Globalization in the Periphery Monetary Policy: What is Gained, What is Lost. Graciela L. Kaminsky George Washington University and NBER

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1 Globalization in the Periphery Monetary Policy: What is Gained, What is Lost Graciela L. Kaminsky George Washington University and NBER Conference on the Occasion of the 2 th Anniversary of the Oesterreichische Nationalbank Central Banking in Times of Change Organized by the OeNB and the BIS Vienna, Austria, September 13 and 14, 216

2 Globalization in the Periphery: The Pros and the Cons The Pros of Globalization: Capital flows from rich to poor countries, financing investment, stimulating economic growth. Consumption smoothing. International diversification of portfolios. The Cons of Globalization: Macroeconomic instability: Capital inflows leading to rapid monetary expansion, inflationary pressures, real exchange rate appreciation, and increasing current account deficits. Cyclical monetary policy in the financial centers at the core of these booms; not domestic fundamentals. The large increases in international liquidity fuel crises and lead to dramatic capital flow reversals. 2

3 Capital Inflow Episodes: Selected Countries Cumulative Change During the Capital Inflow Episode Average During the Capital Inflow Episode Country Reserves (in Billion US Dollars) Reserves (in Percent of Exports ) Real Appreciation Inflation (in Percent) Money Growth (in Percent) The 1997s Latin America Argentina Chile Colombia Mexico Peru The 199s Latin America Argentina Chile Colombia Mexico Peru Asia Korea Malaysia Philippines Thailand

4 The Perils of Globalization in the Periphery? Booms in capital flows lead to real appreciations and current account deficits; in the end, some of these booms end with financial crises. With Fear of Floating, capital inflows lead to an accumulation of reserves, an increase of monetary aggregates, and higher inflation. But does globalization trigger higher inflation and growth in the monetary aggregates? Or, is the opening of domestic financial markets to international capital flows a tool to subdue inflation and increase central banks credibility? To answer this question we need to look at the counterfactual: Monetary policy and inflation under financial repression. 4

5 What I do In this preliminary work, I look at a group of selected countries in Latin America and Asia that during globalization have experienced large capital inflows. To capture both episodes of financial repression and globalization, the sample includes data from 196 to 214. I separate episodes of financial repression and financial liberalization (globalization) using a de jure measure of financial liberalization that focuses on deregulation of the domestic financial sector, the capital account, and the stock market from Kaminsky and Schmukler (RF, 28). I examine the evolution of Central Bank assets. First, I examine what moves CB assets during episodes of repression and liberalization. I decompose those fluctuations into movements in foreign assets and domestic assets (government bonds and loans to the financial sector). I also look at inflation during these two regimes. Second, to examine central banks credibility, I follow Sargent and Surico (AER, 211) and examine the low-frequency correlations between money growth and inflation during repression and globalization. Are they stable? Third, I examine the possible causes of the breakdown in these correlations. Is it globalization? Or are changes in institutions unrelated to globalization? 5

6 12% Growth of Central Bank Assets Korea 8% 4% % -4% -8% 2% Mexico 1% % -1% Change in Other Assets (Claims on Other Sectors) Change in Claims on Central Government Change in Foreign Exchange Reserves and Other Foreign Assets Change in the Exchange Rate 6

7 Episodes of Globalization and Repression The sample is divided using an Index of financial liberalization that includes sub-indices of deregulation of the capital account, the domestic financial sector, and the stock market. The index oscillates between a minimum of 1 (Full Liberalization) and a maximum of 3 (Total Repression). Index of Financial Liberalization Less Liberalization Emerging Markets Mature Markets More Liberalization The globalization episode includes both episodes of Partial and Full Liberalization. Full Liberalization on average occurs after five and a half years following the start of financial deregulation (Partial Liberalization). 7

8 The Evolution of Central Bank Assets and Inflation During Financial Repression and Globalization Globalization Financial Repression Country Assets Growth Foreign Exchange Reserves Growth Government and Bank Lending Growth Inflation Assets Growth Foreign Exchange Reserves Growth Government and Bank Lending Growth Inflation Asia Korea Malaysia Philippines Thailand Latin America Argentina Chile Colombia Mexico Peru Notes: Growth rates are in percent. Growth rates exclude valuation (exchange rate) changes. 8

9 Globalization and Credibility: Central Bank Assets and Inflation To examine central banks credibility, I follow Sargent & Surico (AER, 211). In their paper, they examine the low-frequency correlations between money growth and inflation for the United States over selected subperiods in the sample The question is whether the quantity theory of money holds. That is, whether the correlation between filtered series of money growth and inflation oscillate around one. They find that the inflation on money growth slope is only close to one in the period but is substantially larger than one during , flatter during and even negative during What triggers these changes in slopes? To answer this question they estimate a traditional DSGE model with various exogenous shocks and monetary policy rules and examine whether changes in monetary policy parameters can explain the changing slope. These simulations indicate that a credible future move to an anti-inflationary stance can bring these correlations close to zero or even negative. But if the monetary rule implies persistent increases in money growth, the correlation increases to one. 9

10 Does Globalization Change Monetary Policy in the Periphery? Do policy rules change? Do central banks gain credibility? To have a preliminary answer to this question, I look at the the low-frequency correlation between money growth and inflation as in Sargent and Surico (211). I do not look at the broad monetary aggregates as in those papers. Instead, since the focus of the cons of globalization is mostly on the effect of capital flows on the money base, I focus on the changes in assets of the central banks. I divide the sample into episodes of globalization and financial repression. 1

11 Korea Money Growth and Inflation: Breakdowns or Continuity? Malaysia Inflation with Repression Asset Growth with Globalization β =.31 β = Asset Growth with Repression Inflation with Globalization Inflation with Repression Asset Growth with Globalization β =.2 β = Asset Growth with Repression Inflation with Globalization Philippines Thailand Asset Growth with Globalization Asset Growth with Globalization Inflation with Repression Asset Growth with Repression β =.22 β = Inflation with Globalization Inflation with Repression β =.34 β = Asset Growth with Repression Inflation with Globalization 11

12 Money Growth and Inflation: Breakdowns or Continuity? Argentina Chile Asset Growth with Globalization β = β = Inflation with Repression -7-6 Asset Growth with Repression Inflation with Globalization Asset Growth with Globalization β = β = Inflation with Repression Asset Growth with Repression Inflation with Globalization Colombia Inflation with Repression Asset Growth with Globalization β =.23 β = Asset Growth with Repression Inflation with Globalization Mexico Peru Inflation with Repression 1 5 Asset Growth with Globalization β = 1.37 β = Asset Growth with Repression Inflation with Globalization Inflation with Repression Asset Growth with Globalization β = β = Asset Growth with Repression Inflation with Globalization

13 Globalization and Correlations of Inflation and Money Growth The evidence suggests that monetary policy rules have changed during globalization from the norm under financial repression, with monetary rules leading to less persistent movements in money growth. The evidence also suggests that credibility about low inflation policies has increased leading to lower and even negative low-frequency correlation between inflation and money growth. The question is whether globalization has brought this change or whether improvements in institutions and central bank independence (unrelated to globalization) are at the core of these changes. That is, we need to examine whether changes in institutions trigger financial globalization or whether financial globalization triggers institutional change. 13

14 Sequencing of Government Reforms and Globalization The links between financial liberalization and crises in emerging markets have prompted a debate about the benefits of financial deregulation and its optimal sequencing. There is a consensus that at the core of the link between crises and liberalization is the lack of good public and corporate governance and the existence of weak government policies and institutions. Many (Rodrik (1998) and Stiglitz (2)) suggest that governments should sequence reforms, first improving government institutions and better regulating domestic financial institutions and only then, start deregulating the financial industry and opening the capital account. Still the argument that liberalization should be preceded by institutions reforms may be irrelevant if the timing is such that reforms never predate liberalization: Governments may have few incentives to promote reforms in countries with repressed financial sectors. For example, Rajan and Zingales (23) argue that well-established firms (and therefore public officials) may in general oppose reforms that promote financial development as they imply better disclosure rules and enforcement, reducing the importance of the firm s collateral and reputation. They argue that opposition may be weaker in more open economies with cross-border flows, as incumbent firms can now tap foreign markets for funds at lower costs. What comes first? Globalization or Government Reforms? 14

15 What Comes First? Reforms to Institutions or Globalization? To answer this question, I compare the timing of financial liberalization and institutional reforms. The information on the quality of institutions is captured by the index of law and order published in the International Country Risk Guide. The law sub-index assesses the strength and impartiality of the legal system, while the order sub-index assesses the popular observance of the law. I also use information on the existence and enforcement of insider trading laws constructed by Bhattacharya and Daouk (22). I look at whether reforms to institutions occur prior to the partial or full liberalization of the financial sector. If governments improve the quality of institutions prior to start deregulating the financial sector, one would expect the probability of partial liberalization conditional on improvements in institutions to be close to one. In contrast, if liberalization triggers reforms, those probabilities would be close to zero. In this case, we would also expect the probabilities of full liberalization conditional on reforms to institutions to be close to one since full liberalization on average occurs after five and a half years following the start of financial deregulation. 15

16 Reforms to Institutions and Financial Liberalization Sequencing of Reforms in Emerging Markets Type of Financial Liberalization Probabilities of Liberalization Conditional on Insider Trading Laws Existence Insider Trading Laws Enforcement Improvement in Law and Order Partial Liberalization 62 *** Full Liberalization 77 *** 44 ** 64 *** Hypothesis Test (P-Value) Partial Liberalization = Full Liberalization Sequencing of Reforms in Mature Markets Type of Financial Liberalization Probabilities of Liberalization Conditional on Insider Trading Laws Existence Insider Trading Laws Enforcement Improvement in Law and Order Partial Liberalization 36 ** *** Full Liberalization 64 *** 25 * 5 *** Hypothesis Test (P-Value) Partial Liberalization = Full Liberalization

17 The Evolution of Central Bank Independence I also examine the evolution of Central Bank Independence using estimations from Cukierman, Webb, and Neyapti (WBER, 1992) and Crowe and Meade (JEP, 27). The index of central bank independence reflects legal independence, as captured by measures of independence of the governor of the central bank, its independence in policy formulation, its mandate, and the stringency of limits on its lending to the government. Interestingly, this measure suggests that independence increased significantly in the 199s when these group of countries deregulated financial markets and reduced capital controls. 1. Central Bank Independence Index s 196s 197s 198s 23 17

18 Cyclicality of Monetary Policy Developing countries have typically pursued procyclical macroeconomic policies, which tend to amplify the underlying business cycle (the when-it-rains-it-pours phenomenon). Correlation Between Cycles in Interest Rates and Output Uruguay Panama Indonesia Peru Korea Swaziland Bolivia India Denmark Italy Chile Sri Lanka Source: Kaminsky, Reinhart, and Vegh (24) Norway Oman Gambia Chad Botswana Kenya Cameroon Costa Rica Cent Afr Rep. Mauritius Senegal Venezuela, Rep. Bol. Rwanda Syria Philippines Togo Finland Greece Portugal Honduras Bangladesh Sweden Côte d'ivoire El Salvador Trinidad Tobago United States Malaysia Congo, Rep Guatemala Nigeria Gabon Cape Verde Sierra Leone Thailand South Africa Zimbabwe Jamaica China: Mainland Niger Ireland United Kingdom Canada France Japan Mali Benin Netherlands Switzerland Spain Australia Germany Belgium New Zealand 18 Ecuador Colombia

19 Has the Cyclicality of Monetary Policy Changed? In the early period (196-2) only about 47 percent of the developing countries followed countercyclical monetary policy. In contrast, 75 percent of matured economies followed countercyclical monetary policy. As shown in Vegh and Vuletin (212), during the last decade, the number of developing countries following countercyclical monetary policy increased to 77 percent. Vegh and Vuletin (212) trace this shift in policy to improvements in institutional quality. The authors conclude: Procyclical monetary monetary policy is triggered by Fear of Free Falling. The depreciation of the currency during bad times (typically characterized by large capital outflows) forces policymakers to raise the interest rate to defend the currency to avoid even further capital outflows and systemic bankruptcy of firms indebted in dollars. As many emerging markets matured by undertaking market-friendly reforms and having better institutions, this fear of free falling has subsided, allowing policy makers to follow countercyclical policies. 19

20 Reflections Many have stressed the adverse effects of globalization. Lack of monetary independence, with booms in capital inflows triggering foreign exchange intervention, inflation, and real appreciation. With foreign exchange intervention amplifying the effects of boom-bust cycles in capital flows. Procyclical monetary policy. Still, when compared with episodes of financial repression, the evidence from episodes of financial deregulation in emerging economies suggests that financial globalization promotes: Institutional reforms Central bank credibility and lower inflation Countercyclical monetary policy as reforms progress. Still, even with better institutions and countercyclical monetary policy, the role of central banks in emerging markets with financial globalization is still plagued with challenges, not necessarily exclusive to developing countries as the crisis of 28 clearly attests. 2

Globalization in the Periphery: Monetary Policy: What is Gained, What is Lost

Institute for International Economic Policy Working Paper Series Elliott School of International Affairs The George Washington University Globalization in the Periphery: Monetary Policy: What is Gained,