With its near universal membership, the International Monetary Fund is in a unique position to examine global interrelationships. Indeed, cross-country linkages lie at the heart of the Fund’s role in the world economy. In particular, the central objective of the Fund’s surveillance of exchange rate and domestic policies is to avoid negative spillovers from the policies of one country to its international partners.
This special section of IMF Staff Papers “Global Reach? Perspectives on U.S. International Spillovers” includes three papers, each tackling different aspects of the links between the United States and the rest of the world. Reflecting both recent events and the new focus of the Fund, an important theme in all three papers is the role of financial markets in propagating spillovers. While U.S. trade links have been analyzed in great detail, there has been significantly less work in the past on the overall size and impact of financial spillovers.
As the recent turbulence has shown, however, financial links can have powerful effects on the global economy. This special section is particularly timely, providing insights into how these links work.
The first paper, “Foreign Entanglements: Estimating the Source and Size of Spillovers Across Industrial Countries” by Tamim Bayoumi and Andrew Swiston, examines the general issue of the sources of output spillovers across countries. Recent work on the international business cycle has tended to focus more on the size of the links across countries than on the sources of the underlying shocks. As a result, there remains considerable uncertainty as to whether the international cycle is driven largely by common shocks (all countries facing—say—a similar rise in costs of energy) or by spillovers from some countries to others. The paper aims to untangle the sources of shocks by including both changes in output in the major global currency areas—the United States, euro area, and Japan—and an aggregate of geographically and economically diverse smaller countries. The logic of adding the latter group is that a truly global shock would likely affect these countries at the same time as the large currency areas, and hence by including them in the analysis the impact of global shocks can be differentiated from those emanating from the major currency unions.
The results suggest that the United States has large effects on the rest of the world, but that the euro area and Japan do not, while the impact of global shocks is less well defined. In addition, the paper finds that the main source of U.S. spillovers to the rest of the world comes through financial markets rather than trade or commodity price effects. This helps to explain the disproportionate effect of U.S. growth on the rest of the world compared with the euro area and Japan, which have strong trade links but are less dominant in financial markets.
The next paper, “Yen Carry Trade and the Subprime Crisis” by Masazumi Hattori and Hyun Song Shin, links carry trades to the expansion of liquidity in the United States and elsewhere in recent years. Traditionally, carry trades—the practice of borrowing in a country with low interest rates to invest in countries with higher rates—have been seen as a separate investment strategy driven primarily by interest rate differentials. By contrast, Hattori and Shin suggest that it is often linked to an overall expansion in the balance sheet of international banks. If such a bank wants to expand (say) its U.S. balance sheet, at least some of its funding will come from abroad through borrowing by overseas offices. In essence, some of the most recent expansion of U.S. leverage has been financed from “cheap” foreign sources.
The paper traces this effect by looking at the net interoffice accounts (that is, net borrowing in short-term markets) of foreign banks in Japan. They find that this net borrowing rose rapidly from 2002 to mid-2007 and then fell rapidly in parallel with the behavior of U.S. financial market liquidity. Net interoffice accounts are then found to be closely linked to the net international asset position of foreign banks in Japan, and with measures of market risk aversion and with interest rate differentials. In short, the paper links carry trade financial outflows from Japan to overall U.S. financial market conditions.
The final paper, “Rhyme or Reason: What Explains the Easy Financing of the U.S. Current Account Deficit?” by Ravi Balakrishnan, Tamim Bayoumi, and Volodomyr Tulin, explores alternative explanations for the factors that have attracted the funds needed to finance massive recent U.S. current account deficits. The paper initially notes that most of the funding has occurred in the bond market, which casts doubt on the importance of rapid U.S. growth as an attraction, because equity investments have larger upside potential. Instead, the paper suggests that financing reflected both the dominant position of U.S. financial markets at a time of rapid financial deepening and globalization as well as innovation in U.S. financial markets that were perceived at the time to make the underlying securitized bonds more attractive.
The consequences of U.S. financial links for the rest of the world will continue to be an important issue for many years to come. In this special section, IMF Staff Papers helps to provide some food for thought as to how these links are currently working, and may work in the future.
John Lipsky is First Deputy Managing Director of the IMF.