The Shifting Consensus on Capital Controls: Gallagher’s “Ruling Capital”

Among the many consequences of the global financial crisis of 2007-09 was a shift in the IMF’s stance on capital controls. The IMF, which once urged developing economies to emulate the advanced economies in deregulating the capital account, now acknowledges the need to include controls in the tool kit of policymakers. Kevin Gallagher of Boston University explains how this transformation was achieved in his new book, Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance.

By the 1990s the Fund had long abandoned the Bretton Woods solution to the trilemma: fixed exchange rates and the use of capital controls to allow monetary autonomy. Instead, the IMF encouraged developing economies to open their borders to capital flows that would increase investment and achieve a more efficient allocation of savings (see Chapter 5 here). IMF officials proposed an amendment to its Articles of Agreement that would establish capital account liberalization as a goal for its members, but the amendment was shelved after the Asian financial crisis of 1997-98. The IMF subsequently continued to recommend capital account liberalization as a suitable long-term goal, but acknowledged the need to implement deregulation sequentially, beginning with long-term foreign direct investment before opening up to portfolio flows and bank loans.

The IMF’s position evolved further, however, as the full scale of the global crisis became apparent. First, the IMF allowed Iceland to use controls as part of its financial stabilization program. Then, in the aftermath of the crisis, Fund economists reported in a Staff Position Note that there was  “…a negative association between capital controls that were in place prior to the global financial crisis and the output declines suffered during the crisis…” The next stage came in 2012 when the IMF announced a new view–named the institutional view–of capital flows.  This doctrine acknowledged that capital flows can be volatile and pose a threat to financial stability.  Under these circumstances, controls, now named “capital flow management measures” (CFMs), can be used with other macroeconomic policies to minimize the effects of the capital volatility. Moreover, the responses to disruptive flows should include actions by the countries where the capital flows originate as well as the recipients.

Gallagher explains that these changes were due to both intellectual and political currents. IMF economists had been among those researchers who found little empirical evidence supporting the proposition that capital flows contributed to increased growth rates. This was not a surprise to those influenced by the work of economists such as Ragnar Nurske or Hyman Minsky, who were outside the mainstream. But new theoretical advances by Anton Korinek and Fund economists, including Olivier Jeanne and Jonathan Ostry, showed that the costs of volatile capital flows could be analyzed using the accepted tools of welfare economics. The adverse impact on financial stability of capital outflows can be considered as an externality that private agents ignore in their decision-making. Prudential controls seek to correct these market distortions.

Gallagher points out that at the same time as this new theoretical work was being disseminated, representatives of the emerging markets were lobbying the IMF to allow their governments the freedom to implement measures that they found necessary to offset destabilizing capital flows. The BRICS (Brazil, Russia, India, China, South Africa) coalition, which had worked together to promote reform of the IMF’s governance procedures, joined their efforts to resist any position on capital flows that could restrict their flexibility to limit them. They used the new theoretical perspectives to buttress their arguments in favor of the use of controls, and made similar arguments in other forums such as the meetings of the Group of 20. The BRICS representatives also urged the IMF to pay equal attention to the policies of the upper-income nations where capital flows originated.

The IMF’s Independent Evaluation Office has issued a report updating its 2005 evaluation of the Fund’s approach to capital account liberalization. The IEO describes the discussions leading up to the adoption of the institutional view as “contentious,” and the final document as reflecting a “fragile consensus” among the Executive Directors regarding the merits of full capital account liberalization and the proper use of CFMs. The IEO also reports that the new view seems to have influenced the IMF’s policy advice on capital account liberalization as well as its bilateral surveillance. However, the report cautioned that it is too early to tell whether the adoption of the institutional view will lead to greater consistency in the IMF’s advice on the use of CFMs.

Gallagher shows, moreover, that the battle over the use of capital controls has not ended, but shifted to new arenas. Free-trade agreements (FTAs) and bilateral investment treaties (BITs) signed with the U.S., for example, generally allow governments much less freedom to regulate financial flows. Similarly, the IEO report finds that there is “…a patchwork of bilateral, regional and international agreements regulating cross-border capital flows…” Moreover, the IMF’s attempts to promote international cooperation to reduce volatility due to capital flows have been unsuccessful.

There will be more developments in the story of the (re)regulation of capital. There are still disagreements on the side-effects of capital controls, and a rise in interest rates in the U.S. will test the effectiveness of controls on outflows. Until then, Gallagher’s book serves as a valuable account and analysis of the most recent changes.

The U.S.: Inept Diplomacy, Indispensable Currency

The announcements by several European governments that they would join the new Asian Infrastructure Investment Bank (AIIB) have been widely seen as indicators of the declining position of the U.S.  The AIIB had been proposed by China for the purpose of funding much-needed infrastructure projects in Asian countries. The U.S. had discouraged other governments from joining, ostensibly on the grounds that the new institution would overlap with the World Bank and the Asian Development Bank. But the real reason seemed to be a concern that the Chinese would have a regional forum to wield power.

The New York Times held both the Congress and President Obama responsible for mishandling the issue. The U.S. claimed it sought to ensure better governance in the new institution, but gave no signal of being willing to work with the Chinese and others to make the AIIB an effective agency. The continuing refusal of Congress to approve reforms in the IMF’s governance structure gives the Chinese and other emerging markets ample cause to look elsewhere. The Economist put it starkly: “China has won, gaining the support of American allies not just in Asia but in Europe, and leaving America looking churlish and ineffectual.”

And yet: the same issue of The Economist stated that “In the world of economics, one policy maker towers above all others…,”, and named Federal Reserve Chair Janet Yellen as holder of that position due to the sheer size of the U.S. economy. The influence of the U.S. in financial flows extends far outside national borders. A study by Robert N.McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated that the amount of dollar-denominated credit received by non-financial borrowers outside the U.S. totaled $9 trillion by mid-2014. Over two-thirds of the credit originated outside the U.S., with about $3.7 trillion coming from banks and $2.7 from bond investors. The report’s authors found that dollar credit extended to non-U.S. borrowers grew much more rapidly than did credit within the U.S. during the post-global financial crisis period.

Almost half of this amount went to borrowers in emerging markets, particularly China ($1.1 trillion), Brazil ($300 billion), and India ($125 billion). In the case of Brazil, most of the funds were raised through the issuance of bonds, while bank lending accounted for the largest proportion of credit received by borrowers in China. Much of this credit was routed through the subsidiaries of firms outside their home countries, and balance of payments data would not capture these flows.

The study’s authors attributed the rise in borrowing in emerging markets to their higher interest rates. Consequently, any rise in U.S. interest rates will have global repercussions. The growth in dollar-denominated credit outside the U.S. should slow. But there may be other, less constructive consequences. Borrowers will face higher funding costs, and loans or bonds that looked safe at one interest rate may be less so at another. This situation is worsened by an appreciating dollar if the earnings of the borrowers are not also denominated in dollars. The rise in the value of the dollar has already prompted reassessments of financial fragility outside the U.S.

All this puts U.S. monetary policymakers in a delicate position. Ms. Yellen has made it clear that the Fed is in no hurry to raise interest rates. The Federal Reserve wants to see what happens to prices and wages as well as unemployment before it moves. The appreciation of the dollar pushes that date further into the future by keeping inflation rates depressed while cutting into the profitability of U.S. firms. While the impact of higher rates on credit markets outside the U.S. most likely has a relatively low place on the Fed’s list of concerns, Fed policymakers certainly are aware of the potential for collateral damage.

All this demonstrates the discrepancy between the diplomatic and financial power of the U.S. On the one hand, the U.S. must deal with countries that are eager to claim their places in global governance. The dominance of the U.S. and other G7 nations in international institutions is a relic of a world that came to an end with the global financial crisis. On the other hand, the dollar is still the predominant international currency, and will hold that place for many years to come. The use of the renminbi is slowly growing but it will be a long time before it can serve as an alternative to the dollar. Consequently, the actions of the Federal Reserve may have more international repercussions than those of U.S. policymakers unable to cope with the shifting landscape of financial diplomacy.

 

Global Stability, National Responsibilities

The global financial crisis demonstrated clearly how the flow of money across borders could deepen and widen a financial crisis. A decline in U.S. housing prices led to a re-examination of the safety of financial securities based on them and an implosion in credit markets as financial institutions sought to re-establish their soundness by shedding the securities that were now seen as toxic. These institutions included European banks that had purchased mortgage-backed securities and other collateralized debt obligations. Eventually the emerging markets were brought into the vortex by capital outflows that disrupted their own financial markets. But are we ready to change the rules governing global finance if they impinge on national sovereignty?

Andrew Haldane, chief economist of the Bank of England, spoke last October about the need to manage global finance as a system. He identified four areas that require strengthening: global surveillance, improvements to national debt structures, the establishment of macro-prudential and capital flow management policies, and improved international liquidity assistance. Advances have been made in all these areas since the crisis.

The IMF, for example, has expanded the scope of its surveillance activities to focus more on the spillovers of national policies on other countries and regions. The latest Pilot External Sector Report, for example, examines global imbalances and finds that

“…disorderly external adjustment in some deficit economies remains a risk, particularly in an environment of tightening external financial conditions, and if the policy/institutional environment were to deteriorate or other idiosyncratic shocks materialize. Moreover, country-level risks would have spillovers and carry the potential of becoming systemic, e.g., if a group of EMs (Emerging Markets) with excess deficits were simultaneously affected by negative shocks.”

But is calling attention to possible adverse shocks sufficient? Biagio Bossone and Roberta Marra (see also here) of The Group of Lecce have called for a new commitment by the members of the IMF to be “Global Good Citizens.” This would entail amending the IMF’s Articles of Governance to include ‘global systemic stability’ as a mission of the Fund and its members. This new goal would be defined to include sustainable equilibria in the members’ balance of payments, high levels of domestic employment and income and reasonable price stability, and management of the cross-border transmission of shocks. To achieve these goals, all members would be responsible for implementing external adjustment programs as well as ensuring domestic employment and low inflation, and cooperating with other members to minimize the international transmission of shocks. Moreover, the IMF would be granted the authority to assess whether the policies of its members were consistent with global stability. The Fund could use multilateral consultations to address systemic issues and to call on policymakers to take the cross-national effects of their actions into account.

How good is the IMF’s record on calling out members who have violated existing obligations? Not so good. There were consultations with Sweden and Korea in the 1980s regarding their exchange rates, and discussions in 2006 with China, the U.S., Japan, Saudi Arabia and the Eurozone regarding global imbalances. But the latter were unsuccessful in changing the national policies that led to the imbalances.  Large nations traditionally place little weight on the welfare of other countries when formulating policies, and, if pressed, will claim that their actions benefit the global economy.

But it would be short-sighted to dismiss Bossone and Marra’s innovative proposal to expand the responsibilities of national policymakers to include spillovers. Ignoring cross-border effects is at best myopic and possibly self-defeating. Charles Engel of the University of Wisconsin in a survey of research on spillovers concludes that:

“An optimal policy aimed at inflation and employment will increasingly need to take into account the impact of events in other countries, including the effects of foreign monetary policy. It may ultimately be the case that greater stability and growth at home depends on international coordination.”

Financial markets will continue to grow in the emerging markets as well as frontier markets, and financial flows across national borders will continue to rise. These flows may bring benefits but they also increase financial and economic linkages. Soon the question may be not whether to coordinate, but how and when.

To fix or not to fix: Jeffry Frieden’s “Currency Politics”

The decision by the Swiss National Bank to abandon its peg to the euro serves as an example of the relatively limited life spans of fixed exchange rate regimes. While the fragility of exchange rate commitments has been known since the publication of a 1995 paper by Obstfeld and Rogoff, the question of why some central banks fix the value of their currencies and others do not is less well understood. Jeffry Frieden’s Currency Politics provides a thoughtful guide to the political economy of exchange rate policy.

Frieden, the Stanfield Professor of International Peace at Harvard’s Department of Government, analyzes the decisions on the choice of exchange rate regime and also the level of the exchange rate. There is rarely a consensus within a country on these issues, and the position of the domestic parties depends on how they are affected by fluctuations in the exchange rate. The principal supporters of a fixed rate will be those who are exposed to substantial foreign exchange rate risk in their global activities, such as financial institutions and multinational corporations. Those who have borrowed in a foreign currency will also have a stake in keeping the domestic value of their debt fixed. Producers of tradable goods tied largely to world prices, such as commodities and standardized manufactured goods, will favor a depreciated exchange rate, as will those who use nontradable goods as inputs. While decisions over the choice of regime and the level of a currency’s value are conceptually separate, Frieden writes that the politics usually lead to a split between those who favor a fixed rate versus those who seek a depreciation.

Frieden tests these hypotheses with data from a range of historical experiences: the U.S. from the Civil War through the end of the 20th century, Europe during the period from the end of the Bretton Woods regime to the introduction of the euro, and Latin America from 1970 to 2010. He uses both qualitative and quantitative analysis in these sections of the book, and his use of data from the earlier periods is particularly skillful. The results show that a consideration of exchange rate-related issues sheds light on the divisions that exist over policies, and can lead to revised views of accepted versions of history.

In the case of the U.S., for example, Frieden breaks the post-Civil War era into the 1862-79 period, when the U.S. returned to the gold standard, and the period of 1880-96, when the gold standard came under attack from the Populist movement. In the first era, those business and financial interests who were most exposed to currency volatility sought to resume the linkage to gold that had been broken in order to finance the Civil War. They were opposed by tradable good producers, including many (but not all) manufacturers, farmers and miners. After 1873, the political divisions centered on whether the U.S. would go on a bimetallic standard of gold and silver, or base the dollar solely on gold. Frieden uses Congressional voting patterns to test whether economic divisions were reflected in Congressional voting on measures related to currency policy. The results generally confirm the influence of the interests he suggests were governing factors. For example, Congressional districts from New England and Pennsylvania, which included manufacturers who competed with foreign producers, were more likely to oppose measures that would return the U.S. to the gold standard. Similarly, representatives of farm products that were exported also opposed a return to gold, while other farming districts tended to support it.

The return of the U.S. to the gold standard in 1879 did not end the dispute. Falling agricultural prices prompted farmers to agitate for a bimetallic regime that would lead to a devaluation of the dollar. Miners concentrated in the Rocky Mountains also supported the use of silver. Manufacturers, on the other hand, abandoned the anti-gold movement as they were protected by high tariffs.  Frieden’s empirical analysis of votes on monetary measures between 1892-95 shows that debt, which has often been viewed as the source of farmers’ concerns, did not sway representatives to vote against gold; indeed, the districts with the largest debt levels were pro-gold. But representatives of export-oriented farm districts were more likely to vote against the gold standard. The People’s Party (the “Populists”) united the farmers, miners and other groups in supporting a bimetallic standard, and in 1896 joined the Democratic Party in supporting William Jennings Bryant for President. Bryant’s loss, followed by a second loss in 1900, signaled the end of organized opposition to the gold standard.

Frieden undertakes similar analyses of depreciation and variation in European exchange rates between 1973-94 and reports evidence supporting the argument that producers exposed to currency risk favored stability, while tradable producers preferred flexibility. Similarly, an analysis of the determinants of Latin American choices of exchange rate regime between 1960 and 2010 finds that the more open economies favor fixed exchange rates. However, manufacturers in the more open economies preferred flexibility.

Frieden convincingly demonstrates, therefore, that exchange rate policy is governed by distributional concerns. Different interests take opposing sides over whether a fixed or flexible regime will be chosen, and whether it will be used as a policy tool to favor domestic producers. The relative influence of the competing interest groups can change over time.  An increase in trade or financial openness, for example, can lead to a new alignment of parties.

Can these considerations be applied to the Swiss case? The dropping of the currency peg discomforted both those who favored a fixed rate and those who will be adversely affected by the subsequent appreciation. But the Swiss central bank must be concerned about the impact of the European Central Bank’s policy of quantitative easing, which would require further intervention and the accumulation of more foreign exchange. The Swiss move may be more of a tactical maneuver during a volatile period than a strategic change in policy. However, those Swiss firms who will see their profits from foreign sales plummet will not be quiescent about the new regime.

Inequalities, National and Global

The publication of Thomas Piketty’s Capital in the Twenty-First Century brought attention to an issue that has been slowly seeping into public discourse. President Obama’s State of the Union address made it clear that we will not need to wait until the 2016 Presidential campaign to hear proposals to rectify the rise in inequality. But the data and trends of global inequality reveal a more complex situation than the national states of affairs that Piketty highlights.

Inequality is often measured by the Gini coefficient. This number is based on the Lorenz curve, which shows the proportion of the total income of a population that is cumulatively earned by different segments of the population, beginning at the bottom. The Gini coefficient (or index) is the ratio of the area under an actual Lorenz curve distribution of a society and the area of the distribution of perfect inequality. It is a number between zero and one (or 100), where zero corresponds to a case of perfect equality, and one is a situation of total inequality. A Gini coefficient above 0.50 is considered to be “high.”

We can compare Gini coefficients across countries and regions. Nations in Europe have Gini indixes between 0.24 and 0.36, while the comparable figure for the United States is 0.36. The coefficients are usually higher in middle- and lower-income nations; the average for Latin America and the Caribbean, for example, is 0.48, and for sub-Sahara Africa it is 0.44.

We can also look at how Gini coefficients change over time. What would we expect? The Kuznets curve, a concept based on the work of economist Simon Kuznets, predicts a rise in inequality within nations as they develop economically. The Gini coefficient would rise as workers move from low-productivity agricultural jobs to the industrial sector where wages are higher. But as a society matures and the agricultural sector shrinks, the gap between urban and rural workers should decline, and inequality fall.

The actual historical patterns, however, have been different. Inequality has been on the rise within many nations at high levels of inequality. Piketty claims that such inequality is a basic feature of capitalism, and will only worsen over time. His thesis is based on the relationship between the rate of return on capital, r, which includes profits, dividends, and interest, and the rate of economic growth, g. Piketty claims that when r > g, wealth accumulates quickly and the incomes of the richest members of society grows faster than those of the middle- and lower-classes.

This trend became strong in England, France and the U.S. in the 19th century. However, it was interrupted during the 20th century by the two World Wars and the Great Depression. Goverments intervened within their economies to improve the position of the poorest members, and the economic growth of the 1950s and 1960s reduced the importance of inherited wealth. But today, Piketty argues, we are returning to a world where economic growth is stagnating, and the rate of return on capital exceeds the economic growth rate. Unless governments intervene again, the result will be – and already has been – a return to the levels of inequality of the 19th century.

But there is another way of measuring inequality: not within nations but on a global basis. This has been done by, among others, economist Branko Milanovic. He points out that there are different ways of doing this. One method is to treat each country as a unit of observation, using the  average income of each nation. We can plot a Lorenz curve with all the countries for which there are data, and then calculate the corresponding Gini coefficients over time. If this method is used, there is little movement in the international Gini coefficient between 1960 and 1980. But during the period beginning in the 1980s through 2000, the international Gini coefficient rises. Richer countries grew faster than did the poorer ones, thus reinforcing inequality. This is the period when international trade and finance began to grow most quickly, and the observed trend would indicate that globalization rewarded the rich.

But if each country is treated as a single unit, we ignore the fact that some countries are much bigger than others. When countries are weighted by their population, a different phenomenon is observed: during the period that began in the 1980s, the international Gini coefficient falls, and has continued to do so over time. Why the difference? China and India had rapid economic growth during this period. Since they are countries with large populations, there was a decline in global inequality using population-weighted Gini coefficients during the period of increased globalization.

We can demonstrate this trend using a perspective that transcends national borders. Milanovic points out that If we arrange the world’s population by income regardless of national origin, we can calculate a global Gini coefficient. There are not many years of data available to do this calculation, but the trend that is observed shows that this global Gini coefficient has dropped.

Christoph Lakner and Milanovic showed this phenomenon another way, using global income data from 1988 to 2008. They calculated the rise in income for each decile of the world’s population. They observed the largest gains for the global top 1%, consistent with Piketty’s observations. But they also saw large gains for the the groups in the middle, most of whom were from Asia. This global perspective shows us that Piketty is correct in showing the growth in inequality within nations. But on a global basis there are some interesting movements across people in different nations.

Is there something about globalization itself that has led to these changes? There have many studies that compared the performance of countries that have opened their economies to international trade and finance with those that did not. Some of these studies also looked at the impact of globalization on the poorest members of society.

David Dollar and Aart Kraay, economists at the World Bank, compared the record of two groups of countries that they called globalizers and non-globalizers. The globalizers were those countries which had the largest growth in international trade between the 1970s and the late 1990s. They found that the globalizer nations grew more quickly than the non-globalizer nations. They also tested the effect of this economic growth upon the poor within these nations, and found that the increases in national income were reflected in increases for the poorest group. The authors concluded that open trade regimes lead to faster growth and poverty reduction in poor countries.

However, their conclusions have been challenged. One line of criticism has pointed out that openness to trade may be a result, not a cause, of rapid growth. Recent work on globalization and inequality shows a more complicated picture. A study by IMF economists Florence Jaumotte, Subir Lall and Chris Papageorgiou found that the rise in inequality within developed and developing countries is largely due to technological change, which primarily benefits those with education at the expense of those without education. These authors claimed that the impact of globalization on inequality has actually been relatively minor. Increased trade tends to reduce income inequality because of cheaper food imports, but more foreign investment leads to higher inequality because of the impact of foreign investment on the wages of skilled workers in both developing and developed countries: the more-educated workers gain while those less-educated fall behind. They concluded that the best remedy for increased inequality is more educational opportunities.

The situation we face today is complicated. On the one hand, inequality within nations has risen. On the other hand, inequality across borders may have fallen. Many are concerned that continued inequality might hinder growth. If those at the bottom of the income ladder do not participate in the benefits of globalization, then economic growth will be stunted. How to promote growth while ensuring that its benefits are shared by all is one of the most significant challenges facing nations today.

Tales of Globalization: Russia and China

The end of 2014 marked the 23rd anniversary of the dissolution of the Soviet Union and the establishment of the Russian Federation. Like Chinese leaders in the previous decade, Russian policymakers faced the challenge of integrating their nation into the global economy. Russia’s trade openness (exports and imports scaled by GDP) grew from 26% in 1991 to 51% in 2013, very similar to the rise in China’s trade openness from 29% to 50% during these years. Russian exports increased from 13% of its GDP at the beginning of this period to 28% in 2013, while the corresponding figures for China are 16% and 26%. Both counties gradually allowed foreign capital inflows. But the similarities end there.

Russia’s exports are primarily commodities, particularly oil and natural gas. Consequently, sales of these resources account for a large part of Russia’s GDP: 16% in 2012. The plunge in world oil prices, combined with the sanctions imposed by U.S. and European Union governments following Russia’s annexation of the Crimea and its threats against the Ukraine, threaten to push the economy into a recession. The deterioration of the economic situation caused the ruble to plunge against the dollar in December, before recouping part of its value after the central bank intervened in the foreign exchange market and raised its policy rate to 17%.

Russia is particularly susceptible to a currency depreciation because of its external debt, reported to be $678 billion. Capital controls that had been imposed during the 1998 crisis were removed in the 2000s, and capital inflows, including bank loans and bond issues, increased significantly. These capital flows reversed during the global financial crisis, and there was only a modest recovery before the latest period of political tension. The Russian government’s debt includes $38 billion of bonds denominated in dollars, which is not seen as a vulnerability. But the external exposure of Russian companies is much larger. The Russian central bank claims that in 2015 Russian firms owe $120 billion of interest and repayments on their external debt. Much of this money is owed by Rosneft and Gazprom, the state oil and gas producers.

China has followed a very different path. Its main exports now include electronics and machinery. The Great Recession prompted a reevaluation of the structure of the economy by the Chinese government. Chinese leaders realize that the export- and investment-led growth of the past is no longer feasible or desirable, and have emphasized the expansion of domestic consumption. This transition is taking place while the economy slows from the torrid 10% growth rate of the past to about 7.5%.

China also has external debt, which totaled $863 billion in 2013. But China has been more deliberate in opening up its capital account, and its external liabilities primarily take the form of foreign direct investment. Moreover, its foreign exchange reserves of about $4 trillion should alleviate any concerns about its ability to fulfill its obligations to foreign lenders. Of more concern is the growth in domestic credit, which now surpasses 200% of its GDP. While a financial contraction appears inevitable, there are differences over whether this will lead to economic disruption (see also here).

China’s currency appreciated in value between 2005 and 2008, when the renminbi was “re-pegged” against the dollar. In March, the central bank announced that the renminbi would fluctuate within a band of +/- 2%. A recent study by Martin Kessler and Arvind Subramanian indicates that the renminbi is fairly valued by purchasing power estimates. The government is considering whether the renminbi will become an international currency. Its status may get a boost if the IMF decides to include the renminbi as one of the currencies on which its Special Drawing Rights is based.

China and Russia, therefore, have followed very different paths in globalizing their economies. Russia, of course, could not be expected to forsake its energy resources. But commodity exporters live and die by world prices, and the government passed up an opportunity to diversify the Russian economy. China initially used its own “natural resource” of abundant labor, but has moved up the value chain, as Japan and Korea did. Chinese firms are now expanding into foreign markets. In addition, Russia allowed short-term capital inflows that can easily cease, while China carefully controlled the external sources of finance.

Russia’s GDP per capita recorded a rise of 29% between 1991 and 2013, from $5,386 to $6,924 (constant 2005 US $). China started at a much lower base in 1991, $498, but its per capita income increased by over 7 times (719%) to $3,583. The divergence in the two countries’ fortunes shows that there are many ways to survive in the global economy, but some are more rewarding than others.

The G20 and the (Non)Pursuit of Financial Stability

One of the legacies of the response to global financial crisis was supposed to be a renewed focus on international financial stability. A manifestation of this effort was the transformation of the Financial Stability Forum by the Group of Twenty (G20) into the Financial Stability Board (FSB) to oversee the development of global financial and regulatory standards. A “board,” of course, sounds more substantial than a “forum,” and the membership was expanded to include more G20 emerging market countries.

But the record of the FSB does not demonstrate an organizational commitment to changing the structure of international finance. Howard Davies summarizes its performance:

“…it is a watchdog without teeth. It can neither instruct the other regulators what to do (or not do) nor force countries to comply with new regulations.”

The FSB, of course, is an agent for its principals, the member governments. Davies places the responsibility for the lack of action on the FSB’s overseers:

“So a fair verdict would be that the FSB has done no more and no less than what its political masters have been prepared to allow it to do. There is no political will to create a body that could genuinely police international standards and prevent countries from engaging in competitive deregulation —and prevent banks from engaging in regulatory arbitrage.”

International financial stability is an international public good.  While domestic public goods are the result of failures in domestic markets, international public goods reflect failures of intergovernmental action. The lack of cooperation is due in part to a prisoners’ dilemma: each individual government has an incentive to shirk if it thinks that others will contribute to the provision of the public good.  Consequently, the good is underprovided.

Inci Ötker-Robe has written about other obstacles to collective action. These include problems in formulating and transforming knowledge into action, such as information asymmetries. As an example, she points to a lack of data across financial systems, which makes identifying risks and constructing early warning systems more difficult. Similarly, uncertainties about feedback loops that cross borders can allow financial fragility to escalate and trigger crises.

Ötker-Robe also writes about the incentives that discourage effective risk management. Diverging national interests, for example, prompt governments to protect their own financial systems rather than promote global welfare. (For an example, see the debate among regulators over capital requirements for systematically important banks.) She comes to a prognosis quite similar to that of Davies cited above:

“…the absence of global enforcement authorities with appropriate powers and accountability to forge global cooperation on the different areas of risk has hindered progress.”

What would it take for the situation to change? Ötker-Robe proposes implementing incremental steps to foster cooperation. These include financial transfers to governments to lower participation costs and increase participation. The IMF’s Managing Director Christine Lagarde has called for a new multilateralism, which would ”…instill a broader sense of “civic responsibility” on the part of all players in the modern global economy, including the private sector, and specifically financial sector players”. But if it is difficult for market participants to look past their private welfare, it is also difficult for governments to look beyond national interests, despite the domestic costs if global systems fail. Davies worries that it may take another crisis for the resolve to create international institutions with the necessary powers to be created. If the G20, which recently met in Brisbane, does not back its rhetoric with concrete actions, it might be a casualty of such a crisis.

Dealing with the Fallout from U.S. Policies

The divergence of monetary policies in the advanced economies continues to roil financial markets. The Federal Reserve has reacted to better labor market conditions by ending its quantitative easing policy. The Bank of Japan, on the other hand, will expand its purchases of securities, and the European Central Bank has indicated its willingness to undertake unconventional policies if inflation expectations do not rise. The differences in the prospects between the U.S. and Great Britain on the one hand and the Eurozone and Japan on the other has caused Nouriel Roubini to liken the global economy to a jetliner with only one engine still functioning.

The effect of U.S. interest rates on international capital flows is well-documented. Many countries are vulnerable to changes in U.S. policies that can reverse financial flows. Countries that have relied on capital flows searching for a higher yield to finance their current account deficits are particularly susceptible. Declining commodity prices reinforce the exposure of commodity exporters such as Brazil and Russia.

U.S. markets affect capital flows in other ways. Erlend Nier, Tahsin Saadi Sedik and Tomas Molino of the IMF have investigated the key drivers of private capital flows in a sample of emerging market economies during the last decade. They found that changes in economic volatility, as measured by the VIX (the Chicago Board Options Exchange Market Volatility Index, which measures the implied volatility of S&P 500 index options), are the “dominant driver of capital flows to emerging markets” during periods of global financial stress. During such periods, the influence of fundamental factors, such as growth differentials, diminishes. Countries can defend themselves with higher interest rates, but at the cost of slowing their domestic economies.

When the IMF’s economists included data from advanced economies in their empirical analysis, they found that the impact of the VIX was higher in those economies. They inferred that as countries develop financially, “capital flows could therefore be increasingly influenced by external factors.” Financial integration, therefore, will lead to more vulnerability to the VIX.

Volatility in U.S. equity markets drives up the VIX. Moreover, empirical analyses, such as one by Corradi, Distaso and Mele, find that U.S. variables, such as the Industrial Production Index and the Consumer Price Index, explain part of the changes in the VIX. U.S. economic conditions, therefore, affect global capital flows through more linkages than interest rates alone.

What are the implications for U.S. policymakers? The Federal Open Market Committee does not usually consider the impact of its policy directives on foreign economies. On the other hand, the Fed is well aware of the feedback from foreign economies to the U.S. Moreover, there are measures the U.S. could undertake to lessen the impact of its policy shifts on foreign markets.

During the global financial crisis, for example, the Federal Reserve established swap arrangements for 14 foreign central banks, including those of Brazil, Mexico, Singapore and South Korea. These gave the foreign financial regulators the ability to lend dollars to their banks that had financed holdings of U.S. assets by borrowing in the U.S. However, not all emerging markets’ central banks were deemed eligible for this financial relationship, leaving some of them disappointed (see Prasad, Chapter 11).

Federal Reserve officials have signaled that they are not interested in serving again as a source of liquidity. One alternative would be to allow the IMF to take over this capacity. But the U.S. Congress has not passed the legislation needed to implement long-overdue governance reforms at the Fund, and it is doubtful that the results of the recent elections will lead to a different stance. Not many foreign countries will be in favor of enabling the IMF to undertake new obligations until the restructuring of that institution’s governance is resolved.

Volatile capital flows have the potential of sabotaging already-anemic recoveries in many emerging market countries. The global financial architecture continues to lack reliable backstops in the event of more instability. The U.S. should cooperate with other nations and international financial institutions in addressing the fallout from its economic policies, either by directly providing liquidity or allowing the international institutions to do so.

Volatility in the Emerging Markets

Volatility has returned to the financial markets. Stock prices in the U.S. have fallen from their September highs, and the return on 10-year Treasury bonds briefly fell below 2%.  Financial markets in emerging markets have been particularly hard hit. The Institute for International Finance estimates that $9 billion was withdrawn from equity markets in those countries in October, while the issuance of new bonds fell.

The increased volatility follows a period of rising allocations of portfolio investments by advanced economies to assets in the emerging market economies. The IMF’s latest Global Financial Stability Report reported that equity market allocations increased from 7% of the total stock of advanced economy portfolio investments in 2002 to almost 10% in 2012, which represented $2.4 trillion of emerging market equities. Similarly, bond allocations rose from 4% to almost 10% during the same period, reaching $1.6 trillion of emerging market bonds.

The outflows are due to several factors. The first, according to the IMF, is a decline in growth rates in these countries below their pre-crisis rates. While part of the slowdown reflects global conditions, there are also concerns about slowing productivity increases. China’s performance is one of the reasons for the lower forecast. Its GDP rose at a rate of 7.3% in the third quarter, below the 7.5% that the government wants to achieve.

Second, the prospect of higher interest rates in the U.S. following the winding down of the Federal Reserve’s Quantitative Easing has caused investors to reassess their asset allocations. The importance of “push” factors versus “pull” factors in driving capital flows has long been recognized, but their relative importance may have grown in recent years.   A recent paper by Shaghil Ahmed and Andrei Zlate (working paper here) provides evidence that the post-crisis response in net capital inflows, particularly portfolio flows, in a sample of emerging markets to the difference between domestic and U.S. monetary policy rates increased in the post-crisis period (2009:Q3 – 2013:Q2). They also looked at the impact of the U.S. large-scale asset purchases, and found that the such purchases had a statistically significant impact on gross capital inflows to these countries.

Part of the increased response in flows between advanced and emerging market economies may reflect the actions of large asset managers. In a paper in the latest BIS Quarterly Review, Ken Miyajima and Ilhyock Shim investigate the response of asset managers in advanced economies to benchmarks of emerging market portfolios. They point out that these managers often rely on performance measures of asset markets in emerging markets, which leads to an increased correlation of the assets under the managers’ control. Moreover, relatively small shifts in portfolio allocation by the asset managers can have a significant impact on asset markets in emerging markets. As a result, in recent years “…investor flows to asset managers and EME asset prices reinforced each other’s directional movements.” Investor flows to the emerging market economies are procyclical. If other factors do not provide a reason to reverse the outflows, they will continue.

The IMF’s Global Financial Stability Report also points out that: “An unintended consequence of…stronger financial links between advanced and emerging market economies is the increased synchronization of asset price movements and volatility.” One downside of increased financial globalization, therefore, is a decline in the ability to lower risk through geographic diversification. Similarly, any notion of “decoupling” emerging markets from the advanced economies is a “mirage,” according to Mexico’s central bank head Agustin Carstens. To achieve international financial stability will require monitoring capital flows across asset markets in different countries; volatility does not respect geographic borders.