Tag Archives: financial crises

Can Systemic Financial Risk Be Contained?

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Risk aversion is a basic human characteristic, and in response to it we seek to safeguard the world live in. We mandate airbags and safety belts for automobile driving, set standards for the handling and shipment of food, build levees and dams to control floods, and regulate financial transactions and institutions to avoid financial collapses. But Greg Ip in Foolproof shows that our best attempts at avoiding catastrophes can fail, and even bring about worse disasters than those that motivate our attempts to avoid them. Drivers who feel safer with antilock brakes drive more quickly and leave less space between cars, while government flood insurance encourages building houses on plains that are regularly flooded.

Is the financial sector different? The traditional measures implemented to avoid financial failures are based on attaining macroeconomic stability. Monetary policy was used to control inflation, and when necessary, respond to shocks that destabilized the economy. When a crisis did emerge, the primary responsibility of a central bank was to act as a lender of last resort, providing funds to institutions that were solvent but illiquid. There was a vigorous debate before the global crisis of 2008-09 over whether central banks should attempt to deflate asset bubbles, but most central bankers did not believe that this was an appropriate task.

Fiscal policy was seen as more limited in its ability to combat business downturns because of lags in its design, implementation and effect. A policy that established a balanced budget over the business cycle, thus limiting the buildup of public debt, was often considered the best that could be expected. Automatic stabilizers, therefore, were set up to respond to cyclical fluctuations.

In open economies, flexible exchange rates provided some insulation against foreign shocks, and avoided the dangers that a commitment to a fixed rate entailed. Countries that did fix, or at least manage, their exchange rates stockpiled foreign exchange reserves to forestall speculative attacks. IMF surveillance provided an external perspective on domestic policies, while IMF lending could supplement foreign exchange reserves.

The global financial crisis demonstrated that these measures were inadequate to provide financial stability. The Federal Reserve led the way in implementing new monetary policies—quantitative easing—to supplement lower policy rates that faced a zero lower bound. But policymakers also responded with a broad range of innovative financial regulations. A new type of regulation—macroprudential—was introduced to minimize systemic financial risk, i.e., the risk associated with the collapse of a financial system (as opposed to the microprudential risk of the failure of an individual institution). These measures seek to prevent speculative rises in asset prices and credit creation, and the establishment of risky balance sheet positions. They include limits on interest rate and foreign exchange mismatches on balance sheets, caps on bank loan to value ratios, and countercyclical capital requirements (see here for an overview of these measures).

In the international sector, the Basel Committee on Banking Supervision produced “Basel III,” a new set of regulations designed to strengthen the resilience of its members’  banking systems. Capital control measures, once viewed as hindrances to the efficient allocation of savings, are now seen as useful in limiting inflows of foreign funds that contribute to asset bubbles. Swap lines allow central banks to draw upon each other for foreign exchange to meet the demand from domestic institutions, while the IMF has sought to make borrowing more user-friendly. Meetings of the member governments of the newly-formed Group of 20 allow them to coordinate their policies, while the IMF’s surveillance purview has expanded to include regional and global developments.

Are these measures sufficient? The lack of another global crisis to date is too easy a criterion, given that the recovery is still underway. But there may be inherent problems in the behavior of financial market participants that could frustrate policies that seek to prevent or at least contain financial crises. Moral hazard is often blamed for shoddy decision-making by those who think they can dodge the consequences of their actions. Many who were involved in the creation and sale of collaterized securities may have thought that the government would step in if there were a danger of a breakdown in these markets. But many banks held onto these securities, indicating that they thought that the reward of owning the securities outweighed the risks. Bank officials who oversaw the expansion of mortgage lending generally lost their jobs (and reputations). It is difficult to believe after the crisis that anyone thought that they could manipulate the government into absorbing all the consequences of their actions.

But if moral hazard is not always at fault, there is ample evidence that asymmetric information and behavioral anomalies result in hazardous behavior. Will the regulatory provisions listed above minimize the incidence of risky financial practices? There is some evidence that the provisions of the Dodd-Frank Act are working. But the regulatory framework continues to be implemented, and bankers and other financial market participants will always seek to find loopholes that they can exploit.

Regulatory practices on the international level are also subject to manipulation. Roman Goldbach, a political economist at Deutsche Bundesbank, in his book Global Governance and Regulatory Failure: The Political Economy of Banking points out that the overlap of national and global standards in what he calls the “transnational regulatory regime” results in layering “gaps.” The resulting loopholes in the policymaking process allow private interest coalitions to have a disproportionate influence on policy formulation. Moreover, policy officials consider the competitiveness of domestic financial structures as a goal (at least) equal to financial stability in international negotiations over regulatory standards. While there have been substantial changes since the global crisis, including the formation of the Financial Stability Board, the incentives in the governance structure of global finance have not changed.

Even regulations that work as intended may have unintended and unwanted consequences due to externalities. Kristin Forbes of MIT and Marcel Fratzscher, Thomas Kostka and Roland Straub of the European Central Bank examined Brazil’s tax on capital inflows from 2006 to 2011. They found that the tax did cause investors to decrease their portfolio allocation to Brazilian securities, as planned. But other countries also felt the impact of the tax. Foreign investors increased their allocation to economies that had some similarities to Brazil, while cutting back on those countries that were likely to impose their own control measures. Capital control measures that are imposed unilaterally, therefore, may only divert risky funds elsewhere, and are not a tool for controlling global financial risk.

The flow of money looking for higher yields outside the U.S. may diminish in the wake of the rise in the Federal Funds rate in the U.S. But Lukasz Rachel and Thomas D. Smith of the Bank of England claim that long-term factors account for a decline in the global real interest rate that will not be soon reversed. This poses a challenge for policymakers, as measures implemented in one country to contain a domestic credit boom may be undermined by foreign inflows. Domestic actions, therefore, ideally would be matched by similar measures in other countries, which would require macroprudential policy coordination.

Barry Eichengreen of UC-Berkeley has studied the record of international policy coordination, and finds that it works best under four sets of circumstances: when the coordination is centered on technical issues, such as central bank swaps; when the process is institutionalized; when it is aimed at preserving an existing set of policies, i.e., regime preserving, rather than devising new procedures; and when there exists a sense of mutual interests on a broad set of issues among the participants. Are such conditions present today? At the time of the crisis, central bankers cooperated in setting up the currency swap agreements while discussing their monetary policies. The formation of the Group of 20 provided a new forum for regular consultation, and there was widespread agreement in preserving a regime that encouraged international trade while preventing competitive currency devaluations. But the passage of time has weakened many of the commitments made when the crisis threatened, and the uneven recovery has caused national interests to diverge.

Perhaps a more basic issue is whether it is possible to design a financial system free of volatility. A government that is willing to replace markets in directing financial flows and allocating financial returns can maintain stability, but at a price. Such a system is characterized as “financial repression,” and includes limits on interest rates received by savers, control of banks and their lending, and the use of regulations to prevent capital flows. These regulations penalize household savers, and allow the government and state-sponsored enterprises to receive credit at relatively low rates while blocking credit to firms that do not enjoy government backing.

China used these types of measures during the 1980s and 1990s to finance its investment- and export-led growth, and its self-imposed financial isolation allowed it to escape the effects of the Asian financial crisis. But more recently China has engaged in financial liberalization, removing controls on interest rates and bank activities while deregulating its capital account and allowing more exchange rate flexibility. The responses have included the emergence of a shadow banking system and a boom in private credit, which will require government actions to avoid a crisis.

Several years ago Romain Rancière of the Paris School of Economics, Aaron Tornell of the University of California-Los Angeles and Frank Westermann of Osnabrueck University coauthored a paper (here; working paper here) on the tradeoff between systemic financial crises and economic growth. They showed that financial liberalization leads to more growth and a higher incidence of crises. But their empirical estimates indicated that the direct effect on growth outweighed the negative impact of the crises. They contrasted the examples of Thailand, which had a history of lending booms and crises with that of India, which had a more controlled financial sector, and showed that Thailand had enjoyed higher growth in per capita GDP. In a subsequent paper (here; working paper here), they explored the relationship between crises that produced a negative skewness in the growth of real credit, which in turn had a negative link with growth.

If there is a tradeoff between the volatility associated with financial liberalization and economic growth, then each society must choose the optimal combination of the two. Financial innovations will change the terms of the tradeoff, and lead to movements back and forth as we learn more about the risks of new financial tools. The advantages of novel instruments at the time when they seem most productive must be weighed against the possible (but unknown) dangers they pose. Perhaps the greatest threat is that the decisions over how much control and regulation is needed will be made not by those public officials entrusted with preserving financial stability, but by those who will profit most from the changes.

The Enduring Relevance of “Manias, Panics, and Crashes”

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The seventh edition of Manias, Panics, and Crashes has recently been published by Palgrave Macmillan. Charles Kindleberger of MIT wrote the first edition, which appeared in 1978, and followed it with three more editions. Robert Aliber of the Booth School of Business at the University of Chicago took over the editing and rewriting of the fifth edition, which came out in 2005. (Aliber is also the author of another well-known book on international finance, The New International Money Game.) The continuing popularity of Manias, Panics and Crashes shows that financial crises continue to be a matter of widespread concern.

Kindleberger built upon the work of Hyman Minsky, a faculty member at Washington University in St. Louis. Minsky was a proponent of what he called the “financial instability hypothesis,” which posited that financial markets are inherently unstable. Periods of financial booms are followed by busts, and governmental intervention can delay but not eliminate crises. Minsky’s work received a great deal of attention during the global financial crisis (see here and here; for a summary of Minksy’s work, see Why Minsky Matters by L. Randall Wray of the University of Missouri-Kansas City and the Levy Economics Institute).

Kindleberger provided a more detailed description of the stages of a financial crisis. The period preceding a crisis begins with a “displacement,” a shock to the system. When a displacement improves the profitability of at least one sector of an economy, firms and individuals will seek to take advantage of this opportunity. The resulting demand for financial assets leads to an increase in their prices. Positive feedback in asset markets lead to more investments and financial speculation, and a period of “euphoria,” or mania develops.

At some point, however, insiders begin to take profits and withdraw from the markets. Once market participants realize that prices have peaked, flight from the markets becomes widespread. As prices plummet, a period of “revulsion” or panic ensues. Those who had financed their positions in the market by borrowing on the promise of profits on the purchased assets become insolvent. The panic ends when prices fall so far that some traders are tempted to come back into the market, or trading is limited by the authorities, or a lender of last resort intervenes to halt the decline.

In addition to elaborating on the stages of a financial crisis, Kindleberger also placed them in an international context. He wrote about the propagation of crises through the arbitrage of divergences in the prices of assets across markets or their substitutes. Capital flows and the spread of euphoria also contribute to the simultaneous rises in asset prices in different countries. (Piero Pasotti and Alessandro Vercelli of the University of Siena provide an analysis of Kindleberger’s contributions.)

Aliber has continued to update the book, and the new edition has a chapter on the European sovereign debt crisis. (The prior edition covered the events of 2008-09.) But he has also made his own contributions to the Minsky-Kindleberger (and now –Aliber) framework. Aliber characterizes the decades since the early 1980s as “…the most tumultuous in monetary history in terms of the number, scope and severity of banking crises.” To date, there have been four waves of such crises, which are almost always accompanied by currency crises. The first wave was the debt crisis of developing nations during the 1980s, and it was followed by a second wave of crises in Japan and the Nordic countries in the early 1990s. The third wave was the Asian financial crisis of 1997-98, and the fourth is the global financial crisis.

Aliber emphasizes the role of cross-border investment flows in precipitating the crises. Their volatility has risen under flexible exchange rates, which allow central banks more freedom in formulating monetary policies that influence capital allocation. He also draws attention to the increases in household wealth due to rising asset prices and currency appreciation that contribute to consumption expenditures and amplify the boom periods. The reversal in wealth once investors revise their expectations and capital begins to flow out makes the resulting downturn more acute.

These views are consistent in many ways with those of Claudio Borio of the Bank for International Settlements (see also here). He has written that the international monetary and financial system amplifies the “excess financial elasticity,” i.e., the buildup of financial imbalances that characterizes domestic financial markets. He identifies two channels of transmission. First, capital inflows contribute to the rise in domestic credit during a financial boom. The impact of global conditions on domestic financial markets exacerbates this development (see here). Second, monetary regimes may facilitate the expansion of  monetary conditions from one country to others. Central bankers concerned about currency appreciation and a loss of competitiveness keep interest rates lower than they would otherwise, which furthers a domestic boom. In addition, the actions of central banks with international currencies such as the dollar has international ramifications, as the current widespread concern about the impending rise in the Federal Funds rate shows.

Aliber ends the current edition of Manias, Panics and Crashes with an appendix on China’s financial situation. He compares the surge in China’s housing markets with the Japanese boom of the 1980s and subsequent bust that initiated decades of slow economic growth. An oversupply of new housing in China has resulted in a decline in prices that threatens the solvency of property developers and the banks and shadow banks that financed them. Aliber is dubious of the claim that the Chinese government will support the banks, pointing out that such support will only worsen China’s indebtedness. The need for an eighth edition of Manias, Panics and Crashes may soon be apparent.

The External Debt of the Emerging Market Economies

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The outflow of money from emerging markets this year will most likely surpass inflows for the first time since 2008, and net capital outflows may total $541 billion according to the Institute of International Finance. The flows have been accompanied by currency depreciations, stock market collapses, and in the case of Brazil, a downgrade in its credit rating to junk bond status. The IMF has responded to this turbulence by lowering its forecast for growth in the emerging markets and developing economies this year from 4.2% to 4%.

The emerging market nations that export commodities have been particularly hard hit, as China cuts back on its imports of raw materials and commodity prices plunge. Other factors that could signal further weakness are declining foreign exchange reserves, current account deficits and political uncertainty. Countries besides Brazil that have been identified as most vulnerable to further downturns include Russia, Venezuela, Turkey and Indonesia. When the long-awaited increase in U.S. interest rates finally does take place, the rise in the cost of borrowing in dollars will exacerbate the position of these countries.

There is another factor that will affect how an external shock will affect economic performance: the composition of a country’s external balance sheet. This records the holdings of foreign assets held by domestic residents and domestic liabilities held by foreigners. A country’s net international investment position (NIIP) as a creditor or debtor depends on the difference between its assets and liabilities. Both assets and liabilities can take the form of equity, which includes foreign direct investment (FDI) and portfolio equity, or debt in the form of bonds and bank loans. In addition, countries may hold assets in the form of foreign exchange reserves at their central banks.

Assets are denominated in foreign currencies, particularly the dollar, while equity liabilities are denominated in the home currency. Debt liabilities may be denominated in the domestic or a foreign currency. Foreign lenders who are concerned about the government’s macroeconomic policies—a phenomenon known as “original sin”—may insist that bonds be issued in dollars.

After the financial crises that afflicted many emerging markets during the late 1990s and early 2000s, many of these nations altered the composition of their external balance sheets. Countries that had obtained external funds primarily through debt turned to equity for sources of finance. As a result, their equity liabilities grew steadily, both in terms of absolute magnitude and relative to their debt liabilities. Their assets, on the other hand, largely consisted of foreign exchange reserves, held in the form of U.S. Treasury bonds, and other debt holdings. This profile is known as “long debt, short equity,” and differed from the “long equity, short debt” composition of most advanced economies that held equity and issued debt.

The payout on equity is contingent on the profitability of the firms that issue it, while debt payments are contractual. As a result, over time equity carries a higher return than debt—the “equity premium.” Consequently, the “long equity, short debt” profile in normal times is profitable for those countries that are net holders of equity.

But the situation changes during a crisis. The decline in the value of equity liabilities raises the NIIP of the countries that issued them. In addition, a depreciation of the domestic currency increases the value of the foreign assets while lowering those liabilities denominated in the domestic currency. Bonds issued in a foreign currency, however, will rise in value—a phenomenon observed during the Asian crisis of 1997-98. In addition, short-term liabilities may not be rolled over by foreign lenders, while FDI is much more stable.

Phillip Lane of Trinity College (working paper here) has claimed that the composition of the emerging market economies’ external balance sheets served as a buffer against the global financial crisis (GFC) of 2007-09, while the structure of the advanced economies’ external assets and liabilities heightened their vulnerability. In a recent paper I investigated this claim and found that countries with FDI liabilities had higher growth rates, fewer bank crises and were less likely to borrow from the IMF during the GFC. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit. The “long debt, short equity” strategy of emerging markets did mitigate the effects of the global financial crisis, and acted as a countercyclical crisis buffer.

But the balance sheet profiles of the emerging market economies has changed in the wake of the crisis. The corporate debt of nonfinancial firms in many emerging market economies, particularly bonds denominated in dollars, grew rapidly during this period. The IMF in its latest Global Financial Stability Report has drawn attention to this shift, which it reports has been driven by global drivers, such as the decline in U.S. interest rates.

A newly-issue report by the Committee on International Economic Policy, Corporate Debt in Emerging Economies: A Threat to Financial Stability?, views this increase in debt as a threat to financial stability. The report, written by Viral Acharya of New York University, Stephen Cecchetti of Brandeis University, José De Gregorio of the University of Chile, Sebnem Kalemli-Ozcan of the University of Maryland, Philip Lane of Trinity and Ugo Panizza of the Graduate Institute in Geneva, reviews the changes in the balance sheets of the emerging markets. They find that “…there has been a deterioration in the net foreign debt positions of many emerging economies in recent years.” While the amounts of corporate debt are limited, the authors point out, “…even a category that appears relatively small can be a source of systemic financial stability.” Moreover, bonds denominated in a foreign currency have accounted for a large component of the growth in corporate debt, and there has been “…an overall decline in the net foreign currency position of many emerging economies.” As a result, “…this has made emerging economies vulnerable to a shift in international funding conditions and macroeconomic slowdown.”

Moreover, the amount of emerging market debt may be underestimated. Carmen Reinhart of Harvard’s Kennedy School points out that debt may go undetected until the outbreak of a crisis. She points to the Mexican crisis of 1995-95, the Asian debt crisis of 1997-98 and the current Greek crisis as examples of the detection of “hidden debt” that became visible as the crisis emerged. She fears that lending by Chinese development banks for infrastructure projects in other emerging and developing economies may not be included in the data for their external debt, and could add to their vulnerability.

The authors of the report on corporate debt in emerging economies point out that policymakers have a variety of policy tools to deal with the risks of external borrowing. These include capital and liquidity regulations, directly lending to small and medium-sized enterprises when banks are constrained by exposure limits, and central clearing of derivative contracts. But all this will come after the deterioration to the external balance sheets has taken place. Governments should monitor the external borrowing of domestic firms and public agencies during “boom” periods to track their vulnerability to shocks to global liquidity. Meanwhile, the IMF is preparing for the next crisis.

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.

The Challenges of the Greek Crisis

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The Greek crisis has abated, but not ended. Representatives of the “troika” of the European Commission, the European Central Bank and the International Monetary Fund returned to Athens for talks with the Greek government about a new bailout. This pause allows an accounting of the many challenges that the events in Greece pose to the international community.

The main challenge, of course, is to the Greek government itself, which must implement the fiscal and other measures contained in the agreement with the European governments. These include steps to liberalize labor markets as well as open up protected sectors of the economy. While these structural reforms should promote growth over time, in the short-run they will lead to layoffs and reorganizations. At the same time, Prime Minister Alex Tsipras must oversee tax rises and cuts in spending. The combined impact of all these measures, which follow the virtual shutdown of the financial sector during the protracted negotiations with the European governments, will postpone any resumption in growth that past efforts may have generated.

It is not clear how long the Greek public will endure further misery. Any form of debt restructuring may give policymakers some justification to continue with the agreement. New elections will clarify the degree of political support for the pact. But the possibility of an exit from the Eurozone has not been removed, either in the eyes of Greek politicians or those of officials of other governments.

The Greek crisis, however, is not the only hazard that the Eurozone faces. The Eurozone’s governments have yet to come to terms with the effects of the global financial crisis on its members’ finances. A split prevails between those countries that ally themselves with the German position that debt must be repaid and those that seek with France to find some sort of middle ground. Other European countries with debt/GDP ratios of over 100% include Belgium, Portugal, and Italy. Weak economic growth could push any of them into a situation where the costs of refinancing become daunting. How would the Eurozone governments respond? Would they bail out another member? If so, would the terms differ from those imposed on Greece? Would European banks be able to pass the distressed debt on to their own governments?

In the long-term, the governments of the Eurozone face the dilemma of how to reconcile centralized rule-making with national sovereignty. The ECB, for example, has been granted supervisory oversight of the banks in the Eurozone. It will exercise direct oversight of over 100 banks deemed to be “significant,” while sharing responsibility with national supervisors for the remaining approximately 3,500 banks. The ECB has a Supervisory Board, supported by a Steering Committee, to plan and executes its supervisory tasks, which supposedly allows it to separate its bank supervisory function from its role in setting monetary policy. All these agencies and committees must work out their respective jurisdictions and responsibilities. Meanwhile, the European Commission, which oversees fiscal policies, faces requests for exemptions from its budget guidelines by governments with faltering growth. But if it shows flexibility in enforcing its own rules, it will be derided as weak and ineffective.

The IMF has its own set of challenges. The IMF was sharply criticized for its response to the wave of crises that struck emerging markets in the last 1990s and early 2000s, beginning with Mexico in 1994 and extending to Turkey and Argentina in 2001. Critics charged that the IMF was slow to respond to the rapid “sudden stops” of capital outflows that set off and exacerbated the crises. When the Fund did act, it attached too many conditions to its programs; moreover, these conditions were harsh and inappropriate for crises based on capital outflows.

The global financial crisis gave the IMF a second chance to demonstrate its crisis-management abilities (for a full account, see here). The Managing Director at the time, Dominique Strauss-Kahn, seized the opportunity to redeem the IMF ‘s reputation, as well as reestablish his own political career in France. The IMF lent quickly to its members, attached relatively few conditions to the loans, and allowed the use of fiscal measures to stabilize domestic economies. The result was less severe adjustment, the avoidance of excessive exchange rate movements and a resumption of economic growth. By the time the global economy recovered, the IMF had proven that it could respond in a flexible manner to a financial emergency.

The IMF’s response in 2010 to the Greek debt crisis was very different. The IMF’s loan to Greece was the first to a Eurozone member; moreover, the loan was much larger than any the IMF had extended before, whether measured by the total amount of credit or as a percentage of the borrowing country’s quota at the Fund. To make the loan, the IMF had to overlook one of it own guidelines for granting “exceptional access” by a member to Fund credit. Such loans were to be made only if the borrowing government’s debt would be sustainable in the medium-term. Greece’s debt burden did not pass this criterion, so the Fund justified its actions on the grounds that there was a risk of “international systemic spillovers.”

The IMF’s involvement in the Greek program was also unusual in another sense: the IMF’s contribution, as large as it was, was still smaller than that of the European governments. The IMF was, in effect, a “junior partner.” While it had worked with other governments before (such as the U.S. when it lent to Mexico in 1994-95), this was the first time that the IMF was not in a lead position. This may have initially made it reluctant to disagree with the other members of the troika.

The subsequent contraction in the Greek economy far exceeded the IMF’s forecasts. The IMF later admitted that it underestimated the size of the multipliers for the fiscal policies contained in the program in a paper co-authored by the head of the IMF’s Research Department, Olivier Blanchard (see also here). The failure to properly estimate the impact of these conditions calls into doubt the basic premises of the 2010 and 2012 programs.

More recently, the IMF has challenged its European partners over their projections for the Greek debt, as well as the budget and fiscal targets contained in the latest agreement. The Fund claims that the debt projections are much too optimistic. Greece’s debt will only be sustainable if there is debt relief on a much larger scale than the European governments have been willing to undertake. Moreover, the IMF states that it will not be part of any new programs for Greece if debt relief is not a component.

The public admission of error and the rebukes of the European governments will only partially restore the IMF’s reputation. The generous treatment of Greece as well as Ireland and Portugal reinforces the belief that the European countries and the U.S. control the IMF. The members of the European Union have a total quota share of almost one-third, much larger than their share of world GDP. This voting share combined with the U.S. quota gives these countries almost half of all the voting shares at the IMF. The need for a realignment of the quotas to give the emerging market nations a larger share has long been acknowledged, but approval of the reform measures is mired in the U.S. Congress.

Another aspect of European and U.S. control of the “Bretton Woods twins”—the IMF and the World Bank—has been their selection of the heads of these organizations. All the Managing Directors of the IMF have been Europeans, and until the appointment of Ms. Lagarde, European males. All the heads of the World Bank have been U.S. citizens. Ms. Lagarde’s term expires next July, and the pressure to name a non-European will be tremendous. How the Europeans and U.S. respond to this challenge will go a long way in determining whether these institutions will be shunted aside by the emerging market nations in favor of institutions that they can control.

The last challenge of the Greek crisis comes for the Federal Reserve. Federal Reserve Chair Janet Yellen has been explaining that a rise in the Fed’s policy rate, the Federal Funds rate, is likely to occur later this year. This forecast, however, is contingent on continued economic growth and favorable labor market conditions. These plans could be threatened by any financial volatility that followed a disruption in the latest Greece bailout.

The Federal Reserve is also aware that a rise in interest rates would affect the dollar/euro exchange rate. The euro, which has been depreciating, could fall lower when the Fed raises rates while the ECB keeps its refinancing rate at 0.05%. A further appreciation of the dollar would threaten U.S. exports, thus endangering a recovery.

The Fed also faces concerns about the broader impact of its policy initiatives on the world economy. The IMF is worried about how a rate rise would affect the global economy, and has urged the Fed to hold off on interest rate increases until 20016. Companies that borrowed in dollars through bonds and bank loans will be adversely affected by the combined effects of an interest rate rise and a dollar appreciation.

Greece’s GDP accounts for only 0.4% of world GDP and about 1.3% of the European Union’s total output. But the global financial crisis demonstrated how financial linkages across sectors and countries can disrupt economic activity no matter what their source. The response to these incidents by national and international authorities can risk global stability if they are based on self-interest and organizational agendas. Commitments to cooperation disappear quickly when national concerns are threatened.

(A Powerpoint version of this post is available here.)

Morality Tales and Capital Flows

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When the Federal Reserve finally raises its interest rate target, it will be one of the most widely anticipated policy moves since the Fed responded to the global financial crisis. The impact on emerging markets, which have already begun to see reversals of the inflows of capital they received when yields in the U.S. were depressed, has been discussed and analyzed in depth.  But the morality tale of errant policymakers being punished for their transgressions may place too much responsibility for downturns on the emerging markets and not enough on the volatile capital flows that can overwhelm their financial markets.

Capital outflows—particularly those large outflows known as “sudden stops”—are often attributed to weak economic “fundamentals,” such as rising fiscal deficits and public debt, and anemic growth rates. Concerns about such flows resulted in the “taper tantrums” of 2013 when then-Federal Reserve Chair Ben Bernanke stated that the Fed would reduce its purchases of assets through its Quantitative Easing program once the domestic employment situation improved. The “fragile five” of Brazil, India, Indonesia, South Africa and Turkey suffered large declines in currency values and domestic asset prices. Their current account deficits and low growth rates were blamed for their vulnerability to capital outflows. There have been subsequent updates of conditions in these countries, with India now seen as in stronger shape because of a declining current account deficit and lower inflation rate, whereas Brazil’s situation has deteriorated for the opposite reasons.

But this assignment of blame is too simplistic. Barry Eichengreen of UC-Berkeley and Poonam Gupta of the World Bank investigated conditions in the emerging markets after Bernanke’s announcement. The countries with largest current account deficits also recorded the largest combination of currency depreciations, reserve losses, and stock market declines. But Eichengreen and Gupta found little evidence that countries with stronger policy fundamentals escaped foreign sector instability. On the other hand, the size of their financial markets as measured by capital inflows in the period before 2013 did contribute to the adverse response to Bernanke’s statement. The co-authors interpreted this result as showing that foreign investors withdrew funds from the financial markets where they could most easily sell assets.

These results are consistent with work done by Manuel R. Agosin of the University of Chile and Franklin Huaita of Peru’s Ministry of Economics and Finance. They reported that the best predictor of a “sudden stop” was a previous capital inflow, or “surge.” Sudden stops are more likely to occur when the capital inflow had consisted largely of portfolio investments and cross-border lending.  Moreover, they claimed, capital surges worsen the current account deficits that precede sudden stops (see also here).

Stijn Claessens of the IMF and Swait Ghosh of the World Bank also looked at the impact of capital flows on emerging markets. They found that capital flows to these countries are usually large relative to their domestic financial systems. Capital inflows contribute to the pro-cyclicality of their business cycles by providing funding for increased bank lending, which are dominant in the financial systems of emerging markets. The foreign money also puts pressures on exchange rates and asset prices, and can lead to higher debt ratios. All these lead to buildups in macroeconomic and financial vulnerabilities, which are manifested when there is negative shock, either in the form of a domestic cyclical downturn or a global shock.

What can the emerging market counties do to protect themselves from the effects of volatile capital inflows? Claessens and Ghosh recommend a combination of macroeconomic measures, such as monetary and fiscal tightening; macro prudential policies that include limits on bank credit; and capital flow management measures, i.e., capital controls. However, they point out that the best combination of these policy tools has yet to be ascertained.

Hélène Rey of the London Business School has written about the global financial cycle, which can lead to excessive credit growth that is not aligned with a country’s economic conditions, and subsequent financial booms and busts. The lesson she draws is that in today’s world Mundell’s “trilemma” has become a “dilemma”: “independent monetary policies are possible if and only if the capital account is managed, directly or indirectly, regardless of the exchange-rate regime.” Joshua Aizenman of the University of Southern California, Menzie Chinn of the La Folette School of Public Affairs at the University of Wisconsin-Madison and Hiro Ito of Portland State University, however, report evidence that exchange rate regimes do matter in the international transmission of monetary policies.

Whether or not flexible exchange rates can provide some protection from foreign shocks, the capital controls that have been implemented in recent years will receive a “stress test” once the Federal Reserve does raise its interest rate target. Policymakers will be forced to make difficult decisions regarding exchange rates and monetary policies. Moreover, this tale of financial volatility may have a different moral than the usual one: bad things can happen even to those who follow the rules.

The G20 and the (Non)Pursuit of Financial Stability

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One of the legacies of the response to global financial crisis was supposed to be a renewed focus on international financial stability. A manifestation of this effort was the transformation of the Financial Stability Forum by the Group of Twenty (G20) into the Financial Stability Board (FSB) to oversee the development of global financial and regulatory standards. A “board,” of course, sounds more substantial than a “forum,” and the membership was expanded to include more G20 emerging market countries.

But the record of the FSB does not demonstrate an organizational commitment to changing the structure of international finance. Howard Davies summarizes its performance:

“…it is a watchdog without teeth. It can neither instruct the other regulators what to do (or not do) nor force countries to comply with new regulations.”

The FSB, of course, is an agent for its principals, the member governments. Davies places the responsibility for the lack of action on the FSB’s overseers:

“So a fair verdict would be that the FSB has done no more and no less than what its political masters have been prepared to allow it to do. There is no political will to create a body that could genuinely police international standards and prevent countries from engaging in competitive deregulation —and prevent banks from engaging in regulatory arbitrage.”

International financial stability is an international public good.  While domestic public goods are the result of failures in domestic markets, international public goods reflect failures of intergovernmental action. The lack of cooperation is due in part to a prisoners’ dilemma: each individual government has an incentive to shirk if it thinks that others will contribute to the provision of the public good.  Consequently, the good is underprovided.

Inci Ötker-Robe has written about other obstacles to collective action. These include problems in formulating and transforming knowledge into action, such as information asymmetries. As an example, she points to a lack of data across financial systems, which makes identifying risks and constructing early warning systems more difficult. Similarly, uncertainties about feedback loops that cross borders can allow financial fragility to escalate and trigger crises.

Ötker-Robe also writes about the incentives that discourage effective risk management. Diverging national interests, for example, prompt governments to protect their own financial systems rather than promote global welfare. (For an example, see the debate among regulators over capital requirements for systematically important banks.) She comes to a prognosis quite similar to that of Davies cited above:

“…the absence of global enforcement authorities with appropriate powers and accountability to forge global cooperation on the different areas of risk has hindered progress.”

What would it take for the situation to change? Ötker-Robe proposes implementing incremental steps to foster cooperation. These include financial transfers to governments to lower participation costs and increase participation. The IMF’s Managing Director Christine Lagarde has called for a new multilateralism, which would ”…instill a broader sense of “civic responsibility” on the part of all players in the modern global economy, including the private sector, and specifically financial sector players”. But if it is difficult for market participants to look past their private welfare, it is also difficult for governments to look beyond national interests, despite the domestic costs if global systems fail. Davies worries that it may take another crisis for the resolve to create international institutions with the necessary powers to be created. If the G20, which recently met in Brisbane, does not back its rhetoric with concrete actions, it might be a casualty of such a crisis.

International Debt and Financial Crises

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The latest issue of the IMF’s World Economic Outlook has a chapter on global imbalances that discusses the evolution of net foreign assets (also known as the net international investment position) in debtor and creditor nations. The authors warn that increases in the foreign holdings of domestic liabilities can raise the probability of different types of financial crises, including banking, currency, sovereign debt and sudden stops. A closer inspection of the evidence that has been presented elsewhere suggests that it is foreign-held debt that poses a risk.

The role of international debt in increasing the risk of crises was pointed out by Rodrik and Velasco (working paper 1999), who showed that short-term bank debt contributed to the occurrence of capital flow crises in the period of 1988-98. More recently, Joyce (2011) (working paper here) looked at systemic bank crises in a sample of emerging markets, and found that an increase in foreign debt liabilities contributed to an increase in the incidence of these crises, while FDI and portfolio equity liabilities had the opposite effect. Ahrend and Goujard (2014) (working paper here) confirmed that increases in debt liabilities increase the occurrence of systemic banking crises. Catão and Milesi-Ferretti (2014) (working paper here) found that an increase in net foreign assets lowered the probability of external crises. Moreover, they also reported that this effect was due to net debt. FDI had the opposite effect, i.e., an increase in FDI liabilities lowered the risk of a crisis. Al-Saffar, Ridinger and Whitaker (2013) have looked at external balance sheet positions during the global financial crisis and reported that gross external debt contributed to declines in GDP.

There are also studies that compare the effect of equity and debt flows. Levchenko and Mauro (2007), for example, investigated the behavior of several types of flows, and found that FDI was stable during periods of “sudden stops,” while portfolio equity played a limited role in propagating the crisis. Portfolio debt, on the other hand, and bank flows were more likely to be reversed. Similarly, Furceri, Guichard and Rusticelli (2012) (working paper here) found that large capital inflows driven by debt increase the probability of banking, currency and balance-of-payment crises, while inflows that are driven by FDI or portfolio equity have a negligible effect.

Why are debt liabilities more risky for countries than equity? Debt is contractual: the holder of the debt expects to be paid regardless of economic conditions. Equity holders, on the other hand, know that their payout is tied to the profitability of the firm that issues the debt. Moreover, during a crisis there are valuation effects on external balance sheets. The value of equity falls, which raises the net foreign asset position of those countries that are net issuers of equity, while lowering it for those that hold equity. In addition, debt may be denominated in a foreign currency to attract foreign investors worried about depreciation. A currency depreciation during a crisis raises the value of the debt on the balance sheet of the issuing country.

These results have consequences for the use of capital controls and the sequence of decontrol. Emerging markets should be careful when issuing debt. However, the evidence to date of trends in the international capital markets shows a rise in the use of debt by these countries. Emerging market governments, for example, issued $69 billion in bonds in the first quarter. In addition, the BIS has drawn attention to the issuance of debt securities by corporations in emerging markets.

The IMF has warned of a slowdown in the emerging market countries, with the Fund’s economists forecasting GDP growth rates below the pre-crisis rates.  Speculation about the impact of changes in the Federal Reserve’s quantitative easing policies has contributed to concerns about these countries. If a slowdown does materialize, the debt that was issued by these countries may become a burden that requires outside intervention.

European Doldrums

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European economies are faltering.  The German economy contracted in the second quarter, as did those of France and Italy. Growth in Spain and the Netherlands was not enough to offset the slowdown in the Eurozone’s largest members.  An escalation in the confrontation with Russia would send shockwaves rippling from the Ukraine westwards that world worsen the situation.

The continuing slump confirms Jay C. Shambaugh’s observation (which appears in his paper in the new volume, What Have We Learned? Macroeconomic Policy After the Crisis) that much of what happened during the global financial crisis was consistent with standard international macroeconomics. For example, countries with flexible exchange rates were able to adjust more easily to the shock than those with fixed rates. Shambaugh also compares unemployment rates in the Eurozone with those across the U.S., and notes that while both the range and standard deviation of unemployment rates began to fall in the U.S. in 2010, the dispersion of national unemployment rates continued in the Eurozone. Labor conditions improved in some countries, but not others. Shambaugh cites this as evidence that there is a lack of adequate shock absorbers, such as labor mobility, within the Eurozone.

These structural problems have been exacerbated by fiscal austerity policies. Governments have sought to reestablish fiscal balance despite the impact on economic performance. The latest announcements of lowered growth have led to calls for relaxing fiscal constraints. But the incoming head of the EU Commission, Jean-Claude Juncker, shows little interest in relaxing the limits on fiscal policies, nor does German Chancellor Angela Merkel.

This leaves (once again) Mario Draghi and the European Central Bank as the focus of hope and attention. The central bank is waiting for the impact of policy measures announced in June to take place. But the disappointing economic news only reinforces calls for the ECB to enact a European version of quantitative easing.

The European GDP data have troubling implications for the larger issue of European debt. Last April, the IMF offered projections for the debt/GDP ratios this year and next:

 

2014 2015
France 95.8 96.1
Greece 174.7 171.3
Ireland 123.7 122.7
Italy 134.5 133.1
Spain 98.8 102.0
Eurozone 95.6 94.5

 

The new data will not improve the forecasts for these countries. Greece’s situation, in particular, appears as dire as ever. The Greek government hopes that a cyclically-adjusted fiscal surplus of 2.1% for 2013 will allow it some reduction in the interest rates it must pay and an extension of debt repayments. But the official targets for debt/GDP ratios of 124% in 2020 and 110% in 2022 appear unrealistic.

In a recent paper by Manuel Ramos-Francia, Ana María Aguilar-Argaez, Santiago García-Verdú and Gabriel Cuadra-García (all of the Banco de México) that appeared in the English edition of Monetaria, the authors compare the Latin American debt crisis with the European crisis. They point out that the macro imbalances and the magnitudes of the debt are larger in the peripheral European countries than they were in Latin America. Moreover, the Europeans are not able to rely on exchange rate devaluations to deal with the costs of fiscal austerity. They also remind us that the Latin American situation was finally resolved in 1989 by a reduction in debt and the issuance of “Brady bonds” (see Chapter 4 here), and suggest that some form of debt relief be granted in Europe.

It took seven years from the outbreak of the Latin American crisis for a resolution to be achieved. By that reckoning, European countries have several years of continued stagnation ahead. Political leaders who have seen their predecessors swept out of office by angry voters may not be willing to wait that long.

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.