Global Banks May Grow More Vulnerable to a Dollar Disruption

By Claudio Raddatz and Adolfo Barajas

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When a Mexican airline buys Brazilian airplanes, it’s likely to finance the purchase with a US dollar loan obtained from a non-US bank. That’s just one example of the dollar’s outsize role in international financial transactions between non-US counterparts.

What happens if non-US banks suddenly find themselves short of dollars? That was the case during the global financial crisis of 2007-2008, when US financial firms were reluctant to lend dollars to their foreign counterparts. To prevent the collapse of the global financial system, the Federal Reserve provided more than $500 billion in emergency funds to overseas central banks, which could then on-lend the money to their dollar-starved home-country banks.

As we explain in Chapter 5 of the latest Global Financial Stability Report, non-US banks continue to play a key role in dollar lending around the world. Indeed, their dollar assets rose to $12.4 trillion by mid-2018 from $9.7 trillion in 2012 and remain comparable to pre-crisis levels relative to their total assets.

Although the reforms introduced after the crisis have strengthened banking systems throughout the world, our analysis shows that non-US banks remain vulnerable to a dollar disruption that could transmit shocks to their home economies and to the countries that borrow from them. The first step to address the problem is to properly measure it; we have developed a set of indicators to help policymakers do that.

An increase in dollar funding costs can reverberate across the global financial system.

How do non-US banks get the dollars they need to finance assets such as loans to Mexican buyers of Brazilian airplanes? In contrast to US banks, they have limited access to a stable base of dollar deposits. So they must rely heavily on short-term and potentially more volatile sources of funding, such as commercial paper and loans from other banks. If those sources are insufficient, non-US banks turn to instruments known as foreign currency swaps, which are more expensive and can be unreliable in times of stress.

We used three measures to analyze non-US banks’ exposure to dollar funding and their vulnerability to a potential disruption. One measure shows that the gap between dollar denominated assets and liabilities has widened to about $1.4 trillion, or 13 percent of assets, from $1 trillion, or 10 percent of assets, in mid-2008. This so-called cross-currency funding gap reflects the amount of financing that must be filled by using instruments like foreign currency swaps, making banks more vulnerable.

Another measure we developed focuses on highly liquid dollar assets, which can be sold quickly in times of stress to make up for a sudden withdrawal of dollar funding. This measure shows that dollar liquidity has improved since the crisis but remains lower than the overall liquidity of the banks’ balance sheets.

A third measure reflects banks’ ability to fund their dollar assets over a long time horizon using stable sources. This gauge, which we call the US dollar stable funding ratio, has improved only moderately since 2008.

As the crisis showed, an increase in dollar funding costs can reverberate across the global financial system. Our analysis finds that higher costs boost the odds of bank defaults in the home economies of non-US banks that rely on dollar funding. What is more, they increase stress in third countries that receive loans from non-US banks, with  emerging-market borrowers being most vulnerable because they cannot easily find alternative sources of funding. We also find that US dollar funding fragility can act as an amplifier, as these negative effects are especially pronounced when any of the measures developed in the chapter points to heightened vulnerability.   

On the positive side, our study showed that several factors, some directly related to policy, can act as mitigators, so policy makers have ways to protect their economies in case of a dollar disruption. Ensuring overall health of the banking system, with more profitable, better capitalized banks is one way to provide a cushion. Larger reserve holdings by central banks can also be used to fill the gap if dollar liquidity dries up. Finally, central bank swap arrangements that provide access to US dollars during periods of stress can play in important role, as they did during the crisis.

Related Links:
Taming the Currency Hype
An Imbalance on Global Banks' Dollar Funding

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Fiscal Policies to Curb Climate Change

By Vitor Gaspar, Paolo Mauro, Ian Parry, and Catherine Pattillo

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Global warming has become a clear and present threat. Actions and commitments to date have fallen short. The longer we wait, the greater the loss of life and damage to the world economy. Finance ministers must play a central role to champion and implement fiscal policies to curb climate change. To do so, they should reshape the tax system and fiscal policies to discourage carbon emissions from coal and other polluting fossil fuels.

The Fiscal Monitor helps policymakers choose what to do and how to do it, right now, globally and at home.

A better future is possible. Governments will need to increase the price of carbon emissions to give people and firms incentives to reduce energy use and shift to clean energy sources. Carbon taxes are the most powerful and efficient tools, but only if they are implemented in a fair and growth-friendly way.

To make carbon taxes politically feasible and economically efficient, governments need to choose how to use the new revenue.  Options include cutting other kinds of taxes, supporting vulnerable households and communities, increasing investment in green energy, or simply returning the money to people as a dividend.   

Large emitting countries should take ambitious action equivalent to a carbon tax set to rise quickly to $75 a ton in 2030.

The price to pay

To limit global warming to 2°C or less—the level deemed safe by science—large emitting countries need to take ambitious action. For example, they should introduce a carbon tax set to rise quickly to $75 a ton in 2030.

This would mean household electric bills would go up by 43 percent cumulatively over the next decade on average—more in countries that still rely heavily on coal in electricity generation, less elsewhere. Gasoline would cost 14 percent more on average.

But the revenues from the tax, between ½ and 4½ percent of GDP (depending on the country), could be used to cut other taxes, such as income or payroll taxes that harm incentives for work and investment.

Governments could also use the money to support disproportionately affected workers and communities, for example coal-mining areas, or pay an equal dividend to the entire population. Alternatively, governments could compensate only the poorest 40 percent of households—an approach that would leave three quarters of the revenues for additional investment in green energy, innovation or to fund the Sustainable Development Goals.

Taxpayer money would also help save more than 700,000 people a year in advanced and emerging market economies who currently die from local air pollution. And the money would help contain future global warming, as agreed by the international community.

It can be done

About 50 countries have a carbon pricing scheme in some form. But the global average carbon price is currently only $2 a ton, far below what the planet needs. The challenge is for more countries to adopt one and for them to raise the price.

Sweden has set a good example. Its carbon tax is $127 per ton and has reduced emissions 25 percent since 1995, while the economy has expanded 75 percent since then.

Acting individually, countries may be reluctant to pledge to charge more for carbon if, for example, they are worried about the impact of higher energy costs on the competitiveness of their industries.

Governments could address these problems with agreement on a carbon price floor for countries with high levels of emissions. This can be done equitably with a stricter price floor requirement for advanced economies.

For example, a carbon price floor of $50 and $25 a ton in 2030 for advanced and developing G20 countries respectively would reduce emissions 100 percent more than countries’ current commitments in the 2015 Paris Agreement on Climate Change. Countries that want to use different policies, like regulations to reduce emission rates or curb coal use, could join the price floor agreement if they calculate the carbon price equivalent of their policies.

Polluters pay

Feebates are another option at policymakers’ disposal. As the name implies, in a feebate system governments charge a fee on polluters and give a rebate for energy efficient and environmentally-friendly practices. Feebates encourage people to reduce emissions by choosing hybrid vehicles over gas guzzlers or using renewable energy like solar or wind over coal.

Policies need to go beyond raising the price of emissions from power generation or domestic transportation. It is also necessary to introduce pricing schemes for other greenhouse gases, for example, from forestry, agriculture, extractive industries, cement production, and international transportation.

And governments need to adopt measures to support clean technology investment. These include power grid upgrades to accommodate renewable energy, research and development, and incentives to overcome barriers to new technologies, such as the time it will take companies to efficiently produce clean energy.

The world is looking for ways to foster investment and growth that create jobs. What better way to do it than investing in clean energy to both slow and adapt to climate change. The transition to clean energy may seem daunting, but policymakers can act to change the current course of climate change. As Nelson Mandela once said, “It always seems impossible until it is done.”


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Connecting the Dots Between Sustainable Finance and Financial Stability

Evan Papageorgiou, Jochen Schmittmann, and Felix Suntheim

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Unsafe working conditions. Use of child or forced labor. Environmental impact on protected areas. More and more investors are looking at issues and factors beyond traditional financial analysis when directing their money. Sustainable finance aims to help society better meet today’s needs and ensure that future generations will be able to meet theirs too.

The latest IMF Global Financial Stability Report discusses the link between sustainable finance and financial stability and suggests policies for the way forward.

Sustainable finance incorporates environmental, social, and governance (ESG) principles into business decisions and investment strategies. It covers many issues from climate change and pollution to labor practices, consumer privacy, and corporate competitive behavior. Efforts to incorporate these kinds of considerations in finance started 30 years ago but accelerated only in recent years.

Environmental, social, and governance issues can have a material impact on firms’ performance.

ESG and financial stability

Environmental, social, and governance issues can have a material impact on firms’ performance and on the stability of the financial system more broadly. Governance failures at banks and corporations contributed to the Asian and the global financial crises. Social risks, for example in the case of inequality, may tempt policymakers to unduly facilitate household borrowing for consumption and could lead to financial instability over the medium-term. Environmental catastrophes have caused large losses to firms and insurers.

Climate change features prominently in sustainable finance. Here, there are two main channels of risks. Physical risks include damages from weather-related events and broader climate trends. Transition risks arise from changes in the price of stranded assets (assets such as coal and oil that will not be used during the fossil fuel phase-out) and relate to the economic disruptions from climate-related policies, technology, and market sentiment during the adjustment to a lower-carbon economy.

Financial risks from climate change are difficult to quantify, but most studies point to economic and financial cost estimates in trillions of dollars. Already, insurance losses from climate-related natural disasters such as droughts, floods, and wildfires have quadrupled since the 1980s. Asset prices may not yet fully internalize climate risk and the transition to a cleaner economy. Delayed recognition of these risks could lead to a cliff-like moment when investors suddenly demand this risk be priced into asset values with potentially detrimental consequences for financial stability.

ESG in portfolio investment

Elements of ESG principles (particularly on corporate governance) have long been incorporated in portfolio investment strategies, and today, the assets under management of ESG-related funds range between $3 trillion and $31 trillion, depending on the definition. Applying principles of sustainability began in equities markets through investor activism as an attempt to influence corporate action, and later extended to fixed income markets, primarily with bonds that finance environmental projects, so-called green bonds.

Sustainable investing started with screening out firms or entire sectors viewed as being unsustainable. But concerns about risk management, underperformance, and lack of ultimate impact have created new strategies. With the expectation that companies that “do good, do well,” new strategies focus on positive attributes of firms, such as strong shareholder engagement, minimum environmental or safety standards, or commitments to invest in sustainable activities.

Sustainable finance impact

Corporations don’t report on sustainability regularly or consistently, particularly with respect to the environmental and social dimensions. This makes it difficult for investors to incorporate ESG principles to their portfolios. Third party providers of ESG scores aim to provide standardized assessments, but sometimes it’s difficult for them to arrive at an accurate picture given a lack of information.

There is also uncertainty with measuring the impact of ESG activities in achieving goals such as reducing emissions or raising labor standards. Greenwashing—false claims of ESG compliance of assets and funds—is also a concern that may give rise to reputational risks. Mixed evidence on the performance and impact of ESG funds makes it challenging for investors, especially public sector pension funds, to incorporate these principles in their investments. Firms face challenges as well: although they stand to benefit from integrating ESG factors in their business models, the positive outcomes are usually long term, but the high costs of disclosure are immediate.

Strong policies needed

For sustainable finance to effectively address critical risks, urgent and decisive policies are needed in four key respects:

  • Standardization of ESG investment terminology, as well as clarifications of what activities constitute environmental, social, and governance;
  • Consistent disclosure by firms to incentivize investors to use ESG data;
  • Multilateral cooperation to encourage participation from more countries and avoid setting different standards; and
  • Implementation of policies incentivizing investment in sustainability, and requiring public disclosure of the cost of inaction.

The IMF will continue to incorporate ESG-related considerations, in particular related to climate change, when critical to the macroeconomy through its multilateral surveillance work, such as in the Fiscal Monitor, future Global Financial Stability Reports, as well as its bilateral surveillance efforts.

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Widening Gaps: Regional Inequality within Advanced Economies

By John Bluedorn, Weicheng Lian, Natalija Novta, and Yannick Timmer

Differences in economic performance between regions within countries can be large and sometimes even larger than between countries.

For example, average real GDP per person in the United States is about 90 percent higher than in Slovakia. At the same time, within the United States, per capita GDP in the state of New York is 100 percent higher than in Mississippi.

Many are concerned that these large and persistent gaps signal that regions and people are being left behind, undermining inclusive growth. Poor regional performance can fuel discontent and erode social trust and cohesion.

Chapter 2 of the latest World Economic Outlook looks at the gaps between the better and worse performing regions in advanced economies and finds that these gaps have widened in many cases. We also look at how regional labor markets respond to trade and technology shocks, captured by increases in import competition in external markets and declines in machinery and equipment costs for regions that are more vulnerable to automation. The findings indicate that only technology shocks have lasting effects, especially for worse performing regions.

Differences in economic performance between regions within countries can be large.

Measuring regional differences

One way to measure regional inequality is to calculate the 90/10 ratio—divide real GDP per capita in the top 10 percent regions (or 90th percentile) by the bottom 10 percent within a country. In the case of Italy, the 90/10 ratio is about 2, meaning that GDP per capita of the well-off province of Trento is about twice as large as Sicily’s. In contrast, the 90/10 ratio for Japan is small, at 1.35.

Regional disparities within advanced countries have gradually been creeping upwards since the late 1980s, undoing some of the marked decline of the previous three decades. The 90/10 ratio within advanced economies, including the United States, is now at about 1.7, indicating that the 90th percentile region is, on average, 70 percent richer than the 10th percentile region. That said, incomes tend to vary much more within regions than between them.

Rising disparities also means that poorer regions in advanced economies are no longer catching up to the rich as fast as they used to.

Big differences

The WEO chapter classifies a region as lagging if two conditions are met: the region’s initial real GDP per capita in 2000 is below the country’s median region, and the region’s average growth over the period 2000–16 is below the country’s average growth over the same period.

But there are more differences than just output. On average, people in lagging regions are worse off when it comes to health, with higher infant mortality and lower life expectancy. They also have smaller shares of college-educated workers and people in their prime, considered to be 25 to 54 years old, higher unemployment rates, and a smaller share of people participating in the labor force.

Consistent with these unfavorable demographics, lagging regions tend to have lower labor productivity—output per worker—across sectors. This ranges from about 5 percent less in public services to around 15 percent less in manufacturing industries and finance and professional services.

In addition, poorer regions tend to specialize in agriculture and manufacturing industries rather than high productivity service sectors such as information technology and communications and finance. Climate change may exacerbate disparities as rising temperatures lower labor productivity in agriculture and heat-exposed industries, often affecting lagging regions more.

Responses to shocks

To get a better sense of regional differences, our study analyzes the effects of trade and technology shocks on regional unemployment and migration.

We find that trade shocks—increases in import competition in external markets—do not have significant effects on regional unemployment on average, both overall and for lagging regions specifically. While these shocks tend to reduce labor force participation after one year, this effect quickly fades. These findings may come as a surprise to those who view international trade as particularly disruptive to regional growth.

Technology, however, is a different story. We find that a negative technology shock—proxied by a decline in the cost of machinery and equipment—raises unemployment in all regions that are more vulnerable to automation, but lagging regions are particularly hurt.

Our research also shows that automation-prone lagging regions see a statistically significant drop in people leaving after the shock. This suggests that workers from these regions find it harder to move out in search of better employment than those from other regions. Labor’s adjustment to technology shocks in lagging regions is hampered.

Focus on people and places

Policies that reduce distortions and encourage more open and flexible markets can help regions minimize increases in unemployment to shocks and improve the reallocation of workers and capital. Labor policies to retrain the displaced and speed re-employment can also help, particularly in lagging regions. Product markets that are more open—through lower barriers to entry and greater trade openness—can facilitate the movement of capital to regions and firms where their returns are higher.

In addition, boosting educational and training quality to adapt to the changing world of work—a key recommendation from the literature—would disproportionately benefit lagging regions where unemployment is higher.

Finally, fiscal policies that aim to narrow the gaps across regions—such as targeting fiscal support to lagging regions and programs to ease worker relocation—and to provide buffers against regional shocks may also play a role. But these place-based policies have to be carefully designed to help rather than hinder adjustment.

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How To Reignite Growth in Emerging Market and Developing Economies

By Romain Duval and Davide Furceri

Emerging markets and developing economies have enjoyed good growth over the past two decades. But many countries are still not catching up with the living standards of advanced economies.

At current growth rates, it would take more than 50 years for a typical emerging market economy to close half of its current income gap in living standards, and 90 years for a typical developing economy.

Our research in Chapter 3 of the October 2019 World Economic Outlook finds that implementing major reforms in six key areas at the same time—domestic finance, external finance, trade, labor markets, product markets, and governance—can double the speed of income convergence of the average emerging market and developing economy to the living standards of advanced economies. This could raise output levels by more than 7 percent over a six-year period.

Structural reforms can yield sizable payoffs.

More room for reforms

Policies that change the way governments work—known as structural reforms—are difficult to measure. They often involve policies or issues that are not easy to quantify, such as job protection legislation or the quality of supervision of the domestic banking system.

To address this, the IMF recently developed a comprehensive dataset covering structural regulations in domestic and external finance, trade, and labor and product markets. The data cover a large sample of 90 advanced and developing economies during the past four decades. To the five indicators, we added the quality of governance (for example, how countries control corruption) from the World Gov­ernance Indicators.

The new indicators show that, after the major wave of reforms in the late 1980s and—most importantly—the 1990s, the pace slowed in emerging market and developing economies during the 2000s, especially in low-income developing countries.

While this slowdown reflects the prior generation of reforms, as in advanced economies, there remains ample room for a renewed reform push, particularly in developing economies—notably, across sub-Saharan Africa and, to a lesser extent, in the Middle East and North Africa and the Asia-Pacific region.

Reforms can boost growth and living standards

Based on our empirical research of reforms in 48 current and former emerging markets and 20 developing economies, we find that reforms can yield sizable payoffs. But these gains take time to materialize and vary across different types of regulations. For example, a domestic finance reform of the size that took place in Egypt in 1992 leads to an increase in output of about 2 percent, on average, six years after implementation. We get a similar result for anti-corruption measures, whose effects are sizable in the short run and stabilize at around 2 percent in the medium term. In the other four reforms areas—external finance, trade, product markets, and labor markets—the gains are about 1 percent six years after the reform.

For the average emerging market and developing economy, the results imply that major simultaneous reforms across all six areas considered in this chapter can raise output by more than 7 percent over a six-year period. This would increase annual per capita GDP growth by about 1 percentage point, doubling the average speed of income convergence to advanced-country levels. Model-based analysis—which captures the longer-term effect of reforms and provides insights on the channels through which they affect economic activity—points to output gains about twice as large as the empirical model over the longer term (beyond 6 years).

One channel through which reforms increase output is by reducing informality. For example, lowering barriers to businesses’ entry in the formal sector encourages some informal companies to become formal. In turn, formalization boosts output by increasing companies’ productivity and capital investment. For this reason, the payoff from reforms tends to be larger where informality is pervasive.

Getting the timing, packaging and sequencing right

Some reforms work best when the economy is strong. In good times, reducing layoff costs makes employers more willing to hire new workers, while in bad times it makes them more willing to dismiss existing ones, magnifying the effects of a downturn. Similarly, increasing compe­tition in the financial sector at a time of weak credit demand may push certain financial intermediaries out of business, further weakening the economy.

In countries where the economy is weak, governments may prioritize reforms—such as strengthening product market competition—that pay off regardless of economic conditions, design others to alleviate any short-term costs—such as enacting job protection reforms now with a provision that they will take effect later. These reforms can also be accompanied with monetary or fiscal policy support where possible. 

Reforms also work best if properly packaged and sequenced. Importantly, they typically deliver larger gains in countries where governance is stron­ger. This means that strengthening governance can support economic growth and income convergence not just directly by incentivizing more productive formal enterprises to invest and recruit, but also indirectly by magnifying the payoff from reforms in other areas.

Finally, to fulfill their promise of improving living standards, reforms must be supported by redistributive policies that spread the gains widely across the population—such as strong social safety nets and programs that help workers move across jobs. For reforms to be sustainable and therefore effective, they need to benefit not just some, but all.

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