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Annex I. Real Economy and Liquidity Cycles1
The state of knowledge on the drivers of global liquidity, defined as the “ease of international financing” is limited. The factors driving the ease of financing globally and how they can affect countries are not well understood (for recent reviews see Landau (2013), Shin (2012), CGFS (2011), and Obstfeld (2009); see Holmstrom and Tirole (2011) for an analytical overview of the determinants of liquidity and its private and public management). This lacuna reflects the more general limited knowledge on the roles and effects of financial markets in creating, transmitting and propagating shocks. With this caveat, it is clear that any fuller understanding of global liquidity will occur at the intersections and integration of a number of research areas, some well established, others being explored only more recently.
One strand is the financial accelerator. This channel, largely operating through the demand side of financial transactions and extensively studied within the domestic context, describes how changes in balance sheets of borrowers can amplify macroeconomic fluctuations (Bernanke and Gertler (1989), Carlstrom and Fuerts (1997), Kiyotaki and Moore (1997)). The central idea underlying this channel is a propagation mechanism. Shocks, such as fluctuations in asset prices or changes in real economic prospects, influence the balance sheets of borrowers. Given financial imperfections, resulting changes in the net worth of borrowers then affect the volume of external finance supplied and the cost of capital they face. These propagation mechanisms can have general equilibrium effects as individual agents’ actions affect others in a mutually reinforcing fashion and lead to procyclicality (Bernanke, Gertler and Gilchrist, 1999).
The financial accelerator mechanism has also been studied in the context of open economy models. While the mechanisms are similar to the domestic ones, the relevance of financial imperfections is probably even stronger in an open economy context because contracts are harder to enforce and information asymmetries are greater across borders. As a result, pledgeability of output and verifiability of borrowers’ quality is more limited and net worth influence access to finance more so than in the domestic context. As exchange rate and asset prices increase and countries’ net worth rises, the volume of external financing is likely to increase while its cost declines. Conversely, as net worth declines, the volume of external finance falls while its cost increases. This propagation mechanism has been shown in open economy models to be quantitatively important in explaining how external financing can be procyclical (e.g., Gertler, Gilchrist and Natalucci, 2007). Recent research has also analyzed how such mechanisms can help explain the highly synchronized nature of the global financial crisis (Perri and Quadrini, 2010).
Another strand is associated with the supply side of financial transactions. It emphasizes the importance of balance sheets of banks and other financial institutions in providing financing and liquidity and in determining asset prices, and the broader implications of the state of financial intermediation for the real economy. Changes in the net worth of an intermediary will affect its access to and cost of funding and its ability to make new loans and undertake other intermediation activities. These effects can be a source of aggregate cyclical fluctuations through what has been called the bank capital channel (Van den Heuvel, 2008). When many banks are affected by the same shock, economic wide effects can occur. For example, during a recession, the quality of loan portfolios weakens, adversely impacting banks’ balance sheets. In order to shore up relative capital positions (as desired by the market or to satisfy regulatory requirements) and being unable to raise capital quickly, banks may tighten their lending standards and reduce the volume of risky credit they provide. This “credit crunch” can lead to a slowdown in activity, or even a recession, with more non-performing loans and deteriorating bank balance sheets. With this mechanism, a strong link can arise between capital and the supply of bank financing.
Some recent studies have focused on (endogenous) cycles in leverage. A closely related, but less studied channel is associated with leverage and how shocks stemming from the supply side of finance can have an important impact on the real economy. Models and analyses by Adrian and Shin (2010, 2011) show that, when measured capital is high, risks are perceived to be low and internal risk models and other indicators suggest limited exposures, banks’ balance sheets will tend to expand and leverage to increase (similar relationships can exist for other intermediaries). Since this is more likely when interest rates are low and asset prices relatively high, the monetary policy stance can affect private financing provision. Dell’Ariccia and Marquez (2013) review the link between real interest rates and bank risk taking, and its implications for monetary policy are articulated by Borio and Zhou (2008). Generally, a “search for yield” can occur among banks and institutional investors when interest rates are relatively low. Conversely, equilibria in financial markets can shift rapidly, with many non-linearities, some akin to the self-fulfilling (currency) crises (Obstfeld, 1986), with adverse effects on the supply of liquidity and external financing. Geanakopolos (2010) shows how macroeconomic conditions, including easy monetary policy, can trigger leverage cycles, with booms and busts in the supply of external financing.
Some of these supply side channels also apply to the international context, even though they have been less well studied to date. While some channels are less relevant in an international context (small firms for example generally do not have access to cross-border loans), the bank capital and leverage channels are quite relevant internationally. The capital channel was clearly shown when international banks pulled back from cross-border lending after the recent financial crisis with the degree depending on how severe their balance sheets were hit (Cerutti and Claessens, 2014). Bruno and Shin (2013a and 2013b) model how the capital and leverage channels can give rise to procyclical international lending behavior and demonstrate the empirical relevance of these channels for cross-border banking flows. Hahm, Shin, and Shin (2013) show how reliance on non-core funds help predict banking system vulnerabilities, exactly because it proxies for ease of funding conditions. Chung et al (2014) show how non-core liabilities of international banks, that reflect the activities of non-financial corporations, signal broad credit conditions and predict global trade and growth (see also Shin (2013)). More generally, Rey (2013) attributes the high co-movements in international financial markets to similarities in funding conditions and balance sheets positions of international active banks and other intermediaries located in key financial centers.
Annex II. Common Component Analysis1
Annex III. Global Liquidity and Cross-Border Bank Lending1
Cross-border bank lending increased sharply from the mid-1990s until the global financial crisis erupted in 2007/08, and contracted sharply afterwards. As such, cross-border bank lending is an important aspect of global liquidity. The objectives of this section are to: (i) Document which drivers of global liquidity are statistically correlated with the evolution of cross-border banking lending to banks and non-banks over the period; (ii) Investigate which borrower countries’ policies and characteristics (e.g. exchange rate regimes, participation of foreign banks in domestic banking sector, banking regulation, etc) play a role in dampening or amplifying the impact of global liquidity indicators on cross-border banking lending.
Annex IV. The Role of the International Asset Management Industry1
Both advanced and emerging economies have witnessed a strong growth in the asset management industry (Table 1). While real money managers do not typically use leverage in the proportions that banks do, their growing assets have nonetheless given them an increasingly important role in the global allocation of liquidity. Amid a trend toward professional management of discretionary household assets (Walter, 2011), their growth has partly been driven by a reallocation of portfolios away from domestic fixed income, seeking more diversification. This has been reflected in a decline in home bias (Solnik and Zuo (2013) and GFSR (2011)). Financial innovation in the form of new products and technological advances has also contributed to this expansion. More recently, banking sector deleveraging after the peak of global crisis, and a search for yield in a low-interest rate environment, have further contributed to shifting intermediation to capital markets.
The Size of Global and Local Institutional Investors and Mutual Funds
(In trillions of U.S. dollars, unless otherwise indicated)
Including Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
These data may reflect some double-counting of assets, such as those owned by defined contribution pensions funds and managed by investment companies.
The data include Australia, Finland, France, Greece, Spain, the United Kingdom, and the United States.
Including Argentina, Brazil, Chile, China, Colombia, Croatia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Latvia, Malaysia, Mexico, Nigeria, Morocco, Peru, Philippines, Poland, Russia, South Africa, Sri Lanka, Thailand, Turkey, Uruguay, and Vietnam. China data starts in 2007.
The Size of Global and Local Institutional Investors and Mutual Funds
(In trillions of U.S. dollars, unless otherwise indicated)
|Assets under management of mutual funds and institutional investors|
|Selected advanced economies 1/2/|
|Total in percent of GDP||96||143||159||179||172||167||180|