Emerging economies should not be regulated in terms meant for advanced ones
The collapse of Lehman Brothers in September 2008 sent Western financial markets into the deepest freeze, and their economies into the severest recession, since the Great Depression. The ultimate cause of the global financial crisis is usually traced to the gradual dismantling of the post-war financial regulatory structure. The current crisis is leading to another comprehensive overhaul of financial regulation. In this context, there are problems that are unique to emerging market economies (EMEs).
There is a danger that the scarce savings in EMEs will be pulled away from investment necessary to sustain current levels of high growth to cover non-existent risks. BASEL III constitutes a double whammy for countries like India. It could constrain the rapid credit growth necessary to sustain high growth. On the other hand, it could aggravate the runaway structural fiscal deficit of a government that would need to cough up a substantial chunk of the additional capital by virtue of its large ownership of the banking sector. The cost of capital is already high in EMEs. The enhanced capital requirements of BASEL III are almost guaranteed to keep it high in the foreseeable future. But why should EMEs be pushed towards a regulatory framework calibrated to risks in advanced market economies (AME)?
There is no good reason to suppose EME financial systems will remain where they are presently. Tighter regulation could keep shadow banking in check. Alternatively, if some EMEs see benefits in the development of innovative shadow banking, they could move towards lighter regulation and migrate to AME-type financial systems.
Financial panics are invariably preceded by escalating leverage. The primary drivers of leverage in AMEs and EMEs are, however, strikingly different. The recent galloping leverage in AMEs was an attempt to increase returns on capital through increased trading of claims on real economy assets. This led to a rapid expansion of financial assets as a proportion of GDP. High credit growth in EMEs like India was primarily due to high rates of investment and growth. Global production has long been migrating to these countries