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Managing Elevated Risk

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Nguyễn Gia Hào

Academic year: 2023

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The first and second phases of global liquidity form the basis for the third phase. In this chapter, we describe three recent phases of global liquidity and discuss the policy implications of each phase for emerging Asia.1 The first phase is the period leading up to the 2008/2009 global financial crisis (GFC) and its immediate aftermath. the collapse of Lehman Brothers in September 2008.

Conceptual and Measurement Issues

First, the national income threshold is often used in aggregated economic models to define the unit of decision. In particular, for example, the balance of the decision unit is determined by the limit set by the national income accounts.

First Phase of Global Liquidity

Round-Trip Bank Flows to the US

Additional insight into the nature of gross capital flows through the banking system can be obtained by monitoring the interbank claims of foreign banks operating in the United States. Gross capital flows to the US through European bank lending through the shadow banking system played a key role in influencing US credit conditions in the run-up to the subprime crisis.

Fig. 2.2   Amount owed by banks to US prime money market funds (% of total, by national- national-ity of borrowing bank)
Fig. 2.2 Amount owed by banks to US prime money market funds (% of total, by national- national-ity of borrowing bank)

Banking Sector Flows to the Rest of the World

The interconnected nature of the global banking system generates spillover effects of financial conditions across borders. Thus, the enabling conditions of liquidity in the US dollar wholesale market will be transmitted through the global banking system to other parts of the world.

Figure 2.7 depicts the institutional backdrop to the operation of the global bank- bank-ing system
Figure 2.7 depicts the institutional backdrop to the operation of the global bank- bank-ing system

Exchange Rates and Leverage

In this situation, the initial appreciation of the recipient economy's currency will strengthen the balance sheets of domestic borrowers who borrowed in dollars. The upward phase of the cycle will give the appearance of a virtuous circle in which the mutually reinforcing effect of real appreciation and improved balance sheets work in tandem.

Second Phase of Global Liquidity

If an emerging market corporate borrower issues corporate bonds through its overseas subsidiary - for example in London - the usual balance of payments definition (based on residence) will treat the bonds as a liability of the UK entity. Billions of dollars Non-banks(International . debt securities) Non-banks (external debt obligations) Banks (international debt securities) Banks (external debt obligations).

Fig. 2.11   Government international debt securities outstanding (2005Q1  =  1). Source Debt  Securities Statistics, Bank for International Settlements
Fig. 2.11 Government international debt securities outstanding (2005Q1 = 1). Source Debt Securities Statistics, Bank for International Settlements

The Case of Emerging Asia

The advantage of liability measures comes from the role that NFCs play "along" the border. We investigate the implications for bank behavior using flow of funds (FOF) data from five Asian economies—Indonesia; Republic of Korea; Philippines;

Fig. 2.19   Gross capital inflows—selected East Asian economies. FDI foreign direct invest- invest-ment
Fig. 2.19 Gross capital inflows—selected East Asian economies. FDI foreign direct invest- invest-ment

Third Phase and Onward

Note G3 currency bond issuance covers data for the People's Republic of China; Hong Kong, China;. With the exception of the renminbi and the Philippine peso, all emerging Asian economies fell against the US dollar following the May 22 announcement. CDS spreads in China, Malaysia and the Philippines also rose despite their better fundamentals.

Table 2.1  Vulnerability indicators GDP gross domestic product 1  For India, latest figures are compared with 1991 (annual), not 1997 2  Annual 1996 current account as % of GDP data for People’s Republic of China; Hong Kong, China; India; Malaysia; the Phi
Table 2.1 Vulnerability indicators GDP gross domestic product 1 For India, latest figures are compared with 1991 (annual), not 1997 2 Annual 1996 current account as % of GDP data for People’s Republic of China; Hong Kong, China; India; Malaysia; the Phi

Principles for Selection of Early Warning Indicators

However, some authors raise questions about the real-time properties of the credit-to-GDP measure. Therefore, lending may continue to increase for some time after the onset of the crisis. Thus, the relationship between the two gives a misleadingly large credit-to-GDP ratio during the crisis.

Figure 3.1 shows the CDS spreads of Bears Stearns and Lehman Brothers, with  the right-hand panel giving the longer term perspective and illustrating how these  spreads increased sharply with the onset of the crisis.
Figure 3.1 shows the CDS spreads of Bears Stearns and Lehman Brothers, with the right-hand panel giving the longer term perspective and illustrating how these spreads increased sharply with the onset of the crisis.

Core and Noncore Liabilities

The distinction between core and non-core liabilities becomes meaningful when there are differences in the empirical properties of the two types of liabilities. After a lull in the early 2000s, non-core liabilities rose rapidly in the run-up to the 2008/2009 crisis. The point of contact between FCY liabilities in the Republic of Korea and corporate deposits in the PRC is that both are bank liabilities.

Fig. 3.4    Lending boom financed by noncore liabilities. Note Increased lending during a credit  boom is financed by noncore liabilities
Fig. 3.4 Lending boom financed by noncore liabilities. Note Increased lending during a credit boom is financed by noncore liabilities

Bank-Led Flows, Noncore Liabilities, and Credit Growth

Direct Investment Portfolio and debt-led flows Bank-led flows Official inflows Non-core liabilities of banks. Separated by economy, until 2012, only Hong Kong, China; Singapore; and the Republic of Korea had a higher proportion of non-core liabilities than most developing countries (Fig. 4.7). The slope of non-core liabilities is higher than that of core liabilities in all economies.

Figure  4.4 summarizes this link for emerging Asia. As the cumulative change  (increase) of bank-led flows surged before the global financial crisis, so did   noncore bank liabilities
Figure 4.4 summarizes this link for emerging Asia. As the cumulative change (increase) of bank-led flows surged before the global financial crisis, so did noncore bank liabilities

Reassessing Monetary Policy

Returning our focus to the effect of monetary policy on non-core liabilities, we use a model that directly relates interest rates to non-core liabilities. If monetary policy is effective, the coefficients of the interest rate variables will be significant and have a negative sign. After controlling for GDP growth, none of the policy rate coefficients—when run against non-core liabilities—are found to be significant (Table 4.4).

Table 4.4   Regression results on policy rates and bank liabilities
Table 4.4 Regression results on policy rates and bank liabilities

Appendix

As potent as monetary policy can be, the increasing role of non-core liabilities in influencing credit clearly points to the need for complementary measures to make monetary policy more effective. More specifically, in the case of increased bank-led flows, the impact depends critically on whether the recipient banks take on more risk or not. Using a theory-based ranking and considering the benefits, opportunities, costs and risks of alternative criteria and policies, we find that imposing a macroprudential tax on bank-led flows, the same tool we proposed in an earlier chapter, may actually produce more favorable results.

Fig. 4.13   Bank-led flows and noncore liabilities. Notes (1) Levels (in USD billion) are log- log-transformed
Fig. 4.13 Bank-led flows and noncore liabilities. Notes (1) Levels (in USD billion) are log- log-transformed

National Policy Remains Key

One of the most important – if controversial – components of the liberalization of the financial sector is the liberalization of capital accounts. Policy recommendations thus focus on fixing these institutional factors; they never question the benefit of capital account liberalization itself. Only recently have analysts and researchers admitted that early preaching of financial sector liberalization and capital account liberalization was flawed (CIEPR 2012).

Fig. 5.1   Capital inflows and outflows—selected Asian economies. AFC Asian financial crisis;
Fig. 5.1 Capital inflows and outflows—selected Asian economies. AFC Asian financial crisis;

How Capital Flows Affect Income Inequality

Thus, the income of various entities, including households, is affected by the level of economic activity and this non-factor income.7 The way subsidies are allocated can significantly affect the actual household income; typically, most subsidies go to low-income households. Given that the financial sector often grows much faster than the real sector during a boom, the impact on income distribution is predictable – the rich earn much more than the poor, and urban household income grows faster than rural income. Thus, using this mechanism, we strongly argue that – in addition to standard factors such as technology, globalization, education and domestic institutions – the trend of rising inequality can be exacerbated by the non-inclusive nature of financial sector growth.

Fig. 5.2   Flowchart connecting real financial sector and income distribution. Source Modified  from Azis (2014)
Fig. 5.2 Flowchart connecting real financial sector and income distribution. Source Modified from Azis (2014)

Prioritization for a Multi-objective Goal

We have argued all along that some form of capital control can help – in the form of direct quantitative control, such as imposing a macroprudential levy on bank-led flows (the role of such a levy as macroprudential policy and its application are discussed in the next chapter). While all three rank the same – outflow incentives are most preferred, followed by levies and regional financial backstops (hence the ranking in the last column of Table 5.1) – the normalized eigenvector and 0.1261) under “Normal ” with the sum equal to unit is most commonly used. The top panel ranks BOCR equally, with the last column showing the superiority of "Assign Levy". The middle and bottom panel show the results of sensitivity analyses; the middle represents a more subdued option, with COST and RISK clusters outweighing BENEFITS and OPPORTUNITY.

Fig. 5.5   Eurozone, Japan, United States (US), and People’s Republic of China total outflows   ($ billion)
Fig. 5.5 Eurozone, Japan, United States (US), and People’s Republic of China total outflows ($ billion)

Appendix

Only the order of the other two policies is reversed when an additive approach is used. Min HH (2014) The analysis of the relationship between capital flows and macroeconomic-financial-spatial income distribution indicators: combination of financial CGE and perception models. Saaty TL (2005) Theory and applications of the analytic network process: decision making with benefits, opportunities, costs and risks.

Fig. 5.8   Super-matrix of a  network
Fig. 5.8 Super-matrix of a network

Tailoring Policies to Vulnerabilities

Standard policy measures may need to be revised given the formidable role played by "supply-push" factors, the growing importance of capital markets in the determination of monetary aggregates, and the specific circumstances, including societal development challenges, of each economy. The global financial crisis of 2008/2009 and the unwinding of the first phase of bank-led global liquidity admittedly entailed a lot of deleveraging. The financial market's "taper tantrum" in 2013 and the renewed turbulence in early 2014 were associated with selling pressure in fixed income mutual funds, particularly those with emerging market debt.

Macroprudential Tools

Bank Capital-Oriented Tools

So, these two issues - the accuracy of quantitative indicators and political economy problems - are in fact very closely related. Secondly, there is the direct effect on the growth of non-core liabilities and therefore on the build-up of vulnerabilities arising from the liability side of the balance sheet. However, a disadvantage of the reserve requirement is that it only applies to banks, rather than other financial institutions that use non-core liabilities.

Relative Merits of URR Versus Levies/Taxes

The reserve requirement increases income to the extent that the net income on assets held by the central bank and funded by the reserves will be positive. There is one benefit of URRs that is not shared by the levy—banks will have access to a liquid asset in the event of a liquidity shortage or run on the financial market. In this respect, the URR will have some of the features of the Basel III liquidity requirement on banks (BCBS 2010).

Relationship with Other Stabilization Policies

However, there is much better evidence on the effects of capital controls on financial stability. A study by Maguda et al. 2011) conducts a “meta-analysis” of the existing survey literature on the effects of capital controls. Capital controls (i) make monetary policy more independent; (ii) changes the composition of capital flows; and (iii) reduces pressures on the real exchange rate (although the evidence for the latter is more controversial).

Financial Integration and Institutional Design

As a consequence, foreign claims are quite important and concentrated in Spanish banks, reaching about half of the domestic credit in Peru (Fig. 6.2). If we examine the percentage of total credit taken up by foreign receivables from BIS reporting banks, the presence of Spanish banks is far less visible in Asia compared to Latin America. Overall, foreign claims as a share of domestic credit are a much larger part in Latin America than in Asia.

Fig. 6.1   Foreign claims of BIS-reporting Banks on Latin America and the Caribbean (as of  2011Q2)
Fig. 6.1 Foreign claims of BIS-reporting Banks on Latin America and the Caribbean (as of 2011Q2)

Policy Choices

First, the trigger of capital outflows is a decrease in perceived risk in the US, not changes in the fundamentals of emerging Asia. Second, capital markets in emerging Asia have grown steadily since the crisis of 1997/1998, meaning that monetary aggregates are no longer influenced by monetary policy alone. The effects on the balance sheets of different institutions need to be assessed more precisely. The problem of increased debt service is related to a debt structure in which the proportion of FCY-denominated debt with short maturities is high - the double mismatch problem.

Fig. 6.4   Monthly capital flows to the banking sector in the Republic of Korea. Source Bank of  Korea
Fig. 6.4 Monthly capital flows to the banking sector in the Republic of Korea. Source Bank of Korea

Hình ảnh

Fig. 2.8   Banking sector credit to nonfinancial borrowers in Spain. Source Bank of Spain
Fig. 2.10   Foreign currency assets and liabilities of BIS-reporting banks (by currency)
Fig. 2.11   Government international debt securities outstanding (2005Q1  =  1). Source Debt  Securities Statistics, Bank for International Settlements
Fig. 2.12   Nonfinancial corporate international debt securities outstanding by developing region
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