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A Guide to the (Financial) Universe: Part III

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Parts I and II of this Guide appear here and here.

4.      Stability and Growth

Is the global financial system safer a decade after the last crisis? The response to the crisis by central banks, regulatory agencies and international financial institutions has increased the resiliency of the system and lowered the chances of a repetition. Banks have deleveraged and possess larger capital bases. The replacement of debt by equity financing should provide a more stable source of finance.

Indicators of financial volatility, such as the St. Louis Fed Financial Stress Index, currently show no signs of sudden shifts in market conditions. The credit-to-GDP gap, developed by the Bank of International Settlements (BIS) as an early warning indicator of systemic banking crises, exhibits little evidence of excessive credit booms. One exception is China, although its gap has come down.

But increases in U.S. interest rates combined with an appreciating dollar could change these conditions. Since the financial crisis, financial flows have appeared to be driven in part by a global financial cycle that is governed by U.S. interest rates as well as asset market volatility. This has led Hélène Rey of the London Business School to claim that the Mundell-Fleming trilemma has been replaced by a dilemma, where the only choice policymakers face is whether or not they should use capital controls to preserve monetary control. Eugenio Cerutti of the IMF, Stijn Claessens of the BIS and Andrew Rose of UC-Berkeley, on the other hand ,have offered evidence that the empirical importance of any such cycle is limited. Moreover, Michael W. Klein of Tufts University and Jay C. Shambaugh of George Washington University in one study and Joshua Aizenman of the University of Southern California, Menzie Chinn of the University of Wisconsin and Hiro Ito of Portland State University in another have found that flexible exchange rates can affect the sensitivity of an economy to foreign policy changes and afford some degree of policy autonomy.

A rise in U.S. rates, however, will increase the cost of borrowing in dollars. The volume of credit flows denominated in dollars reflects the continuing predominance of the dollar in international financial markets. Dollar-denominated credit to emerging market economies, for example, rose by 10% in 2017, driven primarily by a rise in the issuance of debt securities. Higher interest rates, a depreciating currency and a deteriorating international trade environment can quickly downgrade the creditworthiness of emerging market borrowers.

Other potential sources of stress remain. One of these is the lack of adequate “safe assets,” which serve as collateral for lending. U.S. Treasury bonds are utilized for this purpose, but in the run-up to the global crisis mortgage-based securities (MBS) with the highest ratings also served that function. Their disappearance leaves a need for other privately-provided safe assets, or alternatives issued by the international public agencies. Moreover, doubts about U.S. fiscal solvency could lead to doubts about the creditworthiness of the U.S. government securities.

Claudio Borio of the BIS perceives another flaw in the international monetary system: “excess financial elasticity” that contributes to financial imbalances. The procyclicality of finance is heightened during boom periods by capital inflows, and the spread of easy monetary conditions in core countries to the rest of the world is facilitated through monetary regimes. The impact of the regimes includes the decision of policymakers to resist currency appreciation which affects their interest rates, and the role of dominant currencies such as the dollar. Borio calls for greater international cooperation to mitigate the volatility of the financial cycle.

Dirk Schoenmaker of the Duisenberg School of Finance and VU University Amsterdam has drawn attention to a fundamental tension within the international system. He suggests that there is a financial trilemma, with only two of these three characteristics of a financial system as feasible: International financial integration, national financial policies and financial stability. A nation that wants to enjoy the benefits of cross-border capital flows needs to coordinate its regulatory activities with those of other countries. Otherwise, banks and other institutions will take advantage of discrepancies across borders in the rules governing their activities to find the least onerous regulations and greatest room for expansion.

These concerns about stability could be accepted if financial development had a positive impact on economic growth. But Boris Cournède, Oliver Denk and Peter Hoeller of the OECD,  in a review of the literature on the relationship of the financial sector and economic growth, report that above a threshold of financial development the linkage with growth is negative (see also here). Their results indicate that this reversal occurs when the financial expansion is based on credit rather than equity markets. Similarly, Stephen G. Cecchetti and Enisse Kharroubi of the BIS (see also here) report that financial development can lower productivity growth.

In addition, it has long been acknowledged that there is little evidence linking international financial flows to growth (see, for example, the summary of this work by Maurice Obstfeld of the IMF (and formerly of UC-Berkeley)).  More recently, Joshua Aizenman of the University of Southern California, Yothin Jinjarik of the University of Wellington and Donghyun Park of the Asian Development Bank have shown that the relationship of capital flows and growth depends on the form of capital. FDI flows possess a robust relationship with growth, while the linkage with other equity is smaller and less stable. The impact of FDI may depend on the development of the domestic financial sector. Debt flows in normal times do not reinforce growth, but can contribute to the probability of a financial crisis.

The impact of international financial flows on income inequality is also a subject of concern. Davide Furceri and Prakash Loungani of the IMF found that capital account liberalization reforms increase inequality and reduce the labor share of income. Furceri, Loungani and Jonathan Ostry also report that policies to promote financial globalization have led on average to limited output gains while contributing to significant increases in inequality. Distributional effects are more pronounced in those countries with low financial depth and inclusion, and where liberalization is followed by a crisis. A similar result was reported by Silke Bumann of the Max Planck Institute for Evolutionary Biology and Robert Lensink of the University of Groningen.

The change in the international financial system that may be the least understood is the evolution of FDI, which has grown in recent decades while the use of bank credit has fallen. FDI flows are increasingly routed thought countries such as Luxembourg and Ireland for the purpose of tax minimization. Moreover, the profits generated by foreign subsidiaries can be reinvested and form the basis of further FDI. Quyen T. K. Nguyen of the University of Reading asserts that such financing may be particularly important for operations in emerging market economies where domestic finance is limited. FDI flows also include intra-firm financing, a form of debt, and therefore FDI may be more risky than commonly understood.

5.     Conclusions

As a result of the substantial capital flows of the 1990s and early 2000s, the scope of financial markets and institutions now transcends national borders, and this expansion is likely to continue. While financial openness as measured by external assets and liabilities has not risen since the global crisis, this measurement is misleading. Emerging market economies with growing GDPs but less financial openness are becoming a larger component of the global aggregate. But financial openness and GDP per capita are correlated, and the populations of those countries will engage in more financial activity as their incomes increase.

A stable international financial system that promotes inclusive growth is a global public good. Global public goods face the same challenge as domestic public goods, i.e., a failure of markets to provide them. In the case of a global public good, the failure is compounded by the lack of an incentive for any one government to supply it.

The central banks of the advanced economies did coordinate their activities during the crisis, and since then international financial regulation has responded to the growth of global systematically important banks. But the growth of multinational firms that manage global supply chains and international financial institutions that move funds across borders poses a continuing challenge to stability. In addition, while the United Kingdom and the U.S. served as a financial hegemons in the past, today we have nations with small economies but extremely large financial sectors that reroute financial flows across border, and their activities are often opaque.

The global financial crisis demonstrates how little was understood of the fragility of the financial system that had built up around mortgage-backed securities. Regulators need to understand and monitor the assets and liabilities that have replaced them if they are not to be caught by surprise by the outcome of the next round of financial engineering. If “eternal vigilance is the price of liberty,” it is also a necessary condition for a stable financial universe.

A Guide to the (Financial) Universe: Part II

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(Part I of this Guide appears here.)

3. Crisis and Response

The global crisis revealed that the pre-crisis financial universe was more fragile than realized at the time. Before the crisis, this fragility was masked by low interest rates, which were due in part to the buildup of foreign reserves in the form of U.S. securities by emerging market economies. The high ratings that mortgage backed securities (MBS) in the U.S. received from the rating agencies depended on these low interest rates and rising housing prices. Once interest rates increased, however, and housing values declined, mortgage borrowers—particularly those considered “subprime”—abandoned their properties. The value of the MBS fell, and financial institutions in the U.S. and Europe sought to remove them from their balance sheets, which reinforced the downward spiral in their values.

The global crisis was followed by a debt crisis in Europe. The governments of Ireland and Spain bolstered their financial institutions which had also lent extensively to the domestic housing sectors, but their support led to a deterioration in their own finances. Similarly, the safety of Greek government bonds was called into question as the scope of Greek deficit expenditures became clear, and there were concerns about Portugal’s finances.

Different systems of response and support emerged during the crises. In the case of the advanced economies, their central banks coordinated their domestic policy responses. In addition, the Federal Reserve organized currency swap networks with its counterparts in countries where domestic banks had participated in the MBS markets, as well as several emerging market economies (Brazil, Mexico, South Korea and Singapore) where dollars were also in demand. The central banks were then able to provide dollar liquidity to their banks. The European Central Bank provided similar currency arrangements for countries in that region, as did the Swiss National Bank and the corresponding Scandinavian institutions.

The emerging market countries that were not included in such arrangements had to rely on their own foreign exchange reserves to meet the demand for dollars as well as respond to exchange rate pressures. Subsequently, fourteen Asian economies formed the Chiang Mai Initiative Multilateralization, which allows them to draw upon swap arrangements. China has also signed currency swap agreements with fourteen other countries.

In addition, emerging market economies and developing economies received assistance from the International Monetary Fund, which organized arrangements with 17 countries from the outbreak of the crisis through the following summer. The Fund had been severely criticized for its policies during the Asian crisis of 1997-98, but its response to this crisis was very different. Credit was disbursed more quickly and in larger amounts than had occurred in past crises, and there were fewer conditions attached to the programs. Countries in Asia and Latin America with credible records of macroeconomic policies were able to boost domestic spending while drawing upon their reserve holdings to stabilize their exchange rates. The IMF’s actions contributed to the recovery of these countries from the external shock.

The IMF played a very different role in the European debt crisis. It joined the European Commission, which represented European governments, and the European Central Bank to form the “Troika.” These institutions made loans to Ireland in 2010 and Portugal in 2011 in return for deficit-reduction policies, while Spain received assistance in 2012 from the other Eurozone governments. In 2013 a banking crisis in Cyprus also required assistance from the Troika.These countries eventually recovered and exited the lending programs.

Greece’s crisis, however, has been more protracted and the provisions of its program are controversial. The IMF and the European governments have been criticized for delaying debt reduction while insisting on harsh budget austerity measures. The IMF also came under attack for suborning its independence by joining the Troika, and its own Independent Evaluation Office subsequently published a report that raised questions about its institutional autonomy and accountability.

In the aftermath of the crisis, new regulations—called “macroprudential policies”—have been implemented to reduce systemic risk within the financial system. The Basel Committee on Banking Supervision, for example, has instituted higher bank capital and liquidity requirements. Other rules include restrictions on loan-to-value ratios. These measures are designed both to prevent the occurrence of credit bubbles and to make financial institutions more resilient. A European Banking Authority has been established to set uniform regulations on European banks and to assess risks. In the U.S., a Financial Stability Oversight Council was given the task of identifying threats to financial stability.

The crisis also caused a reassessment of capital account restrictions. The IMF, which had urged the deregulation of capital accounts before the Asian crisis of 1997-98, published in 2012 a new set of guidelines, named the “institutional view.” The Fund acknowledged that rapid capital flows surges or outflows could be disruptive, and that under some circumstances capital flow management measures could be useful. Capital account liberalization is appropriate only when countries reach threshold levels of institutional and financial development.

One legacy of the response to the crisis is the expansion of central bank balance sheets. The assets of the Bank of England, the Bank of Japan, the European Central Bank (ECB) and the Federal Reserve rose to $15 trillion as the central banks engaged in large-scale purchases of assets, called “quantitative easing”. The Federal Reserve ceased purchasing securities in 2014, and the ECB is expected to cut back its purchases later this year.  But the unwinding of these holdings is expected to take place gradually over many years, and monetary policymakers have signaled that their balance sheets are unlikely to return to their pre-crisis sizes.

(to be continued)