Financial markets, capital flows and the impact of the Doha Round

Current financial reform efforts will be incomplete if they ignore the linkages between the global financial and trade systems. Such reforms can only be successful if action is taken on both the financial and trade fronts, says a veteran trade analyst.

Chakravarthi Raghavan

AS the world economy appears to be showing signs of recovery (though with jobless growth) from its worst crisis since the Great Depression, developing countries need to assess their particular situations, and take precautionary regulatory and other steps to insulate their national economies and financial markets from renewed bouts of financial crisis that could be transmitted through the trading system, in particular, commitments they have or may undertake on trade in financial services and GATS disciplines in the current Doha Round of World Trade Organisation (WTO) negotiations.

The world economy is passing through critical times and has just managed to escape the ravages of the Great Depression. However, despite talk of the end of the recession and the emergence of 'green shoots', the global economy may not really be out of the crisis, and will have to go through a long period of jobless growth. In any event, it may take some years for the effects to be over. In the meantime, if lessons are not learnt from the crisis and remedial measures, including on socially useless financial speculation, are not taken before long, the world economy and developing countries may be enveloped in another financial crisis.

Since the outbreak of the 1997 crisis and more so since 2007, there has been much writing on and attention paid to the financial system and its governance and regulation, and the reforms that need to be undertaken. Some attention has been paid to the effects of the crisis on trade, including the freezing of credit and trade finance.

However, there has been little or no focus on the systemic linkages between the global financial and trade systems, and their feedbacks in loops. This is in contrast with the vision of the designers and architects of the postwar systems, who had a clear vision and perspective on the overarching UN and its political, security, economic and social systems, the Bretton Woods system, and an envisaged Havana Charter and its multilateral trading system.

A working paper for the Intergovernmental Group of Twenty-Four (G24) by this writer, 'Financial Services, the WTO and Initiatives for Global Financial Reform', has focussed on these systemic linkages.

Currently, in the wake of the systemic financial crisis and the massive taxpayer-financed bailouts of major financial institutions in the centres, various processes have been set in motion. These so-called 'Bretton Woods II' processes under way for financial reform will however be incomplete and may even be unsuccessful if parallel efforts are not made at the WTO and its ongoing Doha Round negotiations, in particular, on trade in financial services.

There are attempts in these negotiations to liberalise trade in financial services on the basis of faith and failed theory - due in part to an absence of statistical data and, even more, to a misunderstanding of the systemic linkages between trade and finance.

Need for fundamental financial reforms

For a brief moment after President Barack Obama took office in the United States, it looked as if the view of the former Federal Reserve Chairman Paul Volcker would prevail in the US administration and forces for fundamental reforms would prevail in the main centre of the financial disorder. This is no longer so, however, and it is not even certain that any financial and regulatory reforms being mooted or under way will be more than window dressing or a band-aid approach to an arterial haemorrhage.

In terms of the developing countries, if fundamental regulatory reforms of the global financial system do not take place, it would mean that the financial crisis will come back with a vengeance. Key developing countries and their experts and negotiators, both at the Bretton Woods institutions (like in the G24) and their counterparts in the trading system, need to concert and coordinate and ensure that they are not enveloped in another crisis.

In the current crisis, developing countries by and large escaped direct embroilment in the financial turmoil, simply because they have not yet been 'integrated' into the global financial system and the global capital and financial markets. However, they are still paying the costs in the form of the economic crisis that ensued. Next time, if they do not take actions on both the financial and trade fronts, they may get sucked into the financial crisis too.

Looking at it purely from the perspective of mainstream economics, Nobel laureate Paul Krugman has, in a New York Times Sunday magazine article on 6 September, analysed the failure (with some exceptions) of mainstream economists to predict this crisis and the collapse of the financial markets. He said: 'In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.'

Also, earlier in September, the chair of the UK Financial Services Authority, Lord Turner, questioned the social value of much of the activities of financial traders and called for remedial measures, inviting the wrath of the financial services industry.

In other words, in the view of two eminent market economists, there is nothing like perfect markets, financial markets are inherently unstable and irrational, and regulatory reforms and their strict enforcement need to focus on them.

In any such regulatory reforms, it will be perilous to ignore the issues of international trade in financial services and their regulations - both existing regulatory and systemic gaps (including the complete absence of international bankruptcy regimes, brought to the fore in the collapse of Lehman Brothers) and how to insulate and safeguard national monetary and financial systems from the failures of the global financial system feeding into national systems via trade in financial services.

For example, it is acknowledged that in India, a financial crisis and meltdown was averted because of the wisdom of the country's then Central Bank Governor Yaga Venugopal Reddy in not allowing himself to be carried away by theories touting the benefits of financial liberalisation and globalisation, and imposing bans and severe restrictions on banks and financial sectors from lending money to buy land for development, dealing in subprime mortgages and trading in derivatives, even banning some trades.

He was at that time accused of preventing innovation, but it has been later acknowledged that his actions saved the system. However, his actions would not have been possible or feasible if, for example, India had committed itself to liberalising its trade in financial services and had undertaken commitments under the 1997 WTO Financial Services Agreement in accordance with the Understanding on Commitments in Financial Services (an additional modality proposed in the Uruguay Round and the Marrakesh Final Act), as the US and most of the OECD/G10 countries had done. Apart from them, some of the Caribbean small island economies with offshore financial centres and Nigeria also undertook commitments in accordance with the Understanding. In the current Doha Round, major developing countries are now being asked to undertake financial services liberalisation commitments in accordance with the Understanding.

Commitments in the WTO

For a proper focus on the intricacies of the trade in financial services and the framework of the Financial Services Agreement, it is essential to bear in mind the nature of the overall Marrakesh treaty (the WTO agreement) and its annexed agreements in the areas of trade in goods, trade in services, intellectual property rights and the integrated Dispute Settlement Understanding (DSU). The WTO and its agreements at Marrakesh became a 'single undertaking' (with every member having to sign on to every agreement). In international law, when countries are parties to several agreements, they are expected to abide by all of them. And if there are conflicts, there are some well-known and accepted rules of interpretation, e.g., the later treaty overriding an earlier one, a particular treaty overriding a general one, etc.

However, since Marrakesh, through the dispute settlement process, the WTO's Appellate Body (AB), whose rulings are adopted and become binding through 'negative consensus', has made the clarification and interpretation of the rights and obligations of members under the various agreements a single undertaking, and has said it (the AB) will clarify and interpret the agreements such that there will be no conflict. This has given rise to complaints of the AB undertaking a rule-making role.

The intricacies and complications of these interlocking arrangements are explained in the aforementioned working paper for the G24.

The international trade in financial services, under the WTO, is governed by the 1997 Financial Services Agreement, and the individual market-access commitments and obligations undertaken by countries and inscribed, with some specified limitations, in their country schedules on services and financial services.

The scheme of the WTO, its General Agreement on Trade in Services (GATS) and the DSU ensures that member countries have obligations on the trade in financial services arising not only out of their scheduled commitments (and any future ones they may undertake in the Doha Round or future multilateral negotiations), but also the other rules, disciplines and regulations of the WTO agreement and GATS.

An important element of these, in terms of translating any global financial regulatory reforms into parallel or equivalent reforms of 'trade in finance', would require such reforms to be negotiated and agreement entered into at the WTO. In general, if care is not taken by member countries, this leaves enormous scope for forum games and regulatory capture to frustrate reforms.

Without parallel reforms in the rules relating to trade in financial services and any related rules of GATS and the WTO, some of the financial regulatory reforms that countries are undertaking can be challenged through the WTO dispute settlement process. For example, some of the regulatory actions - like bans on short-selling - or some of the assistance now extended to financial institutions - such as the TARP (Troubled Asset Relief Programme) loans in the US or the government-guaranteed low-interest loans that financial institutions and firms are accessing - may be amenable to challenge in the WTO.

It may seem incongruous that actions taken by a country to save a bank or its financial system could be challenged at the WTO. However, this is the nature of the WTO animal, hence the need for very careful assessments.

Each WTO member which has undertaken commitments in services, in particular, in financial services, has obligations arising from: (a) the WTO treaty and its various annexed agreements, including the DSU; (b) the various provisions of GATS; (c) the provisions of the Financial Services Agreement; and (d) their schedules on market-access commitments in services filed at Marrakesh and subsequently modified by schedules of market-access commitments in financial services - the sectors or sub-sectors or specific services within them on which they have undertaken commitments, limitations for these in terms of market access, any exceptions in terms of national treatment and/or additional commitments.

At the WTO, there is a prudential carve-out set out in paragraph 2(a) of the Financial Services Annex to GATS. The first sentence of that paragraph gives an overriding right to take prudential measures ('Notwithstanding any other provisions of the Agreement, a Member shall not be prevented from taking measures for prudential reasons.'). However, the second sentence then qualifies this by saying that 'where such measures do not conform with the provisions of the Agreement, they shall not be used as a means of avoiding the Member's commitments or obligations under the Agreement'. This makes it a subjective judgement of a panel on a dispute raised before it. And while GATS is yet to formulate the mandated disciplines on subsidies, in the absence of a specific exception to national treatment on this listed in a country's schedule, a member's action in going to the rescue of a bank or insurance enterprise by giving loans at concessional rates, for example, can be challenged.

The US, in a further complication, has incorporated by reference, in the headnotes on its financial services schedule, the Understanding on Commitments in Financial Services. In its services schedule filed at Marrakesh, it has entered a general horizontal national limitation on subsidies. But in its financial services schedule, where it has headnotes and incorporated the Understanding, there is no such national treatment limitation. This makes it a fruitful field for trade lawyers. And it is doubtful whether TARP loans, or the FDIC (Federal Deposit Insurance Corporation) guarantees that enable some big banks to raise money at cheaper interest rates, are covered even by the general horizontal national treatment exception on subsidies in the 1994 schedule.

Perhaps one of the elements inhibiting challenges in the WTO on such issues is the cost of litigation in the dispute settlement process, estimated by Canada recently as involving some C$12 million and a 3-year time period - showing that the DSU is of benefit only for the rich. Another barrier is that despite the attempts to present the dispute settlement process as a kind of independent judicial process, it is not so, as cited in the working paper and in some of the academic writings on this issue. All this introduces at the least an element of uncertainty into the regulatory stability and predictability of a country's financial system and its actions. It is worth noting that there is no time-bar for raising disputes, nor does the Anglo-Saxon legal principle of stare decisis apply in international law or WTO disputes.

In addition, when one talks of 'financial services' in WTO terms, the definition covers a very wide range of activities and not merely the 16 items mentioned in the illustrative list of financial services in the Financial Services Annex of GATS. A financial service, according to paragraph 5(a) of the Financial Services Annex, is 'any service of a financial nature offered by a financial service supplier of a Member'. And GATS does not define what a 'service' or 'a financial nature' is.

For example, very recently, the US and EU took up with China the issue of Chinese regulations and restrictions on three international news services - Reuters, Bloomberg and AP Dow Jones - over their rights for the collection and distribution of 'financial news and services' in China. It was taken up as a dispute bilaterally (prior to raising it at the WTO), and as a violation by China of the GATS and market-access obligations it undertook. And the dispute was settled on that basis, though the terms of that settlement are yet to be notified at the WTO and made public.

The Doha Round and financial reform

In much of the current discussions, the successful conclusion of the Doha Round is being promoted more or less as a panacea for the economic crisis and other problems. Over the last 2-3 years, it has been presented by WTO Director-General Pascal Lamy as a solution to the food crisis, to the financial crisis and, most recently, to the climate change crisis. In fact, it appears to have acquired in international discourse the role that 'motherhood and apple pie' once had in the US political discourse - something one could not disagree with. In the US now, with the obesity problem threatening to be a major health issue of pandemic proportions, and with the 'culture wars' over gay rights and same-sex marriages, perhaps it has become easier to oppose 'motherhood and apple pie', but the successful conclusion of the Doha Round as a panacea is not challenged - except in a growing section of civil society.

In at least three respects, if remedial actions are not taken, the conclusion of the Doha Round even on the basis of 'what is on the table' may have negative effects for financial regulatory reforms.

Firstly, even prior to the launch of the Doha Round, in an era of euphoria about the benefits of liberalisation of trade in services and financial globalisation, the WTO Council for Trade in Services had adopted the Guidelines for Mutual Recognition Agreements or Arrangements in the Accountancy Sector in May 1997 and the Disciplines on Domestic Regulation in the Accountancy Sector in December 1998. The Andersen accounting firm, which was involved in the Enron scandal and subsequently ceased operations as an audit and accounting service, had played a large role in drawing up these rules. These rules will become effective as part of the Doha Round single undertaking. When that happens, countries may find it difficult to take strong regulatory measures against audit firms that combine consultancy with their audit functions or against rating agencies.

Secondly, on the agenda of the Doha Round services negotiations are draft disciplines on domestic regulation (to be adopted under Article VI:4 of GATS). These, as formulated in the negotiating chairperson's text of July 2009, could prove problematic for regulatory provisions of several developing countries (see a South Centre analytical study by Ellen Gould, ‘The Draft GATS Domestic Regulation Disciplines - Potential Conflicts with Developing Country Regulations', July 2009).

A third area of concern is the enormous gaps in statistical data on trade in services, as highlighted in the working paper and in the monograph Developing Countries and Services Trade: Chasing a Black Cat in a Dark Room, Blindfolded (Chakravarthi Raghavan, 2002, Penang: Third World Network). All currently cited data on trade in services (based on the IMF's balance-of-payments (BOP) and extended-balance-of-payments (EBOP) data) do not reflect the services trade of countries or sectors as defined by GATS. At present, the only available data are those bandied about on the basis of the BOP and EBOP data; by definition, these data relate to transactions between 'residents' and 'non-residents'.

Most of the data cited are about benefits of concluding the Doha Round and its liberalisation of trade in services. A recent Petersen Institute working paper estimates a $100 billion trade gain if there is the equivalent of a 10% reduction in services trade barriers! However, the GATS definition of services in Mode 3 (currently the main and major mode on which there is focus in the Doha Round) is by 'commercial presence'. Such trade is between the foreign service provider ‘resident’ in the country and resident consumers. This cannot be reflected in the BOP or EBOP data that are used to project benefits.

And the manual adopted with the imprimatur of the UN (UN Statistical Commission decision/recommendation, formulated on one page of a 28-page report of the Commission to the UN Economic and Social Council (ECOSOC) and taken note of by ECOSOC and in turn by the UN General Assembly) has ignored the GATS definition and the mandate. And the latest is that the task of improving the quality of the manual has been ‘outsourced’ by the UN Statistical Commission to the Organisation for Economic Cooperation and Development (OECD)!

Whatever use such data may be employed for, its use for the WTO services negotiations will be akin to Andrew Lang’s definition of statistics: 'He uses statistics as a drunken man uses lampposts - for support rather than illumination.’     

Chakravarthi Raghavan is Editor Emeritus of the South-North Development Monitor (SUNS). The above is based on remarks made by him at the G24 Technical Group meeting in Geneva on 7 September, during a panel discussion on 'Implications for Regulation of Financial Markets and Capital Flows'. It is reproduced from SUNS (No. 6771, 14 September 2009).

*Third World Resurgence No. 228/229, August-September 2009, pp 21-24