Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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The London summit’s real achievement

by Brad Setser

Put simply, the agreement at the London summit — if key countries actually carry through on their commitment to expand the IMF’s resources — allows the IMF to be able to both:

a) lend large sums, conditionally, to a host of countries in Eastern Europe that ran large current account deficit and are now having trouble rolling over their debts; and
b) lend large sums to a set of emerging economies that didn’t run large current account deficits and don’t have large stocks of external debt outstanding but still are facing a bit of pressure right now — whether from falling capital flows, falling commodity prices or falling demand for the goods — and wouldn’t mind a few more reserves.

A $250 billion IMF would have been stretched to just meet Eastern Europe’s need for emergency financing. It was too small, in some sense, to even be Europe’s monetary fund. A $750 billion IMF is big enough to be able to offer meaningful sums to the larger emerging economies — think of the $50 billion Mexico wants to be able to borrow if it needs it — and still cover a large share of Eastern Europe’s need for emergency financing.

Here is one way of thinking about the IMF’s need for resources:

At the end of 1997 — at the height of Asia’s crisis — the IMF had about $150 billion to lend, a sum that rose to around $250 billion after the IMF’s quotas were increased and the New Arrangement to Borrow provided the IMF with a bigger supplemental credit line.

At the end of 1997, emerging economies at the time had borrowed — according to the BIS — $1.045 trillion from the international banks. They also had something like $300 billion in external sovereign bonds outstanding. And they only had about $600 billion in reserves (from the IMF’s COFER data)

If the fall in bank lending to the emerging world in the years that followed Asia’s crisis had been financed entirely out of existing reserves, the roughly $200 billion fall in gross cross-border bank lending from 1997 to 2000 would have left the emerging world dangerously under-reserved. In practice, that “deleveraging” process was largely financed by a big swing in the emerging world’s current account balance. Deficits turned to surpluses, and the surpluses were used to repay debt.

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Summitry, change and the global financial architecture

by Brad Setser

About three months ago, the editors of Finance and Development (an IMF publication) asked me to reflect on the lessons the effort to reform the international financial architecture in the 1990s holds for today’s effort to reform the global financial system. Then, as now, there was a real desire to create a system that was less prone to major crises — though the financial crises of the late 1990s were concentrated in the emerging economies, not the US and Europe.

One of my conclusions was that summits rarely are the venue for the key decisions that end up defining the character of the world’s financial system. Many of the decisions that ended up mattering the most were fundamentally national decisions. Other key decisions were made in the heat of an acute crisis — not in a conference room hashing out communique language.

Three examples:

The US decision to provide Mexico with a large loan to avoid default in 1995, for example, had a bigger impact on the global regime for responding to acute financial crises in emerging economies than any subsequent communique. The US decision ended up spurring the IMF (with US support) to offer a large loan first to Mexico and then to other emerging economies. Lots of time was spent talking about the need to return to a world of smaller rescue loans, but it never really happened. A new norm had been established. The conditions that the IMF — with the support of the US and the rest of the G-7 — attached to their initial loans to cash-strapped Asian economies in 1997 had an equally profound, though different, impact: even if the IMF was willing to lend more than in the past, no emerging economy wanted to be subject to the IMF’s conditions if there was a realistic alternative.

The global exchange rate system of the past decade was defined by China’s decision to stick to its dollar peg. That fundamentally was a national decision — though one that had profound consequences for the system. If China hadn’t followed the dollar down from 2002 to 2005, China’s current account surplus wouldn’t have grown as large as it did, China’s reserves wouldn’t be as large as they are and China’s economy wouldn’t be as dependent on exports as it is.

The system of global financial regulation was defined by a deep reluctance by key nations to regulate financial institutions too tightly — an unwillingness, incidentally, that was shared by both the US and Europe. Markets were trusted more than regulators, and no one wanted to lose financial business to a rival financial center. Alas, the financial system ended up extending ever-more credit against ever-higher real estate values without a corresponding increase in the capital needed to absorb downside risks.

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The G-20 communique

by Brad Setser

The G-20’s communiqué offered a surprisingly robust work program for regulatory reform. MIT’s Simon Johnson even worries that it may be too robust – and push banks to scale back their lending in a pro-cyclical way. I am a little less worried about this risk. I assume regulators recognize that a sensible macro-prudential regulatory framework requires raising capital charges in good times (to lean against the boom), not forcing banks to squeeze lending to conserve capital in bad times.

The G-20’s ability to reach agreement on a detailed work program on regulatory reform – just think, the US President has signed off on an effort to evaluate whether compensation practices in the financial sector contributed to excessive risk taking — presumably reflects the groundwork done by the Financial Stability Forum. Many of the G-20’s proposals reflect reforms that key countries have already agreed on there.*

It also reflects another reality: agreement on regulatory changes only required a deal among the G-7 countries, not a deal between the G-7 and the emerging world. The big internationally-active banks are still primarily in the US, Europe and Japan – and are still regulated (and bailed out) by these countries. Emerging economies of course feel the impact of a fall in lending if the financial sector in the US and Europe is hobbled – so they aren’t just bystanders. They should want the US and European regulators to do their jobs effectively, so they aren’t sideswiped by a sudden fall in lending. And no doubt regulation in the emerging world is influenced by practices in the US and Europe. But most emerging market banks already held a bit more capital than US or European banks, as the emerging world didn’t bet on the notion that the fall in macroeconomic and financial volatility associated with the “Great Moderation” was permanent. The Great Moderation never really made it to most of the emerging world: they had a lot more recent experience with macroeconomic volatility.

The “regulatory” deal consequently hinged far more on the US and Europe than the emerging world. And they stepped up. I was struck by how robust the G-20 language describing the short-comings in the advanced economies financial systems was. The G-20 leaders:

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

But I was also struck my how quiet the G-20 was on the macroeconomic imbalances that facilitated the expansion of leverage in the US and Europe. Remember, the US had a low savings rate – and required inflows from the rest of the world. If those inflows had fallen off as US household debts – and the financial sector’s balance sheet leverage – increased, the US might not have dug itself into a hole. The communiqué language here was remarkably diplomatic. No mention was made of macroeconomic imbalances across countries – or misaligned exchange rates. The communique language remained very vague: “Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes.” I consequently am surprised (or perhaps I should say less than impressed) that the White House believes that the G-20 reached “a common understanding of the root causes of the global crisis.” Paulson was quite clear on Thursday that the macroeconomic imbalances the G-20 avoided mentioning had something to do with the current mess.

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The money is flowing out even faster than it flowed in …

by Brad Setser

At least for Russia. And probably for a host of emerging economies.

Russia’s reserves fell by over $30 billion during the third week of October — tumbling from $515.7b on October 17 to $484.7b on October 24. Roughly $15 billion of the fall reflects the fall in the dollar value of Russia’s euros and pounds. But about $15 billion reflects Russian intervention in the currency market, as well as the drain on Russia’s reserves associated with the loans Russia’s government is making to Russian banks and firms seeking foreign exchange to repay their foreign currency debts.

A $15 billion weekly outflow is rather large.

$15 billion is as much as the IMF committed to lend Russia back in 1998. And the IMF actually only disbursed a third of that total.

The most the IMF ever actually lent out to a single country in the past was roughly $30 billion (to Brazil, in 2002-03). At the current rate, Russia will run through that much in two weeks.

The pace of decline in Russia’s reserves is partially a function of the fact that Russia had so many reserves back in July. Countries with less money in the bank tend to husband their scarce resources rather than spend them liberally. A lot Russia’s reserve buildup reflected private inflows rather than the oil surplus, so in some sense Russia’s government is just facilitating the reversal of those flows. In the process, of course, the Russian state is helping out some of Russia’s biggest businessmen. Russia’s state will likely end up controlling a broader swath of Russia’s economy at the end of the “deleveraging” process.

But the pace of decline in Russia’s reserves is also evidence of the scale of the reversal in capital flows to emerging economies — and the pace of the current outflow.

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At this rate the world’s financial architecture will have been remade before November 15th

by Brad Setser

Today the Federal Reserve indicated that it would swap US dollars for Brazilian real, Korean won, Mexican pesos and Singapore dollars — effectively allowing a select group of emerging economies to borrow dollars on terms similar to those available to the G-10 economies. Or almost similar terms. The G-10 central banks can currently borrow dollars from the Fed without limit; the four selected emerging market central banks can only borrow $30 billion each. But $120 billion is real money — and if need be, the the size of these swap lines conceivably could be increased.

This move goes some way toward breaking down the line between the G-7 (really G-10) economies and emerging economies that emerged after the G-7 countries guaranteed that systemically important financial institutions in their economies wouldn’t be allowed to fail and the Fed expanded the scale of the swap lines available to European economies whose banks had a large need for dollars. Those moves reduced the risk of lending to another bank in the G-7 (or G-10), but increased the (relative) risk of lending to a bank outside the G-10. German banks needing dollars could get dollars from the ECB, which could get dollars from the Fed. Korean banks had no such luck.

Change has come to the IMF as well. The IMF used to be in the business of providing tranched, conditional loans. And for a long-time the stated goal of fund policy was to return to the funds traditional lending limits (for geeks, 100% of quota in a year, 300% of quota over the life of the program). Now it is willing to lend to some countries unconditionally. And to provide up to 500% of quota upfront. Today’s IMF press release:

The new facility, approved by the IMF’s Executive Board on October 28, comes with no conditions attached once a loan has been approved and offers large upfront financing to help countries restore confidence and combat financial contagion.

“Exceptional times call for an exceptional response,” said IMF Managing Director Dominique Strauss-Kahn. “The Fund is responding quickly and flexibly to requests for financing. We are offering some countries substantial resources, with conditions based only on measures absolutely necessary to get past the crisis and to restore a viable external position,” he said.

That’s change. There was a time when it was fairly standard to argue that the financing that the Fund provided was almost incidental to the success of a Fund program. The conditions were what really mattered. Now, for at least a subset of countries, the Fund thinks all that really matters is money.

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