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Capital Flows in a World of Low Interest Rates

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Interest rates in advanced economies continue to persist at historically low levels. This trend is due not only to the response of central banks to slow growth, but also fundamental factors. If these interest rates continue close to their current levels, what are the consequences for international capital flows?

The decline in rates in the advanced economies has been widely documented and studied. Lukasz Rachel and Thomas D. Smith of the Bank of England have investigated the determinants of the fall in global real interest rates. They attribute the decline in part to increased savings due to demographic forces, higher inequality and a glut of precautionary savings in emerging markets. Investment spending, which has fallen due to the falling price of capital and lower public investment, also contributes to low interest rates. Most of these factors, they claim, will continue to prevail.

Lukasz Rachel and Larry Summers of Harvard have also looked at falling real rates in the advanced economies, which they attribute to secular stagnation. They point out that since the current rates reflect higher levels of government debt, the interest rate that we would observe if there was only a private sector would be even lower. They urge policymakers to tolerate fiscal deficits and also to engage in policies to increase private investment.

The low rates have been an incentive to potential borrowers, and consequently debt levels have risen. The IMF has updated its Global Debt Database,  which includes private and public debt for 190 countries dating back to the 1950s. The data show that the three currently most indebted countries are China, Japan and the U.S., accounting for more than half of global debt. The increase in the debt of China and other emerging markets is due to increases in private debt. Corporate borrowing in these countries has soared, and much of it is denominated in dollars. Public debt has risen in the advanced economies, and more recently in the emerging market and low-income countries as well.

Last spring IMF Managing Director Christine Lagarde warned of unsustainable debt burdens in some of the low income countries. In recent years, the borrowers have included governments with relatively low risk ratings that may fall lower. In some cases, the increased debt reflects loans from China that are part of that country’s Belt and Road Initiative. IMF officials are concerned that some of these countries will turn to the IMF for assistance of they cannot meet their debt obligations.

The Federal Reserve has indicated that it will not raise its policy rates in the near future.  Consequently, the incentive to search for yield will continue to contribute to the pro-cyclical nature of capital flows in the emerging markets. But the current situation is sustainable for only as long as the existing environment continues.

Martin Wolf of the Financial Times has warned that it is only a matter of time until the next financial crisis erupts. He cites four factors that contribute to the outbreak of such crises. First, over time risk moves out of the most regulated parts of the economy to the least regulated. This makes it more difficult for regulators to assess the fragility of the financial sector. Second, an ideological belief that unregulated markets work best contributes to the proliferation of risky lending. Third, the financial sector is a major contributor to election campaigns. This gives them access to lawmakers who are drafting the laws that govern the operations of the financial sector. Finally, there is the human tendency to forget or ignore past events. This allows the financial sector to engage in risky but profitable activities that enrich those conducting them while the public enjoys access to relatively cheap credit.

Continuing low interest rates, therefore, may alleviate some of the pressure on those borrowers with high debt loads. But they are susceptible to other shocks such as slowing economic growth or the breakdown of trade negotiations between the U.S. and China. If such a shock occurs, we may once again witness a flight to safety that leaves borrowers in emerging markets vulnerable to “sudden stops” of capital that, combined with depreciating exchange rates, will disrupt their economies.

 

 

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

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

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

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

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

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

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

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

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

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

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

A Guide to the (Financial) Universe: Part III

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Parts I and II of this Guide appear here and here.

4.      Stability and Growth

Is the global financial system safer a decade after the last crisis? The response to the crisis by central banks, regulatory agencies and international financial institutions has increased the resiliency of the system and lowered the chances of a repetition. Banks have deleveraged and possess larger capital bases. The replacement of debt by equity financing should provide a more stable source of finance.

Indicators of financial volatility, such as the St. Louis Fed Financial Stress Index, currently show no signs of sudden shifts in market conditions. The credit-to-GDP gap, developed by the Bank of International Settlements (BIS) as an early warning indicator of systemic banking crises, exhibits little evidence of excessive credit booms. One exception is China, although its gap has come down.

But increases in U.S. interest rates combined with an appreciating dollar could change these conditions. Since the financial crisis, financial flows have appeared to be driven in part by a global financial cycle that is governed by U.S. interest rates as well as asset market volatility. This has led Hélène Rey of the London Business School to claim that the Mundell-Fleming trilemma has been replaced by a dilemma, where the only choice policymakers face is whether or not they should use capital controls to preserve monetary control. Eugenio Cerutti of the IMF, Stijn Claessens of the BIS and Andrew Rose of UC-Berkeley, on the other hand ,have offered evidence that the empirical importance of any such cycle is limited. Moreover, Michael W. Klein of Tufts University and Jay C. Shambaugh of George Washington University in one study and Joshua Aizenman of the University of Southern California, Menzie Chinn of the University of Wisconsin and Hiro Ito of Portland State University in another have found that flexible exchange rates can affect the sensitivity of an economy to foreign policy changes and afford some degree of policy autonomy.

A rise in U.S. rates, however, will increase the cost of borrowing in dollars. The volume of credit flows denominated in dollars reflects the continuing predominance of the dollar in international financial markets. Dollar-denominated credit to emerging market economies, for example, rose by 10% in 2017, driven primarily by a rise in the issuance of debt securities. Higher interest rates, a depreciating currency and a deteriorating international trade environment can quickly downgrade the creditworthiness of emerging market borrowers.

Other potential sources of stress remain. One of these is the lack of adequate “safe assets,” which serve as collateral for lending. U.S. Treasury bonds are utilized for this purpose, but in the run-up to the global crisis mortgage-based securities (MBS) with the highest ratings also served that function. Their disappearance leaves a need for other privately-provided safe assets, or alternatives issued by the international public agencies. Moreover, doubts about U.S. fiscal solvency could lead to doubts about the creditworthiness of the U.S. government securities.

Claudio Borio of the BIS perceives another flaw in the international monetary system: “excess financial elasticity” that contributes to financial imbalances. The procyclicality of finance is heightened during boom periods by capital inflows, and the spread of easy monetary conditions in core countries to the rest of the world is facilitated through monetary regimes. The impact of the regimes includes the decision of policymakers to resist currency appreciation which affects their interest rates, and the role of dominant currencies such as the dollar. Borio calls for greater international cooperation to mitigate the volatility of the financial cycle.

Dirk Schoenmaker of the Duisenberg School of Finance and VU University Amsterdam has drawn attention to a fundamental tension within the international system. He suggests that there is a financial trilemma, with only two of these three characteristics of a financial system as feasible: International financial integration, national financial policies and financial stability. A nation that wants to enjoy the benefits of cross-border capital flows needs to coordinate its regulatory activities with those of other countries. Otherwise, banks and other institutions will take advantage of discrepancies across borders in the rules governing their activities to find the least onerous regulations and greatest room for expansion.

These concerns about stability could be accepted if financial development had a positive impact on economic growth. But Boris Cournède, Oliver Denk and Peter Hoeller of the OECD,  in a review of the literature on the relationship of the financial sector and economic growth, report that above a threshold of financial development the linkage with growth is negative (see also here). Their results indicate that this reversal occurs when the financial expansion is based on credit rather than equity markets. Similarly, Stephen G. Cecchetti and Enisse Kharroubi of the BIS (see also here) report that financial development can lower productivity growth.

In addition, it has long been acknowledged that there is little evidence linking international financial flows to growth (see, for example, the summary of this work by Maurice Obstfeld of the IMF (and formerly of UC-Berkeley)).  More recently, Joshua Aizenman of the University of Southern California, Yothin Jinjarik of the University of Wellington and Donghyun Park of the Asian Development Bank have shown that the relationship of capital flows and growth depends on the form of capital. FDI flows possess a robust relationship with growth, while the linkage with other equity is smaller and less stable. The impact of FDI may depend on the development of the domestic financial sector. Debt flows in normal times do not reinforce growth, but can contribute to the probability of a financial crisis.

The impact of international financial flows on income inequality is also a subject of concern. Davide Furceri and Prakash Loungani of the IMF found that capital account liberalization reforms increase inequality and reduce the labor share of income. Furceri, Loungani and Jonathan Ostry also report that policies to promote financial globalization have led on average to limited output gains while contributing to significant increases in inequality. Distributional effects are more pronounced in those countries with low financial depth and inclusion, and where liberalization is followed by a crisis. A similar result was reported by Silke Bumann of the Max Planck Institute for Evolutionary Biology and Robert Lensink of the University of Groningen.

The change in the international financial system that may be the least understood is the evolution of FDI, which has grown in recent decades while the use of bank credit has fallen. FDI flows are increasingly routed thought countries such as Luxembourg and Ireland for the purpose of tax minimization. Moreover, the profits generated by foreign subsidiaries can be reinvested and form the basis of further FDI. Quyen T. K. Nguyen of the University of Reading asserts that such financing may be particularly important for operations in emerging market economies where domestic finance is limited. FDI flows also include intra-firm financing, a form of debt, and therefore FDI may be more risky than commonly understood.

5.     Conclusions

As a result of the substantial capital flows of the 1990s and early 2000s, the scope of financial markets and institutions now transcends national borders, and this expansion is likely to continue. While financial openness as measured by external assets and liabilities has not risen since the global crisis, this measurement is misleading. Emerging market economies with growing GDPs but less financial openness are becoming a larger component of the global aggregate. But financial openness and GDP per capita are correlated, and the populations of those countries will engage in more financial activity as their incomes increase.

A stable international financial system that promotes inclusive growth is a global public good. Global public goods face the same challenge as domestic public goods, i.e., a failure of markets to provide them. In the case of a global public good, the failure is compounded by the lack of an incentive for any one government to supply it.

The central banks of the advanced economies did coordinate their activities during the crisis, and since then international financial regulation has responded to the growth of global systematically important banks. But the growth of multinational firms that manage global supply chains and international financial institutions that move funds across borders poses a continuing challenge to stability. In addition, while the United Kingdom and the U.S. served as a financial hegemons in the past, today we have nations with small economies but extremely large financial sectors that reroute financial flows across border, and their activities are often opaque.

The global financial crisis demonstrates how little was understood of the fragility of the financial system that had built up around mortgage-backed securities. Regulators need to understand and monitor the assets and liabilities that have replaced them if they are not to be caught by surprise by the outcome of the next round of financial engineering. If “eternal vigilance is the price of liberty,” it is also a necessary condition for a stable financial universe.

A Guide to the (Financial) Universe: Part I

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A Guide to the (Financial) Universe: Part 1

  1.     Introduction

A decade after the global financial crisis, the contours of the financial system that has emerged from the wreckage are becoming clearer. While the capital flows that preceded the crisis have diminished in size, most of the assets and liabilities they created remain. But there are significant differences between advanced economies and emerging markets in their size and composition, and those nations that are financial centers hold large amounts of international investments. Moreover, the predominance of the U.S. dollar for official and private use seems undiminished, if not strengthened, despite the widespread predictions of its decline. A guide to this new financial universe reveals a number of features that were not anticipated ten years ago.

2.       External Assets and Liabilities

Financial globalization is the result of the flow of capital across borders and the integration of domestic financial markets. Financial flows like trade flows increased during the first wave of globalization during the 19th century, which ended with the outbreak of World War I. After World War II, trade and capital flows started up again and grew rapidly. In the mid-1990s financial flows accelerated more rapidly than trade, particularly in the advanced economies, and peaked on the eve of the global financial crisis.

Philp R. Lane of the Central Bank of Ireland and Gian Milesi-Ferretti of the IMF in their latest survey of international financial integration (see also here) provide an update of their data on the size and composition of the external balance sheets. Financial openness, as measured by the sum of gross assets and liabilities, for most countries has remained approximately the same since the crisis. But its magnitude differs greatly amongst countries.  Financial openness in the advanced economies excluding the financial centers, as measured by the sum of external assets and liabilities scaled by GDP, is over 300%, which is approximately three times as large as the corresponding figure in the emerging and developing economies. This is consistent with the large gross flows among the advanced economies that preceded the crisis. However, the same measure in the financial centers is over 2,000%. These centers include small countries with large financial sectors, such as Ireland, Luxembourg, and the Netherlands, as well as those with larger economies, such as Switzerland and the United Kingdom.

Some advanced economies, such as Germany and Japan, are net creditors, while others including the U.S. and France are net debtors. The emerging market nations excluding China are usually debtors, while major oil exporters are creditors. These net positions reflect not only the acquisition/issuance of assets and liabilities, but also changes in their values through price movements and exchange rate fluctuations. Changes in these net positions can influence domestic expenditures through wealth effects. They affect net investment income investment flows, although these are also determined by the composition of the assets and liabilities (see below). In many countries, such as Japan and the United Kingdom, international investment income flows have come to play a large role in the determination of the current account, and can lead to a divergence of Gross Domestic Product and Gross National Income.

The external balance sheets of the advanced economies are often characterized by holdings of equity and debt liabilities—“long equity, short debt’’—while the emerging market economies hold large amounts of debt and foreign exchange reserves and are net issuers of equity, particularly FDI—“long debt and foreign reserves, short equity.” The acquisition of foreign reserve holdings by emerging Asian economies is responsible for much of the “Lucas paradox,” i.e., the “uphill” flow of capital from emerging markets to advanced economies. However, there has also been a rise in recent years n the issuance of bonds by non-financial corporations in emerging markets, in some cases through offshore foreign affiliates.

As FDI has increased, the amount of investment income accounted for by FDI-related payments has risen. In the case of the emerging markets, these payments now are responsible for most of their investment income deficit, while the amounts due to banks and other lenders have diminished. FDI payments for the advanced economies, on the other hand, show a surplus, reflecting in part their holdings of the emerging market economies’ FDI.

The balance sheets of the international financial centers also include large amounts of FDI assets and liabilities. These holdings reflect these countries’ status as financial intermediaries, and funds are often channeled through them for tax purposes. The double-counting of investment that this entails overstates the actual value of foreign investment. The McKinsey Global Institute in its latest report on financial globalization has estimated that if such double-counting was excluded, the value of global foreign investment would fall from 185 percent of GDP to 140 percent.

The composition of assets and liabilities has consequences for economic performance. First, equity and debt have different effects on recipient economies. Portfolio equity inflows lower the cost of capital in domestic markets, and can enhance the liquidity of domestic stock markets and the transparency of firms that issue stock. In addition, M. Ayhan Kose of the World Bank, Eswar Prasad of Cornell University and Marco E. Terrones of the IMF have shown that equity, and in particular FDI, increases total factor productivity growth. Philip R. Lane of the Central Bank of Ireland and Peter McQuade of the European Central Bank, on the other hand, reported that debt inflows are associated with the growth of domestic credit, which can lead to asset bubbles and financial crises. Second, the differences in the returns on equity and debt affect the investment income flows that correspond to the assets and liabilities. Equity usually carries a premium as an incentive for the risk it carries. The U.S. registers a surplus on its investment income despite its status as a net debtor because of its net positive holdings of equity.

Third, the mix of assets and liabilities influences a country’s response to external shocks. FDI is relatively stable, but its return is state-contingent. Debt, on the other hand, is more volatile and in many cases can be withdrawn, but its return represents a contractual commitment. As a result, the mix of equity and debt on a country’s external balance sheet affects its net position during a crisis as well as its net investment income balance.

The change in the value of equity, for example, can depress or raise a country’s balance sheet during a crisis. Pierre Gourinchas of UC-Berkeley, Hélène Rey of the London Business School and Govillot of Ecole des Mines (see also here) have characterized the U.S. with its extensive holdings of foreign equity as the world’s “venture capitalist.”  Gourinchas, Rey and Kai Truempler of the London Business School showed that the loss of value in its equity holdings during the global crisis provided a transfer of wealth to those countries that had issued the equity.  Those nations that had issued equity, on the other hand, avoided some of the worst consequences of the crisis.

This analysis of external balance sheets, however, assumes that the assets and liabilities are pooled. Stefan Avdjiev, Robert N. McCauley and Hyun Song Shin of the Bank for International Settlements (see also here)  have pointed out that public assets, such as the foreign exchange reserves of the central bank, may not be available to the private sector. South Korea, for example, had a positive net international investment position that included foreign currency assets, which appreciated in value when the global crisis struck. Nonetheless, corporations and banks had issued dollar-denominated liabilities, and their value also rose. The country was one of those that entered into a currency swap arrangement with the Federal Reserve.

Eduardo A. Cavallo and Eduardo Fernández-Arias of the Inter-American Development Bank and and Matías Marzani of Washington University in St. Louis also investigate whether foreign assets provide protection in the case of a shock. They report that portfolio equity assets as well as reserves lower the probability of a banking crisis. Portfolio equity, like reserves, are relatively liquid and therefore residents can draw upon them during periods of volatility.

The difference between private and public assets liabilities has been investigated by Andreas Steiner of Grongien University and Torsten Saadma of the University of Mannheim. They calculate a measure of private financial openness that excludes the reserve assets of central banks as well as loans based on development aid. In the case of emerging markets and developing economies, their measure differs significantly from the standard measure, and results in different findings for the linkage of financial openness and growth.

Avdjiev, McCauley and Shin of the BIS also point out that balance sheets are measured on a national basis. But assets and liabilities may be held through foreign affiliates. International banks, for example, have foreign units with claims and liabilities. If these are consolidated on their parents’ balance sheet, then a very different assessment of the banks’ international creditworthiness may emerge. Similarly, non-financial firms may obtain credit through their foreign branches that borrow in the offshore debt markets. The credit inflow could hamper the ability of domestic authorities to stabilize the financial system. External balance sheets measured on a national basis may give a misleading picture of domestic institutions’ foreign linkages.

(to be continued)

Recent Research

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My recent research has dealt with issues related to financial globalization, and the accumulation of foreign assets and liabilities on external balance sheets. These include equity (foreign direct investment and stock) and debt (bonds and bank loans). Their amounts and composition differ between the emerging market economies and the advanced economies. The former generally hold assets in the form of foreign reserves, and issue equity to finance domestic investment. The latter nations hold the equity of the emerging economies and sell debt. In my work I have investigated the impact of the composition of the external balance sheets on economic performance as well as the determinants of the equity/debt liabilities mix, and this work has now been published.

In “External Liabilities, Domestic Institutions and Banking Crises in Developing Economies” (working paper here), my coauthors, Nabila Boukef Jlassi of the Paris School of Business and Helmi Hamdi of CERGAM EA 4225 Aix-Marseille University, and I examined the impact of foreign equity and debt liabilities on the occurrence of bank crises in 61 lower- and middle-income counties during the period of 1986-2010. We found that FDI liabilities lowered the probability of such crises while debt liabilities increased it. However, we also found that domestic institutions that decreased financial or political risk partially offset the impact of the debt liabilities on the probability of bank crises. A decrease in investment risk directly reduces the incidence of crises.

In “External Balance Sheets as Countercyclical Crisis Buffers” (working paper here), I investigated the claim that the composition of the external balance sheets of many emerging markets—“long debt and foreign exchange, short equity”—affected the performance of these countries during the global financial crisis of 2008-09. Using data from 67 emerging market economies, I showed that those economies that had issued FDI liabilities had higher growth rates during the crisis, fewer bank crises and were less likely to borrow from the IMF. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit.

Why do equity—and FDI in particular—and debt have such different impacts? First, equity represents a sharing of risk, whereas debt is a contractual commitment by the borrower. The equity premium is a compensation for the lower return incurred during a downturn. Second, debt is more likely to be reversed during a crisis than FDI, contributing to a “sudden stop.”. Third, FDI investors may be willing to provide more finance to keep their investment viable during a period of financial stress.

What determines the equity/debt mix of liabilities? In “Partners, Not Debtors: The External Liabilities of Emerging Market Economies” (working paper here), I studied the determinants of equity and debt liabilities on the balance sheets of 21 emerging market economies and 20 advanced economies over the period of 1981-2013. In the analysis I used a measure of domestic financial development that distinguished between financial institutions and financial markets. The results showed that the development of domestic financial markets is linked to an increase in equity liabilities, and in particular, portfolio equity. FDI liabilities, on the other hand, are more common when financial institutions are not well developed. Moreover, countries with higher growth rates are more likely to issue equity. Larger foreign exchange reserves are also associated with more portfolio equity.

The composition of assets and liabilities has other effects. Changes in the their values will impact a country’s net international investment position, which influences domestic spending and international solvency. In addition, they yield different income streams that determine net investment income, a component of the current account. In my current work I am looking at the income investment flows of advanced and emerging market countries. The flows in the advanced economies grew rapidly during the period of financial globalization leading up to the global crisis of 2008-09. In some cases, such as Japan and the United Kingdom, the net flows have become substantial and are a major determinant of the current account. The income flows of the emerging market economies did not have the same rapid growth, but their composition changed from payments to banks to payments on FDI and portfolio equity. I plan to write about these changes in future research papers.

 

Venezuela and the Next Debt Crisis

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The markets for the bonds of emerging markets have been rattled by developments in Venezuela. On November 13,Standard & Poor’s declared Venezuela to be in default after that country missed interest payments of $200 million on two government bonds. Venezuelan President Nicolás Maduro had pledged to restructure and refinance his country’s $60 billion debt, but there were no concrete proposals offered at a meeting with bondholders. By the end of the week, however, support from Russia and China had allowed the country to make the late payments.

Whether or not Venezuela’s situation can be resolved, the outlook for the sovereign debt of emerging markets and developing economies is worrisome. The incentive to purchase the debt is clear: their recent yields of about 5% and total returns of over 10% have surpassed the returns on similar debt in the advanced economies. The security of those returns seem to be based on strong fundamental condtions: the IMF in its most recent World Economic Outlook has forecast growth rates for emerging market and developing economies of 4.6% in 2017, 4.9% next year and 5% over the medium term.

The Quarterly Review of the Bank for International Settlements last September reviewed the government debt of 23 emerging markets, worth $11.7 trillion. The BIS economists found that much of this debt was denominated in the domestic currency, had maturities comparable to those of the advanced economies, and carried fixed rates. These trends, the BIS economists reported, “..should help strengthen public finance sustainability by reducing currency mismatches and rollover risks.”

It was not surprising, then when earlier this year the Institute for International Finance announced that total debt in developing countries had risen by $3 trillion in the first quarter. But surging markets invariably attract borrowers with less promising prospects. A FT article reported more recent data from Dealogic, which tracks developments in these markets, that shows that governments with junk-bond ratings raised $75 billion in syndicated bonds this calendar year. These bonds represented 40% of the new debt issued in emerging markets. Examples of such debt include the $3 billion bond issue of Bahrain, Tajikistan’s $500 million issue and the $3 billion raised by Ukraine. These bonds offer even higher yields, in part to compensate bondholders for their relative illiquidity.

The prospects for many of these economies are not as promising as the IMF’s aggregate forecast indicates. The IMF’s analysis also pointed out that there is considerable variation in performance across the emerging market and developing economies. The projected high growth forecast for the next several years is based in large part on anticipated growth in India and China, which account for more than 40% of the collective GDP of these nations. Weaker growth is anticipated in Latin America and the Caribbean, sub-Saharan Africa, North Africa and the Middle East.

The IMF also raised concerns about the sustainability of the sovereign debt of these countries in October’s Global Financial Stability Report. In the case of low-income countries, the report’s authors warned: “…this borrowing has been accompanied by an underlying deterioration in debt burdens… Indeed, annual principal and interest repayments (as a percent of GDP or international reserves) have risen above levels observed in regular emerging market economy borrowers.” Similarly, Patrick Njoroge, head of Kenya’s central bank, has warned that some African nations have reached a debt-servicing threshold beyond which they should not borrow.

None of these developments will surprise anyone familiar with the Minsky-Kindleberger model of financial crises. This account of the dynamics of such crises begins with an initial change in the economic environment—called a “displacement”—that changes the outlook for some sector (or nation). The prospect of profitable returns attracts investors. Credit is channelled by banks to the new sector, and the increase in funds may be reinforced by capital inflows.The demand for financial assets increases their prices. There is a search for new investments as the original investors take profits from their initial positions while new investors, regretful at missing earlier opportunities, join the speculative surge. The pursuit of yield is met by the issuance of new, increasingly risky assets. The “speculative chase” further feeds a price bubble, which is always justified by claims of strong fundamentals.

At some point there is a reassessment of market conditions. This may be precipitated by a specific event, such as a leveling off of asset prices or a rise in the cost of funding. An initial wave of bankruptcies or defaults leads to the exit of some investors and price declines. Further selling and the revelation of the flimsy undergirding of the speculative bubble results in what Kindleberger calls “revulsion.” In a world of global financial flows there are “sudden stops” as foreign investors pull out their funds, putting pressure on fixed exchange rates. Contagion may carry the revulsion across national boundaries. The end, Kindleberger wrote, comes either when prices fall so low that investors are drawn back; or transactions are shut down; or when a lender of last resort convinces the market that sufficient liquidity will be provided.

The market for the bonds of developing economies has followed this script. The initial displacement was the improvement in the growth prospects of many emerging market countries at a time when the returns on fixed investments in the advanced economies were relatively low. A credible case could be made that emerging market economies had learned the lessons of the past and had structured their debt appropriately. But the subsequent increase in bond offerings by governments with below investment grade ratings shows that foreign investors in their eagerness to enter these markets were willing to overlook more risky circumstances. This leaves them and the governments that issued the bonds vulnerable to shocks in the global financial system. A rise in risk aversion or U.S. interest rates would lead to rapid reassessments of the safety and sustainability of much of this debt.

This potential crisis has caught the attention of those who would be responsible for dealing with its painful termination. The IMF’s Managing Director Christine Lagarde at the Fund’s recent annual fall meeting warned of the risk of “a tightening of the financial markets and the potential capital outflows from emerging market economies or from low‑income countries where there has been such a search for yield in the last few years.” The IMF has dealt with this type of calamity before, and it never ends well.

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 Retreat of Financial Globalization?

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

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

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

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

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

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

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

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

Capital Flows and Financial Crises

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The impact of capital flows on the incidence of financial crises has been recognized since the Asian crisis of 1997-98. Inflows before the crisis contributed to the expansion of domestic credit and asset booms, while the liabilities they created escalated in value once central banks abandoned their exchange rate pegs and their currencies depreciated. More recently, evidence that foreign direct investment lowers the probability of financial crises has been reported. A new paper by Atish R. Ghosh and Mahvash S. Qureshi of the IMF investigates how the different types of capital flows affect financial stability.

The authors point out that capital inflows can be problematic when they lead to appreciations of real exchange rates and increases in domestic spending. The empirical evidence they report from a sample of 53 emerging market economies over the period of 1980-2013 does show linkages between capital inflows on the one hand and both GDP growth and overvaluation of the real exchange rate. But when the authors distinguish among the different types of capital inflows, they find that FDI, which has the largest impact on GDP growth and the output gap, is not significantly associated with overvaluation. Net portfolio and other investment flows, on the other hand, do lead to currency overvaluation as well as output expansion.

Ghosh and Qureshi investigated next the impact of capital flows on financial stability. Capital inflows are associated with higher domestic credit growth, bank leverage and foreign currency-denominated lending. When they looked at the composition of these capital flows, however, FDI flows were not linked to any of these vulnerabilities, whereas portfolio—and in particular debt—flows were.

Ghosh and Quershi also assessed the impact of capital flows on the probability of financial crises, and their results indicate that net financial flows raise the probability of both banking and currency crises. When real exchange rate overvaluation and domestic credit growth are included in the estimation equations, the significance of the capital flow variable falls, indicating that these are the principal transmission mechanisms. But when the capital flows are disaggregated, the “other investment” component of the inflows are significantly linked to the increased probabilities of both forms of financial crises, whereas FDI flows decrease banking crises.

The role of FDI in actually reducing the probability of a crisis (a result also found here and here) merits further investigation. The stability of FDI as opposed to other, more liquid forms of capital is relevant, but most likely not the only factor. Part of the explanation may lie in the inherent risk-sharing nature of FDI; a local firm with a foreign partner may be able to withstand financial volatility better than a firm without any external resources. Mihir Desai and C. Fritz Foley of Harvard and Kristin J. Forbes of MIT (working paper here), for example, compared the response of affiliates of U.S. multinationals and local firms in the tradable sectors of emerging market countries to currency depreciations, and found that the affiliates increased their sales, assets and investments more than local firms did.  As a result, they pointed out, multinational affiliations might mitigate some of the effects of currency crises.

The increased vulnerability of countries to financial crises due to debt inflows makes recent developments in the emerging markets worrisome. Michael Chui, Emese Kuruc and Philip Turner of the Bank for International Settlements have pointed to the increase in the debt of emerging market companies, much of which is denominated in foreign currencies. Aggregate currency mismatches are not a cause for concern due to the large foreign exchange holdings of the central banks of many of these countries, but the currency mismatches of the private sector are much larger. Whether or not governments will use their foreign exchange holdings to bail out over-extended private firms is very much an open issue.

Philip Coggan of the Buttonwood column in The Economist has looked at the foreign demand for the burgeoning corporate debt of emerging markets, and warned investors that “Just as they are piling into this asset class, its credit fundamentals are deteriorating.” The relatively weak prospects of these firms are attributed to the slow growth of international trade and the weakening of global value chains. Corporate defaults have risen in recent years, and Coggan warns that “More defaults are probably on the way.”

The IMF’s latest World Economic Outlook forecasts increased growth in the emerging market economies in 2016. But the IMF adds: “However, the outlook for these economies is uneven and generally weaker than in the past.” The increase in debt offerings by firms in emerging market economies will bear negative consequences for the issuing firms and their home governments in those emerging market economies that do not fare as well as others. Coggan in his Buttonwood column also claimed that “When things do go wrong for emerging-market borrowers, it seems to happen faster.” Just how fast we may be about to learn. Market conditions can deteriorate quickly and when they do, no one knows how and when they will stabilize.

The Repercussions of Financial Booms and Crises

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Financial booms have become a chronic feature of the global financial system. When these booms end in crises, the impact on economic conditions can be severe. Carmen M. Reinhart and Kenneth S. Rogoff of Harvard pointed out that banking crises have been associated with deep downturns in output and employment, which is certainly consistent with the experience of the advanced economies in the aftermath of the global crisis. But the aftereffects of the booms may be even deeper and more long-lasting than thought.

Gary Gorton of Yale and Guillermo Ordoñez of the University of Pennsylvania have released a study of “good booms” and “bad booms,” where the latter end in a crisis and the former do not. In their model, all credit booms start with an increase in productivity that allows firms to finance projects using collateralized debt. During this initial period, lenders can assess the quality of the collateral, but are not likely to do so as the projects are productive. Over time, however, as more and more projects are financed, productivity falls as does the quality of the investment projects. Once the incentive to acquire information about the projects rises, lenders begin to examine the collateral that has been posted. Firms with inadequate collateral can no longer obtain financing, and the result is a crisis. But if new technology continues to improve, then there need not be a cutoff of credit, and the boom will end without a crisis. Their empirical analysis shows that credit booms are not uncommon, last ten years on average, and are less likely to end in a crisis when there is larger productivity growth during the boom.

Claudio Borio, Enisse Kharroubi, Christian Upper and Fabrizio Zampolli of the Bank for International Settlements also look at the dynamics of credit booms and productivity, with data from advanced economies over the period of 1979-2009. They find that credit booms induce a reallocation of labor towards sectors with lower productivity growth, particularly the construction sector. A financial crisis amplifies the negative impact of the previous misallocation on productivity. They conclude that the slow recovery from the global crisis may be due to the misallocation of resources that occurred before the crisis.

How do international capital flows fit into these accounts? Gianluca Benigno of the London School of Economics, Nathan Converse of the Federal Reserve Board and Luca Forno of Universitat Pompeu Fabra write about capital inflows and economic performance. They identify 155 episodes of exceptionally large capital inflows in middle- and high-income countries over the last 35 years. They report that larger inflows are associated with economic booms. The expansions are accompanied by rises in total factor productivity (TFP) and an increase in employment, which end when the inflows cease.

Moreover, during the boom there is also a reallocation of resources. The sectoral share of tradable goods in advanced economies, particularly manufacturing, falls during the periods of capital inflows. A reallocation of investment out of manufacturing occurs, including a reallocation of employment if a government refrains from accumulating foreign assets during the episodes of large capital inflows, as well as during periods of abundant international liquidity. The capital inflows also raise the probability of a sudden stop. Economic performance after the crisis is adversely affected by the pre-crisis capital inflows, as well as the reallocation of employment away from manufacturing that took place in the earlier period.

Alessandra Bonfiglioli of Universitat Pompeu Fabra looked at the issue of financial integration and productivity (working paper here). In a sample of 70 countries between 1975 and 1999, she found that de jure measures of financial integration, such as that provided by the IMF, have a positive relationship with total factor productivity (TFP). This occurred despite the post-financial liberalization increase in the probability of banking crises in developed countries that adversely affects productivity. De facto liberalization, as measured by the sum of external assets and liabilities scaled by GDP, was productivity enhancing in developed countries but not in developing countries.

Ayhan Kose of the World Bank, Eswar S. Prasad of Cornell and Marco E. Terrones of the IMF also investigated this issue (working paper here) using data from the period of 1966-2005 for 67industrial and developing countries. Like Bonfiglioli, they reported that de jure capital openness has a positive effect on growth in total factor productivity (TFP). But when they looked at the composition of the actual flows and stocks, they found that while equity liabilities (foreign direct investment and portfolio equity) boost TFP growth, debt liabilities have the opposite impact.

The relationship of capital flows on economic activity, therefore, is complex. Capital inflows contribute to economic booms and may increase TFP, but can end in crises that include “sudden stops” and banking failures. They can also distort the allocation of resources, which affects performance after the crisis. These effects can depend on the types of external liabilities that countries incur. Debt, which exacerbates a crisis, may also adversely divert resources away from sectors with high productivity. Policymakers in emerging markets who think about the long-term consequences of current activities need to look carefully at the debt that private firms in their countries have been incurring.