The Guardians of the Financial Galaxy

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The rapid expansion of the pandemic and the ensuing economic and financial collapses brought about responses by policymakers, including actions undertaken on an international basis. The Federal Reserve acted together with other central banks to ensure that an adequate supply of dollars was available to support dollar-based financing outside the U.S. Similarly, the IMF moved rapidly to provide financial support to its members. These national and international institutions constitute a “two tier” system in international finance that occupies the role of lender of last resort.

International cooperation has occurred before, and Michael Bordo of Rutgers University gives an account of these efforts in a new NBER working paper, “Monetary Policy Coordination an Global Financial Crises in Historical Perspective.” During the Bretton Woods era, central banks cooperated to sustain the fixed exchange rate system. In 1962, the U.S. established bilateral currency swaps with foreign central banks, which provided dollars to be used in support of their exchange rates.

The swaps continued in the 1970s after the termination of the Bretton Woods regime as policymakers sought to control the volatility of exchange rates. During the early and mid-1980s there were episodes of coordination of foreign exchange market intervention by central banks as governments in the advanced economies sought to stabilize the value of the dollar. But these occurred less frequently in the late 1980s as inflation fell in most of these countries and foreign exchange market intervention became less common.

The outbreak of crises in emerging markets in the 1990s required a joint response, and the IMF took on the role of crisis manager. During the Asian crisis of 1997-98, for example, the Fund provided credit to the governments of the countries in crisis. Their programs included conditions that required included cutbacks in government spending and credit creation, and frequently a currency devaluation. However, the IMF’s policies came under immediate criticism as inappropriate and overly severe. These were not crises based on excessive government spending, but rather financial collapses. The IMF paid a high price in its reputation for its handling of the Asian crisis, but learned a valuable lesson: financial instability can impose a serious cost.

The financial crisis of 2007-09 provided another major challenge to global financial stability and the need for a coordinated response. Banks in Europe and Japan had borrowed dollars to acquire dollar-denominated assets, such as mortgage-based securities. Their access to dollar funding was threatened as the interbank markets for dollars came under strain. In December of 2007, the Federal Reserve announced that it was establishing swap lines with the European Central Bank and the Swiss National Bank. At the crisis escalated in 2008, the Federal Reserve set up similar arrangements with the central banks of Australia, Canada, Denmark, England, Japan, New Zealand, Norway, and Sweden. It also arranged swap arrangements with the central banks of Brazil, Mexico, Korea and Singapore, emerging market economies with substantial exposure to dollar-based financing. The Federal Reserve and the foreign central banks exchanged currencies, and the foreign central banks lent the dollars to its domestic banks that needed them. At the conclusion of the swap period, the currency exchanges were reversed using the same exchange rate, and the central banks would pay the Fed a fee based on what it had charged their own banks.

These arrangements differed from previous efforts in that they were designed to address financial instability, not exchange rate values. The dollar had become the primary global funding currency, so a decrease in dollar liquidity would have had widespread effects. The joint activities of the Federal Reserve and its partner central banks were successful in bringing down the cost of dollar lending in the foreign markets and avoiding the collapse of foreign institutions with dollar liabilities.

The IMF was also active during the crisis. Not all central banks were able to exchange currencies with the Federal Reserve, and the IMF served as an alternative source of financing. During the period from September 2008 through the following summer, the IMF instituted 17 Stand-By Arrangements. The economic policies that were part of these programs reflected an awareness of the origin and severity of the global downturn. Credit was disbursed more quickly and in larger amounts than had occurred in the past and there were fewer conditions attached to the programs. Consequently, the IMF’s record during the great recession was very different from that of the Asian financial crisis.

During the current crisis, central banks and the IMF have built upon and expanded the policies they undertook in 2008-09. Once again, global dollar financing came under strain. In March the Federal Reserve renewed or set up swap facilities with the central banks of 14 countries. In addition, it established a repurchase facility for foreign and international monetary authorities (FIMA) that would allow them to temporarily exchange their holdings of U.S. Treasury securities for dollars.

These efforts were successful in preventing a collapse of dollar financing. Nicola Cetorelli, Linda S. Goldberg and Fabiola Ravazzolo of the Federal Reserve Bank of New York investigated the impact of the Federal Reserve’s facilities by comparing the foreign exchange swap basis spreads of currencies covered by the agreements with those on other currencies. They found that  ”… the swap lines have been an important factor helping to improve market conditions and expand access to dollar liquidity during the period of peak strains in global U.S. dollar funding markets.” They added that the Federal Reserve was engaging in a wide range of other actions that could also have impacted this market.

The central banks that obtained the dollars were able to use them to support banks that provided dollars to other parties in their countries. For example, Gianluca Persi of the European Central Bank showed that the Eurosystems’s use of the swap lines”…not only helped banks to satisfy their immediate U.S. dollar funding needs but also supported market activity.” He concludes that “The swap lines between central banks therefore helped to mitigate the effects of the strains in the U.S. dollar funding market.”

The IMF has also been active in meeting the needs of its members. The IMF has used its rapid financial assistance programs (Rapid Financing Instrument, Rapid Credit Facility) to make loans to 76 countries. These loans do not require full programs or reviews, and carry little conditionality. The IMF is also adjusting existing programs to meet the need for health-related expenditures.

The IMF is making special efforts for its low-income members. It is providing grants to its poorest members to cover the IMF debt obligations. In March the IMF and World Bank called on official bilateral creditors to suspend debt service payments from low-income countries. The Group of 20 governments responded by agreeing to suspend repayment of official bilateral credit from these nations until the end of 2020. The IMF, the World Bank and the G20 also called for private sector creditors to participate in similar debt relief on comparable terms.

IMF Managing Director Kristalina Georgieva at the opening of this spring’s meeting pledged to use the Fund’s  $1 trillion lending capacity to support its members. She also urged governments to be active in addressing the needs of their citizens. In a speech at the London School of Economics on October 6, she pointed out that “flexible and forward-leaning fiscal policy will be critical for the recovery to take hold.” She also called for measures to deal with the debt of low-income countries, including “access to more grants, concessional credit and debt relief, combined with better debt management and transparency.”

A division of labor, therefore, has evolved between the Federal Reserve and the IMF during periods of widespread instability. The Federal Reserve provides dollars to other central banks in upper-income countries and selected emerging market economies to preserve stability in the global financial markets. Since the Federal Reserve lends to central banks, there is little concern about insolvency. In many ways it assumes the traditional role of lender of last resort as conceived by Bagehot and other nineteenth century economists.

In normal times the IMF lends to governments in middle- and low-income countries with balance of payments crises and possible insolvency. The Fund disburses credit in programs that operate over a time horizon at least a year and sometimes longer. However, during the global financial crisis and now the current crisis, the IMF ramps up its lending. It provides credit quickly at little if any cost, and its programs seek to stabilize economic activity. Moreover, the IMF takes public positions to advocate fiscal stimulus and debt relief.

Stanley Fischer, who served as First Deputy Managing Director of the IMF from 1994 to 2001, saw the need for an international lender of last resort for countries facing an external financial crisis, and claimed that the IMF had played that role in the 1980s and 1990s. In subsequent years it became clear that central bankers in advanced economies preferred to deal with each other and organize their own programs. There have been periodic calls for the IMF to become more involved in swap networks, but the central banks have shown no interest in involving the IMF in their networks. The two-tier system functioned relatively well in 2008-09 and to date has stabilized financial markets. But the number of coronavirus cases are surging, and there are concerns about another recession in the U.S. and Europe. The current system to back stop financial markets and institutions will be tested in new ways that may show its limitations.

The Return of Global Imbalances?

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The global economic contraction following the pandemic has led to a massive fiscal response. Governments have acknowledged the need to increase spending in order to offset the declines in consumption and investment. The decreases in public savings can lead to rising current account deficits that offset the capital inflows needed to cover the gap between savings and investment. But will these measures generate a return to the global imbalances that preceded the global financial crisis?

The IMF’s External Sector Report for 2020, subtitled Global Imbalances and the COVID-19 Crisis, appeared in August (see a summary here). The analysis was based on data from 2019, when the global current account imbalance (the absolute sum of all surpluses and deficits) fell by 0.2 of a percentage point to 2.9% of global GDP. But the report’s authors also considered the impact of the pandemic on countries’ balance of payments.

The IMF’s analysis suggested that about 40% of the 2019 current account positions were excessive. Larger than warranted surpluses were registered by Germany and the Netherlands, while deficits were larger than warranted in Canada, the U.K. and the U.S. China’s external position was in line with its fundamentals and policies.

In the report the IMF anticipated that in 2020 the U.S. would report a current account deficit equal to 0.5% of world GDP. Canada and the U.K.’s deficits were each projected to be equal in value to about 0.1% of global output. China was expected to register a surplus of about 0.2% of world GDP, as were Germany and Japan. These forecasts come with a large degree of uncertainty, and the report’s authors acknowledge that global financial stress could lead to more capital flow reversals and larger imbalances.

More recent data show clearly that the U.S. and China are running the largest current account imbalances in absolute terms. Brad Setser of the Council on Foreign Relations points out that Chinese firms have benefitted from the demand for electronic goods as workers stay at home, as well as the need for personal protective equipment. Moreover, the Chinese government has supported its firms that export, with less direct support for households. The U.S. has provided more direct support to households.

The fiscal responses of the two countries to the pandemic also differ. The Economist estimates that the 2020 U.S. budget balance will show a deficit equal to 15.3% of its GDP, while China’s deficit is estimated at 5.6% of GDP. Part of the U.S. fiscal deficit will be offset by household savings, which increased last spring to over 30% of disposable income. The savings rate has slowly come down since then, while households attempt to plan their spending in a world of uncertainty. If the recovery in the U.S. stalls and there is no additional fiscal stimulus, then households will be forced to dip into their savings.

The IMF’s current account forecasts are consistent with the analysis of  Matthew Klein and Michael Pettis in their recent book, Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace.  The authors claim that these imbalances reflect domestic policies that privilege the more affluent members of a country. The trade wars that divide nations reflect divisions within these countries between asset owners and workers.

Klein and Pettis attribute China’s surpluses, for example, to government decisions in the 1990s to foster development through investments and exports while suppressing Chinese consumption in order to generate savings. The government has since acknowledged this imbalance and sought to rebalance domestic spending, in part by promoting consumption expenditures while curbing shadow banking. But whenever economic growth has slowed, the government has responded by encouraging new investment, including housing, and total credit to the private sector has grown to 216% of GDP.

Similarly, Germany’s current account surpluses reflect its policies designed to encourage growth after the decade of the 1990s, when the costs of reunification weighed down the economy. There was a conscious decision to encourage savings, a shift that benefited capital owners at the expense of labor. Until this year the government took pride in its balanced budgets, despite a need for infrastructure spending. The high personal savings rate reflects in part a high degree of income inequality, with most gains going to those households more likely to save them. There was also an emphasis on the country’s external position, and wage increases were limited in order to hold down costs.

The increases in foreign savings were matched by capital flows to the U.S. These reflected the U.S. position as the financial hegemon, with the most liquid financial markets. Moreover, the U.S. provided something of great value: safe assets. U.S. Treasury bonds have been the preferred asset of central banks and European savers, although before the 2008-09 financial crisis mortgage backed securities with AAA ratings were seen as acceptable substitutes. The financial sector within the U.S. benefitted from the increase in domestic and foreign financial activity. But the capital inflows appreciated the dollar, which undermined the export sector. In the years leading up to the global financial crisis the Federal Reserve kept interest rates low in order to boost spending. A weak recovery after that crisis caused the Federal Reserve to continue its low interest rate policy.

The pandemic has brought a return to past conditions. Whether or not the most recent increase in the Chinese trade surplus is a transitory phenomenon, its current account is on track to record a surplus for the year (although at a much lower level than before the global financial crisis). Similarly, while Germany’s budget balance is forecast to show a deficit of 7.2% of its GDP for the year, its current account is expected to register a surplus equal in value to almost 6% of its GDP.  The U.S. current account deficit, which peaked at 6% of GDP in 2005, was equal in value to 3.5% of GDP in the second quarter of this year.

Klein and Pettis write that past global imbalances reflected a complementarity of interests between American financiers and Chinese and German industrialists, and reinforced inequality.  To change these patterns requires policy reorientations within these countries that will allow more income to be transferred to households. They admit that this is a difficult task, but point out that a new system was devised by the Allied nations at Bretton Woods in 1944 in order to guarantee living standards. The upheaval produced by the pandemic is global in nature and has the potential to bring about another policy transformation. The one necessary element that will be contested by those who profit from current arrangements is the political will.

FDI in a Risky World

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The pandemic has shown that global supply chains are vulnerable to shocks. Output contracted as factories were closed in China and the impact was transmitted to firms further along the chains and the distributors of the final goods. Foreign direct investment had already slowed in the aftermath of the global financial crisis of 2008-09, and there were questions about its future (see here). How will multinational firms respond to the new shock?

The McKinsey Global Institute seeks to answer this question in a new report, Risk, Resilience and Rebalancing In Global Value Chains. The authors point out that the pandemic is only one of a range of shocks that can disrupt production. They distinguish between catastrophes that are foreseeable (such as financial crises) and those unanticipated (acts of terrorism), as well as disruptions that take place on a smaller scale. The latter can also be divided between those that are foreseeable (climate change) and those that are unanticipated (cyberattacks).

The report then measures the exposure of different business sectors to the various shocks. Those that are heavily traded are more vulnerable. These include communication equipment, computers and electronics, and semiconductors and components, all industries that are seen as promoting growth. Apparel is another sector that is vulnerable to risks, such as the pandemic and climate change.

These risks will motivate firms to reconfigure their supply chains. The political fissure between China and the U.S., as well as government policies to ensure self-sufficiency in some sectors, will also induce firms to reorganize production. The report’s authors estimated that 16% to 26% of current exports could be shifted. They find that “…the value chains with the largest potential to move production to new geographies are petroleum, apparel, and pharmaceuticals.” In some cases governments may need to provide financial support to induce firms to relocate to domestic economies where the governments seek domestic self-sufficiency.

The United Nations Conference on Trade and Development (UNCTAD) in its World Investment Report 2020 also considers the future of FDI (see here for a summary). It identifies three trends that will shape the future of international production. These include technology trends that contribute to a “New Industrial Revolution;” growing nationalism that leads to more protectionism; and the need to achieve sustainability.  As these forces evolve, they will push firms to increase supply chain resilience and increase national and regional productive ability.

The authors of the UNCTAD point out that economic sectors differ in terms of the length of their existing value chains, their geographical distribution and their governance. Consequently, multinational firms will respond in different ways to the trends the authors identify. But they identify three overall trajectories–reshoring, regionalization and replication–that all involve scaling down global value chains. A fourth trajectory–diversification–would transform existing operations but include a lower geographical distribution of value added and less investment in capital goods.

These changes represent challenges to government policymakers, particularly those in developing economies. A retreat of international production will hamper the prospects of lower-income countries where the global supply chains have been a driver of growth. But there is also the opportunity to attract new investment. Among the measures that the report’s authors recommend are investment promotion strategies in infrastructure and services, and participation in regional initiatives.

The reconfiguration if international production systems will shape FDI in the years to come. But the formation of new production chains will only take place as the global economy recovers from the current collapse. UNCTAD reports that global FDI flows are forecast to fall by up to 40% in 2020 from their 2019 value of $1.54 trillion, and could decline by another 5% to 10% in 2021. All these predictions come with large degrees of uncertainty about the future of the global economy. Multinational firms will hold back on new expenditures until they see a consistent recovery and learn how governments will seek to influence their foreign operation.

International Factor Payments and the Pandemic

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I have written a piece on international factor payments (migrants’ remittances, FDI income) and the pandemic for Econbrowser, the widely followed blog of Menzie Chinn of the University of Wisconsin and James Hamilton of the University of California-San Diego.

You can find it here:

http://econbrowser.com/archives/2020/07/guest-contribution-international-factor-payments-and-the-pandemic

Economists and Inequality

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Binyamin Applebaum of the New York Times has written a book, The Economists’ Hour: False Prophets, Free Markets and the Fracture of Society, in which he claims that economists are responsible for the increase in income inequality in the U.S. I thought this charge was off the mark, and wrote a reply. My piece, “Are Economists Responsible for Income Inequality?“, has been published in the June issue of Society. Here is the abstract:

Economists are held responsible by some for the increase in income inequality that has taken place in recent decades. Milton Friedman in particular has been singled out for advocating the removal of the government from almost all sectors of the economy, which led to an increase in inequality. But this charge is flawed for two reasons. First, Friedman’s views were always contested by other equally well-known and respected economists who advocate government policies to deal with markets where there are distortions, such as health care. Second, policy decisions are undertaken by public officials in response to many factors, including the advancement of personal and ideological agendas as well as the influence of donors and interest groups. The study of the causes and effects of inequality has become a central topic of economic research, and economists have a role to play in developing policies to address it.

The Challenges to the Dollar

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The dollar’s position as the premier global currency has long seemed secure. The dollar accounts for about 60% of the foreign exchange reserves of central banks and similar proportions of international debt and loans. But recent developments raise the possibility of a transition to a stratified world economy in which the use of other currencies for regional trade and finance becomes more common.

Such a statement may seem to be inconsistent with the Federal Reserve’s activities to stabilize global financial markets. As it did during the global financial crisis of 2008-09, the Fed has activated currency swap lines with other central banks, including those of the Eurozone, Great Britain, Japan, Canada and Switzerland, as well as the monetary authorities of South Korea, Mexico and Singapore. Those central banks that do not have swap agreements can borrow dollars from the Fed via its new foreign and international monetary authorities (FIMA) facility. Under this program, central banks that need dollars for their domestic financial institutions exchange U.S. Treasury securities for dollars through a repurchase agreement. These moves accompany the Fed’s extensive range of activities to support the U.S. economy, which include cutting the federal funds rate to zero, purchasing large amounts of Treasury, mortgage backed and corporate securities, and lending to corporations and state and municipal governments.

But other governments are uneasy with the U.S. government’s use of the dollar’s position in international finance to enforce compliance with its foreign policy goals. International transactions in dollars are cleared through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) banking network and the Clearing House Interbank Payments System (CHIPS). The U.S. has denied foreign banks access to these systems when they wanted to penalize the banks for dealing with governments or companies that the U.S. seeks to punish. This practice has become more common under the Trump administration, which has used the sanctions to strike at Iran, North Korea, Russia, Venezuela and others.

European leaders have made clear that they find this use of the dollar’s international role no longer acceptable. When the U.S. abandoned the agreements on nuclear weapons with Iran, European banks were forced to choose between defying the U.S. or their own governments, which encouraged them to continue their ties with Iran. In response, Britain, France and Germany have founded a clearing house, Instex, to serve as an alternative system, and several other European Union members will join it. Moreover, if the Europeans proceed with the issuance of a common EU bond, there will be an alternative safe asset to U.S. Treasury bonds that will foster the use of the euro in foreign exchange reserves.

China is also moving to encourage the international acceptance of its currency as an alternative to the dollar. The Chinese bond market is the world’s second largest, and the foreign appetite for Chinese bonds has increased. Foreigners bought $60 billion of Chinese government bonds last year, and now hold 8.8% of these bonds. Some of these bonds will be held by central banks diversifying the composition of their foreign currency reserves.

China’s Belt and Road Initiatives have expanded its economic presence in emerging markets, which also leads to a wider usage of its currency. Chinese investments in infrastructure and other projects in these countries increase the usage of the renminbi, as will the trade that follows.  The number of banks processing payments in renminbi has grown greatly in recent years, and most of these banks are based in Asia, Africa and the Middle East.

There are obstacles to the wider use of both the euro and the renminbi. While Germany’s Chancellor Angela Merkel has voiced support of a common European bond, the heads of other European governments have expressed their concerns.  China continues to maintain capital controls, although it has allowed foreigners to invest in the bond market through Hong Kong. But the imposition of a new security law for Hong Kong raises concerns about China’s willingness to allow financial concerns to affect its political goals.

The euro was once more widely seen as a viable alternative to the dollar. Hiro Ito and Cesar Rodriguez of Portland State University in their recent research paper, “Clamoring for Greenbacks: Explaining the Resurgence of the U.S. Dollar in International Debt”, examine the determinants of the currency composition of international debt securities. In their analysis they undertake a counterfactual analysis to examine what would have happened to the shares of the dollar and the euro in the composition of these securities if the global financial crisis had not occurred. They report that the predicted share of the euro in international debt would have been higher than it actually has been, while the share of the dollar would be lower.

When Ito and Rodriguez wrote their paper, they forecast that the dollar would continue to be the dominant international currency. But the Trump administration has damaged the international standing of the U.S., and this will have long-term consequences. Benjamin J. Cohen of UC-Santa Barbara has pointed out that “…there is palpable resentment over Trump’s indiscriminate use of financial sanctions to punish countries…” More generally, the U.S. government has sought to limit the county’s international interactions.

Harold James of Princeton wrote about the dominance of the dollar after the global financial crisis in his book, The Creation and Destruction of Value: the Globalization Cycle, which was published in 2009. At that time he foresaw the central role of the dollar as continuing because of the “political and military might of the U.S.”, as well as its economic potential. But he also stated that:

 “Such concentrations of power can be self-sustaining when they attract not only the capital resources, but also the human resources (primarily through skilled immigration) that allow exceptional productivity growth to continue.”

James warned that if a country closes itself off from exchanges with other nations, its relative decline can be hastened. He pointed out that:

“Since the isolationist impulse is a major strand in the American political tradition, it is impossible to close off this possibility; in fact, its likelihood increases as the economic and political situation deteriorates.”

The pandemic has the potential of serving as an inflection point, which follows a period of confrontations with other countries over trade. The fumbled response of the U.S. to the pandemic will encourage the governments of Europe and China to extend their influence in the financial sphere.  A world with several dominant currencies need not be inferior to one with a single hegemonic currency. But it will come about in large part as a result of the self-inflected damage that the Trump administration has perpetrated on the international standing of the U.S.

Is There a Future for FDI?—Update

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The Organization of Economic Cooperation and Development (OECD), which recently reported on foreign direct investment (FDI) in 2019, has released a new study on the impact of the pandemic on future FDI. The OECD points out notes that FDI flows before the pandemic have been on a downward trend since 2015, and FDI flows in 2018 and 2019 were lower than any years since 2010, suggesting that the decline in FDI will not be reversed when the pandemic eases. This comes as policymakers in the U.S. and elsewhere show concern over Chinese acquisition of domestic firms, and the Chinese government clamps down on Hong Kong’s autonomy.

The OECD report’s authors have optimistic, middle and pessimistic scenarios on the effectiveness of public health and economic policy measures, and their impact on FDI flows in the medium term. Under the optimistic scenario, public health measures are effective in controlling the spread of the virus and economic policies successful in restoring economic growth in the latter half of this year. FDI flows would fall between 30% to 40% in 2020 before rising by a similar amount in 2021 to their previous level. Under the middle scenario, public health and economic policy measures are partially but not completely effective, and FDI flows fall between 35% to 45% this year before recovering somewhat in 2021, but would remain about one-third below pre-crisis levels.  The pessimistic scenario is based on the need for continued measures to contain the virus and repair extensive economic damage, which would lead to drop in FDI flows of over 40% this year and no recovery in 2021.

The impact of an extended decline in FDI will be particularly severe for emerging market and developing economies, which have already seen the reversal of portfolio capital flows. The OECD report points out that the primary and manufacturing sectors, which account for a large proportion of FDI in these economies, have been particularly hard hit during the pandemic. Moreover, the corporate earnings that are a major source of the funding of new FDI expenditures by multinational firms fell in 2019 and will decline further this year.

The decline in FDI will be significant for these economies. FDI flows are usually more stable than other forms of capital flows, but even FDI collapses when it by global turbulence. The parent companies often have the financial resources to assist affiliates in troubled economies, but no advanced economy is escaping the downturn. The decline in spending not only affects the employees in the host country, but also harms domestic suppliers and others who benefit from the activities of the multinational.

The pandemic is also motivating governments to monitor and restrict the acquisition of domestic firms. Several U.S. Senators have urged Treasury Secretary Steven Mnuchin to limit the purchase of U.S. firms with depressed stock prices by Chinese firms. The U.S. has already limited Chinese acquisition of domestic firms in critical sectors, and that will now most likely be expanded to include medical goods and services. Portfolio investment is also under scrutiny. The U.S. Senate has passed a bill that requires foreign companies to allow their records to be audited by the Public Company Accounting Oversight Board in order to sell stock or bonds in the U.S., and the House of Representatives is considering a similar bill. While the bill will affect all foreign firms, it clearly is aimed at Chinese firms.

The U.S. is not alone in acting to restrict foreign investment. Several European countries have mechanisms to review foreign investment in order to protect critical technologies, as do India and Australia. These will now be extended to include medical goods and services. The European Union’s competition chief, Margrethe Vestager, has urged the governments of the EU’s members to purchase shares of ownership stakes in companies in order to prevent foreign takeovers.

FDI to China is also likely to suffer from the Chinese government’s enactment of a new security law for Hong Kong. U.S. Secretary of State George Pompeo’s response that the U.S. will no longer consider Hong Kong to have significant autonomy will not only imperil Hong Kong’s status as an international banking center, but also its role as the major source of FDI for China. The Chinese government’s willingness to forsake that source of funding suggests that it no longer believes that FDI has a critical role to play in the country’s economic development.

FDI, then, faces a range of barriers. The pandemic puts multinational plans for expansion, already scaled back, on hold. The division into a world of competing U.S. and Chinese spheres of influence further reduces the scope of foreign investment. Potential host nations can only hope to be viewed as a feasible site for production by multinationals once the world economy revives.

Is There a Future for FDI?

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Among the economic consequences of the coronavirus pandemic will be a drop in foreign direct investment activity. The latest issue of the OECD’s FDI In Figures forecasts a decline of more than 30% in 2020 in FDI flows, even under an optimistic scenario of a recovery in the second half of this year. The falloff reflects not only the deterioration in global economic activity, but also the responses of firms to policies that governments may enact to protect their economies.

The OECD reported that global FDI flows of $1,426 billion, while higher in 2019 than in 2018, nonetheless were below the levels recorded between 2010 and 2017. The increase from the previous year reflected in part that year’s depressed investment expenditures following tax reform in the U.S. and a return to positive outflows from the U.S. FDI inflows to the G20 nations, on the other hand, decreased in 2019, largely due to a drop in inflows to China to the lowest level since 2010.

The decline in FDI flows to China reflects in part the deterioration in relations between the U.S. and China, which has intensified during the pandemic. President Trump blames China for the outbreak of the virus and has threatened to implement new tariffs. The Trump administration is preparing a plan to bring medical supply chains back to the U.S.  Even if Joe Biden is elected President next fall, U.S. and other multinational firms are reconsidering their reliance on Chinese manufacturers in global supply chains.

As the OECD data show, however, this consolidation began before the pandemic. Global supply relationships based solely on cost considerations left firms exposed to external shocks of all kinds, ranging from the Brexit vote to the Japanese tsunami in 2011. In addition, the growth in service exports has allowed firms to locate their operations closer to consumers.

Maria Borga, Perla Ibarlucea Flores and Monika Sztajerowska of the OECD have written about the divestment decisions of multinational firms in a 2019 OECD Working Paper on International Investment, “Drivers of Divestment Decisions of Multinational Enterprises – A Cross-country Firm-level Perspective.” They obtained data on 62,000 foreign owned affiliates in 41 OECD and Group of 20 countries over the period 2007-2014. They found that 22% of the firms that were foreign-owned at the beginning of the period were divested at least once by their parent. The number of divestments was the highest at the beginning of the period during the global financial crisis and generally fell in the following years. Overall, foreign acquisitions outnumbered divestments, but there were years when the numbers were similar, and years when divestments outnumbered the acquisitions.

The paper’s authors undertook an empirical analysis of the decision to disinvest, examining characteristics of the host and home countries as well as of the individual firms. They report that an increase in labor costs in the host country was linked to disinvestment, while an increase in labor market efficiency had the opposite impact. An increase in the control of corruption decreases the probability of divestment, while higher tariffs increase it. Trade openness also increases the probability of divestment, which the authors interpret as a sign of substitutability between FDI and trade. In addition, the existence of a regional trade agreement reduces the probability of divestment.

In projecting the future of FDI, it is important to differentiate between horizontal and vertical FDI. The global supply chains, which evolved in the 1990s and 2000s as information and communication technology improved, represent the latter form. However, Ronald B. Davies of University College and James R. Markusen of the University of Colorado point out in a new NBER working paper, “The Structure of Multinational Firms’ International Activities,” that most of U.S. FDI comes from and goes to other advanced economies, which is suggestive of horizontal FDI.  Similarly, when they look at FDI among country groups, they find that most of the FDI of developed economies takes place amongst those countries. On the other hand, the FDI of U.S. firms that does take place in developing countries occurs in industries that use global supply chains.

If/when the global economy recovers, there may be a resumption of horizontal FDI to take the place of international trade. Firms that face trade barriers may seek to go around them by establishing plants in the countries where they seek to operate, just as Japanese automakers established plants in the U.S. in the 1980s when imports of their cars met resistance. Such a development would be consistent with the finding of Borga, Flores and Sztajerowska that disinvestment and trade are inversely linked. FDI may also pick up if multinational firms seek to establish redundancy by setting up plants outside east Asia.

FDI flows, therefore, will fall precipitously in the short-run. Their recovery will depend on the reconfiguration of the global economy, and how firms respond to government attempts to insulate their economies from foreign shocks. Multinationals will not easily give up historically profitable foreign operations, and will attempt to adapt their activities to surmount whatever new barriers they face. Moreover, the governments of emerging market economies with plummeting GDPs may seek to retain foreign capital to offset the deterioration of domestic economic activity. But it will be a long time before any sort of FDI rebound is recorded.

The Coming Debt Crisis

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After the 2008-09 global financial crisis, economists were criticized for not predicting its coming. This charge was not totally justified, as there were some who were concerned about the run-up in asset prices. Robert Schiller of Yale, for example, had warned that housing prices had escalated to unsustainable levels. But the looming debt crisis in the emerging market economies has been foreseen by many, although the particular trigger—a pandemic—was not.

Last year the World Bank released Global Waves of Debt: Causes and Consequences, written by M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge and Naotaka Sugawara. The authors examined a wave of debt buildup that began in 2010. By 2018 total debt in the emerging markets and developing economies (EMDE) had risen by 54 percentage points to 168% of GDP. Much of this increase reflected a rise in corporate debt in China, but even excluding China debt reached a near-record level of 107% of GDP in the remaining countries.

The book’s authors compare the recent rise in the EMDE’s debt to other waves of debt accumulation during the last fifty years. These include the debt issued by governments in the 1970s and 1980s, particularly in Latin America; a second wave from 1990 until the early 2000s that reflected borrowing by banks and firms in East Asia and governments in Europe and Central Asia; and a third run-up in private borrowing via bank loans in Europe and Central Asia in the early 2000s. All these previous waves ended in some form of crisis that adversely affected economic growth.

While the most recent increase in debt shares some features with the previous waves such as low global interest rates, the report’s authors state that it has been “…larger, faster, and more broad-based than in the three previous waves…” The sources of credit shifted away from global banks to the capital markets and regional banks. The buildup included a rise in government debt, particularly among commodity-exporting countries, as well as private debt. China’s private debt rise accounted for about four-fifths of the increase in private EMDE debt during this period. External debt rose, particularly in the EMDEs excluding China, and much of these liabilities were denominated in foreign currency.

The World Bank’s economists report that about half of all episodes of rapid debt accumulation in the EMDEs have been associated with financial crises. They (with Wee Chian Koh) further explore this subject in a recent World Bank Policy Research Paper, “Debt and Financial Crises.” They identify 256 episodes of rapid government debt accumulation and 263 episodes of rapid private debt accumulation in 100 EMDEs over the period of 1970-2018. They test their effect upon the occurrence of bank, sovereign debt and currency crises in an econometric model, and find that such accumulations do increase the likelihood of such crises. An increase of government debt of 30 percentage points of GDP raised the probability of a debt crisis to 2% from 1.4% in the absence of such a build-up, and of a currency crisis to 6.6% from 4.1%. Similarly, a 15% of GDP rise in private debt doubled the probability of a bank crisis to 4.8% if there were no accumulation, and of a currency crisis to 7.5% from 3.9%. (For earlier analyses of the impact of external debt on the occurrence of bank crises see here and here.)

Kristin J. Forbes of MIT and Francis E. Warnock of the University of Virginia’s Darden Business School looked at episodes of extreme capital flows in the period since the global financial crisis (GFC) in a recent NBER Working Paper, “Capital Flows Waves—or Ripples? Extreme Capital Flow Movements Since the Crisis.”  They update the results reported in their 2012 Journal of International Economics paper, in which they distinguished between surges, stops, flights and retrenchments. They reported that before the GFC global risk, global growth and regional contagion were associated with extreme capital flow episodes, while domestic factors were less important.

Forbes and Warnock update their data base in the new paper. They report that has been a lower incidence of extreme capital flow episodes since 2009 in their sample of 58 advanced and emerging market economies, and such episodes occur more as “ripples” than “waves.” They also find that as in the past the majority of episodes of extreme capital flows were debt-led. When they distinguish between bank versus portfolio debt, their results suggest a substantially larger role for bank flows in driving extreme capital flows.

Forbes and Warnock also repeat their earlier analysis of the determinants of extreme capital flows using data from the post-crisis period. They find less evidence of significant relationships of the global variables with the extreme capital flows. Global risk is significant only in the stop and retrenchment episodes, and contagion is significantly associated only with surges. They suggest that these results may reflect changes in the post-crisis global financial system, such as greater use of unconventional tools of monetary policy, as well as increased volatility in commodity prices.

Corporations can respond to crises by changing how and where they raise funds. Juan J. Cortina, Tatiana Didier and Sergio L. Schmukler of the World Bank analyze these responses in another World Bank Policy Research Working paper, “Global Corporate Debt During Crises: Implications of Switching Borrowing across Markets.” They point out that firms can obtain funds either via bank syndicated lending or bonds, and they can borrow in international or domestic markets. They use data on 56,826 firms in advanced and emerging market economies with 183,732 issuances during the period 1991-2014, and focus on borrowing during the GFC and domestic banking crises. They point out that the total amounts of bonds and syndicated loans issued during this period increased almost 27-fold in the emerging market economies versus more than 7 times in the advanced economies.

Cortina, Didier and Schmukler found that the issuance of bonds relative to syndicated loans increased during the GFC by 9 percentage points from a baseline of 52% in the emerging markets, and by 6 percentage points in the advanced economies from a baseline probability of 28%. There was also an increase in the use of domestic debt markets relative to international ones during the GFC, particularly by emerging economy firms. During domestic banking crises, on the other hand, firms turned to the use of bonds in the international markets. When the authors used firm-level data, they found that this switching was done by larger firms.

The authors also report that the debt instruments have different characteristics. For example, the emerging market firms obtained smaller amounts of funds with bonds as compared to bank syndicated loans. Moreover, the debt of firms in emerging markets in international markets was more likely to be denominated in foreign currency, as opposed to the use of domestic currency in domestic markets.

Cortina, Didier and Schmukler also investigated how these characteristics changed during the GFC and domestic bank crises. While the volume of bond financing increased during the GFC relative to the pre-crisis years, syndicated bank loan financing fell, and these amounts in the emerging market economies fully compensated each other. In the advanced economies, on the other hand, total debt financing fell.

The global pandemic is disrupting all financial markets and institutions. The situation of banks in the advanced economies is stronger than it was during the GFC (but this could change), and the Federal Reserve is supporting the flow of credit. But the emerging markets corporations and governments that face falling exports, currency depreciations and enormous health expenditures will find it difficult to service their debt. Kristalina Georgieva, managing director of the IMF, has announced that the Fund will come to the assistance of these economies, and next week’s meeting of the IMF will address their needs. The fact that alarm bells about debt in emerging markets had been sounding will be of little comfort to those who have to deal with the collapse in financial flows.