World needs to change its financial architecture

David E. Sumual, Analyst, Danareksa Research Institute, Jakarta

As a result of heightening war-hostility and terrorism risks, the world has become a riskier place to do business. And this cycle of violence may get worse in the near future after Israel's recent assassination of Hamas leader Sheikh Ahmed Yassin.

The U.S.'s tacit approval of Israel's killing of Yassin, as expressed in its veto last week of a UN Security Council resolution condemning the assassination, is also likely to increase the risk premium in the future. All of these factors help explain the trend in recent weeks toward a flight to safety and increased speculation on financial and commodity prices.

The volatility of crude oil prices over the past week in part stem from the growing fear of terrorist attacks on oil infrastructure. As such, crude oil prices peaked at US$38.20 per barrel last week. However, the price of oil slid to $35.30 per barrel at the beginning of this week due to speculation that OPEC might cancel its plan to cut production quotas beginning in April.

The terrorist bombings in Madrid have also discouraged investors from continuing to pump new money into equity funds. According to Emerging Portfolio Fund Research, all equity fund categories, except emerging Europe, Middle East and Africa, recorded a net outflow of $846 million last week. Terrorism fears also have had an impact on gold prices, which hit a new high of $422.17 per ounce at the beginning of this week.

However, terrorism and increased violence are not the only factors to blame for the turbulent financial markets and heightened world economic risk. Apart from security concerns, the large imbalance in the world's financial architecture also poses a risk. As there are no clear rules as to how financial systems should be adjusted if such an imbalance arises, the global financial architecture is in urgent need of reform.

Given the current global financial architecture, the world's interlinked economies no longer trade to capture a comparative advantage. Instead, the world, especially East Asian economies, compete in exports to acquire much-needed dollars to sustain the exchange value of their domestic currencies or to service their dollar-denominated debts.

The imbalance in essence arises because, although the U.S. economy does not have the money to pay for its imports, it can continue to import East Asian goods as long as the East Asian economies keep buying U.S. T-Bills. In other words, East Asia is simply recycling U.S. dollars by re-lending to the U.S., and this serves to maintain the dollar's value.

In the short term, East Asia might thus be seen as a savior of the world's economy. This is evident in the false notion being put forward that it is necessary for the rest of the world to buy dollar-denominated papers for the stability and growth of the world economy. But, in the longer term, East Asian central banks are actually delaying a necessary adjustment by allowing the U.S. deficit to grow, creating even greater risks to the world economy.

Although the U.S. budget deficit swelled to 4.6 percent of GDP last year, East Asia's central banks continued to ignore the market signals by accepting artificially low bond yields. This is likely to lead to an even bigger and more dangerous build-up of American foreign debt, meaning that the U.S. administration may ignore the urgency to cut the deficit. As such, the U.S. may still prevail as the global economic superpower even though its economic fundamentals are comparatively weak.

However, sooner or later, East Asia's central banks may have to face the fact that they are holding far too many U.S. denominated papers giving very low returns. As also cited by U.S. Fed chief Alan Greenspan, given the already substantial accumulation of dollar-denominated debts, investors may become less and less willing to absorb ever-growing claims on U.S. papers.

This creates a built-in risk for the world economy, which relies predominantly on the U.S. economy. This is especially true given that any confidence-denting event would be detrimental to the world financial markets. In these circumstances, the gradual decline of the U.S. dollar that now benefits the U.S. economy may pick up speed and become a very dangerous game.

Given these discouraging trends, the initiative for reform may not originate in the U.S. administration. Ahead of this year's presidential election in the U.S., the administration may be reluctant to change the global financial architecture in the near future, which will be dangerous if the situation deteriorates ahead of the elections.

As such, East Asian economies that hold the majority of the world's foreign exchange resources should develop other market financial instruments and develop initiatives on how the world's financial architecture should evolve. East Asian economies can leverage the huge financial resources under their control to shape the reform of the international financial architecture and ensure a more stable financial environment for the region as a whole.

A critical variable in that equation, however, is the willingness of Asia's central banks to strengthen their regional financial cooperation. The position of the Bank of Japan and the Chinese central bank is of significance in this regard, not only because of the size of their reserves or the signal it would send to the rest of the world, but also because of their geopolitical significance.

If the countries of the region are ready to cooperate with each other, with a combined total of more than $1.8 trillion in foreign reserves, East Asian economies could be in the position to improve the major imbalance in the world financial system.

The views represented in this article are personal.