Guest post by Joseph Joyce (re-posted from Capital Ebbs and Flows)
Dealing with the Fallout from U.S. Policies
The divergence of monetary policies in the advanced economies continues to roil financial markets. The Federal Reserve has reacted to better labor market conditions by ending its quantitative easing policy. The Bank of Japan, on the other hand, will expand its purchases of securities, and the European Central Bank has indicated its willingness to undertake unconventional policies if inflation expectations do not rise. The differences in the prospects between the U.S. and Great Britain on the one hand and the Eurozone and Japan on the other has caused Nouriel Roubini to liken the global economy to a jetliner with only one engine still functioning.
The effect of U.S. interest rates on international capital flows is well-documented. Many countries are vulnerable to changes in U.S. policies that can reverse financial flows. Countries that have relied on capital flows searching for a higher yield to finance their current account deficits are particularly susceptible. Declining commodity prices reinforce the exposure of commodity exporters such as Brazil and Russia.
U.S. markets affect capital flows in other ways. Erlend Nier, Tahsin Saadi Sedik and Tomas Molino of the IMF have investigated the key drivers of private capital flows in a sample of emerging market economies during the last decade. They found that changes in economic volatility, as measured by the VIX (the Chicago Board Options Exchange Market Volatility Index, which measures the implied volatility of S&P 500 index options), are the “dominant driver of capital flows to emerging markets” during periods of global financial stress. During such periods, the influence of fundamental factors, such as growth differentials, diminishes. Countries can defend themselves with higher interest rates, but at the cost of slowing their domestic economies.
