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The IMF and the Next Crisis

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The IMF has issued a warning that “increasing financial market turbulence and falling asset prices” are weakening the global economy, which already faces headwinds due to the “…modest recovery in advanced economies, China’s rebalancing, the weaker-than-expected growth impact from lower oil prices, and generally diminished growth prospects in emerging and low-income economies.” In its report to the finance ministers and central bank governors of the Group of 20 nations before their meeting in Shangahi, the IMF called on the G20 policymakers to undertake “…bold multilateral actions to boost growth and contain risk.” But will the IMF itself be prepared for the next crisis?

The question is particularly appropriate in view of the negative response of the G20 officials to the IMF’s warning. U.S. Treasury Secretary Jacob J. Law sought to dampen expectations of any government actions, warning “Don’t expect a crisis response in a non-crisis environment.” Similarly, Germany’s Minister of Finance Wolfgang Schaeuble stated that “Fiscal as well as monetary policies have reached their limits…Talking about further stimulus just distracts from the real tasks at hand.”

The IMF, then, may be the “first responder” in the event of more volatility and weakening. The approval of the long-delayed 14th General Quota Review has allowed the IMF to implement increases in the quota subscriptions of its members that augment its financial resources. Managing Director Christine Lagarde, who has just been reappointed to a second term, has claimed the institution of new Fund lending programs, such as the Flexible Credit Line (FCL) and the Precautionary and Liquidity Line (PLL), has strengthened the global safety net. These programs allow the IMF to lend quickly to countries with sound policies. But outside the IMF, Lagarde claims, the safety net has become “fragmented and asymmetric.” Therefore, she proposes, “Rather than relying on a fragmented and incomplete system of regional and bilateral arrangements, we need a functioning international network of precautionary instruments that works for everyone.” The IMF is ready to provide more such a network.

But is a lack of liquidity provision the main problem that emerging market nations face? The Financial Times quotes Lagarde as stating that any assistance to oil exporters like Azerbaijan and Nigeria should come without any stigma, as “They are clearly the victims of outside shocks…” in the form of collapses in oil prices. But outside shocks are not always transitory, and may continue over long periods of time.

There are many reasons to expect that lower commodity prices may persist. If so, the governments of commodity exporters that became used to higher revenues may be forced to scale down their spending plans. Debt levels that appeared reasonable at one set of export prices may become unsustainable at another. In these circumstances, the countries involved may face questions about their solvency.

But is the IMF the appropriate body to deal with insolvency? IMF lending in such circumstances has become more common. Carmen M. Reinhart of Harvard’s Kennedy School of Government and Christoph Trebesch of the University of Munich write that about 40% of IMF programs in the 1990s and 2000s went to countries in some stage of default or restructuring of official debt, despite the IMF’s official policy of not lending to countries in arrears. Reinhart and Trebesch attribute the prevalence of continued lending (which has been called “recidivist lending”) in part to the Fund’s tolerance of continued non-payment of government debt.

More recently, the IMF’s credibility suffered a blow due to its involvement with Greece and the European governments that lent to it in 2010. (See Paul Blustein for an account of that period.) The IMF ‘s guidelines for granting “exceptional access” to a member stipulate that such lending could only be undertaken if the member’s debt was sustainable in the medium-term. The Greek debt clearly was not, so the Fund justified its lending on the grounds that there was a risk of “international systemic spillovers.” But the IMF’s willingness to participate in the bailout loan of 2010 only delayed the eventual restructuring of Greek debt in 2012. The IMF now insists that the European governments grant Greece more debt relief before it will provide any more financial government.

Reinhart and Trebesch write that the IMF’s “…involvement in chronic debt crises and in development finance may make it harder to focus on its original mission…” of providing credit in the event of a balance of payments crisis. Moreover, its association with cases of long-run insolvency may “taint all of its lending.” This may explain the limited response to the IMF’s programs of liquidity provision. Only Colombia, Mexico and Poland have shown an interest in the FCL, and the Former Yugoslav Republic of Macedonia and Morocco in the PLL.

Even if the IMF receives the power to implement new programs, therefore, its past record of lending may deter potential borrowers. This problem will be worsened if the IMF treats countries that need to adapt to a new global economy as temporary borrowers that only need assistance until commodity prices rise and they are back on their feet. The day when the emerging market economies routinely recorded high growth rates may have come to an end. If so, debt restructuring may become a more common event that needs to be addressed directly.

China’s Vulnerable External Balance Sheet

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The External Debt of the Emerging Market Economies

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

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

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

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

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

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

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

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

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

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

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

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

Capital Flows, Credit Booms and Bank Crises

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Studies of the impact of capital inflows have established that debt inflows can lead to bank crises (see here and here). Unlike equity, payments on debt are contractual and can not be cancelled if there is an economic downturn, which intensifies any shocks to the financial system. In the case of short-term debt, a foreign lender may decide not to roll over credit at the time when it is most needed. But recent papers have shown that foreign debt can also be a determinant of the credit booms that lead to the bank crises.

Philip Lane of Trinity College and Peter McQuade of the European Central Bank (working paper version here) looked at the relationship of domestic credit growth and capital flows in Europe during the period of 1993-2008. They suggest that financial flows can encourage more rapid credit growth by increasing the ability of domestic banks to extend loans, while also contributing to a rise in asset prices that encouraged financial activity. They found that debt flows contributed to domestic credit growth but equity flows did not. Moreover, the linkage of debt and domestic credit was strongest during the 2003-08 pre-crisis period.

Similarly, Julián Caballero of the Inter-American Development Bank (working paper here) investigated capital inflow booms, known as “bonanzas,” in emerging economies between 1973 and 2008. He reported that capital inflow bonanzas increased the incidence of bank crises. When he distinguished among foreign direct investment, portfolio equity and debt bonanzas, the results indicated that only the portfolio equity and debt bonanzas were associated with an increased likelihood of crises. More analysis revealed that the impact of increased debt was due in part to a lending boom. Caballero suggested that the capital inflows could also have increased asset prices, generating an asset bubble and an eventual collapse.

Deniz Iagan and Zhibo Tan of the IMF used both macroeconomic and micro-level firm data to examine the relationship of capital inflows and credit growth. They first examined the impact of capital inflows on aggregate credit to households and non-financial corporations in advanced and emerging market economies during the period of 1980-2011. They distinguished among FDI, portfolio and other inflows. They reported that portfolio and other inflows contributed to rises in household credit, and only the other inflows were significant for corporate credit.

Iagan and Tan also had data on firms in these countries, and sought to identify the determinants of leverage in these firms. They calculated an index, based on work done by Raghuram Rajan and Luigi Zingales (RZ), of a firm’s dependence on external financing. When they interacted the RZ indicator with the different types of capital inflows, the interactive term was always significant in the case of the other inflows, significant with portfolio flows in some specifications, and never significant in the case of FDI flows. The authors concluded that the results of the macro and firm level analyses were consistent: the composition of capital matters. In additional analysis, they found evidence consistent with the hypothesis that the capital inflows led to higher asset prices.

What can be done to insulate an economy from lending booms that may lead to bank crises? Nicolas E. Magud and Esteban R. Versperoni of the IMF and Carmen R. Reinhart of Harvard’s Kennedy School of Government (working paper here) examined whether the nature of the exchange rate regime was relevant. They found that less flexible exchange rate regimes are associated with increases in bank credit and a higher share of foreign currency in bank credit. On the other hand, the exchange rate regime had no impact of the size of the capital inflows. The authors of the Bank for International Settlements 85th Annual Report 2014/15, however, wrote that the insulation property of flexible exchange rates is “overstated.” An exchange rate appreciation can raise the value of firms with debt denominated in foreign currency, which increases the availability of credit.

How can regulators lower the danger of more bank crises due to debt inflows? Magud, Reinhart and Vesperoni suggest the use of macroprudential measures that affect the incentives to borrow in a foreign currency, such as currency-dependent liquidity requirements. But Caballero warns that capital controls on debt inflows may be insufficient if portfolio equity flows also contribute to lending booms that result in banking crises.

These research papers find that domestic asset prices respond to international financial flows. This makes it harder to insulate the domestic financial markets from foreign markets, and leaves these markets vulnerable to spillovers from changes in foreign conditions. The emerging markets already face downturns in their markets, and the combination of increased global volatility with a rise in the costs of servicing the dollar-denominated debt of corporations in emerging markets if the Federal Reserve raises interest rates will only add to their burdens.

Global Volatility, Domestic Markets

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

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

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

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

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

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

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

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

Global Liquidity and U.S. Monetary Policy

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The events in Greece and the Ukraine have only partially drawn attention away from the financial markets’ focus on changes in U.S. monetary policy. Federal Reserve officials seem to be split over when they will raise their Federal Funds rate target, and by how much. But while U.S. policymakers are closely monitoring domestic labor developments, the impact of their actions will have repercussions for foreign markets.

The growth of cross-border financial flows has led to research on global liquidity. Jean-Pierre Landau of SciencesPo (Paris) defines global private liquidity as the international components of liquidity, i.e., “cross-border credit and portfolio flows or lending in foreign currencies to domestic residents,” while official global liquidity is the funding available to settle claims on monetary authorities. Before the global financial crisis, global banking flows were instrumental in extending private credit across borders, while more recently portfolio flows have been important.

Eugenio Cerutti, Stijn Claessens, and Lev Ratnovski of the IMF examined the determinants of global liquidity using data on cross-border bank flows for 77 countries over the period of 1990-2012. They identified four financial centers: the U.S., the Eurozone, the U.K. and Japan. The drivers of global liquidity included factors such as the TED spread (3 month LIBOR minus 3 month government bond yield), an indicator of uncertainty that affects bank behavior. They also included measures related to monetary policy, including the real interest rate and term premium, i.e., the slope of the yield curve, defined as the difference between 10 year and 3 month government securities.

The authors first used U.S. global liquidity factors in their empirical analysis. When the U.S. term premium fell, there was a rise in international lending as banks sought higher returns. The U.S. real interest rate had a positive coefficient, which the authors saw as a sign that global banks lent less when there were favorable domestic conditions. The authors then introduced the same variables for the three other financial centers, and found that term premiums from the U.K. and the Eurozone have the same effect on cross border bank lending as did the U.S. measure. The Japanese term premium, on the other hand, had a positive coefficient, which may reflect the record of Japan’s interest rate.

When cross-border claims were broken out by lending to Asian and the Western Hemisphere countries, the TED spreads for British and European banks were significant determinants for lending to both areas. The U.S. term premium was the only term premium variable with explanatory power in lending to bank and non-banks in the two regions. The authors interpret these results as an indication that the global financial cycle is driven in part by U.S. monetary policy and British and European bank conditions. The authors also find that a borrower country can reduce its exposure to global liquidity drivers through flexible exchange rates, capital controls and stringent bank supervision.

The latest Annual Report of the Bank for International Settlements (BIS) also looks at financial flows across borders in its chapter on the international monetary and financial system. The authors of the chapter detail the growth in dollar- and euro-denominated credit through bank loans and debt securities, which can go to domestic residents in the U.S. or Eurozone, or non-residents. They point out that while U.S. households, corporations and its government account for 80% of global non-financial dollar debt at the end of 2014, the remaining one-fifth—about $9.5 trillion—of dollar credit was held outside the U.S.

These loans and securities have been growing rapidly since the global financial crisis. In particular, non-U.S. borrowers issued $1.8 trillion in bonds between 2009 and 2014. The authors of this chapter of the BIS Report attribute this growth to low lending rates and the reduction of the term premium for U.S. Treasury securities, which reflects the large scale purchase of these securities by the Federal Reserve in its Quantitative Easing (QE) programs. The European Central Bank’s bond purchases and the resulting compression of term premiums on euro-denominated bonds may lead to a similar phenomenon.

Changes in U.S. monetary policy, therefore, will influence global financial flows in both bank lending and bond issuance. If the end of QE results in higher term premiums in the U.S. as the rates on long-term securities rise, then cross-border flows could be negatively impacted. A rise in the Federal Fund Rate, on the other hand, could initially decrease the term premia, although other interest rates would likely follow. These changes take place, moreover, while the Eurozone and Japan are moving in opposite directions, which may intensify their effect. Mark Carney, Governor of the Bank of England, warned last January that the resiliency of the financial system will be tested by Federal Reserve tightening. Once again, policymakers may be forced to respond to fast-breaking developments as they occur. But this time they may not have as much flexibility to maneuver as they need. We may not know the consequences for financial stability until it is too late to avoid them.

Greek Tale(s)

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No matter what new twist the Greek debt crisis takes, there can be no question that it has been a catastrophe for that country and for the entire Eurozone. The Greek economy contracted by over a quarter during the period of 2007 to 2013, the largest decline of any advanced economy since 1950. The Greek unemployment rate last year was 26.5%, and its youth unemployment rate of 52.4% was matched only by Spain’s. But who is responsible for these conditions depends very much on which perspective you take.

From a macroeconomic viewpoint, the Greek saga is one of austere budget polices imposed on the Greek government by the “troika” of the International Monetary Fund, the European Commission and the European Central Bank in an attempt to collect payment on the government’s debt. The first program, enacted in 2010 in response to Greece’s escalating budget deficits, called for fiscal consolidation to be achieved through cuts in government spending and higher taxes. The improvement in the primary budget position (which excludes interest payments) between 2010-11 was 8% of GDP, above its target. But real GDP, which was expected to drop between 2009 and 2012 by 5.5%, actually declined by 17%. The debt/GDP level, which was supposed to fall to about 155% by 2013, actually rose to 170% because of the severity of the contraction in output. The IMF subsequently published a report criticizing its participation in the 2010 program, including overly optimistic macroeconomic assumptions.

To address the continuing rise in the debt ratio, a new adjustment program was inaugurated in 2012, which included a writedown of Greek debt by 75%. Further cuts in public spending were to be made, as well as improvements in tax collection. But economic conditions continued to deteriorate, which hindered the country’s ability to meet the fiscal goals. The Greek economy began to expand in 2014, and registered growth for the year of 0.8%. The public’s disenchantment with the country’s economic and political status, however, turned it against the usual ruling parties. The left-wing Syriza party took the lead position in the parliamentary elections held this past January, and the new Prime Minister, Alexis Tsipras, pledged to undo the policies of the troika. He and Finance Minister Yanis Varoufakis have been negotiating with the IMF, the ECB and the other member governments of the Eurozone in an attempt to obtain more debt reduction in return for implementing new adjustment measures.

The macroeconomic record, therefore, seems to support the position of those who view the Greek situation as one of imposed austerity to force payment of debt incurred in the past. Because of the continuing declines in GDP, the improvement in the debt/GDP ratio has remained an elusive (if not unattainable) goal. (For detailed comments on the impact of the macroeconomic policies undertaken in the 2010 and 2012 programs see Krugman here and Wren-Lewis here.)

Another perspective, however, brings an additional dimension to the analysis. From a public finance point of view, the successive Greek governments have been unable and/or unwilling to deal with budget positions—and in particular expenditures through the pension system—that are unsustainable. Pension expenditures as a proportion of GDP have been relatively high when compared to other European countries, and under the pre-2010 system were projected to reach almost 25% of GDP by 2050.  Workers were able to receive full benefits after 35 years of contributions, rather than 40 as in most other countries. Those in “strenuous occupations,” which were broadly defined, could retire after 25 years with full benefits.  The amount that a retiree received was based on the last year of salary rather than career earnings, and there were extra monthly payments at Christmas and Easter. The administration of the system, split among over 100 agencies, was a bureaucratic nightmare.

Much of this has been changed. The minimum retirement age has been raised, the number of years needed for full benefits is now 40, and the calculation of benefits changed so as to be less generous. But some fear that the changes have not been sufficient, particularly if older workers are “sheltered” from the changes.

Moreover, government pensions are important to a wide number of people. The old-age dependency ratio is around 30%, one of the highest in Europe. The contraction in the Greek economy means that the pension is sometimes the sole income payment received by a family. It is hardly surprising, therefore, that the pension system is seen as a “red line” which can not be crossed any further in Greece.

The challenge, therefore, is for the government to establish its finances on a sound footing without further damaging the fragile economy. This will call for some compromises on both sides. The IMF’s Olivier Blanchard has called for the Greek government “to offer truly credible measures“ to attain the targets for the budget, while showing its commitment to a limited set of reforms, particularly with pensions. But he also asks the European creditors to offer debt relief, either through rescheduling or a further “haircut.” Other proposals have been made (see here) that also attempt to satisfy the need to restructure the government’s finances while offering the Greek people a way to escape their suffering. There may be a strategy that allows Greece to reestablish itself on a new financial footing. But if the European governments insist that Greece must also pay back all its outstanding debt, then there is only one possible ending for this saga, and it will not be a happy one.

Tales of Globalization: Russia and China

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The end of 2014 marked the 23rd anniversary of the dissolution of the Soviet Union and the establishment of the Russian Federation. Like Chinese leaders in the previous decade, Russian policymakers faced the challenge of integrating their nation into the global economy. Russia’s trade openness (exports and imports scaled by GDP) grew from 26% in 1991 to 51% in 2013, very similar to the rise in China’s trade openness from 29% to 50% during these years. Russian exports increased from 13% of its GDP at the beginning of this period to 28% in 2013, while the corresponding figures for China are 16% and 26%. Both counties gradually allowed foreign capital inflows. But the similarities end there.

Russia’s exports are primarily commodities, particularly oil and natural gas. Consequently, sales of these resources account for a large part of Russia’s GDP: 16% in 2012. The plunge in world oil prices, combined with the sanctions imposed by U.S. and European Union governments following Russia’s annexation of the Crimea and its threats against the Ukraine, threaten to push the economy into a recession. The deterioration of the economic situation caused the ruble to plunge against the dollar in December, before recouping part of its value after the central bank intervened in the foreign exchange market and raised its policy rate to 17%.

Russia is particularly susceptible to a currency depreciation because of its external debt, reported to be $678 billion. Capital controls that had been imposed during the 1998 crisis were removed in the 2000s, and capital inflows, including bank loans and bond issues, increased significantly. These capital flows reversed during the global financial crisis, and there was only a modest recovery before the latest period of political tension. The Russian government’s debt includes $38 billion of bonds denominated in dollars, which is not seen as a vulnerability. But the external exposure of Russian companies is much larger. The Russian central bank claims that in 2015 Russian firms owe $120 billion of interest and repayments on their external debt. Much of this money is owed by Rosneft and Gazprom, the state oil and gas producers.

China has followed a very different path. Its main exports now include electronics and machinery. The Great Recession prompted a reevaluation of the structure of the economy by the Chinese government. Chinese leaders realize that the export- and investment-led growth of the past is no longer feasible or desirable, and have emphasized the expansion of domestic consumption. This transition is taking place while the economy slows from the torrid 10% growth rate of the past to about 7.5%.

China also has external debt, which totaled $863 billion in 2013. But China has been more deliberate in opening up its capital account, and its external liabilities primarily take the form of foreign direct investment. Moreover, its foreign exchange reserves of about $4 trillion should alleviate any concerns about its ability to fulfill its obligations to foreign lenders. Of more concern is the growth in domestic credit, which now surpasses 200% of its GDP. While a financial contraction appears inevitable, there are differences over whether this will lead to economic disruption (see also here).

China’s currency appreciated in value between 2005 and 2008, when the renminbi was “re-pegged” against the dollar. In March, the central bank announced that the renminbi would fluctuate within a band of +/- 2%. A recent study by Martin Kessler and Arvind Subramanian indicates that the renminbi is fairly valued by purchasing power estimates. The government is considering whether the renminbi will become an international currency. Its status may get a boost if the IMF decides to include the renminbi as one of the currencies on which its Special Drawing Rights is based.

China and Russia, therefore, have followed very different paths in globalizing their economies. Russia, of course, could not be expected to forsake its energy resources. But commodity exporters live and die by world prices, and the government passed up an opportunity to diversify the Russian economy. China initially used its own “natural resource” of abundant labor, but has moved up the value chain, as Japan and Korea did. Chinese firms are now expanding into foreign markets. In addition, Russia allowed short-term capital inflows that can easily cease, while China carefully controlled the external sources of finance.

Russia’s GDP per capita recorded a rise of 29% between 1991 and 2013, from $5,386 to $6,924 (constant 2005 US $). China started at a much lower base in 1991, $498, but its per capita income increased by over 7 times (719%) to $3,583. The divergence in the two countries’ fortunes shows that there are many ways to survive in the global economy, but some are more rewarding than others.

International Debt and Financial Crises

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The latest issue of the IMF’s World Economic Outlook has a chapter on global imbalances that discusses the evolution of net foreign assets (also known as the net international investment position) in debtor and creditor nations. The authors warn that increases in the foreign holdings of domestic liabilities can raise the probability of different types of financial crises, including banking, currency, sovereign debt and sudden stops. A closer inspection of the evidence that has been presented elsewhere suggests that it is foreign-held debt that poses a risk.

The role of international debt in increasing the risk of crises was pointed out by Rodrik and Velasco (working paper 1999), who showed that short-term bank debt contributed to the occurrence of capital flow crises in the period of 1988-98. More recently, Joyce (2011) (working paper here) looked at systemic bank crises in a sample of emerging markets, and found that an increase in foreign debt liabilities contributed to an increase in the incidence of these crises, while FDI and portfolio equity liabilities had the opposite effect. Ahrend and Goujard (2014) (working paper here) confirmed that increases in debt liabilities increase the occurrence of systemic banking crises. Catão and Milesi-Ferretti (2014) (working paper here) found that an increase in net foreign assets lowered the probability of external crises. Moreover, they also reported that this effect was due to net debt. FDI had the opposite effect, i.e., an increase in FDI liabilities lowered the risk of a crisis. Al-Saffar, Ridinger and Whitaker (2013) have looked at external balance sheet positions during the global financial crisis and reported that gross external debt contributed to declines in GDP.

There are also studies that compare the effect of equity and debt flows. Levchenko and Mauro (2007), for example, investigated the behavior of several types of flows, and found that FDI was stable during periods of “sudden stops,” while portfolio equity played a limited role in propagating the crisis. Portfolio debt, on the other hand, and bank flows were more likely to be reversed. Similarly, Furceri, Guichard and Rusticelli (2012) (working paper here) found that large capital inflows driven by debt increase the probability of banking, currency and balance-of-payment crises, while inflows that are driven by FDI or portfolio equity have a negligible effect.

Why are debt liabilities more risky for countries than equity? Debt is contractual: the holder of the debt expects to be paid regardless of economic conditions. Equity holders, on the other hand, know that their payout is tied to the profitability of the firm that issues the debt. Moreover, during a crisis there are valuation effects on external balance sheets. The value of equity falls, which raises the net foreign asset position of those countries that are net issuers of equity, while lowering it for those that hold equity. In addition, debt may be denominated in a foreign currency to attract foreign investors worried about depreciation. A currency depreciation during a crisis raises the value of the debt on the balance sheet of the issuing country.

These results have consequences for the use of capital controls and the sequence of decontrol. Emerging markets should be careful when issuing debt. However, the evidence to date of trends in the international capital markets shows a rise in the use of debt by these countries. Emerging market governments, for example, issued $69 billion in bonds in the first quarter. In addition, the BIS has drawn attention to the issuance of debt securities by corporations in emerging markets.

The IMF has warned of a slowdown in the emerging market countries, with the Fund’s economists forecasting GDP growth rates below the pre-crisis rates.  Speculation about the impact of changes in the Federal Reserve’s quantitative easing policies has contributed to concerns about these countries. If a slowdown does materialize, the debt that was issued by these countries may become a burden that requires outside intervention.