Managing a Turn in the Global Financial Cycle.

• Author: Gopinath, Gita
• Position: The 2022 Martin S. Feldstein Lecture

It is a tremendous honor for me to give the Martin Feldstein Lecture. Marty was an exceptional colleague at Harvard and inspired my journey from academia to the policy world. His influence in research went well beyond public finance. In fact, one of his most cited papers is a contribution to international economics, widely referred to as the Feldstein-Horioka puzzle. Marty showed empirically that most savings tended to be invested at home, which can be puzzling if international capital markets are well integrated.

In reality, capital markets have many frictions, and my lecture today focuses on the implications of these frictions for policy in emerging and developing economies. I hope to show how policy questions arise at the International Monetary Fund (IMF), the research that gets done to answer these questions, and finally, how this research influences policymaking.

It is an opportune time to discuss this topic because after two years of easy financial conditions around the world, with monetary policy rates kept at record lows to prevent a COVID-driven depression, we are witnessing a tightening in global financial conditions. Almost all central banks are raising interest rates to deal with historically high inflation because of strong demand recoveries from the pandemic, alongside disruptions to supply and elevated energy and food prices exacerbated by Russia's invasion of Ukraine.

As can be seen in Figure 1, global financial conditions have tightened significantly, especially for emerging markets and developing economies, excluding China. According to Figure 2, over 30 percent of emerging markets are paying interest rates over 10 percent on their sovereign foreign-currency bonds, which is close to the levels seen during the Great Financial Crisis of 2008. In addition, as is typically the case when global financial conditions tighten, the US dollar has strengthened against a wide basket of currencies [see Figure 3], raising costs for countries that have borrowed in dollars. All of this is occurring in the aftermath of a pandemic, during which debt in emerging and developing economies has grown significantly.

A key policy question therefore is how emerging and developing economies should respond to this tightening cycle that is driven to an important degree by rising US monetary policy rates. The textbook answer would be to let the exchange rate be the shock absorber. An increase in foreign interest rates lowers domestic consumption. By letting the exchange rate depreciate, and therefore raising the relative price of imports to domestic goods, a country can shift consumption toward domestic goods, raise exports in some cases, and help preserve employment.

However, many emerging and developing economies find this solution of relying exclusively on exchange rate flexibility unsatisfying. This is because rising foreign interest rates come along with other troubles. They can trigger so-called "taper tantrums" and sudden stops in capital flows to their economies. In addition, the expansionary effects of exchange rate depreciations on exports in the short run are modest, consistent with their exports being invoiced in relatively stable dollar prices. (1)

Figure 4, on the following page, depicts one such taper tantrum episode in 2013, when the US Federal Reserve signaled an end to quantitative easing and a lift-off in rates, possibly earlier than expected. This communication triggered a sharp increase in borrowing costs for emerging markets, with median spreads increasing by more than 200 basis points even though there was no meaningful immediate policy action by the United States. Figure 5, on the following page, documents episodes of sudden stops with growth impact, which are defined as an abrupt stop or reversal in capital flows to emerging and developing economies that in turn generate a sharp fall in growth. These episodes capture a sudden tightening of borrowing constraints in emerging markets because of a perceived lower capacity of the country to repay. While they are less frequently observed than taper tantrums, they have larger adverse welfare implications for the country.

Consequently, several emerging and developing economies have in practice used a combination of conventional and unconventional policy instruments to deal with turns in the global financial cycle. Unlike the textbook prescription, they not only adjust monetary policy rates but also rely on foreign exchange intervention (FXI) to limit exchange rate fluctuations, capital...