In 1789, ironically at the beginning of the French revolution and a year before he passed away, Benjamin Franklin (1706-90) remarked that: "In this world nothing can be said to be certain, except death and taxes." More seriously, the uncertainties that developing countries are currently exposed to include: (i) a sharp slowdown in the US economy; (ii) foreign exchange, interest rate and credit risks in managing their FX reserves; and (iii) higher volatility in cross-border capital flows.
In an unscheduled meeting on January 22, the US Federal Reserve reduced the benchmark overnight interest rate by 75 basis points and more rate cuts and a fiscal stimulus package are anticipated to boost spending. Developing countries in Asia are in an absurd situation in which the bulk of their FX reserves are invested in low-yielding deposits in G-7 central banks and government debt securities.
The principal amounts of these investments are exposed to exchange rate risk and interest income will come down on shorter-term instruments since these will be rolled over at lower interest rates. If China has 60 per cent of its more than $1 trillion FX reserves in dollar-denominated assets, it has probably lost around $60 billion, in yuan terms, due to the 10 per cent yuan appreciation against the dollar over 2006-07. Similarly, India has lost about $21 billion, in rupee terms, on its $250 billion of FX reserves (as of end September 2007) due to the 14 per cent appreciation of the Indian rupee against the dollar over the last one year. In the last decade, private firms and high net worth individuals from developed countries have invested heavily in Indian, Chinese and other developing country equity markets. However, FX outflows from Asia to developed countries far outweigh all inflows into Asian countries including investments in its equity markets.
It is necessary, therefore, for Asia to put together a multilateral institution that would address the risks mentioned above, the funding needs of member economies and serve as an economic think-tank for the region. The capital required to set up a multilateral is small compared to the FX reserves losses due to dollar depreciation, e.g. the IBRD's paid-up equity plus reserves is about $40 billion. An Asian Investment Bank, set up by the governments of the region, could address systemic market risks and provide funding in an Asian currency unit, as an accounting unit for loans, to promote infrastructure and intra-Asia trade.
In a globalising world in which private sector cross-border capital-flows dwarf bilateral and multilateral development assistance, many would argue that another government-owned multilateral would be redundant. On the contrary, an AIB would give much needed competition to the World Bank group and the Asian Development Bank in Asia. In addition, whenever issues such as the role of sovereign wealth funds come up, the default option is to seek inputs from the International Monetary Fund and the World Bank. An AIB could offer inputs focusing on the interests of its regional share-holders.
In the last two weeks, leading financial firms Citibank and Merrill Lynch have announced losses of about $10 billion each for the last quarter of 2007. Earlier, New Century Financial, Bear-Stearns, Morgan Stanley and others had announced substantial sub-prime related losses. As Wodehouse may have remarked, it "boggles the mind" that SWFs set up by Asian and oil-exporting countries are providing life-supporting risk capital to major international banks.
The World Bank and the IMF are global in their membership. The European Investment Bank (EIB) has 27 European Union members and there are no non-regional members unlike the ADB, which has 48 regional and 19 non-regional members, or the European Bank for Reconstruction and Development (EBRD), which has 27 regional and 34 non-regional members.
Despite the presence of the World Bank and the EBRD in Europe, the EIB's long-term lending, mainly to the private sector, has been found to be useful. In fact, the EIB's loans, to credit intermediaries and final beneficiaries, stood at $387 billion as of 2006, which was more than the loans outstanding of any of the other multilateral funding institutions listed in the table. As can also be seen in the table, India, Russia and China have limited voting shares resulting in inadequate representation in the management of these institutions. In the ADB, the non-regional members plus Australia and Japan have 52.7 per cent of the voting shares. The World Bank and the IMF were set up in 1945 and the ADB in 1966 and these institutions have been headed by US, European and Japanese nationals since their inception.
ESCAP had suggested setting up an AIB in 2005. Perhaps, it is time to set up a multilateral financial institution, which is "of Asians, for Asians and by Asians". Such an institution could fund cross-country projects, e.g. the ESCAP proposal for a trans-Asia railway network. There are 41 participating countries in this proposal, which include Central Asian countries, China, Iran, Bangladesh, Thailand, Cambodia, Nepal, Sri Lanka and Russia. Unfortunately, India is not a participant as yet. The AIB could provide viability gap funding without getting mired in the environmental disputes that hamper infrastructure projects sponsored by the World Bank or the ADB.
It is possible that setting up an AIB in the face of opposition from developed countries would lead to lower G-7 interest in multilateral development institutions. However, this is happening already as developed countries turn inwards to put their economic houses in order. Further, it would be irrational for Asia not to set up an AIB because doing so would reduce "aid" from affluent countries, which today is minuscule compared to the net capital flows from Asian countries to the developed world.
Views expressed in this column are personal