## _070313a ## Source details **Canonical URL:** [_070313a](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2013/_070313a.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2013/_070313a.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2013/_070313a.pdf.json) --- ### Spillovers from U.S. and European Policy Uncertainty - Measurement and identification - Policy-uncertainty index constructed from news-based indicators, number of expiring tax provisions, and dispersion in economists’ forecasts; U.S. series back to 1985, Europe back to 1997. - “Uncertainty shocks” defined when Hodrick-Prescott detrended index > mean + 1.65 standard deviations. - Controls included for general uncertainty (VXO/VIX), business confidence, and economic activity to address omitted variables and reverse causality. - Channels - Trade channel: reduced U.S./EU import demand lowers trade flows to other regions. - Financial channel: higher global risk aversion causing financial corrections and capital outflows from emerging markets. - Real effects concentrated in investment and durables consumption. - Estimated impacts (quarterly horizon, up to eight quarters) - U.S. policy-uncertainty shocks temporarily reduce GDP growth in other regions by up to ½ percentage point in the year of the shock. - European policy-uncertainty shocks reduce GDP growth in other regions by a smaller amount; U.S. shocks are slightly bigger and more persistent than European shocks. - Baseline comparison: an increase in U.S. policy uncertainty of the size between 2006 and 2011 would reduce U.S. output by up to 3.2 percent and private investment by 16 percent (Baker, Bloom, and Davis (2012) VAR result). - Dynamics and recovery - Negative impacts last between two to four quarters; when uncertainty subsides, a “growth dividend” of between ¼ and ½ percentage point in the year after can occur, varying by region. - Interpretation caveat - True spillover magnitude likely between baseline (no additional controls) and estimates that include controls that may net out mediated channels. ### Stabilizing Policies and Scenario Simulations (U.S. and Euro-area) - Event-study evidence of euro-area stabilizing measures - Long-term government bond yields in Greece, Ireland, Italy, Portugal and Spain fell by 192 basis points. - Equity prices in those periphery countries rose by 14.7 percent, on average. - Long-term government bond yields rose in safe havens by 43 basis points on average. - Averting the U.S. fiscal cliff: fiscal and market assumptions - Structural primary fiscal balance ratio of the general government estimated to increase by 2.8 percentage points less in 2013 if fiscal cliff averted; 88 percent accounted for by revenue measures. - 79 percent of this change estimated to persist over the medium term. - Assumed equity price increases from averting the fiscal cliff: - United States: 10.0 percent - Other advanced economies: 5.0 percent - Emerging economies with open capital accounts: 7.5 percent - Emerging economies with closed capital accounts: 2.5 percent - Simulated output and commodity price effects (2013) - Euro-area stabilizing measures: - Euro-area output +5.3 percent in 2013. - Other advanced economies: +0.8 to +3.9 percent. - Emerging economies: +1.5 to +4.5 percent. - Aggregated world output gain: 3.0 percent. - Commodity price increases: Energy +31.0 percent; Nonenergy +20.1 percent. - Country-specific 2013 gains: Greece +9.8 percent; Ireland +3.6 percent; Italy +6.6 percent; Portugal +7.3 percent; Spain +8.2 percent. - United States stabilizing measures: - U.S. output +3.6 percent in 2013. - Other advanced economies: +0.9 to +1.8 percent. - Emerging economies: +0.8 to +2.1 percent. - Aggregated world output gain: 1.7 percent. - Commodity price increases: Energy +14.7 percent; Nonenergy +8.0 percent. - Transmission: euro-area gains via financial linkages; U.S. gains via trade linkages. ### Market-Based Indicators of Systemic Risks and Unconventional Monetary Policy (UMP) Effects - Funding stress and volatility - LIBOR-OIS spreads peaked at Lehman, normalized later; euro-area tensions raised stress in 2011–early 2012; LTROs and OMT lowered stress. - Equity VIX: peaked at Lehman, near-record lows later due partly to QE; spikes during Europe tensions; MOVE index rose with UST repricing after Bernanke’s May 22 statement. - Swaptions volatility: peaked at Lehman, declined but not to pre-crisis levels; Japan’s swaptions volatility rose after BOJ QE and JGB market disruptions. - G-SIB distress and CoVaR - Joint probability of distress (JPoD) driven by poor growth outlook and euro-area developments; JPoDs tapered since 2009 but spiked in late 2011 and early 2013 driven by European SIBs. - Total CoVaR of 27 G-SIBs declined markedly since October 2008 peak, increased in H2 2011; increases largely driven by European SIBs. - Event-study methodology for UMP spillovers (2003–2013, two-day window) - Sample: 23 advanced economies and 11 emerging markets. - Monetary surprises measured by changes in 1-year-ahead futures on short-term interest rates on policy announcement days. - Two-stage approach: shocks among four major markets (Germany, Japan, UK, US), then feed into country systems. - Key empirical findings - Early AE asset purchase announcements bolstered asset prices globally by decreasing tail risk; effects diminish as markets normalize. - U.S. QE1 had larger spillovers to EMs (bond yields and currency) than QE2. - QE1 associated with short-term improvement in global financial conditions; QE2 did not. - Example: U.S. purchase of MBS and Agency bonds during LSAP1 lowered long-term bond rates in Brazil and Mexico by over 9 basis points. - Role of forward guidance - Conditional forward guidance lowered expectations of future short-term rates and boosted asset prices domestically and internationally. - Recent faster-than-expected unwinding expectations repriced risks: rising domestic rates, weakening EM equities, and higher FX volatility. - Event-study pooled normalized impacts by systemic AE - United States: large loosening of global financial conditions; depreciated dollar moderately versus other AE currencies. - Euro area: reduced periphery long-term yields, raised yields slightly in other AEs; increased equity prices worldwide; appreciated euro moderately versus EM currencies. - Japan: moderate global long-term yield reductions; enormous domestic equity price increases; yen depreciation produced “enormous improvement in external price competitiveness.” - United Kingdom: moderate worldwide reductions in money market and some long-term yields; pound depreciated slightly. ### Scenario Simulations of UMP with G-35 model (first year output effects) - U.S. unconventional easing - U.S. output growth +3.4 percentage points during the first year. - Other AEs: +0.4 to +1.3 percentage points. - Emerging economies with open capital accounts: +1.2 to +2.2 percentage points. - Emerging economies with closed capital accounts: +1.1 to +1.4 percentage points. - World output growth +1.7 percentage points. - Commodity price effects: Energy +20.6 percent; Nonenergy +13.7 percent. - U.S. current account balance ratio decreases by 0.3 percentage points in the first year. - Euro-area unconventional easing - Euro-area output growth +1.7 percentage points during the first year. - Other AEs: +0.3 to +1.4 percentage points. - Emerging economies with open capital accounts: +0.5 to +1.5 percentage points. - Emerging economies with closed capital accounts: +0.8 to +1.0 percentage points. - World output growth +1.1 percentage points. - Commodity price effects: Energy +13.1 percent; Nonenergy +8.6 percent. - Japan and United Kingdom - Japan: small negative output spillovers in simulations; commodity price increases small (Energy +1.8 percent; Nonenergy +0.2 percent). - United Kingdom: small positive spillovers; commodity prices: Energy +4.2 percent; Nonenergy +2.4 percent. ### Current Account and Capital Flow Simulations (selected EM effects) - Simulated current account balance deteriorations (in response to U.S. unconventional easing) reported for select countries: - Saudi Arabia increase of 2.2 percentage points. - Norway increase of 0.7 percentage points. - Korea deterioration by 0.4 percentage points. - Turkey deterioration by 0.2 percentage points. - Poland and Thailand deterioration by 0.1 percentage points. - Aggregate deterioration example: 0.7 percentage points (contextual figure). ### GIMF Stylized Scenarios for QE Spillovers to Emerging Economies - Four scenarios: 1. Sharp reductions in private consumption and investment in AEs with ZIF for two years (no policy response). 2. AEs pursue QE. 3. Adds capital inflows to EMs that reduce corporate risk premiums. 4. EMs prevent currency appreciation and capital inflows when AEs implement QE. - Key stylized findings - Scenario 2 (QE) improves G3 demand and exchange rates, aiding EM export recovery. - Scenario 3 (capital inflows reducing risk premia) raises EM investment and GDP above baseline; monetary tightening in EMs can re-anchor inflation and cause appreciation that slows exports. - Scenario 4 (preventing appreciation) produces GDP recovery similar to Scenario 2 but with larger declines in domestic demand as other tools offset currency pressures. ### Global capital flows in the QE era — empirical facts and regressions - Trends - Capital flows to EMs recovered sharply in 2009–10, reached high pre-crisis levels by mid-2011, fell with euro tensions, resumed after late 2012. - Composition shifted toward fixed income as local debt markets expanded; gross portfolio outflows from QE countries declined recently in the euro area and United States. - Push–pull regression (panel FE, quarterly 1990–2012Q3, 42 EMs; dependent = log gross capital flows) - Push variables: US 10 year yield, Log VIX. - Pull variables: Recipient GDP Growth (t-1), log average nominal GDP, Recipient inflation (t-1). - Baseline regression high-level coefficients and statistics (selected) - US 10 year yield: (Full sample) -0.0146*** (0.0038). - Log VIX: (Full sample) -0.0472*** (0.0102). - Recipients' GDP Growth (t-1): 0.000231*** (0.0001). - Recipients' log average nominal GDP: 0.0168** (0.0066). - Observations (Full sample): 2,892; R-squared: 0.11; Number of IFS: 42. - Post-crisis changes: relationship between interest rates and flows weakened and turned positive in the post-crisis sample; effect of VIX on flows increased post-crisis. - Magnitudes - A one standard deviation decline in VIX (30 percent change) associated with an increase in capital flows of just over 2 percent. - Robustness and alternative measures - Fed securities holdings (stock of OMO / Fed balance sheet size) positively significant post-crisis and highly correlated with VIX (correlation -0.9); inclusion dampens VIX effect. - Using fed funds rate (FFR) or shadow FFR alters coefficients; money market differentials and OMO stock specifications reported with exact coefficient values in tables. ### Latent factor and EPFR analyses on drivers of flows - Bayesian dynamic latent factor model and EPFR weekly fund-flow event studies: - Global factor explains up to one-half of recent flows to key EMs; bond flows primarily driven by global push factors. - EPFR dataset: weekly portfolio (net) flows from >14,000 equity funds and >7,000 bond funds, USD 8 trillion under management; EPFR captures 5–20 percent of market capitalization but closely tracks BOP portfolio flows. - For EMEs, world common shocks predominant source of bond-flow volatility during crisis; in AE bond markets world component about half as important. ### Country case highlights (selected) - Brazil - Foreign capital inflows: 5.3 and 7.4 percent of GDP in 2009 and 2010, respectively; net inflows US$104 billion (4.4 percent of GDP) in 2012. - Reserves ~US$370 billion (16 percent of 2012 GDP). - Policy responses: IOF tax re-imposed 2009 and adjusted, macroprudential measures, FX intervention; CFMs helped reduce portfolio inflows; persistent exchange rate effects unclear. - Canada - Net portfolio inflows averaged 5 percent of GDP per year over 2009–12 vs net outflows of 2 percent per year in 2000–07. - Household debt-to-income ratio reached 165 percent in 2012. - No specific capital flow controls; macroprudential measures adopted to moderate credit and housing imbalances. - Korea - QE1 (2008.11–2010.3) associated with monthly net capital inflows averaging 1.5 billion dollars; QE2 and QE3 saw weaker or negative net flows. - QE1: Net Bonds 1.7; Net Equity 1.8; Net Other -0.5; Net FDI -1.1; Net Derivatives -0.4; Net Capital flow 1.5 (monthly averages, billions of dollars). - Reserve coverage increased to 186 percent in 2012 from 111 percent in 2008. - Macroprudential measures and supervisory checks reduced short-term external debt vulnerabilities. - New Zealand - Net financial account inflows NZD 6.3 billion in 2012 (3 percent of GDP), driven by nonresident holdings of government debt. - Authorities committed to floating exchange rate; limited intervention. - Russia - Net outflows USD57bn (2.7 percent of GDP) in 2012; capital flows not correlated with U.S. QE episodes to date. - South Africa - Net capital flows US$4.4 billion (4.7 percent of GDP) in 2012Q4; nonresident participation in domestic bond market near 40 percent in 2012. - Recent deterioration: sovereign downgrades, Q4 net FDI drop (-2.2 percent of GDP), rand depreciation, wider CDS spreads. - Authorities kept monetary policy loose and monitored CFMs; no changes to CFMs announced given concern about chasing off flows. ### Cross-border banking landscape — deleveraging and Asian expansion - Aggregate cross-border claims - Peaked at almost $28 trillion in 2008 Q1; fell to just over $23 trillion in 2012 Q4 (decline > $4 trillion). - European banks reduced foreign claims by almost $6 trillion from 2008 Q1 to 2012 Q4. - Asian banks - Increased foreign claims as euro-area banks pulled back; Asia was the only region where expansion outpaced euro-area cutbacks. - 2012 regional syndicated loans in Asia: US$352 billion; regional project finance: US$88 billion. - Asian project finance >40 percent of global project finance in 2012. - New vulnerabilities - Asian banks’ increased U.S. dollar exposures funded via local funding and FX swaps create maturity/funding mismatches. - Net foreign asset positions and reliance on wholesale funding vary across regions and banks; Japanese banks hold large net foreign asset positions (~$1.6 trillion). - Bank deleveraging drivers - Wholesale funding runs, higher wholesale funding costs, Basel III liquidity rules, and regulatory ring-fencing. ### Multi-country sovereign stress scenarios (35-country G-35 model) - Sovereign stress shocks and persistence - Example shocks for sovereign stress: short-term government bond yield +100 basis points; long-term yield +200 basis points; equity price -10 percent; phased out with autoregressive coefficient 0.95. - Two policy-response configurations: absence vs allowing conventional monetary policy and automatic fiscal stabilizers. - Simulated aggregate world output growth losses (first-year / near-term) - Sovereign stress in the United States: world output growth loss of 5.0 percentage points. - U.S. output growth falls by 8.6 percentage points in the first year. - Other AEs: -3.3 to -5.8 percentage points. - Emerging economies with open capital accounts: -3.5 to -6.8 percentage points. - Emerging economies with closed capital accounts: -2.8 to -3.4 percentage points. - Commodity-price declines: Energy -46.7 percent; Nonenergy -26.2 percent. - Sovereign stress in Japan: world output growth loss of 1.7 percentage points. - Japan: -6.4 percentage points; other AEs: -0.9 to -1.6 percentage points. - Commodity-price declines: Energy -17.1 percent; Nonenergy -10.0 percent. - Policy relevance - Conventional monetary responses and automatic fiscal stabilizers materially affect spillover magnitudes; procyclical fiscal consolidation amplifies output losses. ### Rebalancing and Combined Rebalancing Scenario (FSGM: G20MOD / EUROMOD) - Combined scenario components (US, UK, euro area, Japan, China) - U.S.: near-term fiscal expansion, medium-term consolidation, temporary rise in private savings. - U.K.: near-term unconventional monetary easing, temporary public investment stimulus, immigration and education reforms. - Euro area: reduced sovereign/corporate risk premia from reduced fragmentation and banking union progress; product/labor reforms in core and periphery; temporary easier fiscal stance in periphery. - Japan: fiscal consolidation and structural reforms (only incremental components beyond baseline included). - China: fiscal reforms reducing public and private savings, financial sector reforms removing distortions, structural reforms raising productivity, reductions in risk premium to avoid crisis beyond WEO horizon. - Growth contributions to world (percentage point deviation from baseline, selected years) - 2013: World 0.18 - 2019: World 0.66 - 2020: World 0.75 - Total (2013–2023 sum): World 3.1; USA 0.3; Euro Area 0.7; China 1.0; Japan 0.2; United Kingdom 0.1; Rest of the World 0.8 - Dynamics - Near-term GDP rises modestly in reforming countries (except China where short-medium term growth falls by about ½ to 1 percentage point relative to baseline). - Longer term: reforms raise growth more substantially; China’s reforms raise long-run growth about 2 percentage points above baseline and reduce current account surplus roughly 3 percent of GDP in medium term and about 4 percentage points after ten years. ### Japan (Abenomics) scenarios and spillovers - Abenomics three pillars: aggressive monetary easing (BoJ QQME), flexible fiscal policy, structural reforms. - Model-based evaluation (G20MOD / EUROMOD / GIMF illustrative) - Successful deployment of all three pillars: positive but small short-term spillovers (~0–0.1 percent of GDP in recipient G20 economies), larger medium-term gains after structural reforms raise Japan’s potential. - BoJ QQME intended to double monetary base by ~¥130 trillion (~27 percent of GDP) over two years; market analysts estimate ~¥40 trillion (US$400 billion) of private assets might be displaced under QQME (highly uncertain). - Institutional investors (GPIF, insurers) holdings and solvency considerations limit large immediate outflows: GPIF foreign holdings shift to maximum permissible range implies <¥5 trillion of outflows based on end-2012 assets. - Channels and magnitudes - Yen depreciation has been ~20 percent in real effective terms and equity prices rose >50 percent in recent episodes. - Corporate and institutional portfolio rebalancing could generate capital outflows but magnitude likely gradual due to hedging, regulation, and risk weights. - Large potential spillovers remain possible if yen depreciation is sustained and global interest rates normalize. ### Accelerated U.S. monetary normalization scenarios (sequenced shocks and outcomes) - Scenario designs (starting 2014Q3 increases) - Scenario 1 (endogenous conventional tightening): nominal policy rate +100 basis points phased over two years; then lowered over 2½ years. Long-term rate increases via intertemporal substitution. - Scenario 2 (exogenous conventional tightening): nominal policy rate +100 basis points phased over one year; lowered over 3½ years. Unconventional tightening represented by +100 basis points in long-term market rates phased over one year and lowered over 3½ years. - All results linearly scalable (halved under 50 basis point rises). - ZIF constraint through 2015Q2 for Czech Republic, Denmark, Euro Area, Japan, Switzerland, United Kingdom. - Simulation outcomes (2015 highlights) - Endogenous normalization (2015) - United States: simulated output gain 2.3 percent. - Canada: 1.0 percent; Mexico: 0.9 percent; Ireland: 0.1 percent. - Other advanced economies: simulated output losses range 0.9 to 1.3 percent. - Emerging economies with open capital accounts: losses 0.6 to 1.6 percent. - Emerging economies with closed capital accounts: losses 0.2 to 1.1 percent. - World output gain: 0.0 percent. - Energy price decline: 1.7 percent; Nonenergy: 1.4 percent. - U.S. current account balance ratio reduction: 1.2 percentage points; U.S. nominal effective dollar appreciation: 2.6 percent; U.S. real effective dollar appreciation: 3.2 percent. - Largest current account increases elsewhere: Mexico +2.7 percentage points; Canada +2.3 percentage points; Ireland +1.5 percentage points; Korea +1.0 percentage points; Thailand +1.0 percentage points. - Exogenous normalization (2015) - United States: simulated output loss 4.0 percent (1.0 percentage points due to conventional measures). - Other advanced economies: losses 1.4 to 2.2 percent. - Emerging economies with open capital accounts: losses 1.5 to 2.5 percent. - Emerging economies with closed capital accounts: losses 1.1 to 1.4 percent. - World output loss: 2.2 percent. - Energy commodity price decline: 23.2 percent; Nonenergy decline: 15.3 percent. - U.S. current account balance ratio improvement: 0.6 percentage points; U.S. real effective dollar appreciation: 0.8 percent. - Largest current account reductions elsewhere: Saudi Arabia -2.3 percentage points; Canada -1.2 percentage points; Norway -1.0 percentage points; Mexico -0.7 percentage points; Russia -0.7 percentage points. - GIMF variants emphasize role of risk-premium responses and trade vs financial channel dominance: when risk premia rise abroad, spillovers outside North America become more negative. *Italic: Source — 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND (content unit _070313a).* ### 1. Spillovers from Policy Uncertainty in the United States and Europe __________________________________6 ### 1. Spillovers from Policy Uncertainty in the United States and Europe ### Overview and motivation - Common view: high uncertainty in general, and high policy uncertainty more specifically, has held back global investment and output growth in the past two years. - Much of the policy uncertainty emanated from the United States (debt ceiling dispute in August 2011; negotiations about the “fiscal cliff” in December 2012) and from Europe (Greek Prime Minister George Papandreou’s call for a referendum on the Greek bailout plan and his subsequent resignation in November 2011; negotiations about a pan-European crisis response through much of 2012). - Policymakers and business leaders worldwide worry about implications of such uncertainty in the United States and Europe—the world’s two largest economies. - Prepared by Abdul Abiad, Nadia Lepeshko, and Katherine Pan. ### Channels of spillovers - Trade channel: increased policy uncertainty can adversely affect economic activity and import demand in the United States and Europe, reducing trade flows to other regions. - Financial channel: policy uncertainty could raise global risk aversion, causing sharp corrections in financial markets and capital outflows from emerging markets. - Real effects are expected to be concentrated in investment (and consumption of durables) because these components depend heavily on future expectations and are costly or impossible to reverse. ### Measurement of policy uncertainty - Uses measures constructed by Baker, Bloom, and Davis (2012), combining: - News-based indicators of policy-related economic uncertainty (relative frequency of newspaper articles that refer to “uncertainty,” “economy,” and “policy”). - The number of expiring tax provisions. - The dispersion in economists’ forecasts about government spending and inflation levels. - These components are combined to construct monthly indices of policy uncertainty: - United States: indices dating back to 1985. - Europe: indices dating back to 1997. - Definition used for “uncertainty shocks”: periods during which detrended uncertainty is more than 1.65 standard deviations above its mean. ### Identification and estimation challenges - Reverse causality: must ensure that policy uncertainty in the United States and Europe is not driven by developments in economic activity elsewhere. Spikes in policy uncertainty are often associated with domestic economic and political events or global geopolitical events that can be treated as exogenous to most individual countries. Robustness checks exclude events that could generate reverse causality (example cited: Russia and Long-Term Capital Management crises in 1998). - Omitted factors: must avoid attributing to policy uncertainty the effects of other co-moving variables (general economic uncertainty, shifts in consumer or business confidence, fluctuations in economic activity). The analysis addresses this by controlling for such variables because uncertainty tends to rise and confidence tends to fall during downturns. ### Key analytical insights from the material provided - Historical evidence: sharp increases in U.S. and European policy uncertainty in the past have temporarily lowered investment and output in other regions to varying degrees. - Potential upside: a marked decrease in policy uncertainty in the United States and Europe in the near term could help boost global investment and output. - Theoretical grounding: builds on Keynes (1936) and formalizations (Bernanke (1983); Bloom (2009))—temporary increases in uncertainty induce firms and households to delay investment and durable consumption, with recovery and possible overshooting once uncertainty dissipates. *Source: 2013 Spillover Report—Analytical Underpinnings and Other Background, Section 1: “Spillovers from Policy Uncertainty in the United States and Europe”* ### 10. To address the first concern, Baker, Bloom, and Davis (2012) offer several “proof of ### 10. To address the first concern, Baker, Bloom, and Davis (2012) offer several “proof of concept” tests ### Validation of the policy-uncertainty measure - Constructed a news-based measure for financial uncertainty by searching for news articles containing “uncertainty,” “economy,” and “stock market” and show that the constructed index tracks the Chicago Board Options Exchange Market Volatility Index (VIX) closely. - The policy-uncertainty measure is highly correlated with other policy-uncertainty measures (Fernández-Villaverde and others (2011); Born and Pfeifer (2011)) that use very different methodologies. - Results are robust to excluding the tax-expiration and forecast-dispersion components and relying solely on the news-based measure of policy uncertainty. ### Evolution of U.S. and European policy uncertainty - Policy uncertainty spikes in response to identifiable economic, financial, and geopolitical events. - Uncertainty shocks are defined as periods during which the Hodrick-Prescott detrended value of the index exceeds its mean by more than 1.65 standard deviations (following Carrière-Swallow and Céspedes (2011)). - Notable U.S. policy-uncertainty spikes cited: - Gulf War start in August 1990 - September 11, 2001, terrorist attacks - Run-up to the Iraq War in early 2003 - Recession-induced monetary and fiscal easing in January 2008 - Bankruptcy of Lehman Brothers in September 2008 - Debt ceiling dispute in August 2011 - Fiscal cliff negotiations in late 2012 - Notable European policy-uncertainty spikes cited: - September 11 attacks - Early 2003 signing of the EU Treaty of Accession - Greek bailout request in May 2010 - Call in November 2011 for a Greek referendum on bailout terms - Discussions on EU-wide policy response to the expanding crisis in 2012 - Policy uncertainty tends to move with general economic uncertainty (financial uncertainty measured by implied stock market volatilities; economic uncertainty measured by dispersion of economists’ GDP forecasts) and with confidence indicators, but divergences exist: - General economic uncertainty retreated from its 2008 highs, whereas policy uncertainty remained high and even increased. - Correlation with confidence indicators is evident but imperfect, allowing their inclusion as control variables. ### Methodology for estimating spillovers - Dependent variables: real GDP growth and real investment growth (both measured in log differences). - Regressors include lagged dependent variables and contemporaneous and lagged values of a dummy equal to 1 during policy-uncertainty shocks and 0 otherwise. - Lags allow for delayed spillover effects. - Full set of country dummies included; time dummies excluded because policy uncertainty is a global common variable. - Regression estimated in changes (growth rates) because of nonstationarity in log levels; cumulated responses recover level responses. Standard errors of impulse responses calculated using the delta method. - Alternative specifications (level of policy uncertainty or hybrid interacting 0–1 dummy with level) produce similar results. - Excluding policy uncertainty shocks originating outside the United States or Europe does not materially change findings. ### Sample and estimation scope - Estimated by region using seasonally adjusted quarterly data for 43 economies from 1990 to 2012; sample is highly unbalanced due to data availability. - No spillover estimates for Middle East and North Africa because of lack of quarterly GDP data. - Quarterly data for sub-Saharan Africa include only Botswana and South Africa; estimates reflect spillovers on the region’s open middle-income economies. - Effects of U.S. and European policy-uncertainty shocks are estimated separately because of high correlation; estimated impacts should be considered an upper bound. ### Quantitative impacts on real GDP - Estimated impact horizon: eight quarters; 90 percent confidence bands reported. - U.S. policy-uncertainty shocks temporarily reduce GDP growth in other regions by up to ½ percentage point in the year of the shock. - European policy-uncertainty shocks temporarily reduce GDP growth in other regions by a smaller amount. - General pattern: - U.S. policy-uncertainty shocks tend to be slightly bigger and more persistent than European shocks. - U.S. shocks affect Europe more than vice versa. - Baker, Bloom, and Davis (2012) vector-autoregression result for comparison: - An increase in U.S. policy uncertainty of the size that occurred between 2006 and 2011 would reduce U.S. output by up to 3.2 percent, and private investment by 16 percent. ### Quantitative impacts on investment and consumption - Policy uncertainty reduces real investment across most regions; sub-Saharan Africa is an exception in the reported estimates. - Biggest investment decline observed for the Commonwealth of Independent States (CIS). - If only South Africa is used in the SSA sample (Botswana excluded), the decline in investment is larger. - Figures show peak effects on real GDP, real consumption, and real investment; peak effects reported both with no additional controls and with various controls. ### Controls, identification challenges, and interpretation scenarios - Potential confounding variables addressed by controlling for general uncertainty, declining confidence, or declines in U.S. or European economic activity. - Two interpretive possibilities when adding control variables: - The control variable affects both policy uncertainty and other countries’ activity; adding it improves the estimate of spillover effects. - The control variable is a mediating channel (policy uncertainty → control variable → foreign activity); adding it nets out mediated effects and may underestimate overall spillovers. - Most likely scenario: both interpretations hold; policy uncertainty affects and is affected by control variables (general uncertainty, confidence, and activity). - Consequently, the true magnitude of spillovers is likely between: - The baseline effects reported in Figures 1.3 and 1.5 (no additional controls), and - The effects estimated when including control variables (Figure 1.6). ### Robustness to additional controls - Adding controls such as financial-uncertainty shocks measured by the VXO, business confidence, S&P 500 shocks, import growth in the United States or Europe, or domestic economic uncertainty generally leaves the magnitude of policy-uncertainty effects broadly similar to the baseline in most regions. - Note on VXO: The Chicago Board Options Exchange S&P 100 Volatility Index (VXO) is similar to the VIX but has longer time coverage (back to 1985). *Source: 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND, INTERNATIONAL MONETARY FUND* ### 7. Commonwealth of ### 7. Commonwealth of ### Spillovers from U.S. and European Policy Uncertainty: effects and persistence - Sharp spikes in U.S. policy uncertainty—of the magnitude observed during the U.S. debt ceiling dispute in August 2011—can temporarily lower investment and output in other regions. - Spillover effects from European policy uncertainty tend to be slightly smaller and less persistent and tend to have smaller effects on U.S. activity than vice versa. - The negative impact of a temporary spike in policy uncertainty lasts from between two to four quarters. - When policy uncertainty subsides, output and investment in other regions begin to recover; the dissipation of uncertainty is associated with a “growth dividend”: - lower U.S. and European policy uncertainty on growth is associated with a “growth dividend” of between ¼ and ½ percentage point in the year after policy uncertainty has subsided, with the impact varying by region. - Transmission channels and controls: - Controlling for import growth in the United States or Europe reduces the estimated effect of policy uncertainty in many regions, implying a trade-based transmission channel in those cases. - For the Commonwealth of Independent States (CIS), effects of European policy uncertainty are diminished when controlling for imports, but effects of U.S. policy uncertainty are not—suggesting European policy uncertainty affects the CIS primarily via trade channels, while U.S. policy uncertainty is transmitted through other channels. - Raising domestic forecast dispersion (a measure of increased uncertainty in other economies) reduces spillovers in some regions but not others; in most regions, policy uncertainty appears to reduce investment through its effect on higher domestic uncertainty. ### Scenario framework and model structure for stabilizing policies - Analysis based on scenarios simulated with a structural macroeconometric model of the world economy disaggregated into thirty five national economies. - Each economy represented by interconnected real, external, monetary, fiscal, and financial sectors. - Spillovers transmitted across economies via trade, financial, and commodity price linkages; financial linkages are both direct (cross-border debt and equity portfolio holdings) and indirect (international comovement in asset risk premia). - Phasing of inferred global financial market responses: - Euro-area risk premium shocks are phased out according to a first order autoregressive process with coefficient 0.85. - U.S. equity risk premium shocks are phased out according to a first order autoregressive process with coefficient 0.75. - Assumption: conventional monetary policy reactions are constrained by the zero lower bound on the nominal policy interest rate through 2015Q2 in the Czech Republic, Denmark, the euro area, Japan, Saudi Arabia, Switzerland, the United Kingdom, and the United States. ### Estimated global financial market responses to euro-area stabilizing measures (event study) - Long-term government bond yields in Greece, Ireland, Italy, Portugal and Spain fell by 192 basis points. - Equity prices in those periphery countries rose by 14.7 percent, on average. - Long-term government bond yields rose in safe havens (Australia, Canada, Denmark, Germany, New Zealand, the United Kingdom, and the United States) by 43 basis points on average. ### Stabilizing policies to avert the U.S. fiscal cliff: fiscal and market assumptions - Averting the fiscal cliff implies substantially less fiscal consolidation: - The structural primary fiscal balance ratio of the general government is estimated to increase by 2.8 percentage points less in 2013 due to averting the fiscal cliff, of which 88 percent is accounted for by revenue measures. - 79 percent of this change in the structural primary fiscal balance ratio is estimated to persist over the medium term. - Assumed equity price increases from averting the fiscal cliff (in the absence of conventional monetary reactions and automatic fiscal stabilizers worldwide): - United States: 10.0 percent - Other advanced economies: 5.0 percent - Emerging economies with open capital accounts: 7.5 percent - Emerging economies with closed capital accounts: 2.5 percent ### Simulated output and commodity price effects of stabilizing policies - Euro-area stabilizing measures (simulated impacts for 2013 and beyond): - Raise output in the euro area by 5.3 percent in 2013. - Raise output by 0.8 to 3.9 percent in other advanced economies. - Raise output by 1.5 to 4.5 percent in emerging economies. - Within the euro area, largest simulated 2013 output gains: - Greece: 9.8 percent - Ireland: 3.6 percent - Italy: 6.6 percent - Portugal: 7.3 percent - Spain: 8.2 percent - Aggregated world output gain from euro-area stabilizing policies: 3.0 percent. - Associated increases in commodity prices for the euro-area scenario: - Energy commodities: 31.0 percent - Nonenergy commodities: 20.1 percent - United States stabilizing measures (simulated impacts for 2013 and beyond): - Raise output in the United States by 3.6 percent in 2013. - Raise output by 0.9 to 1.8 percent in other advanced economies. - Raise output by 0.8 to 2.1 percent in emerging economies. - Aggregated world output gain from U.S. stabilizing policies: 1.7 percent. - Associated increases in commodity prices for the U.S. scenario: - Energy commodities: 14.7 percent - Nonenergy commodities: 8.0 percent - Transmission emphasis: - Euro-area gains transmitted primarily via financial linkages. - U.S. gains transmitted via trade linkages to a greater degree. ### Conclusion and policy implications - Significant spillover effects exist from policy uncertainty and from stabilizing policy measures in the United States and Europe to other regions. - Elevated policy uncertainty in the United States and Europe since the Great Recession may have contributed to serial disappointments and downward revisions in investment and output growth during that period. - A near-term reduction in policy uncertainty in the United States and Europe could provide an added fillip to global investment and output. *Source: IMF staff calculations and scenario analysis contained in the 2013 Spillover Report—Analytical Underpinnings and Other Background.* ### 3. Market-Based Indicators of Systemic Risks ### 3. Market-Based Indicators of Systemic Risks ### Funding stress - LIBOR-OIS spreads gauge market perceptions of credit risk in funding markets; higher spreads = higher risk. - Funding stress peaked during the Lehman bankruptcy and remained elevated during the subsequent months. - At present, spreads have returned to their pre-crisis levels as markets have normalized. - Worries over the European debt crisis increased stress levels in 2011-early 2012; stress declined following the LTROs and the OMT announcement. - Japanese funding markets were much more stable even at the height of the crisis. ### Equity and bond market volatility - Equity VIX indexes are based on the relative price of put options on equity indexes; they are "fear indexes." - Global equity stress levels peaked during the Lehman crisis and have subsequently come down to near-record lows, in part suppressed by the QE. - Volatility spiked again during periods of tensions in Europe. - The Japanese implied volatility index (VXJ) has moved higher following the change of government and the announcement of the QE program by the Bank of Japan, and bouts of volatility in the JGB market. - Investor worries about Fed tapering of QE (notably after the Chairman Bernanke’s statement on May 22) led to a spike in U.S. Treasury yields and implied volatility in the UST market (reflected in the MOVE index). ### Swap market volatility - Swaptions are options to enter into interest rate swaps with a specified strike rate and maturity. - Ten year maturity swaptions on ten year swaps are a benchmark for stress in the fixed income market; swaptions prices typically spike in times of market stress. - Swaptions volatility peaked during the Lehman crisis and declined subsequently but has not returned to pre-crisis levels due to lingering uncertainty regarding monetary policy and the effects of QE policies. - In Japan, swaptions volatility has risen significantly following the BOJ QE announcement due to disruptions in the JGB market. - The JGB market experienced several weeks of poor liquidity and fluctuating prices; frequent shutdowns of the JGB futures market due to tripping of volatility triggers exacerbated swaptions volatility. ### Currency volatility - In FX markets, risk reversals (difference in price between call and put options) gauge risk aversion. - The dollar and the yen are viewed as safe havens; the euro and high yielding emerging market currencies tend to suffer in crises. - At the height of the financial crisis, euro-dollar risk reversals spiked as investors favored euro puts (dollar calls). - At present, risk-reversals are close to pre-crisis levels. ### Likelihood of distress and value-at-risk of G-SIBs - Market-implied probability of all G-SIBs falling in distress (joint probability of distress, JPoDs) has been driven by poor growth outlook and developments in the euro area since Lehman in September 2008. - JPoDs generally tapered off since 2009 but spiked during the last quarter of 2011 due to concerns about the Greek bailout plan and spillovers; the spike was largely driven by European banks. - Events early 2013 (Italian elections, Cyprus bail-out) led to another increase in the JPoD of the European SIBs. - The JPoD of the U.S. SIBs has continued to steadily decline, reflecting improvement in perceived resilience of their balance sheets. - Total value-at-risk of the system comprising 27 G-SIBs, conditional on one failure on average (total CoVaR), has declined markedly since its peak in October 2008 following Lehman’s collapse, in line with balance sheet repair and recapitalization efforts, though total CoVaR increased in the second half of 2011. - Increases in overall CoVaRs have largely been driven by European SIBs; U.S. and Asian SIBs remain relatively flat since 2011. - CoVaR methodology references: Adrian and Brunnermeier (2008); 30-day Moving Average CoVaRs of G-SIBs by Region. ### Impact of Unconventional Monetary Policies on International Asset Prices — Overview - Unconventional policies often launched when market conditions are unsettled; these are periods when international financial spillovers tend to be largest. - Larger impacts from unconventional monetary policies are likely to operate through forward guidance and managing market expectations of future policies. - The study focuses on the impact on foreign asset prices of conventional and unconventional monetary policies in systemic advanced economies. ### Methodology and scope of event-study analysis - Event studies estimate impact on two-daily returns over the 10-year period 2003-2013 for three asset markets (bond, equity, foreign exchange) across 23 advanced economies (AEs) and 11 emerging markets (EMs). - Advanced markets in the analysis: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, adopted Germany, Greece, Ireland, Italy, Japan, Korea, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States. - Emerging markets: Brazil, China, India, Indonesia, Malaysia, Mexico, Poland, Russia, South Africa, Thailand, and Turkey. - Monetary surprises measured by changes in 1-year-ahead futures on short-term interest rates on policy announcement days. - Two-stage approach to account for international and domestic linkages: - First, examine transmission of shocks between bond yields, equity prices, exchange rates and money market rates within and between four major markets (Germany, Japan, the United Kingdom, and the United States) simultaneously. - Second, use corresponding underlying shocks as inputs into a similar system for each other small open economy in turn (e.g., Brazil model accounts for shocks from the four major markets and interactions across Brazilian asset prices). - A two-day window is used to study events because of differing time zones. - Fit of these equations: R-squares ranging between 75 and 90 percent. ### Key empirical findings on spillovers - Early asset purchase announcements in AEs bolstered asset prices globally by decreasing tail risk of a severe recession; effects diminished once markets normalized. - U.S. QE evidence: significant spillover impact on bond yields and currency in EMs, with larger estimated effects from QE1 than QE2. - Shocks from bond and equity markets in the United Kingdom and euro area generated mild spillovers to other AEs. - Divergence in estimated spillovers reflects context of QE implementation, country-specific factors in EMs, and endogenous policy responses. - QE1 tended to be positively associated with short-term improvement in global financial conditions (global risk appetite and global equity prices); QE2 did not. - QE1 was intended to repair markets and provide liquidity; QE2 occurred when many EMs were on an upward growth trend, complicating attribution. - Controlling for monetary surprises and asset price endogeneity across borders broadly confirms these findings (examples reported in Tables 4.2–4.4 and Table 4.1 in source). - Example: Surprise associated with U.S. purchase of MBS and Agency bonds during the first phase of LSAP1 lowered long-term bond rates in Brazil and Mexico by over 9 basis points. ### Role of forward guidance and communication - Conditional forward guidance effectively manages market expectations of future policy and the importance of clear central bank communication on exit strategy. - At the zero lower bound, forward guidance can convince markets central bank will keep rates low longer (allow inflation to go higher) than consistent with usual policy rule. - Surprise effect of Fed’s conditional forward guidance lowered expectations of future short-term interest rates (measured by the 1-year ahead 3-month Libor) and boosted asset prices domestically and internationally. - More recently, market expectations about faster unwinding of U.S. monetary stimulus led to generalized repricing of risks: rising domestic interest rates, weakening equity prices in most emerging markets, and higher foreign exchange volatility. ### Interpretation and caveats - Financial market spillovers of unconventional monetary policies vary by market conditions and nature of the intervention. - Unconventional policies were particularly effective in supporting global financial market conditions when conditions were particularly volatile—examples include early U.S. announcements and more recent euro area announcements. - As markets normalize, impacts of such policies become smaller and more ambiguous; shifts in surprise content of announcements also affect outcomes. - A substantially different program in size or scope could still have strong effects (source notes BoJ’s QQME announcement as an example). - Assessing overall impact on a particular asset price in a particular country is complicated by simultaneous responses in other markets and countries; direct impacts are often magnified by indirect spillovers via third countries and via responses of other domestic assets. - Unconventional policies often occur when financial volatility is high; whether spillovers are helpful depends on cyclical conditions in recipients (helpful if economy below capacity; complicating if economy overheating). *Source: 3. Market-Based Indicators of Systemic Risks (_070313a).* ### 12. Over time, however, the larger impact coming from unconventional monetary policies ### _070313a - 12. Over time, however, the larger impact coming from unconventional monetary policies ### Overview: role and limits of unconventional monetary policies - Unconventional monetary policies primarily operate through guiding market expectations and altering underlying market conditions. - If they reduce uncertainty and tail risks, they can reduce underlying volatility. - If they are used merely as a salve to avoid more fundamental reforms, they are likely to prolong high uncertainty and put more pressure on other financially open economies. - Unconventional policies are described as "a bridge to a solution, not the solution itself." ### Event-study estimated impacts on global financial markets - Methodology highlights: - Event study measures absolute or proportional changes in money market interest rates, long-term government bond yields, equity prices and bilateral exchange rates over windows centered on announcement dates. - An extreme threshold criterion: unconditional probability of observing a larger reduction in the long-term government bond yield is less than 0.005. - Two day event window used except for Japan (one day). - Changes are normalized so that the long-term government bond yield in the systemic advanced economy (or Italy for the euro area) declines by 100 basis points. - Responses are pooled by calculating group medians across structurally similar economies. - Estimated pooled relative cumulative global financial market impacts (by systemic advanced economy): - United States: large loosening of global financial conditions; reduced money market interest rates and long-term government bond yields substantially worldwide; depreciated the dollar moderately versus other advanced-economy currencies. - Euro area: reduced long-term government bond yields substantially in the periphery and raised them slightly in other advanced economies; increased equity prices substantially worldwide; appreciated the euro moderately versus emerging-economy currencies. - Japan: reduced long-term government bond yields moderately worldwide; increased equity prices enormously domestically and reduced them moderately in the rest of the world; depreciation of the yen produced an "enormous improvement in external price competitiveness." - United Kingdom: reduced money market interest rates moderately worldwide; reduced long-term government bond yields moderately in other advanced economies while raising them moderately in emerging economies; depreciated the pound slightly versus other currencies. ### Scenario simulations with the G-35 model: output and macroeconomic effects - Simulation framework: - Uses a structural macroeconometric model of 35 national economies (Vitek (2013)). - Scenarios represent unconventional monetary easing via calibrated adjustments in short-term nominal market rates, long-term nominal market rates, equity prices and nominal bilateral exchange rates to match estimated responses. - Market adjustments phased out gradually by a first order autoregressive process with coefficient 0.75. - Conventional monetary policy reactions allowed, constrained by the zero lower bound in: Czech Republic, Denmark, the euro area, Japan, Saudi Arabia, Switzerland, the United Kingdom, and the United States. - Simulated output growth effects (first year): - Unconventional monetary easing by the United States raises output growth in the United States by 3.4 percentage points during the first year. - Other first-year output effects of U.S. easing: - other advanced economies: by 0.4 to 1.3 percentage points - emerging economies with open capital accounts: by 1.2 to 2.2 percentage points - emerging economies with closed capital accounts: by 1.1 to 1.4 percentage points - Unconventional monetary easing by the euro area raises output growth in the euro area by 1.7 percentage points during the first year. - Other first-year output effects of euro-area easing: - other advanced economies: by 0.3 to 1.4 percentage points - emerging economies with open capital accounts: by 0.5 to 1.5 percentage points - emerging economies with closed capital accounts: by 0.8 to 1.0 percentage points - Japan and the United Kingdom: - Japan: tends to generate small negative output spillovers. - United Kingdom: tends to generate small positive output spillovers. - World output growth impacts: - United States unconventional easing raises world output growth by 1.7 percentage points. - Euro area unconventional easing raises world output growth by 1.1 percentage points. - Japan unconventional easing raises world output growth by 0.4 percentage points. - United Kingdom unconventional easing raises world output growth by 0.5 percentage points. ### Commodity price effects (simulated) - Associated increases in commodity prices in the scenarios (percent): - United States: energy prices increase by 20.6 percent; nonenergy commodities increase by 13.7 percent. - Euro area: energy prices increase by 13.1 percent; nonenergy commodities increase by 8.6 percent. - Japan: energy prices increase by 1.8 percent; nonenergy commodities increase by 0.2 percent. - United Kingdom: energy prices increase by 4.2 percent; nonenergy commodities increase by 2.4 percent. ### Capital flows and current account effects (simulated) - Scenarios imply moderate net capital inflows into each systemic advanced economy to finance deteriorations in their current account balances. - United States example: - Unconventional monetary easing by the United States decreases its current account balance ratio by 0.3 percentage points during the first year. *Source: _070313a - 12. Over time, however, the larger impact coming from unconventional monetary policies (2013 Spillover Report—Analytical Underpinnings and Other Background, IMF).* ### 0.7 percentage points, of Korea by 0.4 percentage points, of Turkey by 0.2 percentage points, and of ### _070313a - 0.7 percentage points, of Korea by 0.4 percentage points, of Turkey by 0.2 percentage points, and of ### Simulated current account balance effects of unconventional monetary easing - Current account balance deteriorations of emerging and other economies are reported as: - Saudi Arabia increase of 2.2 percentage points (in response to unconventional monetary easing by the United States). - Norway increase of 0.7 percentage points (in response to unconventional monetary easing by the United States). - Korea deterioration by 0.4 percentage points. - Turkey deterioration by 0.2 percentage points. - Poland and Thailand deterioration by 0.1 percentage points. - Other reported aggregate deterioration: 0.7 percentage points (contextual figure present in source text). - These current account balance deteriorations are generally financed by net capital outflows from commodity exporters and emerging economies with closed capital accounts. ### GIMF model description and role in the analysis - GIMF characteristics: - Multicountry dynamic structural general equilibrium model with optimizing behavior by households and firms and full intertemporal stock-flow accounting. - Frictions include sticky prices and wages, real adjustment costs, liquidity constrained households, and finite planning horizons. - Multi-region: standard production version comprises 6 regions (United States; the euro area; Japan; emerging Asia; Latin America; the rest of the world). For presentation outputs are aggregated into two regions: advanced economies (United States, the euro area, Japan) and emerging economies (emerging Asia and Latin America). - Purpose: - Illustrate potential spillovers to emerging economies of quantitative easing in advanced economies. - Scenarios are stylized and not designed to proxy for any specific episodes of quantitative easing in advanced countries. ### Scenarios and transmission channels analyzed with GIMF - Four stylized scenarios: 1. Sharp reductions in private consumption and investment in advanced economies with monetary policy constrained by the zero interest rate floor (ZIF) for two years; policy unable to respond for a period of two years. 2. Advanced economies pursue quantitative easing. 3. Builds on scenario 2 and assumes capital inflows to emerging markets reduce corporate risk premiums (lowering cost of capital). 4. Emerging market economies prevent currency appreciation and capital inflows when advanced countries implement quantitative easing. - Key scenario-specific findings: - Scenario 1: - Reduction in G3 domestic demand reduces imports from emerging economies. - With policy rates unchanged in the G3 and inflation declining, real G3 real interest rates rise. - Emerging economies reduce policy interest rates, widening the real interest rate differential with G3; G3 currencies appreciate relative to emerging market currencies. - Emerging market currency depreciation helps competitiveness of exports but real GDP still falls below baseline in emerging economies. - Scenario 2: - G3 quantitative easing significantly reduces the reduction in G3 aggregate demand. - Emerging market currency appreciates relative to the no-QE case as real interest rate differential reverses. - Emerging market exports recover faster and GDP returns to baseline faster (aside from a slightly larger negative impact in the first year). - Scenario 3: - Capital inflows reduce corporate risk premiums in emerging markets, lowering cost of capital. - Real investment rises notably; larger capital stock increases labor demand and household income. - Private consumption and real GDP in emerging economies rise above baseline. - Monetary policy tightens to constrain domestic demand and re-anchor inflation; policy tightening leads to further currency appreciation which slows export recovery. - Scenario 4: - Preventing currency appreciation and capital inflows yields GDP recovery in emerging economies closely matching scenario 2. - Composition differs: exports supported and fall less initially and recover more quickly. - Domestic demand declines by more than in other scenarios because monetary policy eases very little as other policy tools are used to prevent appreciation and capital inflows. ### Quantitative outcomes and model outputs (figures summary) - Figures depict simulated deviations from baseline (in percent or percentage points) for variables including: - Consumption price inflation, output, short-term nominal market interest rate, long-term nominal market interest rate, real effective exchange rate, fiscal balance ratio, current account balance ratio. - Time horizons and axes in figures use: - Percent ranges from -6.0 to 6.0 and time markers 0 4 8 12 16 20 for many country panels. - Real GDP, Real Consumption, Real Investments, Real Exports, Real Imports reported as "% difference" over periods labeled 0 through 10 in some charts. - Nominal Policy Rate (Difference), Real S-T Interest Rate (Difference), Inflation (Difference), External Finance Premium (Difference), Real Effective Exchange Rate (% difference: + = depreciation) shown over periods labeled 0 through 10 with specific axis scales preserved in figures. ### Global capital flows: drivers and policy responses - Recent resurgence in capital flows in the post-crisis period. - Analysis suggests both push and pull factors remain important; risk has grown in importance, reflecting a dramatic drop in the VIX over the post-crisis period. - One interpretation: the impact of unconventional monetary policy (UMP) has mostly been felt through its impact on risk perceptions. - Factor analysis findings: a common global factor explains up to one-half of the recent flows to key emerging markets. - Case studies indicate country authorities have tended to respond with both: - Foreign exchange intervention. - Macro-prudential measures. *Italic: Source — 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND, INTERNATIONAL MONETARY FUND* ### 7. Global Capital Flows in the QE Era ### 7. Global Capital Flows in the QE Era ### Recent trends - Capital flows to emerging markets (EMs) have increased significantly in the last two decades; gross flows have grown dramatically with substantial increase in portfolio and other investment in the last decade. - Post-crisis dynamics: - Following a dramatic slowdown in late 2008/early 2009, capital inflows to most EMs recovered sharply over 2009–10. - By mid 2011 flows had reached high pre-crisis levels; increased uncertainty from the euro area crisis then prompted a decline in inflows lasting until late 2012. - Flows resumed with an easing of euro area tensions; overall volatility of flows has increased since the early years of the great moderation. - Composition changes in outflows from advanced markets (AMs) post-crisis: - Flows into fixed income securities increased as local debt markets expanded. - Gross portfolio investment outflows from QE countries declined in recent years, especially from the euro area and the United States; outflows rose in Japan until 2011. - U.S. and Japan’s holdings of other non-European advanced economies’ bonds almost doubled between 2007 and 2011. - Latin American countries, advanced European countries outside the euro area, and Asian economies were beneficiaries of QE bond portfolio reallocations. - Deleveraging in Europe’s core created opportunities for Asian banks to increase cross-border claims: - Banking systems cut back cross-border exposures in two phases: after the Lehman collapse and from the start of the euro area crisis in 2010. - Asian banks expanded cross-border claims, offsetting euro area bank cutbacks in Asia, particularly in syndicated lending and project finance. - New vulnerabilities emerged from wider use of short-term capital markets to fund expansion in U.S. dollar exposures. ### Main drivers of push and pull - Empirical literature and Fund studies conclude both push and pull factors are important drivers of capital flows to EMs. - Push factors: U.S. interest rates and risk aversion measures (VIX). - Pull factors: EM GDP growth, inflation, economy size, and other EM macroeconomic performance variables. - Limited studies focusing on UMP effects: - Fratzscher, Lo Duca and Straub (2012) find U.S. UMP effects on capital flows to EMEs relatively small compared to other factors, but UMP exacerbated pro-cyclicality of EME capital flows. - Fed measures in late 2008–09 contributed to net capital outflows from EMEs; since mid-2009 they contributed to reversal and surge in inflows. - Key empirical message: U.S. UMP measures have magnified variability and procyclicality of capital flows rather than greatly changing overall magnitude. ### Baseline push–pull regressions: specification and data - Main push factors: U.S. 10 year yields (primary measure), Log VIX. - Pull factors: Recipients' GDP Growth (t-1), Recipients' log average nominal GDP, Recipients' inflation (t-1). - Estimation: - Panel fixed effect regressions. - Quarterly data from 1990 to 2012 Q3. - Sample: 42 EMs. - Dependent variable: log of gross capital flows, adjusted with a constant to keep positive. - GDP growth and inflation entered with one quarter lag to minimize endogeneity. ### Baseline regression results (high-level findings) - Both U.S. interest rate and VIX have strong and significant effects on capital flows to EMs. - Post-crisis changes: - Relationship between interest rates and capital flows weakened and turned positive in the post-crisis period. - Effect of VIX on capital flows increased in the post-crisis period. - Coefficient magnitudes are small: - A one standard deviation decline in the VIX index—corresponding to a 30 percent change—is associated with an increase in capital flows of just over 2 percent. - Results for interest rates are equally small, suggesting substantial influence of country-specific factors. ### Selected coefficient estimates and regression statistics (Table 7.1 excerpts) - Variables (columns: (1) Full sample; (2) Full sample with post crisis dummy on both sides; (3) Pre crisis sample; (4) Post crisis sample): - PUSH - US 10 year yield: (1) -0.0146*** (0.0038); (2) -0.0112*** (0.004); (3) -0.00914*** (0.0032); (4) 0.0136** (0.0061) - Log VIX: (1) -0.0472*** (0.0102); (2) -0.0423*** (0.010); (3) -0.0422*** (0.0102); (4) -0.0844*** (0.0233) - Post crisis dummy 1/0: 0.0546 (0.085) [column (2)] - Post crisis * US 10 yr yield: 0.0288*** (0.009) [column (2)] - Post crisis * Log VIX: -0.0403* (0.021) [column (2)] - PULL - Recipients' GDP Growth (t-1): (1) 0.000231*** (0.0001); (2) 0.000200*** (0.000); (3) 0.000212*** (0.0001); (4) 0.00288** (0.0012) - Recipients' log average nominal GDP 2/: (1) 0.0168** (0.0066); (2) 0.00468*** (0.001); (3) 0.0220*** (0.0057) - Recipients' inflation (t-1): (1) -1.91E-05 (0.0000); (2) 0.0161** (0.006); (3) -1.26E-05 (0.0000); (4) 0.000239 (0.0006) - Post crisis * Recipients' GDP Growth (t-1): -1.92e-05* (0.000) [column (2)] - Constant: (1) 4.123*** (0.0475); (2) 4.089*** (0.042); (3) 4.058*** (0.0362); (4) 4.226*** (0.0781) - Observations: (1) 2,892; (2) 2,892; (3) 2,300; (4) 592 - R-squared: (1) 0.11; (2) 0.138; (3) 0.098; (4) 0.136 - Number of IFS: 42 42 42 42 - Notes: - 1/ Post crisis dummy is equal from one from 2008q4 - 2/ Average for 1990s and post 2000 ### How well regressions explain the post-crisis period - The regression explains the post-crisis surge better than the pre-crisis period: - Forecast errors aggregated across countries show pre-crisis aggregate capital flows were significantly higher than predicted. - Post-crisis surge is better explained by declining 10-year yields and reduced risk aversion (VIX). - Heterogeneity across countries: - Regression underestimates flows for Brazil and India in both pre-crisis and post-crisis periods. - Several EM Europe and Middle East countries report lower flows than predicted. - By construction, forecast errors sum to zero for each country over time. ### Vulnerabilities and capital flows - Capital flows do not seem to differentiate between countries by vulnerabilities: - Adding VEE rating into baseline regression shows VEE rating has no statistical significance in explaining capital flows (see Table 7.2). ### Alternative measures of UMP and interest rates (robustness) - Quantity measure: Fed’s securities holdings (stock of OMO / Fed balance sheet size). - Fed’s securities holdings stable 2002–2007, dropped at crisis onset, then surged since 2009Q1 with LSAP1. - Fed’s balance sheet size highly correlated with VIX in the post-crisis period (correlation of -0.9). - In post-crisis period, Fed’s balance sheet size shows a positive and significant coefficient; adding it dampens VIX effect due to high correlation. - Short-term U.S. interest rates: - Using fed funds rate (FFR) gives a positive impact of short-term rates on capital flows to EMs. - Short-term rate differentials show a significant and negative impact on capital flows. - Results are similar when using the shadow FFR in place of FFR; shadow FFR captures UMP effects absent a zero lower bound. ### Robustness regression excerpts (Table 7.2 highlights) - Selected estimates across alternative specifications (columns include Baseline, Baseline with VEE rating, Baseline with OMO stock, FFR instead of US 10Y yield, FFR shadow, Money market differentials): - US 10 year yield: -0.0112*** (0.004) [Baseline]; -0.0102 (0.014) [with VEE]; 0.0481*** (0.008) [FFR instead] - Fed funds rate: 0.00415*** (0.001) [FFR instead] - Fed funds rate shadow: 0.00414*** (0.001) [shadow] - Money market differential: -1.18e-05*** (0.000) [money market diff column] - Log stock of OMO: -0.0553*** (0.011) [with OMO stock] - Log VIX: estimates vary across specifications, e.g., -0.0423*** (0.010) [Baseline]; -0.0211 (0.014) [with VEE]; -0.0160* (0.008) [with OMO]; -0.0389*** (0.010) [FFR instead]; -0.0389*** (0.010) [FFR shadow]; -0.0435*** (0.013) [money market diff] - Post crisis dummy coefficients vary by specification (examples): 0.0546 (0.085) [Baseline]; 0.0406 (0.131) [with VEE]; -0.371** (0.172) [with OMO stock]; 0.124* (0.068) [FFR instead]; 0.190** (0.073) [FFR shadow]; 0.246*** (0.083) [money market diff] - Post crisis * US 10 yr yield: 0.0288*** (0.009) [Baseline]; 0.0307* (0.016) [with VEE]; -0.0329*** (0.008) [with OMO stock] - Post crisis * Log VIX: e.g., -0.0403* (0.021) [Baseline]; -0.0569** (0.026) [with VEE]; -0.0629*** (0.020) [with OMO stock]; -0.0232 (0.018) [FFR instead]; -0.0441** (0.019) [FFR shadow]; -0.0674** (0.027) [money market diff] - PULL: Recipients' GDP Growth (t-1) and Recipients' log average nominal GDP remain generally positive and significant across specifications, with some variation. - VEE rating: -0.0301 (0.036) [when included] - Constant examples: 4.089*** (0.042) [Baseline]; 4.154*** (0.082) [with VEE]; 4.480*** (0.120) [with OMO stock]; 3.931*** (0.029) [FFR instead]; 3.931*** (0.029) [FFR shadow]; 3.961*** (0.042) [money market diff] - Observations and R-squared examples: - Observations: 2,892 [Baseline]; 921 [with VEE]; 1,436 [with OMO stock]; 2,892 [FFR instead]; 2,892 [FFR shadow]; 2,263 [money market diff] - R-squared: 0.138 [Baseline]; 0.118 [with VEE]; 0.114 [with OMO stock]; 0.131 [FFR instead]; 0.130 [FFR shadow]; 0.154 [money market diff] - Number of IFS across specifications: 42 41 42 42 42 35 ### Role of global, regional and country-specific factors (latent factor model and EPFR data) - Two complementary analyses: 1. Bayesian dynamic latent factor model to estimate common dynamic components for capital flows to emerging and advanced economy markets. 2. Event study analysis on weekly equity and bond flows to tie global bond and equity flows to specific UMP announcements. - Data: EPFR Global dataset: - Weekly portfolio investment (net) flows by >14,000 equity funds and >7,000 bond funds. - USD 8 trillion of capital under management. - EPFR represents only 5-20 percent of market capitalization in equity and bonds for most countries but closely matches portfolio flows from BOP data. - Latent factor model structure: - Estimate (i) a world dynamic factor common to all aggregates, regions, and countries; (ii) nine regional dynamic factors common across aggregates within a region; (iii) 42 country factors capturing comovement across net flows of the 2 asset markets within each country; and (iv) idiosyncratic component for each asset market. - Dynamic factors capture intertemporal cross-correlation among observable variables. - Findings: - Changes in bond flows are primarily determined by global push factors. - For EMEs, common shocks (world component) have been a predominant source of volatility for bond flows over the crisis, evidencing a strong role of push factors in EMEs bond flows. - In AE bond markets, the world component is about half as important as in EME bond markets. *Prepared by Mali Chivakul and Chad Steinberg, with inputs by other contributors as noted; additional related analyses prepared by Lusine Lusinyan and Andrew Tiffin and by Silvia Sgherri.* ### 23. Such a global component is found to be a less important source of volatility for equity ### 23. Such a global component is found to be a less important source of volatility for equity ### Global vs. regional and idiosyncratic components - The global component is a less important source of volatility for equity flows in general. - Region-specific factors play a large role in explaining fluctuations in EMEs equity flows. - Equity flows in advanced economies tend to be largely dominated by idiosyncratic—or in a few cases—country-specific factors. - In Indonesia, Philippines, Malaysia, Thailand, Hungary, Turkey, and Argentina the sum of the global and the regional component accounts for more than half of the volatility of equity flows. ### Event study: How UMP has affected global bond and equity flows - Objective: analyze the impact of specific UMP announcements on bond and equity flows into exchange traded funds and mutual funds across sixty-seven countries (forty-five emerging markets (EMs) and twenty-two advanced economics (AEs)). - U.S. unconventional monetary policy (UMP) episodes examined: - LSAP1 spanning January 9th 2008 to July 28th 2010; - LSAP2 spanning August 4th 2019 to September 2011; - Operation Twist and LSAP3 spanning September 21st, 2011 to May 1st 2013. - Impacts assessed controlling for: relevant FOMC announcements; volatility (VIX); oil price movements (an average of Dubai, Brent, and WTI); and fluctuations in non-energy commodity prices. - Study builds on Bayoumi and Bui (2011) and Fratzscher, Duca, and Straub (2011). ### Diverse regional significance and overall impacts - UMP had a significant impact on capital movements globally, with variation by region, program, and asset purchased. - Purchases of treasuries had larger effects than purchases of debt securities; bond flows were more affected than equity flows. - LSAP1: - Highly significant results for bond flows across all regions in both EMs and AEs when purchases were limited to treasuries. - Significant only for EMs when it came to debt purchases. - LSAP1 had no effect on China for both bonds and equities. - LSAP2: - Significantly impacted bond flows in the euro area and North America when the Fed purchased debt securities. - Affected equity flows in Asia, Europe, and North America when the Fed purchased treasuries. - Overall LSAP2 had a much smaller range of influence and the majority of its effects were outflows of capital. - Largest bond inflows under LSAP2 occurred in Spain, France, Italy, and Australia. - Largest bond outflows under LSAP2 occurred in Germany and, to a lesser extent, Turkey, Malaysia, and Indonesia. - Equity inflows under LSAP2: United States, United Kingdom, and Japan (and to a lesser degree Turkey). - Largest equity outflows under LSAP2: Brazil, Turkey, and Indonesia. - Much European activity during LSAP2 may reflect ECB actions not controlled for in this study. - Operation Twist and LSAP3: - Purchase of treasuries had a significant impact on bond flows across the EM world. - Significant impact on equity flows in advanced economies, notably Asia and to a lesser extent Europe. - LSAP3 witnessed a global shift of bond flows away from advanced economies and into emerging markets—specifically Brazil, Russia, China, Mexico and to a lesser degree Malaysia, Indonesia, Turkey. - The largest bond outflow during LSAP3 occurred in the United States. - The largest equity inflows in LSAP3 occurred in the United Kingdom, France, and Japan; the majority of countries showed no significant equity impact. ### Global patterns (LSAP1 emphasis) - LSAP1 activities limited to treasuries had a positive impact on both debt and equity flows. - Largest increase in bond inflows occurred in the United States, the United Kingdom, Germany, and Japan. - Largest equity inflows were in the United Kingdom and Japan; a large percent of equity money was directed to Brazil and India as well as France and Italy. - Secondary recipients of bond inflows included neighboring countries of the United States, Brazil and Russia, France and Italy. - Secondary recipients of equity inflows included Spain, South Africa, Turkey, Malaysia and Finland. ### Case studies: key messages (summary of cross-country findings) - For most countries, the peak size of capital flows in the post-crisis period was not as high as in the pre-crisis period. Two exceptions: Canada and Korea, where quarterly gross inflows peak in the post-crisis period surpassed pre-crisis peaks. Peak gross inflows mostly happened in 2009; Brazil’s post-crisis peak was in 2010. - Brazil, Canada, Hong Kong SAR and Korea experienced stronger average quarterly gross inflows in percent of GDP in the post-2008Q4 period. Average flows to New Zealand and Russia were much lower during the same period. - Exchange market pressure (EMP) indices show very strong appreciation pressure in 2009 after larger depreciation pressure in 2008; excluding the 2009 rebound, most countries’ EMP indices are within one standard deviation movement except Hong Kong (2010Q3) and New Zealand (2011Q2). - Most countries that experienced stronger average flows also show stronger appreciation pressure than in the 3 years prior to the crisis (Hong Kong, Canada, Korea); on average, appreciation pressure in most countries was not as strong as in the pre-crisis boom years (2005-07). Some countries experienced average depreciation pressure in the post-crisis period (BRA, NZL, ZAF smaller average appreciation; IND and RUS had depreciation pressure). - Global push factors explain almost half of portfolio flows at the country level; much variation remains unexplained (e.g., capital flows to Canada are largely unexplained, possibly reflecting its role as a safe haven). - Policy responses were largely uniform: combination of foreign exchange intervention and macro-prudential measures. Use of foreign exchange intervention was novel for some countries (e.g., New Zealand). Capital flow measures (CFMs) were used only in Brazil. ### Country case: Brazil (selected findings and policy responses) - Trends in capital flows: - Foreign capital inflows reached 5.3 and 7.4 percent of GDP in 2009 and 2010, respectively, with portfolio flows contributing about half of total inflows. - Empirical analysis by the BCB confirms that QE has had a statistically significant impact on inflows. - Since mid-2011 capital inflows moderated; net capital inflows diminished to US$104 billion (4.4 percent of GDP) in 2012, with the share of portfolio flows declining to about 15 percent. - Contributing factors to moderation: global uncertainty, tightening of capital flow measures (CFMs), substantial slowdown in growth, reduction in interest rate differentials (driven by the cumulative cut in the policy rate of 500 bps). - Impact on the economy and asset prices: - The real effective exchange rate appreciated by almost 50 percent between end-2008 and mid-2011, despite sizable interventions. - International reserves increased by more than US$150 billion in that period. - With moderation of inflows since 2011, the real exchange rate has depreciated, recovering about half of the initial appreciation, and reserves have remained broadly constant at US$370 billion (16 percent of 2012 GDP). - Stock market prices remained broadly flat through early 2011 after the recovery and declined more recently; Brazil underperformed relative to other EMs. - Foreign funding contributed to credit growth in 2010-11; it has subsided since then and the share of foreign liabilities in the banking system remains relatively low. - Property prices rose significantly in certain urban areas, though the direct link to capital inflows is unclear. - Long-term local currency bond yields have declined steadily after the crisis, in line with other EMs. - Policy responses and effectiveness: - Brazil used exchange rate appreciation, reserves accumulation, macroprudential tools and price-based CFMs. - The tax on inflows (Imposto de Operações Financeiras, IOF) was re-imposed in 2009 initially for portfolio equity and fixed income flows; the rate and coverage were adjusted several times (including imposing the tax on derivatives transactions and adjusting exempt duration limits on foreign borrowing). - IOF was complemented by macroprudential measures (e.g., reserve requirements on banks’ short FX positions). - The framework responded to intensity of pressures by reducing FX intervention and CFMs when inflow pressures subsided (example: in September 2011 the IOF on equity transactions was lowered from 2 to 0 percent). - Evidence suggests CFMs helped reduce portfolio inflows; evidence of persistent effects on the exchange rate is unclear. Macroprudential measures were somewhat effective in containing rapid domestic credit growth. - Mitigating factors for risks from a faster exit from QE in the United States and other advanced economies: - Portfolio inflows have declined substantially since 2011, reducing the share of portfolio liabilities. - The exit from QE would coincide with expected tightening of monetary policy in Brazil, limiting the impact on interest rate differentials. - Brazil’s flexible exchange rate and sizable FX reserves would be key buffers in the event of disorderly global financial conditions. *Prepared by Manju Ismael; Sources: EPFR, Bloomberg, Haver Analytics, IFS, WEO, and staff estimates.* ### 1. Canada benefited from strong capital inflows since 2009 owing to its perceived safe - ### _070313a - 1. Canada benefited from strong capital inflows since 2009 owing to its perceived safe - ### Capital flow patterns and composition - Total net portfolio (debt and equity) inflows amounted to 5 percent of GDP per year on average over 2009–12 against net outflows of 2 percent of GDP per year in 2000–07. - Gross foreign portfolio investment in Canada: - fluctuated around C$20 billion per year since mid-1990s, - surged to C$110 billion in 2009–10, - was still high at over C$80 billion in 2012. - Net FDI and other investment inflows have been negative since 2008 although other investment turned positive more recently. - Capital flows concentrated in debt securities; the initial surge largely reflected foreign purchases of new bond issues as Canadian corporations and provincial governments stepped up borrowing. - U.S. investor activity: - increased purchases of Canadian long-term bonds from US$[30] billion in 2005–07 to US$[55] billion in 2008–11, - more than doubled purchases of Canadian stocks over the same period, - IMF’s CPIS data: share of Canadian securities in the U.S. investors’ debt portfolio increased from 11 percent in 2007 to 16 percent in 2011. - Large share of flows directed to government bonds — consistent with a safe-haven nature given Canada’s relatively strong fiscal position. ### Structural economic developments and imbalances - Canada’s current account: - turned negative in 2009 for the first time in a decade as external demand contracted and commodity prices plunged, - with the recovery in commodity prices, strengthening of the Canadian dollar, and subdued exports to the United States, the current account deficit widened further, largely financed by foreign purchases of Canadian debt. - Drivers of household leverage and housing market strength over the last decade: - financial liberalization in early 2000s, - low interest rates, - strong immigration flows, - terms of trade gains. - Post-crisis developments: - the leverage and housing uptrend resumed swiftly after 2008–09 due to strong monetary and fiscal stimulus. - Key household and housing metrics: - Household debt-to-income ratio reached 165 percent in 2012 (a historic high). - Real house prices and residential investment are estimated to be way above levels consistent with economic fundamentals. - More recent trends: housing sector and credit growth have been slowing, in part reflecting a series of macro-prudential measures adopted over the last years. ### Observed macro-financial impacts of inflows - Exchange rate: - Safe-haven flows likely contributed to persistent strength of the Canadian dollar. - Over the last decade Canada’s exchange rate has become increasingly correlated with commodity prices; commodity prices appear little affected by global liquidity. - Sovereign yields: - Capital inflows particularly into government bonds helped lower sovereign bond yields while a large fiscal stimulus was being implemented, keeping the spread vis-à-vis U.S. bonds close to zero. - Banking sector and credit: - Relatively easy access of Canadian banks to global liquidity and funding would have encouraged bank lending and contributed to continuing favorable domestic financial conditions. ### Vulnerabilities and external dependence - External financing of non-financial private sector: - Share of Canada’s non-financial private sector credit financed by external sources is estimated at about 30 percent (mostly bonds). - Banks’ exposures: - Around 30 percent and 25 percent of Canadian banks assets and liabilities, respectively, are vis-à-vis nonresidents. - Banks’ reliance on wholesale funding in foreign currency is non-negligible. - Increased role of U.S. debt market: - As the U.S. debt market became a more important source of Canada’s bank and firm funding, sudden tightening of financial conditions in the United States could have a significant negative impact on Canada’s economy. - Caveat: if U.S. monetary tightening (or risk premium increase) is accompanied by a U.S. recovery, the net impact on Canada’s growth could still be positive due to strong trade links with the United States. ### Policy responses and effectiveness - No specific policy responses were taken to capital inflows per se. - Canadian authorities implemented major policy actions since the financial crisis which appear effective in addressing underlying demand conditions and imbalances: - fiscal and monetary stimulus followed by gradual withdrawal, - macro-prudential regulations to moderate credit growth and housing. *Italic: Source — Prepared by the Canada team (WHD); content from the IMF 2013 Spillover Report analytical background chapter on Canada.* ### 5. India’s financial account has been gradually liberalized in the past decade, but ### _070313a - 5. India’s financial account has been gradually liberalized in the past decade, but ### India — liberalization and capital inflows - Restrictions on capital flows remain despite gradual liberalization over the past decade. - Authorities have taken steps to further liberalize capital inflows in view of widening current account deficit and need for increased financing: - FDI regime further liberalized. - External commercial borrowing norms relaxed, including for sectors without a natural FX hedge. - Foreign Institutional Investors (FII) debt quota raised. - Withholding tax on rupee corporate bonds lowered. - Effects: - Increased FII equity (portfolio inflows) and debt flows. - FDI inflows have remained tepid. ### E. Korea — vulnerability before the GFC - Capital account liberalization during the 2000s delivered growth and financial deepening but introduced vulnerabilities: - Capital flows relative to GDP grew sharply and became more volatile. - Short-term debt and portfolio flows increasingly drove cycles. - Debt flows became intertwined with exchange rate expectations and decoupled from current account trends. - Pre-GFC unappreciated risk: expectation of trend appreciation in the won led to large hedging demand by exporters, limited hedging demand by importers, and large liquidity mismatches in banking: - Banks, particularly foreign bank branches, relied heavily on short-term external borrowing to offset currency risks from relatively long-term forward contracts. - Model evidence: - A one percentage point increase in net forward position (scaled by total asset size) of a foreign bank branch is associated with a 0.3 percentage point increase in short-term external debt (scaled the same way) in the same quarter, and 0.2 percentage point increases in subsequent quarters. ### E. Korea — sudden stop of capital during the GFC - 2008Q4 developments: - Sudden outflow of about 33 billion dollars (14 percent of Korea’s gross international reserves) of banking capital from Korea, stemming mainly from unexpected repayment of short-term interbank FX loans by foreign bank branches. - Resulted in liquidation of local bond positions and conversion of won proceeds to dollars. - Sharp depreciation of won (to a maximum of 36 percent during the GFC). - Prompted 11 billion dollars of gross outflows in portfolio bond and 7 billion dollars in equity. - Korea’s gross international reserves decreased by 38 billion dollars that quarter (a decline by 16 percent); the maximum decline during the GFC amounted to 65 billion dollars or a peak to trough fall by 24 percent. - Mechanism (foreign bank branches’ typical positioning): - Branches buy FX forward from clients, borrow FX from headquarters, convert spot to KRW, buy Monetary Stabilization Bonds (MSBs) or Korea Treasury Bonds (KTBs), profiting from interest differential vs swap rates but exposed to FX liquidity mismatches because forward contracts tend to have longer maturity than borrowing. ### E. Korea — policy response to the GFC - Authorities implemented a package: - Aggressive monetary easing. - Fiscal stimulus. - FX liquidity injection to banks through the Bank of Korea’s FX swap. - Bilateral currency swap facilities with United States and Japan. ### E. Korea — post-GFC capital flows and effect of U.S. QE - Complications: - Difficult to isolate spillovers from U.S. quantitative easing (QE) because of Korea’s combined crisis responses and continued efforts to reduce banks’ short-term external debt. - Stylized observations (focused on U.S. QE): - Some push-factor effect during QE1 (November 2008 to March 2010), but not during QE2 (November 2010 to June 2011) and QE3 (September 2012 to now). - During QE1, monthly capital flows to Korea were 1.5 billion dollar net inflows on average; average net flow was negative during QE2 and QE3. - Strong bond and equity flows (3.5 billion dollars) in QE1 more than offset outflows in FDI, banking flows and settlement payments related to derivative liabilities. - The pure impact of U.S. QE on Korea appears modest, given other pull factors (aggressive rate cuts, bilateral swap lines, strong export-led rebound). - Korea — Net capital flows during U.S. quantitative easing (In billions of dollars, monthly average): - QE1: Net Bonds 1.7; Net Equity 1.8; Net Other -0.5; Net FDI -1.1; Net Derivatives -0.4; Net Capital flow 1.5 - QE2: Net Bonds 0.2; Net Equity 0.1; Net Other 0.7; Net FDI -1.6; Net Derivatives 0.2; Net Capital flow -0.3 - QE3: Net Bonds 0.0; Net Equity -0.9; Net Other -2.4; Net FDI -1.3; Net Derivatives 0.5; Net Capital flow -4.1 - QE periods defined: QE1 (2008,11-2010.3); QE2 (2010.11-2011.6); QE3 (2012.9 - 2013. 2) - Comparison with emerging markets: - EPFR flows to emerging markets rose to average 14 billion dollars per month during QE3 from 4-5 billion dollars per month during QE1 and QE2. - For Korea, monthly gross bond and equity flows: 2.1 billion dollars during QE1; 2.4 dollars during QE2; fell back to 2.1 billion dollars during QE3. - Suggests QE factor was weaker for Korea relative to other emerging markets. - Drivers of asset prices: - Evidence that push factors (VIX, changes in allocation of investor base to foreigners, and U.S. interest rate) may have played stronger role than pull factors in compressing local currency bond yields in Korea. - Asset prices may face substantial moderation with exit from QE. ### E. Korea — policy responses to QE and capital flow risks - Macroprudential measures implemented to prevent re-growth of FX liquidity mismatches in banking and improved supervisory checks on banks’ FX liquidity management; these helped reduce Korea’s short-term debt. - Reserve buffer improved: - Reserve coverage increased to 186 percent in 2012 from 111 percent in 2008. - Since late 2012 authorities studied options to strengthen macroprudential toolkits to place safety valves on portfolio bond flows, including range from Tobin tax to financial transactions tax. - New government stance: - Publicly indicated it will first strengthen existing measures should upside risks to capital flows materialize, including those from quantitative easing. - Growing public pressure on the Bank of Korea to cut policy rate to contain further appreciation of won/yen cross rate; BOK has so far not acted. ### F. New Zealand — trends, impacts, and policy stance - Trends since U.S. QE1: - Financial account transactions showed net inflows of NZD 6.3 billion in 2012 (3 percent of GDP), driven mostly by increase in non-resident holdings of government debt. - New Zealand government bond yields remain near historic lows. - Pick up in issuance of NZD-denominated bonds by offshore issuers (Eurokiwi, uridashi and Kauri), indicating stronger demand for NZD investments. - Composition and sources: - Flows into finance and insurance industry have declined since 2009; overseas investors shifted toward government debt instead of banking sector debt. - New Zealand banks’ reliance on offshore funding has been declining steadily. - Total investments from the United States in New Zealand continued to decline from the peak in 2009; Australia remains the largest investor, holding one-third of total foreign investment. - No material reallocation of funds from Japan to New Zealand since QQME. - Impact on economy and asset prices: - Main impact via exchange rate appreciation. - NZD remains elevated despite declines in export commodity prices; helped contain inflation pressure but weighs on tradable sector competitiveness and net exports. - No clear evidence of direct impact of capital inflows on asset prices, but risk that buoyant global risk appetite could add upward pressure on already elevated house prices. - Policy responses: - Authorities committed to floating exchange rate regime. - Reserve Bank of New Zealand ready to intervene subject to certain criteria to smooth the exchange rate but does not consider intervention effective or advisable at this stage; interventions have been rare and modest. ### G. Russia — trends, correlation with U.S. QE1, and policy stance - Bottom line: - Russia experienced large net capital outflows since the beginning of the global financial crisis. - 2012 net outflows amounted to USD57bn (2.7 percent of GDP), down from USD81bn in 2011. - Capital flows to/from Russia do not appear correlated to U.S. QE1 or subsequent waves of QE. - Background: - Historically Russia’s net capital flows have been relatively small and often negative, except for net inflows during 2006-07. - Global financial crisis triggered large outflows. - Structure changes since capital account liberalization in late 2006: - Public-sector outflows replaced by private-sector outflows. - Foreign inflows essentially dried up (except some FDI). - Rebound of high net capital outflows in 2011/12 attributed to global flight to safety amid euro crisis and possibly domestic political uncertainty related to elections. - Impact: - Estimated limited impact thus far on economy and asset prices; outflows may have had mild negative bearing on private investment, asset prices, and exchange rate. - Other domestic factors are more important drivers. - Russia’s flexible exchange rate, large international reserves, and reduced balance sheet mismatches help absorb shocks. - Policy responses: - None. ### H. South Africa — capital inflows, vulnerabilities, and recent deterioration - Through end-2012: - South Africa continued to benefit from strong capital inflows driven by global search for high-yield assets and inclusion in the World Government Bond Index. - Net capital flows into SA were US$4.4 billion (4.7 percent of GDP) in 2012Q4, following a post-Lehman peak of US$7.5 billion in the previous quarter. - Nonresident participation in domestic bond market reached near 40 percent in 2012—one of the highest among EMs—covering about half of that year’s sizeable fiscal deficit. - Sizable nonresident participation, mostly at the longer end, led to substantial decline in long-term bond yields, lowering government financing costs and cost of capital for corporations. - Recent deterioration and vulnerabilities: - Rise in domestic risks (e.g., labor unrests in the mining sector), subdued growth, and weaker fiscal position triggered sovereign credit ratings downgrades by three major agencies. - Reflected in Q4 net FDI drop (-2.2 percent of GDP), strong depreciation of the Rand, and widening in SA’s CDS spreads. - Predominance of non-FDI flows in financing external deficits makes SA highly vulnerable to potential capital flow reversals. *Source: 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND* ### 3. So far price and credit developments remain contained, and the authorities have not ### _070313a - 3. So far price and credit developments remain contained, and the authorities have not ### South Africa — price, credit, and capital flow management (CFM) - Findings - Price and credit developments remain contained. - The authorities have not announced changes to CFM measures on fears that additional controls may chase off capital flows. - South Africa’s financial account remains fairly open to nonresidents, but with restrictions to residents’ FX transactions. - Corporate foreign exchange transactions are subject to exchange control regulations that limit corporate offshore borrowing and FX exposure. - Banks largely rely on wholesale deposits from resident institutional investors as a major source of funding. - Ample liquidity in the corporate and banking sectors, along with subdued private investment, have reduced corporate borrowing needs. - At the household level, unfavorable labor market conditions have kept balance sheets weak (with one of the highest debt service -to-income ratios among EMs) but relatively insulated from capital flows surges. - Equity holders are more susceptible to “unpleasant surprises” related to capital flows reversals as P/E ratios continue to grow faster than supported by fundamentals, and boosted by domestic investors’ exposure limits. - Policy stance and authorities’ view - The authorities have kept monetary policy loose, bringing policy rates to all time lows, with limited FX intervention. - The authorities are carefully monitoring the CFM measures introduced by several countries, but at this juncture they have not signaled any changes to the current policies owing to concern that controls on inflows may permanently drive away capital flows. *Italic source: Excerpt from 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND (International Monetary Fund).* ### Annex: Changes in the Cross-border Banking Landscape — overview - Major transformation since the Global Financial Crisis (GFC): - Banking systems have significantly cut back their cross-border exposures since the start of the GFC. - Two phases of cutbacks: (i) reduction in cross-border activity after the Lehman Brothers collapse; and (ii) continued cutback in cross-border claims by euro area banks from the start of the euro area crisis in 2010. - Recovery unevenness - Five years after the start of the GFC banking systems are still in different stages of repair; old risks remain, with some European banks still highly leveraged and reliant on wholesale funding. ### Bank deleveraging drivers (key points) - Advanced economy banking systems pressured to reduce leverage via raising capital or cutting balance sheets and reducing short-term and cross-border wholesale funding. - Drivers of deleveraging: - Wholesale funding runs experienced during the crisis. - Higher cost of wholesale funding, particularly in the euro area due to sovereign risk spillovers. - Basel III liquidity requirements favoring more stable funding sources. - Increased incidence of regulatory ring-fencing of bank liquidity and capital along national lines. - Progress uneven: leverage and wholesale funding remain relatively high for core euro area banks. ### Changes in cross-border bank lending patterns — key statistics and findings - Aggregate cross-border claims: - Peaked at almost $28 trillion in 2008 Q1. - Fallen by more than $4 trillion to stand at just over $23 trillion in 2012 Q4. - Most cutback by European banks: reduced foreign claims by almost $6 trillion from 2008 Q1 to 2012 Q4. - Regional patterns: - European banks largely cut back claims on Europe and North America. - Reductions in foreign claims to emerging Europe amounted to only $0.1 trillion from 2008 Q1 to 2012 Q4. - European banks concentrated on reducing interbank exposures, which have declined by around 20 percent in the two years to 2012 Q4. - Some European banks, particularly French institutions, reduced U.S. dollar denominated assets following curtailment in dollar funding and swap market disruptions. - Spanish banks increased exposures to Latin America, likely reflecting growth in local deposits. ### Increasing role of Asian banks in international credit - Trade, project and corporate finance lending in foreign currency: - Peaked at $820 billion in the second quarter of 2011 and then collapsed by one third over the next three quarters. - Asian banks stepped in as euro area banks pulled back: - Asian banks increased foreign claims throughout the two crisis phases. - Asia is the only region where cutbacks by euro area banks have been outpaced by an expansion by other (predominantly Asian) banks. - 2012 regional lending figures: - Regional syndicated loans in Asia reached US$352 billion in 2012. - Regional project finance in Asia reached US$88 billion in 2012. - Asian project finance represented over 40 percent of the flow of global project finance in 2012; the next most important region—Advanced Europe—represented around 20 percent of global project finance flows. - Sector focus and market share: - Within Asia, most project finance lending goes towards the oil, transportation and telecommunications industries. - Japanese and Indian banks have been increasing their market share in regional project finance; banks from Australia, China, and the ASEAN economies have also been increasing market share in syndicated lending. ### Old risks and new vulnerabilities from cross-border banking shifts - Persisting old risks - Core euro area banks remain highly leveraged and reliant on wholesale funding, leaving them vulnerable to shocks and potential further deleveraging. - Increased subsidiarization and local matching of assets/liabilities reduce cross-border risk transmission but limit centrally-funded groups’ flexibility to reallocate excess funding across regions. - New vulnerabilities from Asian expansion - Much of Asia’s cross-border activity is denominated in U.S. dollars while being financed by local currency funds and swapped into dollars via FX swap markets. - Net foreign asset positions: - For Asian banks, net foreign assets amount to almost 25 percent of total foreign assets. - European banks (excluding the United Kingdom) reduced their net asset position from around 10 percent of assets to near zero. - U.S. and U.K. banks have a negative foreign asset position. - Much of the net foreign asset position comes from Japanese banks—where the net position amounts to $1.6 trillion, just under 50 percent of foreign assets—with Australian and other Asian banks running a negative, or small, net foreign asset position. - Maturity and funding mismatches: - Around half of Japanese banks’ foreign claims have a long maturity, similar to U.K. banks, unlike U.S. banks where exposures are more short-term. - Banks rely on shorter-term swap markets to fund longer-term dollar assets, creating maturity mismatches and market liquidity risks. - Asian banks place a similar reliance on wholesale funding of their external liabilities as euro area banks. - Japanese banks have recently reduced reliance on wholesale markets by increasing non-bank deposit funding; other systems (e.g., Australia) maintain very high reliance on wholesale funding. - Credit quality and supervision risks: - Expansion may involve lending to less creditworthy borrowers, particularly in specialized areas such as project finance. - Cross-border supervisory challenges: lack of a common regional supervisory framework may complicate monitoring of risks arising from increasing international activity in the region. ### Conclusions (annex) - The GFC and subsequent market and regulatory pressures have substantially transformed global banks’ cross-border lending patterns. - First phase: widespread scaling back of cross-border activity across banking systems after the GFC onset. - Second phase: centered on Europe where highly leveraged, wholesale-funded banks continued to cut back cross-border exposures in response to sovereign risk, funding pressures, dollar funding access problems, and market fragmentation. - Resulting landscape: while some regions and banks expanded foreign claims (notably Asian banks), global patterns of cross-border banking have been fundamentally altered, with a mix of reduced cross-border exposure, subsidiarization, and emergence of new vulnerabilities. *Italic source: Excerpt from 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND (International Monetary Fund).* ### 22. This provided an opportunity for Asian and North American banks, in particular, to ### _070313a - 22. This provided an opportunity for Asian and North American banks, in particular, to ### Cross-border banking flows, funding structures, and emerging vulnerabilities - Asian and North American banks increased their share of cross-border exposures. - U.S. banks had strengthened their balance sheets in the aftermath of the GFC; Japanese banks sought overseas lending as domestic loan demand was weak. - For Asian banks, increased use of cross-currency swap markets to use local funding to back U.S. dollar exposures has led to the emergence of new vulnerabilities. - Wholesale funding is defined in the source as debt, repo and interbank deposits; total funding is wholesale funding plus customer deposits. - Note on data adjustments and groupings: Euro area banks = Austria, Belgium, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal and Spain; Other Advanced European banks = Sweden, Switzerland and United Kingdom; North American banks = United States and Canada; Advanced Asia & Pacific banks = Japan and Australia. ### Bank leverage, funding, and cross-border claims (figures overview) - Figures presented include: Bank Leverage and Wholesale Funding Ratios 2008Q4–2012Q3; Consolidated Foreign Claims Index (2008 Q1 = 100); Total Foreign Claims (in trillions of U.S. dollars); Change in Foreign Claims (2008 Q1 – 2012 Q4, in trillions of U.S. dollars); Change in European Bank Foreign Claims, by Sector 2010Q4–2012Q4 (Percent); U.S. Prime Money Market Fund Exposures to Banks (in billions of U.S. dollars); One-Year Cross Currency Swap Spreads (in basis points); Trade, Project, and Corporate Finance (in billions of U.S. dollars); Global Project Finance (Percent); Asian Project Finance, by Region of the Lending Bank (in billions of U.S. dollars, quarterly flows); Project Finance in Asia, by Industry (in billions of U.S. dollars); Change in Bank Cross-Border Intra-Group Exposures 2009 Q4 – 2012 Q4 (in percent); Bank Net Foreign Asset Position (Percent of foreign claims); Net Foreign Asset Position of Asian and Pacific Banks (Percent of foreign claims); Long-Term International Claims to Developing Asia and Pacific (In percent of total international claims); External Liabilities: Dependence on Wholesale Funding (In percent of total external liabilities). ### Multi-country macroeconomic scenario design (sovereign stress in Japan or the United States) - Model and documentation: - Scenarios simulated with the structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2013). - Each economy represented by interconnected real, external, monetary, fiscal, and financial sectors; spillovers transmitted via trade, financial, and commodity price linkages; financial linkages direct (cross-border debt and equity holdings) and indirect (international comovement in asset risk premia). - Scenario shocks and mechanics: - Sudden loss of market confidence represented by: - increase in the short-term government bond yield of 100 basis points, - rise in the long-term government bond yield of 200 basis points, - fall in the price of equity of 10 percent. - These domestic financial market adjustments are phased out gradually according to a first order autoregressive process having a coefficient of 0.95. - Shocks are generated with internationally correlated sequences of temporary but persistent domestic credit, duration and equity risk premium shocks. - Two policy-response configurations considered: - Absence of conventional monetary policy responses and automatic fiscal stabilizers worldwide (baseline shock construction). - Allowing for conventional monetary policy responses worldwide to the inferred risk premium shocks, and allowing for the full operation of automatic fiscal stabilizers outside of Japan or the United States. - For economies outside the stressed country where a procyclical fiscal consolidation reaction is assumed: primary fiscal balance ratio raised by 1.0 percentage point; this reaction is frontloaded, 75 percent expenditure based, and phased out gradually according to a first order autoregressive process having a coefficient of 0.95. ### Simulation results: relative global impacts - Aggregate simulated world output growth losses: - World output growth loss of 5.0 percentage points for sovereign stress in the United States. - World output growth loss of 1.7 percentage points for sovereign stress in Japan. - Country and region output impacts (first-year / near-term): - Sovereign stress in the United States: - Reduces output growth in the United States by 8.6 percentage points during the first year. - Reduces output growth in other advanced economies by 3.3 to 5.8 percentage points. - Reduces output growth in emerging economies with open capital accounts by 3.5 to 6.8 percentage points. - Reduces output growth in emerging economies with closed capital accounts by 2.8 to 3.4 percentage points. - Sovereign stress in Japan: - Reduces output growth in Japan by 6.4 percentage points. - Reduces output growth in other advanced economies by 0.9 to 1.6 percentage points. - Reduces output growth in emerging economies with open capital accounts by 1.1 to 2.3 percentage points. - Reduces output growth in emerging economies with closed capital accounts by 0.9 to 2.1 percentage points. - Commodity-price impacts (simulated declines in prices): - For the United States scenario: declines in the prices of energy and nonenergy commodities are 46.7 and 26.2 percent, respectively. - For the Japan scenario: declines in the prices of energy and nonenergy commodities are 17.1 and 10.0 percent, respectively. - Financial conditions: - Sovereign stress in the United States tightens global financial conditions substantially. - Financial market spillovers from sovereign stress in Japan are moderate. - Tightening of financial conditions generally greatest in emerging economies with open capital accounts, followed by other advanced economies, and then emerging economies with closed capital accounts, abstracting from policy responses. - Economies with high exposures and flexible exchange rate regimes significantly mitigate tightening of financial conditions with policy responses, particularly contemporaneous and expected future nominal policy interest rate reductions. ### Policy-relevant mechanisms and assumptions highlighted - Conventional monetary policy responses materially affect the magnitude of spillovers and can mitigate tightening of financial conditions, especially where exchange rate flexibility exists. - Automatic fiscal stabilizers reduce the direct impact of sovereign stress when operational; by contrast, a procyclical fiscal consolidation response (as modeled for some economies) raises the primary fiscal balance ratio by 1.0 percentage point and is likely to amplify near-term output losses. - The persistence of shocks is modeled via autoregressive processes with coefficient 0.95 for both financial market adjustments and for the phased-out fiscal consolidation reaction. *Source: 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND, International Monetary Fund* ### 11. Combined Rebalancing Scenario ### 11. Combined Rebalancing Scenario ### Scenario composition - This scenario combines the rebalancing scenarios for the United States, the United Kingdom, the euro area, Japan, and China. For all scenarios except Japan, the rebalancing scenarios are identical to the individual ones done for each country/region. However, for Japan, because the rebalancing scenario had some components that were in the Japan WEO baseline, only those layers of the scenario not in the baseline are included here. - The United States - The scenario consists of near-term fiscal expansion followed by medium-term consolidation and a temporary increase in private savings to capture the transitory impact from entitlement reform. - The United Kingdom - The scenario consists of some near-term unconventional monetary easing and temporary fiscal stimulus via public investment along with reforms to immigration that increase labor supply and reforms to education that raise productivity. - The Euro Area - The scenario embodies a reduction in sovereign and corporate risk premium owing to a reduction in financial fragmentation following ECB policy action and progress on banking union. Product market reforms are implemented in core countries that raise productivity alongside product and labor market reforms that raise productivity in the periphery. In addition, the fiscal dividend from the resulting higher growth in the periphery allows for a temporarily easier fiscal stance. Further reforms in Germany raise private investment and the Netherlands implements some temporary fiscal stimulus. - Japan - The scenario consists of fiscal consolidation and structural reforms. - China - The scenario consists of fiscal reforms that reduce both public and private savings, financial sector reforms that remove subsidies and distortions in the cost of capital, structural reforms that that raise productivity beyond the WEO horizon, and reductions in risk premium as the reforms put China on a sustainable growth path and thus avoid a crisis beyond the WEO horizon. ### Impact and transmission - For all countries implementing reforms except China, GDP rises modestly in the near-term owing to increased productivity, declines in real interest rates, and temporary fiscal stimulus. In China the reforms are designed to achieve but higher-quality, but lower growth which the positive spillovers from reforms in other regions are not sufficient to offset. - The spillovers over the WEO horizon for countries not implementing reforms are modest, but positive. Higher exports to reforming countries and stronger investment owing to declines in the cost of capital (real corporate interest rates) are the key drivers. - Beyond the WEO horizon the benefits from reform grow larger in both reforming and non-reforming countries. This reflects continued adjustment to higher productivity and reductions in real corporate interest rates. - Decline in real interest rates arises in part from the decline in demand for savings in the United States and Japan more than offsetting the effect of the increased demand for savings owing to higher productivity growth and the decline in public and private savings China. In addition, real interest rates decline because of the crisis that is avoided by the reforms that put China on a sustainable growth path. - The exceptions are Sweden and Switzerland where the real corporate interest rate initially rises which suppresses investment. ### Combined spillover scenarios: contributions to world growth (percentage point deviation from baseline) - Table: Total Contribution to world growth (percentage point deviation from baseline) - 2013: World 0.18; USA 0.06; Euro Area 0.01; China 0.01; Japan 0.01; United Kingdom 0.08; Rest of the World 0.01 - 2014: World 0.01; USA 0.03; Euro Area 0.07; China -0.21; Japan 0.02; United Kingdom 0.01; Rest of the World 0.09 - 2015: World 0.01; USA 0.02; Euro Area 0.06; China -0.15; Japan 0.02; United Kingdom 0.00; Rest of the World 0.07 - 2016: World -0.12; USA -0.07; Euro Area 0.08; China -0.10; Japan 0.00; United Kingdom 0.00; Rest of the World -0.02 - 2017: World -0.11; USA -0.10; Euro Area 0.06; China -0.07; Japan -0.01; United Kingdom -0.01; Rest of the World 0.02 - 2018: World 0.04; USA -0.01; Euro Area 0.08; China -0.06; Japan 0.00; United Kingdom 0.00; Rest of the World 0.04 - 2019: World 0.66; USA 0.08; Euro Area 0.13; China 0.09; Japan 0.05; United Kingdom 0.03; Rest of the World 0.27 - 2020: World 0.75; USA 0.11; Euro Area 0.08; China 0.30; Japan 0.03; United Kingdom 0.03; Rest of the World 0.21 - 2021: World 0.60; USA 0.07; Euro Area 0.07; China 0.34; Japan 0.04; United Kingdom 0.01; Rest of the World 0.09 - 2022: World 0.49; USA 0.03; Euro Area 0.05; China 0.36; Japan 0.03; United Kingdom 0.00; Rest of the World 0.00 - 2023: World 0.58; USA 0.04; Euro Area 0.05; China 0.45; Japan 0.03; United Kingdom 0.00; Rest of the World -0.01 - Total: World 3.1; USA 0.3; Euro Area 0.7; China 1.0; Japan 0.2; United Kingdom 0.1; Rest of the World 0.8 ### Notes on modelling and preparation - Prepared by Ben Hunt, Rene Lalonde, and Susanna Mursula (all RES), and the S5 country teams. Based on simulations with the Flexible System of Global Models (FSGM): G20MOD and EUROMOD. *Source: 11. Combined Rebalancing Scenario, 2013 Spillover Report — Analytical Underpinnings and Other Background* ### 3. Simulation results indicate that accelerating reform in China would lower China’s ### _070313a - 3. Simulation results indicate that accelerating reform in China would lower China’s ### Simulation results: growth, composition, and external balance - Short- to medium-term (3-5 years): accelerating reform in China would lower China’s growth by about ½ to 1 percentage point lower than the WEO baseline. - Composition of growth in the short- to medium-term: - Stronger private consumption growth (and as a share of GDP). - Weaker growth in investment and exports. - Current account: - China’s current account surplus would fall by about 3 percent of GDP in the medium term. - Longer term: - Reforms will help maintain annual growth roughly 2 percentage points higher than it would be in the baseline (the baseline is described as unsustainable and ends in a crisis). - Growth in investment and exports rebound sharply while consumption continues to grow relative to the baseline. - After ten years: - The current account as a share of GDP stabilizes roughly 4 percentage points below baseline. - The exchange rate has appreciated by roughly 10 percent. ### Global spillovers (short- to medium-term and beyond) - Short- to medium-term spillovers: - Spillovers to most countries are generally negative, but small. - Negative spillovers primarily operate through higher global real interest rates as a result of lower public and private savings in China. - In most countries, the decline in private investment from a higher cost of capital more than offsets the strengthening in exports due to improved competitiveness relative to China. - Large creditor countries benefit from the small increase in global real interest rates. - Longer-term spillovers: - Once the benefits of reform flow through in China, impacts become positive for all countries as: - Increased Chinese demand further stimulates exports. - Declines in risk premium spur investment. ### Capital account liberalization in China: framing and objectives - Context: - China’s 12th Five-Year Plan pledges to make the renminbi fully convertible. - Historical note: a similar pledge for full convertibility by 2000 was made in 1993 but implementation was delayed after the Asian financial crisis. - Purpose of the analysis: - Investigate how capital flows might respond if China liberalizes its capital account. - Use historical episodes of capital account liberalization in advanced and large emerging markets since the 1970s and empirically estimate a portfolio allocation model. - Main qualitative finding: - Historical episodes were generally followed by large gross flows, but the direction of net flows depended on country-specific and global factors. - The portfolio allocation model suggests domestic savings supporting large domestic financial markets could generate substantial net outflows as Chinese investors diversify. ### Historical episodes of capital account liberalization: stylized facts - Gross flows after liberalization: - Generally increased substantially. - Examples: buildup of gross international assets over five years after liberalization of some 60 percent of GDP in the United Kingdom (1979) and about half that amount in Chile (1992) and Italy (1992). - Direction of net flows: - Depended on many factors; examples: - Net portfolio and other investment outflows after liberalization in Sweden, Finland, and Spain. - Net inflows in Denmark, Chile, and Colombia. - Prasad and Rajan (2008) note nonlinearities and threshold effects that complicate prediction. - Four factors highlighted as determinants of net flows: - Domestic business cycle. - Typically, the more advanced a domestic upswing, the greater the net outflows. - Growth prospects. - Net inflows increased more in countries with higher growth prospects. - World business cycle. - A more advanced upswing in the world business cycle typically increased net portfolio inflows. - Financial sector liberalization. - More recent elimination of financial repression tended to be associated with greater net outflows in portfolio investment. - In Japan and the United States, where capital account liberalization preceded financial sector liberalization, net inflows were negligible after capital account liberalization. ### Empirical portfolio allocation model: specification and variables - Baseline regression: - Multi-country version of Forbes (2010) for the United States. - Dependent variable: bilateral portfolio asset exposure (equity and debt separately) as reported in the IMF’s CPIS database as a share of the source country’s total securities portfolio. - Total securities portfolio defined as domestic stock market capitalization or outstanding domestic debt securities (World Bank GFDD) plus source country’s net international equity or bond assets. - Estimation: FGLS to account for persistence (stock variable) and heteroskedasticity. - Sample period constrained to 2005-10 due to data availability. - Key cost and attraction determinants included: - Financial market size: stock market capitalization or outstanding domestic bonds (% of GDP) in source and destination (GFDD). - Capital controls: measured as in Schindler (2009). - Information asymmetries: proxied by bilateral trade (% of GDP) from IMF DOTS and geodesic distance. - Return differentials: annual average of monthly stock market returns (59 countries) and annual average 5-year sovereign bond yield (37 countries) from Bloomberg. - Return correlations: bilateral correlation coefficient in monthly stock market returns or sovereign bond yields over past three years. - Governance: first standardized principal component of control of corruption, rule of law, and regulatory quality (World Bank WGI). ### Regression results: main coefficients and robustness - Table 14.1 summary (FGLS regression: Share of Bilateral Portfolio Assets in Total Portfolio, 2005–10): - Share of destination in global portfolio: 0.115*** (Stocks, col 1), 0.116*** (col 2), 0.141*** (Bonds, col 3), 0.131*** (col 4). - Stock market capitalization or outstanding domestic bonds (% of GDP) in source: -0.00204*** (col 1), -0.00200*** (col 2), -0.00723*** (col 3), -0.00571*** (col 4). - Stock market capitalization or outstanding domestic bonds (% of GDP) in destination: 0.000376*** (col 1), 0.000287** (col 2), -0.00286*** (col 3), -0.00126** (col 4). - Capital control measures (inflow/outflow restrictions and outflow restrictions) in source and destination: generally negative and significant, with larger negative coefficients for bond exposures. - Governance in source and destination: positive and significant (e.g., governance in source 0.218*** col 1). - Bilateral trade (% of destination GDP): positive and significant (0.0394*** col 1). - Log distance: negative and significant (e.g., -0.353*** col 1). - Stock market return or bond yield in destination: positive and significant for stocks and bonds (e.g., 0.0164*** col 1). - Correlation in returns or yields: positive and significant (e.g., 0.359*** col 1). - Observations: 8,382 (stocks), 4,278 (bonds). Number of country pairs: 1,397 (stocks), 713 (bonds). - P-values reported in parentheses; significance indicated by ***, **, *. - Interpretations: - Capital controls, both in source and destination, significantly reduce cross-border portfolio exposures. - Equity exposures appear less sensitive to capital controls than bond exposures and less sensitive to destination country controls than source country controls. - International investors seek exposure to deeper financial markets and higher returns. - Larger domestic financial markets discourage domestic investors from investing abroad. - Bond exposures are more responsive than equity exposures to returns, source country financial market depth, destination country governance, and other bilateral ties. - Robustness: - Results broadly robust to alternative specifications, including elimination of any one source or destination country, use of aggregate portfolio assets, an expanded sample, and alternative measures of capital controls (Chinn and Ito, 2008). ### Predicted magnitudes and global implications of liberalization for China - Speculative predictions based on estimated coefficients (applying capital controls coefficients to 2010 data): - Capital account liberalization may be followed by a stock adjustment of Chinese assets abroad on the order of 15-25 percent of GDP. - A smaller stock adjustment for foreign assets in China on the order of 2-10 percent of GDP. - Implied net accumulation of Chinese net international assets: 11-18 percent of GDP. - Adjusting market size for nontradable shares (about one quarter of equity market capitalization) and for bond-market holdings by banks (almost half of outstanding bond market debt held by banks) would narrow predicted net accumulation of portfolio assets to 4-8 percent of GDP. - Potential global market impact: - An accumulation of 9-25 percent of GDP in international portfolio assets by Chinese residents could: - Account for up to 3 percent of global financial markets if allocated along MSCI portfolio shares. - Account for up to a quarter of financial markets in emerging market economies. - If Chinese authorities offset outflows by slowing reserve accumulation or reserve drawdown, yields on reserve assets could come under pressure. *Source: 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND, INTERNATIONAL MONETARY FUND* ### References ### References ### Cited works - Bertaut, Carol and Linda Kole (2004), “What makes investors over or underweight?: Explaining international appetites for foreign equities.” International Financial Discussion Papers Number 819. Board of Governors of the Federal Reserve System. - Chinn, Menzie D. and Hiro Ito (2008). "A New Measure of Financial Openness". Journal of Comparative Policy Analysis, Volume 10, Issue 3, p. 309 – 322 (September). - Eichengreen, Barry (2001) “Capital Account Liberalization: What Do Cross-Country Studies Tell Us?” World Bank Economic Review, Vol. 15, No. 3, pp. 341-365. - Forbes, Kristin (2010), “Why do foreigners invest in the Unites States?” Journal of International Economics, Vol. 80, No. 1, pp. 3-21. - He, Dong, Cheung, Lillian, Zhang, Wenlang and Wu, Tommy T., How Would Capital Account Liberalisation Affect China’s Capital Flows and the Renminbi Real Exchange Rates? (April 18, 2012). HKIMR Working Paper No. 09/2012. - Harding, D. and A. Pagan (2002). "Dissecting the cycle: A methodological investigation," Journal of Monetary Economics, 49: 365–81. - Kaminsky, Graciela and Sergio Schmukler, 2003. "Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization," NBER Working Papers No. 9787. - Lane, Philip and Gian Maria Milesi-Ferretti (2008), “International investment patterns.” Review of Economics and Statistics 90 (3), 538–549. - Prasad, Eswar and Raghuram Rajan (2008), “A Pragmatic Approach to Capital Account Liberalization,” Journal of Economic Perspectives, Vol. 22, No. 3, pp. 149-172. - Quinn, Dennis P. 2003. "Capital Account Liberalization and Financial Globalization, 1890 -1999." International Journal of Finance and Economics. 8(July):189-204. - Sedik, Saadi Tahsin and Sun, Tao, Effects of Capital Flow Liberalization - What is the Evidence from Recent Experiences of Emerging Market Economies? (November 2012). IMF Working Paper No. 12/275. - Schindler, Martin, 2009, “Measuring Financial Integration: A New Data Set,” IMF Staff Papers, Vol. 56, No. 1, pp. 222–38. ### VI. Spillovers from the Euro Area — key findings and evidence - Dividends of Euro Area Stabilization - The stabilization of financial markets in the euro area has significantly lowered sovereign and bank financing costs but some fragmentation of the banking system has persisted. - Stabilization contributed to normalize capital flows in other European countries and increased participation of external investors in emerging market sovereign bond markets. - Empirical analysis shows reduction of home country bank funding stress had large impacts on the return of capital flows to other EA countries and to emerging EU countries. - Stabilization of the stock market of Spain contributed to reducing volatility of stock markets of core euro area countries, the United States, Japan, and to a lower extent the United Kingdom. - Policy actions that mitigated tail risks and uncertainties in Europe (dates and actions preserved) - June 29 agreement of the EU Council on the creation of a Single Supervisory Mechanism - July 26 speech by President Draghi stating that “within (the) mandate, the ECB is ready to do whatever it takes to preserve the euro” - September 6, 2012: ECB’s announcement of the detailed Outright Monetary Transactions (OMT) program - September 12, 2012: Decision of the German Constitutional Court to back the ESM - November 26, 2012: Decision to support additional debt relief for Greece - December 13-14 European Council agreement on the regulation of the SSM - European announcements of a roadmap toward a Banking Union - Financial market outcomes and bank-sovereign links - Sovereign spreads over German bunds declined at short-term (2 year) and long-term (10 years) maturities; bank funding conditions improved in both periphery and core. - Exposures of banks to domestic sovereigns declined somewhat at end-2012 but have recently again increased in Italy and Spain, indicating sovereign-bank links remain significant. - Indicators of banking system fragmentation are mixed: Target 2 imbalances narrowed, but cross-border exposures of euro area banks continued to decline through Q4 2012, issuances by periphery banks remained low, and dispersion of retail lending rates between core and periphery continued diverging. - Normalization of capital flows in other European countries - As conditions improved in the euro area, capital flows returned to emerging Europe and funding costs of emerging European sovereigns declined to record low levels. - Safe haven flows stabilized in small advanced European countries (e.g., Switzerland and Denmark), relieving appreciation pressures on their exchange rates. - The exchange market pressure index is constructed based on the methodology of Chapter 3 of the October 2007 WEO. - Empirical analysis of cross-border spillovers of stabilizing euro area banks (methodology summary) - Panel regression of bilateral determinants of capital flows between euro area banks and other European emerging economies, period 2010Q1-2012Q4. - Home country factors: quarterly average of 5 year CDS spreads of banks; previous period’s portfolio composition of banks’ external exposures; bilateral exposure to host country. - Host country factors: quarterly real GDP growth, inflation rate, previous period’s total liabilities to foreign banks in percent of GDP. - Coefficients estimated for stabilization period 2012Q2-2012Q4 to compute impact of improved euro area bank funding conditions on bank capital flows. - Quantitative outcomes from stabilization (exact figures preserved) - Between July and December 2012, the CDS spreads of euro area banks declined substantially (by about 180 basis point on average). - During this period, the average quarterly change of exposures of euro area banks was 0.21 percent of host country GDP, compared to -2 percent of GDP during 2010-2012Q2. - The empirical model predicts that, within the euro area, the decline of bank CDS spreads in home countries on average contributed to a reversal of quarterly bank capital flows of 3.76 percent of host country GDP between Q2 and Q4 of 2012, relative to the period 2010Q1-2012Q2. This compares to an actual reversal of bank quarterly capital flows of 2.84 percent of host country GDP on average. - In emerging Europe, the contribution of the decline of home bank CDS spreads contributed to a reversal of bank capital flows of 2.5 percent of host country GDP, compared to an actual reversal of bank capital flows 2.74 percent of host country GDP on average. - Between 2010-Q1 and 2012Q2, the average quarterly decline of bank exposures vis-à-vis other euro area countries was 2.7 percent of host country GDP. Since mid-2012, exposures have increased by on average 0.14 percent of GDP per quarter. - Sample of host countries includes euro area countries, EU emerging economies (Bulgaria, Hungary, Latvia, Lithuania, Romania, Poland and the Czech Republic) and other European emerging markets (Russia, Belarus, Turkey). - Spillovers to global markets and bank international positions - BIS locational banking statistics by nationality show Italian and German banks increased their international positions after mid-2012, while French and Spanish banks continued to reduce international positions vis-à-vis related offices despite funding costs declining. - Between July 2011 and July 2012, the average quarterly deleveraging of EA4 banks’ international activities was USD 300 billion. In Q3 and Q4 of 2012, the quarterly deleveraging dropped to $140 billion. - Market volatility and directional spillovers (methodology and results) - A VEC model was estimated with sovereign bond yields and stock market indices for 7 euro area countries, the United Kingdom, the United States, Japan, China and several additional large advanced or emerging economies. The period of estimation is July 1st, 2012 to May 3rd 2013. - Forecast errors of 12 days ahead forecasts and directional spillovers indexed, based on generalized forecast error variance decomposition, were computed. - The stock market of Spain was the main source of gross volatility spillovers to other euro area stock markets (except Greece) and to the Spanish and Italian sovereigns. Outside the euro area, Spain generated volatility spillovers to the United Kingdom, the United States, and Japan, and to South Korea and Brazil. - Directional spillover from the Spanish stock market accounted for 10.4 percent, 10.7 percent, 12.2 percent, 9.9 percent, 8.4 percent, and 8.8 percent of the forecast error variance of the stock markets of respectively France, Germany, Italy, the United States, the United Kingdom, and Japan. - The German sovereign was the source of volatility spillovers to other large euro area sovereigns, the United Kingdom, the United States and Japan. - The U.S. sovereign was a source of spillovers to the sovereigns of France, Germany, Spain, Japan, the United Kingdom, and also of Brazil, Turkey, Russia, and South Africa. *Source: _070313a - References (PDF).* ### Annex Table 15.1 Distribution of Dire ctional Spillove rs from Sove reign Yields and Stock Marke t Indices Fore cast ### Annex Table 15.1 Distribution of Directional Spillovers from Sovereign Yields and Stock Market Indices Forecast Error Variance ### Directional spillovers table — description and note - The table reports the distribution of directional spillovers from sovereign yields and stock market indices forecast error variance (in percent of the total forecast error variance of receiver B). - Note: highlighted is greater than top decile of the distribution of bilateral FEV. ### Select entries from the table (sender → receiver: percent of receiver B forecast error variance) - sov_Mexico → sov_Mexico: 0.0 - sov_Mexico → sov_South Korea: 0.4 - sov_Mexico → sov_Russia: 0.3 - sov_Mexico → stock_Brazil: 0.7 - sov_Mexico → stock_Turkey: 1.9 - sov_Mexico → stock_Mexico: 2.2 - sov_South Korea → sov_Mexico: 3.9 - sov_South Korea → sov_South Korea: 0.0 - sov_South Korea → stock_FR: 0.8 - sov_Russia → sov_Mexico: 0.7 - sov_Russia → sov_Russia: 0.0 - stock_Brazil → sov_Mexico: 1.4 - stock_Brazil → stock_Brazil: 0.0 - Stock_Turkey → sov_Mexico: 1.2 - stock_Mexico → stock_CHINA: 1.6 - stock_USA → stock_USA: 1.9 - stock_JAP → stock_JAP: 6.8 - stock_CHINA → stock_CHINA: 1.6 - sov_FRA → sov_FRA: 3.0 - sov_DEU → sov_DEU: 5.6 - sov_GR → sov_GR: 0.8 - sov_IRE → sov_IRE: 3.5 - sov_ITA → sov_ITA: 0.5 - sov_PORT → sov_PORT: 1.1 - sov_ESP → sov_ESP: 0.5 - sov_UK → sov_UK: 4.3 - sov_USA → sov_USA: 3.8 - sov_JAP → sov_JAP: 5.0 - sov_China → sov_China: 9.7 - sov_Brazil → sov_Brazil: 2.9 - sov_Turkey → sov_Turkey: 9.5 - sov_South Africa → sov_South Africa: 0.7 (Note: the full matrix contains bilateral entries for sovereign yields and stock indices across the listed economies; above are selected exact numeric entries as presented in the table.) ### Effects of a Protracted Slowdown in the Euro Area — downside scenario (overview) - Scenario simulated with EUROMOD and G20MOD modules in the Flexible System of Global Models (FSGM). - Monetary policy in euro area countries, the United States, Japan, and the United Kingdom is constrained by the ZIF and interest rates are only allowed to ease as much as the policy space in the WEO baseline allows. - Mechanisms described: - Declining private investment owing to debt overhang reduces labor demand and private consumption. - Lower growth prevents anticipated fiscal improvement, pushing up sovereign risk premium and prompting more tightening in fiscal stances and private credit. - Magnitudes of jumps in sovereign risk premium are proportional to country debt levels and dependence on foreign funding. - Countries with larger current account deficits are hit harder. - Distorting labor and capital taxes to consolidate would undermine supply potential and raise expected debt-to-GDP paths. - Spillovers sufficient to stagnate the core; most negative impact in the periphery. ### Effects of a Protracted Slowdown — technical implementation (exact parameter assumptions) - 2013 euro area investment falls 3 percent below baseline (1 percent in the core, 5 percent in Italy, and 8 percent in the other periphery countries). - 2014 euro area investment deteriorates to 5 percent below baseline (1.5 percent in the core, 9 percent in Italy, and 13 percent in the other periphery countries). - In 2014, overall euro area sovereign risk premium rises by 25 basis points (10 basis points in the core, 40 basis points in Italy, and 65 basis points in the other periphery countries). - Corporate risk premium rises by roughly half of the increase in the sovereign risk premium (5 basis points in the core, 20 basis points in Italy, and 33 basis points in the other periphery countries). - Risk premium surprises of the same magnitude arrive each year until 2018. - Advance country risk premium rise by 30 percent of the increase in the average euro area risk premium, with emerging market risk premium rising by one half. - In 2014, periphery sovereigns front-load fiscal consolidation using labor and capital income taxes: Italy consolidates an additional 0.2 percent of GDP per year; other periphery countries tighten by an additional 0.3 percent of GDP each year. ### Euro Area WEO Downside: Effect on GDP level (cumulative percent difference from baseline) - World: 2012 0.0; 2013 -0.1; 2014 -0.3; 2015 -0.5; 2016 -0.6; 2017 -0.8; 2018 -0.9 - Euro area: 2012 0.0; 2013 -0.5; 2014 -1.3; 2015 -2.0; 2016 -2.7; 2017 -3.4; 2018 -4.1 - Rest of the world: 2012 0.0; 2013 -0.1; 2014 -0.2; 2015 -0.3; 2016 -0.4; 2017 -0.5; 2018 -0.5 ### Euro Area Rebalancing Scenario — components and effects - Two main components: - Euro area-wide policies: fuller banking union with common backstops; further unconventional monetary policy measures to reverse market fragmentation. - Declines in periphery risk premiums reduce overall interest rate on public debt by roughly 100 basis points by 2015; market rate for firms declines by almost 300 basis points. Decline in core is much more modest. - A small portion of decline in average euro area risk premiums transmits to other economies. - National policies: - Periphery actions: - Labor and product market reforms: roughly 50 percent of the best-practice gap closed (productivity increases based on OECD estimates). - Near-term fiscal stance in periphery countries relaxed by roughly one percent of GDP. - Core actions: - Core countries implement product market reforms closing 50 percent of the best-practice gap. - In Germany, policies increase private investment. - In the Netherlands, the fiscal policy stance is temporarily relaxed. - Overall effects: - Positive output effects in the euro area and the rest of the world. - Over the medium term, growth dividends could be substantial (about ¾ percentage points per year). - Reductions in risk premium raise GDP everywhere as they more than offset the impact on interest rates from higher global demand for savings. - Structural reforms raise growth in all euro area countries. - Outside the euro area, a small decline in real GDP may occur as increased euro area investment raises global real interest rates. - Increased investment in Germany raises GDP and lowers the current account, contributing to a higher global real interest rate and slightly lower GDP elsewhere. - Easier fiscal stance in periphery countries and the Netherlands temporarily raises GDP in these countries with mild positive spillovers elsewhere. - Positive confidence effects and reduced uncertainty (not embedded) could further increase growth dividends, especially short run. ### Spillovers from Japan — Abenomics overview and model-based evaluation - Abenomics composed of three pillars: aggressive monetary easing, flexible fiscal policy, and growth-enhancing structural reforms. - BoJ QQME seeks to double the monetary base and widen asset purchases to include long-dated government bonds and additional purchases of risk assets to achieve a 2 percent inflation target with a time horizon of about two years. - Diet approved 1.4 percent of GDP of new debt-financing spending to be executed during 2013–14. - Model-based evaluation (G20MOD) — illustrative results: - If all three arrows of Abenomics are successfully deployed, spillover effects to G20 economies are positive but small—about 0-0.1 percent of GDP in the short-term, before rising over the medium term once structural reforms raise growth in Japan. - Effects of yen depreciation on competitiveness in other countries are broadly offset by higher growth in Japan and lower interest rates in trading partners due to greater capital inflows and lower sovereign risk in Japan. - Scenarios analyzed (relative to a control scenario representing an earlier WEO vintage): - Pre-Abenomics counterfactual scenario: - Sovereign risk premium increases by 50 bps in 2016 and a further 50 bps in 2017, remaining elevated. - Government implements fiscal consolidation of 1 percent of GDP starting in 2016, rising to 5 percent of GDP by 2020. - Plus fiscal stimulus scenario: - Includes Diet’s fiscal stimulus equivalent to ¾ percent of GDP in 2013 and 2014 for a total of 1½ percent of GDP in effective terms. - Plus successful inflation scenario: - Inflation expectations reach 2 percent in two years as targeted by the BoJ. - Plus structural reform scenario: - Successful structural reforms raise potential output growth by ¼ percentage points in 2015 rising to ½ percentage points by 2018. *Source: Annex Table 15.1 and accompanying sections from the 2013 Spillover Report — Analytical Underpinnings and Other Background (International Monetary Fund).* ### 3. It is critical to implement all components of Abenomics for sustained growth and ### _070313a - 3. It is critical to implement all components of Abenomics for sustained growth and ### Scenarios and main simulation findings - Pre-Abenomics counterfactual scenario (blue line) - Fiscal consolidation would help lower the public debt-to-GDP ratio in the medium term, but at the cost of lower growth and inflation. - Plus fiscal stimulus scenario (orange line) - Fiscal stimulus will boost short-term growth by about ½ to 1 percent and yields a modest pickup in inflation, but these effects would gradually disappear in the medium term with the unwinding of the stimulus. - Plus successful inflation scenario (black line) - As inflation expectations rise to 2 percent on the back of aggressive monetary policy easing, the economy would reach 2 percent of actual inflation in two years as targeted by the BoJ and economic activity would pick up strongly in the short-term mainly due to higher investment on the back of lower real interest rates. - However, both growth and inflation would not be sustained at these levels due to medium-term fiscal consolidation and the unwinding of fiscal stimulus. - Plus structural reform scenario (dotted line) - When measures are complemented by growth-enhancing structural reforms, actual inflation not only reaches the inflation target within two years, but also will be sustained at this level. - Higher growth and inflation would further improve public debt dynamics. As private savings recover and the government’s financing requirement declines sharply, the rise in the risk premium will be avoided. ### Net international spillovers from successful reflation in Japan - Main channels - Yen depreciation and corresponding appreciation of trading partner currencies. - Higher growth in Japan as well as the global economy. - Lower interest rates in trading partners due to capital inflows and higher global savings as a result of falling debt in Japan. - Net positive spillover - Negative spillovers arising from yen depreciation are offset by positive spillovers through higher growth and lower interest rates in trading partners. - Japan’s rising current account surplus implies capital inflows into trading partners, reducing interest rates and stimulating investment and growth. - Structural reforms in Japan exert particularly important positive spillover effects by increasing import demand and boosting global growth. - Sensitivity analysis: a sharper yen depreciation case - A scenario in which the yen real effective exchange rate depreciates by 10 percent in the near term and is sustained at this level shows smaller net growth spillover, with selected countries (e.g., China, Germany, Korea) slowing in the near to medium term before benefiting in the long-term. ### Capital flows, asset prices, and portfolio rebalancing - Recent market moves and capital flows - Asset prices soared and the yen weakened following the government’s “three-pronged” strategies to exit deflation and lift growth. - The yen has weakened by about 20 percent in real effective terms while equity prices have risen by over 50 percent. - Despite the sharp yen depreciation, capital outflows from Japan have been limited thus far. - Foreigners’ net purchases of domestic equities increased (cumulative about ¥10 trillion since November), more than offsetting net sales of domestic bonds and notes (cumulative about ¥2.1 trillion) during the same period. - Net assets held in retail investment trusts (toshin funds)—particularly on equity funds—have increased in early 2013, after net declines in 2012; the increase is mostly driven by valuation effects rather than increasing outflows. - BoJ QQME and potential displacement of private assets - The BoJ intends to double the monetary base by about ¥130 trillion (or 27 percent of GDP) in two years. - Market analysts expect about ¥40 trillion (US$400 billion) of private assets would be displaced under the QQME. - The magnitude is subject to high degree of uncertainty given that the private sector can leverage up their financial assets for investments abroad. - Historical context and potential scale - Historically, Japanese investors have often been a net purchaser of foreign assets with an average of about ¥12½ trillion per year and never exceeding ¥25 trillion per year. ### Channels for financial spillovers and corporate responses - Corporates expanding abroad - More accommodative financing conditions and an improved growth outlook will affect incentives for firms to expand abroad. - Rebalancing of portfolio flows - Financial institutions—notably life insurers and public pension funds—and retail investors may shift portfolios away from domestic government bonds to more risky assets (such as domestic equities, foreign bonds, and equities) over the medium term. - This would generate capital outflows, though this could be partly offset by continued foreign inflows into domestic equity markets. - Banks’ foreign exposures - With ample liquidity, banks are likely to continue expanding overseas over the medium term, especially in Asia. ### Institutional investors and potential outflow magnitudes - Life insurers - Total assets for life and nonlife insurance sectors reached ¥335 trillion and ¥27.5 trillion as of end-2012, of which about 15–20 percent are invested abroad, mostly in foreign government bonds. - If only considering investment assets in life and nonlife insurers, foreign securities account for about 19–24 percent of investment assets. - Net purchases of foreign bonds and notes were about ¥3.7 trillion for insurers in 2012, of which about two-thirds of foreign bond investments are FX-hedged. - Some insurers plan to reduce FX-hedged ratios but reductions are likely to be small given capital requirement differences: risk weight for FX-hedged foreign bond investments is 1 percent while that for unhedged ones climbs to 11 percent in the calculation of the solvency margin ratio. - Government Pension Investment Fund (GPIF) - Total investment assets ¥112 trillion as of end-2012, about 23 percent of GDP. - GPIF has been a net seller of JGBs in recent years. - Foreign securities holdings have been slightly above the target levels for both bonds and equities (but still within the permissible range). - Reaching the maximum of the permissible range on foreign securities would imply less than ¥5 trillion of outflows based on current investment assets as of end-2012. - GPIF has indicated it would gradually diversify toward emerging markets for higher yields over the medium term. - Households and retail trusts - Foreign assets made up only 2½ percent of household financial assets as of end-2012 (a decline from the peak of 3.1 percent in 2007). - Foreign exposures in toshin funds are largely unhedged, making those exposures more sensitive to changes in asset prices and exchange rates. ### Recipient countries and regional patterns - Emerging Asia - Emerging Asia has not been a major recipient of Japanese portfolio flows in the past; based on past trends, only a modest share (less than 10 percent) of any additional portfolio flows would go to emerging Asia. - Most portfolio flows would likely go to advanced economies (except peripheral European countries) which have deeper and more stable debt markets. - Moderate flows from Japan may be considered large by recipient countries given relatively thin capital markets in some emerging economies. - FDI trends - The rising trend of outward FDI flows is likely to continue but a successful reflation in Japan may slow the flows. - A rise of 1 percent of GDP in Japanese FDI boosts growth by 0.5‒0.7 percentage point in recipient countries (IMF, 2012). - Empirical analysis suggests overseas production and outward FDI are sensitive to REER movements; a 10-percentage point depreciation in the REER would slow the overseas production ratio by 1.3 percentage points. - Outward FDI is a long-term trend unlikely to reverse given relatively high rate of return on these investments. ### Risks and tail events - Financial spillovers are likely to be moderate and gradual, though may be considered large by some recipient countries. - Larger capital outflows could occur if the yen depreciates further and global interest rates begin to normalize. - Tail risks: a failed Abenomics that poses a threat to financial stability could trigger negative spillovers. *Source: 2013 Spillover Report—Analytical Underpinnings and Other Background (excerpt).* ### 7. Major banks may also generate some financial spillovers through higher overseas ### _070313a - 7. Major banks may also generate some financial spillovers through higher overseas ### Financial spillovers from major banks - Major banks may generate financial spillovers through higher overseas lending activities; these activities have been expanding partly as a result of deleveraging by European banks in the region. - Trends mainly driven by robust growth in Asia, particularly in loan syndication and project finance. - Domestic banks increased foreign assets holdings by ¥9.4 trillion in 2012 (¥8.8 trillion excluding the trust banks). - Those flows are likely to have limited effect on exchange rates given that major banks usually fund those flows through repo transactions and avoid large open FX positions on foreign securities. ### Assessment of capital outflows under Abenomics - Financial linkages have become more complicated, making it difficult to quantify spillover effects on individual countries. - Policies under Abenomics, if successful, would have multiple effects that often work as opposing forces regarding capital flows: - Lower interest rates would encourage more capital outflows. - An improved domestic outlook and asset prices would discourage outflows or even attract more inflows to Japan. - Movements of bilateral exchange rates would exacerbate or alleviate flows between Japan and other countries. - Financial spillovers may remain moderate in terms of capital outflows, as push factors are less sharp, but those flows may be considered large by some recipient countries. - Historical example: after the 2011 earthquake, spillovers to Asia were mainly through supply chains and trade links, rather than capital flows. - Characteristics limiting spillovers: - Closed financial system: Japanese financial system is largely “inward-looking,” portfolio rebalancing has been toward domestic securities rather than an outright shift of capital outflows abroad. - Japanese investors have been steady net purchaser of foreign securities (average about ¥12½ trillion per year) over the past decade. - Higher risk weight of unhedged foreign exchange positions justifies gradual and cautious asset reallocation, limiting financial spillovers. - External developments: global interest rates likely to remain low in near term, as easing by major central banks have narrowed interest differentials; Japan was sometimes a recipient for portfolio flows, especially from U.S. money-market funds. - Conditions that could increase outflows: - Further yen depreciation and normalization of interest rates in other advanced countries could revive yen carry-trades. - Historical analogy: previous quantitative easing during mid-2000s led to sizeable positions in currencies such as the Australian and New Zealand dollars, and the Brazilian real. - Normalization of interest rates in the United States would support reallocation toward foreign securities, though partly offset by higher cost of foreign exchange hedging. - Tail risk: an incomplete Abenomics could raise interest risk exposures of Japanese financial institutions, giving a possibility of a spike in interest rates; this could prompt an outright shift away from domestic bonds and generate sizeable financial spillovers through capital flows. ### The Curious Case of the Yen: a safe haven currency without inflows - Japan’s real exchange rate tends to be relatively volatile: it appreciates during risk-off episodes and more so than other safe haven currencies such as the Swiss franc. - Recent launch of Abenomics contributed to large exchange rate depreciation, yet there are no detectable net capital in- or outflows during risk-off episodes. - Mechanism proposed: self-fulfilling expectations of currency appreciation lead to forward hedging and reduced short positions, which in turn leads to spot appreciation driving the real exchange rate. - Empirical observations: - Large yen movements often coincide with risk-on/off episodes; since the mid-1990s, nominal effective yen appreciations of 6 percent or more within one quarter occurred 12 times. - A one-standard deviation shock to the logarithms of VIX would appreciate the yen by close to 4 percent on impact. - During a global “risk-on” episode and following adoption of Abenomics, the yen has depreciated substantially due to decline in global risk aversion, larger trade deficit, the widening of the expected interest rate differential with the United States and Abenomics. - Safe haven currency characteristics (summary from Habib and Stracca (2012)): - Tend to have low interest rates, a strong net foreign asset position, and deep and liquid financial markets. - For advanced countries, safe haven status is robustly associated with stronger net foreign asset positions, public debt to GDP ratio, measures of financial development, and liquidity of the foreign exchange market (measured by the bid-ask spread). - Paradox: - Among safe haven currencies, the yen stands out as the one that appreciates the most during risk-off episodes. - Yet, unlike the Swiss franc where appreciation occurs through net capital inflows, for the yen portfolio flows in the Balance of Payments did not show a significant change during risk-off episodes. ### Derivative channels and risk-off episodes - Risk-off episodes are defined as beginning on days when the VIX is 10 percentage points higher than its 60 days backward-looking moving average; under this definition, there were 11 risk-off episodes during 1992 to end-March 2013. - Derivatives as a channel: - Derivatives transactions (forwards, currency swaps, and options) may be only partially captured in balance of payments data because cash payments usually represent only a very small fraction of the notional value of derivatives contracts. - Derivative positions can affect the spot exchange rate through portfolio effects: - Forward transactions impact spot instantaneously because banks break forward transactions between a spot and forward desk. - Currency swaps affect spot over time as they are equivalent to a series of forward transactions. - Options affect the spot rate through hedging that usually takes place through the forward market. - FX derivatives transactions largely reflect hedging, funding activities, and speculation. - Empirical findings: - Risk-off episodes trigger a large reduction in yen short positions, more so than for the Swiss franc and in contrast to the euro. - Expectation of yen appreciation induces exporters, overseas affiliates, and resident investors holding dollar assets to increase FX hedging once a risk-off event occurs; importers or institutions with dollar-denominated debt do not have the same incentive. - Increased derivative positions can subsequently trigger the exchange rate movement, possibly supported by fundamental factors. - Wider issues raised: - Traditional focus on capital flows may miss main channels that occur through complex financial instruments not fully reflected in flows. - Welfare effects differ depending on whether exchange rate changes occur with or without capital inflows; similar effects on interest rates and domestic activity may occur if appreciation is triggered by derivatives, although possibly more volatile. - Recent sharp depreciation of the yen has occurred despite large capital outflows, qualifying the belief that quantitative easing will lead to large flows of liquidity to emerging markets—at least for Japan so far. - It is less clear whether macro-prudential policies will limit excessive exchange rate volatility when volatility occurs through speculative positions rather than capital inflows. ### Impact of yen depreciation on export prices in Asian economies - Vertical integration of global production implies a significant amount of imported intermediate inputs are embodied in final exports, mitigating the impact of currency movements on export prices. - Japan is an important supplier of sophisticated manufacturing inputs in the Asia supply chain, limiting deterioration of price competitiveness of neighboring countries when the yen depreciates. - Substitution toward Japanese intermediate inputs would further mitigate negative effects from currency appreciation, but at the cost of lower domestic production in the substituting country. - Micro-based approach insight: - In a world with high vertical integration, the pass-through of changes in exchange rates to export prices is less than one. - Example: with final products made only with domestically produced inputs, a 10 percent appreciation implies export prices increase by 10 percent in the global market. With vertical integration and imported intermediate inputs embodied in final exports, the degree of pass-through from exchange rate changes to export prices is lower. - Extreme case: if a country imports intermediate inputs and re-exports them as final products without any domestic processing or mark up, export prices would remain the same and price competitiveness is not affected by currency movements. *Source: _070313a - 7. Major banks may also generate some financial spillovers through higher overseas (PDF chapter/section).* ### 4. The value of imported intermediate inputs embodied in exports, the so-called “imports ### _070313a - 4. The value of imported intermediate inputs embodied in exports, the so-called “imports ### Imports content of exports in Asian manufacturing - Significant portions of manufacturing exports from Asian countries are imported intermediate inputs: - about 20 to 30 percent for China, India, and Indonesia - about 40 to 50 percent for Korea, Taiwan Province of China, and Thailand - In particular, almost 70 percent of Thailand’s exports in the information and communication technology industry are actually imported intermediate imports - Imports content of exports in Japan is relatively small at about 15 percent ### Dependence on Japan for intermediate inputs - Several industries in these countries rely heavily on Japan as a source of intermediate inputs: - More than 20 percent of exports are intermediate inputs from Japan for motor vehicles, trailers, and semi-trailers and radio, television, and communication equipment industries in Thailand - For Taiwan Province of China, more than 15 percent of exports are intermediate inputs imported from Japan in motor vehicles, trailers, and semi-trailers; electrical machinery and apparatus; and machinery and equipment industries - Industry-level Japanese shares (selected figures from text table): - C24 Chemicals and chemical products: 14.4% - C25 Rubber and plastics products: 13.8% - C27 Basic metals: 12.8% and another entry 10.4% - C29 Machinery and equipment n.e.c: 15.4% and another entry 15.7% - C30 Office, accounting and computing machinery: 13.0% and another entry 11.0% and China C30: 11.2% - C31 Electrical machinery and apparatus n.e.c: 15.8% and another entry 15.9% - C32 Radio, television and communication equipment: 12.3% and Taiwan entry 21.6% and another entry 10.8% - C33 Medical, precision and optical instruments: 13.2% and another entry 14.0% - C34 Motor vehicles, trailers and semi-trailers: 16.1% and Thailand entry 22.2% - C35 Other transport equipment: 12.4% ### Effects of yen depreciation on export prices and supply - Imported intermediate inputs from Japan would offset some of the impact of yen depreciation on export prices: - Under a Leontief production function with no substitution, the impact of currency appreciation on export prices would be offset by the size of imports content of exports - In Taiwan Province of China and Thailand, more than 10 percent of exports are imported intermediate inputs from Japan, implying that the effect of yen depreciation would be offset by more than 10 percent - This benefit would not be fully passed through to importing countries if prices are set in the importer’s currency (local currency pricing) - Substitution effects: - Median estimated elasticities of substitution for machinery/electrical and transportation sectors are about -1 for many Asian countries (Kee, Nicita, and Olarreaga (2008)), implying potential substitution toward relatively cheaper Japanese intermediate inputs in response to yen depreciation - If substitution occurs, export prices would rise by less but potentially at the cost of lower domestic production if substitution is away from domestically-produced intermediate inputs - Vertical integration and export supply elasticities: - Currency depreciation increases prices of imported intermediate inputs, leading to a lower export supply response relative to the case without imported intermediates - Long-run export supply elasticities are more than halved for most countries in the region if feedback through imported intermediate inputs is considered (Tokarick (2010)) - Example: For Thailand, the estimated elasticity in general equilibrium (considering imported intermediates) is smaller than one-fifth of the estimate without this effect (partial equilibrium) - For Korea, Singapore, the Philippines, and Taiwan Province of China, estimated elasticities in the general equilibrium model are smaller than one-third of those in the partial equilibrium model - Competitive effects in third markets: - Countries that use more imported intermediate goods from Japan will benefit from lower import prices of those inputs relative to regions that rely less on imports from Japan, so export prices in third markets would increase less than in other regions if other exchange rates remain the same - Countries or industries competing less with Japan in final products could potentially benefit from yen depreciation in third markets - Japanese export prices and import content: - Import content of Japanese exports in manufacturing is around 10 to 15 percent - As imported intermediate inputs from other countries become more expensive by yen depreciation, export prices of Japanese final products would fall by less than the size of yen depreciation - Reflecting the relatively small imports content of Japanese exports, the difference between export supply elasticities with or without considering vertical integration is relatively smaller for Japan compared to other countries in the region ### Value added linkages with Japan and demand spillovers - OECD-WTO “Trade in Value Added” database (input-output tables as of 2005; trade data 2005, 2008, 2009) traces direct and indirect exports and allows quantifying domestic and foreign value added (FVA) contents in gross exports and final demand; database covers six Asian countries plus Japan in the analysis - Domestic value added directly or indirectly exported to Japan for final demand or intermediate inputs for exports accounts for: - about 3 percent of GDP in Australia, Indonesia, and Korea - about 1.5 percent of GDP in China and New Zealand - Foreign value added (FVA) used for domestic final demand: - Korea: imported FVA used for domestic final demand amounts to about a quarter of GDP - New Zealand: about 20 percent of GDP - Australia, India, Indonesia: more than 15 percent of GDP - In Japan: imported FVA embodied in final domestic demand is less than 10 percent of GDP, of which more than 2 percent are for the mining and quarrying industry and about 3 percent are from the six Asian countries in the sample - Domestic value added (DVA) exported for foreign final demand: - Korea: DVA corresponding to more than 28 percent of GDP are exported to foreign countries for their final domestic demand - Indonesia and New Zealand: more than 20 percent of their GDP exported as DVA for foreign final demand - Domestically created value added of sampled Asian countries that are directly or indirectly exported to Japan for final domestic demand: - about 2½ percent of GDP for Australia, Indonesia, and Korea - 1½ percent for China and New Zealand - Imported intermediate inputs as share of gross exports: - Foreign value added of gross exports varies across countries, with Korea the highest at more than 35 percent among Asian countries (implying DVA less than 65 percent of total gross exports) - Japan: FVA of gross exports are relatively small at less than 15 percent (implying more than 85 percent of gross exports are domestically created value added) - In Japan, five manufacturing industries account for 87½ percent of total exports; FVA of gross exports are among the highest in these five industries: (i) chemicals and non-metallic mineral products, (ii) basic metals and fabricated metal products, (iii) machinery and equipment, nec, (iv) electrical and optical equipment, and (v) transport equipment - Contribution of six Asian countries’ value added to Japanese gross exports: - Value added created in the six Asian countries accounts for about 4¼ percent of total Japanese gross exports - China: 1.9 percent - Australia: 0.9 percent - In terms of each exporting country’s GDP (2009), exported value added eventually used for Japanese gross exports varies from about 0.1 percent in India to more than 0.6 percent in Australia - Policy implication summarized in text: - A successful revitalization of Japan’s economy would be beneficial to other countries in the region through demand spillovers, given existing value added linkages (domestic value added exported to Japan for final demand or intermediate inputs for exports account for about or more than 3 percent of GDP (2009) in Australia, Indonesia, and Korea, and more than 1.5 percent in China and New Zealand) *Source: 2013 Spillover Report—Analytical Underpinnings and Other Background (selected section on imports content of exports and Japan–Asia value added linkages).* ### 1. The exercise starts by matching the path of the WEO projection output gap with a ### _070313a - 1. The exercise starts by matching the path of the WEO projection output gap with a ### Rebalancing scenario: shock, recovery, and policy sequencing - The exercise starts by matching the path of the WEO projection output gap with a (temporary) negative demand shock producing an output gap of about -4 percent. - Baseline recovery: the output gap takes 6 years to close. - Constraint: policy rates are assumed to be constrained by the zero bound, limiting scope for traditional monetary policy easing. - Associated macro dynamics in the baseline: - Weak demand associated with higher -than-usual saving rates and a current account surplus. - Downward pressure on underlying inflation. - With decreasing nominal demand, public debt to GDP increases before coming down as nominal GDP rises and automatic fiscal stabilizers wane. - Nominal rates at the zero bound for 3 years and lower inflation imply higher real rates, putting additional downward pressure on consumption and investment. - The real exchange rate initially moves in line with real interest differentials. ### Policy variations sequenced (monetary, fiscal, immigration, education) - Monetary stimulus variation: - Central bank adopts unconventional monetary policy measures, equivalent to a 60 bps easing in policy rates relative to the baseline. - Fiscal stimulus variation (added to monetary support): - 1 percentage point of additional expenditure on public investment for two years, financed with debt. - Immigration and education reforms (added sequentially): - Immigration reforms boost the labor supply by 1½ percent over the course of 4 years, in addition to the fiscal and monetary support. - Education reforms boost potential output by 3 percent over a 5-year period from 2016 to 2020. ### Impact on U.K. growth, inflation, current account, and public debt - Monetary stimulus: - Immediate effect boosting demand by about 1 percent (effect dissipates after 5 years). - Fiscal stimulus: - Boosts demand and spending on public investment brings permanent increases in productive potential. - Structural reforms: - Slight initial improvements to output; more significant effects later. - Inflation and rates: - Inflation is higher than in the baseline path, reducing real rates. - External and fiscal balances: - Greater domestic absorption reduces the current account surplus relative to baseline. - Higher nominal output leads to a smaller increase in the public debt ratio than in the baseline. ### Real exchange rate dynamics - Long run: increases in productive potential require a shift in the terms of U.K. trade to sell extra production externally — long-run effect is a net depreciation. - Short run: positive real exchange rate differentials encourage an appreciation from the starting point before the negative demand shock. - Under policy measures: the exchange rate is very slightly below its starting point and about 2½ percentage points below the baseline level in 2013. ### Spillovers to other countries - Sterling depreciation requires offsetting real exchange rate appreciation in other economies. - Appreciations are largest in Canada, India, Russia, and the United States. - Despite appreciations, improved demand from the United Kingdom dominates and the net effect for all countries is stronger exports than in the baseline. ### United Kingdom as a global liquidity hub - The United Kingdom retains its position as the most important global hub for cross-border liquidity generation by subsidiaries and branches of banks headquartered outside the United Kingdom. - Current quantum of such liquidity is half its pre-crisis peak of U.S.$ 2.8 trillion, comparable to 2003-06 levels, and broadly stable since early 2010. - The United States and Japan appear to have withdrawn from this liquidity-generation function. - Preliminary estimates suggest Hong Kong SAR and Singapore together generate a similar amount of cross-border liquidity as the United Kingdom. ### Capital requirements for U.K.-headquartered global banks and outward spillovers - Two new capital charges expected to apply to U.K.-headquartered banks over the medium-term: - the 2.5 percent charge for globally-systemically important banks, and - 2.5 percent countercyclical capital buffer. - Empirical basis and extrapolation: - Aiyar et al (2013) estimate: 4 percent reduction in lending for a 1 percentage point higher capital ratio. - Extrapolation: a 2.5 percentage point higher capital requirement → 10 percent impact on cross-border lending (using the 4 percent per 1 pp semi-elasticity). - Assumption: British banks’ foreign affiliate claims on nonbanks will be similarly affected as their cross-border claims. - Possible bank responses and cross-country credit effects: - Option A (proportional reduction): could tighten domestic credit in Hong Kong, Singapore and Ireland by over 1 percent. - Option B (protect top destinations): banks fully protect their 10 largest jurisdictions and largely protect the next 20 jurisdictions; lending to higher-risk jurisdictions (Egypt, Kenya, Pakistan, Tanzania) could drop to zero. - Headquarters relocation (e.g., HSBC and SCB relocating to Asia) is possible but not quantified. ### Policy implication on macroprudential design - U.K. regulators should internalize outward spillovers from capital requirements, since effects can be positive or negative depending on recipient economies’ macroeconomic and financial circumstances. - Authorities should seek to consider such impacts before altering micro- or macroprudential policies as they apply to global banks. ### Rising systemic importance of U.K. nonbanks and supervision implications - Conditional probability of distress (CoPoD) of the U.K. banking system given distress in the nonbank sector (mainly insurance companies) is about 0.5 and has doubled from 2009 levels. - Possible channels for increased bank vulnerability to nonbanks (conjectures): - Banks more reliant on funding from insurance companies. - Insurance companies shoring up asset prices (sovereign, banks, firms), improving prospects for banks. - Risk of activity migration: - Tighter regulation/ring-fencing of banks could induce migration of activity and risks to nonbanks and shadow banks (regulatory arbitrage). - Supervisory response: - Intensive and pro-active supervision of U.K. nonbanks and shadow banks is essential. - U.K. authorities have adopted a “twin-peaks” model with the Prudential Regulatory Authority housing supervision of systemic institutions, including insurers. - Authorities need to monitor nonbanks currently not deemed systemic that may be becoming so. ### Methodological note on probabilities and quantifications - The percentage decline in domestic lending under Scenario A was calculated using: - British banks’ consolidated foreign nonbank claims (proxy) and average 2010-11 credit to private sector for each country. - The percentage decline in domestic lending = 100*(a/b)*(0.04*2.5), where 0.04 is the assumed semi-elasticity of UK-headquartered banks' consolidated foreign claims to capital requirements (extrapolated from Aiyar et al (2013)). ### Introductory note on U.S. accelerated monetary normalization (beginning) - The note analyzes global macroeconomic effects of an accelerated normalization of monetary policy in the United States, ahead of other major currency areas. - Analysis based on scenarios with a structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2013). - Within the framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors; spillovers transmitted via trade, financial, and commodity price linkages, including direct cross-border debt and equity portfolio holdings and indirect comovement in asset risk premia. *Prepared by the U.K. country team; excerpts from 2013 SPILLOVER REPORT—ANALYTICAL UNDERPINNINGS AND OTHER BACKGROUND* ### 2. Our scenarios account for an accelerated monetary normalization in the United States ### 2. Our scenarios account for an accelerated monetary normalization in the United States ### Scenario design and assumptions - Scenario 1 (endogenous conventional tightening): - Conventional tightening driven by endogenous nominal policy interest rate increases in response to a stronger than expected private domestic demand driven cyclical expansion generated with a sequence of temporary but persistent intertemporal substitution shocks, which shift private consumption and investment expenditures. - Intertemporal substitution shocks are phased in gradually to raise the nominal policy interest rate by 100 basis points over two years starting in 2014Q3, and to subsequently lower it by this amount over two and a half years. - Scenario 2 (exogenous conventional tightening): - Conventional tightening driven by exogenous nominal policy interest rate increases generated with a sequence of temporary monetary policy shocks (deviations from the monetary policy rule). - Monetary policy shocks are phased in gradually to raise the nominal policy interest rate by 100 basis points over one year starting in 2014Q3, and to subsequently lower it by this amount over three and a half years. - Unconventional tightening (both scenarios): - Represented by exogenous increases in long term nominal market interest rates via sequences of internationally correlated and temporary but persistent duration risk premium shocks. - Duration risk premium shocks alter the slope of the yield curve and are phased in gradually to contribute to raising the long term nominal market interest rate by 100 basis points over one year starting in 2014Q3, and to subsequently lower it by this amount over three and a half years. - Additional assumptions: - Monetary policy responses remain constrained by the zero lower bound on the nominal policy interest rate through 2015Q2 in the Czech Republic, Denmark, the Euro Area, Japan, Switzerland, and the United Kingdom. - All simulation results are linearly scalable, and would be halved under 50 as opposed to 100 basis point interest rate increases in the United States. ### Simulation outcomes — Endogenous accelerated monetary normalization (key results for 2015) - United States: - Simulated output gain: 2.3 percent in 2015. - Geographically close trading partners (2015 simulated output): - Canada: 1.0 percent - Mexico: 0.9 percent - Ireland: 0.1 percent - Rest of the world (simulated output losses in 2015): - Other advanced economies: range from 0.9 to 1.3 percent - Emerging economies with open capital accounts: range from 0.6 to 1.6 percent - Emerging economies with closed capital accounts: range from 0.2 to 1.1 percent - Aggregated effect: - World output gain: 0.0 percent - Prices and exchange rate: - Energy price decline: 1.7 percent - Nonenergy commodity price decline: 1.4 percent - Dollar nominal effective appreciation: 2.6 percent - Current account and capital flows (2015): - United States current account balance ratio reduction: 1.2 percentage points - United States real effective dollar appreciation: 3.2 percent - Largest current account balance ratio increases in the rest of the world: - Mexico: 2.7 percentage points - Canada: 2.3 percentage points - Ireland: 1.5 percentage points - Korea: 1.0 percentage points - Thailand: 1.0 percentage points - Note: Implied large net capital outflows from these economies would be reduced if they simultaneously experienced private domestic demand driven cyclical expansions. ### Simulation outcomes — Exogenous accelerated monetary normalization (key results for 2015) - United States: - Simulated output loss: 4.0 percent in 2015, of which 1.0 percentage points is due to conventional measures. - Rest of the world (simulated output losses in 2015): - Other advanced economies: range from 1.4 to 2.2 percent - Emerging economies with open capital accounts: range from 1.5 to 2.5 percent - Emerging economies with closed capital accounts: range from 1.1 to 1.4 percent - Aggregated effect: - World output loss: 2.2 percent - Prices: - Energy commodity price decline: 23.2 percent - Nonenergy commodity price decline: 15.3 percent - Current account and capital flows (2015): - United States current account balance ratio improvement: 0.6 percentage points - United States real effective dollar appreciation: 0.8 percent - Largest current account balance ratio reductions in the rest of the world: - Saudi Arabia: 2.3 percentage points - Canada: 1.2 percentage points - Norway: 1.0 percentage points - Mexico: 0.7 percentage points - Russia: 0.7 percentage points ### GIMF scenarios and qualitative outcomes (points from GIMF analysis) - Scenario 1 (GIMF): Faster private consumption and investment recovery starting in 2014 leads to: - U.S. policy rate roughly 50 basis points higher than expected in 2014, 100 basis points higher in 2015, and 150 basis points higher in 2016; policy rate returns to baseline over subsequent 4 years. - Scenario 2 (GIMF): Once U.S. policy rate starts to adjust, increases in risk premium elsewhere normalize interest rates earlier: - Jump in premium: 50 basis points for advanced countries and 100 basis points for emerging markets. - Jump is relatively short lived, decaying with a root of 0.5. - Scenario 3 (GIMF): U.S. risk premium also jumps in line with other advanced economies. - Outcome summaries: - Across the three GIMF scenarios, the increase in U.S. GDP is very similar; normalization sped up with moves in risk premium slightly reduces the increase. - Outside the United States: - When risk premium do not respond, near-term spillovers are positive, with stronger trade-link countries (Canada, Mexico) showing secondary cycling to stabilize inflation. - When risk premiums rise, spillovers to Canada and Mexico remain positive while spillovers to most other countries generally become negative due to financial tightening reducing domestic demand and exports; the fall in imports by countries other than the United States more than offsets higher U.S. imports. ### Additional notes and related exercises in this content unit - Zero lower bound constraint noted for specific economies through 2015Q2: Czech Republic, Denmark, the Euro Area, Japan, Switzerland, and the United Kingdom. - Linearity: all simulation results are linearly scalable (e.g., halved under 50 basis point U.S. interest rate increases). - The content unit also situates these scenarios within broader exercises on U.S. fiscal developments (fiscal cliff adjustment coefficient, rebalancing scenario), though details of those exercises are separate within the source text. *Source: _070313a - 2. Our scenarios account for an accelerated monetary normalization in the United States* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2013/_070313a.pdf_