Tag Archives: bank loans

The Coming Debt Crisis

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.

The Long Reach of U.S. Monetary Policy

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.

U.S. Interest Rates and Global Banking in Emerging Market Economies

The spillover effects of changes in U.S. interest rates are widely recognized (see here and  here). An increase in rates, for example, raises the cost of dollar-denominated financing outside the U.S., which has grown in recent years, while an appreciation of the dollar makes such debt even more expensive to service and refinance. The emerging markets are among the nations adversely affected by the rise in U.S. interest rates. Several recent research papers have shown how global bank lending in these economies is affected.

Stefan Avdjiev, Cathérine Koch, Patrick McGuire and Goetz von Peter of the Bank for International Settlements investigate the impact of a change in U.S. monetary policy on cross-border lending by global banks in their paper, “Transmission of Monetary Policy through Global Banks: Whose Policy Matters?”, BIS Working Paper no. 745. In their analysis they also investigate the effect of changes in the policy stance of the central banks of both the country of the borrower as well as the home country of the lending bank. They use data on cross-border claims denominated in U.S. dollars held by international banks in 32 lender countries on borrowers in 55 countries over the period of 2000-2016.

The authors find that a tightening in U.S. monetary policy does lead to a decrease in dollar-denominated lending, as expected. But they also find that a more contractionary monetary policy in the lending country leads in a rise in cross-border dollar lending out of that country, presumably as the banks within the country switch to the cheaper dollar funding. Similarly, monetary tightening in the country of the borrower also leads to an increase in dollar-denominated credit, although these results are less robust.

The authors then investigate some of the transmission channels and seek to identify which characteristics of the banks are most relevant for these effects. They find, for example, that the negative effect of a tightening in U.S. monetary policy is smaller for banks that are more reliant on short-term wholesale funding and have better access to intragroup funding. These banks may have more alternatives to turn to when the cost of borrowing in dollars rises.

Another analysis of the effects of U.S. monetary policy on credit to emerging markets is offered by Falk Bräuning of the Federal Reserve Bank of Boston and Victoria Ivashina of Harvard Business School in “U.S. Monetary Policy and Emerging Market Credit Cycles”, NBER Working Paper no. 25185. They investigate the impact of shocks in U.S. monetary policy on the issuance of global syndicated corporate loans in a broad range of countries between 1990 and 2016. Dollar-denominated loans represent a large share of cross-border credit in the emerging market economies.

Their results indicate that an easing (tightening) of U.S. monetary policy leads to a rise (decline) in bank flows to the foreign markets. When they distinguish between developed economies and emerging markets, they find that the impact is about twice as large in the latter group. They also report that this result holds for U.S. and non-U.S. lenders, and that this linkage existed before the global financial crisis.

Ilhyock Shim of the Bank for International Settlements and Kwanho Shin of Korea University offer another line of analysis of global bank activity in emerging market economies in “Financial Stress in Lender Countries and Capital Outflows From Emerging Market Economies”, BIS Working Paper no. 745. In their empirical analysis, they use data from bilateral banking flows to construct a measures of capital outflows from the emerging markets to each lender country. To measure stress in lender countries, they use three indicators: an average of bank credit default spreads (CDS) for 66 banks in 29 lender countries, sovereign CDS spreads in the banks’ home countries, and the spread between dollar-denominated corporate bonds in each lender country and the matching U.S. Treasury yield. They also use sovereign spreads for financial stress in the 67 borrower nations.

The authors find that an increase in financial stress in the lending country leads to capital outflows from the emerging markets. When the measure of financial stress in the emerging market is included, it is also significant. But when economic fundamental variables in the emerging markets are added, the significance of stress in the lender countries continues to be strong while stress in the emerging markets is not. In addition, they report that cross-border claims are particularly vulnerable to stress in the lender countries. They also find these results hold in the post-financial crisis period.

Shim and Shin point out that one of the policy implication of their results draw is that strong economic fundamentals in an emerging market economy may not be sufficient to prevent capital outflows during a period of stress in lending countries. The same lesson applies for these countries if U.S. interest rates are rising. Flexible exchange rates, the standard buffer from foreign shocks, may not be able to change global banking flows.

Federal Reserve officials are attempting to pull off a difficult task: raising interest rates without ending the recovery in the U.S. Within the U.S. this challenge has been complicated by the short-run effects of expansionary fiscal policies that are due to run out in coming months. If the rise in rates also contributes to a slowdown in bank lending in other countries, the Fed will face enormous pressure to put further rate hikes on hold.  We have seen the story of higher U.S. rates and emerging market economies before, and the ending is not pretty.

The Retreat of Financial Globalization?

Eight years after the global crisis of 2008-09, its reverberations are still being felt. These include a slowdown in world trade and a reassessment of the advantages of globalization. Several recent papers deal with a decline in international capital flows, and suggest some reasons for why this may be occurring.

Matthieu Bussière and Julia Schmidt of the Banque de France and Natacha Valla of CEPII (Centre d’Etudes Prospectives et d’Informations Internationales) compare the record of the period since 2012 with the pre-crisis period and highlight four conclusions. First, the retrenchment of global capital flows that began during the crisis has persisted, with gross financial flows falling from about 10-15% of global GDP to approximately 5%. Second, this retrenchment has occurred primarily in the advanced economies. particularly in Europe. Third, net flows have fallen significantly, which is consistent with the fall in “global imbalances.” Fourth, there are striking differences in the adjustment of the various types of capital flows. Foreign direct investment has been very resilient, while capital flows in the category of “other investment”—mainly bank loans—have contracted substantially. Portfolio flows fall in between these two extremes, with portfolio equity recovering much more quickly than portfolio debt.

Similarly, Peter McQuade and Martin Schmitz of the European Central Bank investigate the decline in capital flows between the pre-crisis period of 2005-06 and the post-crisis period of 2013-14. They report that total inflows in the post-crisis period reached about 50% of their pre-crisis levels in the advanced economies and about 80% in emerging market economies. The decline is particularly notable in the EU countries, where inflows fell to only about 25% of their previous level. The steepest declines occurred in the capital flows gathered in the “other investment” category.

McQuade and Schmitz also investigate the characteristics of the countries that experienced larger contractions in capital flows in the post-crisis period. They report that inflows fell more in those countries with higher initial levels of private sector credit, public debt and net foreign liabilities. On the other hand, countries with lower GDP per capita experienced smaller declines, consistent with the observation that inflows have been curtailed more in the advanced economies. In the case of outflows, countries with higher GDP growth during the crisis and greater capital account openness were more likely to increase their holdings of foreign assets.

Both studies see an improvement in financial stability due to the larger role of FDI in capital flows. Changes in bank regulation may have contributed to the smaller role of bank loans in capital flows, as has the diminished economic performance of many advanced economies, particularly in the Eurozone. On the other hand, smaller capital flows may restrain economic growth.

While capital flows to emerging markets rebounded more quickly after the crisis than those to advanced economies, a closer examination by the IMF in its April 2016 World Economic Outlook of the period of 2010-2015 indicate signs of a slowdown towards the end of that period. Net flows in a sample of 45 emerging market economies fell from a weighted mean inflow of 3.7% of GDP in 2010 to an outflow of 1.2% during the period of 2014:IV – 2015:III. Net inflows were particularly weak in the third quarter of 2015. The slowdown reflected a combination of a decline in inflows and a rise in outflows across all categories of capital, with the decline in inflows more pronounced for debt-generating inflows than equity-like inflows. However, there was an increase in portfolio debt inflows in 2010-2012, which then declined.

The IMF’s economists sought to identify the drivers of the slowdown in capital flows to these countries. They identified a shrinking differential in real GDP growth between the emerging market economies and advanced economies as an important contributory factor to the decline. Country-specific factors influenced the change in inflows for individual countries, as economies with more flexible exchange rates recorded smaller declines.

In retrospect, the period of 1990-2007 represented an extraordinarily rapid rise in financial globalization, particularly in the advanced economies. The capital flows led to increased credit flows and asset bubbles in many countries, and culminated in an economic collapse of historic dimensions. The subsequent retrenchment of capital flows may be seen as a return to normalcy, and the financial and banking regulations–including capital account controls–enacted since the crisis as an attempt to provide stronger defenses against a recurrence of financial volatility. But the history of finance shows that new financial innovations are always on the horizon, and their risks only become apparent in hindsight.

The Enduring Relevance of “Manias, Panics, and Crashes”

The seventh edition of Manias, Panics, and Crashes has recently been published by Palgrave Macmillan. Charles Kindleberger of MIT wrote the first edition, which appeared in 1978, and followed it with three more editions. Robert Aliber of the Booth School of Business at the University of Chicago took over the editing and rewriting of the fifth edition, which came out in 2005. (Aliber is also the author of another well-known book on international finance, The New International Money Game.) The continuing popularity of Manias, Panics and Crashes shows that financial crises continue to be a matter of widespread concern.

Kindleberger built upon the work of Hyman Minsky, a faculty member at Washington University in St. Louis. Minsky was a proponent of what he called the “financial instability hypothesis,” which posited that financial markets are inherently unstable. Periods of financial booms are followed by busts, and governmental intervention can delay but not eliminate crises. Minsky’s work received a great deal of attention during the global financial crisis (see here and here; for a summary of Minksy’s work, see Why Minsky Matters by L. Randall Wray of the University of Missouri-Kansas City and the Levy Economics Institute).

Kindleberger provided a more detailed description of the stages of a financial crisis. The period preceding a crisis begins with a “displacement,” a shock to the system. When a displacement improves the profitability of at least one sector of an economy, firms and individuals will seek to take advantage of this opportunity. The resulting demand for financial assets leads to an increase in their prices. Positive feedback in asset markets lead to more investments and financial speculation, and a period of “euphoria,” or mania develops.

At some point, however, insiders begin to take profits and withdraw from the markets. Once market participants realize that prices have peaked, flight from the markets becomes widespread. As prices plummet, a period of “revulsion” or panic ensues. Those who had financed their positions in the market by borrowing on the promise of profits on the purchased assets become insolvent. The panic ends when prices fall so far that some traders are tempted to come back into the market, or trading is limited by the authorities, or a lender of last resort intervenes to halt the decline.

In addition to elaborating on the stages of a financial crisis, Kindleberger also placed them in an international context. He wrote about the propagation of crises through the arbitrage of divergences in the prices of assets across markets or their substitutes. Capital flows and the spread of euphoria also contribute to the simultaneous rises in asset prices in different countries. (Piero Pasotti and Alessandro Vercelli of the University of Siena provide an analysis of Kindleberger’s contributions.)

Aliber has continued to update the book, and the new edition has a chapter on the European sovereign debt crisis. (The prior edition covered the events of 2008-09.) But he has also made his own contributions to the Minsky-Kindleberger (and now –Aliber) framework. Aliber characterizes the decades since the early 1980s as “…the most tumultuous in monetary history in terms of the number, scope and severity of banking crises.” To date, there have been four waves of such crises, which are almost always accompanied by currency crises. The first wave was the debt crisis of developing nations during the 1980s, and it was followed by a second wave of crises in Japan and the Nordic countries in the early 1990s. The third wave was the Asian financial crisis of 1997-98, and the fourth is the global financial crisis.

Aliber emphasizes the role of cross-border investment flows in precipitating the crises. Their volatility has risen under flexible exchange rates, which allow central banks more freedom in formulating monetary policies that influence capital allocation. He also draws attention to the increases in household wealth due to rising asset prices and currency appreciation that contribute to consumption expenditures and amplify the boom periods. The reversal in wealth once investors revise their expectations and capital begins to flow out makes the resulting downturn more acute.

These views are consistent in many ways with those of Claudio Borio of the Bank for International Settlements (see also here). He has written that the international monetary and financial system amplifies the “excess financial elasticity,” i.e., the buildup of financial imbalances that characterizes domestic financial markets. He identifies two channels of transmission. First, capital inflows contribute to the rise in domestic credit during a financial boom. The impact of global conditions on domestic financial markets exacerbates this development (see here). Second, monetary regimes may facilitate the expansion of  monetary conditions from one country to others. Central bankers concerned about currency appreciation and a loss of competitiveness keep interest rates lower than they would otherwise, which furthers a domestic boom. In addition, the actions of central banks with international currencies such as the dollar has international ramifications, as the current widespread concern about the impending rise in the Federal Funds rate shows.

Aliber ends the current edition of Manias, Panics and Crashes with an appendix on China’s financial situation. He compares the surge in China’s housing markets with the Japanese boom of the 1980s and subsequent bust that initiated decades of slow economic growth. An oversupply of new housing in China has resulted in a decline in prices that threatens the solvency of property developers and the banks and shadow banks that financed them. Aliber is dubious of the claim that the Chinese government will support the banks, pointing out that such support will only worsen China’s indebtedness. The need for an eighth edition of Manias, Panics and Crashes may soon be apparent.

Capital Flows, Credit Booms and Bank Crises

Studies of the impact of capital inflows have established that debt inflows can lead to bank crises (see here and here). Unlike equity, payments on debt are contractual and can not be cancelled if there is an economic downturn, which intensifies any shocks to the financial system. In the case of short-term debt, a foreign lender may decide not to roll over credit at the time when it is most needed. But recent papers have shown that foreign debt can also be a determinant of the credit booms that lead to the bank crises.

Philip Lane of Trinity College and Peter McQuade of the European Central Bank (working paper version here) looked at the relationship of domestic credit growth and capital flows in Europe during the period of 1993-2008. They suggest that financial flows can encourage more rapid credit growth by increasing the ability of domestic banks to extend loans, while also contributing to a rise in asset prices that encouraged financial activity. They found that debt flows contributed to domestic credit growth but equity flows did not. Moreover, the linkage of debt and domestic credit was strongest during the 2003-08 pre-crisis period.

Similarly, Julián Caballero of the Inter-American Development Bank (working paper here) investigated capital inflow booms, known as “bonanzas,” in emerging economies between 1973 and 2008. He reported that capital inflow bonanzas increased the incidence of bank crises. When he distinguished among foreign direct investment, portfolio equity and debt bonanzas, the results indicated that only the portfolio equity and debt bonanzas were associated with an increased likelihood of crises. More analysis revealed that the impact of increased debt was due in part to a lending boom. Caballero suggested that the capital inflows could also have increased asset prices, generating an asset bubble and an eventual collapse.

Deniz Iagan and Zhibo Tan of the IMF used both macroeconomic and micro-level firm data to examine the relationship of capital inflows and credit growth. They first examined the impact of capital inflows on aggregate credit to households and non-financial corporations in advanced and emerging market economies during the period of 1980-2011. They distinguished among FDI, portfolio and other inflows. They reported that portfolio and other inflows contributed to rises in household credit, and only the other inflows were significant for corporate credit.

Iagan and Tan also had data on firms in these countries, and sought to identify the determinants of leverage in these firms. They calculated an index, based on work done by Raghuram Rajan and Luigi Zingales (RZ), of a firm’s dependence on external financing. When they interacted the RZ indicator with the different types of capital inflows, the interactive term was always significant in the case of the other inflows, significant with portfolio flows in some specifications, and never significant in the case of FDI flows. The authors concluded that the results of the macro and firm level analyses were consistent: the composition of capital matters. In additional analysis, they found evidence consistent with the hypothesis that the capital inflows led to higher asset prices.

What can be done to insulate an economy from lending booms that may lead to bank crises? Nicolas E. Magud and Esteban R. Versperoni of the IMF and Carmen R. Reinhart of Harvard’s Kennedy School of Government (working paper here) examined whether the nature of the exchange rate regime was relevant. They found that less flexible exchange rate regimes are associated with increases in bank credit and a higher share of foreign currency in bank credit. On the other hand, the exchange rate regime had no impact of the size of the capital inflows. The authors of the Bank for International Settlements 85th Annual Report 2014/15, however, wrote that the insulation property of flexible exchange rates is “overstated.” An exchange rate appreciation can raise the value of firms with debt denominated in foreign currency, which increases the availability of credit.

How can regulators lower the danger of more bank crises due to debt inflows? Magud, Reinhart and Vesperoni suggest the use of macroprudential measures that affect the incentives to borrow in a foreign currency, such as currency-dependent liquidity requirements. But Caballero warns that capital controls on debt inflows may be insufficient if portfolio equity flows also contribute to lending booms that result in banking crises.

These research papers find that domestic asset prices respond to international financial flows. This makes it harder to insulate the domestic financial markets from foreign markets, and leaves these markets vulnerable to spillovers from changes in foreign conditions. The emerging markets already face downturns in their markets, and the combination of increased global volatility with a rise in the costs of servicing the dollar-denominated debt of corporations in emerging markets if the Federal Reserve raises interest rates will only add to their burdens.

Global Liquidity and U.S. Monetary Policy

The events in Greece and the Ukraine have only partially drawn attention away from the financial markets’ focus on changes in U.S. monetary policy. Federal Reserve officials seem to be split over when they will raise their Federal Funds rate target, and by how much. But while U.S. policymakers are closely monitoring domestic labor developments, the impact of their actions will have repercussions for foreign markets.

The growth of cross-border financial flows has led to research on global liquidity. Jean-Pierre Landau of SciencesPo (Paris) defines global private liquidity as the international components of liquidity, i.e., “cross-border credit and portfolio flows or lending in foreign currencies to domestic residents,” while official global liquidity is the funding available to settle claims on monetary authorities. Before the global financial crisis, global banking flows were instrumental in extending private credit across borders, while more recently portfolio flows have been important.

Eugenio Cerutti, Stijn Claessens, and Lev Ratnovski of the IMF examined the determinants of global liquidity using data on cross-border bank flows for 77 countries over the period of 1990-2012. They identified four financial centers: the U.S., the Eurozone, the U.K. and Japan. The drivers of global liquidity included factors such as the TED spread (3 month LIBOR minus 3 month government bond yield), an indicator of uncertainty that affects bank behavior. They also included measures related to monetary policy, including the real interest rate and term premium, i.e., the slope of the yield curve, defined as the difference between 10 year and 3 month government securities.

The authors first used U.S. global liquidity factors in their empirical analysis. When the U.S. term premium fell, there was a rise in international lending as banks sought higher returns. The U.S. real interest rate had a positive coefficient, which the authors saw as a sign that global banks lent less when there were favorable domestic conditions. The authors then introduced the same variables for the three other financial centers, and found that term premiums from the U.K. and the Eurozone have the same effect on cross border bank lending as did the U.S. measure. The Japanese term premium, on the other hand, had a positive coefficient, which may reflect the record of Japan’s interest rate.

When cross-border claims were broken out by lending to Asian and the Western Hemisphere countries, the TED spreads for British and European banks were significant determinants for lending to both areas. The U.S. term premium was the only term premium variable with explanatory power in lending to bank and non-banks in the two regions. The authors interpret these results as an indication that the global financial cycle is driven in part by U.S. monetary policy and British and European bank conditions. The authors also find that a borrower country can reduce its exposure to global liquidity drivers through flexible exchange rates, capital controls and stringent bank supervision.

The latest Annual Report of the Bank for International Settlements (BIS) also looks at financial flows across borders in its chapter on the international monetary and financial system. The authors of the chapter detail the growth in dollar- and euro-denominated credit through bank loans and debt securities, which can go to domestic residents in the U.S. or Eurozone, or non-residents. They point out that while U.S. households, corporations and its government account for 80% of global non-financial dollar debt at the end of 2014, the remaining one-fifth—about $9.5 trillion—of dollar credit was held outside the U.S.

These loans and securities have been growing rapidly since the global financial crisis. In particular, non-U.S. borrowers issued $1.8 trillion in bonds between 2009 and 2014. The authors of this chapter of the BIS Report attribute this growth to low lending rates and the reduction of the term premium for U.S. Treasury securities, which reflects the large scale purchase of these securities by the Federal Reserve in its Quantitative Easing (QE) programs. The European Central Bank’s bond purchases and the resulting compression of term premiums on euro-denominated bonds may lead to a similar phenomenon.

Changes in U.S. monetary policy, therefore, will influence global financial flows in both bank lending and bond issuance. If the end of QE results in higher term premiums in the U.S. as the rates on long-term securities rise, then cross-border flows could be negatively impacted. A rise in the Federal Fund Rate, on the other hand, could initially decrease the term premia, although other interest rates would likely follow. These changes take place, moreover, while the Eurozone and Japan are moving in opposite directions, which may intensify their effect. Mark Carney, Governor of the Bank of England, warned last January that the resiliency of the financial system will be tested by Federal Reserve tightening. Once again, policymakers may be forced to respond to fast-breaking developments as they occur. But this time they may not have as much flexibility to maneuver as they need. We may not know the consequences for financial stability until it is too late to avoid them.

The U.S.: Inept Diplomacy, Indispensable Currency

The announcements by several European governments that they would join the new Asian Infrastructure Investment Bank (AIIB) have been widely seen as indicators of the declining position of the U.S.  The AIIB had been proposed by China for the purpose of funding much-needed infrastructure projects in Asian countries. The U.S. had discouraged other governments from joining, ostensibly on the grounds that the new institution would overlap with the World Bank and the Asian Development Bank. But the real reason seemed to be a concern that the Chinese would have a regional forum to wield power.

The New York Times held both the Congress and President Obama responsible for mishandling the issue. The U.S. claimed it sought to ensure better governance in the new institution, but gave no signal of being willing to work with the Chinese and others to make the AIIB an effective agency. The continuing refusal of Congress to approve reforms in the IMF’s governance structure gives the Chinese and other emerging markets ample cause to look elsewhere. The Economist put it starkly: “China has won, gaining the support of American allies not just in Asia but in Europe, and leaving America looking churlish and ineffectual.”

And yet: the same issue of The Economist stated that “In the world of economics, one policy maker towers above all others…,”, and named Federal Reserve Chair Janet Yellen as holder of that position due to the sheer size of the U.S. economy. The influence of the U.S. in financial flows extends far outside national borders. A study by Robert N.McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated that the amount of dollar-denominated credit received by non-financial borrowers outside the U.S. totaled $9 trillion by mid-2014. Over two-thirds of the credit originated outside the U.S., with about $3.7 trillion coming from banks and $2.7 from bond investors. The report’s authors found that dollar credit extended to non-U.S. borrowers grew much more rapidly than did credit within the U.S. during the post-global financial crisis period.

Almost half of this amount went to borrowers in emerging markets, particularly China ($1.1 trillion), Brazil ($300 billion), and India ($125 billion). In the case of Brazil, most of the funds were raised through the issuance of bonds, while bank lending accounted for the largest proportion of credit received by borrowers in China. Much of this credit was routed through the subsidiaries of firms outside their home countries, and balance of payments data would not capture these flows.

The study’s authors attributed the rise in borrowing in emerging markets to their higher interest rates. Consequently, any rise in U.S. interest rates will have global repercussions. The growth in dollar-denominated credit outside the U.S. should slow. But there may be other, less constructive consequences. Borrowers will face higher funding costs, and loans or bonds that looked safe at one interest rate may be less so at another. This situation is worsened by an appreciating dollar if the earnings of the borrowers are not also denominated in dollars. The rise in the value of the dollar has already prompted reassessments of financial fragility outside the U.S.

All this puts U.S. monetary policymakers in a delicate position. Ms. Yellen has made it clear that the Fed is in no hurry to raise interest rates. The Federal Reserve wants to see what happens to prices and wages as well as unemployment before it moves. The appreciation of the dollar pushes that date further into the future by keeping inflation rates depressed while cutting into the profitability of U.S. firms. While the impact of higher rates on credit markets outside the U.S. most likely has a relatively low place on the Fed’s list of concerns, Fed policymakers certainly are aware of the potential for collateral damage.

All this demonstrates the discrepancy between the diplomatic and financial power of the U.S. On the one hand, the U.S. must deal with countries that are eager to claim their places in global governance. The dominance of the U.S. and other G7 nations in international institutions is a relic of a world that came to an end with the global financial crisis. On the other hand, the dollar is still the predominant international currency, and will hold that place for many years to come. The use of the renminbi is slowly growing but it will be a long time before it can serve as an alternative to the dollar. Consequently, the actions of the Federal Reserve may have more international repercussions than those of U.S. policymakers unable to cope with the shifting landscape of financial diplomacy.


Tales of Globalization: Russia and China

The end of 2014 marked the 23rd anniversary of the dissolution of the Soviet Union and the establishment of the Russian Federation. Like Chinese leaders in the previous decade, Russian policymakers faced the challenge of integrating their nation into the global economy. Russia’s trade openness (exports and imports scaled by GDP) grew from 26% in 1991 to 51% in 2013, very similar to the rise in China’s trade openness from 29% to 50% during these years. Russian exports increased from 13% of its GDP at the beginning of this period to 28% in 2013, while the corresponding figures for China are 16% and 26%. Both counties gradually allowed foreign capital inflows. But the similarities end there.

Russia’s exports are primarily commodities, particularly oil and natural gas. Consequently, sales of these resources account for a large part of Russia’s GDP: 16% in 2012. The plunge in world oil prices, combined with the sanctions imposed by U.S. and European Union governments following Russia’s annexation of the Crimea and its threats against the Ukraine, threaten to push the economy into a recession. The deterioration of the economic situation caused the ruble to plunge against the dollar in December, before recouping part of its value after the central bank intervened in the foreign exchange market and raised its policy rate to 17%.

Russia is particularly susceptible to a currency depreciation because of its external debt, reported to be $678 billion. Capital controls that had been imposed during the 1998 crisis were removed in the 2000s, and capital inflows, including bank loans and bond issues, increased significantly. These capital flows reversed during the global financial crisis, and there was only a modest recovery before the latest period of political tension. The Russian government’s debt includes $38 billion of bonds denominated in dollars, which is not seen as a vulnerability. But the external exposure of Russian companies is much larger. The Russian central bank claims that in 2015 Russian firms owe $120 billion of interest and repayments on their external debt. Much of this money is owed by Rosneft and Gazprom, the state oil and gas producers.

China has followed a very different path. Its main exports now include electronics and machinery. The Great Recession prompted a reevaluation of the structure of the economy by the Chinese government. Chinese leaders realize that the export- and investment-led growth of the past is no longer feasible or desirable, and have emphasized the expansion of domestic consumption. This transition is taking place while the economy slows from the torrid 10% growth rate of the past to about 7.5%.

China also has external debt, which totaled $863 billion in 2013. But China has been more deliberate in opening up its capital account, and its external liabilities primarily take the form of foreign direct investment. Moreover, its foreign exchange reserves of about $4 trillion should alleviate any concerns about its ability to fulfill its obligations to foreign lenders. Of more concern is the growth in domestic credit, which now surpasses 200% of its GDP. While a financial contraction appears inevitable, there are differences over whether this will lead to economic disruption (see also here).

China’s currency appreciated in value between 2005 and 2008, when the renminbi was “re-pegged” against the dollar. In March, the central bank announced that the renminbi would fluctuate within a band of +/- 2%. A recent study by Martin Kessler and Arvind Subramanian indicates that the renminbi is fairly valued by purchasing power estimates. The government is considering whether the renminbi will become an international currency. Its status may get a boost if the IMF decides to include the renminbi as one of the currencies on which its Special Drawing Rights is based.

China and Russia, therefore, have followed very different paths in globalizing their economies. Russia, of course, could not be expected to forsake its energy resources. But commodity exporters live and die by world prices, and the government passed up an opportunity to diversify the Russian economy. China initially used its own “natural resource” of abundant labor, but has moved up the value chain, as Japan and Korea did. Chinese firms are now expanding into foreign markets. In addition, Russia allowed short-term capital inflows that can easily cease, while China carefully controlled the external sources of finance.

Russia’s GDP per capita recorded a rise of 29% between 1991 and 2013, from $5,386 to $6,924 (constant 2005 US $). China started at a much lower base in 1991, $498, but its per capita income increased by over 7 times (719%) to $3,583. The divergence in the two countries’ fortunes shows that there are many ways to survive in the global economy, but some are more rewarding than others.

The ECB’s Daunting Task

Mario Draghi, head of the European Central Bank, and the members of the ECB’s Governing Council are receiving praise for the initiatives they announced last week to avoid deflation (see here and here). The immediate impact of the announcement was a rise in European stock prices. But the approval of the financial sector does not mean that the ECB will be successful in its mission to rejuvenate the Eurozone’s economy.

The ECB is taking several expansionary steps. First, it has cut the rate paid on the deposits of banks at the ECB to a negative 0.1%, thus penalizing the banks for not using their reserves to make loans. Second, it is setting up a new lending program, called “Targeted Longer-Term Refinancing Operations (TLTROs),” to provide financing to banks that make loans to households and firms. Third, it will no longer offset the monetary impact of its purchases of government bonds, i.e., no “sterilization.” Moreover, Draghi’s announcement included a pledge that the ECB will consider further steps, including the use of “…unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation.”

Draghi’s promise to take further steps are reminiscent of his announcement in 2012 that the ECB was “…ready to do whatever it takes to preserve the euro.” That promise was successful in calming concerns about massive defaults and a break-up of the Eurozone. Consequently, the returns that sovereign borrowers in the Eurozone had to pay on their bonds began a decline that has continued to the present day.

But the challenges now facing the ECB are in many aspects more daunting. The current Eurozone inflation rate of 0.5% is an indicator of the anemic state of European economies.  Achieving the target inflation target of the ECB of 2% will require a significant increase in spending. The latest forecast for 2014’s GDP Eurozone growth from The Economist is 1.1%, which would be a pick-up from the 0.7% in the latest quarter, with an anticipated inflation rate for the year of 0.8%. Unemployment for the area is 11.7%, and this includes rates of 25.1% in Spain, 26.5% in Greece, and 12.6% in Italy.

More bank lending would encourage economic activity, but it is not clear that European banks are willing to make private-sector loans. Many banks are still dealing with past loans that will never be repaid as they seek to pass bank stress tests. And Draghi’s success in calming fears about sovereign default has (perhaps paradoxically) resulted in banks holding onto government bonds, which are now seen as relatively safe compared to private loans.

There is one other aspect of the European situation that can derail the ECB’s efforts: the distribution of financial wealth. The recent publication of House of Debt by Atif Mian and Amir Sufi has led to discussions of the deterioration of household balance sheets during the global financial crisis, and the economic consequences of the massive decline in household wealth. Larry Summers has praised the authors’ contribution to our understanding of the impact of the crisis on economic welfare by focusing on this channel of transmission.

Mian and Sufi have claimed that income distribution has a role in the response of households to policies that seek to boost spending. Low-income households, they point out, will spend a higher fraction of fiscal stimulus income checks than high-income households. They would most likely also spend a higher proportion of a rise in their financial worth. A concentration of such wealth in the hands of a small proportion of European households, therefore, limits the increase in spending due to higher asset prices.

The ECB, therefore, may find that the plaudits they have earned do not translate to a better policy outcome. The situation they face is not unique, and resembles in many ways the challenges that the Bank of Japan in has faced. Draghi and the ECB may have to follow their lead in devising new measures if European spending and inflation do not pick up.