EME vulnerabilities and the Fed

On 13 September the BIS released its latest Quarterly Review placing emerging market vulnerabilities at centre stage.  On 17 September, the FOMC voted against raising its target policy rate, citing near-term headwinds for the US coming from abroad.  “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”

Let’s connect these dots.

In one particularly interesting chapter of the BIS report, Hofmann and Takats report their finding that, at least for “economies that are closely integrated in the global economy and global financial markets, financial conditions are not independent.  Interest rates in the core financial centres are important driving factors”  (p. 116).  In other words, US monetary policy is, to a large extent, world monetary policy.

The BIS has long been warning of imbalances building up as a consequence of prolonged easy money in the core financial centres.  How ironic it would be if that warning tipped the balance on Thursday toward continued easy money!

Of course, the Fed is not supposed to worry about what is best for the world, but only what is best for the US.  “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.”  How ironic it would be if financial globalization has progressed sufficiently far that the Fed now finds that domestic stability depends on global stability!

Most of the BIS report is taken up with an account of its progress on developing a more satisfactory set of global financial statistics, as an aid to future policy analysis.  For someone like me, it makes fascinating reading.  We have a better picture today of the “geography of international banking” (p. 58) than ever before.


We know that most of world borrowing is in dollars, with the euro a distant second.   We know that in recent months borrowing by emerging market countries has declined sharply while borrowing by advanced countries has continued.  We know that the EME corporate carry trade, borrowing in dollars and lending in domestic currency, is now under serious stress given appreciation of the dollar.  We know that advanced country corporates are now embarking on their own carry trade, borrowing in euros and swapping into dollars, to position themselves for the divergence of central bank policy.

The problem is not that we don’t know the facts, but that we don’t have an adequate lens for understanding what the facts mean.

Generations of economists, including most of the policymakers now running the world, have built their trained intuition on the backbone of the National Income and Product Accounts.  That set of accounts measures the flow of income and expenditure at the national level, and treats the connection between countries as a matter of net exports (X-M).  Back in the day, it was a huge advance, and made a lot of sense.  It makes a lot less sense in the financially integrated and globalized world of today.

What we need is a new generation of economists who build their own trained intuition instead on the backbone of the accounts now being developed by the BIS.

For a glimpse of the payoff from the new economic thinking that might one day be in store once everyone learns their economics from these new accounts, have a look at the little boxes at the beginning of the report, little one- and two-page essays that seem to be intended as examples of how to use the data for analysis.

Just so, Box 2 (p. 14) “Dislocated Markets” draws our attention to the breakdown of the covered interest parity condition, which first happened during the crisis as a consequence of intense dollar funding pressure, but which continues even today when there is no overt crisis.  Liquidity pressures are apparently pushing around asset prices; old economic thinking that assumes perfect arbitrage needs to be updated to connect to this reality.


Another example, Box 3 (p. 28) pulls together data from BIS reporting banks to tell a plausible story about how a Chinese global company, with dollar assets and dollar liabilities both onshore within China and offshore, might respond to a shift in incentives that makes it less attractive to be long renminbi and short the dollar.  The point is that such a firm has multiple margins for adjustment, and we can think about how adjustment on each margin would show up in the new accounts, and then check to see if the data are consistent.  They are.

Finally, one of most interesting new set of accounts that the BIS is publishing begins to construct international debt service ratio statistics.  It is my hope that perusal of this kind of data will help to shift trained intuition that currently thinks about debt only in terms of leverage, and hence risk of insolvency.  Shifting to a debt service concept immediately raises issues of illiquidity.  Is the time pattern of likely cash flows (income) adequate to service the time pattern of promised cash payments on debt, or is timely and smooth refinance being assumed?  The same leverage ratio can be easy to service (long term debt) or hard to service (overnight debt), and that matters.  Liquidity kills you quick.