12 December 2019

International Capital Flows and Using the Global Financial Safety Net

Cédric Tille, Professor of International Economics at the Graduate Institute and Head of the Bilateral Assistance and Capacity Building for Central Banks programme, discusses in this interview a recent article he co-authored on the policy options available to emerging markets to absorb the impact of international capital flows. Focusing on the role of the Global Financial Safety Net, Prof. Tille and co-authors Béatrice Scheubel and Livio Stracca argue that no policy tool is effective against all types of crises; hence, the usage of specific instruments needs to be tailored to the specific problem at hand.

What motivated you and your co-authors to focus on the ability of the Global Financial Safety Net (GFSN) to absorb capital flows to emerging markets driven by global factors?

The economic literature has identified the “global financial cycle” as a feature of growing relevance in international economics. This cycle captures movements in global lending driven by monetary conditions in core economies, such as the United States, and the willingness (or lack thereof) of global financial intermediaries to lend. There are growing concerns that small open economies may be exposed to waves of money coming in or getting out because of the global cycle. Our motivation was to assess whether there are tools available to policymakers that can absorb these gyrations in capital flows.
What are the paper’s main findings? 

The key finding is that the situation is quite heterogeneous. We first distinguish across different types of crises, in particular currency crises with sharp movements in the exchange rate, and so-called “sudden stops” where capital inflows from the rest of the world dry up. We also distinguish between two policy tools, namely foreign exchange reserves and borrowing from the International Monetary Fund (IMF). For each tool we contrast the effect of merely having the tool available from the effect of actually using it. We find that using IMF support limits the recession during currency crises. By contrast, foreign exchange reserves provide little help, and neither tool helps much in a sudden stop episode.
How can these findings impact policy discussions and what could be the main take-away for emerging markets? 

Our findings point that there are no policy tools with a broad effect applying to all types of crises. Instead, the usage of specific instruments needs to be tailored to the specific problem at hand. 
Why is important to not only look at the use of, but also at the access to, GFSN and how does the paper distinguish and measure them?

A priori it could be the case that access to the GFSN might be enough to deter speculators from pulling money out of the country, in the same way that the availability of bank deposit instils confidence in depositors and leads them not to trigger a bank run. We find however that the GFSN has to be actually used to have an effect. For foreign exchange reserves, we measure access by the value of reserves to GDP and use by deviation from the previous trend of reserve accumulation. Access to the IMF support is measured by the country’s quota, and use is measured by the actual amounts that a country borrows.
Why should the IMF use and reserve use be considered jointly for assessing the actual power of the GFSN?

Reserves can be used at the sole discretion of the country facing a challenge, while IMF support is conditioned on approval by the IMF. In addition, the help from the IMF comes with a set of policies that need to be implemented. It could thus well be that the two measures have different effects. Furthermore, the impact of relying on the IMF can be affected by whether the country also uses its own reserves or not.
Why is it important to address endogeneity and how does the paper do that?

Endogeneity has long been an issue of concern in the literature. Support from the IMF does not come randomly, but instead is used in crises. This is similar to the fact that the fire department is only called to houses that have a fire. Even if the fire department does a good job, the damaged house will be in worse shape than the neighbouring one. One should not conclude of course that the fire department actually damaged the house, as it otherwise would have burnt down. We therefore need to control for the fact that the GFSN is used when countries are facing challenges. We do so by relying on variables that make the GFSN use more likely but do not make a crisis more likely. One such variable is the political proximity of the countries with the world main economies.
What do you see as areas of further research that can benefit from this paper? 

Our focus was on globally driven crises. It could thus well be the case that tools that do not work then, such as using foreign exchange reserves, could work when the country is faced with a crisis that reflects its domestic problems. The range of events could also be broadened beyond currency crises and sudden stops.

*  *  *

Full citation of the article:
Scheubel, Beatrice, Livio Stracca, and Cédric Tille. “Taming the Global Financial Cycle: What Role for the Global Financial Safety Net?” Journal of International Money and Finance 94 (2019): 160–82. doi:10.1016/j.jimonfin.2019.01.015.

*  *  *

Interview by Guilherme Suedekum, PhD Candidate in International Economics.
Banner image: excerpt from an image by littleartvector/