Breaking free of the triple coincidence in international finance by Stefan Avdjiev, Robert N McCauley and Hyun Song Shin Monetary and Economic Department October 2015 JEL classification:Breaking free of the triple coincidence in international finance Keywords: capital flows, global liquidity, international currencies. BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). Bank for International Settlements <2015>. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) Breaking free of the triple coincidence in international finance Stefan Avdjiev, Robert N McCauley and Hyun Song Shin1 Abstract The traditional approach to international finance is to view capital flows as the financial counterpart to savings and investment decisions, assuming further that the GDP boundary defines both the decision-making unit and the currency area. This triple coincidence of GDP area, decision-making unit and currency area is an elegant simplification but misleads when financial flows are important in their own right. First, the neglect of gross flows, when only net flows are considered, can lead to misdiagnoses of financial vulnerability. Second, inattention to the effects of international currencies may lead to erroneous conclusions on exchange rate adjustment. Third, sectoral differences between corporate and official sector positions can distort welfare conclusions on the consequences of currency depreciation, as macroeconomic risks may be underestimated. This paper illustrates the pitfalls of the triple coincidence through a series of examples from the global financial system in recent years and examines alternative analytical frameworks based on balance sheets as the unit of analysis. Keywords: capital flows, global liquidity, international currencies. JEL classification: F30, F31, F32, F33, F34. 1 This paper was prepared for the 62nd meeting of the Economic Policy panel in October 2015. The authors thank Mario Barrantes, Stephan Binder, Pablo Garcia-Luna, Koon Goh and Jos Maria Vidal Pastor for research assistance and Claudio Borio, Ingo Fender, Catherine Koch, Ilhyock Shim, Pat McGuire and Goetz von Peter for discussion. The views expressed are those of the authors and not necessarily those of the Bank for International Settlements. Breaking free of the triple coincidence in international finance 1 Contents Breaking free of the triple coincidence in international finance …………………………………… 1 1. Introduction……………………………………………………………………………………………………………………… 3 2. Gross flows matter………………………………………………………………………………………………………….. 7 2.1 A typology of global dollar banking flows ……………………………………………………….. 7 2.2 European banks as enablers of US shadow banking……………………………………..11 2.3 A regional view of ………………………………………………….13 3. Role of international currencies…………………………………………………………………………………..14 3.1 The second phase of global liquidity: bond flows………………………………………….15 3.2 Firms as carry traders …………………………………………………………………………………………..15 3.3 The strong dollar and the risk-taking channel……………………………………………..17 3.4 The role of the US dollar in global banking…………………………………………………….19 4. Consolidation and sectoral disparities……………………………………………………………………….21 4.1 Non-financial firms……………………………………………………………………………………………….22 4.2 Banks……………………………………………………………………………………………………………………….23 4.3 A consolidated external balance sheet for the US economy………………………..26 4.4 Sectoral exposures to foreign exchange risk…………………………………………………..27 5. Next steps and ……………………………………………………………….28 References………………………………………………………………………………………………………………………………34 2 Breaking free of the triple coincidence in international finance 1. Introduction Capital flows are traditionally viewed as the financial counterpart to savings and investment decisions. The unit of analysis is the GDP area, and what is external or internal is defined with reference to its boundaries. From this perspective, the focus is typically on net capital flows. The current account takes on significance as the borrowing requirement of the country as a whole. The textbook analysis then incorporates two further features which, although apparently innocuous, turn out to be hugely consequential for the conclusions. The first is an aggregation property namely, that all sectors in the economy (firms, households, government) can be summed into one representative decision-maker. The second is that each economic area has its own currency and the use of that currency is largely confined to that economic area. The upshot of these two additional assumptions is a triple coincidence between: (1) the economic area defined by the GDP boundary; (2) the decision-making unit; and (3) the currency area. The triple coincidence can be represented by the following triangle of equivalence relationships. In this schematic, Assumption 1 is the proposition that all sectors of the economy can be summed into one representative decision-maker and Assumption 2 is the proposition that each economic area has its own currency and that the use of the currency is largely confined to that currency area. No doubt the triple coincidence is an elegant and useful simplification for analytical purposes. However, it can mislead whenever financial flows are important in their own right. Consider three examples of how the triple coincidence can mislead. The first example is cross-border banking and the subprime mortgage crisis in the United States. Bernanke (2005) famously coined the term global saving glut to explain how the large US current account deficit could co-exist with easy financial conditions in the United States during the run-up to the global financial crisis. In line with the triple coincidence, Bernanke attributed these circumstances to excessive saving in some emerging economies, notably China, combined with a preference for US financial assets by these countries residents. Breaking free of the triple coincidence in international finance 3 In the event, however, investors from China or other emerging market economies did not bear the losses from subprime mortgage securities. Instead, European investors, notably banks, took the hit. The large subprime portfolio positions of European banks had been obscured in the current account by the round-tripping of capital flows. In particular, dollars raised by borrowing from US money market funds flowed back to the United States through purchases of securities built on subprime mortgages. Since the outflows to Europe were matched by the inflows from Europe, the net flows were small. The current account between Europe and the United States remained broadly in balance, even though the gross capital flows from Europe into the United States grew enormously, fuelling the rapid increase in credit to subprime borrowers (McGuire and von Peter (2012)). We return to this point in Section 2, but we summarise it here in the motto that gross flows matter, not just net flows. The assumption of the triple coincidence misleads, because it obscures the role of gross flows. The second example of how the triple coincidence can mislead is in discussions of exchange rate adjustments implied by current account imbalances for countries with international currencies. In the mid-2000s, the US dollar depreciated against major currencies even as the US current account deficit widened to an historically large share of output. In an influential paper delivered at the 2006 Economic Policy panel, Krugman (2007) warned of an impending collapse in the value of the dollar, fretting that the dollar would fall abruptly when the currency market met its Wile E Coyote moment. 2 This would be the moment when investors collectively came to realise the inevitability of the fall in the dollars value, triggering a sudden rush to sell the currency. Krugmans views echoed earlier warnings (Summers (2004), Edwards (2005), Obstfeld and Rogoff (2005), Setser and Roubini (2005)) and remained influential in financial commentary even as the global financial crisis began.3 In the event, the US dollar rose sharply with the onset of the global financial crisis in 2008. Its strong appreciation was associated with the deleveraging of financial market participants outside the United States, such as the European banks mentioned above, who had used short-term dollar funding to invest in risky longterm dollar assets. As the crisis erupted and risky US mortgage bonds fell in value, these financial market participants found themselves overleveraged and with dollar liabilities in excess of depreciating dollar assets. This forced them to bid aggressively for dollars to repay their dollar debts, pushing up the dollars value in the process. An analytical framework with the triple coincidence misleads in that it gives insufficient weight to international funding currencies that are extensively borrowed outside the borders of their home countries. Indeed, the neglect of international currencies in Krugman (2007) stands in contrast to Krugman (1999), who placed the is a hapless cartoon character who is apt to run off cliffs and then hover in mid-air until he looks down and realises that there is nothing to support him below. He then crashes to the ground after a plaintive look to the viewer. See https://en.wikipedia.org/wiki/Wile_E._Coyote_ and_The_Road_Runner. 3 Is this the Wile E Coyote moment?, http://krugman.blogs.nytimes.com/2007/09/20/is-this-thewile-e-coyote-moment/. See also the related blog post Robert Rubin is wrong about the dollar, http://krugman.blogs.nytimes.com/2007/11/10/robert-rubin-is-wrong-about-the-dollar/
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