Understanding, managing financial interdependence

The 18^th Annual Jacques Polak Annual Research Conference last week opened with Managing Director Christine Lagarde noting the ebb and flow of capital movements into emerging market and developing economies since the turn of the millennium. She asked three questions at the heart of the discussion, and to which speakers returned consistently during the conference:

• How do advanced-country policies feed into global financial conditions?
• How are those conditions transmitted to recipient countries?
• How can global finance be harnessed to enhance the benefits it offers while lowering the risks?

Answering these questions requires an understanding of global financial cycles and the contexts in which they have arisen. The questions are particularly timely at a moment when, as underscored at the conference, financial interconnectedness is higher than ever before, and major central banks are transitioning away from unconventional approaches. The conference highlighted the benefits and risks of financial integration and described the role of policy levers and frameworks in responding to global market forces.

Historical perspective

Global interdependence owes, of course, to the historical process of integration in world capital markets, which allows for truly global shocks as well as for substantial spillovers of shocks between countries. Even so, cycles in global capital flows are evident in the balance of payments data going back to 1815, coexisting with cycles in commodity prices that can reinforce financial retrenchment episodes, leading to widespread defaults by emerging and developing economies. Since 1960 there is evidence of a global household debt cycle, with increases in household debt forecasting lower subsequent output growth – a result similar to the findings of the October 2017 Global Financial Stability Report.

Role of major economies

What generates these cycles? One source is clearly financial and monetary conditions in the United States, issuer of the world’s prime reserve and funding currency. Leverage of U.S. broker dealers can stimulate cross-border credit flows globally, with effects on home prices and consumption. Empirically, strength in the U.S. dollar exchange rate is a good indication of tighter global funding conditions, with apparent real effects on global investment levels. U.S. monetary policy also seems to play an important role in driving global risk appetite and thereby driving a trend of increasing equity market co-movement across advanced economies. Benoît Coeuré pointed out that European Central Bank actions, through their effects on interest rates and (at the effective lower nominal interest bound) term premia, can also move the dollar’s exchange rate and global funding conditions. Studies based on macroeconomic data face ambiguities in establishing causality, but micro-level data on banks and firms can go far toward giving a more accurate view of the links between global financial conditions and bank lending, as shown by one of the conference papers, which studies the case of Turkey in detail.

Benefits and risks

Financial integration brings potentially big benefits – allowing diversification and a better global allocation of world savings – but also carries risks. One key finding is that countries differ in their abilities to absorb foreign capital flows: some benefit in terms of productive potential (especially where financial markets are deep and allocate capital efficiently) while others suffer crises and higher inequality. Looked at another way, countries’ exposures to the global price of risk (in turn a function of the stock market’s expectation of volatility, the VIX index) tend to raise their expected income growth, but also the volatility of that growth, creating a tradeoff that depends on the quality of domestic policies.

Taming the cycle

Although global forces are important in transmitting financial conditions worldwide, much if not most of the action in capital flows still comes from country-specific and regional factors, suggesting that policies and policy frameworks can play a big role in tempering possible disruptive effects from global markets. In their interventions, José De Gregorio and Rakesh Mohan presented their own views “from the trenches” on emerging market policy toward capital flows, with De Gregorio stressing sound policy frameworks and Mohan placing more emphasis on the judicious use of both foreign exchange intervention and capital flow management measures. A number of conference papers underscored the role for policy, including measures geared toward preventing currency mismatches. Relatedly, other papers focused on potential theoretical benefits from reducing exchange-rate volatility and management of the external balance sheet. In his lunch-time address, Richard Berner stressed the importance of prudential policies, but also observed the need for strong international cooperation to make them effective in a world of globalized finance.

Challenges ahead

One global shock certainly affecting financially open economies is the global real interest rate, currently at very low levels by most estimates. Hélène Rey focused on new work showing that the global ratio of consumption to wealth has been a reliable forecaster of the global real interest rate since the late 19^thcentury, and now stands at levels suggesting rates will remain low for some time. If so, monetary policy may be challenged to reconcile price with financial stability absent strong macroprudential policies, supported by effective multilateral cooperation.

Of course, while financial integration stands at an all-time high, so does trade integration, and the two are closely interrelated, as Barry Eichengreen reminded the conference. In recent years, he noted, the rules-based multilateral trading system has come under threat. His comprehensive review of history and theory suggests that the effects of both trade and financial integration policies are context specific—at the current juncture, disruptions to the global trading system would have important macroeconomic effects that could well leave all parties worse off.