What to do about spillovers?

Our results provide new insights. We find economically and statistically significant spillovers from the United States to EMEs and smaller advanced economies. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify.

We also find that monetary spillovers take place under both fixed and floating exchange rate regimes, which lends some support to the conjecture in Rey (2013, 2014) that the global financial cycle constrains monetary policy irrespective of the exchange rate regime.

From a policy perspective, our findings suggest that neither are interest rates fully independent nor is monetary policy fully unconstrained when economies and financial markets are closely integrated. Even under flexible exchange rates, central banks – though technically able – seem to find it difficult to conduct a monetary policy that is based purely on domestic factors and which ignores monetary developments in core advanced economies. Furthermore, our findings also shed some light on the causes of the persistently low interest rates that have prevailed globally over the past seven years. Back-of-the-envelope calculations based on our results suggest that easy monetary conditions in the United States have exerted considerable downward pressure on interest rates elsewhere. [Link]

These are from the paper, ‘International Monetary Spillovers’ published in the 3Q2015 Quarterly Review of the Bank for International Settlements.

In his Per Jacobsson Memorial Lecture in 2012, Dr. Y.V. Reddy recognises the difficulty of managing spillovers but does not offer solutions:

Public policy is conducted at the national level, but at the same time, globalisation of economies, often driven by technology, is a reality, and the global macroeconomic environment is an outcome of national policies in a framework of nebulous global governance arrangements. The challenge for national central banks is to find space for the conduct of their own policies in an increasingly inter-dependent global economy.

Too much global policy coordination might lead to the universalisation of risks of policy mistakes. The main contention is that good finance is essentially a function of good economic policies, and such good policies are primarily national, though significantly impacted by the global macroeconomic environment – which, as already mentioned, is not a product of design. [Link]

This is interesting, however:

It is true that successful arrangements for global coordination while retaining space for national public policies are working well in certain sectors, such as aviation, telecoms and the internet. But they seem to get into difficulties in regard to macroeconomic policies and finance. Clearly, there is a need to explore why global agreements work reasonably well in some sectors, leading to acceptable and assured outcomes, while when it comes to macro policies and finance such agreements appear difficult to arrive at – and what we can learn from them.

The spillover issue suggests a few solutions in no particular order of importance or categorisation into financial, macro, domestic and global.

(1) Selective and time-bound application of capital controls and quantitative restrictions including the use of higher risk weights for bank exposure to sectors receiving too much credit and equity – from domestic and foreign sources

(2) Regular, gradual and moderate foreign exchange reserve accumulation

(3) Bailing-in of creditors during banking crises. Living wills and insurance funds from premiums paid by banks can be part of the solution

(4) Encouraging domestic consumption and gradually lower reliance on U.S. consumer

(5) United States to de-emphasise the importance of asset prices for macro-economic growth and stability. The Federal Reserve assigns too much weight to the wealth effect transmission to macro aggregates, especially from the stock market. That has resulted in many other problems too, including the leaking of insider information on a systematic basis to financial institutions, investors and the media.

In other words, the United States needs a new monetary policy framework that incorporates financial cycles and financial stability and not just employment, price stability and stability of long-term interest rates.

(6) United States to conduct more symmetric monetary policy than now

(7) Federal Reserve to obsess far less about managing and minimising market volatility

(8) Less emphasis on forward guidance and transparency in the monetary policy framework of advanced countries. This will moderate risk taking in financial markets which are globally integrated and hence the risk-taking goes global. To the extent they are restrained in the United States, the restraint will also spill over to capital markets around the world. This is a virtuous spillover. Indeed, this is the logic behind suggestions (5) to (7) too.

(9) Higher capital requirement for banks. This will restrain endogenous money creation by banks. That will, in turn, moderate credit and capital flows to emerging economies.

(10) Re-introduction of separation of retail-commercial from investment banking. Same outcome as in (9) as it will moderate risk taking by financial institutions.

(11) This last one is admittedly a hypothesis. For many reasons – benign and not-so-benign – policymaking in the United States is captured by China. One of the benign explanations is that, for U.S. policymakers, China has become another ‘Too big to fail’ institution. Hence, their nervousness about conducting normal monetary policy. One more reason for asymmetric monetary policy. This results in a sub-optimal monetary policy in the United States which is then transmitted to the rest of the world with integrated and pro-cyclical capital markets.

Postscript: the possibility of a multi-polar world of currencies must be deemed remote now. China’s yuan might be part of the SDR basket. But, it is unlikely to be an international currency. China does not have the stomach for it. Its actions in recent years have demonstated that its penchant for control overrides the objective of internationalisation. The Euro is unlikely to become an alternative, ever.

Hence, the reform of the American monetary policy framework is the only hope. Will the Chinese ‘capture’ of American policy in benign or not-so-benign ways end?

Will the Trump administration rise to the challenge on both? My answer, five months ago, would have been more optimistic than it is now.

(For completeness, you can find Raghuram Rajan’s suggested solutions for the spillover problem in his speech delivered in New York in May 2015).

Financial globalisation – just about right now

It is the fourth—bank lending—that has collapsed. In 2015, net cross-border lending was actually negative, as banks called in more international loans than they extended. Taking these figures together, McKinsey calculates that the evaporation of cross-border bank lending explains three-quarters of the overall fall in cross-border finance since 2007. To some extent—indeed, probably to quite a large extent—the retreat from cross-border lending represents a healthy correction.

Cross-border capital flows peaking at 21 percent of global output reflected a toxic mix of ambition and credulity, notably among European banks. But if 2005–07 was an aberration, what is the appropriate benchmark for global integration?

One way to answer this question is to consider the period from 2002 to 2004, a relatively calm interlude between the early 2000s crash of internet-based companies (the so-called dot-com collapse) and the U.S. subprime borrowing and euro area bank lending mania later in the decade. In those three years, cross-border capital flows averaged 9.9 percent of global GDP.

Although there is no denying that finance is less international than it used to be, it is debatable whether this retrenchment is best described as “deglobalization,” with its connotations of retreat, or as something more positive—“sounder global management.” After all, the new regulatory restrictions are at least partly a response to the risks of cross-border financing, which suggests a desirable level of flows considerably lower than the 9.9 percent of global output during 2002–04. If the optimal ratio were, say, around 5 percent, today’s degree of financial globalization might be just about right.

These are select extracts from the article by Sebastian Mallaby in FINANCE & DEVELOPMENT, December 2016, Vol. 53, No. 4 [Link – ht: Gulzar Natarajan]

If cross-border bank lending were down and if, post-2008, global leverage has increased rather than reduced, it follows that bulk of the lending is domestic or through capital market borrowings. I think it is more the former because cross-border bond flows have only slightly decreased, according to Mallaby, in the same article:

Two types of flows—bond purchases and foreign direct investment—have fallen, but not dramatically.

The risks have shifted from the banking sector. Arguably, that is a good thing.

Next, in that article, he deals with international trade flows. He makes distinction between trade flows in volume and trade flows measured in US dollars. Then, he points to the US dollar strength of recent years as another reason why measured US dollar trade flows might overstate the decline in global trade. Fair points, all.

Article well worth a read. Good to have hypotheses on economic and financial trends but better to cross-check with data. Sebastian Mallaby’s work is a necessary corrective on the collective breast-beating on de-globalisation.

Are capital flows contractionary?

In my earlier blog post, I had referred to the work by Blanchard and his co-authors on whether capital inflows were contractionary. The full paper is here. Have not read the full paper yet. Here are some expanded thoughts:

The policy implications drawn are convenient in theory and they are hard to execute in practice. They had conveniently ignored the political economy dynamics and the power of international portfolio investors to keep markets open, especially now that their opportunities and avenues to make returns have shrunk dramatically.

Further, non-bond flows (FDI) are dwarfed by the size and speed of bond flows. Hence, they are a problem for developing countries. For developed countries, currency appreciation should matter relatively less than for small, open and developing economies. They should be happier with bond inflows because it depresses interest rates across the yield curve, something that their policymakers aim for and hence, should welcome! This is particularly true for the United States.

The situation, hence, is this: capital inflows are not contractionary for the developed world. The authors say that they found bond inflows to have slightly negative effect on output. We need to see how big the effect was, what the lag was and for what countries. The devil may be in the details.

In general and, on balance, capital inflows are expansionary for them through the asset market effect. They stoke bubbles in bond and stocks. The currency effect is not important, by and large, for developed countries.

Capital inflows are expansionary for the developing world too, through credit and capital misallocation.

Mundell-Fleming might have been right and appropriate for periods when capital flows had not grown to such Frankenstein proportions. The problem is to deal with the excess stimulus and undesirable side effects of capital inflows and not the other way around.

Global financial integration – especially of the portfolio variety – has to be rethought and urgently too.