At the N.Y. Fed: Capital Flows, Policy Dilemmas, and the Future of Global Financial Integration
Bianca De Paoli, Luca Dedola, Linda Goldberg, Arnaud Mehl, John Rogers, and Livio Stracca
N.Y. Fed December 20, 2016
The New York Fed recently hosted the third biannual Global Research Forum on International Macroeconomics and Finance, an event organized in conjunction with the European Central Bank (ECB) and the Federal Reserve Board. Bringing together a diverse group of academics, policymakers, and market participants, the two-day conference (November 17-18) was aimed at promoting discussion of frontier research on empirical and theoretical issues in international finance, banking, and open-economy macroeconomics. Understanding the drivers and implications of international capital flows was a major area of focus, along with the policy challenges posed by global financial integration.
Trade, Financial Integration, and the Cost of Connectedness
Opening the conference, New York Fed President Bill Dudley noted that global trade increased rapidly in the period prior to the financial crisis as the world economy became more developed and interconnected. Moreover, such trade interactions became more multifaceted as supply chains grew more complex, often stretching across many countries. While global growth has slowed since the financial crisis, trade growth has contracted even more. Although international financial flows formerly tracked the pattern of global trade flows closely, financial markets across the globe have become even more highly integrated in recent decades and the forms of integration are always evolving. These linkages raise many important questions about the structure and performance of the international monetary system, the options available to policymakers in both advanced economies and emerging markets for stabilization, and the broader spillover effects of policies and shocks as domestically focused policies influence foreign outcomes.
Financial crises are often associated with boom-bust cycles in commodity prices and capital flows. In the first presentation of the conference, Carmen Reinhart (Harvard Kennedy School of Government) examined how she documented these cyclical patterns in a recent paper entitled “Global Cycles: Capital Flows, Commodities, and Sovereign Defaults, 1815-2015” (with coauthors Vincent Reinhart and Christoph Trebesch). Since 1815, there has been an evident overlap between cycles in capital flows, commodity prices, and sovereign defaults. Reinhart concluded her presentation with a warning: Given recent developments in financial flows and commodity prices, rising default risk might be the next issue to affect the global economy. But conference participants highlighted that the connection between capital flow disruptions and default crises is much larger than the link between developments in commodity markets and default crises.
International Capital Flows
Diving into international financial flows, Stefan Avdjiev (Bank for International Settlements) highlighted several notable shifts, including a change in the composition of global bank activities and the rise of nonbanks and international debt securities. In “The Shifting Drivers of International Capital Flows,” Avdjiev and coauthors Leonardo Gambacorta, Linda Goldberg, and Stefano Schiaffi find evidence that suggests cross-border loan flows have become more sensitive to U.S. monetary policy in the wake of the financial crisis and less responsive to risk factors. International debt securities, as a form of financing, have evolved to have sensitivities to global liquidity similar to those of cross-border lending flows. Discussion of the presentation centered on how to define a shadow interest rate and how much of the paper’s findings might be explained by the low interest rate and unconventional monetary policy context.
What are the channels—bank and nonbank—through which international capital flows in response to shocks? Clearly balance sheets are impacted. In “Monetary Policy and Global Banking,” Falk Bräuning of the Boston Fed and coauthor Victoria Ivashina find that multinational banks respond to monetary policy shocks by adjusting funding and lending levels, both through internal capital markets and external ones. Banks and nonbanks can change their patterns of demand for sovereign and private assets when monetary policy tools are used.
Risk-taking behavior can also change in response to shocks. Arguably, a risk-taking channel of currency appreciation may be at work in cross-border flows to emerging market economies, depending on the financing currencies used and the composition of balance sheets. Boris Hofmann, presenting his paper “Sovereign Yields and the Risk-Taking Channel of Currency Appreciation” (with coauthors Ilhyock Shim and Hyun Shin—all from the Bank for International Settlements), argued that the compression of emerging-market economies’ sovereign yields is due to reduced risk premiums rather than shifts in forward currency premiums. The authors find no empirical association between currency appreciation and sovereign spreads when using trade-weighted effective exchange rates rather than bilateral exchange rates against the U.S. dollar.
Policy Quandaries
Hélène Rey (London Business School) presented a model featuring time-varying macroeconomic risk that arises from the risk-shifting behavior of financial intermediaries. In “Financial Cycles with Heterogeneous Intermediaries,” Rey and coauthor Nuno Coimbra find that, in a low-interest-rate environment, the monetary authority may face a trade-off between monetary stimulus and financial stability.
Since the global financial crisis, there has been renewed interest in understanding what contributes to the proper functioning of the international monetary system. Matteo Maggiori (Harvard University), based on “A Model of the International Monetary System” (with coauthor Emmanuel Farhi), considered whether a system based on multiple reserve currencies would be more or less stable than one with a single “hegemonic” reserve currency. As he showed, a commitment to issuing safe reserve assets is key to the overall stability of the system; a multipolar system is not necessarily more stable than a hegemonic system if this commitment is insufficient.
Galip Kemal Özhan (University of St. Andrews), in his paper “Financial Intermediation, Resource Allocation, and Macroeconomics Interdependence,” finds that shocks propagate to the real economy, influencing resource allocation across tradable and nontradable sectors and contributing to boom-bust cycles. The author argues that asset purchase programs, coupled with liquidity provision, can help improve economic conditions during busts.
Questions of policy effectiveness and instrumentation likewise were central throughout the conference. Galo Nuño of Banco de España argued, based on his paper “Optimal Monetary Policy in a Heterogeneous Monetary Union” (with coauthor Carlos Thomas), for the possibility of using inflation to redistribute wealth in a heterogeneous monetary union model using innovative mathematical tools. In “Monetary and Financial Policies in Emerging Markets,” Gianluca Benigno of the London School of Economics (with coauthors Kosuke Aoki and Nobuhiro Kiyotaki) examined the scope for monetary and financial policies in an economy in which deposits are denominated in domestic currency while foreign debt is denominated in foreign currency. In another example of how theoretical models inform policy questions, Pedro Gete (Georgetown University) analyzed how different types of financial frictions inform international lender-of-last-resort capacity in “A Quantitative Model of International Lending of Last Resort.”
Whither Global Financial Integration?
The event concluded with a policy panel on “The Future of Global Financial Integration” moderated by Federal Reserve Board Director Steven Kamin. The panel—which featured ECB Board member Peter Praet, Bank of Canada Deputy Governor Sylvain Leduc, Cornell University Professor Eswar Prasad, and Deutsche Bank Chief Economist Peter Hooper—explored a range of views on whether global financial integration is continuing to progress, moving sideways, or retreating. The panelists offered insight on the implications of their views for global financial stability, economic growth, and access to finance across sectors and regions.
Bianca De Paoli is a senior economist in the Federal Reserve Bank of New York’s Research and Statistics Group.
Luca Dedola is an adviser in the Directorate General Research of the European Central Bank and a research affiliate with the Centre for Economic Policy Research.
Linda Goldberg is a senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
Arnaud Mehl is a principal economist in the Directorate General International, European Central Bank.
John Rogers is a senior adviser in the Division of International Finance at the Board of Governors of the Federal Reserve System.
Livio Stracca is head of International Policy Analysis at the European Central Bank.
