Gian-Maria Milesi-Ferretti & Cedric Tille October 2010 The Great Retrenchment: International Capital Flows During the Global Financial Crisis Gian-Maria Milesi-Ferretti & Cedric Tille October 2010 The paper that I will present today was written by Prof. Tille and his co-author Milesi-Ferretti for the 52nd Economic Policy panel in Rome in October 2010.

Contents International Capital Flows Before the Crisis Describe the Patterns of Financial Integration Before the Crisis Identify the Drivers Financial Integration Before the Crisis International Capital Flows During the Crisis Identify the Heterogeneities of Capital Flows Analyze the Determinants of Capital Flows International Capital Flows After the Crisis Evaluate the Prospects of International Financial Integration It is a comprehensive study on the behavior of international capital flows before, during and after the Global Financial Crisis. As such, it it effectively a study of international financial integration. The paper (i) describes the pre-crisis increase in international capital flows; (ii) analyzes the movement of capital flows during the crisis and (iii) speculates about the prospects of capital flows in the aftermath of the crisis. Determinants of international capital flows during the decade preceding the crisis. International capital flows do not move coherently across time, country/region and types of capital. Explain these heterogeneities formally by an econometric analysis Think about the factors that had boosted international financial integration between 1990 and 2007. Evaluate their potential against the stark reality of today.

Capital Inflows/GDP (1975-2009, Annual) Setting the context; Data for most descriptive and analytical statistics come from 75 countries worldwide up to end-2009 with a very extensive balance of payments statistics including bank operations through affiliates and domestic financial balance sheets. Red line is capital inflows/GDP Blue dotted line is imports/GDP This is the picture of financial globalization: Acceleration in the purchases of foreign assets by investors from early 1990s onwards. Don’t ignore the dramatic setbacks. In less than a couple of years during the Global Financial Crisis, the level of international financial integration, proxied by capital flows decreased back to the levels of late1980s.

Capital Inflows/GDP (2000-2009, Quarterly) Observe the heterogeneity across time in the movement of capital inflows… Bear Sterns in 2008q2 and Lehman Brothers in 2008q4…

Motivation What lies behind the retrenchment? Did flows fall evenly across countries and categories of flows? Can we link the intensity of the retrenchment to financial and macroeconomic characteristics? Is the trend for rising financial globalization over? Short answers to these questions are at the very end…

The Time of Financial Globalization (1990-2007) Portfolio Growth Financial Deepening Portfolio Re-allocation Active portfolio management favoring foreign assets Reductions in Formal Restrictions against Capital Decreasing trend in Chin-Ito index and Schindler’s index International Banking Operations Cross-border Lending Lending through Affiliates What drove the boom in international capital flows? Portfolio Growth Financial deepening (ratio of financial assets/GDP) especially from 2002 onwards in the UK and US. Rising asset prices and valuations of non-financial assets along with the boom in securitization drove financial deepening. (A couple of factors: when asset prices increase sharply this drives up the valuation of financial wealth... Higher borrowing becomes possible when your non-financial assets receive higher valuations… When there is a boom in securitization, the total value of your financial instruments outstanding increase.) Portfolio Re-allocation An increase in financial deepening will lead to a reduction in home-bias: as the value of assets/GDP increases even with a stable fraction of your portfolio being allocated to foreign assets, the share of your domestic assets will decline relatively. The key is that given that asset prices increased pretty closely across the world, the share of foreign assets must have increased due to deliberate investment choice by investor’s appetite. Reductions in Formal Restrictions against Capital Mobility De jure restrictions against international capital mobility decreased as evidenced by the two indices. Add to this the regulatory harmonization between EU countries and the advent of euro. Overall, significant decreases in transaction costs. International Banking Operations “Cross-border bank lending increased substantially since the early 1990’s, and particularly between 2000 and 2007, reaching some 60 percent of world GDP (figure 5).” “The growth of international banking in pre-crisis years is also reflected in their increasing share of capital flows.” “Lending through affiliates represents a substantial share of international banking activity. Between 1999 and 2007 overall foreign claims of BIS-reporting banks rose from 32 to 62 percent of world GDP” Note that the majority of these developments took place between 2000 and 2007 among developed economies, mainly between the US and EU. Emerging markets were less reliant on bank lending. FDI and PI were dominant. Also note that the polarization in net external positions and flows across countries coincide with financial globalization: Global Imbalances.

Financial Deepening (Financial Assets/GDP) Ratio of Financial Assets/GDP

World Map Before the Retrenchment Source: McKinsey Global Institute http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets/Mapping_global_capital_markets_fourth_annual_report

Portfolio Re-allocation Green Bars= Due to asset prices Blue Bars= Due to acquisition of assets Change in the ratio of external financial assets to total financial assets, annual rate Note that in the same graph is available for 2007-2009 period showing increasing home bias for a bunch of countries except Greece and Hungary.

Restrictions to Capital Flows Schindler (2009)

Capital Account Liberalization (Chinn and Ito, 2008)

World Map Before the Retrenchment Source: McKinsey Global Institute http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets/Mapping_global_capital_markets_fourth_annual_report

The Time of Great Retrenchment (2007-2010) Let’s first remind ourselves what this great retrenchment looks like. From 1997 to 2007, a 13 percentage point increase in financial integration measured by capital flows/GDP. From 2007 to 2010, a little less than 13 percentage point decrease in financial integration measured as above.

Stylized Facts The Great Retrenchment Financial Regression Regression in financial deepening Rising Home Bias Active portfolio re-allocation away from foreign assets Heterogeneous Patterns Across Time/Countries/Types of Flows Decreasing cross-border lending Effective Policy Response to the Retrenchment The same mechanism that led to financial integration now does works in opposite direction. A negative wealth effect through decline in asset prices decrease the value of total financial assets/GDP and also the share of financial assets invested overseas. In addition, active re-allocation towards home country’s due to declining risk appetite and tolerance for risk ,flight to safety. There is also the “valuation effect” from sharp changes in the exchange rates. For instance, in the UK during the crisis, it seems as if the share of foreign assets in total assets increased but this is because pound depreciated sharply and the value of foreign assets increased as they are denominated in foreign currency. International Bank lending retreats during the crisis, driven mainly by retrenchment in bank capital flows. Retrenchment more evident in cross-border lending than in lending through affiliates.

A Picture of Rising Home Bias

Way Too Many Heterogeneities! Across Time Pre-Crisis Period (2006q1-2007q2) Initial Stage of the Crisis (August 2007 – 2008q3) Collapse Stage of the Crisis (2008q4-2009q1) Recovery Stage of the Crisis (2009q2-2009q4) Across Countries Advanced economies vs. Emerging Economies Across Types of Flows Debt Flows: Bonds and Bank Flows Equity Flows: FDI and Portfolio Investment Reserves and Net Derivative Flows Across Time: Key events such as Bear Sterns and Lehman Brothers accelerated the process. Across Countries: Advanced countries were hit harder and recovered slower relative to emerging markets. Variation within advanced and emerging economies as well. UK and Switzerland, international banking centers hit harder than others. Retrenchment more persistent in Europe than in the U.S. Sharp contractions in bank flows prominent driver of retrenchment in capital flows in advanced economies. Accumulation of reserves Is the key activity in emerging markets to avoid sharp exchange rate fluctuations. FDI and PI resume quickly. Bank flows not significant component.

Developed Economies Gross Outflows and Inflows (USD, bn) Advanced Economies: Slowdown in capital inflows from August 2007 onwards. Financial stress evident with sharp turnaround in capital flows in 2008q2 with Bear Sterns but then quick recovery in 2008q3. When the Lehman Brothers failure hit, the collapse unfolds so does global retrenchment. In the recovery stage not success in reaching mid-2008 levels. Bank flows show the biggest retrenchment. Note: Negative capital flows after Lehman’s failure: repatriation of funds invested overseas.

Emerging Economies Gross Outflows and Inflows (USD, bn) Emerging Economies: Slowdown In capital inflows during Bear Stern incident, not a turnaround. A short-lived but sharp capital flow retrenchment after Lehman’s failure until 2009q1. Acceleration in capital flows to/from emerging markets in recovery stage. During the collapse stage of the crisis, dipping into the reserves Is evident in emerging economies. FDI and PI resumed quickly in early 2009. Bank flows are not significant in these countries.

More Pictures of Heterogeneity

More Pictures of Heterogeneity Note the size and frequency of blue bars in UK compared to other countries. No surprise that it’s a banking center filled with bank flows.

More Pictures of Heterogeneity Similar to the UK, blue bars more frequent and large in EU area as banks dominate the financial system.

More Pictures of Heterogeneity Quick recovery.

More Pictures of Heterogeneity Quick recovery

More Pictures of Heterogeneity Recovery harder in Emerging Europe, the hardest hit region by the crisis.

Policy Responses Emerging Economies Advanced Economies Foreign exchange reserves Advanced Economies Currency Swaps by Central Banks US 50 billion in 2008q3 US 500 billion in 2008q4 Multilateral Institutions IMF and EU -FED lends to central banks abroad which in turn lends to exposed banks that had previously relied on short-term dollar funding by issuing commercial paper to money market mutual funds. Effective in reducing the strain in dollar funding -EU to Eastern European “sudden stop countries” -IMF to broader countries

Causes and Consequences of Crises Incidence of Crisis Financial Excess & Macroeconomic Imbalances International Financial Linkages Incidence of Sudden Stops Specifics and Degree of Financial Integration Currency and Maturity Mismatch Domestic macroeconomic conditions The ultimate recipe for sudden stop…. This part provides a concise view of the literature on crises. The ultimate recipe for sudden stop…. Running a large current account deficit while experiencing a credit boom without having substantial foreign reserves

Drivers of the Capital Flows A Risk Perspective The effect of “risk shock” on cross-border capital flows An increase in financial risk A decrease in the risk tolerance of investors Regress Global Capital Flows on VIX Data: 1996q1-2009q4 Control for world growth and trade openness A statistically significant association between the two Let’s dig deeper into this risk perspective…

Risk Shock Transmission Channels Channel 1: International Trade Sharp decline in exports/imports Sharp decline in commodity prices/export revenues Channel 2: International Financial Exposure Sell-off liquid assets a la bank runs Channel 3: Macroeconomic conditions Weak fundamentals for pre-/during/post-crisis periods Channel 4: Future Economic Prospects Revisions in economic prospects Now that we know not every country is affected identically, we know that the risk shock will affect different countries… Especially the following ones: -Commodity exporters as the commodity prices go down, export revenue declines and so does capital flows. -Countries where banks account for larger share of international assets/liabilities. Timing wise during the collapse stage. Banking flows more affected than FDI and PI. Weak Fundamentals: Pre-crisis credit booms, large CAD, large external liabilities, net external debt, weak credit market regulations. Countries with dim prospects over public deficit, indebtedness and economic growth.

Testing different channels Dependent variable Change in capital flows relative to the pre-crisis situation Compute for each country Compute for collapse and recovery stages Compute for inflows as well as outflows Scale by country GDP and/or external positions in 2005 Exclude official capital flows

Testing different channels Channel 1:International Trade Regressors Trade flows (X+M) Openness to trade (X+M)/GDP Share of manufacturing in GDP Reliance on primary commodities Growth in Trading Partner Channel 2: International Financial Exposure Regressors Size of external balance sheet (Debt vs. Equity) Net Reliance on Foreign Funds (solvency risk) Foreign Reserves

Testing for different channels Channel 3: Macroeconomic Regressors GDP per capita GDP growth (2005-2007) Private credit/GDP Channel 4: Future Economic Prospects Regressors Revisions in Growth Revisions in Fiscal Balance/GDP Revisions in Public Debt/GDP Macro performance during crisis: Compare 2005-07 to 2008-09. Future economic prospects: change in growth, fiscal balance and public debt projections for the country for the period 2009-2012 resulting form the crisis.

Stylized Facts Sudden Stop Countries Reduction in Capital inflows over 30% of GDP larger Larger declines in capital inflows in countries with larger gross external positions in debt instruments banks that have more negative external position higher GDP per capita weaker growth and public finance prospects more openness to trade trading partners who suffered a decline in capital inflows Compare the mean/median value of each regressor for two groups of countries: countries which experienced the smallest and hardest change in capital flows. The results above are for capital inflows. Simlar results for capital outfows.

Econometric Analysis Collapse Stage of the Crisis Larger reductions in capital inflows for countries with larger gross bank assets and liabilities in debt instruments faster pre-crisis growth and higher GDP per capita. slower growth in trading partners during the crisis Larger reductions in capital outflows for countries with Larger pre-crisis cross-border debt positions Net liabilities in debt instruments Larger reductions in banking inflows and net banking flows Official flows are excluded. Changes in bank flows are related to gross and net banking positions, the stock of reserves and pre-Crisis variabels includeing GDP per capita, output growth and oil dummy.

Econometric Analysis Recovery Stage of the Crisis Larger decline in capital inflows in countries with Larger gross debt positions Trading patners who experience slower growth Larger pre-crisis credit growth (CEE) Larger declines in capital outflows in countries with Oil exports dominating their trade Is it only about global panic or does it persist during the recovery stage? Sharp contractions in bank inflows for oil producers and countries with higher net and gross external debt But mild contractions for countries whose trading partners have experienced smaller declines.

Evaluating the Results International financial exposure matters Holdings of large debt and bank positions Dependence on external finance International trade matters Macroeconomic conditions of trading partners Declining export revenues in commodity exporters Macroeconomic conditions and prospects matters GDP per capita Faster pre-crisis growth Higher pre-crisis credit-growth Deterioration in growth prospects and public finances lead to more capital inflow declines. Not every growth is associated with a credit-boom, though. There are significant heterogeneities among growth patterns of countries. Why not growth volatility rather than growth? This way we could differentiate the unsustainable growth countries from the sustainable ones.

Conclusions What lies behind the retrenchment? Contraction in banking flows due to global deleveraging and declining international banking activity Did flows fall evenly across countries/categories of flows? Advanced economies and bank flows are affected much more What drives the intensity of the retrenchment? Financial and macroeconomic characteristics Answer questions raised in the introduction part Financial Countries with high degrees of financial integration through debt and banking Countries with large net liabilities in debt instruments Macroeconomic Downward revisions to the growth and fiscal outlook Growth declines in trading partners Oil exporters affected more as oil prices went down. They might have recovered thanks to the Arab Spring.

Future of International Financial Integration Financial deepening unlikely to recover soon… Weak fiscal prospects for advanced economies Concerns over financial excess by emerging markets No more declining home bias in advanced economies Cross-border banking activities unlikely to recover soon Financial integration in EU has run its course Let’s look into the factors which increased financial integration during the decade preceding the crisis -Financial deepening unlikely to provide the same boost as in the decade preceding -Home bias is increasing in advanced economies… Emerging markets may pick up portfolio diversification as they will probably stop accumulating reserves. -Cross-border banking activity unlikely to recover soon… Steady decline in bank flows at every stage of the crisis Ongoing efforts at reforming banking/financial regulation unlikely to increase cross-border activity Decreasing the size of the large global financial institutions leaves no one to take over cross-border banking activity. Only hope, cross-border banking activity through affiliates. This depends on domestic regulatory regimes in emerging markets..