Monthly Archives: February 2014

Group Therapy

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Pop quiz:  which U.S. policymaker said last week: “We can’t solve everyone else’s problems anymore” in response to foreign criticism of U.S. handling of what issue?

a—Federal Reserve Chair Janet Yellen, responding to criticism by foreign central bankers of the Fed’s tapering of its asset purchases;

b—Treasury Secretary Jack Lew, following denunciations of the refusal of the U.S. Congress to pass legislation that would enable IMF quota reform;

c—an anonymous White House aide, defending the Obama  administration’s  response to the turmoil in the Ukraine.

The correct response is c. But Ms. Yellen and Mr. Lew, who are attending the conference of G20 finance ministers and central bank heads in Sydney, might be forgiven if they held similar (but unspoken) sentiments.

The Federal Reserve has been criticized for not coordinating its policies with its peer institutions, particularly in those emerging markets that have had capital outflows and declines in equity market prices. But the critics have not spelled out precisely what they believe the Federal Reserve should do (or not do), given its assessment of the state of the U.S. economy. Domestic central banks respond to domestic conditions. In some cases, those conditions are linked to the global economy, and a central banker who ignored those linkages would only be postponing the implementation of stronger measures. But is that the case here?

The IMF came the closest to offering a specific criticism:

Advanced economies should avoid premature withdrawal of monetary accommodation as fiscal balances continue consolidating. Given still large output gaps, very low inflation, and ongoing fiscal consolidation, monetary policy should remain accommodative in advanced economies. There is scope for better cooperation on unwinding UMP, including through wider central bank discussions of exit plans.

Does anyone think that the Federal Reserve no longer intends to “remain accommodative”? Are more discussions the only missing element of the Federal Reserve’s plans? That would be surprising, since central bankers have many opportunities to speak to each other, and usually do.

The IMF did not let the emerging market countries off the hook:

In emerging market economies, credible macroeconomic policies and frameworks, alongside exchange rate flexibility, are critical to weather turbulence. Further monetary policy tightening in the context of strengthened policy frameworks is necessary where inflation is still relatively high or where policy credibility has come into question. Priority should also be given to shoring up fiscal policy credibility where it is lacking; subsequently buffers should be built to provide space for counter-cyclical policy action. Exchange rate flexibility should continue to facilitate external adjustment, particularly where currencies are overvalued, while FX intervention— where reserves are adequate—can be used to smooth excessive volatility or prevent financial disruption.

Critics are on firmer grounds when they criticize the U.S. for not passing the necessary legislation to change the IMF’s quota allocations. But perhaps they should not take their annoyance out on Mr. Lew. The U.S. Congress did not approve the needed measures for a number of reasons, none of them particularly compelling. Mr. Lew would be delighted to see the situation change, but that is unlikely to happen.

What, then, can be done at the G20 meeting? If allowing everyone to voice her or his frustrations with the U.S. serves some useful purpose, then all the air miles on the flights to Sydney will have been earned. Perhaps IMF Managing Director Christine Lagarde can serve as mediator/therapist. But before everyone piles on, it may be worth reflecting that the Federal Reserve is not the only central bank with policy initiatives that may ripple across national borders.

Been There, Done That

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President Barack Obama has nominated Stanley Fischer to the Board of Governors of the Federal Reserve Board, where he will succeed Janet Yellen as Vice-Chair of the Board. Fischer’s accomplishments are well-known. But he also brings an interesting set of credentials to the Board at a time when it has been criticized for ignoring the impact of its policies on other countries.

Fischer received his doctoral degree from MIT, and returned there after a stint on the faculty at the University of Chicago. During the 1970s and 1980s he taught or advised such future luminaries as Ben Bernanke, Greg Mankiw and Mario Draghi. He served as Vice President and Chief Economist of the World Bank from 1988 to 1990. He was the First Deputy Managing Director of the IMF from 1994 through 2001, a period when financial crises recurred on a regular basis in the emerging market countries.

Fischer’s experience with those crises gives him a perspective that macroeconomists who work only on the U.S. economy do not possess. Paul Krugman has written about how the financial instability of the post-Bretton Woods era has affected the views of those who follow these events. In 2009, for example, when our profession was castigated for not foreseeing the global financial crisis, Krugman wrote: “

…the common claim that economists ignored the financial side and the risks of crisis seems not quite fair – at least from where I sit. In international macro, one of my two home fields, we’ve worried about and tried to analyze crises a lot. Especially after the Asian crisis of 1997-98, financial crises were very much on everyone’s mind.

Similarly, in 2011 Krugman wrote:

Indeed, my sense is that international macroeconomists – people who followed the ERM crises of the early 1990s, the Latin American debt crisis, the Asian crisis of the late 90s, and so on – were caught much less flat-footed.

The IMF, of course, was widely criticized at the time for its crisis-management policies and its advocacy of deregulating capital flows.  In retrospect, Fischer’s arguments in favor of capital account liberalization appear overly zealous, and he has drawn criticisms for those positions. The IMF has recently adopted a more nuanced position on the use of capital controls as a macro prudential tool.

And yet—in 2000, after the resignation of the IMF’s Managing Director Michel Camdessus, Fischer, who was born in Rhodesia (now Zambia), was nominated to be Camdessus’ replacement by a group of African nations. (Miles Kahler presents the story in his Leadership Selection in the Major Multilaterals.) This was a challenge to the European governments that had always claimed the prerogative of naming the Managing Directors of the IMF since it commenced operations in 1945. But the nomination was also an indication of the respect that Fischer enjoyed amongst the African and other developing countries. In the end, it was impossible to change the IMF’s traditional governing procedures, and Horst Köhler of Germany became the new Managing Director.

After Fischer left the IMF, he went to work at Citigroup. In 2005 he was appointed Governor of the Bank of Israel, and served there until last year. Under his leadership the Bank received praise for its policies. Fischer was widely admired and received an “A” for his stewardship from the magazine Global Finance. Those pouring through his recent speeches and writings for indications of what he might do as a Federal Reserve Governor believe that he endorses the Fed’s accommodative stance, but may have a nuanced approach on the benefits and costs of forward guidance.

Stanley Fischer, therefore, brings several attributes to the Federal Reserve. First, he has an unquestioned command of macroeconomics, and in particular, monetary policy. Second, he has a wealth of experience in dealing with financial calamities. And third, he earned the trust and respect of policymakers in developing nations while he served at the IMF. Those qualities will be much appreciated as foreign officials and financial markets deal with the Federal Reserve’s policy pivot.

Affairs, Domestic and Foreign

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Raghuram Rajan, ex- faculty member of the Booth School of Business at the University of Chicago, ex-head of the research department of the IMF, and currently Governor of the Reserve Bank of India (its central bank), set off a storm of comment when he warned of a breakdown in the global coordination of monetary policy. Frustrated by the decline in the foreign exchange value of the rupee that followed the cutback in asset purchases by the Federal Reserve, Rajan claimed that the Federal Reserve was ignoring the impact of its policies on the rest of the world.  Does he have a valid cause for concern?

Quite a few folks have weighed in on this matter: see here, here, here, here, here and here. Rodrik and Subramanian make several interesting points. First, the Federal Reserve was criticized when it lowered rates, so complaints that it is now raising them are a bit hypocritical (but see here). Second, blaming the Fed for not being a team player as the emerging markets were when they lowered their rates in 2008-09 is not a valid comparison. The emerging markets lowered their rates then because it was in their interest to do so, not out of any sense of international solidarity. Third, their governments allowed short-term capital inflows to enter their economies; did they not realize that the day could come when these flows would reverse? Finally, their policymakers allowed the inflows to contribute to credit bubbles that resulted in inflation and current account deficits, which are significant drivers of the volatility.

Moreover, the Federal Reserve is constrained by law to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S., not the global community But couldn’t turmoil in the emerging markets threaten U.S. conditions? Robin Harding at the Financial Times thinks this is an unlikely scenario. He points to two channels of transmission between the U.S. and the countries that have shown the most turbulence: exports and financial markets. The emerging market nations that have witnessed the most volatility account for very small proportions of U.S. exports. (China, on the other hand, does claim 7.5% of our exports, but so far has not suffered any signs of distress (but see here).) In addition, financial flows might be affected, but to date these have resulted in lower interest rates in the U.S. due to a flight to safety. Previous shocks from the emerging markets pushed U.S. stock prices down, but these effects were short-lived. Therefore, Harding claims, “…it would have to become much more of a crisis…” to endanger the U.S. economy.

The problem with this assessment is that it assumes that we know the extent of our financial vulnerability to a decline in the fortunes of these economies. But one lesson of the 2007-09 global financial crisis is that there may be much we do not know about our financial structure. U.S.-based institutions can be vulnerable to shocks in ways that we do not recognize. Subprime mortgages were not themselves that significant a share of the liabilities of U.S. banks and shadow banks, but they were the foundation of a range of derivatives, etc., that took down the financial markets when these mortgages became toxic.

The threat of more declines in foreign asset prices does not mean that the Federal Reserve should retreat from its current policies. A situation with some interesting similarities took place in the early 1980s. U.S. banks, awash with recycled oil revenues, had lent extensively to countries in Latin America and elsewhere in the 1970s.  A debt crisis ensued after Paul Volcker and the Federal Reserve raised interest rates (see Chapter 4). Volcker recently reflected on these events in an interview with Martin Feldstein in the fall 2013 issue of the Journal of Economic Perspectives:

“What were you going to do? Were you going to conduct an easy-money policy and go back on all the policy you’d undertaken to try to save Mexico, which wouldn’t have saved Mexico anyway? We did save Mexico, but by other means.”

U.S. policymakers have always claimed (with some justification) that a healthy U.S. economy is the best remedy for a troubled world economy, and monetary officials will no doubt proceed as they think best. But we should take a look around before we proceed. The February ice underneath our feet may be a bit thinner than we realize.

Assigned Readings: February 8, 2014

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Based on a dataset of 112 emerging economies and developing countries, this paper addresses two key questions regarding the accumulation of international reserves: first, has the accumulation of reserves effectively protected countries during the 2008-09 financial crisis? And second, what explains the pattern of reserve accumulation observed during and after the crisis? More specifically, the paper investigates the relation between international reserves and the existence of capital controls. We find that the level of reserves matters: countries with high reserves relative to short-term debt suffered less from the crisis, particularly if associated with a less open capital account. In the immediate aftermath of the crisis, countries that depleted foreign reserves during the crisis quickly rebuilt their stocks. This rapid rebuilding has, however, been followed by a deceleration in the pace of accumulation. The timing of this deceleration roughly coincides with the point when reserves reached their pre-crisis level and may be related to the fact that short-term debt accumulation has also decelerated in most countries over this period.

We explore the role of financial openness – capital account openness and gross capital inflows – and a newly constructed gravity‐based contagion index to assess the importance of these factors in the run‐up to currency crises. Using a quarterly data set of 46 advanced and emerging market economies (EMEs) during the period 1975Q1‐2011Q4, we estimate a multi‐variable probit model including in the post‐Lehman period. Our key findings are as follows. First, capital account openness is a robust indicator, reducing the probability of currency crisis for advanced economies, but less so for EMEs. Second, surges in gross (but not net) capital inflows in general increase the risk of a currency crisis, but looking at a disaggregated level, gross portfolio flows increase the risk of a currency crisis for advanced economies, whereas gross FDI inflows decrease the risk of a crisis for EMEs. Third, contagion has a very strong impact, consistent with the past literature, especially during the post‐ Lehman shock episode. Last, our model performs well out‐of‐sample, confirming that early warning models were helpful in judging relative vulnerability of countries during and since the Lehman crisis.

This paper revisits the bipolar prescription for exchange rate regime choice and asks two questions: are the poles of hard pegs and pure floats still safer than the middle? And where to draw the line between safe floats and risky intermediate regimes? Our findings, based on a sample of 50 EMEs over 1980-2011, show that macroeconomic and financial vulnerabilities are significantly greater under less flexible intermediate regimes—including hard pegs—as compared to floats. While not especially susceptible to banking or currency crises, hard pegs are significantly more prone to growth collapses, suggesting that the security of the hard end of the prescription is largely illusory. Intermediate regimes as a class are the most susceptible to crises, but “managed floats”—a subclass within such regimes—behave much more like pure floats, with significantly lower risks and fewer crises. “Managed floating,” however, is a nebulous concept; a characterization of more crisis prone regimes suggests no simple dividing line between safe floats and risky intermediate regimes.

This paper examines the effectiveness of capital outflow restrictions in a sample of 37 emerging market economies during the period 1995-2010, using a panel vector autoregression approach with interaction terms. Specifically, it examines whether a tightening of outflow restrictions helps reduce net capital outflows. We find that such tightening is effective if it is supported by strong macroeconomic fundamentals or good institutions, or if existing restrictions are already fairly comprehensive. When none of these three conditions is fulfilled, a tightening of restrictions fails to reduce net outflows as it provokes a sizeable decline in gross inflows, mainly driven by foreign investors.

Desperate Times, Desperate Measures

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The selloff of emerging market currencies and equities continued last week. A Bank of America report noted that investors withdrew $6.4 billion last week from emerging market stock funds, while bond investors are also showing signs of retreating. Moreover, the declines in currency values have expanded outside the “Fragile Five” of Brazil, India, Indonesia, South Africa and Turkey to include Argentina and Russia. What can policymakers do to offset the declines?

Kristin J. Forbes and Michael W. Klein have examined the policy options available to governments that face crises due to contracting capital flows and their impact on GDP growth, inflation and unemployment. The measures include a rise in interest rates, currency depreciation, the sale of foreign exchange reserves and new controls on capital outflows. They report that currency depreciations and reserve sales will provide support for GDP growth, while increases in interest rates and or imposing capital controls do not. But the beneficial impacts of the first two sets of policies appear with a lag and may generate higher inflation. None of the measures improve unemployment.

Christian Saborowski, Sarah Sanya, Hans Weisfeld and Juan Yepez of the IMF also looked at the effectiveness of capital outflow restrictions. They report that controls on outflows can be effective in reducing net outflows only when countries have good macroeconomic fundamentals, as measured by their records of GDP growth, inflation, fiscal policy and their current account balances, or good institutions. Iceland’s use of controls in 2008 is cited as a recent example of a successful use of controls. Of course, an economy with strong macroeconomic conditions is less likely to face substantial outflows.

We can use the indicators used in the IMF study to assess macroeconomic conditions in the countries in the headlines last week. The data are from 2013:

GDP Growth Inflation Fiscal Budget/GDP Current Acct/GDP
Argentina 5.1% ? -3.3% -0.6%
Brazil 2.2% 6.2% -2.7% -3.7%
India 4.9% 10.1% -5.1% -3.1%
Indonesia 5.6% 7.0% -3.3% -3.9%
Russia 1.5% 6.8% -0.5% +2.3%
South Africa 1.9% 5.8% -4.8% -6.5%
Turkey 3.9% 7.5% -1.2% -7.5%

All the countries had rising inflation rates, with India’s hitting double digits. The current account deficits were particularly high for South Africa and Turkey, while India and South Africa had fiscal deficits of about 5%.  Russia’s growth rate was the lowest in this group.

And then there is Argentina. No one believes the inflation rate that the government reports; unofficial estimates place it at around 28%. The government has sought to restrict capital flows while also pegging the exchange rate. But foreign exchange market intervention by the central bank has not stopped an unofficial market from springing up. Last week the central bank, which saw its foreign exchange reserves shrinking precipitously, stepped back and allowed the peso to fall by more than 15%. The government also enacted a partial liberalization of the controls on the purchase of foreign exchange. But there are no signs of a response to inflation, and President Cristina Fernandez de Kirchner, who faces a term limit, has little incentive to take measures that in the short-term could further anger Argentine citizens.

Turkey’s central bank also acknowledged the strength of the forces arrayed against it when it announced a sharp rise in interest rates.  But foreign investors are concerned about corruption and political instability, and the Turkish currency has continued to slump. The Prime Minister’s opposition to the higher interest rates was not reassuring.

When will the withdrawals of money from the emerging markets end, and how will all this play out? The governments of the affected countries are using combinations of all the measures that Forbes and Klein list. But the most diligent central bank can not neutralize the impact of a weak or conflicted government. The financial volatility will continue until some sort of resolution is found to the political volatility.