Dilemmas, Trilemmas and Difficult Choices

In 2013 Hélène Rey of the London Business School presented a paper at the Federal Reserve Bank of Kansas City’s annual policy symposium. Her address dealt with the policy choices available to a central bank in an open economy, which she claimed are more limited than most economists believe. The subsequent debate reveals the shifting landscape of national policymaking when global capital markets become more synchronized.

The classic monetary trilemma (or “impossible trinity”) is based on the work of Robert Mundell and Marcus Fleming. The model demonstrates that in an open economy, central bankers can have two and only two of the following: a fixed foreign exchange rate, an independent monetary policy, and unregulated capital flows. A central bank that tries to achieve all three will be frustrated by the capital flows that respond to interest rate differentials, which in turn trigger a response in the foreign exchange markets.  Different countries make different choices. The U.S. allows capital to cross its borders and uses the Federal Funds Rate as its monetary policy target, but refrains from intervening in the currency markets. Hong Kong, on the other hand, permits capital flows while pegging the value of its currency (the Hong Kong dollar) to the U.S. dollar, but forgoes implementing its own monetary policy. Finally, China until recently maintained control of both its exchange rate and monetary conditions by regulating capital flows.

Rey showed that capital flows, domestic credit and asset prices respond to changes in the VIX, a measure of U.S. stock market volatility. The VIX, in turn, is driven in part by U.S. monetary policies. Consequently, she argued, there is a global financial cycle that domestic policymakers can not resist. A central bank has one, and only one, fundamental choice to make (the “dilemma”): does it regulate the capital account to control the amount and composition of capital flows? If it does, then it has latitude to exercise an independent monetary policy; otherwise, it does not possess monetary autonomy.

Is Rey’s conclusion correct? Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University have provided a thorough analysis of the trilemma (working paper here; see also here). Their paper focuses on whether the use of partial capital controls is sufficient to provide monetary policy autonomy with a pegged exchange rate. They find that temporary, narrowly-targeted controls–“gates”– are not sufficient to allow a central bank to both fix its exchange rate and conduct an independent policy. A central bank that wants to control the exchange rate and monetary conditions must impose wide and continuous capital controls–“walls.” But they also find that a central bank that forgoes fixed exchange rates can conduct its own policy while allowing capital flows to cross its borders, a confirmation of the trilemma tradeoff.

Helen Popper of Santa Clara University, Alex Mandilaras of the University of Surrey and Graham Bird of the University of Surrey, Claremont McKenna College and Claremont Graduate University (working paper here; see also here) provide a new empirical measure of the trilemma that allows them to distinguish among the choices that governments make over time. Their results confirm, for example, that Hong Kong has surrendered monetary sovereignty in exchange for its exchange rate peg and open capital markets. Canada’s flexible rate, on the other hand, allows it to retain a large degree of monetary sovereignty despite the presence of an unregulated capital market with the U.S.

The choices of the canonical trilemma, therefore, seem to hold. What, then, of Rey’s challenge? Her evidence points to another phenomenon: the globalization of financial markets. This congruence has been documented in many studies and reports (see, for example, here). The IMF’s Financial Stability Report last October noted that asset prices have become more correlated since the global financial crisis. Jhuvesh Sobrun and Philip Turner of the Bank for International Settlements found that financial conditions in the emerging markets have become more dependent on the “world” long-term interest rate, which has been driven by monetary policies in the advanced economies.

Can flexible exchange rate provide any protection against these comovements? Joshua Aizenman of the University of Southern California, Menzie D. Chinn of the University of Wisconsin and Hiro Ito of Portland State University (see also here) looked at the impact of “center economies,” i.e., the U.S., Japan, the Eurozone and China, on financial variables in emerging and developing market economies. They find that for most financial variables linkages with the center economies have been dominant over the last two decades. However, they also found that the degree of sensitivity to changes emanating from the center economies are affected by the nature of the exchange rate regime. Countries with more exchange rate stability are more sensitive to changes in the center economies’ monetary policies. Consequently, a country could lower its vulnerability by relaxing exchange rate stability.

Rey’s dismissal of the trilemma, therefore, may be overstated. Flexible exchange rates allow central banks to retain control of policy interest rates, and provide some buffer to domestic financial markets. But her wider point about the linkages of asset prices driven by capital flows and their impact on domestic credit is surely correct. The relevant trilemma may not be the international monetary one but the financial trilemma proposed by Dirk Schoenmaker of VU University Amsterdam. In this model, financial policy makers must choose two of the following aspects of a financial system: national policies, financial stability and international banking. National policies over international bankers will not be compatible with financial stability when capital can flow in and out of countries.

But abandonment of national regulations by itself is not sufficient: International banking is only compatible with stability if international financial governance is enacted. Is the administration of regulatory authority on an international basis feasible? The Basel Committee on Banking Supervision seeks to coordinate the efforts of national supervisory authorities and propose common regulations. Its Basel III standards set net capital and liquidity requirements, but whether these are sufficient to deter risky behavior is unclear. Those who deal in cross-border financial flows are quite adept in running rings around rules and regulations.

The international monetary trilemma, therefore, still offers policymakers scope for implementing monetary policies. The financial trilemma, however, shows that the challenges of global financial integration are daunting. Macro prudential policies with flexible exchange rates provide some protection, but can not insulate an economy from the global cycle. In 1776, Benjamin Franklin urged the members of the Second Continental Congress to join together to sign the Declaration of Independence by pointing out: “We must, indeed, all hang together, or most assuredly we shall all hang separately.” Perhaps that is the dilemma that national policymakers face today.

Growth in the Emerging Market Economies

In recent decades the global economy has been transformed by the rise of the emerging market economies. Their growth lifted millions out of poverty and gave their governments the right to call for a larger voice in discussions of international economic governance. Therefore it is of no small importance to understand whether recent declines in the growth rates of these countries is a cyclical phenomenon or a longer-lasting transition to a new, slower state. That such a slowdown has wide ramifications became clear when Federal Reserve Chair Janet Yellen cited concerns about growth in emerging markets for the delay in raising the Fed’s interest rate target in September.

The data show the gap between the record of the advanced economies and that of the emerging markets. I used the IMF’s World Economic Outlook database to calculate averages of annual growth rates of constant GDP for the two groups.

2001-07 2008-09 2010-15
Advanced 2.46% -1.62% 1.82%
Emerging and Developing 6.62%  4.48% 5.47%
Difference: (Emerging + Developing)               – Advanced 4.16%  6.1% 3.65%

The difference in the average growth rates was notable before the global financial crisis, and rose during the crisis. Since then their growth rates have fallen a bit but continue to exceed those of the sclerotic advanced economies. Since the IMF pools emerging market economies with developing economies, the differences would be higher if we looked only at the record of emerging markets such as China, India and Indonesia.

And yet: behind the averages are disquieting declines in growth rates, if not actual contractions, for some members of the BRICS as well as other emerging markets. The IMF forecasts a fall in economic activity for Brazil of -3.03% for 2015 and for Russia of -3.83%, which makes South Africa ’s projected rise of 1.4% look vigorous. Even China’s anticipated 6.81% rise is lower than its extraordinary growth rates of previous years, and exceeded by India’s projected growth of 7.26%. The IMF sees economic growth for the current year for the emerging markets and developing economies of 4% , a decline from last year’s 4.6%.

What accounts for the falloff, and can it be reversed? The change in China’s economic orientation from an economy driven by investment and export expenditures to one based on consumption spending has slowed that country down. The decline in that country’s demand for raw materials to transform into finished goods for export is rippling through the economies of the major commodity exporters, such as Australia and Brazil. The Economist has claimed that the resulting fall in commodity prices constitutes a “great bear market.”

This downturn may be aggravated by a failure in institutions. Bill Emmott writes that emerging markets need political institutions that “…mediate smoothly between competing interest groups and power blocs in order to permit a broader public interest to prevail.” He specifically cites the leaderships of Brazil, Indonesia, Turkey and South Africa as examples of governments that have not been able to achieve that task.

The basic model of economic growth, the Solow-Swan model, predicts that income in the poorer countries should catch up with those of the advanced economies as the former countries adopt the advanced technology of the latter. This basic result is modified if there are higher population growth rates or lower savings levels, which can lead to lower per capita income levels. On the other hand, the Asian countries used high savings rates to speed up their economic growth while their birth rates fell.

But convergence has not been achieved for most economies despite periods of rapid growth. Some economists have postulated the existence of “middle-income traps.” Maria A. Arias and Yi Wen of the St. Louis Federal Reserve Bank describe this phenomenon in a recent issue of the institution’s publication, The Regional Economist. They explain that while income rose close to U.S. levels in the “Asian Tigers” (Hong Kong, Singapore, South Korea and Taiwan) as well as Ireland and Spain, per-capita income shows no sign of rising in Latin American economies such as Brazil and Mexico. There may also be a “low-income” trap for developing economies that never break out of their much lower per-capita income.

Why the inability to raise living standards? Arias and Wen, after discussing several proposed reasons such as poor institutions, compare the cases of Ireland and Mexico. They claim that the Irish government opened the economy up to global markets slowly in earlier decades, and encouraged foreign direct investment to grow its manufacturing sector. This allowed the country to benefit from the technology embedded in capital goods. Mexico, on the other hand, turned to foreign capital markets to finance government debt, which left the economy vulnerable to currency crises and capital flight. Arias and Wen conclude that governments should manage the composition of capital inflows and control capital flows that seek short-term gain rather development of the manufacturing sector.

But there may be a more basic phenomenon taking place. In 2013 Lant Pritchett and Lawrence Summers of Harvard presented a paper with the intriguing title, “Asiaphoria Meets Regression to the Mean.” They examined growth rates for a large number of countries for10 and 20 year periods, extending back to the 1950s. They showed that there is ”…very little persistence in country growth rate differences over time, and consequently, current growth has very little predictive power for future growth.” While acknowledging China and India’s achievements, they cautioned that “…the typical degree of regression to the mean imply substantial slowdowns in China and India relative even to the currently more cautious and less bullish forecasts.” They drew particular attention to the lack of strong institutions in the two countries.

If growth does slow for most emerging market economies, then the recent buildup of corporate debt in those countries may be a troubling legacy of the recent, more robust period. Debt loads that looked manageable when borrowing costs were low and future prospects unlimited are less controllable when that scenario changes. While there may not be a widespread crisis that afflicts all the emerging markets, those countries with extended financial sectors are vulnerable to international volatility.

The Continuing Dominance of the Dollar: A Review of Cohen’s “Currency Power”

Every year I choose a book that deals with an important aspect of globalization, and award it the Globalization Book of the Year, also known as the “Globie.” Unfortunately, there is no cash prize to go along with it, so recognition is the sole award. Previous winners can be found here and here.

The winner of this year’s award is Currency Power: Understanding Monetary Rivalry by Benjamin J. Cohen of the University of California: Santa Barbara. The book deals with an issue that is widely-discussed but poorly-understood: the status of the dollar as what Cohen calls the “top currency.” The book’s appearance is quite timely, in view of the many warnings that China’s currency, the renminbi (RMB), is about to replace the dollar (see, for example, here).

Cohen proposes a pyramid taxonomy of currencies. On the top is the “top currency,” and in the modern era only the pound and dollar have achieved that status. The next level is occupied by “patrician currencies,” which are used for cross-border purposes but have not been universally adopted. This category includes the euro and yen, and most likely in the near future the RMB. Further down the pyramid are “elite currencies” with some international role such as the British pound and the Swiss franc, and then “plebeian currencies” that are used only for domestic purposes in their issuing countries. Below these are “permeated currencies” which face competition in their own country of issuance from foreign monies that are seen as more stable, “quasi-currencies” that have a legal status in their own country but little actual usage, and finally at the base of the pyramid are “pseudo-currencies” that exist in name only.

Cohen points out that not too long ago the euro was seen a competitor for the dollar as a “top currency.” The euro’s share of the publicly known currency composition of central banks’ foreign exchange reserves has fluctuated around 25% in the last decade, and its share of the international banking market is higher. But Cohen believes that the relative position of the euro may have peaked due to its inability to devise a way to deal with fiscal imbalances among members of the Eurozone.

Cohen compares the Eurozone’s institutional framework with that of the U.S., which adopted a common currency early in its history. The U.S. system includes fiscal transfers (“automatic stabilizers”) between the federal government and the states but no bailout of a state government in fiscal distress, accompanied by balanced budget restrictions in most states. The European Union’s (EU) Stability and Growth Pact put a limit on the budget deficits of its members and their debt, and was followed by the European Fiscal Compact that mandates balanced budget regulations in national laws. But resistance to the EU’s oversight of national budgets has been widespread. Moreover, the European Stability Mechanism, the EU’s instrument to assist members in financial crisis, is still a work in progress, as the lack of resolution of the Greek debt crisis demonstrates. While the size of the Eurozone ensures the wide usage of the euro and a role as a “patrician currency,” the inability of its member governments to decide on how to handle fiscal governance ensures that it will never rival the dollar.

China does not face the problem of unruly national governments, although the finances of local governments are shaky. The RMB has become more widely used in international commerce, not a surprising development in view of the rise of China as a global trading nation. The IMF is considering the inclusion of the RMB with dollars, euros, pounds and yen in the basket of currencies that comprise the IMF’s own unit of value, the Special Drawing Right. The Chinese government sees the upgrade in the status of the RMB as a confirmation of that country’s ascent in economic status.

But Cohen cautions against interpreting the increasing use of the RMB in trade as a precursor to the widespread adoption of the RMB as a global currency. He points out that there are private functions as well as official roles of an international currency, including its use for foreign exchange trading and financial investments. The RMB is not widely used for financial transactions, in part due to barriers to the foreign acquisition of Chinese securities, while the size of Chinese financial markets, while growing, is limited. Eswar Prasad and Lei Ye of Cornell reported in 2012 that “China still comes up short when it comes to the key dimensions of financial market development, and financial system weaknesses are likely to impede its steps to heighten the currency’s international role.”

Moreover, the government’s response this summer to the volatility in its stock markets was seen as heavy-handed. Cohen questions whether the Chinese government is willing to relinquish its control of the financial sector, despite its desire to promote the international use of the RMB. Capital flight would be a threat to stability and a sign of the government’s loss of legitimacy.

Cohen concludes his insightful analysis with a prediction that “Well into the foreseeable future, the greenback will remain supreme.” The U.S. currency continues to have widespread usage for many purposes. But any sort of triumphalism would be short-sighted. A recent working paper by Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated the amount of dollar-denominated credit outside the U.S. at about $9 trillion. A rise in the cost of borrowing in dollars will be passed on to the foreign borrowers, which will further slow down their economies. The decision in September of the Federal Open Market Committee to delay raising interest rates reflected its concern about the global economy, which complicates its ability to use monetary policy for domestic goals. The U.S. can not ignore the feedback between the international roles of the dollar and its own economic welfare. Great responsibility comes with great power.

The External Debt of the Emerging Market Economies

The outflow of money from emerging markets this year will most likely surpass inflows for the first time since 2008, and net capital outflows may total $541 billion according to the Institute of International Finance. The flows have been accompanied by currency depreciations, stock market collapses, and in the case of Brazil, a downgrade in its credit rating to junk bond status. The IMF has responded to this turbulence by lowering its forecast for growth in the emerging markets and developing economies this year from 4.2% to 4%.

The emerging market nations that export commodities have been particularly hard hit, as China cuts back on its imports of raw materials and commodity prices plunge. Other factors that could signal further weakness are declining foreign exchange reserves, current account deficits and political uncertainty. Countries besides Brazil that have been identified as most vulnerable to further downturns include Russia, Venezuela, Turkey and Indonesia. When the long-awaited increase in U.S. interest rates finally does take place, the rise in the cost of borrowing in dollars will exacerbate the position of these countries.

There is another factor that will affect how an external shock will affect economic performance: the composition of a country’s external balance sheet. This records the holdings of foreign assets held by domestic residents and domestic liabilities held by foreigners. A country’s net international investment position (NIIP) as a creditor or debtor depends on the difference between its assets and liabilities. Both assets and liabilities can take the form of equity, which includes foreign direct investment (FDI) and portfolio equity, or debt in the form of bonds and bank loans. In addition, countries may hold assets in the form of foreign exchange reserves at their central banks.

Assets are denominated in foreign currencies, particularly the dollar, while equity liabilities are denominated in the home currency. Debt liabilities may be denominated in the domestic or a foreign currency. Foreign lenders who are concerned about the government’s macroeconomic policies—a phenomenon known as “original sin”—may insist that bonds be issued in dollars.

After the financial crises that afflicted many emerging markets during the late 1990s and early 2000s, many of these nations altered the composition of their external balance sheets. Countries that had obtained external funds primarily through debt turned to equity for sources of finance. As a result, their equity liabilities grew steadily, both in terms of absolute magnitude and relative to their debt liabilities. Their assets, on the other hand, largely consisted of foreign exchange reserves, held in the form of U.S. Treasury bonds, and other debt holdings. This profile is known as “long debt, short equity,” and differed from the “long equity, short debt” composition of most advanced economies that held equity and issued debt.

The payout on equity is contingent on the profitability of the firms that issue it, while debt payments are contractual. As a result, over time equity carries a higher return than debt—the “equity premium.” Consequently, the “long equity, short debt” profile in normal times is profitable for those countries that are net holders of equity.

But the situation changes during a crisis. The decline in the value of equity liabilities raises the NIIP of the countries that issued them. In addition, a depreciation of the domestic currency increases the value of the foreign assets while lowering those liabilities denominated in the domestic currency. Bonds issued in a foreign currency, however, will rise in value—a phenomenon observed during the Asian crisis of 1997-98. In addition, short-term liabilities may not be rolled over by foreign lenders, while FDI is much more stable.

Phillip Lane of Trinity College (working paper here) has claimed that the composition of the emerging market economies’ external balance sheets served as a buffer against the global financial crisis (GFC) of 2007-09, while the structure of the advanced economies’ external assets and liabilities heightened their vulnerability. In a recent paper I investigated this claim and found that countries with FDI liabilities had higher growth rates, fewer bank crises and were less likely to borrow from the IMF during the GFC. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit. The “long debt, short equity” strategy of emerging markets did mitigate the effects of the global financial crisis, and acted as a countercyclical crisis buffer.

But the balance sheet profiles of the emerging market economies has changed in the wake of the crisis. The corporate debt of nonfinancial firms in many emerging market economies, particularly bonds denominated in dollars, grew rapidly during this period. The IMF in its latest Global Financial Stability Report has drawn attention to this shift, which it reports has been driven by global drivers, such as the decline in U.S. interest rates.

A newly-issue report by the Committee on International Economic Policy, Corporate Debt in Emerging Economies: A Threat to Financial Stability?, views this increase in debt as a threat to financial stability. The report, written by Viral Acharya of New York University, Stephen Cecchetti of Brandeis University, José De Gregorio of the University of Chile, Sebnem Kalemli-Ozcan of the University of Maryland, Philip Lane of Trinity and Ugo Panizza of the Graduate Institute in Geneva, reviews the changes in the balance sheets of the emerging markets. They find that “…there has been a deterioration in the net foreign debt positions of many emerging economies in recent years.” While the amounts of corporate debt are limited, the authors point out, “…even a category that appears relatively small can be a source of systemic financial stability.” Moreover, bonds denominated in a foreign currency have accounted for a large component of the growth in corporate debt, and there has been “…an overall decline in the net foreign currency position of many emerging economies.” As a result, “…this has made emerging economies vulnerable to a shift in international funding conditions and macroeconomic slowdown.”

Moreover, the amount of emerging market debt may be underestimated. Carmen Reinhart of Harvard’s Kennedy School points out that debt may go undetected until the outbreak of a crisis. She points to the Mexican crisis of 1995-95, the Asian debt crisis of 1997-98 and the current Greek crisis as examples of the detection of “hidden debt” that became visible as the crisis emerged. She fears that lending by Chinese development banks for infrastructure projects in other emerging and developing economies may not be included in the data for their external debt, and could add to their vulnerability.

The authors of the report on corporate debt in emerging economies point out that policymakers have a variety of policy tools to deal with the risks of external borrowing. These include capital and liquidity regulations, directly lending to small and medium-sized enterprises when banks are constrained by exposure limits, and central clearing of derivative contracts. But all this will come after the deterioration to the external balance sheets has taken place. Governments should monitor the external borrowing of domestic firms and public agencies during “boom” periods to track their vulnerability to shocks to global liquidity. Meanwhile, the IMF is preparing for the next crisis.

Capital Flows, Credit Booms and Bank Crises

Studies of the impact of capital inflows have established that debt inflows can lead to bank crises (see here and here). Unlike equity, payments on debt are contractual and can not be cancelled if there is an economic downturn, which intensifies any shocks to the financial system. In the case of short-term debt, a foreign lender may decide not to roll over credit at the time when it is most needed. But recent papers have shown that foreign debt can also be a determinant of the credit booms that lead to the bank crises.

Philip Lane of Trinity College and Peter McQuade of the European Central Bank (working paper version here) looked at the relationship of domestic credit growth and capital flows in Europe during the period of 1993-2008. They suggest that financial flows can encourage more rapid credit growth by increasing the ability of domestic banks to extend loans, while also contributing to a rise in asset prices that encouraged financial activity. They found that debt flows contributed to domestic credit growth but equity flows did not. Moreover, the linkage of debt and domestic credit was strongest during the 2003-08 pre-crisis period.

Similarly, Julián Caballero of the Inter-American Development Bank (working paper here) investigated capital inflow booms, known as “bonanzas,” in emerging economies between 1973 and 2008. He reported that capital inflow bonanzas increased the incidence of bank crises. When he distinguished among foreign direct investment, portfolio equity and debt bonanzas, the results indicated that only the portfolio equity and debt bonanzas were associated with an increased likelihood of crises. More analysis revealed that the impact of increased debt was due in part to a lending boom. Caballero suggested that the capital inflows could also have increased asset prices, generating an asset bubble and an eventual collapse.

Deniz Iagan and Zhibo Tan of the IMF used both macroeconomic and micro-level firm data to examine the relationship of capital inflows and credit growth. They first examined the impact of capital inflows on aggregate credit to households and non-financial corporations in advanced and emerging market economies during the period of 1980-2011. They distinguished among FDI, portfolio and other inflows. They reported that portfolio and other inflows contributed to rises in household credit, and only the other inflows were significant for corporate credit.

Iagan and Tan also had data on firms in these countries, and sought to identify the determinants of leverage in these firms. They calculated an index, based on work done by Raghuram Rajan and Luigi Zingales (RZ), of a firm’s dependence on external financing. When they interacted the RZ indicator with the different types of capital inflows, the interactive term was always significant in the case of the other inflows, significant with portfolio flows in some specifications, and never significant in the case of FDI flows. The authors concluded that the results of the macro and firm level analyses were consistent: the composition of capital matters. In additional analysis, they found evidence consistent with the hypothesis that the capital inflows led to higher asset prices.

What can be done to insulate an economy from lending booms that may lead to bank crises? Nicolas E. Magud and Esteban R. Versperoni of the IMF and Carmen R. Reinhart of Harvard’s Kennedy School of Government (working paper here) examined whether the nature of the exchange rate regime was relevant. They found that less flexible exchange rate regimes are associated with increases in bank credit and a higher share of foreign currency in bank credit. On the other hand, the exchange rate regime had no impact of the size of the capital inflows. The authors of the Bank for International Settlements 85th Annual Report 2014/15, however, wrote that the insulation property of flexible exchange rates is “overstated.” An exchange rate appreciation can raise the value of firms with debt denominated in foreign currency, which increases the availability of credit.

How can regulators lower the danger of more bank crises due to debt inflows? Magud, Reinhart and Vesperoni suggest the use of macroprudential measures that affect the incentives to borrow in a foreign currency, such as currency-dependent liquidity requirements. But Caballero warns that capital controls on debt inflows may be insufficient if portfolio equity flows also contribute to lending booms that result in banking crises.

These research papers find that domestic asset prices respond to international financial flows. This makes it harder to insulate the domestic financial markets from foreign markets, and leaves these markets vulnerable to spillovers from changes in foreign conditions. The emerging markets already face downturns in their markets, and the combination of increased global volatility with a rise in the costs of servicing the dollar-denominated debt of corporations in emerging markets if the Federal Reserve raises interest rates will only add to their burdens.

On the Road…to Halle, Germany

Next week I will be attending the 5th IWH/INFER Workshop on Applied Economics and Economic Policy: Trade and Capital Liberalization-Boost for Growth or Bane of Spillover? The workshop takes place in Halle, which is near Leipzig, Germany.

You can see the program and more information about the conference here:



Global Volatility, Domestic Markets

Unlike the global financial crisis of 2008-09, the current disruption in the financial markets of emerging market nations was anticipated. The “taper tantrum” of 2013 revealed the precarious position of many of these nations, particularly those dependent on commodity exports. The combination of a slowdown in Chinese growth, collapsing stock prices and a change in the Chinese central bank’s exchange rate policy indicated that the world’s second-largest economy has its own set of problems. But global volatility itself can roil financial markets, and good fundamentals may be of little help for a government trying to shelter its economy from the instability in world markets.

The importance of global (or “push”) factors for capital flows to emerging markets was studied by Eugenio Cerutti, Stijn Claessens and Damien Puy of the IMF. They looked at capital flows to 34 emerging markets during the period of 2001-2013, and found that global factors such as the VIX, a measure of anticipated volatility in the U.S. stock market, accounted for much of the variation in flows. Not all forms of capital were equally affected: bank-related and portfolio flows (bonds and equity) were strongly influenced by the global factors, but foreign direct investment was not.

Cerutti, Claessens and Puy also investigated whether the emerging markets could insulate themselves from the global environment with good domestic macro fundamentals. They reported that the sensitivity of emerging markets to the external factors depended in large part upon the identity of a country’s investors. The presence of global investors, such as international mutual funds in the case of portfolio flows and global banks in the case of bank finance, drove up the response to the global environment. The authors concluded: “…there is no robust evidence that “good” macroeconomic (e.g., public debt, growth) or institutional fundamentals (e.g., Investment Climate and Rule of Law) have a role in explaining EM different sensitivities to global push factors.”

A similar finding was reported in a study of corporate bond markets in emerging markets, which have grown considerably since the 2007-09 crisis. Diana Ayala, Milan Nedeljkovic and Christian Saborowski, also of the IMF, studied the share of bond finance in total corporate debt in 47 emerging market economies over the period of 2000-13. Domestic factors contributed to the development of bond markets. But the growth in these markets in the post-crisis period was driven by global factors, such as the spread in U.S. high yield bonds, a proxy for global risk aversion, and U.S. broker-dealer leverage. The authors conjecture that the growth in bond finance in the emerging markets was due to a search for higher yields than those available in advanced economies during this period. If this interpretation is correct, then these countries will see capital outflows once interest rates in the U.S. and elsewhere rise.

A third paper from the IMF, written by Christian Ebeke and Annette Kyobe, looked at the markets for emerging market sovereign bonds. Their results are based on data from 17 emerging markets over the 2004-13 period. They found that foreign participation in the market for domestic-currency denominated sovereign bonds increased the impact of U.S. interest rates on the yield of these bonds once a threshold of 30 percent had been reached. Similarly, an increase in the concentration of the investor base made the bond yields more sensitive to global financial shocks.

Are domestic “pull” factors always irrelevant for capital flows? Ahmed Shaghil, Brahima Coulibaly and Andrei Zlate of the Federal Reserve Board constructed a “vulnerability index” of macroeconomic fundamentals for a sample of 20 emerging market economies during 13 periods of financial stress, beginning with the Mexican crisis of 1994 and ending with the 2013 taper tantrum. They looked at the impact of their index upon a measure of depreciation pressure, based on changes in exchange rates and losses in foreign exchange reserves. They found that there was evidence of a linkage between the macro fundamentals and depreciation pressure during the global financial crisis and then again during the European sovereign debt crisis and the taper tantrum, but not before.

Why would the response of emerging market economies to domestic fundamentals become stronger during the most recent crises? Shaghil, Coulibaly and Zlate offer two reasons: first, it may be that foreign investors investors did not distinguish among the emerging market economies until the 2000s. But as the governments of these countries implemented different policy frameworks and the costs of gathering information about them fell due to technology, it became worthwhile to distinguish amongst them based on their individual characteristics. An alternative reason for the change over time could lie in a shift in the origin of the crises away from the emerging markets themselves. Therefore, investors have become more careful in examining the vulnerabilities of individual countries.

The analysis of the relative importance of domestic “pull” vs. global “push” factors should not be posed as a “one or the other” contest (see here). There is ample evidence to indicate that global factors have become increasingly important in driving capital flows across borders. If so, then the news that the VIX hit record levels last week is disturbing. Stock markets in the U.S. and other advanced economies have rebounded, but the emerging market nations face a period of sustained retrenchment as investors reallocate their funds in response to the surge in global volatility.

Greece’s Missing Drivers of Growth

Analyses and discussions of Greece’s economic situation usually begin—and often end—with its fiscal policy. The policies mandated by the “troika” of the European Commission, the European Central Bank and the International Monetary Fund have undoubtedly resulted in a severe contraction that will continue for at least this year. But little has been said about the private sectors of the economy, and why they have not offset at least part of the fiscal “austerity.” Consumption spending is linked to income, so there is no relief there. But what about the other sources of spending, investment and net exports?

Investment expenditures provide no counterweight, as they have plunged in the years since the global financial crisis. The same phenomenon took place in other countries in the southern periphery of the European Union, but the change in Greece’s investment/GDP ratio between its pre-crisis 2007 level and that of 2014 was an extraordinary decline of 16 percentage points at a time when GDP itself was falling:

Investment/GDP 2007 2014
Cyprus 24% 12%
Greece 27% 11%
Ireland 28% 17%
Italy 22% 17%
Portugal 23% 15%
Spain 31% 19%

Source: IMF, World Economic Outlook

In view of the scale of the crisis, it is not surprising that investment fell as much as it did in these countries. The parlous state of the banks only reinforced the decline. The particularly severe decrease in Greece reflects the political uncertainty there as well as the calamitous economic conditions.

Net exports of goods and services have continued to record a deficit in Greece while the other periphery countries by 2013 showed small (or in the case of Ireland large) surpluses:

Balance on goodsand services/GDP 2007 2013
Cyprus -5% 2%
Greece -12% -3%
Ireland 9% 21%
Italy 0% 2%
Portugal -8% 1%
Spain -6% 3%

Source: World Bank, World Development Indicators

Although Greece’s balance continued to show a deficit, the turnaround between 2007 and 2013 of 9 percentage points of GDP was only exceeded by the increase in Ireland’s trade balance by 12 percentage points. But this change was due largely to the decline in imports that accompanied the contraction of the economy rather than a growth in exports, as happened in Ireland and Portugal. The lack of Greek export growth has been surprising in view of the decline in unit labor costs. These had soared in the period leading up to the crisis, as had those in the other periphery countries. Since these countries could not devalue their exchange rates, labor costs had to come down to make their exports competitive. But despite the declines in wages, there has been no corresponding expansion in Greek exports.

Explaining the lack of responsiveness of Greek exports to the decline in wages has been the subject of several analyses. A study on macroeconomic adjustment programs in the Eurozone undertaken for the Economic and Monetary Affairs Committee of the European Parliament by a team of authors that included Daniel Gros, Cinzia Alcidi and Alessandro Giovannini of the Centre for European Policy Studies, Ansgar Belke of the University of Duisberg-Essen, and Leonor Coutinho of the Europrism Research Centre claimed: “Greek exports price competitiveness has not improved nearly as much as its cost (and wage) competitiveness…” The report’s authors attribute the rigidity in prices to “structural deficiencies.”

A similar analysis was offered by Uwe Böwer, Vasiliki Michou and Christph Ungerer of the European Commission’s Directorate-General for Economic and Financial Affairs (see also here). They use a gravity model to predict export flows in 56 countries, and compare the predictions of the model with actual exports. Greek exports were 32.6% lower than those predicted by the model, which they label the “puzzle of the missing Greek trade.” They then add measures of institutional quality to their model, and find that these are quite significant. Since Greece’s institutional quality is seen as relatively poor, the authors claim this deficiency contributes to the lack of exports.

In view of all the institutional measures that have already been introduced into the Greek economy, it may seem surprising that more structural reform is seen as necessary. Alessio Terzi of Bruegel has argued that the initial reforms in Greece were slanted towards reform of the public sector rather than the private sector. Some of this shortfall was rectified in the 2012 program, but implementation was slowed by the political climate and economic collapse. A lack of coordination with changes in labor market practices has resulted in a decline in wages that has not been matched by corresponding adjustments in prices. Terzo claims that responsibility for these flaws in program design is a responsibility of the troika as well as of the Greek government.

Designing the optimal composition and pace of structural reforms is always difficult. Antionio Fatás of INSEAD writes about the record of reform in Europe since the 1970s (see also here). He shows that there has been a convergence of policies and institutions over time. He takes particular note of Greece and Portugal’s progress vis-à-vis the record of other OECD countries in business-related reforms, although he also notes that small differences are associated with noticeable differences in productivity and output. Christian Thimann of the Paris School of Economics and AXA Group believes that there is substantial scope for further change.

Can reforms be implemented when fiscal policy is contractionary? Tamim Bayoumi of the IMF admits that the short-run impact of regulatory changes is likely to be disruptive, which only reinforces the impact of the fiscal policy. Under these circumstances, the IMF can play a critical role in providing external financing while reforms are being implemented. But, he writes, “…structural policies need a strong leader and broad agreement across a wide swath of opinion makers about the need to re invigorate the economy.”

Such an agreement is difficult to achieve in the wake of a crisis. Atif Mian of Princeton, Amir Sufi of the Booth School of Business at the University of Chicago and Francesco Trebbi of the Vancouver School of Economics have shown that countries become more polarized after a financial crisis as voters become more ideologically extreme and ruling coalitions become weaker. This makes consensus much harder to achieve.

The latest bailout provides an opportunity to change the structure of Greece’s private sector. Consumer markets are to be liberalized, labor practices to be reviewed and an upgrade of its infrastructure to be taken. Can Prime Minister Alexis Tsipras maintain the popular support needed to implement the reforms? And can these lead to a turnaround in the Greek economy? The private sector must become viable if the country’s continuing economic degradation is to end. It would be ironic if such a turnaround occurred during the administration of a political leader who campaigned on a platform of defying the troika and its programs, including structural reform measures. But “a foolish consistency is the hobglobin of little minds, adored by little statesmen and philosophers and divines…”


The Challenges of the Greek Crisis

The Greek crisis has abated, but not ended. Representatives of the “troika” of the European Commission, the European Central Bank and the International Monetary Fund returned to Athens for talks with the Greek government about a new bailout. This pause allows an accounting of the many challenges that the events in Greece pose to the international community.

The main challenge, of course, is to the Greek government itself, which must implement the fiscal and other measures contained in the agreement with the European governments. These include steps to liberalize labor markets as well as open up protected sectors of the economy. While these structural reforms should promote growth over time, in the short-run they will lead to layoffs and reorganizations. At the same time, Prime Minister Alex Tsipras must oversee tax rises and cuts in spending. The combined impact of all these measures, which follow the virtual shutdown of the financial sector during the protracted negotiations with the European governments, will postpone any resumption in growth that past efforts may have generated.

It is not clear how long the Greek public will endure further misery. Any form of debt restructuring may give policymakers some justification to continue with the agreement. New elections will clarify the degree of political support for the pact. But the possibility of an exit from the Eurozone has not been removed, either in the eyes of Greek politicians or those of officials of other governments.

The Greek crisis, however, is not the only hazard that the Eurozone faces. The Eurozone’s governments have yet to come to terms with the effects of the global financial crisis on its members’ finances. A split prevails between those countries that ally themselves with the German position that debt must be repaid and those that seek with France to find some sort of middle ground. Other European countries with debt/GDP ratios of over 100% include Belgium, Portugal, and Italy. Weak economic growth could push any of them into a situation where the costs of refinancing become daunting. How would the Eurozone governments respond? Would they bail out another member? If so, would the terms differ from those imposed on Greece? Would European banks be able to pass the distressed debt on to their own governments?

In the long-term, the governments of the Eurozone face the dilemma of how to reconcile centralized rule-making with national sovereignty. The ECB, for example, has been granted supervisory oversight of the banks in the Eurozone. It will exercise direct oversight of over 100 banks deemed to be “significant,” while sharing responsibility with national supervisors for the remaining approximately 3,500 banks. The ECB has a Supervisory Board, supported by a Steering Committee, to plan and executes its supervisory tasks, which supposedly allows it to separate its bank supervisory function from its role in setting monetary policy. All these agencies and committees must work out their respective jurisdictions and responsibilities. Meanwhile, the European Commission, which oversees fiscal policies, faces requests for exemptions from its budget guidelines by governments with faltering growth. But if it shows flexibility in enforcing its own rules, it will be derided as weak and ineffective.

The IMF has its own set of challenges. The IMF was sharply criticized for its response to the wave of crises that struck emerging markets in the last 1990s and early 2000s, beginning with Mexico in 1994 and extending to Turkey and Argentina in 2001. Critics charged that the IMF was slow to respond to the rapid “sudden stops” of capital outflows that set off and exacerbated the crises. When the Fund did act, it attached too many conditions to its programs; moreover, these conditions were harsh and inappropriate for crises based on capital outflows.

The global financial crisis gave the IMF a second chance to demonstrate its crisis-management abilities (for a full account, see here). The Managing Director at the time, Dominique Strauss-Kahn, seized the opportunity to redeem the IMF ‘s reputation, as well as reestablish his own political career in France. The IMF lent quickly to its members, attached relatively few conditions to the loans, and allowed the use of fiscal measures to stabilize domestic economies. The result was less severe adjustment, the avoidance of excessive exchange rate movements and a resumption of economic growth. By the time the global economy recovered, the IMF had proven that it could respond in a flexible manner to a financial emergency.

The IMF’s response in 2010 to the Greek debt crisis was very different. The IMF’s loan to Greece was the first to a Eurozone member; moreover, the loan was much larger than any the IMF had extended before, whether measured by the total amount of credit or as a percentage of the borrowing country’s quota at the Fund. To make the loan, the IMF had to overlook one of it own guidelines for granting “exceptional access” by a member to Fund credit. Such loans were to be made only if the borrowing government’s debt would be sustainable in the medium-term. Greece’s debt burden did not pass this criterion, so the Fund justified its actions on the grounds that there was a risk of “international systemic spillovers.”

The IMF’s involvement in the Greek program was also unusual in another sense: the IMF’s contribution, as large as it was, was still smaller than that of the European governments. The IMF was, in effect, a “junior partner.” While it had worked with other governments before (such as the U.S. when it lent to Mexico in 1994-95), this was the first time that the IMF was not in a lead position. This may have initially made it reluctant to disagree with the other members of the troika.

The subsequent contraction in the Greek economy far exceeded the IMF’s forecasts. The IMF later admitted that it underestimated the size of the multipliers for the fiscal policies contained in the program in a paper co-authored by the head of the IMF’s Research Department, Olivier Blanchard (see also here). The failure to properly estimate the impact of these conditions calls into doubt the basic premises of the 2010 and 2012 programs.

More recently, the IMF has challenged its European partners over their projections for the Greek debt, as well as the budget and fiscal targets contained in the latest agreement. The Fund claims that the debt projections are much too optimistic. Greece’s debt will only be sustainable if there is debt relief on a much larger scale than the European governments have been willing to undertake. Moreover, the IMF states that it will not be part of any new programs for Greece if debt relief is not a component.

The public admission of error and the rebukes of the European governments will only partially restore the IMF’s reputation. The generous treatment of Greece as well as Ireland and Portugal reinforces the belief that the European countries and the U.S. control the IMF. The members of the European Union have a total quota share of almost one-third, much larger than their share of world GDP. This voting share combined with the U.S. quota gives these countries almost half of all the voting shares at the IMF. The need for a realignment of the quotas to give the emerging market nations a larger share has long been acknowledged, but approval of the reform measures is mired in the U.S. Congress.

Another aspect of European and U.S. control of the “Bretton Woods twins”—the IMF and the World Bank—has been their selection of the heads of these organizations. All the Managing Directors of the IMF have been Europeans, and until the appointment of Ms. Lagarde, European males. All the heads of the World Bank have been U.S. citizens. Ms. Lagarde’s term expires next July, and the pressure to name a non-European will be tremendous. How the Europeans and U.S. respond to this challenge will go a long way in determining whether these institutions will be shunted aside by the emerging market nations in favor of institutions that they can control.

The last challenge of the Greek crisis comes for the Federal Reserve. Federal Reserve Chair Janet Yellen has been explaining that a rise in the Fed’s policy rate, the Federal Funds rate, is likely to occur later this year. This forecast, however, is contingent on continued economic growth and favorable labor market conditions. These plans could be threatened by any financial volatility that followed a disruption in the latest Greece bailout.

The Federal Reserve is also aware that a rise in interest rates would affect the dollar/euro exchange rate. The euro, which has been depreciating, could fall lower when the Fed raises rates while the ECB keeps its refinancing rate at 0.05%. A further appreciation of the dollar would threaten U.S. exports, thus endangering a recovery.

The Fed also faces concerns about the broader impact of its policy initiatives on the world economy. The IMF is worried about how a rate rise would affect the global economy, and has urged the Fed to hold off on interest rate increases until 20016. Companies that borrowed in dollars through bonds and bank loans will be adversely affected by the combined effects of an interest rate rise and a dollar appreciation.

Greece’s GDP accounts for only 0.4% of world GDP and about 1.3% of the European Union’s total output. But the global financial crisis demonstrated how financial linkages across sectors and countries can disrupt economic activity no matter what their source. The response to these incidents by national and international authorities can risk global stability if they are based on self-interest and organizational agendas. Commitments to cooperation disappear quickly when national concerns are threatened.

(A Powerpoint version of this post is available here.)