BERKELEY – It is fitting that the upcoming G-20 summit is being held in Pittsburg, an old industrial center of an advanced industrial country, for the advanced countries have been allowed to set the agenda for strengthening financial systems. Other than schadenfreude, emerging markets have brought little to the table.

The United States is emphasizing higher capital requirements. The Europeans are pushing for reform of compensation practices in the financial sector. While both proposals have merit, whether they will be enough to stabilize our dangerously unstable financial systems is at best dubious.

What emerging markets can add to this agenda is, to put it charitably, unclear. They have said little about how they would reform financial systems.

They can argue that this is not their problem – that the crisis of the last two years has been centered in the advanced economies, and that it is these countries’ financial systems that need to be fixed.

But the agenda set at Pittsburgh will shape, for better or worse, not just the US and European financial systems, but also the global financial system. Financial markets are too integrated – and will remain so, like it or not – for whatever rules are established not to profoundly affect emerging markets.

China, Brazil, and Russia have offered ambitious proposals, which may bear fruit in 10 or 20 years, to make the International Monetary Fund’s Special Drawing Rights a true international currency. But they have not said how they would reform financial systems and policies now.

The first priority should be international banks. Until now, the international regime, led by the IMF and OECD, has pushed countries to allow foreign banks to enter their markets.

It would be understandable if emerging markets, having seen deep problems in the conduct of foreign banks, now insist on domestic ownership and control of financial institutions.

But a blanket policy would be a mistake. Contrary to concerns that foreign banks would cut and run at the first sign of trouble, in the current crisis they maintained a remarkable degree of support for their subsidiaries in emerging markets.

Other things being equal, cross-border lending fell less in countries with significant foreign-bank presence than in emerging markets where foreign ownership of banks was not dominant.

If anything, domestic banks with shallower pockets were more likely to cut back in the crisis.

Some will say that Baltic and Southeast European countries were fortunate that responsible Swedish and Austrian banks, rather than their toxic US and British counterparts, had entered their markets.

But this observation points to what is needed: a regime that defines the conditions to be met before a country’s banks are allowed in.

The home country must put a cap on leverage, limit acceptable liquidity and funding practices, and have a resolution regime for winding up complex financial institutions.

Otherwise, emerging markets should be able to say that banks from that country will not be allowed to enter.

The second priority should be defining a strict emerging-market standard for regulating foreign banks after they are allowed in.

Other positive aspects notwithstanding, the presence of foreign banks is associated with currency mismatches.

In Central and Eastern Europe, foreign banks extended euro- and Swiss franc-denominated corporate, home, and car loans to firms and households with incomes in local currency, which added to corporate and household financial distress when local currencies tanked.

Austrian, Italian, and Swiss regulators, seeing that their banks’ assets and liabilities were in their own currencies, looked the other way.

The implication is that emerging markets, while encouraging foreign banks’ entry, should at the same time strictly regulate such banks’ local lending practices.

And, since strict regulation, if adopted unilaterally, might simply cause foreign banks to shun a country, emerging markets need to put up a united front.

Finally, emerging markets need to redouble their efforts to build bond markets, but on a local basis. Countries with more developed bond markets experienced less negative fallout from the crisis, since their large firms retained access to non-bank sources of finance.

But opening those markets to foreign investors, which has been the dominant strategy for developing them, was a mixed blessing.

South Korea, the Asian country with the largest share of foreign investment in its securities market, also experienced the sharpest price and exchange-rate declines as those investors, mainly hedge funds, were forced to deleverage and repatriate their funds.

Encouraging participation by foreign investors is a quick way to jump-start local bond market activity. But recent experience suggests that quickest is not best. Regulations limiting foreign participation to prudent levels should be part of the new international regime.

The next chair of the G-20 will be South Korea. Emerging markets should start preparing now to ask it for the floor.
Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.
Copyright: Project Syndicate, 2009.
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