Reserve Bank of India Governor Raghuram Rajan’s recent plea for increased coordination is merely the latest protest by emerging-market economy (EME) policymakers about the spillovers from advanced-economy (AE) monetary policy. Such complaints have been common since AE central banks first implemented unconventional policies in 2008. The most famous was Brazilian Finance Minister Guido Mantega’s September 2010 remark that “We’re in the midst of an international currency war.”
The targets of these comments—policymakers in Europe, Japan and the United States—responded that the world would be better off if their economies grew. A deeper recession in the advanced world was surely in no one’s interest. Extraordinary monetary policy easing was therefore justified by both domestic and global concerns. U.S. and European policymakers further defended their actions by saying that their mandate was to promote price stability and sustainable growth domestically, which required taking account of the external impact of their policies only insofar as they then fed back onto their own economies. That is, while spillovers per se were not their responsibility, spillbacks were.
Debates over the potential benefits from international policy coordination have a long history. In areas like trade and defense policy, the benefits are sufficiently clear that a consensus for cooperation has emerged among experts (if not among politicians). But when it comes to monetary policy, matters are quite different. For example, as Olivier Blanchard emphasized last week at the Asian Monetary Policy Forum, a range of economic models indicate that the welfare benefits from coordination are small. Blanchard’s focus is on macroeconomic stabilization—that is, ensuring high, stable growth. In that context, exchange rates provide the traditional mechanism for insulating one country from interest rate changes in another.
So, why have thoughtful EME policymakers like Rajan become so much more vocal today about the spillovers than they were a decade ago? One possible answer is that finance itself has become substantially more global and that—in addition to influencing economic stability—global finance also affects the stability of financial systems around the world. International investment positions have grown by a factor of roughly seven since the mid-1990s and cross-border bank claims are up a factor of four. While this international financial integration brings clear benefits, it also brings risks through increased exposure to shocks in the AE world.
We are still at the early stages of understanding all of this—both how it works and whether there is anything that can or should be done about it. The reaction of some policymakers has been to reconsider the implementation of capital controls: that is, the implementation of policies that impede cross-border capital flows. Even before Mantega’s invocation of a “currency war,” Brazil had imposed a tax on incoming financial flows. In 2008, Iceland introduced controls to protect its economy from the threat of enormous outflows in the aftermath of the collapse of its banks. And, several years ago, the IMF reiterated its view that capital controls were a legitimate policy tool. However, as the Fund emphasized, such controls might be sensible only in the rather uncommon circumstances that monetary, fiscal and structural policies are already set appropriately.
But perhaps the real question is whether AE policymakers have underestimated not only the spillovers, but the potential for spillbacks. And, in particular, whether they are insufficiently attentive to the financial stability risks that their policies may cause—not just domestically, but globally.
One way to examine this is to consider the impact of policy accommodation on the risk-taking behavior of financial intermediaries. For example, what happens to leverage of financial intermediaries when policymakers cut interest rates. At first blush, one might expect lower interest rates to improve their balance sheets. The reason is that a reduction in the policy rate is normally accompanied by a steepening of the yield curve. This drives up the value of long-term assets, improves the creditworthiness of borrowers, and lowers the cost of issuing liabilities. For a bank, which is using short-term deposits to make long-term loans, this balance-sheet effect should be a good thing.
However, there can be a dark side to monetary policy accommodation. First, the fall in borrowing costs creates an incentive for greater reliance on debt (and, possibly, on short-term debt). Second, lower nominal and real returns encourage investors to take on additional risk (for a discussion, see here). And third, lower domestic interest rates induce currency depreciation, increasing the burden of foreign-currency-denominated debt (see here). These considerations lead us to ask whether the short-run impact of policy easing on financial intermediaries’ balance sheets may be different from the long-run impact.
The plots below show the median leverage ratios from a sample of 994 publicly traded financial institutions in 22 countries over the period from 1998 to 2014 (they are based on work that one of us—Steve—has done with colleagues at the IMF; see Box 4 here). The left-hand panel shows the impact on the leverage ratio for each of six different types of financial firms from a single quarter of easing in the institution’s home-country monetary policy. The short-term impact of policy easing is minimal. The leverage of banks rises very slightly, and that for the other types of intermediaries is unchanged. (To avoid problems created by accounting conventions used in measuring assets, leverage here is computed as liabilities plus market value of equity over the market value of equity.)
Leverage ratios (median) before and after monetary policy easing by a firm’s own-country authority (median ratio)
Source: Cecchetti, Mancini-Griffoli and Narita, forthcoming.
However, the leverage of some intermediaries rises markedly when the accommodation is sustained. In the right-hand panel, the green bars depict the impact of accommodation that lasts for one year, while the purple bars show the effect after two years of policy easing. In the latter case, for example, the leverage of the median bank rises from 10.2 to 12.5. For insurance companies, leverage rises from 6.5 to 7.4
The sizable impact on leverage of an extended period of accommodation on banks and insurers is consistent with the evidence on broker-dealers that Hyun Song Shin of the BIS described in a recent speech. Shin emphasized the procyclicality of their leverage: that is, when times are good they tend to lever up.
So, how do these findings relate to spillovers from AE policies? It turns out that the impact on leverage abroad from an easing of U.S. monetary policy is a multiple of the impact of easing by the home-country central bank! For example, non-U.S. bank leverage jumps from a baseline of 15.8 to 23.6 following two years of U.S. accommodation (see chart below).
Leverage ratio (median) of non-U.S. firms following temporary and extended monetary policy easing in the United States
Source: Cecchetti, Mancini-Griffoli and Narita, forthcoming.
Why is the U.S. spillover so enormous? As we emphasized in an earlier post, the dollar's position in the global economy is special. Not only are substantial quantities of dollar securities and loans held abroad, but many EME borrowers raise funds in U.S. dollars. Indeed, the parallel Global Dollar system that operates outside the United States is probably larger than the liabilities of banks operating within the United States. The dollar also continues to dominate currency, trade and broader financial transactions. We suspect that it is this Global Dollar system that magnifies the impact of changes in Federal Reserve policy on the behavior of intermediaries around the world.
This all leaves us wondering if AE policymakers—especially those in Washington--shouldn’t be more attentive to the possibility of spillovers and resulting spillbacks. As we wrote some time ago, the existence of the Global Dollar financial system implies that financial stability depends on the stability of dollar funding. This, in turn, means that the Federal Reserve has an obligation that other central banks do not have: namely, to prevent a collapse of dollar intermediation globally. In the end, this is very clearly in the U.S. interest because the spillbacks from global financial instability will almost surely be large.