Challenges Ahead: Managing Spillovers

IMF Blog, November 26, 2014

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Publication: Olivier Blanchard, Luc Laeven, Esteban Vesperoni; November 26, 2014.
Event: IMF’s 15th Jacques Polak Annual Research Conference, Washington DC, November 13 and 14, 2014; theme: Cross-Border Spillovers.
Helene Rey (Mundell-Fleming lecture) — two main points:
- Large correlated movements in capital flows, risky asset prices and credit growth across developed and emerging economies constitute a “global financial cycle”.
- Countries cannot fully insulate themselves through exchange rate flexibility: effects of U.S. monetary policy on mortgage spreads were roughly the same for countries that adjusted interest rates and those that did not.
Implication from Rey: capital flows and valuation changes linked to the international use of the dollar have substantial effects on domestic financial systems beyond exchange rate movements; macroprudential policies and capital controls may be required to provide sufficient insulation.

Unconventional monetary policy (two papers):
- Simon Gilchrist, Vivian Yue, Egon Zakrajek:
- Conventional U.S. monetary policy surprises steepened foreign yield curves.
- Unconventional U.S. monetary policy flattened foreign yield curves.
- Marcel Fratzscher, Marco Lo Duca, Roland Straub:
- ECB unconventional policies had positive spillovers on equity prices across many countries.
- Impact on yields was limited to the euro area, especially Italy and Spain.
- ECB policies increased market confidence (reduced implied volatilities and sovereign and banks spreads) but had little impact on international portfolio flows.
Fiscal policy:
- Alan Auerbach and Yuriy Gorodnichenko:
- Addressed contradiction between models predicting exchange rate appreciation following higher public spending and empirical evidence of depreciation.
- Using U.S. daily data on defense spending commitments to identify public spending shocks, they find these shocks were typically associated with an appreciation, supporting theoretical predictions.
Trade and supply chains:
- Christoph Boehm, Aaron Flaaen, Nitya Pandalai Nayar:
- Study of the 2011 tsunami and earthquake in Japan shows strong effects of disruptions on imports and production of Japanese affiliates in the United States.
- Conclusion: in the short run, supply chains are very rigid and disruptions can affect the whole chain.

Anton Korinek:
- Provided an analytical framework to characterize when spillovers are a concern and when market equilibrium is efficient.
- Example result: FX intervention used to provide insurance to the tradable sector in response to capital flows can lead to an efficient allocation.
Marcos Chamon and Márcio Garcia:
- Examined capital controls in Brazil.
- Controls helped segment Brazil’s domestic financial market from the global one, creating a wedge between onshore and offshore prices of similar assets.
- Initial measures had limited success mitigating exchange rate appreciation.
- A tax on the notional amount of derivatives adopted in mid-2011 triggered a significant depreciation—likely due to complementarities with previous measures and supported by the beginning of the monetary easing cycle.
Julien Bengui and Javier Bianchi:
- Analyzed implementation challenges for capital controls.
- Despite leakages via unregulated agents, stabilization gains from preventing financial crises remain large.

Maurice Obstfeld:
- Financial openness challenges prudential tools.
- Even with effective monetary policy and exchange rate flexibility, financial stability is difficult to manage with an open capital account.
- Identified a ‘financial trilemma’: financial integration with global markets, national control over financial supervision and regulation, and financial stability are not all mutually compatible.
- Conclusion: the need for international policy coordination depends on the efficacy of macroprudential policies.
- Suggested critical areas for coordination: financial regulation, clear rules for capital controls, enhanced facilities for international liquidity support in key currencies to counteract downsides of gross reserve accumulation.
Jean Boivin:
- Political-level coordination is complex; a precondition is national acknowledgement of the importance of international spillovers.
Hector Torres:
- Unconventional policies place the global economy in uncharted waters; uncertainty and disagreements complicate cooperation.
- The IMF has an important role in clarifying and fostering consensus about spillovers.
David Vines:
- Full coordination may be too hard; advocated ‘concerted unilateral reforms’ whereby reforms in some countries influence others’ domestic reform choices (a strategy used by the G-20).

Conditional premises:
- (i) Helene Rey’s view: U.S. monetary policy is a driver of a global factor in asset prices, risk premia, mortgage spreads, etc., and its impact on global liquidity is stronger than effects from changes in future short-term rates.
- (ii) Evidence that ECB unconventional policy has a milder impact on capital flows and global liquidity than U.S. unconventional policies (per Fratzscher, Lo Duca, Straub).
Potential takeaway:
- An asynchronous exit from unconventional monetary policies between the U.S. and Europe could raise significant policy challenges.
- Such an asynchronous monetary cycle may require serious policy dialogue, especially among central bankers in advanced economies.

Source: Challenges Ahead: Managing Spillovers, IMF blog page, November 26, 2014.