Working through some of the effects of Global Capital Flows

In a monetary arrangement that promotes free capital mobility, capital flight causes either the FX rate to decline, interest rates to rise, a reserve drain, or some combination of all three.  Without having to resort to capital controls, if the CB decides to manage their FX rate then they essentially force the bulk of any adjustment in capital flows to fall on domestic interest rates.

The problem that smaller open economies seem to face is the procyclical nature of capital flows.  If the CB is intent on managing or pegging the FX rate, they are in essence attempting to fix/peg expectations concerning the future path of that rate.  In an open economy that promotes relatively free capital mobility, this attempt at suppressing FX rate volatility can induce global market participants to issue debt denominated in the lower interest rate currency in order to fund the purchase of debt denominated in the higher yielding currency.  During good times, this can cause interest rates to converge in debt markets with some very dangerous consequences.  

The adoption of the Euro by Eurozone member states exemplifies this as it in essence implemented a very hard FX rate peg. During the expansion phase prior to the crisis, banks and asset managers had the incentive to issue relatively cheap debt in core nations to fund the purchase of higher yielding peripheral debt until interest rate spreads narrowed enough to make this trade unattractive.    

The following attempts to work though some of the consequences that may result from a policy that seeks to eliminate or reduce FX rate volatility.       

If interest rates are higher domestically than those found in the monetary system which the FX rate is pegged to, then it becomes logical to attempt to:

1.  Issue liabilities (borrow) denominated in the foreign FX 

2.  Buy assets (lend) denominated in domestic FX which offer a higher yield than the cost of the liability 

3.  These two steps will cause capital to flow into the domestic economy causing the FX to appreciate.

4.  In order for the CB to successful target their desired FX rate, they must be ready to buy foreign currency reserves by creating domestic reserves (CB liabilities) in the domestic banking system.  This has the effect of putting downward pressure on the policy interest rate (ex. the SNB's CHF peg to the Euro).

5.  Therefore, in a domestic economy where capital flows are unrestricted, a CB that manages the FX rate ends up adopting the monetary policy instituted by their foreign counterpart. (ex.  Denmark in maintaining their fixed FX rate to the Euro responses by instituting a more negative interest rate policy as the ECB does.)  

Potential Effects

As capital flows into the domestic financial system due to the interest rate differentials the following may occur. 

1.  Domestic interest rates decline. 

2.  A credit boom may (will likely) occur domestically which puts upward pressure on the inflation rate as aggregate demand increases.  If so, as interest rates converge to those found abroad, inflation rates and likely labor costs will diverge resulting in a loss of competitiveness as domestic prices and incomes rise relative to those found abroad (ex. the EZ periphery).

3.  Economically, this lending boom pushes down on unemployment as either investment (ex. Spanish real estate) or consumption spending increases. 

4.  The CB may have to expand their balance sheet in order to accumulate foreign reserves as a consequence of their FX rate policy.  

5.  The domestic fiscal authority may (perhaps inappropriately) decide to expand government bond issuance either denominated in local or foreign FX as interest rates decline.    

6.  This possibility of fiscal expansion also puts upward pressure on the rate of inflation if the economy cannot expand productive capacity enough to meet the increase in aggregate demand. 

7.  An increase in domestic spending could put pressure on the trade balance as tradable goods are imported.  This can negate the FX appreciation and/or the foreign reserve accumulation on the balance sheet of the domestic CB.  This can be incredibly dangerous once the psychology surrounding the capital flows begin to question whether the CB can credibly defend the FX peg/objective.  When foreign capital flows are flooding into the domestic economy, the CB can always create more domestic reserves in order to accommodate this increased demand for it's currency reserves. However, when capital flows reverse the CB can certainly run out of the accumulated foreign reserves especially if they are mismanaged.   

8.  Downward pressure on domestic interest rates and upward pressure on inflation eventually may lead to negative real interest rates on domestic deposits.  It becomes logical for domestic holders to want to trade away assets that suffer from a negative real interest rate.  This may even result in foreign currency hoarding (Argentina's black market for dollar bills). If capital flight occurs, this either causes a foreign reserve drain from the CB’s balance sheet or a loss of the CB's credibility in their FX rate policy.  As these trends intensify, expectations of an FX rate devaluation may start to arise as CB credibility comes into question.  These expectations work to reinforce the trends creating a feedback loop in the process.  

Then again, the negative real interest rate could very well fuel the domestic credit expansion as those suffering from the negative real rate increase their demand for higher yielding but riskier financial securities.  It goes without saying that low quality security issuers would be one of the biggest beneficiaries as increased demand may enable them to expand equity and debt issuance at very low real rates.       

9.  If investment spending becomes unproductive this risks creating an asset bubble which becomes problematic especially if in real estate.

10.  If the capital flows reverse, the risk of a credit crunch emerges which works to rebalance the system by depressing domestic consumption (forcing an increase in the savings rate) and reducing investment spending.  This causes a rise in unemployment and either slower real growth or outright economic contraction.  In certain instances this works to dampen inflationary pressures.  Then again, capital flight induced or exacerbated by low or negative real rates as a result of high inflation and a lack of credibility between the Central Bank and fiscal authority could lead to shortages of goods if the economy is dependent on key imports (Venezuela).      

If capital flows lead to productive investment domestically, especially if the country (but not necessarily) has been running a current account surpluses or small deficits, then this process does not need to be destabilizing.  Productive domestic investment allows the private sector or government to expand productive capacity.  Surplus real output can then be exported abroad.  This generates increased income for the domestic private sector, boosts employment/household income, and increases government tax revenues.  This allows the domestic financial system to safely delever while the economy begins to run current account surpluses which work to offset the prior current account deficits.  Externally denominated debt on the balance sheets of the private sector aren't necessarily a burden either especially if the revenues of exporters are also denominated in the foreign currency.  In certain cases, currency depreciation can result in higher corporate profits (Japan during Abenomics) and/or an increase in net exports particularly if labor costs are rigid and slow to respond. 

However, this dynamic is not solely in the hands of the domestic economy.  To see this, envision a scenario with only two nations.  By definition (accounting identity) one nation's current account surplus is the other's current account deficit.  In order for the domestic economy (in prior paragraph) to properly delever by running current account surpluses or smaller deficits, the foreign country must comply by running current account deficits (after running surpluses) or smaller surpluses.  This can be brought on by a foreign consumption (caused by an increasing share of household income) or investment spending boom (via the corporate or government sector) both of which can result in a rise in net imports.  A foreign investment boom can lead entities in the foreign country to increase their imports of capital goods and/or commodities (ex. China purchasing commodities from Latin America, Australia etc) while a consumption boom can boost demand for foreign finished goods (ex. US buying Asian manufactured products).  

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Where are the balance sheet mismatches?

If the domestic private or government sector issues foreign denominated liabilities (external debt) which are held as assets by foreign market participants while then using the funding to either lend domestically or increase spending, then the currency mismatch is found here on domestic balance sheets.

If however the domestic private or government sector issue domestically (local) denominated liabilities/financial securities which are bought by foreign market participants then the mismatch exists on foreign balance sheets.  This can be problematic when leverage is introduced.  If the foreign market participant issues debt denominated in their domestic currency in hopes of taking advantage of interest rate spread between both systems plus the potential foreign currency appreciation, they expose themselves to a few adverse scenarios. 

Example:

If a US fund manager (or global asset managers via Eurodollars for that matter) borrows in US dollars to fund the purchase of foreign denominated assets, they are exposed to not only foreign credit risk, but also the change in market expectations concerning the likely future path of US interest rates as well as the FX rate.  If the fund manager suspects that the foreign CB will be unable to manage the FX rate according to previously set expectations, then this may induce them to hedge (FX forward contracts or foreign exchange swaps etc) or reduce their exposure by selling all or parts of their position.  This change in expectations can induce the capital flight which is cause and consequence of the knock-on effects listed above.  From there, it can become a self-fulfilling prophecy as the actions taken by the market participants create the very outcomes which they anticipated.    

The manager is also exposed to the potential change in US monetary policy or a rise in the long end of the US yield curve.  If the US CB were to target higher short rates, then the US fund manager may need to role over their debt at higher rates otherwise they must reduce their holdings of foreign assets.  If the expectations of Fed tightening results in higher real rates on the long end of the treasury curve, this changes the trade-off between holding now higher yielding risk free treasury securities or foreign denominated securities.  The marginal holder of foreign securities may have the incentive to switch their portfolio position if appropriate.  This induces capital flight which brings about the knock-on effects listed above.  Again to support a managed FX rate the foreign CB ends up adopting the Fed’s monetary policy as they are forced to raise their policy interest rate if the Fed tightens; otherwise the CB risks losing credibility in managing their FX rate.  However in doing so the risk is that increasing the policy interest rate may end up slowing down their domestic economy as the domestic banking system and private sector come under pressure (Emerging Market countries).

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The potential effects of US Fiscal Policy

Another risk which can be problematic is the change in US fiscal policy (treasury issuance).  A reduction in fiscal policy reduces aggregate demand and inflation, boosting real interest rates unless the Fed offsets this by signaling and eventually engaging in expansionary monetary policy.  Secondly, a decrease in US aggregate demand/nominal GDP/aggregate spending will cause fewer US dollar denominated reserves to flow abroad as the US trade deficit narrows.  This impairs the ability for other CBs to accumulate dollar reserves when managing their FX rate.  This can change expectations as the flow of US reserves held by foreign CBs start to disappoint.  At worst, this can cause nations who once managed to run current account surpluses to being running deficits. A slowdown in US nominal GDP induced by more restrictive fiscal policy can reduce dollar revenues by the foreign private sector. 

If the Fed responds to a potential slowdown in US nominal GDP by instituting more accommodative monetary policy and real rates in the US decline, then more restrictive fiscal policy can be offset where private dollar lending can replaces fiscal deficit spending.  In this scenario, a more restrictive fiscal deficit results in fewer treasuries being issued, but the domestic and global private sectors offset this by expanding private dollar credit as these sectors increase non-US government debt issuance.  In other words, a reduction of the US government deficit causes an increase in non-government private leverage in order to maintain domestic and perhaps global NGDP.        

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Conclusion

If the above is an accurate portrayal then suppressing FX rate or interest rate volatility might be incredibly destabilizing as this may lead to very unfavorable, unpredictable, and volatile episodes once expectations shift.  This is problematic given that as the global financial system grows increasingly more integrated, it may become very difficult for policymakers to manage expectations throughout the incredibly complex and interconnected global community. 

It is important to appreciate the reflexive relationships between changes in the expectations and psychology of all parties involved.  Especially in a volatile environment, sentiment may become the driving force behind balance sheet decisions where reason is only left to justify actions after the they have already been taken.

It cannot be underscored enough that such episodes not only affect balance sheets, but can lead to political upheaval which in turn can intensify psychology.  That incredibly important aspect is beyond the scope of this post, but must always be at the front of anyone’s mind when considering how the shifts in the financial system affect the communities in which we live.  

As Hyman Minsky warned, stability is destabilizing.