Monday, March 21
Dubravko Mihaljek, Head of Macroeconomic Analysis, Bank for International Settlements
What are the current patterns of global capital flows? Why are some countries running persistent current account deficits or surpluses? On March 21, Mr. Dubravko Mihaljek, Head of Macroeconomic Analysis at the Bank for International Settlements in Basel and currently visiting the Oesterreichische Nationalbank, presented his views on what has recently been learned about international capital flows at the JVI.
Mr. Mihaljek first reminded the audience that traditionally domestic and external imbalances were perceived as mirror images of each other, with capital flows a counterpart to domestic saving and investment decisions. The traditional understanding rests on some strong assumptions, including that activities of households, firms and the government can be summed up and analyzed as activities of a single agent; that all economic activity of this agent takes place only within the national GDP boundary; and that all lending and borrowing within that boundary takes place only in domestic currency. This “triple coincidence” of the decision-making unit and economic and currency areas helps distinguish between the national economy and the rest of the world, and sees the two sides as counterbalancing each other. That is, the current account deficit in the national economy equals the current account surplus in the rest of the world, and surplus countries finance the deficit countries. This also implies that one can approach the external balance by looking at net flows between different countries. In such a world, standard macroeconomic policies should be able to correct any imbalances and the so-called “trilemma” guides strategic policy choices.
Old and New Puzzles
Economists have long observed a number of developments that they have found challenging to explain in this framework. Mr. Mihaljek included among the older “puzzles” the persistence of current account deficits or surpluses, and “uphill” capital flows from less developed to advanced economies. For instance, advanced economies such as Australia, the United Kingdom and the United States have run current account deficits for many decades, while emerging markets like China and South Korea have run persistent surpluses. And both groups of countries have simultaneously invested abroad and received large capital inflows. Such patterns of external imbalances and capital flows are hard to reconcile with the traditional model.
New puzzles emerged during the recent global financial crisis, including substantial capital flows between the euro area and the U.S., despite the roughly balanced current account for the euro area as a whole. A close look at gross capital flows data showed that EU banks were borrowing from the United States mainly through short-term loans, which were invested back into U.S. bonds, many backed by subprime mortgages. This way, growing capital inflows from Europe to the U.S. effectively relaxed financing conditions in the latter and contributed to the housing bubble there as well as the build-up of vulnerabilities in the European banking sector. When the crisis began in September 2008, EU banks not only suffered major losses on U.S. securities, but also contributed to turbulence in foreign exchange markets by pushing up demand for dollars in order to repay the short-term dollar loans.
Lessons and the Emerging View
Looking back at what might have failed, Mr. Mihaljek emphasized that while the capital flows data were ample, financial regulation in both advanced and emerging market economies was lax, and monetary policy effectively encouraged borrowers to increase their short-term debt. At the same time, the prevailing international finance models based on the “triple coincidence” made it difficult to identify vulnerabilities as they were building. For instance, the ability of foreign (EU) banks to operate in the national (U.S.) market with seemingly balanced net financial positions could not be captured by the traditional macroeconomic models.
Mr. Mihaljek asked whether something similar had been going on in recent years. Before the crisis, cross-border bank lending was the single most important contributor to growing capital flows. Today, those flows have greatly diminished. At the same time, corporations from EMEs have massively expanded their external borrowing by issuing bonds in international markets, often in off-shore financial centers. Such offshore borrowing by EME firms has often ended up in risky financial products rather than real investment in home markets, thus contributing to the build-up of domestic financial vulnerabilities in EMEs.
In conclusion, Mr. Mihaljek suggested that the traditional “triple coincidence” view guiding our policies could be quite misleading. He called for more attention to financial rather than current account imbalances, to gross rather than net capital flows and, given recent developments, to sectoral rather than aggregate balance sheets.
Asel Isakova, Economist, JVI