As emerging and developing economies (EMDEs) navigate a volatile world of intense geopolitical conflict and worsening climate change, the question of new development models has risen to the top of the growth agenda. The debate now is where EMDEs will take their position between the unstable wealthy Western countries and the emerging BRICS (Brazil, Russia, India, China, South Africa) countries seeking an alternative order to the current G7-led neoliberal order.
The Biden administration’s story of choosing between democracy and autocracy and upholding a rules-based order is not convincing today in the Global South, where the West can selectively “do as we say and not as we do.” The free market order is in serious retreat as tariffs and sanctions are unilaterally raised and industrial policies and state interventions increase day by day. The issue is not so much capitalism vs socialism, but rather that some capitalist countries are turning to fascism, while climate change policies transcend ideological boundaries. All countries face two serious imbalances: the social injustice of rising incomes and wealth, and the global injustice of natural capital being plundered by pollution, loss of biodiversity and ruthless extraction of minerals and irreplaceable natural resources.
Attending the World Forum on Islamic Economics and Finance in Kuala Lumpur this week, I felt that the theme portrayed a dilemma in policy choices: Should we prioritise the real economy over finance, or vice versa? Finance has driven the real economy in global growth since the 1980s, when financial liberalisation became synonymous with the neoliberal order. Opening up capital accounts, encouraging free financial markets and competition seemed to lead to efficient capital flows that would be conducive to economic development. The Washington Consensus was discredited by the 1997 Asian Financial Crisis and the 2008 Global Financial Crisis. These crises made it clear that the free market order fosters concentration, financial fragility, market instability and social inequality.
The pandemic and economic lockdowns of 2020-2022 were “mitigated” at the economic level by increased money creation and looser fiscal policies, but since 2008, global growth has slowed because financialization has increased debt at the expense of productivity in the real economy, and has encouraged short-term speculation over long-term investment and structural but painful reforms. The “low-hanging fruit” policy of taking easy (politically less painful) solutions has ended up with “tall gardens and high fences”, i.e. de facto protectionism and containment instead of multilateral cooperation to solve global challenges.
The dilemma between finance and real sector is easily seen with the example of a country's balance sheet, where the asset (real) side of the country is funded by the liability (monetary or financial structures) side. Finance is important because if the real sector is fully funded by debt, especially external debt, and the country does not have the foreign currency to pay it back when it needs to, the country will be in crisis. This is exactly what happened with the Latin American economies in the 1980s and with the East Asian economies in 1997/98. The European debt crisis of 2008/2009 revealed that even though Europe was rich and prosperous, the deficit countries of Ireland, Greece and Italy could not pay back their debts (even in euros), so debts had to be “mutualized” across Europe.
From the perspective of a country's financial situation, if the return on total assets exceeds the cost of financing the debt side, the country is viable. If the return on assets falls below the cost of financing the debt, the country will be in debt and in deficit, especially if a large part of consumption is financed by debt. The free market model has allowed debt to balloon since the 1980s. In 1980, the ratio of total financial assets to GDP was nearly 100%, but has risen to over 400% due to a massive increase in debt. Meanwhile, capital has remained at around 100% of GDP.
In other words, total leverage (debt to equity) has risen by about three times. This is where the US stock market model has an advantage over the bank-led Chinese, European and Japanese models. The US corporate sector is not bank-funded and prefers to invest heavily in technology through private equity venture capital model financing using IPOs (initial public offerings) to attract public funds. Both China and the US have considerable strengths in artificial intelligence, but with the backing of the Magnificent Seven, the US stock market market cap will increase by $10 trillion in 2023, while the market value of China's technology platforms remained flat last year. Which do you think has the better technology and market story and the ability to attract talent from around the world? In other words, a country with a stronger real economy story, funded with the right type of risk capital, will outperform its competitors with weak real economy development models, funded with weak debt.
The story of Islamic economy and finance illustrates this dilemma well. Muslims number about 1.6 billion, making up about one-fifth of humanity, but while the GDP of Islamic countries is about 9% of the world's GDP, Islamic financial assets are $6.7 trillion, or only about 1.5% of the world's financial assets of over $461 trillion. Clearly, there is still a considerable way to go to develop the Islamic economy in real and financial terms. Islamic finance is an equity-based or risk-sharing model that takes into account ethical or Shariah principles. Islam abhors usury and encourages the rich to give zakat or charity. In that sense, the logic of Islamic finance promotes a circular economy that upholds self-restraint and discipline through faith, and is more fair through risk sharing. Debt finance operates on the basis of risk transfer. The lender protects its interests through collateral or third-party guarantees, and the borrower bears all the risk of failure.
So in a world where geopolitical and climate risks are becoming increasingly volatile and unpredictable, financing development through equity and ethical values demonstrates the implementation of sustainable ESG (environmental, social, and governance) goals. In a free-market model with one dominant hegemon, free-market policies make sense because the hegemon maintains overall stability and everyone benefits from playing by its rules. In a world of competing powers, rising risks, and increasing uncertainty, implementing real-economy strategies and engaging in prudent, low-leverage, equity-based financing that addresses both social and environmental injustices seems the right way to go. Playing with finance is shuffling the Titanic deck. Keeping the Titanic away from existential threat is the real approach for the real economy, and that is where we should focus our collective efforts.
(The author is a former central banker and a fellow at the Asia-Global Institute at the University of Hong Kong.) A special contribution to ANN.
