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Capital Flows in a World of Low Interest Rates

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

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

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

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

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

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

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

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

 

 

Can Globalization Be Reversed?

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The wide-scale imposition of tariffs by the Trump administration is part of a larger effort to undo the expansion of markets around the globe and ensure that the goods consumed in the U.S. will be produced here. Will it be successful? And what would a world that represented a retreat from the globalization of the 1990s and early 2000s look like?

Martin Sandbu of the Financial Times believes that the open world economy “can withstand the assault.” He points out that the emerging market economies that have benefitted from the increase in international trade have an interest in maintaining the current regime. Moreover, it will be difficult to replace global supply chains with production facilities in each economy where a firm sells its products. Finally, limiting overseas expansion of markets will do nothing to address the problem it is supposed to correct: the stagnant wages of relatively low-skilled people. There are policies to help those whose jobs have been eliminated by technology, but these include better educational opportunities and health care, not limitations on trade.

While globalization will not be replaced by national autarchies, it is possible to imagine more narrow organizations of production and finance. The increase in the number of regional trade pacts will accelerate If the World Trade Organization is undermined by the Trump administration. Whether or not regional trade agreements are the source of trade creation or diversion is an empirical issue. Research by Caroline Freund of the Peterson Institute for International Economics and Emanuel Ornelas of Sao Paulo School of Economics-FGV indicates that such pacts in the past were beneficial for trade. But there is no guarantee that this outcome will continue in the future, particularly if the regional pacts replace wider agreements.

The world could divide into competing spheres of influence. China is taking advantage of the withdrawal of the U.S. from international pacts to advance its Belt and Road Initiative that will link it to resource-rich developing economies in Asia and Africa as well as markets in Europe. Advocates of British withdrawal from the European Union claim that there are better opportunities in the “Anglosphere” of English-speaking countries such as the U.S. and Australia.

But the Trump administration has exhibited animus to even regional pacts such as NAFTA, and seemingly favors bilateral pacts guided by mercantilist goals. Such an approach would be a serious problem for U.S. based multinationals that have integrated production lines across the borders with Mexico and Canada. Nor will the governments of those agree to mercantilist arrangements that are designed to ensure bilateral trade surpluses for the U.S.

A world of tariffs and quotas, moreover, would also be a step towards increased government controls on the private sector. Anne Krueger of Johns Hopkins points out that quotas, such as those on steel that South Korea has agreed to, must be administered by either the Korean or U.S. government. Similarly, exemptions from tariffs must be granted by a bureaucracy that reviews applications from private firms. These grants of authority open up opportunities for corruption. They also act as barriers to entry for new firms, and lessen incentives to innovate. All this adds to the higher costs that consumers and those who rely on imported intermediate goods will pay.

Perhaps the most self-defeating counter-globalization measure would be to lower immigration. While most of the benefits of immigration flow to the migrants themselves, there is also a “migration surplus” for the economy that hosts them. The tax payments of migrants can be used to pay rising Social Security payments at a time when the native U.S. population is aging.  Moreover, immigrants have a strong record of establishing new businesses. The Center for American Entrepreneurship reports that 43% of firms listed in the 2017 Fortune 500 were founded or co-founded by first- or second-generation migrants.

Not all movements towards globalization were beneficial for those countries that opened up their borders. In the area of finance, financial flows led to the Asian crisis of 1997-98 and the global financial crisis of 2008-09, while their impact on growth is slim at best. The IMF has renounced its previous advocacy of capital account deregulation and now views capital controls as part of a government’s toolkit of macroprudential measures to stabilize the financial sector.

Moreover, Dani Rodrik of the Kennedy School has pointed out that the hyperglobalization drive of the 1980s and 1990s pushed trade agreements beyond their “traditional focus on import restrictions and impinged on domestic policies…” Rodrik argues that some of the recent trade pacts are designed to increase the revenues of multinational firms, and their redistributive effects will overwhelm any increases in efficiency.

But attempting to impose a system of nationalistic managed trade that limits the movements of people is inherently difficult, and will lead to widespread government intervention. Workers and firms who benefit from such measures will be outnumbered by those who lose export opportunities and those who must pay higher domestic prices. Over time, firms will cut back on investments if they feel the need to secure government approval. All this will lower productivity in economies where productivity growth is already depressed. There is a need for a better-designed globalization, but what we are seeing is a movement to a world of national barriers that will only fuel xenophobia and hamper long-term growth.

The Spillover Effects of Rising U.S. Interest Rates

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

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

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

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

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

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

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

A Guide to the (Financial) Universe: Part III

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

4.      Stability and Growth

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

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

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

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

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

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

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

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

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

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

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

5.     Conclusions

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

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

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

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

A Guide to the (Financial) Universe: Part II

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(Part I of this Guide appears here.)

3. Crisis and Response

The global crisis revealed that the pre-crisis financial universe was more fragile than realized at the time. Before the crisis, this fragility was masked by low interest rates, which were due in part to the buildup of foreign reserves in the form of U.S. securities by emerging market economies. The high ratings that mortgage backed securities (MBS) in the U.S. received from the rating agencies depended on these low interest rates and rising housing prices. Once interest rates increased, however, and housing values declined, mortgage borrowers—particularly those considered “subprime”—abandoned their properties. The value of the MBS fell, and financial institutions in the U.S. and Europe sought to remove them from their balance sheets, which reinforced the downward spiral in their values.

The global crisis was followed by a debt crisis in Europe. The governments of Ireland and Spain bolstered their financial institutions which had also lent extensively to the domestic housing sectors, but their support led to a deterioration in their own finances. Similarly, the safety of Greek government bonds was called into question as the scope of Greek deficit expenditures became clear, and there were concerns about Portugal’s finances.

Different systems of response and support emerged during the crises. In the case of the advanced economies, their central banks coordinated their domestic policy responses. In addition, the Federal Reserve organized currency swap networks with its counterparts in countries where domestic banks had participated in the MBS markets, as well as several emerging market economies (Brazil, Mexico, South Korea and Singapore) where dollars were also in demand. The central banks were then able to provide dollar liquidity to their banks. The European Central Bank provided similar currency arrangements for countries in that region, as did the Swiss National Bank and the corresponding Scandinavian institutions.

The emerging market countries that were not included in such arrangements had to rely on their own foreign exchange reserves to meet the demand for dollars as well as respond to exchange rate pressures. Subsequently, fourteen Asian economies formed the Chiang Mai Initiative Multilateralization, which allows them to draw upon swap arrangements. China has also signed currency swap agreements with fourteen other countries.

In addition, emerging market economies and developing economies received assistance from the International Monetary Fund, which organized arrangements with 17 countries from the outbreak of the crisis through the following summer. The Fund had been severely criticized for its policies during the Asian crisis of 1997-98, but its response to this crisis was very different. Credit was disbursed more quickly and in larger amounts than had occurred in past crises, and there were fewer conditions attached to the programs. Countries in Asia and Latin America with credible records of macroeconomic policies were able to boost domestic spending while drawing upon their reserve holdings to stabilize their exchange rates. The IMF’s actions contributed to the recovery of these countries from the external shock.

The IMF played a very different role in the European debt crisis. It joined the European Commission, which represented European governments, and the European Central Bank to form the “Troika.” These institutions made loans to Ireland in 2010 and Portugal in 2011 in return for deficit-reduction policies, while Spain received assistance in 2012 from the other Eurozone governments. In 2013 a banking crisis in Cyprus also required assistance from the Troika.These countries eventually recovered and exited the lending programs.

Greece’s crisis, however, has been more protracted and the provisions of its program are controversial. The IMF and the European governments have been criticized for delaying debt reduction while insisting on harsh budget austerity measures. The IMF also came under attack for suborning its independence by joining the Troika, and its own Independent Evaluation Office subsequently published a report that raised questions about its institutional autonomy and accountability.

In the aftermath of the crisis, new regulations—called “macroprudential policies”—have been implemented to reduce systemic risk within the financial system. The Basel Committee on Banking Supervision, for example, has instituted higher bank capital and liquidity requirements. Other rules include restrictions on loan-to-value ratios. These measures are designed both to prevent the occurrence of credit bubbles and to make financial institutions more resilient. A European Banking Authority has been established to set uniform regulations on European banks and to assess risks. In the U.S., a Financial Stability Oversight Council was given the task of identifying threats to financial stability.

The crisis also caused a reassessment of capital account restrictions. The IMF, which had urged the deregulation of capital accounts before the Asian crisis of 1997-98, published in 2012 a new set of guidelines, named the “institutional view.” The Fund acknowledged that rapid capital flows surges or outflows could be disruptive, and that under some circumstances capital flow management measures could be useful. Capital account liberalization is appropriate only when countries reach threshold levels of institutional and financial development.

One legacy of the response to the crisis is the expansion of central bank balance sheets. The assets of the Bank of England, the Bank of Japan, the European Central Bank (ECB) and the Federal Reserve rose to $15 trillion as the central banks engaged in large-scale purchases of assets, called “quantitative easing”. The Federal Reserve ceased purchasing securities in 2014, and the ECB is expected to cut back its purchases later this year.  But the unwinding of these holdings is expected to take place gradually over many years, and monetary policymakers have signaled that their balance sheets are unlikely to return to their pre-crisis sizes.

(to be continued)

A Guide to the (Financial) Universe: Part I

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A Guide to the (Financial) Universe: Part 1

  1.     Introduction

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

2.       External Assets and Liabilities

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

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

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

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

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

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

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

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

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

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

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

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

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

(to be continued)

Venezuela and the Next Debt Crisis

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

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

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

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

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

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

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

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

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

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

Capital Flows and Domestic Responses

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The international impact of financial shocks became apparent during the global financial crisis. But how do financial flows affect economic conditions during non-crisis times? And are there ways to shelter the domestic economy from these flows? Some new evidence from the IMF seeks to answer these questions.

IMF economists Bertrand Gruss, Malhar Nabar and Marcos Poplawski-Ribeiro, in a chapter in the IMF’s latest World Economic Outlook entitled “Roads Less Traveled: Growth in Emerging Markets and Developing Economies in a Complicated External Environment,” examine the impact of external conditions on growthsince the 1970s in over 80 emerging market and developing economies. This issue is particularly important in light of the contribution to global growth—80%—by these economies since the financial crisis.

The authors construct measures for the countries in their sample to capture the following external conditions: external demand, as measured by domestic absorption in a country’s trading partners; external finance, based on capital flows to peer economies; and the terms of trade, constructed from commodity prices. The cross-correlation across these measures is low, indicating that they capture different sources of external variation. The country-specific measures often diverge from their global values, which the authors attribute to domestic factors.

The three measures are all economically and statistically significant in explaining the growth rate of GDP per capita over five-year windows in the countries under stud , contributing almost 2 percentage points to income per capita growth over the 40-year period. Their collective impact rose from about 1.7 percentage points to 2.3 percentage points over the entire period. External financial conditions in particular have become increasingly important over time. Their contribution to growth increased by about half of a percentage point between the 1995-2004 and 2004-1014 periods, and represented half of the contribution from external factors since 2005. The authors attribute the rise in part to the increased financial integration of capital markets.

How do local conditions affect the impact of external financial flows on the domestic economy? In general, a loosening of external financial conditions contributes to growth when they are channeled to “…financially constrained agents while maintaining relatively robust risk management and origination standards that minimize the pitfalls of excessive credit growth.” This will occur when there is financial development and a healthy pace of increase in domestic credit to accompany capital account openness.

How do policymakers in emerging market economies actually respond to capital flows? IMF economists Atish R. Ghosh, Jonathan D. Ostry and Mahvash Qureshi look at this issue in a recent IMF working paper, “Managing the Tide: How Do Emerging Markets Respond to Capital Flows?” Using a sample of 50 emerging market economies over the period of 2005 to 2013, they investigate whether these countries sought to restrain the impact of capital inflows on their countries. Their evidence indicates that central bankers did seek to check their impact by foreign exchange market intervention and setting higher policy rates. Moreover, macro prudential policies were strengthened and capital controls tightened in response to capital surges. On the other hand, capital flows were associated a pro-cyclical response in government expenditures, signaling that fiscal and monetary policymakers have different goals.

The authors leave open for future research the question of whether such measures decrease the probability of experiencing a subsequent financial crisis (see here). The existence of global financial cycles (see here) indicates that global financial markets have become increasingly dependent on conditions in the advanced economies, particularly the U.S., which may limit the efficacy of domestic measures. Political turmoil in the U.S. may be the factor that upends the recent historically low levels of VIX (see also here). If so, policymakers in the emerging markets will need to take more steps to shield their economies from the ensuing turbulence.

The Emerging Market Economies and the Appreciating Dollar

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

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

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

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

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

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

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

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

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

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

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

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

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

The 2016 Globie: “Global Inequality”

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Each year I name a book as the “Globalization Book of the Year” (also known as the “Globie”). The selection is a recognition of its author’s contribution to our understanding of the causes and effects of globalization. There is no money attached to the prize—recognition is the sole reward. Recent winners can be found here and here.

This year’s awardee is Global Inequality by Branko Milanovic. The book has received a great deal of well-deserved attention for its analysis of how inequality has evolved in an era when goods, services and money—but not people—have been able to cross borders more easily than during any other period since the first era of globalization of 1870-1914. The returns from these transactions, Milanovic demonstrates, have been distributed in a very unequal fashion, which has changed the global distribution of income.

A graph of the gains in real per capita income over the periods of 1988-2008 (see here) shows that those at the bottom of the distribution of global income received some increases. But income rose more quickly for those in the middle percentiles, the 40th to the 60th. This group includes one-fifth of the world’s population, most of whom live in Asia, primarily China and India. Growth in those countries elevated their middle classes to become the world’s middle class. However, despite these advances these “winners” of globalization would still be considered poor by the standards of the upper-income countries.

The other group that recorded large gains during this period comprises the world’s richest people, the upper 1% whom Milanovic calls the “global plutocrats.” Their gains shrink if the data are extended to include the global financial crisis and its immediate aftermath. Nonetheless, this relatively small group benefitted enormously from the expansion of the global economy. While they are located around the world, one half of this group lives in the U.S.

The intervals of the income distribution space between the global middle class and the top 1% include the “lower middle class of the rich world” in Western Europe, North America, Oceania and Japan. They saw few gains during this period. Consequently, the benefits of globalization were skewed to those who knew how to benefit from it. Inequality as measured within countries increased in recent decades in the U.S. and other upper income countries.

What about the “Kuznets curve,” which predicts rising and then falling inequality in a country over time as it develops? Milanovic extends this concept to “Kuznets cycles” with alternating increases and decreases in inequality. Since the Industrial Revolution, wages have generally increased as income has grown in the advanced economies. But inequality also increased as the manufacturing sector with its higher wages attracted workers from the rural sectors. Inequality subsequently fell during the twentieth century  due to “benign forces,” which included increased education and government policies as well as “malign forces,” such as wars and civil conflict. That downswing ended sometime during the 1970s-1980s, and the upper income countries commenced on a new upswing that Milanovic attributes to a new technological revolution and globalization.

What does the future hold? Milanovic is careful in framing answers to that question, but emphasizes two main trends. The first is convergence, the diminution of the gap in income between poor and rich nations due to higher growth rates in the former as they catch up with the latter. If it continues, then global inequality will shrink. However, not all poor countries have recorded relatively higher growth rates, and African nations have recorded relatively lower growth rates. Overall, though, Milanovic judges that global convergence is more like to continue than to reverse.

The other trend to follow is inequality within countries. Milanovic writes that “…inequality in the United States is either still rising or is about to reach a peak of the second Kuznets wave.” The same pattern is found in other upper-income nations. How can these countries further the reversal of inequality? In the past inequality was lowered through government measures that included increased taxation and social transfers, as well as episodes of hyperinflation and wars. But increased taxes are harder to impose in a global environment. Milanovic, therefore, urges equalization in assets and in education. The former can be achieved through high inheritance taxes, corporate tax policies that distribute shares of ownership to workers, and tax and administrative policies that enable the poor and middle classes to hold financial assets. State-funded education is needed as well to equalize educational returns across all schools.

In the current political environment, however, elected officials seem more interested in reducing inequality by upending globalization. In the U.S., President-elect Trump has made renegotiating trade deals a top priority. Congressional representatives are looking at changes in the tax code that would encourage exports and discourage imports. The incoming Attorney General, Jeff Sessions, has hard-line views on migration. Moreover, the new Secretary of Education, Betsy DeVos, is an advocate of charter schools, not public schooling, while estate taxes may disappear as part of an overhaul of the tax system that will benefit the wealthy. In Europe, the government of Great Britain and officials of the European Union are preparing to negotiate the terms of Britain’s withdrawal from the EU.

Milanovic’s book provides a valuable perspective on inequality. It shows that there has been an historic turnaround  in inequality across national borders after a long period when Western countries kept drawing ahead of other nations. But inequality within many nations, including some emerging market economies, has risen. The challenge is to reverse the latter movement without offsetting the former. How countries deal with this challenge has become the dominant political issue of our time.

Milanovic ends his book by posing the question: “Will Inequality Disappear as Globalization Continues?” His answer: “No. The gains from globalization will not be equally distributed.” Milanovic deserves credit for putting that issue squarely on the global agenda.