Economics

How the U.S. economic meltdown helped create a crisis in Honduras.

By Fernando Carrera Castro

The coup d'état in Honduras has received due international attention for its political implications -- and its potential to erode democracy across Latin America. Unfortunately, that's only half the story. Equally important are the economic factors that both catalyzed discontent and could now exacerbate the country's internal crisis.

Honduras is the most open economy of Central America and the one that most depends on its relationship with the United States. Exports to the United States accounted for almost a quarter of Honduras's GDP in 2007 (the second highest in Central America, after Nicaragua), according to figures collected by the Central American Institute for Fiscal Studies. Remittances from migrants amounted to 21 percent of GDP in 2008 and are expected to remain about the same this year. Meanwhile, U.S. direct investment in Honduras is among the highest in Central America. All told, Honduras's links to the U.S. economy represented close to 60 percent of the country's GDP in 2007.

Such a remarkable dependence was a blessing from 2003 to early 2008, while markets were booming and U.S. consumption was at an all-time high. But it turned out to be a major problem with the first signs of economic downturn, and since the last quarter of 2008, the situation has become a nightmare. The impact on exports, foreign direct investment, and tourism has resonated across Honduras. Businesses have gone belly up, consumer expenditure is down, unemployment and poverty are rising, and the government's coffers are running dry.

The downturn might have played well for ousted President Manuel Zelaya's increasingly populist rhetoric. But it also presented Zelaya with an awkward reality: Despite his nationalist rhetoric, Honduras would desperately need help from the United States and the international community to keep his government afloat. Calculations made in the early months of 2009 indicated that a fifth of the fiscal budget was expected to be financed with international loans and donations. By June, with the worsening economic situation and fallen fiscal revenue, this figure might have reached 35 percent. It is clear, then, that the government was not going to be able to pay its employees' salaries this year without external financial support. And this was the situation before the coup.

The current political crisis can only make matters worse (if such a situation is even possible). Any Honduran government will depend on the international community's financial support to survive in the coming year. The poorest citizens in Honduras, with one of the highest malnutrition and infant mortality rates in Latin America, might even need international humanitarian assistance if things continue on their current path.

Given this daunting situation, it is rather impressive that anyone wants to be president of Honduras at all. But if you are not poor, and your future is not threatened by the current economic crisis, you might find the presidency a very attractive job. One could ask Manuel Zelaya and Roberto Micheletti about that.

Fernando Carrera Castro is executive director of the Central American Institute for Fiscal Studies (Instituto Centroamericano de Estudios Fiscales).

Photo: ORLANDO SIERRA/AFP/Getty Images

Why the Middle Kingdom's popularity is about to take a nosedive.

By Ben Simpfendorfer

China's reputation as a major economic power is growing by the day. Talk of a "G-2" symbolizes the growing importance of the U.S.-China relationship to the global economy. Financial markets are meanwhile captivated by China's speculation on the future of the dollar, while economists hope that a Chinese economic recovery will drag the rest of the world up with it.

Yet China's reputation as a leader of the emerging world is about to take a tumble: The country's exports to emerging markets are surging, and the resulting increase in cheap Chinese goods could create a long-term backlash that will undermine China's patient "charm offensive" for years to come.

Over the last five years alone, the annual value of China's shipments to Africa, Latin America, and the Middle East rose from $38 billion to $192 billion (in fact, China recently overtook the United States as the world's largest exporter to the Middle East). This surge in exports is a rational response to economic problems at home and a collapse in demand in China's traditional markets in Europe and the United States. The global economy has weakened purchasing power in the West, and the competition is less intense -- and the profit margins higher -- in the developing world.

But there is an economic and social cost to this shift in trade patterns. For now, households from Egypt to Brazil are delighted at their newfound ability to purchase ordinary goods once considered unaffordable. A new middle class is rising to meet falling prices for microwave ovens and washing machines. But the cheap imports are hurting local producers, as a flood of "made-in-China" imports shuts down factories across the emerging world.

India's largest commercial body recently noted that nearly two thirds of small- and medium-sized enterprises are suffering from the sudden rise in Chinese capital and consumer goods imports. Meanwhile, manufacturers in the Palestinian city of Hebron claim that the number of textile workers has fallen from 15,000 to 5,000. Textile factories in the Syrian city of Aleppo are closing while factory owners complain about unfair competition from cheap imports. Similar grumblings can be heard in Iran's bazaars.

China faces a dilemma. It needs to protect jobs at home to secure social stability, so it has repeatedly hiked rebates for the value-added tax applied to exports to stem the pace of factory closures. These policies appear to be working. But they could backfire if governments in the emerging world are unable to bear the economic and social costs of a flood of cheap "made-in-China" imports. Indeed, Syria has recently imposed new tariffs on textile imports, while the number of anti-dumping cases filed by India against China has jumped. So far, China has yet to adjust its rebate policy.

If Beijing can manage to strengthen the Chinese currency and economy, production will shift from China to other emerging economies, and Chinese demand for goods produced abroad will increase -- the best-case scenario for everyone. But the rebalancing will take years, if not decades.

China's status as a major economic power is rising as a result of the economic crisis. But its relations with the emerging world are about to provide an important test of its leadership qualities.

Ben Simpfendorfer is chief China economist for the Royal Bank of Scotland and author of The New Silk Road: How a Rising Arab World Is Turning Away from the West and Rediscovering China.

HAZEM BADER/AFP/Getty Images

Meet our new regulatory structure, almost as bad as the old one.

By David Andrew Singer

Last week, the administration of U.S. President Barack Obama released a wide-ranging plan to reform the regulation of financial institutions and markets. Pundits and economists, pleased by the attempt to control "too big to fail" institutions and systemic risk, met the plan with guarded caution.

Harsher criticism would have been warranted. The proposal falls short, as it fails to address a crucial problem: the United States' fragmented, and thus broken, financial regulatory structure. Indeed, rather than emulating the world's best regulatory systems -- which are streamlined and unitary, like Canada's -- the United States has simply dusted off its current Balkanized system and tried to pass it off as new. American companies and investors deserve better.

Of course, Obama's proposal includes many sensible reforms. For example, all nationally chartered banks would be supervised by a new national bank supervisor, rather than multiple agencies. Financial holding companies would be subject to strict capital and other prudential standards, thereby closing the loophole that AIG, Bear Stearns, and other institutions exploited for enormous financial gain (but which ultimately led to their downfall). And hedge funds and other private pools of capital would have to register with the Securities and Exchange Commission (SEC) and open themselves to monitoring.

However, as the biggest regulatory overhaul since the Great Depression, the proposal leaves much to be desired. It would abolish just one regulatory agency -- the Office of Thrift Supervision (OTS). Accountability for financial stability, whether of individual firms or the entire system, would continue to be spread thinly across the Federal Reserve, Treasury Department, and an alphabet soup of bank, securities, and insurance regulators.

The national bank supervisor would not have jurisdiction over thousands of state-chartered banks, which could still choose to be regulated by either the Federal Deposit Insurance Corporation (FDIC) or the Fed. Fifty separate state regulators would still oversee insurance companies, with only a new token Office of National Insurance to "coordinate" their disparate regulatory regimes. The Commodity Futures Trading Commission and the SEC would remain institutionally separate, despite the clear overlap in their jurisdictions. Complex financial institutions such as Bank of America would continue to face a multitude of masters, including the new national bank supervisor, the Fed, and the SEC.

This regulatory hodgepodge inevitably creates loopholes to be exploited. In the past, banks and other financial institutions have been able to to play regulators off one another. For instance, in 2007 OTS actually courted Countrywide Financial away from another agency by offering more-flexible oversight. There's too little in the Obama proposal that promises to stop such malfeasance.

Another troubling part of Obama's proposal is the creation of a Financial Services Oversight Council to "identify emerging systemic risks and improve interagency cooperation." In place of regulatory consolidation, the new council would give the full gamut of regulators a seat at the table and no doubt invite the very turf wars and blame shifting that contributed to the financial crisis. The need for such a council reflects the underlying fragmentation that should be rectified -- and not by committee.

The United States has much to learn from other rich countries -- Australia, Canada, Finland, and South Korea, for instance -- that have simplified their regulatory structures. Financial institutions in these places, from the largest holding company all the way down to the smallest subsidiary, have a single regulator. Requirements are clearer and better enforced as a result.

Moreover, central banks in these countries are focused solely on keeping prices stable and monitoring systemic risks. The Fed currently has a dizzying array of responsibilities, from administering the White House's distressed-asset programs to determining if a company is overleveraged. It is difficult to imagine it will succeed, particularly with other Balkanized agencies muddying the waters.

The time has come for the United States to rationalize its regulatory structure by simplifying it. The rest of the world is waiting.

David Andrew Singer is assistant professor of political science at the Massachusetts Institute of Technology. He is the author of Regulating Capital: Setting Standards for the International Financial System.

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Governments across Europe are about to slash their defense budgets -- but they need to ensure they cut correctly.

By Tomas Valasek

The economic crisis has wracked government budgets across Europe, as revenues have fallen and spending on stimulus and bailouts has soared. Already, there are signs that defense spending across the continent will suffer. Finance ministers will be looking for ways to reduce deficit and debt, and military budgets are a tempting target.

Such budget cuts will have some salutary effects: Defense establishments, with their resistance to civilian oversight and emphasis on continuity, tend to get bloated in times of relative plenty. It often takes a crisis to force meaningful reforms. But cuts also threaten to sap the effectiveness of European fighting forces and leave parts of the world exposed to insecurity.

The easiest portion of the budget to cut is operations. But it's also the most important portion. Withdrawing soldiers from faraway places plays well at home and requires no layoffs, but it means fewer troops in some of the world's most imperiled regions. Poland announced in April that it would withdraw from all U.N. peacekeeping operations. While the Poles may be no less safe, fragile countries such as Chad and Lebanon still need foreign troops to keep the peace.

Rather than withdrawing from conflict zones, European countries and agencies should stop sending overlapping missions to the same trouble spots. Both the EU and NATO sent missions to Sudan in 2007, and three different forces are currently fighting piracy off the coast of Somalia. Better to roll those operations into one; the current duplication wastes taxpayer money.

As defense ministries slash their budgets, their instinct will be to cut multinational weapons programs and make any purchases domestically so as to protect jobs at home. But that carries risks. Many truly necessary systems, such as transport airplanes, are so expensive and complex that they are best funded and shared between countries.

Granted, many past collaborative programs have been disastrous, such as the seven-nation plan to develop the A400M military transport aircraft. A modern-day Spruce Goose, the plane cannot fly because its engines, made by a four-nation European consortium, lack the proper certification; the plane is also said to be too heavy.

But the trouble with the A400M lies not in the collaborative nature of the program. The plane is a failure because its designers have been more concerned with securing production jobs than with obtaining a good product. In return for investing in the aircraft, they have demanded that a commensurate number of production jobs go to their country. As a result, bits of the plane are being built all over Europe -- and not necessarily in the countries most qualified to do the job.

European governments must be smarter. They should accept that it makes more sense to order the needed parts from the plant with the most relevant technical expertise. The governments also need to be more ready to buy off-the-shelf components, rather than try to generate jobs by manufacturing parts from scratch.

The impact of the budget cuts -- particularly the reductions in personnel and equipment -- also threaten to turn some European militaries into showcase forces, incapable of deploying abroad and thus irrelevant to most EU and NATO operations. It makes little sense, for example, for all but very few allies to keep tanks unless they are upgraded to be able to operate in faraway places such as Afghanistan and unless the governments have access to aircraft big enough to transport the tanks. As an excellent new study commissioned by the Nordic governments concluded, "small and medium-sized countries lose their ability to maintain a credible defence" when certain units shrink too much.

There are two ways to avoid such outcomes while cutting budgets. Some of the key equipment that makes modern warfare possible -- such as planes providing air-to-ground surveillance or military transport -- needs to be jointly owned. NATO operates a common fleet of aircraft that coordinates air traffic, and the alliance plans to buy transport airplanes for its members to use. This arrangement allows militaries of smaller and poorer European states, like the new allies in Eastern Europe, to take part in complex operations in distant places.

But that alone will not generate enough savings. Indeed, the time has come for European governments to consider abandoning parts of their national forces and infrastructure and to form joint units with their neighbors. Modern militaries do virtually all their fighting abroad and in coalition with others. If they lack the money to equip and deploy their soldiers overseas, they need to consider radical cost-saving measures. More governments should do as Belgium, the Netherlands, and Luxembourg did -- they merged parts of their air forces -- or emulate the Nordic countries, which are considering joining their amphibious units.

Most European governments have, in the past, found it too difficult to part with the cherished symbol of national sovereignty that is a proper army or an air force. But the practical value of such military services in Europe is often negligible. As the recession deepens, defense ministers across Europe should see the crisis as an opportunity to combine certain units and programs across countries. This will save money, which could be put to use properly training and equipping forces for EU and NATO operations.

Tomas Valasek is director of foreign policy and defense at the Centre for European Reform in London. A version of this article first appeared as a post on the Centre for European Reform blog.

Photo: Flickr user Jerome K

The EU wants to cut deficits. What is it thinking?

By Desmond Lachman

One has to be struck by the oddity and poor timing of the European Union's call on Greece, Ireland, and Spain to begin reducing their budget deficits. At the very time that the International Monetary Fund is counseling countries to engage in aggressive fiscal stimulus to fight the worst postwar global recession, the European Union is pushing for belt-tightening. And it is doing so for those euro-zone countries that are hardest hit by the global economic crisis.

Greece, Ireland, and Spain are all neck-deep in recessions of epic proportions that will soon raise unemployment to the highest levels in the past 70 years. In Ireland and Spain, the bubbles bursting in the housing market make the United States' own predicament look benign. All three countries also must cope with a global collapse in trade and tourism.

Under usual circumstances, a country experiencing a recession of this proportion would sharply reduce its interest rates and allow for a sharp depreciation of its currency. However, stuck within the euro zone, Greece, Ireland, and Spain have to live with interest rates set by an overly cautious European Central Bank (ECB) and a euro whose relatively high price on world currency markets renders their economies grossly uncompetitive. At the very least, these countries should be allowed a reprieve from having to fight widening budget deficits even as their economies weaken.

History is littered with examples of fixed-exchange-rate countries that have tried and failed to balance their budgets in deep recessions by raising taxes and cutting expenditures. In counseling budget tightening for Greece, Ireland, and Spain this week, the European Union seems blithely oblivious to this experience. Policymakers in these countries need only look as far as the Baltic countries to see that economic collapse is being exacerbated by hair-shirt budget tightening.

Rather than counseling budget austerity for Greece, Ireland, and Spain, the European Union would be better advised to push for aggressive fiscal stimulus in Germany, Europe's major economy. Or how about a decidedly more expansionary monetary policy from the ECB? The German government itself now concedes that, with present policies, the German economy will contract a staggering 6 percent in 2009 before recovering only marginally in 2010. Absent more vigorous growth in that country, it is difficult to see how Greece, Ireland, and Spain can extricate themselves from deep recessions -- even if they ignore the European Union's advice. This time, the real deficit to watch out for is that of common sense.

Desmond Lachman is resident fellow at the American Enterprise Institute.

Photo: SAMUEL KUBANI/AFP/Getty Images

The International Monetary Fund now has $750 billion to lend to needy nations during the Great Recession. But will the additional capacity hurt the IMF's mission? 

By Martin Edwards

Two years ago, global economic consensus held that the International Monetary Fund -- the lender of last resort for ill-managed countries with a desperate, immediate need to borrow -- was dying or dead. Its bungling of the Asian financial crisis in 1997 harmed its reputation; the availability of foreign capital made it obsolete.

But global economic consensus now holds that the IMF will play an integral part in alleviating today's crisis. The "Great Recession" has created a strong demand for its lending, and the G-20 countries tripled its resources to $750 billion at their latest conference. Once a black sheep, the IMF overnight became the world's economic shepherd.

Yet the reforms undertaken to expand the IMF dramatically alter its modus operandi and fundamental purpose. They might even make the fund less effective over time.

At the latest G-20 conference, the IMF announced two major changes in response to the global economic crisis: It eased the conditions on its standard loans and created a new lending facility for approved countries. Standard IMF loans now have negotiable installment schedules and easier conditional restrictions. Countries were once required to make big changes -- rewriting their tax codes, for instance -- in order to receive loans. Now, the fund is much less aggressive in cleaning up governments' acts. Second, the IMF created the "Flexible Credit Line" (FCL) program to provide loans to countries with strong macroeconomic fundamentals. FCL loans have essentially no conditions whatsoever -- and Poland, Mexico, and Colombia have already received them.

Thus, the IMF has greatly expanded and turned itself into a provider of loans to prevent crises, not just alleviate them. The amount pledged to fund borrowers is now twice as much as was committed at the height of both the Asian crisis in 1998 and the Latin American crisis in 2002. That is all well and good for the Polands and Colombias of the world. Their IMF loans will surely help them avoid economic catastrophe. But it isn't necessarily good for either the developing countries that may be worst hit by the crisis, or for the IMF itself.

Indeed, with its much-heralded unveiling of the FCL, the IMF placated G-20 countries unwilling to provide loans to struggling countries themselves. Industrialized countries, such as the United States, pledged to lend directly to the fund to meet the $750 billion goal. But middle-income emerging countries, like Brazil, Russia, India, and China, proposed to provide resources in the form of purchases of IMF-issued bonds, rather than permanent lines of credit. These new resources will help the fund better meet the challenges of the economic crisis in the short term. In the long term, however, they mean that Brazil, Russia, India, and China will have a greater procedural voice within the fund. The golden days of the IMF being autonomous and distant from the desires of developing countries has surely reached an end.

Second, the fund's easing of conditionalities stemmed from a perceived need to reduce the stigma associated with seeking a loan from the IMF. But many countries value these conditions and tolerate the stigma. In a weak state, politicians might not want to take vital steps that will be electorally costly, such as cutting government spending or raising taxes. The fund plays a valuable role as a scapegoat, providing political cover for policymakers and ensuring changes are made. Making conditionality "cheaper" by reducing the stigma, then, may net the IMF more loans as states with weak commitment seek fund programs, but it is not likely to produce the reforms many of these countries urgently need.

These developments should temper our enthusiasm about the reemergence of the IMF. A more responsive fund is not necessarily a better one. Having a degree of autonomy from member states allows international organizations to be influential. The conditionality reforms, combined with the likely exchange of bond purchases for more voting power, by diminishing this autonomy, may make the fund's new prominence brief indeed.

Martin Edwards is assistant professor at the John C. Whitehead School of Diplomacy and International Relations at Seton Hall University and the author most recently of "The International Monetary Fund, Conditionality, and the World Economic Crisis: New Beginning or False Dawn?" (pdf).

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