Tag Archives: financial stability

Capital Flows and Domestic Responses

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

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

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

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

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

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

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

Crises and Coordination

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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 Retreat of Financial Globalization?

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Eight years after the global crisis of 2008-09, its reverberations are still being felt. These include a slowdown in world trade and a reassessment of the advantages of globalization. Several recent papers deal with a decline in international capital flows, and suggest some reasons for why this may be occurring.

Matthieu Bussière and Julia Schmidt of the Banque de France and Natacha Valla of CEPII (Centre d’Etudes Prospectives et d’Informations Internationales) compare the record of the period since 2012 with the pre-crisis period and highlight four conclusions. First, the retrenchment of global capital flows that began during the crisis has persisted, with gross financial flows falling from about 10-15% of global GDP to approximately 5%. Second, this retrenchment has occurred primarily in the advanced economies. particularly in Europe. Third, net flows have fallen significantly, which is consistent with the fall in “global imbalances.” Fourth, there are striking differences in the adjustment of the various types of capital flows. Foreign direct investment has been very resilient, while capital flows in the category of “other investment”—mainly bank loans—have contracted substantially. Portfolio flows fall in between these two extremes, with portfolio equity recovering much more quickly than portfolio debt.

Similarly, Peter McQuade and Martin Schmitz of the European Central Bank investigate the decline in capital flows between the pre-crisis period of 2005-06 and the post-crisis period of 2013-14. They report that total inflows in the post-crisis period reached about 50% of their pre-crisis levels in the advanced economies and about 80% in emerging market economies. The decline is particularly notable in the EU countries, where inflows fell to only about 25% of their previous level. The steepest declines occurred in the capital flows gathered in the “other investment” category.

McQuade and Schmitz also investigate the characteristics of the countries that experienced larger contractions in capital flows in the post-crisis period. They report that inflows fell more in those countries with higher initial levels of private sector credit, public debt and net foreign liabilities. On the other hand, countries with lower GDP per capita experienced smaller declines, consistent with the observation that inflows have been curtailed more in the advanced economies. In the case of outflows, countries with higher GDP growth during the crisis and greater capital account openness were more likely to increase their holdings of foreign assets.

Both studies see an improvement in financial stability due to the larger role of FDI in capital flows. Changes in bank regulation may have contributed to the smaller role of bank loans in capital flows, as has the diminished economic performance of many advanced economies, particularly in the Eurozone. On the other hand, smaller capital flows may restrain economic growth.

While capital flows to emerging markets rebounded more quickly after the crisis than those to advanced economies, a closer examination by the IMF in its April 2016 World Economic Outlook of the period of 2010-2015 indicate signs of a slowdown towards the end of that period. Net flows in a sample of 45 emerging market economies fell from a weighted mean inflow of 3.7% of GDP in 2010 to an outflow of 1.2% during the period of 2014:IV – 2015:III. Net inflows were particularly weak in the third quarter of 2015. The slowdown reflected a combination of a decline in inflows and a rise in outflows across all categories of capital, with the decline in inflows more pronounced for debt-generating inflows than equity-like inflows. However, there was an increase in portfolio debt inflows in 2010-2012, which then declined.

The IMF’s economists sought to identify the drivers of the slowdown in capital flows to these countries. They identified a shrinking differential in real GDP growth between the emerging market economies and advanced economies as an important contributory factor to the decline. Country-specific factors influenced the change in inflows for individual countries, as economies with more flexible exchange rates recorded smaller declines.

In retrospect, the period of 1990-2007 represented an extraordinarily rapid rise in financial globalization, particularly in the advanced economies. The capital flows led to increased credit flows and asset bubbles in many countries, and culminated in an economic collapse of historic dimensions. The subsequent retrenchment of capital flows may be seen as a return to normalcy, and the financial and banking regulations–including capital account controls–enacted since the crisis as an attempt to provide stronger defenses against a recurrence of financial volatility. But the history of finance shows that new financial innovations are always on the horizon, and their risks only become apparent in hindsight.

Capital Flows and Financial Activity in Commodity Exporters

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Emerging markets and developing economies have struggled in recent years to regain the growth rates of the last decade before the global financial crisis. The slowdown has been particularly evident in commodity-exporters that face declining prices. The World Bank’s most recent Global Economic Prospects, for example, projects growth for those countries of only 0.4% in 2016. Moreover, the fall in commodity prices is linked to capital flows to those countries and an increase in the fragility of their financial sectors.

In a recent paper in the Journal of International Money and Finance, Joseph P. Byrne of Heriot-Watt University and Norbert Fiess of the World Bank examined the determinants of capital inflows to 64 emerging market economies. Among the drivers of capital flows were real commodity prices: an increase in these prices increased flows to the emerging markets, particularly total equity and bank flows. Real commodity prices also contributed to an increase in the global volatility of capital flows.

Commodity price cycles, therefore, should be associated with capital flow cycles, and declines in both may lead to financial crises. Carmen Reinhart of Harvard’s Kennedy School, Vincent Reinhart of the American Enterprise Institute and Christoph Trebesch of the University of Munich documented such a correspondence of capital flows, commodity prices and sovereign defaults during the period 1815 to 2015 in a paper in the American Economic Review Papers and Proceedings 
(working paper here). They found evidence of an overlap between booms in capital flows and commodity prices, which resulted in a “double bonanza,” and a “double bust” when capital flows and prices declined. They also recorded the incidence of sovereign defaults, and found that four of six global peaks in defaults followed double busts in capital flows and commodity markets. The most recent boom was exceptionally prolonged, beginning in 1999 and lasting until 2011, and was followed by a “double bust.”

Commodity prices can also affect the fragility of domestic financial sectors. Tidiane Kinda, Montfort Mlachila and Rasmané Ouedraogo in an IMF working paper looked at the impact of commodity price shocks on the financial sectors in 71 emerging market and developing economies that are commodity exporters. Falling prices weakened the financial sector as manifested through higher non-performing loans and reduced bank profits, and an increased probability of a banking crisis. The transmission channels included an increase in the amount of debt denominated in foreign currency as well as lower economic growth and less government revenues.

The fragility of the financial sectors of the commodity exporters has been exacerbated by a growth in private credit. The World Bank’s Global Economic Prospects has reported that credit to the nonfinancial sector in emerging markets and developing economies increased in the five years ending in 2015, and credit growth was particularly pronounced in commodity exporting countries. Much of this credit went to nonfinancial corporations, and the borrowing was concentrated in the energy sector. As a result, credit growth in the commodity exporting emerging market and developing economies has risen to levels of credit/GDP that in the past have been associated with credit booms that have often (but not always) been followed by bank crises.

Commodity price fluctuations, therefore, are accompanied by changes in capital flows and the status of financial sectors in commodity exporters. Booms in domestic credit can further threaten long-term financial stability. More flexible exchange rates may alleviate some of the strain of a downturn in commodity prices and capital inflows. But countries such as Brazil, Indonesia and Russia face little relief from the drag on their economic performance as long as commodity prices remain depressed. The accommodative monetary policies of the advanced economies have bolstered asset prices in many emerging markets, but that situation can not be counted on to continue indefinitely.

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

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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.

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.

Dilemmas, Trilemmas and Difficult Choices

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In 2013 Hélène Rey of the London Business School presented a paper at the Federal Reserve Bank of Kansas City’s annual policy symposium. Her address dealt with the policy choices available to a central bank in an open economy, which she claimed are more limited than most economists believe. The subsequent debate reveals the shifting landscape of national policymaking when global capital markets become more synchronized.

The classic monetary trilemma (or “impossible trinity”) is based on the work of Robert Mundell and Marcus Fleming. The model demonstrates that in an open economy, central bankers can have two and only two of the following: a fixed foreign exchange rate, an independent monetary policy, and unregulated capital flows. A central bank that tries to achieve all three will be frustrated by the capital flows that respond to interest rate differentials, which in turn trigger a response in the foreign exchange markets.  Different countries make different choices. The U.S. allows capital to cross its borders and uses the Federal Funds Rate as its monetary policy target, but refrains from intervening in the currency markets. Hong Kong, on the other hand, permits capital flows while pegging the value of its currency (the Hong Kong dollar) to the U.S. dollar, but forgoes implementing its own monetary policy. Finally, China until recently maintained control of both its exchange rate and monetary conditions by regulating capital flows.

Rey showed that capital flows, domestic credit and asset prices respond to changes in the VIX, a measure of U.S. stock market volatility. The VIX, in turn, is driven in part by U.S. monetary policies. Consequently, she argued, there is a global financial cycle that domestic policymakers can not resist. A central bank has one, and only one, fundamental choice to make (the “dilemma”): does it regulate the capital account to control the amount and composition of capital flows? If it does, then it has latitude to exercise an independent monetary policy; otherwise, it does not possess monetary autonomy.

Is Rey’s conclusion correct? Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University have provided a thorough analysis of the trilemma (working paper here; see also here). Their paper focuses on whether the use of partial capital controls is sufficient to provide monetary policy autonomy with a pegged exchange rate. They find that temporary, narrowly-targeted controls–“gates”– are not sufficient to allow a central bank to both fix its exchange rate and conduct an independent policy. A central bank that wants to control the exchange rate and monetary conditions must impose wide and continuous capital controls–“walls.” But they also find that a central bank that forgoes fixed exchange rates can conduct its own policy while allowing capital flows to cross its borders, a confirmation of the trilemma tradeoff.

Helen Popper of Santa Clara University, Alex Mandilaras of the University of Surrey and Graham Bird of the University of Surrey, Claremont McKenna College and Claremont Graduate University (working paper here; see also here) provide a new empirical measure of the trilemma that allows them to distinguish among the choices that governments make over time. Their results confirm, for example, that Hong Kong has surrendered monetary sovereignty in exchange for its exchange rate peg and open capital markets. Canada’s flexible rate, on the other hand, allows it to retain a large degree of monetary sovereignty despite the presence of an unregulated capital market with the U.S.

The choices of the canonical trilemma, therefore, seem to hold. What, then, of Rey’s challenge? Her evidence points to another phenomenon: the globalization of financial markets. This congruence has been documented in many studies and reports (see, for example, here). The IMF’s Financial Stability Report last October noted that asset prices have become more correlated since the global financial crisis. Jhuvesh Sobrun and Philip Turner of the Bank for International Settlements found that financial conditions in the emerging markets have become more dependent on the “world” long-term interest rate, which has been driven by monetary policies in the advanced economies.

Can flexible exchange rate provide any protection against these comovements? Joshua Aizenman of the University of Southern California, Menzie D. Chinn of the University of Wisconsin and Hiro Ito of Portland State University (see also here) looked at the impact of “center economies,” i.e., the U.S., Japan, the Eurozone and China, on financial variables in emerging and developing market economies. They find that for most financial variables linkages with the center economies have been dominant over the last two decades. However, they also found that the degree of sensitivity to changes emanating from the center economies are affected by the nature of the exchange rate regime. Countries with more exchange rate stability are more sensitive to changes in the center economies’ monetary policies. Consequently, a country could lower its vulnerability by relaxing exchange rate stability.

Rey’s dismissal of the trilemma, therefore, may be overstated. Flexible exchange rates allow central banks to retain control of policy interest rates, and provide some buffer to domestic financial markets. But her wider point about the linkages of asset prices driven by capital flows and their impact on domestic credit is surely correct. The relevant trilemma may not be the international monetary one but the financial trilemma proposed by Dirk Schoenmaker of VU University Amsterdam. In this model, financial policy makers must choose two of the following aspects of a financial system: national policies, financial stability and international banking. National policies over international bankers will not be compatible with financial stability when capital can flow in and out of countries.

But abandonment of national regulations by itself is not sufficient: International banking is only compatible with stability if international financial governance is enacted. Is the administration of regulatory authority on an international basis feasible? The Basel Committee on Banking Supervision seeks to coordinate the efforts of national supervisory authorities and propose common regulations. Its Basel III standards set net capital and liquidity requirements, but whether these are sufficient to deter risky behavior is unclear. Those who deal in cross-border financial flows are quite adept in running rings around rules and regulations.

The international monetary trilemma, therefore, still offers policymakers scope for implementing monetary policies. The financial trilemma, however, shows that the challenges of global financial integration are daunting. Macro prudential policies with flexible exchange rates provide some protection, but can not insulate an economy from the global cycle. In 1776, Benjamin Franklin urged the members of the Second Continental Congress to join together to sign the Declaration of Independence by pointing out: “We must, indeed, all hang together, or most assuredly we shall all hang separately.” Perhaps that is the dilemma that national policymakers face today.

Global Volatility, Domestic Markets

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Unlike the global financial crisis of 2008-09, the current disruption in the financial markets of emerging market nations was anticipated. The “taper tantrum” of 2013 revealed the precarious position of many of these nations, particularly those dependent on commodity exports. The combination of a slowdown in Chinese growth, collapsing stock prices and a change in the Chinese central bank’s exchange rate policy indicated that the world’s second-largest economy has its own set of problems. But global volatility itself can roil financial markets, and good fundamentals may be of little help for a government trying to shelter its economy from the instability in world markets.

The importance of global (or “push”) factors for capital flows to emerging markets was studied by Eugenio Cerutti, Stijn Claessens and Damien Puy of the IMF. They looked at capital flows to 34 emerging markets during the period of 2001-2013, and found that global factors such as the VIX, a measure of anticipated volatility in the U.S. stock market, accounted for much of the variation in flows. Not all forms of capital were equally affected: bank-related and portfolio flows (bonds and equity) were strongly influenced by the global factors, but foreign direct investment was not.

Cerutti, Claessens and Puy also investigated whether the emerging markets could insulate themselves from the global environment with good domestic macro fundamentals. They reported that the sensitivity of emerging markets to the external factors depended in large part upon the identity of a country’s investors. The presence of global investors, such as international mutual funds in the case of portfolio flows and global banks in the case of bank finance, drove up the response to the global environment. The authors concluded: “…there is no robust evidence that “good” macroeconomic (e.g., public debt, growth) or institutional fundamentals (e.g., Investment Climate and Rule of Law) have a role in explaining EM different sensitivities to global push factors.”

A similar finding was reported in a study of corporate bond markets in emerging markets, which have grown considerably since the 2007-09 crisis. Diana Ayala, Milan Nedeljkovic and Christian Saborowski, also of the IMF, studied the share of bond finance in total corporate debt in 47 emerging market economies over the period of 2000-13. Domestic factors contributed to the development of bond markets. But the growth in these markets in the post-crisis period was driven by global factors, such as the spread in U.S. high yield bonds, a proxy for global risk aversion, and U.S. broker-dealer leverage. The authors conjecture that the growth in bond finance in the emerging markets was due to a search for higher yields than those available in advanced economies during this period. If this interpretation is correct, then these countries will see capital outflows once interest rates in the U.S. and elsewhere rise.

A third paper from the IMF, written by Christian Ebeke and Annette Kyobe, looked at the markets for emerging market sovereign bonds. Their results are based on data from 17 emerging markets over the 2004-13 period. They found that foreign participation in the market for domestic-currency denominated sovereign bonds increased the impact of U.S. interest rates on the yield of these bonds once a threshold of 30 percent had been reached. Similarly, an increase in the concentration of the investor base made the bond yields more sensitive to global financial shocks.

Are domestic “pull” factors always irrelevant for capital flows? Ahmed Shaghil, Brahima Coulibaly and Andrei Zlate of the Federal Reserve Board constructed a “vulnerability index” of macroeconomic fundamentals for a sample of 20 emerging market economies during 13 periods of financial stress, beginning with the Mexican crisis of 1994 and ending with the 2013 taper tantrum. They looked at the impact of their index upon a measure of depreciation pressure, based on changes in exchange rates and losses in foreign exchange reserves. They found that there was evidence of a linkage between the macro fundamentals and depreciation pressure during the global financial crisis and then again during the European sovereign debt crisis and the taper tantrum, but not before.

Why would the response of emerging market economies to domestic fundamentals become stronger during the most recent crises? Shaghil, Coulibaly and Zlate offer two reasons: first, it may be that foreign investors investors did not distinguish among the emerging market economies until the 2000s. But as the governments of these countries implemented different policy frameworks and the costs of gathering information about them fell due to technology, it became worthwhile to distinguish amongst them based on their individual characteristics. An alternative reason for the change over time could lie in a shift in the origin of the crises away from the emerging markets themselves. Therefore, investors have become more careful in examining the vulnerabilities of individual countries.

The analysis of the relative importance of domestic “pull” vs. global “push” factors should not be posed as a “one or the other” contest (see here). There is ample evidence to indicate that global factors have become increasingly important in driving capital flows across borders. If so, then the news that the VIX hit record levels last week is disturbing. Stock markets in the U.S. and other advanced economies have rebounded, but the emerging market nations face a period of sustained retrenchment as investors reallocate their funds in response to the surge in global volatility.

Global Liquidity and U.S. Monetary Policy

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The events in Greece and the Ukraine have only partially drawn attention away from the financial markets’ focus on changes in U.S. monetary policy. Federal Reserve officials seem to be split over when they will raise their Federal Funds rate target, and by how much. But while U.S. policymakers are closely monitoring domestic labor developments, the impact of their actions will have repercussions for foreign markets.

The growth of cross-border financial flows has led to research on global liquidity. Jean-Pierre Landau of SciencesPo (Paris) defines global private liquidity as the international components of liquidity, i.e., “cross-border credit and portfolio flows or lending in foreign currencies to domestic residents,” while official global liquidity is the funding available to settle claims on monetary authorities. Before the global financial crisis, global banking flows were instrumental in extending private credit across borders, while more recently portfolio flows have been important.

Eugenio Cerutti, Stijn Claessens, and Lev Ratnovski of the IMF examined the determinants of global liquidity using data on cross-border bank flows for 77 countries over the period of 1990-2012. They identified four financial centers: the U.S., the Eurozone, the U.K. and Japan. The drivers of global liquidity included factors such as the TED spread (3 month LIBOR minus 3 month government bond yield), an indicator of uncertainty that affects bank behavior. They also included measures related to monetary policy, including the real interest rate and term premium, i.e., the slope of the yield curve, defined as the difference between 10 year and 3 month government securities.

The authors first used U.S. global liquidity factors in their empirical analysis. When the U.S. term premium fell, there was a rise in international lending as banks sought higher returns. The U.S. real interest rate had a positive coefficient, which the authors saw as a sign that global banks lent less when there were favorable domestic conditions. The authors then introduced the same variables for the three other financial centers, and found that term premiums from the U.K. and the Eurozone have the same effect on cross border bank lending as did the U.S. measure. The Japanese term premium, on the other hand, had a positive coefficient, which may reflect the record of Japan’s interest rate.

When cross-border claims were broken out by lending to Asian and the Western Hemisphere countries, the TED spreads for British and European banks were significant determinants for lending to both areas. The U.S. term premium was the only term premium variable with explanatory power in lending to bank and non-banks in the two regions. The authors interpret these results as an indication that the global financial cycle is driven in part by U.S. monetary policy and British and European bank conditions. The authors also find that a borrower country can reduce its exposure to global liquidity drivers through flexible exchange rates, capital controls and stringent bank supervision.

The latest Annual Report of the Bank for International Settlements (BIS) also looks at financial flows across borders in its chapter on the international monetary and financial system. The authors of the chapter detail the growth in dollar- and euro-denominated credit through bank loans and debt securities, which can go to domestic residents in the U.S. or Eurozone, or non-residents. They point out that while U.S. households, corporations and its government account for 80% of global non-financial dollar debt at the end of 2014, the remaining one-fifth—about $9.5 trillion—of dollar credit was held outside the U.S.

These loans and securities have been growing rapidly since the global financial crisis. In particular, non-U.S. borrowers issued $1.8 trillion in bonds between 2009 and 2014. The authors of this chapter of the BIS Report attribute this growth to low lending rates and the reduction of the term premium for U.S. Treasury securities, which reflects the large scale purchase of these securities by the Federal Reserve in its Quantitative Easing (QE) programs. The European Central Bank’s bond purchases and the resulting compression of term premiums on euro-denominated bonds may lead to a similar phenomenon.

Changes in U.S. monetary policy, therefore, will influence global financial flows in both bank lending and bond issuance. If the end of QE results in higher term premiums in the U.S. as the rates on long-term securities rise, then cross-border flows could be negatively impacted. A rise in the Federal Fund Rate, on the other hand, could initially decrease the term premia, although other interest rates would likely follow. These changes take place, moreover, while the Eurozone and Japan are moving in opposite directions, which may intensify their effect. Mark Carney, Governor of the Bank of England, warned last January that the resiliency of the financial system will be tested by Federal Reserve tightening. Once again, policymakers may be forced to respond to fast-breaking developments as they occur. But this time they may not have as much flexibility to maneuver as they need. We may not know the consequences for financial stability until it is too late to avoid them.

The U.S.: Inept Diplomacy, Indispensable Currency

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The announcements by several European governments that they would join the new Asian Infrastructure Investment Bank (AIIB) have been widely seen as indicators of the declining position of the U.S.  The AIIB had been proposed by China for the purpose of funding much-needed infrastructure projects in Asian countries. The U.S. had discouraged other governments from joining, ostensibly on the grounds that the new institution would overlap with the World Bank and the Asian Development Bank. But the real reason seemed to be a concern that the Chinese would have a regional forum to wield power.

The New York Times held both the Congress and President Obama responsible for mishandling the issue. The U.S. claimed it sought to ensure better governance in the new institution, but gave no signal of being willing to work with the Chinese and others to make the AIIB an effective agency. The continuing refusal of Congress to approve reforms in the IMF’s governance structure gives the Chinese and other emerging markets ample cause to look elsewhere. The Economist put it starkly: “China has won, gaining the support of American allies not just in Asia but in Europe, and leaving America looking churlish and ineffectual.”

And yet: the same issue of The Economist stated that “In the world of economics, one policy maker towers above all others…,”, and named Federal Reserve Chair Janet Yellen as holder of that position due to the sheer size of the U.S. economy. The influence of the U.S. in financial flows extends far outside national borders. A study by Robert N.McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated that the amount of dollar-denominated credit received by non-financial borrowers outside the U.S. totaled $9 trillion by mid-2014. Over two-thirds of the credit originated outside the U.S., with about $3.7 trillion coming from banks and $2.7 from bond investors. The report’s authors found that dollar credit extended to non-U.S. borrowers grew much more rapidly than did credit within the U.S. during the post-global financial crisis period.

Almost half of this amount went to borrowers in emerging markets, particularly China ($1.1 trillion), Brazil ($300 billion), and India ($125 billion). In the case of Brazil, most of the funds were raised through the issuance of bonds, while bank lending accounted for the largest proportion of credit received by borrowers in China. Much of this credit was routed through the subsidiaries of firms outside their home countries, and balance of payments data would not capture these flows.

The study’s authors attributed the rise in borrowing in emerging markets to their higher interest rates. Consequently, any rise in U.S. interest rates will have global repercussions. The growth in dollar-denominated credit outside the U.S. should slow. But there may be other, less constructive consequences. Borrowers will face higher funding costs, and loans or bonds that looked safe at one interest rate may be less so at another. This situation is worsened by an appreciating dollar if the earnings of the borrowers are not also denominated in dollars. The rise in the value of the dollar has already prompted reassessments of financial fragility outside the U.S.

All this puts U.S. monetary policymakers in a delicate position. Ms. Yellen has made it clear that the Fed is in no hurry to raise interest rates. The Federal Reserve wants to see what happens to prices and wages as well as unemployment before it moves. The appreciation of the dollar pushes that date further into the future by keeping inflation rates depressed while cutting into the profitability of U.S. firms. While the impact of higher rates on credit markets outside the U.S. most likely has a relatively low place on the Fed’s list of concerns, Fed policymakers certainly are aware of the potential for collateral damage.

All this demonstrates the discrepancy between the diplomatic and financial power of the U.S. On the one hand, the U.S. must deal with countries that are eager to claim their places in global governance. The dominance of the U.S. and other G7 nations in international institutions is a relic of a world that came to an end with the global financial crisis. On the other hand, the dollar is still the predominant international currency, and will hold that place for many years to come. The use of the renminbi is slowly growing but it will be a long time before it can serve as an alternative to the dollar. Consequently, the actions of the Federal Reserve may have more international repercussions than those of U.S. policymakers unable to cope with the shifting landscape of financial diplomacy.