A Global Shift from Equity to Debt?

The McKinsey Global Institute has an intriguing report out on \”The emerging equity gap.\” The starting point is that listed equities are 28% of the $200 trillion or so in global financial assets in 2010, but are on track to drop to 22% of global assets by 2020.

This change isn\’t because stock market values are expected to melt down! Instead, it\’s mainly because growth in the world economy is happening in places like China and India and other emerging market economies where stock markets are not well-established. Households in those countries are much more likely to put their money in bank accounts, rather than in stock market funds. Businesses in those countries get their financing through debt markets: banks, bonds, and other loans. 

What economic issues arise if stock markets don\’t expand with the economic growth in emerging markets? The McKinsey report explains:

\”Expansion of equity markets has provided an important source of funding for companies; it has offered an exit option for venture funders who are so important to innovation; it ushered in a new era of corporate ownership and governance, as families and founders transferred control of companies to a diverse set of shareholders; and it has spurred greater competition within industry sectors and fostered faster entry and exit of firms through M&A and spin-offs. In most countries, equity investments have offered investors higher returns on savings over the long term than bonds or deposits, helping them to accumulate wealth and fund retirement. Reducing this enabler of dynamic performance will have implications for economic performance and global rebalancing. …

\”GDP growth rates could be slowed somewhat by a reduction in the relative role of equity funding and a rise in debt financing. Equities provide not only long-term funding, but also an important means of absorbing risk and dispersing it across many investors. During economic downturns, high levels of debt in the economy—in households, or in the corporate or government sectors—create a higher risk of bankruptcy. By contrast, companies that are financed with higher levels of equity have less risk of financial distress than those financed mainly with debt. The procyclical dynamic of high leverage exacerbates the depth of recessions, forcing more companies to cut back employment to meet debt payments and leaving more firms in danger of bankruptcy. In addition, over-reliance on debt financing may help fuel asset bubbles. When a downturn does occur, more diversified financial systems can withstand the strain better and can resume growth more rapidly because their companies are less indebted and have alternative means of raising financing. …

Today, policy makers and economists continue to debate the relative merits of equity financing versus bank financing and there are certainly ample examples of countries that have sustained strong growth with limited equity markets: South Korea during its fastest growth phase, Germany, and recently China, for example. Current academic thinking suggests that the optimal financial market structure for a country depends on its stage of economic and industrial development: as economies advance, firms need larger and more robust equity markets to facilitate innovation and supply large amounts of capital for new industries. Empirical evidence suggests that if legal protections for shareholders are strong, financial systems that include robust capital markets—in addition to bank financing—promote faster economic growth than purely bank-based ones.

The broad outlines of a policy response to this issue are clear enough: emerging-market economies can start taking steps to develop their equity markets, and the financial sector can start figuring out how to make it  easier for American and European investors to buy such equities. Both changes are likely.

Historically, as economies grow, they place a greater emphasis on stock markets: \”Over the past century, there has been a clear pattern: with few exceptions, as countries have grown richer, investors have become more willing to put some money at risk in equities to achieve higher rates of return. We have seen this pattern not only in the United States and Europe, but more recently in Singapore,South Korea, and Hong Kong. However, other factors must also be in place for equity markets to thrive: rules and regulations that protect minority investors, transparency by listed companies, sufficient liquidity in the stock market, the
presence of institutional investors, and easy access to markets by retail investors.\”

If American investors as a group want to own a larger quantity of stocks over time, they will need to turn to stocks in emerging market economies. McKinsey explains: \”In the United States and several other developed countries, investor demand for equities will most likely continue to exceed what companies will need because
many companies in these economies generate sufficient profits to finance investment needs. Indeed, US companies at the end of 2010 had more than $1.4 trillion in cash, and over the past decade nonfinancial corporations have been buying back shares, rather than issuing new ones.\”

Globalization isn\’t just about trade in goods and services. It\’s about financial flows and allocations of risks and returns across international borders as well. IMF data from its Coordinated Portfolio Investment Survey shows that international portfolio investment (that is, cross-border positions in debt and equity securities) rose from $6 trillion in 1997 to about $40 trillion in 2010. Bigger changes are coming.

Dangers of Low Interest Rates: The Future of Banking #1

Thorstein Beck has edited an e-book for Vox on \”The Future of Banking.\” It consists of 12 short and highly readable essays by expert economists, based on their academic research. The book is packed full of interesting and relevant analysis. This is the first of three posts on a few of the ideas that jumped out at me. The topics of the three posts are:

1) The dangers of persistently low interest rates
2) The misguidedness of a financial transactions tax
3) The rise of global banks in emerging markets 

The Federal Reserve and central banks all around the world dropped interest rates to rock-bottom levels. This step made good sense in the depths of the financial crisis from 2007 into 2009. But now it\’s late 2011, and the policy of super-low interest rates continues on with no end in sight. Such a policy isn\’t risk free.

One issue is raised by Steven Ongena and José-Luis Peydró in their essay: \”Loose monetary policy and excessive credit and liquidity risk-taking by banks.\” 

\”Recent theoretical work has modelled how changes in short-term interest rates may affect credit and liquidity risk-taking by financial intermediaries. Banks may take more risk in their lending when monetary policy is expansive and, especially when afflicted by agency problems, banks’ risk-taking can turn excessive. …

 Our results in Jiménez et al (2011) suggest that, fully accounting for the credit-demand, firm, and bank balance-sheet channels, monetary policy affects the composition of credit supply. A lower monetary-policy rate spurs bank risk-taking. Suggestive of excessive risk-taking are their findings that risk-taking occurs especially at banks with less capital at stake, ie, those afflicted by agency problems, and that credit risk-taking is combined with vigorous liquidity risk-taking (increase in long-term lending to high credit risk borrowers) even when controlling for a long-term interest rate.\”

A similar point is made by the IMF in its Global Financial Stability report last June

Low interest rates in advanced economies are promoting pockets of re-leveraging by lowering the “all-in” cost of debt capital for corporate borrowers. This is encouraging investors to use financial leverage to generate sufficiently attractive returns on equity. Although credit spreads are still higher than before the crisis, ultra-low short-term interest rates mean that the cost of debt is now lower, both for floating-rate and fixed-rate debt. This lower cost of borrowing renders debt servicing ratios more favorable, even at higher debt loads, thereby enabling companies to operate with more financial leverage …

As leveraged loan prices recover (after the deep discounts of 2008–2009) and yields fall, investors are increasingly turning to financial engineering to achieve double-digit returns. Both new and refinanced private equity transactions suggest that related corporate balance sheets are quickly approaching pre-crisis leverage multiples. Though the aggregate amount of financial leverage provided remains far less than before the crisis, high-yield corporate bond and leveraged loan investors have recently been borrowing at higher earnings multiples, not much below 2007 levels.

Notwithstanding recent market jitters, the “search for yield” is also spurring flows into emerging markets, notably corporate debt markets. These inflows, although volatile, are often magnifying already ample domestic liquidity. These conditions, if they continue, risk stretching valuations and raising worries that some countries could be re-leveraging too quickly. Flows into mutual funds for emerging market debt have been strong (behind only high-yield and commodities funds as a percent of total outstanding amounts). Even record amounts of EM corporate bond issuance cannot keep up with demand, and investor due diligence is waning.

Much of the discussion about the ultra-low interest rates seems to be based on an assumption that the only danger is a re-emergence of inflation, and as long as inflation is comfortably around the corner, then the low interest rate policy can persist indefinitely. But if the low-interest rate policy is promoting excessive leverage, tricky financial engineering, and a waning of due diligence in other assets, this set of risks also needs to be taken into account.

I would also add that when central banks use a combination of low interest rates and the \”quantitative easing\” policies where they purchase large quantities of government and private-sector debt, the central bank is setting up a situation where if or when interest rates rise, the central bank will face enormous losses on the low-interest rate financial assets they are now holding. 

The "Chermany" Problem of Unsustainable Exchange Rates

Martin Wolf coined the term \”Chermany\” in one of his Financial Times columns in March 2010. China and Germany have been running the largest trade surpluses in the world for the last few years. Moreover, one of the reasons they both have such large trade surpluses is that the exchange rate of their respective currencies is set at a low enough level vis-a-vis their main trading partners to assure a situation of strong exports and weaker imports. Germany\’s huge trade surpluses are part of the reason that the euro-zone is flailing. Could China\’s huge trade surpluses at some point be part of a broader crisis in the U.S. dollar-denominated world market for trade?

Start with some facts about Chermany\’s trade surpluses, using graphs generated from the World Bank\’s World Development Indicators database. The first graph shows their current account trade surpluses since 1980 expressed as a share of GDP: China in blue, Germany in yellow. The second graphs shows their trade surpluses in U.S. dollars. Notice in particular that the huge trade surpluses for Chermany are a relatively recent phenomenon. China ran only smallish trade surpluses or outright trade deficits up to the early 2000s. Germany ran trade deficits through most of the 1990s. In recent years, China\’s trade surpluses are larger in absolute dollars, but Germany\’s surpluses are larger when measured as a share of GDP.

Those who have trade surpluses, like China and Germany, wear them as a badge of economic virtue. Those with trade deficits, like the United States, like to complain about those trade surpluses as a sign of unfairness, and wear our own trade deficits as a hairshirt of economic shame. In my view, the balance of trade is the most widely misunderstood basic economic statistic.

The economic analysis of trade surpluses starts by pointing out that a trade surplus isn\’t at all the same thing as healthy economic growth. Economic growth is about better-educated and more-experienced workers, using steadily increasing amounts of capital investment, in a market-oriented environment where innovation and productivity are rewarded. Sometimes that is accompanied by trade surpluses; sometimes not.China had rapid growth for several decades before its trade surpluses erupted. Germany has been a high-income country for a long time without running trade surpluses of nearly this magnitude. Japan has been running trade surpluses for decades, with a stagnant economy over the last 20 years. The U.S. economy ran trade deficits almost every year since the 1980, but has had solid economic growth and reasonably low unemployment rates during much of that time.

Instead, think of trade imbalances as creating mirror images. A country like China can only have huge trade surpluses if another country, in this case the United States, has correspondingly large trade deficits. China\’s trade surplus means that it earns U.S. dollars with its exports, doesn\’t use all of those U.S. dollars to purchase imports, and ends up investing those dollars in U.S. Treasury bonds and other financial investments. China\’s trade surpluses and enormous holdings of U.S. dollar assets are the mirror image of U.S. trade deficits and the growing indebtedness of the U.S. economy.

For the European Union as a whole, its exports and imports are fairly close to balance. Thus, if any country like Germany is running huge trade surpluses, it must be balanced out by other EU countries running large trade deficits. Germany\’s trade surpluses mean that it was earning euros selling to other countries within the EU, not using all of those euros to buy from the rest of the EU, and ending up investing the extra euros in debt issued by other EU countries. In short, Germany\’s trade surpluses and build-up of financial holdings are the necessary flip side of the high levels of borrowing by Greece, Italy, Spain, Portugal, and Ireland.

Joshua Aizenman and Rajeswari Sengupta explored the parallels between Germany and China in an essay in October 2010 called: \”Global Imbalances: Is Germany the New China? A sceptical view.\” They carefully mention a number of differences, and emphasize the role of the U.S. economy in global imbalances as well. But they also point out the fundamental parallel that China runs trade surpluses and uses the funds to finance U.S. borrowing. They write: \”Ironically, Germany seems to play the role of China within the Eurozone, de-facto financing deficits of other members.\”

Of course, when loans are at risk of not being repaid, lenders complain. German officials blames the profligacy of the borrowers in other EU countries. Chinese officials like to warn the U.S. that it needs to rectify its overborrowing. But whenever loans go really bad, it\’s fair to put some of the responsibility on the lender, not just the borrowers.

If a currency isn\’t allowed to fluctuate–like the Chinese yen vs. the U.S. dollar, or like Germany\’s euro vs the euros of its EU trading partners–and if the currency is undervalued when compared with wages and productivity in trading partners, then huge and unsustainable trade imbalances will result. And without enormous changes in economic patterns of wages and productivity, as well as in levels of government borrowing, those huge trade imbalances will eventually lead to financial crisis.

A group of 16 prominent economists and central bank officials calling themselves the \”Committee on International Economic Policy and Reform\” wrote a study on \”Rethinking Central Banking\” that was published by the Brookings Institution in September 2011. They point out that most international trade used to be centered on developed countries with floating exchange rates: the U.S., the countries of Europe, and Japan. A number of smaller economies might seek to stabilize or fix their exchange rate, but in the context of the global macroeconomy, their effect was small. There was a sort of loose consensus that when economies became large enough, their currencies would be allowed to move.

But until very recently, China was not letting its foreign exchange rate move vis-a-vis the U.S. dollar. As the Committee points out: \”While a large part of the world economy has adopted this model,
some fast-growing emerging markets have not. The coexistence of floaters and fixers therefore remains a characteristic of the world economy. … A prominent instance of the uneasy coexistence of floaters and fixers is the tug of war between US monetary policy and exchange rate policy in emerging market “fixers” such as China.\” The Committee emphasizes that the resulting patterns of huge trade surpluses and corresponding deficits lead to spillover effects around the world economy.

The Brookings report doesn\’t discuss the situation of Germany and the euro, but the economic roots of an immovable exchange rate leading to unsustainable imbalances apply even more strongly to Germany\’s situation inside the euro area.

The world economy needs a solution to its Chermany problem: What adjustments should happen when exchange rates are fixed at levels that lead to unsustainably large levels of trade surpluses for some countries and correspondingly large trade deficits for others? Germany\’s problems with the euro and EU trading system are the headlines right now. Unless some policy changes are made, China\’s parallel problems with the U.S. dollar and the world trading system are not too many years away.

Financial Transactions Tax: The Vatican vs. the IMF

In a hedged and roundabout way, the Vatican has endorsed a financial transactions tax. The announcement came in a Note on financial reform from the Pontifical Council for Justice and Peace , which is one branch within the official governing structure of the Catholic Church. The Note advocates a \”world Authority\” and \”global monetary management,\” but also admits: \”However, a long road still needs to be travelled before arriving at the creation of a public Authority with universal jurisdiction.\” When the note gets down to more immediate suggestions, it offers three:

\”On the basis of this sort of ethical approach, it seems advisable to reflect, for example, on: a) taxation measures on financial transactions through fair but modulated rates with charges proportionate to the complexity of the operations, especially those made on the “secondary” market. Such taxation would be very useful in promoting global development and sustainability according to the principles of social justice and solidarity. It could also contribute to the creation of a world reserve fund to support the economies of the countries hit by crisis as well as the recovery of their monetary and financial system; b) forms of recapitalization of banks with public funds making the support conditional on “virtuous” behaviours aimed at developing the “real economy”; c) the definition of the domains of ordinary credit and of Investment Banking. This distinction would allow a more effective management of the “shadow markets” which have no controls and limits.\”

I will sidestep here the second and third points, on what it means to have \”virtuous\” bankers who develop the \”real economy\” and what kind of financial regulation is appropriate for all the institutions in a modern economy. But on the issue of a financial transactions tax, Thornton Matheson of the IMF offers a nice review of the economics of \”Taxing Financial Transactions: Issues and Evidence\” in Working Paper WP/11/54 released last March. Here are a few  highlights (footnotes and citations omitted):

Financial transactions have increased substantially

\”Transaction costs have indeed fallen dramatically across financial markets over the past 35 years due to advances in information technology, deregulation, and product innovation. In the U.S. equity market, commission deregulation (1975) and decimalization (2000) both substantially lowered transactions costs. Bid/ask spreads on the NYSE now average about 0.1 percent, vs. 1.3 percent in the mid-1980s. In the foreign exchange market, bid-ask spreads for major currencies are currently as little as 1–4 basis points, half the level of a decade ago. Spreads in interest rate futures and swaps are also on the order of a few basis points. Development of the interest rate and credit default swap markets has enabled investors to tailor their fixed-income exposure more cheaply than by trading the underlying bonds.\”

\”As economic theory would predict, this steep decline in financial transaction costs has produced an increase in financial transactions relative to real activity. The value of world financial transactions, which was 25 times world GDP in 1995, rose to70 times that value by 2007. The growth of transactions has been concentrated in derivatives markets, which often have much lower transaction costs relative to notional values than spot markets. Growth in interest rate and equity derivatives transactions has far outstripped growth in business investment in North America and Europe, while the ratio of spot transactions to investment has remained fairly steady. As theory would also predict, lower transactions costs have particularly spurred short-term trading. The past decade has witnessed explosive growth in algorithm or computer-driven trading that relies on high-speed transactions. In 2009, algorithm trading accounted for at least 60 percent of U.S. equity trading volume (up from about 30 percent in 2006), and 30–40 percent of European and Japanese equity trading. Algorithm trading also accounts for 10–20 percent of foreign exchange trading volume, 20 percent of U.S. options volume, and 40 percent of U.S. futures volume.\”

 Many countries already have some version of a financial transactions tax at a low level
In the United States, for example: \” The United States’ Securities and Exchange Commission (SEC), its equity market regulator, imposes a 0.17 basis point chargeon stock market transactions to fund its regulatory operations. … New York State levies a tax of up to five cents per share on within-state stock trades with a cap of $350 per trade …\” However, the trend in recent decades is that the level of such taxes has been dropping around the world.

The case for a financial transactions tax is weak

\”The potentially large base of an STT [security transactions tax] promises an opportunity to raise substantial revenue with a low-rate tax. Current estimates of the revenue potential of a low-rate (0.5–1 basis point) multilateral CTT [currency transactions tax] on the four major trading currencies suggest that it could raise about  $20–40 billion annually, or roughly 0.05 percent of world GDP. A one basis point STT on global stocks, bonds and derivatives is estimated to raise approximately 0.4 percent of world GDP.

\”However, financial transactions taxes create many distortions that militate against using an STT to raise revenue. STTs reduce security values and raise the cost of capital for issuers, particularly issuers of frequently traded securities. STTs also reduce trading volume: studies of existing STTs and other transaction costs suggest that the elasticity of trading volume with respect to transactions costs ranges broadly between -0.4 and -2.6, depending on the market studied. Markets with products for which there are more untaxed substitutes, such as derivatives or foreign listings, have higher elasticities. Lower trading volume in turn reduces liquidity and slows price discovery.

\”An STT is also an inefficient instrument for regulating financial markets and preventing bubbles. There is no convincing evidence that STTs lower short-term price volatility, and high transaction costs are likely to increase it. Current economic thought attributes asset bubbles to excessive leverage, not excessive transactions per se. …

\”The short-run incidence of an STT would likely be quite progressive, as securities values fell in response to the tax. Financial activity, particularly short-term trading, would contract, lowering financial sector profits. Financial firms would likely pass the cost of an STT on surviving activity on to clients, which include not only wealthy individuals and corporations but also charities and pension and mutual funds. In the medium term, release of resources from the financial sector could lower the equilibrium return to highly skilled labor. In the long run, the burden of an STT depends on the elasticity of the capital supply: Like the corporate income tax, the higher financing costs imposed by an STT will fall more heavily on labor than on capital owners as the elasticity of the supply of capital increases.\”

This last argument points out that in the long run, if a financial transactions tax makes it more costly to raise capital, then it will lead to a capital stock that is lower than it would otherwise be. As a result, workers in that country who have less capital with which to work will end up bearing the burden of the tax.

If the goal is to discouraging asset bubbles, tax changes to discourage leverage are more appropriate
\”To discourage leverage at the institutional level, a tax on balance sheet debt (net of insured deposits and equity), such as the financial sector contribution (FSC), could be used. The FSC could be tailored to tax systemically important institutions more heavily, since their risks pose a greater danger to the broad economy. Another means of combating leverage at the firm level is reform of the corporate income tax (CIT), which
encourages debt over equity finance due to its disparate treatment of interest and earnings. To discourage debt finance while raising revenue, interest deductibility could be reduced or even eliminated, as in a comprehensive business income tax …\”

If the goal is to raise tax revenue from the financial sector, think VAT or FAT

\”To tax the financial sector, the base of an existing VAT [value-added tax] could be broadened to include fee-based financial services, or an FAT could be introduced.\” A FAT is a “financial activities tax,” which would be levied on the sum of financial institutions profits and wages.

Why Didn\’t Dot-Com Crash Hurt Like Housing Crash Did?

In the late 1990s, the U.S. economy suffered the end of the dot-com bubble, but had only a mild recession lasting for 8 months in 2001. But when the housing bubble popped, the U.S. economy had a brutally deep 18 month recession from December 2007 to June 2009, followed by a Long Slump of a recovery. Why did the bursting of the housing bubble hurt so much more? 

The magnitude of the two event is roughly similar. The value of corporate equities owned by households went from $9 trillion in 1999 to $4.1 trillion in the third quarter of 2002, according to stats in Table B.100 of the Federal Reserves Flow of Funds Accounts in September 2003. The value of household real estate dropped from $22.7 trillion in 2006 to $17.1 trillion by 2009, and since then has fallen to $16.2 trillion by the second quarter of 2011, according to stats in Table B.100 of the latest Flow of Funds Accounts released by the Federal Reserve

The answer is that when the dot-com boom collapsed, the lost value was in stock prices. Those who bought stocks knew in advance that stock prices could rise and fall. The losses for pension funds and retirement accounts were large, but they didn\’t cause widespread household or firm bankruptcies. However, when the housing price bubble burst, the losses were in the form of debts that couldn\’t be paid off. People couldn\’t pay their mortgages. Banks and financial institutions which were holding dicey mortgage-backed securities faced huge losses, and a financial crisis resulted. If the dot-com boom had been financed by enormous waves of household and business borrowing, and that borrowing had been turned into securities widely held by banks, then the bursting of the dot-com boom would have been much more economically destructive.

The key difference here is between equity and debt. The value of equity is contingent on what happens in the stock market, and so can rise or fall. But debt is typically not contingent on how other values change: you borrowed it, you need to pay it on schedule. Otherwise, defaults, foreclosures, bankruptcies, and financial crisis can result. Kenneth Rogoff thinks through many of these issues in the 2011 Martin Feldstein Lecture to the Natural Bureau of Economic Research: \”Sovereign Debt in the Second Great Contraction: Is This Time Different?\”

Rogoff focuses on this difference between non-contingent debt and contingent equity: [E]ven before the onset of the Second Great Contraction, it should have bothered macro-theorists more that such a large fraction of world capital markets consists of non-contingent debt, including public and private bonds, as well as bank credit. It is difficult to pin down global aggregates, but a recent McKinsey study found that at the end of 2008, the equity market accounted for roughly $34 trillion out of $178 trillion in global assets, with government debt, private credit, and banking accounting for the rest. This figure, of course, is exaggerated by the global stock market crash that occurred after the collapse of Lehman Brothers in 2008, but even at the pre-crisis equity level of $54 trillion, equity markets represented less than one third of the total. True, there is an entire zoology of derivative markets that makes some of the debt contingent, but incorporating these would not dramatically change the basic point.\”

As Rogoff points out, there have been proposals by Robert Shiller and others that when governments borrow, they should do so in a more contingent form–for example, perhaps the debt payments could adjust automatically if their GDP growth is faster or slower than expected. But in practice, given how governments can play games with their own economic statistics, such an approach has had limited appeal. In general, the clear promise to repay debt is easier to monitor and to enforce than a payment schedule linked to some other variable. But this widespread use of non-contingent debt, which in turn is subject to a wide array of poorly-understood risks, contributes to making the world economy a fragile place when bad news arises.

How Are Global Investors Allocating their Assets?

The second chapter of the IMF\’s most recent Global Financial Stability Report is about \”Long-Term Investors and their Asset Allocation: Where Are They Now?\” Here are a few of the main themes, with citations and footnotes eliminated throughout:

What are the big trends? 
\”To set the stage, the longer-term developments in global asset allocation show three main trends: (i) a gradual broadening of the distribution of assets across countries, implying a globalization of portfolios with a slowly declining home bias; (ii) a long-term decline in the share of assets held by pension funds and insurance companies in favor of asset management by investment companies; and (iii) the increasing importance of the official sector in global asset allocation through sovereign wealth funds and managers of international reserves.\”

Does the inflow of capital to emerging markets pose danger if there is a sudden stop or reversal?

\”While the trend toward longer-term investment in emerging markets is likely to continue, shocks to
growth prospects or other drivers of private investment could lead to large investment reversals. The
structural trend of investing in emerging market assets accelerated following the crisis, driven mostly by relatively good economic and investment outcomes. Still, the sensitivity analysis in this chapter showed that a negative shock to growth prospects in emerging markets could potentially lead to flows out of emerging market equities and bonds. These flows could reach a scale similar to—or even larger than—the outflows these countries experienced during the financial crisis. … Policymakers should prepare for the possibility of a pullback from their markets in order to mitigate the risk of potentially disruptive liquidity problems, especially if market depth may not be sufficient to avoid large price swings. Emerging market policymakers … should prepare contingency plans to maintain liquidity in asset markets during periods of market turmoil, perhaps using sovereign asset managers as providers of liquidity as other investors exit, as some did during the crisis …

Will countries start taking more risk with foreign exchange reserves?

\”As heightened risk awareness and regulatory initiatives push private investors to hold “safer” assets, sovereign asset managers may take on some of the longer-term risks that private investors now avoid. … However, global foreign exchange reserve holdings (excluding gold) have grown so fast in recent
years that their size for many countries now exceeds that needed for balance of payments and monetary purposes. … Therefore, an increasing share of reserves could be available for potential investment in less liquid and longer-term risk assets. A new IMF estimate puts core reserves needed for balance of payments purposes in emerging market economies at $3.0–$4.4 trillion, leaving $1.0–$2.3 trillion potentially available to be invested beyond the traditional mandate of reserve managers, in a manner more like that of SWFs.\”

What about sovereign wealth funds?

\”Sovereign wealth funds (SWFs) hold some $4.7 trillion in assets … while international foreign exchange reserves amount to $10 trillion. Taken together, the value of assets in SWFs and foreign exchange reserves is equal to about one-fourth of the assets under management of private institutional investors. …\”

No More Original Sin (in International Finance): Jackson Hole III

This is the third of three posts on some of the papers presented at the Jackson Hole conference held in late August by the Kansas City Fed. The first two posts are here and here. All the papers from the conference are posted here.

Back in the 1999 edition of the Jackson Hole conference, Barry Eichengreen and Ricardo Hausmann presented a paper on \”Exchange Rates and Financial Fragility.\”  In that paper they applied the term \”original sin\” in this way:

\”This is a situation in which the domestic currency cannot be used to borrow abroad or to borrow long term, even domestically. In the presence of this incompleteness, financial fragility is unavoidable because all domestic investments will have either a currency mismatch (projects that generate pesos will be financed with dollars) or a maturity mismatch (long-term projects will be financed with short-term loans). … Original sin seems to capture a fact about the world. What causes it is an open question. One hypothesis is that a history of inflation and depreciation renders investors reluctant to invest in domestic-currency assets and to invest long term. In fact, however, original sin appears to apply as well to more than a few emerging markets that do not have a recent history of high inflation. Essentially, all non-OECD countries have virtually no external debt denominated in their own

Original sin was often near the root of international financial crises during the last few decades, because when an emerging market economy had borrowed in another currency, and then its exchange rate fell, the repayment of loans in domestic currency could no longer repay the international debts in the foreign currency. At the most recent Jackson Hole conference, Eswar Prasad points out in \”Role Reversal in Global Finance\” that emerging economies have now responded to wash their hands of \”original sin.\”

Prasad points out that international financial integration is increasing: \”[T]here has been a generalized
increase in de facto financial openness, as measured by the ratio of the sum of gross stocks of external assets and liabilities to GDP. Among advanced economies, the median level of this ratio has more than doubled over the past decade. The increase is large but less spectacular for emerging markets. … China and India were relatively closed in de facto terms in 2000 but have become much more open since then. Other than Brazil and Russia, which experienced minor dips, virtually every major economy—advanced or emerging—has a higher level of assets and liabilities relative to GDP in 2010 compared to 2007, indicating that the financial crisis did not reverse or stop rising global financial integration. Rising gross external positions have important implications for growth, international risk sharing and financial stability. As gross stocks of external assets and liabilities grow in size, currency volatility will have a larger impact on fluctuations in external wealth and on current account balances.\”

However, the form of these international assets and liabilities for emerging markets has dramatically changed. Back in the 1980s, the main international liabilities for these economies was debt incurred in foreign currency. But now, the liabilities for countries in emerging market economies have shifted dramatically. Prasad describes a figure this way: \”Stocks of foreign direct investment (FDI), portfolio equity (PE) and external debt are shown as ratios of total external liabilities (L). The stock of foreign exchange reserves is shown as a ratio to total external assets (A). … The weighted mean is the ratio of the sum of external assets and liabilities for all countries in the group expressed as a ratio of the sum
of nominal GDP for all countries in that group.\”

As the figure shows, there has been a dramatic shift in international liabilities for emerging markets toward foreign direct investment and portfolio equity. On the asset side, there has been a substantial move toward building up foreign exchange reserves, mainly in U.S. dollars. Here\’s Prasad\’s figure showing that build-up.

For emerging economies, the risks of international finance have changed quite substantially. With their huge foreign exchange reserves and their lack of borrowing in foreign currencies, they are much better insulated against shocks to their exchange rates than they were in the 1990s. However, instead of having risks on the liability side, from the risk that they would be unable to repay their borrowing in foreign currency, they now face two new risks.

A first risk is that their enormous foreign exchange holdings will be diminished in value, either because of a rise in inflation in the U.S., Europe and Japan which reduces the real value of the debt, or because of a depreciation of the dollar, euro, yen, and pound relative to the currencies of the emerging market economies. As Prasad writes: \”As the safety of these assets comes into question, the risk on emerging market balance sheets has now shifted mostly to the asset side. These countries may be forced to rethink the notion of advanced economy sovereign assets as being \”safe\” assets, although they are certainly highly liquid.\”

The second risk is that the current inflows of financial capital, in the form of foreign direct investment and portfolio equity, can create problems for domestic markets in emerging countries. Prasad explains: \”For emerging markets, the major risks from capital inflows are now less about balance of payments crises arising from dependence on foreign capital than about capital inflows accentuating domestic policy conundrums. For instance, foreign capital inflows can boost domestic credit expansions, a factor that made some emerging markets vulnerable to the aftershocks of the recent crisis. New risks from capital account opening are related to existing sources of domestic instability–rising inequality in wealth and in opportunities for diversification and sharing risk. Capital inflows and the resulting pressure for currency appreciations also have distributional implications as they affect inflation and adversely affect industrial employment growth. The right solution to a lot of these problems involves financial market development, especially a richer set of financial markets that would improve the ability to absorb capital inflows and manage volatility, broader domestic access to the formal financial system (financial inclusion), and improvements in the quality of domestic institutions and governance.\”

Will Emerging Economies Dominate the World Economy?

Start with the G-7 countries: that is, the United States, Japan, Germany, France, Italy, United Kingdom, and Canada. Now compare them with the largest 7 \”emerging\” economies: the E-7 would beChina, India, Brazil, Russia, Indonesia, Mexico and Turkey. A January 2011 report from pwc offers some projections comparing where these two groups are headed by 2050.

First, compare the total size of the G-7 and the E-7 economies, in 2009. At market exchange rates, the E-7 is about one-third of the G-7 in 2009. In purchasing power parity exchange rates (which help to account for the fact that money can often buy more of certain goods in low-income countries), the E-7 is about two-thirds of the G-7 in 2009. \”In our base case projections, the E7 economies will by 2050 be around 64% larger than the current G7 when measured in dollar terms at market exchange rates (MER), or around twice as large in PPP terms.\”

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This change represents a remarkable shuffling of the economies of the world. To get a sense of the change, compare the rank order of the economies of the world in 2009 and 2050.  In 2009, the U.S. is the world\’s largest economy. By 2050, U.S. economy will be about 2.5 times as large–and is projected to be in third place in absolute size, behind China and  India.  What other countries move up the rankings notably by 2050? Brazil, Mexico, Indonesia, Turkey, Nigeria, and Vietnam. To my 20th century mindset, some of those countries just don\’t seem like global economic heavyweights. Time to start adjusting my mind to the coming realities.

Of course, per capita GDP looks quite a bit different.  China and India have vastly larger populations than the United States. After 40 more years of rapid growth, per capita GDP in China will by 2050 roughly reach the U.S. per capita GDP in 2009. But by that time, U.S. per capita GDP will have more-or-less doubled. On a per capita GDP basis, China won\’t come close to catching any of the G-7 countries even by 2050–in fact, on these projections, China doesn\’t catch up to Mexico in per capita GDP by 2050.

In an earlier post, I discussed China\’s Will China catch up to the U.S. economy? 

Inbound Foreign Direct Investment in the U.S.

The Council of Economic Advisers has a short summary of \”U.S. Inbound Foreign Direct Investment.\” This seems to be defined in the report as \”U.S. affiliates of foreign-domiciled corporations.\” I see a lot of commentary that mentions foreign ownership of U.S. portfolio assets, like U.S. Treasury bonds, but much less on FDI in the United States.

The CEA says: \”The United States continues to receive the most foreign direct investment (FDI) of any country in the world. … U.S. “majority-owned” affiliates of foreign corporations owned $11.7 trillion in U.S.
assets and had $3.5 trillion in annual sales in 2008, according to the most recently available data from the Bureau of Economic Analysis. Their value-added production within the United States was $670 billion in goods and services, which accounted for 5.9 percent of total U.S. private output. These firms employed 5.7 million U.S. workers, accounting for 5.0 percent of employment in the U.S. private workforce. … The U.S. affiliates of multinational companies are typically high-productivity firms that are major private-sector contributors to national efforts to innovate and build.\”

Here\’s a bar graph putting the activities of U.S. affiliates of foreign corporations in the context of the U.S. economy.

Here\’s a figure showing stocks of inbound FDI, where the U.S.  clearly leads the world by a lot. It also shows the Foreign Direct Investment Restrictiveness Index from the OECD. The U.S. isn\’t much above the OECD average on this restrictiveness index, but it\’s interesting to me that it is above the average at all.