Abstract: In this paper I make the following ten remarks on the topics of
exchange rate policy, capital flow management, protectionism, and global cooperation: 1) The gains to exchange rate flexibility are worse than you think; 2)
The ‘Trilemma’ lives on; 3) The U.S. dollar exchange rate drives global trade
prices and volumes; 4) Gross capital flows matter as much as net flows, and
global banks have internationalized U.S. monetary policy. 5) Emerging markets
tilt away from foreign currency to local currency debt reduces their exposure to
global risk factors; 6) Low interest rate environments can lead to misallocation
of resources and lower productivity; 7) The relationship between global imbalances, reserve accumulation, and currency manipulation is not well identified. 8)
Uniform border taxes are not neutral; 9) Trade is not the main driver of earnings
inequality, but at the same time policy has failed to address its redistributive
consequences. 10) Global coordination of financial regulation is essential alongside country level macroprudential polices. Reserve accumulation and currency
swap lines do not substitute for the lender of last resort role of the IMF.
∗This paper was prepared for the conference on “Rethinking Macroeconomic Policy IV” organized by
the Peterson Institute on International Economics. I acknowledge that this material is based upon work
supported by the NSF under Grant Number #1628874. Any opinions, findings, and conclusions or recommendations expressed in this material are those of the author and do not necessarily reflect the views of the
NSF. All remaining errors are my own.
1
The global financial crisis and its aftermath have inspired many new ideas on international
macroeconomic policy, though to survey them all is quite near impossible. Some of these
ideas, such as the arguments in favor of capital controls, have been discussed at length over
the years and so I touch on them only briefly. Instead I focus on a subset of issues on which
I believe the ‘rethinking’ is relatively new both in terms of empirical evidence and theory,
not as well absorbed, and maybe not surprisingly, that I have paid more attention to in my
own work.
I organize the paper as a set of ten remarks on exchange rate policy, capital flow management, protectionism, and global cooperation. On exchange rate policy, described in Section
1, I highlight new thinking on the virtues or lack of it of exchange rate flexibility for emerging
markets, on the ‘trilemma,’ and discuss a new finding on the relationship between the U.S.
dollar and global trade. On the topic of capital flow management I make three remarks in
Section 2. I first flag the new focus on gross capital flows and its components as opposed
to the traditional focus on the current account, and the sharp rise in global banking
1 Exchange Rate Policy
The vast majority of countries in the world have de facto embraced ‘limited flexibility’ as
their exchange rate policy. Ilzetzki et al. (2017) estimate that ‘limited flexibility’ exchange
rate arrangements now describe 80% of all countries and half of world GDP. Following the
collapse of Bretton Woods countries have indeed moved away from explicit de jure pegs
but then settled into managed floats away from the corner of freely floating exchange rates.
There is every reason to believe that for most countries, especially in the developing world,
this will continue to be the constrained optimal policy. This leads me to my first remark.
Remark 1 The gains to exchange rate flexibility are worse than you think
The classic argument for the optimality of floating exchange rates, dating back to Milton
Friedman, goes along the following lines: When prices are sticky, shocks to the economy
generate deviations of output from its potential and consequently inefficient recessions and
booms. For example a positive productivity shock at home should with flexible prices lower
the relative price of home goods relative to foreign goods. When prices are sticky in the
producers currency this relative price adjustment however does not happen automatically.
In this case a depreciation of the exchange rate can bring about the right relative price
adjustment. A depreciation raises the price of imports relative to exports generating a
depreciation of the terms of trade and therefore a shift in demand towards domestically
produced goods and away from foreign goods. This exchange rate flexiblity closes the output
gap and leaves the economy at its first best level. On the other hand, if the exchange rate
is fixed then the economy suffers from a negative output gap (output below its potential).
A core piece of this argument that favors flexible exchange rates is the strong comovement
of the nominal exchange rate and the terms of trade: A depreciation of the nominal exchange
rate should be associated with an almost one-to-one depreciation of the terms of trade (of
goods with sticky prices). That is a 1% depreciation of the bilateral exchange rate should
be associated with a close to 1% depreciation of the terms of trade.
Boz et al. (2017) find no evidence of this in the data. Using a newly constructed data set
of harmonized (non-commodity) annual bilateral import and export unit value and volume
3
indices for 55 countries covering 91% of world trade for the period 1989-2015, they estimate
that a 1% depreciation of the bilateral exchange rate is associated with only a 0.1% depreciation of the bilateral terms of trade (in the year of the depreciation), a coefficient that is
not significantly different from zero as reported in Table 1.
This finding while strongly counter to the implications of the Mundell-Fleming producer
currency pricing assumptions that drive the case for flexible exchange rates, is consistent
with the fact that prices in international trade are not sticky in the producers currency but
are sticky in a dominant currency, which is overwhelmingly the dollar. Importantly, the
dollar’s share in trade invoicing is far out of proportion to the U.S. economy’s role as an
exporter or importer of traded goods. In a sample of 43 countries, Gopinath (2015) finds
that the dollar’s share as an invoicing currency is approximately 4.7 times the share of U.S.
goods in world imports and 3.1 times its share in world exports. In comparison, the euro
invoicing share is more closely aligned with its share in world trade as the corresponding
multiple is 1.2 only (Figure 1). For the vast majority of countries the share of their own
currency in their own trade with the world is close to zero.
Casas et al. (2017) incorporate this dollar dominance fact into a Keynesian framework
and develop a “dominant currency paradigm” (DCP) where trade prices are sticky in dollars
and demonstrate that this predicts a stable terms of trade even at annual frequencies. Quite
simply, when imports and exports are all priced and sticky in dollars in the short-run the
terms of trade which is the ratio of the two should be insensitive to the exchange rate. While
invoicing alone does not guarantee that prices are also ‘sticky’ in the invoicing currency,
the evidence in Casas et al. (2017) and Boz et al. (2017) strongly supports the sticky price
assumption.
An important implication of DCP is that even in the best case scenario there is no socalled “divine coincidence,” that is inflation targeting does not suffice to close the output
gap, a result that is obtained under Mundell-Fleming assumptions. As derived in Casas
et al. (2017) inflation targeting (domestic producer price inflation) continues to be optimal
monetary policy from a small open economy’s perspective, except that now the output gap
fluctuates with shocks and this gap is greater the more open the economy is.
4
Terms of trade and exchange rates
(1)
VARIABLES ∆totij,t
∆eij,t 0.0121
(0.0127)
∆eij,t−1 -0.0126
(0.0169)
∆eij,t−2 -0.00807
(0.0105)
PPI controls Yes
Table 1: Disconnect between ER and Terms of Trade; Source Boz et al. (2017)
Figure 1: Dollar Dominance in World Trade; Source: Gopinath (2015)
The reason the output gap does not close can be understood as follows: Under MundellFleming assumptions an exchange rate depreciation accomplishes two things. First, it raises
the prices of imports relative to domestically produced goods and, second, it depreciates the
terms of trade that is lowers the price of exports relative to world prices in world currency.
Under DCP the exchange rate depreciation accomplishes the first but not the second and
consequently the output gap cannot be closed.
The additional implications of DCP for exchange rate policy are as follows:
1. While exchange rate flexibility continues to be valuable for macroeconomic stabiliza5
tion it is not as powerful as originally believed given that international trade is best
described as being governed by dominant currency pricing.
2. The exports of non-dominant currency countries (non-U.S. and non-Euro) will not be
very sensitive to exchange rates. This is consistent with the weak response of exports
to exchange rate fluctuations including during large devaluations in emerging markets,
as has been documented by Alessandria et al. (2013), Casas et al. (2017), Boz et al.
(2017) among others.
3. This does not imply that exporters in non-dominant currency countries do not benefit
from an exchange rate depreciation. They do, it but mainly works through increases in
mark-ups and profits even while the quantity exported does not change significantly.
The benefits of higher profits in a world with financial frictions can of course be large
and raise production and export capacity in the longer run.
4. Tourism is the one export that should be most sensitive to exchange rate changes
given that its prices are sticky in the producer’s currency. The dramatic growth in
tourism in Iceland following the large exchange rate depreciation is testimony to this
(Benediktsdttir et al. (2017)).
5. Once you include all the other arguments for the disruptive effects of exchange r
of having some exchange rate flexibility over none as commodity exporters with flexible
exchange rates appear to have had greater resilience to the shock.
This last comment presumes that flexible exchange rates allow for greater independence of
monetary policy. This presumption has however been questioned in recent years triggered
by Rey (2013). In my next remark I summarize the state of our knowledge on this all
important question of whether or not exchange rate flexibility allows for greater monetary
policy independence.
Remark 2 The ‘Trilemma’ lives on.
Rey (2013) in highly influential work argues that flexible exchange rates alone do not
suffice to maintain monetary policy independence as long as capital mobility is unrestricted.
This goes counter to the ‘trilemma’ that countries can choose two of the following three:
stable exchange rates, monetary policy independence and free capital mobility, but not all
three. According to the ‘dilemma not trilemma’ once you allow for capital mobility then
you give up monetary policy independence regardless of your exchange rate regime. This
‘dilemma’ follows from the astute observation of Rey (2013) that there is a global financial
cycle in capital flows, asset prices and credit growth and this cycle is influenced by U.S.
monetary policy. This claim finds strong support from the evidence on spillovers of U.S.
monetary policy onto long term interest rates in the rest of the world via global banks.
However, just to ensure that the pendulum does not swing to the other extreme that
flexible exchange rates provide no greater monetary independence and ability to control
credit growth (something I suspect Rey would not also argue for) it is important to recognize
the following findings. Firstly, Shambaugh (2004) demonstrates that short term rates of
countries with pegged exchange rates tracks the short term rates of the country whose
currency they are pegged to much more closely as compared to floaters, even conditional
on capital mobility, in direct support of the trilemma. Secondly, Obstfeld et al. (2017)
document that while increases in global risk measures like the VIX negatively impact capital
flows into emerging markets, their domestic credit growth and asset prices, this negative
effect is greater for emerging markets that are on a fixed exchange rate as compared to pure
7
floats or managed floats (Figure 2). They conclude that consistent with the Trilemma fixed
exchange rate regimes are more sensitive to global risk shocks and therefore more prone to
economic boom-bust cycles because of the greater loss of monetary independence. So the
take away from this research is that while the trilemma is weakened for reasons Rey (2013)
highlights, it continues to have bite.
28
Figure 5. Correlation of Financial and Macroeconomic Variables in EMEs
(a) With Global Investor Risk Aversion
(b) With Capital Flows
Source: Authors’ calculations.
Note: Panel [a] shows the unconditional correlation across countries between the (log) VXO index and three-quarter moving average of real
domestic private sector credit growth, real house price growth, real stock price growth, change in loan-to-deposit ratio, net capital flows to GDP,
and real GDP growth. Panel [b] shows the unconditional correlation between three-quarter moving average of net and liability flows, and real
domestic private sector credit growth, real house price growth, real stock price growth, change in loan-to-deposit ratio, net capital flows to G
exporting firms infrequently change prices denominated in their own home currency. Casas
et al. (2017) and Boz et al. (2017) demonstrate that in fact it is not the bilateral exchange
rate but the dollar exchange rate that drives trade between country pairs. That is the dollar
exchange rate quantitatively dominates the bilateral exchange rate in price pass-through and
trade elasticity regressions for country pairs where the U.S. is on neither side of the trade
transaction.
Boz et al. (2017) estimate that a 1% depreciation of an importing country’s currency
relative to the dollar raises the import prices of goods in home currency by 0.78% even
when controlling for its bilateral exchange rate with its trading partner. On the other hand,
a 1% depreciation relative to its trading partners currency raises import prices by only
0.16%, when controlling for the importing country’s exchange rate relative to the dollar.
The strength of the U.S. dollar is therefore shown to be a key predictor of rest-of-world
aggregate trade volume and consumer/producer price inflation. Specifically, they establish
that a persistent 1% U.S. dollar appreciation against all other currencies in the world predicts
a 0.6–0.8% decline within a year in the volume of total trade between countries in the rest
of the world, holding constant various proxies for the global business cycle. The dollar’s role
as an invoicing currency is also special as it handily beats the explanatory power of the euro
in predicting trade prices and volumes.
To summarize, the consequences of exchange rate variability and the determination of
exchange rate policy should be viewed through the lens of the dominant currency paradigm
given the dollars dominance in world trade. Flexible exchange rates provide greater monetary
policy independence but its benefits in an open economy environment may not be as large
as you think.
2 Capital Flow Management
In this section I address issues related to capital flows and its management. This is an area
where there has been a major rethink of policy over the last many years even preceding
the financial crisis. There is now a new consensus that capital account liberalizations are a
9
mixed blessing, they are associated with excess volatility tied to abrupt surges and reversals in
capital flows, and consequently there can be prudent limits to capital account liberalization.
The recent financial crisis and its aftermath made these tradeoffs with capital flows even
more stark with the collapse in capital flows in the immediate aftermath of the financial crisis
and the surge in capital inflows into emerging markets during the period of exceptionally
loose monetary policy and quantitative easing in advanced economies. In my next remark I
address two important lessons from the last two decades of capital flows.
Remark 4 Gross capital flows matter as much as net flows, and global banks have internationalized U.S. monetary policy.
As argued by Obstfeld (2012) and Gourinchas and Rey (2014) the crisis made a compelling
case for the importance of expanding surveillance beyond the traditional focus on current
accounts that is the difference between net savings and investment decisions to include gross
flows. In the run up to the crisis there were large increases in gross flows (Figure 3) especially
between advanced economies that did not necessarily show up as large net imbalances but
were a major source of financial instability.
A separate but equally important gross flow that does not show up in measures of crossborder flows but played an important rule in the transmission of the crisis was highlighted
by Bruno and Shin (2015), Shin (2012). This was the phenomenon of European banks
raising dollar funds in the U.S. and reinvesting it into U.S. subprime mortgages (Figure 4).
These flows do not show up in the current account nor as cross-border gross flows as the
transactions took place within the boundaries of the U.S. Avdjiev et al. (2016) argue that
such flows played a central role in the transmission of the financial crisis and should therefore
be monitored.
Post-crisis there is a renewed focus on the so called ‘Global Financial Cycle,’ which
captures the co-movement in global capital flows triggered mainly by monetary policy and
risk appetite in advanced economies (Rey (2013), Blanchard et al. (2016)). In the case
of emerging markets these flows have been primarily intermediated through global banks
and large domestic banks and as highlighted in Brauning and Ivashina (2017) the claims
of global banks nearly doubled since the onset of the global financial crisis reaching about
10
4
Figure 2
The explosion of international lending in the mid-2000s goes far beyond what any global
saving glut story would imply and, to my mind, points to a driver of last decade’s global
imbalances that receives only brief mention in Menzie’s paper: an international liquidity
explosion that increased global collateral values and loosened borrowing constraints in a
financially deregulated environment. Along with increased saving from East Asia and
commodity exporters, the financial factor for advanced economies helps explain the pattern
of external deficits of advanced economies, as argued by several writers (e.g., Obstfeld and
Rogoff 2009 and Chinn and Frieden 2011).3 Adam, Kuang, and Marcet (2012), for example,
quantify the role of house-price booms specifically in driving current account deficits. The
recycling of foreign borrowing from the euro area core to its periphery drove current
accounts but even more broadly set the stage for the euro crisis (Hale and Obstfeld 2016).
These episodes illustrate a main reason large external deficits are worrisome: as a possible
signal of building financial fragility.
This is not to deny a role for “saving glut” or “safe asset” factors in pushing down global
interest rates. At this conference in 2006, Prasad, Rajan, and Subramanian (2006) pointed to
the tendency for important fast-growing East Asian economies such as China to supply
3 For other accounts of the role financial factors in laying the basis for the financial crisis, see Hume and
Sentance (2009), Borio and Disyatat (2011), Bernanke, Bertaut, Demarco, and Kamin (2011), and Bayoumi
(2017).
-25
-20
-15
-10
-5
0
5
10
15
20
25
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Global Gross Financial Flows, 1990-2016
(percent of world GDP)
FDI Outflow
FDI Inflow
Portfolio Investment Outflow
Portfolio Investment Inflow
Other Investment Outflow
Other Investment Inflow
Source: IMF, Balance of Payment Statistics
Figure 3: Cross border gross flows matter; Source: Obstfeld (2017)
and Europe contracted by $724 billion. In contrast, cross-border bank lending to Asia
surged by $636 billion both from banks located in the United States ($382 billion) and
in Europe ($254 billion). Much of the latter increases favoured banks located in
advanced Asia-Pacific countries, which in turn lent to non-bank borrowers in emerging
Asia. As a consequence of this growth in intraregional banking, banks located in Asia
and the Pacific now account for more than 50% of the international claims on emerging
Asia-Pacific (Remolona and Shim, 2015).
Figure 9. US dollar-denominated cross-border claims. (In billions of US dollars)
1 The thickness of the arrows indicates the size of the outstanding stock of claims. The direction of the arrows indicates the direction of the claims: arrows directed from region A to region B indicate lending from banks located
in region A to borrowers located in region B.
Source: BIS locational banking statistics.
428 STEFAN AVDJIEV, ROBERT N. MCCAULEY AND HYUN SONG SHIN
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by Harvard College Library, Cabot Science Library user
on 16 September 2017
Figure 4: Within country gross flows matter; Source: Avdjiev et al. (2016)
seven trillion dollars in 2016. According to Brauning and Ivashina (2017) over a typical
U.S. monetary easing cycle there is a 32 percent loan volume increase for emerging market
economies, with a similarly large effect upon reversal of U.S. monetary stance, controlling for
demand factors. Baskaya et al. (2017) estimate that increases in global risk-appetite (VIX)
enabled large domestic banks in Turkey to lower credit rates and this channel explains 43%
of the observed credit growth in Turkey.
11
While global banking has raised sensitivity to global factors there is one phenomenon
that has reduced it:
Remark 5 Emerging markets tilt away from foreign currency to local currency debt reduces
their exposure to global risk factors.
The shift in the currency composition of emerging market sovereign external borrowing
away from foreign and towards local currency is one of the prominent trends of recent decades,
a decline in so called ‘original sin’ (Eichengreen and Hausmann (2005)) for emerging markets.
Du and Schregger (2016b) document that the mean share of local currency debt in total
external sovereign debt held by nonresidents increased from around 10% in 2000 to nearly
60% in 2013 for a sample of fourteen emerging markets. They also document that the
share of local currency debt in total offshore emerging market debt trading volume increased
from 35% to 66% in 2013 reaching 3.5 trillion over the same period. This phenomenon is
owed to an important extent to more independent central banks and inflation targeting in
these countries, as foreign investors worry less about losing real value through unanticipated
devaluations. IMF (2016) importantly attribute some of the greater resilience of emerging
markets to the post financial crisis slow down in net capital inflows to the decline in the
reliance of emerging markets on foreign currency debt (Figures 5, 6, 7).
While the balance sheet gains of matching the currency of assets and liabilities are
73
CHAPTER 2 Understanding the Slowdown in Capital Flows to Emerging Markets
International Monetary Fund | April 2016
notion that outflows played the role of a buffer during
that period. Yet over 2012–14, outflows exacerbated
the decline in net inflows, suggesting that a potentially
destabilizing role cannot be ruled out.
Decline in Currency Mismatches
A large literature has documented the propensity
of emerging markets to acquire foreign-currency debt
liabilities and the attendant risks of doing so, stemming mainly from adverse balance sheet effects in case
of a currency devaluation. Indeed, as discussed later,
almost the entire stock of emerging market debt until
the early 2000s was denominated in foreign currencies. By increasing their holdings of external assets by
more than the increase in their external debt liabilities,
emerging market economies as a whole have therefore
considerably reduced the currency mismatch in their
overall net external portfolios. When only external debt
assets are considered, the overall improvement in the
net external position since the 1980s is about 20 percent of emerging market GDP. When foreign reserve
assets are added, the decline in the net external position goes up to 30 percent of GDP (Figure 2.13).24
The improvement is even more remarkable if external
portfolio equity assets and the stock of FDI abroad are
taken into account.
A second and more direct force reducing the
currency mismatch has been the rise of debt liabilities denominated in domestic currency. The “original
sin” of emerging market economies—the propensity
to issue debt denominated in foreign currency (documented by Eichengreen and Hausmann 1998 and
Eichengreen, Hausmann, and Panizza 2002)—has
been substantially alleviated in both international and
domestic markets.
The domestic-currency share of outstanding government debt rose substantially between 1995 and
24These trends in emerging market currency exposures have been
documented in more detail by Lane and Shambaugh (2010) and
Benetrix, Shambaugh, and Lane (2015).
–2
–1
0
1
2
3
4
5
6
7
8
9
10
1980 85 90 95 2000 05 10 14
Inflows Outflows
Figure 2.12. Gross Capital Inflows and Outflows of Emerging
Market Economies, 1980–2014
(Percent of GDP)
Gross capital inflows played a dominant role in net capital inflow slowdown
episodes in the 1980s and 1990s. However, the role of gross capital outflows
increased in the 2010–15 slowdown.
Sources: CEIC Asia database; CEIC China database; Haver Analytics; IMF, Balance
of Payments Statistics; IMF, International Financial Statistics; World Bank, World
Development Indicators database; and IMF staff calculations.
Note: Balanced sample of 22 economies from the full sample of 45 emerging
market economies. See Annex 2.1 for a complete list of the sample countries.
–10
–5
0
5
10
15
20
25
30
35
40
1980 85 90 95 2000 05 10 14
Net external debt liabilities (excluding reserves)
Net external debt liabilities
Figure 2.13. Net External Debt Liabilities of Emerging Market
Economies, 1980–2014
(Percent of GDP)
Overall, emerging markets’ currency mismatches, as proxied by net external debt
liabilities, have declined considerably over the past three decades. An increase in
both external nonreserve assets and reserve assets has contributed to the decline.
Sources: External Wealth of Nations Mark II database; and IMF staff calculations.
Note: Balanced sample of 22 economies from the full sample of 45 emerging
market economies. See Annex 2.1 for the complete list of sample countries. All
variables are GDP weighted.
Figure 5: Net external debt liabilities of Emerging Market Economies (percent of GDP), 1980-
2014; Source: IMF (2016)
71
CHAPTER 2 Understanding the Slowdown in Capital Flows to Emerging Markets
International Monetary Fund | April 2016
developing country debt crisis of the 1980s, while the
second one overlaps with the Asian crisis of 1997–98
and other major emerging market crises. All three
episodes were preceded by a prolonged surge in capital
inflows, and all three are similar both in the aggregate
size of the slowdown (ranging from 2.4 percent to 4.8
percent) and in the fraction of the economies with
declining ratios of net capital inflows to GDP (65
percent to 76 percent).17
17In terms of the aggregate size of the slowdown, the 2010–15
episode is more comparable with earlier episodes when China is
excluded from the sample, decreasing the size of the slowdown from
–4.8 percent to –3.3 percent of GDP.
Changing Structure of External Portfolios
Capital flows to and from emerging market economies affect those economies’ external portfolios,
and the external portfolio structures, in turn, affect
capital flows. After each of the previous two slowdowns, emerging market economies saw a surge in
cross-border capital flows; as a result, over time they
accumulated external assets and liabilities and became
increasingly integrated into global financial markets.
This has meant more asset trade with other countries,
especially with advanced economies, but potentially
also more cross-border spillovers.18
Between 1980 and 2014, external equity liabilities
of emerging market economies surged, from below 10
18The IMF’s Coordinated Portfolio Investment Survey shows that
advanced economies are the main source of, and destination for, the
increased capital flows involving emerging market economies. Flows
among emerging market economies have also increased, but from a
low base.
0
100
200
300
400
500
600
700
800
2000:Q1 02:Q1 04:Q1 06:Q1 08:Q1 10:Q1 12:Q1 14:Q1
Basis points
1. Cost of Financing and Sovereign Spreads (2000–15:Q3)
–300
–200
–100
0
100
200
300
400
500
–15 –10 –5 0 5 10 15
ZAF
VNM
URY TUR
POL PHL
PER
MYS
MEX
LTU
LKAKAZIDN
HUN GEO
ECU
COL
CHN
CHL
BRA
BLR
BGR
ARG
EMBI basis point change
Change in gross capital inflows,
GDP percentage points
2. EMBI versus Capital Inflows
(2010–15:Q3)
Median: EMBI spreads
Interquartile range: EMBI spreads
10-year U.S. Treasury bond yield
–200
–150
–100
–50
0
50
100
150
–50 –30 –10 10 30
ZAF
VNM
URY
TUR
POL
PHL
PER
MYS
MEXLKA IDN
HUN GEO
ECU
COL
CHN
CHL
BRA
BGR
EMBI basis point change
Percent change in nominal
effective exchange rate
3. EMBI versus NEER
(2010–15:Q3)
Figure 2.9. Cost of Financing, Sovereign Spreads, and Capital
Flows in Emerging Market Economies
The cost of financing, defined as the sum of the 10-year U.S. Treasury bond yield
and EMBI spreads, remains well below historical peaks, but has increased in
recent quarters. Recent increases in sovereign spreads are positively associated
with (1) net capital inflow slowdowns and (2) exchange rate depreciations.
Sources: Bloomberg L.P.; CEIC Asia database; CEIC China database; Haver
Analytics; IMF, Balance of Payments Statistics; IMF, International Financial
Statistics; World Bank, World Development Indicators database; and IMF staff
calculations.
Note: See Annex 2.1 for the complete list of sample countries included in each
panel. EMBI = J.P. Morgan Emerging Market Bond Index; NEER = nominal effective
exchange rate. Data labels in the figure use International Organization for
Standardization (ISO) country codes.
–2
–1
0
1
2
3
4
5
1980 85 90 95 2000 05 10 15
Weighted mean excluding China and Russia
Weighted mean
Percent of countries
with slowdown:
70%
Percent of countries
with slowdown:
65%
Percent of
countries with
slowdown:
76%
–2.4%
–3.1%
–4.8%
Figure 2.10. Three Major Net Capital Inflow Slowdown
Episodes
(Percent of GDP)
The recent net capital inflow slowdown episode was similar to previous episodes
in terms of the magnitude and breadth of the slowdown.
Sources: CEIC Asia database; CEIC China database; Haver Analytics; IMF, Balance
of Payments Statistics; IMF, International Financial Statistics; World Bank, World
Development Indicators database; and IMF staff calculations.
Note: Calculations are based on a sample of 45 emerging market economies. The
observation for 2015 refers to the first three quarters. See Annex 2.1 for the
complete list of sample countries.
Figure 6: Episodes of Net Capital Inflows Slowdown (% of GDP); Source: IMF (2016)
13
74
WORLD ECONOMIC OUTLOOK: too slow for too long
International Monetary Fund | April 2016
2010 (Figure 2.14, panel 1). Given the finding that
the share of total government debt held by nonresidents was stable between 2004 and 2012 (Arslanalp
and Tsuda 2014), the decline in original sin in public
debt appears to have occurred both domestically and
internationally. Original sin also declined in the nongovernment sector (Figure 2.14, panel 2). The much
stronger increases for the weighted average share issued
in domestic currency than for the median share suggest
that original sin declined more in larger emerging
market economies.
Despite the documented decline in currency mismatches, substantial vulnerabilities related to exchange
rate movements remain. First, the net external debt
position shown in Figure 2.13 abstracts from differences in maturity and liquidity of assets and liabilities
as well as from sectoral mismatches within economies. Second, as documented in Chapter 3 of the
October 2015 Global Financial Stability Report, the
stock of emerging market corporate debt has grown
substantially over the past decade, even as the share
of foreign-currency-denominated debt in total debt
has declined. Finally, the majority of indicators of
foreign-currency mismatches in Figures 2.13 and 2.14
peaked prior to 2010 and have remained stable or
declined since.25
Shifts in Policy
Under the balance of payments identity, the sum of
net nonreserve capital inflows and the current account
balance equals the change in foreign reserves.26 Hence,
slowdowns in net nonreserve capital inflows are countered by some combination of a slower accumulation
(or a faster decumulation) of foreign reserves and a
higher current account balance. The three components
of the identity are jointly determined. For example,
during the years leading up to the global financial
crisis, many commodity-exporting emerging market
economies received strong capital inflows amid rising
investment opportunities and accumulated reserves,
with strong terms-of-trade gains offsetting the impact
of rapid import growth on the current account. With
the decline in commodity prices and more subdued
growth prospects from 2011 onward, the process began
to reverse. The following analysis uses the balance of
payments identity as a guiding framework and discusses three relevant dimensions of the macro adjustment across episodes: exchange rates, foreign reserves,
and the current account.
Foreign Reserves as a Buffer
Relative to previous slowdown episodes, in 2010–15
reserves played an important buffer role. To document
this, based on the balance of payments identity, this
subsection examines the extent to which the recent
slowdown in emerging market net capital inflows has
been countered by an increase in the current account
balance—with potentially negative consequences for
25Only a part of the decline can be attributed to recent exchange
rate depreciations in emerging markets. 26Two other items in the identity, typically small, are the capital
account balance and errors and omissions. Here these terms are
included in capital flows. Inclusion of errors and omissions in capital
flows improves the measurement of changes in the current account
and foreign reserves.
Weighted mean Median Interquartile range
0
10
20
30
40
50
60
70
80
90
100
1995 2000 05 10 15
1. Government Debt Stock in Domestic Currency
0
10
20
30
40
50
60
70
80
90
100
1995 2000 05 10 15
2. Nongovernment Debt Stock in Domestic Currency
Figure 2.14. Outstanding Debt of Emerging Market Economies
Denominated in Domestic Currency, 1995–2015
(Percent of total)
Since 1995 both the government and the private sector in emerging market
economies have increasingly been able to issue domestic-currency-denominated
debt, which has further contributed to the reduction in currency mismatches.
Sources: IMF, Vulnerability Exercise Securities Database; and IMF staff calculations.
Note: Calculations for government and private sectors are based on a balanced
sample of 43 and 42 economies, respectively, within the 45 economies in the
sample. See Annex 2.1 for the complete list of sample countries.
Figure 7: Local currency financing of government debt (% of total); Source: IMF (2016)
foreign currency. Policies that encourage a switch away from foreign currency debt (alongside maintaining sustainable overall debt levels) should therefore continue to be a part of
the toolkit of capital flow management.
Remark 6 Low interest rate environments can lead to misallocation of resources and lower
productivity.
Interest rates are predicted to remain at low levels in advanced economies (Summers
(2014), Gourinchas and Rey (2016)) and therefore it is helpful to keep in mind the potential
risks they pose especially when unaccompanied by financial sector reforms. Besides the risks
associated with disruptive capital flows to emerging markets in the search for yield and the
temptation for the finance industry to load up on risk, another lesson of the financial crisis is
the potential for low interest rates to cause a misallocation of resources and therefore lower
aggregate productivity.
One striking feature of the run up to the Euro crisis was the divergence in the current
accounts of Germany and Spain alongside a divergence in productivity (Figure 8). From
1999 to 2007 Germany ran large current account surpluses and was a net lender while experiencing strong productivity growth. During the same period Spain ran large current account
deficits financed by large capital inflows while experiencing a decline productivity. This is an
allocation puzzle if any as standard forces would predict that capital flows into the country
with higher productivity growth.
14
Gopinath et al. (2016) provide an explanation that reverses the direction of causation.
They argue that lower borrowing costs for Spain that arose from euro convergence caused
a decline in productivity through greater misallocation of resources. The mechanism is as
follows: Lower borrowing costs disproportionately benefit larger (high net worth) firms because they are less constrained in their borrowing in financial markets as compared to small
firms. Because larger firms are not necessarily the most productive firms this ends up with
resources being misallocated away from more productive to less productive firms, thus generating a decline in aggregate productivity. In support of this argument they document
that for manufacturing firms in Spain between 1999 and 2007 capital was increasingly misallocated as the dispersion of the return to capital (marginal revenue product of capital)
across firms increased significantly without an increase in dispersion of the return to labor
(marginal revenue product of labor) as depicted in Figure 9. Further this rise in dispersion
was not evident within the group of large firms but was driven by the difference in returns
to capital across large and small firms. They estimate that the increasing misallocation of
resources lead to a significant decline in productivity.
A lesson of this period is therefore that low interest rate environments when combined
with less developed financial markets can have perverse effects on productivity. As in the case
of Spain, low interest rates can lead to rapid capital accumulation but weaken productivity
through inefficient resource allocation.
To summarize, international finance like domestic finance turns out to be far less benign than previously thought and all its complexity deserves attention including the strong
spillovers across countries in a world of globalized finance. There are sound arguments for
intervening in capital markets, including the use of capital controls and macro prudential
regulation, based on market failures such as pecuniary externalities and aggregate demand
externalities. At the same time one certainly should not ‘throw the baby out with the bath
water’ as not all capital flows have negative consequences for recipient countries. Foreign
direct investment continues to get top billing among capital flows, but some portfolio flows
and loan flows are shown to positively impact growth and consequently have benefits for the
recipient country (Blanchard et al. (2016), Varela (2016)).
15
-.1 -.05
0 .05 Current Account / GDP
1995 1997 1999 2001 2003 2005 2007 2009 2011
ESP ITA GER .9 .95 1 1.05 1.1 Aggregate TFP
1995 1997 1999 2001 2003 2005 2007 2009 2011
ESP ITA GER
Figure 8: Misallocation of Capital: Source: Gopinath et al. (2016) .9 1 1.1 1.2 1.3 Standard Deviation
2000 2005 2010
log(MRPK) log(MRPL)
Figure 9: Misallocation of Capital in Spain Manufacturing: Source: Gopinath et al. (2016)
3 Protectionism and Currency Wars
Globalization faces serious threats and though so far there have been no major reversals
in trade policy the odds that it will happen have risen significantly over the past year.
Surveys by the Pew Research Institute on attitudes towards international trade point to a
divergence between developed and developing economies, with the former viewing trade far
more unfavorably in recent years as compared to the latter. There is a sense in the developed
world that they have lost their prosperity to developing countries because of trade.
This triggers concerns of unfair trade practices in developing countries with large surpluses. One prominent accusation is that of currency manipulation by China. The dramatic
accumulation of dollar reserves by China is accused of directly causing its large surpluses
(Figure 10) . Such arguments have lead to proposals to include currency manipulation clauses
in trade agreements (Bergsten and Gagnon (2017)).
Large imbalances certainly raise concerns of sustainable global growth and require monitoring and redressal, however it is important to flag that the state of knowledge on what
causally drives global imbalances is quite limited. This is quite simply because imbalances
are equilibrium phenomenon and driven by decisions of private agents, the government,
domestic and foreign shocks, that all interact in nonlinear ways. Moreover there exist several explanations for global imbalances that have nothing to do with manipulation such as
differential (across countries) demand for precautionary savings, differing ability to produce
financial assets, differing demographics etc. (Gourinchas and Rey (2014)). For these reasons,
Remark 7 The empirical relationship between global imbalances, reserve accumulation, and
currency manipulation is not well identified.
Bayoumi et al. (2015), Gagnon et al. (2017) and Chinn (2017) explore the empirical relation
between reserve accumulation and current account balances. While this research provides
valuable insights, the estimated relation is sensitive to the sample period covered and the
variables controlled for (see also the discussion by Obstfeld (2017)). Germany’s large current
account surpluses clearly have no relation to reserve accumulation. While more research is
required the bottom line is that caution needs to be exercised in arriving at conclusions of
17
currency manipulation and its ability to cause trade surpluses.
7
Figure 3
Menzie’s paper, like others in this vein (including the EBA model), tries to address the
problem with instrumental variables and controls. If not properly instrumented, however,
these regressions could capture little of the causal impact of intervention on the current
account over time (that is, the within effect) but instead mostly capture the between effect
that many high surplus countries have also tended to accumulate reserves. My worries
heighten when I am told that one instrument is emerging-market status, which has little time
series variation. Menzie is correct not to include country fixed effects in his baseline current
account regressions—doing so might hide important facts about slow-moving variables such
as institutional quality or reserve-currency status--but here, I think their omission may
obscure the dynamics around intervention (which are already blurred by his use of five-year
periods). The result in Menzie’s Table 4 that, with instrumental variables, intervention has an
unconditional near unit effect on the current account, is simply not credible.
By contrast, our EBA methodology and the papers by Bayoumi et al. and Gagnon et al. find
(in annual data over shorter sample periods) comparably high coefficients on intervention
only when the capital account is fully closed, but a near-zero effect when the capital account
is fully open. For example, Gagnon et al. find that for a country at the mid-point of their
capital mobility index, a $1 FX purchase translates into about a 35-cent current account
improvement; the estimate of Phillips et al. is half that size. These findings are far more
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Global Reserve Purchases by Region, 1990-2016
(percent of world GDP)
EMDE Commodity Exporters EMDEs Other China Advanced Economies Total
Source: IMF, World Economic Outlook
Figure 10: Global Imbalances and Reserve Accumulation: Source Obstfeld (2017)
A policy that recently grabbed headlines is the border adjustment tax (BAT) proposed as
part of the House Republican plan for U.S. business tax reform (Auerbach et al. (2017).) The
BAT disallows deductions of imported input costs from corporate revenue when computing
taxable corporate profits, and excludes export revenue from taxation. This sparked a debate
on whether this amounted to protectionism and what the implications were for trade. Some
argued that the U.S. dollar would appreciate to offset the tax advantage fully and therefore
trade would be unaffected. More strongly, the BAT itself would be neutral, that is have no
effect on real allocations, consumption, GDP, investment, saving etc, as flexible exchange
rates adjust to undo any real effect of the border tax. There were others who questioned
both the prediction about the exchange rate and the claims of neutrality.
It now seems unlikely that the BAT will be implemented but I doubt this is the last time
countries consider tax interventions of this kind. Moreover there are other tax interventions
that are in the same economic equivalence class as BAT, such as uniform changes to the
value added tax (VAT) and the payroll tax. These are all forms of “Uniform Border Taxes
(UBT)”. It is therefore useful to be clear what the economic consequences are to inform
18
current and future policy. I summarize the state of knowledge here on UBTs and why such
taxes are unlikely to be neutral.
Remark 8 Uniform border taxes are not neutral
The prediction that UBTs are neutral has its origins in a classic result in the field of
international trade, called the Lerner (1936) symmetry, and in its applications in Grossman
(1980) and Feldstein and Krugman (1990). According to this result, when prices and wages
are fully flexible and trade is balanced a combination of a uniform import tariff and an
export subsidy of the same magnitude must be neutral, having no effect on imports, exports
and other economic outcomes. This is because the tax leads to an increase in domestic
wages relative to foreign wages (in a common currency), which in turn leaves unchanged the
post-tax relative price of imported to domestically produced goods in all countries. That is,
despite the higher tax on imports relative to domestically produced goods the lower relative
wage of foreign products leaves the relative price of imported to domestic goods unchanged.
Similarly on the export side, despite the export subsidy, the higher relative domestic wage,
leaves unchanged the relative price of domestic goods in foreign markets. This result follows
through if instead the tax combination was a uniform value added tax increase and cut in
payroll taxes, or the BAT. If, in addition, monetary policy targets the price level then the
nominal exchange rate does all the adjusting and we obtain the prediction that the nominal
exchange rate appreciates by the amount of the tax and there are no real effects.
It is of course unrealistic to assume that prices are flexible and trade is balanced. Based
on the work of Farhi et al. (2014) and Barbiero et al. (2017) I summarize the five conditions
that all need to hold to maintain neutrality when we depart from these assumptions (see
Gopinath (2017) for a lengthier discussion).
1. When prices/wages are sticky, if there is symmetry in the pass-through of exchange
rates and taxes into prices faced by buyers in each market then neutrality is preserved.
This symmetry is satisfied when prices are sticky in the producer’s currency or in the
local currency. In the former case, with fully preset prices, the pass-through of either
is 100% and consequently the exchange rate appreciation offsets taxes and there are
19
no real effects. In the later case the pass-through is zero in either case and there are
no real effects.
In reality though prices of traded goods are sticky in dollars regardless of origin and
destination, which leads to a break down of neutrality. In this case, with fully preset
prices, the exchange rate appreciation has no pass-through into import prices faced
by domestic households and firms while taxes have 100% pass-through. On the flip
side the tax has no pass-through into export prices (in foreign currency) while the
exchange rate has 100% passthrough. In this case, the exchange rate appreciation
leads to a decline in imports and in exports and therefore a decline in overall trade
in the short-run. These results hold more generally with staggered or state-contingent
pricing.
2. Monetary policy should respond only to the output gap and CPI inflation, and not respond to the exchange rate, to maintain neutrality. If exchange rates are targeted then
these same taxes serve the purpose of stimulating the economy. Famously, Keynes in
1931 proposed in the Macmillan Report to the British Parliament that a combination
of an import tariff and an export subsidy be used to mimic the effects of an exchange
rate devaluation while maintaining the gold pound parity. Farhi et al. (2014) demonstrate the equivalence of the VAT-payroll tax swap policy to replicate the effects of a
nominal exchange rate devaluation in economies with a fixed exchange rate. Relatedly,
if foreign monetary authorities attempt to mitigate the depreciation of their currencies,
a reasonable assumption, it will also lead to a break down in neutrality.
3. When trade is not balanced neutrality continues to hold as long as all international
assets and liabilities are in foreign currency. If however, some international holdings are
in domestic currency then neutrality is no longer preserved. Because this assumption
breaks down for the U.S. with its large dollar liabilities the BAT would lead to wealth
transfers from the U.S. to the rest of the world.
4. The implementation of the border adjustment tax must take the form of a one-time
permanent and unanticipated policy shift for it to be neutral. Otherwise, expectations
20
of a border tax in the future will cause immediate exchange rate appreciations that
impact portfolio choices of private agents and therefore will have real consequences.
Similarly, neutrality fails to hold if the policy is expected to be reversed and therefore
transitory, or if the other countries are expected to retaliate with their own policies in
the future.
5. Neutrality requires that the border taxes be uniform and cover all goods and services.
Service sectors such as tourism whose sales to foreigners take place within borders are
not treated the same as exports that cross borders, which in turn effects neutrality.
Because all of these conditions need to be satisfied simultaneously the UBTs are unlikely to
be neutral and will have significant consequences for international trade.
Remark 9 Trade is not the main driver of earnings inequality, but at the same time policy
has failed to address its redistributive consequences.
In terms of the bigger picture the main policy challenge to globalization is to ensure that the
gains are more fairly shared. While it is well understood that trade, despite raising aggregate
welfare, creates winners and losers the expectation was that losers would be compensated
and they would migrate to better performing sectors and geographic locations. The evidence
however points to the fact that inter-regional mobility is limited and trade assistant programs
do not come close to compensating losers (Pavcnik (2017)). Consequently the adverse effects
of trade on labor markets have persisted for long periods in some countries. Dix-Carneiro and
Kovak (2016) document that in the case of Brazil the negative effects of import liberalization
lasted twenty years. Autor et al. (2014) similarly point to long lasting negative effects of
China’s import competition on U.S. labor markets in some geographical areas.
While the academic literature has concluded that trade is not the main driver of earnings
inequality within countries and factors like automation and skill biased technical change play
a bigger role (Helpman (2016)), the bottom line is that trade will continue to be a scape
goat for labor market woes. It is therefore imperative to correct the failures in addressing
the redistributive effects arising not just from trade but also from technology so as to avoid
a costly reversal in globalization.
21
Given the fact that some advanced country administrations are trigger happy with protectionsim it is useful to remind ourselves of the empirical evidence on protectionism and
growth. Despite the contentious nature of the evidence I believe a fair summary is that there
is no evidence that tariffs are good for growth in high-income countries in the post-world
war period. DeJong and Ripoll (2006) examine the relationship between ad valorem tariffs
and growth, using a panel data set comprising sixty countries and spanning 1975-2000. They
find that while there is no significant relation between tariffs and growth in low income countries, higher tariffs are associated with significantly lower growth in high income countries
(Figure 11). Specifically, a 10 percentage point increase in tariff rates corresponds with a
1.6 percentage point decline in per capita growth rate for the country.
Alternative GMM-based approaches can be derived by
taking first differences of equation (2), which yields
yit yit 1 wit 1 wit 2 cit 1 cit 2
t t 1 εit εit 1. (3)
Least squares procedures cannot be used to estimate
equation (3), because, by construction, yi(t 1) yi(t 2) is
correlated with εit εi(t 1). Moreover, one would like to
deal with the likely endogeneity of all the explanatory
variables. Arellano and Bond (1991) propose a GMM difference estimator that uses lagged levels of the explanatory
variables as instruments in the estimation of equation (3).
The estimator is based on the following identifying assumptions:
E εitεit j 0 for all j 0, (4)
E tεit
s 0 for all t and for s 0, (5)
E wit 1εit
s 0 for all t and for s 0, (6)
E cit 2εit
s 0 for all t and for s 0, (7)
where equation (4) implies that the error term εit is not
serially correlated, equation (5) says that the period-specific
constant t is strictly exogenous, and, as indicated by equations (6) and (7), both the predetermined explanatory variables wi(t 1) and ci (t 2) are weakly exogenous, that is, past
stock and flow variables are uncorrelated with current and
future shocks. Under these assumptions, lagged levels of the
explanatory variables can be used as instruments as specified by the following moment conditions:8
E t sεit εit 1 0 for s 0, t 3, . . . , T, (8)
E wit sεit εit 1 0 for s 2,
t 3, . . . , T, (9)
E cit sεit εit 1 0 for s 3,
t 3, . . . , T. (10)
As discussed in Easterly and Levine (2001), this difference estimator has the statistical shortcoming that if the
regressors in equation (3) are persistent, then lagged levels
of w and c are weak instruments, that is, they are not highly
correlated with the regressors, and so the estimated coefficients may be biased. Further, by taking differences of the
original level equation (2), one loses information that speaks
to the relationship between the explanatory variables and
GDP growth. To overcome these problems, Arellano and
Bover (1995) and Blundell and Bond (1998) developed a
systems estimator that combines the differenced model (3)
8 Notice that the control variables ci(t 2) correspond to half-decade
averages computed between time periods t 2 and t 1, and the error
term εi(t 1) is a function of shocks realized between periods t 2 and t
1, so that the levels of ci(t 2) are not valid instruments for the difference
equation at period t. Thus, for control variables the most recent levels that
are valid instruments at period t are ci(t 3). In contrast, the state variables
si(t 2) are predetermined at period t 2, and so are valid instruments for
the difference equation at period t.
FIGURE 2.—PARTIAL REGRESSION PLOTS FOR OLS—INCOME SAMPLE SPLITS
Note: The set of regressors X includes initial income, life expectancy, schooling, I/Y, and G/Y. E(growthX) is the fitted growth, and E(tariffX) is the fitted tariff.
628 THE REVIEW OF ECONOMICS AND STATISTICS
Figure 11: Protectionism and Growth: Source DeJong and Ripoll (2006)
4 Global Cooperation
Issues related to cross-border cooperation on financial regulation, on global safety nets, and
maybe even on monetary policy will continue to be center stage in discussions on the next
generation of the international financial and monetary system. Despite the U.S. threatening
to withdraw from multilateralism, the arguments for cooperation have only strengthened
22
over time. This leads me to my last remark,
Remark 10 Global coordination of financial regulation is required alongside individual countries macroprudential polices. Reserve accumulation and currency swap lines do not substitute for the lender of last resort role of the International Monetary Fund.
The arguments in favor of international cooperation in financial regulation are clearly
articulated in Cecchetti and Tucker (2016). Quite simply, when financial institutions are
global, individual countries that maximize their own welfare do not internalize all the costs
and benefits of their regulatory policies and consequently such policies are suboptimal. Countries can engage in a race to the bottom with lax regulations so as to win the favor of the
financial services industry, while imposing large costs on the rest of the world. The lessons
of the financial crisis if anything should highlight the costs of weak financial regulation and
the virtues of international coordination of regulatory standards.
Safety Nets: The many financial crisis of the eighties and nineties in emerging markets
have led them to accumulate large amounts of international reserves as a rainy day fund for
future crisis. These reserves certainly help countries weather crisis as evidenced by the recent
financial crisis and therefore should continue to be a part of the arsenal of macroprudential
policies. That said, countries appear to display a ‘fear of losing international reserves’ as
articulated by Aizenman and Sun (2009), with the majority of the emerging markets not
willing to deplete their reserves by more than 25%. This suggests that there are hard-toexplain limits to how reserves can be used in the event of a crisis, which then should be
weighed against the costs of accumulating these reserves.
One very successful act of global cooperation that emerged during the financial crisis
was the creation of the central bank swap lines that were created to deal with the dollar
shortage in financial markets following the Lehman collapse. Since then there has developed
a proliferation of bilateral and regional swap lines with the potential to ameliorate panic
driven currency shortages (Denbee et al. (2016).) The virtue of these swap lines is that they
appear limitless and consequently they are a useful deterrence tool for self-fulfilling panics.
The downside is that they can be used only if they are consistent with the mandate of the
23
country providing the liquidity and the loans tend to be of very short duration of up to three
months, which may in turn reduce its deterrence potential.
Given these limitations to reserve accumulation and swap lines it is apparent that they are
not substitutes for the IMF’s role as as the international lender of last resort. As highlighted
in Denbee et al. (2016) IMF financing has the following virtues: First, it shares risks across
the largest group of countries (all of its 188 members). Second, it serves a broader purpose
than just dealing with currency shortages by targeting all the manifestations of a balance
of payments crisis. Third, the lending is of longer three to five year maturities. The main
critique against the IMF’s role is the stigma attached with borrowing from the IMF which
leads countries to not use their facilities. That has changed some over the past few years with
the creation of facilities that provide funding without conditionalities such as the ‘Flexible
Credit Line’ for countries with sound fundamentals. Figure 12 from Denbee et al. (2016)
documents the growing sources of safety nets besides reserve accumulation by countries.
The structure of the international monetary system with the dominance of the dollar in
international trade, finance, and in central bank reserves poses its own challenges such as
the new age Triffin dilemma arising from a potential conflict between demand for U.S. safe
assets and the fiscal capacity of the U.S. to produce these safe assets. In addition there are
spillovers from U.S. monetary policy onto global trade that I previously described. Further,
the dollars role as a funding currency in international markets raises the sensitivity of nonU.S. balance sheets to dollar exchange rate fluctuations (Avdjiev et al. (2016)). While these
spillovers raise demands for greater cooperation in monetary policy, the answers for how to
get this done will probably remain elusive. It is then all the more important for countries
to cooperate on financial regulation, to strengthen the global safety net, and to reduce the
stigma attached to the lender of last resort role of the IMF.
The creation of regional monetary funds like the European Stability Mechanism (ESB) set
up in 2012, the Chiang Mai Initiative Multilateralization (CMIM) in 2012, BRICS Contingent
Reserve Arrangement (CRA) in 2014 and other smaller regional arrangements that taken
together have committed resources of US 1.3 trillion dollars similar to that of the IMF
(Denbee et al. (2016)) are welcome developments that complement the IMF in supporting a
24
Figure 12: Global financial safety net as percentage of external liabilities, 1980-2014: Source:
Denbee et al. (2016)
well functioning international monetary and financial system
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