Moderator Ashoka Mody, IMF Research Department, summarized the conference results to provide a context for the policy discussion. Research shows, he said, that there has been increasing co-movement across national stock markets, and more so for the seven largest industrial countries than emerging markets. No similar trend is apparent in co-movement of real activity, however: among both developed and developing countries, the correlation of GDP growth rates has remained remarkably stable over time. Indeed, in the research literature, there is some debate as to whether the synchronization of the real economy has risen, declined, or remained unchanged.
Underlying this contrast is a corresponding contrast between the steady rise in trade between countries and the much greater increase in financial openness. Conference participants explored the explanations for and the implications of these developments in financial and trade links, including how they may be related to each other. Mody emphasized that large global shocks, such as the recent stock market bubble, could cause financial markets to move together temporarily. This should not be interpreted as a sign of greater international integration, he noted.
Global links and stock prices
Increased global links are also of concern for private financial market participants. Asset managers have asked themselves what determines stock prices—country factors or global industry factors? According to Stefano Cavaglia, in developed markets, global industry factors now dominate country factors, whereas in emerging market countries, country factors determine more of the volatility of stock market returns. Over time, however, industry factors are becoming more closely correlated internationally. Thus, the technology sector is increasingly behaving like the same sector in the developed and emerging market countries. Are stock price movements linked to fundamentals? Cavaglia said they were. “The fundamentals are very much in line with the prices that we see in the marketplace.” If asset prices provide information about productive capital, he said, they may also provide information about employment. Thus, sector share price indices in the move toward globalization would be a good leading indicator for sectoral unemployment—something that policymakers can act on.
Lessons for macroeconomists
Vincent Reinhart, speaking as a macroeconomist and not as a U.S. Federal Reserve official, outlined what he thought a macroeconomist should have learned from the conference. He addressed three issues—financial openness and the volatility of real GDP, differences in corporate governance internationally, and the way increased financial links affect monetary policymakers in the country at the core of the global financial system—that is, the United States.
Noting that the volatility of GDP growth in the United States started to decline in 1982, Reinhart said that a macroeconomist would attribute the decline to changes in investment behavior, changes in purchases of durable goods, and different cycles in the auto industry. That spin, he said, centers on the U.S. experience and does not explain why the drop in volatility is even more evident in world GDP. He noted it was also possible that the deepening of financial markets might explain the reduced volatility of real GDP growth. But that might be true only for mature countries with developed financial infrastructures, whereas emerging market countries may be more prone to financial crisis. This raises the question of whether there is something about the structure of the markets that might indicate that some countries can reap the macroeconomic benefits of tighter financial linkages while others cannot.
Discussing corporate governance, Reinhart noted the differences between countries at the core of the global financial system and those at the periphery. The latter face a local cost of funds that is much higher than their world cost and will thus invest less capital. This runs counter to theory, which says that, as an economy opens, the cost of funds falls from high local to lower global rates—increasing the capital stock and making emerging markets better off. But the volume of capital flows from the core to the periphery is inadequate in light of the latter’s large development needs, according to Reinhart. Suppose, he said, that there is more managerial misuse of borrowed funds at the periphery, which adds to the cost of total capital. When the periphery opens up, the capital stock will be lower, suggesting the need for improved corporate governance at the periphery, as well as international codes and standards to establish best practices.
Finally, Reinhart asked whether U.S. monetary policy lost its effectiveness as global financial links increased. It’s difficult to predict how international monetary arrangements are affected, he said, but under either fixed or floating exchange rates, U.S. economic conditions are more likely to be influenced by foreign factors. The Federal Reserve will have to gauge the effects of those influences on U.S. activity and inflation and set its policy accordingly. For economies at the periphery, U.S. monetary policy has always been an important influence and, thus, “increasing global financial linkages provide no reason for a major change in the conduct of policy” in emerging market countries.
In developed markets, global industry factors now dominate country factors, whereas in emerging market countries, country factors determine more of the volatility of stock market returns.
Lessons for Latin America
Anoop Singh discussed the effect of closer economic links on Latin America. While noting that the IMF generally made the case for liberalization (trade, capital account, and capital market) with reference to its impact on efficiency and growth, he said that the balance between trade and capital integration had implications for countries’ vulnerability and susceptibility to crises. And the balance in Latin America is different from that observed in some other regions, with Latin America much more open to capital than to trade.
As a result, Singh said, although the debt-to-GDP ratios in Latin America do not appear to be out of line with those in other parts of the world, the ratios of debt to exports (especially public debt to exports) are much higher—a clear indicator of vulnerability. As for the policy implications of this imbalance, Singh said that, as exchange rates adjusted, Latin America could have difficulty mustering the type of export-led recovery that occurred in East Asia. Latin American economies could also have difficulty managing fiscal sustainability because of the possible effect of exchange rate changes on revenues and spending in government budgets.
What, then, is the next step? It is clear, Singh said, that there needs to be more focus on trade liberalization, which has been shown to improve economic efficiency and stimulate growth. Moreover, industrial countries can play an important role in increasing market access. It is also clear that economies cannot make radical changes overnight. Overall, Singh said, these considerations suggest that it will take time for some countries in Latin America to recover fully from their current difficulties. [For more on Latin America’s prospects, see remarks by IMF Deputy Managing Director Eduardo Aninat on p. 49.]
U.S. report looks at other countries
Randal Kroszner spoke of the 2003 Economic Report of the President, which discusses for the first time the role of U.S. policies in assisting economic development.
He noted that, in emerging market countries, global linkages might either cause instability, which could harm growth, or provide greater integration, which could promote growth. In connection with the increase in capital flows, a theme raised by Reinhart, he reiterated that countries at the periphery had to establish good governance and the rule of law, without which capital would not flow to them. Reviewing numbers for trade and GDP, Kroszner noted that world merchandise trade volume had nearly quadrupled since the mid-1970s—an increase from about 15 percent of world GDP to about 25 percent—and that participation in this more extensive trade would help reduce instability and foster growth.
Revisiting the subject of monetary policy and inflation, also discussed by Reinhart, Kroszner noted that inflation had come down over the past decade. Despite fears of explosive inflation in Russia, Brazil, and Argentina as these countries grappled with financial difficulties, none of them experienced anything close to historical episodes of hyperinflation. The reasons, he said, are greater currency competition—attributable to globalization—and technological innovations that make it easier to switch large sums of money between currencies and between countries. Kroszner also agreed with Reinhart that U.S. monetary policy was having a greater effect worldwide; it has become more difficult for countries to deviate too far from U.S. inflation levels. Ultimately, he said, “we can push for greater trade openness, because … it sets in motion a virtuous circle in terms of the politics as well as the economics.”
Increased economic links have broad policy implications
On January 30-31, the IMF hosted a conference in Washington, D.C., to explore how economic linkages across countries had changed in recent years and what implications these changes had for policymakers in developed and emerging markets. Academics, IMF staff, and policymakers from around the world attended the conference.
Kenneth Rogoff, IMF Economic Counsellor and Director of the Research Department, opened the conference by noting that countries had become increasingly interconnected through trade and financial linkages but that the impact of these linkages on the international transmission of shocks was not yet well understood. In particular, he noted that the implications of these linkages for co-movement across financial markets and for the synchronization of business cycles were often ambiguous in theory, so that a better understanding of the empirical stylized facts on financial and real co-movement was critical.
Papers by Robin Brooks (IMF) and Marco Del Negro (Federal Reserve Bank of Atlanta); Kristin Forbes (MIT) and Menzie Chinn (University of California, Santa Cruz); and Will Goetzmann (Yale School of Management), Lingfeng Li (Yale University), and Geert Rouwenhorst (Yale School of Management) examined the link between financial markets and the real economy. These papers drew their motivation from the recent rise in co-movement across national stock markets. Until the mid-1990s, the correlation coefficient of U.S. stock returns with returns in other developed countries was on the order of 0.4. Since the mid-1990s, however, it has increased substantially, rising to 0.9 in the past two years. All three papers explored the extent to which changes in stock market correlations were linked to real (trade) and financial linkages (capital flows) across countries.
Brooks and Del Negro quantified the firm-level link between international stock market co-movement and the degree to which businesses operated internationally. Their results suggest that a firm that raises the international component of its total sales by 10 percent increases its exposure to global stock market shocks by 2 percent and reduces its exposure to country-specific stock market shocks by 1.5 percent. This is the first time that such a large and significant firm-level link has been found—a result they attributed to a new way of addressing measurement error in the data and a novel estimation approach. Their results suggest that the increasingly global nature of businesses is indeed an important contributor to the recent rise in international stock market co-movement.
The work of Forbes and Chinn, which was based on more aggregate-level data, bore out this finding. They indicated that bilateral stock market correlations had historically been hard to explain in terms of cross country linkages, such as bilateral trade, bank lending, and foreign direct investment. However, they found that the importance of bilateral trade had increased in recent years, a result paralleling the firm-level evidence of Brooks and Del Negro.
At much longer horizons, Goetzmann, Li, and Rouwenhorst observed that there was a positive association between co-movement across national stock markets and the depth of international linkages. They identified historical episodes during which crosscountry linkages were important and found that co-movement in international stock returns was, on average, higher during periods of capital market integration.
The conference also explored the nature of financial linkages at high frequency and investigated the role that these linkages played in the transmission of shocks to emerging markets. Graciela Kaminsky (George Washington University) and Carmen Reinhart (IMF) examined the transmission of extreme stock returns in mature markets to developing countries and found that returns in emerging markets were particularly strongly affected through their regional financial centers. Papers by John Griffin (Arizona State University), Federico Nardari (Arizona State University), and Rene Stulz (Ohio State University) and by Hali Edison (IMF) and Francis Warnock (U.S. Federal Reserve Board) examined equity flows to developing countries and holdings of emerging market stocks, respectively, finding that the global business cycle, cross-listings, and American depositary receipts (ADRs) played an important role in determining equity positions in emerging markets.
Finally, the conference focused on long-term factors that were causing business cycles and financial markets to become increasingly synchronized across markets. On that subject, Jean Imbs (London Business School) argued that the rise in business cycle synchronicity was due in part to closer alignment of sectoral composition across countries, while Ayhan Kose (IMF), Chris Otrok (University of Virginia), and Charles Whiteman (University of Iowa) reported that global co-movement in real activity across developed countries had increased substantially from the 1960s to the 1990s. Andrew Karolyi (University of Chicago) reported that such financial innovations as ADRs were an important institutional factor in easing access to capital markets for firms in emerging markets, although he noted there was also a risk of hollowing out of these markets as the biggest and most liquid stock left for larger exchanges.
For additional coverage of some of the conference papers and the associated forum, see the Financial Times, February 4.
Art Editor/Graphic Artist
Julio R. Prego
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