Monthly Archives: October 2014

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 The Institute for International Finance estimates that $9 billion was withdrawn from equity markets in those countries in October, while the issuance of new bonds fell.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.

Martin Wolf’s Warning

It is time for the 2014 Globie—a (somewhat fictitious) prize I award once a year to a book that deserves recognition for its treatment of the consequences of globalization. (Previous winners can be found here.) The financial turmoil of the last week makes this year’s award-winner particularly appropriate: Martin Wolf for The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis. Wolf, a distinguished writer for the Financial Times, once viewed globalization as a positive force that enhanced welfare. But the events of the last few years have changed his views of financial markets and institutions. He now views financial flows as inherently susceptible to the occurrence of crises. And Wolf’s intellectual evolution leaves him deeply concerned about the consequences of financial globalization.

Part I of the book deals with the “shocks” to the global economy. Wolf begins in the U.S. with the crisis of 2008-09 and the relatively weak recovery. He shares the view of Richard Koo of Nomura Research that this was a “balance sheet recession,” with the private sector seeking to shed the debt it had built up during the pre-crisis period. The cutback in private sector spending was initially matched by an increase in the government’s fiscal deficit, which arose as expenditures on unemployment benefits and other programs grew and revenues fell. The rise in the fiscal deficit was particularly appropriate as the “liquidity trap” limited the downward fall of interest rates and the expansionary effects of monetary policy. However, the political acceptance of deficits and debts ended prematurely in 2010, and the recovery has not been as robust as it needs to be.

Wolf then turns to the Eurozone, which experienced its shift towards fiscal austerity after the crisis in Greece erupted. Wolf views the monetary union as “incomplete and imperfect.” On the one hand, its members have sovereign powers that include issuing debt; on the other hand, they do not have the risk-sharing mechanisms that a federal union possesses. When the capital flows that had fed housing bubbles in Spain and Ireland and financed fiscal deficits in Greece and Portugal ended, the borrowing countries were encumbered with  the debt they had accumulated either directly through fiscal borrowing or indirectly as they bailed out their domestic banks. Those increases in public  debt were seen by Germany and others as proof that the crises were due to fiscal excess, which had to be met by fiscal austerity. But Wolf claims that the German view “…was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis.”

After surveying the relartvely more benign experience of the emerging and developing countries during the crisis, Wolf turns to the “shifts” that led to the breakdown of the financial system. These include the liberalization of market forces, particularly finance; technological change, which speeded up the integration of markets and financial markets; and ageing, which transformed the savings-investment balance in high-income countries. These led to an increase in financial fragility that made financial markets unstable and crises endemic. The changes took place in a global economy where global savings where channeled from oil-exporters and Asian economies, particularly China, to the U.S., thus reinforcing the credit boom.

The last section of the book deals with solutions to the crises. Wolf is ready to consider “radical reform,” which includes higher capital ratios for the banks and macroprudential policies that seek to achieve both asset market and macroeconomic stability. Policies to rebalance the global economy include encouraging less risky forms of finance, increasing insurance against external shocks, and moving towards a global reserve asset. The steps needed to assure the continued existence of the euro start with a mechanism to assure symmetrical adjustment across the Eurozone, debt restructuring, and a banking union.

None of these measures will be easy to implement. But Wolf’s willingness to discuss them is a sign of how much the crisis has unsettled those who thought they understood the risks of financial globalization. Wolf attributes the responsibility for the crisis to “Western elites,” who misunderstood the consequences of financial liberalization, allowed democracy to be weakened, and in the case of the Eurozone, imposed a system without accountability. The loss in public confidence, he writes, reduces trust in domestic legitimacy.

The title of the last chapter, “Fire Next Time,” is taken from James Baldwin’s book of the same name, which in turn borrowed from an African-American spiritual: “God gave Noah the rainbow sign, no more water but fire next time.” Wolf warns that the next global economic crisis “could end in the fire.” While he  does not explicitly explain what this fire will be, he mentions in the preface that his father was a Jewish refugee from Austria in the 1930s, and the historical reference is clear. At a time when right-wing parties are ascendant in Europe, Wolf’s warning is a sober reminder that unsettled economic circumstances can lead to political extremism and instability.

International Debt and Financial Crises

The latest issue of the IMF’s World Economic Outlook has a chapter on global imbalances that discusses the evolution of net foreign assets (also known as the net international investment position) in debtor and creditor nations. The authors warn that increases in the foreign holdings of domestic liabilities can raise the probability of different types of financial crises, including banking, currency, sovereign debt and sudden stops. A closer inspection of the evidence that has been presented elsewhere suggests that it is foreign-held debt that poses a risk.

The role of international debt in increasing the risk of crises was pointed out by Rodrik and Velasco (working paper 1999), who showed that short-term bank debt contributed to the occurrence of capital flow crises in the period of 1988-98. More recently, Joyce (2011) (working paper here) looked at systemic bank crises in a sample of emerging markets, and found that an increase in foreign debt liabilities contributed to an increase in the incidence of these crises, while FDI and portfolio equity liabilities had the opposite effect. Ahrend and Goujard (2014) (working paper here) confirmed that increases in debt liabilities increase the occurrence of systemic banking crises. Catão and Milesi-Ferretti (2014) (working paper here) found that an increase in net foreign assets lowered the probability of external crises. Moreover, they also reported that this effect was due to net debt. FDI had the opposite effect, i.e., an increase in FDI liabilities lowered the risk of a crisis. Al-Saffar, Ridinger and Whitaker (2013) have looked at external balance sheet positions during the global financial crisis and reported that gross external debt contributed to declines in GDP.

There are also studies that compare the effect of equity and debt flows. Levchenko and Mauro (2007), for example, investigated the behavior of several types of flows, and found that FDI was stable during periods of “sudden stops,” while portfolio equity played a limited role in propagating the crisis. Portfolio debt, on the other hand, and bank flows were more likely to be reversed. Similarly, Furceri, Guichard and Rusticelli (2012) (working paper here) found that large capital inflows driven by debt increase the probability of banking, currency and balance-of-payment crises, while inflows that are driven by FDI or portfolio equity have a negligible effect.

Why are debt liabilities more risky for countries than equity? Debt is contractual: the holder of the debt expects to be paid regardless of economic conditions. Equity holders, on the other hand, know that their payout is tied to the profitability of the firm that issues the debt. Moreover, during a crisis there are valuation effects on external balance sheets. The value of equity falls, which raises the net foreign asset position of those countries that are net issuers of equity, while lowering it for those that hold equity. In addition, debt may be denominated in a foreign currency to attract foreign investors worried about depreciation. A currency depreciation during a crisis raises the value of the debt on the balance sheet of the issuing country.

These results have consequences for the use of capital controls and the sequence of decontrol. Emerging markets should be careful when issuing debt. However, the evidence to date of trends in the international capital markets shows a rise in the use of debt by these countries. Emerging market governments, for example, issued $69 billion in bonds in the first quarter. In addition, the BIS has drawn attention to the issuance of debt securities by corporations in emerging markets.

The IMF has warned of a slowdown in the emerging market countries, with the Fund’s economists forecasting GDP growth rates below the pre-crisis rates.  Speculation about the impact of changes in the Federal Reserve’s quantitative easing policies has contributed to concerns about these countries. If a slowdown does materialize, the debt that was issued by these countries may become a burden that requires outside intervention.