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1 eonstor Der Open-Aess-Publikationsserver er ZBW Leibniz-Informationszentrum Wirtshaft The Open Aess Publiation Server of the ZBW Leibniz Information Centre for Eonomis Hoffmann, Anreas; Shnabl, Gunther Working Paper Monetary Poliies of Large Inustrialise Countries, Emerging Market Creit Cyles an Feebak Effets CESifo Working Paper, No. 723 Provie in Cooperation with: Ifo Institute Leibniz Institute for Eonomi Researh at the University of Munih Suggeste Citation: Hoffmann, Anreas; Shnabl, Gunther (201) : Monetary Poliies of Large Inustrialise Countries, Emerging Market Creit Cyles an Feebak Effets, CESifo Working Paper, No. 723 This Version is available at: Stanar-Nutzungsbeingungen: Die Dokumente auf EonStor ürfen zu eigenen wissenshaftlihen Zweken un zum Privatgebrauh gespeihert un kopiert weren. Sie ürfen ie Dokumente niht für öffentlihe oer kommerzielle Zweke vervielfältigen, öffentlih ausstellen, öffentlih zugänglih mahen, vertreiben oer anerweitig nutzen. Sofern ie Verfasser ie Dokumente unter Open-Content-Lizenzen (insbesonere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweihen von iesen Nutzungsbeingungen ie in er ort genannten Lizenz gewährten Nutzungsrehte. Terms of use: Douments in EonStor may be save an opie for your personal an sholarly purposes. You are not to opy ouments for publi or ommerial purposes, to exhibit the ouments publily, to make them publily available on the internet, or to istribute or otherwise use the ouments in publi. If the ouments have been mae available uner an Open Content Liene (espeially Creative Commons Lienes), you may exerise further usage rights as speifie in the iniate liene. zbw Leibniz-Informationszentrum Wirtshaft Leibniz Information Centre for Eonomis

2 Monetary Poliies of Large Inustrialise Countries, Emerging Market Creit Cyles an Feebak Effets Anreas Hoffmann Gunther Shnabl CESIFO WORKING PAPER NO. 723 CATEGORY 7: MONETARY POLICY AND INTERNATIONAL FINANCE MARCH 201 An eletroni version of the paper may be ownloae from the SSRN website: from the RePE website: from the CESifo website: Twww.CESifo-group.org/wpT

3 CESifo Working Paper No. 723 Monetary Poliies of Large Inustrialise Countries, Emerging Market Creit Cyles an Feebak Effets Abstrat This paper explores the link between monetary poliies of large inustrial ountries an international reit yles. Base on an overinvestment framework, we show that in the prevailing asymmetri worl monetary system, monetary poliies of large entre ountries an fuel reit booms in emerging markets. We argue that the absorption of inflationary pressure by emerging markets uring boom perios as well as the fear of feebak effets of rises in emerging markets enourage elaye monetary tightening in entre ountries. The paper helps explain asymmetri monetary poliy patterns in entre ountries an why the urrent global low interest rate environment is likely to prevail. JEL-Coe: E20, E580, F330, F0. Keywors: asymmetri worl monetary system, reit yles, monetary poliy, finanial risis, ontagion. Anreas Hoffmann University of Leipzig Grimmaishe Str. 12 Germany 0109 Leipzig Gunther Shnabl University of Leipzig Grimmaishe Str. 12 Germany 0109 Leipzig

4 1 Introution The reent tapering of quantitative easing in the US has triggere instability in a set of emerging markets, inluing eonomi heavyweights suh as Inia, Turkey, South Afria an Brazil. Falling markets oul initiate a wave of ontagion aross the emerging worl, with possibly severe feebak effets on the still fragile finanial system of the large inustrialise ountries. Similarly, the 1997/1998 Asian risis ha triggere the Japanese finanial risis, whih fore the Bank of Japan into its still ontinuing zero interest rate poliy. The European Central Bank keeps postponing the exit from its low interest rate an unonventional monetary poliy ue to the sluggish eonomi reovery in the southern European risis ountries. The monetary poliies of the large inustrialise ountries at the entre of the worl monetary system (partiularly US, Japan an euro area) have been esigne to fit omesti nees suh as inflation an growth (Taylor 1993). In this spirit, prominent entral bankers ontinue to use low levels of omesti onsumer prie inflation as primary measure of monetary poliy suess (Bernanke 201, Draghi 201). Yet in an asymmetri worl monetary system, the monetary poliies of the large entral banks at the entre have a farreahing impat on the maroeonomi evelopment of the periphery ountries, with feebak effets on the inustrialise ountries themselves. In the 1930s, Hayek (1937 [1989]) stresse that purely nationally oriente monetary poliies ha ontribute to the beggar-thy-neighbour poliies that were followe by eonomi isintegration, sluggish growth an politial instability. More reently, MKinnon (2013) reate the notion of an unlove ollar stanar, whih exports finanial instability to the emerging markets. In line with this, Borio an Disyatat (2011) foun that the worl s low funing interest rates in the 2000s ontribute to reit booms an finanial imbalanes on a global sale. While China has alle for a new international monetary system that is less 2

5 epenent on the US monetary poliy (Xiaohuan 2009), Stokes (201) suggeste that "ollar hegemony" has even inrease sine the risis. This paper explores the link between monetary poliies of large inustrial ountries an unsustainable reit booms in emerging market eonomies. While the previous literature mainly analyse the impat of the monetary poliies of inustrialise eonomies on emerging markets, we partiularly fous on the feebak effets of reit booms an finanial instability in emerging markets on monetary poliy eisions in the entre ountries of the worl monetary system. Base on an augmente overinvestment framework, our stuy shows that uring the boom perio of the 2000s, entral banks in inustrialise eonomies postpone monetary tightening, as emerging markets tene to absorb inflationary pressure. Furthermore, we illustrate that the subsequent rises in emerging markets, or the fear thereof, provie grouns for hesitant monetary tightening an further interest rate uts. Base on our analysis, we erive asymmetri monetary poliy patterns an the lok-in effets of low interest rate poliies in the large inustrialise ountries that help explain why a eisive exit from the urrent low interest rate environment has beome unlikely. 2 Asymmetri Monetary Poliy in the Large Inustrial Countries The monetary overinvestment theories by Hayek (1929 [1976]) an Mises (1912) are use as a framework to efine the possible role of monetary poliy in the boom an bust in finanial markets. This framework helps to erive asymmetri monetary poliy patterns in the large inustrialise ountries that have brought short-term interest towars zero an have ontribute to inflating entral bank balane sheets. 3

6 2.1 Monetary Poliy an Domesti Finanial Market Booms Base on the monetary overinvestment theories by Mises (1912) an Hayek (1929 [1976]), three interest rates an be istinguishe. First, the entral bank interest rate is the interest rate that the entral bank harges ommerial banks for refinaning operations. Seon, the apital market interest rate is the interest rate set by the private banking (finanial) setor for reit provie to private househols an enterprises. Thir, the natural interest rate balanes supply (savings [S]) an eman (investment [I]) on omesti apital markets (I=S). It is a theoretial onept that annot be empirially observe. 1 The savings-investment eisions in an eonomy are assume to be in equilibrium when the natural rate of interest is equal to the entral bank an apital market interest rates. In the monetary overinvestment theories, a reit yle begins with a fall of the apital market rate below the natural rate. This situation an be ause by a entral bank that aims at stimulating eonomi ativity via the Phillips urve effet by lowering the entral bank 2 interest rate (see for instane, Garrison 200 an Huerta e Soto 2009). The fall in the entral bank rate allows for easy refinaning onitions, with the apital market rate falling as well. As the natural interest rate stays unhange, the apital market rate an natural interest rate iverge. The falling apital market rate triggers aitional investment. With onsumption being expete to eline in the present an to inrease in the future, high future returns on investment in apital goos (whih aim at prouing onsumer goos in the future) are expete (Mises 1912, pp ; Hayek 1929 [1976], p. 101). This senario onstitutes an unsustainable isequilibrium between planne savings an investment. 3 An overinvestment 1 Most reently, in the ontext of (lose to) zero entral bank rates, a ontroversial isussion has emerge whether the natural interest rate an be negative. See e.g. von Weizsäker (2011) or Summers (2013). 2 Alternatively, Hayek (1929 [1976], p. 83) stresse the ruial role of the elastiity of the reit system in the emergene of reit yles. 3 Garrison (200) moelle the istortionary effets of monetary poliy on the proution struture with the help of proution possibility frontiers an the Hayekian triangle.

7 boom in the apital goos setor is inue, whih raws unemploye apaities an labour into the proution of investment goos. Rising employment, wages an inome stimulate onsumption. Given low interest rates, the eman for onsumer goos partiularly urable goos rises as well. Growing aggregate eman provies an inentive to further inrease apaities (Garrison 200). The positive expetations an be transmitte to asset markets, as profit expetations of enterprises have inrease. Speulation may set in, an prie expetations for stoks an other real assets an be isonnete from real eonomi evelopment. The turnaroun is either triggere by the entral bank, when interest rates are lifte in response to rising inflation, or by the banking setor, when reit onitions are tightene beause of hanging sentiment onerning the sustainability of the upswing. Investment projets, with expete returns below the inrease apital market rate, have to be ismantle. Asset pries start to eline; the equity positions an reit worthiness of enterprises fall. As investment rops, the natural interest rate is pulle below the entral bank an the apital market rates (whih are kept high). A savings overhang emerges, with savings being more lurative at relatively higher interest rates. In ontrast, investment an output eline. Unuse apaities an unemployment rise, while wages fall. With falling onsumption (at higher interest rates), pries start to eflate. The proess of ismantling low-return investment projets the leansing effet in Shumpeter s (193) wors goes within falling wages an pries, whih is the basis for eonomi reovery. 2.2 Ientifying Monetary Poliy Mistakes The monetary overinvestment theories of Hayek (1929 [1976]) an Mises (1912) allow the ientifiation of two types of monetary poliy mistakes. First, uring an eonomi upswing, The symptoms of prosperity themselves finally beome, in the well-known manner, a fator of prosperity (Shumpeter 193, p. 226). 5

8 the entral bank keeps the entral bank rate below the natural interest rate (type 1 monetary poliy mistake), triggering an unsustainable overinvestment boom. Although over the past three eaes, overinvestment booms in the narrow sense of the monetary overinvestment theories oul harly be observe, several authors linke benign liquiity onitions to booman-bust yles in finanial markets. Revankar an Yoshino (2008) argue that for Japan a low interest rate in response to the post-1985 Plaza appreiation ontribute to unue reit growth an the bubble in the Japanese real estate an stok markets. Taylor (2009) saw the monetary poliy stane by the Feeral Reserve uner Alan Greenspan at the ore of the exuberane in the US real estate market after the turn of the millennium. He showe that the feeral funs rate was set substantially below the benhmark, as efine by the Taylor rule (Taylor 1993). Shnabl an Wollmershäuser (2013) provie empirial eviene that the post-2001 low interest rate poliies of the European Central Bank (paire with expansionary fisal poliies of the later risis ountries) an be viewe as the origin of unsustainable real estate an onsumption booms in parts of the euro area an beyon, for instane in Central an Eastern Europe. Seon, uring a ownswing, the entral bank keeps the interest rate too high, aggravating the eonomi ownturn (type 2 monetary poliy mistake). With respet to Japan, Posen (2000) lassifie as a poliy mistake the Bank of Japan s attempt to ontain the bubble eonomy with interest rate inreases starting from 1988 an to eflate the bubble by keeping interest rates high, even after the bubble ha burst. Bernanke (2000) ubbe the Japanese post-bubble stagnation of the 1990s as a self-inue paralysis, whih oul have been avoie by eisive interest rate uts an unonventional monetary poliy measures suh as outright purhases of government bons an isretionary urreny epreiation. Frieman an Shwartz (1963), as well as Bernanke (201), stresse that the Feeral Reserve System s tight monetary poliy uring the Great Depression of the 1930s strongly 6

9 aggravate the ownturn. During the urrent European finanial an ebt risis, a onflit within the European Monetary Union (EMU) has emerge. In Germany, the interest rate set by the European Central Bank is regare as too low, whereas the majority of EMU member states see benign liquiity as a onition for a lasting eonomi reovery. 2.3 Asymmetri Monetary Poliy Patterns In pratie, it seems that the two types of poliy mistakes have been inorporate in ifferent ways into monetary poliy making sine the mi-1980s. Central banks have tene to keep interest rates low uring boom perios, as onsumer prie inflation has remaine wiely ontaine in a perio ubbe as the Great Moeration (Bernanke 200). Domesti finanial market booms have been regare as outsie the responsibility of entral banks, sine entral banks have been onsiere as unable to spot bubbles an/or to target prie evelopments on speifi finanial market segments (Bliner & Reis 2005). 5 Aoring to Bernanke an Gertler (2001, p. 253) entral banks shoul respon to asset pries only to the extent that they affet the entral bank s foreast of inflation. As a result, entral banks have tene to keep interest rates low for long perios uring finanial market booms, possibly beoming subjet to type 1 monetary poliy mistakes. In ontrast, given the Japanese experiene with monetary tightening in response to the bursting bubble an the tight monetary poliies pursue by the Feeral Reserve in the early years of the Great Depression, interest rates ame to be slashe in the fae of finanial risis to avoi type 2 monetary poliy mistakes. In the so-alle Jakson Hole onsensus, US entral bankers agree that entral banks o not have suffiient information to spot bubbles, but shoul intervene in times of finanial turmoil (Bliner & Reis 2005). This reate a situation where finanial markets oul expet a quasi-bailout via interest rate uts in times of risis, the so-alle Greenspan put (Stiglitz 2010). Given the 5 Mishkin (2008) viewe regulation as the aequate tool to ontrol possible asset market bubbles. 7

10 rising sensibility of entral banks onerning finanial stability uring a risis, they may even have tene to transform type 2 poliy mistakes into type 1 poliy mistakes. Central bank rates may have fallen below the natural interest rate, whih woul have balane savings an investment uring the risis. There are three possible reasons for too expansionary monetary poliies uring a risis. First, in times of finanial pani, the entral bank has inomplete information onerning the egree of finanial instability an assumes the natural interest rate to be lower than it atually is. Seon, entral banks make a orret assessment of the natural interest rate, but there is no lear institutional separation between the finanial setor an the entral bank. The entral bank sets interest rates too low to minimise the losses of the finanial setor. Thir, the entral bank is epenent on the government an inreases the probability of inumbent publi offiials re-eletion by minimising unemployment an government efiits. 6 The outome has been asymmetri monetary poliy patterns. Central bank interest rates have eline more uring the risis perio than they have been lifte uring the sueeing reovery. As shown in Figure 1, the average short-term interest rates in the large inustrialise ountries (Japan, US, Germany/euro area) have eline graually from a level of about 12% in the early 1980s to lose to zero sine the outbreak of the US subprime risis. In Japan, where finanial market exuberane ha ourre muh earlier than in the US an Europe, the money market interest rate ha alreay reahe the zero-boun in Buhanan an Wagner (1977 [1999], p. 120) argue that the ations of the Feeral Reserve Boar have not been inepenent of the finaning nees of the feeral government. Our hypothesis is that politial pressures also impinge on the eisions of monetary authorities. 7 This oes not neessarily imply that the strutural eline of G3 interest rates originate in Japan. Moreover, it an be argue that the Feeral Reserve ha the largest egree of freeom in monetary poliy eision making, whih beame transmitte via the exhange rate on Japanese monetary poliy. Sine the early 1980s, Japan s interest rate level ha tene to remain lower than that of the US beause of Japan s strutural urrent aount surpluses, rising foreign urreny-enominate net international assets an thereby persistent appreiation expetations of the Japanese yen. Uner this onition, a strutural eline of the US interest rate woul push Japanese interest rates towars zero (see Goyal & MKinnon 2003). 8

11 After the sope for interest uts reahe zero, the entral bank balane sheets have been inflate by unonventional monetary poliy measures, pioneere by the Bank of Japan (Iwata & Takenaka 2011). These measures fous on purhases of government bons of overinebte ountries (to further epress interest rates at the long en of the yiel urve) an ba assets from ailing finanial institutions. Figure 2 shows the ramati inflation of the balane sheets of the Bank of Japan sine the mi-1990s, followe by those of the Feeral Reserve Bank an the European Central Bank sine 2007/2008. Figure 1: G3 Short-Term Interest Rates (Arithmeti Average) 1% 12% 10% 8% Nominal Real Nominal (Tren) Real (Tren) 6% % 2% 0% -2% -% Jan 80 Jan 86 Jan 92 Jan 98 Jan 0 Jan 10 G3=US, Japan an Germany (up to 1998)/euro area Soure: International Monetary Fun (IMF), via Datastream, The ommon tren of struturally elining interest rates an quasi-synhronise inflation of entral bank balane sheets in all large inustrial ountries raises the question of the interepenene of monetary poliy making. Prior to the breakown of the Bretton Woos system, it was argue that the eoupling from the US ollar woul enable ountries suh as Germany an Japan to fit their monetary poliy eisions with omesti maroeonomi 9

12 Perent of GDP nees in the fae of prie an wage rigiities (Frieman 1953). However, Figures 1 an 2 suggest that in a finanially globalise worl, the monetary poliy eisions of the large inustrialise ountries have remaine interepenent. For instane, monetary poliy making in Japan has remaine strongly epenent on the appreiation pressure on the Japanese yen, with yen appreiation being respone to by (partially massive) foreign exhange intervention or outright interest rate uts (Goyal & MKinnon 2003). For the European Central Bank, the notion has also emerge that its interest rate eisions woul ten to follow those of the Feeral Reserve, partiularly sine the southern European ountries have proven to be vulnerable to euro appreiation (Belke & Gros 2003). Figure 2: G3 Monetary Bases as Perent of Gross Domesti Prout (GDP) European Central Bank Bank of Japan Feeral Reserve Soures: Worl Eonomi Outlook (WEO), European Central Bank an Eurostat,

13 3 Monetary Poliy Reperussions on Periphery Countries In an asymmetri worl monetary system, monetary poliy eisions of entral banks issuing international urrenies (Feeral Reserve, European Central Bank, Bank of Japan) have global impliations. Outsie of Europe, the worl is on a US ollar stanar (MKinnon 2013); international trae inluing the burgeoning intra-inustry trae within regions is mainly invoie in ollars. The ollar is the ominant means of settling international payments among banks an is the prinipal reserve an intervention urreny use by governments for smoothing exhange rate flutuations. Whereas the US remains inative in the foreign exhange market, the ountries at the periphery of the worl ollar stanar peg their exhange rates more or less tightly to the ollar to reue transation osts for international trae an apital flows. On the other han, in Europe, the euro has aquire the role of a regional urreny. This asymmetri nature of the worl monetary system is reflete in asymmetri apital market strutures. Capital markets in the ountries issuing international urrenies are highly evelope, offering a wie range of investment opportunities at all terms of maturities. Transation osts are low, an instruments to hege foreign exhange risk are available. In ontrast, in emerging markets an eveloping ountries, apital markets are unerevelope an fragmente (Eihengreen & Hausmann 1999). Transation volumes are small, an investment opportunities are limite, partiularly at the long en of the yiel urve. Instruments to hege foreign exhange risk are rare an ostly. With foreign liabilities an assets being enominate in foreign urrenies (ollars an euros), governments stabilise exhange rates against the international anhor urrenies to ontribute to a stable maroeonomi performane (MKinnon & Shnabl 200). 11

14 3.1 Capital Inflows an Exhange Rate Stabilisation in Emerging Markets The strutural eline of interest rates in the large inustrialise ountries issuing international urrenies has triggere the growing influx of both portfolio investment an foreign iret investment (FDI) into an inreasing number of emerging market eonomies. With returns being epresse towars historially low levels in the evelope finanial markets, a hunt for yiel has set in. Carry traers have use low-ost finaning opportunities in the large inustrialise ountries to profit from the higher returns in emerging markets, where (linke to the buoyant apital inflows) risk has erease in two ways. First, given that interest rates in the large inustrialise ountries are expete to fall further or ontinue to be low, exhange rate expetations for emerging market urrenies an be assume to beome tilte towars appreiation. This orrespons to a quasi-insurane mehanism for urreny risk. Seon, the persistent apital inflows into emerging markets are equivalent to a stabilisation fun; as interest rates eline, investments inrease, growth aelerates an government revenues inrease. Default risk beomes struturally reue as a (kin of self-fulfilling) pull fator for apital inflows. Sine the turn of the millennium, the buoyant apital inflows into emerging market eonomies have le to ramatially aelerating foreign reserve aumulation, inepenent from the exhange rate regime ue to a persistent fear of floating (Calvo & Reinhart 2002). In the ase of tight (ollar or euro) pegs, interest rate uts in the anhor ountries have le to quasi-automati reserve aumulation in the periphery ountries. In the ase of soft pegs an flexible exhange rates, the expansionary monetary poliies of the large inustrialise ountries have inrease the probability of isretionary ollar or euro purhases that are epenent on the negative growth effets of the appreiation of periphery urrenies. 8 8 Conerning the impat of appreiation on emerging market eonomies with foreign urreny-enominate net foreign assets, suh as China, see MKinnon an Shnabl (200). China provies an example of one-way bets on the ontrolle appreiation path being reflete in high foreign reserve aumulation. If eonomi agents an irumvent the inboun apital ontrols to invest at a higher interest rate in China, large arbitrage profits (positive Chinese-US interest ifferential plus yuan appreiation versus the ollar) an be realise. 12

15 Billion USD Uner the benign liquiity onitions in the large inustrialise ountries, a ompetitive attration of speulative apital inflows an emerge. With periphery ountries being subivie into ountries with tight exhange rate pegs an freely floating exhange rates, arry traers an realise low-risk speulation profits by investing in freely floating urrenies with quasi-persistent appreiation expetations. Countries with more flexible exhange rates woul attrat more apital inflows an therefore woul experiene stronger appreiation pressure, whih woul inrease the likelihoo an sale of foreign reserve aumulation. Figure 3: Global Foreign Reserve Aumulation 8,000 7,000 6,000 5,000,000 3,000 Afria Asia Emerging Europe Inustrial Countries Mile East Western Hemisphere 2,000 1,000 0 Jan-80 Jan-8 Jan-88 Jan-92 Jan-96 Jan-00 Jan-0 Jan-08 Jan-12 Soures: IMF, IFS, 201. Alternatively an omplementarily to foreign exhange intervention, interest rate uts an shiel off speulative apital inflows. The unerlying monetary expansion is often performe base on the aquisition of foreign assets, as omesti apital markets are shallow. Figure 3 shows the resulting ramati inrease in foreign reserve holings of emerging 13

16 markets, eveloping ountries an smaller inustrialise ountries. As Rey (2013, p. 1) put it, the global finanial yle transforms the trilemma into a ilemma or an irreonilable uo : inepenent monetary poliies are possible if an only if the apital aount is manage. 3.2 Monetary Expansion an Creit Booms in Emerging Markets If unsterilise, the reserve aumulation of emerging markets entral banks goes with a respetive expansion of base money, a eline in interest rates an possibly a reit boom (Corsetti et al. 1999). For internationally integrate apital markets, Figure presents a partial equilibrium moel of the impat of monetary expansion in a large inustrialise ountry on international borrowing as soure of an unsustainable reit boom in a periphery ountry. The moel an be regare as an open eonomy version of the overinvestment theories by Mises (1912) an Hayek (1929 [1976]), as presente in setion 2. We assume that there are two types of eonomies with ifferent planne savings an investment. The large inustrialise ountry (entre) has higher planne savings than investment ( S1 I1 ). It is the reitor in international apital markets, with the gap between savings an investment being equivalent to the apital export ( CX 1 ). 9 The periphery 10 has higher investment than savings ( I S1 ). It is the apital importer ( 1 CM 1 ), i.e., the ebtor in international apital markets. The international apital market is leare at the global apital market interest rate w i 1, whih is equivalent to the national apital market interest rate ( i w i i 1 1 1, with CX 1 1 CM ).11 We further assume an equilibrium in international apital markets, with the global apital market interest rate being equal to the global natural interest 9 Luas (1990) argue that apital oes not always flow from rih to poor ountries, e.g., ue to apital market imperfetions an iverging risk premiums. 10 In pratie, the apital exports of one large reitor ountry is mathe by the apital imports of a group of ebtor ountries, as in the ase of Germany an many smaller European ountries. 11 Note that in line with the balane of payments ientity, apital exports an apital imports are equivalent to urrent aount positions with inverse signs, refleting national preferenes for intertemporal savings an onsumption. 1

17 rate ( w w i i 1 n1 ). Central bank rates are equal to national an global apital market interest rates, as well as the global natural interest rate ( i w w b i in i i i b 1 ). Due to the asymmetri nature of the worl monetary system, we assume that the global interest rate is etermine by the entre entral bank. If the entral bank in the entre (reitor) lowers the poliy rate (below the global natural interest rate) to ib 2 to promote omesti investment an growth, the finanial setor will reate aitional reit C 1 (as in Garrison 200). The reit expansion mimis an inrease in planne savings, moelle by a shift of the savings urve to the right. The global apital market interest rate falls from w i 2. The apital exports (imports) of the reitor (ebtor) inrease to CX 2. w i 1 to Figure : International Transmission of a Creit Boom inreases from Given the lower interest rates, new investment projets are starte. Investment ativity I 1 to I 2 in the entre (reitor) eonomy an from (ebtor) eonomies. Planne savings fall to I 1 to I 2 in the periphery S 2 ' in the reitor (entre) eonomy an to S 2 in the ebtor (periphery) eonomies. The term S 2 represents the reit supply in the reitor 15

18 eonomy S S C ) at ( 2 2' 1 w i 2. Rising apital exports are reflete in a growing gap between savings an investment ( S 2' C1 I2 S2 I2 0 ) in the entre (reitor) eonomy an ( I 2 S 2 0 ) in the ebtor eonomy. Beause planne savings have not inrease with the reit expansion but have fallen to S2' S2, the global apital market interest rate is below the global natural interest rate, i w w w in i 2 2 n 1. A global isequilibrium between savings an investment has emerge, whih aounts for the ifferene between I I2 an 2 S2' S2. The eline of global interest rates below the natural rate triggers (over-)investment with lower expete marginal returns, as moelle in setion 2. The efault risk of investment inreases if (given resoure onstraints) the global apital market rate shoul return to the global natural rate. 12 In line with Figure, interest rate levels in emerging market eonomies (for instane, in East Asia, Latin Ameria an Central an Eastern Europe) have followe the ownwar tren observe in large inustrialise ountries (albeit at ifferent egrees an remaining at higher levels) (Figure 5). The question of whether the apital inflows an interest rate uts will trigger reit an overinvestment booms (as moelle in Figure ) hinges on the amount of apital inflows, the extent of monetary expansion an the egree of reit growth originating from foreign reserve aumulation. Beause both goos an apital markets in emerging markets are small an unerevelope, ompare to those of the inustrialise ountries, the absorption apaity of apital markets with respet to monetary expansion an growing reit to the private setor is smaller than those of inustrialise ountries (MKinnon & Shnabl 201). This implies that 12 No reit boom (inrease in investment) may emerge in the entre eonomy espite interest rate uts. This an be the ase in the aftermath of a finanial risis, when investors an banks o not expet an eonomi reovery espite easy liquiity onitions, as in Japan s ase after its bubble eonomy burst. A low interest rate elastiity of omesti investment woul orrespon to a lose to vertial investment urve I 2 in Figure. After the entre eonomy s entral bank has lowere poliy rates, the aitional reit is exporte entirely. This amplifies the (potential) reit an overinvestment boom of the periphery. 16

19 Perent in ase of monetary expansion in entre ountries, inflation an asset pries will ten to rise faster in the emerging market eonomies. The reit boom elastiity of monetary easing is larger. Figure 5: Interest Rates in G3 an Selete Emerging Market Country Groups G3 East Asia Emerging Europe Latin Ameria Arithmeti averages. Emerging Europe omprises the new member states of the European Union (EU), exluing Cyprus an Malta. Latin Ameria inlues Argentina, Brazil, Chile, Colombia, Mexio an Peru. East Asia onsists of China, Thailan, Hong Kong, Inonesia, the Philippines, Malaysia, Singapore an South Korea. Soures: IMF, IFS, Sterilisation Poliies an Capital Controls in Emerging Markets To prevent onsumer an asset prie inflation from inreasing in the fae of buoyant apital inflows, entral banks in emerging markets may feel fore to sterilise the monetary effets of exessive foreign reserve aumulation. Figure 6 shows the balane sheets of the entral banks of China an Estonia. In the balane sheets of both the People s Bank of China an Eesti Pank, foreign assets have substantially grown sine In China, the pronoune 17

20 inrease of foreign reserve has triggere extensive sterilisation operations to ontain unue reit growth. Prinipally, there are two sterilisation tehniques (Löffler et al. 2010). In market-base sterilisation, the entral bank sells omesti urreny bons to finanial entities to reue their liquiity holings. The ownsie is that upwar pressure on the open-market, omesti interest rate inues even greater inflows of hot money, with sterilisation osts (potential entral bank losses) beoming substantial. Nonmarket-base sterilisation raises reserve requirements on bank eposits so that less bank reit an be issue for any given inrease in base money. Sine usually the remuneration for require reserves is low or even zero, the sterilisation osts are minimise. The isavantage is that sterilisation osts are shifte to ommerial banks, whih beome restrite in their funtion as finanial intermeiaries. Refinaning via the entral bank may be substitute by international borrowing, whih again inues aitional apital inflows. The upper left panel of Figure 6 shows the sterilisation instruments of the People s Bank of China, with negative signs on the liability sie of the entral bank s balane sheet. The lower left panel shows the interest rates on sterilisation instruments. The People s Bank of China has issue entral bank bons to a ertain extent to sterilise the liquiity effets of reserve aumulation. The interest rate pai on entral bank bills is lose to the money market rate, iniating that the remuneration has generally been market base (lower left panel, Figure 6). In ontrast, as reflete by fast-growing bank eposits, require reserves have aquire a ominating role as sterilisation instruments, with the reserve requirement rate being graually inrease. The remuneration rate of reserve requirements is substantially lower than the money market rate, iniating nonmarket-base sterilisation. To enhane the effetiveness of (nonmarket-base) sterilisation operations, apital ontrols restriting inwar flows are neessary to shiel off aitional apital inflows (MKinnon & Shnabl 201). Whereas in China, FDI inflows have beome wiely 18

21 Perent Perent Trillion CNY Trillion CNY Billion EEK Billion EEK liberalise, but portfolio an external bank inflows are tightly ontrolle (Ma & MCauley 2007). In Brazil, Tobin-type taxes on fixe-inome investments, bon an stok purhases an issuane of epositary reeipts were impose to urtail apital inflows (Reinhart 2012). Nevertheless, the high egree of reserve aumulation in most emerging markets iniates that the effetiveness of apital ontrols has been limite. Figure 6: Central Bank Balane Sheets an Interest Rates in China an Estonia Net Foreign Assets Claims on Finanial Institutions Net Government Deposits Bons Bank Deposits Curreny in Cirulation Other Items Balane Sheet, People s Bank of China Net Foreign Assets Other Items Capital Aounts Curreny in Cirulation Bank Deposits Balane Sheet, Eesti Pank Interbank Offere Rate, Overnight Central Bank Bill Yiel, Three Month 8 7 Interbank Rate, Three Month Reserve Requirement Remuneration Rate Reserve Requirement Remuneration Rate Interest Rates, China Soures: IMF, IFS, Interest Rates, Estonia In ontrast, in Estonia the large-sale, foreign reserve aumulation resulting from apital inflows remaine wiely unsterilise. A ifferent institutional setting of the urreny boar arrangement, as well as the provision of free apital flows within the EU, neither allowe for nonmarket-base sterilisation nor for apital ontrols. In ontrast to China, the reserve requirement rate an the basis for reserve requirement holings remaine wiely unhange uring the reit boom. Therefore, the substantial inrease of bank eposits (an 19

22 urreny in irulation) was available for reit growth in Estonia, with the reserve requirement remuneration rate following the money market (interbank) rate (iniating market-base remuneration). A similar phenomenon oul be observe in the southern periphery of the euro area (the later risis ountries), where per efinition the apital inflows remaine unsterilise, feeing into unsustainable reit growth, stok an real estate market booms, as well as inflation above the euro area average (Shnabl & Wollmershäuser 2013). Similarly, uring the 1990s, the apital inflows into the Southeast Asian later risis ountries (originating in the low interest rate poliy of the Bank of Japan in response to the post-bubble reession) remaine wiely unsterilise, ausing an unsustainable reit boom, rising urrent aount efiits an growing foreign urreny-enominate, international ebt. The ifferent egrees of sterilisation ha ifferent feebak effets on the entre ountries. Given the high egree of sterilisation at the periphery of the informal ollar stanar sine the turn of the millennium (partiularly in East Asia as a lesson from the Asian risis), the inflationary pressure in both the periphery an the entre was supresse. The inflationary feebak effets on the entre ountry in the form of rising pries of importe goos (for instane, as measure by the US prie inflation of imports from China) remaine ontaine. This implies that the absorption of liquiity at the periphery postpone the monetary tightening in the entre ountry, where the subprime market bubble emerge. The inflationary effets on some euro area ountries were ompensate by lower inflation within other euro area ountries (e.g. Germany), sine the European Central Bank targets an average inflation rate for the euro area as a whole. The inflationary effets of the booming European ountries outsie the euro area an be assume to have riven up euro area inflation via import pries (with their eonomi weight being omparatively small). Figure 7 shows the impliations of ifferent sterilisation strategies (after the turn of the millennium) for reit growth an the urrent aount positions. In East Asia, the sterilisation 20

23 Current Aount in Perent of GDP Current Aount in Perent of GDP Domesti Creit in Perent of GDP Domesti Creit in Perent of GDP proess an be seen as a lesson from the 1997/1998 Asian risis, whih ha been ause by an unsustainable reit boom. As shown on the left sie panels, reit growth has generally reflete GDP growth sine the turn of the millennium. Only with the Feeral Reserve s three generations of quantitative easing from 2007/2008 onwars we observe a new inrease in reit to the private setor as a perentage of GDP. Given the relatively restritive monetary poliy stanes relative to the US, urrent aount positions have tene to improve. Only with the re-emerging growth of reit to the private setor sine 2008, has the average urrent aount surplus of East Asia eline. Figure 7: Creit Growth an Current Aounts in East Asia an Emerging Europe East Asia: Domesti Creit Emerging Europe: Domesti Creit East Asia: Current Aount Balane Emerging Europe: Current Aount Balane Arithmeti averages. Soure: Worl Development Iniators (WDI), In ontrast, as shown on the right-han panels of Figure 7, reit to the private setor as a perentage of GDP ramatially inrease in the Central an Eastern European new member states of the EU after the turn of the millennium. This proess went along with a graual loss 21

24 of ompetitiveness an strongly inreasing urrent aount efiits. The rising foreign urreny-enominate ebt beame the breeing groun for the risis starting in A similar proess took plae in the southern an western peripheries of the euro area (see e.g. Shnabl & Wollmershäuser 2013). Periphery Crisis an Reperussions on the Centre The monetary overinvestment theories of Mises (1912) an Hayek (1929 [1976]) suggest that a risis ours when entral banks tighten reit by inreasing the entral bank interest rate. Alternatively, the private banking setor tightens reit ue to hanging eonomi sentiment. Emerging markets that have generally abstaine from sterilisation an therefore have aumulate larger stoks of foreign urreny-enominate international ebt ten to be more vulnerable to a global tightening of liquiity..1 Poliy Reversal an Periphery Crisis Figure 8 illustrates the poliy reversal in the entre (reitor) eonomy. When the entral bank in the entre tightens money supply, the banking setor has to reue the reit exposure, for instane, by C 2. The entral bank rate inreases to i b 3, whih is, for instane, equivalent to the global natural interest rate. 13 The savings urve shifts bak to its initial position ( S S1 3 ). Capital exports from the entre to the periphery eonomies fall from CX 2 to CX 3. Global apital market interest rates rise to i w 3, along with the entre poliy rate. This lifts the threshol for the profitability of investment projets. Strutural istortions are leare, as investments with expete returns below the natural interest rate have to be ismantle. Investment in the entre (reitor) eonomy falls to I 3 an investment 13 We assume that ue to the asymmetry of the worl monetary system, the global interest rate is etermine by the entre entral bank. 22

25 in the periphery (ebtor) to I 3. Planne savings inrease from S 2 ' to S 3 in the entre (reitor) eonomy an from S 2 to S 3 in the periphery (ebtors). Global planne savings an investment are balane again, as the global apital market rate is equal to the global natural interest rate. 1 Figure 8: Poliy Reversal A estabilising effet of tightening reit onitions by entre entral banks oul be observe prior to the European finanial an ebt risis in many entral an eastern European ountries, as well as in the later risis ountries of the euro area. Currently, announements of a phasing out of quantitative easing by the Feeral Reserve System have triggere instability in many emerging market eonomies, inluing Inia, Brazil, South Afria an Turkey. In ontrast, the eonomi turnaroun in the Southeast Asian ountries prior to the Asian risis was triggere by a hanging eonomi sentiment onerning the sustainability of the Southeast Asian eonomi mirale, whih orrespone to a reit tightening originating in apital markets. 1 Note that in this ase, planne savings are equivalent to overall savings. 23

26 .2 Crisis an Fragmentation of International Capital Markets If apital markets antiipate an eonomi turnaroun in the emerging markets, a flight to the safe havens sets in. This imposes even tighter monetary onitions on the emerging markets. When investment projets in the periphery eonomies are ismantle, the risk premium in international borrowing rises. If linke to apital outflows, a periphery ountry s urreny woul epreiate, an its foreign urreny ebt woul be inflate in terms of the omesti urreny (Corsetti et al. 1999). With finanial markets antiipating the joint efault of the periphery s banking setor, apital flows to the periphery ry up. In Figure 9, apital exports of the entre shift from CX 3 to CX, i.e., to zero. 15 As the periphery is ut off from international apital markets, its apital market interest rate shifts upwar towars the self-suffiieny rate natural interest rate i, whih is equivalent to the periphery s omesti in. In the fae of risis, the periphery s entral bank rate is lifte towars ib to keep the exhange rate stable an to ountersteer apital outflows. (Dollar sales an purhases of omesti urreny orrespon to monetary tightening.) Figure 9: Crisis an Disintegration of International Capital Markets 15 For simpliity, we assume that apital exports of the entre ountry beome zero. In reality, the apital flight to the safe haven tens to turn the emerging market s (entre ountry s) finanial aount to positive (negative). 2

27 When liquiity in international apital markets ries up, the umulative ownwar proess in the periphery aelerates. Investment eman falls. In Figure 9, the investment urve shifts from I to I risis, an the natural interest rate elines to in 5. In this situation, holing entral bank interest rates high at ib is equivalent to a type 2 monetary poliy mistake, whih amplifies the ownturn, with planne savings being larger than investment ( S I ). With apital remaining in the safe haven of the entre ountry, the entre s omesti natural interest rate elines to in. If the entral bank aims to avoi a type 2 monetary poliy mistake by holing the interest rate unhange at i b3, it will allow the apital market rate to rop to i by reuing the entral bank rate ib towars the omesti natural rate in. At the lower interest rate, planne investment rises from I 3 to I, while planne savings fall from S 3 to S (balaning investment)..3 Feebak Effets on Centre Countries an Monetary Poliy Resue Measures If the periphery entral bank aims to avoi a type 2 monetary poliy mistake by utting the entral bank interest rate towars the omesti natural interest rate i 5 ( n i b i 5 5 ) (or if foreign reserves are eplete), the resulting epreiation of the omesti urreny inflates the foreign urreny-enominate ebt in terms of the omesti urreny. The finanial setor ollapses. This auses painful ontagion effets on the entre s finanial setor an onstitutes an inentive for the entre entral bank to ut interest rates below the (omesti) natural interest rate i n to ontain a potential finanial risis. In East Asia an Europe, we oul observe that rises in periphery ountries have suh negative feebak effets on entre ountries. In the 1997/1998 Asian risis, Japanese banks (whih were alreay ailing from the onsequenes of the bursting Japanese bubble) suffere from the new reit efault in Southeast Asia. The reit efaults, together with Japanese 25

28 enterprises elining exports to Southeast Asia, triggere the sharp eline in stok pries, whih beame the foal point of the 1998 Japanese finanial risis (Hoffmann & Shnabl 2011). The risis fore the Bank of Japan to ut interest rates further to zero an to embark on quantitative easing. In Europe, the risis insie an outsie the EMU (inluing the simultaneous risis in the US subprime market) ha painful ontagion effets on the northern European banks, partiularly the German banking setor. The tremenous reit exposure of mainly northern European banks to ailing banking setors at the periphery of the EMU mae monetary poliy resue measures neessary. These omprise interest rate uts towars zero, several measures of quantitative easing, the aumulation of risis ountries government bons in the ECB s balane sheets, as well as an announement that everything neessary woul be one to save the euro. In Figure 10, the entre s entral bank pushes the entral bank interest rate own to ib 5 (below the omesti natural interest rate in ) by injeting aitional reit C 3. The aim is to restore onfiene in finanial markets an prevent a potential omesti finanial ollapse an a subsequent reit runh. The benign liquiity onitions shrink the risk premium an reanimate apital flows to the periphery. The apital export urve shifts to as international apital markets start to reintegrate. CX 5, As international lening piks up, apital outflows put an upwar pressure on omesti interest rates in the entre ountry towars w i 5. As at w i 5, the entre s investment woul fall again to I I ), the entre entral bank moves towars further monetary 5 ( expansion to keep the interest rate at i w b i i The aitional reit expansion C shifts the apital supply urve to S C (while planne savings fall). As the global natural interest rate is not affete by the reit expansion ( w w in i 5 n6 ), the global apital market 26

29 interest rate is now far below the global natural interest rate i w w ib i 6 6 n 6. At the lower global apital market rate w i 6, apital exports strongly inrease from CX 5 to CX 6, an investment grows further to I 6 ( I 5 ) in the periphery an to I 6 ( I I5 ) in the entre ountry. Monetary poliy has sown the sees of a new, even larger overinvestment yle. Figure 10: Exessive Monetary Poliy Response 5 Outlook: The Low Interest Rate Trap We have shown that asymmetri interest rate uts an quantitative easing in large inustrialise ountries inrease the likelihoo an sope of boom-an-bust yles in emerging market eonomies. We have further explaine that the international transmission of monetary poliies from the entre to the periphery of the worl monetary system an its feebak effets on the entre may have ontribute to asymmetri monetary poliy patterns, as observe in the large inustrialise ountries (i.e., hesitant interest rate inreases uring boom perios an eisive uts in risis perios). In an asymmetri worl monetary system, the absorption of inflationary pressure at the periphery onstitutes an inentive for the entre entral bank to further expan monetary aommoation, possibly beyon what ensures a stable, global maroeonomi evelopment. 27

30 Due to rising international apital flows the emerging markets have grown in importane for finanial stability of the entre ountries. (Potential) periphery rises have beome a threat to finanial stability in the entre eonomies. (Inter alia) to prevent finanial turbulene in the emerging markets, poliymakers seem to opt for an overly extene perio of low interest rates. With interest rates having reahe the zero-boun in the reent risis, quantitative easing initiatives aim to tilt interest rates further ownwars on the long en of the yiel urve. Meanwhile, preventing government efault is also seen as a tool to safeguar finanial stability. This opens the path towars the persistene of the low interest rate environment via the impat of the prime interest rate uts an quantitative easing on publi ebt evelopments, as most eviently observe in Japan. The reason is that struturally elining interest rates enourage rising government ebt. In Japan, where the risis has ontinue sine the early 1990s, espite an inrease of gross government ebt from roughly 60% of the GDP in 1990 (when the bubble burst) to 20% in 201, the interest rate payments as a share of the general government buget have generally remaine onstant. Yet, the higher the level of government ebt, the higher will be the pressure on the entral bank to keep interest rates lose to zero an to reue the yiels on government bons by unonventional monetary poliy measures. The impliations are the lok-in effets of low interest rate poliies an unonventional monetary poliies, i.e., a low interest rate trap. This is even more the ase, as any monetary tightening is likely to ause new finanial instability, with the ost of the efault of finanial institutions being shifte to the publi setor. The hysteresis of the low interest rate an the high ebt environment in the inustrialise ountries is likely to ontinue to have estabilising effets on the emerging markets at the periphery of the asymmetri worl monetary system. 28