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.

The Next “Lost Decade”?

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The 1980s were a “lost decade” of economic growth for those developing countries in Latin America that were enveloped in a debt crisis. Many now fear that we are on the verge of another debt crisis in the wake of borrowing by governments to support their economies during the pandemic. A concerted response will be needed to avoid it.

Countries such as Mexico and Brazil had borrowed during the 1970s to finance oil bills that had skyrocketed after OPEC had raised petroleum prices. International banks were happy to recycle the dollars that the oil-exporters had placed on deposit with them. The crisis came when the Federal Reserve under Paul Volcker raised interest rates, and the U.S. experienced back-to-back recessions that lowered the demand for these countries’ exports. It took a decade of negotiations and failed initiatives before the bank debt was refinanced as bonds or written off.

The IMF’s latest Global Financial Stability Report provides data on the recent rise in government debt: “Government debt in emerging markets (excluding China) is expected to reach 61 percent of GDP in 2021, and gross financing needs are anticipated to remain elevated at 13 percent of GDP in 2021, coming off record levels in 2020.” This escalation follows the pre-pandemic period when public debt/GDP levels had already risen in emerging market economies and advanced economies outside Europe.

The governments issuing debt were able to finance their expenditures at very low interest rates that reflected the 2020 collapse in economic activity and the rapid response by central banks. The “sudden stop” of capital flows to emerging markets last spring was reversed as investors returned seeking the higher yields that emerging market debt could provide. Moody’s reports record sales of Eurobonds in 2020 by emerging markets of $639 billion. Foreign investors also purchased sizable amounts of local currency debt in many of these countries.

But the favorable conditions of the past year are changing. Economic recovery will be much slower for countries such as Brazil and India, where the numbers of people infected by the coronavirus continue to soar. In April’s World Economic Outlook, the IMF reported improved prospects for growth in the advanced economies but less a less favorable outlook for the emerging and developing economies with the exception of China. Second, interest rates have risen from their very low levels In the U.S., reflecting expectations of increased growth and inflation. Third, a strong U.S. dollar makes servicing dollar-denominated debt more expensive.

Many of those issuing bonds relied on the analysis of Olivier Blanchard, until recently chief economist of the IMF, to justify their borrowing. Blanchard had pointed out that an increase in public debt may be sustainable if the rate of economic growth exceeds the interest on the public debt. The governments of some emerging markets used this line of reasoning to justify their borrowing as they responded to the worldwide lockdown and the need for medical equipment and supplies.

But emerging markets face different circumstances than those of advanced economies. They pay a risk premium that can escalate when conditions deteriorate.  IMF economists Marcos Chamon and Jonathan D. Ostry warn that borrowing costs for emerging markets and developing economies may become significantly higher relatively quickly. The Economist cites a bank study that lists Brazil, Indonesia, Mexico and South Africa as among the countries most vulnerable to any jump in interest rates.

If (or when) conditions do deteriorate, what responses will be available? The IMF, the World Bank and the Group of 20 have suspended the debt servicing of their loans to low-income countries via a Debt Service Suspension Initiative (DSSI). The response has been limited, perhaps due to fears of what acceptance would imply about domestic economic management. Moreover, DSSI does not apply to private bondholders, and the commercial share of the holdings of public debt rose over the last decade.

During the 1980s the IMF worked with the governments in distress and the international banks that were their lenders. This time, however, there is a more disparate group of lenders, and it will be more difficult to formulate a common response. China has become a major lender, and China has joined the DSSI. But some of their loans were made state-owned banks and agencies, which may be classified as private lenders. Some foreign bondholders claim they are concerned that any debt relief they extend will be used to pay the Chinese lenders.

The IMF intends a more direct response through an issuance of Special Drawing Rights (SDRs), the official currency of the Fund. These can be sold or used as foreign exchange reserves, thus freeing up other reserve assets. Their allocation are based on the quotas which reflect a country’s size and international economic activity, so favors the advanced economies. But there are mechanisms that allow countries that do not need the new allocation to lend or donate them to countries that do. The U.S. had withheld its approval of the increase, but Treasury Secretary Yellen reversed that decision and the allocation is expected to take place next summer.

Kris James Mitchener of Santa Clara University and Christoph Trebesch of the Kiel Institute for the World Economy review the literature on sovereign debt in their paper, “Sovereign Debt in the 21st Century: Looking Backward, Looking Forward.” While their survey emphasizes debt problems in advanced economies, they point out implications for the emerging market economies. For example, they find that the enforcement of debt contracts via legal challenges has become more common. Distressed debt funds purchase debt that has been discounted in value because of concerns over default, and then demand full repayment from the issuing government in court in London or New York. They show that such tactics were used in the cases of Argentina, Greece and the Ukraine. Similar challenges may emerge if emerging markets attempt to restructure their obligations.

The record of the last debt crisis makes clear the adverse implications for allowing debt problems to fester. The pandemic has already undone much of the progress in reducing poverty, pushing tens of millions many back below the poverty line.   A new debt crisis would exacerbate the divergent impacts of the pandemic on the developing economies and the advanced. Just as it is in the self-interest of all countries to contain the virus itself, all have a stake in dealing with its financial fallout.

The Need for a Global Corporate Tax Regime

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When the Organization for Economic Cooperation and Development began its call for a reform of the rules of global taxes in order to clamp down on the avoidance of taxes by multinational corporations, its efforts looked quixotic. But the OECD persisted, and U.S. Treasury Secretary Janet Yellen is now participating in negotiations with the other OECD members to reform the (non-)system. While there is much left to negotiate, the broad framework of an agreement to establish a new regime, which governs where taxes are assessed and the determination of a global minimum tax, now exists.

A new volume edited by IMF economists Ruud A. de Mooij, Alexander D. Klemm and Victoria J. Perry, Corporate Income Taxes under Pressure : Why Reform Is Needed and How It Could Be Designed, presents the case for implementing a global approach. The first part of the volume describes the reasons for taxing corporate profits, explains the emergence of the rules governing how multinationals could be treated, and shows the complications that the growth in services and digital trade placed on an already fragile system. The second section examines the workings of the current system, including the difference between source-based and residence-based taxes, the use of bilateral tax treaties to allocate taxing rights, and the ability of corporations to use the differences amongst tax regimes to lower their liabilities by shifting the source of their profits to low-tax jurisdictions. The third section analyzes the relative merits of various reform proposals.

The magnitude of lost tax revenues can only be estimated, since multinationals are not required to report all the data on their operations. But economists have used the available data in inventive ways to estimate the losses.  Kimberly Clausing of Reed College explains the data limitations and the attempts to provide reasonable estimates with the data that are available in a recent paper,  “How Big is Profit Shifting?”. Most of the profit shifting undertaken by U.S.-based multinationals occurs with a few tax havens: Bermuda, Cayman Islands, Ireland, Luxembourg, Netherlands. Singapore, and Switzerland. Clausing calculates that U.S. tax revenue losses from such activities may gave reached $100 billion in 2017, about a third of federal corporate tax revenues.

The OECD has made available a great deal of documentation on the challenges of profit shifting and the proposals to arrest these activities. Many of these analyses are summarized in Addressing the Tax Challenges from the Digitalisation of the Economy: Highlights. The first part of the document explains the proposals under negotiation, known as Pillar One and Pillar Two. Pillar One expands the right to tax a firm beyond its physical presence in a jurisdiction to include “…a significant and sustained participation of a business in the economy of the jurisdiction, either physically or remotely.” Pillar Two ensures a minimum level of tax on the profits of multinationals.

The OECD estimates that if both proposals were implemented, there would be revenue gains for low, middle and high income jurisdictions. The impact of “investment hubs” is more ambiguous, but they would lose some of their tax base. But could these changes adversely affect business activity? The OECD acknowledges that investment costs would rise, but estimates that the impact on investment would be minor.

Tibor Hanappi amd Ana Cinta González Cabral of the OECD Centre for Tax Policy and Administration present a detailed examination of the effect on investment costs in their paper, “The Impact of the Pillar One and Pillar Two Proposals on MNE’s Investment Costs: An Analysis Using Forward-Looking Effective Tax Rates.” They estimate that the rise in the effective average tax rates (EATR) of multinationals in their sample of 70 jurisdictions would be 0.4 of a percentage point, which is small compared to the existing weighted average 24% EATR. Moreover, the reduction in tax differentials would make other factors, such as education and infrastructure in host countries, more important in determining the location and scale of investments.

An agreement on multinational taxes would benefit the Biden administration, which needs revenue to pay for its ambitious infrastructure plans. The administration could use the implementation of a global tax to counter claims that an increase in the U.S. corporate income tax rate, which fell from 35% to 21% in the Trump administration, would make U.S. firms uncompetitive. A coordinated system of taxes would also be a response to the challenge to the ability of governments to tax businesses that profit shifting has posed. Only a global system would stop the “race to the bottom” of national corporate taxes that has resulted in the current tax regime.

Financial Globalization and Inequality

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The global financial crisis slowed the pace of financial globalization, while the impact of the pandemic on its future course is unclear. But enough time has elapsed to assess the record of integrated financial markets that greatly expanded in the 1990s and early 2000s. The evidence on one issue—financial openness and inequality—is clear: financial globalization has increased inequality.

Enrico D’Elia of the Italian Ministry of Economy and Finance and the Italian Institute of Statistics (ISTAT) and Roberta De Santiss, also of ISTAT, analyzed this issue in their 2019 working paper, “Growth Divergence and Income Inequality in OECD Countries: The Role of Trade and Financial Openness.” They used an error-correction model to differentiate between short- and long-run effects on the Gini index, and divided the OECD countries into low-, middle- and high income over the period of 1995-2016. Increases in financial integration, as measured by foreign assts and liabilities scaled by GDP, increased income disparities in both the short- and long-run in the total sample. In the long-run there is a negative effect on the Gini index within the low-income countries, but there is a much larger positive impact within the high-income group. They attribute this finding to the advantage that the financial sector derives from financial innovation in those countries. In their results relating to growth, they reported that financial openness had a positive impact on the economic growth of the middle-income group alone, and it only occurred in the short-run.

Xiang Li of the Halle Institute for Economic Research and Dan Su of the University of Minnesota investigated the impact of capital account liberalization in their 2020 article, “Does Capital Account Liberalization Affect Income Inequality?” in the Oxford Bulletin of Economics and Statistics. They used several measures of capital account openness, and both Gini coefficients and the income shares of different groups as their measures of inequality in samples of OECD and non-OECD countries. In their panel data analysis, they found that capital account liberalization had positive impacts on the Gini coefficients in the non-OECD countries, but not the OECD sample. They also found that capital account liberalization increased the income share of the top 10% of households. They reported similar results from a difference-in-differences analysis.

Philipp Heimberger of the Vienna Institute for International Economic Studies offered a summary of the empirical analyses of economic globalization and inequality in his paper, Does Economic Globalisation Affect Income Inequality? A Meta-analysis, which was published in The World Economy in 2020. He undertook a meta-analysis of 123 peer-reviewed papers and a meta-regression empirical analysis. In his results he found that financial globalization has had a sizeable and significant inequality-increasing impact, which is not true of trade globalization. Moreover, this result holds for advanced countries as well as developing nations.

The evidence, therefore, seems clear: increased capital flows do lead to more income inequality. But what are the channels of transmission? Barry Eichengreen of UC-Berkeley, Balazs Csonto and Asmaa A. El-Ganainy of the IMF, and Zsoka Koczan of the European Bank for Reconstruction and Development investigate this issue in their IMF working paper, “Financial Globalization and Inequality: Capital Flows as a Two-Edged Sword.” They point out that the various types of capital flows will have different effects and review the separate impacts to explain why inequality increased in both advanced and developing economies.

In the case of inward FDI in developing economies, the inflow of foreign capital could increase the return to labor. But, the authors point out, if capital substitutes for labor or works with skilled labor, then wage inequality will increase amongst laborers. This effect will be magnified when foreign capital flows to sectors that are dependent on external capital and are also complementary with skilled labor. Similarly, outward FDI reduces the demand for less skilled labor in the home countries of the multinationals responsible for the FDI. The outflows can also lower the bargaining power of labor in those countries.

The authors also examine portfolio capital, which can have many of the same distributional consequences as FDI in the host countries. Moreover, inflows of portfolio capital can lead to increased macroeconomic and financial volatility, and culminate in crises. Aggregate volatility heightens inequality because the poor suffer more the effects of economic downturns. In addition, portfolio flows can lead to increased demand for assets and higher prices. A rise in housing prices helps their owners, and the distributional impact depends on the pattern of ownership. In the case of higher stock prices, the benefits flow to stockholders who almost always are located in high-income households.

FDI, portfolio capital and bank flows also affect tax payments. Multinationals can use financial centers with low tax rates to minimize their tax liabilities across nations. Portfolio and bank flows can be used by the rich to shelter their asset holdings to avoid taxes. The loss of tax revenues decreases the ability of governments to deliver services that may benefit poorer households.

What can be done in the face of these impacts on income inequality? The authors of the IMF paper point out that adverse consequences are lessened when there are higher levels of educational achievement in the population. More educated workers benefit from the increased skill premium paid by multinationals. Capital flow measures can be used to control short-run inflows that can lead to “sudden stops” that overwhelm domestic financial markets.

A multilateral initiative seeks to reform the tax treatment of multinationals to avoid base erosion and profit shifting (BEPS) that result in lower tax revenues for governments. The OECD has organized negotiations amongst governments to coordinate the tax treatments of multinational firms. The OECD proposals have two sections: the first deals with the allocation of the right to levy taxes on corporations by nations and the second would establish a minimum global tax. These issues are particularly relevant for digital companies that have minimum physical presence in many countries where they do business. U.S. Treasury Secretary Janet Yellen has announced that the U.S. would reverse its position under the Trump administration and engage in these talks.

Finance, if designed properly, need not be exclusionary. Indeed, in some countries financial inclusion has helped low-income households to increase their living standards. International financial flows are not the only cause of increased inequality, but they have played a role. International finance in all its forms can have adverse consequences and governments need to acknowledge these and plan to offset them if/when financial globalization resumes.

The IMF and the Coronavirus

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A global threat such as the coronavirus should be met with a global response. National governments, however, have generally not coordinated their efforts, with the exception of those that belong to the European Union, and even there the distribution of vaccines has not gone smoothly. International agencies, on the other hand, such as the International Monetary Fund have responded more quickly. Moreover, the IMF has shown a willingness to play an active role in preparing for the post-pandemic world and to take on issues outside its usual remit.

The IMF’s past attempts to resolve financial crises have not always been successful (for an account see here). The IMF’s policy prescriptions at the outset of the East Asian crisis of 1997-98 included contractionary fiscal policy conditions for the governments that adopted IMF programs, as well as higher interest rates. There were  also structural conditions that dealt with the privatization of government-owned enterprises. While such policies may have been appropriate for a crisis that was due to expansionary macroeconomic policies, fiscal and monetary measures did not precipitate the East Asian crisis. Capital inflows had fueled bank lending and asset prices had soared, while central banks were committed to fixed exchange rates. Once foreign investors became alarmed about the exposure of private borrowers to currency and maturity mismatches, they began to exit, provoking a “sudden stop” of capital and currency devaluations.

The IMF faced criticism not only from the East Asian governments but from economists outside Asia. The macroeconomic policy conditions were inappropriate for a crisis that originated in private capital flows, and were based on overly optimistic projections of growth. Structural conditions were viewed as unnecessary and diverted attention from the measures that need to be undertaken. The IMF was also blamed for indirectly provoking the crisis through its advocacy of the removal of capital controls before the crisis. The IMF subsequently relaxed many of its program conditions as the nature of the crisis became more clear, but the damage to its reputation was enormous.

A decade later the IMF again faced a widespread financial crisis, and this time its response was very different. The global financial crisis of 2008-09 showed some similarities in its background with the Asian crisis. Inflows of capital to the U.S. and several European countries had fueled increases in asset prices and distorted expenditures. Once the bubbles in housing prices burst, financial institutions sought to unload mortgage-backed securities, forcing their prices down further. The rapid nature of the collapse in asset values and the lack of liquidity in financial markets exposed the fragility of the financial sector.

While the central banks of the advanced economies coordinated their responses, the IMF assisted emerging market economies that were caught up in the economic downturn precipitated by the financial collapse. The Fund lent to 17 countries, with the largest amounts of credit going to Hungary, Pakistan, Romania, and the Ukraine. Moreover, the policy conditions attached to the programs reflected an awareness of the origin and severity of the global contraction. Fiscal policy in the program countries was utilized to respond to falling private demand, although their governments avoided the large deficits that occurred in the advanced economies. Interest rate increases designed to prevent runs on currencies were limited and exchange rates did stabilize. Moreover, the IMF allowed the use of capital controls. Overall, the IMF received high marks for its initiatives during the global financial crisis.

In retrospect, the post-crisis recovery did not go as smoothly as it should have. Many countries felt compelled to reverse the expansionary policies of the crisis period because of fears of excessive debt. This contractionary trend was exacerbated by a sovereign debt crisis in Greece. Other European governments sought the inclusion of the IMF in addressing the crisis, and for the first time the Fund had partners: the European Central Bank and the European Commission. The initial macro policy changes imposed by this “troika” sought to restore fiscal balance, but their contractionary effects kept tax revenues below their anticipated levels, which led to further cutbacks. The IMF differed with the European governments over the sustainability of Greece’s debt burden and the need for debt forgiveness. Eventually the Greek economy began a recovery, but in retrospect the austerity policies there and elsewhere led to a slower recovery that there could have been.

The IMF has drawn upon these past experiences in formulating its response to the pandemic. The Fund has again responded quickly to assist its members, approving emergency financing  through its Rapid Credit Facility and its Rapid Financing Instrument to 80 countries and assistance under other arrangements to another five nations. It has extended debt service relief to 29 of its poorest members that have obligations to the IMF. The Fund and the World Bank have called on bilateral lenders to suspend debt service payments from the poorest countries, and the governments of the Group of 20  agreed to do so for official debt. The agencies have called for private lenders to implement similar measures.

The IMF has also sought to prepare countries for the post-pandemic world. Kristalina Georgieva, the current Managing Director of the IMF and the first from a East European country (Bulgaria), has supported policy initiatives in areas that traditionally do not fall under the IMF’s purview. She has supported national policies that seek to address different forms of inequality, including income and wealth inequality as well as gender and generational inequality. She has also called for including climate related risk in the IMF’s economic and financial assessments , and using fiscal expenditures to target “…climate-resilient infrastructure and expanding green public transportation, renewable energy, and smart electricity grids.”

Will the IMF be able to engineer such broad changes? The IMF is an agent responsible to 190 principals, the sovereign governments that are the IMF’s members and oversee its activities. Some of these may feel that Georgieva’s policy agenda is too ambitious and/or expensive. There are also disagreements over how to finance the IMF’s assistance to its poorest members. Proposals to issue more Special Drawing Rights (SDRS) have faced opposition from the U.S. On the other hand, differences amongst its principals may allow the IMF more freedom to expand the scope of its mandate. There is also the danger that a wave of debt crises following the wave of public borrowing by emerging maket governments may force the IMF to focus on debt restructuring.

The IMF, and Georgieva in particular, deserve credit for bringing forward issues that traditionally have not been addressed in discussions of international macroeconomic concerns. Monetary and fiscal policies, for example, have impacts on racial and gender inequality that have been overlooked. Climate change will constrain the actions of the governments of the most vulnerable countries. Whether the IMF is successful in actually steering governmental actions towards these areas will depend on the willingness of its members to adopt wider and inclusive approaches in their responses to the coronavirus

[I had the opportunity of interviewing Ms. Georgieva for the Madeleine Korbel Albright Institute of Wellesley College. The transcript of the interview can be found here.]

FDI and the Pandemic

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The fluctuations in portfolio capital flows to emerging markets over the past year have been well documented. But foreign direct investment (FDI) has also plunged in those countries as well as in the advanced economies. Moreover, FDI faces more long-term challenges than other forms of capital flows.

In October the Organization of Economic Cooperation and Development (OECD) reported FDI data for the first half of the year. The OECD found that global FDI flows fell by half in the first six months as compared to the second half of 2019. Inflows to the OECD area countries fell by 74%, driven by lower flows to the U.S. and reverse flows from Switzerland, the Netherlands and the United Kingdom. Outflows fell by 43%. FDI inflows to the non-OECD members of the Group of Twenty (G20) decreased by 30% and outflows decreased by 60%.

These declines followed a period of reduced FDI flows (see here and here). The OECD had reported in April that FDI flows in 2019 were below the levels recorded between 2010 and 2017. U.S.-based firms were reassessing their foreign operations in the wake of changes in the U.S. tax regulations governing the taxation of foreign profits. The tariffs imposed by the Trump administration on Chinese goods affected multinational activities in that country, while Chinese acquisitions of U.S. firms came under much stricter government scrutiny. Similarly, the vote in favor of Brexit forced firms to reconsider supply chains that linked the U.K. with the rest of Europe.

Pol Antrás of Harvard provides an insightful examination of the future of global supply chains in a recent NBER working paper, “De-Globalisation? Global Value Chains in the Post-Covid-19 Era.” He points out that rapid pace of globalization that began in the late 1980s and extended through the early 2000s was unsustainable, and that some slowdown was inevitable. The rapid expansion reflected the development of information and communication technology, as well as a fall in trade costs due to declines in government barriers as well as faster methods of shipping. He also cites the expansion of the global economy to include the former Communist countries, as well as the Asian countries that expanded the market-based sectors of their economies.

Could these developments be reversed? Antrás writes that while the impact of automation and 3D printing on globalization is unclear, there are digital technologies that may give a new impetus to trade and investment. Moreover, the economies of scale associated with global supply chains make their dismantling unlikely.

On the other hand, the policy and institutional factors that fueled the previous expansion of globalization could come to a halt or be reversed. Antrás attributes the fall in support for international trade to its impact on income distribution. While technology and other factors have contributed to the rise in inequality, there is sufficient evidence that trade integration has been a factor as well. Recent studies have linked support for protectionist measures to trade-induced inequality.

Antrás also provides some conjectures about the consequences of COVID-19 on globalization. Once the pandemic is behind us, international travel will most likely be more expensive, and this may affect the initiation of new enterprises, although the increased use of technology to provide contacts between people may offset that effect. On the other hand, the political response to the pandemic threatens to exacerbate already existing tensions between China and the U.S., and could lead to a global partition. Moreover, the cost of the pandemic has been borne disproportionately by low-wage earners, and any increase in inequality will further weaken support for global trade.

The pandemic heightened the awareness of global supply chains, and last spring there was a great deal of discussion of “reshoring,” i.e., bringing foreign operations back to the home countries of multinationals.  The Economist reports that to date there is little sign that U.S. firms are replacing operations in other countries with domestic production. However, the article points out that the expansion of global production networks was based in part on the belief that governments would not hamper their activities since interference would hurt importers and exporters. But recent events have shown that political divisions can affect trade policy in unexpected ways. The steps that the Biden administration to reengage with international agencies, such as the World Trade Organization, and trade partners, particularly China, will be carefully watched.

Portfolio Capital Flows to Emerging Markets amid the Pandemic

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Among the most notable economic responses to the COVID-19 pandemic has been the turnaround in capital flows to emerging markets. A sudden reversal in portfolio flows of over $100 billion to these countries in March has been offset by a surge of capital this fall. But many of these countries have accumulated debt burdens that will affect their ability to recover from the pandemic.

The IMF examined portfolio flows to these economies in last April’s issue of the Global Financial Stability Report (see also here). The report showed that prior to the pandemic, bond portfolio inflows had been larger than equity portfolio flows, with cumulative flows since 2005 of approximately $2.5 trillion for bonds vs. about $1 trillion for equity. The bonds included both bonds denominated in foreign currency as well as local currency debt. These flows had constituted significant amounts of finance in the emerging and frontier markets’ debt and equity markets.

The authors of the report analyzed the determinants of the different types of portfolio flows. They reported that changes in global conditions (or “push factors”) are largely responsible for debt inflows. Among these factors are the VIX index, a measure of global risk appetite, the U.S. Treasury bond yield, and the foreign exchange value of the dollar. Equity flows are also influenced by foreign conditions, but domestic economic growth (a “pull” factor) is a larger factor in raising the likelihood of capital inflows. This reflects the dependency of the returns on portfolio equity on profitable business operations.

These results explain a large part of the retreat from portfolio securities last March. When the extent of the pandemic became clear, the VIX measure rose while the dollar initially appreciated as investors sought a “safe harbor.” These developments contributed to the reversal of foreign holdings of debt securities. The rapid deterioration in the prospects for economic growth in the emerging markets influenced the turnaround of portfolio equity flows.

But capital inflows were flowing back to the emerging markets by the summer and continued to rise this fall. The Institute for International Finance (IIF) reported inflows of $76.5 billion in November alone, with $39.8 billion for emerging market equities and $37.7 billion for bonds and other debt. For the fourth quarter the IIF expected the strongest level of inflows since the first quarter of 2013.

The turnaround reflects several factors. First, the Federal Reserve’s strong response to stabilize financial markets has been successful, and market volatility has dropped. At the same time, the Fed’s lowering of the Federal Funds rate caused investors to look elsewhere for yields. Finally, the announcements of successful vaccines offers the prospect of an economic recovery in 2021.

However, there are concerns that the desire for the higher yield on riskier debt is fostering the issuance of bonds by borrowers who may not be able to fulfill their obligations. The ability of many of the governments and firms in the emerging market economies to meet their debt obligations is very much open to question. In December, S&P Global Ratings noted that “short-term risks still loom large” in the emerging markets.  Moreover, the agency stated that  “Debt overhang among governments and pressure on corporate earnings would constrain an economic recovery.” Five of the 16 key emerging market sovereign bonds that S&P rates carry negative outlooks: Chile, Colombia, Mexico, Indonesia and Malaysia.

The dangers of government spending in emerging markets financed by debt have been noted by Michael Spence of Stanford and Danny Leipziger in “The Pandemic Public-Debt Dilemma.” While the current cost of debt financing is relatively cheap, Spence and Leipziger pointed out that “a country’s citizens are not well-served when their government becomes more indebted in order to spend imprudently.” They warn that “borrowing in hard currencies when exports are depressed and their own exchange rates are under duress simply makes future debt re-scheduling more likely…”

Similarly, Raghuram G. Rajan of the University of Chicago and former governor of the Reserve Bank of India also questions how much debt a government can issue in “How Much Debt Is Too Much?” While some governments can roll over existing debt, Rajan claims that ”… investors will buy that new debt only if they are confident that the government can repay all its debt from its prospective revenues.” He warns that “Many an emerging market has faced a debt “sudden stop” well before it reached full employment, triggered by evaporating market confidence in its ability to roll over debt.”

Jeremy Bulow of Stanford, Carmen M. Reinhart, currently chief economist of the World Bank Group, Kenneth Rogoff of Harvard and Christoph Trebesch of the Kiel Institute for the World economy foresee a need to plan measures to deal with debt problems in “The Debt Pandemic.” They warn of debt restructurings on a scale not seen since the debt crisis of the 1980s. They view the pandemic as “…a once-in-a-century shock that merits a generous response from official and private creditors toward emerging market and developing economies.” Among the measures they suggest is new legislation to support orderly restructurings.

The need for policy measures to deal with debt restructuring is also expressed by Kristalina Georgieva, Managing Director of the IMF, Ceyla Pazarbasioglu,  Director of the IMF’s Strategy, Policy, and Review Department, and Rhoda Weeks-Brown,  General Counsel and Director of the IMF’s Legal Department. They specifically call for strengthening provisions that minimize economic disruption when debtors are in distress. These could include lower debt payments or the automatic suspension of  debt service. They also ask for increased debt transparency and agreement by creditor governments that are part of the Paris Club on a common approach to restructuring.  The latter two steps are aimed in part at China, which has become the largest bilateral creditor for many developing countries. There is considerable uncertainty over the size and conditions of debt owed to China, and how China will respond to the inability of debtor governments to make payments on the debt.

The IMF itself has pledged to provide debt service relief to its poorest members, while working with the Group of 20 on its Debt Service Suspension Initiative. Under this program, the governments of the G20 have offered to suspend the payments of government-to-government debt for 73 developing economies. The G20 also called on private lenders to offer similar relief, but there has been little response.

The onset of a debt crisis among the emerging market countries has been foreseen.  The widespread borrowing to deal with pandemic, however, has exacerbated the debt overhang. The pandemic will continue to affect financial stability and economic performance even as medical measures are implemented to deal with the virus .

2020 “Globie”: The Carry Trade

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It is time to announce the recipient of this year’s “Globie”, i.e., the Globalization Book of the Year. The award gives me a chance to draw attention to a book that is particularly insightful about some aspect of globalization. This year’s winner is The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee and Kevin Coldiron. The prize lacks any monetary reward, but no doubt the distinction of having won has value in itself. Previous winners are listed at the bottom.

The classic carry trade involves borrowing and investing in different currencies. For many years the Japanese yen served as the source of cheap loans that could then be exchanged for Australian dollars that yielded a higher return. At the end of the period the dollars would be exchanged for yen, and the loan repaid. As long as the funding currency had not appreciated in value, the trader would profit from the difference in returns. A profitable carry trade, however, violates uncovered interest rate parity, which stipulates that any difference in returns should be offset by an expected appreciation of the funding currency. At times the currencies would realign, and purchasing the originating currency to repay the loan could eliminate any previous gains.

The authors extend the concept of carry trades to include all those transactions that provide a stream of income but are subject to the risk of “…a sudden loss when a particular event occurs or when underlying asset values change substantially.”  Since carry transactions are based on borrowing, leverage is a key component. Buying stock on margin, for example, is another form of carry trade, as is a private equity leveraged buyout.

The trader benefits only as long as asset prices remain close to their current levels. Volatility can wipe out a position, and the financial losses can spill over to the economy. Those negative consequences bring central banks into the financial markets. Their intervention may reestablish stability, but it allows those who would have suffered a loss to transfer that loss to the public sector. Central bankers acting as lenders of last resort, the authors write, “…underwrite some of the losses associated with carry. This encourages further growth of carry, and a self-reinforcing cycle develops.”

The authors investigate the spread of carry trade and its broad scope, including the transformation of global financial markets. Firms in emerging markets use capital markets to obtain finance from cheaper foreign sources. Changes in the VIX measure of volatility have international reverberations and engender global financial cycles.The Federal Reserve’s use of swap facilities to help their counterparts in other countries assist domestic institutions that face a dollar liquidity squeeze demonstrates that carry crashes require global responses.

The authors also claim that the carry trade increases income and wealth inequality, as only those with sufficient assets engage in carry and profit from central bank intervention.  The continuing returns from these transactions flow to those who know how the system works and how to exploit it. These rewards act as an incentive to draw more people to finance, contributing to the growth of the financial sector.

The book was written before the events of this year, but the analysis is very relevant. In March, financial markets crashed as the global extent of the pandemic became evident. Stock prices plunged and foreign capital fled emerging markets. This outbreak of volatility engendered a massive response by the Federal Reserve that dwarfed their actions in the 2008-09 crisis (see here and here for overviews of central bank policies). The markets responded by regaining lost ground, and the Standard & Poor’s 500 has set new highs.

After the latest meeting of the Federal Open Market Committee, the Federal Reserve reiterated its pledge to keep  the target range for the Federal Funds Rate at 0 to ¼% “…until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” The Fed’s commitment to low interest rates provides an incentive for more carry trade activities, and these are appearing. Special Purpose Acquisition Company (SPACS), for example, are pools of money that are established to purchase privately-held firms and take them public, profiting from the IPO price. The SPACS investors do not know which company will be acquired or when, and they may not realize a return for years. But they are providing liquidity, and at minimal cost due to the Federal Reserve’s interest rate policy.

Lee, Lee and Coldiron convincingly demonstrate that the carry trade has contributed to the financialization of the economy, which has grave and disturbing implications. As the subtitle of the book indicates, the suppression of volatility leads to lower growth and recurring crises. When a vaccine for the coronavirus is available, there will undoubtedly be a burst of financial activity that will prepare the way for the next crisis. We will not be able to say that we were never warned.

An interview with the authors is available on the podcast Hidden Forces.

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