Monthly Archives: January 2014

Shake, Rattle and Roll

The selloff last week of the currencies of many emerging market countries while stock prices also declined can be seen as the result of “known unknowns” and “unknown unknowns.” How these will play out will become evident during the rest of the year. Either set of factors would be unsettling for the emerging market countries, but the combination of the two may lead to a long period of chaotic financial conditions.

The “known unknown” is the magnitude of the increase in U.S. interest rates following the scaling down of asset purchases by the Federal Reserve and the ensuing impact on capital flows to developing economies. A recent analysis at the World Bank of the response established a baseline assumption of an increase of 50 basis points in U.S. long-term interest rates by the end of 2015 and another 50 basis point rise in 2016. The European Central Bank, the Bank of Japan and the Bank of England would also relax their quantitative easing policies. The result, according to their model, would be a slow rise in global interest rates and a gradual tightening in capital flows to developing countries of about 10%, or 0.6% of their GDP. The biggest declines would occur in portfolio flows to these countries.

However, the World Bank analysts also allowed for alternative scenarios. If there is a “fast normalization,” then U.S. long-term interest rates will rise by 100 basis points this year and capital inflows to the developing economies drop by up to 50% by the end of the year. In the “overshooting scenario,” long-term rates rise by 200 basis points, and capital inflows could decline by 80%. These developments would raise the probability of financial crises in the emerging markets, particularly in countries where there have been sizeable increases in domestic credit fueled in part by foreign debt

But the U.S. is not the only source of anxiety for policymakers in emerging market economies.  A decline in Chinese manufacturing activity in January may be reversed next month, and by itself likely means little. The decline in Asian stock prices that followed the announcement of the fall, however, demonstrated the importance of China’s economy for the region, and why China’s economic performance is the “unknown unknown.” The financial system in China has become overextended, and the Bank of China has fluctuated between signaling that it would rein in the shadow banking system while also injecting credit when short-term interest rates rise. How long the authorities can continue their delicate balancing act is unclear.

The state of the financial system is only one of the aspects of the Chinese economy that raises concerns. Given the uncertainty about the impact of demographic and migration trends, the continuation of FDI flows, etc., any forecast is conditional on a host of factors.  The IMF reported increased growth in China at the end of 2013, but warned that it will moderate this year to around 7.5%.

The conundrum is that we do not know what we should be concerned about in China, whereas we can imagine all too well what may happen to financial markets in emerging markets following higher interest rates in the advanced economies. The result is likely to be continued declines in exchange rates and financial asset prices, as the vulnerabilities of individual countries are revealed. As Warren Buffet warned, “Only when the tide goes out do you discover who’s been swimming naked.”

Update: See Menzie Chin’s views on these issues here.


The Spirit of Versailles?

The newly-approved U.S. budget bill did not include authorization for changes at the IMF in funding and quotas (see also here). Those measures require approval of 85% of the voting power of the IMF’s members, and since the U.S. controls 17.67%, the reforms cannot be enacted. This leaves the U.S and the Fund in difficult positions.

The IMF received loans from its members during the 2007-09, but has sought to convert these to increases in the quotas that provide the funding for the IMF’s lending programs. The IMF is not about to run out of money, but the opportunity to put its financing on a regular basis has been (at best) delayed.  The IMF’s members also agreed to shift quota shares, which also determine voting powers, to the emerging market nations while reducing the European presence on its Executive Board. China has made clear that it wants a larger voting share, and the other middle-income countries have taken a similar position. The postponement in increasing their quotas allows their governments to adopt a position of high dudgeon when the IMF next advocates policy changes in their countries. The Europeans, on the other hand, must be delighted that the they are no longer on the spot for obstructing the realignment.

What important Constitutional principle was at stake in the refusal of Congress to approve the measures? According to the New York Times, it was a lack of willingness to support multilateral financial institutions. This ties in with popular opposition in the U.S. to foreign aid, always a perennial target of right-want opprobrium, and it bodes poorly for the future. If a significant segment of political opinion consistently opposes U.S. involvement in international ventures and forums, then the U.S. will pay a price in diminished global influence.

Is it too dramatic to compare this event with the failure of the U.S. Senate to approve the Treaty of Versailles? Probably, but the similarities are suggestive of what is driving the rejection. A significant part of the American electorate was tired then of foreign wars and wished to retreat from foreign obligations, just as many do today. Anything that seems to support the financial sector is also viewed with suspicion.  Personal enmity between President Woodrow Wilson and Republican Senator Henry Cabot Lodge is echoed in the animosity between President Barak Obama and members of the Republican Congressional delegation. Lodge was concerned that the League would supersede the U.S. government’s ability to conduct foreign affairs, just as many contemporary conservatives are worried about the influence of the United Nations on domestic matters. Both Wilson and Obama have been accused of being unwilling (or unable) to persuade opponents of the need to approve the desired measures.

While the U.S. never joined the League of Nations, it is not about to leave the IMF. But the refusal to ratify the changes in the IMF’s governance will leave the U.S. vulnerable to the charge that it seeks to retain control of an organization that was established at the end of World War II long after its hegemonic position had ebbed. If this were the reason for these developments, it would at least be understandable from a realpolitik perspective. The truth may be more dispiriting: perhaps we do not understand what we have to lose.

Time For a Change?

The imminent (or not) taper of purchases of securities by the Federal Reserve has resulted in a great deal of speculation about its effects on other countries. Among the more intriguing views that have been advanced is the claim that a withdrawal of foreign capital will lead to much-needed reform measures in emerging markets.  This is an interesting assertion, in part because it contradicts the meme that capital inflows act as a catalyst for “collateral benefits” that contribute to the establishment of better institutions. So, which is it—will a reversal of foreign money lead to an improvement in domestic governance or not?

The collateral benefits view was advanced after empirical analyses failed to find evidence that capital account liberalization contributed to economic growth. Then-IMF economists Ayhan Kose, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei (Prasad is now at Cornell, Rogoff at Harvard and Wei at Columbia) claimed that capital inflows promoted the development of the domestic financial sector, and contributed to institutional development, better governance and macroeconomic discipline. There was an intuitive appeal to this argument: shouldn’t foreign investors favor conditions that facilitate the development of local markets and institutions that lead to profits?

The problem is the (lack of) evidence for this linkage. Indeed, the wreckage of a decade of financial crises in Mexico, East Asia, Russia, Brazil, Turkey and Mexico suggested that foreign lenders had been blind to local conditions. Dani Rodrik and Arvind Subramanian, in their review of the arguments for financial globalization,  were unconvinced that collateral benefits could be found, and pointed to Turkey as a counter-example.

The second perspective builds off this contrasting view that capital inflows serve as a stopgap measure that allows recalcitrant governments to avoid implementing the reforms that domestic lenders demand. Easy money from aboard allows government officials to finance fiscal deficits that may include payments to supporters of the regime. Once the conditions that led to the inflows of foreign money disappear, the government is forced to deal with the domestic creditors.

Another version of this story sees capital inflows as contributing to bubbles in the country’s financial markets and institutions. A reversal of foreign money reveals the fragility of the domestic financial conditions and necessitates reforms. South Korea is sometimes cited as an example of a country that enacted economic and financial reform measures after its 1997-98 crisis that made the country better off.  Of course, a country pays a high price if a capital outflow occurs precipitously.

Recent concerns have centered on the “Fragile Five” of  Brazil, Indonesia, India, Turkey and South Africa. Their currencies depreciated when Federal Reserve Chair Ben Bernanke first raised the issue of cutting back on asset purchases last year. Increasing current account deficits in all but India have revealed a dependence on foreign capital. But it is India that most requires reform of the financial sector. Raghuram Rajan, governor of the country’s central bank, has sought to modernize the financial system, but faces political opposition and inertia. It would be unfortunate if he needed a crisis to get the attention of domestic politicians.

Birds of a Feather

Policy coordination on the international level is one of those ends that governments profess to aspire to achieve but only realize when there is a crisis that requires a global response.  There are many reasons why this happens, or rather, does not. But in one area—monetary policy—central bankers have in the past acted in concert, and their activities provide lessons for the conditions needed to bring about coordination in other policy spheres.

Jonathan D. Ostry and Atish R. Ghosh suggest several reasons for the lack of coordination.  First, policymakers may only focus on one goal at a time, and ignore intertemporal tradeoffs. Second, governments may not agree on the size of spillovers from national policies. Finally, those countries that do not participate in policy consultations do not have a chance to influence the policy decisions. Consequently, the policies that are adopted are not optimal from a global perspective.

All this was supposed to change when the G20 became the “premier forum for international economic co-operation.” The government leaders agreed to a Mutual Assessment Process, through which they would identify objectives for the global economy, the specific steps needed to attain them, and then monitor each other’s progress. How has that worked? Most observers agree: not so well. Different reasons are advanced for the lack of progress (see here and here and here), but the diversity of the members’ economic situations works against their ability to agree on what the common problems are and a joint response.

There is one area, however, where there has been evidence of communication and even coordination: monetary policy. What accounts for the difference?  The linkages of global financial institutions and markets complicate the formulation of domestic policies. Steve Kamin has examined the literature on financial globalization and monetary policy, and summarized the main findings. First, the short-term rates that policymakers use as targets are influenced by foreign conditions. Second, the long-term rates that affect spending are also affected by foreign factors. The “savings glut” of the last decade, for example, has been blamed for bringing down U.S. interest rates and fuelling the housing bubble. Third, the financial crises that monetary policymakers face have foreign dimensions. Capital flows exacerbate volatility in financial markets, and disrupt the operations of banks (see here). Therefore, central bankers can not ignore the foreign dimensions of their policies.

The actions of monetary policymakers during the global crisis are instructive. In October 2008, the Federal Reserve, the European Central Bank, and several other central banks simultaneously announced that they were reducing their primary lending rates. The Federal Reserve established swap lines with fourteen other central banks, including those of Brazil, Mexico, Singapore, and South Korea.  The central banks used the dollars they borrowed from the Federal Reserve to lend to their own banks that needed to finance their dollar-denominated acquisitions. The Federal Reserve also lent to foreign owned financial institutions operating in the U.S.

While the extent of their cooperation in 2008-09 was unprecedented, it was not the first time that the heads of central banks operated in concert. There are several features of monetary policy that allow such collaboration. First, monetary policy is often delegated by governments to central bankers, who may have some degree of political independence and longer terms of office than most domestic politicians. This gives the central bankers more confidence when they deal with their counterparts at other central banks. Second, central banking has been viewed as a more technical policy area than fiscal policy and requires professional expertise. In addition, the benign economic conditions associated with the “Great Moderation” gave central bankers credibility with the public that manifested itself in the apotheosis of Alan Greenspan. Third, central bankers meet periodically at the Bank for International Settlements, and have a sense of how their counterparts view their economies and how they might respond to a shock. A prestigious group of economists have proposed that a group of central bankers of systemically significant banks meets under the auspices of the Committee on the Global Financial System of the BIS to discuss the implications of their policies for global financial stability.

All this can change, and already has to some extent. Monetary policy has become politicized in the U.S. and the Eurozone, and even Alan Greenspan’s halo has been tarnished. Policymakers from emerging markets were caught off-guard by the rise in U.S. interest rates last spring and argued for more monetary policy coordination.

Are there lessons for international coordination on other fronts? The conditions for formulating fiscal policy are very different. Fiscal policies are enacted by legislatures and executives, who are subject to domestic public opinion in democracies.  There is little consensus in the public arena on whether fiscal policy is effective, which can lead to stalemates. Finally, there is no common meeting place for fiscal policymakers except at the G20 summits, where there is less discussion and more posturing in front of the press.

The G20 governments enacted fiscal stimulus policies at the time of the crisis. Since then, the U.S. has been unable to fashion a coherent policy plan, much less coordinate one with foreign governments. The Europeans are mired in their debt crisis, and the G20 meetings have stalled. It is difficult to see how these countries could act together even in the event of another global crisis. Like St. Augustine’s wish for chastity, governments may want to coordinate their policies—but not quite yet.