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The Spillover Effects of Rising U.S. Interest Rates

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U.S. interest rates have been rising, and most likely will continue to do so. The target level of the Federal Funds rate, currently at 1.75%, is expected to be raised at the June meeting of the Federal Open Market Committee. The yield on 10-year U.S. Treasury bonds rose above 3%, then fell as fears of Italy breaking out the Eurozone flared. That decline is likely to be reversed while the new government enjoys a (very brief) honeymoon period. What are the effects on foreign economies of the higher rates in the U.S.?

One channel of transmission will be through higher interest rates abroad. Several papers from economists at the Bank for International Settlements have documented this phenomenon. For example, Előd Takáts and Abraham Vela of the Bank for International Settlements in a 2014 BIS Paper investigated the effect of a rise in the Federal Funds rate on foreign policy rates in 20 emerging market countries, and found evidence of a significant impact on the foreign rates. They did a similar analysis for 5-year rates and found comparable results. Boris Hofmann and Takáts also undertook an analysis of interest rate linkages with U.S. rates in 30 emerging market and small advanced economies, and again found that the U.S. rates affected the corresponding rates in the foreign economies. Finally, Peter Hördahl, Jhuvesh Sobrun and Philip Turner attribute the declines in long-term rates after the global financial crisis to the fall in the term premium in the ten-year U.S. Treasury rate.

The spillover effects of higher interest rates in the U.S., however, extend beyond higher foreign rates. In a new paper, Matteo Iacoviello and Gaston Navarro of the Federal Reserve Board investigate the impact of higher U.S. interest rates on the economies of 50 advanced and emerging market economies. They report that monetary tightening in the U.S. leads to a decline in foreign GDP, with a larger decline found in the emerging market economies in the sample. When they investigate the channels of transmission, they differentiate among an exchange rate channel, where the impact depends on whether or not a country pegs to the dollar; a trade channel, based on the U.S. demand for foreign goods; and a financial channel that reflects the linkage of U.S. rates with the prices of foreign assets and liabilities. They find that the exchange rate and trade channels are very important for the advanced economies, whereas the financial channel is significant for the emerging market countries.

Robin Koepke, formerly of the Institute of International Finance and now at the IMF, has examined the role of U.S. monetary policy tightening in precipitating financial crises in the emerging market countries. His results indicated that there are three factors that raise the probability of a crisis: first, the Federal Funds rate is above its natural level; second, the rate increase takes place during a policy tightening cycle; and third, the tightening is faster than expected by market participants. The strongest effects were found for currency crises, followed by banking crises.

According to the trilemma, policymakers should have options that allow them to regain monetary control. Flexible exchange rates can act as a buffer against external shocks. But foreign policymakers may resist the depreciation of the domestic currency that follows a rise in U.S. interest rates. The resulting increase in import prices can trigger higher inflation, particularly if wages are indexed. This is not a concern in the current environment. But the depreciation also raises the domestic value of debt denominated in foreign currencies, and many firms in emerging markets took advantage of the previous low interest rate regime to issue such debt. Now the combination of higher refinancing costs and exchange rate depreciation is making that debt much less attractive, and some central banks are raising their own rates to slow the deprecation (see, for example, here and here and here).

Dani Rodrik of the Kennedy School and Arvin Subramanian, currently Chief Economic Advisor to the Government of India, however, have little sympathy for policymakers who complain about the actions of the Federal Reserve. As they point out, “Many large emerging-market countries have consciously and enthusiastically embraced financial globalization…there were no domestic compulsions forcing these countries to so ardently woo foreign capital.” They go on to cite the example of China, which “…has chosen to insulate itself from foreign capital and has correspondingly been less affected by the vagaries of Fed actions…”

It may be difficult for a small economy to wall itself off from capital flows. Growing businesses will seek new sources of finance, and domestic residents will want to diversify their portfolios with foreign assets. The dollar has a predominant role in the global financial system, and it would be difficult to escape the spillover effects of its policies. But those who lend or borrow in foreign markets should realize, as one famed former student of the London School of Economics warned, that they play with fire.

Not All Global Currencies Are The Same

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The dollar may be the world’s main global currency, but it does not serve in that capacity alone. The euro has served as an alternative since its introduction in 1999, when it took the place of the Deutschemark and the other European currencies that had also been used for that purpose. Will the renminbi become the next viable alternative?

A new volume, How Global Currencies Work: Past, Present and Future by Barry Eichengreen of the University of California-Berkeley and Arnaud Mehl and Livia Chiţu of the European Central Bank examines the record of the use of national currencies outside their borders. The authors point out that regimes of multiple global currencies have been the norm rather than an exception. Central banks held reserves in German marks and French francs as well as British sterling during the period of British hegemony, while the dollar became an alternative to sterling in the 1920s. The authors foresee an increased use of China’s renminbi and “..a future in which several national currencies will serve as units of account, means of payments, and stores of value for transactions across borders.”

Camilo E. Tovar and Tania Mohd Nor of the IMF examine the use of the reminbi as a global currency in a IMF working paper, “Reserve Currency Blocs: A Changing International Monetary System.” They claim that the international monetary system has transitioned for a bi-polar one based on the dollar and the euro to a tri-polar system that also includes the renminbi. They provide estimates of a dollar bloc equal in value to 40% of global GDP that is complemented by a renminbi bloc valued at 30% of global GDP and a euro bloc worth 20% of world output. The renminbi bloc, however, is not primarily Asian, but rather dominated by the BRICS countries (Brazil, Russia, India, China, South Africa). This suggests that its increased use may be due to geopolitical reasons rather than widespread regional use.

If relative size is a driving factor in the adoption of a currency for international transactions, then an increasing role for the renminbi is inevitable. But the dollar will continue to be the principal currency for many years to come. Ethan Ilzetzki of the London School of Economics, Carmen Reinhart of Harvard’s Kennedy School and Kenneth Rogoff of Harvard examine the predominance of the dollar in a NBER working paper, “Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?” They show that the dollar is far ahead of other currencies in terms of trade invoicing , foreign exchange trading, and most other measures.

The U.S. also holds a dominant role in international financial flows. Sarah Bauerle Danzman and W. Kindred Winecoff of Indiana University Bloomington have written about the reasons for what they call U.S. “financial hegemony” (see also their paper with Thomas Oatley of the University of North Carolina-Chapel Hill and Andrew Penncok of the University of Virginia). They point to the central role of the U.S. financial system in the network of international financial relationships. They claim that the financial crisis of 2008-09 actually reinforced the pivotal position of the U.S., in part due to the policies undertaken by U.S. policymakers at that time to stabilize financial markets and institutions. This included the provision by the Federal Reserve of swap lines to foreign central banks in countries where domestic banks had borrowed dollars to invest in U.S. mortgage-backed securities. (Andrew Tooze provides an account of the Federal Reserve’s activities during the crisis.)

The central position of the U.S., moreover, evolved over time, and reflects a number of attributes of the U.S. economy and its governance. Andrew Sobel of Washington University examined the features that support economic hegemony in Birth of Hegemony. He cites Charles Kindleberger’s claim of the need for national leadership in order to forestall or at least offset international downturns, such as occurred during the depression (see The World in Depression 1929-1939). Kindleberger specifically referred to the need for international liquidity and the coordination of macroeconomic policies by a nation exercising economic leadership.

Sobel, drawing upon the history of the Netherlands, Great Britain and the U.S., maintains that the countries that have provided these collective goods have possessed public and private arrangements that allowed them to provide such leadership. The former include adherence to the rule of law, a fair tax system and effective public debt markets. Among the private attributes are large and liquid capital markets and openness to foreign capital flows. Sobel shows that these features evolved in the historical cases he examines in response to national developments that did not occur in other countries that might have been alternative financial hegemons (such as France).

Will a new dominant financial hegemon appear to take the place of the U.S.? It is difficult to see the European Union or China assuming that role in the short- or medium-term. European leaders are dealing with disagreements over the nature of their union and the discontent of their voters, while China is establishing its own path. (See Milanovic on this topic.) U.S. financial institutions are dedicated to preserving their interests, and not likely to surrender their predominance. It would take a major shock, therefore, to current arrangements to upend the existing network of financial relationships. But we now live in a world where such things could happen.

2017 Globie: “Grave New World”

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Once a year I choose a book that deals with an aspect of globalization in an interesting and illuminating way, and bestow on it the “prize” of the Globalization Book of the Year (known as the “Globie”). The prize is strictly honorific—no check is attached! But I enjoy drawing attention to an author who has an insight on the process of globalization.  Previous winners are listed below.

This year’s Globie goes to Stephen D. King for Grave New World: The End of Globalization, The Return of History. King is senior economic adviser at HSBC Holdings, where he was chief economist from 1998 to 2015. He is the author of Losing Control: The Emerging Threats to Western Prosperity, which won the Globie in 2010, and therefore is the first two-time winner.

In the new book King addresses the current status of globalization, and how it may evolve in the future. In the book he makes six claims:

  • Globalization is not irreversible;
  • Technology can both enable globalization and destroy it;
  • Economic development that reduces inequality between states but reinforces domestic inequality creates a tension between a desire for gains in global living standards and social stability at home;
  • Migration in the 21st century will affect domestic stability;
  • The international institutions that have helped govern globalization have lost their credibility;
  • There is more than one version of globalization.

King is particularly perceptive in pointing out alternative viewpoints to those usually espoused in Western media. In Chapter 7, for example, he gives six different perspectives on how globalization has affected economic welfare. He begins with the Western version, and follows it with the Chinese, Ottoman, Russian, Persian and African versions. Each region sees history filtered through its own experiences and comes to very different conclusions on the benefits and costs of globalization.

Differences over globalization also exist within Western nations, as recent elections have shown. King points out that supporters of Donald Trump in the U.S. were concerned about immigration and terrorism, while Hilary Clinton’s supporters were worried about inequality. Nor are these concerns confined to the U.S., as the Brexit vote revealed. Part of these divisions are responses to the hardships and dislocations caused by the global financial crisis. But whatever the source, this upheaval hastens a retreat by Western countries from global engagement.

While the Western economies are withdrawing from international commitments, others are actively pursuing their own global agendas. China’s Silk Road initiative, for example, extends its trade ties with central Asia and Europe. The Asian Infrastructure Investment Bank bolsters China’s neighbors’ capacity to engage in more transactions. At some point India will undoubtedly respond with its version of an Asian initiative.

King readily admits that his view of the future is “unsettling.” Our faith in technology and markets has not led to the widespread adoption of Western values or shared prosperity. The challenge is to formulate international mechanisms that mitigate market failures, including inequality. A vision based on every nation following its own interests is not likely to achieve that goal.

Previous Globie Winners

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

2015    Benjamin J. Cohen: Currency Power: Understanding Monetary Rivalry

2016    Branko Milanovic: Global Inequality

 

The Emerging Market Economies and the Appreciating Dollar

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U.S. policymakers are changing gears. First, the Federal Reserve has signaled its intent to raise its policy rate several times this year. Second, some Congressional policymakers are working on a border tax plan that would adversely impact imports. Third, the White House has announced that it intends to spend $1 trillion on infrastructure projects. How all these measures affect the U.S. economy will depends in large part on the timing of the interest rate rises and the final details of the fiscal policy measures. But they will have consequences outside our borders, particularly for the emerging market economies.

Forecasts for growth in the emerging markets and developing economies have generally improved. In January the IMF revised its global outlook for the emerging markets and developing economies (EMDE):

EMDE growth is currently estimated at 4.1 percent in 2016, and is projected to reach 4.5 percent for 2017, around 0.1 percentage point weaker than the October forecast. A further pickup in growth to 4.8 percent is projected for 2018.

The improvement is based in part on the stabilization of commodity prices, as well as the spillover of steady growth in the U.S. and the European Union. But the U.S. policy initiatives could upend these predications. A tax on imports or any trade restrictions would deter trade flows. Moreover, those policies combined with higher interest rates are almost guaranteed to appreciate the dollar. How would a more expensive dollar affect the emerging markets?

On the one hand, an appreciation of the dollar would help countries that export to the U.S. But the cost of servicing dollar-denominated debt would increase while U.S. interest rates were rising. The Bank for International Settlements has estimated that emerging market non-bank borrowers have accumulated about $3.6 trillion in such debt, so the amounts are considerable.

In addition, Valentina Bruno and Hyun Song Shin of the BIS have examined (working paper here) a “risk-taking” channel of U.S. monetary policy that links exchange rate movements to cross-border banking flows. In the case of an appreciation of a foreign currency, domestic banks in the affected countries channel funds from global banks to firms with local currency assets that have risen in value. A domestic currency depreciation in response to U.S. monetary policy will lead to a contraction in such lending.

Jonathan Kearns and Nikhil Patel of the BIS have sought to determine whether the “financial channel” of exchange rates offsets the “trade channel.” The sample of countries they use in their empirical analysis includes 22 advanced economies and 22 emerging market economies, and the data for most of these countries begins in the mid-1990s and extends through the third quarter of 2016. They use two exchange rate indexes, where the indexes measures the foreign exchange values of the domestic currency, in one case weighted by trade flows and the second by foreign currency-denominated debt.

Their results provide evidence for both channels that is consistent with expectations: the trade-weighted index has a negative elasticity, while the debt-weighted index has a positive linkage. For 13 of the 22 emerging market economies, the sum of the two elasticities is positive, indicating than an equal appreciation of the domestic currency would be expansionary. The financial channel is stronger for those emerging market economies with more foreign currency debt.

Does this indicate that further appreciation of the dollar will lead to the long-anticipated debt crisis in the emerging markets? When Kearns and Patel replaced the debt-weighted exchange rate index with the bilateral dollar rate, they found that the debt-weighted index does a better job in capturing the financial channel than the dollar exchange rate alone. The other foreign currencies in the debt-weighted index included the euro, the yen, the pound and the Swiss franc, so a rise in the dollar is not as important when the debt is denominated in the other currencies.

Domestic policymakers in the emerging market countries seem to have done a good job in restraining domestic credit growth, which is often the precursor of financial crises. There is one significant exception: China. One recent estimate of its debt/GDP ratio placed that figure at 277% at the end of 2016. The government is attempting to slow this expansion down without destabilizing the economy, which now has a growth target of 6.5%. What happens if the dollar appreciates against the renminbi as it did last year, when China used up a trillion dollars in foreign exchange reserves in an attempt to slow the loss in value of its currency? About half of China’s external debt is denominated in its own currency, so it has less to fear on this score than do other borrowers.

A team of IMF economists that included Julian Chow, Florence Jaumotte, Seok Gil Park, and Yuanyan Sophia Zhang examined in 2015 the spillovers from a dollar appreciation. They noted that many emerging market economies are currently less vulnerable to a dollar appreciation than they were during previous periods. However, they also reported that some countries in eastern Europe and the Commonwealth of Independent States have short positions in dollar-denominated debt instruments. They investigated corporate borrowing, including debt denominated in foreign currencies, and performed a stress test analysis based on higher borrowing costs, a decline in earnings and an exchange rate depreciation to see which countries had the most vulnerable firms. They reported that increases in foreign exchange exposure would be largest in Brazil, Chile, India, Indonesia and Malaysia. They concluded their report: “Should a combination of severe macroeconomic shocks affect the nonfinancial sector, debt at risk would further rise, putting pressure on banking systems’ buffers, especially in countries where corporate and banking sectors are already weak. “

Another team of Fund economists, led by Selim Elekdag, also investigated rising corporate borrowing in the emerging market economies in the October 2015 Global Financial Stability Report. They attributed the rise in corporate debt in these countries to accommodative global monetary conditions. Consequently, these firms are quite vulnerable to changes in U.S. interest rates.

Some analysts see signs of a “virtuous cycle” in many emerging market economies. The motivating factors range from pro-growth policies in India to China’s ability (to date) to avoid a severe slowdown. But these economies are quite vulnerable to external developments. The Federal Reserve recognize this, and takes the foreign impact of its policies into account. But no such assurance comes from the rest of the U.S. government. President Trump’s fulfillment of his promise to disrupt the normal policy process in Washington will have a broad impact outside the U.S. as well.

The Changing Fortunes of the Renminbi and the Dollar

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Last fall the International Monetary Fund announced that China’s currency, the renminbi, would be included in the basket of currencies that determine the value of the IMF’s reserve asset, the Special Drawing Right (SDR). The IMF’s statement appeared to confirm the rise in the status of the currency that could at some point serve as an alternative to the U.S. dollar as a global reserve currency. But in retrospect the renminbi is a long way from achieving widespread use outside its regional trading partners, and recent policies will only limit the international use of the currency.

It has been widely speculated that the drive to include the renminbi in the IMF’s currency basket was a tool by reformers such as People’s Bank of China governor Zhou Xiaochuan to move their country towards a more liberal economic regime. The SDR currencies are supposed to be “freely usable” by foreign and domestic investors, so capital controls were eased in the run-up to the SDR announcement. But Chinese authorities are loath to give up their ability to control foreign transactions.

This has become particularly true as a result of China’s recent capital outflows. These have in part reflected outward foreign direct investment by Chinese firms seeking to expand. But the outflows are also due to Chinese firms and individuals moving money outside their country. These movements both reflect and contribute to a continuing depreciation of the renminbi, particularly against the dollar. Chinese authorities have burned through almost $1 trillion of their $4 trillion in foreign exchange reserves as they sought to slow the slide in the value of their currency.

To reduce pressure on the renminbi, the authorities are imposing controls on the overseas use of its currency. But these regulations to protect the value of the currency reduce the appeal of holding the renminbi. As Christopher Balding of the HSBC Business School in Shenzhen points out, monetary authorities can not control the exchange rate and the money supply while allowing unregulated capital flows.

Even if the authorities manage to weather the effects of capital outflows, the long-term prospects of the renminbi becoming a major reserve currency are limited. Eswar Prasad of Cornell University has written about the role of the renminbi in the international monetary system in Gaining Currency: The Rise of the Renminbi. After reviewing the extraordinary growth of the Chinese economy and the increased use of the renmimbi, Prasad evaluates China on the criteria he believes determine whether it will graduate to the status of a global currency. China had until recently been removing capital controls and allowing the exchange rate to become more flexible, benchmarks followed by foreign investors. Its public debt is relatively low, so there are no fears of sovereign debt becoming unmanageable or inflation getting out of hand.

On the other hand, the rise in total debt to GDP to 250% has drawn concerns about the stability of the financial sector. This is troubling, because as Prasad points out, this is the area of China’s greatest weakness. This vulnerability reflects not only on the increasing amount of private debt but also precarious business loans on the books of the banks, the growth of the shadow banking system and stock market volatility. Prasad writes: “China’s financial markets have become large, but they are highly volatile, poorly regulated, and lack a supporting institutional framework.” This is crucial, since ”… financial market development is likely, ultimately, to determine winners and losers in the global reserve currency sweepstakes.”

The growth in the use of renminbi has not eroded the primacy of the dollar in the international monetary system.. An investigation by Benjamin J. Cohen of UC-Santa Barbara and Tabitha M. Benney of the University of Utah of the degree of concentration in the system indicates that there is little evidence of increased competition among currencies. The dollar is widely used as a vehicle currency for private foreign exchange trading and cross-border investments, as well as for official holdings of reserves. Expectations for the euro have been scaled back as the Eurozone area struggles with its own long-term stability.

Carla Norrlof of the University of Toronto examines the sources of the dominance of the dollar. She investigates the factors that contribute to “monetary capability,” the resources base necessary for exercising currency influence. These include GDP, trade flows, the size and openness of capital markets, and defense expenditures. Norrlof’s empirical analysis leads her to confirm the status of the U.S. as the monetary hegemon: “The United States is peerless in terms of monetary capability, military power and currency influence.”

Cohen and Benney stress that their analysis holds for the current system, which could change. What could undermine the status of the dollar? Benjamin Cohen worries that President-elect Trump’s policies may increase the government’s debt and restrict trade, and possibly capital flows as well. These measures need not immediately demolish the role of the dollar. But Cohen writes, “…the dollar could succumb to a long, slow bleeding out, as America’s financial rivals try to make their own currencies more attractive and accessible.”

The renminbi, therefore, does not represent any short-term threat to the dollar’s place in the international monetary system. But the U.S. itself could undermine that status, and a potential opening may spur Chinese efforts to establish a firmer basis for the use of its currency, just as it has done in international trade in the wake of the demise of the Trans-Pacific pact. The transition could take decades, and during that period the global system could disintegrate into regional alliances that encourage unstable trade and financial flows. Those in the U.S. who voted for change may rue the consequences of President-elect Trump’s efforts to deliver on that electoral promise.

China’s Vulnerable External Balance Sheet

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China’s capital outflow last year is estimated to have totaled $1 trillion. Money has been channeled out of China in various ways, including individuals carrying cash, the purchase of foreign assets, the alteration of trade invoices and other more indirect ways. The monetary exodus has pushed the exchange rate down despite a trade surplus, and raised questions about public confidence in the government’s ability to manage the economy. Moreover, the changes in the composition of China’s external assets and liabilities in recent years will further weaken its economy.

Before the global financial crisis, China had an external balance sheet that, like many other emerging market economies, consisted largely of assets held in the form of foreign debt—including U.S. Treasury bonds—and liabilities issued in the form of equity, primarily foreign direct investment, and denominated in the domestic currency. This composition, known as “long debt, short equity,” was costly, as the payout on the equity liabilities exceeded the return on the foreign debt. But there was an offsetting factor: in the event of an external crisis, the decline in the market value of the equity liabilities strengthened the balance sheet. Moreover, if there were an accompanying depreciation of the domestic currency, then the rise in the value of the foreign assets would further increase the value of the external balance sheet. and help stabilize the economy.

After the crisis, however, there was a change in the nature of China’s assets and liabilities. Chinese firms acquired stakes in foreign firms, while also investing in natural resources. The former were often in upper-income countries, and were undertaken to establish a position in those markets as much as earn profits. Many of these acquisitions now look much less attractive as the world economy shows little sign of a robust recovery, particularly in Europe.

Moreover, many of these acquisitions were financed with debt, including funds from foreign lenders denominated in dollars. Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated that Chinese borrowing in dollars, mostly in the form of bank loans, reached $1.1 trillion by 2014. The fall in the value of the renminbi raises the cost of this borrowing. Menzie Chinn points out that if the corporate sector’s foreign exchange assets are taken into account, then the net foreign exchange debt is a more manageable $793 billion. But not all the firms with dollar-denominated debt possess sufficient foreign assets to offset their liabilities.

Declines in the values of the foreign assets purchased through Chinese outward FDI combined with an increase in the currency value of foreign-held debt pushes down the value of the Chinese external balance sheet. This comes at a time when the Chinese central bank is using its foreign exchange assets to slow the decline of the renminbi. The fall in reserves last year has been estimated to have reached $500 billion. Moreover, foreign firms and investors are cutting back on their acquisition of Chinese assets while repatriating money from their existing investments. China’s external position, therefore, is deteriorating, albeit from a strong base position.

Policymakers have a limited range of responses. They are tightening controls on the ability of households and companies to send money abroad, as the head of the central bank of Japan has urged. But controls on capital outflows are often seen as a sign of weakness, and do not inspire confidence. Raising interest rates to deter capital outflows would only further weaken the domestic economy, and may not work. Such moves would be particularly awkward to defend in the wake of the IMF’s inclusion of the Chinese currency in the basket of currencies that the IMF’s Special Drawing Rights are based on.

China’s remaining foreign exchange reserves and trade surplus allow policymakers some breathing room, as Menzie Chinn points out. The Chinese authorities retain a great deal of administrative control over financial transactions.  As policy officials are shuffled around, those still in office seek to reassure investors that the economy remains in good shape. But injecting more credit into the economy does not alleviate concerns about mounting debt. The economic measures promised by the leadership are being judged in the financial markets, and the verdict to date seems to be one of little or no confidence.

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

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

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

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

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

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

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

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

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

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

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 Continuing Dominance of the Dollar: A Review of Cohen’s “Currency Power”

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Every year I choose a book that deals with an important aspect of globalization, and award it the Globalization Book of the Year, also known as the “Globie.” Unfortunately, there is no cash prize to go along with it, so recognition is the sole award. Previous winners can be found here and here.

The winner of this year’s award is Currency Power: Understanding Monetary Rivalry by Benjamin J. Cohen of the University of California: Santa Barbara. The book deals with an issue that is widely-discussed but poorly-understood: the status of the dollar as what Cohen calls the “top currency.” The book’s appearance is quite timely, in view of the many warnings that China’s currency, the renminbi (RMB), is about to replace the dollar (see, for example, here).

Cohen proposes a pyramid taxonomy of currencies. On the top is the “top currency,” and in the modern era only the pound and dollar have achieved that status. The next level is occupied by “patrician currencies,” which are used for cross-border purposes but have not been universally adopted. This category includes the euro and yen, and most likely in the near future the RMB. Further down the pyramid are “elite currencies” with some international role such as the British pound and the Swiss franc, and then “plebeian currencies” that are used only for domestic purposes in their issuing countries. Below these are “permeated currencies” which face competition in their own country of issuance from foreign monies that are seen as more stable, “quasi-currencies” that have a legal status in their own country but little actual usage, and finally at the base of the pyramid are “pseudo-currencies” that exist in name only.

Cohen points out that not too long ago the euro was seen a competitor for the dollar as a “top currency.” The euro’s share of the publicly known currency composition of central banks’ foreign exchange reserves has fluctuated around 25% in the last decade, and its share of the international banking market is higher. But Cohen believes that the relative position of the euro may have peaked due to its inability to devise a way to deal with fiscal imbalances among members of the Eurozone.

Cohen compares the Eurozone’s institutional framework with that of the U.S., which adopted a common currency early in its history. The U.S. system includes fiscal transfers (“automatic stabilizers”) between the federal government and the states but no bailout of a state government in fiscal distress, accompanied by balanced budget restrictions in most states. The European Union’s (EU) Stability and Growth Pact put a limit on the budget deficits of its members and their debt, and was followed by the European Fiscal Compact that mandates balanced budget regulations in national laws. But resistance to the EU’s oversight of national budgets has been widespread. Moreover, the European Stability Mechanism, the EU’s instrument to assist members in financial crisis, is still a work in progress, as the lack of resolution of the Greek debt crisis demonstrates. While the size of the Eurozone ensures the wide usage of the euro and a role as a “patrician currency,” the inability of its member governments to decide on how to handle fiscal governance ensures that it will never rival the dollar.

China does not face the problem of unruly national governments, although the finances of local governments are shaky. The RMB has become more widely used in international commerce, not a surprising development in view of the rise of China as a global trading nation. The IMF is considering the inclusion of the RMB with dollars, euros, pounds and yen in the basket of currencies that comprise the IMF’s own unit of value, the Special Drawing Right. The Chinese government sees the upgrade in the status of the RMB as a confirmation of that country’s ascent in economic status.

But Cohen cautions against interpreting the increasing use of the RMB in trade as a precursor to the widespread adoption of the RMB as a global currency. He points out that there are private functions as well as official roles of an international currency, including its use for foreign exchange trading and financial investments. The RMB is not widely used for financial transactions, in part due to barriers to the foreign acquisition of Chinese securities, while the size of Chinese financial markets, while growing, is limited. Eswar Prasad and Lei Ye of Cornell reported in 2012 that “China still comes up short when it comes to the key dimensions of financial market development, and financial system weaknesses are likely to impede its steps to heighten the currency’s international role.”

Moreover, the government’s response this summer to the volatility in its stock markets was seen as heavy-handed. Cohen questions whether the Chinese government is willing to relinquish its control of the financial sector, despite its desire to promote the international use of the RMB. Capital flight would be a threat to stability and a sign of the government’s loss of legitimacy.

Cohen concludes his insightful analysis with a prediction that “Well into the foreseeable future, the greenback will remain supreme.” The U.S. currency continues to have widespread usage for many purposes. But any sort of triumphalism would be short-sighted. A recent working paper by Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated the amount of dollar-denominated credit outside the U.S. at about $9 trillion. A rise in the cost of borrowing in dollars will be passed on to the foreign borrowers, which will further slow down their economies. The decision in September of the Federal Open Market Committee to delay raising interest rates reflected its concern about the global economy, which complicates its ability to use monetary policy for domestic goals. The U.S. can not ignore the feedback between the international roles of the dollar and its own economic welfare. Great responsibility comes with great power.