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Dilemmas, Trilemmas and Difficult Choices

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In 2013 Hélène Rey of the London Business School presented a paper at the Federal Reserve Bank of Kansas City’s annual policy symposium. Her address dealt with the policy choices available to a central bank in an open economy, which she claimed are more limited than most economists believe. The subsequent debate reveals the shifting landscape of national policymaking when global capital markets become more synchronized.

The classic monetary trilemma (or “impossible trinity”) is based on the work of Robert Mundell and Marcus Fleming. The model demonstrates that in an open economy, central bankers can have two and only two of the following: a fixed foreign exchange rate, an independent monetary policy, and unregulated capital flows. A central bank that tries to achieve all three will be frustrated by the capital flows that respond to interest rate differentials, which in turn trigger a response in the foreign exchange markets.  Different countries make different choices. The U.S. allows capital to cross its borders and uses the Federal Funds Rate as its monetary policy target, but refrains from intervening in the currency markets. Hong Kong, on the other hand, permits capital flows while pegging the value of its currency (the Hong Kong dollar) to the U.S. dollar, but forgoes implementing its own monetary policy. Finally, China until recently maintained control of both its exchange rate and monetary conditions by regulating capital flows.

Rey showed that capital flows, domestic credit and asset prices respond to changes in the VIX, a measure of U.S. stock market volatility. The VIX, in turn, is driven in part by U.S. monetary policies. Consequently, she argued, there is a global financial cycle that domestic policymakers can not resist. A central bank has one, and only one, fundamental choice to make (the “dilemma”): does it regulate the capital account to control the amount and composition of capital flows? If it does, then it has latitude to exercise an independent monetary policy; otherwise, it does not possess monetary autonomy.

Is Rey’s conclusion correct? Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University have provided a thorough analysis of the trilemma (working paper here; see also here). Their paper focuses on whether the use of partial capital controls is sufficient to provide monetary policy autonomy with a pegged exchange rate. They find that temporary, narrowly-targeted controls–“gates”– are not sufficient to allow a central bank to both fix its exchange rate and conduct an independent policy. A central bank that wants to control the exchange rate and monetary conditions must impose wide and continuous capital controls–“walls.” But they also find that a central bank that forgoes fixed exchange rates can conduct its own policy while allowing capital flows to cross its borders, a confirmation of the trilemma tradeoff.

Helen Popper of Santa Clara University, Alex Mandilaras of the University of Surrey and Graham Bird of the University of Surrey, Claremont McKenna College and Claremont Graduate University (working paper here; see also here) provide a new empirical measure of the trilemma that allows them to distinguish among the choices that governments make over time. Their results confirm, for example, that Hong Kong has surrendered monetary sovereignty in exchange for its exchange rate peg and open capital markets. Canada’s flexible rate, on the other hand, allows it to retain a large degree of monetary sovereignty despite the presence of an unregulated capital market with the U.S.

The choices of the canonical trilemma, therefore, seem to hold. What, then, of Rey’s challenge? Her evidence points to another phenomenon: the globalization of financial markets. This congruence has been documented in many studies and reports (see, for example, here). The IMF’s Financial Stability Report last October noted that asset prices have become more correlated since the global financial crisis. Jhuvesh Sobrun and Philip Turner of the Bank for International Settlements found that financial conditions in the emerging markets have become more dependent on the “world” long-term interest rate, which has been driven by monetary policies in the advanced economies.

Can flexible exchange rate provide any protection against these comovements? Joshua Aizenman of the University of Southern California, Menzie D. Chinn of the University of Wisconsin and Hiro Ito of Portland State University (see also here) looked at the impact of “center economies,” i.e., the U.S., Japan, the Eurozone and China, on financial variables in emerging and developing market economies. They find that for most financial variables linkages with the center economies have been dominant over the last two decades. However, they also found that the degree of sensitivity to changes emanating from the center economies are affected by the nature of the exchange rate regime. Countries with more exchange rate stability are more sensitive to changes in the center economies’ monetary policies. Consequently, a country could lower its vulnerability by relaxing exchange rate stability.

Rey’s dismissal of the trilemma, therefore, may be overstated. Flexible exchange rates allow central banks to retain control of policy interest rates, and provide some buffer to domestic financial markets. But her wider point about the linkages of asset prices driven by capital flows and their impact on domestic credit is surely correct. The relevant trilemma may not be the international monetary one but the financial trilemma proposed by Dirk Schoenmaker of VU University Amsterdam. In this model, financial policy makers must choose two of the following aspects of a financial system: national policies, financial stability and international banking. National policies over international bankers will not be compatible with financial stability when capital can flow in and out of countries.

But abandonment of national regulations by itself is not sufficient: International banking is only compatible with stability if international financial governance is enacted. Is the administration of regulatory authority on an international basis feasible? The Basel Committee on Banking Supervision seeks to coordinate the efforts of national supervisory authorities and propose common regulations. Its Basel III standards set net capital and liquidity requirements, but whether these are sufficient to deter risky behavior is unclear. Those who deal in cross-border financial flows are quite adept in running rings around rules and regulations.

The international monetary trilemma, therefore, still offers policymakers scope for implementing monetary policies. The financial trilemma, however, shows that the challenges of global financial integration are daunting. Macro prudential policies with flexible exchange rates provide some protection, but can not insulate an economy from the global cycle. In 1776, Benjamin Franklin urged the members of the Second Continental Congress to join together to sign the Declaration of Independence by pointing out: “We must, indeed, all hang together, or most assuredly we shall all hang separately.” Perhaps that is the dilemma that national policymakers face today.

Growth in the Emerging Market Economies

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In recent decades the global economy has been transformed by the rise of the emerging market economies. Their growth lifted millions out of poverty and gave their governments the right to call for a larger voice in discussions of international economic governance. Therefore it is of no small importance to understand whether recent declines in the growth rates of these countries is a cyclical phenomenon or a longer-lasting transition to a new, slower state. That such a slowdown has wide ramifications became clear when Federal Reserve Chair Janet Yellen cited concerns about growth in emerging markets for the delay in raising the Fed’s interest rate target in September.

The data show the gap between the record of the advanced economies and that of the emerging markets. I used the IMF’s World Economic Outlook database to calculate averages of annual growth rates of constant GDP for the two groups.

2001-07 2008-09 2010-15
Advanced 2.46% -1.62% 1.82%
Emerging and Developing 6.62%  4.48% 5.47%
Difference: (Emerging + Developing)               – Advanced 4.16%  6.1% 3.65%

The difference in the average growth rates was notable before the global financial crisis, and rose during the crisis. Since then their growth rates have fallen a bit but continue to exceed those of the sclerotic advanced economies. Since the IMF pools emerging market economies with developing economies, the differences would be higher if we looked only at the record of emerging markets such as China, India and Indonesia.

And yet: behind the averages are disquieting declines in growth rates, if not actual contractions, for some members of the BRICS as well as other emerging markets. The IMF forecasts a fall in economic activity for Brazil of -3.03% for 2015 and for Russia of -3.83%, which makes South Africa ’s projected rise of 1.4% look vigorous. Even China’s anticipated 6.81% rise is lower than its extraordinary growth rates of previous years, and exceeded by India’s projected growth of 7.26%. The IMF sees economic growth for the current year for the emerging markets and developing economies of 4% , a decline from last year’s 4.6%.

What accounts for the falloff, and can it be reversed? The change in China’s economic orientation from an economy driven by investment and export expenditures to one based on consumption spending has slowed that country down. The decline in that country’s demand for raw materials to transform into finished goods for export is rippling through the economies of the major commodity exporters, such as Australia and Brazil. The Economist has claimed that the resulting fall in commodity prices constitutes a “great bear market.”

This downturn may be aggravated by a failure in institutions. Bill Emmott writes that emerging markets need political institutions that “…mediate smoothly between competing interest groups and power blocs in order to permit a broader public interest to prevail.” He specifically cites the leaderships of Brazil, Indonesia, Turkey and South Africa as examples of governments that have not been able to achieve that task.

The basic model of economic growth, the Solow-Swan model, predicts that income in the poorer countries should catch up with those of the advanced economies as the former countries adopt the advanced technology of the latter. This basic result is modified if there are higher population growth rates or lower savings levels, which can lead to lower per capita income levels. On the other hand, the Asian countries used high savings rates to speed up their economic growth while their birth rates fell.

But convergence has not been achieved for most economies despite periods of rapid growth. Some economists have postulated the existence of “middle-income traps.” Maria A. Arias and Yi Wen of the St. Louis Federal Reserve Bank describe this phenomenon in a recent issue of the institution’s publication, The Regional Economist. They explain that while income rose close to U.S. levels in the “Asian Tigers” (Hong Kong, Singapore, South Korea and Taiwan) as well as Ireland and Spain, per-capita income shows no sign of rising in Latin American economies such as Brazil and Mexico. There may also be a “low-income” trap for developing economies that never break out of their much lower per-capita income.

Why the inability to raise living standards? Arias and Wen, after discussing several proposed reasons such as poor institutions, compare the cases of Ireland and Mexico. They claim that the Irish government opened the economy up to global markets slowly in earlier decades, and encouraged foreign direct investment to grow its manufacturing sector. This allowed the country to benefit from the technology embedded in capital goods. Mexico, on the other hand, turned to foreign capital markets to finance government debt, which left the economy vulnerable to currency crises and capital flight. Arias and Wen conclude that governments should manage the composition of capital inflows and control capital flows that seek short-term gain rather development of the manufacturing sector.

But there may be a more basic phenomenon taking place. In 2013 Lant Pritchett and Lawrence Summers of Harvard presented a paper with the intriguing title, “Asiaphoria Meets Regression to the Mean.” They examined growth rates for a large number of countries for10 and 20 year periods, extending back to the 1950s. They showed that there is ”…very little persistence in country growth rate differences over time, and consequently, current growth has very little predictive power for future growth.” While acknowledging China and India’s achievements, they cautioned that “…the typical degree of regression to the mean imply substantial slowdowns in China and India relative even to the currently more cautious and less bullish forecasts.” They drew particular attention to the lack of strong institutions in the two countries.

If growth does slow for most emerging market economies, then the recent buildup of corporate debt in those countries may be a troubling legacy of the recent, more robust period. Debt loads that looked manageable when borrowing costs were low and future prospects unlimited are less controllable when that scenario changes. While there may not be a widespread crisis that afflicts all the emerging markets, those countries with extended financial sectors are vulnerable to international volatility.

The External Debt of the Emerging Market Economies

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The outflow of money from emerging markets this year will most likely surpass inflows for the first time since 2008, and net capital outflows may total $541 billion according to the Institute of International Finance. The flows have been accompanied by currency depreciations, stock market collapses, and in the case of Brazil, a downgrade in its credit rating to junk bond status. The IMF has responded to this turbulence by lowering its forecast for growth in the emerging markets and developing economies this year from 4.2% to 4%.

The emerging market nations that export commodities have been particularly hard hit, as China cuts back on its imports of raw materials and commodity prices plunge. Other factors that could signal further weakness are declining foreign exchange reserves, current account deficits and political uncertainty. Countries besides Brazil that have been identified as most vulnerable to further downturns include Russia, Venezuela, Turkey and Indonesia. When the long-awaited increase in U.S. interest rates finally does take place, the rise in the cost of borrowing in dollars will exacerbate the position of these countries.

There is another factor that will affect how an external shock will affect economic performance: the composition of a country’s external balance sheet. This records the holdings of foreign assets held by domestic residents and domestic liabilities held by foreigners. A country’s net international investment position (NIIP) as a creditor or debtor depends on the difference between its assets and liabilities. Both assets and liabilities can take the form of equity, which includes foreign direct investment (FDI) and portfolio equity, or debt in the form of bonds and bank loans. In addition, countries may hold assets in the form of foreign exchange reserves at their central banks.

Assets are denominated in foreign currencies, particularly the dollar, while equity liabilities are denominated in the home currency. Debt liabilities may be denominated in the domestic or a foreign currency. Foreign lenders who are concerned about the government’s macroeconomic policies—a phenomenon known as “original sin”—may insist that bonds be issued in dollars.

After the financial crises that afflicted many emerging markets during the late 1990s and early 2000s, many of these nations altered the composition of their external balance sheets. Countries that had obtained external funds primarily through debt turned to equity for sources of finance. As a result, their equity liabilities grew steadily, both in terms of absolute magnitude and relative to their debt liabilities. Their assets, on the other hand, largely consisted of foreign exchange reserves, held in the form of U.S. Treasury bonds, and other debt holdings. This profile is known as “long debt, short equity,” and differed from the “long equity, short debt” composition of most advanced economies that held equity and issued debt.

The payout on equity is contingent on the profitability of the firms that issue it, while debt payments are contractual. As a result, over time equity carries a higher return than debt—the “equity premium.” Consequently, the “long equity, short debt” profile in normal times is profitable for those countries that are net holders of equity.

But the situation changes during a crisis. The decline in the value of equity liabilities raises the NIIP of the countries that issued them. In addition, a depreciation of the domestic currency increases the value of the foreign assets while lowering those liabilities denominated in the domestic currency. Bonds issued in a foreign currency, however, will rise in value—a phenomenon observed during the Asian crisis of 1997-98. In addition, short-term liabilities may not be rolled over by foreign lenders, while FDI is much more stable.

Phillip Lane of Trinity College (working paper here) has claimed that the composition of the emerging market economies’ external balance sheets served as a buffer against the global financial crisis (GFC) of 2007-09, while the structure of the advanced economies’ external assets and liabilities heightened their vulnerability. In a recent paper I investigated this claim and found that countries with FDI liabilities had higher growth rates, fewer bank crises and were less likely to borrow from the IMF during the GFC. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit. The “long debt, short equity” strategy of emerging markets did mitigate the effects of the global financial crisis, and acted as a countercyclical crisis buffer.

But the balance sheet profiles of the emerging market economies has changed in the wake of the crisis. The corporate debt of nonfinancial firms in many emerging market economies, particularly bonds denominated in dollars, grew rapidly during this period. The IMF in its latest Global Financial Stability Report has drawn attention to this shift, which it reports has been driven by global drivers, such as the decline in U.S. interest rates.

A newly-issue report by the Committee on International Economic Policy, Corporate Debt in Emerging Economies: A Threat to Financial Stability?, views this increase in debt as a threat to financial stability. The report, written by Viral Acharya of New York University, Stephen Cecchetti of Brandeis University, José De Gregorio of the University of Chile, Sebnem Kalemli-Ozcan of the University of Maryland, Philip Lane of Trinity and Ugo Panizza of the Graduate Institute in Geneva, reviews the changes in the balance sheets of the emerging markets. They find that “…there has been a deterioration in the net foreign debt positions of many emerging economies in recent years.” While the amounts of corporate debt are limited, the authors point out, “…even a category that appears relatively small can be a source of systemic financial stability.” Moreover, bonds denominated in a foreign currency have accounted for a large component of the growth in corporate debt, and there has been “…an overall decline in the net foreign currency position of many emerging economies.” As a result, “…this has made emerging economies vulnerable to a shift in international funding conditions and macroeconomic slowdown.”

Moreover, the amount of emerging market debt may be underestimated. Carmen Reinhart of Harvard’s Kennedy School points out that debt may go undetected until the outbreak of a crisis. She points to the Mexican crisis of 1995-95, the Asian debt crisis of 1997-98 and the current Greek crisis as examples of the detection of “hidden debt” that became visible as the crisis emerged. She fears that lending by Chinese development banks for infrastructure projects in other emerging and developing economies may not be included in the data for their external debt, and could add to their vulnerability.

The authors of the report on corporate debt in emerging economies point out that policymakers have a variety of policy tools to deal with the risks of external borrowing. These include capital and liquidity regulations, directly lending to small and medium-sized enterprises when banks are constrained by exposure limits, and central clearing of derivative contracts. But all this will come after the deterioration to the external balance sheets has taken place. Governments should monitor the external borrowing of domestic firms and public agencies during “boom” periods to track their vulnerability to shocks to global liquidity. Meanwhile, the IMF is preparing for the next crisis.

Capital Flows, Credit Booms and Bank Crises

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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 Volatility, Domestic Markets

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Unlike the global financial crisis of 2008-09, the current disruption in the financial markets of emerging market nations was anticipated. The “taper tantrum” of 2013 revealed the precarious position of many of these nations, particularly those dependent on commodity exports. The combination of a slowdown in Chinese growth, collapsing stock prices and a change in the Chinese central bank’s exchange rate policy indicated that the world’s second-largest economy has its own set of problems. But global volatility itself can roil financial markets, and good fundamentals may be of little help for a government trying to shelter its economy from the instability in world markets.

The importance of global (or “push”) factors for capital flows to emerging markets was studied by Eugenio Cerutti, Stijn Claessens and Damien Puy of the IMF. They looked at capital flows to 34 emerging markets during the period of 2001-2013, and found that global factors such as the VIX, a measure of anticipated volatility in the U.S. stock market, accounted for much of the variation in flows. Not all forms of capital were equally affected: bank-related and portfolio flows (bonds and equity) were strongly influenced by the global factors, but foreign direct investment was not.

Cerutti, Claessens and Puy also investigated whether the emerging markets could insulate themselves from the global environment with good domestic macro fundamentals. They reported that the sensitivity of emerging markets to the external factors depended in large part upon the identity of a country’s investors. The presence of global investors, such as international mutual funds in the case of portfolio flows and global banks in the case of bank finance, drove up the response to the global environment. The authors concluded: “…there is no robust evidence that “good” macroeconomic (e.g., public debt, growth) or institutional fundamentals (e.g., Investment Climate and Rule of Law) have a role in explaining EM different sensitivities to global push factors.”

A similar finding was reported in a study of corporate bond markets in emerging markets, which have grown considerably since the 2007-09 crisis. Diana Ayala, Milan Nedeljkovic and Christian Saborowski, also of the IMF, studied the share of bond finance in total corporate debt in 47 emerging market economies over the period of 2000-13. Domestic factors contributed to the development of bond markets. But the growth in these markets in the post-crisis period was driven by global factors, such as the spread in U.S. high yield bonds, a proxy for global risk aversion, and U.S. broker-dealer leverage. The authors conjecture that the growth in bond finance in the emerging markets was due to a search for higher yields than those available in advanced economies during this period. If this interpretation is correct, then these countries will see capital outflows once interest rates in the U.S. and elsewhere rise.

A third paper from the IMF, written by Christian Ebeke and Annette Kyobe, looked at the markets for emerging market sovereign bonds. Their results are based on data from 17 emerging markets over the 2004-13 period. They found that foreign participation in the market for domestic-currency denominated sovereign bonds increased the impact of U.S. interest rates on the yield of these bonds once a threshold of 30 percent had been reached. Similarly, an increase in the concentration of the investor base made the bond yields more sensitive to global financial shocks.

Are domestic “pull” factors always irrelevant for capital flows? Ahmed Shaghil, Brahima Coulibaly and Andrei Zlate of the Federal Reserve Board constructed a “vulnerability index” of macroeconomic fundamentals for a sample of 20 emerging market economies during 13 periods of financial stress, beginning with the Mexican crisis of 1994 and ending with the 2013 taper tantrum. They looked at the impact of their index upon a measure of depreciation pressure, based on changes in exchange rates and losses in foreign exchange reserves. They found that there was evidence of a linkage between the macro fundamentals and depreciation pressure during the global financial crisis and then again during the European sovereign debt crisis and the taper tantrum, but not before.

Why would the response of emerging market economies to domestic fundamentals become stronger during the most recent crises? Shaghil, Coulibaly and Zlate offer two reasons: first, it may be that foreign investors investors did not distinguish among the emerging market economies until the 2000s. But as the governments of these countries implemented different policy frameworks and the costs of gathering information about them fell due to technology, it became worthwhile to distinguish amongst them based on their individual characteristics. An alternative reason for the change over time could lie in a shift in the origin of the crises away from the emerging markets themselves. Therefore, investors have become more careful in examining the vulnerabilities of individual countries.

The analysis of the relative importance of domestic “pull” vs. global “push” factors should not be posed as a “one or the other” contest (see here). There is ample evidence to indicate that global factors have become increasingly important in driving capital flows across borders. If so, then the news that the VIX hit record levels last week is disturbing. Stock markets in the U.S. and other advanced economies have rebounded, but the emerging market nations face a period of sustained retrenchment as investors reallocate their funds in response to the surge in global volatility.

Global Liquidity and U.S. Monetary Policy

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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.

Morality Tales and Capital Flows

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When the Federal Reserve finally raises its interest rate target, it will be one of the most widely anticipated policy moves since the Fed responded to the global financial crisis. The impact on emerging markets, which have already begun to see reversals of the inflows of capital they received when yields in the U.S. were depressed, has been discussed and analyzed in depth.  But the morality tale of errant policymakers being punished for their transgressions may place too much responsibility for downturns on the emerging markets and not enough on the volatile capital flows that can overwhelm their financial markets.

Capital outflows—particularly those large outflows known as “sudden stops”—are often attributed to weak economic “fundamentals,” such as rising fiscal deficits and public debt, and anemic growth rates. Concerns about such flows resulted in the “taper tantrums” of 2013 when then-Federal Reserve Chair Ben Bernanke stated that the Fed would reduce its purchases of assets through its Quantitative Easing program once the domestic employment situation improved. The “fragile five” of Brazil, India, Indonesia, South Africa and Turkey suffered large declines in currency values and domestic asset prices. Their current account deficits and low growth rates were blamed for their vulnerability to capital outflows. There have been subsequent updates of conditions in these countries, with India now seen as in stronger shape because of a declining current account deficit and lower inflation rate, whereas Brazil’s situation has deteriorated for the opposite reasons.

But this assignment of blame is too simplistic. Barry Eichengreen of UC-Berkeley and Poonam Gupta of the World Bank investigated conditions in the emerging markets after Bernanke’s announcement. The countries with largest current account deficits also recorded the largest combination of currency depreciations, reserve losses, and stock market declines. But Eichengreen and Gupta found little evidence that countries with stronger policy fundamentals escaped foreign sector instability. On the other hand, the size of their financial markets as measured by capital inflows in the period before 2013 did contribute to the adverse response to Bernanke’s statement. The co-authors interpreted this result as showing that foreign investors withdrew funds from the financial markets where they could most easily sell assets.

These results are consistent with work done by Manuel R. Agosin of the University of Chile and Franklin Huaita of Peru’s Ministry of Economics and Finance. They reported that the best predictor of a “sudden stop” was a previous capital inflow, or “surge.” Sudden stops are more likely to occur when the capital inflow had consisted largely of portfolio investments and cross-border lending.  Moreover, they claimed, capital surges worsen the current account deficits that precede sudden stops (see also here).

Stijn Claessens of the IMF and Swait Ghosh of the World Bank also looked at the impact of capital flows on emerging markets. They found that capital flows to these countries are usually large relative to their domestic financial systems. Capital inflows contribute to the pro-cyclicality of their business cycles by providing funding for increased bank lending, which are dominant in the financial systems of emerging markets. The foreign money also puts pressures on exchange rates and asset prices, and can lead to higher debt ratios. All these lead to buildups in macroeconomic and financial vulnerabilities, which are manifested when there is negative shock, either in the form of a domestic cyclical downturn or a global shock.

What can the emerging market counties do to protect themselves from the effects of volatile capital inflows? Claessens and Ghosh recommend a combination of macroeconomic measures, such as monetary and fiscal tightening; macro prudential policies that include limits on bank credit; and capital flow management measures, i.e., capital controls. However, they point out that the best combination of these policy tools has yet to be ascertained.

Hélène Rey of the London Business School has written about the global financial cycle, which can lead to excessive credit growth that is not aligned with a country’s economic conditions, and subsequent financial booms and busts. The lesson she draws is that in today’s world Mundell’s “trilemma” has become a “dilemma”: “independent monetary policies are possible if and only if the capital account is managed, directly or indirectly, regardless of the exchange-rate regime.” Joshua Aizenman of the University of Southern California, Menzie Chinn of the La Folette School of Public Affairs at the University of Wisconsin-Madison and Hiro Ito of Portland State University, however, report evidence that exchange rate regimes do matter in the international transmission of monetary policies.

Whether or not flexible exchange rates can provide some protection from foreign shocks, the capital controls that have been implemented in recent years will receive a “stress test” once the Federal Reserve does raise its interest rate target. Policymakers will be forced to make difficult decisions regarding exchange rates and monetary policies. Moreover, this tale of financial volatility may have a different moral than the usual one: bad things can happen even to those who follow the rules.

The Shifting Consensus on Capital Controls: Gallagher’s “Ruling Capital”

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Among the many consequences of the global financial crisis of 2007-09 was a shift in the IMF’s stance on capital controls. The IMF, which once urged developing economies to emulate the advanced economies in deregulating the capital account, now acknowledges the need to include controls in the tool kit of policymakers. Kevin Gallagher of Boston University explains how this transformation was achieved in his new book, Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance.

By the 1990s the Fund had long abandoned the Bretton Woods solution to the trilemma: fixed exchange rates and the use of capital controls to allow monetary autonomy. Instead, the IMF encouraged developing economies to open their borders to capital flows that would increase investment and achieve a more efficient allocation of savings (see Chapter 5 here). IMF officials proposed an amendment to its Articles of Agreement that would establish capital account liberalization as a goal for its members, but the amendment was shelved after the Asian financial crisis of 1997-98. The IMF subsequently continued to recommend capital account liberalization as a suitable long-term goal, but acknowledged the need to implement deregulation sequentially, beginning with long-term foreign direct investment before opening up to portfolio flows and bank loans.

The IMF’s position evolved further, however, as the full scale of the global crisis became apparent. First, the IMF allowed Iceland to use controls as part of its financial stabilization program. Then, in the aftermath of the crisis, Fund economists reported in a Staff Position Note that there was  “…a negative association between capital controls that were in place prior to the global financial crisis and the output declines suffered during the crisis…” The next stage came in 2012 when the IMF announced a new view–named the institutional view–of capital flows.  This doctrine acknowledged that capital flows can be volatile and pose a threat to financial stability.  Under these circumstances, controls, now named “capital flow management measures” (CFMs), can be used with other macroeconomic policies to minimize the effects of the capital volatility. Moreover, the responses to disruptive flows should include actions by the countries where the capital flows originate as well as the recipients.

Gallagher explains that these changes were due to both intellectual and political currents. IMF economists had been among those researchers who found little empirical evidence supporting the proposition that capital flows contributed to increased growth rates. This was not a surprise to those influenced by the work of economists such as Ragnar Nurske or Hyman Minsky, who were outside the mainstream. But new theoretical advances by Anton Korinek and Fund economists, including Olivier Jeanne and Jonathan Ostry, showed that the costs of volatile capital flows could be analyzed using the accepted tools of welfare economics. The adverse impact on financial stability of capital outflows can be considered as an externality that private agents ignore in their decision-making. Prudential controls seek to correct these market distortions.

Gallagher points out that at the same time as this new theoretical work was being disseminated, representatives of the emerging markets were lobbying the IMF to allow their governments the freedom to implement measures that they found necessary to offset destabilizing capital flows. The BRICS (Brazil, Russia, India, China, South Africa) coalition, which had worked together to promote reform of the IMF’s governance procedures, joined their efforts to resist any position on capital flows that could restrict their flexibility to limit them. They used the new theoretical perspectives to buttress their arguments in favor of the use of controls, and made similar arguments in other forums such as the meetings of the Group of 20. The BRICS representatives also urged the IMF to pay equal attention to the policies of the upper-income nations where capital flows originated.

The IMF’s Independent Evaluation Office has issued a report updating its 2005 evaluation of the Fund’s approach to capital account liberalization. The IEO describes the discussions leading up to the adoption of the institutional view as “contentious,” and the final document as reflecting a “fragile consensus” among the Executive Directors regarding the merits of full capital account liberalization and the proper use of CFMs. The IEO also reports that the new view seems to have influenced the IMF’s policy advice on capital account liberalization as well as its bilateral surveillance. However, the report cautioned that it is too early to tell whether the adoption of the institutional view will lead to greater consistency in the IMF’s advice on the use of CFMs.

Gallagher shows, moreover, that the battle over the use of capital controls has not ended, but shifted to new arenas. Free-trade agreements (FTAs) and bilateral investment treaties (BITs) signed with the U.S., for example, generally allow governments much less freedom to regulate financial flows. Similarly, the IEO report finds that there is “…a patchwork of bilateral, regional and international agreements regulating cross-border capital flows…” Moreover, the IMF’s attempts to promote international cooperation to reduce volatility due to capital flows have been unsuccessful.

There will be more developments in the story of the (re)regulation of capital. There are still disagreements on the side-effects of capital controls, and a rise in interest rates in the U.S. will test the effectiveness of controls on outflows. Until then, Gallagher’s book serves as a valuable account and analysis of the most recent changes.

The U.S.: Inept Diplomacy, Indispensable Currency

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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.

 

Global Stability, National Responsibilities

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The global financial crisis demonstrated clearly how the flow of money across borders could deepen and widen a financial crisis. A decline in U.S. housing prices led to a re-examination of the safety of financial securities based on them and an implosion in credit markets as financial institutions sought to re-establish their soundness by shedding the securities that were now seen as toxic. These institutions included European banks that had purchased mortgage-backed securities and other collateralized debt obligations. Eventually the emerging markets were brought into the vortex by capital outflows that disrupted their own financial markets. But are we ready to change the rules governing global finance if they impinge on national sovereignty?

Andrew Haldane, chief economist of the Bank of England, spoke last October about the need to manage global finance as a system. He identified four areas that require strengthening: global surveillance, improvements to national debt structures, the establishment of macro-prudential and capital flow management policies, and improved international liquidity assistance. Advances have been made in all these areas since the crisis.

The IMF, for example, has expanded the scope of its surveillance activities to focus more on the spillovers of national policies on other countries and regions. The latest Pilot External Sector Report, for example, examines global imbalances and finds that

“…disorderly external adjustment in some deficit economies remains a risk, particularly in an environment of tightening external financial conditions, and if the policy/institutional environment were to deteriorate or other idiosyncratic shocks materialize. Moreover, country-level risks would have spillovers and carry the potential of becoming systemic, e.g., if a group of EMs (Emerging Markets) with excess deficits were simultaneously affected by negative shocks.”

But is calling attention to possible adverse shocks sufficient? Biagio Bossone and Roberta Marra (see also here) of The Group of Lecce have called for a new commitment by the members of the IMF to be “Global Good Citizens.” This would entail amending the IMF’s Articles of Governance to include ‘global systemic stability’ as a mission of the Fund and its members. This new goal would be defined to include sustainable equilibria in the members’ balance of payments, high levels of domestic employment and income and reasonable price stability, and management of the cross-border transmission of shocks. To achieve these goals, all members would be responsible for implementing external adjustment programs as well as ensuring domestic employment and low inflation, and cooperating with other members to minimize the international transmission of shocks. Moreover, the IMF would be granted the authority to assess whether the policies of its members were consistent with global stability. The Fund could use multilateral consultations to address systemic issues and to call on policymakers to take the cross-national effects of their actions into account.

How good is the IMF’s record on calling out members who have violated existing obligations? Not so good. There were consultations with Sweden and Korea in the 1980s regarding their exchange rates, and discussions in 2006 with China, the U.S., Japan, Saudi Arabia and the Eurozone regarding global imbalances. But the latter were unsuccessful in changing the national policies that led to the imbalances.  Large nations traditionally place little weight on the welfare of other countries when formulating policies, and, if pressed, will claim that their actions benefit the global economy.

But it would be short-sighted to dismiss Bossone and Marra’s innovative proposal to expand the responsibilities of national policymakers to include spillovers. Ignoring cross-border effects is at best myopic and possibly self-defeating. Charles Engel of the University of Wisconsin in a survey of research on spillovers concludes that:

“An optimal policy aimed at inflation and employment will increasingly need to take into account the impact of events in other countries, including the effects of foreign monetary policy. It may ultimately be the case that greater stability and growth at home depends on international coordination.”

Financial markets will continue to grow in the emerging markets as well as frontier markets, and financial flows across national borders will continue to rise. These flows may bring benefits but they also increase financial and economic linkages. Soon the question may be not whether to coordinate, but how and when.