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The protests at Smith College that led to the withdrawal of Christine Lagarde, Managing Director of the International Monetary Fund, as this year’s commencement speaker have been widely denounced as a manifestation of intolerance. They also demonstrate a lack of understanding of the IMF and the many changes that have taken place at that institution in the last decade, as well as Ms. Lagarde’s own record. The IMF adjusted its policies in response to the criticisms it received after the crises of the 1990s, but apparently its critics are mired in the past.

A petition signed by several hundred Smith students and faculty (but not supported by many Smith faculty, including members of the Economics Department) explains the grounds for their opposition to Lagarde’s appearance on their campus:

“By having her speak at our commencement, we would be publicly supporting and acknowledging her, and thus the IMF. Even if we give Ms. Lagarde the benefit of the doubt, and recognize that she is just a good person working in a corrupt system, we should not by any means promote or encourage the values and ideals that the IMF fosters. The IMF has been a primary culprit in the failed developmental policies implanted in some of the world’s poorest countries. This has led directly to the strengthening of imperialist and patriarchal systems that oppress and abuse women worldwide.”

This statement exhibits the “vagueness and sheer incompetence” that George Orwell cited as characteristics of modern English prose, particularly political writing. In addition, the assignment of responsibility to the IMF for the “imperialist and patriarchal systems” is a contemporary example of the “staleness of imagery” that Orwell deplored. Holding the IMF responsible for global poverty reveals a lack of knowledge about the decline in global poverty in recent decades as well as a gross misunderstanding of the IMF’s role. The IMF long ago retreated from the structural adjustment policies that were criticized as inappropriate, and ceded the lead role in addressing poverty to the World Bank. More recently, the IMF was active in responding to the global financial crisis. The Fund in 2008-09 provided large amounts of credit relatively quickly with limited conditionality, and the IMF’s programs contributed to the recovery of global economic activity (see here for more detail).

Blaming Lagarde for global poverty is particularly unjustified in view of her acknowledgement of this issue. She has spoken eloquently about the combined impact of the economic crisis, the environmental crisis and the social crisis that reflects a widening gap in income distribution. To tackle the latter, she has supported more spending on health and education, and the development of social safety nets. Lagarde has also been a strong spokeswoman for gender equality (see also here). The change in the IMF’s position on the use of capital controls predates Lagarde’s tenure, but she has encouraged the continuing intellectual evolution of its Research Department under Olivier Blanchard.

And then there is the irony of students at a prestigious women’s college protesting the invitation extended to a woman who has been a pioneer in raising the professional profile of women. In the male-dominated world of international finance she was the first female finance minister of a member country of the Group of 8, and is the first female head of the IMF. The top position at the IMF became available when her predecessor at the IMF, Dominique Strauss-Kahn, resigned after being charged with sexual assault at a New York hotel. Ironically, the controversy over Lagarde arose as a movie about Strauss-Kahn was being shown at Cannes.

If protestors want to do something to improve the position of the world’s poorest countries, they should aim their ire at those members of the U.S. Congress who are blocking reform at the IMF. The politicians have been stalling passage of the required authorization of changes at the IMF, which would increase the representation of emerging market countries at the Fund. In a rare act of (muted) public criticism, the government of Great Britain has publicly urged the U.S. Congress to ratify the required measures. Reforming the IMF would be a more effective response to global inequality than protesting against someone who has sought to lessen that inequality.

China’s Trilemma Maneuvers

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China’s exchange rate, which had been appreciating against the dollar since 2005, has fallen in value since February. U.S. officials, worried about the impact of the weaker renminbi upon U.S.-China trade flows, have expressed their concern. But the new exchange rate policy most likely reflects an attempt by the Chinese authorities to curb the inflows of short-run capital that have contributed to the expansion of credit in that country rather than a return to export-led growth. Their response illustrates the difficulty of relaxing the constraints of Mudell’s “trilemma”.

Robert Mundell showed that a country can have two—but only two—of three features of international finance: use of the money supply as an autonomous policy tool, control of the exchange rate, and unregulated international capital flows. Greg Mankiw has written about the different responses of U.S., European and Chinese officials to the challenge of the trilemma. Traditionally, the Chinese sought to control the exchange rate and money supply, and therefore restricted capital flows.

In recent years, however, the Chinese authorities have pulled back on controlling the exchange rate and capital flows, allowing each to respond more to market forces. The increase in the value of renminbi followed a period when it had been pegged to increase net exports. As the renminbi appreciated, foreign currency traders and others sought to profit from the rise, which increased short-run capital inflows and led to an increase in foreign bank claims on China. But this inflow contributed to the domestic credit bubble that has fueled increases in housing prices. Private debt scaled by GDP has risen to levels that were followed by crises in other countries, such as Japan in the 1980s and South Korea in the 1990s. All of this gave the policymakers a motive for trying to discourage further capital inflows by making it clear the renminbi’s movement need not be one way.

Moreover, the authorities may have wanted to hold down further appreciation of the renminbi. The release of new GDP estimates for China based on revised purchasing power parity data showed that country’s economy to be larger than previously thought. The new GDP data, in turn, has led to revisions by Marvin Kessler and Arvind Subramanian of the renminbi exchange rate that would be consistent with the Balassa-Samuelson model that correlates exchange rates to levels of income. Their results indicate that the exchange rate is now “fairly valued.” With the current account surplus in 2013 down to 2% of GDP, Chinese officials may believe that there is little room for further appreciation.

Gavyn Davies points out that there is another way to relieve the pressure on the exchange rate due to capital inflows: allow more outflows. Even if domestic savers receive the higher rates of return that government officials are signaling will come, Chinese investors would undoubtedly want to take advantage of the opportunity to diversity their asset holdings. As pointed out previously, however, capital outflows could pose a threat to the Chinese financial system as well as international financial stability. Chinese economists such as Yu Yongding have warned of the consequences of too rapid a liberalization of the capital account.

The Chinese authorities, therefore, face difficult policy choices due to the constraints of the trilemma. Relaxing the constraints on capital flows could cause the exchange rate to overshoot while further adding to the domestic credit boom that the central bank seeks to restrain. But clamping down on capital flows would slow down the increase in the use of the renminbi for international trade. As long as the policymakers seek to maneuver around the restraints of the trilemma, they will be reacting to the responses in foreign exchange and capital markets to their own previous initiatives.

Can the U.S. Rebalance without Raising Inequality?

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Last week’s estimate of an anemic U.S. GDP first-quarter growth rate of 0.1% will be revised. Moreover, the good news regarding job growth in April suggests that the U.S. economy is expanding at a quicker pace in the second quarter. But a closer look at the first quarter data reveals a disturbing drop in investment and net exports that does not bode well for a reorientation of the U.S. economy.

The rise in economic activity was entirely due to a rise in consumption expenditures, which rose at annual rate of 2.04%. Gross private domestic investment expenditures, on the other hand, fell. Private nonresidential investment expenditures totaled $2.091 trillion, slightly down from $2.096 in the last quarter of 2013. Moreover, spending on new plants and equipment, when adjusted by GDP, reflects a continuation of a slow cyclical rise after the global financial crisis, with no sign of any acceleration:

*Year*	*Private Nonresidential Investment/GDP*	*Federal Budget/GDP*	*Current Account/GDP*
2004	11.92%	-3.36%	-5.06%
2005	12.31%	-2.43%	-5.63%
2006	12.82%	-1.79%	-5.74%
2007	13.26%	-1.11%	-4.90%
2008	13.19%	-3.12%	-4.61%
2009	11.33%	-9.80%	-2.64%
2010	11.09%	-8.65%	-3.04%
2011	11.65%	-8.37%	-2.94%
2012	12.13%	-6.69%	-2.70%
2013	12.19%	-4.04%	-2.33%

An investment “dearth” (or “drought’) is not unique to the U.S. Antonio Fatas has shown that investment expenditures as a share of GDP have fallen in the advanced economies. Restricted spending on new plants and equipment has been blamed for continuing low growth rates in these countries, presaging a new period of “secular stagnation.”

Stephen Roach, former chief economist at Morgan Stanley and currently a Senior Fellow at Yale University’s Jackson Institute, has another concern. In his recent book, Unbalanced: The Codependency of America and China, he writes about the breakdown of the pre-crisis growth models in the two countries. China’s rapid expansion was based on investment and exports, backed by high savings rates. In the U.S., on the other hand, consumption expenditures, financed in part by borrowing against rising home values, were the basis of the economy’s growth. The flows of goods and capital between the two countries established a pattern of co-dependency between them. But the crisis revealed the weaknesses of both patterns of spending, and the two countries need to rebalance and reorient their economies.

Roach believes that China is taking the first steps to change the structure of its economy. President Xi Jinping and Prime Minister Li Keqiang have pledged to increase the role of private markets in allocating resources. Economic growth will be based on domestic demand, which will be focused on consumer expenditures. Success is not guaranteed, however, as there will be resistance from those who profited from the old export-dependent model and government control of the financial system. The government also faces daunting environmental challenges.

Roach is decidedly not optimistic about the ability of the U.S. to make the corresponding adjustments to its economy. While the deficit in federal budget has shrunk (see above), household savings remain too low. The U.S., he writes “…has ignored its infrastructure, investing in human capital and the manufacturing capacity.” The recent fall of the U.S. current account deficit could be reversed if consumption expenditures remain the engine of economic growth.

Roach is not alone in his concerns about the need for increasing national savings. Former Federal Reserve Chair Ben Bernanke raised the same issue in testimony to Congress last year. Raising savings rates during an economic recovery, however, is difficult, particularly given the slow decline of unemployment. Moreover, the work of Thomas Piketty and others on income distribution has drawn attention to a troubling aspect of this issue: savings are concentrated among the those in highest income brackets who hold such a large share of the wealth in the U.S. Many Americans live paycheck to paycheck, with little opportunity of funding individual retirement accounts to finance their retirements.

Raghuram Rajan, in Fault Lines: How Hidden Fractures Still Threaten the World Economy, pointed to the connection between the U.S. external position and growing inequality. While the U.S. economy has largely recovered from the financial crisis, the “fault lines” that Rajan wrote about still exist. It will be a daunting challenge for the U.S. to increase national savings without reinforcing the “forces of divergence” that skew income distribution.

Recovery in Europe?

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Greece has returned to the bond market, issuing $4.2 billion of five-year bonds at an interest rate of 4.95%. The government’s ability to borrow again is a “reward” for posting a surplus on its primary budget (although the accounting that produced the surplus has been questioned). This has been viewed as a sign, albeit fragile, of recovery. Portugal has also sold bonds and hopes to exit its bailout program this spring. But what does recovery mean for these countries, and is it sustainable?

Growth for these countries reflects a rise from a brutally harsh downturn. Greece has an unemployment rate of 26.7%, with much higher rates for its youth. Portugal’s unemployment rate of 15.3% was achieved in part by emigration.

A look forward indicates that the debt that drove these countries to borrow from their European neighbors and the IMF will fall in the next five years but continue at elevated levels. The latest Fiscal Monitor of the International Monetary Fund forecasts gross government debt to GDP ratios for these countries, as well as for the Eurozone:

	2015	2016	2017	2018	2019
Greece	171.3	162.5	153.7	146.1	137.8
Portugal	124.8	122.6	119.1	116.6	113.8
Eurozone	94.5	92.6	90.4	88.1	85.5

Even if the debt/GDP ratios above the Reinhart-Rogoff 90% threshold do not pose a threat to growth, it is noticeable that the Eurozone’s debt does not fall below it until 2018, while debt/GDP in Greece and Portugal will be in triple digits for many years.

These debt levels become more worrisome in light of fears of deflation in the Eurozone. Greek consumer prices have been falling, and inflation in the Eurozone is below its 2% target level. European Central Bank head Mario Draghi has downplayed these concerns, pointing to rising prices in other Eurozone countries. But IMF economists Reza Moghadem, Ranjit Teja and Pelin Berkman point out that even low inflation can also pose problems. Deflation and less than expected rates of inflation increase the burden of existing debt. Greece’s debt will become more of a burden if it rises in real terms. Low inflation also makes wage adjustment harder to achieve.

The ECB would (presumably) respond if the prospect of deflation became more likely. But would it be able to stave off falling prices through its version of quantitative easing? There are concerns that large-scale purchases of assets by the ECB might not be as effective as anticipated. Interest rates have already fallen and are unlikely to fall further. Moreover, the decline in borrowing costs for Greece and other sovereign borrowers may have already have factored in ECB intervention.

Draghi’s pledge in 2012 to do “whatever it takes” to protect the euro undoubtedly lowered concerns about a collapse of the Eurozone. But, as I have argued before, the confidence within the Eurozone inspired by the ECB’s powers could vanish, particularly if there were doubts about the ECB’s ability to actually accomplish whatever it takes to avoid deflation. Lower borrowing costs based on faith in the ECB will ease conditions in the Eurozone crisis countries. But they need to be backed up by improving economic fundamentals before they are seen as justified. Until then, purchasing sovereign debt is a high-risk proposition, no matter what the interest rates signal.

China’s Place in the Global Economy

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Last week’s announcement that China’s GDP grew at an annualized rate of 7.4% in the first quarter of this year has stirred speculation about that country’s economy. Some are skeptical of the data, and point to other indicators that suggest slower growth. Although a deceleration in growth is consistent with the plans of Chinese officials, policymakers may respond with some form of stimulus. Their decisions will affect not just the Chinese economy, but all those economies that deal with it.

The latest World Economic Outlook of the International Monetary Fund has a chapter on external conditions and growth in emerging market countries that discusses the impact of Chinese economic activity. The authors list several channels of transmission, including China’s role in the global supply chain, importing intermediate inputs from other Asian economies for processing into final products that are exported to advanced economies. Another contact takes place through China’s demand for commodities. The author’s econometric analysis shows that a 1% rise in Chinese growth results in a 0.1% immediate rise in emerging market countries’ GDPs. There is a further positive effect over time as the terms of trade of commodity-exporters rise. Countries in Latin America are affected as well as in Asia.

These consequences largely reflect trade flows, although China’s FDI in other countries is acknowledged. But what would happen if China’s capital account regulations were relaxed? Financial flows conceivably could be quite significant. Chinese savers would seek to diversity their asset holdings, while foreigners would want to hold Chinese securities. Chinese banks could expand their customer base, while some Chinese firms might seek external financing of their capital projects. A study by John Hooley of the Bank of England offers an analysis of the possible increase in capital flows that projects a rise in the stock of China’s external assets and liabilities from about 5% of today’s world GDP to 30% of world GDP in 2025.

While the study points out that financial liberalization by China would allow more asset diversification, it also acknowledges that world financial markets would become vulnerable to a shock in China’s financial system. Martin Wolf warns that the down-side risk is quite large. He cites price distortions and moral hazard as possible sources of instability, as well as regulators unfamiliar with global markets and an existing domestic credit boom. Similarly, Tahsin Saadi Sedik and Tao Sun of the IMF in an examination of the consequences of capital flow liberalization claim that deregulation of the Chinese capital account would result in higher GDP per capita and lower inflation in that country, but also higher equity returns and lower bank adequacy ratios, which could endanger financial stability.

There could be another result. A sizable Chinese presence in global asset markets would lead to even more scrutiny of Chinese monetary policy. A policy initiative undertaken in response to domestic conditions would affect financial flows elsewhere, and foreign policymakers most likely would voice their unhappiness with the impact on their economies. The Peoples Bank of China, accustomed to criticism from the U.S. over its handling of its exchange rate, might find the accusation of “currency wars” coming from other emerging market countries. The price of a successful integration of Chinese financial markets with global finance will be calls for more sensitivity to the external impacts of domestic policies.

Capital Liberalization and Inequality

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Inequality, which has drawn a great deal of comment and analysis following the publication of Thomas Piketty’s Capital in the Twenty-First Century, has sometimes been seen as a byproduct to increased international trade. But now other international economic linkages are being investigated. The International Monetary Fund’s Managing Director, Christine Lagarde, has acknowledged the need to take distributional consequences into consideration when designing IMF policy programs. Moreover, Fund economists have contributed to the research on the linkages between financial globalization and inequality.

Davide Furceri and Prakash Loungani of the IMF have investigated the effect of capital account liberalization on inequality. They looked at 58 episodes of capital account reform in 17 advanced economies, and found that the Gini coefficient (a measure of inequality) increased by about 1% a year after liberalization and by 2% after five years. One channel of transmission from the capital account to inequality could be the Increased borrowing by domestic firms that allows them to hire skilled workers, who pull ahead of the less-skilled workers.

A similar impact was found by Florence Jaumotte, Subir Lall and Chris Papageorgiou, also of the IMF. They analyzed the effect of financial globalization and trade as well as technology on income inequality in 51 countries over the period of 1981 to 2003. They reported that technology played a larger role in increasing inequality than globalization. But while trade actually reduced inequality through increased exports of agricultural goods from developing countries, foreign direct investment played a different role. Inward FDI (like technology) favored workers with relatively higher skills and education, while outward FDI reduced employment in lower skill sectors. Consequently, the authors concluded, while financial deepening has been associated with higher growth, a disproportionate share of the gains may go to those who already have higher incomes.

Jayati Ghosh of Jawaharlal Nehru University of New Delhi has examined the role of capital inflows in developing countries. She maintains that the inflows appreciate the real exchange rate and encourage investment in non-tradable sectors and domestic asset markets. The resulting rise in asset prices pulls funds away from the financing of agriculture and small firms, hurting farmers and workers in traditional sectors. Eventually, the asset bubbles break, and the poor are usually those most vulnerable to the ensuing crisis.

After the Asian crisis of 2007-08, Barry Eichengreen of UC-Berkeley analyzed some of the other linkages that could tie inequality to capital account liberalization. He dismissed claims that capital mobility hinders the ability of governments to maintain social safety nets or to use macroeconomic policy to stabilize output. He agreed that developing countries were more likely to suffer the negative effects of capital mobility. But the problem lay in the combination of an open capital account and inadequate institutions and regulations.

The global financial crisis demonstrated that weak regulation and volatility in financial flows are not unique to emerging markets and developing countries. Moreover, while the U.S. economy now shows signs of increased growth, the long-term unemployed are not sharing in the recovery. The U.S. Senate has passed a bill that would extend benefits to this group of workers, but it faces opposition in the House of Representatives. On the other hand, those households that own substantial financial assets have benefited greatly from the increase in their value since 2009, which is due in large part to monetary policy. Similar patterns can be found in Europe.

Those most hurt by the outcome of financial instability should be the first to benefit from government policies intended to mitigate its impact. But we know that politicians are much more responsive to their more affluent constituents, who hold financial assets. The uneven recoveries that follow financial crises injure those least capable of dealing with misfortune, thus exacerbating the disparity between those at the top of the income distribution and those at the bottom.

The IMF and Ukraine

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The International Monetary Fund last week announced an agreement with Ukraine on a two year Stand-By Arrangement. The amount of money to be disbursed depends on how much other financial support the country will receive, but will be total at least $14 billion. Whether or not this IMF program will be fully implemented (unlike the last two) depends on the government’s response to both the economic crisis and the external threat that Russia poses. There is also the interesting display of the use of the IMF by the U.S., the largest shareholder, to pursue its international strategic goals even though the U.S. Congress will not approve reforms in the IMF’s quota system.

Ukraine’s track record with the IMF is not a good one. In November 2008 as the global financial crisis intensified, the IMF offered Ukraine an arrangement worth $16.4 billion. But only about a third of that amount was disbursed because of disagreements over fiscal policy. Another program for $15.3 billion was approved in 2010, but less than a quarter of those funds were given to the country.

The recidivist behavior is the product of a lack of political commitment to the measures contained in the Letters of Intent signed by the government of Ukraine. Ukraine, like other former Soviet republics, was slow to move to a market system, and therefore lagged behind East European countries such as Poland and Romania in adopting new technology. Andrew Tiffin of the IMF attributed the country’s economic underachievement to a “market-unfriendly institutional base” that has allowed continued rent-seeking. Promises to enact reform measures have been made but not fulfilled.

Are the chances of success any better now? Peter Boone of the Centre for Economic Performance at the London School of Economics and Simon Johnson of MIT are not convinced that there has been a change in attitude within the Ukrainian government, despite the overthrow of President Viktor Yanukovych (see also here). Consequently, they write: “There is no point to bailing out Ukraine’s creditors and backstopping Ukrainian banks when the core problems persist: pervasive corruption, exacerbated by the ability to play Russia and the West against each other.”

Leszek Balcerowicz, a former deputy prime minister of Poland and former head of its central bank, is more optimistic about the country’s chances. The political movement that drove out Yankovich, he claims, is capable of promoting reform. Further aggression by Russia, however, will threaten whatever changes the Ukrainian people seek to undertake.

The “back story” to the IMF’s program for Ukraine has its own intramural squabbling. The U.S. Congress has not passed the legislation needed to change the IMF’s quotas so that voting power would shift from the Europeans to the emerging market nations. The changes would also put the the Fund’s ability to finance its lending programs on a more regular basis. Senate Majority Leader Harry Reid sought to insert approval of the IMF-related measures within the bill to extend assistance to the Ukraine, but Republicans lawmakers refused to allow its inclusion. While U.S. politicians expect the organization to serve their political ends, they reject changes that would grant the IMF credibility with its members from the developing world.

The Economist has called the failure of Congress to support the IMF “shameful and self-defeating.” Similarly, Ted Truman of the Peterson Institute for International Economics warns that the U.S. is endangering its chances of obtaining support for Ukraine. The Europeans, of course, are delighted, as they will keep their place in the Fund’s power structure while the blame is shifted elsewhere. And the response of the emerging markets to another program for Ukraine, despite its dismal record, while they are refused a larger voice within the IMF? That will no doubt make for some interesting discussions at the Annual Spring Meetings of the IMF and the World Bank that begin on April 11.

Tapering and the Emerging Markets

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The response of the exchange rates of emerging markets and their equity markets to the Federal Reserve’s “taper,” i.e., reduction in asset purchases, continues to draw comment (see, for example, here). Most analysts agree that these economies are in better shape to deal with capital outflows than they were in the past, and that the risk of another Asian-type crisis is relatively low. But that does not mean that their economies will react the way we expect.

Gavyn Davies of Fulcrum Asset Management, who has a blog at the Financial Times, has posted the transcript of a “debate” he organized with Maurice Obstfeld of UC-Berkeley, Alan M. Taylor of UC-Davis and Dominic Wilson, chief economist and co-head of Global Economics Research at Goldman Sachs, on the financial turbulence in the emerging markets. “Debate” is not the best word to describe the discussion, as there are many areas of agreement among the participants. Obstfeld points out that there are far fewer fixed exchange rate regimes in today’s emerging markets, and many of their monetary policymakers have adopted policy regimes of inflation targeting. Moreover, the accumulation of foreign exchange by the central banks leaves them in a much stronger position than they were in the 1990s. Taylor adds fiscal prudence and less public debt to the factors that make emerging markets much less risky.

But all the participants are concerned about the winding down of the credit booms that capital inflows fueled. Wilson worries about economies with current account deterioration, easy monetary policy, above-target inflation, weak linkages to the recovery in the developed markets and institutions of questionablestrength. He cites Turkey, India and Brazil as countries that meet these criteria. Similarly, Taylor lists countries with relatively rapid expansion in domestic credit over the 2002-2012 period, and Brazil and India appear vulnerable on these dimensions as well.

Another analysis of the determinants of international capital flows comes from Marcel Förster, Markus Jorra and Peter Tillmann of the University of Giessen. They estimate a dynamic hierarchical factor model of capital flows that distinguishes among a common global factor, a factor dependent on the type of capital inflow, a regional factor and a country-specific component. They report that the country component explains from 60 – 80% of the volatility in capital flows, and conclude that domestic policymakers have a large degree of influence over their economy’s response to capita flows.

But are “virtuous” policies always rewarded? Joshua Aizenman of the University of Southern California, Michael Hutchison of UC-Santa Cruz and Mahir Binici of the Central Bank of Turkey have a NBER paper that investigates the response in exchange rates, stock markets and credit default swap (CDS) spreads to announcements from Federal Reserve officials on tapering. They utilize daily data for 26 emerging markets during the period of November 27, 2012 to October 3, 2013. They looked at the response to statements from Federal Reserve Chair Ben Bernanke regarding tapering, as well as his comments about the continuation of quantitative easing. They also looked at the impact of statements from Federal Reserve Governors and Federal Reserve Bank Presidents on these topics, as well as official Federal Open Market Committee (FOMC) statements.

Their results show that Bernanke’s comments on winding down asset purchases led to significant drops in stock markets and exchange rate depreciations, but had no significant impact on CDS spreads. There were no significant responses to statements from the other Fed officials. On the other hand, there were significant responses in exchange rates when Bernanke spoke about continuing quantitative easing, as well as to FOMC statements and announcements by the other policymakers.

The countries in the sample were then divided between those viewed as possessing “robust” fundamentals, with current account surpluses, large holdings of foreign exchange reserves and low debt, and those judged to be “fragile” due to their current account deficits, small reserve holdings and high debt. Bernanke’s tapering comments resulted in larger immediate depreciations in the countries with current account surpluses as oppose to those with deficits, more reserves and less debt. Similarly, Bernanke’s statements led to increased CDS spreads in the countries with current account surpluses and large reserve holdings, while lowering equity prices in countries with low debt positions. The immediate impact of the news regarding tapering, therefore, seemed to be tilted against those with strong fundamentals.

The authors provide an explanation for their results: the robust countries had received larger financial flows previous to the perceived turnaround in Fed policy, and therefore were more vulnerable to the impact of tapering. Moreover, as the change in the Federal Reserve’s policy stance was assimilated over time, the exchange rates of the fragile nations responded, and by the end of the year had depreciated more than those of the more robust economies. Similarly, their CDS spreads rose more. By the end of 2013, Brazil, India, Indonesia, South Africa and Turkey had been identified as the “Fragile Five.”

What do these results tell us about the impact on emerging markets from future developments in the U.S. or other advanced economies? There may be a graduated response, as the relative standings of those nations that have attracted the most capital are reassessed. However, if capital outflows continue and are seen as including more than “hot money,” then the economic fundamentals of the emerging markets come to the fore. But financial markets follow their own logic and timing, and can defy attempts to foretell their next twists and turns.

Capital Ebbs and Flows

Global Finance and How It Shapes Our World

The ECB’s Daunting Task

The Challenges of Achieving Financial Stability

Protesting the IMF’s Madame Lagarde