Misaligned exchange rates are more often than not a prelude to trade friction. Yet so far, in spite of sporadic outbreaks of warlike political rhetoric between the US and China, currency misalignments between the world's surplus savings countries and the world's borrowers and spenders have not ended in disaster. Buy America provisions and bail-outs for bankrupt motor companies are less damag- ing than trade barriers of the kind erected by the Smoot-Hawley Act in the 1930s. Yet the reality, in this financial crisis, is that we have protectionism by the financial backdoor and may soon have it by the front door.
Until August 2007, liberalisation in global banking enhanced the efficiency of the financial system and facilitated trade in goods and services along with cross-border movements of capital. The huge advantage of such globalisation was that lenders no longer needed to be physically close to borrowers. Since the collapse of Lehman Brothers last September, trade credit has become scarce, causing international trade to implode. The impact has been quite as severe as any controls over imports, although a return of financial stability would mitigate the damage. A more lasting problem lies in foreign- owned banks' retreat from cross border activity. Capital and financial flows tend to display a homing instinct in a crisis. And this is now being reinforced by the regulatory response to the financial debacle.
Home countries, Iceland being the most obvious case in point, may not be able to honour obligations to depositors abroad if their banks are too big for their economies. There are plenty of countries that potentially fall into this category. New York-based econo- mist Geoffrey Bell points out, for example, that Ireland's bank liabilities are 954 per cent of GDP, while Switzerland's are 644 per cent, which has led to suggestions that UBS and Credit Suisse should be forced to shrink. At the same time, host countries are less happy about having foreign-owned banks on their soil, especially in the form of branches supported only by capital back in the home country. Host country supervisors will thus demand that more business is done via locally incorporated, well capitalised subsidiaries.