Tag Archives: Federal Reserve

The Challenges to the Dollar

The dollar’s position as the premier global currency has long seemed secure. The dollar accounts for about 60% of the foreign exchange reserves of central banks and similar proportions of international debt and loans. But recent developments raise the possibility of a transition to a stratified world economy in which the use of other currencies for regional trade and finance becomes more common.

Such a statement may seem to be inconsistent with the Federal Reserve’s activities to stabilize global financial markets. As it did during the global financial crisis of 2008-09, the Fed has activated currency swap lines with other central banks, including those of the Eurozone, Great Britain, Japan, Canada and Switzerland, as well as the monetary authorities of South Korea, Mexico and Singapore. Those central banks that do not have swap agreements can borrow dollars from the Fed via its new foreign and international monetary authorities (FIMA) facility. Under this program, central banks that need dollars for their domestic financial institutions exchange U.S. Treasury securities for dollars through a repurchase agreement. These moves accompany the Fed’s extensive range of activities to support the U.S. economy, which include cutting the federal funds rate to zero, purchasing large amounts of Treasury, mortgage backed and corporate securities, and lending to corporations and state and municipal governments.

But other governments are uneasy with the U.S. government’s use of the dollar’s position in international finance to enforce compliance with its foreign policy goals. International transactions in dollars are cleared through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) banking network and the Clearing House Interbank Payments System (CHIPS). The U.S. has denied foreign banks access to these systems when they wanted to penalize the banks for dealing with governments or companies that the U.S. seeks to punish. This practice has become more common under the Trump administration, which has used the sanctions to strike at Iran, North Korea, Russia, Venezuela and others.

European leaders have made clear that they find this use of the dollar’s international role no longer acceptable. When the U.S. abandoned the agreements on nuclear weapons with Iran, European banks were forced to choose between defying the U.S. or their own governments, which encouraged them to continue their ties with Iran. In response, Britain, France and Germany have founded a clearing house, Instex, to serve as an alternative system, and several other European Union members will join it. Moreover, if the Europeans proceed with the issuance of a common EU bond, there will be an alternative safe asset to U.S. Treasury bonds that will foster the use of the euro in foreign exchange reserves.

China is also moving to encourage the international acceptance of its currency as an alternative to the dollar. The Chinese bond market is the world’s second largest, and the foreign appetite for Chinese bonds has increased. Foreigners bought $60 billion of Chinese government bonds last year, and now hold 8.8% of these bonds. Some of these bonds will be held by central banks diversifying the composition of their foreign currency reserves.

China’s Belt and Road Initiatives have expanded its economic presence in emerging markets, which also leads to a wider usage of its currency. Chinese investments in infrastructure and other projects in these countries increase the usage of the renminbi, as will the trade that follows.  The number of banks processing payments in renminbi has grown greatly in recent years, and most of these banks are based in Asia, Africa and the Middle East.

There are obstacles to the wider use of both the euro and the renminbi. While Germany’s Chancellor Angela Merkel has voiced support of a common European bond, the heads of other European governments have expressed their concerns.  China continues to maintain capital controls, although it has allowed foreigners to invest in the bond market through Hong Kong. But the imposition of a new security law for Hong Kong raises concerns about China’s willingness to allow financial concerns to affect its political goals.

The euro was once more widely seen as a viable alternative to the dollar. Hiro Ito and Cesar Rodriguez of Portland State University in their recent research paper, “Clamoring for Greenbacks: Explaining the Resurgence of the U.S. Dollar in International Debt”, examine the determinants of the currency composition of international debt securities. In their analysis they undertake a counterfactual analysis to examine what would have happened to the shares of the dollar and the euro in the composition of these securities if the global financial crisis had not occurred. They report that the predicted share of the euro in international debt would have been higher than it actually has been, while the share of the dollar would be lower.

When Ito and Rodriguez wrote their paper, they forecast that the dollar would continue to be the dominant international currency. But the Trump administration has damaged the international standing of the U.S., and this will have long-term consequences. Benjamin J. Cohen of UC-Santa Barbara has pointed out that “…there is palpable resentment over Trump’s indiscriminate use of financial sanctions to punish countries…” More generally, the U.S. government has sought to limit the county’s international interactions.

Harold James of Princeton wrote about the dominance of the dollar after the global financial crisis in his book, The Creation and Destruction of Value: the Globalization Cycle, which was published in 2009. At that time he foresaw the central role of the dollar as continuing because of the “political and military might of the U.S.”, as well as its economic potential. But he also stated that:

 “Such concentrations of power can be self-sustaining when they attract not only the capital resources, but also the human resources (primarily through skilled immigration) that allow exceptional productivity growth to continue.”

James warned that if a country closes itself off from exchanges with other nations, its relative decline can be hastened. He pointed out that:

“Since the isolationist impulse is a major strand in the American political tradition, it is impossible to close off this possibility; in fact, its likelihood increases as the economic and political situation deteriorates.”

The pandemic has the potential of serving as an inflection point, which follows a period of confrontations with other countries over trade. The fumbled response of the U.S. to the pandemic will encourage the governments of Europe and China to extend their influence in the financial sphere.  A world with several dominant currencies need not be inferior to one with a single hegemonic currency. But it will come about in large part as a result of the self-inflected damage that the Trump administration has perpetrated on the international standing of the U.S.

The Coming Debt Crisis

After the 2008-09 global financial crisis, economists were criticized for not predicting its coming. This charge was not totally justified, as there were some who were concerned about the run-up in asset prices. Robert Schiller of Yale, for example, had warned that housing prices had escalated to unsustainable levels. But the looming debt crisis in the emerging market economies has been foreseen by many, although the particular trigger—a pandemic—was not.

Last year the World Bank released Global Waves of Debt: Causes and Consequences, written by M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge and Naotaka Sugawara. The authors examined a wave of debt buildup that began in 2010. By 2018 total debt in the emerging markets and developing economies (EMDE) had risen by 54 percentage points to 168% of GDP. Much of this increase reflected a rise in corporate debt in China, but even excluding China debt reached a near-record level of 107% of GDP in the remaining countries.

The book’s authors compare the recent rise in the EMDE’s debt to other waves of debt accumulation during the last fifty years. These include the debt issued by governments in the 1970s and 1980s, particularly in Latin America; a second wave from 1990 until the early 2000s that reflected borrowing by banks and firms in East Asia and governments in Europe and Central Asia; and a third run-up in private borrowing via bank loans in Europe and Central Asia in the early 2000s. All these previous waves ended in some form of crisis that adversely affected economic growth.

While the most recent increase in debt shares some features with the previous waves such as low global interest rates, the report’s authors state that it has been “…larger, faster, and more broad-based than in the three previous waves…” The sources of credit shifted away from global banks to the capital markets and regional banks. The buildup included a rise in government debt, particularly among commodity-exporting countries, as well as private debt. China’s private debt rise accounted for about four-fifths of the increase in private EMDE debt during this period. External debt rose, particularly in the EMDEs excluding China, and much of these liabilities were denominated in foreign currency.

The World Bank’s economists report that about half of all episodes of rapid debt accumulation in the EMDEs have been associated with financial crises. They (with Wee Chian Koh) further explore this subject in a recent World Bank Policy Research Paper, “Debt and Financial Crises.” They identify 256 episodes of rapid government debt accumulation and 263 episodes of rapid private debt accumulation in 100 EMDEs over the period of 1970-2018. They test their effect upon the occurrence of bank, sovereign debt and currency crises in an econometric model, and find that such accumulations do increase the likelihood of such crises. An increase of government debt of 30 percentage points of GDP raised the probability of a debt crisis to 2% from 1.4% in the absence of such a build-up, and of a currency crisis to 6.6% from 4.1%. Similarly, a 15% of GDP rise in private debt doubled the probability of a bank crisis to 4.8% if there were no accumulation, and of a currency crisis to 7.5% from 3.9%. (For earlier analyses of the impact of external debt on the occurrence of bank crises see here and here.)

Kristin J. Forbes of MIT and Francis E. Warnock of the University of Virginia’s Darden Business School looked at episodes of extreme capital flows in the period since the global financial crisis (GFC) in a recent NBER Working Paper, “Capital Flows Waves—or Ripples? Extreme Capital Flow Movements Since the Crisis.”  They update the results reported in their 2012 Journal of International Economics paper, in which they distinguished between surges, stops, flights and retrenchments. They reported that before the GFC global risk, global growth and regional contagion were associated with extreme capital flow episodes, while domestic factors were less important.

Forbes and Warnock update their data base in the new paper. They report that has been a lower incidence of extreme capital flow episodes since 2009 in their sample of 58 advanced and emerging market economies, and such episodes occur more as “ripples” than “waves.” They also find that as in the past the majority of episodes of extreme capital flows were debt-led. When they distinguish between bank versus portfolio debt, their results suggest a substantially larger role for bank flows in driving extreme capital flows.

Forbes and Warnock also repeat their earlier analysis of the determinants of extreme capital flows using data from the post-crisis period. They find less evidence of significant relationships of the global variables with the extreme capital flows. Global risk is significant only in the stop and retrenchment episodes, and contagion is significantly associated only with surges. They suggest that these results may reflect changes in the post-crisis global financial system, such as greater use of unconventional tools of monetary policy, as well as increased volatility in commodity prices.

Corporations can respond to crises by changing how and where they raise funds. Juan J. Cortina, Tatiana Didier and Sergio L. Schmukler of the World Bank analyze these responses in another World Bank Policy Research Working paper, “Global Corporate Debt During Crises: Implications of Switching Borrowing across Markets.” They point out that firms can obtain funds either via bank syndicated lending or bonds, and they can borrow in international or domestic markets. They use data on 56,826 firms in advanced and emerging market economies with 183,732 issuances during the period 1991-2014, and focus on borrowing during the GFC and domestic banking crises. They point out that the total amounts of bonds and syndicated loans issued during this period increased almost 27-fold in the emerging market economies versus more than 7 times in the advanced economies.

Cortina, Didier and Schmukler found that the issuance of bonds relative to syndicated loans increased during the GFC by 9 percentage points from a baseline of 52% in the emerging markets, and by 6 percentage points in the advanced economies from a baseline probability of 28%. There was also an increase in the use of domestic debt markets relative to international ones during the GFC, particularly by emerging economy firms. During domestic banking crises, on the other hand, firms turned to the use of bonds in the international markets. When the authors used firm-level data, they found that this switching was done by larger firms.

The authors also report that the debt instruments have different characteristics. For example, the emerging market firms obtained smaller amounts of funds with bonds as compared to bank syndicated loans. Moreover, the debt of firms in emerging markets in international markets was more likely to be denominated in foreign currency, as opposed to the use of domestic currency in domestic markets.

Cortina, Didier and Schmukler also investigated how these characteristics changed during the GFC and domestic bank crises. While the volume of bond financing increased during the GFC relative to the pre-crisis years, syndicated bank loan financing fell, and these amounts in the emerging market economies fully compensated each other. In the advanced economies, on the other hand, total debt financing fell.

The global pandemic is disrupting all financial markets and institutions. The situation of banks in the advanced economies is stronger than it was during the GFC (but this could change), and the Federal Reserve is supporting the flow of credit. But the emerging markets corporations and governments that face falling exports, currency depreciations and enormous health expenditures will find it difficult to service their debt. Kristalina Georgieva, managing director of the IMF, has announced that the Fund will come to the assistance of these economies, and next week’s meeting of the IMF will address their needs. The fact that alarm bells about debt in emerging markets had been sounding will be of little comfort to those who have to deal with the collapse in financial flows.

The Long Reach of U.S. Monetary Policy

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 Spillover Effects of Rising U.S. Interest Rates

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

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

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

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

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

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

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

A Guide to the (Financial) Universe: Part II

(Part I of this Guide appears here.)

3. Crisis and Response

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

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

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

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

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

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

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

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

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

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

(to be continued)

Not All Global Currencies Are The Same

The dollar may be the world’s main global currency, but it does not serve in that capacity alone. The euro has served as an alternative since its introduction in 1999, when it took the place of the Deutschemark and the other European currencies that had also been used for that purpose. Will the renminbi become the next viable alternative?

A new volume, How Global Currencies Work: Past, Present and Future by Barry Eichengreen of the University of California-Berkeley and Arnaud Mehl and Livia Chiţu of the European Central Bank examines the record of the use of national currencies outside their borders. The authors point out that regimes of multiple global currencies have been the norm rather than an exception. Central banks held reserves in German marks and French francs as well as British sterling during the period of British hegemony, while the dollar became an alternative to sterling in the 1920s. The authors foresee an increased use of China’s renminbi and “..a future in which several national currencies will serve as units of account, means of payments, and stores of value for transactions across borders.”

Camilo E. Tovar and Tania Mohd Nor of the IMF examine the use of the reminbi as a global currency in a IMF working paper, “Reserve Currency Blocs: A Changing International Monetary System.” They claim that the international monetary system has transitioned for a bi-polar one based on the dollar and the euro to a tri-polar system that also includes the renminbi. They provide estimates of a dollar bloc equal in value to 40% of global GDP that is complemented by a renminbi bloc valued at 30% of global GDP and a euro bloc worth 20% of world output. The renminbi bloc, however, is not primarily Asian, but rather dominated by the BRICS countries (Brazil, Russia, India, China, South Africa). This suggests that its increased use may be due to geopolitical reasons rather than widespread regional use.

If relative size is a driving factor in the adoption of a currency for international transactions, then an increasing role for the renminbi is inevitable. But the dollar will continue to be the principal currency for many years to come. Ethan Ilzetzki of the London School of Economics, Carmen Reinhart of Harvard’s Kennedy School and Kenneth Rogoff of Harvard examine the predominance of the dollar in a NBER working paper, “Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?” They show that the dollar is far ahead of other currencies in terms of trade invoicing , foreign exchange trading, and most other measures.

The U.S. also holds a dominant role in international financial flows. Sarah Bauerle Danzman and W. Kindred Winecoff of Indiana University Bloomington have written about the reasons for what they call U.S. “financial hegemony” (see also their paper with Thomas Oatley of the University of North Carolina-Chapel Hill and Andrew Penncok of the University of Virginia). They point to the central role of the U.S. financial system in the network of international financial relationships. They claim that the financial crisis of 2008-09 actually reinforced the pivotal position of the U.S., in part due to the policies undertaken by U.S. policymakers at that time to stabilize financial markets and institutions. This included the provision by the Federal Reserve of swap lines to foreign central banks in countries where domestic banks had borrowed dollars to invest in U.S. mortgage-backed securities. (Andrew Tooze provides an account of the Federal Reserve’s activities during the crisis.)

The central position of the U.S., moreover, evolved over time, and reflects a number of attributes of the U.S. economy and its governance. Andrew Sobel of Washington University examined the features that support economic hegemony in Birth of Hegemony. He cites Charles Kindleberger’s claim of the need for national leadership in order to forestall or at least offset international downturns, such as occurred during the depression (see The World in Depression 1929-1939). Kindleberger specifically referred to the need for international liquidity and the coordination of macroeconomic policies by a nation exercising economic leadership.

Sobel, drawing upon the history of the Netherlands, Great Britain and the U.S., maintains that the countries that have provided these collective goods have possessed public and private arrangements that allowed them to provide such leadership. The former include adherence to the rule of law, a fair tax system and effective public debt markets. Among the private attributes are large and liquid capital markets and openness to foreign capital flows. Sobel shows that these features evolved in the historical cases he examines in response to national developments that did not occur in other countries that might have been alternative financial hegemons (such as France).

Will a new dominant financial hegemon appear to take the place of the U.S.? It is difficult to see the European Union or China assuming that role in the short- or medium-term. European leaders are dealing with disagreements over the nature of their union and the discontent of their voters, while China is establishing its own path. (See Milanovic on this topic.) U.S. financial institutions are dedicated to preserving their interests, and not likely to surrender their predominance. It would take a major shock, therefore, to current arrangements to upend the existing network of financial relationships. But we now live in a world where such things could happen.

Crises and Coordination

Policy coordination often receives the same type of response as St. Augustine gave chastity: “Lord, grant me chastity and continence, but not yet.” A new volume from the IMF, edited by Atish R. Ghosh and Mahvash S. Qureshi, includes the papers from a 2015 symposium devoted to this subject. Policymakers in an open economy who take each other’s actions into account should be able to reach higher levels of welfare than they would working in isolation.  But actually engaging in coordination turns out to be harder–and less common– than many may think.

Jeffrey Frankel of Harvard’s Kennedy School of Government uses game theory to illustrate the circumstances that hamper coordination. One factor may be a fundamental divergence in how different policymakers view a situation. Many analysts on this side of the Atlantic, for example, use the “locomotive game” to show that Germany should engage in expansionary fiscal policies that would raise output for all nations. But (most) German policymakers have different views of the external impact of deficit spending. In the case of the Eurozone, a deficit in one country increases the probability that it will need a bailout by the other members of the monetary union. Only rules such as those of the Stability and Growth Pact that limit deficit expenditures can eliminate the moral hazard that would otherwise lead to widespread defaults.

Charles Engel of the University of Wisconsin (working paper here) also examines the recent literature on central bank coordination. He points out that the identifying the source of shocks is necessary to assess the benefits of cooperation to address them, and suggests that financial sector shocks may be most relevant for modeling open-economy coordination. But widespread cooperation could undercut the ability of a central bank to credibly commit to a single target, such as an inflation target.

Policymakers in emerging markets who must deal with the consequences of policies in advanced economies have been particularly mindful of their spillover effects. Raghuram Rajan, for example, who is back at the University of Chicago after serving as head of India’s central bank, has urged the Federal Reserve and other central banks to take into account the impact that their policies have on other nations, particularly when unwinding their Quantitative Easing asset purchases. He pointed out: “Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country.”

If international cooperation is viewed as a bargaining game, what incentives do the advanced economies have for cooperative behavior in light of the asymmetries among nations? Engel points out that in such circumstances, “…the emerging markets may believe that they have too little say in this implicit agreement, which is to say that they may perceives themselves as having too little weight in the bargaining game.” Conversely, central banks in the upper-income countries may in ordinary circumstances see little need to extend the scope of their decision-making outside their borders.

This attitude changes, however, when a crisis occurs, as Frederic Mishkin of Columbia shows in his examination of the response of central bankers to the global financial crisis. The Federal Reserve established swap lines to provide dollars to foreign central banks in countries where domestic banks faced a withdrawal of the funding they had used to acquire dollar-denominated assets. In addition, six central banks—the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank—announced a coordinated reduction of their policy rates. Coordination becomes quite relevant in a world of sudden stops and capital flight.

The need for such activities could increase if there is a global financial cycle, as Hélène Rey of the London Business School has stated. She presents evidence of the impact of global volatility, as measured by VIX, on international asset prices and capital flows. An important determinant of such volatility is monetary policy in the center countries. Rey agrees with Rajan that: “Central bankers of systemically important countries should pay more attention to their collective policy stance and its implications for the rest of the world.”

Perhaps a better motivation for the need for joint action comes from Charles Kindleberger’s list of the responsibilities that a hegemonic power such as Great Britain played in the period before World War I. These included acting as a lender of last resort during a financial crisis; indeed, it was the lack of such an international lender in the 1930s that Kindleberger believed was an important contributory factor to the Great Depression. Since the end of World War II the U.S. has vacillated in this role while the international monetary system has moved from crisis to crisis. Meanwhile, offshore credits denominated in dollars have grown in size, and could conceivably constrain the Federal Reserve’s ability to undertake purely domestic measures.

A policy of “America First” that means “America Only First and Last” ignores the fragility of the international financial system. Just as there are no atheists in foxholes, no one doubts the merits of coordination when there is a disruption of global markets. But suffering another crisis would be an expensive reminder that the best time to minimize systemic risk is before a crisis erupts.

The Emerging Market Economies and the Appreciating Dollar

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

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

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

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

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

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

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

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

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

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

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

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

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

The Search for an Effective Macro Policy

Economic growth in the advanced economies seems stalled. This summer the IMF projected increases in GDP in these economies of 1.8% for both 2016 and 2017. This included growth of 2.2% this year in the U.S. and 2.5% in 2017, 1.6% and 1.4% in the Eurozone in 2016 and 2017 respectively, and 0.3% and 0.1% in Japan. U.S. Treasury Secretary Jack Lew has called on the Group of 20 countries to use all available tools to raise growth, as has the IMF’s Managing Director Christine Lagarde. So why aren’t the G20 governments doing more?

The use of discretionary fiscal policy as a stimulus seems to be jammed, despite renewed interest in its effectiveness by macroeconomists such as Christopher Sims of Princeton University. While the U.S. presidential candidates talk about spending on much-needed infrastructure, there is little chance that a Republican-controlled House of Representatives would go along. In Europe, Germany’s fiscal surplus gives it the ability to increase spending that would benefit its neighbors, but it shows no interest in doing so (see Brad Setser and Paul Krugman). And the IMF does not seem to be following its own policy guidelines in its advice to individual governments.

One of the traditional concerns raised by fiscal deficits rests on their impact on the private spending that will be crowded out by the subsequent rise in interest rates. But this is not a relevant problem in a world of negative interest rates in many advanced economies and very low rates in the U.S. The increase in sovereign debt payments should be more than offset by the increase in economic activity that will be reinforced by the effect of spending on infrastructure on future growth.

On the other hand, there has been no hesitation by monetary policymakers in responding to economic conditions. They initially reacted to the global financial crisis by cutting policy rates and providing liquidity to banks. When the ensuing recovery proved to be weak, they undertook large-scale purchases of assets, known in the U.S. as “quantitative easing,” to bring down long-term rates that are relevant for business loans and mortgages.The asset purchases of the central banks led to massive expansions of their balance sheets on a scale never seen before. The Federal Reserve’s assets, for example, rose from about $900 billion in 2007 to $4.4 trillion this summer. Similarly, the Bank of Japan holds assets worth about $4.5 trillion, while the European Central Bank owns $3.5 trillion of assets.

The interventions of the central banks were successful in bringing down interest rates. They also elevated the prices of financial assets, including stock prices. But their impact on real economic activity seems to be stunted. While the expansion in the U.S. has lowered the unemployment rate to 4.9%, the inflation rate utilized by the Federal Reserve continues to fall below the target 2%. Investment spending is weaker than desired, despite the low interest rates. Indeed, many firms have sufficient cash to finance capital expenditures, but prefer to hold it back. The situations in Europe and Japan are bleaker. Investment in the Eurozone, where the unemployment rate is 10.1%., remains below its pre-crisis peak. Japan also sees weak investment that contributes to its stagnant position.

If lower interest rates do not stimulate domestic demand, there is an alternative channel of transmission: the exchange rate, which can improve the trade balance through expenditure switching. But there are several disturbing aspects of a dependence on a currency depreciation to increase output (see also here). First, there is an adverse impact on domestic firms with liabilities denominated in a foreign currency, as the cost of servicing and repaying that debt rises. Second, expansionary monetary policy does not always have the expected impact on the exchange rate. The Japanese yen appreciated last spring despite the central bank’s acceptance of negative interest rates to spur spending. Third, a successful depreciation requires the willingness of some other nation to accept an appreciation of its currency. The U.S. seems to have accepted that role, but Mohammed A. El-Erian has pointed out, U.S. firms are concerned “…about the impact of a stronger dollar on their earnings…” He also points to “…declining inward tourism and a deteriorating trade balance…” Under these circumstances, the willingness of the U.S. government to continue to accept an appreciating dollar is not guaranteed.

There is one other consequence of advanced economies pushing down their interest rates: increased capital flows to emerging market economies. Foreign investors, who had pulled out of bond markets in these countries for much of the last three years, have now reversed course. The inflows may help out those countries that face adverse economic conditions. But if/when the Federal Reserve resumes raising its policy rate, the attraction of these markets may pall.

The search for an effective macro policy tool, therefore, is constrained by political considerations as much as the paucity of options. But there is another factor: is it possible to return to pre-2008 economic growth rates? Harvard’s Larry Summers points out that those rates were based on an unsustainable housing bubble. He believes that private spending will not return us to full-employment, and urges the Fed to keep interest rates low and the government to engage in debt-financed investments in infrastructure projects. Ken Rogoff (also of Harvard), on the other hand, believes that we are suffering the downside of a debt supercycle. Joseph Stiglitz of Columbia University blames deficient aggregate demand in part on income inequality.

The one common theme that emerges from these different analyses is that there is no “quick fix” that will restore the advanced economies to some economic Eden. Structural and other forces are acting as headwinds to slow growth. But voters are not interested in long-run analyses, and many will turn to those who claim that they have solutions, no matter how potentially disastrous those are.


The Role of the U.S. in the Global Financial System

The mandate of the Federal Reserve is clear: “…promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” How to achieve those goals, of course, has been the subject of great debate: should the central bank use interest rates or monetary aggregates? should it rely on rules or discretion? The ongoing controversy within the U.S. over the benefits and costs of globalization opens up the issue of the geographic scope of the Fed’s responsibilities: does the Fed (and for that matter the U.S. Treasury) need to worry about the rest of the world?

Stanley Fischer, Federal Reserve Vice Chair (and former first deputy managing director of the IMF) sees a role for limited intervention. Fischer acknowledges the feedback effects between the U.S. and the rest of the world. The U.S. economy represents nearly one quarter of the global economy, and this preponderance means that U.S. developments have global spillovers. Changes in U.S. interest rates, for example, are transmitted to the rest of the world, and the “taper tantrum” showed how severe the responses could be. Therefore, Fischer argues, our first responsibility is “to keep our own house in order.” It also entails acknowledging that efforts to restore financial stability can not be limited by national borders. During the global financial crisis, the Fed established swap lines with foreign central banks so that they could provide liquidity to their own banks that had borrowed in dollars to hold U.S. mortgage-backed securities. Fischer cautions, however, that the Fed’s global responsibilities are not unbounded. He acknowledges Charles Kindleberger’s assertion that international stability can only be ensured by a financial hegemon or global central bank, but Fischer states, “…the U.S. Federal Reserve System is not that bank.”

The U.S. did hold that hegemonic position, however, during the Bretton Woods era when we ensured the convertibility of dollars held by central banks to gold. We abandoned the role when President Richard Nixon ended gold convertibility in 1971 and the Bretton Woods system subsequently ended. Governments have subsequently experimented with all sorts of exchange rate regimes, from fixed to floating and virtually everything in between.

While many countries do not intervene in the currency markets, others do, so there is a case for a reserve currency. But perhaps more importantly, we live in an era of global finance, and much of these financial flows are denominated in dollars. The offshore dollar banking system, which began in the 1960s with the Eurodollar market, now encompasses emerging markets as well as upper-income countries. This financial structure is vulnerable to systemic risk. Patrick Foulis of The Economist believes that “The lesson of 2007-08 was that a run in the offshore dollar archipelago can bring down the entire financial system, including Wall Street, and that the system needs a lender of last resort.”

Are there alternatives to the U.S. as a linchpin? The IMF is the international agency assigned the task of ensuring the provision of the international public good of international economic and financial stability. Its track record during the 2008-09 crisis showed that it could respond quickly and with enough financial firepower to deal with global volatility (see Chapter 10). But it can only move when its principals, the 189 member nations, allow it to do so. The Fund’s subsequent dealings with the European nations in the Greek financial crisis demonstrate that it can be tripped up by politics.

Is China ready to take on the responsibilities of an international financial hegemon? Its economy rivals, if not surpasses, that of the U.S. in size, and it is a dominant international global trader. China’s financial footprint is growing as well, and the central bank has established its own series of swap lines. This past year the renminbi was included in the basket of currencies that are used to value the IMF’s Special Drawing Rights. But the government has moved cautiously in removing capital account regulations in order to avoid massive flows in either direction, so there is limited liquidity. Chinese debt problems do not encourage confidence in its ability to deal with financial stress.

The Federal Reserve is well aware that international linkages work both ways. Fed Chair Janet Yellen cited concerns about the Chinese economy last fall when the Fed held back its first increase in the Federal Funds rate. And Fed Governor Lael Brainard believes that the global role of the dollar and the proximity to a zero lower bound may amplify spillovers from foreign conditions onto the U.S.

Whether or not the U.S. has a special responsibility to promote international financial stability may depend in part on one’s views of the stability of global capital markets. If they are basically stable and only occasionally pushed into episodes of excess volatility, then coordinated national policies may be sufficient to return them to normalcy. But if the structure of the global financial system is inherently shaky, then the U.S. needs to be ready to step in when the next crisis occurs. Andrés Velasco of Columbia University believes that “Recent financial history suggests that the next liquidity crisis is just around the corner, and that such crises can impose enormous economic and social costs. And in a largely dollarized world economy, the only certain tool for avoiding such crises is a lender of last resort in dollars.”

Unfortunately, if a crisis does occur it will take place during a period when the U.S. is reassessing its international ties. Donald Trump, the presumptive Republican candidate, achieved that position in part because of his argument that past U.S. trade and finance deals were against our national interests. He shows little interest in maintaining multilateral arrangements such as the United Nations. Trump has announced that he would most likely replace Janet Yellen because of her political affiliation. It is doubtful that the criteria for a new Chair would include a sensitivity to the international ramifications of U.S. policies.

The interest of the U.S. public in international dealings has always waxed and waned, and Trump’s nomination is a sign that we are in a period when many believe we should minimize our engagement with the rest of the world. But this will be difficult to do as long as the dollar remains the predominant world currency for private as well as official use. Regardless of domestic politics, we will not escape the fallout of another crisis, regardless of where it starts. It would be better to accept our international role and seeks ways to minimize risk than to undertake a futile attempt to make the world go away.