Tag Archives: IMF

The Costs of the Defragmentation of the Global Economy

Leave a reply

The integration of markets across borders has slowed down, and in some cases, reversed. These changes come in the wake of the global financial crisis, Donald Trump’s embrace of trade restrictions, Great Britain’s withdrawal from the European Union, the disruptions in global supply chains during the pandemic, and the invasion of Ukraine. President Biden has shown a willingness to use trade and financial restrictions in response to what he views as Chinese and Russian threats to U.S. strategic interests, and there are responses to the use of sanctions and other tools of disruption. The fallout from this rift will take years to play out.

A team of IMF economists have written a Discussion Note on Geoeconomic Fragmentation and the Future of Multilateralism. They attribute the reversal of economic integration to national considerations, such as the desire of governments to increase their domestic production capabilities in particular areas. But the authors of the Note point out that while fragmentation may achieve some goals, it also imposes costs. These include: “higher import prices, segmented markets, diminished access to technology and to both skilled and unskilled labor, and ultimately reduced productivity which may result in lower living standards.” Moreover, fragmentation will slow down joint efforts to address global issues such as climate change.

The Discussion Note summarizes the results of several studies of the loss from geoeconomic fragmentation. In all the studies they cite, the costs are greater the larger the degree of fragmentation. Among the reasons for the losses in output are reduced knowledge diffusion due to technological decoupling. Not surprisingly, low income and emerging market countries are most at risk from a separation from the latest technological developments.

Pinelopi K. Goldberg of Yale and Tristan Reed of the World Bank Group (Goldberg is former chief economist of the World Bank) examine the prospects for global trade in their recent NBER Working Paper “Is the Global Economy Deglobalizing? And if so, why? And what is next?” They find that “slowbalization” is a better description of the recent trend in international trade than “deglobalization.” Foreign direct investment and migration have exhibited relatively less slowdowns. But the authors also document changes in U.S. policies and public attitudes that represent a marked shift away from the liberalization of trade. They attribute these reversals to various factors, including the impact of imports on U.S. labor, concerns over the resilience of global supply chains, and national security considerations.

Goldberg and Reed conclude their analysis with some projections of the consequences of deglobalization. They point out that the previous regime of the last three decades led to growth and technological progress They warn that global innovation will be particularly slowed by a decoupling of the U.S. and China  Reconfiguring production supply chains will slow growth as well. These reversals and changes raise the possibility that the recent decline in global inequality will halt, with low-income countries most at risk.

Trade, of course, is not the only component of international commerce that has undergone changes in how it is organized. Chapter 4 of the IMF’s most recent World Economic Outlook analyses the geoeconomic fragmentation of FDI. The authors point to an increase in the “reshoring” and “friend-shoring” of production facilities domestically or to countries with similar political alignments. They estimate a model of the impact of geopolitical alignment on FDI flows, and find that geopolitical factors account for part of the shift in bilateral FDI to countries with governments with similar views to the home country. This could presage a shift to more FDI among advanced economies, rather than emerging markets and developing economies that may differ on political issues.

The Fund’s economists also analyzed the output costs of FDI fragmentation. They utilized different scenarios of geopolitical alignment, such as a world divided into a U.S.-centered block and a China-centered block, with India and Indonesia and Latin America and the Caribbean as nonaligned. In this scenario, the impact of smaller capital stocks and less productivity cumulate with long-term output losses of 2%. Other scenarios allow for the diversion of investment flows to some areas that could offset a decline in global economic activity. However, the chapter’s authors also warn that nonaligned nations may face pressures to choose one side over the other. They conclude from their analysis: “…a fragmented global economy is likely to be a poorer one. While there may be relative—and possibly absolute—winners from diversion, such gains are subject to substantial uncertainty.”

Other forms of capital flows are also subject to fragmentation, and the IMF’s economists examine these trends is a chapter of the latest Global Stability Report. In their analysis, geopolitical tensions can lead to instability through two channels. The first is a financial channel that could respond to increased restrictions on capital flows, greater uncertainty or conflict. The second channel is a real channel, due to disruptions in trade and technology transfers or volatile commodity markets. These two channels can reinforce each other. Restrictions in trade, for example, could discourage cross-border investments.

Geopolitical affinities affect cross-border capital allocation, and the evidence reported in the chapter indicates that recent events have reinforced this impact. The empirical analysis based on a gravity model finds that a rise in geopolitical tensions can trigger sizable portfolio and bank outflows, particularly in developing and emerging market economies. Geopolitical fragmentation can also lead to a loss in international risk diversification, thus leaving countries more vulnerable to adverse shocks and a sizable welfare loss.

All these analyses from multilateral institutions warn of the negative economic consequences arising from the decoupling of trade and financial ties. But the most threatening effects may come from the deepening division of the world into different blocs. As the dividing lines become solidified, the chances of discord extending beyond economic interactions increase. All this friction arising when climate warming already poses a clear threat to our existence only intensifies the dangers we will face.

The Restructuring of Sovereign Debt

Leave a reply

The economic repercussions of Russia’s invasion of Ukraine will be devastating for many countries that have yet to recover from the pandemic. Higher prices for commodities, particularly energy and food, will increase inflation rates and widen trade deficits for those nations that import those items. Increases in interest rates will raise the cost of debt financing and hamper the ability of borrowers to meet their obligations or refinance existing debt.

Carmen Reinhart, Chief Economist of the World Bank, warned that the pandemic had exacerbated existing financial weaknesses in her Mundell-Fleming Lecture, “From Health Crisis to Financial Distress,” which has been published in the IMF Economic Review. She points out that economic and financial crises, including banking, currency, debt, etc., often occur together. The resulting “conglomerate crisis” can lead to a severe economic downturn. She warns that initial attempts to arrange a “shallow” restructuring of sovereign debt that does not reduce the intertemporal value of the debt may be followed by one or more subsequent restructurings, exacerbating the impact of the crisis.

Governments that need to restructure debt may be able to lessen the resulting impact if they act early. Tamon Asonuma, Marcos Chamon, Aitor Erce and Akira Sasahara have examined the consequences of debt restructurings in an IMF Working Paper, “Costs of Sovereign Defaults: Restructuring Strategies, Bank Distress and the Capital Inflow-Credit Channel.” The authors looked at 179 restructurings of the sovereign debt held by private holders over the period of 1978-2010. They divided the sample into three categories: “strictly preemptive,” where no payments were missed; “weakly preemptive,” where some payments were missed but only temporarily and only after the start of negotiations with creditors; and “post-default,” which occurred when payments were missed and without agreement with the creditors.

They reported that banking crises and severe declines of credit and net capital inflow occurred more frequently following post-default restructurings. They also found that contractions of GDP and investment spending were substantial in post-default restructurings, less severe in weakly preemptive restructurings and did not occur in the case of strictly preemptive cases. Private credit and capital inflows remained below the pre-crisis levels and interest rates rose after post-default restructurings. Their results indicate that governments that can restructure without missing payments will avoid some of the costs associated with restructurings. The authors acknowledge that large shocks can force a halt in payments, but even in those cases collaboration with creditors is more advantageous than unilateral actions.

The IMF reviewed the institutional mechanisms that address sovereign debt restructurings in 2020 policy paper, The International Architecture for Resolving Sovereign Debt Involving Private-Sector Creditors—Recent Developments, Challenges, And Reform Options. The review found that recent restructurings of sovereign debt had been much smoother than those in previous periods. It attributed this change to several factors, including the increased use of collective action clauses which allow a majority of the creditors to override a minority that oppose a restructuring. The paper’s authors called for more contractual reforms as well as an increase in debt transparency, and also recommended that the international financial institutions support debt restructurings financially when appropriate. But the report  warned that the pandemic could engender a widespread crisis that could overwhelm existing procedures:

“Should a COVID-related systemic sovereign debt crisis requiring multiple deep restructurings materialize, the current resolution toolkit may not be adequate in addressing the crisis effectively and additional instruments may need to be activated at short notice.”

The IMF sought to establish new instruments in 2020 when it joined the Group of 20 nations to create an institutional mechanism for low-income countries with unsustainable debt loads called the “Common Framework” (see here). The initiative sought to bring together official creditors, including the traditional lenders such as the U.S. and France, with more recent lenders, such as China and India, to coordinate debt relief efforts. Private creditors were to use comparable terms in their negotiations.

But the Framework has not been widely adopted because of reluctance by some lenders and borrowers. Chinese lending has been funneled through several institutions, and they are not always willing to join other creditors. The governments of the nations with the debt loads have been reluctant to signal that they may need relief, in part because of a negative signaling effect. The IMF has called for reorganizing and expanding the Common Framework.

A wave of restructuring may be triggered by a Russian default on its dollar-denominated bonds. The credit rating agencies have downgraded the Russian bonds to junk bond status (“C” in the case of Fitch’s rating). President Putin has stated that the bond payments will be paid in rubles, but the Russian currency has lost its international value. A default would hasten the collapse of the Russian economy. It would also lead to a reassessment of the solvency of other governments and their ability to fulfill their debt obligations. Foreign bondholders could decide to cut their losses by selling the bonds of the emerging markets and developing economies. A wave of such selling that occurs at the same time as the Federal Reserve raises interest rates will almost certainly lead to a new debt crisis for many countries. The IMF and World Bank will be hard-pressed to coordinate relief efforts across so many borrowers and lenders.

The Coming Wave of Debt Restructurings

Leave a reply

The news that the Federal Reserve will raise interest rates in 2022 sooner than anticipated was not surprising in view of the continued high rates of U.S. inflation. While U.S. asset prices are falling in response to the prospect of higher rates as well as a smaller Fed balance sheet, foreign markets are straining to decipher the spillover effects on their economies. But it is only a matter of time until emerging markets and developing economies face higher financing costs and the need for debt restructurings.

The World Bank pointS out in its most recent Global Economic Prospects that global debt levels in 2020 rose to their highest levels relative to GDP in decades. The publication also shows that economic projections for the emerging markets and developing economies excluding China are for lower growth rates than those of the advanced economies. Consequently, servicing and repaying the debt represents a challenge for those countries. World Bank President David Malpass warned that 60% of the poorest countries need to restructure their debt or will need to.

Ayhan Kose, Franziska L. Ohnsorge and Carmen Reinhart of the World Bank and Kenneth Rogoff of Harvard University examine the options that countries with elevated debt levels face in their NBER working paper, ”The Aftermath of Debt Surges.” They divide the possible responses into orthodox and heterodox solutions. The former includes strong economic growth that reduces relative debt levels as well as fiscal consolidation that can generate surpluses to pay off debt. Other measures are the privatization of public assets and higher wealth taxation, both of which can yield needed revenues. All come with associated downsides hazards, such as higher interest rates if growth comes with more inflation, or a lack of the conditions needed for successful privatization.

Heterodox approaches include unexpected inflation to erode real debt levels, financial repression to maintain low interest rate and debt default or restructuring. The authors point out that external defaults and restructuring impose long-term costs in the form of higher bond yields. Nonetheless, they warn that debt default, both external and domestic, may become more common in the wake of the increase in debt in response to the pandemic.

Similarly, Stephan Danninger, Kenneth Kang and Hélène Poirson of the IMF have a post on the IMF’s Blog, “Emerging Economies Must Prepare for Fed Policy Tightening,” that presents measures that the governments of these countries should undertake to limit the fallout from higher foreign rates. These include allowing their currencies to depreciate while raising their own interest rates. Of course, such measures make supporting a weak domestic economy more difficult. They warn that countries with significant nonperforming debt levels will face solvency concerns.

The IMF, the World Bank and the Group of 20 have joined together to implement a “Common Framework” to help low-income countries deal with their unsustainable debt. Creditor Committees will be created on a case-by-case basis to coordinate debt restructuring by private and official creditors. Private lenders, however, have not shown an interest in joining the program and to date, only three countries—Chad, Zambia and Ethiopia—have applied for assistance.

Another challenge facing the Common Framework is the role of China, which has become the largest bilateral lender to the low-income countries. China has not joined the Paris Club, the organization of creditor nations that deals with bilateral debt between advanced economies and low-income countries. However, it has to date followed the policies of the Paris Club members in deferring debt. One possible complication consists of whether loans from Chinese policy banks, such as the China Development Bank and the Export-Import Bank of China, and state-owned commercial banks, such as the Industrial and Commercial Bank of China, should be treated as private or official creditors.

Anne Krueger of Johns Hopkins University has warned that debt restructuring and further lending should be accompanied by appropriate economic policies. Some countries were engaging in unsustainable spending before the pandemic, and any new lending should be used for spending related to the pandemic. She cites Bolivia, Ghana, Madagascar, Pakistan, Sri Lanka, and Zambia as countries that had excessive expenditures before the pandemic.

The possibility of a debt crisis among the emerging markets and developing nations has long been foreseen (see here and here). The wave of new lending to these countries in the period preceding the pandemic was similar to previous surges that had led to financial crises, and the pandemic further raised debt levels. The combination of higher interest rates in the advanced economies, sluggish economic growth and the possibility of further disruptions due to the pandemic pose a challenge to governments with limited abilities to respond.

Portfolio Capital Flows to Emerging Markets amid the Pandemic

Leave a reply

Among the most notable economic responses to the COVID-19 pandemic has been the turnaround in capital flows to emerging markets. A sudden reversal in portfolio flows of over $100 billion to these countries in March has been offset by a surge of capital this fall. But many of these countries have accumulated debt burdens that will affect their ability to recover from the pandemic.

The IMF examined portfolio flows to these economies in last April’s issue of the Global Financial Stability Report (see also here). The report showed that prior to the pandemic, bond portfolio inflows had been larger than equity portfolio flows, with cumulative flows since 2005 of approximately $2.5 trillion for bonds vs. about $1 trillion for equity. The bonds included both bonds denominated in foreign currency as well as local currency debt. These flows had constituted significant amounts of finance in the emerging and frontier markets’ debt and equity markets.

The authors of the report analyzed the determinants of the different types of portfolio flows. They reported that changes in global conditions (or “push factors”) are largely responsible for debt inflows. Among these factors are the VIX index, a measure of global risk appetite, the U.S. Treasury bond yield, and the foreign exchange value of the dollar. Equity flows are also influenced by foreign conditions, but domestic economic growth (a “pull” factor) is a larger factor in raising the likelihood of capital inflows. This reflects the dependency of the returns on portfolio equity on profitable business operations.

These results explain a large part of the retreat from portfolio securities last March. When the extent of the pandemic became clear, the VIX measure rose while the dollar initially appreciated as investors sought a “safe harbor.” These developments contributed to the reversal of foreign holdings of debt securities. The rapid deterioration in the prospects for economic growth in the emerging markets influenced the turnaround of portfolio equity flows.

But capital inflows were flowing back to the emerging markets by the summer and continued to rise this fall. The Institute for International Finance (IIF) reported inflows of $76.5 billion in November alone, with $39.8 billion for emerging market equities and $37.7 billion for bonds and other debt. For the fourth quarter the IIF expected the strongest level of inflows since the first quarter of 2013.

The turnaround reflects several factors. First, the Federal Reserve’s strong response to stabilize financial markets has been successful, and market volatility has dropped. At the same time, the Fed’s lowering of the Federal Funds rate caused investors to look elsewhere for yields. Finally, the announcements of successful vaccines offers the prospect of an economic recovery in 2021.

However, there are concerns that the desire for the higher yield on riskier debt is fostering the issuance of bonds by borrowers who may not be able to fulfill their obligations. The ability of many of the governments and firms in the emerging market economies to meet their debt obligations is very much open to question. In December, S&P Global Ratings noted that “short-term risks still loom large” in the emerging markets.  Moreover, the agency stated that  “Debt overhang among governments and pressure on corporate earnings would constrain an economic recovery.” Five of the 16 key emerging market sovereign bonds that S&P rates carry negative outlooks: Chile, Colombia, Mexico, Indonesia and Malaysia.

The dangers of government spending in emerging markets financed by debt have been noted by Michael Spence of Stanford and Danny Leipziger in “The Pandemic Public-Debt Dilemma.” While the current cost of debt financing is relatively cheap, Spence and Leipziger pointed out that “a country’s citizens are not well-served when their government becomes more indebted in order to spend imprudently.” They warn that “borrowing in hard currencies when exports are depressed and their own exchange rates are under duress simply makes future debt re-scheduling more likely…”

Similarly, Raghuram G. Rajan of the University of Chicago and former governor of the Reserve Bank of India also questions how much debt a government can issue in “How Much Debt Is Too Much?” While some governments can roll over existing debt, Rajan claims that ”… investors will buy that new debt only if they are confident that the government can repay all its debt from its prospective revenues.” He warns that “Many an emerging market has faced a debt “sudden stop” well before it reached full employment, triggered by evaporating market confidence in its ability to roll over debt.”

Jeremy Bulow of Stanford, Carmen M. Reinhart, currently chief economist of the World Bank Group, Kenneth Rogoff of Harvard and Christoph Trebesch of the Kiel Institute for the World economy foresee a need to plan measures to deal with debt problems in “The Debt Pandemic.” They warn of debt restructurings on a scale not seen since the debt crisis of the 1980s. They view the pandemic as “…a once-in-a-century shock that merits a generous response from official and private creditors toward emerging market and developing economies.” Among the measures they suggest is new legislation to support orderly restructurings.

The need for policy measures to deal with debt restructuring is also expressed by Kristalina Georgieva, Managing Director of the IMF, Ceyla Pazarbasioglu,  Director of the IMF’s Strategy, Policy, and Review Department, and Rhoda Weeks-Brown,  General Counsel and Director of the IMF’s Legal Department. They specifically call for strengthening provisions that minimize economic disruption when debtors are in distress. These could include lower debt payments or the automatic suspension of  debt service. They also ask for increased debt transparency and agreement by creditor governments that are part of the Paris Club on a common approach to restructuring.  The latter two steps are aimed in part at China, which has become the largest bilateral creditor for many developing countries. There is considerable uncertainty over the size and conditions of debt owed to China, and how China will respond to the inability of debtor governments to make payments on the debt.

The IMF itself has pledged to provide debt service relief to its poorest members, while working with the Group of 20 on its Debt Service Suspension Initiative. Under this program, the governments of the G20 have offered to suspend the payments of government-to-government debt for 73 developing economies. The G20 also called on private lenders to offer similar relief, but there has been little response.

The onset of a debt crisis among the emerging market countries has been foreseen.  The widespread borrowing to deal with pandemic, however, has exacerbated the debt overhang. The pandemic will continue to affect financial stability and economic performance even as medical measures are implemented to deal with the virus .

The Guardians of the Financial Galaxy

Leave a reply

The rapid expansion of the pandemic and the ensuing economic and financial collapses brought about responses by policymakers, including actions undertaken on an international basis. The Federal Reserve acted together with other central banks to ensure that an adequate supply of dollars was available to support dollar-based financing outside the U.S. Similarly, the IMF moved rapidly to provide financial support to its members. These national and international institutions constitute a “two tier” system in international finance that occupies the role of lender of last resort.

International cooperation has occurred before, and Michael Bordo of Rutgers University gives an account of these efforts in a new NBER working paper, “Monetary Policy Coordination an Global Financial Crises in Historical Perspective.” During the Bretton Woods era, central banks cooperated to sustain the fixed exchange rate system. In 1962, the U.S. established bilateral currency swaps with foreign central banks, which provided dollars to be used in support of their exchange rates.

The swaps continued in the 1970s after the termination of the Bretton Woods regime as policymakers sought to control the volatility of exchange rates. During the early and mid-1980s there were episodes of coordination of foreign exchange market intervention by central banks as governments in the advanced economies sought to stabilize the value of the dollar. But these occurred less frequently in the late 1980s as inflation fell in most of these countries and foreign exchange market intervention became less common.

The outbreak of crises in emerging markets in the 1990s required a joint response, and the IMF took on the role of crisis manager. During the Asian crisis of 1997-98, for example, the Fund provided credit to the governments of the countries in crisis. Their programs included conditions that required included cutbacks in government spending and credit creation, and frequently a currency devaluation. However, the IMF’s policies came under immediate criticism as inappropriate and overly severe. These were not crises based on excessive government spending, but rather financial collapses. The IMF paid a high price in its reputation for its handling of the Asian crisis, but learned a valuable lesson: financial instability can impose a serious cost.

The financial crisis of 2007-09 provided another major challenge to global financial stability and the need for a coordinated response. Banks in Europe and Japan had borrowed dollars to acquire dollar-denominated assets, such as mortgage-based securities. Their access to dollar funding was threatened as the interbank markets for dollars came under strain. In December of 2007, the Federal Reserve announced that it was establishing swap lines with the European Central Bank and the Swiss National Bank. At the crisis escalated in 2008, the Federal Reserve set up similar arrangements with the central banks of Australia, Canada, Denmark, England, Japan, New Zealand, Norway, and Sweden. It also arranged swap arrangements with the central banks of Brazil, Mexico, Korea and Singapore, emerging market economies with substantial exposure to dollar-based financing. The Federal Reserve and the foreign central banks exchanged currencies, and the foreign central banks lent the dollars to its domestic banks that needed them. At the conclusion of the swap period, the currency exchanges were reversed using the same exchange rate, and the central banks would pay the Fed a fee based on what it had charged their own banks.

These arrangements differed from previous efforts in that they were designed to address financial instability, not exchange rate values. The dollar had become the primary global funding currency, so a decrease in dollar liquidity would have had widespread effects. The joint activities of the Federal Reserve and its partner central banks were successful in bringing down the cost of dollar lending in the foreign markets and avoiding the collapse of foreign institutions with dollar liabilities.

The IMF was also active during the crisis. Not all central banks were able to exchange currencies with the Federal Reserve, and the IMF served as an alternative source of financing. During the period from September 2008 through the following summer, the IMF instituted 17 Stand-By Arrangements. The economic policies that were part of these programs reflected an awareness of the origin and severity of the global downturn. Credit was disbursed more quickly and in larger amounts than had occurred in the past and there were fewer conditions attached to the programs. Consequently, the IMF’s record during the great recession was very different from that of the Asian financial crisis.

During the current crisis, central banks and the IMF have built upon and expanded the policies they undertook in 2008-09. Once again, global dollar financing came under strain. In March the Federal Reserve renewed or set up swap facilities with the central banks of 14 countries. In addition, it established a repurchase facility for foreign and international monetary authorities (FIMA) that would allow them to temporarily exchange their holdings of U.S. Treasury securities for dollars.

These efforts were successful in preventing a collapse of dollar financing. Nicola Cetorelli, Linda S. Goldberg and Fabiola Ravazzolo of the Federal Reserve Bank of New York investigated the impact of the Federal Reserve’s facilities by comparing the foreign exchange swap basis spreads of currencies covered by the agreements with those on other currencies. They found that  ”… the swap lines have been an important factor helping to improve market conditions and expand access to dollar liquidity during the period of peak strains in global U.S. dollar funding markets.” They added that the Federal Reserve was engaging in a wide range of other actions that could also have impacted this market.

The central banks that obtained the dollars were able to use them to support banks that provided dollars to other parties in their countries. For example, Gianluca Persi of the European Central Bank showed that the Eurosystems’s use of the swap lines”…not only helped banks to satisfy their immediate U.S. dollar funding needs but also supported market activity.” He concludes that “The swap lines between central banks therefore helped to mitigate the effects of the strains in the U.S. dollar funding market.”

The IMF has also been active in meeting the needs of its members. The IMF has used its rapid financial assistance programs (Rapid Financing Instrument, Rapid Credit Facility) to make loans to 76 countries. These loans do not require full programs or reviews, and carry little conditionality. The IMF is also adjusting existing programs to meet the need for health-related expenditures.

The IMF is making special efforts for its low-income members. It is providing grants to its poorest members to cover the IMF debt obligations. In March the IMF and World Bank called on official bilateral creditors to suspend debt service payments from low-income countries. The Group of 20 governments responded by agreeing to suspend repayment of official bilateral credit from these nations until the end of 2020. The IMF, the World Bank and the G20 also called for private sector creditors to participate in similar debt relief on comparable terms.

IMF Managing Director Kristalina Georgieva at the opening of this spring’s meeting pledged to use the Fund’s  $1 trillion lending capacity to support its members. She also urged governments to be active in addressing the needs of their citizens. In a speech at the London School of Economics on October 6, she pointed out that “flexible and forward-leaning fiscal policy will be critical for the recovery to take hold.” She also called for measures to deal with the debt of low-income countries, including “access to more grants, concessional credit and debt relief, combined with better debt management and transparency.”

A division of labor, therefore, has evolved between the Federal Reserve and the IMF during periods of widespread instability. The Federal Reserve provides dollars to other central banks in upper-income countries and selected emerging market economies to preserve stability in the global financial markets. Since the Federal Reserve lends to central banks, there is little concern about insolvency. In many ways it assumes the traditional role of lender of last resort as conceived by Bagehot and other nineteenth century economists.

In normal times the IMF lends to governments in middle- and low-income countries with balance of payments crises and possible insolvency. The Fund disburses credit in programs that operate over a time horizon at least a year and sometimes longer. However, during the global financial crisis and now the current crisis, the IMF ramps up its lending. It provides credit quickly at little if any cost, and its programs seek to stabilize economic activity. Moreover, the IMF takes public positions to advocate fiscal stimulus and debt relief.

Stanley Fischer, who served as First Deputy Managing Director of the IMF from 1994 to 2001, saw the need for an international lender of last resort for countries facing an external financial crisis, and claimed that the IMF had played that role in the 1980s and 1990s. In subsequent years it became clear that central bankers in advanced economies preferred to deal with each other and organize their own programs. There have been periodic calls for the IMF to become more involved in swap networks, but the central banks have shown no interest in involving the IMF in their networks. The two-tier system functioned relatively well in 2008-09 and to date has stabilized financial markets. But the number of coronavirus cases are surging, and there are concerns about another recession in the U.S. and Europe. The current system to back stop financial markets and institutions will be tested in new ways that may show its limitations.

The Coming Debt Crisis

Leave a reply

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

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

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

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

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

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

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

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

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

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

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

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

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

The Parting of Ways: The U.S. and China

Leave a reply

The agreement of U.S. President Donald Trump and Chinese President Xi Jingping to restart trade talks put offs planned increases of tariffs on Chinese exports. But there is little doubt that the U.S. intends to move ahead with its intention to undo the economic integration that has been underway since the 1990s. Even when it proves impossible to reverse history, the consequences of such a move will have long-lasting consequences for the global economy.

To understand what is at stake, think of the following simple guide to the status of the world’s nations in the aftermath of World War II. Countries separated into three groups, each anchored on its own tectonic plate. The “first world” consisted of the advanced economies of the U.S., Canada, the West European nations, Japan, Australia and New Zealand. These economies enjoyed rapid growth in the 1950s and 1960s, due in part to the expansion of trade amongst them. The formation of the European Community (now Union) eventually led to a single market in goods and services, capital and labor for its members. The largest of the advanced economies exerted their control through the “Group of Seven,” i.e., Canada, France, Germany, Italy, Japan, the United Kingdom and the U.S. Their leaders met periodically to discuss economic and other types of policies and issued communiques that listed their agreements. Their predominance extended to their control of the International Monetary Fund and the World Bank.

The “second world” included the Communist nations: the Soviet Union and the countries it controlled in Eastern Europe, as well as China and North Korea. These were command economies, run by government ministers. There was some commerce between the Soviet Union and its East European satellites, but all trade was managed. There were virtually no commercial or financial interactions with the first world.

Finally, there was the “third world,” consisting of the remaining nations located in Latin America, Africa, the Middle East and South and East Asia. These countries, also known as the developing economies, encompassed a wide range of economic and political models. Many of them formed an association of “nonaligned” countries that sought to preserve their political independence from the first and second worlds.

The third world had limited trade with the first world nations, and this usually consisted of commodity exports in exchange for imports of industrial goods. Import substitution, i.e., the domestic production of manufactured goods, was proposed in the 1950s as a means to counteract the disadvantageous terms of trade these nations faced for their goods. There was some migration between the first and third worlds, and there was a shift in the home countries of U.S. immigrants from Europe to Latin American and Asia. But the movements of people never approached the magnitudes of the first wave of globalization of 1870-1914.

This account is simplistic, and there are important exceptions. Yugoslavia, for example, escaped the control of the Soviet Union and had its own form of a command economy. Taiwan and South Korea began implementing export-led development policies in the 1970s. There were important differences between the capitalist economies of the U.S. and the Scandinavian nations. But the relative separation of the three “worlds” did limit their interaction, as did the political tensions between the U.S. and its allies on the one hand and the Communist governments on the other.

The partition, however, began to dissolve at the end of the 1980s as the economic tectonic plates underneath these clusters of countries began to split and move. China sought to grow its economy through the use of markets and private firms. The government promoted foreign trade, and allowed investments by foreign firms that could provide capital, technology and managerial expertise.

The dissolution of the Soviet bloc of nations was followed by the integration of the eastern European nations with the rest of Europe. Poland, Hungary, the Czech Republic and other countries provided workforces for foreign–particularly German–firms and their economies grew rapidly. The European Union expanded to include these new members, Russia itself was less successful in adapting its economy to the new configuration, and remained dependent on its oil and natural gas resources.

While the nations of the second world were moving towards those of the first world, the countries in the third world also sought to become part of the global economy. Asian nations, such as India, Indonesia, Thailand and Malaysia, adopted pro-market policies in order to accelerate development. Their expanded trade brought these countries closer to the first world. Global poverty fell, principally due to a fall in the proportion of the poor in the populations of China and India.

But there were serious disruptions to these advances, particularly in those emerging market economies that suffered financial crises: Mexico in 1995, several of the East Asian countries in 1997, Russia in 1998, and Argentina and Turkey in 2001. While some of the crises were the result of unsustainable government policies, there were also outflows of private capital that had fueled credit bubbles. The massive disruption of economic activity in the wake of these “sudden stops” necessitated outside assistance for the countries to recover. The reputation of the IMF suffered a serious blow for its slow response to the Asian crisis, and the Fund subsequently acknowledged that it had underestimated the extent and consequences of their financial fragility.

Moreover, there was collateral damage accompanying the melding of the economic tectonic plates. China’s emergence as a mega-trader had an impact on the production of manufactured goods in the U.S. and other nations. The resulting job losses, that were often conflated with those lost due to technology, turned parts of the populations of the advanced economies against globalization. Migrants were also blamed for the loss of jobs, as were global supply chains by multinational firms.

The global financial crisis of 2007-09 and the ensuing weak recovery increased the questioning of the policies of the previous two decades. Unemployment in the U.S. fell slowly, and debt crises in several European nations kept growth rates depressed. There was an acknowledgement that the benefits of globalization had not been shared equally as public awareness of income and wealth inequality increased.

There was also adverse reactions to political integration. European governments bristled against EU restrictions on their budgetary policies, while In the United Kingdom nationalists argued that EU officials in Brussels had usurped their government’s sovereignty. The waves of refugees who fled to Europe from Syria and elsewhere awakened fears of a loss of national identity.

The election of Donald Trump and the vote in the United Kingdom in favor of leaving the EU made clear the depth of the reaction against the global integration of 1990-2006. Trump’s campaign was based on a pledge to return to some past era when America had been “great,” while proponents of Brexit promised that their country would prosper outside the boundaries of the EU. The bases of support for these policies were not always wide, but they were strongly motivated.

At the same time, the Chinese government has been keen to assert its control of the country’s economic future and to resist outside interference. The Chinese also seek to establish a zone of political domination in Asia. Similarly, Russia’s President Putin has sought to set up a sphere of political and military influence around its borders. Neither government wants to cut their ties with the U.S. and other advanced economies, but they do want to maintain control over their respective geographic areas.

The China-U.S. split, therefore, is part of a larger reaction to the integration of the global economy. The removal of the barriers separating the three post-World War II “worlds” has led to anxiety and fear in those countries that were part of the first world. They look for a return to the economic dominance that they once enjoyed.

But it is not feasible to undo all the ties that have developed over recent decades, and the nations of what had been the second and third worlds will never accept subordinate status. Moreover, it is possible for the U.S. to place barriers on trade and finance that will undo the gains of the last two decades without any offsetting benefits. Even more worrisome is the possibility that economic and political divisions will exacerbate military division and result in conflict.

The earth has several geographic plates, and they move at a rate of one to two inches (three to five centimeters) per year. Over very long periods of time, the plates do collide, and the force of their movements as they smash into each other creates mountain ranges such as the Himalayas. Economic plates can move more quickly, and their collisions can be equally powerful.

We have entered into a reactionary period as self-proclaimed populists promise to segregate their countries from the outside world to achieve some form of national destiny. But it is not feasible to live in isolation, and ignoring the linkages that exist means that we are not responding to global challenges such as climate change. There may be multiple plates, but they all share one planet.

A Guide to the (Financial) Universe: Part II

1 Reply

(Part I of this Guide appears here.)

3. Crisis and Response

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

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

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

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

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

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

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

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

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

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

(to be continued)

Venezuela and the Next Debt Crisis

Leave a reply

The markets for the bonds of emerging markets have been rattled by developments in Venezuela. On November 13,Standard & Poor’s declared Venezuela to be in default after that country missed interest payments of $200 million on two government bonds. Venezuelan President Nicolás Maduro had pledged to restructure and refinance his country’s $60 billion debt, but there were no concrete proposals offered at a meeting with bondholders. By the end of the week, however, support from Russia and China had allowed the country to make the late payments.

Whether or not Venezuela’s situation can be resolved, the outlook for the sovereign debt of emerging markets and developing economies is worrisome. The incentive to purchase the debt is clear: their recent yields of about 5% and total returns of over 10% have surpassed the returns on similar debt in the advanced economies. The security of those returns seem to be based on strong fundamental condtions: the IMF in its most recent World Economic Outlook has forecast growth rates for emerging market and developing economies of 4.6% in 2017, 4.9% next year and 5% over the medium term.

The Quarterly Review of the Bank for International Settlements last September reviewed the government debt of 23 emerging markets, worth $11.7 trillion. The BIS economists found that much of this debt was denominated in the domestic currency, had maturities comparable to those of the advanced economies, and carried fixed rates. These trends, the BIS economists reported, “..should help strengthen public finance sustainability by reducing currency mismatches and rollover risks.”

It was not surprising, then when earlier this year the Institute for International Finance announced that total debt in developing countries had risen by $3 trillion in the first quarter. But surging markets invariably attract borrowers with less promising prospects. A FT article reported more recent data from Dealogic, which tracks developments in these markets, that shows that governments with junk-bond ratings raised $75 billion in syndicated bonds this calendar year. These bonds represented 40% of the new debt issued in emerging markets. Examples of such debt include the $3 billion bond issue of Bahrain, Tajikistan’s $500 million issue and the $3 billion raised by Ukraine. These bonds offer even higher yields, in part to compensate bondholders for their relative illiquidity.

The prospects for many of these economies are not as promising as the IMF’s aggregate forecast indicates. The IMF’s analysis also pointed out that there is considerable variation in performance across the emerging market and developing economies. The projected high growth forecast for the next several years is based in large part on anticipated growth in India and China, which account for more than 40% of the collective GDP of these nations. Weaker growth is anticipated in Latin America and the Caribbean, sub-Saharan Africa, North Africa and the Middle East.

The IMF also raised concerns about the sustainability of the sovereign debt of these countries in October’s Global Financial Stability Report. In the case of low-income countries, the report’s authors warned: “…this borrowing has been accompanied by an underlying deterioration in debt burdens… Indeed, annual principal and interest repayments (as a percent of GDP or international reserves) have risen above levels observed in regular emerging market economy borrowers.” Similarly, Patrick Njoroge, head of Kenya’s central bank, has warned that some African nations have reached a debt-servicing threshold beyond which they should not borrow.

None of these developments will surprise anyone familiar with the Minsky-Kindleberger model of financial crises. This account of the dynamics of such crises begins with an initial change in the economic environment—called a “displacement”—that changes the outlook for some sector (or nation). The prospect of profitable returns attracts investors. Credit is channelled by banks to the new sector, and the increase in funds may be reinforced by capital inflows.The demand for financial assets increases their prices. There is a search for new investments as the original investors take profits from their initial positions while new investors, regretful at missing earlier opportunities, join the speculative surge. The pursuit of yield is met by the issuance of new, increasingly risky assets. The “speculative chase” further feeds a price bubble, which is always justified by claims of strong fundamentals.

At some point there is a reassessment of market conditions. This may be precipitated by a specific event, such as a leveling off of asset prices or a rise in the cost of funding. An initial wave of bankruptcies or defaults leads to the exit of some investors and price declines. Further selling and the revelation of the flimsy undergirding of the speculative bubble results in what Kindleberger calls “revulsion.” In a world of global financial flows there are “sudden stops” as foreign investors pull out their funds, putting pressure on fixed exchange rates. Contagion may carry the revulsion across national boundaries. The end, Kindleberger wrote, comes either when prices fall so low that investors are drawn back; or transactions are shut down; or when a lender of last resort convinces the market that sufficient liquidity will be provided.

The market for the bonds of developing economies has followed this script. The initial displacement was the improvement in the growth prospects of many emerging market countries at a time when the returns on fixed investments in the advanced economies were relatively low. A credible case could be made that emerging market economies had learned the lessons of the past and had structured their debt appropriately. But the subsequent increase in bond offerings by governments with below investment grade ratings shows that foreign investors in their eagerness to enter these markets were willing to overlook more risky circumstances. This leaves them and the governments that issued the bonds vulnerable to shocks in the global financial system. A rise in risk aversion or U.S. interest rates would lead to rapid reassessments of the safety and sustainability of much of this debt.

This potential crisis has caught the attention of those who would be responsible for dealing with its painful termination. The IMF’s Managing Director Christine Lagarde at the Fund’s recent annual fall meeting warned of the risk of “a tightening of the financial markets and the potential capital outflows from emerging market economies or from low‑income countries where there has been such a search for yield in the last few years.” The IMF has dealt with this type of calamity before, and it never ends well.

The IMF’s Flexible Credit Line

Leave a reply

The policy conditions attached to the disbursement of an IMF loan have long been the subject of controversy. In the wake of the global financial crisis, the IMF introduced a new lending program—the Flexible Credit Line—that allowed its members to apply for a loan before a crisis took place. If approved, the member can elect to draw upon the arrangement in the event of a crisis without conditionality, and there is no cap to the amount of credit. However, only three countries—Colombia, Mexico and Poland—have signed up for the FCL, and the lack of response to an IMF program without conditions has been a bit of a mystery. A new paper, “The IMF and Precautionary Lending: An Empirical Evaluation of the Selectivity and Effectiveness of the Flexible Credit Line“ by Dennis Essers and Stefaan Ide of the National Bank of Belgium, provides evidence that helps to explain the muted response.

Essers and Ide deal with two aspects of the FCL: first, the factors that explain the decision to participate in the program, and second, the effectiveness of the program in boosting market confidence in its users. This paper is very well-done, both from the perspective of dealing with an important issue as well using appropriate econometric tools for the analysis, and it received a prize for best paper at the INFINITI conference in Valencia. The authors point out that the views expressed in the paper are theirs, and do not necessarily reflect the views of the National Bank of Belgium or any other institution to which they are affiliated.

The results in the first half of the paper can explain why so few countries have adopted the FCL. On the “demand side,” Colombia, Mexico, and Poland applied for the FCL because they were vulnerable to currency volatility as manifested by exchange market pressure. On the “supply side,” the IMF was willing to accept them into the program because 1—the economies were not showing signs of financial or economic instability, as manifested by lower bond interest rate spreads and inflation rates, and 2—they met the “political” criteria of high shares in U.S. exports and acceptable United Nations voting patterns.

If this line of reasoning is correct, then the adoption of the FCL will always be limited. The authors point out that the “…the influence of the first two variables (EMBI spread, inflation) is in line with supply-side arguments…” The qualifying criteria on the IMF web page that explains the program include:

  • “A track record of steady sovereign access to international capital markets at favorable terms”
  • “Low and stable inflation, in the context of a sound monetary and exchange rate policy framework”

However, lower bond spreads and inflation (and macroeconomic stability) can also be viewed as factors that lower the demand for IMF programs, as would most of the other criteria, i.e., a “sustainable external position,” “a capital position dominated by private flows,” “a reserve position which…remains relatively comfortable,” “a sustainable public debt position,” and “the absence of solvency problems.” My first paper on the economic characteristics of IMF program countries found that countries that entered IMF programs in the early 1980s had higher rates of domestic credit growth, larger shares of government expenditure, more severe current account deficits, and smaller reserve holdings. Therefore, the applicants for the FCL have been countries that do not have the features of those that apply for the standard IMF program, the Stand-By Arrangement, and yet decided to apply for the FCL because of some form of exchange market pressure.

Such a confluence of factors may be relatively rare. If the country is experiencing exchange market pressure, ordinarily we would expect to see increased bond spreads. Moreover, exchange market pressure could be a reaction to domestic macroeconomic instability, which could be linked to rising inflation rates. The three countries were experiencing some combination of exchange rate depreciation and/or a drain on their international reserves, but their bond rate spreads were not rising and domestic inflation was not a concern. In addition, the governments also met the IMF’s (hidden) political criteria.

If such a combination is unusual, then to enhance participation in the FCL, the IMF would have to be willing to relax its official criteria for selection. It would also need to deal with countries that have not always accommodated U.S. foreign policy. This may require some “bargaining” among the major shareholder countries at a time when international agreements and organizations are being looked on with suspicion. The time to promote the program, however, is now, while international financial markets are relatively calm. Unfortunately, there is always a tendency to project current conditions into the future, and to delay adopting precautionary measures. When circumstances force governments to turn to the Fund, they will not qualify for the no-conditions FCL, but for programs with much more stringent criteria.