SETTING THE SCENE: THE SIZE AND SOURCES OF U.S. SPILLOVERS
1. The massive global recession set off by U.S. shocks confirmed the reality of major U.S. spillovers to the rest of the world. Financial weaknesses from badly underwritten subprime mortgages in a highly interconnected U.S. financial system during a period of excess borrowing in the U.S. and elsewhere rapidly metastasized into a global crisis. Typical trade and financial market spillovers were accentuated as market disruption rendered liquidity scarce for major global banks and quasi-banks dependent on dollar wholesale funding. With credit to households, firms, and importers suddenly curtailed, confidence collapsed alongside private spending. This led to the deepest and most synchronized world recession since the 1930s, consistent with research finding that U.S. growth spillovers are large and transmitted mainly via financial channels.
Empirical estimates of growth spillovers
Source: Bayoumi and Bui, IMF WP/10/239
2. Simulations involving “standard” international links typically report small U.S. growth spillovers. Standard macroeconomic models focus mainly on links via exports and imports, which depend on activity and exchange rates (the latter driven by interest rate differentials), as well as wealth effects from international asset holdings. Estimated spillovers are generally limited as bilateral trade and portfolio links are fairly small, particularly across systemic countries whose size and diversity tends to make them relatively closed to external trade. U.S. trade is a major driver of activity only in Canada and Mexico, immediate neighbors and signatories to the North American Free Trade Agreement (NAFTA), as well as the Caribbean and Central America.
Growth spillovers - Model without asset price links
Source: Selected Issues chapter 4
3. U.S. markets are central to global asset pricing, an aspect not well captured in conventional policy simulations. The United States accounts for about one-third of both global stock and bond market capitalization. However, the true importance of U.S. markets is captured by turnover—they represent close to two-thirds of equity and government bond market turnover in the S5. Deep markets and the accompanying vast volume of market analysis mean that, despite the strong domestic orientation of U.S. markets, U.S. financial assets are bellwethers for global prices. Consistent with this central role in global price discovery, numerous studies have found that U.S. news is a major driver of foreign asset prices, while foreign events have only weak effects on U.S. asset prices.
4. These financial market ties are a major conduit spreading the impact of U.S. policies abroad. Analysis using different techniques consistently finds that a change in U.S. bond yields has a significant impact on yields in other countries and the ratio for equity price changes is larger still (Selected Issues, Chapters 1-3). While the ultimate source of these financial linkages—global market integration or more-difficult-to-analyze “animal spirits” associated with private sector confidence—remains uncertain, imposing observed correlations between U.S. and foreign asset prices on a standard macroeconomic model generates larger and more plausible international spillovers.
Growth spillovers - Model with asset price links
Source: Selected Issues chapter 4
5. Beyond close neighbors, spillovers via global asset prices are estimated to typically dominate trade channels. The relative importance of these two channels can be assessed by comparing outcomes from a standard macroeconomic model with those from the same model with typical international bond and equity price associations superimposed. Results across a mix of shocks indicate that spillovers via financial market channels typically dominate beyond close neighbors or countries with extensive capital controls (China and, in bond markets, India). For most G20 countries, a one percentage point increase in U.S. growth is estimated to raise growth by around half a percentage point, with some three-quarters of the impact coming via asset prices. By contrast, overall Canadian and Mexican growth spillovers are estimated at more like four-fifths of a percent, with trade channels accounting for two-thirds of the total. During the crisis, the impact of disruptions in U.S. wholesale funding on global banking added a further layer to spillovers via financial channels, explaining the virulence of cross-border effects at the time.
6. The critical role of financial prices in spillovers underscores the importance of the macroeconomic and financial environment. Given the forward-looking nature of asset markets, spillovers will in part depend upon the factors prompting the policy change and the overall environment in which the policy change takes place. As elaborated below, estimated spillovers from similar policies can therefore vary significantly over time. In what follows, event studies—which have been applied by others to identify the domestic impacts of U.S. policies over the crisis—are used to assess international impacts (Selected Issues, Chapter 2). While such analysis by its nature measures only initial financial market responses, it provides a powerful tool for considering potential asset price linkages associated with specific policy decisions.
Spillovers to a typical shock without and with financial links
Source: Selected Issues chapter 4
7. Some senior U.S. officials were sympathetic to staff analysis, while others were less convinced on the size and sources of spillovers. Some senior officials agreed that spillovers appear to travel largely through financial market prices adding that uncertainty about the reasons for these asset price correlations implied equal uncertainty about the underlying channels of transmission. Other senior officials, pointing to factors such as global risk-aversion, were less convinced that financial market connections (which in any case could reflect real sector behavior) predominated in the transmission of shocks, and pointed to the lower estimates of U.S. spillovers in Chapter 4 of the Spring 2007 World Economic Outlook. Officials also noted that while U.S. policies inevitably created positive and negative spillovers, this did not imply that the U.S. should counteract such effects. Staff agreed, noting that one goal of spillover reports was to support analysis by other countries of changes to the global environment.
BACKGROUND: MAPPING THE LINKAGES
A. Direct Financial Ties
8. The pivotal role of dollar markets in the global economy is reflected in the composition of U.S. net international liabilities, the largest in the world. Reflecting the dollar’s status as the main global reserve asset, the United States has massive net bond debt, worth almost 10 percent of global GDP and implying relatively large wealth spillovers. The net debt ratio has almost doubled since 2000, with foreign official holdings of U.S. Treasuries ballooning from half to three-quarters of the total. U.S. gross bond liabilities of 13 percent of global GDP comprise about equal quantities of government and private debt, plus a large amount of quasi-government “agency” bonds dominated by the mortgage giants Fannie Mae and Freddie Mac. By contrast, the United States has a positive net asset position in equities and foreign direct investment.
9. Bilateral portfolio links are strongest for major reserve holders and financial centers, focused on public and private bonds, respectively:
- Net holdings of U.S. bonds are particularly large (over 5 percent of GDP) in some major reserve-holding emerging markets—most notably China. Demand for reserves has helped lower U.S. yields (see the China Spillover Report).
- Financial centers such as the United Kingdom hold large amounts of (mainly private) U.S. debt. However, this is offset by large reciprocal U.S. holdings of foreign assets.
- Foreign holdings of U.S. equities and U.S. holdings of foreign equities are both large. This is particularly true in advanced economies (given deep markets that allow more scope for portfolio allocation) and the Americas (given proximity).
- The stock of U.S. foreign direct investment is large in close neighbors (reflecting trade links) and other English-speaking advanced economies. Foreign direct investment flows, however, are increasingly focused on emerging markets and low income countries.
B. Trade Relationships
10. The United States plays an important, but not predominant, role in global trade. U.S. trade is second to Euro area trade in value, and is only slightly larger than that of China, whose smaller economic size is offset by higher trade openness. The limited role played by the United States in global trade partly reflects its relatively low level of export compared to other systemic countries, reflected in the huge U.S. trade deficit and large trade surpluses of China and Japan. U.S. imports, conversely, are around the same size as those of the Euro area and larger than those of the other systemic economies.
11. Bilateral spillovers from U.S. real activity and competitiveness are largest for neighboring countries:
- U.S. activity and trade volumes. For trade volumes in goods and services, the strongest spillovers are on NAFTA countries, Central America, and Asia. These estimates adjust for international supply chains (see Selected Issues. Chapters 5-6, and the China and Japan Spillover Reports).
- U.S. activity and the terms of trade. Spillovers are largest for the Middle East, Africa, and some oil producers. Higher U.S. activity mainly boosts global demand and prices of cyclically sensitive commodities such as fuels and metals.
- Competitiveness. The bilateral effects of dollar fluctuations tend to diminish with distance. Dollar appreciation increases output in NAFTA members and parts of Central America, as well as in Asia and parts of South America (Selected Issues, Chapter 5 discusses the impact on trade composition).
12. Low income countries’ linkages with the United States vary across regions. Workers’ remittances are important inflows to Central America (they also matter for Mexico), while tourism and financial services are crucial for many countries in the Caribbean. By contrast, links with low income African countries come mainly via commodity prices, while in the case of Asia demand for basic manufactured goods (such as textiles) matters most.
C. Asset Price Links
13. A percentage point rise in the 10-year U.S. Treasury bond yield is associated with significant global market effects that have changed dramatically over the crisis (Figure 1). Before the crisis typical relationships were:
- Foreign bond yields. Advanced economy bond yields typically rose by 0.4 percentage points, the effect being larger for Australia and Canada and lower for Japan. Most emerging market dollar bond yields showed a larger rise—more like 0.8 percentage points—except in China and India where capital controls prevented any significant impact.
- Exchange rates. A nominal depreciation against the dollar of 1-2 percent in financially open economies, but little impact on emerging markets with managed exchange rates. This resulted in nominal effective appreciation in countries with managed rates, and depreciations elsewhere.
- A fall in commodity prices and little effect on global risk appetite. The commodity effect was particularly important for growth prospects in emerging markets that are commodity producers.
- These associations were consistent with markets identifying increases in U.S. yields with higher U.S. growth prospects and expected monetary tightening. The dollar typically appreciated as capital flowed from other countries to the United States.
Figure 1.Estimated Bond Yield and Exchange Rates Spillovers
Source: Bloomberg, Haver, and IMF Staff calculations.
14. Post-crisis, rising Treasury yields became associated with better global financial sentiment and capital outflows from the United States. With abundant liquidity providing incentives to invest spare cash and the zero federal funds rate allowing cheap dollar funding, safe haven considerations (or the converse) came to dominate market responses. In contrast to the pre-crisis norm, rising U.S. yields was associated with improvements in global risk appetite, increases in commodity prices, higher equity valuations, and depreciations of the dollar (except against other low-interest-rate currencies also used for cheap funding such as the yen). The pre-crisis positive link between Treasury and emerging market yields disappeared, possibly because capital inflows to emerging markets associated with better global prospects offset the usual upward pressure on local bond yields.
15. The timing of the return to more typical asset price relationships, and the nature of the “new normal,” is a key uncertainty in assessing future policy spillovers. While there is no strong evidence of such a reversion at this point, rising U.S. Treasury yields should at some point again become more an indicator of future monetary policy tightening than of better global market sentiment. At that point, capital would likely flow back into the United States in response to higher Treasury yields, rather than away from it—although (as event studies suggest) correlations among bond yields may also be less tight post-crisis because of changing perceptions of relative fiscal risks between emerging and advanced economies.
D. Global Liquidity
16. Deep asset and money markets that channel liquidity globally largely explain the central U.S. role in financial intermediation and the virulence of crisis spillovers:
- U.S. assets dominate collateralized credit markets. The short-term nature of secured lending and repurchase agreements explains why many banks quickly found it difficult and increasingly costly to obtain term dollar funding as collateral and counterparty risks rose over the crisis.
- The United States also has the largest global pension, mutual fund, and insurance industries given its wealth and limited social safety net relative to other advanced economies. This “real money” investor base is central to the U.S. arm’s-length, bond-based financing model.
- Dollar wholesale funding is further boosted by the fact that large money market mutual funds are an intrinsically U.S. phenomenon. Their systemic role was confirmed by the Treasury’s guarantee program after a fund “broke the buck” during the crisis.
- Strains in dollar funding over the crisis were partly relieved by swap arrangements between the Fed and other central banks. The continuing importance of this channel is underlined by the latest extension of these swap arrangements through August 2012.
17. The importance of dollar wholesale funding explains the heavy foreign presence in the U.S. banking system despite the domestic focus of U.S. markets. Foreign banks have some $5.4 trillion of assets in the United States versus U.S. banks’ $2.5 trillion of assets abroad, the largest difference in the world. Most other advanced-economy banks have major U.S. operations, while U.S. commercial banks tend to be more engaged in emerging markets (Selected Issues, Chapter 7).
18. Pension and mutual fund outflows from the United States are larger and more diversified than inflows, again reflecting the role of New York in wholesale funding. Large gross inflows and outflows from and to offshore centers such as the Cayman Islands reflect the complex financial engineering and book-entry practices prevalent in modern financial markets. However, the United States is also a significant net supplier of funds to countries as diverse as Brazil, Egypt, and India, underscoring the global reach of its role as a financial intermediary (see the U.K. Spillover Report for a related discussion of the role of London as an international financial center).
MOTIVATION: VIEWS OF OTHER AUTHORITIES ON U.S. POLICY SPILLOVERS
19. The support to global demand provided by U.S. policies was generally welcomed by foreign officials. While acknowledging the benefits of macroeconomic policies supporting U.S. growth, concern was often voiced that U.S. policies and those of other systemic economies were designed only to solve their own domestic difficulties, and could cause problems elsewhere. In particular, U.S. policy slippages could lead to further capital inflows, spikes in inflation, and risked a hard landing for foreign growth.
20. Monetary policy was generally seen as the main area that gave rise to spillovers:
- Several authorities were concerned that ample global liquidity had raised commodity prices and fed into inflation, which could become entrenched. Several interlocutors ascribed these developments to quantitative easing, sometimes arguing that the 2010 easing (“QE2”) was more important than Chinese demand in stoking commodity prices. By contrast, authorities in one country made a point of stating they did not believe U.S. monetary policy had an impact on commodity prices.
- Currency strength and strong capital inflows in some countries were often seen as partly the result of QE2. U.S. monetary policy was described as an important push factor for capital flows, while pull factors were also acknowledged to have had a role.
- Views on the appropriate countervailing policies were mixed. Some authorities saw exchange rate flexibility/appreciation as the best tool to address capital inflows, and resisting appreciation as only leading to higher flows. Authorities in several economies with restrictions on the capital account, however, mentioned that they did not receive massive capital inflows as a result of QE2. Others saw U.S. monetary policy as counteracting their own exchange rate strategy, and in some cases new capital restrictions were seen as having helped dampen flows.
- Some were concerned that the unwinding of QE2 and/or U.S. policy rate hikes could trigger damaging capital flow reversals. As returns on investment picked up in the United States and other advanced economies, funds would be diverted back to the source markets. Furthermore, monetary policy in some countries might have become more synchronized with that of the United States, exacerbating spillovers: when the U.S. tightens, others would also see the need to tighten further.
21. Fiscal policies in advanced countries with unsustainable current deficits, including the United States, were often described as having raised global tail risks. Concern was expressed over the possibility of a market reassessment of U.S. fiscal sustainability which could lead to a rapid deterioration in global financing conditions, capital flows, and possibly the value of the dollar:
- Global bond yields could rise rapidly if markets demanded higher premiums against fiscal risks (as well as possible inflation concerns). Other countries could face a sudden stop in capital inflows given increased U.S. financing needs.
- Fiscal risks were also described as complicating the task of rebalancing the growth model of some countries. Such rebalancing might have to be undertaken against the background of weak foreign demand and financial conditions, volatile currency and capital flows, and questions about the safety of dollar denominated foreign assets.
22. U.S. financial sector policies were also cited as a potential source of spillovers:
- Authorities in some countries noted the importance of better supervisory cooperation. They observed that if financial channels dominate in transmitting spillovers, then better regulatory and supervisory cooperation may be at least as important as macroeconomic policy coordination, the current focus of international efforts.
- The Dodd-Frank Act in particular was seen as potentially having spillover effects via regulatory arbitrage, although the channels were uncertain. Authorities in one country also expressed concern that a commitment to not bail out systemic financial institutions could be disruptive if carried out bluntly or time-inconsistently.
- Limited supervision of money market funds, upon which many non-U.S. banks depend for wholesale funding, was seen as adding fragility to the global financial system. Potential spillovers from deleveraging of U.S. financial institutions affected by, say, new losses on commercial property were also mentioned as a risk.
ANALYSIS: POLICY SPILLOVERS
23. Further fiscal stimulus and QE in 2010 have increased the likelihood of negative spillovers when macroeconomic policy support is reversed. With policy options diminishing and further delay of fiscal consolidation increasingly problematic, deficit reduction could occur more abruptly than earlier envisaged. This would improve U.S. saving, reduce global imbalances and real interest rates, and lower the risk that concerns about the long-term fiscal path will lead to a rapid increase in bond yields. However, it will also dampen U.S. growth and could delay monetary tightening. When it comes, such tightening is likely to reverse some capital flows to emerging markets with open capital accounts by reducing interest rate differentials, particularly if it occurs at a faster-than-anticipated pace. Meanwhile, implementation of the Dodd-Frank Act could put further pressure on bank credit, including cross-border lending.
A. Monetary Policy: Quantitative Easing and Future Rate Hikes
24. Concerns over monetary policy spillovers currently focus on the global impact of the end of quantitative easing and eventual Fed rate hikes at some point in the future. While fiscal policy operates on U.S. aggregate demand directly, with financial market effects as a by-product partly offsetting the impact on growth, monetary policy acts primarily through financial markets and hence international asset price linkages will normally amplify spillovers. This may be even more true currently, as very low interest rates may increase incentives to take financial risks. Spillovers from unexpected potential global asset price shifts reinforce the case for clear communication of future monetary policy intentions.
25. Estimated asset price spillovers of QE1 announcements are larger than pre-crisis monetary policy messages, while QE2 announcement spillovers appear generally smaller (Figure 2, top panel). Event studies were used to estimate the response of foreign asset prices per unit impact on U.S. 10-year bond yields and equity prices:
- Both sets of easing announcements were associated with declines in foreign bond yields, but the response seems to have been notably larger for QE1. A similar pattern emerges for appreciation in dollar exchange rates and higher U.S. inflation expectations.
- Unlike QE1 or pre-crisis policy announcements, QE2 announcements do not appear to be associated with a short-term improvement in global financial conditions. This is true for the VIX (i.e., global risk appetite), oil and nonoil commodity prices, and global equity prices. This divergence appears to largely explain the more muted effects of QE2 on foreign bond yields/dollar exchange rates.
- These asset price responses were generally similar to pre-crisis monetary policy announcements and significantly different from “typical” post-crisis ones. Event studies of policy announcements involve a range of identifying assumptions. Yet the abnormal foreign asset price knock-ons uncovered suggests that this approach may provide a reasonable, albeit imprecise, estimate of global financial market effects.
- Vector autoregressions fitted to weekly data find that quantitative easing announcements were associated with higher capital inflows to emerging market bond and equity funds (Selected Issues, Chapter 8). Actual Fed purchases of securities (i.e., implementation of the announcements) did not appear to affect such inflows.
Figure 2.Estimated U.S. Monetary Policy Spillovers
Source: Selected Issues, Chapters 2 and 9.
26. Growth spillovers from U.S. monetary policy were assessed by incorporating estimated asset price linkages from event studies into macro model simulations. Policy simulations were used to illustrate how estimated short-term impacts of policy announcements on asset prices (based on event studies) could percolate into activity. Pre-crisis spillovers were calculated by incorporating into a macroeconomic model estimated knock-ons between U.S. monetary policy (via U.S. asset prices) and foreign bond yields, equity prices, and exchange rates. The results suggest somewhat larger growth spillovers (per percentage point change in U.S. bond yields) than those from the generic shock reported in Section I, with the main channel being via bond yields (Figure 2, middle panel and Selected Issues, Chapter 9).
27. Growth spillovers from QE1 announcements are also estimated to have been larger than pre-crisis monetary policy spillovers would suggest, and those from QE2 smaller (Figure 2, bottom panel). This ordering of the size of spillovers holds across a wide range of economies, reflecting the more positive international financial market knock-ons estimated for QE1 than for QE2. Analysis of the latter is complicated by the marked improvement in global financial conditions not long after Chairman Bernanke’s August 2010 speech at Jackson Hole announcing QE2. Extensive analysis fails to establish a link between QE2 announcements and this development. However, if larger spillovers of the type estimated for QE1 are assumed, it is important that the full array of effects—on risk aversion, exchange rates, and commodity prices—be jointly considered, rather than focusing on some and not others.
28. Looking forward, some reversal of inflows to emerging markets is likely when markets start expecting monetary tightening over the near future. With the end of QE2 having been fully anticipated, its impact has likely already been absorbed by markets. By contrast, when the Fed eventually starts to prepare to tighten policies, including by draining liquidity, it could cause a jump in Treasury yields and sharper capital outflows from emerging markets, particularly if the move was unexpected. This is because such a shift would be the precursor to future rate hikes (or swift balance sheet unwinding) thereby signaling smaller interest rate differentials and either greater confidence in the U.S. expansion or rising inflationary pressures (see also Chapter 3 of the Spring 2011 World Economic Outlook).
29. The monetary policy dilemmas facing emerging markets are generally more acute than for advanced economies. Limited market depth makes emerging market financial conditions particularly susceptible to changing capital flows. Against a background of diverse monetary regimes, spillovers from U.S. monetary policy in any one country depend partly on exchange rate policies elsewhere, as the benefits (costs) to foreign activity of a dollar appreciation (depreciation) will be amplified if a close trading partner fixes to the dollar. This helps explain why exchange rate volatility versus the dollar tends to be regional, with much lower volatility in Asia and the Middle East than in other regions, supported by active currency management and (in some cases) capital controls.
Pre-crisis historical volatility of dollar exchanges rates
Source: IFS and IMF Staff calculations
30. Senior Fed officials were qualitatively comfortable with staff views on spillover channels from QE2 but less concerned about capital flow reversals. Regarding the impact of eventual monetary exit, emerging market capital flows were seen as mainly involving a structural component rather than a cyclical component that could be reversed, so that U.S. monetary tightening shouldn’t constitute an untoward shock. In a market environment where the “winds had shifted”, they felt that reactions of some authorities to QE2 may well have reflected strong cyclical positions that made the boost to global activity less attractive than was true at the time of QE1. Officials stressed that the FOMC was fully committed to be as transparent as possible, and agreed that good communication would make for a smoother exit from the zero bound.
B. Fiscal Policy: Stimulus and Consolidation
31. Concerns over fiscal spillovers are largely focused on the risks from a loss of market confidence in the U.S. fiscal policy trajectory. In principle, fiscal consolidation creates permanent positive growth spillovers via lower global real interest rates as well as short-term negative spillovers via losses in U.S. activity. In order to assess the net spillover effects from U.S. fiscal policy, a multi-pronged approach was used, combining standard regression analysis; macroeconomic model simulations allowing for various degrees of credibility and financial linkages; and event studies focusing on the possible impact of key fiscal policy announcements on the relationship between U.S. Treasury yields and foreign asset prices.
32. The long-term impact of U.S. fiscal consolidation on foreign output is positive as lower U.S. government debt and higher saving reduce global real interest rates. Staff regression analysis finds that each percentage point reduction in the U.S. general government debt-to-GDP ratio lowers global real interest rates by 3-4 basis points over the long run, consistent with the prevailing literature (Selected Issues, Chapter 10). Macroeconomic model simulations then suggest that the long-term boost to foreign potential output from a 10 basis point permanent reduction in global real interest rates is a fairly uniform 0.1 percent (Figure 3, top panel). Importantly, this would also help rebalance global demand by reducing the U.S. current account deficit.
33. The short-term impact on foreign activity from a typical pre-crisis fiscal consolidation is estimated to be generally small and its sign uncertain (Figure 3 middle panel, and Selected Issues, Chapter 11). While results vary somewhat with assumptions about the size, speed, credibility, and composition of the package as well as the monetary policy response to it, for a generic fiscal stimulus the following general observations can be made:
Figure 3.Estimated U.S. Fiscal Spillovers
Source: Selected Issues, Chapter 11.
- For close trading partners such as Canada and Mexico short-term losses through trade generally dominate. This also holds for countries with extensive capital controls, most notably China and (for bond markets) India.
- Elsewhere, the net impact is generally small and ambiguous. Using the foreign bond yield and exchange rate co-movements implied by a generic pre-crisis budget announcement, the net impact on output is found to be relatively limited.
- Nonetheless, there are significant implications for trade and the composition of demand. Although the net effects on foreign output are small relative to the impact on U.S. output, this conceals a significant shift between external and domestic demand, at least for countries with flexible exchange rates.
34. The 2009 fiscal stimulus is estimated to have led to larger-than-expected support to foreign activity while, if anything, the 2010 package likely had the opposite effect. Event studies find that the estimated spillover from U.S. to foreign bond yields in response to stimulus announcements in 2009 was generally more limited than would have been expected given pre-crisis experiences. Illustrative policy simulations of a generic fiscal package generate correspondingly more-positive growth spillovers. Conversely, the relatively strong estimated bond market links after the 2010 stimulus announcement imply less benign spillovers. This underlines the importance of market sentiment in understanding global effects: in 2009, facing the risk of a Depression, U.S. fiscal expansion may well have led to a lowering of foreign bond risk premiums that largely offset the crowding out from higher U.S. government debt; by 2010, this effect appears to have reversed. It also emphasizes the importance of adopting a clear medium-term fiscal framework.
35. Looking ahead, a gradual, credible U.S. deficit reduction is unlikely to have major growth spillovers, particularly compared to those from a loss of fiscal credibility (Figure 3, bottom panel). Measured, well articulated, and credible fiscal consolidation that culminates in a major reduction in U.S. government debt as a ratio to GDP would likely provide positive net spillovers to the rest of the world in the short-run via lower bond yields than otherwise—notwithstanding their current low levels in the United States and some foreign economies—although a less credible adjustment could generate more generalized short-term output losses abroad. Gradual consolidation also reduces the tail risk of a global bond market event where investors would lose confidence in the ability of the United States to respond decisively to its looming fiscal challenges. Such a loss in confidence would generate major negative spillovers to the rest of the world given the role of U.S. government bond yields as global benchmarks.
36. Senior officials generally agreed on the importance of having a credible fiscal path to avoid crowding out and head-off tensions on U.S. and possibly global interest rates. They were less optimistic, however, on the short-run benefits of consolidation, as crowding out was not thought to be currently operative given low credit demand and bond yields. They cautioned that the negative short-run impact (including on foreign economies) from severe and frontloaded U.S. fiscal tightening could plausibly be large.
C. Financial Policy: Investment Banking and the Dodd-Frank Act
37. Disruptions in U.S. financial markets after the Lehman bust created major negative growth spillovers and exposed flaws in U.S. financial oversight. Regulators had made a sharp distinction between banks, subject to prudential supervision and special resolution procedures and with access to Fed liquidity, and nonbanks (notably investment banks, also known as broker-dealers) where supervision was focused on market conduct and official liquidity/resolution were not available. In response to the chaos in wholesale funding markets after the collapse of Lehman, access to Fed liquidity support was rapidly widened to include major investment banks, money market funds, and selected foreign central banks.
38. U.S. wholesale funds are generally channeled to the global banking system via major investment banks as well as money market mutual funds. In addition to U.S.-owned broker-dealers (such as Goldman, Sachs & Co. and Citigroup Global Markets that have become or already were part of bank holding companies) several large northern European banks have U.S. operations deeply involved in investment banking. These include Barclays, Credit Suisse, Deutsche Bank, and UBS. In addition to the much simpler U.S. money market funds—which just on-lend short-term funds—investment banks are the arteries that connect the global banking system to U.S. securities and wholesale funding, often through the more internationalized U.K. markets (see the U.K. Spillover Report). Their systemic role was confirmed by the Fed’s emergency lending actions during the crisis.
39. Wholesale funding uncertainties likely explain why co-movements of major U.S. and European bank equity returns have become much tighter since the crisis (Figure 4, top panel). Banking spillovers are measured using “beta” coefficients that estimate how excess equity returns of major foreign commercial and investment banks (i.e., bank stock returns relative to the overall market) react to U.S. bank excess returns. Before the crisis, only the major Swiss banks had a beta of over one-quarter. After the crisis, this was also true of major U.K., German, French, and Italian banks—especially investment banks. The dependence of European banks on U.S. wholesale funding provides a potential conduit for a European financial shock to affect the rest of the world (see the Euro area Spillover Report).
Figure 4.Estimated U.S. Financial Policy Spillovers
Source: Bayoumi and Bui (2011).
40. Dollar markets stretch well beyond U.S. borders, reinforcing spillovers while limiting the impact of U.S. regulatory choices. This reflects the global role of the dollar as a reserve currency and liquid store of value. Pre-crisis, U.S. regulations were often circumvented by investment banks moving trades to less-regulated markets; for example, looser U.K. rules on collateral “rehypothecation” drove some prime-brokerage business to London (see the U.K. Spillover Report). More generally, financial centers tend to have complementary strengths, e.g., New York’s deep securities markets and London’s derivatives focus and internationalism. Indeed, the nexus between the U.S. and U.K. dollar markets is symbolized by the fact that the world’s most important private short-term dollar interest rate—the London inter-bank offered rate or LIBOR—is determined in London and only three of the 16 banks on the panel are U.S.-based.
Consistent with the crisis experience, significant spillovers are estimated to come from widespread U.S. wholesale funding disruption. Such disruption crystallized after Lehman’s failure caused counterparty risks on other banks to jump on fears of a systemic crisis. This is illustrated by simulations using data on cross-border loans between U.S. and foreign-based banks to calibrate the knock-ons from disruptions in U.S. wholesale funding costs on foreign funding costs. The same model also provides estimates of the (potentially significant) growth spillovers of U.S. regulatory capital top-ups for systemic players mandated by the Dodd-Frank Act (Selected Issues, Chapter 12). In that case, however, costs must be viewed against the gains from greater financial stability.
41. The U.S. structural response to these pressures was embodied in the July 2010 Dodd-Frank Act, the biggest reform of U.S. financial regulations since the 1930s. As elaborated in last year’s U.S. Financial Assessment Program (FSAP), the Act strengthens the Fed’s consolidated supervisory powers over bank holding companies (which now include all major U.S.-owned broker-dealers) but retains an element of “deference” to the securities and futures regulators. It establishes a Financial Stability Oversight Council (FSOC) that makes the regulatory perimeter dynamic by permitting any financial firm to be designated as systemic and brought under Fed oversight. The Fed may only lend to systemic nonbanks in extremis, however, with “Volcker rules” separating retail banking from more risky proprietary trading. The Act also creates a resolution mechanism for systemic holding companies.
42. The Dodd-Frank Act seems to have succeeded in its aim of reducing potential knock-on effects from major individual U.S. banks to the global financial system. As measures of the probability of default based on credit default swap spreads are contaminated by market assessments of whether a given bank’s debt holders will be bailed out—the very behavior the legislation aims to curb—staff analysis gauges the risk of insolvency from prices of bank equity options (Selected Issues, Chapter 13). The positive relationship over the crisis between risks to individual banks and systemic risk seems to have flattened after the Act was passed, consistent with its core objective—thereby containing spillovers.
Individual Versus Systemic U.S. Bank Risks
Source: Selected Issues chapter 13
43. A signal moment in the regulatory reform process appears to have been President Obama’s speech on financial regulation in January 2010. The speech provoked a major market response, with negative excess returns on bank equity simultaneously in the United States and much of Europe (Figure 4, middle panel). More than the specifics, it would appear that the speech telegraphed U.S. seriousness on tightening financial regulations, with the market reaction confirming perceptions of U.S. leadership and expectations that similar regulatory stringency would follow in other jurisdictions. This interpretation is supported by the fact that the impact on banking systems outside of Europe, that were more highly capitalized and less dependent on wholesale funding, was considerably more muted.
44. Market responses to subsequent Dodd-Frank announcements, however, may raise concerns about regulatory arbitrage between the United States and Europe. Announcements that led to increases (decreases) in excess returns on major U.S. banks are estimated to have led to oppositely signed excess returns on major U.K. and Swiss banks (Figure 4, bottom panel). Such opposing movements could indicate that markets may have seen these regulations as changing the relative competitive position of U.S. and European banks, rather than promulgating internationally consistent policy initiatives.
45. Going forward, decisions by the Oversight Council and proactive supervision by the Fed will matter deeply for international financial stability. Given the importance of U.S. wholesale funding for foreign banks and the role of U.S.-based investment banks as conduits, Council decisions on which institutions to designate as systemic will be key. Strong international links—which could rebound back onto U.S. financial stability—strengthen the case for designating all U.S.- and foreign-owned major investment banks as systemic and putting them under Fed umbrella supervision. Inside the perimeter, the equally difficult challenge will be to successfully prudentially supervise investment banks with highly malleable balance sheets. This may test the effectiveness of the FSOC, as the systemic overseer, to coordinate across specialized regulators.
46. Ideally, U.S. rules governing trading and funding activities will be closely synchronized with other major international financial centers—especially the United Kingdom. In practice, however, regulatory coordination seems strongest in the commercial banking context. New U.S. regulations risk pushing trading activities to less regulated sectors or jurisdictions. Already, major European investment banks have dissolved their U.S. bank holding companies to avoid higher capital requirements, while Volcker rules have led to the spin-off of trading activities to unregulated entities with strong but implicit links to regulated affiliates.
47. The authorities underlined that U.S. financial regulatory reform was geared toward achieving international consistency on big-picture issues. With capital standards being left to Basel, U.S. law is meant to augment the framework through systemic surcharges and responsibility fees, which were seen as examples of U.S. leadership. Some U.S.-specific measures, such as the Volcker rules, were not necessarily meant to be adopted by others. Large investment banks would be designated as systemic nonbanks and subjected to the same scrutiny as large bank holding companies. Nevertheless, regulatory arbitrage is recognized as a reality necessitating coordination through the Financial Stability Board.
48. The size of the U.S. economy and, in particular, the global dominance of its financial markets create uniquely large policy spillovers. Beyond close neighbors, these come largely through links associated with global financial asset prices, which directly affect financial conditions abroad and seep into domestic activity everywhere. These spillovers strengthen the case for clear communication of U.S. policies and for better-defined medium-term fiscal policy framework.
49. Concerns that the end of QE2 could lead to a rapid reversal of emerging market capital flows appear overblown. Markets reacted to quantitative easing announcements, with little or no additional impact from actual purchases of assets. The fully anticipated end to QE2 seems unlikely to provoke much market reaction. Emerging market capital flows are more likely to reverse as it becomes apparent that the Fed will hike rates in the foreseeable future, signaling smaller interest rate differentials and confidence in the U.S. expansion and/or fears about inflation.
50. A credible plan for a gradual U.S. fiscal consolidation would likely have limited short-term spillovers and substantial longer-term benefits. A gradual and credible consolidation would raise U.S. national saving, lowering global real interest rates and imbalances over the medium-term. Beyond close neighbors, negative spillovers from lower U.S. activity would likely be largely if not completely offset by improved global financial market sentiment given the high level of U.S. government deficits and debt.
51. The risk of major spillovers from a freeze in dollar wholesale funding reinforces the case for strong implementation of Dodd-Frank rules. Given the central role of U.S.-based (but not necessarily U.S.-owned) investment banks in funneling dollar liquidity to the rest of the world, stronger U.S. prudential supervision of these entities—preferably in concert with supervisors in other major financial centers given the geographic mobility of trading activity—would help contain renewed spillovers through this channel.
52. Overall, U.S. and foreign goals appear better aligned for U.S. fiscal and financial policies than for monetary policies. Fiscal consolidation and sounder financial regulation help avoid global tail risks. While there may be disagreements about the pace and details of implementation, all countries have a stake in a successful outcome. Monetary policy is more complex. While spillovers from QE2 appear limited, low short-term interest rates and abundant liquidity partly work by increasing incentives to take financial risks. This may be helpful for other countries in a similar cyclical position, but can be more problematic for those with open capital markets that have already shaken off the crisis and where investment opportunities are more plentiful. These other countries, however, also have macroeconomic tools to steer their economies.