Tag Archives: exchange rates

Japan’s Net Income Surplus and Its Exchange Rate

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Japan’s current account surplus may not be a surprise to those of us who remember Japan as a major exporter. But a closer examination shows that the current account surpluses recorded today are not due to the trade account but rather the net primary income balance. Japan used the trade surpluses of the 1970s and 1980s to build up its holdings of foreign assets and prepare for the day when it would need income from abroad to pay for its aging population. Last year, according to The Economist, the country earned a net $269 billion on its primary income balance, equal to 6% of its GDP.

Mariana Colacelli, Deepali Gautam and Cyril Rebillard of the IMF examine Japan’s income balance in their 2021 working paper,“ Japan’s Foreign Assets and Liabilities: Implications for the External Accounts.” They point out that the surplus reflects Japan’s status as a net creditor nation, as shown by its Net Investment Income Position of $5.4 billion, which equals 63% of its GDP.  The surplus reflects higher yields on its foreign assets than its liabilities , including both foreign direct investment as well as portfolio equity and debt assets. The U.S., on the other hand, has a surplus on FDI income but a deficit on its portfolio-related return.

Japan’s income balance is negatively corelated to its trade balance, and this relationship holds for other countries. They cite several factors that could be relevant in Japan’s case, including:

  • aging population, which uses its assets to finance consumption (including imports);
  • income effect, which boosts spending on imports;
  • offshoring by multinationals, which shifts income from exports to income received from the multinationals’ subsidiaries.

Colacell, Gautam and Rebillard also study the response of the income balance to changes in the real exchange rate in order to compare this with the response of the trade balance. An appreciation of the real exchange rate in a country like Japan with a large net creditor position would likely lead to a decrease in the income balance, reinforcing the expected trade response to an appreciation. On the other hand, a currency appreciation in a net debtor nation would most likely lead to an increase in the income balance, which would lead to an income surplus that could offset the trade response.

They present evidence of negative responses in the income balance to an appreciation. This result differs from that reported of Takahiro Hattori, Ayako Tomita and Kohei Asao in a new working paper from the Policy Research Institute of the Japan’s Ministry of Finance, “The Accumulation of Income Balance and Its Relationship with Real Exchange Rate: Evidence from Japan.” They use data from 1999 through 2020 and find that the real exchange rate does not have a significant impact on Japan’s real exchange rate.

They expand their empirical analysis to a panel of 39 countries, and find again that the estimates of the real exchange rate impact on the income balance are insignificant. These results are similar to those reported by Enrique Alberola of the IMF with Ángel Estrada and Francesca Viana of the Bank of Spain in their 2020 paper in the Journal of International Money and Finance, “Global Imbalances from a Stock Perspective: The Asymmetry between Creditors and Debtors.” (BIS working paper version here). They investigated the impact of the role of the net income balance on the adjustment of the current account via the real exchange rate using annual data from 1980-2015, but found no evidence of such an effect. I also looked at the response of the income balance to the dollar exchange rate in 26 emerging market countries during the period of 1998– 2015  in my 2020 paper in the Review of International Economics, “The Sources of International Investment Income in Emerging Market Economics”, and did not find evidence of an impact of the exchange rate.

Further evidence on this channel of transmission to current account imbalances via the exchange rate impact on the net income balance appears in Alberto Behar and Ramin Hasan’s of the IMF in their 2022 working paper, “The Current Income Balance: External Adjustment Channel or Vulnerability Amplifier?” They did find evidence of a significant effect of the exchange rate on income credits and debits. However, these effects are relatively small when compared with the impact on the trade balance.

Japan’s net income balance, therefore, may an outlier in terms of its size and position in that country’s current income. However, the increasing importance of net income balances and their impact on a country’s balance of payments will necessitate further work on this topic. In particular, the role of the exchange rate in determining the primary income balance canl be further examined.

The Rising Dollar

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The foreign currency value of the dollar has been rising. The nominal broad dollar index of the Federal Reserve shows the dollar has incresed by by about 9% since its low point a year ago while other indexes register larger gains. What does this mean for the U.S. and other economies?

The appreciation reflects several factors. First, higher interest rates make investing in dollar-denominated assets more appealing, particularly since many other major central banks lag the Federal Reserve’s in its monetary tightening. The European Central Bank will not begin to raise its rates until July, while the Bank of Japan has no plans to change its accomodative policy stance. Second, the dollar’s “safe asset” status draws investors who fear the economic and political uncertainty due to the Russian invasion of Ukraine. Third, the COVID19 lockdowns in China have disrupted its economy, while the U.S. has not (yet) exhibited any significant slowdown.

A rising dollar will contribute to the increasing U.S. trade deficit. American consumers may be losing confidence because of inflation, but they are still purchasing foreign goods. Lower import prices will assist the Fed in combatting inflation, which could slow future hikes in interest rates..

 The dollar’s appreciation will also have an impact on the foreign-based revenues and profits of U.S. based multinationals. A 2018 S&P 500 research paper by Philip Brzenk showed that changes in the value of the dollar had an impact on S&P 500 companies with significant foreign activities. An appreciation (depreciation) of the dollar lowers (raises) the value of the foreign earnings of those companies with major foreign currency exposure, which is accompanied by decreases (increases) in the values of their share prices relative to those firms in the S&P 500 with little foreign exposure. A decline in foreign-sourced income will also affect the net income balance of the U.S. balance of payments, contributing to a further weakening of the current account.

The impact on foreign economies of the rising dollar is also mixed. On the one hand, those countries that export to the U.S. should benefit from lower prices for their goods. However, this effect is mitigated when their export prices are denominated in dollars.  Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le Mezo, Arnaud Mehl and Tra Nguyen of the IMF drew attention to the growing use of the dollar as a vehicle currency and the implications for trade balances in a 2020 IMF working paper, “Patterns in Invoicing Currency in Global Trade.”

Moreover, any expansionary effect due to increased trade can be offset by what has been called the “finance channel.” The financial channel reflects the impact of the exchange rate on the value of foreign currency liabilities, such as loans taken in a foreign currency. An appreciating dollar will raise the domestic value of those liabilities. Jonathan Kearns and Nikhil Patel of the Bank for International Settlements examined these channels in their article, “Does the Financial Channel of Exchange Rates Offset the Trade Channel?”, which appeared in the December 2016 issue of the BIS Quarterly Review. They found evidence that the financial channel partly offsets the trade channel for emerging market economies (EMEs) but that it is weaker for the advanced economies.

Similarly, Boris Hoffman and Taejon Park of the BIS reported that a dollar apperciation contributes to a deterioration of growth prospects of emerging market economies in their 2020 BIS Quarterly Review paper, “The Broad Dollar Exchange Rate as an EME Risk Factor.” They found that a dollar appreciation dampens investment growth, and even export growth. These effects were larger in countries with high dollar debt and high foreign investor presence in local currency bond markets, which conttibute to the financial channel.

Another examination of the impact of changes in the value of the dollar on emerging market economies was undertaken by Pablo Druck, Nicolas E. Magud and Rodrigo Mariscal of the IMF in “Collateral Damage: Dollar Strength and Emerging Markets’ Growth,” which appeared in the North American Journal of Economics and Finance in 2018 (IMF working paper version here). They found evidence of a negative relationship between the strength of the dollar and emerging markets’ growth. They attributed this empirical relationship to two channels of transmission: first, a negative linkage with commodity prices that depresses demand for the exports of commodity producers; second, an increase in the cost of imported capital imports that are necessary for growth. While supply shocks will keep commodity prices elevated, the price of capital imports has already risen due to widespread inflation.

The impact of the appreciation of the dollar will spread far outside U.S. borders. These effects will occcur in countries already grappling with higher food and energy costs, and the consequences of a slowing Chinese economy. A global recession is not inevitable, but the IMF’s Managing Director Kristalina Georgieva is not exagerating when she says that the world economy faces “its biggest test since the second world war.”

The 2021 Globie: “Three Days at Camp David” and “The Global Currency Power of the US Dollar”

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Fall is the time of the year to announce the recipient of this year’s “Globie”, i.e., the Globalization Book of the Year. The prize is strictly honorific and does not come with a check. But the award gives me a chance to draw attention to a recent book—or books—that are particularly insightful about globalization. Previous winners are listed at the bottom of the column.

This year there are two winners, Jeff Garten for Three Days at Camp David and Anthony Elson for The Global Currency Power of the US Dollar. Each book deals with the financial hegemony of the U.S. dollar in the global financial system. Together they provide a fascinating account of how the dollar came to hold—and hold onto—this role.

Garten looks at the decision by President Richard Nixon in the summer of 1971 to end the link between the dollar and gold, a central foundation of the Bretton Woods system. Foreign central pegged their exchange rates to the dollar, which was convertible to gold by the U.S. government for $35 an ounce. This arrangement reflected the U.S. position at the end of World War II as the predominant economic power, able to use its influence at Bretton Woods to ensure a dollar-dominated system.

But the imbalance between the U.S. and the rest of the world shifted during the 1950s, particularly as Germany and Japan emerged as economic powers with growing trade surpluses. U.S. government spending resulted in growing foreign holdings of dollars. Yale Professor Robert Triffin pointed out that the ability of the U.S. to exchange its gold for dollars was deteriorating, and this incipient crisis became known as the “Triffin dilemma.” By 1971 this situation was no longer sustainable. Foreign central banks held about $40 billion in dollars while U.S. gold holdings had fallen to $10 billion. Speculators were taking positions on the response of the U.S. and other central banks in a global chicken game.

Garten describes the main players in the decision to end the link with the dollar. Nixon had appointed John Connolly as Treasury Secretary mainly because of Connolly’s political skills.  Connolly in turn depended on the expertise in international finance of Paul Volcker, then under secretary of the Treasury for international monetary affairs. George Schulz was known for his organizational expertise and served as the director of the Office of Management and Budget. Arthur Burns, Chair of the Federal Reserve, sought to serve Nixon while maintaining some semblance of institutional autonomy. Other participants in the decision included Paul McCracken of the Council of Economic Advisors and Peter Peterson of the White House Council on International Economic Policy.

These men (yes, all men) had different perspectives on the best way to handle the crisis. Volcker and Burns shared an appreciation of the existing framework, and wanted to consult with their counterparts in other countries on reforming the system. Schulz, influenced by his background at the University of Chicago, looked forward to a day when flexible exchange rates would replace pegged rates. Connolly, on the other hand, had no ideological agenda. He sought to promote American interests and Nixon’s re-election, and saw the two as entirely compatible.

Nixon, Garten makes clear, was concerned about the impact of the situation on his 1972 election campaign, and his response must be understood in that context. Nixon consulted with these advisors at Camp David on the weekend of August 13 – 15 on how best to meet the dollar crisis. After a broad discussion, the decision to end the link of the dollar with gold sales was made. The rest of the weekend was spent on deciding on how to present the issue to the American public and U.S. allies.

Nixon spoke that Sunday night, making the case on the need to achieve economic prosperity in the aftermath of the Vietnam war. Other measures he presented included a tax credit for investment, a freeze on wages and prices and the establishment of a Cost of Living Council to enact measures to control inflation, and a 10% temporary tariff on imports. He justified the latter on the “unfair edge” that competitors had gained while the U.S. promoted their post-World War II recovery.

The U.S. subsequently negotiated with the other leading advanced economies on establishing new fixed rates, but the effort was unsuccessful. By March 1973, almost all of the Western European economies and Japan had embraced flexible exchange rates. The Jamaica Accords of 1978 marked the official of the Bretton Woods exchange rate system. Central banks could continue to peg their currencies against the dollar, but there was no obligation on the U.S. to support the “non-system.”

Anthony Elson brings the story forward in time to explain the continuing dominant position of the dollar. It is doubtful that anyone in 1971 or 1978 would have predicted a key role for the dollar in the post-Bretton Woods era, and Elson shows that the dollar’s continued dominance reflects several factors. First, the dollar continues to be used for invoicing international trade, even for non-U.S. trade flows. The dollar is used for this purpose in order to minimize transaction costs, as well as its record of macro stability. Second, the continued dominance of financial markets in the U.S. draws foreign investors looking for safe and liquid markets. This in turn has encouraged the growth of dollar-based financing outside the U.S. Third, the dollar continues to the most commonly-used currency for the foreign exchange reserves of central banks. U.S. Treasury bonds are seen as a global “safe asset.”

All this, Elson points out, bring benefits for U.S. traders and investors, who can use the dollar to purchase foreign goods and assets. In addition, the government can finance a continuing current account deficit through its provision of U.S. Treasury bonds. The foreign demand  for these securities also lowers the cost of financing the fiscal deficits. On the political side, the government has learned how to use access to the dollar-based international clearing system as a tool of foreign policy, effectively “weaponzing the dollar.”

Can this system continue? The “new Triffin dilemma” has arisen as a result of the relative decline of the U.S. economy in terms of its share of world GDP at the same time as the demand for safe assets continues to grow. An increase in the issuance of U.S. securities to finance fiscal deficits coupled to the political posturing over the debt ceiling may threaten the confidence of foreign investors in the ability of the U.S. government to meet its obligations, much as the declining gold stock led to the 1971 crisis.

But what alternatives are there? The Eurozone and China have grown in size and importance and their currencies may serve as regional rivals for the dollar. But a multipolar reserve currency system may itself be unstable. The IMF’s Special Drawing Rights were designed to supplement the dollar, but their use has been limited, and it would take concerted intergovernmental action to encourage its use. Digital currencies may change how we view money, and central banks are actively investigating their use.

There is little history to provide a guide on the circumstances that lead to a change in the hegemonic currency. The dollar began to rival the British pound in usage in the 1920s as the U.S. economy rapidly grew. But the transition was finalized by the costs to Great Britain of fighting World War II. If a peaceful transition to a new reserve currency system is to take place, it will require more international cooperation than has been shown on other issues.

 

2020    Tim Lee, Jamie Lee and Kevin Coldiron, The Rise of Carry: the Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis

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

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

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

2016    Branko Milanovic,  Global Inequality

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

The Long Reach of U.S. Monetary Policy

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

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

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

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

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

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

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

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

The 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.

Monetary Policy in an Open Economy

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The recent research related to the trilemma (see here) confirms that policymakers who are willing to sacrifice control of the exchange rate or capital flows can implement monetary policy. For most central banks, this means using a short-term interest rate, such as the Federal Funds rate in the case of the Federal Reserve in the U.S. or the Bank of England’s Bank Rate. But the record raises doubts about whether this is sufficient to achieve the policymakers’ ultimate economic goals.

The short-term interest rate does not directly affect investment and other expenditures. But it can lead to a rise in long-term rates, which will have an effect on spending by firms and households. The relationship of short-term and long-term rates appears in the yield curve. This usually has a positive slope to reflect expectations of future short-term real rates, future inflation and a term premium. Changes in short-term rates can lead to movements in long-term rates, but in recent years the long-term rates have not always responded as central bankers have wished. Former Federal Reserve Chair Alan Greenspan referred to the decline in U.S. long-term rates in 2005 as a “conundrum.” This problem is exacerbated in other countries’ financial markets, where long-term interest rates are affected by U.S. rates (see, for example, here and here) and global factors.

Central banks that sought to increase spending during the global financial crisis by lowering interest rates faced a new obstacle: the zero lower bound on interest rates. Policymakers who could not lower their nominal policy rates any further have sought to increase inflation in order to bring down real rates. To accomplish this, they devised a new policy tool, quantitative easing. Under these programs, central bankers purchased large amounts of bonds with longer maturities than they use for open market transactions and from a variety of issuers in order to bring down long-term rates. The U.S. engaged in such purchases between 2008 and 2014, while the European Central Bank and the Bank of Japan are still engaged in similar transactions. As a consequence of these purchases, the balance sheets of central banks swelled enormously.

In an open economy, there is another channel of transmission to the economy for monetary policy: the exchange rate. If a central bank can engineer a currency depreciation, an expansion in net exports could supplement or take the place of the desired change in domestic spending. A series of currency depreciations last summer led to concerns that some central banks were moving in that direction.

But there are many reasons why using exchange rate movements are not a solution to less effective domestic monetary policies. First, if a central bank wanted to use the exchange rate as a tool, it would have to fix it. But it then would have to surrender control of domestic money or block capital flows to satisfy the constraint of the trilemma. Second, there is no simple relationship between a central bank’s policy interest rate and the foreign exchange value of its currency. Exchange rates, like any asset price, exhibit a great deal of volatility. Third, the impact on an economy of a currency depreciation does not always work the way we might expect. Former Federal Reserve Chair Ben Bernanke has pointed out that the impact of a cheaper currency on relative prices is balanced by the stimulative effect of the easing of monetary policy on domestic income and imports.

Of course, this does not imply that central banks need not take notice of exchange rate movements. There are other channels of transmission besides trade flows. The Asian crisis showed that a depreciation raises the value of debt liabilities denominated in foreign currencies, which can lead to bankruptcies and banking crises. We may see this phenomenon again in emerging markets as those firms that borrowed in dollars when U.S. rates were cheap have difficulty in meeting their obligations as both interest rates and the value of the dollar rise (see here).

Georgios Georgiadis and Arnaud Mehl of the European Central Bank have investigated the impact of financial globalization on monetary policy effectiveness. They find that economies that are more susceptible to global financial cycles show a weaker response of output to monetary policy. But they also find that economies with larger net foreign currency exposures exhibit a stronger response of output to monetary policy shocks. They conclude: “Overall, we find that the net effect of financial globalization since the 1990s has been to amplify monetary policy effectiveness in the typical advanced and emerging markets economy.”

While their results demonstrate the importance of exchange rate in economic fluctuations, that need not mean that monetary policy is “effective” as a policy tool. As explained above, flexible (or loosely managed) exchange rates are unpredictable. They can change in response to capital flows that react to foreign variables as well as domestic factors. The trilemma may hold in the narrow sense that central banks maintain control of their own policy rates if exchange rates are flexible. But what the policymakers can achieve with this power is circumscribed in an open economy.

China’s Trilemma Maneuvers

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China’s exchange rate, which had been appreciating against the dollar since 2005, has fallen in value since February. U.S. officials, worried about the impact of the weaker renminbi upon U.S.-China trade flows, have expressed their concern. But the new exchange rate policy most likely reflects an attempt by the Chinese authorities to curb the inflows of short-run capital that have contributed to the expansion of credit in that country rather than a return to export-led growth. Their response illustrates the difficulty of relaxing the constraints of Mudell’s “trilemma”.

Robert Mundell showed that a country can have two—but only two—of three features of international finance: use of the money supply as an autonomous policy tool, control of the exchange rate, and unregulated international capital flows. Greg Mankiw has written about the different responses of U.S., European and Chinese officials to the challenge of the trilemma. Traditionally, the Chinese sought to control the exchange rate and money supply, and therefore restricted capital flows.

In recent years, however, the Chinese authorities have pulled back on controlling the exchange rate and capital flows, allowing each to respond more to market forces. The increase in the value of renminbi followed a period when it had been pegged to increase net exports. As the renminbi appreciated, foreign currency traders and others sought to profit from the rise, which increased short-run capital inflows and led to an increase in foreign bank claims on China. But this inflow contributed to the domestic credit bubble that has fueled increases in housing prices. Private debt scaled by GDP has risen to levels that were followed by crises in other countries, such as Japan in the 1980s and South Korea in the 1990s. All of this gave the policymakers a motive for trying to discourage further capital inflows by making it clear the renminbi’s movement need not be one way.

Moreover, the authorities may have wanted to hold down further appreciation of the renminbi. The release of new GDP estimates for China based on revised purchasing power parity data showed that country’s economy to be larger than previously thought. The new GDP data, in turn, has led to revisions by Marvin Kessler and Arvind Subramanian of the renminbi exchange rate that would be consistent with the Balassa-Samuelson model that correlates exchange rates to levels of income.  Their results indicate that the exchange rate is now “fairly valued.” With the current account surplus in 2013 down to 2% of GDP, Chinese officials may believe that there is little room for further appreciation.

Gavyn Davies points out that there is another way to relieve the pressure on the exchange rate due to capital inflows: allow more outflows. Even if domestic savers receive the higher rates of return that government officials are signaling will come, Chinese investors would undoubtedly want to take advantage of the opportunity to diversity their asset holdings. As pointed out previously, however, capital outflows could pose a threat to the Chinese financial system as well as international financial stability. Chinese economists such as Yu Yongding have warned of the consequences of too rapid a liberalization of the capital account.

The Chinese authorities, therefore, face difficult policy choices due to the constraints of the trilemma. Relaxing the constraints on capital flows could cause the exchange rate to overshoot while further adding to the domestic credit boom that the central bank seeks to restrain. But clamping down on capital flows would slow down the increase in the use of the renminbi for international trade. As long as the policymakers seek to maneuver around the restraints of the trilemma, they will be reacting to the responses in foreign exchange and capital markets to their own previous initiatives.

Tapering and the Emerging Markets

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The response of the exchange rates of emerging markets and their equity markets to the Federal Reserve’s “taper,” i.e., reduction in asset purchases, continues to draw comment (see, for example, here). Most analysts agree that these economies are in better shape to deal with capital outflows than they were in the past, and that the risk of another Asian-type crisis is relatively low. But that does not mean that their economies will react the way we expect.

Gavyn Davies of Fulcrum Asset Management, who has a blog at the Financial Times, has posted the transcript of a “debate” he organized with Maurice Obstfeld of UC-Berkeley, Alan M. Taylor of UC-Davis and Dominic Wilson, chief economist and co-head of Global Economics Research at Goldman Sachs, on the financial turbulence in the emerging markets. “Debate” is not the best word to describe the discussion, as there are many areas of agreement among the participants. Obstfeld points out that there are far fewer fixed exchange rate regimes in today’s emerging markets, and many of their monetary policymakers have adopted policy regimes of inflation targeting. Moreover, the accumulation of foreign exchange by the central banks leaves them in a much stronger position than they were in the 1990s. Taylor adds fiscal prudence and less public debt to the factors that make emerging markets much less risky.

But all the participants are concerned about the winding down of the credit booms that capital inflows fueled. Wilson worries about economies with current account deterioration, easy monetary policy, above-target inflation, weak linkages to the recovery in the developed markets and institutions of questionablestrength. He cites Turkey, India and Brazil as countries that meet these criteria. Similarly, Taylor lists countries with relatively rapid expansion in domestic credit over the 2002-2012 period, and Brazil and India appear vulnerable on these dimensions as well.

Another analysis of the determinants of international capital flows comes from Marcel Förster, Markus Jorra and Peter Tillmann of the University of Giessen. They estimate a dynamic hierarchical factor model of capital flows that distinguishes among a common global factor, a factor dependent on the type of capital inflow, a regional factor and a country-specific component. They report that the country component explains from 60 – 80% of the volatility in capital flows, and conclude that domestic policymakers have a large degree of influence over their economy’s response to capita flows.

But are “virtuous” policies always rewarded? Joshua Aizenman of the University of Southern California, Michael Hutchison of UC-Santa Cruz and Mahir Binici of the Central Bank of Turkey have a NBER paper that investigates the response in exchange rates, stock markets and credit default swap (CDS) spreads to announcements from Federal Reserve officials on tapering. They utilize daily data for 26 emerging markets during the period of November 27, 2012 to October 3, 2013. They looked at the response to statements from Federal Reserve Chair Ben Bernanke regarding tapering, as well as his comments about the continuation of quantitative easing. They also looked at the impact of statements from Federal Reserve Governors and Federal Reserve Bank Presidents on these topics, as well as official Federal Open Market Committee (FOMC) statements.

Their results show that Bernanke’s comments on winding down asset purchases led to significant drops in stock markets and exchange rate depreciations, but had no significant impact on CDS spreads. There were no significant responses to statements from the other Fed officials. On the other hand, there were significant responses in exchange rates when Bernanke spoke about continuing quantitative easing, as well as to FOMC statements and announcements by the other policymakers.

The countries in the sample were then divided between those viewed as possessing “robust” fundamentals, with current account surpluses, large holdings of foreign exchange reserves and low debt, and those judged to be “fragile” due to their current account deficits, small reserve holdings and high debt. Bernanke’s tapering comments resulted in larger immediate depreciations in the countries with current account surpluses as oppose to those with deficits, more reserves and less debt.  Similarly, Bernanke’s statements led to increased CDS spreads in the countries with current account surpluses and large reserve holdings, while lowering equity prices in countries with low debt positions. The immediate impact of the news regarding tapering, therefore, seemed to be tilted against those with strong fundamentals.

The authors provide an explanation for their results: the robust countries had received larger financial flows previous to the perceived turnaround in Fed policy, and therefore were more vulnerable to the impact of tapering. Moreover, as the change in the Federal Reserve’s policy stance was assimilated over time, the exchange rates of the fragile nations responded, and by the end of the year had depreciated more than those of the more robust economies. Similarly, their CDS spreads rose more. By the end of 2013, Brazil, India, Indonesia, South Africa and Turkey had been identified as the “Fragile Five.”

What do these results tell us about the impact on emerging markets from future developments in the U.S. or other advanced economies? There may be a graduated response, as the relative standings of those nations that have attracted the most capital are reassessed. However, if capital outflows continue and are seen as including more than “hot money,” then the economic fundamentals of the emerging markets come to the fore. But financial markets follow their own logic and timing, and can defy attempts to foretell their next twists and turns.

Riding the Waves

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The volatility in emerging markets has abated a bit, but may resume in the fallout of the Russian takeover of the Crimea. The capital outflows and currency depreciations experienced in some emerging market nations have been attributed to their choice of policies. But their economic situations reflect the domestic impact of capital inflows as well as their macroeconomic policies.

 Fernanda Nechio of the Federal Reserve Bank of San Francisco, for example, shows that exchange rate depreciations of emerging markets are linked to their fiscal and current account balances, with larger depreciations occurring in those countries such as Brazil and India with deficits in both balances. Kristin Forbes of MIT’s Sloan School also draws attention to the connection between the extent of the currency depreciations and the corresponding current account deficits. Nechio and Forbes both advise policymakers in emerging markets to make sound policy choices to avoid further volatility.

Good advice! But Stijn Claessens of the IMF and Swati Ghosh of the World Bank have pointed out in the World Bank’s Dealing with the Challenges of Macro Financial Linkages in Emerging Markets that capital flows can exacerbate prevailing economic trends. Relatively large capital inflows to emerging markets (“surges”) tend to take the form of bank and portfolio debt, which contribute to increased domestic bank lending and domestic credit. Claessens and Ghosh write (p.108) that “…large inflows in net terms are the financial counterpart to the savings and investment decisions in the country and affect the exchange rate, inflation, and current account positions.” They also endanger the stability of the financial system as bank balance sheets expand and lending standards deteriorate. These financial flows contribute to increases in asset prices and further credit extension until some domestic or foreign shock leads to an economic and financial downturn.

Are the authorities helpless to do anything? Claessens and Ghosh list policies that may reduce macro vulnerability, which include exchange rate appreciation, monetary and fiscal policy tightening, and the use of capital controls. They also mention, as do the authors of the other chapters of the World Bank volume, the use of macro prudential policies (MaPPs) aimed at financial institutions and borrowers. But they admit that the evidence on the effectiveness of the MaPPs is limited.

Moreover, the macroeconomic policies they enumerate may not be sufficient to deal with the impact of capital inflows. Tightening monetary policy can draw more foreign capital. Fiscal policy is not a nimble policy lever, and usually operates with a lag

What about the use of flexible exchange rates as a buffer against foreign shocks? Emerging market policymakers have been reluctant to fully embrace flexible rates. More importantly, as pointed out here, it is not clear that flexible rates provide the protection that the theory of the “trilemma” suggests it does. Hélène Rey of the London Business School claimed last summer that there fluctuating exchange rates cannot insulate economics from global financial cycles in capital flows and credit growth. Macroprudential measures such as higher leverage ratios are needed, and the use of capital controls should be considered.

Last week we learned that capital flows to developing countries fell in February, with syndicated bank lending falling to its lowest level since 2005. This was followed by the news that domestic credit growth is falling in many emerging markets, including Brazil and Indonesia. The ensuing changes in fundamentals in these countries may or may not alleviate further depreciation pressures. But they will reflect the procyclical linkage of capital flows and domestic credit growth as much as wise policy choices. And there is no guarantee that the reversals will not overshoot and bring about a new set of troubles. The waves of capital can be as tricky to ride as are ocean waves.