The Emerging Global Financial Architecture

Events, particularly these days, tend to outrun the best laid plans to anticipate research trends. And it might seem that this was true in the case of this conference, sponsored by UCSC’s Santa Cruz Center for International Economics, the Journal of International Money and Finance, and the Federal Reserve Bank of San Francisco. The conference was planned last year, at a time when most academic researchers were aware and concerned about the incipient economic slowdown, and whether the major economies would “de-couple”, and in turn how these factors would impact the constellation of global imbalances.

As it turns out, the papers were all, in my opinion, remarkably germane to issues we’re concerned about right now: how the composition of debt determines vulnerability to crises, the effect of capital controls on capital flows, the role of the IMF, and the usefulness of macroeconometric models to predict exchange rates even during periods of financial disorder. That’s a testament to the organizer’s (Joshua Aizenman) skill (plus a bit of luck), but also a reflection of the fact, some outsider views notwithstanding, that academics do often incorporate real-world driven questions and concerns into their research (e.g., see this silly debate in the blogosphere in the wake of the last AEA meetings).First off was Bob Flood (IMF/Notre Dame) and Andy Rose‘s (UC Berkeley) paper, entitled “Inflation Targeting and Business Cycle Synchronization”:

Inflation targeting seems to have a small but positive effect on the synchronization of business cycles; countries that target inflation seem to have cycles that move slightly more closely with foreign cycles. Thus the advent of inflation targeting does not explain the decoupling of global business cycles, for two reasons. Indeed business cycles have not in fact become less synchronized across countries.

The authors use as their primary measure of business cycle synchronization the (contemporaneous) correlation of output gaps defined using Hodrick-Prescott filters, Baxter-King filters, linear detrending, and growth rates (on quarterly data, since 1980) (see this post for a discussion of detrending techniques applied to US data.

The discussant, James Lothian (Fordham), among other things, suggested that the use of “correlations” might be problematic to the extent that there were mean shifts in the relationships between the measures of the business cycle.

“Controlling Capital? Legal Restrictions and the Asset Composition of International Financial Flows” by Mahir Binici (UCSC), Michael Hutchison (UCSC), and Martin Schindler (IMF):

Legal restrictions on international capital movements are imposed in many countries in an attempt to (partially) insulate their economies from abroad and pursue some degree of domestic policy independence. But is the imposition of capital controls effective in achieving these goals? We investigate this issue from a new angle by linking de jure restrictions on three specific asset categories of outflows and inflows with the corresponding component of capital flows. The analysis is based on a novel panel data set of capital controls data, disaggregated by asset class and by inflows/outflows, and covering 74 countries during 1995-2005. Using panel LSDV regressions, and including a host of well-known determinants of capital flows, we estimate a model of capital flows with four categories: equity-like flows (including FDI) and debt for both capital inflows and capital outflows. The estimated effects of capital controls vary markedly with the type of controls imposed: they are binding on capital outflows (debt, equity and FDI); have no apparent effect on capital inflows of various types; and are less effective in low and middle-income countries. Moreover, there are no apparent substitution effects so that controls on debt and equity outflows change the volume and composition of capital flows as well as the net flow of capital in each asset class. The large differences across asset categories in the effects of capital controls suggest that the common use of aggregate capital control indicators can be misleading.

Next up was a paper entitled “The Emerging Global Financial Architecture: Tracing and Evaluating the New Patterns of the Trilemma’s Configurations”, by Joshua Aizenman (UCSC), myself, and Hiro Ito (Portland State). This paper was described in this post from last month. trilemma0.gifFigure 2 from Aizenman, Chinn, Ito (2009): “The Trilemma and International Reserves Configurations over Time: Regional Patterns for Developing Countries”

Using the indexes we developed (Aizenman, Chinn, and Ito (2008)) to measure the degree of the three policy choices countries make with respect to the trilemma: exchange rate stability, monetary independence, and capital account openness, we investigate the normative questions pertaining to the trilemma, that is, how the policy choices among the three trilemma policies affect output growth volatility, inflation rates, and the volatility of inflation, with focus on developing economies. Some key findings for developing countries include: (i) greater monetary independence can dampen output volatility while greater exchange rate stability implies greater output volatility, which can be mitigated by reserve accumulation; (ii) greater monetary autonomy is associated with a higher level of inflation while greater exchange rate stability and greater financial openness could lower the inflation level; (iii) a policy pursuit of stable exchange rate while financial development is at the medium level can increase output volatility, and while greater financial openness with a high level of financial development can reduce output volatility, greater financial openness with a low level of financial development can be volatility increasing; (iv) net inflow of portfolio investment and bank lending can increase output volatility and higher levels of short-term debt or total debt services can increase both the level and the volatility of inflation.

The discussant, Helen Popper (Santa Clara U.) made a number of observations. Two salient ones were (i) countries choose the tradeoffs between monetary independence, exchange rate stability, financial integration and reserve accumulation as a consequence of characteristics and experiences of those countries, and so estimating macro outcomes as a consequence of policy choices might be subject to endogeneity; and (ii) the measure of monetary independence in some cases yielded counterintuitive categorizations (e.g., Canada). She suggested that a more economic approach, such as the extent to which Canadian policy rates could be described by US variables.

Michael Bordo (Rutgers) and Harold James‘s (Princeton) paper, entitled “The Long Running Quest for Economic Reform”:

This paper examines changes in the role of the IMF since its inception in 1944, in response to the breakdown of the par value system, the liberalization of capital movements, and financial deregulation. In the 2000s, as IMF lending contracted, the role of the Fund has become less controversial but also less important; with the eruption of a global financial crisis in 2008, IMF lending again assumed a major importance. A need for public goods provision arises out of the major new problems of the twenty-first century: controversies over exchange rates, over the management of reserve assets, the politicized debate over sovereign wealth funds (SWFs), and the management of financial globalization. The paper examines ways in which the new demand for a role of the Fund could be met, and its implications for governance reform.

The discussant, Barry Eichengreen (UC Berkeley) was largely in agreement, spending some time arguing that it would be indeed better for the world economy if somehow countries could diversify out of the dollar as the key reserve asset, perhaps using the SDR as a substitute. For more on this idea, see here.

In “The International Transmission of Interest Rate Shocks: The Federal Reserve and Emerging Markets in Latin America and Asia”, Sebastian Edwards (UCLA) examined linkages mostly before the onset of the crisis:

In this paper I use high frequency data to investigate the extent to which interest rate changes originated in the United States are transmitted to a group of emerging countries. More specifically, I am interested in understanding the effects of changes in the Federal Reserve Federal Fund’s interest rates on differential between (short term) local currency interest rates. I also investigate how changes in the U.S. term structure affects short term rates in and international interest rates, properly adjusted by currency and country risk. Other shocks considered in the analysis include changes in the US dollar-Euro exchange rate, changes in the international price of oil, risk ratings, and the degree of capital mobility. The results indicate that there is a strong and fairly rapid transmission of changes in the Federal Funds rate into interest rates differentials in the Latin American countries in the sample. This effect is equally large in the Asian nations in the long run. The adjustment path is different across the two regions, however. Adjustment is very fast and cyclical in Latin America; it is gradual and slower in East Asia.

The discussant, Reuven Glick (SF Fed), observed that while the short run dynamics of propagation differed, the implied long run elasticities were quite similar. In addition, he observed that not all Fed Funds rate changes were (are) created equal — and anticipated changes probably differ in effect from unanticipated.

The keynote address was given by Maurice Obstfeld (UC Berkeley). I thought this wide ranging survey, entitled “The Immoderate World Economy” was very insightful. I can’t summarize the entire presentation (and it’s not online), but I can highlight what I thought were the important parts.

First, he enumerated “Myths We Lived by through 2007”:

  • Efficient capital markets will smoothly finance and absorb large global imbalances.
  • Housing losses will be limited and the wealth effects offset by central bank interest rate cuts.
  • Central banks are firmly in control of inflation.
  • A new era of stability in emerging markets may make the IMF redundant. There is no systemic global threat because emerging markets are small players, rich countries have robust institutions.

The end of these myths set the stage for the two main components of his talk, namely (1) the relation of global imbalances and the US financial collapse, and (2) the major lesson of this episode, namely that we need to take a systemic view of the global financial architecture.

On the first point, Obstfeld notes gross international imbalances (large gross asset and liability positions) helped create pyramids of counterparties, and could have occurred without current account deficits. “But world’s willingness to finance US deficit kept US spending high, interest low, and the dollar strong.” If I am reading his comments correctly, there are large roles for monetary policy and adverse incentives in this story of boom and bust.

In terms of the lessons, Obstfeld observes that there is a fallacy of composition in thinking that micro-prudential regulation that is aimed at mitigating idiosyncratic risk might exacerbate macro-level risk. The challenges associated with dealing with such risk is highlighted by Obstfelds concluding points:

  • Assets that melt down only when everything else does may carry high excess returns (cf. rare disasters and the equity premium).
  • Some who invest in them, however, may place insufficient weight on the risks of rare disasters.
  • This may make the financial system as a whole more vulnerable.
  • Systemic risks are likely to be associated with large “overvaluations” (as in housing) or large borrowing flows (current account deficits, term mismatches).
  • The macro-prudential perspective requires that such imbalances be monitored and addressed.

And, so (from my view), one can see how we have come full circle — the end of the myths laid out by Obstfeld raises enormous challenges for managing the world economy. But the first step in progress is to dispense with those myths, that even now, some people adhere to.

On the second day, Chris Messner (UC Davis) presented his paper with Michael Bordo (Rutgers) entitled “Foreign Currency Debt, Financial Crises and Economic Growth: A Long Run View”.

What are the costs of hard currency liabilities? After being implicated in the global financial instability of the late 1990s, the costs are widely believed to be large, and as a result many emerging markets have pushed to minimize currency mismatches. We study the growth effects of exposure to foreign currency debt using data from two periods of international financial integration (1880-1913 and 1973-2002) for over 45 countries. Hard currency debt is associated with increased risks of currency and debt crises in both periods, especially when a country’s macroeconomic financial fundamentals are weak. We find the risk of financial crisis associated with hard currency debts translated into significantly diminished growth rates. However, we also find evidence that strong financial development and policy credibility attenuate the crisis risks associated with high exposure to hard currency debt, which has implications for eastern European countries where large current account deficits and high levels of hard currency debt are believed to pose financial risks. In this region some countries have adopted flexible exchange rates and avoided foreign currency debt. Several others have built up large net foreign currency liabilities and are exposed to a significant likelihood of a financial crisis in the near future.

The discussant, Mark Spiegel (SF Fed), pointed out that one key assumption of the paper is that the model assumes the debtors make the decision. But in fact, creditors and debtors joint come to make the decision regarding borrowing and lending. Hence, one has to be careful not to take the results to mean that countries can mitigate the likelihood and costs of a crisis by reducing hard currency debt. The alternative to lots of hard currency debt might be no debt at all.

Oscar Jorda presented his paper with Alan Taylor (both UC Davis) entitled “The Carry Trade and the Real Exchange Rate: Nothing to Fear but FEER Itself”.

The carry trade refers to the investment strategy of going long in high-yield target currencies and short in low-yield funding currencies. In recent years this naive trade has seen very high returns for long periods, followed by crashes where large depreciations of the high-yield currencies cause large losses. Based on low Sharpe ratios and negative skew, these trades may therefore appear unattractive, even when diversified across many currencies. But more sophisticated conditional trading strategies exhibit more favorable payoffs. We develop these strategies based on the simplest equal-weighted portfolios analyzed in the literature, and apply novel (within economics) statistical binary-outcome classification tests to show that our directional trading forecasts outperform their rivals. The critical conditioning variable, we argue, is the fundamental equilibrium exchange rate (FEER). Expected returns are lower, all else equal, when the target currency is overvalued. Like traders, academic researchers should incorporate this information when evaluating trading strategies. When we do so, some questions are resolved: negative skewness is purged, and market volatility (VIX) is uncorrelated with returns; other puzzles remain: the more sophisticated strategy has a very high Sharpe ratio, suggesting market inefficiency.

The discussant,Eric Fisher (CSU Polytechnic), observed that while the procedure seems to do very well, it — like many other seemingly profitable algorithms — may disappear once the procedure becomes well known in the practitioner community.

I’ll note that the FEER used in this model is not like a typical FEER; rather it is better to characterize the equilibrium exchange rate concept as PPP.

The final paper, by Shang-jin Wei (Columbia) and Zhiwei Zhang (IMF), was “Does the Global Fireman Inadvertently Add Fuel to the Fire? New Evidence from Institutional Investors’ Response to IMF Program Announcements”:

Fighting global financial crises is a primary charge of the International Monetary Fund (IMF). Yet it has often been criticized to have hindered rather than helped the recovery of many countries in a crisis by demanding policy changes that may not be appropriate for them in that particular moment. Such actions would tend to damage investor confidence. Using monthly data on investment in 94 developing countries by 168 institutional investors during 1996-2005, this paper re-assesses this important question. We find that international investors tend to revise upward an economy’s outlook after an IMF program is announced, and increase their investment in the country. Patterns of concurrent asset price movement suggest that it is unlikely due to a bailout/moral hazard effect. Based on this evidence, we conclude that the IMF has typically restored rather than reduced investor confidence.

I unfortunately did not get a chance to see this paper presented, which was discussed by Michael Melvin (BGI).

Originally published at Econbrowser and reproduced here with the author’s permission.