Asia's Foreign Reserves - A New Pool

Businessweek reports that a group of Asian nations who collectively hold 65% of the world's foreign exchange reserves has agreed to create a new "pooling arrangement" to help prevent fallout in the aftermath of incidents like the 1997 Asian Contagion that rapidly spread throughout the region. The group is motivated by the perception that the IMF, the global body usually acting as a lender of last resort in these types of scenarios, imposed conditions like higher interest rates and lower government spending in exchange for loans.

The first obvious implication of this unprecedented regional cooperation is that China, Japan, and the rest of southeast Asia are finally willing to cooperate without outside interference to advance their own interests. The continued economic dynamism of the region will ensure that an increasing share of the global economy will depend on the institutions constructed by the region. Despite the recent historical weakness of these financial institutions, this new multilateral endeavor indicates that the major players have internalized the importance of cooperation.

The second, far less positive implication is that much of the region, and China in particular, is interested in constructing a parallel global economic framework that embraces nonintervention in nation economics as a first order principle. The real concern here is that enabling despotic regimes such as Thailand, Myanmar, or even North Korea will result in humanitarian disasters. But just as frightening to the economies of the region is a commitment to not imposing fiscal reforms. The real causes of financial collapse are weak institutions and poor policy. By setting up an additional bulwark against failure before intervention by the IMF, this "pooling arrangement" is going to ensure that weaker, less wide-ranging reforms are enacted at the conclusion of each economic shock, making future failures more likely.

The good done by increasing political cooperation between these critical components of the global economy is at least partially offset by the purpose of their cooperation. The world would be much better off if China and the rest of the region put their reserves into existing institutions like the IMF in exchange for increased consideration. With the failure of the Doha Round at the WTO, the world looked immediately to bilateral agreements to continue trade progress. While regional cooperation is superior to earlier bilateral cooperation, only truly global cooperation will best advance everyone's interests.

Private Equity: NOT A Risk to Financial Stability

Forbes reported that the IMF has warned investors to pay attention to "areas of risk which could cause a disorderly correction in financial markets". First came a discussion of the carry trade in the Japanese yen that could have occurred at any time in the past decade with precisely the same arguments and exactly the same amount of evidence - none. Financial analysts at the IMF have noted the potential trouble emanating from Japan's ultra-low interest rates, but they aren't paying attention to the fact that the Japanese are also aware of the situation and are highly unlikely to wreck the global financial system since that would immediately destroy their own export dependent economy as well.

The new area of risk that the IMF wants investors to watch is private equity. The problem is that every time a buyout occurs, the acquired firm takes on a great deal of debt that could make the business more vulnerable to a downturn. While it is certainly true that taking on debt up to your eyeballs is a risky financial strategy, the greater reality is that not leveraging your business is itself a decision to hold back and retain your flexibility to ignore the needs of your customers. All businesses are going to end up taking on lots of debt before they go belly up, simply because they can. If companies already have a significant debt load, they can't slowly fade away over the course of decades. While it might be more psychologically satisfying to give everyone years and years to get used to the fact that a given company isn't producing any value, the economy is better off when resources flow to their most efficient uses.

At any rate, the geniuses behind private equity are constrained in their ability to take on excessive debt both by their bankers, who rightly fear default, and their own profit motive, because a failed company is never in the interest of its owner.

If this is the new risk facing the world economy, the next few years should witness some impressive growth.