Strategic Retreat or Tactical Pause?

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Several recent analyses of financial globalization offer different perspectives on whether the recent contraction in capital flows represents a cyclical decline or a long-term reversal. On the one hand, the expansion of gross financial flows in the last decade among upper-income countries will not continue at the same pace. But the development of financial markets in emerging markets will increase capital flows within that group of countries as well as draw funds from the advanced economies.

Richard Dobbs and Susan Lund of the McKinsey Global Institute note that cross-border flows are more than 60% below the pre-crisis peak. They attribute the decline to a “dramatic reversal of European financial integration” as European banks curtail their lending activities. They also draw attention to “a retrenchment of global banking” due to a reassessment by banks of their foreign activities in light of new capital requirements and regulations. Dobbs and Lund are concerned that too strong a reversal will result in a segregated global financial system.

Greg Ip of The Economist also writes about a reversal of financial integration for a similar set of reasons. Bankers are shrinking their balance sheets while regulators seek to shield their domestic financial markets from foreign shocks. In addition, Ip draws attention to the renewed interest in the use of capital controls to lower volatility. The IMF now includes controls as a tool that policymakers can use to manage the risks associated with surges of capital flows. But like Dobbs and Lund, Ip is concerned about financial fragmentation, and urges financial regulators to cooperate in order to achieve common standards.

The authors of the World Bank’s Capital for the Future: Saving and Investment in an Interdependent World, on the other hand, draw attention to developing countries and emerging markets as both a source and destination of capital flows. These countries are likely to account for an increasing share of gross capital flows, which will be driven (p. 125)  “…by more rapid economic growth and lower population aging in developing countries than in advanced countries, as well as by developing countries’ relatively greater scope for increasing openness and strengthening financial sector institutions.” They see evidence of this trend prior to the global financial crisis, as the share of gross capital inflows to developing countries rose from 4 percent of the total in 2000 to 11 percent in 2007.

Foreign direct investment accounted for most of these inflows, although bank loans have also increased. While portfolio flows have constituted a relatively small share of inflows to these countries, the authors of Capital for the Future believe that in the future a larger proportion will flow through the capital markets. Ultimately, they claim (p. 131), there will be “developing-country convergence with advanced economies in terms of their composition of their capital inflows.” Policymakers can expedite the transition to more portfolio flows through the development of domestic financial markets and their regulatory structure.

China will play a major role in any increase in capital flows to emerging economies. Foreign exchange reserves have been the traditional form of asset accumulation in that country. Tamim Bayoumi and Franziska Ohnsorge of the IMF use a portfolio allocation model to speculate about the effects of the liberalization of capital regulations by the Chinese authorities on the private sector. They infer from their estimates that (p. 14) “capital account liberalization may be followed by a stock adjustment of Chinese assets abroad on the order of 15-25 percent of GDP and a smaller stock adjustment for foreign assets in China on the order of 2-10 percent of GDP.” The acquisition of foreign stocks and bonds by Chinese investors who would seek to diversify their portfolios could offset any continued increase in FDI inflows. The IMF economists contrast this forecast with one for India, which they believe would have more balanced flows following capital account deregulation because of smaller asset holdings by Indian investors and hence a more restricted scope for diversification.

These scenarios for the future of financial globalization need not contradict each other. On the one hand, bank lending in the U.S. and Europe is likely to be limited as governments enact new regulations and Europe continues to deal with its debt crisis. But investors in those countries may look to the emerging and “frontier” markets for higher returns based on their growth, while increased income in the emerging markets will drive a demand for liquid financial instruments that will spill over into foreign markets. In addition, firms in those countries will look to expand their operations in other developing economies through investments. Financial flows may follow a new course, but will not be contained for long.

Here and There: Nov. 5, 2013

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  1. Jérémie Cohen-Sutton has a review at the Bruegel blog of the recent discussion regarding the impact of the choice of exchange rate regimes on economic performance. He provides links to the relevant posts.
  2. The IMF holds its Fourteenth Jacques Polak Annual Research Conference at its headquarters in Washington, DC on November 7-8, 2013. The program is here and there is a preview here.
  3. There is an informative summary at Twenty-Cent Paradigms of the discussion over Germany’s current account surplus.

1944, 1976, 2013?

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When the financial crisis of 2007 was changing into the Great Recession of 2008-09, national leaders such as French President Nicolas Sarkozy and British Prime Minister Gordon Brown turned to the Bretton Woods conference of 1944 for inspiration. They invoked the spirit of the conference as they sought to resolve the crisis and devise regulations that would allow them to rein in the financial institutions that they held responsible for instigating the crisis. Indeed, Bretton Woods is often used as a model of international cooperation. (See, for example, here and here.)

But Bretton Woods is an odd choice for a prototype of international collaboration. Benn Steil in The Battle of Bretton Woods has shown how the conference proceedings were controlled by the U.S. delegation headed by Harry White, the U.S. Assistant Secretary of the Treasury. John Maynard Keynes, a member of the British delegation, was out-maneuvered by White, and the final agreement reflected the U.S. vision for the post-war international monetary regime more than anyone else’s. While the conference had a Quota Committee, for example, in reality the quotas assigned the members were chosen by the U.S. officials.

A more apt historical precedent may be the negotiations that took place during the early 1970s over the design of an international monetary system to replace Bretton Woods. Michelle Frasher has provided an account of these consultations in Transatlantic Politics and the Transformation of the International Monetary System. The U.S. had ended the conversion of gold for dollars by foreign central banks in August 1971. This act, according to Frasher, reflected the belief of U.S. President Richard Nixon and his Treasury Secretary John Connally that maintaining gold conversion limited their domestic and foreign policy options rather than any ideological view regarding Bretton Woods.

However, George Schultz, Connally’s successor as Treasury Secretary, came to favor floating exchange rates after the breakdown of the Smithsonian agreement in 1973. But while the U.S. had been able to dominate its Allies in 1944, it faced a different situation in the early 1970s.  It could not ignore the wishes of its major European allies, France, West Germany and Great Britain, which were concerned about unconstrained markets. The French in particular sought to place restraints on the ability of nations to maintain floating rates. In the end, the U.S. and French negotiators agreed to amend the IMF’s Article IV to include a commitment by the IMF’s members “to assure orderly exchange arrangements and to promote a stable system of exchange rates…” The IMF is still struggling to explain what this means in terms of which practices are permissible and which are not.

Over three decades later, many of the same tensions persist. Now, however, it is China and other Asian countries that express concerns about the U.S. Frasher (p. 135), for example, describes the source of the Europeans’ resentment in the 1970s:

…the US tendency to behave paternally and use its reserve status to disregard European opinions, act unilaterally on major policy initiatives, frame the relations in terms of US interests, and dictate the conditions of international monetary reform constantly frustrated European views about partnership. The economic and political differences within the transatlantic alliance made for an unconstructive, uneven, and often tense partnership.

Substitute “Asian” for “European” and “transpacific” for “transatlantic,” and we have a good summary of the Asians’ current views of the U.S. For example, Justin Yifu Lin, a former Chief Economist of the World Bank and the founding director of the China Center for Economic Research, wrote in Against the Consensus: Reflections on the Great Recession (p. 156)

One of the main flaws in the nonsystem that evolved in the post-Bretton-Woods period eventually led to the 2008-9 global crisis: the potential conflict of interest between US macroeconomic policy for domestic objectives and the dollar’s role as a global reserve currency…Inevitably, national economic concerns guided US fiscal and monetary policies, at times in ways that were detrimental to global stability.

Similarly, Xu Hongcai of the China Center for International Economic Exchanges in an article in the Global Summitry Journal co-authored with Yves Tiberghien wrote (p. 10):

Despite the status of the US as anchor for the global monetary system, the US central bank, the Federal Reserve is strictly mandated to set its monetary policy with consideration for US inflation, growth, and employment only. There is no channel for inputs from the rest of the world in managing the world’s currency. Thus, the major international reserve currency issuer continues to implement quantitative easing monetary policies in light of the needs of its own economy without considering the global spillover effect of such policies. These policies have caused inflationary pressures on emerging economies, and in turn increased the systemic risks of the global financial system.

After 1976, France gave up trying to devise a rule-based global system and turned to a regional system. What are China’s options? It has already shown a willingness to join with other Asian nations in a currency swap arrangement, the Chiang Mai initiative. It has the potential to do more, and could become a regional reserve currency. But to increase the use of the renminbi would require further financial decontrol, and until recently it did not appear that the government was ready to move in that direction. Most observers thought that a “fully global renminbi was a distant goal.”

The political battles over the debt ceiling, however, may push the Chinese government to rethink its long-run plans for the renminbi. Chinese officials expressed their frustration with the indifference of the U.S. to the global consequences of its domestic political discord. If Chinese policymakers now advance their timetable for expanding the renminbi’s use as a global currency, we may look back at 2013 as an inflection point.

The 2013 Globie!

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Once a year I choose a book that deals with some aspect of globalization in an interesting and illuminating way, and award it the “prize” for the Globalization Book of the Year (also known as the “Globie”). Previous winners are listed below. This year (for only the second time), I have two titles to recommend.

The first is The Alchemists: Three Central Bankers and a World on Fire by Neil Irwin of the Washington Post. Irwin describes the responses of Ben Bernanke of the Federal Reserve, Mervyn King of the Bank of England and Jean-Claude Trichet of the European Central Bank to the financial and economic crisis that began in 2007. The account of how each man reacted to the crisis is quite riveting. Bernanke emerges as the policymaker who most quickly understood the magnitude and consequences of the implosion in the financial markets. The narrative also provides an overview of central banks and monetary policy.

Angus Deaton of Princeton University deals with very different aspects of globalization in The Great Escape: Health, Wealth, and the Origins of Inequality. In the first part he offers an account of the medical and other advancements that have contributed to prolonging our lives, and how uneven that progress has been across nations. The second part of the book deals with inequality, first within the U.S. and then the rest of the world. The last section presents his view that foreign aid has failed to assist nations that have not shared in the improvements in the human condition. Deaton, a well-respected development economist, combines historical with economic analysis to explain the reasons why so many of us live longer and in better circumstances, and why so many others have not yet made that transition.

Globalization Books of the Year

Year

Author

Title

2005

 Pietra Rivoli The Travels of a T-Shirt in the Global Economy: An Economist Examines the Markets, Power, and Politics of World Trade

2006

 Jeffry A. Frieden Global Capitalism: Its Fall and Rise in the Twentieth Century

2007

 Kwame A. Appiah Cosmopolitanism: Ethics in a World of Strangers

2008

 Farid Zakaria The Post-American World

2009

 Alan Beattie False Economy: A Surprising Economic History of the World

2010

 Stephen D. King Losing Control: The Emerging Threats to Western Prosperity 

2011

 Gideon Rachman 

Dani Rodrik

 Zero-Sum Future: American Power in Age of Anxiety  

The Globalization Paradox: Democracy and the Future of the World Economy

2012

 Daron Acemoglu and James A. Robinson Why Nations Fail: The Origins of Power, Prosperity, and Poverty

U.S. and Them

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Among the causalities of the U.S. budget dispute has been the chance to enact crucial changes at the IMF. Leaders of the G20 nations agreed in 2010 on the proposals that require approval by member governments to be implemented. The U.S., however, is delaying its endorsement, and as a result the enactment of the measures has been put on hold.

There are two proposals under review. One stems from the IMF’s 14th General Review of Quotas, and the second takes the form of an amendment to the IMF’s Articles of Agreement. Among the changes that would follow from their implementation are:

  • A doubling of the amount of funds available to the IMF through the quotas of its members to about $720 billion, scheduled to take place in January 2014.
  • A shift of six percentage points of quota, which are the basis of voting shares as well as financial contributions, to emerging market countries.
  • The establishment of an all-elected 24-member Executive Board in place of the current system that allots individual seats to the Fund’s five largest members. A reallocation of two seats from the European members to emerging market countries will also occur.

Are these changes important? The increase in total quota would not change the IMF’s current capability to assist countries in crisis. Member governments agreed to lend directly to the IMF in the wake of the 2008-09 crisis through a plan known as the New Arrangements to Borrow. The proposed quota increase would make access to the additional credit consistent with the IMF’s use of its quota resources, and would be offset by a reduction of the NAB.

The change in relative quota shares, on the other hand, would lead to a long-overdue realignment of the relative quotas of the member countries. All four BRIC nations would appear on the list of the ten members with the largest shares. The current ten largest members and the proposed new line-up are:

Rank Current Proposed
1. United States (17.67) United States (17.41)
2. Japan (6.56) Japan (6.46)
3. Germany (6.11) China (6.39)
4. France (4.50) Germany (5.59)
5. United Kingdom (4.50) France (4.23)
6. China (4.00) United Kingdom (4.23)
7. Italy (3.31) Italy (3.16)
8. Saudi Arabia (2.93) India (2.75)
9. Canada (2.67) Russia (2.71)
10. Russia (2.49) Brazil (2.32)

The reallocation of seats on the Executive Board is the logical counterpart of the quota realignment. The change in how representation is arranged would open the way for the Europeans to form coalitions to appoint common representatives, such as one for the Eurozone. Such a grouping, because of the size of its combined quota, could increase the influence of the Europeans at the IMF.

James Boughton, former IMF historian, believes that changing quotas and votes should have little impact on decision making. Votes are rarely taken, and the emerging market nations are unlikely to push the IMF in a different direction, particularly now that the IMF has adopted a new view on capital flows and the use of capital controls. But Boughton also claims that the reforms are vital to preserve the IMF’s creditibility. The current allocation of quotas and seats on the Executive Board is a relic of the political and economic landscape of the post-World War II era when the IMF was established. The Europeans are overrepresented on the Executive Board and the Managing Director of the IMF continues to be a European. Officials of the emerging market countries have expressed their impatience with the delay in changing the allocations in response to their growth.

Ratification of the reform measures requires approval of 85% of the total voting power of the IMF’s members, and the U.S. has a share large enough (16.75%) to prevent passage. Why has the U.S. not approved the changes? Congressional support is needed, and that has been held back. The basic reason for the delay is the same as the reason why Congress resisted raising the debt ceiling: politics. The Republican Chair of the House Financial Services Subcommittee has stated that he will consider the quota increase only if it is included within a proposal for fiscal consolidation.

But the failure of the U.S. to support the reforms also reveals an emerging drift towards isolationism. This reflects weariness with foreign wars as well as the slow recovery from the 2008-09 crisis. The latter was marked by the end of the domination of the G7 in international economic governance. We are still waiting to see whether the G20 will be an effective replacement. But the ability of any coalition to exercise leadership will be limited if the world’s largest economy turns away.

Chinese officials were incensed at the possibility of a default on U.S. debt. Further delay of the IMF reforms only reinforces the impression that the U.S. no longer takes its international responsibilities seriously. The inward turn of U.S. politics signals a further retreat from the internationalist vision that created the IMF and other multilateral institutions.

Great Britain, it was claimed, gained an empire “…in a fit of absence of mind.” The U.S. may, on the other hand, lose its global position through indifference.

In and Out

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

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

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

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

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

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

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

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

Assigned Readings: October 9, 2013

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

 

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

 

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

Reality and Illusion

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U.S. Senators and Representatives have urged President Obama to place the issue of currency manipulation on the agenda for the negotiations for the Trans-Pacific Partnership, a trade pact (see here). The lawmakers claim that China and Japan manipulate their exchange rates in order to boost exports at the expense of U.S. firms. In the current political environment, this may be the only issue on which there is bipartisan agreement.

The charge that China manipulates its exchange rate is less relevant today than it was several years ago. The Chinese currency has appreciated against the dollar since 2005, although the pace of this rise has moderated. Moreover, the Chinese have made clear that they will not accept linking exchange rates to trade talks. Blaming the Japanese for currency manipulation revives memories of the 1970s and 1980s when concerns about Japan’s economic might were common. The subsequent decline in Japan’s relative fortunes might give pause to those who fear Chinese predominance.

The fall in the value of the yen is due to “Abenomics,” the economic policies introduced by Japan’s Prime Minister Shinzo Abe after his election in December 2012 to stimulate the Japanese economy. These include aggressive monetary expansion by the Bank of Japan, which raised its inflation target to 2% and promised to double the size of the monetary base over a two-year period. Not surprisingly, this has led to a 25% depreciation of the yen against the dollar.

The U.S. lawmakers are responding to those developments. But they should be careful in their finger-pointing. The Federal Reserve’s Quantitative Easing 1, 2 and 3, which were implemented to stimulate the U.S. economy, led to charges of “currency wars” by foreign finance ministers. Barry Eichengreen, however, has pointed out that these policies were not implemented to depreciate the dollar but to stimulate the U.S. economy, and will have positive externalities for other nations. This differs from intervention in the foreign currency market undertaken to keep an exchange rate undervalued to boost exports. Bergsten and Gagnon claim that more than 20 countries manipulate their economies in this manner.

There is another interesting aspect of the U.S criticism. The prices of Japanese goods in the U.S. are determined by the real exchange rate, i.e., the nominal rate adjusted by the U.S. and Japanese price levels. Japanese prices have fallen in recent years, which by itself would result in a depreciation of the yen’s real exchange rate. The five-year averages of the annual rates of change in the Japanese and U.S. GDP deflators show this trend very clearly:

% GDP Deflator Japan U.S.
1998-2002 -1.06 1.78
2003-2007 -1.27 2.87
2008-2012 -1.34 1.78

The causes of Japanese deflation have been the subject of much research (and dispute): see, for example, here and here. Ito and Mishkin hold the Bank of Japan’s monetary policy largely responsible for the fall in prices during this period. The increase in the Bank of Japan’s targeted inflation rate is intended to break that trend.

But why didn’t U.S. officials criticize this aspect of Japanese monetary policy? Perhaps because the yen was appreciating in nominal terms, which partly offset the cumulative impact of the decline in Japanese prices on U.S.-Japanese trade (and was hardly evidence of a currency manipulator). But this may also be an example of the “money illusion” that exists with respect to exchange rates. Observers often overlook the distinction of real and nominal rates. The impact of Chinese inflation on the real exchange value of its currency, for example, is usually ignored or not understood (but see here). U.S. policymakers who confuse the two should not be surprised when their indignation is not met with a respectful response.

Here and There: October 3, 2013

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

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

Apples and Naranjas

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The Economist has published its indicator of vulnerability to a “capital freeze.” (An earlier version published on September 7 was revised.) The ranking for 26 emerging markets is based on each country’s current account balance as a percent of its GDP, its short-term external debt and debt repayments relative to foreign exchange reserves and sovereign wealth fund assets, the growth rate of credit to the private sector, and the Chinn-Ito index of financial openness. The ten countries rated as most at risk are Turkey, Romania, Poland, Mexico, Colombia, Peru, Argentina, Indonesia and Chile.

Not surprisingly, there has been some pushback from officials of the countries at the top of the rankings. Mauricio Cárdenas, Colombia’s minister of finance, defends his country’s economic reputation in a letter. The minister claims that those who devised the rankings ignored the sources of vulnerability to a sudden stop, including the source of financing for the current account.  Mr. Cárdenas points out that Colombia’s current account is “fully financed by foreign direct investment instead of short-term capital flows.”

Does he have a case? We calculated Colombia’s current account/GDP and FDI/GDP ratios over the last three years (2010-12), and compared them with other Latin American economies on the index:

% Current Account/GDP FDI/GDP
Argentina -0.05 2.34
Brazil -2.24 2.92
Mexico -0.70 1.67
Venezuela 4.28 0.76
Colombia -3.05 3.54

Score one for the minister: the current account deficits of the last three years were indeed offset by inflows of FDI.  Game, set, match for Colombia?

Perhaps not. The size of the current account deficits, one of the components of the capital-freeze index, stands out. More importantly, the minister is mixing flows and stocks. The FDI inflows create FDI liabilities that are not easily reversed. But the country’s short-term external debt is the source of vulnerability to a sudden stop. Nervous lenders can simply cease renewing lines of credit or other credit facilities, and domestic borrowers will be cut off from funding. Reversals of short-term external debt were features of the Mexican, East Asian, Russian and Brazilian crises of the 1990s.

The debt data for the five South American countries in 2011 show why Brazil is rated as less risky than Colombia and the other nations. These countries are more vulnerable to a change in sentiment by foreign lenders. Venezuela does not appear in the top ten on the capital-freexe index in part because it is not as financially open as the others, and thus less exposed.

% External Debt/GNI Short-term Debt/External Debt
Argentina 26.35 14.53
Brazil 16.64 10.42
Mexico 25.20 17.88
Venezuela 21.82 24.56
Colombia 24.31 14.06

Colombia’s finance minister has justification to be proud that his country attracts sufficient FDI to finance its current account deficits. And there is no reason to expect that those flows will cease. But the country’s external debt liabilities, the result of past borrowing, are the source of potential hazard.