Economic interdependence in a globalised environment

When it comes to modern global finance, no country is an island. Once the assumption of financial independence is dropped, it becomes easier to piece together the causes of today's financial crisis. Take China for example. Although capital spending in China has been booming, China still manages to save more than it invests, reflected in a large current account surplus. The excess savings are invested abroad. Their cautious approach means they are happy to buy lots of safe assets, notably US Treasuries. Chinese demand for Treasuries leaves yields on Treasuries rather low. That creates a problem for global investors, who discover that returns on Treasuries are not high enough to meet their investment objectives. They demand other assets which offer higher yields.

Turn the clock back a few years, and the assets which became fashionable were mortgage-backed securities, effectively, bundles of mortgage loans, sold by banks to investors who needed higher yield. So long as the ratings agencies were prepared to give these securities high ratings, investors did not need to worry: they could enjoy higher yields, apparently with no additional risk. The problem was the rising demand for mortgage-backed securities made it easier for banks to increase their lending in the housing market.

House prices rose rapidly, creating the conditions for even more lending. A housing bubble was the inevitable result. We are not suggesting China is responsible for the current financial crisis we are only pointing out by means of an example that economic interdependence has become greater. It is not enough to worry about the size of America's current account deficit. It is as important to contemplate the effects of large current account surpluses elsewhere in the world.

The success of economic policies today must take this interdependency into account. The US and the UK are beginning to believe that monetary policy, on its own, is not going to be sufficient to solve the current crisis, notwithstanding the bold interest rate cuts over the last few days. With the rapid rehabilitation of John Maynard Keynes, fiscal policy will also play a role. The reason is simple. Following the collapse in demand for mortgage-backed securities and the increase in mistrust between the banks, the banks' sources of funds dried up. Loans are too high relative to deposits. Even if the price of loans comes down, the quantity of loans supplied will shrink. This is what a credit crunch is all about.

Interest rate cuts alone cannot guarantee levels of demand which will pull economies quickly out of recession. Governments have a fiscal role to play, creating demand in areas inaccessible to monetary policy. They can do this by borrowing more.

But from whom? Around half of all the Treasuries that exist are held outside the US. Big creditors include the central banks of China, Russia and the various oil-rich countries of the Middle East. If the US and the UK are going to spend their way out of recession, it is to these countries that they will need to turn if they are going to raise fiscal funds through conventional means. The creditors may not be so enthusiastic. For them, an increase in the supply of Treasuries or gilts will feel a bit like an equity rights issue but without the voting rights.

The creditors may decide to play hardball. Rather than lending to Western governments who then decide how the money is best spent, perhaps China and others will instead demand to own Western companies outright, requiring a sale of the West's family silver. Would the incoming US administration sanction such a move? Is it likely that American banks, car companies and industrial conglomerates would be allowed to fall into foreign hands?

Perhaps not. Nevertheless, until now, the role of the creditor nations had received scant attention in the Western press. Moreover, Western policymakers have, doubtless unintentionally, created anxiety within the emerging world as a result of the various banking bailouts. Understandably, Western taxpayers want to see some benefits from the cash injections into the financial system. Governments, in response, have asked banks to protect certain kinds of domestic lending, notably to households and to small and medium-size enterprises. If, though, there is a shortage of funds to support lending, ring fencing lending in some areas must lead to greatly reduced lending elsewhere. Emerging economies are directly in the firing line.

The West desperately needs funding to support its broken financial system. The emerging markets desperately need Western demand to enable their own economies to generate the income gains which will drag people out of poverty. If, though, there is a failure to recognise the important roles being played by both creditor and debtor nations, we could end up in a world of cross-border capital and exchange controls as countries seek to protect their "national interest". This would be a disaster. Countries are more closely interconnected than ever before.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.