VoxEU Column International Finance Macroeconomic policy

Challenges ahead: Managing spillovers

The events of the last five years have been a forceful reminder of the interconnections among nations. There has been renewed debate on the optimal way to combine fiscal, monetary, and financial policies to deal with international spillovers, and on the scope for coordination of such policies. This column discusses the highlights of a recent IMF conference on “Cross-Border Spillovers”, and applies the lessons to the challenges of the US and the Eurozone exiting from their unconventional monetary policies.

Events of the last five years have forcefully reminded the global community of the risks present in the global economy and the interconnections among nations. Intense discussions have arisen on the optimal way to combine fiscal, monetary, and financial policies to deal with spillovers across nations, and on the scope for coordination of such policies. In this context, the theme chosen for the IMF’s 15th Jacques Polak Annual Research Conference was “Cross-Border Spillovers”.1 This column discusses the conference highlights.

Hélène Rey’s Mundell–Fleming Lecture

Hélène Rey set the stage with her Mundell–Fleming lecture (Rey 2014). Her lecture made two main points.

  • The world economy is marked by a “global financial cycle”.

That is, there are large, correlated movements of capital flows, risky asset prices, and credit growth across developed and emerging economies.

  • Countries cannot insulate themselves from this cycle through exchange rate flexibility.

Looking at the effects of the capital flows and valuation changes triggered by a change in US monetary policy, she showed that the effects on mortgage spreads were roughly the same for countries that adjusted their interest rate and those that did not. This suggests that, in contrast to the traditional Mundell–Fleming model, capital flows and valuation changes linked to the important international use of the dollar have substantial and complex effects on the domestic financial system of recipient countries, quite apart from their effect on the exchange rate. This led her to conclude that only macroprudential policies and capital controls can provide sufficient insulation from the global financial cycle.

Specific spillovers

Two papers on unconventional monetary policy examined in more detail some of the spillovers that characterise the global financial cycle. Gilchrist et al. (2014)[RB1]  contrasted the effects of conventional and unconventional US monetary policy on foreign sovereign yields.

  • They showed that conventional monetary policy surprises in the US steepened foreign yield curves, while unconventional policies flattened foreign yield curves.

Fratzscher et al. (2014) looked at the use of unconventional monetary policy in Europe.

  • They found that ECB policies had positive spillovers on equity prices across a wide set of countries, but the impact on yields was limited to the Eurozone, especially Italy and Spain.

ECB policies increased market confidence (i.e. reduced implied volatilities and sovereign and bank spreads) but had little impact on international portfolio flows.

On the fiscal side, Auerbach and Gorodnichenko (2014) studied the contradiction between theory and evidence when it comes to exchange rate effects of higher public spending. The models typically predict that higher spending should cause the exchange rate to appreciate, while the empirical evidence suggests the opposite.

  • Their hypothesis is that the theory is right and the empirical findings wrong (due to poor identification of the timing of shocks).

Specifically, the spending shocks used in existing studies were probably anticipated by investors, and thus the appreciation was already in the data when the announcement arrived. To get around this, they focus on spending shocks that were much less likely to have been anticipated, namely daily data on US defence spending commitments. With this novel approach, they find that spending shocks did indeed tend to appreciate the dollar, as predicted by the theory.

Trade linkages have evolved over time, one of the reasons being the development of global supply chains. Boehm et al. (2014) looked at the spillover effects of the 2011 tsunami and earthquake in Japan. They indeed find strong effects of the disruptions in Japan on the imports and the production of Japanese affiliates in the US. Their main conclusion is that, at least in the short run, supply chains are very rigid, and disruptions can affect the whole chain.

Reducing spillovers

Korinek (2014) provided an analytical framework to characterise the conditions under which spillovers should or should not be a source of concern, the conditions under which the market equilibrium is efficient. His results do not lend themselves to a simple characterisation. But he showed for example that a world in which countries use foreign exchange intervention to provide insurance to the tradable sector in response to capital flows can lead to an efficient allocation.

Chamon and Garcia (2014) examined the effectiveness of capital controls in Brazil. They showed that controls helped to segment Brazil’s domestic financial market from the global one, opening a wedge between onshore and offshore prices of similar assets. The initial measures had limited success in mitigating exchange rate appreciation, but the tax on the notional amount of derivatives adopted in mid-2011 triggered a significant depreciation – likely driven by complementarities with previous measures and supported by the beginning of the monetary easing cycle as well.

Bengui and Bianchi (2014) analysed challenges associated with the implementation of capital controls, suggesting that despite leakages due to the presence of unregulated agents, stabilisation gains from preventing financial crises remain large.

A final panel took on the discussion of policy challenges raised by increasing financial integration – including the scope for policy autonomy – and potential areas for policy coordination.

Obstfeld (2014) highlighted that financial openness inevitably challenges prudential tools. He stressed that financial stability issues are difficult to manage in the context of an open capital account – even with effective monetary policy and even in the presence of exchange rate flexibility.

Cross-border lending curbs the ability to control domestic credit, and a ‘financial trilemma’ arises under any exchange rate regime – namely, national control over financial regulation and financial stability are not compatible when global markets are financially integrated. This leads to an important conclusion:

  • The need for international policy coordination depends largely on the efficacy of macroprudential policies to deal with financial stability issues.

He stressed that critical areas for future coordination are: financial regulation, clear rules of the road for capital controls, and enhanced facilities for international liquidity support in key currencies to counteract the downsides of gross reserve accumulation.

Boivin (2014) emphasised that coordination at the political level is complex, and a critical precondition to agree on a strategy is the acknowledgment at the country level of the importance of international spillovers on economic conditions. Torres (2014) noted that unconventional policies put the global economy in unchartered waters, and uncertainty and disagreements made cooperation harder to achieve. He argued that the IMF had an important role to play in clarifying and fostering consensus about spillovers. Finally, Vines (2014) argued that full coordination might be too hard to achieve, and called for ‘concerted unilateral reforms’ in which opportunities created by reforms in some countries influence the extent to which other countries pursue their own domestic reforms, a strategy adopted by the G20.

Asynchronous monetary cycle: Exiting the crisis one by one

One potential take away from the set of papers, relevant to the current monetary policy challenges, relates to asynchronous exit from unconventional monetary policies.  If it is indeed the case that (i) as Hélène Rey stresses, US monetary policy is a driver of a global factor in asset prices, term premia, and risk premia, ; and (ii) unconventional monetary policy by the ECB has a milder impact on capital flows and global liquidity than US unconventional policies, as suggested by Fratzscher et al. (2014), then an asynchronous monetary cycle between the US and Europe going forward might raise significant policy challenges and require serious policy dialogue, in particular among central bankers in advanced economies.


[All presented at the 15th Jacques Polak Annual Research Conference hosted by the International Monetary Fund, Washington, DC, 13–14 November 2014. http://www.imf.org/external/np/res/seminars/2014/arc/index.htm]

Auerbach, A J and Y Gorodnichenko (2014), “Effects of Fiscal Shocks in a Globalized World”. 

Bengui, J and J Bianchi (2014), “Capital Flow Management when Capital Controls Leak”. 

Boehm, C, A Flaaen, and N Pandalai (2014), “Input Linkages and the Transmission of Shocks: Firm-Level Evidence from the 2011 Tōhoku Earthquake”. 

Boivin, J (2014), Contribution to panel discussion on “Cross-Border Spillovers and International Policy Coordination”.

Chamon, M and M Garcia (2014), “Capital Controls in Brazil: Effective?”. 

Fratzscher, M, M Lo Duca, and R Straub (2014), “ECB Unconventional Monetary Policy Actions: Market Impact, international Spillovers and Transmission Channels”.

Gilchrist, S, V Yue, and E Zakrajšek (2014), “U.S. Monetary Policy and Foreign Bond Yields”. 

Korinek, A (2014), “International Spillovers and Guidelines for Policy Cooperation”. 

Obstfeld, M (2014), “Exchange Rates and Financial Globalization”. 

Rey, H (2014), “The International Credit Channel and Monetary Autonomy”. 

Torres, H (2014), Contribution to panel discussion on “Cross-Border Spillovers and International Policy Coordination”.

Vines, D (2014), “On Concerted Unilateralism: How can a higher global growth rate be achieved?”. 


[1] They can all be downloaded, and videos of each session are available, at http://www.imf.org/external/np/res/seminars/2014/arc/.

2,100 Reads