Photo: Reuters
Photo: Reuters

Contagion and spillovers in the world of finance

The current global financial system is really a non-system

Investors and observers of global markets would have woken up on Friday, 21 August, to dire headlines, as equity markets fell across the world. And on Black Monday, the headlines were even grimmer.

While the reasons for market and exchange rate volatility are always many and it is impossible to pin it down to a single cause, there is a general pattern that, in the wake of turmoil in the global markets and geopolitical uncertainty, there is a flight to safety. In this case, the trigger appears to be collapsing equity prices in China.

Investors who had put their money into high-yielding investments in emerging economies suddenly begin to worry about the currency risk, or other risks, and stash their savings in dollar securities, both government and blue chip, which are universally seen as safe havens in the storm—as gold was once considered.

Sometimes, volatility is unwittingly induced by policymakers themselves. The most famous—or infamous—recent example of such policy-induced market volatility was the taper tantrum crisis. In May 2013, then US Federal Reserve chairperson Ben Bernanke announced a winding down or tapering of the Fed’s quantitative easing (QE)—the popular term for its large-scale asset purchases by printing money. QE, in its turn, was the principal weapon in a new battery of policy instruments meant to tackle the aftermath of the global financial crisis of 2008—known generally as unconventional monetary policies (UMPs), which also included pushing the short-term policy interest rate close to zero—the zero lower bound (ZLB)—as well as announcing the path of future policy, or forward guidance.

With yields in advanced economies having been flattened since 2008 by the Fed and other central bankers trying to jumpstart their moribund economies, investors and speculators, searching for yield, had invested heavily in emerging markets, including India. With the taper announcement, it appeared there were the first glimmerings of a return to normalcy, with monetary tightening in the offing in the US, and, with that, the prospects of higher interest rates and a stronger dollar.

Investors, who had poured their funds into India and other emerging markets, got spooked and ran for the exits. What followed was a period of bloodletting in global financial markets, especially emerging markets, including India, which saw stock indices crashing and emerging economy currencies, including the rupee, under relentless pressure. The crisis finally eased when a chastened Bernanke announced tapering would proceed more guardedly than his original announcement had suggested.

That there was a strong impact of the Fed’s activities on the emerging economies is not in dispute. A discussion note published by the International Monetary Fund (IMF) in September 2014 and written by a team led by Ratna Sahay, concludes: “Fed’s monetary policy announcements were strongly correlated with movements in asset prices and capital inflows in emerging markets, with the effects being largest during the phase of unconventional monetary policy (post-2008) and when tapering was first discussed (summer of 2013)."

Not surprisingly, economists, central bankers and policymakers in the emerging economies held the Fed responsible for what they saw as its self-serving and irresponsible policy of promoting US economic interests no matter the cost of exported volatility and disarray in the emerging economies.

From the outset, one of the staunchest and sharpest of the critics has been Reserve Bank of India (RBI) governor Raghuram Rajan. In a now famous speech, “Competitive Monetary Easing: Is it yesterday once more?", delivered at the Brookings Institution in Washington DC in April 2014, Rajan did not mince words in ascribing blame to the Fed for engaging in a modern form of competitive currency devaluation, as had disfigured the global economy during the Great Depression of the 1930s.

The difference was that now such an attempt to depreciate one’s national currency was legitimated by advanced economy central bankers as a necessary response to the global financial crisis and conducted, not through traditional tools such as open market operations in foreign exchange markets, but through the new tools of UMPs.

As it happens, Bernanke, by then retired as Fed chief, was in the audience at Rajan’s Brookings talk, and shot back irately during the question and answer session—a very public spat between two central bankers that was reported in the US media. Since then, at most of his speeches abroad, Rajan has returned to the same theme, most recently, and again in a much publicized talk, in London in June.

On that occasion, Rajan developed further the argument that the net effect of spillovers from advanced economy UMPs to emerging economies such as India could well be negative, and that such policies should rightly be seen as a return to competitive devaluation in a new guise.

Such a view has also been echoed, if not spelled out so explicitly, by the Bank for International Settlements, and has received the approbation of Mint. Not surprisingly, advanced economy central bankers, such as the Fed’s current chief Janet Yellen, reject such accusations and assert that they are doing what is in the best interests of their own national economies. Yellen, notably, made her case in a speech at the IMF in July 2014, hot on the heels of Rajan’s speech at Brookings down the road.

Someone with a jaundiced eye might remark Rajan’s and Yellen’s positions dovetail neatly with the exigencies of the particular central bank chairs that they occupy. However, it is not just central bankers, but academic economists, with no official brief to carry, who have been calling out the dangers for emerging economies of loose monetary policy in the advanced economies.

One of the most important of these academic critics is the late Ronald McKinnon, whose last book, The Unloved Dollar Standard: From Bretton Woods to the Rise of China, dealt with this issue. McKinnon presented a synopsis of the book’s ideas at the 2014 Santa Colomba Conference, which I wrote about here for Mint. A distillation of the book’s main arguments is to be found in a paper McKinnon presented in Paris a few months before his tragic death.

Going beyond the recent experience of the taper tantrum, McKinnon has studied the history of US monetary policy since the collapse of the Bretton Woods system in 1971. This is a period in which the dollar has remained the de facto global currency, but without the monetary discipline imposed upon US central bank behaviour by the fixed-exchange parities of the Bretton Woods system. McKinnon meticulously traces a series of damaging shocks emanating out from the US to the rest of the world’s economies, starting with the original 1971 Nixon shock, which took the dollar off gold, culminating in the taper tantrum of 2013.

McKinnon is forthright in his sharp appraisal of US monetary policy during the post-Bretton Woods period. He writes: “Instead of behaving appropriately as the world’s de facto central bank, the US Federal Reserve became a serial bubble blower by inducing flows of volatile ‘hot money’ into economically important peripheral countries—mainly Western Europe and Japan in the 1970s and 1980s, but also in emerging markets in the new millennium."

As McKinnon clearly articulates, this creates a dilemma for emerging economy central banks: “a surge of hot money inflows forces the central bank into a difficult choice between letting its currency appreciate sharply or intervening to buy foreign exchange and losing control of its domestic money supply".

Conversely, when a subsequent shock triggers the flow of hot money back to the US, the dilemma is played in reverse, with emerging economy central banks facing sharp depreciations of their currencies if they do not intervene in foreign exchange markets, and, likewise, a loss of monetary control if they do.

For those of a technical bent, sterilization of foreign exchange operations, which are offsetting open-market operations intended to cancel their effects on money supply, is both costly and never fully effective. Thus, large-scale intervention to attenuate currency fluctuations necessarily has some impact on the monetary base.

Indeed, this is precisely the phenomenon to which Rajan has pointed, and it is no mere academic curiosity. This is exactly the tricky situation in which the RBI and other emerging economy central banks found themselves in May 2013 after Bernanke’s taper announcement.

When faced with a dilemma, there is no right answer. As such, it points to what Nobel economist Robert Mundell has argued right from 1971, that the current global financial system is really a non-system. Rather than the coordination and discipline imposed by the Bretton Woods arrangement, what we have had since its collapse is a law of the jungle in which larger economies, principally the US, have advanced their own interests at the expense of the global public good of world monetary and financial stability, with weaker economies the losers.

With a period of protracted global economic uncertainty, allied with festering geopolitical flash points likely to be in the offing—everything from the faltering Chinese economy to the forthcoming Greek election, amid continuing turmoil in the euro zone and continuing security risks emanating from West Asia—global financial markets may once again be on the cusp of a major bout of destabilizing volatility.

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

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