Global Factors in Capital Flows and Credit Growth by Valentina Bruno, American University Hyun Song Shin, Princeton University Griswold Center for Economic Policy Studies Working Paper No. 237, June 2013
Global Factors in Capital Flows and Credit Growth Valentina Bruno and Hyun Song Shin It is a cliché that the world has become more connected, but the financial crisis and the boom that preceded it have focused attention on the global factors behind credit growth and capital flows. Calvo, Leiderman and Reinhart (1993, 1996) famously distinguished the global "push" factors for capital flows from the country specific "pull" factors, and the BIS report on global liquidity (the Landau report ) has highlighted the role of cross border banking in the transmission of financial conditions (BIS (2011)). Figure 1: Propagation of Global Liquidity Borrowers in A in A Borrowers in B in B Global Wholesale Funding Market in C Borrowers in C In a recent paper (Bruno and Shin (2012a)) we examine the theoretical and empirical basis for global liquidity. Schematically, global liquidity propagates as in Figure 1. When global banks apply more lenient conditions on local banks in supplying wholesale funding, the local banks transmit the more lenient conditions to their borrowers through greater availability of local credit. In this way, global liquidity is transmitted through the interactions of global and local banks through the waxing and waning of bank risk taking. In our panel regression study of 46 countries we find that global "supply push" factors play the dominant role relative to local "demand pull" factors (such as GDP growth) in determining credit growth and capital flows. Figure 2 highlights the international evidence on how cross border bank claims expanded dramatically and in synchronized fashion in the years prior to the crisis. 1
Figure 2: Claims of BIS reporting banks on counterparties in countries as listed (March 2003 = 100) (Source: Bruno and Shin (2012a), data from BIS Locational banking statistics, Table 7A) 500 450 400 350 Dec 2008 Ireland Spain Turkey 300 250 200 150 100 50 Mar 2003 =100 Australia South Korea Chile Brazil South Africa 0 Dec.2011 Mar.2011 Jun.2010 Sep.2009 Dec.2008 Mar.2008 Jun.2007 Sep.2006 Dec.2005 Mar.2005 Jun.2004 Sep.2003 Dec.2002 Mar.2002 Jun.2001 Sep.2000 Dec.1999 Mar.1999 The experience of Spain is particularly instructive on how global liquidity converts capital flows into domestic credit growth. Total bank credit in Spain stood at 414 billion euros on the eve of the euro, but subsequently increased five fold to nearly 2 trillion euros (Figure 3). At the launch of the euro, bank lending could be financed entirely from Spanish residents (Figure 4), but global liquidity changed all that as capital flows and the lending boom fed off each other. At the peak of the cycle in 2008, only half of the bank lending in Spain was financed from domestic sources. The rest came from capital inflows, as foreign banks increased their lending to Spanish banks (Figure 4). Our findings underscore how the crisis in the eurozone is part of a larger global picture. Global liquidity mirrors the procyclical nature of the global banking system. Figure 3: Banking sector credit to non financial borrowers in Spain (1992 2012) (source: Bank of Spain) Trillion Euros 2.0 1.8 1.6 1.4 Dec 2008 1.87 trillion IE_8.9.12,13,14 Other loans to households and nonprofits IE_8_9.11 Credit for purchase of consumer durables IE_8_9.10 Credit for homeownership 1.2 1.0 0.8 0.6 0.4 0.2 414 billion Dec 1998 8_9.9-9_9.10 Home improvement credit IE_8_9.7 Loans for real estate financing IE_8_9.5 Credit for construction funding 8_9.6-8_9.7 Credit financing services (non real estate) IE_8_9.4 Credit financing industry (excluding construction) 0.0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 IE_8_9.3 Credit for financing agriculture, hunting, forestry and fishing 2
Figure 4: Funding gap of Spanish banks. Liabilities of banks in Spain to domestic residents are indicated as core liabilities. Red region is lending financed with capital inflows, and yellow is ECB funding (Source: Bank of Spain) Trillion Euros 2.0 1.8 1.6 1.4 1.2 1.0 0.8 Private crossborder liabilities (total credit - core liabilties - Eurosystem LTRO Eurosystem Long term refinancing operations 0.6 0.4 Core Liabilities to residents 0.2 0.0 Dec-11 Dec-10 Dec-09 Dec-08 Dec-07 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Dec-99 Figure 5: Foreign currency assets and liabilities of BIS reporting banks by currency (Source: BIS Locational banking statistics, Table 5A) Other Swiss Franc Yen Sterling Euro US dollar 2008Q1 20.0 15.0 10.0 5.0 Trillion dollars Assets 0.0-5.0 Liabilities -10.0-15.0 1977-Q4 1979-Q2 1980-Q4 1982-Q2 1983-Q4 1985-Q2 1986-Q4 1988-Q2 1989-Q4 1991-Q2 1992-Q4 1994-Q2 1995-Q4 1997-Q2 1998-Q4 2000-Q2 2001-Q4 2003-Q2 2004-Q4 2006-Q2 2007-Q4 2009-Q2 2010-Q4 2012-Q2-20.0 Monetary policy looms large in the propagation of global liquidity through the risk taking channel, as shown in a separate, related paper (Bruno and Shin (2012b)). The US dollar takes center stage in the risk taking channel as the currency that underpins the global banking system. Figure 5 shows foreign 3
currency assets and liabilities of global banks tracked by the BIS, arranged by currency. The US dollar series shows the US dollar assets and liabilities of banks outside the United States, the euro series gives the euro denominated assets and liabilities of banks that are outside the euro area, and so on. The US dollar asset series exceeded 10 trillion dollars in 2008:Q1, briefly exceeding the total assets of the US chartered commercial bank sector (Shin (2012)). Bruno and Shin (2012b) find that the risk taking channel is a powerful determinant of leverage, thereby acting as the linchpin in the propagation of global liquidity. A further distinctive feature of the risk taking channel is that currency appreciation can fuel capital inflows rather than stem them, as currency appreciation strengthens local borrower balance sheets and creates further slack in lending capacity for banks, thereby stimulating further inflows, as sketched in Figure 6. Figure 6: Feedback created by currency appreciation in the presence of the risk taking channel (Source: Bruno and Shin (2012b)) Decline in Bank funding cost Increased risk-taking Decline in measured risks Capital inflows and currency appreciation Dampened volatility What is the right policy in such circumstances? Just letting the currency appreciate may not be sufficient to stem credit booms and capital inflow pressures when global liquidity is rampant, and policy makers may inadvertently set the economy up for a bigger boom bust episode. Iceland is perhaps the poster child in this respect, but the lessons are more general. Some combination of micro and macroprudential instruments in concert with domestic monetary policy tools will be crucial in leaning against the wind. Macroprudential policy and monetary policy are likely to be strong complements when global liquidity is operating strongly, where the prudential rules create sufficient space for domestic monetary policy to operate without the distortionary effect of capital flows. In another recent paper (Bruno and Shin (2013)), we assess the impact of the macroprudential policies implemented in Korea in 2010. Korea was one of the countries hardest hit in the 1997 Asian financial crisis, and was again at the sharp end of the financial turmoil unleashed after the failure of Lehman Brothers in September 2008. In recognition of its susceptibility to global liquidity, Korea introduced a leverage cap on FX derivatives and a macroprudential levy on non core bank liabilities, both aimed dampening the bank risk taking channel. Figure 7 shows some evidence that short term bank liabilities continued to shrink, and was replaced with long term liabilities after the introduction of the new measures starting in June 2010. Panel 4
regressions confirm that Korea s sensitivity to global factors decreased markedly relative to a comparison group of countries. Figure 7: Capital flows to banking sector in Korea by category of liabilities (Source: Bruno and Shin (2013), data from Bank of Korea balance of payments statistics) Bank long-term loan liabilities Bank short-term loan liabilities Central bank deposit liabilities Lehman Crisis Bank long-term debt securities Bank short-term debt securities 13.0 Billion Dollars 8.0 3.0-2.0-7.0 June 2010-12.0-17.0 2005/01 2005/05 2005/09 2006/01 2006/05 2006/09 2007/01 2007/05 2007/09 2008/01 2008/05 2008/09 2009/01 2009/05 2009/09 2010/01 2010/05 2010/09 2011/01 2011/05 2011/09 2012/01 2012/05 2012/09 2013/01-22.0 Although it is too early to come to a definitive assessment of such policy initiatives, researchers and policy makers would do well to recognize the role of global liquidity as a key concept in international finance one that gives rise to conclusions that differ from standard textbook prescriptions but which is critically important to understand well. References Bank for International Settlements (2011) "Global liquidity concept, measurement and policy implications" CGFS Papers 45, Committee on the Global Financial System http://www.bis.org/publ/cgfs45.pdf Bruno, Valentina and Hyun Song Shin (2012a) "Capital Flows, Cross Border Banking and Global Liquidity" NBER working paper w19038 http://www.princeton.edu/~hsshin/www/capital_flows_global_liquidity.pdf Bruno, Valentina and Hyun Song Shin (2012b) "Capital Flows and the Risk Taking Channel of Monetary Policy" NBER working paper w18942 http://www.princeton.edu/~hsshin/www/capital_flows_risk taking_channel.pdf Bruno, Valentina and Hyun Song Shin (2013) "Assessing Macroprudential Policies: Case of Korea NBER working paper w19084 http://www.princeton.edu/~hsshin/www/capital_flows_risk taking_channel.pdf forthcoming in the symposium issue of the Scandinavian Journal of Economics on global finance. 5
Calvo, Guillermo A., Leonardo Leiderman, and Carmen Reinhart (1993) "Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," IMF Staff Papers, 40 (1), 108 151. Calvo, Guillermo A., Leonardo Leiderman, and Carmen Reinhart (1996) "Capital Flows to Developing Countries in the 1990s: Causes and Effects," Journal of Economic Perspectives, 10, Spring 1996, 123 139. Shin, Hyun Song (2012) "Global Banking Glut and Loan Risk Premium" Mundell Fleming Lecture, IMF Economic Review 60 (2), 155 192. 6