Trilemmas and Financial Instability

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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

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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.

Exiting the Planet

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The full impact of President Trump’s announcement that the U.S. will withdraw from the Paris climate accord will not be fully realized for years, and indeed, decades to come. But the withdrawal is part of a series of disavowals of international agreements and commitments that were created after World War II. It represents a fundamental change away from engagement with allies and partners in the global community to a mindset sees every interaction with a foreign partner as a zero-sum situation, with only one country benefitting from the dealing.

The administration’s actions can be analyzed in the framework offered by Albert O. Hirschman’s in Exit, Voice and Loyalty. A member of an organization or an agreement that commits its members to a course of action, who is dissatisfied with the current arrangements, can decide whether to leave (“exit”), or remain and seek to correct the perceived problems. Those with more basic loyalty to the goals or principles of the existing arrangement are more likely to choose the latter option. Clearly the Trump administration does not share the loyalty to the international liberal order.

This position has its roots in U.S. history. The country initially sought to avoid involvement in World War I, and it took years of German offenses (such as the sinking of the Lusitania) before President Wilson could obtain agreement to enter the war. However, the Senate failed to approve U.S. membership in the League of Nations, and during the 1930s there was little interest in opposing German expansion in Europe or Japanese incursion in Asia. Only with the bombing of Pearl Harbor could President Roosevelt receive approval to take up arms against Japan, and Hitler’s declaration of war on the U.S. solved the problem of justifying a European conflict at the same time.

These experiences and the emergence of the U.S. as a global superpower after the war led to a fundamental change in the U.S. position. John Ruggie and others have described the rise of multilateralism, a system of international alliances and intergovernmental organizations formed under U.S. leadership for the purpose of achieving shared objectives. In many cases, these were  global public goods. The institutions ranged from the United Nations to the North Atlantic Treaty Organization, and more recently, the Paris Accord. While the fortunes of these organizations and pacts fluctuated over time, they contributed to international peace despite a half century of “cold war” between the Soviet Union and the U.S. They also facilitated the process of economic globalization that accelerated during the 1990s after the disintegration of the Soviet Union and the entry of China into the global economy.

All these organizations face challenges. The emerging market nations, for example, have sought a larger role within the IMF and the World Bank. NATO has grappled with redefining its mission in the post-Soviet world. But the success of all these efforts depends in large part on the involvement of the U.S. Agreements can be reached without U.S. participation But this country accounts for almost one-quarter of the global economy, and holds a commanding lead in terms of innovation. It will be difficult to organize a response to a global challenge without the involvement of the hegemonic country.

President Trump believes that he can achieve a better deal for the U.S. by negotiating with other countries on a bilateral basis. The results to date do not back this up (see also here). This does not mean that we can not do a better job of minimizing the disruptions that globalization entails. But devising a better safety net is primarily a domestic issue, and revising international accords is easier to achieve when there are gains for both sides.

More importantly, many of the key challenges we face—environmental, economic, defense—are not zero-sum issues. Cleaner air, a stable financial system or security in other nations do not threaten the U.S.; indeed, many of these are public goods that can not be obtained without international cooperation. Walking away from international agreements in a fit of nationalist pique only lowers the prospects of future peace and prosperity.

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.

Crises and Coordination

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Policy coordination often receives the same type of response as St. Augustine gave chastity: “Lord, grant me chastity and continence, but not yet.” A new volume from the IMF, edited by Atish R. Ghosh and Mahvash S. Qureshi, includes the papers from a 2015 symposium devoted to this subject. Policymakers in an open economy who take each other’s actions into account should be able to reach higher levels of welfare than they would working in isolation.  But actually engaging in coordination turns out to be harder–and less common– than many may think.

Jeffrey Frankel of Harvard’s Kennedy School of Government uses game theory to illustrate the circumstances that hamper coordination. One factor may be a fundamental divergence in how different policymakers view a situation. Many analysts on this side of the Atlantic, for example, use the “locomotive game” to show that Germany should engage in expansionary fiscal policies that would raise output for all nations. But (most) German policymakers have different views of the external impact of deficit spending. In the case of the Eurozone, a deficit in one country increases the probability that it will need a bailout by the other members of the monetary union. Only rules such as those of the Stability and Growth Pact that limit deficit expenditures can eliminate the moral hazard that would otherwise lead to widespread defaults.

Charles Engel of the University of Wisconsin (working paper here) also examines the recent literature on central bank coordination. He points out that the identifying the source of shocks is necessary to assess the benefits of cooperation to address them, and suggests that financial sector shocks may be most relevant for modeling open-economy coordination. But widespread cooperation could undercut the ability of a central bank to credibly commit to a single target, such as an inflation target.

Policymakers in emerging markets who must deal with the consequences of policies in advanced economies have been particularly mindful of their spillover effects. Raghuram Rajan, for example, who is back at the University of Chicago after serving as head of India’s central bank, has urged the Federal Reserve and other central banks to take into account the impact that their policies have on other nations, particularly when unwinding their Quantitative Easing asset purchases. He pointed out: “Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country.”

If international cooperation is viewed as a bargaining game, what incentives do the advanced economies have for cooperative behavior in light of the asymmetries among nations? Engel points out that in such circumstances, “…the emerging markets may believe that they have too little say in this implicit agreement, which is to say that they may perceives themselves as having too little weight in the bargaining game.” Conversely, central banks in the upper-income countries may in ordinary circumstances see little need to extend the scope of their decision-making outside their borders.

This attitude changes, however, when a crisis occurs, as Frederic Mishkin of Columbia shows in his examination of the response of central bankers to the global financial crisis. The Federal Reserve established swap lines to provide dollars to foreign central banks in countries where domestic banks faced a withdrawal of the funding they had used to acquire dollar-denominated assets. In addition, six central banks—the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank—announced a coordinated reduction of their policy rates. Coordination becomes quite relevant in a world of sudden stops and capital flight.

The need for such activities could increase if there is a global financial cycle, as Hélène Rey of the London Business School has stated. She presents evidence of the impact of global volatility, as measured by VIX, on international asset prices and capital flows. An important determinant of such volatility is monetary policy in the center countries. Rey agrees with Rajan that: “Central bankers of systemically important countries should pay more attention to their collective policy stance and its implications for the rest of the world.”

Perhaps a better motivation for the need for joint action comes from Charles Kindleberger’s list of the responsibilities that a hegemonic power such as Great Britain played in the period before World War I. These included acting as a lender of last resort during a financial crisis; indeed, it was the lack of such an international lender in the 1930s that Kindleberger believed was an important contributory factor to the Great Depression. Since the end of World War II the U.S. has vacillated in this role while the international monetary system has moved from crisis to crisis. Meanwhile, offshore credits denominated in dollars have grown in size, and could conceivably constrain the Federal Reserve’s ability to undertake purely domestic measures.

A policy of “America First” that means “America Only First and Last” ignores the fragility of the international financial system. Just as there are no atheists in foxholes, no one doubts the merits of coordination when there is a disruption of global markets. But suffering another crisis would be an expensive reminder that the best time to minimize systemic risk is before a crisis erupts.

The Emerging Market Economies and the Appreciating Dollar

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U.S. policymakers are changing gears. First, the Federal Reserve has signaled its intent to raise its policy rate several times this year. Second, some Congressional policymakers are working on a border tax plan that would adversely impact imports. Third, the White House has announced that it intends to spend $1 trillion on infrastructure projects. How all these measures affect the U.S. economy will depends in large part on the timing of the interest rate rises and the final details of the fiscal policy measures. But they will have consequences outside our borders, particularly for the emerging market economies.

Forecasts for growth in the emerging markets and developing economies have generally improved. In January the IMF revised its global outlook for the emerging markets and developing economies (EMDE):

EMDE growth is currently estimated at 4.1 percent in 2016, and is projected to reach 4.5 percent for 2017, around 0.1 percentage point weaker than the October forecast. A further pickup in growth to 4.8 percent is projected for 2018.

The improvement is based in part on the stabilization of commodity prices, as well as the spillover of steady growth in the U.S. and the European Union. But the U.S. policy initiatives could upend these predications. A tax on imports or any trade restrictions would deter trade flows. Moreover, those policies combined with higher interest rates are almost guaranteed to appreciate the dollar. How would a more expensive dollar affect the emerging markets?

On the one hand, an appreciation of the dollar would help countries that export to the U.S. But the cost of servicing dollar-denominated debt would increase while U.S. interest rates were rising. The Bank for International Settlements has estimated that emerging market non-bank borrowers have accumulated about $3.6 trillion in such debt, so the amounts are considerable.

In addition, Valentina Bruno and Hyun Song Shin of the BIS have examined (working paper here) a “risk-taking” channel of U.S. monetary policy that links exchange rate movements to cross-border banking flows. In the case of an appreciation of a foreign currency, domestic banks in the affected countries channel funds from global banks to firms with local currency assets that have risen in value. A domestic currency depreciation in response to U.S. monetary policy will lead to a contraction in such lending.

Jonathan Kearns and Nikhil Patel of the BIS have sought to determine whether the “financial channel” of exchange rates offsets the “trade channel.” The sample of countries they use in their empirical analysis includes 22 advanced economies and 22 emerging market economies, and the data for most of these countries begins in the mid-1990s and extends through the third quarter of 2016. They use two exchange rate indexes, where the indexes measures the foreign exchange values of the domestic currency, in one case weighted by trade flows and the second by foreign currency-denominated debt.

Their results provide evidence for both channels that is consistent with expectations: the trade-weighted index has a negative elasticity, while the debt-weighted index has a positive linkage. For 13 of the 22 emerging market economies, the sum of the two elasticities is positive, indicating than an equal appreciation of the domestic currency would be expansionary. The financial channel is stronger for those emerging market economies with more foreign currency debt.

Does this indicate that further appreciation of the dollar will lead to the long-anticipated debt crisis in the emerging markets? When Kearns and Patel replaced the debt-weighted exchange rate index with the bilateral dollar rate, they found that the debt-weighted index does a better job in capturing the financial channel than the dollar exchange rate alone. The other foreign currencies in the debt-weighted index included the euro, the yen, the pound and the Swiss franc, so a rise in the dollar is not as important when the debt is denominated in the other currencies.

Domestic policymakers in the emerging market countries seem to have done a good job in restraining domestic credit growth, which is often the precursor of financial crises. There is one significant exception: China. One recent estimate of its debt/GDP ratio placed that figure at 277% at the end of 2016. The government is attempting to slow this expansion down without destabilizing the economy, which now has a growth target of 6.5%. What happens if the dollar appreciates against the renminbi as it did last year, when China used up a trillion dollars in foreign exchange reserves in an attempt to slow the loss in value of its currency? About half of China’s external debt is denominated in its own currency, so it has less to fear on this score than do other borrowers.

A team of IMF economists that included Julian Chow, Florence Jaumotte, Seok Gil Park, and Yuanyan Sophia Zhang examined in 2015 the spillovers from a dollar appreciation. They noted that many emerging market economies are currently less vulnerable to a dollar appreciation than they were during previous periods. However, they also reported that some countries in eastern Europe and the Commonwealth of Independent States have short positions in dollar-denominated debt instruments. They investigated corporate borrowing, including debt denominated in foreign currencies, and performed a stress test analysis based on higher borrowing costs, a decline in earnings and an exchange rate depreciation to see which countries had the most vulnerable firms. They reported that increases in foreign exchange exposure would be largest in Brazil, Chile, India, Indonesia and Malaysia. They concluded their report: “Should a combination of severe macroeconomic shocks affect the nonfinancial sector, debt at risk would further rise, putting pressure on banking systems’ buffers, especially in countries where corporate and banking sectors are already weak. “

Another team of Fund economists, led by Selim Elekdag, also investigated rising corporate borrowing in the emerging market economies in the October 2015 Global Financial Stability Report. They attributed the rise in corporate debt in these countries to accommodative global monetary conditions. Consequently, these firms are quite vulnerable to changes in U.S. interest rates.

Some analysts see signs of a “virtuous cycle” in many emerging market economies. The motivating factors range from pro-growth policies in India to China’s ability (to date) to avoid a severe slowdown. But these economies are quite vulnerable to external developments. The Federal Reserve recognize this, and takes the foreign impact of its policies into account. But no such assurance comes from the rest of the U.S. government. President Trump’s fulfillment of his promise to disrupt the normal policy process in Washington will have a broad impact outside the U.S. as well.

Conferences

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It is the time to plan for the spring conferences that feature work in international macroeconomics. This year’s venues include:

Date             Location                                               Name

5/25-5/27   Crete, Greece            Annual Conference on Macro Analysis &  International Finance

5/31-6/3     Poznan, Poland          International Trade & Finance Association 27th Int’l Conference

6/8-6/9        Barcelona, Spain        Barcelona GSE Summer Forum: International Capital Flows

6/12-6/13   València, Spain            Infiniti 2017

6/15-6/16   Aarhus, Denmark       13th Danish International Economics Workshop

6/19-6/20   Dublin, Ireland            IM-TCD-ND Workshop: Int’l Macroeconomics and Capital Flows

6/22-6/25   Ljublijana, Slovenia    European Economics & Finance Society Conference

7/5-7/6       Paris, France               34th International Symposium on Money, Banking & Finance

7/10-7/14  Cambridge, U.S.           NBER: International Finance & Macroeconomics

Greece, the IMF and the Euro

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Talk about possible trade wars with China and the Brexit negotiations has crowded the Greek debt crisis out of the headlines, but a new decision point is approaching. It is possible that this time the beleaguered Greek government will announce a withdrawal from the Eurozone, if only to drive home the point to other European governments that the status quo is not acceptable. But those governments, facing resistance from voters suspicious of foreign engagements, may not offer terms acceptable to the Greek government. Moreover, the IMF does not want to approve the next stage of a bailout agreement that it believes is not credible. Consequently, each side may feel pushed to accept an outcome it knows is not optimal. If that comes to pass, the consequences for the Eurozone will be far-reaching.

Greek economic performance, after years of contraction, has stabilized. The IMF projected that GDP, after stagnating in 2016, would increase in the current year by 2.8%. But the ratio of gross debt to GDP, according to the IMF’s projection in last fall’s Global Stability Report, was 183.4% last year, up from 176.9% in 2015 and 180.1% in 2014. Moreover, a draft report from the Fund projects continuing growth in the debt burden, ultimately reaching a crushing 275% in 2060.

The IMF’s concerns come as European governments are assessing Greek compliance with its current bailout agreement. Greece needs a successful review to qualify for disbursal of about $90 billion, which the government requires for debt repayments. Greece has met its recent fiscal targets, but the agreement calls for a 3.5% primary budget surplus target by 2018. The IMF fears that this is not achievable without a degree of fiscal austerity that would kill off the incipient recovery. Not everyone shares the IMF’s apprehensions, and the agency that administers the European Stability Mechanism has issued a positive assessment. But if the IMF does not approve the next stage of the bailout, at least some European governments will not want to proceed.

George Papaconstantinou in Game Over has provided an insider’s look at the outbreak of the crisis and the course of negotiations in the early years. Papaconstantinou, who earned a Ph.D. in economics at the London School of Economics, served first as Finance Minister and then Minister of Environment, Energy and Climate Change, in the government of Prime Minister George Papandreou from 2009 to 2012. He faced what he calls a “disconnect” between the demands from European ministers that the Greek government close the fiscal deficit and the realization at home what the abrupt change in the government’s fiscal position meant for the economy. There was a continuous refusal on both sides to address the reality of the situation and to temporize in the unfounded hope that the arrival of another day would deliver a solution—or at least delay any decision that would generate voter unhappiness, either at home or in the European electorate. But postponement only raised the cost of what became three bailout agreements. Among the lessons that Papaconstantinou draws: “time is expensive: the more you delay, the more you pay.”

The IMF was also facing challenges in its involvement in the crisis negotiations, as Paul Blustein recounts in Laid Low. The Fund joined the European Central Bank and the European Commission, representing the European Union, in an arrangement known as the “troika.” The IMF, however, was viewed as a “junior partner,” and had to negotiate with its partners as well as with the Greek government. This was a departure from past practice, and placed the IMF in the position of making compromises that it came to regret.

The principal violation of the Fund’s own practices took place early in the crisis when it approved “exceptional access” credit to Greece, i.e., an unusually large amount of credit. Such approval was supposed to be contingent on a high probability that the debt was sustainable. This condition had clearly not been met in 2010, but the IMF gave itself a loophole when it approved exceptional credit if there is a high risk of international systemic spillovers. The insertion of the systemic exception clause violated any notion of the IMF’s evenhandedness when dealing with members who required assistance, and reinforced the image of the Fund as an agency dominated by its richer members.

The IMF subsequently has sought to recover its reputation as an institution that has extensive experience in macro adjustment and is willing to “speak truth to power.” It eliminated the exceptional access provision in 2016. The Fund now admits that the fiscal policies imposed on Greece in the earlier bailout programs were contractionary. And in a statement it issued on Tuesday, the IMF called for more debt relief by the European creditor governments:

“Most Directors considered that, despite Greece’s enormous sacrifices and European partners’ generous support, further relief may well be required to restore debt sustainability.”

But in a highly unusual public statement, the IMF also announced that the Board was split on the feasibility of the new agreement:

“Most Directors agreed that Greece does not require further fiscal consolidation at this time, given the impressive adjustment to date which is expected to bring the medium-term primary fiscal surplus to around 1½ percent of GDP, while some Directors favored a surplus of 3½ percent of GDP by 2018.”

Could there be a better outcome? Joseph Stiglitz of Columbia University argues that the monetary union is inherently flawed in The Euro. He points out that the euro was justified on the premise that a single currency would facilitate trade and financial flows, and “…the resulting economic integration would improve societal welfare everywhere within the Eurozone.” In fact, there were winners and losers, and the latter were not compensated for their losses. Such a redistribution requires political integration, which does not automatically follow the establishment of economic integration.

Stiglitz does not want to abandon what he calls the “European project,” and offers several structural reforms to rescue the euro. But all of these require political resolution as well intellectual flexibility, and these are not qualities rewarded by voters. Upcoming elections in France and Germany will show whether their citizens approve of the attempts to maintain the viability of the euro. If they follow the examples of the U.S. and British electorates, then the days of the euro may be numbered.

The Changing Fortunes of the Renminbi and the Dollar

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Last fall the International Monetary Fund announced that China’s currency, the renminbi, would be included in the basket of currencies that determine the value of the IMF’s reserve asset, the Special Drawing Right (SDR). The IMF’s statement appeared to confirm the rise in the status of the currency that could at some point serve as an alternative to the U.S. dollar as a global reserve currency. But in retrospect the renminbi is a long way from achieving widespread use outside its regional trading partners, and recent policies will only limit the international use of the currency.

It has been widely speculated that the drive to include the renminbi in the IMF’s currency basket was a tool by reformers such as People’s Bank of China governor Zhou Xiaochuan to move their country towards a more liberal economic regime. The SDR currencies are supposed to be “freely usable” by foreign and domestic investors, so capital controls were eased in the run-up to the SDR announcement. But Chinese authorities are loath to give up their ability to control foreign transactions.

This has become particularly true as a result of China’s recent capital outflows. These have in part reflected outward foreign direct investment by Chinese firms seeking to expand. But the outflows are also due to Chinese firms and individuals moving money outside their country. These movements both reflect and contribute to a continuing depreciation of the renminbi, particularly against the dollar. Chinese authorities have burned through almost $1 trillion of their $4 trillion in foreign exchange reserves as they sought to slow the slide in the value of their currency.

To reduce pressure on the renminbi, the authorities are imposing controls on the overseas use of its currency. But these regulations to protect the value of the currency reduce the appeal of holding the renminbi. As Christopher Balding of the HSBC Business School in Shenzhen points out, monetary authorities can not control the exchange rate and the money supply while allowing unregulated capital flows.

Even if the authorities manage to weather the effects of capital outflows, the long-term prospects of the renminbi becoming a major reserve currency are limited. Eswar Prasad of Cornell University has written about the role of the renminbi in the international monetary system in Gaining Currency: The Rise of the Renminbi. After reviewing the extraordinary growth of the Chinese economy and the increased use of the renmimbi, Prasad evaluates China on the criteria he believes determine whether it will graduate to the status of a global currency. China had until recently been removing capital controls and allowing the exchange rate to become more flexible, benchmarks followed by foreign investors. Its public debt is relatively low, so there are no fears of sovereign debt becoming unmanageable or inflation getting out of hand.

On the other hand, the rise in total debt to GDP to 250% has drawn concerns about the stability of the financial sector. This is troubling, because as Prasad points out, this is the area of China’s greatest weakness. This vulnerability reflects not only on the increasing amount of private debt but also precarious business loans on the books of the banks, the growth of the shadow banking system and stock market volatility. Prasad writes: “China’s financial markets have become large, but they are highly volatile, poorly regulated, and lack a supporting institutional framework.” This is crucial, since ”… financial market development is likely, ultimately, to determine winners and losers in the global reserve currency sweepstakes.”

The growth in the use of renminbi has not eroded the primacy of the dollar in the international monetary system.. An investigation by Benjamin J. Cohen of UC-Santa Barbara and Tabitha M. Benney of the University of Utah of the degree of concentration in the system indicates that there is little evidence of increased competition among currencies. The dollar is widely used as a vehicle currency for private foreign exchange trading and cross-border investments, as well as for official holdings of reserves. Expectations for the euro have been scaled back as the Eurozone area struggles with its own long-term stability.

Carla Norrlof of the University of Toronto examines the sources of the dominance of the dollar. She investigates the factors that contribute to “monetary capability,” the resources base necessary for exercising currency influence. These include GDP, trade flows, the size and openness of capital markets, and defense expenditures. Norrlof’s empirical analysis leads her to confirm the status of the U.S. as the monetary hegemon: “The United States is peerless in terms of monetary capability, military power and currency influence.”

Cohen and Benney stress that their analysis holds for the current system, which could change. What could undermine the status of the dollar? Benjamin Cohen worries that President-elect Trump’s policies may increase the government’s debt and restrict trade, and possibly capital flows as well. These measures need not immediately demolish the role of the dollar. But Cohen writes, “…the dollar could succumb to a long, slow bleeding out, as America’s financial rivals try to make their own currencies more attractive and accessible.”

The renminbi, therefore, does not represent any short-term threat to the dollar’s place in the international monetary system. But the U.S. itself could undermine that status, and a potential opening may spur Chinese efforts to establish a firmer basis for the use of its currency, just as it has done in international trade in the wake of the demise of the Trans-Pacific pact. The transition could take decades, and during that period the global system could disintegrate into regional alliances that encourage unstable trade and financial flows. Those in the U.S. who voted for change may rue the consequences of President-elect Trump’s efforts to deliver on that electoral promise.