Tag Archives: capital flows

Dealing with the Fallout from U.S. Policies

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The divergence of monetary policies in the advanced economies continues to roil financial markets. The Federal Reserve has reacted to better labor market conditions by ending its quantitative easing policy. The Bank of Japan, on the other hand, will expand its purchases of securities, and the European Central Bank has indicated its willingness to undertake unconventional policies if inflation expectations do not rise. The differences in the prospects between the U.S. and Great Britain on the one hand and the Eurozone and Japan on the other has caused Nouriel Roubini to liken the global economy to a jetliner with only one engine still functioning.

The effect of U.S. interest rates on international capital flows is well-documented. Many countries are vulnerable to changes in U.S. policies that can reverse financial flows. Countries that have relied on capital flows searching for a higher yield to finance their current account deficits are particularly susceptible. Declining commodity prices reinforce the exposure of commodity exporters such as Brazil and Russia.

U.S. markets affect capital flows in other ways. Erlend Nier, Tahsin Saadi Sedik and Tomas Molino of the IMF have investigated the key drivers of private capital flows in a sample of emerging market economies during the last decade. They found that changes in economic volatility, as measured by the VIX (the Chicago Board Options Exchange Market Volatility Index, which measures the implied volatility of S&P 500 index options), are the “dominant driver of capital flows to emerging markets” during periods of global financial stress. During such periods, the influence of fundamental factors, such as growth differentials, diminishes. Countries can defend themselves with higher interest rates, but at the cost of slowing their domestic economies.

When the IMF’s economists included data from advanced economies in their empirical analysis, they found that the impact of the VIX was higher in those economies. They inferred that as countries develop financially, “capital flows could therefore be increasingly influenced by external factors.” Financial integration, therefore, will lead to more vulnerability to the VIX.

Volatility in U.S. equity markets drives up the VIX. Moreover, empirical analyses, such as one by Corradi, Distaso and Mele, find that U.S. variables, such as the Industrial Production Index and the Consumer Price Index, explain part of the changes in the VIX. U.S. economic conditions, therefore, affect global capital flows through more linkages than interest rates alone.

What are the implications for U.S. policymakers? The Federal Open Market Committee does not usually consider the impact of its policy directives on foreign economies. On the other hand, the Fed is well aware of the feedback from foreign economies to the U.S. Moreover, there are measures the U.S. could undertake to lessen the impact of its policy shifts on foreign markets.

During the global financial crisis, for example, the Federal Reserve established swap arrangements for 14 foreign central banks, including those of Brazil, Mexico, Singapore and South Korea. These gave the foreign financial regulators the ability to lend dollars to their banks that had financed holdings of U.S. assets by borrowing in the U.S. However, not all emerging markets’ central banks were deemed eligible for this financial relationship, leaving some of them disappointed (see Prasad, Chapter 11).

Federal Reserve officials have signaled that they are not interested in serving again as a source of liquidity. One alternative would be to allow the IMF to take over this capacity. But the U.S. Congress has not passed the legislation needed to implement long-overdue governance reforms at the Fund, and it is doubtful that the results of the recent elections will lead to a different stance. Not many foreign countries will be in favor of enabling the IMF to undertake new obligations until the restructuring of that institution’s governance is resolved.

Volatile capital flows have the potential of sabotaging already-anemic recoveries in many emerging market countries. The global financial architecture continues to lack reliable backstops in the event of more instability. The U.S. should cooperate with other nations and international financial institutions in addressing the fallout from its economic policies, either by directly providing liquidity or allowing the international institutions to do so.

Volatility in the Emerging Markets

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Volatility has returned to the financial markets. Stock prices in the U.S. have fallen from their September highs, and the return on 10-year Treasury bonds briefly fell below 2%.  Financial markets in emerging markets have been particularly hard hit. The Institute for International Finance estimates that $9 billion was withdrawn from equity markets in those countries in October, while the issuance of new bonds fell.

The increased volatility follows a period of rising allocations of portfolio investments by advanced economies to assets in the emerging market economies. The IMF’s latest Global Financial Stability Report reported that equity market allocations increased from 7% of the total stock of advanced economy portfolio investments in 2002 to almost 10% in 2012, which represented $2.4 trillion of emerging market equities. Similarly, bond allocations rose from 4% to almost 10% during the same period, reaching $1.6 trillion of emerging market bonds.

The outflows are due to several factors. The first, according to the IMF, is a decline in growth rates in these countries below their pre-crisis rates. While part of the slowdown reflects global conditions, there are also concerns about slowing productivity increases. China’s performance is one of the reasons for the lower forecast. Its GDP rose at a rate of 7.3% in the third quarter, below the 7.5% that the government wants to achieve.

Second, the prospect of higher interest rates in the U.S. following the winding down of the Federal Reserve’s Quantitative Easing has caused investors to reassess their asset allocations. The importance of “push” factors versus “pull” factors in driving capital flows has long been recognized, but their relative importance may have grown in recent years.   A recent paper by Shaghil Ahmed and Andrei Zlate (working paper here) provides evidence that the post-crisis response in net capital inflows, particularly portfolio flows, in a sample of emerging markets to the difference between domestic and U.S. monetary policy rates increased in the post-crisis period (2009:Q3 – 2013:Q2). They also looked at the impact of the U.S. large-scale asset purchases, and found that the such purchases had a statistically significant impact on gross capital inflows to these countries.

Part of the increased response in flows between advanced and emerging market economies may reflect the actions of large asset managers. In a paper in the latest BIS Quarterly Review, Ken Miyajima and Ilhyock Shim investigate the response of asset managers in advanced economies to benchmarks of emerging market portfolios. They point out that these managers often rely on performance measures of asset markets in emerging markets, which leads to an increased correlation of the assets under the managers’ control. Moreover, relatively small shifts in portfolio allocation by the asset managers can have a significant impact on asset markets in emerging markets. As a result, in recent years “…investor flows to asset managers and EME asset prices reinforced each other’s directional movements.” Investor flows to the emerging market economies are procyclical. If other factors do not provide a reason to reverse the outflows, they will continue.

The IMF’s Global Financial Stability Report also points out that: “An unintended consequence of…stronger financial links between advanced and emerging market economies is the increased synchronization of asset price movements and volatility.” One downside of increased financial globalization, therefore, is a decline in the ability to lower risk through geographic diversification. Similarly, any notion of “decoupling” emerging markets from the advanced economies is a “mirage,” according to Mexico’s central bank head Agustin Carstens. To achieve international financial stability will require monitoring capital flows across asset markets in different countries; volatility does not respect geographic borders.

Martin Wolf’s Warning

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It is time for the 2014 Globie—a (somewhat fictitious) prize I award once a year to a book that deserves recognition for its treatment of the consequences of globalization. (Previous winners can be found here.) The financial turmoil of the last week makes this year’s award-winner particularly appropriate: Martin Wolf for The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis. Wolf, a distinguished writer for the Financial Times, once viewed globalization as a positive force that enhanced welfare. But the events of the last few years have changed his views of financial markets and institutions. He now views financial flows as inherently susceptible to the occurrence of crises. And Wolf’s intellectual evolution leaves him deeply concerned about the consequences of financial globalization.

Part I of the book deals with the “shocks” to the global economy. Wolf begins in the U.S. with the crisis of 2008-09 and the relatively weak recovery. He shares the view of Richard Koo of Nomura Research that this was a “balance sheet recession,” with the private sector seeking to shed the debt it had built up during the pre-crisis period. The cutback in private sector spending was initially matched by an increase in the government’s fiscal deficit, which arose as expenditures on unemployment benefits and other programs grew and revenues fell. The rise in the fiscal deficit was particularly appropriate as the “liquidity trap” limited the downward fall of interest rates and the expansionary effects of monetary policy. However, the political acceptance of deficits and debts ended prematurely in 2010, and the recovery has not been as robust as it needs to be.

Wolf then turns to the Eurozone, which experienced its shift towards fiscal austerity after the crisis in Greece erupted. Wolf views the monetary union as “incomplete and imperfect.” On the one hand, its members have sovereign powers that include issuing debt; on the other hand, they do not have the risk-sharing mechanisms that a federal union possesses. When the capital flows that had fed housing bubbles in Spain and Ireland and financed fiscal deficits in Greece and Portugal ended, the borrowing countries were encumbered with  the debt they had accumulated either directly through fiscal borrowing or indirectly as they bailed out their domestic banks. Those increases in public  debt were seen by Germany and others as proof that the crises were due to fiscal excess, which had to be met by fiscal austerity. But Wolf claims that the German view “…was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis.”

After surveying the relartvely more benign experience of the emerging and developing countries during the crisis, Wolf turns to the “shifts” that led to the breakdown of the financial system. These include the liberalization of market forces, particularly finance; technological change, which speeded up the integration of markets and financial markets; and ageing, which transformed the savings-investment balance in high-income countries. These led to an increase in financial fragility that made financial markets unstable and crises endemic. The changes took place in a global economy where global savings where channeled from oil-exporters and Asian economies, particularly China, to the U.S., thus reinforcing the credit boom.

The last section of the book deals with solutions to the crises. Wolf is ready to consider “radical reform,” which includes higher capital ratios for the banks and macroprudential policies that seek to achieve both asset market and macroeconomic stability. Policies to rebalance the global economy include encouraging less risky forms of finance, increasing insurance against external shocks, and moving towards a global reserve asset. The steps needed to assure the continued existence of the euro start with a mechanism to assure symmetrical adjustment across the Eurozone, debt restructuring, and a banking union.

None of these measures will be easy to implement. But Wolf’s willingness to discuss them is a sign of how much the crisis has unsettled those who thought they understood the risks of financial globalization. Wolf attributes the responsibility for the crisis to “Western elites,” who misunderstood the consequences of financial liberalization, allowed democracy to be weakened, and in the case of the Eurozone, imposed a system without accountability. The loss in public confidence, he writes, reduces trust in domestic legitimacy.

The title of the last chapter, “Fire Next Time,” is taken from James Baldwin’s book of the same name, which in turn borrowed from an African-American spiritual: “God gave Noah the rainbow sign, no more water but fire next time.” Wolf warns that the next global economic crisis “could end in the fire.” While he  does not explicitly explain what this fire will be, he mentions in the preface that his father was a Jewish refugee from Austria in the 1930s, and the historical reference is clear. At a time when right-wing parties are ascendant in Europe, Wolf’s warning is a sober reminder that unsettled economic circumstances can lead to political extremism and instability.

The Challenges of Achieving Financial Stability

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The end of the dot.com bubble in 2000 led to a debate over whether central banks should take financial stability into account when formulating policy, in addition to the usual indicators of economic stability such as inflation and unemployment. The response from many central bankers was that they did not feel confident that they could identify price bubbles before they collapsed, but that they could always deal with the byproducts of a bout of speculation. The global financial crisis undercut that response and has led to the development of macroprudential tools to address systemic vulnerabilities. But regulators and other policymakers who seek to achieve financial stability face several challenges.

First, they have to distinguish between the signals given by financial and economic indicators, and weigh the impact of any measures they consider on anemic economic recoveries. The yields in Europe on sovereign debt for borrowers such as Spain, Portugal and Ireland are at their lowest levels since before the crisis. Foreign investors are scooping up properties in Spain, where housing prices have fallen by over 30% since their 2007 highs. But economic growth in the Eurozone for the first quarter was 0.2% and in the European Union 0.3%. Stock prices in the U.S. reached record levels while Federal Reserve Chair Janet Yellen voiced concerns about a weak labor market and inflation below the Federal Reserve’s 2% target. When asked about the stock market, Yellen admitted that investors may be taking on extra risk because of low interest rates, but said that equity market valuations were within their “historical norms.” Meanwhile, Chinese officials seek to contain the impact of a deflating housing bubble on their financial system while minimizing any economic consequences.

Second, regulators need to consider the international dimensions of financial vulnerability. Capital flows can increase financial fragility, and the rapid transmission of financial volatility across borders has been recognized since the 1990s. Graciela L. Kaminsky, Carmen M. Reinhart and Carlos A. Végh analyzed the factors that led to what they called “fast and furious” contagion. Such contagion occurred, they found, when there had been previous surges of capital inflows and when the crisis was unanticipated. The presence of common creditors, such as international banks, was a third factor. U.S. banks had been involved in Latin America before the debt crisis of the 1980s, while European and Japanese banks had lent to Asia in the 1990s before the East Asian crisis.

The global financial crisis revealed that financial integration across borders exacerbated the downturn.  The rise of international financial networks that transmit risk across frontiers was the subject of a recent IMF conference. Joseph Stiglitz of Columbia University gave the opening talk on interconnectedness and financial stability, and claimed that banks can be not only too big to fail, and can also be “too interconnected, too central, and too correlated to fail.” But dealing with interconnected financial networks is difficult for policymakers whose authority ends at their national borders.

Finally, officials have to overcome the opposition of those who are profiting from the current environment. IMF Managing Director Christine Lagarde has attributed insufficient progress on banking reform to “fierce industry pushback” from that sector. Similarly, Bank of England head Mark Carney has told bankers that they must develop a sense of their responsibilities to society. Adam J. Levitin, in a Harvard Law Review essay that summarizes the contents of several recent books on the financial crisis, writes that “regulatory capture” by financial institutions has undercut financial regulation that was supposed to restrain them, and requires a political response. James Kwak has emphasized the role of ideology in slowing financial reform.

Markets for financial and other assets exhibit little sign of stress. The Chicago Board Options Exchange Volatility index (VIX), which measures expectations of U.S. stock price swings, fell to a 14-month low that matched pre-crisis levels. Such placidity, however, can mask the buildup of systemic stresses in financial systems. Regulators and other policy officials who seek to forestall another crisis by acting peremptorily will need to possess political courage as well as economic insight.

China’s Trilemma Maneuvers

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China’s exchange rate, which had been appreciating against the dollar since 2005, has fallen in value since February. U.S. officials, worried about the impact of the weaker renminbi upon U.S.-China trade flows, have expressed their concern. But the new exchange rate policy most likely reflects an attempt by the Chinese authorities to curb the inflows of short-run capital that have contributed to the expansion of credit in that country rather than a return to export-led growth. Their response illustrates the difficulty of relaxing the constraints of Mudell’s “trilemma”.

Robert Mundell showed that a country can have two—but only two—of three features of international finance: use of the money supply as an autonomous policy tool, control of the exchange rate, and unregulated international capital flows. Greg Mankiw has written about the different responses of U.S., European and Chinese officials to the challenge of the trilemma. Traditionally, the Chinese sought to control the exchange rate and money supply, and therefore restricted capital flows.

In recent years, however, the Chinese authorities have pulled back on controlling the exchange rate and capital flows, allowing each to respond more to market forces. The increase in the value of renminbi followed a period when it had been pegged to increase net exports. As the renminbi appreciated, foreign currency traders and others sought to profit from the rise, which increased short-run capital inflows and led to an increase in foreign bank claims on China. But this inflow contributed to the domestic credit bubble that has fueled increases in housing prices. Private debt scaled by GDP has risen to levels that were followed by crises in other countries, such as Japan in the 1980s and South Korea in the 1990s. All of this gave the policymakers a motive for trying to discourage further capital inflows by making it clear the renminbi’s movement need not be one way.

Moreover, the authorities may have wanted to hold down further appreciation of the renminbi. The release of new GDP estimates for China based on revised purchasing power parity data showed that country’s economy to be larger than previously thought. The new GDP data, in turn, has led to revisions by Marvin Kessler and Arvind Subramanian of the renminbi exchange rate that would be consistent with the Balassa-Samuelson model that correlates exchange rates to levels of income.  Their results indicate that the exchange rate is now “fairly valued.” With the current account surplus in 2013 down to 2% of GDP, Chinese officials may believe that there is little room for further appreciation.

Gavyn Davies points out that there is another way to relieve the pressure on the exchange rate due to capital inflows: allow more outflows. Even if domestic savers receive the higher rates of return that government officials are signaling will come, Chinese investors would undoubtedly want to take advantage of the opportunity to diversity their asset holdings. As pointed out previously, however, capital outflows could pose a threat to the Chinese financial system as well as international financial stability. Chinese economists such as Yu Yongding have warned of the consequences of too rapid a liberalization of the capital account.

The Chinese authorities, therefore, face difficult policy choices due to the constraints of the trilemma. Relaxing the constraints on capital flows could cause the exchange rate to overshoot while further adding to the domestic credit boom that the central bank seeks to restrain. But clamping down on capital flows would slow down the increase in the use of the renminbi for international trade. As long as the policymakers seek to maneuver around the restraints of the trilemma, they will be reacting to the responses in foreign exchange and capital markets to their own previous initiatives.

China’s Place in the Global Economy

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Last week’s announcement that China’s GDP grew at an annualized rate of 7.4% in the first quarter of this year has stirred speculation about that country’s economy. Some are skeptical of the data, and point to other indicators that suggest slower growth.  Although a deceleration in growth is consistent with the plans of Chinese officials, policymakers may respond with some form of stimulus. Their decisions will affect not just the Chinese economy, but all those economies that deal with it.

The latest World Economic Outlook of the International Monetary Fund has a chapter on external conditions and growth in emerging market countries that discusses the impact of Chinese economic activity. The authors list several channels of transmission, including China’s role in the global supply chain, importing intermediate inputs from other Asian economies for processing into final products that are exported to advanced economies. Another contact takes place through China’s demand for commodities.  The author’s econometric analysis shows that a 1% rise in Chinese growth results in a 0.1% immediate rise in emerging market countries’ GDPs. There is a further positive effect over time as the terms of trade of commodity-exporters rise. Countries in Latin America are affected as well as in Asia.

These consequences largely reflect trade flows, although China’s FDI in other countries is acknowledged. But what would happen if China’s capital account regulations were relaxed? Financial flows conceivably could be quite significant. Chinese savers would seek to diversity their asset holdings, while foreigners would want to hold Chinese securities. Chinese banks could expand their customer base, while some Chinese firms might seek external financing of their capital projects. A study by John Hooley of the Bank of England offers an analysis of the possible increase in capital flows that projects a rise in the stock of China’s external assets and liabilities from about 5% of today’s world GDP to 30% of world GDP in 2025.

While the study points out that financial liberalization by China would allow more asset diversification, it also acknowledges that world financial markets would become vulnerable to a shock in China’s financial system.  Martin Wolf warns that the down-side risk is quite large. He cites price distortions and moral hazard as possible sources of instability, as well as regulators unfamiliar with global markets and an existing domestic credit boom. Similarly, Tahsin Saadi Sedik and Tao Sun of the IMF in an examination of the consequences of capital flow liberalization claim that deregulation of the Chinese capital account would result in higher GDP per capita and lower inflation in that country, but also higher equity returns and lower bank adequacy ratios, which could endanger financial stability.

There could be another result. A sizable Chinese presence in global asset markets would lead to even more scrutiny of Chinese monetary policy. A policy initiative undertaken in response to domestic conditions would affect financial flows elsewhere, and foreign policymakers most likely would voice their unhappiness with the impact on their economies. The Peoples Bank of China, accustomed to criticism from the U.S. over its handling of its exchange rate, might find the accusation of “currency wars” coming from other emerging market countries.  The price of a successful integration of Chinese financial markets with global finance will be calls for more sensitivity to the external impacts of domestic policies.

Tapering and the Emerging Markets

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The response of the exchange rates of emerging markets and their equity markets to the Federal Reserve’s “taper,” i.e., reduction in asset purchases, continues to draw comment (see, for example, here). Most analysts agree that these economies are in better shape to deal with capital outflows than they were in the past, and that the risk of another Asian-type crisis is relatively low. But that does not mean that their economies will react the way we expect.

Gavyn Davies of Fulcrum Asset Management, who has a blog at the Financial Times, has posted the transcript of a “debate” he organized with Maurice Obstfeld of UC-Berkeley, Alan M. Taylor of UC-Davis and Dominic Wilson, chief economist and co-head of Global Economics Research at Goldman Sachs, on the financial turbulence in the emerging markets. “Debate” is not the best word to describe the discussion, as there are many areas of agreement among the participants. Obstfeld points out that there are far fewer fixed exchange rate regimes in today’s emerging markets, and many of their monetary policymakers have adopted policy regimes of inflation targeting. Moreover, the accumulation of foreign exchange by the central banks leaves them in a much stronger position than they were in the 1990s. Taylor adds fiscal prudence and less public debt to the factors that make emerging markets much less risky.

But all the participants are concerned about the winding down of the credit booms that capital inflows fueled. Wilson worries about economies with current account deterioration, easy monetary policy, above-target inflation, weak linkages to the recovery in the developed markets and institutions of questionablestrength. He cites Turkey, India and Brazil as countries that meet these criteria. Similarly, Taylor lists countries with relatively rapid expansion in domestic credit over the 2002-2012 period, and Brazil and India appear vulnerable on these dimensions as well.

Another analysis of the determinants of international capital flows comes from Marcel Förster, Markus Jorra and Peter Tillmann of the University of Giessen. They estimate a dynamic hierarchical factor model of capital flows that distinguishes among a common global factor, a factor dependent on the type of capital inflow, a regional factor and a country-specific component. They report that the country component explains from 60 – 80% of the volatility in capital flows, and conclude that domestic policymakers have a large degree of influence over their economy’s response to capita flows.

But are “virtuous” policies always rewarded? Joshua Aizenman of the University of Southern California, Michael Hutchison of UC-Santa Cruz and Mahir Binici of the Central Bank of Turkey have a NBER paper that investigates the response in exchange rates, stock markets and credit default swap (CDS) spreads to announcements from Federal Reserve officials on tapering. They utilize daily data for 26 emerging markets during the period of November 27, 2012 to October 3, 2013. They looked at the response to statements from Federal Reserve Chair Ben Bernanke regarding tapering, as well as his comments about the continuation of quantitative easing. They also looked at the impact of statements from Federal Reserve Governors and Federal Reserve Bank Presidents on these topics, as well as official Federal Open Market Committee (FOMC) statements.

Their results show that Bernanke’s comments on winding down asset purchases led to significant drops in stock markets and exchange rate depreciations, but had no significant impact on CDS spreads. There were no significant responses to statements from the other Fed officials. On the other hand, there were significant responses in exchange rates when Bernanke spoke about continuing quantitative easing, as well as to FOMC statements and announcements by the other policymakers.

The countries in the sample were then divided between those viewed as possessing “robust” fundamentals, with current account surpluses, large holdings of foreign exchange reserves and low debt, and those judged to be “fragile” due to their current account deficits, small reserve holdings and high debt. Bernanke’s tapering comments resulted in larger immediate depreciations in the countries with current account surpluses as oppose to those with deficits, more reserves and less debt.  Similarly, Bernanke’s statements led to increased CDS spreads in the countries with current account surpluses and large reserve holdings, while lowering equity prices in countries with low debt positions. The immediate impact of the news regarding tapering, therefore, seemed to be tilted against those with strong fundamentals.

The authors provide an explanation for their results: the robust countries had received larger financial flows previous to the perceived turnaround in Fed policy, and therefore were more vulnerable to the impact of tapering. Moreover, as the change in the Federal Reserve’s policy stance was assimilated over time, the exchange rates of the fragile nations responded, and by the end of the year had depreciated more than those of the more robust economies. Similarly, their CDS spreads rose more. By the end of 2013, Brazil, India, Indonesia, South Africa and Turkey had been identified as the “Fragile Five.”

What do these results tell us about the impact on emerging markets from future developments in the U.S. or other advanced economies? There may be a graduated response, as the relative standings of those nations that have attracted the most capital are reassessed. However, if capital outflows continue and are seen as including more than “hot money,” then the economic fundamentals of the emerging markets come to the fore. But financial markets follow their own logic and timing, and can defy attempts to foretell their next twists and turns.

Too Much of a Good Thing?

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Global banks do not have much to cheer about these days. Earnings are falling, and the banks are responding by cutting jobs. The Federal Deposit Insurance Corporation has charged 16 banks of colluding to rig the London Interbank Offer rate (LIBOR). And the Federal Reserve has approved a rule that requires foreign banks with $50 billion of assets in the U.S. to establish holding companies for their American units that meet the same capital adequacy standards as do their U.S. peers. The latter move has been interpreted as a sign of the fragmentation of global finance that will hinder the global allocation of credit.

The Federal Reserve supported the foreign banks in the fall of 2008 when the it lent to distressed institutions. The U.S. units of European banks accounted for $538 billion of the Federal Reserve’s emergency loans, over half of the total. Federal Reserve Chair Ben Bernanke had to answer criticism from U.S. lawmakers that the loans did not benefit U.S. taxpayers. At the same time, the Federal Reserve was establishing swap lines with central banks in 14 countries. The dollars those monetary authorities acquired were used to prop up their banks that needed to finance their holding of U.S. debt.

Banks have various ways to meet the new capital adequacy standards. They can hold back on dividend payouts from their earnings, although that may not be popular with their stockholders. They can raise funds in the capital markets. And some banks, such as Deutsche Bank, will shrink their balance sheets in order to comply with the regulations. This has led to fears of cutbacks in lending.

The announcement of the new standard came as the Bank of International Settlements (BIS) was publishing its quarterly report on the international banking markets. The BIS data showed that the cross-border claims of BIS reporting banks fell by $500 billion in the their quarter of 2013, the biggest contraction since the second quarter of 2012. Most of this decline occurred in Europe, as lending between parents banks and their subsidiaries in the Eurozone and the United Kingdom declined.

Would a contraction in bank credit have negative consequences? It certainly will for those firms in Europe that are unable to obtain credit. But there are also grounds for believing that a reduction in banking activity may under some circumstances be advantageous for an economy. The same issue of the BIS Quarterly Review that reported the international banking data also carried an article by BIS economists Leonardo Gambacorta, Jung Yang and Kostas Tsataronis. They compared the impact of bank and capital market activity on economic growth, and found that increases in both contributed to higher growth, but only up to threshold levels of GDP. After those thresholds are reached, further expansion in banking or capital markets had negative impacts on growth. Similar results have been reported by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza of the IMF, Stephen G. Cecchetti and Enisse Kharroubi also at the BIS, and Sioong Hook Law of Universiti Putra Malaysia and Nirvikar Sinth of UC-Santa Cruz in the Journal of Banking & Finance (working paper version here).

These studies deal with the domestic impacts of financial activity. How about bank lending across borders? The record there also demonstrates that bank lending can have adverse consequences. Martin Feldkircher of Oesterreichische Nationalbank (the National Bank of Austria) has a paper in the Journal of International Money and Finance (working paper version here) that examines the determinants of the severity of the global financial crisis in 63 countries, using 97 candidate variables. He reports that the change in domestic credit provided by the banking sector is a robust determinant of crisis severity. When he further investigated by interacting the bank credit variable with measures of risk, including macro, external, fiscal, financial and contagion and spillover risk, he found that the interaction of bank credit with foreign claims from banks in advanced countries robustly explained crisis severity. He concludes: “Countries with high credit growth and considerable exposure to external funding saw their economies more severely affected during times of financial distress.”

There is a line between financing new economic activities and bankrolling speculation. The former promotes welfare, the latter ends in volatility and distress. Unfortunately, that line shifts as new opportunities appear. Trying to find it is a constant challenge for regulators.

Affairs, Domestic and Foreign

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Raghuram Rajan, ex- faculty member of the Booth School of Business at the University of Chicago, ex-head of the research department of the IMF, and currently Governor of the Reserve Bank of India (its central bank), set off a storm of comment when he warned of a breakdown in the global coordination of monetary policy. Frustrated by the decline in the foreign exchange value of the rupee that followed the cutback in asset purchases by the Federal Reserve, Rajan claimed that the Federal Reserve was ignoring the impact of its policies on the rest of the world.  Does he have a valid cause for concern?

Quite a few folks have weighed in on this matter: see here, here, here, here, here and here. Rodrik and Subramanian make several interesting points. First, the Federal Reserve was criticized when it lowered rates, so complaints that it is now raising them are a bit hypocritical (but see here). Second, blaming the Fed for not being a team player as the emerging markets were when they lowered their rates in 2008-09 is not a valid comparison. The emerging markets lowered their rates then because it was in their interest to do so, not out of any sense of international solidarity. Third, their governments allowed short-term capital inflows to enter their economies; did they not realize that the day could come when these flows would reverse? Finally, their policymakers allowed the inflows to contribute to credit bubbles that resulted in inflation and current account deficits, which are significant drivers of the volatility.

Moreover, the Federal Reserve is constrained by law to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S., not the global community But couldn’t turmoil in the emerging markets threaten U.S. conditions? Robin Harding at the Financial Times thinks this is an unlikely scenario. He points to two channels of transmission between the U.S. and the countries that have shown the most turbulence: exports and financial markets. The emerging market nations that have witnessed the most volatility account for very small proportions of U.S. exports. (China, on the other hand, does claim 7.5% of our exports, but so far has not suffered any signs of distress (but see here).) In addition, financial flows might be affected, but to date these have resulted in lower interest rates in the U.S. due to a flight to safety. Previous shocks from the emerging markets pushed U.S. stock prices down, but these effects were short-lived. Therefore, Harding claims, “…it would have to become much more of a crisis…” to endanger the U.S. economy.

The problem with this assessment is that it assumes that we know the extent of our financial vulnerability to a decline in the fortunes of these economies. But one lesson of the 2007-09 global financial crisis is that there may be much we do not know about our financial structure. U.S.-based institutions can be vulnerable to shocks in ways that we do not recognize. Subprime mortgages were not themselves that significant a share of the liabilities of U.S. banks and shadow banks, but they were the foundation of a range of derivatives, etc., that took down the financial markets when these mortgages became toxic.

The threat of more declines in foreign asset prices does not mean that the Federal Reserve should retreat from its current policies. A situation with some interesting similarities took place in the early 1980s. U.S. banks, awash with recycled oil revenues, had lent extensively to countries in Latin America and elsewhere in the 1970s.  A debt crisis ensued after Paul Volcker and the Federal Reserve raised interest rates (see Chapter 4). Volcker recently reflected on these events in an interview with Martin Feldstein in the fall 2013 issue of the Journal of Economic Perspectives:

“What were you going to do? Were you going to conduct an easy-money policy and go back on all the policy you’d undertaken to try to save Mexico, which wouldn’t have saved Mexico anyway? We did save Mexico, but by other means.”

U.S. policymakers have always claimed (with some justification) that a healthy U.S. economy is the best remedy for a troubled world economy, and monetary officials will no doubt proceed as they think best. But we should take a look around before we proceed. The February ice underneath our feet may be a bit thinner than we realize.

Shake, Rattle and Roll

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The selloff last week of the currencies of many emerging market countries while stock prices also declined can be seen as the result of “known unknowns” and “unknown unknowns.” How these will play out will become evident during the rest of the year. Either set of factors would be unsettling for the emerging market countries, but the combination of the two may lead to a long period of chaotic financial conditions.

The “known unknown” is the magnitude of the increase in U.S. interest rates following the scaling down of asset purchases by the Federal Reserve and the ensuing impact on capital flows to developing economies. A recent analysis at the World Bank of the response established a baseline assumption of an increase of 50 basis points in U.S. long-term interest rates by the end of 2015 and another 50 basis point rise in 2016. The European Central Bank, the Bank of Japan and the Bank of England would also relax their quantitative easing policies. The result, according to their model, would be a slow rise in global interest rates and a gradual tightening in capital flows to developing countries of about 10%, or 0.6% of their GDP. The biggest declines would occur in portfolio flows to these countries.

However, the World Bank analysts also allowed for alternative scenarios. If there is a “fast normalization,” then U.S. long-term interest rates will rise by 100 basis points this year and capital inflows to the developing economies drop by up to 50% by the end of the year. In the “overshooting scenario,” long-term rates rise by 200 basis points, and capital inflows could decline by 80%. These developments would raise the probability of financial crises in the emerging markets, particularly in countries where there have been sizeable increases in domestic credit fueled in part by foreign debt

But the U.S. is not the only source of anxiety for policymakers in emerging market economies.  A decline in Chinese manufacturing activity in January may be reversed next month, and by itself likely means little. The decline in Asian stock prices that followed the announcement of the fall, however, demonstrated the importance of China’s economy for the region, and why China’s economic performance is the “unknown unknown.” The financial system in China has become overextended, and the Bank of China has fluctuated between signaling that it would rein in the shadow banking system while also injecting credit when short-term interest rates rise. How long the authorities can continue their delicate balancing act is unclear.

The state of the financial system is only one of the aspects of the Chinese economy that raises concerns. Given the uncertainty about the impact of demographic and migration trends, the continuation of FDI flows, etc., any forecast is conditional on a host of factors.  The IMF reported increased growth in China at the end of 2013, but warned that it will moderate this year to around 7.5%.

The conundrum is that we do not know what we should be concerned about in China, whereas we can imagine all too well what may happen to financial markets in emerging markets following higher interest rates in the advanced economies. The result is likely to be continued declines in exchange rates and financial asset prices, as the vulnerabilities of individual countries are revealed. As Warren Buffet warned, “Only when the tide goes out do you discover who’s been swimming naked.”

Update: See Menzie Chin’s views on these issues here.