Making Friends in the New Global Order

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U.S. Treasury Secretary Janet Yellen gave a talk at the Atlantic Council last April on the future role of cooperation in the global economy. In October Chrystia Freeland, Deputy Prime Minister of Canada and its Minister of Finance, gave an address at the Brookings Institution that presented a similar perspective on how the global economy must be reorganized to meet security demands. Their speeches raise questions about how the new arrangements would operate, and how the rest of the world would fit into the proposed framework.

Yellen declared that the war between Russia and Ukraine had “redrawn the contours of the world economic outlook…” The sanctions imposed by the U.S., the other members of the Group of 7 and the European Union were in response to Russia’s “…having flaunted the rules, norms, and values that underpin the international economy.” She also drew attention to China’s ties with Russia and declared that “The world’s attitude towards China and its willingness to embrace further economic integration may well be affected by China’s reaction to our call for resolute action on Russia.”

Looking forward, she enunciated several propositions to govern future action. The first of these dealt with the need to modernize the existing multilateral approach. Yellen proposed basing economic integration by confining the “friend-shoring” of supply chains to “a large number of trusted countries…” This orientation would lower our vulnerability to countries using their economic resources to “disrupt our economy or exercise unwanted geopolitical leverage.” Left unsaid were the issues of which countries merited trust, and how to deal with those that do not fulfill that criterion.

Freeland spelt out some of the details in her address. She spoke of “a brutal end to a three-decade-long era in geopolitics,” and proposed a new orientation based on three pillars. The first is a strengthening of the connections among democracies, and Freeland specifically cites Yellen’s “friend-shoring” as one way to accomplish this.

The second pillar deals with “in-between countries” in Asia, Africa, the Middle East and Latin America. Freeland insisted that friend-shoring should be open to any countries that “…share our values and is willing to play by collectively agreed upon rules.” She made the claim that a rules-based order will be valuable to smaller countries “…most susceptible to coercion by larger and more hostile economies.”

Finally, with respect to authoritarian governments, Freeland advocated a sharp break with the assumptions of the 33 years. These states have little respect for a rules-based disorder, she claimed, and are hostile to the democracies. The democracies can continue to trade with the authoritarian states but should avoid strategic vulnerabilities in their supply chains.

Yellen and Freeland, therefore, agree that the economic relationships of democratic nations should be based on common values and goals. This is a major pivot from the guiding principles of the last three decades that more trade and investment would lead to shared prosperity, the development of democratic political systems and a diminution of conflict. It is also much more of a “top-down” approach, with governments overseeing the relationships of domestic firms with the rest of the world and evaluating the entry of foreign firms into domestic markets.

These ambitious proposals have met a variety of reactions. Branko Milanovic has called the trading links “trade blocs,” similar to those in the past such as the United Kingdom’s imperial preferences, and “mercantilism under a new name.” But mercantilism was a characteristic of President Trump’s trade policies, as he saw trade as a zero-sum relationship with trade deficits as a loss for the country that sustained them. The new proposals seek security and freedom from the weaponization of trade.

How will other countries, particularly those in Freeland’s second group, respond to these initiatives? The new lineup of countries bears many similarities to the post-World War II division among the “first world” of advanced economies, the “second world” of the Communist bloc that included the Soviet Union and China and the “third world” that was the category of every other country, which included nations with colonial pasts in Asia, Africa and Latin America. Many of the third-world countries sought to establish their independence from the first and second worlds.

Today there are a wide variety of economic and political systems outside the advanced economies. Many would undoubtedly desire to continue exporting to the U.S., the European Union, Japan and Australasia. But do they qualify for Freeland’s friend shoring club?

Vietnam has taken the place of China for many multinationals as a source of low-wage production, and its trade with the U.S. and other countries has propelled its growth. Its government, on the other hand, is a one-party system led by the Communist Party, and Freedom House ranks it as “Not Free.” Bangladesh is another country where growth has been driven by exports, mainly in garments. The Awami League keeps a firm hold on political power and the country is characterized by Freedom House as “partly free.”

The transition to “green energy technologies,” will require the use of cobalt, and the Democratic Republic of Congo supplies more than 63% of the world’s use of the element, as well as other natural resources. But the inhabitants of that country do not benefit from their extraction and export, and their political system has been volatile at best. Freedom House rates it as “not free.”

Many other countries that engage in transactions with the advanced democracies will not qualify for membership in the friend-shoring club as defined by Freeland. Moreover, they may not want to choose ideological sides between the two sides in the new order. How will Yellen and Freeland’s democracies deal with these countries? Will they be excluded from trade and financial flows? Or will economic relationships with them be allowed to avoid dependence on the authoritarian countries that are viewed as threats to the security of the democracies? The diversity of economic and political systems in the emerging markets and developing countries will resist easy categorization and pose challenges to Yellen’s and Freeland’s configuration of the world’s economies.

Has the Third Era of Globalization Ended?

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Behind the headlines forecasting a global economic recession there is another narrative about the end of globalization. This reflects political tensions over trade, the impact of the pandemic on global supply chains and the shutdown of economic ties with Russia. But dating the beginning and end of the most recent era of the integration of global markets poses challenges.

All chronological assignments for the purpose of establishing historical eras are arbitrary. Did World War II begin in 1939 when Germany and the Soviet Union invaded Poland? Or in 1937 when Japan invaded China? When was the First Industrial Revolution succeeded by the Second Revolution? Mid or late 19th century? And good luck finding agreement on when the golden age of rock and roll took place.

The dating of economic eras also involves assumptions. Did the First Era of Globalization begin in the early 1870s as usually stated, and if so, why? Germany’s adoption of the gold standard at that time is usually seen as a shift in monetary regimes that facilitated international capital flows, but trade and migration flows had expanded prior to the 1870s. Assigning a date to the end of the First Era is easier to do, as currency convertibility was suspended during World War I and borders were shut to migration.

The commencement of the Bretton Woods (BW) system marks the beginning of the Second Era of Globalization. The agreement was signed in 1944 and the IMF commenced operations in 1947, so 1945 can be seen as the beginning of the post-war era. But the system actually described in the agreement did not operate until 1958 when European currencies became fully convertible for current account transactions. Did the BW regime end in 1971, when President Richard Nixon ended the convertibility of foreign central bank holdings of dollars to gold? Or in 1973, when attempts to establish new fixed exchange rate values ended and the major currencies began to float? The IMF’s Articles of Agreement were not amended to reflect the new practices until 1976.

The Bretton Woods system ended in the 1970s, but globalization did not go into reverse. The post-World War II era can be extended to include the following decades, but that would overlook several important changes in how international economic affairs were conducted. The elections of Margaret Thatcher and Ronald Reagan in 1980 are widely seen as marking the beginning of what has been called the neoliberal era, which has been characterized as a shift to dependence on market outcomes. (Gary Gerstle of Cambridge University, however, shows that the term “neoliberal” encompasses a number of political agendas, not all of them consistent, in a compelling account in his book The Rise and Fall of the Neoliberal Order: America and the World in the Free Market Era.) The initial policy changes occurred domestically, but this was also the period when the IMF began to promote the removal of capital controls. On the other hand, the 1980s was a “lost decade” of growth for those countries, mainly in Latin America, that were embroiled in the debt crisis.

The year 1990 is another candidate for dating the start of a new era of globalization. Douglas Irwin of Dartmouth College has described the era of 1985-1995 as the period of “the greatest reduction in global trade barriers in world history.” China began to allow private enterprises to flourish at the end of the 1980s, while East European nations sought to integrate their economies with those of Western Europe and the rest of the global economy after the collapse of the Soviet Union in 1991. The North American Free Trade Agreement (NAFTA) signed in 1994 by Canada, Mexico, and the U. S. created a trilateral trade area amongst the three countries.  In 1995, the World Trade Organization was established, with a mission to facilitate international trade. The new international agency sought to promote new trade agreements while administering a mechanism to resolve trade disputes amongst its members. Economic inequality among nations narrowed during this period as many emerging markets enjoyed rapid growth, although inequality within nations rose as the benefits of global trade and financial flows were not equally shared.

But if the Third Era of Globalization is no longer operating, when did it cease? The global financial collapse of 2008-09 demonstrated the fragility of extended financial sectors even in the advanced economies, and lacerated confidence in the ability of regulators to anticipate sudden collapses of financial flows. The response of domestic governments and international agencies to the crisis led to a revival of economic activity but the recovery was slow, particularly for those who did not benefit from the rise in asset prices that low interest rates fostered. Foreign expansion by multinational firms continued but the pace of foreign direct investment slackened, while the IMF issued a reappraisal of its policy recommendations regarding capital flows to include capital controls as an acceptable macro policy tool.

The year 2016 has a strong claim for marking the end of this era of globalization. Donald Trump campaigned advocating the use of tariffs to end trade deficits and the erection of a wall along the border with Mexico to halt illegal immigration. He sought to implement those policies after his election, including the imposition of tariffs on Chinese goods. The votes in favor of Britain leaving the European Union (“Brexit”) in the same year demonstrated the distrust of many British citizens of multilateral governance as well as a fear of immigration. The result in that country has been a reduction in trade and migrant flows, with no evidence of a positive economic payoff.

Whatever momentum was left in international economic expansion was throttled by the pandemic and then the Russian-Ukraine war. The pandemic exposed the vulnerability of global supply chains to national shutdowns, and the dangers of dependence on single suppliers of strategic goods, such as medical equipment. In response to the invasion of Ukraine, the U.S. and European allies have sought to cut off trade and financial flows with Russia, which in turn seeks to use higher oil and gas prices to lower Western morale. The U.S. hopes to slow down Chinese technological advances by scrutinizing Chinese acquisition of U.S. firms while supporting U.S. firms in areas where they may fallen behind.

Whether or not the third era of globalization expired in 2016, 2020 or 2022, there is a strong sense that a new era has begun. But is it the end of globalization? Richard Baldwin of the Geneva Institute in his NBER paper, “Globotics and Macroeconomics: Globalisation and Automation of the Service Sector” and in a series of blog posts argues that changes in global economic activity have been misunderstood and misinterpreted. The drop of world trade/GDP since 2008 was largely a function of the decline in the value of commodities, particularly mining goods and fuels.

There has also been a slowdown in the transfer of manufacturing from advanced economies to a handful of emerging economies, as well as a reorganization of supply chains. But Baldwin shows that a new wave of globalization is taking place in the provision of intermediate service activities, which include accounting, financial analysis, legal analysis, and other activities. Advanced economies still account for the majority of service exports but emerging economies including China, India, Korea, Poland, the Philippines and Brazil have recorded rapid growth in these activities. The barriers to further expansion are technological, not regulatory, and those barriers are falling rapidly.

It is premature, therefore, to proclaim the end of globalization. Trade in manufactured goods may not be advancing at the same pace as it has in the past but that slowdown was inevitable. Trade in services, on the other hand, has grown continuously since 1990, although some deceleration in the current economic environment is inevitable. However, advances in artificial intelligence (AI) will alter the supply of both goods and services. Its impact on national economies and global markets is a matter of speculation, but the widespread use of AI may herald the start of the next era of glovalization.

China and the Debt Crisis

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Sri Lanka is not the first developing economy to default on its foreign debt, and certainly won’t be the last. The Economist has identified 53 countries as most vulnerable to a combination of “heavy debt burdens, slowing global growth and tightening financial conditions.” The response of China to what will be a rolling series of restructurings and write-downs will reveal much about its position in the 21st century international financial system.

Debt crises are (unfortunately) perennial events. In the 1970s many developing countries, particularly in Latin America, borrowed from international banks to pay energy bills that had escalated after oil price increases enacted by the Organization of Petroleum Countries (OPEC). Repaying those loans became more difficult after the Federal Reserve raised interest rates in 1979 to combat U.S. inflation. Mexico announced that it could no longer make debt payments in August 1982, and other governments soon followed (see here for more detail).

The U.S. government supported negotiations that brought together the governments unable to make payments, the banks that had made the loans, and the International Monetary Fund. The banks were willing to restructure the debt while the IMF lent funds to the governments that allowed them to keep up their interest payments while staving off acknowledging their inability to pay off the debt. But this only delayed a final resolution of the crisis and led to a “lost decade” in Latin America. In 1989 Secretary of the Treasury Nicholas Brady proposed a plan that led to reductions of the loan principals in return for the issuance of “Brady bonds” by the debtor governments.

The U.S. allowed the IMF to take the lead during subsequent crises, including the East Asian crisis of 1997-98, Russia in 1998 and Argentina in 2000. As the member with the largest quota, the U.S. could influence the design and implementation of the IMF’s programs. It also took a more active role when U.S. interests were directly affected, as it did with Mexico in 1994-95. While U.S. attention was focused on its own crisis in 2008-09, the IMF took on the task of lending to middle- and low-income countries that were caught up in the economic shock waves of the financial collapse. The Federal Reserve, however, established currency swap lines with the central banks of other advanced economies as well as those of four emerging markets: Brazil, South Korea, Mexico and Singapore.  The Fed reactivated the swap lines in March 2020 in response to the disruption in international credit markets caused by the pandemic and also set up a new facility to provide dollar funding to foreign official institutions.

China has taken a different position with regards to the debt of developing nations. Its state-owned banks have made bilateral loans as part of the Belt and Road initiative, with many of these loans made to African governments for infrastructure projects. But the amount of lending and the terms have not always been made transparent. Sebastian Horn of the University of Munich, Carmen Reinhart, currently Chief Economist at the World Bank while on leave from Harvard University’s Kennedy School, and Christoph Trebesch of the Kiel Institute for the World Economy developed a database of Chinese lending over the period of 1949-2017 which they published in a 2021 NBER paper, “China’s Overseas Lending.” They found “…that a substantial portion of China’s overseas lending goes unreported and that the volume of “hidden” lending has grown to more than 200 billion USD as of 2016.” Another study from AidData, a research lab at William & Mary, also documented Chinese lending to low- and middle-income countries, and found that many loans are collateralized against future commodity export receipts.

Some of these loans have already been restructured, with China pushing back repayment dates. If there is a systemic wave of defaults, the Chinese government must decide whether it will continue to negotiate directly with the governments that borrowed, or whether it will join the governments that belong to the Paris Club, a group of official creditors that attempt to devise sustainable solutions to debt problems, in designing a mechanism to reduce the volume of debt.

In 2020, the Group of 30 working with the IMF and the World Bank instituted the Debt Service Initiative (DSSI), which suspended debt service payments from low-income countries to official creditors, including China. Forty-eight countries participated in the program, which ended in December 2021.  The DSSI has been followed by the Common Framework, which brings together official creditors and low-income borrowers to provide some form of assistance to insolvent nations. However, private lenders have not agreed to participate and only three nations have requested relief through the Common Framework. There are concerns about the process, and there will undoubtedly be calls for broad-based debt cancellation as countries with mounting food and energy bills seek relief.

The decisions that China makes regarding its participation in new initiatives have implications for its future role in the international financial system. The government has sought to enhance the role of its currency, the renminbi, and its share in the foreign exchange reserves of central banks has risen as trade with China has grown. Serkan Arslanalp of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have documented the decline in the relative share of dollar-denominated foreign reserves and the increase in renminbi-denominated reserves in “The Stealth Erosion of Dollar Dominance and the Rise of Nontraditional Reserve Currencies” in the Journal of International Economics (working paper here). They find, however, that the changes in the composition of foreign reserves involve more than the Chinese currency, and show increases in the relative shares of the Australian dollar, the Canadian dollar, the Korean won, the Singapore dollar and the Swedish krona as wells. They attribute these changes in part to more active management of reserves by central bankers and also the existence of more liquid foreign exchange markets that facilitate non-dollar trading.

The use of the dollar-based international financial system as a financial weapon against Russia, including seizure of more than $300 billion of its central bank assets, could be an opportunity for another system to take its place, and there has been much speculation about the emergence of a Chinese-based rival. But Adam Tooze of Columbia University has pointed out that

“It (the dollar system) is a sprawling, resilient network of state-backed, commercially driven, profit-orientated transactions, lubricated by the easy availability of dollars, interwoven with American geopolitical influence, a repeated game in which intelligent players continuously gauge their advantages and disadvantages and the (very few) alternatives open to them and then, when all is said and done, again and again come back for more.”

A new system would take years to establish. Whether China’s government wants to allow its financial markets to become enmeshed in a global system by removing the remaining capital controls is unclear. The combination of drought, COVID-19 and its real estate crisis fully occupy the attention of the Chinese government. It may have to deal with a debt crisis among the developing nations however, and its response will be monitored for signs of how it sees its position within the global financial network of rules and institutions.

The Global Financial Cycle and Emerging Market Economies

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

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

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

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

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

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

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

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

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

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

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

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

The Rising Dollar

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The foreign currency value of the dollar has been rising. The nominal broad dollar index of the Federal Reserve shows the dollar has incresed by by about 9% since its low point a year ago while other indexes register larger gains. What does this mean for the U.S. and other economies?

The appreciation reflects several factors. First, higher interest rates make investing in dollar-denominated assets more appealing, particularly since many other major central banks lag the Federal Reserve’s in its monetary tightening. The European Central Bank will not begin to raise its rates until July, while the Bank of Japan has no plans to change its accomodative policy stance. Second, the dollar’s “safe asset” status draws investors who fear the economic and political uncertainty due to the Russian invasion of Ukraine. Third, the COVID19 lockdowns in China have disrupted its economy, while the U.S. has not (yet) exhibited any significant slowdown.

A rising dollar will contribute to the increasing U.S. trade deficit. American consumers may be losing confidence because of inflation, but they are still purchasing foreign goods. Lower import prices will assist the Fed in combatting inflation, which could slow future hikes in interest rates..

 The dollar’s appreciation will also have an impact on the foreign-based revenues and profits of U.S. based multinationals. A 2018 S&P 500 research paper by Philip Brzenk showed that changes in the value of the dollar had an impact on S&P 500 companies with significant foreign activities. An appreciation (depreciation) of the dollar lowers (raises) the value of the foreign earnings of those companies with major foreign currency exposure, which is accompanied by decreases (increases) in the values of their share prices relative to those firms in the S&P 500 with little foreign exposure. A decline in foreign-sourced income will also affect the net income balance of the U.S. balance of payments, contributing to a further weakening of the current account.

The impact on foreign economies of the rising dollar is also mixed. On the one hand, those countries that export to the U.S. should benefit from lower prices for their goods. However, this effect is mitigated when their export prices are denominated in dollars.  Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le Mezo, Arnaud Mehl and Tra Nguyen of the IMF drew attention to the growing use of the dollar as a vehicle currency and the implications for trade balances in a 2020 IMF working paper, “Patterns in Invoicing Currency in Global Trade.”

Moreover, any expansionary effect due to increased trade can be offset by what has been called the “finance channel.” The financial channel reflects the impact of the exchange rate on the value of foreign currency liabilities, such as loans taken in a foreign currency. An appreciating dollar will raise the domestic value of those liabilities. Jonathan Kearns and Nikhil Patel of the Bank for International Settlements examined these channels in their article, “Does the Financial Channel of Exchange Rates Offset the Trade Channel?”, which appeared in the December 2016 issue of the BIS Quarterly Review. They found evidence that the financial channel partly offsets the trade channel for emerging market economies (EMEs) but that it is weaker for the advanced economies.

Similarly, Boris Hoffman and Taejon Park of the BIS reported that a dollar apperciation contributes to a deterioration of growth prospects of emerging market economies in their 2020 BIS Quarterly Review paper, “The Broad Dollar Exchange Rate as an EME Risk Factor.” They found that a dollar appreciation dampens investment growth, and even export growth. These effects were larger in countries with high dollar debt and high foreign investor presence in local currency bond markets, which conttibute to the financial channel.

Another examination of the impact of changes in the value of the dollar on emerging market economies was undertaken by Pablo Druck, Nicolas E. Magud and Rodrigo Mariscal of the IMF in “Collateral Damage: Dollar Strength and Emerging Markets’ Growth,” which appeared in the North American Journal of Economics and Finance in 2018 (IMF working paper version here). They found evidence of a negative relationship between the strength of the dollar and emerging markets’ growth. They attributed this empirical relationship to two channels of transmission: first, a negative linkage with commodity prices that depresses demand for the exports of commodity producers; second, an increase in the cost of imported capital imports that are necessary for growth. While supply shocks will keep commodity prices elevated, the price of capital imports has already risen due to widespread inflation.

The impact of the appreciation of the dollar will spread far outside U.S. borders. These effects will occcur in countries already grappling with higher food and energy costs, and the consequences of a slowing Chinese economy. A global recession is not inevitable, but the IMF’s Managing Director Kristalina Georgieva is not exagerating when she says that the world economy faces “its biggest test since the second world war.”

The IMF’s Proposed Policies on the Management of Capital Flows

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The IMF’s views on the advantages and drawbacks of capital flows have substantially evolved over time. The Fund reversed its opposition to capital controls in the wake of the global financial crisis of 2007-09, when it adopted the “Institutional View on the Liberalization and Management of Capital Flows.” That framework included capital flows measures (CFMs) as one of the policy measures available to a government facing surges of capital inflows, i.e., large inflows that could destabilize an economy. The Fund has now moved further in the direction of using CFMs, proposing that they can be used in a preemptive manner to avoid future instability.

The IMF had advocated the removal of capital controls before the Asian financial crisis of 1997-98, so that developing economies could benefit from capital flows. That crisis demonstrated the volatility of capital flows and the catastrophic impact of “sudden stops” on economic activity. Subsequently, the Fund refined its position on deregulation, advising governments to implement adequate supervisory and regulatory regimes before liberalizing their capital accounts, and to begin with opening to foreign direct investment before allowing short-term capital. The IMF moved further during the global financial crisis when it allowed Iceland to implement controls. The Institutional View was adopted in 2012, when countries such as Brazil used CFMs to manage the inflows of foreign capital seeking higher yields than those available in the U.S. The CFMs were part of a toolkit that also includes Macroprudential Prudential Measures (MPMs), which are designed to limit systemic risks. CFM/MPMs are measures designed to limit such risk by controlling capital flows.

The IMF’s new proposals are presented in an IMF Policy Paper, “Review of the Institutional View on the Liberalization and Management of Capital Flows.”  The first proposal extends the Institutional View by allowing the preemptive use of CFM/MPMs on foreign currency debt inflows in order to address the systemic risk that could result from foreign exchange mismatches on balance sheets. Such mismatches can occur slowly, and not just following surges. They increase the probability of capital flow reversals and exchange rate depreciations that disrupt economic activity and could not be adequately addressed with conventional policy tools.

The proposal would also allow CFM/MPMs in the case of high foreign investor participation in local-currency debt markets. In these cases, the danger is a “sudden stop” by foreign investors, which would have particularly adverse consequences if there were illiquid capital markets. Other domestic measures may be unavailable, and the CFM is a second-best solution.

The second proposed policy change exempts certain types of capital control measures that are enacted by governments for specific purposes from review. These include: first, measures adopted for national or international security; second, measures based on international prudential standards, such as those related to the Basel Framework on banking; third, measures designed to deal with money laundering and the combating of financial terrorism; and fourth, measures related to international cooperation standards related to the avoidance or evasion of taxes.

The usefulness of preemptive policies has been demonstrated in a new NBER working paper, “Preemptive Policies and Risk-Off Shocks in Emerging Markets” by Mitali Das and Gita Gopinath of the IMF and Sebnem Kalemli-Özcan of the University of Maryland. The authors investigate the impact of preemptive CFMs on the external finance premia in 56 emerging markets and developing economies during the Taper Tantrum and the COVID-19 shocks. The premia are measured by deviations from uncovered interest rate parity. They consider the impact of CFMs on inflows and outflows, as well as the effect of domestic MPMs.

The paper’s authors report that countries with preemptive CFMs on inflows in place during the five-year period preceding the shocks experienced lower premia and exchange rate volatility. They infer that use of the CFMs provide enhanced access to international capital markets during volatile periods. CFMs on outflows, on the other hand, had a positive effect on the UIP premiums, which may reflect the demand by foreign investors for higher returns to compensate for the CFMs in outflows.

The IMF’s capital flow policies under the Institutional View had been reviewed by the IMF’s Independent Evaluation Office (IEO) in its 2020 report , “IMF Advice on Capital Flows.” The report praised the IMF for the changes in its policy stance, and called the adoption of the Institutional View “a major step forward.” The IEO’s report, however, also called for further changes, including revisiting the Institutional View to take into account recent experience with capital flows, building up the monitoring, analysis and research of capital acccount issues, and strengthening multilateral cooperation on policy issues.

Anton Korinek of the University of Virginia, who wrote a briefing paper for the IEO report, Prakash Loungani, assistant director of the IEO and co-leader of the 2020 report, and Jonathan Ostry of Georgetown University, who was at the IMF when it issued the Institutional View, have written a review of the IMF’s latest policy proposals, “The IMF’s Updated View on Capital Controls: Welcome Fixes but Major Rethinking Is Still Needed.” While welcoming the new measures, they bring up several additional issues that should be addressed. These include the use of capital controls for domestic objectives, such as the impact of capital flows on income inequality and also real estate prices. Such a move would in many ways be consistent with the original aims of the Bretton Woods agreements.

The authors point out that the targets for the IMF’s capital policies are the host countries that receive capital inflows. But challenges associated with capital flows should also involve the countries that are the source of the capital flows. Since these are usually the advanced economies which have a major role in the IMF’s governance, such a move would require the cooperation of the IMF’s most influential members.

Korinek, Loungani and Ostry also urge the IMF to investigate the use of controls on capital outflows. The Fund’s current policy stance only approves the use of such measures during crises. Given the current economic and financial situation (see, for example, here), governments of developing countries are concerned about a repeat of the outflows of March and April 2020. The IMF should be working with these policymakers now to minimize the turbulence that large capital outflows would bring.

When Safe Assets Are No Longer Safe

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The U.S. has long benefitted from its ability to issue “safe assets” to the rest of the world. These usually take the form of U.S. Treasury bonds, although there was a period before the 2008-09 global financial crisis when mortgage-backed securities with Triple A ratings were also used for this purpose. The inflow of foreign savings has offset the persistent current account deficits, and put downward pressure on interest rates. But what will happen if U.S. government bonds are no longer considered safe?

The word safe has been used to describe different aspects of financial securities. The U.S. government in the past was viewed as committed to meeting its debt obligations, although the political theater around Congressional passage of the federal debt limit has introduced a note of uncertainty. In an extreme case, the U.S., like other sovereign borrowers with their own currencies, has the ability to print dollars to make debt payments. However, there is also a constituency of U.S. bondholders who would vehemently object if they were paid in inflated dollars.

Safety has also been linked with liquidity. U.S. financial markets are deep and active. Moreover, there is little concern that the government will impose capital controls on these portfolio flows (although FDI is now being scrutinized to deny access to domestic technology). Therefore, foreign holders of U.S. Treasury bonds can be confident that they can sell their holdings without disrupting the bond markets and contributing to sudden declines in bond prices.

However, there has always been another implicit component of the safety feature of Treasury bonds. Bondholders expect that they can claim their assets whenever they need to use them. The decision by the U.S. and European governments to deny the Russian central bank access to its own reserves has shown that foreign holders of assets placed on deposit in the U.S. or the other G7 countries (Canada, France, Germany, Italy, France, United Kingdom) may not be able to use these assets at precisely the times when they are most needed. The Russian central bank had accumulated about $585 billion, but approximately half of that amount is no longer available. The central bank still has access to about $80 billion held in China and $29 billion at international institutions, as well as its holdings of gold. But the latter will be hard to convert to foreign currency if potential buyers are concerned about retaliatory sanctions.

The loss of access deprives the Russian central bank of foreign currency that could have helped the government deal with sanctions on its foreign trade. Moreover, the monetary authorities have not been able to use their reserves to halt the rapid decline in the ruble’s value. The other sanctions, therefore, will have a deep impact on the Russian economy. The Institute of International Finance has issued a forecast of a drop in its GDP of 15% in 2022 and another decline the following year.

The use of sanctions to cut off a central bank’s access to its own reserves raises questions concerning the structure of the international financial system. Other central banks will reassess their holdings and consider alternatives to how they are held. But what other country has safe and liquid capital markets that are not subject to capital controls and are not vulnerable to U.S. and European sanctions?  The Chinese currency is used by some central banks, but it is doubtful that there will be a wide-spread transition from dollars to the renminbi.

Another concern has arisen regarding the ability of the U.S. government to meet its obligations. In order to satisfy a continued demand for safe assets, the government will need to continue to run budget deficits. But increases in the debt/GDP ratio leads to concerns about the creditworthiness of the government. This problem has been called a “new Triffin dilemma,” similar to the problem that emerged during the Bretton Woods era when the U.S. was pledged to be ready to exchange the dollar holdings of foreign central banks for gold. Economist Robert Triffin pointed out that the ability of the government to meet this obligation was threatened once the dollar liabilities of the U.S. exceeded its gold holdings. The “gold window” was finally shut in the summer of 1971 by President Richard Nixon.

These long-term concerns are arising just as the market for U.S. Treasury bonds has entered a new phase. The combination of higher inflation and changes in the Federal Reserve’s policy stance have led to increases in the rate of return on U.S. Treasury bonds to about 2.5%. With an annual increase in the CPI minus food and energy of approximately 6%, that leaves the real rate at -3.5%. Several more increases in the Federal Funds Rate will be needed to raise the real rate to positive values.

A fall in the demand for U.S. Treasury bonds by foreign banks and private holders would contribute to lower bond prices and higher yields. All this could affect the Federal Reserve’s policy moves if the Fed thought that it needed to factor lower foreign demand for Treasury bonds into their projections. Moreover, a shift from U.S. bonds would affect the financial account of the U.S., and the ability to run current account deficits.  The exchange rate would also be affected by such a transition.

None of these possible changes will take place in the short-run. Central bankers have more pressing concerns, such as the impact of higher food and fuel prices on domestic inflation rates, and foreign central bankers will focus on the changes in the Fed’s policies, as well as those of the European Central Bank. But the sanctions on the use of foreign reserve assets will surely lead to changes over time in the amounts of reserves held by central banks as well as their composition. The imposition of these measures may one day be seen as part of a wider change in the international financial system that marks the end of globalization as we have known it.

The Restructuring of Sovereign Debt

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The economic repercussions of Russia’s invasion of Ukraine will be devastating for many countries that have yet to recover from the pandemic. Higher prices for commodities, particularly energy and food, will increase inflation rates and widen trade deficits for those nations that import those items. Increases in interest rates will raise the cost of debt financing and hamper the ability of borrowers to meet their obligations or refinance existing debt.

Carmen Reinhart, Chief Economist of the World Bank, warned that the pandemic had exacerbated existing financial weaknesses in her Mundell-Fleming Lecture, “From Health Crisis to Financial Distress,” which has been published in the IMF Economic Review. She points out that economic and financial crises, including banking, currency, debt, etc., often occur together. The resulting “conglomerate crisis” can lead to a severe economic downturn. She warns that initial attempts to arrange a “shallow” restructuring of sovereign debt that does not reduce the intertemporal value of the debt may be followed by one or more subsequent restructurings, exacerbating the impact of the crisis.

Governments that need to restructure debt may be able to lessen the resulting impact if they act early. Tamon Asonuma, Marcos Chamon, Aitor Erce and Akira Sasahara have examined the consequences of debt restructurings in an IMF Working Paper, “Costs of Sovereign Defaults: Restructuring Strategies, Bank Distress and the Capital Inflow-Credit Channel.” The authors looked at 179 restructurings of the sovereign debt held by private holders over the period of 1978-2010. They divided the sample into three categories: “strictly preemptive,” where no payments were missed; “weakly preemptive,” where some payments were missed but only temporarily and only after the start of negotiations with creditors; and “post-default,” which occurred when payments were missed and without agreement with the creditors.

They reported that banking crises and severe declines of credit and net capital inflow occurred more frequently following post-default restructurings. They also found that contractions of GDP and investment spending were substantial in post-default restructurings, less severe in weakly preemptive restructurings and did not occur in the case of strictly preemptive cases. Private credit and capital inflows remained below the pre-crisis levels and interest rates rose after post-default restructurings. Their results indicate that governments that can restructure without missing payments will avoid some of the costs associated with restructurings. The authors acknowledge that large shocks can force a halt in payments, but even in those cases collaboration with creditors is more advantageous than unilateral actions.

The IMF reviewed the institutional mechanisms that address sovereign debt restructurings in 2020 policy paper, The International Architecture for Resolving Sovereign Debt Involving Private-Sector Creditors—Recent Developments, Challenges, And Reform Options. The review found that recent restructurings of sovereign debt had been much smoother than those in previous periods. It attributed this change to several factors, including the increased use of collective action clauses which allow a majority of the creditors to override a minority that oppose a restructuring. The paper’s authors called for more contractual reforms as well as an increase in debt transparency, and also recommended that the international financial institutions support debt restructurings financially when appropriate. But the report  warned that the pandemic could engender a widespread crisis that could overwhelm existing procedures:

“Should a COVID-related systemic sovereign debt crisis requiring multiple deep restructurings materialize, the current resolution toolkit may not be adequate in addressing the crisis effectively and additional instruments may need to be activated at short notice.”

The IMF sought to establish new instruments in 2020 when it joined the Group of 20 nations to create an institutional mechanism for low-income countries with unsustainable debt loads called the “Common Framework” (see here). The initiative sought to bring together official creditors, including the traditional lenders such as the U.S. and France, with more recent lenders, such as China and India, to coordinate debt relief efforts. Private creditors were to use comparable terms in their negotiations.

But the Framework has not been widely adopted because of reluctance by some lenders and borrowers. Chinese lending has been funneled through several institutions, and they are not always willing to join other creditors. The governments of the nations with the debt loads have been reluctant to signal that they may need relief, in part because of a negative signaling effect. The IMF has called for reorganizing and expanding the Common Framework.

A wave of restructuring may be triggered by a Russian default on its dollar-denominated bonds. The credit rating agencies have downgraded the Russian bonds to junk bond status (“C” in the case of Fitch’s rating). President Putin has stated that the bond payments will be paid in rubles, but the Russian currency has lost its international value. A default would hasten the collapse of the Russian economy. It would also lead to a reassessment of the solvency of other governments and their ability to fulfill their debt obligations. Foreign bondholders could decide to cut their losses by selling the bonds of the emerging markets and developing economies. A wave of such selling that occurs at the same time as the Federal Reserve raises interest rates will almost certainly lead to a new debt crisis for many countries. The IMF and World Bank will be hard-pressed to coordinate relief efforts across so many borrowers and lenders.

Risk and FDI

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While FDI flows recovered in 2021 from the previous year’s decline, not all countries benefitted from the increase. UNCTAD reported that almost three quarters of global FDI flows in 2021 occurred in advanced economies, and China and other Asian economies recorded the largest increases amongst the emerging markets and developing economies. Multinational companies are evaluating the course of the pandemic in those countries and their suitability for new global supply routes. Risk, always a factor in FDI decisions, has become an even more important concern.

There are, of course, many forms of risk. Neil M. Kellard, Alexandros Konotonikas and Stefano Maini of the University of Essex with Michael J. Lamla of Leuphana University Lüneburg and Geoffrey Wood of Western University examined the effects of financial system risk in “Risk, Financial Stability and FDI“, published in the Journal of International Money and Finance this year (working paper version here). They specifically investigated the impact of risk on inward FDI stocks within 16 Eurozone between 2009 and 2016, and used bilateral data drawn from the origin countries and host economies to compare the effects of different forms of risk in both locations.

Their results indicated that an increase in risk in the banking sector of an origin country—as measured by the proportion of non-performing loans—led to a decrease in FDI in the host countries. However, changes in bank risk in the host country had no similar impact. They interpret this result as indicating that multinationals are dependent on bank financing in their origin countries to finance their expansion.

In addition, inward FDI was negatively linked to upturns in sovereign yields in both the origin and host countries. The impact of the sovereign yield variable in the origin countries was larger than that of the corresponding yield in the host countries. They interpret the latter results as showing that an increase in sovereign risk in the origin country discouraged risk-taking by multinational firms based there, while the increase in risk in the host country caused multinationals to turn to other hosts. Moreover, when they separated the Eurozone countries into two groups, with Greece, Ireland, Italy, Portugal and Spain as the stressed group, they found that the size of the impact of the sovereign risk variables was comparatively larger in the stressed group.

Risk is also the subject of a recent NBER working paper by Caroline Jardet and Cristina Jude of the Banque de France and Menzie Chin of the University of Wisconsin-Madison, “Foreign Direct Investment Under Uncertainty: Evidence From A large Panel of Countries.” They examined host country “pull” factors and global “push” factors for inward FDI flows in a panel of 129 advanced, emerging market and developing economies over the period of 1995 to 2019. They focused on domestic and global uncertainty, using the World Uncertainty Index (WUI) and the Economic Policy Uncertainty Index as well as the VIX as measures of risk.

Their initial results indicate that the effects of uncertainty depend on the country group, and therefore they disaggregated the data.  Domestic uncertainty does not appear to be a factor for any of the three groups, but global uncertainty as measured by the WUI has a large and significant negative impact on FDI in the advanced and emerging market economies.

The authors also examined the impact of global financial factors on FDI. They iniitally used the real value of the Standard & Poor’s 500 index, and report that an increase in that measure is linked to increases in FDI in the advanced economies but declines in the emerging market and developing economies. The higher returns in the U.S. draw funds away from those propsetive hosts.

Similarly, when they replace the S&P 500 with the nominal shadow Federal Funds rate or a world interest rate, they report that increases in either rate increased FDI in the advanced economies and lowered FDI flows in the developing economies. They suggest that this result reflects the existence of booms in the financial center countries that GDP data do not capture. They also reexamine the significance of the world uncertainty index as the different global financial variables are used, and find that the negative and significant impact holds up in the case of the emerging market economies.

Many types of risk, therefore, have an impact on FDI. Domestic financial risk in an origin country, for example, leads to less outward FDI by multinational firms based in that country. But firms are also affected by global uncertainty, and their response in terms of foreign investment seems to be most evident in the emerging market economies. Geopolitical tensions over the Ukraine,  the possibility of a new variant of the virus and the prospect of higher U.S. interest rates all reinforce global uncertainty and complicate the decision over where to locate new investments.