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International Financial Markets
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International Financial MarketsBIS working paper Borio
Economics attempts to design international monetary and financial arrangements to facilitate
sustained, non-inflationary and balanced growth. Borio argues the Achilles heel of present-day
international monetary and financial system IMFS is that it amplifies excess financial elasticity,
which is a key weakness of domestic monetary and financial regimes. Excess financial elasticity
refers to their inability to prevent the build-ups of financial imbalances in the form of unsustainable
credit and asset price booms that overstretch balance sheets and lead to banking crises and
macroeconomic dislocations. Failure to tame pro-cyclicality.
Most influential policy view is that current arrangements are unable to contain current account
imbalances (main focus of G20), and that the asymmetry of adjustment between creditor and
debtor countries imparts a deflationary or contractionary bias: debtors have to retrench (austerity)
while creditors already have surpluses (Keynes argued this).
Another view argues that the IMFS magnifies a shortage of safe assets by encouraging a strong
precautionary demand for foreign exchange reserves. This shortage is exacerbated by the
dominant role of the US dollar. This leads to countries building up precautionary balances,
stressing deflationary forces. These two views are the excess saving and excess demand for save
assets views respectively.
They contrast with the excess financial elasticity view: it highlights financial imbalances and
thereby the role of capital account, rather than current account. The current account measures
imports and exports of goods and services, payments to foreign holders of a country’s
investments, payments received from investments abroad, and aid or remittances transfers.
The capital account measures cross-border investments in financial instruments and changes in
central bank reserves. A positive current account makes a country a net lender to the rest of the
world. Current account represents net income of a country, capital account net change of assets
and liabilities for a certain period. Any surplus (deficit) in the current account is cancelled out by a
deficit (surplus) in the capital account. If a country can’t fund its imports through exports, it must
run down its reserves: a balance of payments deficit.
A persistent expansionary bias, as the system fails to prevent a capital build-up, actually creates a
deflationary (contractionary) outcome in the end.
The excess financial elasticity view: weaknesses in domestic policy regimes
The excess financial elasticity in individual economies considered in isolation arises from
limitations in economic agents’ behaviour and policy regimes. These limitations cause excess
financial elasticity and fall into three categories:
-Perceptions of value and risk. These are loosely anchored and highly procyclical: assessments of
risk, probabilities of default, volatilities, etcetera tend to fall during booms and rise sharply during
busts. The impact of these perceptions on risk-taking is amplified by agents’ natural tendency to
take on more risk as their perceived wealth increases. Lower risk perceptions cause higher asset
prices, encouraging further risk taking in turn.
-Incentives to take on risk. Key problem is a wedge between individual rationality and the
desirable aggregate outcome: why would one bank adopt less procyclical measures of risk if they
only reduce the odds of a bust when all banks adopt them? A type of prisoner’s dilemma. Short
horizons play a key role in risk and value perceptions and incentives having a procyclical effect.
-Powerful feedback mechanisms. Loosely anchored perceptions and incentives to take on risk
and liquidity constraints are connected by a powerful feedback mechanism: as risk perceptions
decline, asset values surge, and incentives to take risks grow, feeding into financing constraints
by decreasing these constraints as funding becomes cheaper. In a boom, both external funding
liquidity for investments and market liquidity from selling assets increases, making further risk-
taking investments easier.
Though the root cause of this excess financial elasticity lies with economic agents’ behaviour,
policy is also critical: liberalised financial systems weaken financing constraints, fuelling the build-
up of financial imbalances, causing credit and asset price booms. Monetary policy focused on
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,near-term inflation control provides less resistance to the buildup of such imbalances (credit
booms) since authorities have no incentive to tighten policy as long as inflation remains low and
stable. The build-up of financial imbalances is most likely following major positive supply-side
developments putting downward pressure on inflation.
Central banks’ reluctance to tighten policy as long as inflation is low and stable combined with
liberalised financial systems allowing for credit and asset price bubbles causes outsize financial
cycles. Aggressive risk-taking overstretches balance sheets.
Weakness in international interaction
The International Monetary and Financial System amplifies these weaknesses in two ways:
through the interaction of financial regimes (mobile financial capital across currencies and
borders) and monetary policy regimes (spillovers from policy decisions).
This adds an external source of finance boosting further domestic financial booms: the cross-
border component of credit actually tends to outgrow the purely domestic one during financial
booms. This holds both for direct borrowing from foreign banks and for indirect funding, from
domestic banks borrowing abroad and in turn lending to domestic borrowers. Wholesale funding,
banks using funding other than demand deposits to finance operations, increases during credit
booms. This is reflected in rising loan-to-deposit ratios for financial institutions.
More global forces influencing credit supply conditions no doubt are also at work: risk perceptions
and attitudes are transmitted across asset classes through arbitrage and embodied in risk
premiums, explaining why global price risk proxies like the VIX are closely correlated with global
asset pricing and capital and credit flows.
In addition, the interaction of financial regimes can make exchange rates subject to overshooting.
E.g. carry-trade trading strategies, borrowing a low-interest currency and lending in a high-interest
rate one, bet on the failure of uncovered interest parity. Another is the strong wealth effect of
currency appreciation, encouraging borrowers to take on more risk since appreciation decreases
the value of their foreign currency liabilities, risky if the currency depreciates again.
The interaction of monetary regimes spreads easy monetary conditions from core economies to
the rest of the world, hence heightening the risk of build-up of financial imbalances. This is
caused firstly by countries’ resistance to exchange rate appreciation, fearing a loss of
competitiveness, causing monetary authorities to keep interest rates lower than otherwise and
intervene in the foreign exchange market, investing the proceeds in reserve currency assets,
putting downward pressure on foreign bond yields.
Secondly, the outsize role of the US dollar in other countries means any monetary policy actions
of the Fed have global effects.
Historical record
The historical record is broadly consistent with the excess financial elasticity hypothesis.
The amplitude and duration of financial cycles have grown substantially since policy regimes have
become more supportive, starting in the 80s due to financial liberalisation and the establishment
of credible anti-inflation regimes. The amplitude of financial cycles has grown even further since
the 90s, coinciding with positive supply-side developments linked to China and former communist
regimes joining world trade.
The US is graphed here, with the blue line tracing the financial cycle (with credit and property
prices), showing the duration and amplitude of the financial cycle growing. It also indicates that
the financial cycle is much longer
than the traditional business cycle
(red line).
The business cycle is said to have a
duration of up to 8 years, whereas
the financial cycle since the early
80s has been 16 to 20 years, making
it a medium-term process.
Financial imbalances have been
prominent in the global economy
both before and after the Great
Financial Crisis (2007) but there are
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,some differences. Pre-crisis, the
imbalances built mainly in some large
advanced economies such as the US, UK,
and Euro area. Their size meant these
imbalances were also reflected in the
growth of aggregate cross-border credit,
reaching historical highs relative to world
GDP as seen in the first graph. Post-crisis,
as those economies experienced a
financial bust, aggregate cross-border
credit slowed down.
Several emerging market economies
however, and advanced economies less
affected by the crisis, have seen signs of a
build-up of financial imbalances eerily similar.
Typical symptoms are very strong credit
growth (in excess of GDP), booming property
prices as seen in the graph on the right, and
the outsize role of external credit as seen in
the graph above. Whereas credit-to-GDP,
property prices, an outsize role of external
credit, and other indicators of a build-up of
financial imbalances have gone down in the
(advanced) economies most affected by the
’07 crisis, it’s now seen in several emerging
markets.
Another factor supporting the
build-up of financial imbalances
has been an unusually
accommodative global monetary
policy stance alongside strong
foreign exchange accumulation,
as illustrated on the right.
There is considerable evidence
that US monetary policy strongly
influences monetary and financial
conditions elsewhere, suggesting
exchange rates don’t effectively
insulate countries, especially with
regards to bond yields.
Two popular alternative views
The excess financial elasticity hypothesis differs from two popular alternatives: the excess saving
& the excess demand for safe assets view.
The excess saving view
Keynes strongly advocated for the excess saving view in policy making. The excess saving view is
concerned with current account imbalances and the asymmetry of adjustment: surplus countries
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, are under no pressure to adjust, but deficit countries will have no choice to if markets come to
regard their current account deficit as unsustainable. Once markets deem a country’s current
account deficit to be too large, they will deny the country access to financial markets and refuse
to finance it. This causes a crisis and falling aggregate demand, creating a deflationary or
contractionary bias in the global economy. The answer is to generate incentives for surplus
countries to allow their currency to appreciate, or boost their domestic demand. The main large
surplus countries in recent years were China and Germany. Germany is an especially precarious
case given that there is no exchange rate safety valve within the euro area for countries to
devaluate their currencies relative to Germany, making it hard to be competitive for e.g. Italy with
Germany as they lost any option to depreciate relative to the Deutschmark.
A variant of the excess saving view has linked current account imbalances with the Great
Financial Crisis, stating an excess of saving over investment in emerging market countries (as
reflected in their current account surpluses) eased financial conditions in deficit countries and put
downward pressure on world interest rates. This excess saving over investment helped fuel a
credit boom and risk-taking in major advanced economies, as low interest rates encourages risk
taking. From this perspective, monetary policy was simply offsetting powerful deflationary forces.
The author concedes that large and persistent current account imbalances are cause for concern
to the extent they reflect domestic imbalances or unsustainable policies. They may signal chronic
loss of competitiveness, inducing sharp adjustments after a period of neglect, in the form of
exchange rate or external crises. When banking crises break out, large current account deficits
may easily increase the costs to the economy. Persistent current account imbalances coupled
with surplus countries’ unwillingness to allow their exchange rate to appreciate could even cause
protectionism in politics, damaging the world economy.
However, Borio argues that a focus on current accounts is misleading since gross capital flows
are much greater than current account positions, which represent the net capital flow across
countries. Changes in the value of assets and liabilities are much greater than changes in current
accounts driving the net transfer of wealth across countries: the value of gross stocks of assets
and liabilities, and the imbalances they hide, are the main drivers of vulnerability.
Consider the hypothesis that sees current account imbalances and the excess savings they
represent as the origin of the financial crisis. Borio argues that the main driver of banking crises is
the build up of financial imbalances and their subsequent unwinding. The relation between this
build-up and current accounts is not robust: current account deficits aren’t that correlated with
the build-up of financial imbalances. Some major financial crises build up and then unwound
again in countries who actually ran current account surpluses, e.g. the US Great Depression. The
link between current account and financial imbalances is more nuanced, as the building of
financial imbalances boost domestic expenditures relative to output, which tends reduce a current
account surplus or increase a deficit. Large and persistent current account positions are better
seen as reflections of capital flows themselves.
The limited effect of current accounts in this context is simple: current accounts represent net
capital flows, revealing little about financing. Current accounts only capture changes in net claims
on a country arising from trade, thus net resource flows. However, current account excludes the
underlying changes in gross flows and their contributions to existing stocks: trade in financial
assets makes up the bulk of cross-border financial activities, but are not reflected in the current
account. Therefore, current accounts tell us little about a country’s role in international borrowing,
lending, and the degree of foreign credit financing its investments. Or the impact of cross-border
capital flows on domestic financial conditions.
Proponents of the excess saving view argue that surplus countries have room to expand
aggregate demand and should do so to rebalance the world. Whether expanding aggregate
demand helps however depends on domestic conditions: when close to full employment this
could trigger inflationary pressures, and its fiscal position may not be sustainable. The key issue
however is whether the expansion could generate or exacerbate financial vulnerabilities, and if so
the solution could introduce even graver problems, e.g. Japan reducing its large current account
surplus by increasing domestic aggregate demand in the 80s, feeding the build-up of financial
imbalances the caused a later financial crisis.
This all reflects a failure to make a distinction between saving and financing: saving is income
(output) not consumed. Financing is access to purchasing power in the form of some settlement,
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