Global liquidity and procyclicality

Global liquidity and procyclicality*

Hyun Song ShinBank for International Settlements

Barcelona Graduate School of Economics Lecture, 27 April 2017

* The views expressed here are mine, not necessarily those of the Bank for International Settlements.

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Financial channel of exchange rates

Conventional view Global economy as a collection of islands Exchange rates determine trade balance Depreciation is expansionary

Financial channel of exchange rates Global economy is matrix of financial claims Matrix does not respect geography Exchange rates influence risk-taking Appreciation is expansionary

Impact of currency appreciation on bond spreads

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The two panels show the accumulated impulse response functions (IRFs) in a panel VAR of EME bond market indicators to a one standard deviation exchange rate shock. Each IRF comes from a separate VAR with exchange rate ordered last. The left-hand panels show IRF for a one standard deviation appreciation shock to the bilateral exchange rate against the US dollar, while the right-hand panel show IRFs for a one standard deviation appreciation shock to the nominal effective exchange rate (NEER). See Hofmann, Shim and Shin (2017) for further details

Impact of appreciation against dollar on local currency bond spread over UST

Impact of appreciation against dollar on Du-Schreger (2015) spread over UST

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Impact of currency appreciation on industrial production

Impact of currency appreciation against dollar on industrial production

The two panels show the accumulated impulse response functions (IRFs) in a panel VAR of EME industrial production to a one standard deviation exchange rate shock. Each IRF comes from a separate VAR with exchange rate ordered last. The left-hand panels show IRF for a one standard deviation appreciation shock to the bilateral exchange rate against the US dollar, while the right-hand panels show IRF for a one standard deviation appreciation shock to the nominal effective exchange rate (NEER). See Hofmann, Shim and Shin (2017) for further details

Impact of trade-weighted exchange rate appreciation on industrial production

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Two questions

Why are global financial conditions so attuned to the strength of the dollar?

Why is the real economy so sensitive to global financial conditions?

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Cross-border US dollar denominated positions of BIS reporting banksIn trillions of US dollarsBy residence By nationality1

1 The break in series between Q1 2012 and Q2 2012 is due to the Q2 2012 introduction of a more comprehensivereporting of cross-border positions. For more details, see www.bis.org/publ/qtrpdf/r_qt1212v.htm.

Sources: BIS locational banking statistics, Tables A5 (by residence) and A7 (by nationality).

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US dollar-denominated cross-border bank claims In USD billions

2002

Source: BIS locational banking statistics by residence.

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US dollar-denominated cross-border bank claims In USD billions

2003

Source: BIS locational banking statistics by residence.

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US dollar-denominated cross-border bank claims In USD billions

2004

Source: BIS locational banking statistics by residence.

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US dollar-denominated cross-border bank claims In USD billions

2005

Source: BIS locational banking statistics by residence.

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US dollar-denominated cross-border bank claims In USD billions

2006

Source: BIS locational banking statistics by residence.

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US dollar-denominated cross-border bank claims In USD billions

2007

Source: BIS locational banking statistics by residence.

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US dollar- and euro-denominated cross-border bank claims In USD billions

2007

Source: BIS locational banking statistics by residence.

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2008

US dollar-denominated cross-border bank claims In USD billions

Source: BIS locational banking statistics by residence.

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2009

US dollar-denominated cross-border bank claims In USD billions

Source: BIS locational banking statistics by residence.

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2010

US dollar-denominated cross-border bank claims In USD billions

Source: BIS locational banking statistics by residence.

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2011

US dollar-denominated cross-border bank claims In USD billions

Source: BIS locational banking statistics by residence.

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2012

US dollar-denominated cross-border bank claims In USD billions

Source: BIS locational banking statistics by residence.

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2013

US dollar-denominated cross-border bank claims In USD billions

Source: BIS locational banking statistics by residence.

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2014

US dollar-denominated cross-border bank claims In USD billions

Source: BIS locational banking statistics by residence.

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Global role of the dollar

Step 1: invoicing currency for trade

Step 2: funding currency for investment Oil and gas sector, for example Currency denomination of diversified global portfolio

Step 3: dollar liabilities of global banks who provide hedging for investors

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Risk-taking channel of exchange rates

“When an international currency depreciates, foreigners borrow more in that currency”

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US dollar cross-border bank lending depends on the dollar exchange rateCross-border bank lending to non-residents vs NEER1

20-quarter rolling window regressions2

1 Plot of quarterly growth rate of cross-border bank lending in US dollars on quarterly changes in the US dollar nominaleffective exchange rate (NEER) for Q1 2003–Q3 2015. Lending refers to loans by BIS reporting banks to all (bank andnon-bank) borrowers outside the US. The line is a fitted regression line. Positive changes indicate an appreciation of thedollar. 2 Rolling regression coefficient for 20-quarters window.

Sources: BIS locational banking statistics; BIS effective exchange rate indices; BIS calculations.

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Euro-denominated cross-border bank lending

Cross-border bank lending to non-residents vs NEER1

20-quarter rolling window regressions2

1 Plot of quarterly growth rate of cross-border bank lending in euros on quarterly changes in the euro NEER forQ1 2003–Q3 2015. Lending refers to loans by BIS reporting banks to all (bank and non-bank) borrowers outside the euroarea. Positive changes indicate an appreciation of the euro. 2 Rolling regression coefficient for 20-quarters window.

Sources: BIS locational banking statistics; BIS effective exchange rate indices; BIS calculations.

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Risk-taking channel in EMEs

Many have dollar cash flows Exporters Commodity producers

Some do not Property developers Utilities

Even with dollar cash flows, strong dollar present strains Commodity prices negatively correlated with the dollar Fiscal tightening Spillover into local currency sovereign yields

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Illustrating the risk-taking channel for EMEsBilateral USD exchange rate and five-year sovereign CDS, change from end-2012

End-September

2013

BR = Brazil; ID = Indonesia; MX = Mexico; MY = Malaysia; RU = Russia; TR = Turkey; ZA = South Africa. The size of the bubbles indicates the size of US dollar-denominated credit to non-banks in the respective economies in Q4 2015.

Sources: Avdjiev et al (2015); Datastream; Markit; national data; BIS; BIS calculations.

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Illustrating the risk-taking channel for EMEsBilateral USD exchange rate and five-year sovereign CDS, change from end-2012

End-June2015

BR = Brazil; ID = Indonesia; MX = Mexico; MY = Malaysia; RU = Russia; TR = Turkey; ZA = South Africa. The size of the bubbles indicates the size of US dollar-denominated credit to non-banks in the respective economies in Q4 2015.

Sources: Avdjiev et al (2015); Datastream; Markit; national data; BIS; BIS calculations.

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Illustrating the risk-taking channel for EMEsBilateral USD exchange rate and five-year sovereign CDS, change from end-2012

End-September

2015

BR = Brazil; ID = Indonesia; MX = Mexico; MY = Malaysia; RU = Russia; TR = Turkey; ZA = South Africa. The size of the bubbles indicates the size of US dollar-denominated credit to non-banks in the respective economies in Q4 2015.

Sources: Avdjiev et al (2015); Datastream; Markit; national data; BIS; BIS calculations.

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Illustrating the risk-taking channel for EMEsBilateral USD exchange rate and five-year sovereign CDS, change from end-2012

End-April2016

BR = Brazil; ID = Indonesia; MX = Mexico; MY = Malaysia; RU = Russia; TR = Turkey; ZA = South Africa. The size of the bubbles indicates the size of US dollar-denominated credit to non-banks in the respective economies in Q4 2015.

Sources: Avdjiev et al (2015); Datastream; Markit; national data; BIS; BIS calculations.

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Breaking free of the triple coincidenceUnit of analysis is national income (GDP) area

Economic territory 1 Economic territory 2

Output 1 Output 2

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Breaking free of the triple coincidenceGDP boundary defines decision making unit

Economic territory 1 Economic territory 2

A L A L

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Breaking free of the triple coincidenceUse of currency largely within GDP boundary

Central bank 1 Central bank 2

Residents in 1 Residents in 2

Exchange rate

Economic territory 1 Economic territory 2

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A L

A L

Local currency

Local currency Local

currency

US dollars

Bank

Non-financial corporation

Border

International capital market

Balance sheets do not map neatly to GDP boundaryExample 1: EME firm borrowing dollars offshore

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Borrowersin A

Borrowersin B

Borrowersin C

Banksin A

Banksin B

Banksin C

GlobalBanks

WholesaleFundingMarket

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Borrowersin A

Borrowersin B

Borrowersin C

Banksin A

Banksin B

Banksin C

GlobalBanks

WholesaleFundingMarket

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Balance sheets do not map neatly to GDP boundaryExample 2: European bank lending dollars in Asia

Asset side of the global bank could be in a regional financial centre (Hong Kong or Singapore, say)

Liabilities side of the global bank could in the United States

What of the European headquarters? Where does it fit in the picture?

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Failure of covered interest parity (CIP)

Failure of covered interest parity is window on strains in global financial system

Covered interest parity “Interest rates implicit in foreign exchange markets are

consistent with market interest rates.”

Are they?

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US dollar interest rate implied by FX swaps

Three-month US dollar interest rate implied by FX swaps1

In per cent

1 Implied US dollar interest rate in an FX swap involving the indicated currency. Three-month US dollar Libor rate is plotted for comparison.

Sources: Bloomberg; Datastream; BIS calculations.

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Cross-currency basis against US dollar

FX swap spread, three-month1

Basis points

1 Spread between three-month US dollar Libor and three-month dollar rate implied US dollar interest rate in an FX swap involving the indicated currency.Sources: Bloomberg; Datastream; BIS calculations.

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The cross-currency basis is the mirror image of dollar strength.

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The basis co-moves very closely with the exchange rate...

…even at a daily frequency.

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Challenges for models of international finance

General equilibrium models are about GDP components Consumption, investment, …

But balance sheets do not always follow the GDP boundary Can be messy to have two overlapping partitions of all

decision makers in the world

Some progress can be made if concern is with global variables Global factors determining economic conditions “Global liquidity” Risk-taking channel