Understanding and Managing Financial Interdependence

IMF Blog, November 8, 2017

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Publication: Understanding and Managing Financial Interdependence
Author: Maurice Obstfeld
Date: November 8, 2017
Event framed: 18th Annual Jacques Polak Annual Research Conference
Key questions highlighted:
- How do advanced-country policies feed into global financial conditions?
- How are those conditions transmitted into recipient countries?
- How can global finance be harnessed to enhance the benefits it offers while lowering the risks?

Global capital flow cycles visible in balance of payments data going back to 1815.
Cycles coexist with commodity price cycles that can reinforce financial retrenchment and lead to widespread defaults by emerging and developing economies.
Since 1960 there is evidence of a global household debt cycle, with increases in household debt forecasting lower subsequent output growth — aligned with findings of the October 2017 Global Financial Stability Report.

The United States, as issuer of the world’s prime reserve and funding currency, is a key source of global cycles.
Mechanisms identified:
- Leverage of U.S. broker dealers can stimulate cross-border credit flows, affecting home prices and consumption.
- Strength in the U.S. dollar exchange rate indicates tighter global funding conditions and has apparent real effects on global investment levels.
- U.S. monetary policy influences global risk appetite and increasing equity market co-movement across advanced economies.
European Central Bank actions can also move the dollar’s exchange rate and global funding conditions via effects on interest rates and term premia (noting the effective lower nominal interest bound).
Micro-level bank and firm data can clarify causality and link global financial conditions to bank lending; a conference paper studied Turkey in detail.

Benefits:
- Allows diversification and a better global allocation of world savings.
Risks and heterogeneity:
- Countries differ in abilities to absorb foreign capital flows; some gain productive potential (especially where financial markets are deep and allocate capital efficiently), others suffer crises and higher inequality.
- Exposure to the global price of risk (a function of the stock market's expectation of volatility, the VIX index) tends to raise expected income growth but also raises the volatility of that growth, creating a tradeoff dependent on domestic policy quality.

Much of capital flow dynamics remain driven by country-specific and regional factors; strong policy frameworks can temper disruptive global market effects.
Policy views presented:
- José De Gregorio stressed sound policy frameworks.
- Rakesh Mohan emphasized judicious use of foreign exchange intervention and capital flow management measures.
Conference papers underscored:
- Role for policy measures geared toward preventing currency mismatches.
- Potential theoretical benefits from reducing exchange-rate volatility and managing the external balance sheet.
Prudential and cooperative imperatives:
- Richard Berner highlighted the importance of prudential policies and the need for strong international cooperation to make them effective in a globalized financial system.

The global real interest rate is currently at very low levels by most estimates.
Hélène Rey's work: the global ratio of consumption to wealth has been a reliable forecaster of the global real interest rate since the late 19th century and now stands at levels suggesting rates will remain low for some time.
Implications:
- Monetary policy may be challenged to reconcile price and financial stability absent strong macroprudential policies and effective multilateral cooperation.
Trade-finance interaction:
- Trade integration is at an all-time high and closely interrelated with financial integration.
- Barry Eichengreen noted threats to the rules-based multilateral trading system; disruptions to the global trading system would have important macroeconomic effects that could leave all parties worse off.

The International Monetary Fund hosted its 18th Annual Jacques Polak Research Conference on November 2-3, 2017.
Conference theme: “The Global Financial Cycle.”
Conference featured fourteen papers and discussants, the Mundell-Fleming lecture, and a distinguished policy panel and luncheon speaker.
Speakers drawn from academia and the policy community, including from within the Fund.

Source: Maurice Obstfeld, "Understanding and Managing Financial Interdependence", November 8, 2017.