Category Archives: Capital Flows

The Global Financial Cycle and Emerging Market Economies

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The Federal Reserve’s latest increase in its policy rate is a signal of its desire to reestablish its credibility after U.S. inflation rose to 8.6% in May, and a precursor of more hikes.  Similar increases have been implemented by the Bank of England and the Swiss National Bank, and the European Central Bank has announced that an increase in its policy rate will occur in July.  These and other policy moves by central bankers indicate that we are in a new global financial cycle (GFC), which will have wide-ranging implications for emerging market and developing economies (EMDEs).

Maurice Obstfeld of UC-Berkeley and former chief economist of the IMF explains the linkages between monetary policy in advanced economies and economic activity in other countries in a Peterson Institute Working Paper, “The International Financial System after COVID-19.” Recent research has shown that U.S. financial conditions and Federal Reserve monetary policy, as well as conditions and policies in other advanced economies, affect asset prices, capital flows and commodity prices across a broad range of economies, evidence of a global financial cycle.

Researchers have devised measures of the cycle and studied its behavior. An index of global financial conditions shows a close correlation with output in the EMDEs. Part of this linkage is exerted via the dollar’s exchange rate, which appreciates in response to higher U.S. interest rates. Obstfeld lists several mechanisms that drive the relationship (see also here). He cites the impact of dollar appreciation on the tightening of trade finance credit, the role of the dollar as a safe haven during periods of heightened risk aversion, the contractionary impact of a stronger dollar on export demand when exports are denominated in dollars, a global decline in investment and a fall in real commodity prices. Exchange rate flexibility can mitigate the impact of shocks in the global financial cycle, but spillover effects are always present.

Obstfeld warns that higher interest rates in the advanced economies will affect the EMDEs. While the levels of government debt to GDP in many EMDEs are below those in most advanced economies, the rises in these ratios since the pandemic have been similar in magnitude. Refinancing will force these countries to deal with higher financing costs, and foreign-currency denominated debt adds another source of stress. Obstfeld cautions that one particular source of financial fragility is the concentration of sovereign debt on the balance sheets of banks in EMDEs.

An empirical assessment of the factors that drive capital flows to EMDEs is provided by Xichen Wang of the Chongqing Technology and Business University and Cheng Yan of the Essex Business School in their paper in the current IMF Economic Review, “Does the Relative Importance of the Push and Pull Factors of Foreign Capital Flows Vary Across Quantiles?  (working paper version here). They contrast the impact of “push” factors that are external to capital flow recipients and domestic “pull” factors on capital flows to 51 emerging markets. They use quantile analysis, which allows them to investigate the effect of the independent variables on different quantiles of the distribution of the dependent variable. The lower quantiles (such as the first 20%) are periods of relatively low capital flows, the median quantiles are tranquil and smooth periods, and the higher quantiles are periods of abundant capital financing.

The authors use several indicators of a GFC, including the U.S. 3-month Treasury bill rate deflated by U.S. inflation and the VIX index, which is based on the volatility of S&P 500 stock options. They also utiliized U. S. economic growth and average net capital flows to other countries in the region. For pull variables they utilized domestic variables, such as the domestic real interest rate, economic growth, public indebtedness, private credit expansion and the current account.

Wang and Yan’s results show that VIX and regional capital flows are highly significant for all the quantiles of gross capital inflows.  An increase in risk, as manifested in a rise in VIX, lowers capital flows to the emerging markets while an increase in capital flows to other countries in the region has a positive effect. Several of the domestic pull factors, such as economic growth and international reserves, are statistically significant at the lower quantiles, but their significance diminishes in the higher quantiles. Foreign investors pay attention to domestic conditions when capital flows are relatively limited.

The authors also present results for disaggregated capital flows (FDI, portfolio equity, portfolio debt, bank). The significance of VIX remains for all forms of capital, including FDI which is sometimes seen as less affected by global conditions. The domestic push factors are significant for the non-FDI flows at the lower quantiles, but not at the upper quantiles.

The authors conclude that policymakers need to pay attention to the manifestation of GFCs, as they can lead to a sudden fall in gross inflows. VIX has risen this year from 16.60 on January 3 to a high of 36.45 on March 7, and currently stands at 27.53. The nominal Treasury bill rate rose from 0.09% at the beginning pf the year and has risen to 1.59%.  But the rate of inflation rose from 7.5% to 8.6% over the same period, largely offsetting the rise in the nominal rate.

The World Bank has evaluated the prospects of the EMDES in the June edition of its Global Economic Prospects. They forecast a slowdown in economic growth in the EMDEs from 6.6% in 2021 to 3.4% this year, and warn that the war in Ukraine has increased the risk of a further negative adjustment. The World Bank also cites global financial conditions as a cause of concern:

“As global financing conditions tighten and currencies depreciate, debt distress—previously confined to low-income economies—is spreading to middle-income countries. The removal of monetary accommodation in the United States and other advanced economies, along with the ensuing increase in global borrowing costs, represents another significant headwind for the developing world.”

There is a well-established link, therefore, from monetary policies in the U.S. and other advanced economies to the rest of the global economy. As the Federal Reserve and its counterparts show their determination to face down inflation, they can trigger spillovers that exacerbate capital outflows from the EMDEs. The result will be a further deterioration in the economies of countries that have already endured a series of negative shocks.

Financial Globalization and Inequality

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The global financial crisis slowed the pace of financial globalization, while the impact of the pandemic on its future course is unclear. But enough time has elapsed to assess the record of integrated financial markets that greatly expanded in the 1990s and early 2000s. The evidence on one issue—financial openness and inequality—is clear: financial globalization has increased inequality.

Enrico D’Elia of the Italian Ministry of Economy and Finance and the Italian Institute of Statistics (ISTAT) and Roberta De Santiss, also of ISTAT, analyzed this issue in their 2019 working paper, “Growth Divergence and Income Inequality in OECD Countries: The Role of Trade and Financial Openness.” They used an error-correction model to differentiate between short- and long-run effects on the Gini index, and divided the OECD countries into low-, middle- and high income over the period of 1995-2016. Increases in financial integration, as measured by foreign assts and liabilities scaled by GDP, increased income disparities in both the short- and long-run in the total sample. In the long-run there is a negative effect on the Gini index within the low-income countries, but there is a much larger positive impact within the high-income group. They attribute this finding to the advantage that the financial sector derives from financial innovation in those countries. In their results relating to growth, they reported that financial openness had a positive impact on the economic growth of the middle-income group alone, and it only occurred in the short-run.

Xiang Li of the Halle Institute for Economic Research and Dan Su of the University of Minnesota investigated the impact of capital account liberalization in their 2020 article, “Does Capital Account Liberalization Affect Income Inequality?” in the Oxford Bulletin of Economics and Statistics. They used several measures of capital account openness, and both Gini coefficients and the income shares of different groups as their measures of inequality in samples of OECD and non-OECD countries. In their panel data analysis, they found that capital account liberalization had positive impacts on the Gini coefficients in the non-OECD countries, but not the OECD sample. They also found that capital account liberalization increased the income share of the top 10% of households. They reported similar results from a difference-in-differences analysis.

Philipp Heimberger of the Vienna Institute for International Economic Studies offered a summary of the empirical analyses of economic globalization and inequality in his paper, Does Economic Globalisation Affect Income Inequality? A Meta-analysis, which was published in The World Economy in 2020. He undertook a meta-analysis of 123 peer-reviewed papers and a meta-regression empirical analysis. In his results he found that financial globalization has had a sizeable and significant inequality-increasing impact, which is not true of trade globalization. Moreover, this result holds for advanced countries as well as developing nations.

The evidence, therefore, seems clear: increased capital flows do lead to more income inequality. But what are the channels of transmission? Barry Eichengreen of UC-Berkeley, Balazs Csonto and Asmaa A. El-Ganainy of the IMF, and Zsoka Koczan of the European Bank for Reconstruction and Development investigate this issue in their IMF working paper, “Financial Globalization and Inequality: Capital Flows as a Two-Edged Sword.” They point out that the various types of capital flows will have different effects and review the separate impacts to explain why inequality increased in both advanced and developing economies.

In the case of inward FDI in developing economies, the inflow of foreign capital could increase the return to labor. But, the authors point out, if capital substitutes for labor or works with skilled labor, then wage inequality will increase amongst laborers. This effect will be magnified when foreign capital flows to sectors that are dependent on external capital and are also complementary with skilled labor. Similarly, outward FDI reduces the demand for less skilled labor in the home countries of the multinationals responsible for the FDI. The outflows can also lower the bargaining power of labor in those countries.

The authors also examine portfolio capital, which can have many of the same distributional consequences as FDI in the host countries. Moreover, inflows of portfolio capital can lead to increased macroeconomic and financial volatility, and culminate in crises. Aggregate volatility heightens inequality because the poor suffer more the effects of economic downturns. In addition, portfolio flows can lead to increased demand for assets and higher prices. A rise in housing prices helps their owners, and the distributional impact depends on the pattern of ownership. In the case of higher stock prices, the benefits flow to stockholders who almost always are located in high-income households.

FDI, portfolio capital and bank flows also affect tax payments. Multinationals can use financial centers with low tax rates to minimize their tax liabilities across nations. Portfolio and bank flows can be used by the rich to shelter their asset holdings to avoid taxes. The loss of tax revenues decreases the ability of governments to deliver services that may benefit poorer households.

What can be done in the face of these impacts on income inequality? The authors of the IMF paper point out that adverse consequences are lessened when there are higher levels of educational achievement in the population. More educated workers benefit from the increased skill premium paid by multinationals. Capital flow measures can be used to control short-run inflows that can lead to “sudden stops” that overwhelm domestic financial markets.

A multilateral initiative seeks to reform the tax treatment of multinationals to avoid base erosion and profit shifting (BEPS) that result in lower tax revenues for governments. The OECD has organized negotiations amongst governments to coordinate the tax treatments of multinational firms. The OECD proposals have two sections: the first deals with the allocation of the right to levy taxes on corporations by nations and the second would establish a minimum global tax. These issues are particularly relevant for digital companies that have minimum physical presence in many countries where they do business. U.S. Treasury Secretary Janet Yellen has announced that the U.S. would reverse its position under the Trump administration and engage in these talks.

Finance, if designed properly, need not be exclusionary. Indeed, in some countries financial inclusion has helped low-income households to increase their living standards. International financial flows are not the only cause of increased inequality, but they have played a role. International finance in all its forms can have adverse consequences and governments need to acknowledge these and plan to offset them if/when financial globalization resumes.

The True Owners of Foreign Capital

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Explaining the sources and destinations of capital flows is a key focus of research in international finance. But capital flows between countries can flow through financial centers before they arrive at their ultimate destination, and these intermediary flows distort the record of the actual ownership of investments. Two recent papers seek to provide a more accurate picture of the true sources of foreign finance.

Jannick Damgaard of Danmarks Nationalbank, Thomas Elkjaer of the International Monetary Fund and Niels Johannesen of the University of Copenhagen differentiate between “phantom” and “real” foreign direct investment in their 2019 IMF working paper, “What Is Real and What Is Not in the Global FDI Network?”  Phantom FDI flows to shell companies that do not engage in any business activities, and are used to minimize corporate taxation before the funds are channeled to their final destination. Among the host countries that receive a significant amount of phantom investment are the Netherlands, Luxembourg, Hong Kong, Switzerland, Singapore and Ireland. The phantom FDI overstates the actual amount of investment that takes place and obfuscates the ultimate ownership of foreign capital.

Damgaard, Elkjar and Johannsen use several sources of data in order to uncover the actual owners of FDI. These include the IMF’s Coordinated Direct Investment Survey, which reports foreign investments in 110 countries by the country of the immediate owner; the OECD’s Foreign Direct Investment Statistics, which differentiates between FDI in Special Purpose Entities (SPEs), a form of shell company, and non-SPE investment, and also includes information on the ultimate owners of investment; and Orbis, a global database of corporate data, including ownership information. Since the OECD data are incomplete, they estimate the share of real FDI in total FDI by using the negative relationship of real FDI/total FDI and total FDI/GDP.

Their results show that in 2017 global FDI of almost $40 trillion included real FDI of $25 trillion and phantom FDI of about $15 trillion. Moreover, the share of phantom FDI in total FDI has risen from above 30% in 2009 to just below 40% in 2017. Luxembourg reported the largest amount of phantom FDI of $3.8 trillion, followed by the Netherlands with around $3.3 trillion. The largest stock of real FDI, on the other hand, was located in the U.S., which also owned the largest amount of outward FDI. China has been a significant recipient of inward FDI (but see below), as were the United Kingdom, Germany and France. The authors also found evidence of “round tripping,” i.e., supposedly inward foreign investment that is actually held by domestic investors. In the case of China and Russia about 25% of real FDI is owned by investors in those countries.

Another investigation of the data on international capital was undertaken by Antonio Coppola of Harvard, Matteo Maggiori of Stanford’s Graduate School of Business, Brent Neiman of the University of Chicago’s Booth School of Business and Jesse Schreger of the Columbia Business School, and they report their results in “Redrawing the Map of Global Capital Flows: The Role of Cross-Border Financing and Tax Havens.” Global firms have increasingly issued securities through affiliates in tax haven, and these authors seek to uncover the ultimate issuers of these securities. Their results allow them to distinguish between data reported on a “residency” basis based on the country where the securities are issued versus a “nationality” basis, which shows the country of the ultimate parent.

The authors begin with data from several databases that allows them to uncover global ownership chains of securities through tax haven nations such as Luxembourg and the Cayman Islands.  They use this mapping to determine the ultimate issuers of securities held by mutual funds and exchange traded fund shares that are reported by Morningstar. Finally, they use their reallocation matrices to transform residency-based holdings of securities as reported in the U.S. Treasury’s International Capital data and the IMF’s Coordinated Portfolio Investment Survey to nationality-basis holdings.

Their results lead to a number of important findings. Investments from advanced economies to emerging market countries, for example, have been much larger than had been reported. For example, U.S. holdings of corporate bonds in the BRIC economies (Brazil, Russia, India and China) total $99 billion, much larger than the $17 billion that appears in the conventional data. U.S. holdings of Chinese corporate bonds alone rises from $3 billion to $37 billion, and of Brazilian bonds the total increases from $8 billon to $44 billion. These figures are even higher when the U.S. subsidiaries of corporations in emerging markets which issue securities in the U.S. are accounted for. Similarly, holdings of common equities in the emerging markets by investors in the U.S. and Europe are much larger when the holdings are reallocated from the tax havens to the ultimate owners. This is particularly evident in the case of China.

The reallocation also shows that the amount of corporate bonds issued by firms in the emerging markets has been more significant than realized. While the issuance of sovereign bonds is accurately reported, the issuance of corporate bonds has often occurred via offshore subsidiaries. These bonds are often denominated in foreign currencies, so their reallocation to their ultimate issuers results in an increase in foreign currency exposure for their home countries.

As in the previous study, Coppla, Maggiori, Neiman and Schreger also find that some “foreign” investment represents domestic investment routed through a tax haven, such as the Cayman Islands. These flows are particularly significant in the case of the U.S. In addition, some FDI flows to China should be classified as portfolio, since they reflect foreign participation in offshore affiliates that is channeled to China. FDI positions are not revalued as often as portfolio holdings, and as a result the authors claim that China’s net foreign asset position is overstated.

The results of these ground-breaking papers have important implications. First, the international ownership of capital is more concentrated than realized. The “Lucas paradox” of international capital flowing from developing to advanced economies was based on misleading data. The U.S. and several other advanced economies have large stakes in the emerging markets. Second, some of emerging markets are more vulnerable to currency depreciations than the official data suggest because their corporations have issued debt through subsidiaries in ta haven countries. Third, multinational corporations have been successful in shielding their income from taxation by using tax havens. The OECD has been working to bring this profit shifting under control, but effective reform may require a fundamental change in how multinationals are taxed by national governments.

Capital Controls in Theory and Practice

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It has been a decade since the global financial crisis effectively ended opposition to the use of capital controls. The IMF’s drive towards capital account deregulation had been blunted by the Asian financial crisis of 1997-98, but there was still a belief in some quarters that complete capital mobility was an appropriate long-run goal for emerging markets once their financial markets sufficiently matured. The meltdown in financial markets in advanced economies in 2008-09 ended that aspiration. Several recent papers have summarized subsequent research on the justification for capital controls and the evidence on their effectiveness.

Bilge Erten of Northeastern University, Anton Korinek of the University of Virginia and José Antonio Ocampo of Columbia University have a paper, “Capital Controls: Theory and Evidence,” that was prepared for the Journal of Economic Literature and summarizes recent work on this topic. In this literature, the micro-foundations for the use of capital controls to improve welfare are based on externalities that private agents do not internalize. The first type of externality is pecuniary, which can lead to a change in the value of collateral and a redistribution between agents. In such cases, private agents may borrow more than is optimal for society, which suffers the consequences in the event of a financial shock. Policymakers can restrict capital flows to limit financial fragility.

The second justification of capital controls is due to aggregate demand externalities, which are associated with unemployment. Private agents may borrow in international markets and fuel a domestic boom that leaves the domestic economy vulnerable to a downturn. If there are domestic frictions and constraints on the use of monetary policy that limit the response to an economic contraction, then capital controls may be useful in mitigating the downturn.

Alessandro Rebucci of Johns Hopkins and Chang Ma of Fudan University also summarize this literature in “Capital Controls: A Survey of the New Literature,” prepared for the Oxford Research Encyclopedia of Economics and Finance. They discuss the use capital controls in the case of both pecuniary and demand externalities, and capital controls in the context of the trilemma. In their review of the empirical literature on capital controls, they summarize two lines of research. The first deals with the actual use of capital controls, and the second their relative effectiveness.

Whether or not capital controls are used as a countercyclical instrument together with other macroprudential tools has been an issue of dispute.  Rebucci and Ma report there is recent evidence that indicates that such instruments have been utilized in this manner, as the recent theoretical literature proposes. There are also cross-country studies of capital control effectiveness that are consistent with the theoretical justification for the use of such measures. For example, capital controls can limit financial vulnerability by shifting the composition of a country’s external balance sheet away from debt.

Some recent papers from the IMF investigate the actual use of capital controls and other policy tools in emerging market economies. Atish R. Ghosh, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF investigated the response of emerging markets to capital flows in a 2017 working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” They report that policymakers in a sample of 51 countries over the period of 2005-13 used a number of instruments to deal with capital flows. In addition to foreign exchange market intervention and central bank policy rates, capital controls were utilized, particularly when the inflows took the form of portfolio and other flows. Tightening of capital inflow controls was more likely during periods of credit growth and real exchange rate appreciation. The authors’ finding that several major emerging markets have used capital controls to deal with risks to financial and macroeconomic stability is consistent with the theoretical literature cited above. However, the authors caution that their results do not indicate whether managing capital flows actually prevents or dampens instability.

This subject has been addressed by Gaston Gelos, Lucyna Gornicka, Robin Koepke, Ratna Sahay and Silvia Sgherri  in their new IMF working paper, “Capital Flows at Risk: Taming the Ebbs and Flows.” They examine the policy responses to sharp portfolio flow movements in 35 emerging market and developing economies during the 1996-2018 period, using a rise in BBB-rated U.S. corporate bond yields as a global shock. The authors look at the structural characteristics and policy frameworks of the countries as well as their policy actions. Among their results they find that more open capital accounts at the time of the shock are associated with fewer large inflows after the shock. Moreover, a tightening of capital flow measures is linked to larger outflows in the short-run. They also find that monetary and macroprudential policies have limited effectiveness in shielding countries from the risks associated with global shocks.

Capital controls have become an important tool for many developing economies, and there are ample grounds to justify their implementation. Recent empirical literature seems to show that the actual implementation of such measures is undertaken in a manner that meets the criteria outlined in the theoretical literature. However, whether regulatory limits on capital mobility actually achieve their financial and macroeconomic goals is still not proven. The Federal Reserve has signaled its intention to maintain the Federal Funds Rate at its current level, but shocks can come from many sources. Policymakers may find themselves drawing upon all the tools available to them in the case of a new global disruption to capital flows.

Does France Have an “Exorbitant Privilege”?

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The U.S. has long been accused of using the international role of the dollar to exercise an “exorbitant privilege.” The term, first used by French finance minister Valéry Giscard d’Estaing, refers to the ability of the U.S. to finance its current account deficits and acquire foreign assets by issuing dollars as a reserve currency. While flexible exchange rates have lowered the need for reserve currencies, the use of the dollar in international trade and finance ensures that there is a continuing need for dollar-denominated assets. The status of the dollar contributes to the surplus in U.S. international investment income despite its negative net international investment position (NIIP). But France also has a surplus in international investment income and a negative NIIP. Does it possess its own privilege?

The U.S. surplus reflects the composition of its external balance sheet as well as the return on its assets and liabilities. The U.S. has a positive balance on equity, and in particular, FDI, which is offset by the negative balance on portfolio securities, such as bonds. U.S. Treasury bonds are the universal “safe asset,” held by private foreign investors as well as central banks. The return on the equity assets exceeds that paid on the debt liabilities, thus yielding a positive investment income balance. This is the return that the U.S. receives for playing the role of the “world’s venture capitalist,” according to Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School. In addition, the U.S. receives a higher return on its FDI assets than it pays out on its FDI liabilities.

France also has a negative NIIP but a positive net international investment income balance. In 2018, for example, it received $35.6 billion in investment income. Moreover, the Banque de France pointed out in the 2015 Annual Report on the French Balance of Payments and International Investment Position that while the ratio of outward direct investment stocks to liabilities was 2 to 1, the ratio of FDI receipts to payments was 3 to 1. The French surplus, like that of the U.S., therefore can be attributed to both a “composition” effect reflecting the difference in the types of assets and liabilities it possesses, but also a “returns” effect due to the relatively higher return on its direct investment assets vis-à-vis its liabilities.

Vincent Vicard of CEPII (Centre d’Etudes Prospectives et d’Informations Internationales) has examined this return in a CEPII working paper, “The Exorbitant Privilege of High Tax Countries.” He finds that French firms earn higher returns on their foreign operations in low tax countries and tax havens, evidence of using the reporting of profits to increase returns. Profit shifting by the French multinationals account for two percentage points of the difference in returns on French assets and liabilities. Four European countries account for much of this activity: Luxembourg, Netherlands, Switzerland and the United Kingdom.

These results are consistent with those reported for other countries, particularly the U.S. Kim Clausing of Reed College, for example, examined the impact of differentials in tax rates on the profits of U.S affiliates in “Multinational Firm Tax Avoidance and Tax Policy” in the National Tax Journal in 2009.  More recently, Thomas Tørsløv and Ludvig Wier, both of the University of Copehhagen, and Gabriel Zucman of UC-Berkeley investigated the profit-shifting of multinationals in a range of countries in a NBER Working Paper, “The Missing Profits of Nations.” They estimate that close to 40% of multinational profits are shifted to tax havens globally each year. The non-haven European Union countries appear to be the main losers from this maneuvering.

But it would be too simple to dismiss the foreign earnings of French or U.S. firms as a purely accounting artifact. Multinationals have used information and communications technology to form global supply chains that allow them to source operations in low-cost countries and assemble the components elsewhere before shipment to the final market. France has its share of multinationals, including firms such as BNP Paribus, Carrefour and Peugeot. Moreover, foreign economic expansion by French firms and investors predates modern tax codes. Thomas Piketty of the School for Advanced Studies in the Social Sciences and the Paris School of Economics  pointed out in Capital in the Twenty-First Century that the income earned from foreign holdings were sufficient to finance trade deficits and capital outflows in Great Britain and France during the late nineteenth and early twentieth centuries.

The U.S. and other governments have lowered corporate tax rates in part to lure multinationals back to their home countries, and the members of the Organization for Economic Cooperation and Development intend to limit profit shifting by multinationals. Whether or not this strategy will be successful is not clear. Chris Jones and Yama Temouri of the Aston Business School have pointed out in “The Determinants of Tax Haven FDI” in the Journal of World Business that tax havens have advantages for multinationals besides lower tax rates, including few regulations and restricted openness. But President Trump has also made clear that he wants U.S. firms to operate domestically, and is willing to limit access to U.S. markets by foreign firms. France’s “privilege,” exorbitant or not, will be affected by these restrictions.

Partners, Not Debtors: The External Liabilities of Emerging Market Economies

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My paper,  “Partners, Not Debtors: The External Liabilities of Emerging Market Economies,” has been published in the January 2019 issue of the Journal of Economic Behavior & Organization.

Here is the abstract:

This paper investigates the change in the composition of the liabilities of emerging market countries from primarily debt (bonds, bank loans) to equity (foreign direct investment, portfolio) in the decades preceding the global financial crisis. We examine the determinants of equity and debt liabilities on external balance sheets in a sample of 21 emerging market economies and 20 advanced economies over the period of 1981-2013. We include a new measure of domestic financial development that allows us to distinguish between financial institutions and financial markets. Our results show that countries with higher economic growth rates have larger amounts of equity liabilities. The development of domestic financial markets is also linked to an increase in equity liabilities, and in particular, portfolio equity. In addition, larger foreign exchange reserves are associated with larger amounts of portfolio equity. FDI liabilities are more common when domestic financial institutions are not well developed.

The publisher, Elsevier, provides a link to provide free access to the paper for 50 days. You can find it here:

https://authors.elsevier.com/a/1YoqV_3pQ3g~6e

 

Capital Flows in a World of Low Interest Rates

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Interest rates in advanced economies continue to persist at historically low levels. This trend is due not only to the response of central banks to slow growth, but also fundamental factors. If these interest rates continue close to their current levels, what are the consequences for international capital flows?

The decline in rates in the advanced economies has been widely documented and studied. Lukasz Rachel and Thomas D. Smith of the Bank of England have investigated the determinants of the fall in global real interest rates. They attribute the decline in part to increased savings due to demographic forces, higher inequality and a glut of precautionary savings in emerging markets. Investment spending, which has fallen due to the falling price of capital and lower public investment, also contributes to low interest rates. Most of these factors, they claim, will continue to prevail.

Lukasz Rachel and Larry Summers of Harvard have also looked at falling real rates in the advanced economies, which they attribute to secular stagnation. They point out that since the current rates reflect higher levels of government debt, the interest rate that we would observe if there was only a private sector would be even lower. They urge policymakers to tolerate fiscal deficits and also to engage in policies to increase private investment.

The low rates have been an incentive to potential borrowers, and consequently debt levels have risen. The IMF has updated its Global Debt Database,  which includes private and public debt for 190 countries dating back to the 1950s. The data show that the three currently most indebted countries are China, Japan and the U.S., accounting for more than half of global debt. The increase in the debt of China and other emerging markets is due to increases in private debt. Corporate borrowing in these countries has soared, and much of it is denominated in dollars. Public debt has risen in the advanced economies, and more recently in the emerging market and low-income countries as well.

Last spring IMF Managing Director Christine Lagarde warned of unsustainable debt burdens in some of the low income countries. In recent years, the borrowers have included governments with relatively low risk ratings that may fall lower. In some cases, the increased debt reflects loans from China that are part of that country’s Belt and Road Initiative. IMF officials are concerned that some of these countries will turn to the IMF for assistance of they cannot meet their debt obligations.

The Federal Reserve has indicated that it will not raise its policy rates in the near future.  Consequently, the incentive to search for yield will continue to contribute to the pro-cyclical nature of capital flows in the emerging markets. But the current situation is sustainable for only as long as the existing environment continues.

Martin Wolf of the Financial Times has warned that it is only a matter of time until the next financial crisis erupts. He cites four factors that contribute to the outbreak of such crises. First, over time risk moves out of the most regulated parts of the economy to the least regulated. This makes it more difficult for regulators to assess the fragility of the financial sector. Second, an ideological belief that unregulated markets work best contributes to the proliferation of risky lending. Third, the financial sector is a major contributor to election campaigns. This gives them access to lawmakers who are drafting the laws that govern the operations of the financial sector. Finally, there is the human tendency to forget or ignore past events. This allows the financial sector to engage in risky but profitable activities that enrich those conducting them while the public enjoys access to relatively cheap credit.

Continuing low interest rates, therefore, may alleviate some of the pressure on those borrowers with high debt loads. But they are susceptible to other shocks such as slowing economic growth or the breakdown of trade negotiations between the U.S. and China. If such a shock occurs, we may once again witness a flight to safety that leaves borrowers in emerging markets vulnerable to “sudden stops” of capital that, combined with depreciating exchange rates, will disrupt their economies.

 

 

U.S. Interest Rates and Global Banking in Emerging Market Economies

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The spillover effects of changes in U.S. interest rates are widely recognized (see here and  here). An increase in rates, for example, raises the cost of dollar-denominated financing outside the U.S., which has grown in recent years, while an appreciation of the dollar makes such debt even more expensive to service and refinance. The emerging markets are among the nations adversely affected by the rise in U.S. interest rates. Several recent research papers have shown how global bank lending in these economies is affected.

Stefan Avdjiev, Cathérine Koch, Patrick McGuire and Goetz von Peter of the Bank for International Settlements investigate the impact of a change in U.S. monetary policy on cross-border lending by global banks in their paper, “Transmission of Monetary Policy through Global Banks: Whose Policy Matters?”, BIS Working Paper no. 745. In their analysis they also investigate the effect of changes in the policy stance of the central banks of both the country of the borrower as well as the home country of the lending bank. They use data on cross-border claims denominated in U.S. dollars held by international banks in 32 lender countries on borrowers in 55 countries over the period of 2000-2016.

The authors find that a tightening in U.S. monetary policy does lead to a decrease in dollar-denominated lending, as expected. But they also find that a more contractionary monetary policy in the lending country leads in a rise in cross-border dollar lending out of that country, presumably as the banks within the country switch to the cheaper dollar funding. Similarly, monetary tightening in the country of the borrower also leads to an increase in dollar-denominated credit, although these results are less robust.

The authors then investigate some of the transmission channels and seek to identify which characteristics of the banks are most relevant for these effects. They find, for example, that the negative effect of a tightening in U.S. monetary policy is smaller for banks that are more reliant on short-term wholesale funding and have better access to intragroup funding. These banks may have more alternatives to turn to when the cost of borrowing in dollars rises.

Another analysis of the effects of U.S. monetary policy on credit to emerging markets is offered by Falk Bräuning of the Federal Reserve Bank of Boston and Victoria Ivashina of Harvard Business School in “U.S. Monetary Policy and Emerging Market Credit Cycles”, NBER Working Paper no. 25185. They investigate the impact of shocks in U.S. monetary policy on the issuance of global syndicated corporate loans in a broad range of countries between 1990 and 2016. Dollar-denominated loans represent a large share of cross-border credit in the emerging market economies.

Their results indicate that an easing (tightening) of U.S. monetary policy leads to a rise (decline) in bank flows to the foreign markets. When they distinguish between developed economies and emerging markets, they find that the impact is about twice as large in the latter group. They also report that this result holds for U.S. and non-U.S. lenders, and that this linkage existed before the global financial crisis.

Ilhyock Shim of the Bank for International Settlements and Kwanho Shin of Korea University offer another line of analysis of global bank activity in emerging market economies in “Financial Stress in Lender Countries and Capital Outflows From Emerging Market Economies”, BIS Working Paper no. 745. In their empirical analysis, they use data from bilateral banking flows to construct a measures of capital outflows from the emerging markets to each lender country. To measure stress in lender countries, they use three indicators: an average of bank credit default spreads (CDS) for 66 banks in 29 lender countries, sovereign CDS spreads in the banks’ home countries, and the spread between dollar-denominated corporate bonds in each lender country and the matching U.S. Treasury yield. They also use sovereign spreads for financial stress in the 67 borrower nations.

The authors find that an increase in financial stress in the lending country leads to capital outflows from the emerging markets. When the measure of financial stress in the emerging market is included, it is also significant. But when economic fundamental variables in the emerging markets are added, the significance of stress in the lender countries continues to be strong while stress in the emerging markets is not. In addition, they report that cross-border claims are particularly vulnerable to stress in the lender countries. They also find these results hold in the post-financial crisis period.

Shim and Shin point out that one of the policy implication of their results draw is that strong economic fundamentals in an emerging market economy may not be sufficient to prevent capital outflows during a period of stress in lending countries. The same lesson applies for these countries if U.S. interest rates are rising. Flexible exchange rates, the standard buffer from foreign shocks, may not be able to change global banking flows.

Federal Reserve officials are attempting to pull off a difficult task: raising interest rates without ending the recovery in the U.S. Within the U.S. this challenge has been complicated by the short-run effects of expansionary fiscal policies that are due to run out in coming months. If the rise in rates also contributes to a slowdown in bank lending in other countries, the Fed will face enormous pressure to put further rate hikes on hold.  We have seen the story of higher U.S. rates and emerging market economies before, and the ending is not pretty.

Capital Flows and Domestic Responses

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The international impact of financial shocks became apparent during the global financial crisis. But how do financial flows affect economic conditions during non-crisis times? And are there ways to shelter the domestic economy from these flows? Some new evidence from the IMF seeks to answer these questions.

IMF economists Bertrand Gruss, Malhar Nabar and Marcos Poplawski-Ribeiro, in a chapter in the IMF’s latest World Economic Outlook entitled “Roads Less Traveled: Growth in Emerging Markets and Developing Economies in a Complicated External Environment,” examine the impact of external conditions on growthsince the 1970s in over 80 emerging market and developing economies. This issue is particularly important in light of the contribution to global growth—80%—by these economies since the financial crisis.

The authors construct measures for the countries in their sample to capture the following external conditions: external demand, as measured by domestic absorption in a country’s trading partners; external finance, based on capital flows to peer economies; and the terms of trade, constructed from commodity prices. The cross-correlation across these measures is low, indicating that they capture different sources of external variation. The country-specific measures often diverge from their global values, which the authors attribute to domestic factors.

The three measures are all economically and statistically significant in explaining the growth rate of GDP per capita over five-year windows in the countries under stud , contributing almost 2 percentage points to income per capita growth over the 40-year period. Their collective impact rose from about 1.7 percentage points to 2.3 percentage points over the entire period. External financial conditions in particular have become increasingly important over time. Their contribution to growth increased by about half of a percentage point between the 1995-2004 and 2004-1014 periods, and represented half of the contribution from external factors since 2005. The authors attribute the rise in part to the increased financial integration of capital markets.

How do local conditions affect the impact of external financial flows on the domestic economy? In general, a loosening of external financial conditions contributes to growth when they are channeled to “…financially constrained agents while maintaining relatively robust risk management and origination standards that minimize the pitfalls of excessive credit growth.” This will occur when there is financial development and a healthy pace of increase in domestic credit to accompany capital account openness.

How do policymakers in emerging market economies actually respond to capital flows? IMF economists Atish R. Ghosh, Jonathan D. Ostry and Mahvash Qureshi look at this issue in a recent IMF working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” Using a sample of 50 emerging market economies over the period of 2005 to 2013, they investigate whether these countries sought to restrain the impact of capital inflows on their countries. Their evidence indicates that central bankers did seek to check their impact by foreign exchange market intervention and setting higher policy rates. Moreover, macro prudential policies were strengthened and capital controls tightened in response to capital surges. On the other hand, capital flows were associated a pro-cyclical response in government expenditures, signaling that fiscal and monetary policymakers have different goals.

The authors leave open for future research the question of whether such measures decrease the probability of experiencing a subsequent financial crisis (see here). The existence of global financial cycles (see here) indicates that global financial markets have become increasingly dependent on conditions in the advanced economies, particularly the U.S., which may limit the efficacy of domestic measures. Political turmoil in the U.S. may be the factor that upends the recent historically low levels of VIX (see also here). If so, policymakers in the emerging markets will need to take more steps to shield their economies from the ensuing turbulence.