Category Archives: Capital Flows

In and Out

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Two recent IMF publications offer different perspectives on how policymakers should handle capital outflows. One outlines a tactical response to an unplanned reversal, while the second provides a strategy to prepare for volatility before it occurs.

The first approach appears in an IMF Policy Paper, Global Impact and Challenges of Unconventional Monetary Policies. Most of the paper deals with the effects of unconventional monetary policies (UMP) designed to restore the operations of financial markets and/or to support economic activity when the central bank’s policy rate has hit the lower bound. The measures include the purchase of bonds not usually bought by a central bank and forward guidance on interest rates. The paper draws upon the experiences of the Bank of England, the Bank of Japan, the European Central Bank, and the Federal Reserve.

The paper also deals with the possible challenges posed by the eventual winding down of the UMP both within the countries that have implemented them and in non-UMP countries. The authors of the report warn that ”In non-UMP countries, currencies will depreciate (to balance changes in relative bond returns) and bond yields might rise…” They further caution that “Some capital flow reversal and higher borrowing costs are to be expected, but further volatility could emerge, even if exit is well managed by UMP countries.” The report points to one source of volatility: “Further amplification could come from the financial system, where stability could be undermined as non-performing loans rise, capital buffers shrink, and funding evaporates.”

What can the non-UMP policymakers do to offset or least minimize this turbulence? Relatively little, according to the report. Central banks should maintain their credibility through appropriate monetary policies (always a good idea), allow some change in their exchange rates (but avoid disorderly adjustment!), and reverse measures that were implemented during periods of capital inflows (but only if this does not endanger financial stability!). The IMF offers to coordinate national policies to curtail negative spillovers, and promises to provide credit as needed. The IMF’s message for the non-UMP countries, therefore, seems to be: A storm is coming! It might be bad! Close the windows and doors, and place your faith in a higher power (conveniently located at 700 19th Street in Washington, DC)!

A different message comes from the authors of Chapter 4 of the IMF’s latest World Economic Outlook, entitled “The Yin and Yang of Capital Flow Management: Balancing Capital Inflows with Capital Outflows.”  Its authors make the distinction between those emerging market countries that respond to capital inflows through a current account deterioration (a “real” adjustment) versus those with offsetting capital outflows (“financial” adjustment). They find that the latter group registered a smaller response to the 2008-09 global financial crisis, as manifested in changes in GDP, consumption and unemployment. The former group includes Argentina, India and Turkey, while the latter group includes Brazil, Mexico and Thailand. The authors attribute the better experience of those countries that experienced “financial adjustment” to several factors, including the repatriation by their residents of their foreign assets to smooth consumption in the face of a shock.

Of course, the withdrawal of assets from foreign countries is feasible only if those assets are relatively liquid. Evidence on this aspect of the financial crisis comes from Philip Lane in his authoritative account of the role of financial globalization in precipitating and propagating the global crisis, “Financial Globalisation and the Crisis,” which appeared in Open Economies Review  (requires subscription). He reports that emerging economies were “long debt, short equity” in the period preceding the crisis. Their assets consisted of liquid foreign debt that they could draw upon if needed, while their liabilities were in the form of FDI and portfolio equity. The advanced economies, on the other hand, followed the opposite strategy of “long equity, short debt,” which was profitable but hazardous once the crisis hit.

There is another way, however, to evaluate the strategy of “financial adjustment.” Countries that match inflows with outflows have less exposure on a net basis, and net exposure may be tied to the occurrence of an external crisis. A recent IMF working paper by Luis A. V. Catão and Gian Maria Milesi-Ferretti, “External Liabilities and Crises,” reports that the risk of a crisis increases when net foreign liabilities rise above 50% of GDP and the NFL/GDP ratio rises 20% above a country’s historic mean. Moreover, when they examine exposure on different classes of liabilities, they find that the increase in crisis risk is linked to net debt liabilities.

Financial adjustment, therefore, was a successful strategy for minimizing the capital flow volatility for several reasons. The emerging market countries that implemented it lowered their international financial exposure and issued risk-sharing equity rather than debt. They were therefore less vulnerable than those countries with more liabilities that included relatively more debt. Given the cyclical nature of capital flows, such prophylactic measures should be enacted before the next storm arrives.

Assigned Readings: October 9, 2013

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This paper investigates the potential impacts of the degree of divergence in open macroeconomic policies in the context of the trilemma hypothesis. Using an index that measures the relative policy divergence among the three trilemma policy choices, namely monetary independence, exchange rate stability, and financial openness, we find that emerging market countries have adopted trilemma policy combinations with the least degree of relative policy divergence in the last fifteen years. We also find that a developing or emerging market country with a higher degree of relative policy divergence is more likely to experience a currency or debt crisis. However, a developing or emerging market country with a higher degree of relative policy divergence tends to experience smaller output losses when it experiences a currency or banking crisis. Latin American crisis countries tended to reduce their financial integration in the aftermath of a crisis, while this is not the case for the Asian crisis countries. The Asian crisis countries tended to reduce the degree of relative policy divergence in the aftermath of the crisis, probably aiming at macroeconomic policies that are less prone to crises. The degree of relative policy divergence is affected by past crisis experiences – countries that experienced currency crisis or a currency-banking twin crisis tend to adopt a policy combination with a smaller degree of policy divergence.

 

A central result in international macroeconomics is that a government cannot simultaneously opt for open financial markets, fixed exchange rates, and monetary autonomy; rather, it is constrained to choosing no more than two of these three. In the wake of the Great Recession, however, there has been an effort to address macroeconomic challenges through intermediate measures, such as narrowly targeted capital controls or limited exchange rate flexibility. This paper addresses the question of whether these intermediate policies, which round the corners of the triangle representing the policy trilemma, afford a full measure of monetary policy autonomy. Our results confirm that extensive capital controls or floating exchange rates enable a country to have monetary autonomy, as suggested by the trilemma. Partial capital controls, however, do not generally enable a country to have greater monetary control than is the case with open capital accounts unless they are quite extensive. In contrast, a moderate amount of exchange rate flexibility does allow for some degree of monetary autonomy, especially in emerging and developing economies.

 

The more severe a financial crisis, the greater has been the likelihood of its management under an IMF-supported programme and the shorter the time from crisis onset to programme initiation. Political links to the United States have increased programme likelihood but have prompted faster response mainly for ‘major’crises. Over time, the IMF’s response has not been robustly faster, but the time sensitivity to the more severe crises and those related to fixed exchange rate regimes did increase from the mid-1980s. Similarly, democracies had tended to stall programme initiation but have become more supportive of financial markets’ demands for quicker action.

Here and There: October 3, 2013

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1. Jérémie Cohen-Sutton has a review at the Bruegel blog of the recent literature on the trilemma. He provides links to the relevant papers.

2. Michael Hutchison of the University of California-Santa Cruz and Helen Popper of the University of Santa Clara have organized this year’s West Coast Workshop on International Finance and Open Economy Macroeconomics on October 11. The program is here.

Hobglobins and Hypocrites

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“A foolish consistency is the hobglobin of little minds…”

Ralph Waldo Emerson

Before this week’s announcement by Federal Reserve Chairman Ben Bernanke that the Fed would continue its asset purchases under Quantitative Easing 3, finance ministers and other leaders in emerging market nations had been voicing their concerns over the prospect of U.S. policymakers winding down their operations (see here). They feared that higher interest rates in the U.S. would bring back the capital that had flowed out in search of higher returns, which would leave the emerging market officials in the uncomfortable position of raising their own interest rates or watching their currencies depreciate. The calls for the Federal Reserve to exercise caution peaked at the G20 leaders summit in St. Petersburg, where the final communiqué called for “Further changes to monetary policy settings…to be carefully calibrated and clearly communicated.”

It would be easy to dismiss the foreign reaction on the grounds that there was a large measure of hypocrisy in these exhortations to the Federal Reserve to move slowly.  Many of these officials had previously castigated the Federal Reserve for the currency appreciations that accompanied the earlier capital inflows. Surely, it can be claimed, they should welcome a reversal in Federal Reserve policy.

But the calls for caution demonstrate that a country’s economic welfare incorporates many diverse interests that exercise influence at different times. The worries voiced earlier about currency appreciation were based on the fears of exporters that they would be adversely affected by the resulting increases in prices in foreign markets. Their grievances were heard sympathetically by domestic policy officials who have been dealing with an unsteady recovery from the Great Recession of 2008-09. The decline in import prices was of little import, as inflation has not been a concern. Human nature dictates that we resent adverse changes and take for granted those that benefit us. Moreover, Mancur Olson pointed out that when the benefits are diffuse and the “pain” concentrated, it is not surprising that the voices of those who feel threatened are predominant.

Capital outflows and currency depreciations, on the other hand, will affect other interest groups. Those who have liabilities denominated in dollars fear a rising burden in repaying their debts. Domestic firms dependent on imports worry about their higher costs. Regulators of domestic financial markets are anxious about financial volatility and declines in asset prices. Finance ministry and central bank officials fret about the financing of current account deficits. It would be surprising if their calls for protective actions were offset by a wave of messages from exporters jubilant at regaining market share.

When U.S. interest rates do rise, those outside the U.S. who are adversely affected will register their complaints. Their government representatives will respond by criticizing the Federal Reserve for ignoring the global impact of their policies. It may be inconsistent, but not hypocritical, for them to serve whichever domestic interests have the largest megaphones.

Nurske and Lagarde

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The outflows of capital from emerging market economies such as Brazil, India, Turkey and Indonesia and accompanying currency depreciations have led to discussions of what has caused the reversals in fortune of these countries (see, for example, here and here and here.). Higher U.S. interest rates and signs of an improving U.S. economy are seen as “pull factors” that lure investors to the U.S.. Deteriorating fundamentals in the crisis countries, such as rising current account deficits or falling growth rates, are portrayed as push factors that drive foreign investors away.

Capital volatility is a familiar and possibly systemic problem. Seventy years ago, Ragnar Nurske (1907-2007) blamed capital flows for destabilizing exchange rates. Nurske served in the Financial Section and Economic Intelligence Service of the League of Nations from 1934 to 1945. While there he wrote most of International Currency Experience: Lessons of the Interwar Period (1944). In this study, Nurske blamed the exchange rate depreciations of the 1930s on destabilizing capital flows:

…As funds moved out to take refuge abroad, pressure on the exchange market was increased and the rate of depreciation accelerated, which resulted in a further loss of confidence and a further flight of capital. In its effects on the balance of payments the capital flow became disequilibrating instead of equilibrating.       (League of Nations 1944:114)

Nurske’s views appear more relevant today than they did during the last decade, when financial globalization was generally viewed as a positive force, despite a lack of supporting evidence. The IMF, which had regarded an unregulated capital account as a suitable long-term goal for developing economies, reversed its stance during the 2008-09 crisis. The IMF now regards capital controls as an appropriate macroprudential tool (see, for example, here.).

Ben Bernanke, then a Federal Reserve Board Governor, issued a now-famous apology to Milton Friedman on the occasion of Friedman’s ninetieth birthday in 2002. Bernanke referred to Friedman’s work with Anna J. Schwarz that showed that the Federal Reserve had exacerbated the Great Recession of 1929 through its monetary policies, and promised: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”  Perhaps it is time for a new (albeit belated) apology, in this case from the IMF’s Managing Director Christine Lagarde to Nurske.  Friedman, who believed that successful speculators would return a misaligned exchange rate to its fundamental value, would be aghast. But perhaps the passage of time would allow the views of both Nobel Prize-winners to co-exist and guide current-day policy.

Correction: An alert reader has pointed out that Ragnar Nurske did not win the Nobel Prize. Perhaps I was confusing him with Ragnar Frisch, who shared with Jan Tinbergen the first Nobel prize in economics to be awarded in 1969.

Assigned Readings: September 3, 2013

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This paper assesses the implications of Chinese capital account liberalization for capital flows. Stylized facts from capital account liberalization in advanced and large emerging market economies illustrate that capital account liberalization has historically generated large gross capital in- and outflows, but the direction of net flows has depended on many factors. An econometric portfolio allocation model finds that capital controls significantly dampen cross-border portfolio asset holdings. The model also suggests that capital account liberalization in China may trigger net portfolio outflows as large domestic savings seek to diversify abroad.

Has the unprecedented financial globalization of recent years changed the behavior of capital flows across countries? Using a newly constructed database of gross and net capital flows since 1980 for a sample of nearly 150 countries, this paper finds that private capital flows are typically volatile for all countries, advanced or emerging, across all points in time. This holds true across most types of flows, including bank, portfolio debt, and equity flows. Advanced economies enjoy a greater substitutability between types of inflows, and complementarity between gross inflows and outflows, than do emerging markets, which reduces the volatility of their total net inflows despite higher volatility of the components. Capital flows also exhibit low persistence, across all economies and across most types of flows. Inflows tend to rise temporarily when global financing conditions are relatively easy. These findings suggest that fickle capital flows are an unavoidable fact of life to which policymakers across all countries need to continue to manage and adapt.

There is a global financial cycle in capital flows, asset prices and in credit growth. This cycle co‐moves with the VIX, a measure of uncertainty and risk aversion of the markets. Asset markets in countries with more credit inflows are more sensitive to the global cycle. The global financial cycle is not aligned with countries’ specific macroeconomic conditions. Symptoms can go from benign to large asset price bubbles and excess credit creation, which are among the best predictors of financial crises. A VAR analysis suggests that one of the determinants of the global financial cycle is monetary policy in the centre country, which affects leverage of global banks, capital flows and credit growth in the international financial system. Whenever capital is freely mobile, the global financial cycle constrains national monetary policies regardless of the exchange rate regime.

For the past few decades, international macroeconomics has postulated the “trilemma”: with free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. The global financial cycle transforms the trilemma into a “dilemma” or an “irreconcilable duo”: independent monetary policies are possible if and only if the capital account is managed.

So should policy restrict capital mobility? Gains to international capital flows have proved elusive whether in calibrated models or in the data. Large gross flows disrupt asset markets and financial intermediation, so the costs may be very large. To deal with the global financial cycle and the “dilemma”, we have the following policy options: ( a) targeted capital controls; (b) acting on one of the sources of the financial cycle itself, the monetary policy of the Fed and other main central banks; (c) acting on the transmission channel cyclically by limiting credit growth and leverage during the upturn of the cycle, using national macroprudential policies; (d) acting on the transmission channel structurally by imposing stricter limits on leverage for all financial intermediaries. We argue for a convex combination of (a), (c) and (d).