A conspicuous if not shocking feature of today’s world is its unambiguously upside-down state. While various industrialized countries find themselves on the verge of sovereign default, emerging markets have come to represent the engine of growth and dynamism for the global economy. A noticeable consequence of this new economic environment is the rise of anxiety in Western economic debate, and, in some cases, a general neglect of sound economic principles as various countries undertake a process of financial regulatory reform. If anything, the impending regulatory onslaught has considerably heightened the need to reassess both the merits of financial liberalization and the lessons to be drawn from the crisis.
Although the crisis has not affected the world equally, it seems to have raised similar doubts everywhere. A case in point is Saudi Arabia. Notwithstanding its relatively good economic performance during the financial storm, some opinion leaders have come to question the desirability of pushing ahead with the Kingdom’s financial liberalization process. After all, some ask, didn’t countries with heavily controlled financial systems such as China and India fair better than the notoriously open UK and US during the crisis?
The Conceptual Mush
Opponents of free markets have been (too) quick to herald the incompatibility of financial liberalization with a stable economy. By rashly equating liberalization with deregulation, these critics have used the unruly nature of unregulated financial markets as a justification for their questionable policy proposals. Their success is such that, nowadays, attempting to highlight this intellectual incoherence only seems to draw criticism as a free market extremist
Be that as it may, the failure on the part of critics to see the contradictions in their position does not make reality any less real. After all, shooting yourself in the foot will not make you feel good, no matter how much you want to believe it. As economists (should) know, correlation is not causation; Canada and Australia were also left relatively unscathed by the financial turmoil, and this despite their fairly open financial systems.
In fact, much of this speculative incoherence is due to major misconceptions about the definition of financial liberalization as well as the origins of the global financial crisis. Contrary to what many critics assert, financial liberalization does not mean deregulation. Rather, it means giving more rein to market forces by, inter alia, reducing capital controls and restrictions on currency convertibility, and removing barriers to market access and discriminatory treatment between foreign and domestic suppliers. In fact, financial liberalization encourages better, not less regulation.
Although there is little doubt, as many opponents to the liberalization process have asserted, that the rash financial deregulation of the 1990s contributed to triggering the crisis, these critics seem to have slyly glossed over one of the much more powerful triggers: the global “savings glut.” According to this theory, for the past decade or so the US—acting as a sort of massive hedge/investment fund—has absorbed much of the extra-capital (i.e. the difference between domestic savings and domestic investment) from East Asia and the Middle East. This global financial imbalance fuelled massive current account deficits in the US, where real interest rates were kept very low. The resulting low cost of money led to massive overinvestment—what Hayek calls mal-investment—in low return assets (real-estate), creating a boom and, eventually, a bust. In this much more compelling and economically sound interpretation of the crisis, the role of haphazard deregulation is circumscribed to systematizing the crisis rather than causing it. Even so, blame should be placed on imprudent deregulation rather than financial liberalization.
Liberalization In the Kingdom
Truth be told, financial liberalization is no panacea; it is even less so if carried out arbitrarily. Nevertheless, a properly sequenced liberalization process accompanied by sound regulation and effective regulatory oversight could not only help solve the Saudi economic diversification conundrum, but could also help address politically sensitive issues such as unemployment. From this standpoint, the creation of the Tadawul, two regulatory oversight agencies (e.g. SAMA) and the King Abdullah Financial District are all positive, even if small, steps forward.
While the stock market and Saudi corporate structure slowly mature, however, it is crucial that the private sector be able to meet its capital needs. To ensure this, policymakers should continue the process of eliminating market access barriers and discriminatory treatment to foreign suppliers. By increasing competition, these policies would reduce profitability and overall costs, and encourage an increase in both quality and range of service. This would facilitate firm entry in other sectors, thus improving economic diversification and the competitiveness of markets throughout the economy.
Finally, no matter how politically sensitive the issue, capital controls need to be eased if the government is serious about promoting economic diversification and tackling unemployment. The undervaluation of the riyal encourages Saudi oil exports and supports an inherently inefficient industrial sector. This artificial competitiveness of the industrial sector, in turn, attracts capital and labor that would have otherwise been allocated elsewhere. In “economics speak,” an undervalued peg is therefore a redistribution of income, a “subsidy” if you will, which benefits the tradable sector at the expense of the untradeable sector.
This situation results in two problems. First, the undervaluation of the riyal benefits a sector (industrial goods) that will never be able to compete with Asian industrial sectors without government intervention (the oil sector is inherently competitive and hence does not need this “subsidy”). Second, as a 2008 Chatham House report makes clear, the tradable sectors benefiting from these policies employ less labor than a vibrant untradeable sector (services sector in general) would.
Easing capital controls and restrictions on currency convertibility (floating or at least revaluating the riyal) would therefore contribute to reducing the structural distortions of the Saudi economy. It would siphon capital and labor back into the untradeable sector and encourage the diversification of the economy. This would be an efficient way of increasing the contribution of the non-oil sector to Saudi GDP (which already doubled between 2002 and 2007) and could considerably reduce unemployment since the Saudi untradeable sector is notoriously more labor intensive than the oil sector.
Yet, there is one principal requirement for all this to work. The liberalization process must be properly phased and structured within a sound regulatory framework. Government and corporate transparency is also a key ingredient for a stable and efficient financial system. Moreover, liberalization of the Saudi financial sector could help rebalance global finance by reducing the Kingdom’s chronic capital account surplus and, therefore, the financing of the American current account deficit. But this is a whole other story.
Emma Carswell-Engle - Manager, Regulation and Trade Policy at TheCityUK. The views expressed here are her own and do not necessarily express those of TheCityUK.
