Financial Protectionism Is Latest Threat to Global Recovery

By BOB DAVIS DAVOS, Switzerland --The chill at last week's global economic conference wasn't from the Alpine air but from the threat of financial protectionism. Public officials and business leaders warned that the global recession could sharply reduce lending across borders and lead to more subsidies tucked away in economic-stimulus plans. Investment of private capital to emerging markets this year is expected to be 82% lower than it was in 2007. The Institute of International Finance, an association of the world's largest banks, said that in emerging European countries, which had been engines of growth, the volume of flow is expected to be $30 billion in 2009, down from $254 billion in 2008. "If you go around the world, then what you are seeing is the withdrawal of banks from a number of emerging-market countries with a pretty weak domestic-banking system," British Prime Minister Gordon Brown said in an interview with The Wall Street Journal. "What you've got then is a form of financial mercantilism. What you've got is people retreating to their home-based banking systems. It's the first stage of a financial protectionism that will lead eventually to the kind of trade protectionism that we've seen in the past." A repeat of 1930s-style tariff wars is remote, but the new form of protectionism could play out in Depression-era style. If a few major nations favor their own industries at the expense of foreigners, invariably so will others, producing rounds of retaliation. That could choke off trade further -- the International Monetary Fund already predicts a 2.8% decline in trade in 2009 -- and clog a global engine of growth. Mr. Brown and Stephen Green, the chairman of HSBC Holdings, both said during meetings in Davos that a lack of lending would spill into the broader economy and hurt global trading. The problem of banks retreating is being felt in Britain. Mr. Brown said Royal Bank of Scotland Group, which received a state bailout and is now majority-owned by taxpayers, along with other British banks, are stepping up lending -- yet significant lending gaps remain. Dealing with financial protectionism is far more difficult than heading off tariff wars. Nations have slashed their tariffs during 50 years of global trade negotiations, and the World Trade Organization effectively polices trade disputes. There is no equivalent of the WTO for financial disputes. Instead, "there are a whole load" of different forums, said Lord Adair Turner, Britain's top financial regulator. Political leaders are looking at three approaches for handling financial protectionism, all with a deadline of April 2, when leaders of the Group of 20 industrial and developing countries meet in London. One track is to strengthen the IMF so it can better police financial issues. Another is to revamp financial regulation, which could help restore market confidence. A third is to limit "buy local" provisions in nations' stimulus plans, which have gotten the most attention as an economic threat. It is an ambitious agenda, with much of the attention focused on the IMF. At Davos, there was no end of proposals to remake -- or even abolish -- the IMF. German Chancellor Angela Merkel rejected "unfettered capitalism" and suggested a "U.N. economic council" that might turn out to be a replacement for the IMF. But nations that once criticized the IMF -- South Africa, India -- and that are now due to get more power at the institution rose to its defense. The IMF should have more "teeth," said South African Finance Minister Trevor Manuel. The U.K.'s Mr. Brown suggested the IMF should operate like a central bank, meaning it should have much more independence from political pressure. But radical changes aren't likely. The IMF is a political institution dominated by the U.S., which has a large enough share of the votes to veto major changes. After the Asian financial crisis more than a decade ago, the U.S. batted down the "central bank" idea and is likely to do so again. Some of the same people who ran U.S. international economic policy then, Lawrence Summers and Timothy Geithner, now have the top economic jobs with the Obama administration. What is more likely is that the IMF will toughen and broaden its reviews of its 185 member nations, highlighting potential financial pitfalls. It may also conduct the investigations with another group, the Financial Stability Forum, a collection of central bankers and regulators from financial centers who have more stature than IMF economists. Even that, though, presents political problems. Powerful countries routinely ignore IMF advice. When the IMF lobbied the U.S. to attack its banking problems in the spring of 2008, its recommendations were dismissed. The IMF's annual review of China has been held up for at least eight months because of dispute over China's exchange-rate policy. The fight has dragged on for so long that the IMF will have to start a new review to take into account changed economic circumstances, said John Lipsky, the IMF's No. 2 official. "If the IMF tries to tell people what to do before there is a crisis, the response is, 'Who elected you?' " says Harvard economist Robert Lawrence. The second track, financial regulatory overhaul, was initially seen as a longer-term effort to restructure global regulation and head off future crises. But the effort has gained immediacy partly because of the fear of financial protectionism. The new rules are likely to limit the activities of banks whose failure could endanger the global financial system. If the G-20 agrees to endorse and implement the rules consistently, said Financial Stability Forum Chairman Mario Draghi, it could produce a burst of confidence in the financial system that might spur lending across borders. "The only thing we can do to help restart the market is to tell the world that there are certain kinds of real products that are simple to understand, easy to price and satisfy certain legal conditions," Mr. Draghi, who is also governor of the Bank of Italy, said in an interview. The third track, discouraging local-content provisions, also faces political hurdles. The Obama administration won House approval of its huge economic-stimulus package solely with the support of Democrats, many of whom sought a provision that required U.S.-made steel be used in stimulus projects. The bill now goes to the Senate, where lawmakers are championing still more-sweeping restrictions. Senior Democratic Senate aides say the administration hasn't done anything to signal whether it wants the restrictive language stripped from the bill. The White House says the matter remains under review. The U.S. is hardly the only country using the financial crisis to favor its own businesses. A number of European countries have put together rescue plans for their local car companies. The U.K. has insisted that banks boost lending to local small businesses. Mr. Brown says RBS has, in fact, stepped up lending to small companies and homeowners. Mr. Brown said British firms are being hurt by a reduction in lending by foreign banks. "Once you have identified that the problem is a form of financial protectionism that could potentially lead to worse forms of protectionism, then you have got to ask yourself how you can actually solve that problem," the prime minister said. —Neil King Jr. contributed to this article. Write to Bob Davis at bob.davis@wsj.com