Monthly Archives: July 2017

Trilemmas and Financial Instability

Whether or not the international monetary trilemma (the choice facing policymakers among monetary autonomy, capital mobility and a fixed exchange rate) allows policymakers the scope for policy autonomy has been the subject of a number of recent analyses (see here for a summary). Hélène Rey of the London Business School has claimed that the global financial cycle constrains the ability of policymakers to affect domestic conditions regardless of the exchange rate regime. Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University, on the other hand, have found that exchange rate flexibility does provide a degree of monetary autonomy. But is monetary policy sufficient to avoid financial instability if accompanied by unregulated capital flows ?

A recent paper by Maurice Obstfeld, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF’s Research Department examines the impact of the trilemma in 40 emerging market countries over the period of 1986-2013. They report that the choice of exchange rate regime does affect the sensitivity of domestic financial variables, such as domestic credit, house prices and bank leverage, to global conditions. Economies with fixed exchange rate regimes are more impacted by changes in global market volatility than those with flexible exchange rate regimes. They also find that capital inflows are sensitive to the choice of exchange rate regime.

However, the insulation properties of flexible exchange rates are not sufficient to protect a country from financial instability. Maurice Obstfeld of the IMF and Alan M. Taylor of UC-Davis in a new paper point out that while floating rates and capital mobility allow policy makers to focus on domestic objectives, “…monetary policy alone may be a relatively ineffective tool for addressing potential financial stability problems….exposure to global financial shocks and cycles, perhaps the result of monetary or other developments in industrial-country financial markets, may overwhelm countries even when their exchange rates are flexible.”

Global capital flows can adversely affect a country through multiple channels. The Asian financial crisis of 1998 demonstrated the impact of sudden stops, when inflows of foreign capital turn to outflows. The withdrawal forces adjustments in the current account and disrupts domestic financial markets, and can trigger a devaluation of the exchange rate. The fall in the value of the currency worsens a country’s situation when there are liabilities denominated in foreign currencies, and this balance sheet effect can overwhelm the expansionary impact of the devaluation on the trade balance.

The global financial crisis of 2008-09 showed that gross inflows and outflows as well as net flows can lead to increased financial risk. Before the crisis there was a tremendous buildup of external assets and liabilities in the advanced economies. Once the crisis began, the volatility in their financial markets was reinforced as residents liquidated their foreign assets in response to their need for liquidity (see Obstfeld here or here).

International financial integration can also raise financial fragility before a crisis emerges. Capital flows can be highly procyclical, fluctuating in response to business cycles (see here and here). Many studies have shown that the inflows result in increases in domestic credit that foster more economic activity (see here for a summary of recent papers). Moritz Schularick of the Free University of Berlin and Alan Taylor of UC-Davis (2012)  have demonstrated that these credit booms can result in financial crises.

What can governments do to forestall international financial instability?  Dirk Schoenmaker of VU University Amsterdam and the Duisenberg School of Finance has offered another trilemma, the financial trilemma, that addresses this question (see also here). In this framework, a government can choose two of the following three financial objectives: national financial regulatory policies, international banking with international regulation, and/or financial stability. For example, financial stability can occur when national financial systems are isolated, such as occurred under the Bretton Woods system. Governments imposed barriers on capital integration and effectively controlled their financial systems, and Obstfeld and Taylor point out that the Bretton Woods era was relatively free of financial crises. But once countries began to remove capital controls and deregulated their financial sectors in the post-Bretton Woods era, financial crises reappeared.

International financial integration combined with regulatory cooperation could lessen the consequences of regulation-shopping by global financial institutions seeking the lowest burden. But while the Financial Stability Board and other forums may help regulators monitor cross-border financial activities and design crisis resolution schemes, such coordination may be necessary but not sufficient to avoid volatility. Macroprudential policies to minimize systemic risk in the financial markets are a relatively new phenomenon, and largely planned and implemented on the national level. The global implications are still to be worked out, as Stephen G. Cecchetti of the Brandeis International Business School and Paul M. W. Tucker of the Systemic Risk Council and a Fellow at Harvard’s Kennedy School of Government have shown. A truly stable global system requires a degree of financial regulation and coordination that current national governments are not willing to accept.

The IMF’s Flexible Credit Line

The policy conditions attached to the disbursement of an IMF loan have long been the subject of controversy. In the wake of the global financial crisis, the IMF introduced a new lending program—the Flexible Credit Line—that allowed its members to apply for a loan before a crisis took place. If approved, the member can elect to draw upon the arrangement in the event of a crisis without conditionality, and there is no cap to the amount of credit. However, only three countries—Colombia, Mexico and Poland—have signed up for the FCL, and the lack of response to an IMF program without conditions has been a bit of a mystery. A new paper, “The IMF and Precautionary Lending: An Empirical Evaluation of the Selectivity and Effectiveness of the Flexible Credit Line“ by Dennis Essers and Stefaan Ide of the National Bank of Belgium, provides evidence that helps to explain the muted response.

Essers and Ide deal with two aspects of the FCL: first, the factors that explain the decision to participate in the program, and second, the effectiveness of the program in boosting market confidence in its users. This paper is very well-done, both from the perspective of dealing with an important issue as well using appropriate econometric tools for the analysis, and it received a prize for best paper at the INFINITI conference in Valencia. The authors point out that the views expressed in the paper are theirs, and do not necessarily reflect the views of the National Bank of Belgium or any other institution to which they are affiliated.

The results in the first half of the paper can explain why so few countries have adopted the FCL. On the “demand side,” Colombia, Mexico, and Poland applied for the FCL because they were vulnerable to currency volatility as manifested by exchange market pressure. On the “supply side,” the IMF was willing to accept them into the program because 1—the economies were not showing signs of financial or economic instability, as manifested by lower bond interest rate spreads and inflation rates, and 2—they met the “political” criteria of high shares in U.S. exports and acceptable United Nations voting patterns.

If this line of reasoning is correct, then the adoption of the FCL will always be limited. The authors point out that the “…the influence of the first two variables (EMBI spread, inflation) is in line with supply-side arguments…” The qualifying criteria on the IMF web page that explains the program include:

  • “A track record of steady sovereign access to international capital markets at favorable terms”
  • “Low and stable inflation, in the context of a sound monetary and exchange rate policy framework”

However, lower bond spreads and inflation (and macroeconomic stability) can also be viewed as factors that lower the demand for IMF programs, as would most of the other criteria, i.e., a “sustainable external position,” “a capital position dominated by private flows,” “a reserve position which…remains relatively comfortable,” “a sustainable public debt position,” and “the absence of solvency problems.” My first paper on the economic characteristics of IMF program countries found that countries that entered IMF programs in the early 1980s had higher rates of domestic credit growth, larger shares of government expenditure, more severe current account deficits, and smaller reserve holdings. Therefore, the applicants for the FCL have been countries that do not have the features of those that apply for the standard IMF program, the Stand-By Arrangement, and yet decided to apply for the FCL because of some form of exchange market pressure.

Such a confluence of factors may be relatively rare. If the country is experiencing exchange market pressure, ordinarily we would expect to see increased bond spreads. Moreover, exchange market pressure could be a reaction to domestic macroeconomic instability, which could be linked to rising inflation rates. The three countries were experiencing some combination of exchange rate depreciation and/or a drain on their international reserves, but their bond rate spreads were not rising and domestic inflation was not a concern. In addition, the governments also met the IMF’s (hidden) political criteria.

If such a combination is unusual, then to enhance participation in the FCL, the IMF would have to be willing to relax its official criteria for selection. It would also need to deal with countries that have not always accommodated U.S. foreign policy. This may require some “bargaining” among the major shareholder countries at a time when international agreements and organizations are being looked on with suspicion. The time to promote the program, however, is now, while international financial markets are relatively calm. Unfortunately, there is always a tendency to project current conditions into the future, and to delay adopting precautionary measures. When circumstances force governments to turn to the Fund, they will not qualify for the no-conditions FCL, but for programs with much more stringent criteria.