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Empires, Past and Present

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Economists rarely write about “empires,” unless they are referring to historical examples such as the Roman empire. But Thomas Hauner of the Federal Reserve Bank of Minneapolis,  Branko Milanovic of the Graduate Center of City University of New York and Suresh Naidu of Columbia University have presented a study of empires using criteria drawn from an economics classic, John Hobson’s Imperialism (1902). The same criteria can be used to examine whether any empires exist today.

Hobson was not a Marxist, but his work greatly influenced later Marxist writers who wrote about imperialism, including Vladimir Lenin, Rudolf Hilferding and Rosa Luxemburg. Hobson believed that there was chronic underconsumption in advanced capitalist countries due to unequal distributions of income. This lowered the return on domestic investment, and as a result the owners of financial capital turned to foreign markets where returns would be higher. These investors relied on their governments to guarantee the safety of their foreign holdings from seizure.

Hauner, Milanvic and Naidu demonstrate that there was a high degree of inequality within the advanced capitalist countries in the late 19th century. The foreign assets held by wealthy investors in Britain and France expanded greatly during this period, and these assets generated rates of return higher than those available from domestic investments. They also present evidence of a linkage between the accumulation of foreign assets and militarization that led to World War I. These results are consistent with Hobson’s work.

Hobson’s empires established positive net international investment positions (NIIP) and received income from these foreign investments. The payments appear in the current account of the balance of payments as “net primary income.” This component of the current account records the difference between payments received by domestic residents for providing productive resources, such as their labor, financial resources or land, to foreigners minus the payments made to foreigners for their productive resources made available to the domestic economy. For most countries, receipts and payments on financial assets are the largest component of their net primary income.

Great Britain was a financial center and the preeminent creditor nation during the zenith of its empire, and a net recipient of foreign income. It earned net income worth 5.4% of GDP in the period 1874-1890, and 6.8% from 1891 to 1913 (Matthews, Feinstein and Odling-Smee 1982). The surpluses were large enough to offset a trade deficit and allow the country to continue to invest abroad and expand their foreign holdings.

What are the largest creditor nations today? Are they also Hobsonian empires? Japan is the leading creditor nation, with a net international investment position of $2.8 trillion in 2015, which represented 67% of its GDP. It earned $165.88 billion in net primary income, worth 3.8% of its GDP. Germany is also a creditor nation, with a NIIP of about $1.5 trillion (45% of GDP) in 2015 and net income of $74.6 billion (2.2% of its GDP).

But Japan and Germany nations do not fulfill the other criteria to be called empires. They do not have the disparities in wealth that the U.S. and many developing countries possess. Their Gini coefficients are almost identical: 32.1 for Japan and 31.4 for Germany. These are similar in magnitude to those of other European countries, higher than those of the Scandinavian nations but below those of Portugal and Spain.

Moreover, the two nations are not militaristic powers. Japan’s constitution forbids the use of force, although the country does have Self-Defense Forces. Prime Minister Shinzo Abe is seeking to amend the country’s constitution in order to clarify the rules governing the disposition of these troops. Germany is part of NATO, but the foreign deployment of German forces is strictly supervised by Parliament.

The situation of other large countries is more anomalous. China is a leading creditor nation, with a NIIP in 2015 only slightly lower than Germany’s and equal to 194% of its GDP. But that country registered a deficit of net primary income of $41.8 billion. On the other hand, the country with the largest inflow of income in absolute terms was the U.S., a debtor nation with a NIIP of -$7.8 trillion in 2015, worth about 45% of GDP. Its net income inflow of $204.5 billion represented 1.1% of its GDP.

The explanation for these seemingly inconsistent results lies with the composition of the external assets and liabilities. The U.S. is “long equity, short debt,” with assets largely composed of foreign direct investments (FDI) and portfolio equity, and liabilities primarily in the form of debt (bonds, such as U.S. Treasury securities, or bank loans). In 2015, for example, 60% of its assets were held in the form of FDI or portfolio equity, which earn an equity premium because of their riskier nature. China, on the other hand, is “long debt and short equity,” where the debt includes the central bank’s foreign reserves held in the form of U.S. Treasury bonds. Debt assets and foreign reserves constituted 79% of China’s foreign assets in 2015, and the returns on these have been quite low in recent years. FDI and portfolio equity liabilities, on the other hand, accounted for 74% of the external liabilities.

The unusual nature of these income flows have attracted great attention. Yu Yongding of China’s Academy of Social Sciences, for example, has written about his country’s “irrational IIP structure.” He attributes this to an undervalued exchange rate that has allowed the country to have surpluses in both the current and capital accounts that were balanced by increases in foreign reserves, as well as government policies that favored FDI from abroad.

The positive return that the U.S. receives has been called an “exorbitant privilege” that is due to the status of the dollar as a reserve currency. In 1966 Emile Despres of Stanford University, Charles P. Kindleberger of MIT and Walter S. Salant of the Brookings Institution wrote that the configuration of the U.S. balance of payments was due to its status as the “world’s banker”, issuing short-term liabilities in exchange for long-term assets. More recently, Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School updated this description of the U.S. to the “world venture capitalist.”

The global financial crisis might have ended this status of the U.S., but the influence of the U.S. economy and its monetary policies has not diminished. Changes in U.S. interest rates have widespread effects on capital flows and credit creation. Several recent studies, including one by Òscar Jordàof UC-Davis, Moritz Schularick of the University of Bonn and Alan Taylor of UC-Davis, have referred to the existence of a global financial cycle that is very responsive to U.S. monetary policy. Similarly, Matteo Iacoviello and Gaston Navarro  of the Federal Reserve Board have written about the spillover effects of U.S. interest rates on foreign economeis.

It may be time for a new definition of imperialism. If the U.S. possesses an empire, it is based on its ownership of foreign capital that it accumulates in return for the issuance of “safe assets.” It takes advantage of this position to invest in more lucrative equity. In addition, it hosts the largest and most liquid financial markets and networks. Moreover, the U.S. government has shown its willingness to use financial sanctions as a policy tool.

With respect to the other attributes of 19thcentury empires, we no longer send Marines to Central America to safeguard our foreign holdings. But our military spending greatly exceeds that of other nations. Wealth is heavily concentrated; the richest U.S. families—those in the top 1% of the distribution of wealth—own 40% of the wealth in this country. Those assets undoubtedly include direct and indirect ownership in foreign enterprises, which contribute to the returns they receive.

What could end this arrangement? The renminbi and the euro are rival currencies, but it is doubtful that they will attain the global status of the dollar. Under ordinary circumstances, one might expect the U.S. position to continue for the foreseeable future. But these are not ordinary times. The Trump administration seems ready to shred a wide range of international agreements, such as those that established the World Trade Organization and the North American Free Trade Association. Moreover, the tax legislation passed last year that lowered personal and corporate tax rates is pushing up the government’s budget deficit. The Congressional Budget Office’s projection for this fiscal year’s deficit has risen from $563 billion to $804 billion and is projected to reach $1 trillion by 2020. Will U.S. Treasury securities continue to be viewed as safe?

The record of transitions in international monetary regimes does not bode well for the future. The gold standard collapsed in the 1930s as governments sought to escape the world-wide contraction in global economic activity. The Bretton Woods regime began to disintegrate when the Nixon administration ended the conversion of the dollar reserves of foreign central banks into gold in 1971. None of these regime ends were planned and they led to further instability. The end of America’s hegemonic financial position has long been forecasted–and avoided. But the shockwaves of the global financial crisis are still taking place, and eventually may be even more disruptive than we ever imagined.

A Guide to the (Financial) Universe: Part III

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

4.      Stability and Growth

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

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

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

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

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

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

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

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

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

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

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

5.     Conclusions

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

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

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

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

A Guide to the (Financial) Universe: Part I

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A Guide to the (Financial) Universe: Part 1

  1.     Introduction

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

2.       External Assets and Liabilities

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

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

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

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

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

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

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

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

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

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

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

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

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

(to be continued)

Recent Research

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

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

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

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

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

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

 

Capital Flows and Financial Crises

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

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

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

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

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

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

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

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

Capital Flows, Credit Booms and Bank Crises

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

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

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

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

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

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

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

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

China’s Outward FDI

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According to the United Nations Conference on Trade and Development’s latest World Investment Report Overview 2014, Foreign Direct Investment inflows to China reached $124 billion last year, while outflows rose to $101 billion. The Report anticipates that outflows will surpass inflows within the next few years, changing China from a net recipient of FDI to a net supplier. This change will affect China’s external balance sheet, and its response to financial crises.

China’s foreign assets have traditionally been overwhelmingly concentrated in foreign exchange reserves. In 2011, for example, reserves accounted for two-thirds of all the country’s foreign assets.  While the central bank’s holdings of foreign currencies (mostly held as U.S. Treasury securities) allowed it to deter any speculative currency attacks, they carried a low rate of return. That return fell even further during and after the global financial crisis as the Federal Reserve drove down interest rates, both short- and long-term. Therefore, China’s assets have not been very profitable. In addition, the foreign exchange reserves have lost value over time as the dollar depreciated. Menzie Chinn has pointed out that the political theater in Washington, DC only heightened Chinese concerns about their holdings of dollars.

A very large proportion of China’s foreign liabilities, on the other hand, has consisted largely of FDI; in 2011, the share of FDI in foreign liabilities was 59%. These investments were very profitable for the foreign firms that held them, producing a substantial stream of income. Consequently, as Yu Yongding, director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences has emphasized, China’s net return on international investments has usually been negative, despite its status as a net international creditor.  China’s net international investment position in 2011 represented +21% of its GDP, but it recorded a negative net primary income flow of about -1% of its GDP.

More assets held in the form of FDI, therefore, will raise the income that China receives from its assets.  Holding FDI in other countries will also give China a chance to diversity the currency composition of its assets. But there is a downside: equity holders share the risks of the ventures they own. In the past, this meant that China’s negative net FDI position acted as a crisis buffer. China’s net primary income turned positive in 2007 and 2008; its foreign exchange assets continued to pay returns, while the return on domestic FDI fell due to the global financial crisis.  Moreover, a decline in the value of FDI as well as portfolio equity lowered China’s liabilities, contributing to an improvement in the net international investment position.

China is not unique in the composition of its foreign assets and liabilities. Philip Lane of Trinity College/Dublin has written about the “long debt, short equity” position of many emerging markets, which helped them ride out the economic turbulence of the global crisis. Many advanced economies, on the other hand, were “long equity, short debt,” which while profitable in normal times, exacerbated the decline in their economies when the crisis hit.

China’s situation will change if there is a shift towards a net positive FDI position. The flow of income from foreign assets will become more pro-cyclical. Moreover, those assets will lose value in the event of a downturn. A depreciation of the renminbi would only increase this valuation effect.

Chinese firms traditionally moved abroad to secure reliable supplies of natural resources. More recently, the surge of outward FDI has also reflected aspirations to venture into foreign markets. The movement outward will eventually raise China’s net investment return and provide it with the ability to hold assets in currencies other than the dollar. But it will also diminish the role of FDI liabilities to act as a crisis buffer. This is one factor that should be added to the list of benefits and costs of a change in China’s net FDI position.

Strategic Retreat or Tactical Pause?

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Several recent analyses of financial globalization offer different perspectives on whether the recent contraction in capital flows represents a cyclical decline or a long-term reversal. On the one hand, the expansion of gross financial flows in the last decade among upper-income countries will not continue at the same pace. But the development of financial markets in emerging markets will increase capital flows within that group of countries as well as draw funds from the advanced economies.

Richard Dobbs and Susan Lund of the McKinsey Global Institute note that cross-border flows are more than 60% below the pre-crisis peak. They attribute the decline to a “dramatic reversal of European financial integration” as European banks curtail their lending activities. They also draw attention to “a retrenchment of global banking” due to a reassessment by banks of their foreign activities in light of new capital requirements and regulations. Dobbs and Lund are concerned that too strong a reversal will result in a segregated global financial system.

Greg Ip of The Economist also writes about a reversal of financial integration for a similar set of reasons. Bankers are shrinking their balance sheets while regulators seek to shield their domestic financial markets from foreign shocks. In addition, Ip draws attention to the renewed interest in the use of capital controls to lower volatility. The IMF now includes controls as a tool that policymakers can use to manage the risks associated with surges of capital flows. But like Dobbs and Lund, Ip is concerned about financial fragmentation, and urges financial regulators to cooperate in order to achieve common standards.

The authors of the World Bank’s Capital for the Future: Saving and Investment in an Interdependent World, on the other hand, draw attention to developing countries and emerging markets as both a source and destination of capital flows. These countries are likely to account for an increasing share of gross capital flows, which will be driven (p. 125)  “…by more rapid economic growth and lower population aging in developing countries than in advanced countries, as well as by developing countries’ relatively greater scope for increasing openness and strengthening financial sector institutions.” They see evidence of this trend prior to the global financial crisis, as the share of gross capital inflows to developing countries rose from 4 percent of the total in 2000 to 11 percent in 2007.

Foreign direct investment accounted for most of these inflows, although bank loans have also increased. While portfolio flows have constituted a relatively small share of inflows to these countries, the authors of Capital for the Future believe that in the future a larger proportion will flow through the capital markets. Ultimately, they claim (p. 131), there will be “developing-country convergence with advanced economies in terms of their composition of their capital inflows.” Policymakers can expedite the transition to more portfolio flows through the development of domestic financial markets and their regulatory structure.

China will play a major role in any increase in capital flows to emerging economies. Foreign exchange reserves have been the traditional form of asset accumulation in that country. Tamim Bayoumi and Franziska Ohnsorge of the IMF use a portfolio allocation model to speculate about the effects of the liberalization of capital regulations by the Chinese authorities on the private sector. They infer from their estimates that (p. 14) “capital account liberalization may be followed by a stock adjustment of Chinese assets abroad on the order of 15-25 percent of GDP and a smaller stock adjustment for foreign assets in China on the order of 2-10 percent of GDP.” The acquisition of foreign stocks and bonds by Chinese investors who would seek to diversify their portfolios could offset any continued increase in FDI inflows. The IMF economists contrast this forecast with one for India, which they believe would have more balanced flows following capital account deregulation because of smaller asset holdings by Indian investors and hence a more restricted scope for diversification.

These scenarios for the future of financial globalization need not contradict each other. On the one hand, bank lending in the U.S. and Europe is likely to be limited as governments enact new regulations and Europe continues to deal with its debt crisis. But investors in those countries may look to the emerging and “frontier” markets for higher returns based on their growth, while increased income in the emerging markets will drive a demand for liquid financial instruments that will spill over into foreign markets. In addition, firms in those countries will look to expand their operations in other developing economies through investments. Financial flows may follow a new course, but will not be contained for long.

In and Out

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Two recent IMF publications offer different perspectives on how policymakers should handle capital outflows. One outlines a tactical response to an unplanned reversal, while the second provides a strategy to prepare for volatility before it occurs.

The first approach appears in an IMF Policy Paper, Global Impact and Challenges of Unconventional Monetary Policies. Most of the paper deals with the effects of unconventional monetary policies (UMP) designed to restore the operations of financial markets and/or to support economic activity when the central bank’s policy rate has hit the lower bound. The measures include the purchase of bonds not usually bought by a central bank and forward guidance on interest rates. The paper draws upon the experiences of the Bank of England, the Bank of Japan, the European Central Bank, and the Federal Reserve.

The paper also deals with the possible challenges posed by the eventual winding down of the UMP both within the countries that have implemented them and in non-UMP countries. The authors of the report warn that ”In non-UMP countries, currencies will depreciate (to balance changes in relative bond returns) and bond yields might rise…” They further caution that “Some capital flow reversal and higher borrowing costs are to be expected, but further volatility could emerge, even if exit is well managed by UMP countries.” The report points to one source of volatility: “Further amplification could come from the financial system, where stability could be undermined as non-performing loans rise, capital buffers shrink, and funding evaporates.”

What can the non-UMP policymakers do to offset or least minimize this turbulence? Relatively little, according to the report. Central banks should maintain their credibility through appropriate monetary policies (always a good idea), allow some change in their exchange rates (but avoid disorderly adjustment!), and reverse measures that were implemented during periods of capital inflows (but only if this does not endanger financial stability!). The IMF offers to coordinate national policies to curtail negative spillovers, and promises to provide credit as needed. The IMF’s message for the non-UMP countries, therefore, seems to be: A storm is coming! It might be bad! Close the windows and doors, and place your faith in a higher power (conveniently located at 700 19th Street in Washington, DC)!

A different message comes from the authors of Chapter 4 of the IMF’s latest World Economic Outlook, entitled “The Yin and Yang of Capital Flow Management: Balancing Capital Inflows with Capital Outflows.”  Its authors make the distinction between those emerging market countries that respond to capital inflows through a current account deterioration (a “real” adjustment) versus those with offsetting capital outflows (“financial” adjustment). They find that the latter group registered a smaller response to the 2008-09 global financial crisis, as manifested in changes in GDP, consumption and unemployment. The former group includes Argentina, India and Turkey, while the latter group includes Brazil, Mexico and Thailand. The authors attribute the better experience of those countries that experienced “financial adjustment” to several factors, including the repatriation by their residents of their foreign assets to smooth consumption in the face of a shock.

Of course, the withdrawal of assets from foreign countries is feasible only if those assets are relatively liquid. Evidence on this aspect of the financial crisis comes from Philip Lane in his authoritative account of the role of financial globalization in precipitating and propagating the global crisis, “Financial Globalisation and the Crisis,” which appeared in Open Economies Review  (requires subscription). He reports that emerging economies were “long debt, short equity” in the period preceding the crisis. Their assets consisted of liquid foreign debt that they could draw upon if needed, while their liabilities were in the form of FDI and portfolio equity. The advanced economies, on the other hand, followed the opposite strategy of “long equity, short debt,” which was profitable but hazardous once the crisis hit.

There is another way, however, to evaluate the strategy of “financial adjustment.” Countries that match inflows with outflows have less exposure on a net basis, and net exposure may be tied to the occurrence of an external crisis. A recent IMF working paper by Luis A. V. Catão and Gian Maria Milesi-Ferretti, “External Liabilities and Crises,” reports that the risk of a crisis increases when net foreign liabilities rise above 50% of GDP and the NFL/GDP ratio rises 20% above a country’s historic mean. Moreover, when they examine exposure on different classes of liabilities, they find that the increase in crisis risk is linked to net debt liabilities.

Financial adjustment, therefore, was a successful strategy for minimizing the capital flow volatility for several reasons. The emerging market countries that implemented it lowered their international financial exposure and issued risk-sharing equity rather than debt. They were therefore less vulnerable than those countries with more liabilities that included relatively more debt. Given the cyclical nature of capital flows, such prophylactic measures should be enacted before the next storm arrives.

Apples and Naranjas

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The Economist has published its indicator of vulnerability to a “capital freeze.” (An earlier version published on September 7 was revised.) The ranking for 26 emerging markets is based on each country’s current account balance as a percent of its GDP, its short-term external debt and debt repayments relative to foreign exchange reserves and sovereign wealth fund assets, the growth rate of credit to the private sector, and the Chinn-Ito index of financial openness. The ten countries rated as most at risk are Turkey, Romania, Poland, Mexico, Colombia, Peru, Argentina, Indonesia and Chile.

Not surprisingly, there has been some pushback from officials of the countries at the top of the rankings. Mauricio Cárdenas, Colombia’s minister of finance, defends his country’s economic reputation in a letter. The minister claims that those who devised the rankings ignored the sources of vulnerability to a sudden stop, including the source of financing for the current account.  Mr. Cárdenas points out that Colombia’s current account is “fully financed by foreign direct investment instead of short-term capital flows.”

Does he have a case? We calculated Colombia’s current account/GDP and FDI/GDP ratios over the last three years (2010-12), and compared them with other Latin American economies on the index:

% Current Account/GDP FDI/GDP
Argentina -0.05 2.34
Brazil -2.24 2.92
Mexico -0.70 1.67
Venezuela 4.28 0.76
Colombia -3.05 3.54

Score one for the minister: the current account deficits of the last three years were indeed offset by inflows of FDI.  Game, set, match for Colombia?

Perhaps not. The size of the current account deficits, one of the components of the capital-freeze index, stands out. More importantly, the minister is mixing flows and stocks. The FDI inflows create FDI liabilities that are not easily reversed. But the country’s short-term external debt is the source of vulnerability to a sudden stop. Nervous lenders can simply cease renewing lines of credit or other credit facilities, and domestic borrowers will be cut off from funding. Reversals of short-term external debt were features of the Mexican, East Asian, Russian and Brazilian crises of the 1990s.

The debt data for the five South American countries in 2011 show why Brazil is rated as less risky than Colombia and the other nations. These countries are more vulnerable to a change in sentiment by foreign lenders. Venezuela does not appear in the top ten on the capital-freexe index in part because it is not as financially open as the others, and thus less exposed.

% External Debt/GNI Short-term Debt/External Debt
Argentina 26.35 14.53
Brazil 16.64 10.42
Mexico 25.20 17.88
Venezuela 21.82 24.56
Colombia 24.31 14.06

Colombia’s finance minister has justification to be proud that his country attracts sufficient FDI to finance its current account deficits. And there is no reason to expect that those flows will cease. But the country’s external debt liabilities, the result of past borrowing, are the source of potential hazard.