Policy Coordination in the Global Financial Crisis

The global financial crisis of 2008-2009 that originated from a U.S. subprime mortgage crisis created devastating impacts throughout the whole world. In the midst of the 2008 presidential election, protectionism and anti-China sentiment were prevalent in the United States, focusing on China’s currency policies and practices. Across the Pacific Ocean, national pride and honor were surging in China following the Summer Olympics hosted in Beijing, and with them a growing antipathy to an overweening Washington. Despite intensifying acrimony, in the face of the most devastating economic crisis since the Great Depression, the two governments shelved differences, pursued cooperation, and led an international collective effort to stabilize the global financial system. The crisis gave birth to the G-20 Summits mechanism, whereby Beijing’s international role and responsibilities were expanded. China-U.S. joint action in the crisis helped usher in a new era in which Beijing would play a more visible role in global governance.

 

 

In February 2007, HSBC announced that it had suffered huge losses in its home mortgage business in North America; two months later, New Century Financial, the second-largest subprime mortgage company in the United States, filed for bankruptcy because it was insolvent, another early sign of an imminent mortgage crisis. Over the next year and a half, the crisis continued to spread, and the two largest mortgage institutions, Fannie Mae and Freddie Mac, reported huge losses on their retained portfolios and were taken over by the U.S. Treasury Department on September 6, 2008. Lehman Brothers, the fourth-largest investment bank on Wall Street, filed for bankruptcy on September 15, 2008, marking the outbreak of the most serious financial crisis since the Great Depression. It soon spilled into the real economy, which contracted by 6.1 percent in the fourth quarter of 2008. At that time, China, the third-largest economy in the world, had accumulated nearly $2 trillion in foreign exchange reserves, of which $1.1 trillion was invested in U.S. securities, making it the second-largest foreign owner of U.S. federal debt.[1] The financial crisis sharpened the Chinese and U.S. awareness that in a globalized world their interests were intertwined in a fragile global financial system and that in times of crisis they had no other option than “helping each other like two people in the same boat.”[2] Against this background, the two governments put aside their differences and carried out effective cooperation in response to the crisis.

 

Beijing and Washington took complementary measures to restore global financial stability and facilitate the recovery of the world economy. Washington mainly focused on boosting confidence in the financial system. On the one hand, the Federal Reserve began steadily reducing interest rates to near-zero and used unconventional policy tools to inject liquidity into the market. Congress passed the Troubled Asset Relief Program (TARP) and authorized $700 billion to purchase toxic assets and equities from financial institutions, and the Treasury used the funds to inject capital directly into more than 700 banks to stabilize market confidence. On the other hand, the crisis exposed the loopholes in the U.S. financial regulatory regime and the limits of the market, prompting the government to implement the largest financial regulatory reform since the Great Depression to prevent future crises. The government released the Blueprint for a Modernized Financial Regulatory Structure on March 31, 2008, and issued a series of legal and policy documents, including, most notably, the Dodd-Frank Wall Street Reform and Consumer Protection Act signed by President Obama on July 21, 2010. The Dodd-Frank Act marked the beginning of the most sweeping financial regulatory reform since the Great Depression.[3]

 

The financial crisis also hit China’s stock market, but on the whole, China’s financial system was less open at that time, so its financial institutions were less affected by the subprime mortgage crisis. Beijing coordinated with Washington along two lines of effort. First, China’s sovereign wealth fund, China Investment Corporation, which had held trillions of dollars in U.S. assets and registered huge losses on investments companies like Blackstone Group, refrained from panic selling, a critical measure contributing to Washington’s rescue efforts. Henry M. Paulson, Jr., then the secretary of the Treasury, recalled that although the Chinese government did not further invest in the troubled J.P. Morgan Chase, the largest investment bank in America, as the Japanese had done at the U.S. request, it declined to go along with the Russian plan of “selling some of their GSE securities to force the United States to use its emergency authorities to support the companies.” The secretary appreciated Beijing’s “admirable resolve in cooperating with [the U.S.] government.”[4]

 

Second, in order to boost demand, China announced a four trillion yuan ($586.9 billion) economic stimulus program in early November 2008 to support infrastructure investment and real economic recovery. Although the large-scale investment plan accumulated greater financial risks for China’s economy, it played an indispensable role in promoting the recovery of the world economy. Advanced and emerging economies in the fourth quarter of 2008 shrank by 7.1 percent and four percent respectively. China’s economy grew by 6.1 percent in the first quarter of 2009, the lowest in 17 years, but rebounded to 7.7 percent in the third quarter. China’s strong recovery boosted global economic outlook in the second quarter of 2009, and the world economy began to register positive growth in October 2009.[5]

 

 

Since the beginning of the new century, with growing economic interdependence, competitions and disputes had also increased between China and the United States. Even as the long-running differences on intellectual property protection, exchange rates, government subsidies, non-market economy status, and trade imbalances persisted, conflicts on new cross-domain issues such as commercial espionage, cyber security, and the global commons had emerged. In this context, Beijing and Washington realized that a new framework of dialogue mechanisms was needed to address a wide range of economic and trade issues.

 

On August 1, 2005, Deputy Secretary of State Robert Zoellick and Vice Foreign Minister Dai Bingguo met in Beijing to launch a ministerial dialogue mechanism. At the meeting, Zoellick urged China to become a “responsible stakeholder.” However, there were differences between the two sides on the name and positioning of the mechanism. China called it a “high-level strategic dialogue,” whereas the United States termed it “high-level dialogue.” In early 2006, the newly appointed Treasury Secretary Henry Paulson initiated a ministerial economic dialogue between Beijing and Washington, i.e., “Strategic Economic Dialogue”(SED), elevating it for the first time to the strategic level, but prompting strong opposition from the U.S. hawks at that time.[6] But the onset of the financial crisis made the United States realize for the first time that the two countries had switched places and that Washington now needed Beijing’s help.[7] In April 2009, President Hu Jintao and President Obama met during the G-20 summit in London and decided to launch the “Strategic and Economic Dialogue” (S&ED) by merging the “High-Level (Strategic) Dialogue” and the “Strategic Economic Dialogue.” It was upgraded from the ministerial to cabinet level, allowing for across-the-board discussions on issues of strategic and economic importance. Obama addressed the opening ceremony of the first S&ED in late July 2009 and emphasized that the United States needed China’s support and cooperation to cope with the global financial crisis. During his trip to Washington, D.C. in February 2012, Vice President Xi Jinping called for “a new type of relationship between major countries in the 21st century,” seeking to build a more reciprocal relationship with the United States.

 

Of course, a higher-level and more coherent dialogue mechanism did not mean that all differences had been resolved. The financial crisis had reshaped Chinese and the world’s perceptions of the U.S.-led capitalist system, and widened policy differences over some major issues. For example, on the eve of the crisis, Washington accused Beijing of “manipulating the RMB exchange rate” and pressured China to speed up the opening of its financial market. After the crisis broke out, there were even stronger opposition in China to opening up its capital account and financial market and market-oriented reforms of RMB exchange rates. On the sidelines of the first G-20 summit in Washington in mid-November 2008, President Hu Jintao said to Henry Paulson that “I bet you’re glad we didn’t move the currency faster than we did. I hope you now understand why. Some of the things you wanted us to do would have been dangerous. Now we’re stable and can stimulate the economy, and that’s helping us and the whole world.” But Paulson believed that it was China’s fiscal spending, not its currency policies, that had bolstered this growth.[8] In the aftermath of the crisis, the IMF had also changed its view on capital account liberalization—from one that considered capital controls as almost always counterproductive to greater acceptance of controls to deal with the volatility of capital flows.[9] But the United States still clung to its free-market orthodoxy and continued to push China to open its financial market and liberalize the RMB exchange rate at an early date.

 

 

The outbreak of the Asian financial crisis in 1997 prompted the G-8 to expand its membership and initiate a meeting of G-20 finance ministers in the hopes of “establish[ing] a new mechanism for informal dialogue in the framework of the Bretton Woods institutional system, to broaden the dialogue on key economic and financial policy issues among systemically significant economies.”[10] Nonetheless, emerging countries were still underrepresented under this new initiative. Before the crisis, China was invited as a representative of emerging economies to G-8 talks on issues like climate change. After the outbreak of the crisis, President George W. Bush upgraded the G-20 finance ministers’ meeting to summit level and invited Chinese President Hu Jintao to attend the first G-20 summit. Since then, the G-20 has become the “primary forum” for coordinating international economic cooperation. Joint China-U.S. efforts have facilitated coordinated actions by the world’s major economies and international financial institutions under the G-20 framework. Furthermore, a G-20 membership has helped amplify China’s voice and views in global governance, enabling Beijing to assume more international responsibilities and influence the evolution of the global economic governance architecture.

 

First, China pushed the G-20 to adopt collective rescue programs to enhance the capacity of international financial institutions to respond to the crisis. In April 2009, the G-20 London Summit approved a $1.1 trillion program of support to restore credit, growth, and jobs in the world economy. Even before the quota reform, China bought $40 billion bonds to support IMF. At the G-20 Los Cabos Summit in 2012, China again announced that it would contribute $43 billion to the IMF’s response to the European debt crisis.

 

Second, China remained committed to improving global financial reforms and coordination. The financial regulatory reform in the United States drove a new round worldwide regulatory coordination, prompting the G-20 to adopt Basel III in 2010. By January 1, 2015, banks must raise their total Tier 1 capital from two percent to six percent, and minimum common equity capital from two percent to 4.5 percent, so that the foundation of today’s global financial system would be more resilient. Even though the Covid-19 pandemic has triggered shock waves across global stock markets, the banking system still maintains good fundamentals.

 

Before the financial crisis, China had mainly been involved in global trade rule-making under the WTO framework, as the lion’s share of financial rule-making power was in the hands of the United States and Europe. After joining the G-20, Beijing obtained its seats at the Financial Stability Oversight Council, the Global Forum on Transparency and Exchange of Information for Tax Purposes, and other regulatory institutions, and was given a larger say in the Basel Committee, the International Organization of Securities Commissions, and other international organizations. China was also an active party to the negotiations on macroprudential regulation.[11] Moreover, as its banking system was less affected by the crisis, Beijing was better positioned to implement Basel III faster than other countries and met the requirements of Basel III in January 2015.[12]

 

Third, China advocated for vigorous governance reforms in the World Bank and IMF for the two multilateral financial institutions to acquire new resources and assume new responsibilities. In 2010, through the World Bank’s voice reform program, developing and transition countries earned more voting power, an increase of 4.59 percentage points since 2008; through the IMF’s quota reform, more than six percent of quota shares were shifted to dynamic emerging markets and developing countries, which was not approved by U.S. Congress until 2015. Although China insisted on its developing country status, it put forward a fiscal doctrine at the end of 2014 that underlined its great power aspirations and a more rational balance between domestic and international responsibilities. Since then Beijing has steadily increased financial contributions to international organizations.

 

China and the United States still had conflicts of interest and diverging policy positions within the G-20 framework and on larger global governance issues, but disagreements and disputes had not hindered cooperation between the two countries. Washington and Beijing held different views on the root causes of the crisis since the very beginning. The United States believed that it was the “imbalances” in the world economy that had caused the crisis and persistent trade surplus was to blame. It endorsed the IMF’s efforts to develop indicative guidelines to promote the rebalancing of the global economy by launching the Mutual Assessment Process (MAP). As its current account balance was around 9-10 percent of GDP in 2007-2008, China strongly opposed the U.S. efforts to rebalance the global economy, believing that Washington was trying to shift the blame onto Beijing so that it could force China to make concessions on such issues as the RMB exchange rate and bilateral trade imbalance. In fact, China had already launched structural reforms to advance its own long-term interests, and as a result, relevant economic indicators had changed for the better. Although the goals set by the G-20 appeared to have ben achieved, it did not mean that the two countries had arrived at a new, more balanced economic relationship, suggesting that bilateral relations should not be regulated by certain quantitative indicators.[13]

 

 

First, the many downsides and uncertain future of globalization require closer coordination between China and the United States. As economic growth relies more and more on flows of fictitious capital than on the real economy’s dynamism, the global economy is increasingly unsustainable and unequal, with more potential Minsky Moments on the horizon. The still rampaging coronavirus pandemic has once again proven that great power confrontation in a time of crisis has disastrous consequences for the whole world.

 

Second, high-level dialogue mechanisms help create bonds of respect and trust between Chinese and U.S. government officials that ultimately lead to pragmatic cooperation. Dialogues themselves are not solutions to long-running disputes, but without dialogues disagreements are more likely to escalate into major crises or even conflicts. Top leaders and high-level officials involved in the SED and S&ED all agreed that diverging policy positions had not prevented dialogue mechanisms from functioning as venues for confidence building and intense personal interaction. It turned out that these personal bonds played a crucial role in facilitating coordinated response to the financial crisis. Over the course of the first five SEDs that took place between 2006 and 2008, there were 30 face-to-face meetings among Chinese and U.S. officials and more than two dozen phone calls between ministers.[14] Unfortunately, President Trump has expressed little interest in reviving the dialogue mechanisms since late 2018, believing that nothing substantive has emerged from them. 

 

Third, Beijing and Washington should build a fair and inclusive global governance architecture to facilitate bilateral cooperation and manage competition and dispute. By initiating the G-20 and inviting China to be part of a globally-coordinated response to the financial crisis, government officials in Washington had increased mutual trust and understanding with their Chinese counterparts. These positive sentiments led to the transition from SED to S&ED, which greatly enhanced the effectiveness of China-U.S. cooperation in response to the global financial crisis. As China’s economy and global influence continue to grow, Beijing’s demand for a more equal redistribution of rights, interests, and responsibilities between China and Washington will also grow. As a result, bilateral competition in the G-20 and other global governance institutions will only intensify. As the story of China-U.S. coordination amid the financial crisis has shown, competition on one issue does not necessarily preclude cooperation on another. During the Obama administration, despite strong U.S. suspicion about the China-led AIIB, Beijing and Washington managed to reach a strategic agreement within the S&ED in which China pledged to continue its support of U.S.-led international institutions even as Beijing devoted more resources to develop its own multilateral initiatives. As Ngaire Woods, the Oxford University professor and AIIB adviser, put it, the first reason why the differences between China and the United States will not destroy multilateralism is that China still firmly supports multilateral institutions.[15] Approaches and mechanisms for global economic governance are not static but change over time with the evolving global economic landscape. There is no and should not be ready-made, one-size-fits-all pattern and paradigm of international cooperation. Beijing and Washington must realize that to achieve real results the best policy should always be flexibility, adaptation, and agility.

 

Fourth, Washington should respect Beijing’s own timetable and roadmap for market reforms. China remains committed to building a modern economic system centered around vibrant markets and a responsive government. Despite significant disagreements over the development model of a market economy, Beijing and Washington see eye-to-eye on some of the fundamental features of a market economy, such as fairness, transparency, openness, and the rule of law. As the world’s largest developing country with its own national conditions, China insists on pursuing an independent development model that relies on reform and opening-up whose pace, scope, and degree are of Beijing’s own choosing and not subject to foreign pressure. As the past four-plus decades have shown, American assistance, ranging from capital and training to technological know-how and managerial expertise, has played a unique role in China’s modernization, which is acknowledged and appreciated by the Chinese. And in some instances, such as RMB exchange rate reforms in 2015 and the opening of the financial market in 2019, Chinese policymakers agreed with their American counterparts on the end results of reforms but disputed over the pace. The Chinese slowed down their financial reforms after 2008 to reflect on the global financial crisis, but to their disappointment, such an innocuous moment was interpreted by orthodox neoliberals as a suspicious sign of regression.

 

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