Posts by OtavianoCanuto:
Crisis Recovery: Flying on a Single Engine
March 8th, 2014
By Otaviano Canuto,
Policy makers in the advanced economies at the core of the global financial crisis can make the claim that they prevented a new “Great Depression”. However, recovery since the outbreak of the crisis more than five years ago has been sluggish and feeble. These macroeconomic outcomes have to some extent been shaped by the policy mix predominantly adopted in those economies in response to the crisis, one in which very loose monetary policies have been combined with tight fiscal policies.
Actual GDP has lagged behind its potential along the recovery
The ongoing recovery in advanced economies has been sluggish and fragile when compared to the three previous ones (Kose et al, 2013). While real GDP per capita returned to positive trajectories soon after previous temporary downturns, this time it not only started decelerating well prior to the global recession year (2009), but has not yet fully recovered its peak levels.
Chart 1 – from Davies (2013) – depicts several key features of the ongoing recovery in the group formed by the US, Euro Area, Japan and UK. First, the aggregate growth trend exhibited prior to the crisis is no longer there, either because it was not really sustainable in the long run and/or as a legacy of the crisis. Second, a new “Great Depression” has been avoided but actual GDP has remained subpar relative to the latest IMF/OECD estimates for potential output. Finally, despite the possibility of catching-up with potential GDP in two years, as outlined in the central GDP projection, such an outcome remains subject to policymakers properly calibrating their responses to a wide range of idiosyncratic challenges ahead (Canuto, 2014).
Chart 1
At first glance, this is not surprising, given the nature of the factors underlying the crisis: the pervasiveness and magnitude of asset booms and busts; design flaws of the Eurozone fully revealed as the crisis unfolded; the degree of synchronization of recessions; policy uncertainty associated with a loss of confidence on the sufficiency of established policy blueprints; and so on. Moreover, any such transition from a previously booming economy to a “new normal” would necessarily entail a significant reallocation of resources, with creation/destruction of jobs and productive assets. As remarked byRajan (2013):
“(…) the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.”
On the other hand, gauging by the size and persistence of the gap between actual and potential GDPs exhibited in Chart 1, one may question whether such a transition might have been made faster with appropriate macroeconomic policies. After all, while economists often assume that, no matter where potential GDP might be, actual GDP will eventually move to it, convergence can occur in the reverse direction. Losses associated with prolonged periods of significant output gaps – e.g., labor de-skilling, foregone R&D efforts, and resource idleness – then become permanent.
The crisis response has been single-handedly based on monetary policy
Kose et al (2013) point out how the recovery in advanced economies may have reflected peculiarities of the policy mix adopted as responses to the recent economic downturn, as compared to previous experiences. While both fiscal and monetary policies have been implemented in a countercyclical direction in the past, that has not been the case this time.
Monetary policy has been extremely accommodative. As policy interest rates approached the bottom – the lower zero bound – central banks went so far as to expand their balance sheets, in conjunction with other unconventional monetary policies (Canuto, 2013a). Chart 2 illustrates that by matching short-term interest rates during previous and current (the “Great Recession”) experiences.
Conversely, while previous recovery experiences were supported by the expansion of public spending, fiscal policy has this time moved in the opposite direction (Chart 3). The fiscal stimulus implemented in the US at the outset of the downturn was reversed not long after, followed by fiscal contraction. In the Eurozone, in turn, fiscal austerity policies were implemented as financial havoc morphed into fiscal unsustainability of its crisis-ridden members. Austerity has also been favored in the UK.
Chart 2
Short-term interest rate during global recessions and recoveries (percent)
Note: Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group.
Source: Kose et al (2013)
Chart 3
Real primary expenditure (index, PPP weighted)
Notes: Dashed lines denote WEO forecasts. Figures are indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line shows the PPP-weighted average of the countries in the respective group.
Source: Kose et al (2013)
Why has the fiscal and monetary policy mix been so different? On the fiscal policy side, as shown by Kose et al (2013), public debt levels in advanced economies were much higher than in the past when the macroeconomic downturn took place. Public deficit levels had soared in the run-up to the recession, given the scale of financial support measures and substantial revenue losses.
However, one may also say that a policy option for austerity was exercised. In the cases of the US and UK, financial markets were not imposing any substantial short-term fiscal retrenchment – especially if medium-to-long-term structural adjustment plans were to be announced. In the Eurozone, in turn, the intensity of fiscal adjustment in crisis-ridden members could have conceivably been lower provided that a correspondingly higher financial support from outside had been made available.
Unconventional monetary policies, in turn, came out of the urgency of halting potentially catastrophic processes of debt deflation and bank-credit freezes that threatened to transform solvent-but-illiquid balance sheets into insolvent ones. In the case of the Eurozone, such risks of financial meltdown were compounded by negative feedback loops between banks’ portfolios and rising risk premiums associated with crisis-ridden national public debts.
Very loose monetary policies smoothed the process of private-sector balance-sheet deleveraging by keeping yields at low levels and propping up asset values. In the Eurozone, risk premiums abated after the European Central Bank pledge to do “what it takes” to keep currency convertibility.
The phasing out of unconventional policies has been protracted as a reflection of the sluggishness and feebleness of the macroeconomic recovery and the absence of fiscal stimulus as an alternative. In the Eurozone, the debt overhang is still salient and balance-sheet deleveraging still has some way to go, but certainly in the case of the US, where debt deleveraging has already been substantial, fears regarding consequences of the unwinding of quantitative easing have made it a measured and paced process.
Can one point out the single-handed reliance on monetary policy to counter downturn as a factor underlying actual GDP tracking behind potential levels? After all, most analysts attribute an asymmetric capacity to monetary policy in economic downturns: the ability to countervail risks of asset-debt deflation is not accompanied by an equivalently strong capacity to induce agents to invest in new productive assets. As the saying goes, “one can pull a string, not push it!” Furthermore, after a certain point, ultra-loose monetary policy would only lead to a repeat of the bubble-blowing process seen before the crisis.
In this sense, countercyclical moves by policy makers might have reduced the length and size of the observed output gap had fiscal policy operated as a countercyclical tool complementary to monetary policy. Regardless of whether restrictive fiscal policies have been a necessity or an option, the fact is that they have constituted a major factor leading to a subpar recovery performance
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China and Emerging Markets: Riding Wild Horses
February 16th, 2014By Otaviano Canuto.
One month ago, I discussed some major risks to a slight upturn in the global economic scenario for 2014. Among those risks, concerns with the growth slowdown and challenges with shadow banking in China have already come to the fore as the Chinese Year of the Horse approached its inauguration last Friday.
Higher perceived risks about China have added another potential vulnerability, as witnessed by a new round of capital flows out from emerging markets in the last few weeks, resembling the one of last summer. While US 10-year Treasury yields have descended a bit since December, despite the beginning of the actual Fed tapering, news on China’s industrial production softness have sped up the on-going steady course of reduction of exposure of global portfolios to emerging markets in general, in favor of advanced economies. Idiosyncratic political and/or economic events also mattered in particular cases (Turkey, Ukraine, South Africa, and Argentina) but the fact that countries with liquid markets and less fluid conditions — like Mexico, Poland, and Malaysia — also suffered some asset sell-off indicates a much broader scope is at play.
How significant are the potential global spillovers from China’s economic growth slowdown? Why has the latest news particularly affected emerging markets? Last Friday, JPMorgan’s “Global Data Watch” offered some clues. Their research estimates that a 1 percentage point fall in Chinese GDP growth rates tends to have something like a total 0.46 p.p. negative impact on global growth, over four quarters, with effects through oil prices embedded. However, while this reflects a 0.21 p.p. drop in the GDP growth of advanced economies, the corresponding figure for the other emerging markets as a whole is 0.73 p.p. Commodity-dependent countries would be especially hard-hit, as the others may count on some revival of imports from advanced economies.
The world has kept close watch on the ongoing downward adjustment of China’s shadow banking system — credit intermediation involving entities and activitiesoutside the regular banking system — with the near-default of a large trust product during the last few weeks being part of the worrisome news coming from the country. Not because of financial linkages with the rest of the world, as foreign ownership of entities is low and domestic sources and destinations of flows are overwhelmingly predominant, but for the risks that a disorderly unwinding might deepen the already expected growth slowdown.
The Chinese shadow banking system did not look very large compared to other countries (including other emerging markets) in the recent past — see Ghosh et al (2012). However, not only has the expansion of the shadow banking system been extraordinary over the last three years, but also the private non-financial sector debt as a percentage of GDP, which has risen dramatically since 2009. China’s economic policy reaction to the post-2008 fears of a global crash led to some laxity with respect to the rapid expansion of shadow-banking channels of finance of investments and real-estate spending through special purpose vehicles, including those owned by subnational governments. As it often happens with sudden and intense spurts of credit ease, part of the pyramid of newly created assets and liabilities has “pyramids” or “white elephants” as their real-side counterpart.
Chinese authorities must therefore tread cautiously. While maintaining the pressure to correct balance sheets, by taking a hard stance on the side of official refinance backstops, they shall try to avoid panicky effects of occasional bankruptcies by ring-fencing some systemically relevant financial entities. How well this is done will bear consequences on Chinese current GDP growth rates, their impact on emerging markets in general and, therefore, on the risk that a panicky unwinding of exposure to emerging markets might provoke a strong deceleration of the latter, engendering in turn a negative feedback loop to advanced economies. The 2014 baseline for the global economy still appears to be trending upwards, but the Year of the Horse may be jumpy.
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Clogged Metropolitan Arteries
February 12th, 2014
By Otaviano Canuto.
Bad conditions of mobility and accessibility to jobs and services in most metropolitan regions in developing countries are a key development issue. Besides the negative effects on the wellbeing of their populations associated with traffic congestion and time spent on transportation, the latter mean economic losses in terms of waste of human and material resources.
That led me to read with much interest a recent book – available on Google Play – onthe impact of rail-based networks in São Paulo and Mumbai written by Jorge Rebelo, a transport specialist who worked for more than 25 years at the World Bank. São Paulo and Mumbai are both mega-metropolitan regions with about 20 million inhabitants and in dire need of quick solutions for better mobility and accessibility for their populations. As their population and income grew, auto and motorcycle ownership and their use also increased in both cities. Their mass transport systems are overloaded and traveling conditions are reaching their limit or are above their limit at peak-hours. Congestion is becoming unbearable in these two megacities and any new infrastructure requires relocation of houses and businesses, a very sensitive issue which in turn demands careful planning and heavy investment.
Both Mumbai and São Paulo metropolitan regions have extensive suburban railway networks dating from the 19th century that are now serving primarily a huge number of mostly low-income commuters every day. Built initially for transportation of freight and intercity passengers, these railways are now major commuter networks which are used by millions of passengers every day. According to Rebelo, both mega-metropolitan regions have delayed too long the substantial extension of their subways and other rail based systems either because of lack of coordination between levels of government and/or unreliable financing mechanisms which did not allow the required continuity to ensure annual additions to their rail based systems. The price for having procrastinated in facing those challenges has been huge!
Increasing challenges with mobility are of course not unique to those two mega-metropolises. Nineteen of the twenty-six largest metropolitan areas in the world are in non-advanced economies and most of them have suffered from a mismatch between, on the one hand, the fast dynamics of densification and transformation of space use and, on the other, the slower pace of institutional adaptation and/or investment finance to cope with the evolution of transportation needs. Mobility difficulties have become more intense even where population dynamics and rural-urban migration are not major factors, like in Russia, as approached by JungEun Oh and Kenneth Gwilliam in a recent World Bank review of the urban transport sector in the Russian Federation:
“Russian cities are undergoing critical economic and social changes that affect the performance and condition of their urban transport systems. While the population of most large cities in Russia (over one million residents) has remained relatively unchanged over the last decade, the average income of the urban dwellers has sharply increased. The number of private cars per capita has increased rapidly, generating a demand for urban mobility which is increasingly difficult to meet.”
Through the long series of projects and analyses with which the World Bank has been supporting urban transport improvements in developing countries over the years – openly accessible on www.worldbank.org – one can notice how challenges associated with the mismatch between evolution of urban transport needs and institutional and investment finance responses are widespread in the developing world. One can also see how far ago those challenges had already become significant. For instance, a World Bank appraisal report on a project in Rio de Janeiro more than 20 years ago stated the following:
“Urban Transportation is in a crisis in Brazil. Although the nation has invested heavily in the sector over the past 15 years, the effective demand for urban transport services particularly in major metropolitan regions (MRs), increased by about 82% in the last decade, and under present pricing policies, exceeds the existing peak hour supply in most MRs. To add to this capacity shortage, the Brazilian urban transport sector suffers from institutional problems due to a lack of coordination between the three levels of government responsible for urban transport in the MRs.”
Not by chance, the issue of coordination between levels of government is highlighted in a set of policy proposals argued in Rebelo’s book – one that certainly serves as a reference for most metropolitan areas in developing countries. First and foremost, it is fundamental to establish some sort of real, effective Metropolitan Authority as a coordinator of long-term planning, evaluation and prioritization of new investments and coordination of their tariff and subsidy policy. This has also been pinpointed in a recent World Bank report – Institutional Labyrinth:
“Typically, multiple agencies, at different levels of government, are involved in the management and delivery of urban transport infrastructure and services. More often than not, there is little or no coordination among them. This results in duplication and inefficiency in the use of resources and poor-quality services. The need for institutional coordination across space and function is increasingly being recognized as critical to developing an integrated and comprehensive urban transport system.”
The rapid transformation of space use and densification of connections between urban areas tends to turn previous transport- and urban-related political and administrative mandates obsolete and dysfunctional. Natural political inertia or resistance then often becomes a hindrance to building some sort of new, effective authority able to cope with the evolving metropolitan reality.
Some other recommendations follow in Rebelo’s book. For instance, there should be a search for financing mechanisms that are less dependent on floating government general budgets. A greater use of Public-Private Partnerships seems to be a trend in many parts of the world, and that might require operating subsidies. Therefore, financing mechanisms to guarantee the payment on time of those subsidies must be in place to avoid situations where concessions risk failing when operating subsidies are not paid on time. Revenues from advertising, use of station space, real estate developments around stations and urban operations can also be carefully planned.
Another key consideration is to strongly encourage the transparency of the bidding and evaluation process to foster international competitiveness and decrease costs. It also seems advisable to create an inventory of projects contained in the long-term strategy well beyond preliminary design stages. That would cut in the implementation schedule and make projects more attractive from a political standpoint. Finally, in most cases probably with the help of the judiciary, an effort must be made to find ways to simplify and accelerate expropriation/resettlement processes that may be deemed as necessary. All these recommended procedures require a definition of lines of authority appropriate to the evolving metropolitan reality.
The reality is some of the developing world’s transport infrastructures are beyond simple congestion; they are in danger of complete collapse or paralysis. There is reason to believe, however, that authorities in many countries have got the message and started to act more decisively. For instance, Mumbai just had its first monorail inaugurated and there are other rail and metro projects underway under the leadership of the Mumbai Metropolitan Region Development Authority. Sao Paulo and Rio are also undertaking substantial programs to try to address their mobility issues, and it’s high time they do it. Pay-offs from adjusting institutions and finance to the urban dynamics are clearly huge. It’s time to unclog the arteries of urban transport now to prevent stroke and paralysis tomorrow!
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Brazil, Korea: Two Tales of a Macroprudential Regulation
February 7th, 2014By Otaviano Canuto.
The pervasiveness and relevance of asset price booms and busts in modern economies has now been fully acknowledged. So has the case for combining prudential regulation and monetary policy in the complementary pursuit of financial and macroeconomic stability. This is a key issue particularly for policy makers in emerging markets, where the interaction of real and financial cycles tends to be sharper than in advanced economies, with both recessions and recoveries often overlapping with financial events and much larger real-side impacts.
The devil is in the details, however. There are still serious questions on how to proceed with the complementary use of prudential regulation and monetary policy. While there are already lessons from emerging markets’ use of the macroprudential policy toolkit, more experience and analysis, particularly on its interaction with monetary policy is needed.
To this point, recent experiences of Brazil and Korea, as reported in two chapters of a newly released book on macro-financial linkages in emerging markets — edited by my World Bank Group colleague Swati Ghosh and I help fill that gap. They offer complementary examples of the learning-as-you-go process, by which the various components of macroprudential regulation are put in place. This contrasts with the advanced stage of policymaking blueprints that have been attained on the monetary-policy front.
Furthermore, those country experiences also illustrate how both time-series and cross-section dimensions of macrofinancial risks must be on the radar of policy makers. AsMatheus Cavallari and I have remarked:
Reflecting the two types of macrofinancial risks, macroprudential instruments can either assume a time series or a cross-section dimension. When systemic behavior over time is considered, the key issue is how risks can be amplified by interactions within the financial system and between the financial system and the real economy. On the other hand, the cross-section dimension relates to the common exposure of institutions at each point in time. Correlated assets, or even counterparty interrelations, create such a link among financial institutions.
Brazil and Korea present seemingly opposite but complementary examples of the relevance of taking both dimensions into account.
Consider that after the 2008 global financial crisis, Brazilian policy makers deployed macroprudential policies in articulation with monetary policy while jointly pursuing anti-inflation and financial stability objectives. The economy had over-rebounded and started to exhibit signs of overheating in 2010 as a result of fiscal and monetary policies implemented after the global shock. Global liquidity, high commodity prices and strong capital inflows further fueled aggregate demand expansion through domestic credit — which had been rising already at high rates since 2005. It was clearly an opportunity when monetary and prudential instruments could appropriately be combined in unidirectional retrenching, avoiding simultaneous build-up of both inflation and financial fragility. After all, any use of either monetary or prudential policies on their own under those circumstances might have led to contradictory and self-defeating impacts on those two objectives: simply hiking interest rates would attract more capital inflows; and restraining credit supply with no policy interest rate increase would lead to channeling demand for credit to other intermediation vehicles.
Instead there was a combination of policy interest rate hikes and an announced fiscal tightening along with several macroprudential policies. These included: higher bank reserve requirements to curb the transmission of excessive global liquidity to domestic credit markets; stronger terms for specific segments of the credit market to stem the deterioration in the quality of loan origination; reserve requirements on banks’ short spot foreign exchange positions; and taxes applied to specific types of capital inflows to correct imbalances in the foreign exchange market and to dampen intensified, volatile inflows of capital.
Those measures succeeded in slowing the growth of household credit to a more sustainable pace. Nevertheless, partly as a consequence of a second dip of the global financial crisis associated with political and policy stalemates in the US and the Euro zone, and partly because of domestic developments, Brazilian policy-makers were pushed to not only suddenly reverse its monetary-policy stance in 2011, but also felt the need to rapidly fine-tune its macroprudential toolkit, given the unevenness of results. Reflecting on this time,Pereira da Silva and Harris note that:
Most of the macro prudential measures applied in Brazil since 2010 related to the time dimension of systemic risk, in other words to “leaning against the wind” and dealing with the cyclicality of the financial system. However, experience gained from the 2008 crisis has illustrated that, as the financial system becomes more complex and sophisticated, risks can arise not only in a single sector but also as an interlinked, system-wide issue. In fact, the Brazilian financial system is characterized by a high degree of conglomeration and concentration. (…) Therefore, another challenge is to develop effective indicators and to monitor cross sectional risks related to the interconnectedness of the financial system and the real economy.
Korea in turn, had acquired some experience with several macroprudential policy instruments much prior to the 2008 global financial crisis. Liquidity ratio regulations had long been in place in response to the 1997 financial crisis. Furthermore, as signals of euphoria in the housing market became clear in the 2000s, loan-to-value and debt-to-income control ratios were also enacted. But unlike Brazil, Korea lacked specific measures aimed at the time-series risk dimension. This left loopholes for banks to raise excessive leverage through funding with “non-core liabilities” — instruments banks would not draw on during normal times, such as retail deposits by households — leading to a round of crisis-like events in 2008. As Jong Kyu Lee points out regarding the focus of Korea’s regulation on ratios:
(…) a liquidity ratio is unable to fully and flexibly reflect all aspects of structural changes in the related financial markets, and cannot prevent accumulation of financial imbalance. Reliance on a few ratios, (…) even though applied from the [macroprudential policy] perspective is not sufficient for securing financial stability.
Let me highlight three of many lessons stemming from Brazil’s and Korea’s recent experiences.
First, while some division of labor between monetary policy and macroprudential regulation may be maintained in their combined application (Canuto and Cavallari), policy-makers need to make sure that prudential policies are mutually consistent and comprehensive enough to avoid regulatory arbitrage and exploration of loopholes. Second, a balance must be struck between the need for policies to be ahead of the curve, and the fact that learning-as-you-go is unavoidable.
Finally, communication by policy makers becomes trickier as they move from the clarity of rule-based monetary policy to its combination with macroprudential regulation. In the case of Brazil, for example, markets required an extraordinary effort from the Central Bank to clarify that macroprudential regulations were being implemented as a complement — rather than a substitute – to monetary policy.
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