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Economic Diplomacy By M.R.Sivaraman

C3S Paper No. 0018/ 2015


Delivered at the Press Institute of India Taramani Chennai

Ladies and gentlemen,

At the outset I would like to thank the PII and the ORF for inviting me to give a talk on economic diplomacy to this informed audience. Economic diplomacy has been in the forefront in the last two decades particularly after the East Asian Crises in 1997.This has been followed by one problem or the other culminating in the collapse of Lehman Brothers in 2008 in the US and the domino effect it had on all countries of the world big or small. These economic events with deleterious consequences on growth and employmentin many countries inevitably led to the formation of the G20 group that has the leaders of the19 largest economies of the world and the EU.Many countries have gone into deep recession after 2008 and in every meeting of the G20 they have been discussing and agreeing on measures to pull the economies back into the growth path by various coordinated measures the most important of which has been the monetary easing by central banks and governments going easy on fiscal deficits. This coordinated action by all countries require tremendous efforts on the part of all those who negotiate final declarations by the leaders issued in the form of a communiqué. It has to be kept in mind that one shoe does not fit all.India has been having high interest rates while many of the developed world countries near zero rates of interest.Our Interest rates are high as our inflation is high and central bankers believe that high interest rates curb inflation, which is debatable, and I do not want to go into that issue. Our economic and monetary policies are divergent and yet have to move in step not violating the G 20 agreed principles of coordinated efforts.

What is economic diplomacy? While there are many definitions, as a practitioner I have this definition to offer. Economic diplomacy is a continuing process of interaction amongst individual economic agents, corporates, multi-nationals, international institutions and governments, to reach mutually advantageous arrangements, so that all parties can benefit not necessarily always in a measurable way, leading to overall increase in collective global welfare. This requires sacrifice of certain elements of sovereignty by all for the collective good. You can discuss this and attack it whenever you have time.

Flag follows the trade is something that has been debated for long. It is believed that trading nations generally do not go to war. Historically that has not happened, as before the world wars, the nations that went to war were also trading amongst themselves. In the case of India, the East India Company started owning a country after it started trading. Some evidence shows that even during the 15 century BC the pharaohs had established trade routes to other African countries. There was regular trade between countries including India with the Romans and the Greek countries. After the end of World War II, colonialism ended and the number of sovereign countries multiplied even though they were indifferent camps of the Soviet Bloc or the Free world bloc as they called it with the US in the lead.

While the war was coming to a close bureaucrats and economists of the UK and the US, as well as many other countries including India had been discussing ways and means of stabilizing the monetary and exchange rate fluctuations bedeviling the world, so as to allow countries to grow while conducting their trade in an atmosphere of relative stability.Earlier during the inter war years, countries had been following policies that suited them best without realizing that it benefitted none in the long run.

The world was in shambles and the Marshall plan was put in place in 1947 by the US to help rebuild Europe as well as benefit by it. The assistance was partly used for imports from the US creating a win- win situation. Eastern Europe remained outside the Marshal plan as the Soviet Union declined the aid.

The discussions on how to reconstruct the war shattered world, to restore trade and commerce and also help countries to grow occupied the minds of leaders, interestingly even while they were dividing the world into two groups of the communist block countries and the rest.

The UK fielded John Maynard Keynes the Einstein of modern economics while the US, Harry Dexter White their Assistant Secretary of the Treasury. From India we had Sir C.D. Deshmukh ICS, who was the first Indian Governor of the RBI and J.V.Joshi economic advisor to these meetings. These prolonged and difficult negotiations took place in Bretton Woods in New Hampshire a county in the US, between I July 1944 and 22 July 1944.As I mentioned there was the Keynes Plan, the White’s Plan, the French Plan and the Canadian Plan. The then Indian Legislature was angry that India had agreed to become a member of the proposed Institutions whenever hey got established without Legislative concurrence. But thereafter they agreed to participate .The discussions in Bretton Woods ended in the establishment of the IMF and the International Bank for Reconstruction and Development now known as the World Bank with distinct functions, the former for ensuring monetary and Exchange rate stability and the latter for being the world level Financial Institution to help in the post war reconstruction of the world. In the words of Henry Morgenthau.Jr, Secretary of the US treasury the institutions will result in“[the] creation of a dynamic world community in which the people of every nation will be able to realize their potentialities in peace”.Today 188 countries aremembers of these two institutions.

The WTO was also born out of negotiations, and everything the WTO does is the result of negotiations and consensual decisions although there is a provision for voting. The discussions in Bretton Woods on the creation of a third Institution to oversee world trade ended only as a General Agreement on Tariffs and Trade, which ultimately has become the WTO. After prolonged negotiations amongst the member countries of GATT between 1986-1994 called the Uruguay round an agreement was reached to set up the WTO.It was set up in 1995 with Geneva as its headquarters. The WTO has launched in 2001 a new round of discussions on further trade liberalization called the Doha round.It is still in progress and has over a score of subjects that are being negotiated.

The creation of such world institutions after prolonged debates and discussions means the setting up of rules and regulations that countries have to follow in regard to monetary, fiscal, exchange rate and trade policies.The negotiations are never easy and they start from extreme positions to eventually culminate in agreed rules and regulations. If a country deviates from these accepted rules then there are mechanisms for dispute resolution. Countries have to give up some of their sovereign powers and be subject to some regulation. The IMF has three major responsibilities:

a)Surveillance of financial and monetary conditions in member countries and in the global economy;

  1. b) Financial assistance to members to overcome any major balance of payments problems and,

  2. c) Technical assistance. For example Article IV casts certain general obligations on its members. Under Article VIII of the agreement no member of the Fund can without the approval of the Fund impose any restrictions on current account payments. The members also have to subject themselves to surveillance every year known as Article IV consultations over the exchange rate monetary, fiscal and even tradepolicies of the members and they have to furnish all required information and also consult with the Fund on its exchange rate policies.

The source of Funds for the IMF are the quota contributions of members and also special borrowings under the General Arrangements to borrow form 11 industrialized countries and when needed from 38 member countries in what is called the New Arrangements to Borrow. India has agreed to provide 8 Billion SDR against the US 69 billions and China 31 billions out of a total of 369.99 billion SDRs. The WB has lending programmes for projects at very favourable rates of interest with IDA lending done almost at negligible rate of interest. Its associate the IFC lends to industries. India is still qualified to borrow from IDA but with 1.25% interest for 25-year term. India owes $37.28bilion to the WB of which $25.34 billion is to the IDA and the rest to the IBRD as of Dec 2014.Internatiional Finance Corporation another associate of the WB lends to the private sector ona variable rate basis and its portfolio in India stood at a little over 4.7 billion dollars as of June 30, 2014.Indian ED is on the board of the IFC. The WB also responded by increasing its lending to stressed countries during the crises.Multilateral Investment Guarantee Agency is another outfit of the WB that provides political risk insurance guarantees to private investors mostly in IDA eligible countries.

In the context of the world financial crises functioning of the IMF and the World Bank has to be examined. The US has a dominating position in both with almost 17 % of the voting strength. With 85% vote being required in the IMF for any major decision the US can always veto a decision. The World Bank being a lending institution its say in general policy matters are only advisory even though stringent conditions are at time imposed on the individual borrowers.

Despite the severe criticism that even Joseph Stglitz the Nobel Laureate economist has leveled against the IMF, the world leaders have reinforced their trust in that institution as a watchdog of global stability

The G 20 meeting held in London after the financial crises called upon major reforms in the governance of these institutions while agreeing upona huge increase in the IMF quotas to $ 750 billion a doubling of the then existing quota.

On December 15,2010, the Board of Governors of the IMF accepted the recommendations of the Executive Directors on the 14th General Review of Quotas, which involved a package of far reaching reforms of the Fund’s quotas and governance that is expected to enhance the say of the emerging market economies as well as the other members of the Fund. The 14th General Review of Quotas will:

  1. Double quotas from approximately SDR 238.5 billion to approximately SDR 477 billion (close to US$737 billion at current exchange rates), This is in accordance with the decision of the G20 summit meeting held in London 2 April, 2010

  2. Shift more than 6 percent of quota shares from over-represented to under-represented member countries,

  3. Shift more than 6 percent of quota shares to dynamic emerging market and developing countries (EMDCs),

  4. Significantly realign quota shares. China will become the 3rd largest member country in the IMF, and there will be four EMDCs (Brazil, China, India, and Russia) among the 10 largest shareholders in the Fund, and

  5. Preserve the quota and voting share of the poorest member countries. This group of countries is defined as those eligible for the low-income Poverty Reduction and Growth Trust (PRGT) and whose per capita income fell below US$1,135 in 2008 (the threshold set by the International Development Association) or twice that amount for small countries. (IMF)

Once the member countries approve, there will be an unprecedented 100% increase in the quotas, and a major realignment of quota shares affecting also the voting strength. At present China has a voting strength of 3.81 and India 2.441 as compared to France, which has 4.29.In terms of nominal GDP India, ranks tenth in the world with China occupying the second position. In terms of PPP GDP the WB has ranked India third with China as the second after the US. So far, only 146 members countries of the 188 members with voting strength of 77.07 percent have given approval for this amendment, which requires 85%of the votes. Post 2010 reforms India’s voting strength will be 2.749 and China 6.39. The US will have 16.471. It is clear that even if the reforms are implemented the US will always have the veto power.Even then the US has Congress has not yet ratified it. The G 20 Brisbane Communiqué issued in November 2014 expressed its disappointment on this and urged its early approval by the US. The communiqués are always unanimously agreed statements.

It is noteworthy that the US President is an important part of the G 20 and yet the US Congress has not yet approved this important decision not even in its 2015 budget leading to the MD of the IMF threatening to explore alternative options. She has only echoed the observation of the G 20 in its Brisbane communiqué. It is not clear as to how the threat can be carried out unless in other decisions of the Fund that requires only a majority the US is isolated. That is very unlikely.

On April 25,2010 the members board of Governors of the WB also accepted major reforms by increasing its capital by $86.2 billion and a 3.13% increase in voting strength of the developing and transition countries.The latter’s voting strength increased to 47.19 %. The WB shareholding pattern is compatible with IMF in so far as the weight of the economy is concerned that is the GDP measured in nominal and PPP terms. The other two elements are the country’s past contributions to the WB mission and IDA with an incentive for future contributions. India’s voting strength is 2.91 as against China’s 4.42%. The US has 15.85%. The WB added one DIR to represent Sub- Saharan Africa taking the total number of directors to 25 as against 24 in the IMF.India is a founding member of the ADB and its shareholding there is 6.33% and voting strength 5.36%.

The voting strength rarely comes into play excepting on occasions when politics becomes dominant over economic issues. For example in sanctioning a major facility to a country the executive board either in the Fund or the WB could impose stringent conditions on the use of funds. The ED representing the country may have a say but his voice may be feeble. Similarly on policy issues voting strength becomes important.So long as the EU and the US have dominant shares in both the institutions they will call the shots.

It is interesting to recall what Lord Keynes had to say in 1944 about an International Economic system that he had proposed during the discussions on the formation of such institutions immediately after the war-

That there should be least interference with internal policies,

That the technique of the plan must be universally applicable irrespective of the principle of government and economic policies existing in prospective member countries

And the management of the institution must be genuinely international without preponderant power of veto or enforcement to any country or group with the rights and privileges of smaller countries being safeguarded.

What happened to governance in the IMF has been contrary to these profound principles. Even the plan proposed by the US representative Mr. White contained a suggestion for decision making by a simple majority.However as the votes allotted were in proportion to the contribution to the Fund the US has always had the upper hand.

During the East Asian crisis some of us in the board strongly resisted certain conditions particularly related to belt tightening but we were over ruled. The MD also is beholden to the dominant countries and he could in secret consult the EDs of those countries on major issues.

The reforms approved in the G20 have not been implemented in the IMF, which is the policy making body in areas of monetary, fiscal and exchange rate. This could be one of the main reasons for the setting up of the BRICS Bank. Similarly there is also an arrangement amongst many East Asian countries led by China for currency swaps in the case of any currency distress. The Chiang Mai initiative is the arrangement entered into by the 10 countries of the ASEAN and, China, Japan and South Korea thatwere launched on Dec 10, 2010 with a currency pool of $ 120 billion. It has gone up to $240 billion now. India has also currency swap arrangements with many countries where in the course of trade only the local currencies are used instead of the Dollar.

These arrangements have to see a crisis before they can be judged.

But it has to be appreciated that it is only account of these arrangements, agreements and institutions that have the support of all the countries that trade is taking place without much hassle. Even when there are bilateral arrangements to solve disagreements there are established procedures of arbitration etc., which are again facilitated by agreements.It must be kept in mind that for any international contact, business or for that mater anything cross border there are some treaties, agreements or other arrangements are in place that have been negotiated by governments. That is diplomacy in action.

Economic diplomacy is not easy. Today there are hundreds of international agreements and scores of international institutions that have come into place through negotiations and after the approval by the Parliament of the respective countries. What we confront is the non-working or partially working of these institutions and agreements. In between, major roadblocks come up by way of unilateral economic sanctions issued by countries, which are quite contrary to these arrangements. They not only affect the countries directly sanctioned against but all others who have economic or trading relations with those countries. This problem of power play cannot end until a few other countries emerge as contenders for the status of economic super powers. China is reaching that stage and their efforts are to surpass the GDP of the US in the near future. India may not be far behind. Economic supremacy gives political and military strength also. But it is interesting that in the ‘Valor of Ignorance’ by Homer Lea written in the 1930s by an American who was rejected by the US army and became a general in the Chinese army has argued that advancement in human civilization has not changed human nature and wars will be fought for one reason or the other. One has to be worried about poor but very militant nations. We have two poor countries like Pakistan and North Korea armed with nuclear weapons threatening world peace. Their economic isolation would only drive them further into a corner and in such circumstances also economic diplomacy can play a major role

The economic divide, which was very sharp between countries, is getting slowly narrowed. The progress in communication, information and other technologies has been so rapid that nations have to come together to get maximum advantage for human welfare and happiness. The call for globalization followed this info-tech revolution when it was found that that communication could not be easily controlled. The best thing was to call for an opening up of the frontiers of countries for trade and economic contacts without restrictions. The world got into globalization frenzy with countries vying with one another to get in front. With globalizationthe danger of financial disease spreading has increased manifold.

The collapse of Lehman Bros and its domino effect has made countries re-think on the extent to which they have to globalize. The G20 which came into existence in 1999 consisting of the world’s largest economies has been meeting every year and issuing communiqués regarding the world economic order that has to be established to avoid the crisis that confronted nations in the wake of the Lehman Bros collapse.

There are several institutional arrangements that oversee the implementation of the decisions of the G 20. The Financial Stability Board was set up to provide early warningof macro economic and financial risks and the action needed to address them.They have agreed to resist protectionism and promote global trade and investment. They have also agreed to set up a mechanism for the automatic exchange of tax information. Their communiqués cover all-important issues concerning global good governance practices. But in spite of all this and Russia being a part of G 20 it is being sanctioned against for political reasons. There will always be a tango between economic and political diplomacy the stronger partner at times tiring out the other till submission.

India has always been supporting all the initiatives that lead to global good governance but also subtly avoiding politics of sanctions that thwart them.

Thank you.

(This paper was presented at the conference held on 23-24th January at the premises of PII by Mr. M.R.Sivaraman IAS (Retd.), former Revenue Secretary, Ministry of Finance, Government of India and presently Associate, Chennai Centre of China Studies.Email- madras.sivaraman@gmail.com) FORMER REVENUE SECRETARY AND ED IMF

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