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The Costs of the Defragmentation of the Global Economy

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The integration of markets across borders has slowed down, and in some cases, reversed. These changes come in the wake of the global financial crisis, Donald Trump’s embrace of trade restrictions, Great Britain’s withdrawal from the European Union, the disruptions in global supply chains during the pandemic, and the invasion of Ukraine. President Biden has shown a willingness to use trade and financial restrictions in response to what he views as Chinese and Russian threats to U.S. strategic interests, and there are responses to the use of sanctions and other tools of disruption. The fallout from this rift will take years to play out.

A team of IMF economists have written a Discussion Note on Geoeconomic Fragmentation and the Future of Multilateralism. They attribute the reversal of economic integration to national considerations, such as the desire of governments to increase their domestic production capabilities in particular areas. But the authors of the Note point out that while fragmentation may achieve some goals, it also imposes costs. These include: “higher import prices, segmented markets, diminished access to technology and to both skilled and unskilled labor, and ultimately reduced productivity which may result in lower living standards.” Moreover, fragmentation will slow down joint efforts to address global issues such as climate change.

The Discussion Note summarizes the results of several studies of the loss from geoeconomic fragmentation. In all the studies they cite, the costs are greater the larger the degree of fragmentation. Among the reasons for the losses in output are reduced knowledge diffusion due to technological decoupling. Not surprisingly, low income and emerging market countries are most at risk from a separation from the latest technological developments.

Pinelopi K. Goldberg of Yale and Tristan Reed of the World Bank Group (Goldberg is former chief economist of the World Bank) examine the prospects for global trade in their recent NBER Working Paper “Is the Global Economy Deglobalizing? And if so, why? And what is next?” They find that “slowbalization” is a better description of the recent trend in international trade than “deglobalization.” Foreign direct investment and migration have exhibited relatively less slowdowns. But the authors also document changes in U.S. policies and public attitudes that represent a marked shift away from the liberalization of trade. They attribute these reversals to various factors, including the impact of imports on U.S. labor, concerns over the resilience of global supply chains, and national security considerations.

Goldberg and Reed conclude their analysis with some projections of the consequences of deglobalization. They point out that the previous regime of the last three decades led to growth and technological progress They warn that global innovation will be particularly slowed by a decoupling of the U.S. and China  Reconfiguring production supply chains will slow growth as well. These reversals and changes raise the possibility that the recent decline in global inequality will halt, with low-income countries most at risk.

Trade, of course, is not the only component of international commerce that has undergone changes in how it is organized. Chapter 4 of the IMF’s most recent World Economic Outlook analyses the geoeconomic fragmentation of FDI. The authors point to an increase in the “reshoring” and “friend-shoring” of production facilities domestically or to countries with similar political alignments. They estimate a model of the impact of geopolitical alignment on FDI flows, and find that geopolitical factors account for part of the shift in bilateral FDI to countries with governments with similar views to the home country. This could presage a shift to more FDI among advanced economies, rather than emerging markets and developing economies that may differ on political issues.

The Fund’s economists also analyzed the output costs of FDI fragmentation. They utilized different scenarios of geopolitical alignment, such as a world divided into a U.S.-centered block and a China-centered block, with India and Indonesia and Latin America and the Caribbean as nonaligned. In this scenario, the impact of smaller capital stocks and less productivity cumulate with long-term output losses of 2%. Other scenarios allow for the diversion of investment flows to some areas that could offset a decline in global economic activity. However, the chapter’s authors also warn that nonaligned nations may face pressures to choose one side over the other. They conclude from their analysis: “…a fragmented global economy is likely to be a poorer one. While there may be relative—and possibly absolute—winners from diversion, such gains are subject to substantial uncertainty.”

Other forms of capital flows are also subject to fragmentation, and the IMF’s economists examine these trends is a chapter of the latest Global Stability Report. In their analysis, geopolitical tensions can lead to instability through two channels. The first is a financial channel that could respond to increased restrictions on capital flows, greater uncertainty or conflict. The second channel is a real channel, due to disruptions in trade and technology transfers or volatile commodity markets. These two channels can reinforce each other. Restrictions in trade, for example, could discourage cross-border investments.

Geopolitical affinities affect cross-border capital allocation, and the evidence reported in the chapter indicates that recent events have reinforced this impact. The empirical analysis based on a gravity model finds that a rise in geopolitical tensions can trigger sizable portfolio and bank outflows, particularly in developing and emerging market economies. Geopolitical fragmentation can also lead to a loss in international risk diversification, thus leaving countries more vulnerable to adverse shocks and a sizable welfare loss.

All these analyses from multilateral institutions warn of the negative economic consequences arising from the decoupling of trade and financial ties. But the most threatening effects may come from the deepening division of the world into different blocs. As the dividing lines become solidified, the chances of discord extending beyond economic interactions increase. All this friction arising when climate warming already poses a clear threat to our existence only intensifies the dangers we will face.

China and the Debt Crisis

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Sri Lanka is not the first developing economy to default on its foreign debt, and certainly won’t be the last. The Economist has identified 53 countries as most vulnerable to a combination of “heavy debt burdens, slowing global growth and tightening financial conditions.” The response of China to what will be a rolling series of restructurings and write-downs will reveal much about its position in the 21st century international financial system.

Debt crises are (unfortunately) perennial events. In the 1970s many developing countries, particularly in Latin America, borrowed from international banks to pay energy bills that had escalated after oil price increases enacted by the Organization of Petroleum Countries (OPEC). Repaying those loans became more difficult after the Federal Reserve raised interest rates in 1979 to combat U.S. inflation. Mexico announced that it could no longer make debt payments in August 1982, and other governments soon followed (see here for more detail).

The U.S. government supported negotiations that brought together the governments unable to make payments, the banks that had made the loans, and the International Monetary Fund. The banks were willing to restructure the debt while the IMF lent funds to the governments that allowed them to keep up their interest payments while staving off acknowledging their inability to pay off the debt. But this only delayed a final resolution of the crisis and led to a “lost decade” in Latin America. In 1989 Secretary of the Treasury Nicholas Brady proposed a plan that led to reductions of the loan principals in return for the issuance of “Brady bonds” by the debtor governments.

The U.S. allowed the IMF to take the lead during subsequent crises, including the East Asian crisis of 1997-98, Russia in 1998 and Argentina in 2000. As the member with the largest quota, the U.S. could influence the design and implementation of the IMF’s programs. It also took a more active role when U.S. interests were directly affected, as it did with Mexico in 1994-95. While U.S. attention was focused on its own crisis in 2008-09, the IMF took on the task of lending to middle- and low-income countries that were caught up in the economic shock waves of the financial collapse. The Federal Reserve, however, established currency swap lines with the central banks of other advanced economies as well as those of four emerging markets: Brazil, South Korea, Mexico and Singapore.  The Fed reactivated the swap lines in March 2020 in response to the disruption in international credit markets caused by the pandemic and also set up a new facility to provide dollar funding to foreign official institutions.

China has taken a different position with regards to the debt of developing nations. Its state-owned banks have made bilateral loans as part of the Belt and Road initiative, with many of these loans made to African governments for infrastructure projects. But the amount of lending and the terms have not always been made transparent. Sebastian Horn of the University of Munich, Carmen Reinhart, currently Chief Economist at the World Bank while on leave from Harvard University’s Kennedy School, and Christoph Trebesch of the Kiel Institute for the World Economy developed a database of Chinese lending over the period of 1949-2017 which they published in a 2021 NBER paper, “China’s Overseas Lending.” They found “…that a substantial portion of China’s overseas lending goes unreported and that the volume of “hidden” lending has grown to more than 200 billion USD as of 2016.” Another study from AidData, a research lab at William & Mary, also documented Chinese lending to low- and middle-income countries, and found that many loans are collateralized against future commodity export receipts.

Some of these loans have already been restructured, with China pushing back repayment dates. If there is a systemic wave of defaults, the Chinese government must decide whether it will continue to negotiate directly with the governments that borrowed, or whether it will join the governments that belong to the Paris Club, a group of official creditors that attempt to devise sustainable solutions to debt problems, in designing a mechanism to reduce the volume of debt.

In 2020, the Group of 30 working with the IMF and the World Bank instituted the Debt Service Initiative (DSSI), which suspended debt service payments from low-income countries to official creditors, including China. Forty-eight countries participated in the program, which ended in December 2021.  The DSSI has been followed by the Common Framework, which brings together official creditors and low-income borrowers to provide some form of assistance to insolvent nations. However, private lenders have not agreed to participate and only three nations have requested relief through the Common Framework. There are concerns about the process, and there will undoubtedly be calls for broad-based debt cancellation as countries with mounting food and energy bills seek relief.

The decisions that China makes regarding its participation in new initiatives have implications for its future role in the international financial system. The government has sought to enhance the role of its currency, the renminbi, and its share in the foreign exchange reserves of central banks has risen as trade with China has grown. Serkan Arslanalp of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have documented the decline in the relative share of dollar-denominated foreign reserves and the increase in renminbi-denominated reserves in “The Stealth Erosion of Dollar Dominance and the Rise of Nontraditional Reserve Currencies” in the Journal of International Economics (working paper here). They find, however, that the changes in the composition of foreign reserves involve more than the Chinese currency, and show increases in the relative shares of the Australian dollar, the Canadian dollar, the Korean won, the Singapore dollar and the Swedish krona as wells. They attribute these changes in part to more active management of reserves by central bankers and also the existence of more liquid foreign exchange markets that facilitate non-dollar trading.

The use of the dollar-based international financial system as a financial weapon against Russia, including seizure of more than $300 billion of its central bank assets, could be an opportunity for another system to take its place, and there has been much speculation about the emergence of a Chinese-based rival. But Adam Tooze of Columbia University has pointed out that

“It (the dollar system) is a sprawling, resilient network of state-backed, commercially driven, profit-orientated transactions, lubricated by the easy availability of dollars, interwoven with American geopolitical influence, a repeated game in which intelligent players continuously gauge their advantages and disadvantages and the (very few) alternatives open to them and then, when all is said and done, again and again come back for more.”

A new system would take years to establish. Whether China’s government wants to allow its financial markets to become enmeshed in a global system by removing the remaining capital controls is unclear. The combination of drought, COVID-19 and its real estate crisis fully occupy the attention of the Chinese government. It may have to deal with a debt crisis among the developing nations however, and its response will be monitored for signs of how it sees its position within the global financial network of rules and institutions.

The Global Impact of the Fed’s Pivot on Asset Purchases

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Federal Reserve Chair Jerome Powell announced last month that the Fed would slow its purchases of bonds, most likely by the end of this year. The timing of the cutback will depend on several factors related to the economy, and last week’s disappointing employment report if repeated could push back the date. The financial markets will now begin anticipating the impact of the reduction in the Fed’s asset holdings.

The origins of the increase in the Fed’s holdings of Treasury bonds and mortgage-backed securites can be traced back to the global financial crisis. The Fed’s assets grew from $870 billion in August 2007 to $2 trillion in early 2009. When the Fed introduced its quantitative easing program, it claimed that the purchases of bonds would lead to lower long-term interest rates more quickly than if it relied only on lowering the Federal Funds rate. In addition, the purchases showed the Fed’s commitment to keeping interest rates low in order to boost the economic recovery. This latter form of signaling was called “forward guidance.”

Subsequent quantitative easing programs eventually raised its holdings to $4.5 trillion by 2015. The Fed maintained that level until 2018, when it allowed its holdings to fall as bonds matured. But it reversed course in 2019, and the Fed responded to the pandemic in the spring of 2020 by ramping up its purchases of assets in order to support the financial markets. Its asset holdings now total about $8.3 trillion.

The Fed has not been alone in using asset purchases as a tool of policy. The European Central Bank increased its holdings of bonds during the period preceding the pandemic from 2 trillion Euros at the end of 2014 to 4.6 trillion Euros. It accelerated its purchases last year and now holds about 8.2 trillion Euros in assets. The Bank of Japan and the Bank of England have their own versions of asset purchase programs. Many of these central banks have also announced changes in the pace of their asset purchases.

When then Fed chair Ben Bernanke noted in 2013 that continued strengthening of the economy could lead to a cutback in asset purchases, this was interpreted as a sign that the Fed would also allow interest rates to rise. This led to the infamous “taper tantrum,” as financial markets overreacted to the prospects of higher interest rates. The response included capital outflows from emerging market countries such as India as their exchange rates depreciated and their own asset markets fell in value. Stability was eventually reestablished once the Fed clarified that it had no plans to enact a contractionary policy, but the incident demonstrated the volatility of financial markets, particularly in the emerging market countries.

Powell has sought to avoid such an outcome by explicitly delinking asset purchases from interest rates. He pledged to keep the Federal Funds rate at its current setting until “maximum employment and sustained 2% inflation” area achieved. The (lack of a)  response in the financial markets to Powell’s speech seemed to indicate that this promise was seen as credible, despite concerns about inflation.

But there will be consequences when the Fed cuts back on its asset purchases. The increases in the Fed’s balance sheet, as well as those of the other central banks, released a wave of liquidity with wide-ranging consequences. In the U.S. it has kept stock price valuations at elevated levels, which contributes to widening wealth inequality. For example, in 2019 families in the top 10% of the income distribution owned 70% of total stock values. Similarly, the provision of easy credit has contributed to rising housing prices that also reflects demand and supply conditions.

The increase in liquidity also benefited emerging markets and developing economies. In the period immediately before the pandemic the World Bank warned that the world had experienced a rise in debt, both private and government. Total debt in the emerging markets and developing economies had risen from 114% of their GDP in 2010 to 170% at the end of 2018. Part of this increase reflected accommodative monetary policies in the advanced economies and a search for higher yield by investors in those countries. A rising global demand for the bonds of the emerging market and developing economies countries was met by an increase in their issuance.

These countries suffered massive reversals of foreign capital in the spring of 2020. The “sudden stops” confirmed the existence of a global financial cycle that can overwhelm vulnerable economies. But the withdrawals were soon reversed, in part because investors were reassured by the rapid responses of central banks in the advanced economies to the financial meltdown.

There are many who voice concerns about the ending of the current financial cycle. Mohammed El-Erian, president of Queens’ College of Cambridge University, is worried about the excessive risk-taking that the financial sector has undertaken in response to its “unhealthy codependency” with central banks.  Raghuram Rajan of the University of Chicago’s Booth School of Business is alarmed about the impact that future interest rate hikes could have on government finances. Jeremy Grantham of asset management firm GMO believes that the stock market will experience a massive crash. And IMF Managing Director Kristalina Georgieva is concerned about a diveregence in the prospects of advanced economies and a few emerging markets versus those of most developing economies that could lead to a debt crisis.

Much of the impact of the policy changes at the Federal Reserve depends on how the financial markets respond to the slowdown in purchases, and whether the Fed is successful in delinking a cutback in asset purchases from its interest rate policy. The lack of a strong response in the bond markets suggests that there has not been a change in expectations of future interest rates. But ouside the U.S. there is always the prospect that a slowdown in economic growth and the continuation of the pandemic imperil the solvency of corporate and government borrowers. These developments would be enough to fuel a debt crisis despite the Fed’s careful footwork.

Will A Rise in Interest Rates Lead to a New Debt Crisis?

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The question of when the Federal Reserve will begin to reverse its loose policy stance continues to be a topic of widespread speculation. At last month’s meeting of the Federal Open Market Committee, its members showed a willingness to cut back on asset purchases in 2022 and to raise interest rates in 2023, but kept monetary policy on its current setting due to slower growth in employment than desired. The latest inflation reading may bring forward the Fed’s tightening measures. If and when interest rates do rise in the U.S. and other advaneced economies, what will be the impact for holders of foreign assets?

There is a split in opinions on the vulnerability of emerging market economies (EMEs) to rising interest rates. In an interview with Finance & Development, Richard House of Allianz Global Investors and David Lubin of Citibank played down the chances of a disruption of foreign markets when the Federal Reserve begins its reversal. They cite the increase in foreign exchange reserves and the decrease in the number of countries with fixed exchange rates as reasons why systemic crises can be avoided. In the same issue, however, Şebnem Kalemli-Özcan of the University of Maryland points out that country-dependent risk will affect the response to a new external environment. Many EMEs used monetary policy to finance their fiscal spending in response to the pandemic. There is a concern that their bond purchases and monetary creation could lead to higher inflation that will raise the cost of new financing at the same time as the U.S. is raising its interest rates.  

The author of the Buttonwood column of The Economist, however, notes that the central banks in several EMEs have already raised their policy rates in response to concerns of rising inflation following currency depreciations. Higher rates attract capital from foreign investors looking for higher yields, which strengthens the currency. An appreciating currency keeps down import prices and inflation in check.

Jasper Hoek and Emre Yoldas of the Federal Reserve Board and Steve Kamin of the American Enterprise Institute show that the response of emerging market economies to rising U.S. interest rates will depend in part on the reasons for the increase. If rates rise because of favorable economic growth in the U.S., then the EMEs should benefit from the increase in U.S. demand for their goods and increased investor confidence. If, on the other hand, the higher rates are due to higher inflation that requires a marked tightening of the U.S. policy stance, then interest rates on the debt of EME issuers will rise as their currencies fall in value.

The response to the pandemic in the EMEs is the biggest challenge those nations face.  While firms in the U.S. and Europe are busy meeting surging consumer demand, the virus continues to spread in Africa, South American and South Asia. The response in advanced economies to a recovery that brings with it higher inflation may threaten the ability of the EMEs’ policymakers to maintain their accommodative stance. Agustín Carstens, General Manager of the Bank for International Settlements, warns: “… it could be hard for EME policymakers to maintain accommodative policy stances should global financial conditions tighten materially. But tighter policy will make economic recovery even more difficult.”

The record of responses to Federal Reserve policy retrenchment is not encouraging. In May 2013, then Fed Chair Ben Bernanke responded to a question at a Congressional committee meeting about future Fed policy by noting that “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases.” This innocuous remark led to turbulence in the financial markets, which became known as the “taper tantrum.” Increases in the Federal Funds Rate in 2018 under Fed Chair Jerome Powell met widespread criticism and concerns about their impact on slow economic growth, and the Federal Reserve reversed course in 2019.

Economists can always provide well-reasoned narratives as to how and why financial markets respond to events. Unfortunately, market volatility is almost always unanticipated. No matter how careful policymakers are with their statements, there is the potential for an unforeseen response. The continuation of the pandemic heightens the uncertainty, and the current elevated levels of stock prices and the increase in debt leaves asset markets vulnerable to a “Minsky moment” when an initial reversal leads to a demand for liquidity and cascading falls in financial markets. The EMEs will become part of the collateral damage of such a collapse.

2020 “Globie”: The Carry Trade

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It is time to announce the recipient of this year’s “Globie”, i.e., the Globalization Book of the Year. The award gives me a chance to draw attention to a book that is particularly insightful about some aspect of globalization. This year’s winner is The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee and Kevin Coldiron. The prize lacks any monetary reward, but no doubt the distinction of having won has value in itself. Previous winners are listed at the bottom.

The classic carry trade involves borrowing and investing in different currencies. For many years the Japanese yen served as the source of cheap loans that could then be exchanged for Australian dollars that yielded a higher return. At the end of the period the dollars would be exchanged for yen, and the loan repaid. As long as the funding currency had not appreciated in value, the trader would profit from the difference in returns. A profitable carry trade, however, violates uncovered interest rate parity, which stipulates that any difference in returns should be offset by an expected appreciation of the funding currency. At times the currencies would realign, and purchasing the originating currency to repay the loan could eliminate any previous gains.

The authors extend the concept of carry trades to include all those transactions that provide a stream of income but are subject to the risk of “…a sudden loss when a particular event occurs or when underlying asset values change substantially.”  Since carry transactions are based on borrowing, leverage is a key component. Buying stock on margin, for example, is another form of carry trade, as is a private equity leveraged buyout.

The trader benefits only as long as asset prices remain close to their current levels. Volatility can wipe out a position, and the financial losses can spill over to the economy. Those negative consequences bring central banks into the financial markets. Their intervention may reestablish stability, but it allows those who would have suffered a loss to transfer that loss to the public sector. Central bankers acting as lenders of last resort, the authors write, “…underwrite some of the losses associated with carry. This encourages further growth of carry, and a self-reinforcing cycle develops.”

The authors investigate the spread of carry trade and its broad scope, including the transformation of global financial markets. Firms in emerging markets use capital markets to obtain finance from cheaper foreign sources. Changes in the VIX measure of volatility have international reverberations and engender global financial cycles.The Federal Reserve’s use of swap facilities to help their counterparts in other countries assist domestic institutions that face a dollar liquidity squeeze demonstrates that carry crashes require global responses.

The authors also claim that the carry trade increases income and wealth inequality, as only those with sufficient assets engage in carry and profit from central bank intervention.  The continuing returns from these transactions flow to those who know how the system works and how to exploit it. These rewards act as an incentive to draw more people to finance, contributing to the growth of the financial sector.

The book was written before the events of this year, but the analysis is very relevant. In March, financial markets crashed as the global extent of the pandemic became evident. Stock prices plunged and foreign capital fled emerging markets. This outbreak of volatility engendered a massive response by the Federal Reserve that dwarfed their actions in the 2008-09 crisis (see here and here for overviews of central bank policies). The markets responded by regaining lost ground, and the Standard & Poor’s 500 has set new highs.

After the latest meeting of the Federal Open Market Committee, the Federal Reserve reiterated its pledge to keep  the target range for the Federal Funds Rate at 0 to ¼% “…until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” The Fed’s commitment to low interest rates provides an incentive for more carry trade activities, and these are appearing. Special Purpose Acquisition Company (SPACS), for example, are pools of money that are established to purchase privately-held firms and take them public, profiting from the IPO price. The SPACS investors do not know which company will be acquired or when, and they may not realize a return for years. But they are providing liquidity, and at minimal cost due to the Federal Reserve’s interest rate policy.

Lee, Lee and Coldiron convincingly demonstrate that the carry trade has contributed to the financialization of the economy, which has grave and disturbing implications. As the subtitle of the book indicates, the suppression of volatility leads to lower growth and recurring crises. When a vaccine for the coronavirus is available, there will undoubtedly be a burst of financial activity that will prepare the way for the next crisis. We will not be able to say that we were never warned.

An interview with the authors is available on the podcast Hidden Forces.

2019    Branko Milanovic, Capitalism Alone: the Future of the System That Rules the World

2018    Adam Tooze,  Crashed: How a Decade of Financial Crises Changed the World

2017    Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic, Global Inequality

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

The True Owners of Foreign Capital

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

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

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

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

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

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

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

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

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

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

The Long Reach of U.S. Monetary Policy

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

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

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

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

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

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

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

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

The Exorbitant Privilege in a World of Low Interest Rates

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The U.S. dollar has long enjoyed what French finance minister Valéry Giscard d’Estaing called an “exorbitant privilege.”  The U.S. can finance its current account deficits and acquisition of foreign assets by issuing Treasury securities that are held by foreign central banks as reserves. The dollar’s share of foreign reserves, while falling, remains over 60%.  But in a world of low interest rates, how exorbitant is this privilege, and is it solely a U.S. phenomenon?

John Plender of the Financial Times has pointed out that U.S. Treasury bonds offer a rate of return that matches or is higher than that of other government bonds with similar risk ratings.  This is true whether we look at nominal returns or real rates of return. The nominal returns reported below are those available on the ten-year government bonds of Germany, Japan, the U.K. and the U.S., while the changes in prices are those reported for their Consumer Price Indexes :

 

Nominal Return Change in Prices Real Return
Germany -0.05% 2.0% -2.05%
Japan -0.06% 0.5% -0.56%
U.K. 1.13% 1.9% -0.77%
U.S. 2.47% 1.9% 0.57%

 

The bonds of other advanced economies offer higher yields but more risk. The rate of return on ten-year Italian government bonds is 2.68% and on Greek bonds 3.49%. An investor in government bonds can do better in Brazil (8.76%) or Mexico (8.09%), but these securities also come with the risk of depreciation.

Private foreign investors also hold U.S. Treasury debt as well as U.S. corporate securities. John Ammer of the Federal Reserve Board (FRB) , Stijn Claessens of the Bank for International Settlements (BIS), Alexandra Tabova (FRB) and Caleb Wroblewski (FDB) analyzed the foreign private holdings of U.S. bonds in “Home Country Interest Rates and International Investment in U.S. Bonds,” published in the  Journal of International Money and Finance in 2018 (working paper here). They collected data for 31 countries where private residents held both U.S. Treasury securities and corporate bonds during the period of 2003-2016.  They found that low domestic interest rates led to increased holdings of U.S. bonds, and in particular, corporate securities. The corporate share of foreign-held U.S. securities in these countries had risen to about 60% by the end of their sample period.

The “long equity, short debt” structure of the U.S. external balance sheet is not unique to the U.S. Robert McCauley of the BIS in “Does the US Dollar Confer an Exorbitant Privilege?”, also published in the JIMF in 2015, shows that foreign holdings of Australian government bonds have allowed that country to accumulate foreign currency assets. Some of these holdings were attributed to the desire of foreign central banks to hold safe and liquid assets.

U.S. Treasury securities possess an appeal besides their relatively attractive rates of return in a world of low interest rates. They are seen as safe assets, and given the size of the U.S. economy and the liquidity of its capital markets, it is not surprising that they hold a predominant role in the global financial system. But Pierre-Olivier Gourinchas of UC-Berkeley, Hélène Rey of the London Business School and Maxime Sauzet of UC-Berkeley have pointed out in “The International Monetary and Financial System” (NBER Working paper #25782) that the mounting size of the eternal debt of the U.S. may lead to a loss of confidence in the U.S. government’s ability to service it without engaging in inflationary finance or triggering a depreciation of the dollar. At the same time, the relative size of the U.S. economy in global output is shrinking while the demand for dollar liquidity is growing. They conclude that this may be the basis of a “New Triffin Dilemma.”

There is, however, another, more immediate danger. The U.S. reached its debt ceiling of $22 trillion on March 2. The Department of the Treasury can engage in various measures to continue paying the government’s bills until next fall. The White House wants to obtain a rise in the debt ceiling this spring before it has to engage in budget negotiations with Congress. But given the toxic relations between the Trump administration and the House of Representatives, the danger of a lack of agreement cannot be dismissed. The Trump administration promised to disrupt the global order, and the full extent of that disruption may have only begun.

Searching for Stimulus

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The global economy seems headed for a slowdown. The IMF now expects global growth this year of 3.3%, a drop of 0.2 of a percentage point from its previous forecast. Growth in the advanced economies is projected to be particularly feeble, with expected U.S. economic growth of 2.2%, growth of 1.3% predicted for the Eurozone , and Japan’s growth anticipated to be 1%. Of course, a breakdown of U.S.-China trade talks, the imposition of new U.S. tariffs on European cars or a disorderly Brexit could disrupt the forecasts. Can government policymakers improve these conditions?

Central banks have limited policy space. In the U.S., the Federal Reserve has made clear that it does not expect to raise the Federal Funds rate this year, and retains the option of lowering it if conditions deteriorate. Some–including one of President Trump’s anticipated nominees to the Board, Stephen Moore–are already calling for lower rates. But the current Federal Funds rate of 2.5% does not give the central bank much scope for lowering it.  Japan’s central bank already has negative nominal rate targets, while the European Central Bank’s policy rates include a lending rate of zero percent and a negative deposit facility return.

If monetary policy is constrained, what else can policymakers do? Adair Turner, former chair of the United Kingdom’s Financial Services Authority, believes that zero interest rates means that the time has come for “massive fiscal expansion” financed by central banks. He acknowledges that excessive monetary growth can be harmful. But, he argues, when faced with “slow growth, political discontent and large inherited debt burdens…”, policy measures that in other times would be seen as radical need to be considered.

Martin Wolf of the Financial Times is also concerned about the current low interest rates, which he attributes to secular stagnation. He believes that the low rates have created a disinflationary debt overhang, and calls for the use of fiscal policy to supplement private demand. Similarly, Mohammed El-Erian of Allianz points to Japan’s continued low growth as evidence of the limitations of monetary policy. He calls for looser government budgets that raise productivity through spending on education and infrastructure.

The recent record of increased deficits in the U.S. gives some guidance on the impact of a fiscal stimulus. Lower taxes did increase GDP growth in 2018, but the effect has faded and GDP is returning to its trend growth. Corporate taxes also declined, and as a result, the budget deficit widened. The Congressional Budget Office has forecast that the budget deficit will increase from 3.5% of GDP in 2017 to 5.4% in 2022, and the impact on the budget will persist.

The borrowing required to finance these deficits will reinforce the U.S. position, along with Japan and China, as one of the largest debtor nations. As in Japan, government debt represents a significant amount of U.S. total debt. The U.S. stands out, however, for increasing government debt during an expansionary phase of the business cycle when ordinarily debt shrinks. Other advanced economies have used this opportunity to lower their debt burdens.

Olivier Blanchard, former chief economist of the IMF, spoke about government borrowing at this year’s meetings of the American Economics Association. He pointed out that the ratio of debt to GDP need not rise as long as the growth rate of GDP exceeds the interest rate on government debt. That condition has been met since the 19th century  except during the decade of the 1980s. Moreover, the “crowding out” of private investment is less of a concern in a world of low interest rates.

There is one other aspect of fiscal expansion that should be considered: the impact on a country’s current account, and the impact on other countries. Menzie Chinn of the LaFolette School of Public Affairs at the University of Wisconsin and Hiro Ito of Portland State University have investigated the determinants of global imbalances. Using data from 24 industrial and 138 developing countries between 1972 and 2016, they report: “Fiscal factors determine imbalances, and have accounted for a noticeable share of the recent variation in imbalances, including in the U.S. and Germany.” In the group of industrial countries, a one percentage point increase in the deficit scaled by GDP leads to a 0.42% increase in the current account deficit, similarly scaled.  A significant part of the fiscal expansion, therefore, is transmitted to the rest of the world.

If advanced economies do share low growth rates and constrained monetary policies in common, then a coordinated fiscal expansion may be the best way of generating growth amongst them. But the record on fiscal coordination is, at best, mixed. All the members of the Group of Twenty enacted stimulus policies of different magnitudes during the global financial crisis. However, an earlier agreement in 1978 by Japan and Germany to enact expansionary fiscal measures while the U.S. decontrolled energy prices did not turn out so well. The German fiscal stimulus coincided with the second oil price shock of the decade, but the former was blamed for the subsequent increase in inflation. This experience confirmed German views of the futility of discretionary policies.

The chances, therefore, of a coordinated fiscal expansion among the advanced economies in the absence of another global shock are low. If this means that we do not have temporary surges in growth fueled by lower tax rates, then the long-run cost is low. But all the calls for fiscal policy cited above are for spending measures that would boost productivity. In the long-run, growth will only return if productivity increases, as it did in the 1990s in the U.S. In addition, any tax cuts should be designed to benefit those who have not shared in the gains of globalization. The largest increases in income in the U.S. have accrued to those in the upper tiers of the income distribution. Those below deserve a stimulus that actually benefits them.

Partners, Not Debtors: The External Liabilities of Emerging Market Economies

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My paper,  “Partners, Not Debtors: The External Liabilities of Emerging Market Economies,” has been published in the January 2019 issue of the Journal of Economic Behavior & Organization.

Here is the abstract:

This paper investigates the change in the composition of the liabilities of emerging market countries from primarily debt (bonds, bank loans) to equity (foreign direct investment, portfolio) in the decades preceding the global financial crisis. We examine the determinants of equity and debt liabilities on external balance sheets in a sample of 21 emerging market economies and 20 advanced economies over the period of 1981-2013. We include a new measure of domestic financial development that allows us to distinguish between financial institutions and financial markets. Our results show that countries with higher economic growth rates have larger amounts of equity liabilities. The development of domestic financial markets is also linked to an increase in equity liabilities, and in particular, portfolio equity. In addition, larger foreign exchange reserves are associated with larger amounts of portfolio equity. FDI liabilities are more common when domestic financial institutions are not well developed.

The publisher, Elsevier, provides a link to provide free access to the paper for 50 days. You can find it here:

https://authors.elsevier.com/a/1YoqV_3pQ3g~6e