Monthly Archives: December 2013

Assigned Readings: Dec. 30, 2013

In the run-up to the financial crisis the world economy was characterized by large and growing current-account imbalances. Since the onset of the crisis, China and the U.S. have rebalanced. As a share of GDP, their current-account imbalances are now less than half their pre-crisis levels. For China, the reduction in its current-account surplus post-crisis suggests a structural change. Panel regressions for a sample of almost 100 countries over the thirty-year period 1983-2013 confirm that the relationship between current-account balances and economic variables such as performance, structure, wealth and the exchange rate changed in important ways after the financial crisis.

I discuss how the unconventional monetary policy measures implemented over the past several years – quantitative and credit easing, and forward guidance – can be analysed in the context of conventional models of asset prices, with particular reference to exchange rates. I then discuss alternative approaches to interpreting the effects of such policies, and review the empirical evidence. Finally, I examine the ramifications for thinking about the impact on exchange rates and asset prices of emerging market economies. I conclude that although the implementation of unconventional monetary policy measures may introduce more volatility into global markets, in general it will support global rebalancing by encouraging the revaluation of emerging market currencies.

We study the long-run relationship between public debt and growth in a large panel of countries. Our analysis takes particular note of theoretical arguments and data considerations in modeling the debt-growth relationship as heterogeneous across countries. We investigate the issue of nonlinearities (debt thresholds) in both the cross-country and within-country dimensions, employing novel methods and diagnostics from the time-series literature adapted for use in the panel. We find some support for a nonlinear relationship between debt and long-run growth across countries, but no evidence for common debt thresholds within countries over time.

  • Atish R. Ghosh, Mahvash S. Qureshi, Juk Il Kim and Juan Zalduendo. “Surges.” Journal of International Economics, forthcoming.

This paper examines when and why capital sometimes surges to emerging market economies (EMEs). Using data on net capital flows for 56 EMEs over 1980−2011, we find that global factors, including US interest rates and investor risk aversion act as “gatekeepers” that determine when surges of capital to EMEs will occur. Whether a particular EME receives a surge, and the magnitude of that surge, however, are largely related to domestic factors such as its external financing need, capital account openness, and exchange rate regime. Differentiating between surges driven by exceptional behavior of asset flows (repatriation of foreign assets by domestic residents) from those driven by exceptional behavior of liability flows (nonresident investments into the country), shows the latter to be relatively more sensitive to global factors and contagion.

In bilateral and multilateral surveillance, countries are often urged to consider alternative policies that would result in superior outcomes for the country itself and, perhaps serendipitously, for the world economy. While it is possible that policy makers in the country do not fully recognize the benefits of proposed alternative policies, it is also possible that the existing policies are the best that they can deliver, given their various constraints, including political. In order for the policy makers to be able and willing to implement the better policies some quid pro quo may be required—such as a favorable policy adjustment in the recipients of the spillovers; identifying such mutually beneficial trades is the essence of international policy coordination. We see four general guideposts in terms of the search for globally desirable solutions. First, all parties need to identify the nature of spillovers from their policies and be open to making adjustments to enhance net positive spillovers in exchange for commensurate benefits from others; but second, with countries transparent about the spillovers as they see them, an honest broker is likely to be needed to scrutinize the different positions, given the inherent biases at the country level. Third, given the need for policy agendas to be multilaterally consistent, special scrutiny is needed when policies exacerbate global imbalances and currency misalignments; and fourth, by the same token, special scrutiny is also needed when one country’s policies has a perceptible adverse impact on financial-stability risks elsewhere.

Be Careful What You Wish For

Policymakers, including finance ministers and central bank governors, are as entitled to have holiday wishes as much as anyone else. But they should be careful with their wish list. Sometimes the law of unintended consequences leads to unexpected and undesirable side effects.

The expansion of domestic financial markets can promote economic growth through a more efficient allocation of savings and other mechanisms.  Foreign participation in these markets can contribute to their development in several ways. Foreign investors, for example, can provide more liquidity that leads to lower yields. Shanaka Pereis found that a 1% increase in the share of foreign investors in government bond markets in ten emerging markets led to a decrease of about 6 basis points in the yield on those bonds. All this suggests that capital flows benefit financial markets.

But larger financial markets can also bring unanticipated consequences. After Federal Reserve Chair Ben Bernanke spoke last spring of tapering the Fed’s asset purchases, the exchange rates of many emerging markets depreciated while their central banks used their foreign reserves to slow the changes. Barry Eichengreen and Poonam Gupta have investigated these reactions. They find that the magnitude of the changes in exchange rates and reserves were linked to the size and openness of a country’s financial markets. They interpret this as evidence that foreign investors rebalanced their portfolios in those markets with the most largest and liquid financial systems. They conclude that “success at growing the financial sector can be a mixed blessing.” Financial regulators need to be ready for the volatility that increased capital flows can bring along with all their benefits.

Who’s In Control?

In the post-financial crisis world, capital controls have become viewed in many quarters as an acceptable policy tool. A number of studies have investigated how controls may affect macroeconomic and financial performance. But how controls are implemented is also a topic of interest, in part because the inopportune use of these measures may exacerbate the conditions they are intended to ameliorate.

Charles Collyns of the Institute of International Finance presents a classification of the use of controls to deal with capital inflows. The first template is the “Classical Chinese”: the capital account is largely closed except for FDI flows, the exchange rate is fixed and there is a repressed domestic financial system.  But China itself is moving away from this method, as are many low-income countries. The second model is the “Textbook” pre-2008 IMF model: flexible exchange rates with the long-run goal of capital account liberalization. This model showed itself vulnerable to financial shocks in 2008. The third scheme is the “Brazilian Defense”: a floating exchange rate and the use of macroprudential and tax tools to restarin capital flows. This approach has also been utilized by India and Turkey. The fourth classification is dubbed by Collyns the “New Orthodoxy,” and is defined by a commitment to both an open capital account and the development of domestic financial markets. Mexico is offered as an example country that uses such an approach.

If the “Classical Chinese” and the “Textbook” models are being discarded, then one popular alternative is the discretionary use of capital controls. But are capital controls used to avoid inflows that lead to credit bubbles and a boom-bust cycle? A new paper by Andrés Fernández, Alessandro Rebucci and Martín Uribe examines whether policymakers use capital controls in a macroprudential manner. If they were, we would expect to see a tightening of controls on inflows and a relaxation of restrictions on outflows during expansions, and the opposite pattern of policy measures during downturns.

The authors use three indicators—the output gap, the cyclical component of the real exchange rate, and the cyclical component of the current account—to date their boom-and-bust episodes. They update Schindler’s index of capital controls, which distinguishes among controls on inflows and outflows on six types of assets. The authors report that over the period of 2005-2011 there was no correspondence of changes in capital controls and macroeconomic conditions. Controls were not responsive to economic expansions or contractions, over- or undervaluations of the real exchange rate or large current account imbalances.

They offer two interpretations for their results. One is that theory has outrun practice, and controls will become increasingly used in a macroprudential fashion as policymakers become accustomed to using them in this fashion. The second interpretation is that there are other factors that determine the cyclical properties of the usage of capital controls. But what?

There was a literature on the political and economic determinants of capital account liberalization in the 1980s and 1990s, summarized by Eichengreen. Among the factors found to contribute to decontrol were the deregulation of domestic financial markets, the abandonment of exchange rate pegs, and a trend towards democratization in many developing countries. But Eichengreen cautioned that there might have been other factors that were difficult to measure but nonetheless significant. The latest contributions to the literature on the use of capital controls indicate that there are still unanswered questions regarding their implementation.

Speaking Truth to Power

When the full history of the European debt crisis is related, one important part of the story will be the uneasy relationship of the International Monetary Fund with its European partners in the “Troika,” the European Commission and the European Central Bank. The Fund and the Europeans came to hold different views on the nature of the crisis and how it should be handled soon after its outbreak in 2010. Their disagreements reflect the split in the Fund’s membership between creditors and debtors, and the inherent ambiguity of the position of an intergovernmental organization that serves principals with different interests.

Greece obtained $145 billion from the Troika in May 2010. Of that amount, $40 billion was provided by the IMF in the form of a three-year Stand-by Arrangement. This represented 3,200% of the Greek quota at the IMF, far above the usual access limits. Susan Schadler has drawn attention to the modification of IMF policy that was made in order to allow the agreement to go forward.

The IMF has criteria to be met in deciding whether to allow a member “exceptional access” to its resources. One of these of these is a high probability that the borrowing member’s public debt will be sustainable in the medium-term. At the time of the arrangement, the IMF’s economists realized that there was little probability that Greek sovereign debt would be sustainable within any reasonable timeframe. The IMF, therefore, amended the criteria so that exceptional access could also be provided if there were a “high risk of international systemic spillover effects.” There was little doubt that such effects would occur in the event of a default, but whether this justified lending such large amounts was questionable.

It soon became clear that the two of the other four criteria would not be met. Greece would not regain access to private capital markets while it participated in the Fund program (criterion #3). Moreover, there was little prospect of a successful implementation of the policies contained in the original agreement (criterion #4). By 2011, it was evident that the program with Greece was not viable. Talks began on a new program and a restructuring of the debt, which eventually occurred in 2012. Moreover, Ireland received assistance from the Troika in December 2010, as did Portugal in February 2011.

This was the background when newly-appointed Fund Managing Director Christine Lagarde, a former French finance minister, appeared at the annual gathering of central bankers and financiers at Jackson Hole, Wyoming, in August 2011. Ms. Lagarde voiced her concerns that her fellow Europeans were responding too slowly to the dangers posed by the sovereign debt crisis. (Lagarde also called upon U.S. policymakers to undertake steps to resolve the housing crisis.) But her recommendations for more vigorous actions went unheeded. Her call for a more accommodative monetary policy was ignored by outgoing ECB President Jean-Claude Trichet. And European bankers were displeased by her assessment of their capital base as inadequate and her proposal of public injections of capital if private sources were inadequate.

In retrospect, Lagarde’s judgments look prescient. Trichet’s successor at the ECB, Mario Draghi, came to a very different view of what that institution needed to do to maintain financial stability. The ECB lowered its key interest rate in November 2011, and the following month instituted a longer-term refinancing operation for European banks. European banks, however, are still seen as relatively frail.

The IMF subsequently reassessed the response to sovereign debt crises and reviewed the framework for debt restructuring. Its review found that “debt restructurings have often been too little and too late, thus failing to re-establish debt sustainability and market access in a durable way.” The report’s authors claimed that: “Allowing an unsustainable debt situation to fester is costly to the debtor, creditors and the international monetary system.” The policy review raised the possibility of more involvement of the official sector in debt restructuring.

But the development at the IMF of a proposal to write down unsustainable debt at an earlier stage of a crisis has aroused resistance from German and other policy officials. They see the suggestion of a standstill on debt repayments as an assault on the rights of bondholders. Any mention of delay or reduction of payments is viewed as the first step towards the evasion of borrowers’ responsibilities.

Such a position in the wake of the restructuring of the Greek debt is alarming. Other borrowers will suffer financing problems, and relying on exhortations to repay in full will not improve their circumstances. Moreover, ignoring the costs to the debtor of a (attempted) repayment is self-defeating. The Greek economy may have touched bottom, but even under the most optimistic scenario its debt/GDP ratio will not decline for years.

The IMF is the agent of 188 principals. To be credible, it must  serve the interests of all its members, not just its partners in a lending arrangement. Moreover, the IMF has established more credibility in this crisis than those who have consistently refused to acknowledge its extent. In seeking to improve the process of dealing with debt restructuring,  the IMF is fulfilling its mission to provide “…the machinery for consultation and collaboration on international monetary problems.” (IMF Article of Agreement I(i).) Its members should allow it to meet that mandate.

Another Divergence

The decline in inflation rates in advanced economies to historically low rates has been widely reported.  But inflation is increasing in some of the largest emerging markets. This divergence poses dilemmas for policymakers in those countries.

The annual difference between the GDP-weighted average inflation rates of high income countries and developing nations has fluctuated between 3-4% between 2010 and 2012 (see data here). More recently, the gap has jumped to 4.8%. Among the countries where prices are rising more rapidly are Brazil (5.8% in the most recent month), Egypt (10.5%), India (10.1%), Indonesia (8.3%), Russia (6.2%), and South Africa (5.5%).  Moreover, all except Russia are recording current account deficits.

The increase in prices is drawing attention. In Brazil and Indonesia, rising prices are fueling popular discontent with the governments. The Russian central bank has admitted that it will miss its inflation target for the year. Arvind Subramanian finds inflation in India worrisome, in part because it is unprecendently high.

What fuels the rises? In many emerging markets, the governments have sought to offset reduced demand by their trade partners in the advanced economies by stimulating domestic demand. The result has been increases in domestic credit and household debt, and in these countries escalating prices.

Some central bankers have responded by raising their target interest rates. In India, the new target rate is 7.75%. Brazil’s central bank has raised its target rate to 10%, and Indonesian monetary policymakers have hiked their rate to 7.5%. South Africa’s central bank has kept its rate unchanged, but signaled that this may change.

These increases could leave the central bankers in a quandary. After blaming the Federal Reserve for capital flows to their countries, it would be awkward if the same policymakers were now seen as responsible for creating the conditions that could attract capital. Moreover, higher rates might choke off the domestic spending that it is seen as essential. But allowing inflation to continue unchecked could result in harsher measures later. Of course, higher growth in the advanced economies could alleviate many of these problems. Convergence can work in more than one direction.