- Christopher Crowe, Simon Johnson, Jonathan Ostry, and Jeronimo Zettelmeyer
- Published Date:
- August 2010
© 2010 International Monetary Fund
Nothing contained in this book should be reported as representing the views of the IMF, its Executive Board, member governments, or any other entity mentioned herein. The views in this book belong solely to the authors.
Macrofinancial linkages: trends, crises, and policies / editors, Christopher Crowe… [et al.].—Washington, D.C.: International Monetary Fund, 2010.
p. ; cm.
Includes bibliographical references.
1. Financial crises. 2. Credit. 3. International finance. 4. Monetary policy. I. Crowe, Christopher (Christopher W.). II. International Monetary Fund.
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- Part I. Financial Boom-Bust Cycles
- Chapter 1. Lending Booms and Lending Standards
- Giovanni Dell’Ariccia · Robert Marquez
- Chapter 2. Are Weak Banks Leading Credit Booms? Evidence from Emerging Europe
- Deniz Igan · Natalia Tamirisa
- Chapter 3. Growth Dynamics: The Myth of Economic Recovery
- Valerie Cerra · Sweta Chaman Saxena
- Chapter 4. From Subprime Loans to Subprime Growth? Evidence for the Euro Area
- Martin Čihák · Petya Koeva Brooks
- Chapter 5. The Real Effect of Banking Crises
- Giovanni Dell’Ariccia · Enrica Detragiache · Raghuram Rajan
- Chapter 6. Systemic Crises and Growth
- Romain Rancière · Aaron Tornell · Frank Westermann
- Part II. Financial Integration, Financial Liberalization, and Economic Performance
- Chapter 7. Measuring Financial Integration: A New Data SetMartin Schindler
- Chapter 8. The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970 – 2004
- Philip R. Lane · Gian Maria Milesi-Ferretti
- Chapter 9. Reaping the Benefits of Financial Globalization
- Giovanni dell’Ariccia · Julian Di Giovanni · André Faria · M. Ayhan Kose · Paolo Mauro · Jonathan D. Ostry · Martin Schindler · Marco Terrones
- 9.1. Introduction
- 9.2. Some Facts on Financial Globalization
- 9.3. Determinants of Financial Globalization: A Cross-Country Perspective
- 9.4. Risk-Sharing Benefits of Financial Globalization: Theory and Practice
- 9.5. How Does Financial Globalization Affect Stability and Growth?
- 9.6. Conclusion
- Appendix I. Country List
- Appendix II. Capital Control Indices
- Appendix III. Case Studies on Financial Account Liberalization
- Chapter 10. Financial Globalization: A Reappraisal
- M. Ayhan Kose · Eswar Prasad · Kenneth Rogoff · Shang-Jin Wei
- 10.1. Introduction
- 10.2. A Brief Overview of Theory
- 10.3. Measuring Financial Openness
- 10.4. Macroeconomic Evidence on the Effects of Financial Globalization
- 10.5. How Does the Composition of Capital Flows Matter?
- 10.6. Organizing Principles
- 10.7. Collateral Benefits of Financial Globalization
- 10.8. Threshold Effects in the Outcomes of Financial Globalization
- 10.9. Conclusion
- Data Appendix
- Chapter 11. International Financial Integration and Economic Growth
- Hali Edison · Ross Levine · Luca Antonio Ricci · Torsten Sløk
- Chapter 12. The Quality Effect: Does Financial Liberalization Improve the Allocation of Capital?
- Abdul Abiad · Nienke Oomes · Kenichi Ueda
- Part III. Policy Issues
- Chapter 13. Monetary Policy and Asset Prices: Does “Benign Neglect” Make Sense?
- Michael D. Bordo · Olivier Jeanne
- Chapter 14. Corporate Governance Quality: Trends and Real Effects
- Gianni De Nicoló · Luc Laeven · Kenichi Ueda
- Chapter 15. Country Insurance: The Role of Domestic Policies
- Törbjörn Becker · Olivier Jeanne · Paolo Mauro · Jonathan D. Ostry · Romain Rancière
- 15.1 Introduction
- 15.2. Insurance Against What?
- 15.3. Sound Fundamentals and Liability Structures
- 15.4. Self-Insurance Through International Reserves
- 15.5. Conclusion
- Appendix I. Data Sources and Definitions
- Appendix II. Behavior of Different Types of Financial Flow
- Appendix III. A Model of Optimal Reserves
- Chapter 16. International Reserves in Emerging Market Countries: Too Much of a Good Thing?
- Olivier Jeanne
- Chapter 17. Policy Responses to Systemic Banking Crises
- Luc Laeven · Fabian Valencia
- Table 2.1 Sample Coverage
- Table 2.2 Summary Statistics by Period and Region
- Table 2.3 Simultaneous Modeling of Bank Credit Growth and Distance to Default
- Table 2.4 Credit Growth in the Weakest Banks
- Table 2.5 Differences in Bank Credit Growth in the Baltics and Other CEECs
- Table 2.6 Differences in Credit Growth in Banks with High Exposures to Foreign-Currency Lending and Household Lending
- Table 2.7 Summary Statistics
- Table 2.8 Summary Statistics by Country
- Table 2.9 Variable Description
- Table 3.1 Probability of Shocks
- Table 3.2 Consensus Forecast Errors for Growth
- Table 4.1 Demand and Supply in the Disequilibrium Model, 1997–2007
- Table 4.2 Ordinary Least Squares Regression of Output on Loans
- Table 4.3 First Stage IV Regression: Loans on Money Demand Shocks
- Table 4.4 Second Stage IV Regression of Output on Loans
- Table 5.1 Summary Statistics
- Table 5.2 Differential Effect of Banking Crises on Value-Added Growth
- Table 5.3 Differential Effects of Banking Crises on Value-Added Growth: Differences beteen Developed and Developing Countries
- Table 5.4 Differential Effect of Banking Crises on Value-Added: Difference Among Countries and Crises
- Table 5.5 Differential Effects of Banking Crises on Growth in Capital Formationand the Number of Establishments
- Table 5.6 Differential Effects of Banking Crises on Value-Added Growth: Industries Differentiated Based on Establishment Size
- Table 5.7 Differential Effects of Banking Crises on Value-Added Growth: Industries Differentiated Based on Export Orientation
- Table 5.8 Policy Interventions during Crises as Classified by Honohanand Klingebiel (2003)
- Table 5.9 Differential Effects of Banking Crises and Intervention Policies
- Table 5.10 External Dependence Index
- Table 5.11 Summary Statistics
- Table 5.12 Correlations Between Measures of External Dependence
- Table 5.13 Banking Crises Inception Dates
- Table 5.14 Average Growth of Real Value Added in Crisis and Noncrisis Years
- Table 6.1 Skewness, Crises, and Extreme Observations
- Table 6.2 Skewness and Growth: Baseline Estimations
- Table 6.3 Skewness and Growth: Country Grouping Estimates
- Table 6.4 Crisis Indexes and Growth
- Table 6.5 Skewness, Investment, and Growth
- Table 7.1 List of Countries in the Dataset
- Table 7.2 Pairwise Correlations of Alternative Capital Control Indices
- Table 8.1 Portfolio Equity Liabilities Reported by Destination and Investor Countries, 2004
- Table 8.2 Portfolio Equity Liabilities Reported by Destination and Investor Countries,2004
- Table 8.3 Cumulative Value of Net Errors and Omissions, Selected Countries (1970–2004)
- Table 8.4 Correlation Between Current Account and Change in Net Foreign Assets:Industrial Countries and Emerging Markets, Annual Data, 1971–2004
- Table 8.5 Standard Deviation of Current Account and Change in Net Foreign Assets, 1982–2004
- Table 8.6 Cumulative Current Account and Change in Net Foreign Asset Position, 1982–2004
- Table 8.7 Decomposition of Net Foreign Asset Position Dynamics, 1996–2004
- Table 9.1 Gross and Net External Positions, 2004
- Table 9.2 Capital Controls by Type, 1995–2005
- Table 9.3 Determinants of Gross External Liabilities Per Capita, 2004
- Table 9.4 Gravity Estimates for Bilateral Foreign Asset Positions, 2004
- Table 9.5 Potential Gains from Risk Pooling Among Countries
- Table 9.6 Impact of Financial Integration on Consumption Volatility
- Table 9.7 Countries with De Facto Open Financial Accounts:Frequency of Crises, 1970–2004
- Table 9.8 Financial Integration and Economic Growth
- Table 9.9 Impact of FDI on GDP Growth
- Table 9.10 Financial Openness (De Jure) and Total Factor Productivity Growth
- Table 9.11 Financial Integration and Financial Sector Development
- Table 9.12 Summary of Findings and Policy Implications
- Table 9.13 Evidence From Selected Case Studies, 1979–2004
- Table 10.1 International Financial Integration
- Table 10.2 Fastest- and Slowest-Growing Developing Economiesduring 1980–2005 and Their Status of Financial Openness
- Table 10.3 Summary of Key Empirical Studies on Financial Integration and Growth
- Table 10.4 Summary of Key Empirical Studies on Foreign Direct Investment and Growth
- Table 10.5 Summary of Key Empirical Studies on Equity Market Liberalization and Growth
- Table 11.1 Data Description
- Table 11.2 Benchmark Growth Regression (Dependent Variable:Real Per Capita GDP Growth)
- Table 11.3 Economic Growth and International Financial Integration(Dependent Variable: Real Per Capita GDP Growth
- Table 11.4 Economic Growth and International Financial Integration:Initial Economic Conditions
- Table 11.5 Economic Growth and International Financial Integration:Financial Development
- Table 11.6 Economic Growth and International Financial Integration:Institutional Factors
- Table 11.7 Economic Growth and International Financial Integration:Macroeconomic Policies
- Table 12.1 International Finance Corporation (IFC) Corporate Financial Database Coverage (Number of firms per year)
- Table 12.2 Fixed Effects Regressions
- Table 12.3 Fixed Effects Regressions With Financial Deepening Indicators
- Table 12.4 Arellano-Bond Dynamic Panel Regressions
- Table 12.5 Regressions Using Financial Liberalization Components
- Table 14.1 Changes in Creditor Rights and Shareholder Protection
- Table 14.2 Correlation Matrix of Creditor Rights, Shareholder Protection, and CGQ Index
- Table 14.3 Aggregate Economic Activity and Corporate Governance: Benchmark Model
- Table 14.4 Aggregate Economic Activity and Corporate Governance:Excluding “Crisis” Country-Years Observations
- Table 14.5 Aggregate Economic Activity and Corporate Governance: Accounting for Complex Dynamics
- Table 14.6 Aggregate Economic Activity and Corporate Governance:Accounting for Financial Development
- Table 14.7 Industry Growth, Financial Dependence, and Corporate Governance
- Table 14.8 Industry Growth, Financial Dependence, and Corporate Governance: Excluding Crisis Countries
- Table 14.9 Controlling for Financial Development
- Table 14.10 Summary Statistics of Main Variables in Country Panel Regressions
- Table 14.11 Summary Statistics of Main Variables in Industry Panel Regressions
- Table 15.1 Output Events: Frequency, Duration, and Loss,1970–2001
- Table 15.2 Frequencies and Cost of Shocks
- Table 15.3 Cost of Reserves in Emerging Market Countries, 2001–05
- Table 15.4 Changes in Fundamentals and Optimal Reserves: Simulations for Emerging Markets
- Table 15.5 Types of Insurance and Crisis-Prevention Measures
- Table 15.6 Economies, by Group
- Table 15.7 Financial Account and Its Subcomponents, 1970–2003
- Table 15.8 Calibration Parameters
- Table 15.9 Probit Estimation of Probability of Sudden Stop
- Table 16.1 Reserves Accumulation and the Financial Account in Emerging Market Countries, 2000–05
- Table 16.2 Regressions of Crisis Variables on Alternative Measures of Reserves, 1980–2000
- Table 16.3 Opportunity Cost of Reserves, 2000–05
- Table 16.4 Benchmark Calibration Parameters
- Table 16.5 Probit Regressions of the Probability of Crisis on Macroeconomic Fundamentals, 1980–2000
- Table 16.6 Actual and Model-Predicted Levels of Reserves
- Table 16.7 Benefit and Cost of Reserves Accumulation, 2000–05
- Table 16.8 Correlation Between the Change in Reserves-to-GDP Ratio and Selected Macroeconomic Variables, 2000–05
- Table 16.9 Impact of Emerging Market Reserves Diversification on Financial Market Capitalization
- Table 16.10 Countries in the Sample
- Table 16.11 Crisis Definitions
- Table 16.12 Currency Crises and Sudden Stops in Emerging Market Countries, 1980–2000
- Table 16.13 Variables Considered in the Probit Analysis
- Table 17.1 Timing of Systemic Banking Crises
- Table 17.2 Timing of Financial Crises
- Table 17.3 Frequency of Financial Crises
- Table 17.4 Descriptive Statistics of Initial Conditions of Selected Banking Crises
- Table 17.5 Descriptive Statistics of Crisis Policies of selected Banking Crisis Episodes
- Figure 3.1 (A) Asian crisis. (B) Debt crisis
- Figure 3.2 Protracted civil wars
- Figure 3.3 Impulse responses: Currency crises
- Figure 3.4 Impulse responses: Banking crises
- Figure 3.5 Impulse responses: Twin financial crises (currency and banking
- Figure 3.6 Impulse responses: Civil wars
- Figure 3.7 Impulse responses: Stronger executive power
- Figure 3.8 Impulse responses: Twin political crises (war and stronger executive power)
- Figure 3.9 Impulse responses: Financial crises using Kaminsky and Reinhart (1999) dates
- Figure 3.10 Impulse responses: Penn World Tables dataset
- Figure 3.11 Controlling for oil price changes
- Figure 3.12 Impulse responses: Controlling for common period shocks
- Figure 3.13 Forecast errors
- Figure 3.14 Impulse responses: Lagged response of output to crises
- Figure 4.1 Euro area: Money market and retail lending rates
- Figure 4.2 Euro area: Changes in credit standards to enterprises and households, 2005–08
- Figure 4.3 Euro area: Corporate and equity market prices, 2007–08
- Figure 4.4 Euro area: Growth in bank loans and securities issuance, 2003–08
- Figure 4.5 Euro area: Distance to default for banks, 1991–2008
- Figure 4.6 Euro area: Excess demand for loans, 1997–2008
- Figure 4.7 Euro area: Growth in real output and bank loans, 2000–08
- Figure 4.8 Euro area: Corporate debt issuance, 1990–2008
- Figure 4.9 Euro area: Response of annual growth in industrial production to one-standard-deviation innovation in corporate bond spread
- Figure 4.10 Euro area: Estimated default probability (banks and nonbanks), 1991–2008
- Figure 4.11 Euro area: Estimated default probability (public sector), 1997–2008
- Figure 4.12 Capitalization in euro area banks, 1997–2008
- Figure 6.1 Safe versus risky growth path: A comparison of India and Thailand, 1980–2002
- Figure 6.2 Model economy: Growth and crises
- Figure 6.3 Kernel distributions of real credit growth, 1980–2002
- Figure 6.4 Measuring systemic risk: Skewness and crisis indexes
- Figure 7.1 De facto financial globalization, 1970–2006
- Figure 7.2 Trends in de jure financial openness, 1975–2005
- Figure 7.3 Regional averages of de jure financial openness, 1995
- Figure 7.4 The composition of capital controls, 1995–2005
- Figure 7.5 Changes in de facto financial integration following large de jure reforms/reversals
- Figure 8.1 World NFA discrepancy and cumulative current account discrepancy, 1980–2004
- Figure 8.2 Composition of the world NFA discrepancy, 1980–2004
- Figure 8.3 International financial integration, 1970–2004
- Figure 8.4 Financial integration versus trade integration, 1970–2004
- Figure 8.5 International equity integration, 1970–2004
- Figure 8.6 Equity share in external liabilities, 1970–2004
- Figure 8.7 External debt and official reserves, emerging markets, and developing group, 1970–2004
- Figure 8.8 Net foreign assets and GDP per capita: All countries, 2004
- Figure 8.9 Net foreign assets by country group (percent of group GDP), 1980–2004
- Figure 8.10 NFA to GDP ratio: 1996 and 2004
- Figure 8.11 (A) Net equity position versus net debt position: Industrial group, 2004. (B) Net equity and net debt position: Emerging markets and developing countries, 2004
- Figure 9.1 Gross external assets and liabilities by income group
- Figure 9.2 Composition of gross external assets and liabilities, 1975 and 2004
- Figure 9.3 Capital controls by financial openness and income group)
- Figure 9.4 Patterns of de jure financial openness, 1995–97 versus 2003–05
- Figure 9.5 Gross external assets and liabilities by levels and changes in de jure financial openness
- Figure 9.6 Financial integration and consumption volatility
- Figure 10.1 Evolution of international financial integration, 1970–2004
- Figure 10.2 GDP per capita, PPP-weighted
- Figure 10.3 Financial openness and growth
- Figure 10.4 Two views of financial globalization on macroeconomic outcomes
- Figure 10.5 Threshold conditions: A complication
- Figure 10.6 Potential indirect benefits of financial globalization
- Figure 12.1 Dispersion measures, pre- and postliberalization
- Figure 13.1 Boom-bust in residential property prices, 1970–98
- Figure 13.2 Boom-bust in industrial share prices, 1970–2001
- Figure 13.3 U.S. stock prices: S & P 500, 1874–1999
- Figure 13.4 U.S. stock prices: Dow Jones Industrial Average, 1899–1999
- Figure 13.5 Ancillary variables
- Figure 13.6 Function f(·)
- Figure 13.7 The optimal monetary policy
- Figure 14.1 CGQ index, subperiod averages
- Figure 14.2 CGQ index in Asia
- Figure 14.3 Earning smoothing indicator, subperiod averages
- Figure 14.4 Stock price synchronicity indicator, subperiod averages
- Figure 14.5 Accounting standards indicator, subperiod averages
- Figure 15.1 A “concluded” output event
- Figure 15.2 Expected cost of shocks (in percent of pre-event GDP per capita
- Figure 15.3 Composition of financial flows around all sudden stops,1980–2004
- Figure 15.4 Emerging market economies: Central government domestic debt composition, 1980–2004
- Figure 15.5 Emerging market economies: Shares of long-term and medium-term fixed-rate domestic currency debt, 1990–2003
- Figure 15.6 International reserves by country group, 1990–2005
- Figure 15.7 International reserve ratios by country group,1990–2005
- Figure 15.8 Asia and Latin America: Reserves as shares of GDP, 1980–2003
- Figure 15.9 Optimal level of reserves as function of various factors
- Figure 16.1 International reserves in emerging market and industrial countries, 1980–2005
- Figure 16.2 Composition of stock and foreign assets and liabilities in emerging market and industrial countries, 2000–05 averages
- Figure 16.3 Reserve adequacy in emerging market countries, 1980–2005
- Figure 16.4 Sudden stops in emerging market countries, 1980–2000, using the SS2 definition of a sudden stop
- Figure 16.5 Yearly changes in reserves-to-GDP ratios in five Asian countries (Indonesia, Korea, Malaysia, the Philippines, and Thailand), 1980–2000
- Figure 16.6 Total loss and the optimal level of reserves
- Figure 16.7 Reserves and crisis prevention
- Figure 16.8 Domestic absorption and output, net capital inflows, and reserves in sudden stops
- Figure 16.9 Alternative measures of the opportunity cost of reserves, 2000–05
- Figure 16.10 Sensitivity analysis of the optimal level of reserves
- Figure 16.11 Probabilities of currency crises and sudden stops, 1980–2006
- Figure 16.12 Composition of foreign official and nonofficial holdings of U.S. assets, 2005
Today we are only too aware that vulnerabilities and excesses built up in financial markets and institutions can affect the wider economy, with sometimes devastating results. By the same token, the health of the financial sector can be severely tested by developments elsewhere in the economy. In fact, these two-way macrofinancial linkages all too often create potentially dangerous feedback mechanisms that—without rapid and effective policy interventions—can trigger deep and long-lasting economic downturns.
As economists and policymakers, we should not need reminding of the critical importance of these macrofinancial linkages. But in case we had been tempted to play down their importance, the recent global financial crisis surely provided the necessary corrective.
Analysis of these two-way macrofinancial linkages is not a new field in macroeconomics. In fact, the field is rather like a classic play, perhaps enjoying periodic off-Broadway revivals, sometimes winning critical acclaim, but never reaching a mass audience. Irving Fisher’s 1933 model of the debt-deflation mechanism remains the classic text. In fact, the damaging feedback loop between declining house prices, household default, credit contraction, and unemployment evident in the U.S. economy in the last couple of years is simply the latest manifestation of the classic debt-deflation mechanism: Fisher in modern dress.
More recently, economists such as Ben Bernanke and Mark Gertler (1989) have sought to integrate these mechanisms into mainstream macroeconomic models through their analysis of the so-called financial accelerator. Kiyotaki and Moore (1997) represent another key recent contribution. However, mainstream modern macroeconomic models typically used for policy analysis have, until recently, paid insufficient attention to these insights, and analysis of macrofinancial linkages has languished at the fringes of macroeconomics. The recent crisis has brought such analysis to center stage.
The IMF has participated actively in this renewed debate. Even before the global economy felt the full force of the crisis, as part of a wider effort to refocus the work of this institution, I sought to place the analysis of macrofinancial linkages and attendant risks at the center of our mandate. In fact, I felt that this was a key area of comparative advantage for the IMF, and one where we should be doing more. As I have argued elsewhere, with our involvement in the real economy and the financial sector, the IMF stands at the corner of Main Street and Wall Street.
There is a hunger around the world—in both emerging markets and advanced economies—for greater understanding of the links between finance and the wider economy. The IMF, with its global membership—and the legitimacy and breadth of experience that comes from that—is the institution with the greatest capacity to provide insights into this complex web of interactions. We have sought to meet this demand for cutting-edge analysis of macrofinancial linkages through the research undertaken by IMF staff, as well as in the analysis in our flagship publications and multilateral and bilateral surveillance more generally.
As an example of our renewed focus on macrofinancial analysis, I am very happy to present this collection of research by IMF economists. The papers in this volume are representative of the high caliber of the IMF’s policy-relevant research on financial sector issues and linkages with the real economy—research that is increasingly guiding the IMF’s surveillance and policy advice.
The work in this volume addresses a wide range of topical questions. For instance, do financial crises, of the kind that recently engulfed global markets, have a long-term effect on economic growth? Has financial liberalization gone too far, or can further reforms, appropriately sequenced, aid economic development without creating additional volatility? And how do the significant gross crossborder asset holdings that have built up in recent years affect economic stability? Contributions to the volume also tackle some increasingly relevant policy issues, such as how monetary policy should respond to asset price bubbles, the optimal level of international reserves to insure against the risk of financial crisis, and the design of policies for resolving banking crises.
Although these contributions largely predate the recent crisis, their relevance and topicality is obvious. I am certain that this volume will find a ready audience among policy makers and researchers alike, and I am delighted that researchers here at the IMF are playing an active role in shaping the global debate on these topics. As we seek to learn from the recent crisis and build stronger and more effective global institutions—rewriting the script to better manage risks and vulnerabilities in our increasingly integrated global economy—I hope and expect IMF researchers to remain in the vanguard of this endeavor.
International Monetary Fund
The editors are grateful to Sean Culhane and Patricia Loo of the External Relations department for their help in coordinating the publication of this volume, and to Max Bonici for administrative assistance.
Christopher Crowe is an Economist in the Research Department at the International Monetary Fund.
Simon Johnson, former Chief Economist of the International Monetary Fund, is a Professor at the MIT Sloan School of Management, a Senior Fellow at the Peterson Institute for International Economics, and a member of the Congressional Budget Office’s Panel of Economic Advisers.
Jonathan D. Ostry is Deputy Director in the Research Department at the International Monetary Fund.
Jeromin Zettelmeyer is Director for Policy Studies at the European Bank for Reconstruction and Development (EBRD) and formerly an Advisor in the Research Department of the International Monetary Fund.
Abdul Abiad is a Senior Economist in the Research Department at the International Monetary Fund.
Törbjörn Becker is Director of the Stockholm Institute of Transition Economicsat the Stockholm School of Economics. His contribution to this volume wasundertaken while he was a Senior Economist in the Research Department at the International Monetary Fund.
Michael D. Bordo is a Professor of Economics at Rutgers University and a Research Associate at the National Bureau of Economic Research (NBER).
Valerie Cerra is Deputy Division Chief in the African Department at the International Monetary Fund.
Martin Čihák is Deputy Division Chief in the Monetary and Capital Markets Department at the International Monetary Fund.
Giovanni Dell’Ariccia is an Advisor in the Research Department at the International Monetary Fund and a Research Fellow at the Centre for Economic Policy Research (CEPR).
Gianni De Nicolò is a Senior Economist in the Research Department at the International Monetary Fund.
Enrica Detragiache is an Advisor in the IMF Institute.
Hali Edison is Lead Evaluator at the Independent Evaluation Office (IEO) of the International Monetary Fund.
André Faria is currently a Vice President in the Global Market Strategies Groupat Black Rock. His contribution to this volume was carried out while he was an Economist in the Research Department at the International Monetary Fund.
Julian Di Giovanni is an Economist in the Research Department at the International Monetary Fund.
Deniz Igan is an Economist in the Research Department at the International Monetary Fund.
Olivier Jeanne is a Professor in the Department of Economics at Johns Hopkins University, a Research Associate at the National Bureau of Economic Research(NBER), a Research Fellow at the Centre for Economic Policy Research (CEPR), and a visiting Senior Fellow at the Peterson Institute for International Economics. His contributions to this volume were carried out while he was Deputy Division Chief in the Research Department of the International Monetary Fund.
Petya Koeva Brooks is Division Chief in the Research Department at the International Monetary Fund.
M. Ayhan Kose is Assistant to the Director of the Research Department at the International Monetary Fund, Co-Editor of the IMF Economic Review, and Editor of the IMF Research Bulletin.
Luc Laeven is Deputy Division Chief in the Research Department at the International Monetary Fund, as well as a Research Fellow at the Centre for Economic Policy Research (CEPR) and a Research Associate at the European Corporate Governance Institute (ECGI).
Philip R. Lane is Professor of International Macroeconomics at Trinity College Dublin and a Research Fellow of the Centre for Economic Policy Research (CEPR).
Ross Levine is James and Merryl Tisch Professor of Economics at the Departmentof Economics and Director of the William R. Rhodes Center for International Economics and Finance at Brown University, as well as a Research Associate at the National Bureau of Economic Research (NBER).
Robert Marquez is an Associate Professor at the Boston University School of Management.
Paolo Mauro is Division Chief in the Fiscal Affairs Department at the International Monetary Fund.
Gian Maria Milesi-Ferretti is Assistant Director in the Research Department atthe International Monetary Fund and a Research Fellow at the Centre for Economic Policy Research (CEPR).
Nienke Oomes is Deputy Division Chief in the Middle East and Central Asia Department at the International Monetary Fund.
Eswar Prasad is the Tolani Senior Professor of Trade Policy at Cornell University. He is also a Senior Fellow at the Brookings Institution, where he holds the New Century Chair in International Economics, and a Research Associate at the National Bureau of Economic Research. He was previously Division Chief in the International Monetary Fund’s Research Department.
Romain Ranciére is an Economist in the Research Department at the International Monetary Fund, currently on leave, and an Assistant Professor atthe Paris School of Economics (PSE) and Research Affiliate at the Centre for Economic Policy Research (CEPR).
Raghuram Rajan, former Chief Economist of the International Monetary Fund, is the Eric J. Gleacher Distinguished Service Professor of Finance at the Universityof Chicago’s Booth School of Business and an economic advisor to the Prime Minister of India.
Luca Antonio Ricci is Deputy Division Chief in the Research Department at the International Monetary Fund.
Kenneth Rogoff, former Chief Economist of the International Monetary Fund, is Professor of Economics and Thomas D. Cabot Professor of Public Policy at Harvard University, as well as a Research Associate at the National Bureau of Economic Research (NBER) and a Member of the Council on Foreign Relations.
Sweta Chaman Saxena is a Senior Economist in the African Department at the International Monetary Fund.
Martin Schindler is a Senior Economist in the European Department at the International Monetary Fund.
Torsten Sløk is Director of Global Economics at Deutsche Bank Securities andpreviously worked at the International Monetary Fund as well as the Organisationfor Economic Co-operation and Development (OECD).
Natalia Tamirisa is Assistant to the Director in the Research Department at the International Monetary Fund.
Marco Terrones is Deputy Division Chief in the Research Department at the International Monetary Fund.
Aaron Tornell is a Professor in the Department of Economics at the Universityof California, Los Angeles (UCLA).
Kenichi Ueda is a Senior Economist in the Research Department at the International Monetary Fund.
Fabian Valencia is an Economist in the Research Department at the International Monetary Fund.
Shang-Jin Wei is Professor of Finance and Economics, Professor of International Affairs, and N.T. Wang Professor of Chinese Business and Economy at Columbia University, as well as Director of the Jerome A. Chazen Institute of International Business at the Columbia Business School, a Research Associate at the National Bureau of Economic Research (NBER), a Research Fellow at the Centre for Economic Policy Research (CEPR), a Member of the Council on Foreign Relations, and is a former Assistant Director in the Research Department at the International Monetary Fund.
Frank Westermann is Professor and Chair of International Economic Policy atthe University Osnabrueck.
The global financial crisis has exposed the numerous and critical interactions between the world of high finance and the real economy of jobs, growth, and development. Although these issues have grabbed the headlines over the past year or two, macrofinancial linkages have long been at the core of the IMF’s mandate to oversee the stability of the global financial system. Research at the IMF on these issues stretches back decades, including significant efforts to improve the availability of data to assess financial sector risks and stock-taking exercises following previous episodes of financial crisis, but has received renewed impetus by recent events, including the long period of boom and rising macrofinancial imbalances in the global economy in the runup to the most recent crisis. Anchoring this work has been the objective of understanding the two-way transmission of shocks between the real and financial sectors as an underpinning of IMF surveillance and policy advice to member countries. With the advent of the crisis, the IMF has drawn on this research in order to contribute to critical debates on the nature of appropriate policy responses at both the national and multilateral levels.
The current juncture offers a good opportunity both to take stock of this body ofresearch by IMF staff, and to share it with a wider audience. This volume bringstogether 17 papers on macrofinancial topics. The majority has already been publishedin top journals, while the others represent high-quality unpublished work thatwe expect to be of wide interest. The papers fit into three broad themes. The firstgroups a number of papers on financial crises and boom-bust cycles. The second setof papers is focused on the theme of financial integration, financial liberalization, andeconomic performance. The final set of papers looks at a range of policy issues, inthe realm of macroeconomic policy and policies vis-à-vis the corporate and financialsectors—including domestic and external financial liberalization.
Financial Boom-Bust Cycles
The chapters in this section of the volume can broadly be divided into two strands. The first deals with the origin of financial crises, focusing in particular on howmisaligned incentives in the banking sector can contribute to unsustainablebooms. These chapters seem particularly relevant in the wake of the U.S. subprimecrisis, where reckless lending by individual financial institutions appears to havebeen a critical factor.
Dell’Ariccia and Marquez’s contribution, on lending booms and lending standards, outlines a theoretical model of the banking sector that can account for theboom-bust pattern of a lending binge followed by a deterioration in loan quality, losses for the banks, and a credit crunch. In the model, banks face both knownand unknown borrowers, where the latter can be either good or bad credit risks. When the number of unknown borrowers is relatively small, the pool of borrowersunknown to a particular bank will include a significant number of borrowersrejected by other banks as a bad credit risk. In this case, banks will require loansto be collateralized in order to screen out the bad borrowers. However, when thereis an increase in credit demand, so that many new unknown borrowers enter themarket, the share of bad credit risk borrowers is diluted. In this environment, banks will drop collateral standards, offering credit to all unknown borrowers, inan effort to boost market share. This creates a credit boom (greater than the initialshift in credit demand) but lowers the quality of borrowers, reducing bank profitabilityand increasing the risks of banking sector insolvency.
Igan and Tamirisa’s chapter on the credit boom in emerging Europe provides anempirical treatment of some similar themes. They analyze whether the pronouncedcredit boom in a sample of European emerging markets was being driven disproportionatelyby banks with weak balance sheets. The risk of weak banks driving thecredit boom arises from the heightened incentives for excessive risk taking when abank’s balance sheet is already impaired (so-called “gambling for resurrection”). Theauthors find some evidence that the role of weak banks in the credit boom did infact increase over time in some countries in the sample, notably among the Balticcountries. Moreover, weaker banks appeared to be increasing their market share insome particularly risky areas, notably foreign currency lending. Hence, this chaptersheds some light on banking sector trends in emerging Europe that may have contributedto the economic problems that several countries in the region now face.
The second set of chapters within the first section offers contrasting analysesof the effects of boom-bust cycles. The key question is whether financial criseshave long-run growth effects.
Cerra and Saxena investigate the growth impact of financial and political crisesin a wide-ranging sample of countries. They find that crises are associated with asubsequent period of lower economic growth and hence a permanent decline ineconomic activity of around 4 percent, an effect that is robust across differentcrisis definitions and samples. Crises thus appear to be bad for growth.
Čihák and Koeva Brooks focus more narrowly on the impact of the 2007–08crisis on financial conditions and hence on real activity in the euro area. A declinein bank soundness led to a reduction in bank loan supply, with a subsequentnegative impact on economic activity. Similarly, an increase in corporate bondspreads led to a significant decline in industrial output.
Dell’Ariccia, Detragiache, and Rajan’s contribution supports the view that crisesare bad for growth. They analyze the impact of banking crises across economicsectors, using the different patterns of dependence on external (bank) financingacross sectors to identify whether banking crises have independent effects. Thisapproach overcomes the difficulty of separating out the effect of the banking sectorcrisis from the general economic downturn (which may have been caused by thebanking crisis or alternatively may be causing the crisis). They find that, in thewake of a banking crisis, value added, capital formation, and the number of establishmentsall grew more slowly in sectors that were more dependent on externalfinance. This effect is strongest in developing countries, in countries with lessaccess to foreign finance, and where bank distress is more severe.
However, Rancière, Tornell, and Westermann’s chapter suggests that criseshave only limited long-run growth effects. In fact, they show that countries wherereal bank credit to the private sector is subject to periodic sharp declines (so thatthe distribution of credit growth is negatively skewed) in general grow more rapidly than countries whose credit growth is more symmetrically distributed. Toaccount for this relationship, they outline a model in which borrowers are creditconstrained because of problems enforcing contracts, so that growth is constrainedby credit availability. In this model, risk taking can be excessive when thefinancial sector is liberalized but contract enforceability problems are acute. Hence, growth will be higher, but at the same time the financial system is morevulnerable to intermittent credit crunches and crises. In other words, occasionalfinancial crises may be the price that has to be paid for higher, credit-fueled, economic growth, at least for emerging and developing countries (with relativelyweak contract enforcement).
Key to understanding these chapters’ contrasting findings is that, whereas thefirst three focus on the period of adjustment and recovery following a crisis, Rancière, Tornell, and Westermann’s analysis also takes in the precrisis boomperiod. Hence, although crises are associated with sharp output declines and onlypartial recoveries, the precrisis boom more than offsets the postcrisis gloom.
Financial Integration, Financial Liberalization, and Economic Performance
While the first section is concerned with the runup to and aftermath of crises, thesecond section focuses on the role of financial factors in longer-run economicperformance. In particular, the chapters in this section deal with issues related tofinancial liberalization in individual countries, financial integration across countriesand markets, and the long-run effects of both.
Schindler’s chapter outlines a new dataset that provides de jure measures offinancial integration for 91 countries covering the period 1995–2005. The datameasure legal restrictions or capital controls on transactions relating to differentforms of cross-border capital flows: a key contribution is providing more disaggregatedmeasures of restrictions on different types of flow than has been availablein the past.
Lane and Milesi-Ferretti’s chapter outlines a revised and extended version oftheir dataset covering estimates of countries’ external assets and liabilities (for145 countries over 1970–2004). The data point to significant increases in financialintegration—the de facto counterpart of the de jure moves identified by Schindler—across industrial, emerging market, and developing countries. The authors alsoidentify some interesting additional trends, including a growing reliance on debtfinancing among industrial countries and on equity financing among emergingmarkets, and the rapid increase in foreign exchange reserves in emerging marketeconomies in the wake of the Asian and Russian crises in the mid- to late-1990s. One important implication of the increased financial integration captured in thedata is that exchange rate movements imply significant wealth effects across countriesarising from the large gross positions that have built up.
The remaining chapters in this section assess whether the claims made in favorof financial liberalization and integration (better-functioning global capital markets, more efficient allocation of resources, and improved cross-border risk sharing, among others) have been achieved in practice. Dell’Ariccia and coauthorsdocument the increase in financial globalization, defined as the extent to whichcountries are linked through cross-border financial holdings. The chapter findsthat financial globalization has been most pronounced in advanced economies, and that these countries have typically gained most in terms of international risksharing. By contrast, financial globalization appears to have increased the level ofmacroeconomic volatility in emerging market and developing countries withpoor institutional quality. As a result, the authors favor a sequenced process offinancial liberalization that stresses complementary reforms to domestic institutionsto reap the benefits of external financial liberalization.
Kose and coauthors argue that the benefits of international financial liberalizationare mostly indirect, and not via the direct channel of providing access tofinancing for domestic investment. These indirect benefits include developmentof the domestic financial sector, greater discipline on macroeconomic policies, and efficiency gains among domestic firms arising from exposure to foreign competition. The authors argue that the mixed picture on the benefits of financialliberalization may simply be because these indirect gains occur only slowly overtime, whereas some of the costs accrue relatively quickly. They argue that thelong-run benefits of financial liberalization are therefore greater than a casualreading of the evidence would suggest.
The last two chapters in this section analyze more specific questions. Edison andcoauthors test whether international financial integration improves long-rungrowth performance. The authors use a variety of techniques and different measuresof financial integration, and find that the evidence suggests there is essentially nogrowth effect. Abiad, Oomes, and Ueda assess whether financial liberalizationimproves allocative efficiency in capital markets, by testing whether liberalizationreduces the dispersal of Tobin’s Q (as a measure of expected returns) across firms. Ifliberalization improves allocative efficiency, then expected returns should becomemore equal as investment flows from less to more profitable firms. The authors testthis proposition using firm-level data in five emerging market economies, and findthat liberalization did indeed have this “quality effect” of reduced variance ofexpected returns.
The evidence in favor of financial liberalization therefore appears mixed. Insome environments, liberalization is clearly harmful, whereas in others it may begrowth-enhancing, especially if collateral benefits are taken into account. Thishighlights the importance of taking a broad approach to examining the effects ofliberalization in order to shed light on the full range of channels through whichit may operate.
The chapters in this final section of the book deal with a range of policy issues relatingto macrofinancial linkages, including how to conduct monetary policy faced withthese linkages, how to help countries insure themselves against external shocks, andthe relationship between reforms at the firm level and macroeconomic performance.
Bordo and Jeanne analyze what is emerging as a fundamental question in theanalysis of monetary policy: should central banks take into account asset prices insetting monetary policy and, if so, how? Traditional models used for policy analysis(new Keynesian models with sticky prices but a minimal treatment of financial frictions)have suggested that central bankers should adopt a policy of “benign neglect”toward asset prices, responding to asset price fluctuations only to the extent thatthey have direct implications for the general price level. However, the authors demonstratethat a more proactive policy stance—increasing interest rates when a boomemerges—can be optimal when macrofinancial linkages are modeled more comprehensively. In particular, intervention is justified when the bust following the burstingof the bubble can be expected to entail a significant output cost, and when thecost of tightening policy is not too high. However, the authors advise against asimple rules-based approach (e.g., augmenting a traditional Taylor rule with a termfor asset prices), arguing that the conditions where the authorities should take assetprices into account are too complex to be easily summarized by a simple rule.
De Nicolò, Laeven, and Ueda analyze trends in the quality of corporate governanceacross a range of countries. They find that corporate governance has tendedto improve over time, with a degree of convergence so that the greatest improvementshave been in countries where performance was initially worse. They also findthat improvements in corporate governance have been associated with improvedmacroeconomic performance across a range of indicators, including GDP growth, productivity growth, and the level of investment. These correlations are highest forindustrial sectors most dependent on external finance, suggesting a causal relationshipfrom improved corporate governance to economic performance via the channelof enhanced access to external finance for better-governed firms.
The next two papers in this section deal with the issue of how countries can insurethemselves against macroeconomic and financial shocks. This issue has been a criticalone for the IMF’s member countries in recent years, even before the most recent crisis. Becker and coauthors outline the type of shocks that countries typically face, andestimate that certain types of shocks—notably sudden stops for emerging marketeconomies and terms of trade shocks for developing countries—are associated withsignificant costs in terms of lost output. They go on to analyze what domestic policies(as opposed to regional or multilateral arrangements) can help to minimize these costs. Key policies include improving countries’ external liability structure to reduce currencyand maturity mismatches and sharing risks more broadly by moving from debtto equity-like liabilities (e.g., foreign direct investment). Reserves accumulation canalso play an important role in country insurance. However, the authors find that somecountries’ accumulation of reserves has gone beyond what could be justified on thebasis of plausible changes in fundamentals, a conclusion reached also by Jeanne’sstudy. Having said this, what is considered plausible may have shifted since these studieswere written, and recent evidence from the current crisis—where countries withhigh levels of reserves appeared to have fared better than others—suggests that theoptimal level of reserves remains an open issue.
The final chapter is concerned with crisis resolution policies. Laeven and Valencia draw on a unique database of banking crises and crisis resolution policiesto assess which policies have been most effective and in what circumstances. Theyargue that key determinants of the success of crisis resolution policies include havingan effective framework in place prior to the crisis, acting quickly to prevent contagionto previously immune institutions, providing direct support to households andfirms where necessary, and putting in place policies to minimize moral hazard. Although the costs of policy interventions can be extremely high, and the benefitsuncertain, the costs of inaction are typically even higher. Governments simply donot have time to adequately assess the optimal policy response, and so interventionstend to be second-best almost by definition. Meanwhile, open questions include theappropriate fiscal and monetary policy responses, beyond the immediate fiscal outlaysand liquidity injection associated with bank rescues.
The chapters in this volume touch upon a broad range of topics. Nevertheless, it is possible to discern some common themes that are particularly relevant now, in the wake of the deepest financial crisis since the 1930s. First, macrofinanciallinkages matter. This is most obviously true in the extreme case of banking crises, where several chapters identify significant real costs, but holds more generally andthrough a diverse range of channels. Second, macrofinancial linkages seem to havebecome more salient, as financial globalization has created new opportunities for bothsharing and spreading risk. Third, macrofinancial linkages are complicated: difficultto capture using traditional theoretical models, with feedback channels that tend tobe highly context-specific, and lacking simple empirical regularities to guide policy. Hence, useful theoretical work in this area needs to take seriously issues of asymmetricor incomplete information, limited commitment, and other financial frictions. Empirical work must be particularly meticulous, in the face of almost intractableidentification problems. Most importantly, policy making has become more difficult, as existing problems become more complex and new problems emerge. In otherwords, macrofinancial linkages are hard to model, hard to measure, and hard tomanage. But the chapters in this volume make progress on all three fronts.
The current crisis has come after a long period of increasing financial globalization, with financial systems having become more liberalized domestically and more integratedinternationally. As the crisis recedes, a fundamental rethinking about theappropriate balance between regulation and laissez-faire in financial markets isundoubtedly underway, with the aim of improving tradeoffs between efficiency gainsfrom a liberal financial system and volatility costs. It is our hope that research willcontinue to provide useful pointers to policy makers as they seek to reform financialregulatory policies in order to achieve the right balance between stability and innovation, and that the papers in this volume make a modest contribution in this direction.