The True Owners of Foreign Capital

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Explaining the sources and destinations of capital flows is a key focus of research in international finance. But capital flows between countries can flow through financial centers before they arrive at their ultimate destination, and these intermediary flows distort the record of the actual ownership of investments. Two recent papers seek to provide a more accurate picture of the true sources of foreign finance.

Jannick Damgaard of Danmarks Nationalbank, Thomas Elkjaer of the International Monetary Fund and Niels Johannesen of the University of Copenhagen differentiate between “phantom” and “real” foreign direct investment in their 2019 IMF working paper, “What Is Real and What Is Not in the Global FDI Network?”  Phantom FDI flows to shell companies that do not engage in any business activities, and are used to minimize corporate taxation before the funds are channeled to their final destination. Among the host countries that receive a significant amount of phantom investment are the Netherlands, Luxembourg, Hong Kong, Switzerland, Singapore and Ireland. The phantom FDI overstates the actual amount of investment that takes place and obfuscates the ultimate ownership of foreign capital.

Damgaard, Elkjar and Johannsen use several sources of data in order to uncover the actual owners of FDI. These include the IMF’s Coordinated Direct Investment Survey, which reports foreign investments in 110 countries by the country of the immediate owner; the OECD’s Foreign Direct Investment Statistics, which differentiates between FDI in Special Purpose Entities (SPEs), a form of shell company, and non-SPE investment, and also includes information on the ultimate owners of investment; and Orbis, a global database of corporate data, including ownership information. Since the OECD data are incomplete, they estimate the share of real FDI in total FDI by using the negative relationship of real FDI/total FDI and total FDI/GDP.

Their results show that in 2017 global FDI of almost $40 trillion included real FDI of $25 trillion and phantom FDI of about $15 trillion. Moreover, the share of phantom FDI in total FDI has risen from above 30% in 2009 to just below 40% in 2017. Luxembourg reported the largest amount of phantom FDI of $3.8 trillion, followed by the Netherlands with around $3.3 trillion. The largest stock of real FDI, on the other hand, was located in the U.S., which also owned the largest amount of outward FDI. China has been a significant recipient of inward FDI (but see below), as were the United Kingdom, Germany and France. The authors also found evidence of “round tripping,” i.e., supposedly inward foreign investment that is actually held by domestic investors. In the case of China and Russia about 25% of real FDI is owned by investors in those countries.

Another investigation of the data on international capital was undertaken by Antonio Coppola of Harvard, Matteo Maggiori of Stanford’s Graduate School of Business, Brent Neiman of the University of Chicago’s Booth School of Business and Jesse Schreger of the Columbia Business School, and they report their results in “Redrawing the Map of Global Capital Flows: The Role of Cross-Border Financing and Tax Havens.” Global firms have increasingly issued securities through affiliates in tax haven, and these authors seek to uncover the ultimate issuers of these securities. Their results allow them to distinguish between data reported on a “residency” basis based on the country where the securities are issued versus a “nationality” basis, which shows the country of the ultimate parent.

The authors begin with data from several databases that allows them to uncover global ownership chains of securities through tax haven nations such as Luxembourg and the Cayman Islands.  They use this mapping to determine the ultimate issuers of securities held by mutual funds and exchange traded fund shares that are reported by Morningstar. Finally, they use their reallocation matrices to transform residency-based holdings of securities as reported in the U.S. Treasury’s International Capital data and the IMF’s Coordinated Portfolio Investment Survey to nationality-basis holdings.

Their results lead to a number of important findings. Investments from advanced economies to emerging market countries, for example, have been much larger than had been reported. For example, U.S. holdings of corporate bonds in the BRIC economies (Brazil, Russia, India and China) total $99 billion, much larger than the $17 billion that appears in the conventional data. U.S. holdings of Chinese corporate bonds alone rises from $3 billion to $37 billion, and of Brazilian bonds the total increases from $8 billon to $44 billion. These figures are even higher when the U.S. subsidiaries of corporations in emerging markets which issue securities in the U.S. are accounted for. Similarly, holdings of common equities in the emerging markets by investors in the U.S. and Europe are much larger when the holdings are reallocated from the tax havens to the ultimate owners. This is particularly evident in the case of China.

The reallocation also shows that the amount of corporate bonds issued by firms in the emerging markets has been more significant than realized. While the issuance of sovereign bonds is accurately reported, the issuance of corporate bonds has often occurred via offshore subsidiaries. These bonds are often denominated in foreign currencies, so their reallocation to their ultimate issuers results in an increase in foreign currency exposure for their home countries.

As in the previous study, Coppla, Maggiori, Neiman and Schreger also find that some “foreign” investment represents domestic investment routed through a tax haven, such as the Cayman Islands. These flows are particularly significant in the case of the U.S. In addition, some FDI flows to China should be classified as portfolio, since they reflect foreign participation in offshore affiliates that is channeled to China. FDI positions are not revalued as often as portfolio holdings, and as a result the authors claim that China’s net foreign asset position is overstated.

The results of these ground-breaking papers have important implications. First, the international ownership of capital is more concentrated than realized. The “Lucas paradox” of international capital flowing from developing to advanced economies was based on misleading data. The U.S. and several other advanced economies have large stakes in the emerging markets. Second, some of emerging markets are more vulnerable to currency depreciations than the official data suggest because their corporations have issued debt through subsidiaries in ta haven countries. Third, multinational corporations have been successful in shielding their income from taxation by using tax havens. The OECD has been working to bring this profit shifting under control, but effective reform may require a fundamental change in how multinationals are taxed by national governments.

Eastern Economic Association Conference, Boston, 3/1

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Sunday, March 1, 8:30 – 9:50

Boston Sheraton, Boston MA

[L3] Topics in International Finance (JEL Code: F)

Beacon C

Pushing or Pulling: Quantitative Easing, Quantitative Tightening, and International Capital Flows Nathan Converse, Federal Reserve Board; Stephanie Curcuru, Federal Reserve Board; Chiara Scotti, Federal Reserve Board

Who Really Receives FDI Income?      Joseph Joyce, Wellesley College

Economic Effects of Monetary and Fiscal Austerity Measures in the Presence of Foreign Debt Olena Mykhaylova, Holy Cross College; Josh Staveley-O’Carroll, Babson College; Evan Tanner, International Monetary Fund

Currency Composition of International Debt and Macroprudential Policies in Developing Countries         Olena Ogrokhina, Lafayette College; Cesar Rodriguez, Portland State University

The Long Reach of U.S. Monetary Policy

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The spillover of U.S. monetary policy on foreign economies has become an active area of research. Analysts seek to identify the channels of transmission between the policy stance of the Federal Reserve and foreign interest rates and credit extension. The usual account is that an expansionary Fed policy leads to capital outflows and an appreciation of foreign currencies as investors seek higher yields abroad. Two recent papers have focused on different aspects of this linkage.

Silvia Albrizio of the Bank of Spain, Sangyup Choi of Yonsei University, Davide Furceri of the IMF and Chansik Yoon of Princeton University investigated the impact of monetary tightening on cross-border bank lending in an IMF working paper, “International Bank Lending Channel of Monetary Policy.” Previous work was divided on whether a contractionary U.S. policy would lead to a decline or an increase in international bank lending. These economists used data on exogenous policy shocks in the U.S., which are based on the narrative approach of  Romer and Romer (2004), to examine their impact on cross-border bank lending in 45 countries.

The results show clear signs of a significant negative effect of U.S. monetary policy shocks on cross-border lending. A 100 basis point rise in the policy rate leads to a sizable more than 10% fall in lending after two quarters. When the authors extended their analysis to include monetary policy shocks in Canada, Germany, Italy, Japan, the Netherlands, Spain, Sweden and the U.K., they again found that exogenous monetary tightening in these economies led to a decline in cross-border bank lending. These results hold even when the authors control for global uncertainty or liquidity risks.

Sebnem Kalemli-Özcan of the University of Maryland focused on the impact of U.S. monetary policy changes on risk in her 2019 Jackson Hole presentation, “U.S. Monetary Policy and International Risk Spillovers.” In her analysis, there are two components of risk, global risk and country-specific risk, and these are crucial elements in the transmission of changes in U.S. policies to the emerging market economies. In these countries, a tightening of U.S. monetary policy leads to a rise in global risk as well as an increase in country risk. These changes in the risk premia affect the domestic response to the U.S. policy. The advanced economies, on the other hand, do not show similar responses.

For example, in the empirical analysis Kalemli-Özcan finds that an increase in the U.S. Treasury rate leads to an increase in the differential with domestic government bond rates in her sample of 46 emerging market economies, but a decline in the same differential in her sample of 13 advanced economies. However, the differential in the emerging market countries falls when a measure of global risk aversion (VIX) is added to the analysis, and becomes insignificant when an indicator of country risk (Emerging Market Bond Index Global of JPMorgan) is also utilized.

Risk premia also affect the linkage of domestic policy rates and lending rates. The presence of risk injects a wedge between the two domestic interest rates. If domestic bank rates are regressed on the policy rate in the emerging markets, the pass-through is less than complete, whereas the pass-through is almost complete in the case of the advanced economies. But the impact in the emerging markets rises when the two indicators of risk are included in the empirical analysis.

Kalemli-Özcan infers that the central banks of the emerging markets loosen their policies when risk rises, and tighten when risk falls. This response is determined in part by the type of exchange rate regime that a country has. Those emerging markets that manage their exchange rates raise their policy rates in response to the increased risk premia following a U.S. tightening. These interest rate upswings in turn affect domestic economic activity. A flexible exchange rate regime, on the other hand, mitigates the undesirable effects of the risk spillovers by absorbing the response to the higher risk. The differences in exchange rate regimes, therefore, may explain the divergence in the responses of emerging market and advanced economies to U.S. policy shocks.

Both papers acknowledge that U.S. policies have significant effects on foreign economies. Albrizio, Choi, Furceri and Yoon conclude that U.S. monetary policy is a contributor to the “global financial cycles” that Rey (2015) and others have identified. Kalemli-Özcan finds that U.S. policies are a “powerful force in driving international risk spillovers.” While global trade flows may have fallen, capital flows until the coronavirus were robust. As long as the U.S. dollar is dominant in international commerce and finance, the Fed’s influence will continue to unsettle foreign nations.

Conferences in 2020

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The submission deadlines for several conferences that feature work in international macroeconomics are coming up:

Con Date       Sub Date                        Name                                          Location

5/27 – 5/30     1/31            Int’l Trade and Finance Association     Richmond, VA, U.S.

5/28 – 5/30      1/31            Int’l Con on Macro Anal & Int’l Fin       Rethymno, Crete, Greece

6/4 – 6/7          4/4              European Economics & Finance Soc   Kracow, Poland

6/25 – 6/26      2/3             Spanish Ass of Int’l Econ & Finance      Toledo, Spain

7/8 – 7/10        3/18          National Bureau of Econ Research       Cambridge, MA, U.S.

The U.S. Position in the World Economy

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The election of 2016 in the U.S. saw the popularity of campaigning against international trade, foreign investments and immigration. Under the Trump administration the U.S. has implemented policies that mark a retreat from the globalization that was engineered during the 1990s and 2000s. What role has the U.S. played in the integration of global markets, and what happens if we withdraw?

Anthony Elson’s new book, The United States in the World Economy: Making Sense of Globalization, provides a thorough description and analysis of the position of the U.S. in the world economy. Elson, a former IMF staff member, shows that the U.S. retains a predominant position in international economic transactions. But the foreign sector is not as important for our domestic economy as it is for many other countries, and as a result its contributions to the domestic economy are often overlooked.

In international trade, for example, the U.S. share of global merchandise exports and imports lags China’s very narrowly, 11.46% versus 11.86% in 2015. But trade openness (the sum of exports and imports as a share of GDP) in the U.S. was 28%, lower than China’s openness of 40% and significantly less than Germany’s 86%. This disparity may explain the lack of attention paid to exports, while imports are seen as a threat. (One exception has been the agricultural sector, where China’s cutback of its purchases of U.S. soybeans and other products has forced the Trump administration to make payments to farmers).

Trump has cut back existing institutional arrangements, exiting the Trans-Pacific Partnership (TPP) and renegotiating the North American Free Trade Agreement (NAFTA). (However, its successor, the United States, Mexico and Canada Agreement (USMCA), does not substantively change the basic provisions of the earlier pact.) The administration actively uses tariffs as a tool of policy, often with little justification, and these inflict damage on the global economy. The U.S. agreement with China halts the scheduled escalation in trade measures but leaves in place tariffs that disrupt the domestic economy, leaving great uncertainty about the timing of the next stage. Training programs that could facilitate the movement of workers across sectors, on the other hand, have been underutilized.

Elson also documents the dominance of the U.S. dollar in international finance. The dollar is the most widely traded currency in foreign exchange markets. Currencies linked to the dollar represent about 60% of world GDP, which is much larger than the euro’s usage. About two-thirds of foreign central bank reserves are denominated in dollars; similarly, about 60% of global corporate debt is denominated in dollars. U.S. Treasury debt is the world’s safe asset, which allows the U.S. to fund its fiscal deficits more cheaply. But global finance only becomes relevant for many Americans in the event of foreign travel or study.

The one form of capital inflows that has attracted the attention of the current administration is foreign direct investment. The Committee on Foreign Investment in the United States (CFIUS) is a governmental interagency committee that reviews investments in the U.S. that may have national security implications. CFIUS has become particularly interested in Chinese acquisitions of U.S. firms that may allow access to U.S.-developed technology, and has broadened its scope to include property acquisition. There is also some discussion on tightening the access of Chinese firms to U.S. financial markets.

Immigration, on the other hand, is an issue that arouses great public interest, and in many quarters, opposition. Elson reports that the U.S. has the largest number of immigrants—44 million—than any other country, and this group represents about one-fifth of the global immigrant population. But the migrants’ share of the total U.S. population of about 14% is less than that of many other nations. Canada’s migrants, for example, represent about 22% of its population, while Australia’s migrant share is 28%.

The consensus among economists who have studied the impact of immigrants on the U.S. economy is that migrant labor is a complement rather than a substitute for native workers. Any negative impact on domestic wages falls mainly on prior immigrants. While local communities bear the cost of increased services such as education, there are fiscal benefits at the federal level that come from taxes on migrant labor. Elson points out that in addition to the “immigration surplus” that accrues to the complementary workers and the firms that hire them, there are also long-run benefits arising from the positive impact of migrants’ entrepreneurship and innovations on economic activity.

But opposition to migration is a bedrock issue for the administration. Not only does it seek to curb illegal immigration through a border wall, but members of the administration want to revamp many of the provisions that govern legal migration. For example, family-related immigration may be reduced in favor of “merit-based immigration,“ which is related to education.  There is also opposition to the “diversity lottery,” which in recent years has allowed African migrants to enter the country. All these measures are under consideration as the native-born working population ages and there is a need for new workers.

The U.S., therefore, remains a major power in the global economy, but this position is often not understood at home. The benefits are often hidden, while the costs (sometimes fabricated) are widely publicized. Politicians find taking xenophobic positions, particularly on immigration, an easy way to court electoral support.

It is inevitable that the relative position of the U.S. in the global economy will continue to erode as that of other economies, particularly China’s, rise. But historian Adam Tooze of Columbia University writes that the two pillars of American power, global and military, remain in place. The primary threat to this hegemonic position, therefore, comes not from abroad but from shifts in long-established norms and policies. The international order abhors a vacuum, and an American retreat will be met by active counter-moves.

Capital Controls in Theory and Practice

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It has been a decade since the global financial crisis effectively ended opposition to the use of capital controls. The IMF’s drive towards capital account deregulation had been blunted by the Asian financial crisis of 1997-98, but there was still a belief in some quarters that complete capital mobility was an appropriate long-run goal for emerging markets once their financial markets sufficiently matured. The meltdown in financial markets in advanced economies in 2008-09 ended that aspiration. Several recent papers have summarized subsequent research on the justification for capital controls and the evidence on their effectiveness.

Bilge Erten of Northeastern University, Anton Korinek of the University of Virginia and José Antonio Ocampo of Columbia University have a paper, “Capital Controls: Theory and Evidence,” that was prepared for the Journal of Economic Literature and summarizes recent work on this topic. In this literature, the micro-foundations for the use of capital controls to improve welfare are based on externalities that private agents do not internalize. The first type of externality is pecuniary, which can lead to a change in the value of collateral and a redistribution between agents. In such cases, private agents may borrow more than is optimal for society, which suffers the consequences in the event of a financial shock. Policymakers can restrict capital flows to limit financial fragility.

The second justification of capital controls is due to aggregate demand externalities, which are associated with unemployment. Private agents may borrow in international markets and fuel a domestic boom that leaves the domestic economy vulnerable to a downturn. If there are domestic frictions and constraints on the use of monetary policy that limit the response to an economic contraction, then capital controls may be useful in mitigating the downturn.

Alessandro Rebucci of Johns Hopkins and Chang Ma of Fudan University also summarize this literature in “Capital Controls: A Survey of the New Literature,” prepared for the Oxford Research Encyclopedia of Economics and Finance. They discuss the use capital controls in the case of both pecuniary and demand externalities, and capital controls in the context of the trilemma. In their review of the empirical literature on capital controls, they summarize two lines of research. The first deals with the actual use of capital controls, and the second their relative effectiveness.

Whether or not capital controls are used as a countercyclical instrument together with other macroprudential tools has been an issue of dispute.  Rebucci and Ma report there is recent evidence that indicates that such instruments have been utilized in this manner, as the recent theoretical literature proposes. There are also cross-country studies of capital control effectiveness that are consistent with the theoretical justification for the use of such measures. For example, capital controls can limit financial vulnerability by shifting the composition of a country’s external balance sheet away from debt.

Some recent papers from the IMF investigate the actual use of capital controls and other policy tools in emerging market economies. Atish R. Ghosh, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF investigated the response of emerging markets to capital flows in a 2017 working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” They report that policymakers in a sample of 51 countries over the period of 2005-13 used a number of instruments to deal with capital flows. In addition to foreign exchange market intervention and central bank policy rates, capital controls were utilized, particularly when the inflows took the form of portfolio and other flows. Tightening of capital inflow controls was more likely during periods of credit growth and real exchange rate appreciation. The authors’ finding that several major emerging markets have used capital controls to deal with risks to financial and macroeconomic stability is consistent with the theoretical literature cited above. However, the authors caution that their results do not indicate whether managing capital flows actually prevents or dampens instability.

This subject has been addressed by Gaston Gelos, Lucyna Gornicka, Robin Koepke, Ratna Sahay and Silvia Sgherri  in their new IMF working paper, “Capital Flows at Risk: Taming the Ebbs and Flows.” They examine the policy responses to sharp portfolio flow movements in 35 emerging market and developing economies during the 1996-2018 period, using a rise in BBB-rated U.S. corporate bond yields as a global shock. The authors look at the structural characteristics and policy frameworks of the countries as well as their policy actions. Among their results they find that more open capital accounts at the time of the shock are associated with fewer large inflows after the shock. Moreover, a tightening of capital flow measures is linked to larger outflows in the short-run. They also find that monetary and macroprudential policies have limited effectiveness in shielding countries from the risks associated with global shocks.

Capital controls have become an important tool for many developing economies, and there are ample grounds to justify their implementation. Recent empirical literature seems to show that the actual implementation of such measures is undertaken in a manner that meets the criteria outlined in the theoretical literature. However, whether regulatory limits on capital mobility actually achieve their financial and macroeconomic goals is still not proven. The Federal Reserve has signaled its intention to maintain the Federal Funds Rate at its current level, but shocks can come from many sources. Policymakers may find themselves drawing upon all the tools available to them in the case of a new global disruption to capital flows.

The 2019 Globie: “Capitalism, Alone” by Branko Milanovic

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The time to announce the recipient of this year’s “Globie” is finally here. Each year I choose a book as the Globalization Book of the Year. The prize is—alas—strictly honorific and does not come with a monetary reward. But it gives me a chance to draw attention to a book that is particularly insightful about some aspect of globalization.  Previous winners are listed at the bottom.

This year’s winner is Branko Milanovic’s Capitalism, Alone: The Future of the System That Rules the World. (This is the second Globie for Milanovic, who won it in 2016 for Global Inequality.) The book is based on the premise that capitalism has become the universal form of economic organization. This type of system is characterized by “production organized for profit using legally free wage labor and mostly privately owned capital, with decentralized coordination.” However, there exist two different types of capitalism: the liberal meritocratic form that developed in the West, and state-led political capitalism, which exists primarily in Asia but also parts of Europe and Africa.

The two models are competitors, in part because of their adoption in different parts of the world and also because they arose in different circumstances. The liberal meritocratic system arose from the class capitalism of the late 19th century, which in turn evolved out of feudalism. Communism, Milanovic writes, took the place of bourgeoise development. Communist parties in countries such as China and Vietnam overthrew the domestic landlord class as well as foreign domination. These countries now seek to re-establish their place in the global distribution of economic power.

Milanovic highlights one characteristic that the two forms of capitalism share: inequality. Inequality in today’s liberal meritocratic capitalism differs from that of classical capitalism in several features. Capital-rich individuals are also labor-rich, which reinforces the inequality. Assortative mating leads to more marriages within income classes. The upper classes use their money to control the political process to maintain their position of privilege.

Because of limited data on income distribution in many of the countries with political capitalism, Milanovic focuses on inequality in China. He attributes its rise to the gap between growth in the urban areas versus the rural, as well the difference in growth between the maritime provinces and those in the western portion of the country. There is also a rising share of income from capital , as well as a high concentration of capital income. In addition, corruption has become systemic, as it was before the communist revolution.

The mobility of labor and capital allows capitalism to operate on a global basis. Migrants from developing economies benefit when they move to advanced economies. But residents in those countries often fear migration because of its potentially disruptive effect on cultural norms, despite the positive spillover effects on the domestic economy. Milanovic proposes granting migrants limited rights, such as a finite term of stay, in order to facilitate their acceptance. He points out, however, the potential downside of the creation of an underclass.

Multinational firms have organized global supply chains that give the parent units in their home countries the ability to coordinate production in different subsidiary units and their suppliers in their host nations. Consequently, the governments of home countries seek to limit the transfer of technology to the periphery nations to avoid losing innovation rents. The host countries, on the other hand, hope to use technology to jump ahead in the development process.

The Trump administration clearly shares these concerns about the impact of globalization. President Trump has urged multinational firms to relocate production facilities within the U.S. Government officials are planning to limit the export of certain technologies while carefully scrutinizing foreign acquisitions of domestic firms in tech-related areas. New restrictions on legal immigration have been enacted that would give priority to a merit-based system. Moreover, the concerns over migration are not unique to the U.S.

Milanovic ends with some provocative thoughts about the future of capitalism. One path would be to a “people’s capitalism,” in which everyone has an approximately equal share of both capital and labor income. This would require tax advantages for the middle class combined with increased taxes on the rich, improvements in the quality of public education, and public funding of political campaigns. But it is also feasible that there will be a move of liberal capitalism toward a form of political capitalism based on the rise of the new elite, who wish to retain their position within society.

Milanovic’s book offers a wide-ranging review of many of the features of contemporary capitalism. He is particularly insightful about the role of corruption in both liberal and political capitalism. Whether or not it is feasible to reform capitalism in order to serve a wider range of interests is one of the most important issues of our time.

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

2014    Martin Wolf, The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis

The Changing Nature of FDI

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The OECD has published its data on flows of foreign direct investment (FDI) for the first half of 2019. They reveal how multinational firms are responding to the slowdown in global trade and the U.S.-Chinese tariffs. They may also reflect longer-term trends in FDI as multinationals reconfigure the scope of their activities.

Overall global FDI flows fell by 20% in the first half of the year as compared to the previous half-year. Much of the decrease was due to lower investments in the OECD economies, including the U.S., the United Kingdom, and the Netherlands, and disinvestments in Belgium and Ireland. FDI inflows to the non-OECD members for the Group of 20 countries, on the other hand, increased, with higher investments recorded in Russia, China and India.

Some of the decline can be linked to the slowdown in international trade. The World Trade Organization forecasts growth in trade this year of 1.2%, the weakest since 2009, and lower than the IMF’s expected global economic growth of 3%. But the disinvestment in Belgium and other countries may also be due to the decline in the use of Special Purpose Entities for routing FDI through low-tax jurisdictions before reaching their ultimate destination. The OECD has sought to limit the spread of Base Erosion and Profits Shifting (BEPS) activities.

The OECD also reported a large drop in Chinese FDI in the U.S., from a peak of $14 billion in the second half of 2016 to less than $1.2 billion. The decline shows the impact of the tariffs imposed by the U.S. and Chinese governments, as well as the overall uncertainty of relations between the two countries. Moreover, the Chinese government has cracked down on outward FDI while the U.S. government scrutinizes Chinese acquisitions more carefully.

The changes in the allocation of FDI may also reflect longer-run factors in the development of global supply (or value) chains. Multinational firms used information and communications technology in the 1990s and 2000s to organize production on a worldwide bases, linking together suppliers and assembly plants in many countries. The OECD has estimated that about 70% of global trade now involves such chains.

Koen De Backer and Dorothée Flaig of the OECD wrote about some of the developments that could affect these chains over time in an OECD Policy Paper, “The Future of Global Value Chains: Business As Usual or “A New Normal’?” They point to a number of factors that could contribute to the continuing expansion of global chains. These include cheaper telecommunications, the emergence of new host countries, and the growth in economics services, including the coordination of the activities of value chains. But there are other factors that may slow the growth of global supply chains, such as the increasing costs of production (particularly wages) in some emerging markets and growing public pressure on firms to lower their use of natural resources, such as energy-related expenditures for transportation.

Another factor that could limit the expansion of multinationals is the advance of information technologies. These include robotics, artificial intelligence and 3-D printing, which would offset the advantages of low-cost wages in developing economies and provide an incentive to return production to the advanced economies. In addition, all these methods may allow firms to produce customized products for local needs that do not need global distribution networks.

The authors use the OECD’s Metro model to estimate the impact of these different factors on global value chains (GVCs). They find that overall the “…negative impacts on GVCs are found to be larger than the positive impacts, thereby suggesting that “A new normal” is developing for GVCs.” In particular, they report that “…the digitalisation of production is most likely the biggest game-changer for the future of GVCs…The growing importance of information technologies like robotics, artificial intelligence, automation, etc. will significantly redraw the contours of the global economy and have a disruptive impact on GVCs.”

In addition to these long-term developments, host and home country governments are less encouraging of multinationals than they have been in the past. The Economist (“The Retreat of the Global Company”, 1/28/2017) reports that home countries are concerned about a loss of jobs and a fall in tax revenues due to BEPS. President Donald Trump has made clear his desire for U.S.-based firms to produce domestically. The host countries of emerging markets are more welcoming to multinational expansion, but they also seek jobs that may not be forthcoming if much of the growth of the multinationals is based on services rather than manufacturing. Moreover, these governments place limits on what digital firms are allowed to do in their jurisdictions and they seek to encourage domestic competitors.

The future of foreign direct investment, therefore, is in flux. Part of this reflects uncertainty due to current economic and political trends. But there are also longer-term developments that may reshape the nature of the cross-border expansion of the multinational firms that took place between the 1990s and 2008. Multinationals will continue to play an important role in the global economy, but their activities may be less encompassing as they have been, and this will affect FDI flows.

Does France Have an “Exorbitant Privilege”?

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The U.S. has long been accused of using the international role of the dollar to exercise an “exorbitant privilege.” The term, first used by French finance minister Valéry Giscard d’Estaing, refers to the ability of the U.S. to finance its current account deficits and acquire foreign assets by issuing dollars as a reserve currency. While flexible exchange rates have lowered the need for reserve currencies, the use of the dollar in international trade and finance ensures that there is a continuing need for dollar-denominated assets. The status of the dollar contributes to the surplus in U.S. international investment income despite its negative net international investment position (NIIP). But France also has a surplus in international investment income and a negative NIIP. Does it possess its own privilege?

The U.S. surplus reflects the composition of its external balance sheet as well as the return on its assets and liabilities. The U.S. has a positive balance on equity, and in particular, FDI, which is offset by the negative balance on portfolio securities, such as bonds. U.S. Treasury bonds are the universal “safe asset,” held by private foreign investors as well as central banks. The return on the equity assets exceeds that paid on the debt liabilities, thus yielding a positive investment income balance. This is the return that the U.S. receives for playing the role of the “world’s venture capitalist,” according to Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School. In addition, the U.S. receives a higher return on its FDI assets than it pays out on its FDI liabilities.

France also has a negative NIIP but a positive net international investment income balance. In 2018, for example, it received $35.6 billion in investment income. Moreover, the Banque de France pointed out in the 2015 Annual Report on the French Balance of Payments and International Investment Position that while the ratio of outward direct investment stocks to liabilities was 2 to 1, the ratio of FDI receipts to payments was 3 to 1. The French surplus, like that of the U.S., therefore can be attributed to both a “composition” effect reflecting the difference in the types of assets and liabilities it possesses, but also a “returns” effect due to the relatively higher return on its direct investment assets vis-à-vis its liabilities.

Vincent Vicard of CEPII (Centre d’Etudes Prospectives et d’Informations Internationales) has examined this return in a CEPII working paper, “The Exorbitant Privilege of High Tax Countries.” He finds that French firms earn higher returns on their foreign operations in low tax countries and tax havens, evidence of using the reporting of profits to increase returns. Profit shifting by the French multinationals account for two percentage points of the difference in returns on French assets and liabilities. Four European countries account for much of this activity: Luxembourg, Netherlands, Switzerland and the United Kingdom.

These results are consistent with those reported for other countries, particularly the U.S. Kim Clausing of Reed College, for example, examined the impact of differentials in tax rates on the profits of U.S affiliates in “Multinational Firm Tax Avoidance and Tax Policy” in the National Tax Journal in 2009.  More recently, Thomas Tørsløv and Ludvig Wier, both of the University of Copehhagen, and Gabriel Zucman of UC-Berkeley investigated the profit-shifting of multinationals in a range of countries in a NBER Working Paper, “The Missing Profits of Nations.” They estimate that close to 40% of multinational profits are shifted to tax havens globally each year. The non-haven European Union countries appear to be the main losers from this maneuvering.

But it would be too simple to dismiss the foreign earnings of French or U.S. firms as a purely accounting artifact. Multinationals have used information and communications technology to form global supply chains that allow them to source operations in low-cost countries and assemble the components elsewhere before shipment to the final market. France has its share of multinationals, including firms such as BNP Paribus, Carrefour and Peugeot. Moreover, foreign economic expansion by French firms and investors predates modern tax codes. Thomas Piketty of the School for Advanced Studies in the Social Sciences and the Paris School of Economics  pointed out in Capital in the Twenty-First Century that the income earned from foreign holdings were sufficient to finance trade deficits and capital outflows in Great Britain and France during the late nineteenth and early twentieth centuries.

The U.S. and other governments have lowered corporate tax rates in part to lure multinationals back to their home countries, and the members of the Organization for Economic Cooperation and Development intend to limit profit shifting by multinationals. Whether or not this strategy will be successful is not clear. Chris Jones and Yama Temouri of the Aston Business School have pointed out in “The Determinants of Tax Haven FDI” in the Journal of World Business that tax havens have advantages for multinationals besides lower tax rates, including few regulations and restricted openness. But President Trump has also made clear that he wants U.S. firms to operate domestically, and is willing to limit access to U.S. markets by foreign firms. France’s “privilege,” exorbitant or not, will be affected by these restrictions.

Is Inflation a Global Phenomenon?

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The persistence of inflation at relatively low rates despite years of monetary stimulus has led to wide-ranging investigations into its determinants. Traditionally the rate of inflation has been linked via a Phillips curve relationship to domestic factors, such as slack in the labor market. But is there also a global element?

Maurice Obstfeld, who has returned to UC-Berkeley from his post as chief economist at the International Monetary Field, examines some of the mechanisms by which global factors could affect U.S. inflation in a new National Bureau of Economic Research working paper, “Global Dimensions of U.S. Monetary Policy.” He reviews the evidence on the Phillips curve, and reports that there is little evidence that globalization has had a direct impact on the response of wages to unemployment. An indirect linkage, however, may exist through labor’s lower share of GDP, which could respond to foreign factors such as global supply chains. There may also be a relationship through the correlation of import prices and Consumer Price Index (CPI) inflation.

Another mechanism is based in the linkages of U.S. financial markets with those abroad. If these markets are integrated, then the natural rate of interest (r*) depends on foreign savings and investment as well as the domestic counterparts. An increase in foreign savings will lower the global r* which will stimulate domestic spending. Former Federal Reserve Board Chair Ben Bernanke claimed that this effect the cause of the housing boom in the U.S. that led to the global financial crisis.

Obstfeld points out this financial linkage is intensified by the status of the U.S. dollar as a safe asset and as a reserve currency. He also cites the special role of the U.S. currency as an invoice currency for international trade and a vehicle currency for cross-border lending. Consequently, actions taken to affect domestic spending have significant spillover effects.

Kristin Forbes of MIT also examined the role of global factors in the determination of prices in her Bank for International Settlements working paper, “Has Globalization Changed the Inflation Process?” In this analysis she uses three methodologies: principal components, the Phillips curve and trend-cycle decomposition. In the principal component investigation she looks at inflation in 43 advanced economies and emerging market countries from 1990 through 2017. She reports that 40% of the total variance in CPI inflation is explained by one common principal component. Moreover, this global component of CPI inflation has increased over time. On the other hand, the common component of core inflation (a measurement of inflation without volatile food and energy costs) is smaller and has fallen.

In the Phillips curve analysis, she includes changes in the real exchange rate, the world output gap, changes in oil and other commodity prices, and world producer price dispersion, with the domestic variables. The results for CPI inflation indicate that the foreign variables are significant in explaining inflation. The results for core inflation, however, do not show the same pattern of responses.

When Forbes tests the stability of the coefficients over time, she finds that the global output gap and world commodity prices, which were insignificant in the determination of CPI inflation at the beginning of the sample period, were significant during the period that began in 2007. But these changes are not seen when the measure of inflation is core inflation. As a further test, she compares the predicted changes in CPI and core inflation in regressions using the full set of variables and others with only the domestic variables. The results indicate that the models using the full set of coefficients do better in predicting both inflation rates than the domestic alternatives.

Finally, Forbes utilizes a “trend-cycle” approach that separates inflation into a persistent trend component and a cyclical component. She calculates these components of CPI and core inflation, and then investigates how the trend component and the variables in the Phillips curve analysis affect cyclical inflation. As in the Phillips curve results, she reports that most of the global variables are significant in the regressions for CPI inflation, but not core inflation. She also finds that there was a change in these relationships over time. But when she uses trend inflation as the dependent variable, she finds that the global variables are less significant, even with CPI trend inflation.

Forbes concludes that the evidence she has presented show that global variables should not be considered as ancillary in models of inflation dynamics. Moreover, these dynamics are evolving. Changes in the world output gap and commodity prices now have an impact on CPI inflation that was not evident before the most recent period. Whether or not they will continue to do so is a topic for future research.

Obstfeld’s and Forbes’ results pose a challenge for monetary policymakers. If it is difficult to formulate policies based on domestic economic conditions, it is even more so with foreign factors. This challenge is exacerbated by the constraints on central bank actions due to the current low levels of interest rates. Coordination among central bankers could provide some assistance, but it comes with its own limitations.

Even if the Trump administration is successful in scaling back the trade and financial ties of the U.S. with the rest of the world, inflation will continue to possess a global dimension. The cross-border integration of markets will not be reversed, and domestic prices will respond to foreign shocks. Central bankers are expected to avert another slowdown,  but their ability to maneuver the economy has become more constrained.