Monthly Archives: September 2013

Apples and Naranjas

The Economist has published its indicator of vulnerability to a “capital freeze.” (An earlier version published on September 7 was revised.) The ranking for 26 emerging markets is based on each country’s current account balance as a percent of its GDP, its short-term external debt and debt repayments relative to foreign exchange reserves and sovereign wealth fund assets, the growth rate of credit to the private sector, and the Chinn-Ito index of financial openness. The ten countries rated as most at risk are Turkey, Romania, Poland, Mexico, Colombia, Peru, Argentina, Indonesia and Chile.

Not surprisingly, there has been some pushback from officials of the countries at the top of the rankings. Mauricio Cárdenas, Colombia’s minister of finance, defends his country’s economic reputation in a letter. The minister claims that those who devised the rankings ignored the sources of vulnerability to a sudden stop, including the source of financing for the current account.  Mr. Cárdenas points out that Colombia’s current account is “fully financed by foreign direct investment instead of short-term capital flows.”

Does he have a case? We calculated Colombia’s current account/GDP and FDI/GDP ratios over the last three years (2010-12), and compared them with other Latin American economies on the index:

% Current Account/GDP FDI/GDP
Argentina -0.05 2.34
Brazil -2.24 2.92
Mexico -0.70 1.67
Venezuela 4.28 0.76
Colombia -3.05 3.54

Score one for the minister: the current account deficits of the last three years were indeed offset by inflows of FDI.  Game, set, match for Colombia?

Perhaps not. The size of the current account deficits, one of the components of the capital-freeze index, stands out. More importantly, the minister is mixing flows and stocks. The FDI inflows create FDI liabilities that are not easily reversed. But the country’s short-term external debt is the source of vulnerability to a sudden stop. Nervous lenders can simply cease renewing lines of credit or other credit facilities, and domestic borrowers will be cut off from funding. Reversals of short-term external debt were features of the Mexican, East Asian, Russian and Brazilian crises of the 1990s.

The debt data for the five South American countries in 2011 show why Brazil is rated as less risky than Colombia and the other nations. These countries are more vulnerable to a change in sentiment by foreign lenders. Venezuela does not appear in the top ten on the capital-freexe index in part because it is not as financially open as the others, and thus less exposed.

% External Debt/GNI Short-term Debt/External Debt
Argentina 26.35 14.53
Brazil 16.64 10.42
Mexico 25.20 17.88
Venezuela 21.82 24.56
Colombia 24.31 14.06

Colombia’s finance minister has justification to be proud that his country attracts sufficient FDI to finance its current account deficits. And there is no reason to expect that those flows will cease. But the country’s external debt liabilities, the result of past borrowing, are the source of potential hazard.

Hobglobins and Hypocrites

“A foolish consistency is the hobglobin of little minds…”

Ralph Waldo Emerson

Before this week’s announcement by Federal Reserve Chairman Ben Bernanke that the Fed would continue its asset purchases under Quantitative Easing 3, finance ministers and other leaders in emerging market nations had been voicing their concerns over the prospect of U.S. policymakers winding down their operations (see here). They feared that higher interest rates in the U.S. would bring back the capital that had flowed out in search of higher returns, which would leave the emerging market officials in the uncomfortable position of raising their own interest rates or watching their currencies depreciate. The calls for the Federal Reserve to exercise caution peaked at the G20 leaders summit in St. Petersburg, where the final communiqué called for “Further changes to monetary policy settings…to be carefully calibrated and clearly communicated.”

It would be easy to dismiss the foreign reaction on the grounds that there was a large measure of hypocrisy in these exhortations to the Federal Reserve to move slowly.  Many of these officials had previously castigated the Federal Reserve for the currency appreciations that accompanied the earlier capital inflows. Surely, it can be claimed, they should welcome a reversal in Federal Reserve policy.

But the calls for caution demonstrate that a country’s economic welfare incorporates many diverse interests that exercise influence at different times. The worries voiced earlier about currency appreciation were based on the fears of exporters that they would be adversely affected by the resulting increases in prices in foreign markets. Their grievances were heard sympathetically by domestic policy officials who have been dealing with an unsteady recovery from the Great Recession of 2008-09. The decline in import prices was of little import, as inflation has not been a concern. Human nature dictates that we resent adverse changes and take for granted those that benefit us. Moreover, Mancur Olson pointed out that when the benefits are diffuse and the “pain” concentrated, it is not surprising that the voices of those who feel threatened are predominant.

Capital outflows and currency depreciations, on the other hand, will affect other interest groups. Those who have liabilities denominated in dollars fear a rising burden in repaying their debts. Domestic firms dependent on imports worry about their higher costs. Regulators of domestic financial markets are anxious about financial volatility and declines in asset prices. Finance ministry and central bank officials fret about the financing of current account deficits. It would be surprising if their calls for protective actions were offset by a wave of messages from exporters jubilant at regaining market share.

When U.S. interest rates do rise, those outside the U.S. who are adversely affected will register their complaints. Their government representatives will respond by criticizing the Federal Reserve for ignoring the global impact of their policies. It may be inconsistent, but not hypocritical, for them to serve whichever domestic interests have the largest megaphones.

Nurske and Lagarde

The outflows of capital from emerging market economies such as Brazil, India, Turkey and Indonesia and accompanying currency depreciations have led to discussions of what has caused the reversals in fortune of these countries (see, for example, here and here and here.). Higher U.S. interest rates and signs of an improving U.S. economy are seen as “pull factors” that lure investors to the U.S.. Deteriorating fundamentals in the crisis countries, such as rising current account deficits or falling growth rates, are portrayed as push factors that drive foreign investors away.

Capital volatility is a familiar and possibly systemic problem. Seventy years ago, Ragnar Nurske (1907-2007) blamed capital flows for destabilizing exchange rates. Nurske served in the Financial Section and Economic Intelligence Service of the League of Nations from 1934 to 1945. While there he wrote most of International Currency Experience: Lessons of the Interwar Period (1944). In this study, Nurske blamed the exchange rate depreciations of the 1930s on destabilizing capital flows:

…As funds moved out to take refuge abroad, pressure on the exchange market was increased and the rate of depreciation accelerated, which resulted in a further loss of confidence and a further flight of capital. In its effects on the balance of payments the capital flow became disequilibrating instead of equilibrating.       (League of Nations 1944:114)

Nurske’s views appear more relevant today than they did during the last decade, when financial globalization was generally viewed as a positive force, despite a lack of supporting evidence. The IMF, which had regarded an unregulated capital account as a suitable long-term goal for developing economies, reversed its stance during the 2008-09 crisis. The IMF now regards capital controls as an appropriate macroprudential tool (see, for example, here.).

Ben Bernanke, then a Federal Reserve Board Governor, issued a now-famous apology to Milton Friedman on the occasion of Friedman’s ninetieth birthday in 2002. Bernanke referred to Friedman’s work with Anna J. Schwarz that showed that the Federal Reserve had exacerbated the Great Recession of 1929 through its monetary policies, and promised: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”  Perhaps it is time for a new (albeit belated) apology, in this case from the IMF’s Managing Director Christine Lagarde to Nurske.  Friedman, who believed that successful speculators would return a misaligned exchange rate to its fundamental value, would be aghast. But perhaps the passage of time would allow the views of both Nobel Prize-winners to co-exist and guide current-day policy.

Correction: An alert reader has pointed out that Ragnar Nurske did not win the Nobel Prize. Perhaps I was confusing him with Ragnar Frisch, who shared with Jan Tinbergen the first Nobel prize in economics to be awarded in 1969.

Assigned Readings: September 3, 2013

This paper assesses the implications of Chinese capital account liberalization for capital flows. Stylized facts from capital account liberalization in advanced and large emerging market economies illustrate that capital account liberalization has historically generated large gross capital in- and outflows, but the direction of net flows has depended on many factors. An econometric portfolio allocation model finds that capital controls significantly dampen cross-border portfolio asset holdings. The model also suggests that capital account liberalization in China may trigger net portfolio outflows as large domestic savings seek to diversify abroad.

Has the unprecedented financial globalization of recent years changed the behavior of capital flows across countries? Using a newly constructed database of gross and net capital flows since 1980 for a sample of nearly 150 countries, this paper finds that private capital flows are typically volatile for all countries, advanced or emerging, across all points in time. This holds true across most types of flows, including bank, portfolio debt, and equity flows. Advanced economies enjoy a greater substitutability between types of inflows, and complementarity between gross inflows and outflows, than do emerging markets, which reduces the volatility of their total net inflows despite higher volatility of the components. Capital flows also exhibit low persistence, across all economies and across most types of flows. Inflows tend to rise temporarily when global financing conditions are relatively easy. These findings suggest that fickle capital flows are an unavoidable fact of life to which policymakers across all countries need to continue to manage and adapt.

There is a global financial cycle in capital flows, asset prices and in credit growth. This cycle co‐moves with the VIX, a measure of uncertainty and risk aversion of the markets. Asset markets in countries with more credit inflows are more sensitive to the global cycle. The global financial cycle is not aligned with countries’ specific macroeconomic conditions. Symptoms can go from benign to large asset price bubbles and excess credit creation, which are among the best predictors of financial crises. A VAR analysis suggests that one of the determinants of the global financial cycle is monetary policy in the centre country, which affects leverage of global banks, capital flows and credit growth in the international financial system. Whenever capital is freely mobile, the global financial cycle constrains national monetary policies regardless of the exchange rate regime.

For the past few decades, international macroeconomics has postulated the “trilemma”: with free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. The global financial cycle transforms the trilemma into a “dilemma” or an “irreconcilable duo”: independent monetary policies are possible if and only if the capital account is managed.

So should policy restrict capital mobility? Gains to international capital flows have proved elusive whether in calibrated models or in the data. Large gross flows disrupt asset markets and financial intermediation, so the costs may be very large. To deal with the global financial cycle and the “dilemma”, we have the following policy options: ( a) targeted capital controls; (b) acting on one of the sources of the financial cycle itself, the monetary policy of the Fed and other main central banks; (c) acting on the transmission channel cyclically by limiting credit growth and leverage during the upturn of the cycle, using national macroprudential policies; (d) acting on the transmission channel structurally by imposing stricter limits on leverage for all financial intermediaries. We argue for a convex combination of (a), (c) and (d).