Raghuram Rajan on Global Cooperation and Cross-border Capital Flows
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- Authors: RAGHURAM RAJAN
- Published: June 1, 2019
Main thesis
- Global cooperation is needed to reap the benefits and avoid the pitfalls of cross-border capital flows.
- Cross-border capital flows can be beneficial to recipient countries (making up deficiencies in long-term risk capital and improving corporate governance) and to sending countries (offering investment avenues for savings generated by aging populations).
- Cross-border capital flows can also be problematic when they arrive at the wrong time, in the wrong form, or leave at the wrong time.
Mechanics of risk: domestic credit boom
- Sustained expectations of high future liquidity encourage firms to increase leverage because:
- Debt financing allows firms to operate with less of their own capital.
- Lenders expect to recover debt by reselling seized assets at high prices, lowering incentives for rigorous due diligence.
- High anticipated liquidity reduces managerial incentives to implement costly governance structures (for example, good accounting rules and an unimpeachable auditor).
- Housing-boom analogy: lenders dispense with normal safeguards (example cited: the NINJA loan—no income, no job, no assets).
Mechanics of risk: sudden stop and currency linkage
- Three added assumptions for emerging market exposure:
1. Domestic companies have substantial borrowing from source countries or denominated in source-country currencies (typically the United States; typically the dollar). 2. Easier monetary policy in the source country pushes capital into higher-interest-rate environments, raising the recipient currency’s value in dollar terms and increasing corporate net worth/liquidity for borrowers with dollar debt. 3. At some point, source-country monetary policy normalizes (tightens), causing recipient-currency depreciation, higher local-currency repayments on foreign borrowing, and lower corporate liquidity.
- Consequences of normalization:
- Higher leverage at the onset of tightening because lenders had anticipated continued liquidity.
- Neglected corporate governance exacerbates the fall in debt repayment capacity.
- Preexisting short-term foreign borrowing can precipitate runs and immediate corporate distress.
- The boom–bust in the emerging market can be a genuine spillover from source-country policy and need not reflect recipient-country macroeconomic policy or credibility.
- Empirical example: 2013 “taper tantrum” after signals from then-Chairman Ben Bernanke led to capital outflows from emerging markets and sharp declines in emerging market assets and currencies.
The “great moderation” view and its limits
- Pre-2007–08 consensus: monetary policy focused solely on domestic price stability via flexible inflation targeting, allowing exchange rates to float and removing the need for reserve accumulation.
- Post-crisis evidence suggests this approach is too complacent: exchange-rate appreciation does not necessarily offset spillovers from capital inflows; appreciation can attract more capital chasing prior returns (Bruno and Shin 2015).
- Fluctuations in the exchange rate are a primary driver of fluctuations in corporate liquidity in receiving countries.
- Emerging market attempts to smooth exchange-rate movements may aim to avoid large swings in credit availability and macroeconomic volatility rather than to gain trade competitiveness.
- Reserve accumulation and FX intervention by emerging markets (purchases of assets such as US Treasury securities) may be intended to moderate appreciation and prepare for future depreciation, but such intervention exacerbates moral hazard by encouraging overborrowing in foreign currency.
Limits of domestic policy tools in receiving countries
- Few effective tools that do not significantly disrupt the domestic economy:
- Tighter domestic monetary policy risks shifting borrowing into cheaper dollars, potentially exacerbating domestic currency appreciation in the short run.
- More accommodative domestic monetary policy risks excessive credit expansion.
- Quiescent inflation in source countries makes their monetary policy accommodative for long periods ("low for long"), implying sustained easy liquidity in receiving countries and a substantial buildup in leverage and financial fragility.
Responsibility of source countries and scope for multilateral action
- Debate over whether sending-country central banks bear responsibility for spillovers:
- Some advanced-economy central bankers focus on domestic mandates and deny responsibility.
- Others accept spillovers exist but see limited policy options other than encouraging recipient-country macroprudential measures (the IMF’s approach).
- Macroprudential policy is narrow in scope and may not cover the whole financial system; monetary policy can affect many parts of the economy.
- Multiple tools may be needed; macroprudential tools should not be the only response.
- Proposal in Mishra and Rajan (2019): certain unconventional monetary policy actions in specific environments could be ruled out of order because of the large adverse spillovers they create—without changing central bank mandates or requiring broad international coordination.
- An Eminent Persons Group (tasked by the Group of Twenty) recommended a “rules-based international framework, drawing on a comprehensive and evolving evidence base… to provide policy advice through which countries seek to avoid policies with large spillovers, develop resilient markets, and benefit from capital flows while managing risks to financial stability.” The Group suggested the IMF develop a framework to enable sending countries “to meet their domestic objectives while avoiding large international spillovers.”
Additional angle: domestic financial stability mandate in source countries
- A long period of easy monetary policy could increase leverage and asset-price inflation in ways that threaten the source country’s own financial stability.
- If source-country central banks had an explicit domestic financial stability mandate, their policy choices might change in ways that also mitigate external spillovers.
Policy recommendations and multilateral role
- Countries should temper sovereign policymaking with international responsibilities to avoid major spillovers.
- Use multiple tools responsibly across countries; do not rely solely on recipient-country measures.
- The IMF should conduct necessary research, lay out a mutually agreed framework, and call out habitual defaulters.
- A rules-based international framework—developed from evolving evidence and facilitated by the IMF—could limit policies with large spillovers while allowing countries to meet domestic objectives.
Raghuram Rajan — F&D Magazine, June 2019.
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