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The Costs of the Defragmentation of the Global Economy

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

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

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

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

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

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

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

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

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

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

The Global Financial Cycle and Emerging Market Economies

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The Federal Reserve’s latest increase in its policy rate is a signal of its desire to reestablish its credibility after U.S. inflation rose to 8.6% in May, and a precursor of more hikes.  Similar increases have been implemented by the Bank of England and the Swiss National Bank, and the European Central Bank has announced that an increase in its policy rate will occur in July.  These and other policy moves by central bankers indicate that we are in a new global financial cycle (GFC), which will have wide-ranging implications for emerging market and developing economies (EMDEs).

Maurice Obstfeld of UC-Berkeley and former chief economist of the IMF explains the linkages between monetary policy in advanced economies and economic activity in other countries in a Peterson Institute Working Paper, “The International Financial System after COVID-19.” Recent research has shown that U.S. financial conditions and Federal Reserve monetary policy, as well as conditions and policies in other advanced economies, affect asset prices, capital flows and commodity prices across a broad range of economies, evidence of a global financial cycle.

Researchers have devised measures of the cycle and studied its behavior. An index of global financial conditions shows a close correlation with output in the EMDEs. Part of this linkage is exerted via the dollar’s exchange rate, which appreciates in response to higher U.S. interest rates. Obstfeld lists several mechanisms that drive the relationship (see also here). He cites the impact of dollar appreciation on the tightening of trade finance credit, the role of the dollar as a safe haven during periods of heightened risk aversion, the contractionary impact of a stronger dollar on export demand when exports are denominated in dollars, a global decline in investment and a fall in real commodity prices. Exchange rate flexibility can mitigate the impact of shocks in the global financial cycle, but spillover effects are always present.

Obstfeld warns that higher interest rates in the advanced economies will affect the EMDEs. While the levels of government debt to GDP in many EMDEs are below those in most advanced economies, the rises in these ratios since the pandemic have been similar in magnitude. Refinancing will force these countries to deal with higher financing costs, and foreign-currency denominated debt adds another source of stress. Obstfeld cautions that one particular source of financial fragility is the concentration of sovereign debt on the balance sheets of banks in EMDEs.

An empirical assessment of the factors that drive capital flows to EMDEs is provided by Xichen Wang of the Chongqing Technology and Business University and Cheng Yan of the Essex Business School in their paper in the current IMF Economic Review, “Does the Relative Importance of the Push and Pull Factors of Foreign Capital Flows Vary Across Quantiles?  (working paper version here). They contrast the impact of “push” factors that are external to capital flow recipients and domestic “pull” factors on capital flows to 51 emerging markets. They use quantile analysis, which allows them to investigate the effect of the independent variables on different quantiles of the distribution of the dependent variable. The lower quantiles (such as the first 20%) are periods of relatively low capital flows, the median quantiles are tranquil and smooth periods, and the higher quantiles are periods of abundant capital financing.

The authors use several indicators of a GFC, including the U.S. 3-month Treasury bill rate deflated by U.S. inflation and the VIX index, which is based on the volatility of S&P 500 stock options. They also utiliized U. S. economic growth and average net capital flows to other countries in the region. For pull variables they utilized domestic variables, such as the domestic real interest rate, economic growth, public indebtedness, private credit expansion and the current account.

Wang and Yan’s results show that VIX and regional capital flows are highly significant for all the quantiles of gross capital inflows.  An increase in risk, as manifested in a rise in VIX, lowers capital flows to the emerging markets while an increase in capital flows to other countries in the region has a positive effect. Several of the domestic pull factors, such as economic growth and international reserves, are statistically significant at the lower quantiles, but their significance diminishes in the higher quantiles. Foreign investors pay attention to domestic conditions when capital flows are relatively limited.

The authors also present results for disaggregated capital flows (FDI, portfolio equity, portfolio debt, bank). The significance of VIX remains for all forms of capital, including FDI which is sometimes seen as less affected by global conditions. The domestic push factors are significant for the non-FDI flows at the lower quantiles, but not at the upper quantiles.

The authors conclude that policymakers need to pay attention to the manifestation of GFCs, as they can lead to a sudden fall in gross inflows. VIX has risen this year from 16.60 on January 3 to a high of 36.45 on March 7, and currently stands at 27.53. The nominal Treasury bill rate rose from 0.09% at the beginning pf the year and has risen to 1.59%.  But the rate of inflation rose from 7.5% to 8.6% over the same period, largely offsetting the rise in the nominal rate.

The World Bank has evaluated the prospects of the EMDES in the June edition of its Global Economic Prospects. They forecast a slowdown in economic growth in the EMDEs from 6.6% in 2021 to 3.4% this year, and warn that the war in Ukraine has increased the risk of a further negative adjustment. The World Bank also cites global financial conditions as a cause of concern:

“As global financing conditions tighten and currencies depreciate, debt distress—previously confined to low-income economies—is spreading to middle-income countries. The removal of monetary accommodation in the United States and other advanced economies, along with the ensuing increase in global borrowing costs, represents another significant headwind for the developing world.”

There is a well-established link, therefore, from monetary policies in the U.S. and other advanced economies to the rest of the global economy. As the Federal Reserve and its counterparts show their determination to face down inflation, they can trigger spillovers that exacerbate capital outflows from the EMDEs. The result will be a further deterioration in the economies of countries that have already endured a series of negative shocks.

The IMF’s Proposed Policies on the Management of Capital Flows

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The IMF’s views on the advantages and drawbacks of capital flows have substantially evolved over time. The Fund reversed its opposition to capital controls in the wake of the global financial crisis of 2007-09, when it adopted the “Institutional View on the Liberalization and Management of Capital Flows.” That framework included capital flows measures (CFMs) as one of the policy measures available to a government facing surges of capital inflows, i.e., large inflows that could destabilize an economy. The Fund has now moved further in the direction of using CFMs, proposing that they can be used in a preemptive manner to avoid future instability.

The IMF had advocated the removal of capital controls before the Asian financial crisis of 1997-98, so that developing economies could benefit from capital flows. That crisis demonstrated the volatility of capital flows and the catastrophic impact of “sudden stops” on economic activity. Subsequently, the Fund refined its position on deregulation, advising governments to implement adequate supervisory and regulatory regimes before liberalizing their capital accounts, and to begin with opening to foreign direct investment before allowing short-term capital. The IMF moved further during the global financial crisis when it allowed Iceland to implement controls. The Institutional View was adopted in 2012, when countries such as Brazil used CFMs to manage the inflows of foreign capital seeking higher yields than those available in the U.S. The CFMs were part of a toolkit that also includes Macroprudential Prudential Measures (MPMs), which are designed to limit systemic risks. CFM/MPMs are measures designed to limit such risk by controlling capital flows.

The IMF’s new proposals are presented in an IMF Policy Paper, “Review of the Institutional View on the Liberalization and Management of Capital Flows.”  The first proposal extends the Institutional View by allowing the preemptive use of CFM/MPMs on foreign currency debt inflows in order to address the systemic risk that could result from foreign exchange mismatches on balance sheets. Such mismatches can occur slowly, and not just following surges. They increase the probability of capital flow reversals and exchange rate depreciations that disrupt economic activity and could not be adequately addressed with conventional policy tools.

The proposal would also allow CFM/MPMs in the case of high foreign investor participation in local-currency debt markets. In these cases, the danger is a “sudden stop” by foreign investors, which would have particularly adverse consequences if there were illiquid capital markets. Other domestic measures may be unavailable, and the CFM is a second-best solution.

The second proposed policy change exempts certain types of capital control measures that are enacted by governments for specific purposes from review. These include: first, measures adopted for national or international security; second, measures based on international prudential standards, such as those related to the Basel Framework on banking; third, measures designed to deal with money laundering and the combating of financial terrorism; and fourth, measures related to international cooperation standards related to the avoidance or evasion of taxes.

The usefulness of preemptive policies has been demonstrated in a new NBER working paper, “Preemptive Policies and Risk-Off Shocks in Emerging Markets” by Mitali Das and Gita Gopinath of the IMF and Sebnem Kalemli-Özcan of the University of Maryland. The authors investigate the impact of preemptive CFMs on the external finance premia in 56 emerging markets and developing economies during the Taper Tantrum and the COVID-19 shocks. The premia are measured by deviations from uncovered interest rate parity. They consider the impact of CFMs on inflows and outflows, as well as the effect of domestic MPMs.

The paper’s authors report that countries with preemptive CFMs on inflows in place during the five-year period preceding the shocks experienced lower premia and exchange rate volatility. They infer that use of the CFMs provide enhanced access to international capital markets during volatile periods. CFMs on outflows, on the other hand, had a positive effect on the UIP premiums, which may reflect the demand by foreign investors for higher returns to compensate for the CFMs in outflows.

The IMF’s capital flow policies under the Institutional View had been reviewed by the IMF’s Independent Evaluation Office (IEO) in its 2020 report , “IMF Advice on Capital Flows.” The report praised the IMF for the changes in its policy stance, and called the adoption of the Institutional View “a major step forward.” The IEO’s report, however, also called for further changes, including revisiting the Institutional View to take into account recent experience with capital flows, building up the monitoring, analysis and research of capital acccount issues, and strengthening multilateral cooperation on policy issues.

Anton Korinek of the University of Virginia, who wrote a briefing paper for the IEO report, Prakash Loungani, assistant director of the IEO and co-leader of the 2020 report, and Jonathan Ostry of Georgetown University, who was at the IMF when it issued the Institutional View, have written a review of the IMF’s latest policy proposals, “The IMF’s Updated View on Capital Controls: Welcome Fixes but Major Rethinking Is Still Needed.” While welcoming the new measures, they bring up several additional issues that should be addressed. These include the use of capital controls for domestic objectives, such as the impact of capital flows on income inequality and also real estate prices. Such a move would in many ways be consistent with the original aims of the Bretton Woods agreements.

The authors point out that the targets for the IMF’s capital policies are the host countries that receive capital inflows. But challenges associated with capital flows should also involve the countries that are the source of the capital flows. Since these are usually the advanced economies which have a major role in the IMF’s governance, such a move would require the cooperation of the IMF’s most influential members.

Korinek, Loungani and Ostry also urge the IMF to investigate the use of controls on capital outflows. The Fund’s current policy stance only approves the use of such measures during crises. Given the current economic and financial situation (see, for example, here), governments of developing countries are concerned about a repeat of the outflows of March and April 2020. The IMF should be working with these policymakers now to minimize the turbulence that large capital outflows would bring.

The Restructuring of Sovereign Debt

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The economic repercussions of Russia’s invasion of Ukraine will be devastating for many countries that have yet to recover from the pandemic. Higher prices for commodities, particularly energy and food, will increase inflation rates and widen trade deficits for those nations that import those items. Increases in interest rates will raise the cost of debt financing and hamper the ability of borrowers to meet their obligations or refinance existing debt.

Carmen Reinhart, Chief Economist of the World Bank, warned that the pandemic had exacerbated existing financial weaknesses in her Mundell-Fleming Lecture, “From Health Crisis to Financial Distress,” which has been published in the IMF Economic Review. She points out that economic and financial crises, including banking, currency, debt, etc., often occur together. The resulting “conglomerate crisis” can lead to a severe economic downturn. She warns that initial attempts to arrange a “shallow” restructuring of sovereign debt that does not reduce the intertemporal value of the debt may be followed by one or more subsequent restructurings, exacerbating the impact of the crisis.

Governments that need to restructure debt may be able to lessen the resulting impact if they act early. Tamon Asonuma, Marcos Chamon, Aitor Erce and Akira Sasahara have examined the consequences of debt restructurings in an IMF Working Paper, “Costs of Sovereign Defaults: Restructuring Strategies, Bank Distress and the Capital Inflow-Credit Channel.” The authors looked at 179 restructurings of the sovereign debt held by private holders over the period of 1978-2010. They divided the sample into three categories: “strictly preemptive,” where no payments were missed; “weakly preemptive,” where some payments were missed but only temporarily and only after the start of negotiations with creditors; and “post-default,” which occurred when payments were missed and without agreement with the creditors.

They reported that banking crises and severe declines of credit and net capital inflow occurred more frequently following post-default restructurings. They also found that contractions of GDP and investment spending were substantial in post-default restructurings, less severe in weakly preemptive restructurings and did not occur in the case of strictly preemptive cases. Private credit and capital inflows remained below the pre-crisis levels and interest rates rose after post-default restructurings. Their results indicate that governments that can restructure without missing payments will avoid some of the costs associated with restructurings. The authors acknowledge that large shocks can force a halt in payments, but even in those cases collaboration with creditors is more advantageous than unilateral actions.

The IMF reviewed the institutional mechanisms that address sovereign debt restructurings in 2020 policy paper, The International Architecture for Resolving Sovereign Debt Involving Private-Sector Creditors—Recent Developments, Challenges, And Reform Options. The review found that recent restructurings of sovereign debt had been much smoother than those in previous periods. It attributed this change to several factors, including the increased use of collective action clauses which allow a majority of the creditors to override a minority that oppose a restructuring. The paper’s authors called for more contractual reforms as well as an increase in debt transparency, and also recommended that the international financial institutions support debt restructurings financially when appropriate. But the report  warned that the pandemic could engender a widespread crisis that could overwhelm existing procedures:

“Should a COVID-related systemic sovereign debt crisis requiring multiple deep restructurings materialize, the current resolution toolkit may not be adequate in addressing the crisis effectively and additional instruments may need to be activated at short notice.”

The IMF sought to establish new instruments in 2020 when it joined the Group of 20 nations to create an institutional mechanism for low-income countries with unsustainable debt loads called the “Common Framework” (see here). The initiative sought to bring together official creditors, including the traditional lenders such as the U.S. and France, with more recent lenders, such as China and India, to coordinate debt relief efforts. Private creditors were to use comparable terms in their negotiations.

But the Framework has not been widely adopted because of reluctance by some lenders and borrowers. Chinese lending has been funneled through several institutions, and they are not always willing to join other creditors. The governments of the nations with the debt loads have been reluctant to signal that they may need relief, in part because of a negative signaling effect. The IMF has called for reorganizing and expanding the Common Framework.

A wave of restructuring may be triggered by a Russian default on its dollar-denominated bonds. The credit rating agencies have downgraded the Russian bonds to junk bond status (“C” in the case of Fitch’s rating). President Putin has stated that the bond payments will be paid in rubles, but the Russian currency has lost its international value. A default would hasten the collapse of the Russian economy. It would also lead to a reassessment of the solvency of other governments and their ability to fulfill their debt obligations. Foreign bondholders could decide to cut their losses by selling the bonds of the emerging markets and developing economies. A wave of such selling that occurs at the same time as the Federal Reserve raises interest rates will almost certainly lead to a new debt crisis for many countries. The IMF and World Bank will be hard-pressed to coordinate relief efforts across so many borrowers and lenders.

Risk and FDI

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While FDI flows recovered in 2021 from the previous year’s decline, not all countries benefitted from the increase. UNCTAD reported that almost three quarters of global FDI flows in 2021 occurred in advanced economies, and China and other Asian economies recorded the largest increases amongst the emerging markets and developing economies. Multinational companies are evaluating the course of the pandemic in those countries and their suitability for new global supply routes. Risk, always a factor in FDI decisions, has become an even more important concern.

There are, of course, many forms of risk. Neil M. Kellard, Alexandros Konotonikas and Stefano Maini of the University of Essex with Michael J. Lamla of Leuphana University Lüneburg and Geoffrey Wood of Western University examined the effects of financial system risk in “Risk, Financial Stability and FDI“, published in the Journal of International Money and Finance this year (working paper version here). They specifically investigated the impact of risk on inward FDI stocks within 16 Eurozone between 2009 and 2016, and used bilateral data drawn from the origin countries and host economies to compare the effects of different forms of risk in both locations.

Their results indicated that an increase in risk in the banking sector of an origin country—as measured by the proportion of non-performing loans—led to a decrease in FDI in the host countries. However, changes in bank risk in the host country had no similar impact. They interpret this result as indicating that multinationals are dependent on bank financing in their origin countries to finance their expansion.

In addition, inward FDI was negatively linked to upturns in sovereign yields in both the origin and host countries. The impact of the sovereign yield variable in the origin countries was larger than that of the corresponding yield in the host countries. They interpret the latter results as showing that an increase in sovereign risk in the origin country discouraged risk-taking by multinational firms based there, while the increase in risk in the host country caused multinationals to turn to other hosts. Moreover, when they separated the Eurozone countries into two groups, with Greece, Ireland, Italy, Portugal and Spain as the stressed group, they found that the size of the impact of the sovereign risk variables was comparatively larger in the stressed group.

Risk is also the subject of a recent NBER working paper by Caroline Jardet and Cristina Jude of the Banque de France and Menzie Chin of the University of Wisconsin-Madison, “Foreign Direct Investment Under Uncertainty: Evidence From A large Panel of Countries.” They examined host country “pull” factors and global “push” factors for inward FDI flows in a panel of 129 advanced, emerging market and developing economies over the period of 1995 to 2019. They focused on domestic and global uncertainty, using the World Uncertainty Index (WUI) and the Economic Policy Uncertainty Index as well as the VIX as measures of risk.

Their initial results indicate that the effects of uncertainty depend on the country group, and therefore they disaggregated the data.  Domestic uncertainty does not appear to be a factor for any of the three groups, but global uncertainty as measured by the WUI has a large and significant negative impact on FDI in the advanced and emerging market economies.

The authors also examined the impact of global financial factors on FDI. They iniitally used the real value of the Standard & Poor’s 500 index, and report that an increase in that measure is linked to increases in FDI in the advanced economies but declines in the emerging market and developing economies. The higher returns in the U.S. draw funds away from those propsetive hosts.

Similarly, when they replace the S&P 500 with the nominal shadow Federal Funds rate or a world interest rate, they report that increases in either rate increased FDI in the advanced economies and lowered FDI flows in the developing economies. They suggest that this result reflects the existence of booms in the financial center countries that GDP data do not capture. They also reexamine the significance of the world uncertainty index as the different global financial variables are used, and find that the negative and significant impact holds up in the case of the emerging market economies.

Many types of risk, therefore, have an impact on FDI. Domestic financial risk in an origin country, for example, leads to less outward FDI by multinational firms based in that country. But firms are also affected by global uncertainty, and their response in terms of foreign investment seems to be most evident in the emerging market economies. Geopolitical tensions over the Ukraine,  the possibility of a new variant of the virus and the prospect of higher U.S. interest rates all reinforce global uncertainty and complicate the decision over where to locate new investments.

The Coming Wave of Debt Restructurings

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The news that the Federal Reserve will raise interest rates in 2022 sooner than anticipated was not surprising in view of the continued high rates of U.S. inflation. While U.S. asset prices are falling in response to the prospect of higher rates as well as a smaller Fed balance sheet, foreign markets are straining to decipher the spillover effects on their economies. But it is only a matter of time until emerging markets and developing economies face higher financing costs and the need for debt restructurings.

The World Bank pointS out in its most recent Global Economic Prospects that global debt levels in 2020 rose to their highest levels relative to GDP in decades. The publication also shows that economic projections for the emerging markets and developing economies excluding China are for lower growth rates than those of the advanced economies. Consequently, servicing and repaying the debt represents a challenge for those countries. World Bank President David Malpass warned that 60% of the poorest countries need to restructure their debt or will need to.

Ayhan Kose, Franziska L. Ohnsorge and Carmen Reinhart of the World Bank and Kenneth Rogoff of Harvard University examine the options that countries with elevated debt levels face in their NBER working paper, ”The Aftermath of Debt Surges.” They divide the possible responses into orthodox and heterodox solutions. The former includes strong economic growth that reduces relative debt levels as well as fiscal consolidation that can generate surpluses to pay off debt. Other measures are the privatization of public assets and higher wealth taxation, both of which can yield needed revenues. All come with associated downsides hazards, such as higher interest rates if growth comes with more inflation, or a lack of the conditions needed for successful privatization.

Heterodox approaches include unexpected inflation to erode real debt levels, financial repression to maintain low interest rate and debt default or restructuring. The authors point out that external defaults and restructuring impose long-term costs in the form of higher bond yields. Nonetheless, they warn that debt default, both external and domestic, may become more common in the wake of the increase in debt in response to the pandemic.

Similarly, Stephan Danninger, Kenneth Kang and Hélène Poirson of the IMF have a post on the IMF’s Blog, “Emerging Economies Must Prepare for Fed Policy Tightening,” that presents measures that the governments of these countries should undertake to limit the fallout from higher foreign rates. These include allowing their currencies to depreciate while raising their own interest rates. Of course, such measures make supporting a weak domestic economy more difficult. They warn that countries with significant nonperforming debt levels will face solvency concerns.

The IMF, the World Bank and the Group of 20 have joined together to implement a “Common Framework” to help low-income countries deal with their unsustainable debt. Creditor Committees will be created on a case-by-case basis to coordinate debt restructuring by private and official creditors. Private lenders, however, have not shown an interest in joining the program and to date, only three countries—Chad, Zambia and Ethiopia—have applied for assistance.

Another challenge facing the Common Framework is the role of China, which has become the largest bilateral lender to the low-income countries. China has not joined the Paris Club, the organization of creditor nations that deals with bilateral debt between advanced economies and low-income countries. However, it has to date followed the policies of the Paris Club members in deferring debt. One possible complication consists of whether loans from Chinese policy banks, such as the China Development Bank and the Export-Import Bank of China, and state-owned commercial banks, such as the Industrial and Commercial Bank of China, should be treated as private or official creditors.

Anne Krueger of Johns Hopkins University has warned that debt restructuring and further lending should be accompanied by appropriate economic policies. Some countries were engaging in unsustainable spending before the pandemic, and any new lending should be used for spending related to the pandemic. She cites Bolivia, Ghana, Madagascar, Pakistan, Sri Lanka, and Zambia as countries that had excessive expenditures before the pandemic.

The possibility of a debt crisis among the emerging markets and developing nations has long been foreseen (see here and here). The wave of new lending to these countries in the period preceding the pandemic was similar to previous surges that had led to financial crises, and the pandemic further raised debt levels. The combination of higher interest rates in the advanced economies, sluggish economic growth and the possibility of further disruptions due to the pandemic pose a challenge to governments with limited abilities to respond.

The Return of FDI

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Last year’s collapse in foreign direct investment was seen by many as the first stage of a period of retrenchment. Political pressure to “reshore” production, particularly of goods of national importance such as medical equipment, would cause multinational firms to rearrange their global supply chains to minimize foreign exposure. The data released for FDI in the first half of this year shows that in fact foreign investment has rebounded from last year’s decline. But the largest growth rates were recorded for the upper-income countries, where FDI had fallen precipitously in 2020, and China. FDI also rose in middle-income countries where it  had not fallen as sharply in 2020. Low income countries, on the other hand, did not see any increase in foreign investment.

The October issue of the Organization of Economic Cooperation and Development’s FDI In Figures reports that global FDI flows rose to $870 billion in the first half of 2021. These flows were more than double those of the last half of 2020 and even higher than pre-pandemic flows. The largest increase was recorded in China, the world’s major recipient of FDI. But the second and third largest inward flows were recorded in the U.S. and the U.K. FDI inflows to the Group of 20 economies increased by 42% in the first half of this year as compared to the previous half-year. They were up in 83% in the OECD G20 countries, and 12% in the non-OECD G20, reflecting a split by income level.

Earnings on inward OECD FDI increased by about 30% in the first half of the year, from the previous half-year. About half of this amount was distributed to affiliates and the remaining funds reinvested. Earnings on outward FDI increased by 28%, and a larger share of these payments were reinvested rather than distributed. Compared to pre-pandemic levels, these earnings were 14% higher. Growth in the earnings of outward FDI was particularly noticeable in the U.S., France, Germany, Japan, and the Netherlands, all home countries of multinational firms.

Much of the FDI activity in the OECD economies consisted of mergers and acquisitions (M&As), as both M&A deal values and the number of acquisitions rose in the advanced economies. Many of these deals were made in the healthcare and technology sectors. M&A activity in the emerging market and developing economies, however, was much less.

Investment in greenfield projects was relatively low compared to pre-pandemic levels. Announced greenfield projects increase by 9% in advanced economies but fell by 6% in the emerging market and development economies. Corporations are holding back from building new production facilities in those countries that saw large amounts of investment in the 1990s and early 2000s.

The difference in FDI activity amongst countries also appears in the October issue of UNCTAD’s  Investment Trends Monitor. It reports that FDI recorded growth rates of 117% in the high-income countries, 30% in the middle-income countries but a decline of 9% in the low-income group. The report cites “the duration of the health crisis and the pace of vaccinations, especially in developing countries” as “factors of uncertainty.”  This report also noted the decline in greenfield projects.

A similar discrepancy in national growth prospects was noted by the IMF in the latest issue of the World Economic Report. The report stated:

Advanced economy output is forecast to exceed pre-pandemic medium-term projections—largely reflecting sizable anticipated further policy support in the United States that includes measures to increase potential. By contrast, persistent output losses are anticipated for the emerging market and developing economy group due to slower vaccine rollouts and generally less policy support compared to advanced economies.

As noted above, China is a conspicuous exception to the FDI trends for emerging market and developing economies. Megan Greene of Harvard’s Kennedy School, in a column “Don’t Believe the Deglobalisation Narrative” in the Financial Times, interpreted the data on the inflows of FDI and other financial flows as showing that there isn’t any evidence of a corporate retreat from China. The country continues to offer modern infrastructure for the movement of parts and goods, domestic supplier networks and a large labor force. Moreover, China’s own markets represent potential sources of profits if consumption expenditures increase.

FDI may have rebounded from its downturn in 2020, but the increase in investment flows has been distributed unevenly. Part of the unequal allocation is due to the virus, with a new mutation appearing in some African countries. As long as the virus evolves into more virulent strains, there will always be the threat of another outbreak. Only a truly global effort that includes the delivery of vaccines to those nations most in need can stop the cycle and reorient foreign investment.

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

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

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

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

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

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

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

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

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

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

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

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

The Next “Lost Decade”?

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The 1980s were a “lost decade” of economic growth for those developing countries in Latin America that were enveloped in a debt crisis. Many now fear that we are on the verge of another debt crisis in the wake of borrowing by governments to support their economies during the pandemic. A concerted response will be needed to avoid it.

Countries such as Mexico and Brazil had borrowed during the 1970s to finance oil bills that had skyrocketed after OPEC had raised petroleum prices. International banks were happy to recycle the dollars that the oil-exporters had placed on deposit with them. The crisis came when the Federal Reserve under Paul Volcker raised interest rates, and the U.S. experienced back-to-back recessions that lowered the demand for these countries’ exports. It took a decade of negotiations and failed initiatives before the bank debt was refinanced as bonds or written off.

The IMF’s latest Global Financial Stability Report provides data on the recent rise in government debt: “Government debt in emerging markets (excluding China) is expected to reach 61 percent of GDP in 2021, and gross financing needs are anticipated to remain elevated at 13 percent of GDP in 2021, coming off record levels in 2020.” This escalation follows the pre-pandemic period when public debt/GDP levels had already risen in emerging market economies and advanced economies outside Europe.

The governments issuing debt were able to finance their expenditures at very low interest rates that reflected the 2020 collapse in economic activity and the rapid response by central banks. The “sudden stop” of capital flows to emerging markets last spring was reversed as investors returned seeking the higher yields that emerging market debt could provide. Moody’s reports record sales of Eurobonds in 2020 by emerging markets of $639 billion. Foreign investors also purchased sizable amounts of local currency debt in many of these countries.

But the favorable conditions of the past year are changing. Economic recovery will be much slower for countries such as Brazil and India, where the numbers of people infected by the coronavirus continue to soar. In April’s World Economic Outlook, the IMF reported improved prospects for growth in the advanced economies but less a less favorable outlook for the emerging and developing economies with the exception of China. Second, interest rates have risen from their very low levels In the U.S., reflecting expectations of increased growth and inflation. Third, a strong U.S. dollar makes servicing dollar-denominated debt more expensive.

Many of those issuing bonds relied on the analysis of Olivier Blanchard, until recently chief economist of the IMF, to justify their borrowing. Blanchard had pointed out that an increase in public debt may be sustainable if the rate of economic growth exceeds the interest on the public debt. The governments of some emerging markets used this line of reasoning to justify their borrowing as they responded to the worldwide lockdown and the need for medical equipment and supplies.

But emerging markets face different circumstances than those of advanced economies. They pay a risk premium that can escalate when conditions deteriorate.  IMF economists Marcos Chamon and Jonathan D. Ostry warn that borrowing costs for emerging markets and developing economies may become significantly higher relatively quickly. The Economist cites a bank study that lists Brazil, Indonesia, Mexico and South Africa as among the countries most vulnerable to any jump in interest rates.

If (or when) conditions do deteriorate, what responses will be available? The IMF, the World Bank and the Group of 20 have suspended the debt servicing of their loans to low-income countries via a Debt Service Suspension Initiative (DSSI). The response has been limited, perhaps due to fears of what acceptance would imply about domestic economic management. Moreover, DSSI does not apply to private bondholders, and the commercial share of the holdings of public debt rose over the last decade.

During the 1980s the IMF worked with the governments in distress and the international banks that were their lenders. This time, however, there is a more disparate group of lenders, and it will be more difficult to formulate a common response. China has become a major lender, and China has joined the DSSI. But some of their loans were made state-owned banks and agencies, which may be classified as private lenders. Some foreign bondholders claim they are concerned that any debt relief they extend will be used to pay the Chinese lenders.

The IMF intends a more direct response through an issuance of Special Drawing Rights (SDRs), the official currency of the Fund. These can be sold or used as foreign exchange reserves, thus freeing up other reserve assets. Their allocation are based on the quotas which reflect a country’s size and international economic activity, so favors the advanced economies. But there are mechanisms that allow countries that do not need the new allocation to lend or donate them to countries that do. The U.S. had withheld its approval of the increase, but Treasury Secretary Yellen reversed that decision and the allocation is expected to take place next summer.

Kris James Mitchener of Santa Clara University and Christoph Trebesch of the Kiel Institute for the World Economy review the literature on sovereign debt in their paper, “Sovereign Debt in the 21st Century: Looking Backward, Looking Forward.” While their survey emphasizes debt problems in advanced economies, they point out implications for the emerging market economies. For example, they find that the enforcement of debt contracts via legal challenges has become more common. Distressed debt funds purchase debt that has been discounted in value because of concerns over default, and then demand full repayment from the issuing government in court in London or New York. They show that such tactics were used in the cases of Argentina, Greece and the Ukraine. Similar challenges may emerge if emerging markets attempt to restructure their obligations.

The record of the last debt crisis makes clear the adverse implications for allowing debt problems to fester. The pandemic has already undone much of the progress in reducing poverty, pushing tens of millions many back below the poverty line.   A new debt crisis would exacerbate the divergent impacts of the pandemic on the developing economies and the advanced. Just as it is in the self-interest of all countries to contain the virus itself, all have a stake in dealing with its financial fallout.

Portfolio Capital Flows to Emerging Markets amid the Pandemic

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Among the most notable economic responses to the COVID-19 pandemic has been the turnaround in capital flows to emerging markets. A sudden reversal in portfolio flows of over $100 billion to these countries in March has been offset by a surge of capital this fall. But many of these countries have accumulated debt burdens that will affect their ability to recover from the pandemic.

The IMF examined portfolio flows to these economies in last April’s issue of the Global Financial Stability Report (see also here). The report showed that prior to the pandemic, bond portfolio inflows had been larger than equity portfolio flows, with cumulative flows since 2005 of approximately $2.5 trillion for bonds vs. about $1 trillion for equity. The bonds included both bonds denominated in foreign currency as well as local currency debt. These flows had constituted significant amounts of finance in the emerging and frontier markets’ debt and equity markets.

The authors of the report analyzed the determinants of the different types of portfolio flows. They reported that changes in global conditions (or “push factors”) are largely responsible for debt inflows. Among these factors are the VIX index, a measure of global risk appetite, the U.S. Treasury bond yield, and the foreign exchange value of the dollar. Equity flows are also influenced by foreign conditions, but domestic economic growth (a “pull” factor) is a larger factor in raising the likelihood of capital inflows. This reflects the dependency of the returns on portfolio equity on profitable business operations.

These results explain a large part of the retreat from portfolio securities last March. When the extent of the pandemic became clear, the VIX measure rose while the dollar initially appreciated as investors sought a “safe harbor.” These developments contributed to the reversal of foreign holdings of debt securities. The rapid deterioration in the prospects for economic growth in the emerging markets influenced the turnaround of portfolio equity flows.

But capital inflows were flowing back to the emerging markets by the summer and continued to rise this fall. The Institute for International Finance (IIF) reported inflows of $76.5 billion in November alone, with $39.8 billion for emerging market equities and $37.7 billion for bonds and other debt. For the fourth quarter the IIF expected the strongest level of inflows since the first quarter of 2013.

The turnaround reflects several factors. First, the Federal Reserve’s strong response to stabilize financial markets has been successful, and market volatility has dropped. At the same time, the Fed’s lowering of the Federal Funds rate caused investors to look elsewhere for yields. Finally, the announcements of successful vaccines offers the prospect of an economic recovery in 2021.

However, there are concerns that the desire for the higher yield on riskier debt is fostering the issuance of bonds by borrowers who may not be able to fulfill their obligations. The ability of many of the governments and firms in the emerging market economies to meet their debt obligations is very much open to question. In December, S&P Global Ratings noted that “short-term risks still loom large” in the emerging markets.  Moreover, the agency stated that  “Debt overhang among governments and pressure on corporate earnings would constrain an economic recovery.” Five of the 16 key emerging market sovereign bonds that S&P rates carry negative outlooks: Chile, Colombia, Mexico, Indonesia and Malaysia.

The dangers of government spending in emerging markets financed by debt have been noted by Michael Spence of Stanford and Danny Leipziger in “The Pandemic Public-Debt Dilemma.” While the current cost of debt financing is relatively cheap, Spence and Leipziger pointed out that “a country’s citizens are not well-served when their government becomes more indebted in order to spend imprudently.” They warn that “borrowing in hard currencies when exports are depressed and their own exchange rates are under duress simply makes future debt re-scheduling more likely…”

Similarly, Raghuram G. Rajan of the University of Chicago and former governor of the Reserve Bank of India also questions how much debt a government can issue in “How Much Debt Is Too Much?” While some governments can roll over existing debt, Rajan claims that ”… investors will buy that new debt only if they are confident that the government can repay all its debt from its prospective revenues.” He warns that “Many an emerging market has faced a debt “sudden stop” well before it reached full employment, triggered by evaporating market confidence in its ability to roll over debt.”

Jeremy Bulow of Stanford, Carmen M. Reinhart, currently chief economist of the World Bank Group, Kenneth Rogoff of Harvard and Christoph Trebesch of the Kiel Institute for the World economy foresee a need to plan measures to deal with debt problems in “The Debt Pandemic.” They warn of debt restructurings on a scale not seen since the debt crisis of the 1980s. They view the pandemic as “…a once-in-a-century shock that merits a generous response from official and private creditors toward emerging market and developing economies.” Among the measures they suggest is new legislation to support orderly restructurings.

The need for policy measures to deal with debt restructuring is also expressed by Kristalina Georgieva, Managing Director of the IMF, Ceyla Pazarbasioglu,  Director of the IMF’s Strategy, Policy, and Review Department, and Rhoda Weeks-Brown,  General Counsel and Director of the IMF’s Legal Department. They specifically call for strengthening provisions that minimize economic disruption when debtors are in distress. These could include lower debt payments or the automatic suspension of  debt service. They also ask for increased debt transparency and agreement by creditor governments that are part of the Paris Club on a common approach to restructuring.  The latter two steps are aimed in part at China, which has become the largest bilateral creditor for many developing countries. There is considerable uncertainty over the size and conditions of debt owed to China, and how China will respond to the inability of debtor governments to make payments on the debt.

The IMF itself has pledged to provide debt service relief to its poorest members, while working with the Group of 20 on its Debt Service Suspension Initiative. Under this program, the governments of the G20 have offered to suspend the payments of government-to-government debt for 73 developing economies. The G20 also called on private lenders to offer similar relief, but there has been little response.

The onset of a debt crisis among the emerging market countries has been foreseen.  The widespread borrowing to deal with pandemic, however, has exacerbated the debt overhang. The pandemic will continue to affect financial stability and economic performance even as medical measures are implemented to deal with the virus .