not only denies us examples of the application of our talents, but it is nothing short of a disgrace.

The demonstrative failures here will prove an impediment to the next levels of development I want to implore you to pursue. I have tried to show what opportunities are available to us if we think profoundly and act productively.

One example is that there is a little over $11 billion dollars on deposit here in the Caribbean. However, that money is sitting in bank accounts losing value to annual inflation. Why is that ? First, we do not have the institutional mechanisms to source those funds to region-wide investments. Second, for the very reasons – the varieties of poverties - I listed above, we in this region have too little faith in each other to buy each other’s financial products. And in none of our jurisdictions, are our courts sufficiently respected, particularly in commercial matters – not to mention the absence of proper bankruptcy laws or competent enforcement - that we can sustain a regional capital market in the supply of investment options for ourselves and others.

In a Landfall Centre monthly newslettre, I have proposed the development of regional bond facility, which has the credibility to attract, rate and issue regional government and corporate bonds. Much of our infrastructural development – which as I hope I have shown is a key element in our structural weakness as recipients of inward investment or our march toward emerging market status – can be funded by such a facility, which also provides project management services to ensure the underlying investment are free from inefficiencies and political influences.

To achieve this, again, you will have to return to my opening remarks, which asserted the following:

1. In our economic system, our bankers are passive by-standers when large investments take place
2. The world will not allow you to maintain any status quo
3. To develop a dynamic model you will have to develop a basis of demonstrative professional respect for each other
4. This must be done through professional organizations
5. The knowledge base which you must master is the architecture of the global financial system, which must be the basis of the vision for financial services and banking in The Bahamas
6. You must work through professional organizations to discipline the support professions
7. You must make your presence felt in your immediate communities
8. You must set you own standards, and cease in any way to have your future possibilities and the shape of your sector determined by external forces

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.