The Coming Wave of Debt Restructurings

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The news that the Federal Reserve will raise interest rates in 2022 sooner than anticipated was not surprising in view of the continued high rates of U.S. inflation. While U.S. asset prices are falling in response to the prospect of higher rates as well as a smaller Fed balance sheet, foreign markets are straining to decipher the spillover effects on their economies. But it is only a matter of time until emerging markets and developing economies face higher financing costs and the need for debt restructurings.

The World Bank pointS out in its most recent Global Economic Prospects that global debt levels in 2020 rose to their highest levels relative to GDP in decades. The publication also shows that economic projections for the emerging markets and developing economies excluding China are for lower growth rates than those of the advanced economies. Consequently, servicing and repaying the debt represents a challenge for those countries. World Bank President David Malpass warned that 60% of the poorest countries need to restructure their debt or will need to.

Ayhan Kose, Franziska L. Ohnsorge and Carmen Reinhart of the World Bank and Kenneth Rogoff of Harvard University examine the options that countries with elevated debt levels face in their NBER working paper, ”The Aftermath of Debt Surges.” They divide the possible responses into orthodox and heterodox solutions. The former includes strong economic growth that reduces relative debt levels as well as fiscal consolidation that can generate surpluses to pay off debt. Other measures are the privatization of public assets and higher wealth taxation, both of which can yield needed revenues. All come with associated downsides hazards, such as higher interest rates if growth comes with more inflation, or a lack of the conditions needed for successful privatization.

Heterodox approaches include unexpected inflation to erode real debt levels, financial repression to maintain low interest rate and debt default or restructuring. The authors point out that external defaults and restructuring impose long-term costs in the form of higher bond yields. Nonetheless, they warn that debt default, both external and domestic, may become more common in the wake of the increase in debt in response to the pandemic.

Similarly, Stephan Danninger, Kenneth Kang and Hélène Poirson of the IMF have a post on the IMF’s Blog, “Emerging Economies Must Prepare for Fed Policy Tightening,” that presents measures that the governments of these countries should undertake to limit the fallout from higher foreign rates. These include allowing their currencies to depreciate while raising their own interest rates. Of course, such measures make supporting a weak domestic economy more difficult. They warn that countries with significant nonperforming debt levels will face solvency concerns.

The IMF, the World Bank and the Group of 20 have joined together to implement a “Common Framework” to help low-income countries deal with their unsustainable debt. Creditor Committees will be created on a case-by-case basis to coordinate debt restructuring by private and official creditors. Private lenders, however, have not shown an interest in joining the program and to date, only three countries—Chad, Zambia and Ethiopia—have applied for assistance.

Another challenge facing the Common Framework is the role of China, which has become the largest bilateral lender to the low-income countries. China has not joined the Paris Club, the organization of creditor nations that deals with bilateral debt between advanced economies and low-income countries. However, it has to date followed the policies of the Paris Club members in deferring debt. One possible complication consists of whether loans from Chinese policy banks, such as the China Development Bank and the Export-Import Bank of China, and state-owned commercial banks, such as the Industrial and Commercial Bank of China, should be treated as private or official creditors.

Anne Krueger of Johns Hopkins University has warned that debt restructuring and further lending should be accompanied by appropriate economic policies. Some countries were engaging in unsustainable spending before the pandemic, and any new lending should be used for spending related to the pandemic. She cites Bolivia, Ghana, Madagascar, Pakistan, Sri Lanka, and Zambia as countries that had excessive expenditures before the pandemic.

The possibility of a debt crisis among the emerging markets and developing nations has long been foreseen (see here and here). The wave of new lending to these countries in the period preceding the pandemic was similar to previous surges that had led to financial crises, and the pandemic further raised debt levels. The combination of higher interest rates in the advanced economies, sluggish economic growth and the possibility of further disruptions due to the pandemic pose a challenge to governments with limited abilities to respond.

The Return of FDI

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Last year’s collapse in foreign direct investment was seen by many as the first stage of a period of retrenchment. Political pressure to “reshore” production, particularly of goods of national importance such as medical equipment, would cause multinational firms to rearrange their global supply chains to minimize foreign exposure. The data released for FDI in the first half of this year shows that in fact foreign investment has rebounded from last year’s decline. But the largest growth rates were recorded for the upper-income countries, where FDI had fallen precipitously in 2020, and China. FDI also rose in middle-income countries where it  had not fallen as sharply in 2020. Low income countries, on the other hand, did not see any increase in foreign investment.

The October issue of the Organization of Economic Cooperation and Development’s FDI In Figures reports that global FDI flows rose to $870 billion in the first half of 2021. These flows were more than double those of the last half of 2020 and even higher than pre-pandemic flows. The largest increase was recorded in China, the world’s major recipient of FDI. But the second and third largest inward flows were recorded in the U.S. and the U.K. FDI inflows to the Group of 20 economies increased by 42% in the first half of this year as compared to the previous half-year. They were up in 83% in the OECD G20 countries, and 12% in the non-OECD G20, reflecting a split by income level.

Earnings on inward OECD FDI increased by about 30% in the first half of the year, from the previous half-year. About half of this amount was distributed to affiliates and the remaining funds reinvested. Earnings on outward FDI increased by 28%, and a larger share of these payments were reinvested rather than distributed. Compared to pre-pandemic levels, these earnings were 14% higher. Growth in the earnings of outward FDI was particularly noticeable in the U.S., France, Germany, Japan, and the Netherlands, all home countries of multinational firms.

Much of the FDI activity in the OECD economies consisted of mergers and acquisitions (M&As), as both M&A deal values and the number of acquisitions rose in the advanced economies. Many of these deals were made in the healthcare and technology sectors. M&A activity in the emerging market and developing economies, however, was much less.

Investment in greenfield projects was relatively low compared to pre-pandemic levels. Announced greenfield projects increase by 9% in advanced economies but fell by 6% in the emerging market and development economies. Corporations are holding back from building new production facilities in those countries that saw large amounts of investment in the 1990s and early 2000s.

The difference in FDI activity amongst countries also appears in the October issue of UNCTAD’s  Investment Trends Monitor. It reports that FDI recorded growth rates of 117% in the high-income countries, 30% in the middle-income countries but a decline of 9% in the low-income group. The report cites “the duration of the health crisis and the pace of vaccinations, especially in developing countries” as “factors of uncertainty.”  This report also noted the decline in greenfield projects.

A similar discrepancy in national growth prospects was noted by the IMF in the latest issue of the World Economic Report. The report stated:

Advanced economy output is forecast to exceed pre-pandemic medium-term projections—largely reflecting sizable anticipated further policy support in the United States that includes measures to increase potential. By contrast, persistent output losses are anticipated for the emerging market and developing economy group due to slower vaccine rollouts and generally less policy support compared to advanced economies.

As noted above, China is a conspicuous exception to the FDI trends for emerging market and developing economies. Megan Greene of Harvard’s Kennedy School, in a column “Don’t Believe the Deglobalisation Narrative” in the Financial Times, interpreted the data on the inflows of FDI and other financial flows as showing that there isn’t any evidence of a corporate retreat from China. The country continues to offer modern infrastructure for the movement of parts and goods, domestic supplier networks and a large labor force. Moreover, China’s own markets represent potential sources of profits if consumption expenditures increase.

FDI may have rebounded from its downturn in 2020, but the increase in investment flows has been distributed unevenly. Part of the unequal allocation is due to the virus, with a new mutation appearing in some African countries. As long as the virus evolves into more virulent strains, there will always be the threat of another outbreak. Only a truly global effort that includes the delivery of vaccines to those nations most in need can stop the cycle and reorient foreign investment.

The 2021 Globie: “Three Days at Camp David” and “The Global Currency Power of the US Dollar”

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Fall is the time of the year to announce the recipient of this year’s “Globie”, i.e., the Globalization Book of the Year. The prize is strictly honorific and does not come with a check. But the award gives me a chance to draw attention to a recent book—or books—that are particularly insightful about globalization. Previous winners are listed at the bottom of the column.

This year there are two winners, Jeff Garten for Three Days at Camp David and Anthony Elson for The Global Currency Power of the US Dollar. Each book deals with the financial hegemony of the U.S. dollar in the global financial system. Together they provide a fascinating account of how the dollar came to hold—and hold onto—this role.

Garten looks at the decision by President Richard Nixon in the summer of 1971 to end the link between the dollar and gold, a central foundation of the Bretton Woods system. Foreign central pegged their exchange rates to the dollar, which was convertible to gold by the U.S. government for $35 an ounce. This arrangement reflected the U.S. position at the end of World War II as the predominant economic power, able to use its influence at Bretton Woods to ensure a dollar-dominated system.

But the imbalance between the U.S. and the rest of the world shifted during the 1950s, particularly as Germany and Japan emerged as economic powers with growing trade surpluses. U.S. government spending resulted in growing foreign holdings of dollars. Yale Professor Robert Triffin pointed out that the ability of the U.S. to exchange its gold for dollars was deteriorating, and this incipient crisis became known as the “Triffin dilemma.” By 1971 this situation was no longer sustainable. Foreign central banks held about $40 billion in dollars while U.S. gold holdings had fallen to $10 billion. Speculators were taking positions on the response of the U.S. and other central banks in a global chicken game.

Garten describes the main players in the decision to end the link with the dollar. Nixon had appointed John Connolly as Treasury Secretary mainly because of Connolly’s political skills.  Connolly in turn depended on the expertise in international finance of Paul Volcker, then under secretary of the Treasury for international monetary affairs. George Schulz was known for his organizational expertise and served as the director of the Office of Management and Budget. Arthur Burns, Chair of the Federal Reserve, sought to serve Nixon while maintaining some semblance of institutional autonomy. Other participants in the decision included Paul McCracken of the Council of Economic Advisors and Peter Peterson of the White House Council on International Economic Policy.

These men (yes, all men) had different perspectives on the best way to handle the crisis. Volcker and Burns shared an appreciation of the existing framework, and wanted to consult with their counterparts in other countries on reforming the system. Schulz, influenced by his background at the University of Chicago, looked forward to a day when flexible exchange rates would replace pegged rates. Connolly, on the other hand, had no ideological agenda. He sought to promote American interests and Nixon’s re-election, and saw the two as entirely compatible.

Nixon, Garten makes clear, was concerned about the impact of the situation on his 1972 election campaign, and his response must be understood in that context. Nixon consulted with these advisors at Camp David on the weekend of August 13 – 15 on how best to meet the dollar crisis. After a broad discussion, the decision to end the link of the dollar with gold sales was made. The rest of the weekend was spent on deciding on how to present the issue to the American public and U.S. allies.

Nixon spoke that Sunday night, making the case on the need to achieve economic prosperity in the aftermath of the Vietnam war. Other measures he presented included a tax credit for investment, a freeze on wages and prices and the establishment of a Cost of Living Council to enact measures to control inflation, and a 10% temporary tariff on imports. He justified the latter on the “unfair edge” that competitors had gained while the U.S. promoted their post-World War II recovery.

The U.S. subsequently negotiated with the other leading advanced economies on establishing new fixed rates, but the effort was unsuccessful. By March 1973, almost all of the Western European economies and Japan had embraced flexible exchange rates. The Jamaica Accords of 1978 marked the official of the Bretton Woods exchange rate system. Central banks could continue to peg their currencies against the dollar, but there was no obligation on the U.S. to support the “non-system.”

Anthony Elson brings the story forward in time to explain the continuing dominant position of the dollar. It is doubtful that anyone in 1971 or 1978 would have predicted a key role for the dollar in the post-Bretton Woods era, and Elson shows that the dollar’s continued dominance reflects several factors. First, the dollar continues to be used for invoicing international trade, even for non-U.S. trade flows. The dollar is used for this purpose in order to minimize transaction costs, as well as its record of macro stability. Second, the continued dominance of financial markets in the U.S. draws foreign investors looking for safe and liquid markets. This in turn has encouraged the growth of dollar-based financing outside the U.S. Third, the dollar continues to the most commonly-used currency for the foreign exchange reserves of central banks. U.S. Treasury bonds are seen as a global “safe asset.”

All this, Elson points out, bring benefits for U.S. traders and investors, who can use the dollar to purchase foreign goods and assets. In addition, the government can finance a continuing current account deficit through its provision of U.S. Treasury bonds. The foreign demand  for these securities also lowers the cost of financing the fiscal deficits. On the political side, the government has learned how to use access to the dollar-based international clearing system as a tool of foreign policy, effectively “weaponzing the dollar.”

Can this system continue? The “new Triffin dilemma” has arisen as a result of the relative decline of the U.S. economy in terms of its share of world GDP at the same time as the demand for safe assets continues to grow. An increase in the issuance of U.S. securities to finance fiscal deficits coupled to the political posturing over the debt ceiling may threaten the confidence of foreign investors in the ability of the U.S. government to meet its obligations, much as the declining gold stock led to the 1971 crisis.

But what alternatives are there? The Eurozone and China have grown in size and importance and their currencies may serve as regional rivals for the dollar. But a multipolar reserve currency system may itself be unstable. The IMF’s Special Drawing Rights were designed to supplement the dollar, but their use has been limited, and it would take concerted intergovernmental action to encourage its use. Digital currencies may change how we view money, and central banks are actively investigating their use.

There is little history to provide a guide on the circumstances that lead to a change in the hegemonic currency. The dollar began to rival the British pound in usage in the 1920s as the U.S. economy rapidly grew. But the transition was finalized by the costs to Great Britain of fighting World War II. If a peaceful transition to a new reserve currency system is to take place, it will require more international cooperation than has been shown on other issues.

 

2020    Tim Lee, Jamie Lee and Kevin Coldiron, The Rise of Carry: the Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis

2019    Branko Milanovic, Capitalism Alone: the Future of the System That Rules the World

2018    Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World

2017   Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic,  Global Inequality

2015   Benjamin J. Cohen,  Currency Power: Understanding Monetary Rivalry

The Global Impact of the Fed’s Pivot on Asset Purchases

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Federal Reserve Chair Jerome Powell announced last month that the Fed would slow its purchases of bonds, most likely by the end of this year. The timing of the cutback will depend on several factors related to the economy, and last week’s disappointing employment report if repeated could push back the date. The financial markets will now begin anticipating the impact of the reduction in the Fed’s asset holdings.

The origins of the increase in the Fed’s holdings of Treasury bonds and mortgage-backed securites can be traced back to the global financial crisis. The Fed’s assets grew from $870 billion in August 2007 to $2 trillion in early 2009. When the Fed introduced its quantitative easing program, it claimed that the purchases of bonds would lead to lower long-term interest rates more quickly than if it relied only on lowering the Federal Funds rate. In addition, the purchases showed the Fed’s commitment to keeping interest rates low in order to boost the economic recovery. This latter form of signaling was called “forward guidance.”

Subsequent quantitative easing programs eventually raised its holdings to $4.5 trillion by 2015. The Fed maintained that level until 2018, when it allowed its holdings to fall as bonds matured. But it reversed course in 2019, and the Fed responded to the pandemic in the spring of 2020 by ramping up its purchases of assets in order to support the financial markets. Its asset holdings now total about $8.3 trillion.

The Fed has not been alone in using asset purchases as a tool of policy. The European Central Bank increased its holdings of bonds during the period preceding the pandemic from 2 trillion Euros at the end of 2014 to 4.6 trillion Euros. It accelerated its purchases last year and now holds about 8.2 trillion Euros in assets. The Bank of Japan and the Bank of England have their own versions of asset purchase programs. Many of these central banks have also announced changes in the pace of their asset purchases.

When then Fed chair Ben Bernanke noted in 2013 that continued strengthening of the economy could lead to a cutback in asset purchases, this was interpreted as a sign that the Fed would also allow interest rates to rise. This led to the infamous “taper tantrum,” as financial markets overreacted to the prospects of higher interest rates. The response included capital outflows from emerging market countries such as India as their exchange rates depreciated and their own asset markets fell in value. Stability was eventually reestablished once the Fed clarified that it had no plans to enact a contractionary policy, but the incident demonstrated the volatility of financial markets, particularly in the emerging market countries.

Powell has sought to avoid such an outcome by explicitly delinking asset purchases from interest rates. He pledged to keep the Federal Funds rate at its current setting until “maximum employment and sustained 2% inflation” area achieved. The (lack of a)  response in the financial markets to Powell’s speech seemed to indicate that this promise was seen as credible, despite concerns about inflation.

But there will be consequences when the Fed cuts back on its asset purchases. The increases in the Fed’s balance sheet, as well as those of the other central banks, released a wave of liquidity with wide-ranging consequences. In the U.S. it has kept stock price valuations at elevated levels, which contributes to widening wealth inequality. For example, in 2019 families in the top 10% of the income distribution owned 70% of total stock values. Similarly, the provision of easy credit has contributed to rising housing prices that also reflects demand and supply conditions.

The increase in liquidity also benefited emerging markets and developing economies. In the period immediately before the pandemic the World Bank warned that the world had experienced a rise in debt, both private and government. Total debt in the emerging markets and developing economies had risen from 114% of their GDP in 2010 to 170% at the end of 2018. Part of this increase reflected accommodative monetary policies in the advanced economies and a search for higher yield by investors in those countries. A rising global demand for the bonds of the emerging market and developing economies countries was met by an increase in their issuance.

These countries suffered massive reversals of foreign capital in the spring of 2020. The “sudden stops” confirmed the existence of a global financial cycle that can overwhelm vulnerable economies. But the withdrawals were soon reversed, in part because investors were reassured by the rapid responses of central banks in the advanced economies to the financial meltdown.

There are many who voice concerns about the ending of the current financial cycle. Mohammed El-Erian, president of Queens’ College of Cambridge University, is worried about the excessive risk-taking that the financial sector has undertaken in response to its “unhealthy codependency” with central banks.  Raghuram Rajan of the University of Chicago’s Booth School of Business is alarmed about the impact that future interest rate hikes could have on government finances. Jeremy Grantham of asset management firm GMO believes that the stock market will experience a massive crash. And IMF Managing Director Kristalina Georgieva is concerned about a diveregence in the prospects of advanced economies and a few emerging markets versus those of most developing economies that could lead to a debt crisis.

Much of the impact of the policy changes at the Federal Reserve depends on how the financial markets respond to the slowdown in purchases, and whether the Fed is successful in delinking a cutback in asset purchases from its interest rate policy. The lack of a strong response in the bond markets suggests that there has not been a change in expectations of future interest rates. But ouside the U.S. there is always the prospect that a slowdown in economic growth and the continuation of the pandemic imperil the solvency of corporate and government borrowers. These developments would be enough to fuel a debt crisis despite the Fed’s careful footwork.

China’s Outward FDI

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Chinese firms that want to list their stock in U.S. equity markets face a series of hurdles. The Securities and Exchange Commission is implementing a new rule that requires the firms to provide information regarding their ties to the Chinese government, while the Biden administration is banning Americans from investing in 59 Chinese firms. Moreover, Chinese authorities have their own concerns about the foreign listing of Chinese firms. Chinese multinationals also face impediments to their foreign expansion through direct investment, but they have been successful in expanding their foreign operations, and this is slowly transforming China’s external balance sheet.

China, of course, is a creditor country, with a net international investment position (NIIP) in 2020 of $2,150 billion. Historically its balance sheet has been characterized as “long debt, short equity,” i.e., China held the debt issued by borrowers in the advanced economies (such as U.S. Treasury bonds) and issued equity liabilities, usually in the form of foreign direct investment (FDI). This strategy allowed China to benefit from the expertise of multinational firms and foreign technology, while avoiding the need to depend on its own undeveloped financial markets to arrange financing. But Chinese firms are at the stage where they can compete in foreign markets, and have been acquiring foreign affiliates.

In 2010, Chinese FDI assets were worth $317 billion, while Chinese FDI liabilities were valued at $1,570 billion, for a net FDI position of -$1,252 billion, or -20.6% of Chinese GDP. Chinese  outward FDI flows have grown since then, and the stock of assets reached $2,237 billion in 2019. (These changes also reflect the effects of currency value fluctuations.)  While the stock of liabilities was still larger at $2,796 billion, the gap between them had shrunk to $560 billion, only about 4% of GDP.

Dongkun Li and Yang Zhang provide an occount of the evolution of Chinese outward FDI in their article, “Compressed Development of Outward Foreign Direct Investment: New Challenges to the Chinese Government,” which appeared in the Journal of African and Asian Studes in 2020.  In the 1990s Chinese FDI was usually undertaken by state owned enterprises and focused on the acquisition of natural resources, particularly in developing economies. The government endorsed FDI as part of its growth strategy, however, and FDI outflows grew rapidly after 2001 as private enterprises increased their share of China’s outward expansion. There was a slowdown in 2017 when the Chinese government, concerned about capital outflows, imposed restrictions on outward FDI. Foreign expansion has continued, albeit at a slower pace, and has been given a new focus under the Belt and Road Initiative.

The increase in Chinese firms’ foreign activities has also affected China’s net investment income. Despite its NIIP creditor position, China has recorded deficits on net investment income, as payments on its FDI liabilities traditionally have exceeded the returns China received on its largely debt-dominated assets. But China’s net investment income deficit, which reached $85.3 billion in 2011, had fallen to $43.4 billion in 2019.

There was a reversal in these trends last year. China was the largest recipient of FDI in 2020, bypassing the U.S. Chinese FDI liabilities jumped to $3,179 billion, and the net FDI position fell to -$765 billion, about -5.2% of GDP. The deficit on net investment income rose to $107 billion. FDI inflows continued to be strong in the first quarter of this year. However, outward FDI increased from its depressed 2020 amount.

The future development of FDI both inside and outside China depends a great deal on government policies, as well as the uncertain course of the pandemic. In the U.S., the Committee on Foreign Investment examines proposed acquisitions of U.S. firms,  and blocks access to U.S. technology that could affect U.S. security. European governments are also scrutinizing Chinese investment, and that screening combined with the effect of the pandemic resulted in a large drop in Chinese FDI flows to Europe last year. The Chinese government also seeks to controls foreign ties as part of its overall move to assert more government control of the economy. But Chinese firms are eager to expand, and over time their search for new markets should lead to further shifts in China’s net FDI position and foreign investment earnings.

Will A Rise in Interest Rates Lead to a New Debt Crisis?

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The question of when the Federal Reserve will begin to reverse its loose policy stance continues to be a topic of widespread speculation. At last month’s meeting of the Federal Open Market Committee, its members showed a willingness to cut back on asset purchases in 2022 and to raise interest rates in 2023, but kept monetary policy on its current setting due to slower growth in employment than desired. The latest inflation reading may bring forward the Fed’s tightening measures. If and when interest rates do rise in the U.S. and other advaneced economies, what will be the impact for holders of foreign assets?

There is a split in opinions on the vulnerability of emerging market economies (EMEs) to rising interest rates. In an interview with Finance & Development, Richard House of Allianz Global Investors and David Lubin of Citibank played down the chances of a disruption of foreign markets when the Federal Reserve begins its reversal. They cite the increase in foreign exchange reserves and the decrease in the number of countries with fixed exchange rates as reasons why systemic crises can be avoided. In the same issue, however, Şebnem Kalemli-Özcan of the University of Maryland points out that country-dependent risk will affect the response to a new external environment. Many EMEs used monetary policy to finance their fiscal spending in response to the pandemic. There is a concern that their bond purchases and monetary creation could lead to higher inflation that will raise the cost of new financing at the same time as the U.S. is raising its interest rates.  

The author of the Buttonwood column of The Economist, however, notes that the central banks in several EMEs have already raised their policy rates in response to concerns of rising inflation following currency depreciations. Higher rates attract capital from foreign investors looking for higher yields, which strengthens the currency. An appreciating currency keeps down import prices and inflation in check.

Jasper Hoek and Emre Yoldas of the Federal Reserve Board and Steve Kamin of the American Enterprise Institute show that the response of emerging market economies to rising U.S. interest rates will depend in part on the reasons for the increase. If rates rise because of favorable economic growth in the U.S., then the EMEs should benefit from the increase in U.S. demand for their goods and increased investor confidence. If, on the other hand, the higher rates are due to higher inflation that requires a marked tightening of the U.S. policy stance, then interest rates on the debt of EME issuers will rise as their currencies fall in value.

The response to the pandemic in the EMEs is the biggest challenge those nations face.  While firms in the U.S. and Europe are busy meeting surging consumer demand, the virus continues to spread in Africa, South American and South Asia. The response in advanced economies to a recovery that brings with it higher inflation may threaten the ability of the EMEs’ policymakers to maintain their accommodative stance. Agustín Carstens, General Manager of the Bank for International Settlements, warns: “… it could be hard for EME policymakers to maintain accommodative policy stances should global financial conditions tighten materially. But tighter policy will make economic recovery even more difficult.”

The record of responses to Federal Reserve policy retrenchment is not encouraging. In May 2013, then Fed Chair Ben Bernanke responded to a question at a Congressional committee meeting about future Fed policy by noting that “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases.” This innocuous remark led to turbulence in the financial markets, which became known as the “taper tantrum.” Increases in the Federal Funds Rate in 2018 under Fed Chair Jerome Powell met widespread criticism and concerns about their impact on slow economic growth, and the Federal Reserve reversed course in 2019.

Economists can always provide well-reasoned narratives as to how and why financial markets respond to events. Unfortunately, market volatility is almost always unanticipated. No matter how careful policymakers are with their statements, there is the potential for an unforeseen response. The continuation of the pandemic heightens the uncertainty, and the current elevated levels of stock prices and the increase in debt leaves asset markets vulnerable to a “Minsky moment” when an initial reversal leads to a demand for liquidity and cascading falls in financial markets. The EMEs will become part of the collateral damage of such a collapse.

“The Sources of International Investment Income in Emerging Market Economies”

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The Review of International Economics has published my paper on “The Sources of International Investment Income in Emerging Market Economies” in its latest issue. You can find the paper here, and this is the abstract:

We investigate international investment income flows in 26 emerging market countries during the period of 1998–2015. Net investment income registered a deficit for this group of countries of between 2% and 3% of GDP during this period. This deficit has been dominated by payments on foreign direct investment liabilities, which is consistent with the change in the composition of the external liabilities of these countries. Our results indicate that both capital account and trade openness are associated with the deficits on direct investment income. In addition, there was a small deficit in portfolio investment income, which is affected by the development of domestic financial markets and investor protection. Other investments’ income and the income from foreign exchange reserves have a negligible role in total investment income.

International Factor Income in 2020

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The sharp contraction in economic activity in the first half of 2020 due to the COVID pandemic was followed by a slow and uneven recovery in the second half of the year. The decline slowed global trade and capital flows, although not as much as initially expected. The economc slowdown also lowered investment income and remittances, the two main forms of international factor income payments. (There is also rent received on property.) Will these also recover as economic growth resumes?

Net investment income appears in the current account of the balance of payments as part of net primary income. For most countries FDI income is the largest component of investment income, followed by portfolio (equity and debt) income and other (mainly bank) income. The largest net recipients of FDI income are the U.S., Japan, Germany and France, all home countries for multinationals. Emerging markets economies that attract FDI flows, such as India and China, are major net payers of FDI income. Ireland, which attracts multinationals with its low corporate tax rates and its proximity to continental Europe, also records large FDI income deficits.

The latest issue of the OECD’s FDI in Figures reports FDI income for 2020 for the OECD area. Total FDI receipts were $1.80 trillion and payments were $1.04 trillion, which result in net FDI income payments of $418 billion. Almost three-quarters of the OECD income earnings were paid out to the parent countries, with the remainder reinvested in the host countries.

As expected, the 2020 FDI income flows represented declines from those of 2019, which the OECD attributed to the pandemic. The percent changes—a drop in receipts of 16% and of 15% in payments—were similar to those recorded during the global financial crisis. Moreover, the 2019 earnings were below those of 2018 due to slowing economic growth.

A recovery in FDI income will depend in part on the future course of FDI flows. Global FDI flows decreased by 38% in 2020 to $846 billion, their lower level since 2005. When scaled by GDP, they represented 1% of world GDP, the lowest relative level since 1999. In the OECD area, much of this decline was driven by disinvestments from Switzerland and the Netherlands, which serve as financial centers for companies with headquarters in other countries. The OECD reports a rise in cross-border mergers and acquisitions in the second half of 2020 and the first quarter to 2021.

The outlook for FDI-associated income also depends on the outcome of the talks sponsored by the OECD to harmonize the rules governing how tax rights are determined amongst jurisdictions, and also to set a minimum global tax rate. Multinational firms have been able to take advantage of the differences in corporate tax rates among nations by basing their operations in tax havens such as Luxembourg and Bermuda. If the negotiating parties come to an agreement, multinational firms will have to reassess the locations of their operations. They are most likely to cut back their use of the tax havens, but how they will restructure their activities and the impact on global supply chains is not clear.

There is also uncertainty over the impact of government policies on multinational investments. The U.S. and Chinese governments have indicated that they want to build up their respective domestic capacities in a number of areas, and will use trade and financial restrictions to promote domestic suppliers while limiting foreign access. Controls on inward FDI, for example, are used to deny foreign firms and governments access to domestic technology. Trade barriers also inhibit companies from expanding their operations, and the Biden administration has indicated that it will take an aggressive response to what it perceives as unfair Chinese policies.

Remittances fared better in 2020, according to the World Bank, falling to $540 billion, only 1.6% below the previous year’s level. With the exception of China, remittances exceeded the total of FDI flows and financial assistance to developing countries. The true value may be higher since not all remittances are recorded. The largest recipients in absolute terms were India, China, Mexico, the Philippines and Egypt, all countries with large labor forces. The U.S. was the largest source of the remittances, followed by the United Arab Emirates, Saudi Arabia and the Russian Federation.

Why were remittances so strong? Gabriella Cova of the Atlantic Council writes that many migrants believed that conditions in their home countries were worse than in their host countries, and continued to send money home. Consequently, the reminttances were counter-cyclical for the recipient countries, partially offsetting the domestic economic contraction. The migrants who retained jobs in “essential” sectors were able to send money to their home countries. Moreover, the appreciation of the dollar increased the domestic values of their payments.

The future for migrants and their remittances, like FDI, is also uncertain. Developed countries with aging workforces will increasingly need migrants to take the place of native-born workers. On the other hand, the closure of borders during the pandemic may reinforce the trend to technological solutions. Japan, for example, has been developing robotic care for the health sector. Border control is a contentious area of public policy, although the pandemic also demonstrated the need for workers to undertake basic tasks in food production, distribution and delivery.

International factor payments have become increasingly important components of the balance of payments. Depending upon their value, they can either offset or amplify a trade account deficit (see Forbes, Hjortsoe and Nenova 2016). They also distinguish GDP from GNP, and can affect income inequality in both the home and host countries. The COVID pandemic disrupted them, particularly FDI income, and their future depends on how capital and labor flows are restructured after the pandemic.