Monthly Archives: August 2015

Global Volatility, Domestic Markets

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Unlike the global financial crisis of 2008-09, the current disruption in the financial markets of emerging market nations was anticipated. The “taper tantrum” of 2013 revealed the precarious position of many of these nations, particularly those dependent on commodity exports. The combination of a slowdown in Chinese growth, collapsing stock prices and a change in the Chinese central bank’s exchange rate policy indicated that the world’s second-largest economy has its own set of problems. But global volatility itself can roil financial markets, and good fundamentals may be of little help for a government trying to shelter its economy from the instability in world markets.

The importance of global (or “push”) factors for capital flows to emerging markets was studied by Eugenio Cerutti, Stijn Claessens and Damien Puy of the IMF. They looked at capital flows to 34 emerging markets during the period of 2001-2013, and found that global factors such as the VIX, a measure of anticipated volatility in the U.S. stock market, accounted for much of the variation in flows. Not all forms of capital were equally affected: bank-related and portfolio flows (bonds and equity) were strongly influenced by the global factors, but foreign direct investment was not.

Cerutti, Claessens and Puy also investigated whether the emerging markets could insulate themselves from the global environment with good domestic macro fundamentals. They reported that the sensitivity of emerging markets to the external factors depended in large part upon the identity of a country’s investors. The presence of global investors, such as international mutual funds in the case of portfolio flows and global banks in the case of bank finance, drove up the response to the global environment. The authors concluded: “…there is no robust evidence that “good” macroeconomic (e.g., public debt, growth) or institutional fundamentals (e.g., Investment Climate and Rule of Law) have a role in explaining EM different sensitivities to global push factors.”

A similar finding was reported in a study of corporate bond markets in emerging markets, which have grown considerably since the 2007-09 crisis. Diana Ayala, Milan Nedeljkovic and Christian Saborowski, also of the IMF, studied the share of bond finance in total corporate debt in 47 emerging market economies over the period of 2000-13. Domestic factors contributed to the development of bond markets. But the growth in these markets in the post-crisis period was driven by global factors, such as the spread in U.S. high yield bonds, a proxy for global risk aversion, and U.S. broker-dealer leverage. The authors conjecture that the growth in bond finance in the emerging markets was due to a search for higher yields than those available in advanced economies during this period. If this interpretation is correct, then these countries will see capital outflows once interest rates in the U.S. and elsewhere rise.

A third paper from the IMF, written by Christian Ebeke and Annette Kyobe, looked at the markets for emerging market sovereign bonds. Their results are based on data from 17 emerging markets over the 2004-13 period. They found that foreign participation in the market for domestic-currency denominated sovereign bonds increased the impact of U.S. interest rates on the yield of these bonds once a threshold of 30 percent had been reached. Similarly, an increase in the concentration of the investor base made the bond yields more sensitive to global financial shocks.

Are domestic “pull” factors always irrelevant for capital flows? Ahmed Shaghil, Brahima Coulibaly and Andrei Zlate of the Federal Reserve Board constructed a “vulnerability index” of macroeconomic fundamentals for a sample of 20 emerging market economies during 13 periods of financial stress, beginning with the Mexican crisis of 1994 and ending with the 2013 taper tantrum. They looked at the impact of their index upon a measure of depreciation pressure, based on changes in exchange rates and losses in foreign exchange reserves. They found that there was evidence of a linkage between the macro fundamentals and depreciation pressure during the global financial crisis and then again during the European sovereign debt crisis and the taper tantrum, but not before.

Why would the response of emerging market economies to domestic fundamentals become stronger during the most recent crises? Shaghil, Coulibaly and Zlate offer two reasons: first, it may be that foreign investors investors did not distinguish among the emerging market economies until the 2000s. But as the governments of these countries implemented different policy frameworks and the costs of gathering information about them fell due to technology, it became worthwhile to distinguish amongst them based on their individual characteristics. An alternative reason for the change over time could lie in a shift in the origin of the crises away from the emerging markets themselves. Therefore, investors have become more careful in examining the vulnerabilities of individual countries.

The analysis of the relative importance of domestic “pull” vs. global “push” factors should not be posed as a “one or the other” contest (see here). There is ample evidence to indicate that global factors have become increasingly important in driving capital flows across borders. If so, then the news that the VIX hit record levels last week is disturbing. Stock markets in the U.S. and other advanced economies have rebounded, but the emerging market nations face a period of sustained retrenchment as investors reallocate their funds in response to the surge in global volatility.

Greece’s Missing Drivers of Growth

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Analyses and discussions of Greece’s economic situation usually begin—and often end—with its fiscal policy. The policies mandated by the “troika” of the European Commission, the European Central Bank and the International Monetary Fund have undoubtedly resulted in a severe contraction that will continue for at least this year. But little has been said about the private sectors of the economy, and why they have not offset at least part of the fiscal “austerity.” Consumption spending is linked to income, so there is no relief there. But what about the other sources of spending, investment and net exports?

Investment expenditures provide no counterweight, as they have plunged in the years since the global financial crisis. The same phenomenon took place in other countries in the southern periphery of the European Union, but the change in Greece’s investment/GDP ratio between its pre-crisis 2007 level and that of 2014 was an extraordinary decline of 16 percentage points at a time when GDP itself was falling:

Investment/GDP 2007 2014
Cyprus 24% 12%
Greece 27% 11%
Ireland 28% 17%
Italy 22% 17%
Portugal 23% 15%
Spain 31% 19%

Source: IMF, World Economic Outlook

In view of the scale of the crisis, it is not surprising that investment fell as much as it did in these countries. The parlous state of the banks only reinforced the decline. The particularly severe decrease in Greece reflects the political uncertainty there as well as the calamitous economic conditions.

Net exports of goods and services have continued to record a deficit in Greece while the other periphery countries by 2013 showed small (or in the case of Ireland large) surpluses:

Balance on goodsand services/GDP 2007 2013
Cyprus -5% 2%
Greece -12% -3%
Ireland 9% 21%
Italy 0% 2%
Portugal -8% 1%
Spain -6% 3%

Source: World Bank, World Development Indicators

Although Greece’s balance continued to show a deficit, the turnaround between 2007 and 2013 of 9 percentage points of GDP was only exceeded by the increase in Ireland’s trade balance by 12 percentage points. But this change was due largely to the decline in imports that accompanied the contraction of the economy rather than a growth in exports, as happened in Ireland and Portugal. The lack of Greek export growth has been surprising in view of the decline in unit labor costs. These had soared in the period leading up to the crisis, as had those in the other periphery countries. Since these countries could not devalue their exchange rates, labor costs had to come down to make their exports competitive. But despite the declines in wages, there has been no corresponding expansion in Greek exports.

Explaining the lack of responsiveness of Greek exports to the decline in wages has been the subject of several analyses. A study on macroeconomic adjustment programs in the Eurozone undertaken for the Economic and Monetary Affairs Committee of the European Parliament by a team of authors that included Daniel Gros, Cinzia Alcidi and Alessandro Giovannini of the Centre for European Policy Studies, Ansgar Belke of the University of Duisberg-Essen, and Leonor Coutinho of the Europrism Research Centre claimed: “Greek exports price competitiveness has not improved nearly as much as its cost (and wage) competitiveness…” The report’s authors attribute the rigidity in prices to “structural deficiencies.”

A similar analysis was offered by Uwe Böwer, Vasiliki Michou and Christph Ungerer of the European Commission’s Directorate-General for Economic and Financial Affairs (see also here). They use a gravity model to predict export flows in 56 countries, and compare the predictions of the model with actual exports. Greek exports were 32.6% lower than those predicted by the model, which they label the “puzzle of the missing Greek trade.” They then add measures of institutional quality to their model, and find that these are quite significant. Since Greece’s institutional quality is seen as relatively poor, the authors claim this deficiency contributes to the lack of exports.

In view of all the institutional measures that have already been introduced into the Greek economy, it may seem surprising that more structural reform is seen as necessary. Alessio Terzi of Bruegel has argued that the initial reforms in Greece were slanted towards reform of the public sector rather than the private sector. Some of this shortfall was rectified in the 2012 program, but implementation was slowed by the political climate and economic collapse. A lack of coordination with changes in labor market practices has resulted in a decline in wages that has not been matched by corresponding adjustments in prices. Terzo claims that responsibility for these flaws in program design is a responsibility of the troika as well as of the Greek government.

Designing the optimal composition and pace of structural reforms is always difficult. Antionio Fatás of INSEAD writes about the record of reform in Europe since the 1970s (see also here). He shows that there has been a convergence of policies and institutions over time. He takes particular note of Greece and Portugal’s progress vis-à-vis the record of other OECD countries in business-related reforms, although he also notes that small differences are associated with noticeable differences in productivity and output. Christian Thimann of the Paris School of Economics and AXA Group believes that there is substantial scope for further change.

Can reforms be implemented when fiscal policy is contractionary? Tamim Bayoumi of the IMF admits that the short-run impact of regulatory changes is likely to be disruptive, which only reinforces the impact of the fiscal policy. Under these circumstances, the IMF can play a critical role in providing external financing while reforms are being implemented. But, he writes, “…structural policies need a strong leader and broad agreement across a wide swath of opinion makers about the need to re invigorate the economy.”

Such an agreement is difficult to achieve in the wake of a crisis. Atif Mian of Princeton, Amir Sufi of the Booth School of Business at the University of Chicago and Francesco Trebbi of the Vancouver School of Economics have shown that countries become more polarized after a financial crisis as voters become more ideologically extreme and ruling coalitions become weaker. This makes consensus much harder to achieve.

The latest bailout provides an opportunity to change the structure of Greece’s private sector. Consumer markets are to be liberalized, labor practices to be reviewed and an upgrade of its infrastructure to be taken. Can Prime Minister Alexis Tsipras maintain the popular support needed to implement the reforms? And can these lead to a turnaround in the Greek economy? The private sector must become viable if the country’s continuing economic degradation is to end. It would be ironic if such a turnaround occurred during the administration of a political leader who campaigned on a platform of defying the troika and its programs, including structural reform measures. But “a foolish consistency is the hobglobin of little minds, adored by little statesmen and philosophers and divines…”