DESPITE the internationalization of financial markets and the growing links between national financial systems, for the most part, economic policy is still conducted at the national level. The creation of global capital markets can therefore make it more difficult for countries to assess, diagnose, and prescribe macroeconomic policies. The platitude that markets will swiftly and brutally punish deviations from prudent policies is well worn but not the full truth. In fact, markets often seem quite capricious from the domestic point of view: sometimes they seem to tolerate imprudent behavior for a remarkable stretch of time, and sometimes they react preemptively; usually, their reactions are governed by a wide array of domestic and international considerations.
The financial aspects of national economic analysis—and IMF health checks of member countries, known as surveillance—therefore need to be more sophisticated in three distinct but related areas.
• Monitoring of the interactions between financial markets and macroeconomic conditions. A sophisticated analysis of high-frequency data from financial markets—that is, parsing the data for signals about market expectations, volatility, risk, default probabilities, arbitrage potential, and the like—can be an important diagnostic tool for macroeconomic advice and policy prescription.
• Analysis of the financial sector itself—that is, its robustness or fragility, whether it will cushion or amplify shocks, and how it is regulated and supervised.
• Assessment of both underlying vulnerabilities in the economy and potential events that could interact with these vulnerabilities to trigger a financial crisis.
The analytics we would want to bring to bear on these issues span a broad range, with no simple “cookbook” guide. But at the conceptual level, there are useful general characterizations: what we refer to as the balance sheet approach and the prevention of financial and capital account crises. These terms recognize that open economies must be viewed as sets of globally interlinked balance sheets that are vulnerable to exposure and counterparty risk.
Policymakers and country authorities should therefore be concerned about the potential for problems to spill over to other sectors, the economy as a whole, and the regional or global economy. This is what former IMF Managing Director Michel Camdessus (1987-2000) was alluding to when, with extraordinary insight, he referred to the Mexican crisis of the mid-1990s as the “first crisis of the 21st century.” That crisis and those that followed in Asia, Latin America, and central and eastern Europe over the ensuing decade have forced us to rethink the relationship between finance and macroeconomics. This article explores the centrality of finance to macroeconomic analysis by focusing on three rather practical cases: the first centered on balance sheet vulnerabilities, the second on the interaction of domestic monetary policy with global financial markets, and the third on a national stabilization program in a highly integrated capital market.
Vulnerabilities and triggers
Much of the work on balance sheet exposures now makes a conceptual distinction between underlying vulnerabilities, or exposures, on the one hand, and trigger events—that is, events that, combined with underlying vulnerabilities, could trigger a crisis—on the other.
Take the hypothetical country Xanadu, which can borrow abroad only in foreign currency (see table). The official position shows liquid foreign assets (40) that cover 80 percent of total short-term liabilities (50), which is less than ideal but not dire. (It would, of course, be useful to know something about current account flows and the maturity structure of medium-and long-term positions.) The banking system has a seemingly balanced foreign exchange position. And the nonbank corporate sector has sizable foreign exchange exposure.
How would we figure out Xanadu’s underlying vulnerability? It is clear from the numbers that the banks are hedging their currency exposure with the nonbank corporate sector, which, in addition, has sizable currency exposure to foreigners. Much depends, therefore, on the characteristics of the nonbank corporations with foreign exchange liabilities. If they are exporters with foreign currency revenues, they may well be naturally hedged. Alternatively, they may have solid derivative hedges (assuming that there are foreign counterparties prepared to have some exposure to the domestic currency), and the return on their investments may be such that the foreign borrowing is profitable even after hedging costs. The data are consistent with these benign scenarios. If we consider the trigger of a sudden contagion-induced repricing of risk with an immediate, large exchange rate effect, the worst that will happen is a banking sector liquidity problem that the country could address through its reserves or an IMF program.
But the data are also consistent with a more problematic situation: commercial banks borrowing money short term abroad to lend longer term in foreign exchange to domestic companies, such as domestic real estate developers, without any natural or derivative hedge. In this case, any shock to the exchange rate could cripple the nonbank corporate sector and, by effectively eliminating the banking system’s currency hedge, the banking system too. In effect, the exchange rate shock transforms the banks’ foreign exchange risk into credit risk.
Sectoral balance sheets may appear relatively safe, but could mask hidden dangers.
|General government (to foreigners)||40||10||30|
|Medium- and long-term||0||8||-8|
|Short-term (to foreigners)||3||28||-25|
|Medium- and long-term||34||9||25|
|Domestic foreign currency position||30||0||30|
|Short-term (to foreigners)||1||20||-19|
|Medium- and long-term||0||55||-55|
|Domestic foreign currency position||0||30||-30|
|Short-term (to foreigners)||44||50||-6|
|Medium- and long-term (to foreigners)||4||42||-38|
|Medium- and long-term (domestic)||30||30||0|
In situations like these, some knowledge of the characteristics of the corporations with foreign exchange exposure is critical to assessing the vulnerability. The necessary non-bank corporate data may be hard to come by, and the importance of obtaining them will depend, to some extent, on the domestic institutional structure. Certainly, if the country has an exchange rate with little flexibility (and a government, therefore, perceived to be essentially underwriting foreign exchange risk), there will be moral hazard problems and a substantial likelihood of unhedged foreign currency borrowing. There may thus be a presumption of an underlying vulnerability that needs to be uncovered and discussed. But if the country has a history of wide exchange rate movements, corporations that are forced to bear the brunt of these fluctuations, appropriate regulatory incentives for banks, and efficient bankruptcy mechanisms, the likelihood of risky currency exposures is much lower.
As noted above, there are two separate aspects to assessing the potential for a crisis: the underlying vulnerability and the trigger event. In this example, the trigger is a sudden repricing of risk. This may be highly unlikely (a “tail event”), perhaps because the country has excellent policies with a strong current account position and the region in general is sound. Although it is always worthwhile being aware of the underlying vulnerability, whether it is worth focusing on the potential crisis is a judgment call and depends on the probability of the trigger event and the likely severity of a crisis. Of course, an analysis of vulnerabilities and triggers is often made more difficult by imponderables (for example, the duration of a shock) and insufficient data (for example, on corporate balance sheets). As a matter of policy, moreover, analysis of severely detrimental hypothetical events—“thinking the unthinkable”—always needs to be handled with great discretion.
Nothing here implies that all vulnerabilities should be avoided: if a country needs external financing to realize its growth potential and can borrow very little in its own currency, it will almost certainly have some foreign exchange exposure. Banks that do their normal job of maturity transformation will almost certainly have some interest rate exposure. These vulnerabilities are a normal aspect of business and cannot be eliminated without an excessive increase in intermediation costs. At best, they will be borne by the institutions most robust to the risks entailed.
Tough monetary policy choices
In our second case, an open capital account and integrated financial markets make it even more complicated to conduct monetary policy, especially if the country (like many of the emerging market economies) is experiencing significant underlying real (structural) changes.
Conventional wisdom favors an inflation-targeting regime with a floating exchange rate, which does, indeed, have advantages: the monetary authorities are relieved of the formal responsibility for growth and unemployment, and there is no implicit exchange rate guarantee that encourages unwise foreign currency exposure. As a result, a “fear-of-floating” trap (when so much foreign exchange exposure has been built up under a fixed or quasi-fixed exchange rate that the authorities resist a depreciation) is less likely. An alternative is a hard peg with a fully credible exit strategy—for example, a peg to the euro at a rate that is credible as the eventual entry rate to the euro area. Some countries, however, have continued to opt for ad hoc intervention strategies guided by a combination of factors, including the competing demands of mercantilist trading objectives and a desire to control the money supply.
The difficulty with any of these strategies is that they say nothing about a huge potential problem: international portfolio adjustments can generate enormous shifts in the capital account that can undermine domestic objectives. It is useful to start with two generalizations:
• Changes in interest rates for domestic stabilization purposes are unlikely to be accompanied instantaneously by changes in risk premiums or exchange rate expectations; thus, they may induce huge actual or incipient portfolio adjustments that could swamp domestic stabilization policy.
• The behavior of risk premiums and exchange rate expectations often appears entirely capricious and unpredictable to the domestic monetary authorities.
These points have implications for policy in many countries—see, for example, “The Tosovsky Dilemma” (F&D, September 2002), which analyzed the problems of monetary policy in the more advanced transition countries of central and eastern Europe. But the case of Iceland in 2003-06 provides a poignant illustration of how the interaction between domestic cyclical developments, monetary policy, and global financial markets can exert a destabilizing effect (see box).
As it turned out, a perfectly sensible increase in domestic interest rates—in the context of liquid global capital markets and a voracious hunt for higher yields—elicited massive capital inflows, a dramatic expansion of bank credit, and an eventual capital account reversal. Even when these relationships are well understood in theory, it is difficult to conduct policies when substantial capital flows raise the possibility of large exchange rate and/or interest rate fluctuations. Fortunately, in Iceland, hedging behavior and generally sound balance sheets made the financial system relatively robust to the shocks.
But the problem for monetary policy is acute in cases like this. Suppose the domestic monetary authority wants to cool an overheated economy—that is, raise interest rates consistent with its inflation-targeting regime. It decides, on the basis of a slew of empirical evidence, that interest rates should be raised by 1 percentage point. But for a flexible exchange rate regime, the contractionary effect of this interest rate shift will depend critically on the exchange rate change it elicits—a 1 percentage point increase coupled with no exchange rate change is massively different from one coupled with a 10 percent appreciation. Moreover, to the extent that the portfolio effects will depend on decisions made in New York, London, or Frankfurt and will be based on spreads on, and exposure to, other currencies, there is no way for the domestic monetary authorities to predict the outcome. A country’s best course of action in these difficult circumstances—although this may not seem like much of a policy prescription—is to go slowly, watch the markets continuously, and be fully aware of underlying vulnerabilities.
Iceland weathers market jitters
In Iceland beginning in 2003, large investment projects, based on an abundance of cheap energy, were tightening local labor markets, contributing to robust overall demand, and widening the current account deficit—although they were expected to generate growth and some currency appreciation. As monetary policy was tightened in response to the strong demand, interest rates rose and there was a significant trade-weighted appreciation of the Icelandic krona.
Icelandic banks exploited the interest rate differential by borrowing in euros, hedging their exposure, and lending in kronur. The combination of a rising currency, high interest rates, and good credit quality—the sovereign was rated AAA—also attracted foreign portfolio investors, who financed their long positions in krona debt by borrowing in lower-yielding currencies—the “carry trades.” (This was exacerbated by financial innovation—that is, the offshore issuance of króna-denominated eurobonds (“glacier bonds”) by foreign institutions that swapped their krona liabilities for the euro liabilities of Icelandic banks.) Yield differentials including exchange rate adjustments were about 9¼ percent in 2003, 7½ percent in 2004, and 18 percent in 2005.
With commercial banks flush with funds and looking for new ways to lend, policy changes encouraged banks in mid-2004 to start competing directly with the government-run Housing Finance Fund for first mortgages. Banks were able to offer more favorable terms than this housing fund, and their lending to households grew by 98 percent in 2004, fueling the rapid rise in housing prices and the associated withdrawal of housing equity through refinancings. This, in turn, underpinned the surge in domestic consumption, further widening the current account deficit.
Iceland’s financial changes were enormous. External debt surged. Private sector borrowing tripled between 2003 and 2006, with huge increases in both household and corporate debt. Real estate and equity prices appreciated rapidly, with stock market valuations rising almost fourfold between mid-2003 and end-2005. Eventually, all this led to significant market jitters and pressures on the currency and equity-prices in the spring and summer of 2006.
Finally, let’s look at stabilization programs for countries with globally integrated financial markets. In monitoring these programs—which detail the policies countries are implementing or will implement to achieve macroeconomic stabilization—both the IMF and many national authorities often use some variant of a financial programming framework based on the balance sheet of the central bank or the consolidated banking system. The central bank balance sheet looks like this:
|Net foreign assets (NFA)||Base money (BM)|
|Net domestic assets (NDA)|
|Private credit (PC)|
|Net government credit (NGC)|
|Other items net (OIN)|
The accounting identity from the central bank balance sheet is a useful organizing device and consistency test. Net domestic assets are defined as the sum of private credit, government credit, and other items net; base money is defined as the sum of net domestic assets and net foreign assets. The financial programming framework would normally set some floor for net foreign assets and some ceiling for net domestic assets.
In the old days of fixed exchange rates and more or less closed capital accounts, this organizational device was wonderfully simple. We had some idea of the stock of NFA that was consistent with prudent policy and a plausible projection of current account flows. Therefore, given an estimate of the demand for money from our econometric exercises, we could also get a reasonable fix on the appropriate rate of credit expansion and its allocation between the government and the private sector, consistent with achieving reasonable rates of growth and inflation. Of course, we might get the money demand equation wrong—that is, over- or underestimate the rate of money supply expansion consistent with our income and inflation targets—but we would probably be able to pick this up when reviewing the program. If, for example, inflation and income were more or less on track, but credit expansion was significantly more rapid than targeted and the NFA position was stronger than envisaged, this would be prima facie evidence of stronger-than-estimated money demand, and we could adjust the NDA ceiling.
In a situation of floating exchange rates with inflation targeting, interpretation of the balance sheet identity is slightly more complex—even with limited capital market integration. If, for example, the authorities use foreign exchange intervention to limit a (supposedly temporary) incipient depreciation (for fear of its inflationary effects), the NFA floor will limit the scope of intervention, and the NDA ceiling will limit the scope for sterilizing its monetary effects. It might certainly make sense to intervene to resist short-lived downward pressure on the currency and to sterilize this intervention. But if the depreciation forces prove durable, there is a point at which the intervention-sterilization strategy needs to be questioned—the simple financial programming identity constraints can help to define that point and bring the appropriate questions to the fore.
But consider how much more complicated the financial programming framework is with full integration with global capital markets. NFA and/or exchange rates become highly unpredictable, with fluctuations dominated by capital market conditions. If NFA are more or less fixed by the prudent objective of covering short-term external foreign exchange liabilities, then a jump in the risk premium on the currency would result in some combination of a depreciated currency and higher interest rates. This could influence the liquidity position of the financial system if it is engaged in foreign currency maturity transformation, the solvency of the financial system if it has foreign currency loans to unhedged domestic borrowers, the sustainability of the government’s debt position, and the sustainability of the debt positions of the non-bank corporate sector and the household sector. All or some of these effects could elicit a call on the central bank—for foreign exchange or additional credit expansion—and undermine the integrity of monetary policy.
By the time any of these effects shows up in a central bank’s accounts, the damage will be done and the situation may be irretrievable. Thus, we move from the simple world of a closed capital account to the complex world of vulnerabilities and trigger events—that is, into the world of the first case given above. In this world, data needs are more exacting, and only imaginative, forward-looking modes of analysis will suffice. This is a world in which we need to determine vulnerabilities and assess the likelihood of crises by analyzing scenarios with potential trigger events of uncertain probability.
In sum …
The three cases described in this article are complex and suggest that there are no easy answers. But they do point the way to better macroeconomic analysis in the highly unpredictable world of integrated global financial systems and capital markets. This is a world in which macroeconomists need to think preemptively about possible future events. They must therefore be aware of vulnerabilities and events capable of triggering crises; of the global context within which domestic monetary policy has to operate; and of how shifts in risk assessments, interest rates, exchange rates, and growth will influence the financial position of the government, the banks, and other parts of the private sector.
Leslie Lipschitz is Director of the IMF Institute.