Benoît Coeuré: Global liquidity and international risk-sharing in the
postcrisis environment
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the Bank of Korea International Conference 2013 "Assessing global liquidity in a global
framework", Seoul, 3 June 2013.
* * *
I wish to thank Roland Beck and Georgios Georgiadis for their contributions to these remarks, as well as Georges
Pineau for his comments. I remain solely responsible for the opinions contained herein.
Ladies and Gentlemen,
Let me first thank the Bank of Korea for the kind invitation to this conference, which is taking
place at a critical time for the global economy. I am delighted that the organisers selected
"Global Liquidity in a Global Framework" as the theme for this year's International
Conference. It is indeed essential that the central bank community makes further progress on
this important issue.
Let me briefly recall how we arrived at this point. Against the background of the G20's work
on global liquidity management, the BIS - via the Committee on the Global Financial System
(CGFS) - undertook important groundwork leading to the Landau Report of the CGFS.1 The
IMF carried out important complementary work in response to the G20's initiative in 2011.2
And the central bank community as well as academia were closely involved in these joint
research efforts. The ECB, for its part, hosted a joint workshop with the BIS on global liquidity
and its international repercussions in February 2012. Since then, further progress has been
made and it is a good time to take stock of where we stand.
The measurement of global liquidity and its drivers
The CGFS has established a relatively broad definition of global liquidity by referring to the
"ease of financing" at the level of the global financial system.3 This definition includes official
liquidity and private liquidity.
An important observation with regard to the drivers of global liquidity is that while official
liquidity can ultimately only be created by central banks, private liquidity is pro-cyclical and
highly endogenous to the conditions that prevail in the global financial system. As a result of
this, there is, as I explained elsewhere in more detail, a "self-reinforcing interaction between
risk appetite and liquidity".4
Against this backdrop, a relatively large set of indicators has been proposed to monitor
trends in global liquidity. But how many of these quantity- and price-based indicators are
really relevant for policy-makers and show developments which are "orthogonal" to what the
other indicators show? Recent research has found that a large set of financial and
macroeconomic indicators for global liquidity can be represented by three main factors which
can be labelled "monetary policy", "credit supply" and "credit demand". These three structural
liquidity factors have contributed to shaping global financial dynamics in the run-up to, and in
the aftermath of, the financial crisis (see slide 2). Before 2007 global credit supply was a
driving force of low interest rates and rapid credit expansion, while since 2008 looser official
liquidity has partly compensated for tighter private liquidity (see slide 3).5 While such purely
statistical exercises should be always treated with caution, it is encouraging that there is a
broad agreement on the main drivers of global liquidity in the academic literature.6
A long-term view on international risk sharing and financial globalisation
A lot of attention is currently being paid to the negative externalities associated with
fluctuations of global liquidity. One prominent example is the discussion about the
international spillovers of unconventional monetary policies in the advanced economies.
Clearly, sustained low interest rates and domestic bond purchases by central banks can spill
over to asset prices elsewhere. Recent empirical studies indicate, however, that the effect of
the various rounds of QE policies by the US Federal Reserve has so far had a relatively
small, albeit pro-cyclical, global impact.7
Furthermore, the international transmission of unconventional monetary policies is not
homogeneous. The first round of QE in the US, mainly aimed at improving market
functioning, had a smaller impact on equity markets and exchange rates in emerging market
economies (EMEs) than the second round of QE policies implemented through large-scale
asset purchases (see slide 4). In addition, "pull-factors" such as positive growth differentials
and financial deepening in EMEs have also been important drivers of capital flows to these
countries (see slide 5). Likewise, while the Bank of Japan's new monetary policy strategy
prompted fears of a "currency war", it is not proven so far that its global impact could be
negative. Nevertheless, this is an important debate, and we have to take the arguments put
forward by EME policy-makers seriously.
However, the current debate focuses too much today on the negative externalities of
domestic monetary policy decisions, and overlooks the fact that global liquidity is closely
intertwined with the degree of international risk-sharing.
International risk-sharing is usually defined as a situation where fluctuations in consumption
are decoupled from idiosyncratic fluctuations in output, and where consumption growth rates
across countries are highly correlated. The disconnect between consumption and output is of
course made possible by lending to, and borrowing from, abroad, hence by cross-border
complete
liquidity flows. Access to a set of contingent financial assets in the sense of Arrow
and Debreu would allow countries to perfectly insure against idiosyncratic risk. As is well
known from the theoretical literature, the benefits of international risk-sharing may be
considerable and should not be underestimated.8
5
See S. Eickmeier, L. Gambacorta and B. Hofmann, "Understanding Global Liquidity", BIS Working Paper
No 402, February 2013. In addition, the relative importance of global liquidity factors varies across regions.
For instance, M2 growth seems dominated by the "credit supply" factor in the euro area, while it is dominated
by monetary policy and macro factors in emerging Asia.
6
See for example V. Bruno and H. Shin: "Capital Flows, Cross-Border Banking and Global Liquidity", Princeton
University, mimeo.
7
See M. Fratzscher, M. Lo Duca and R. Straub, "A global monetary tsunami? On the spillovers of US
Quantitative Easing", CEPR Discussion Paper No 9195, October 2012.
8
See M. Obstfeld, "Evaluating risky consumption paths: The role of intertemporal substitutability", European
Economic Review, vol. 38, no. 7, August 1994, pp. 1471-86, and "Risk-taking, global diversification, and
growth", American Economic Review, vol. 84, no. 5, December 1994, pp. 1310-29. See also more recently,
K. Lewis and E. Liu, "Evaluating International Consumption Risk Sharing Gains: An Asset Return View",
October 2012, working paper presented at the 2013 American Economic Association meeting.
One simple metric often used to gauge the extent of international risk-sharing is the ratio of
gross foreign assets relative to GDP in major economies. This measure has the advantage of
being able to draw on historical time series, allowing us to look at long cycles in financial
globalisation.
Let's look back for a moment. During the first wave of financial globalisation, which was
driven by the British, who were often called the "bankers to the world", foreign assets relative
to GDP reached a peak between 1900 and 1914 (see slide 6). Following a sharp decline
from 1914 to 1945, the share of foreign assets returned to its previous levels only by 1990.
The period between 1990 and the global financial crisis was marked by extensive financial
liberalisation, which led to an unprecedented rise in foreign asset positions. Since the crisis
started this process appears to have levelled off. I will come back to this in a moment.
The euro was introduced in 1999 in a region where all restrictions on capital movements had
been lifted. It is no surprise then that unleashed financial forces led to an expansion of
intraregional cross-border capital flows (mostly flowing from "core" to "peripheral" euro area
economies), exploiting the expanded risk-sharing opportunities created by the single
currency. We now know that risk was neither well assessed nor well monitored, and that
unchecked cross-border lending supported projects with low intrinsic profitability, such as in
the housing sector. Moreover, the structure of these flows (i.e. wholesale interbank credit,
rather than direct loans to firms or capital market investment) was inherently fragile. Credit
between institutions with domestic deposit bases and implicit guarantees from their own
governments soon fragmented along national lines when the financial crisis erupted and
shook confidence in banks.
Let me highlight two salient features of the recent wave of financial globalisation, which have
important consequences for the post-crisis steady state.
The first feature is the geography of wealth transfers before and after the global financial
crisis. As the academic literature9 indicates, the US external balance sheet displays a very
specific pattern: short in "safe" or liquid securities and long in "risky" or illiquid ones. This
implies that the US earned a risk premium before the global financial crisis, but suffered
disproportionate losses during the crisis, when the value of its risky external financial portfolio
collapsed relative to the value of its safe external liabilities.10 In other words, the United
States acted as the world's global insurer (see slide 7). As noted by the same literature, the
euro area and Switzerland have played a comparable role, albeit at a regional level and on a
smaller scale.
Within the euro area, Germany has played a similar role as the United States at the global
level: it was the "regional insurer" in the run-up to the crisis, investing in risky assets in other
euro area countries while selling safe government bonds. Note that Germany did not need to
run a current account deficit to play this role, confirming the modern disconnect between
international risk-sharing and flows of goods and services.
Another salient feature of the recent wave of financial globalisation is the role of cross-border
banking and the interaction between liquidity cycles and the leverage of global banks.11
Before the crisis, the expansion of cross-border lending (and hence of international
risktaking) was made possible by increased bank leverage in a period when perceived risk was
low - in other words, there was "excess elasticity" in the global credit supply.12 The
intermediation role of European banks in the global dollar-denominated market before the
crisis is a case in point.
Following the crisis, global banks retreated from cross-border lending, amplifying the impact
of the financial crisis on those economies that did not have alternative sources of funding,
and prompting partial substitution by official credit. This happened both at the global level
after the demise of Lehman Brothers, prompting large-scale intervention by the IMF and by
multilateral development banks, and within the euro area after 2010, prompting official
support through the EFSF and ESM, and liquidity support by the Eurosystem to banks in
stressed jurisdictions. Here again, the euro area can be seen as a microcosm of the global
economy - just as a Korean garden is a microcosm of nature.
Global liquidity and international risk-sharing in the current environment
One important point in this context is the emergence of a "home bias" and de-globalisation
following the global financial crisis.
These trends have profound effects on the degree of international risk-sharing. But are they
only temporary or do they constitute a level shift in the steady-state level of financial
integration?
An optimistic view is to consider the global financial crisis as a temporary shock, which
impact will fade away.
The persistence of a shock, however, depends on the structural and institutional features of
an economy, as well as the corresponding policy response. And there are some worrying
signals at the global level. In the following brief examples, I will illustrate how the interaction
of institutions and shocks can shape the new post-crisis steady-state level of financial
integration.
In advanced economies, for example, financial regulation and other forms of public
intervention have contributed to global fragmentation. Government bail-outs, risk-based
capital requirements and the ring-fencing of capital and liquidity by local supervisors have
constrained banks' risk-taking outside domestic jurisdictions.13 In the euro area, this has
been compounded by the perception of a rising risk of sovereign default, eroding the fiscal
backing of cross-border liquidity provision.14 As a result, the rise in idiosyncratic country risk
in peripheral countries and the associated increase in government bond yields was
accompanied by a steady increase in the share of domestic holdings of government debt
securities (see slide 8).
Financial fragmentation can, however, also be observed at the global level. Looking at
banking statistics in advanced economies, the relationship between domestic and
international bank lending has steepened compared with the pre-crisis credit boom (see
slide 9).
This is also reflected in the re-emerging correlation between domestic saving and domestic
investment, known as the Feldstein-Horioka puzzle. This is not only driven by declining
current account positions in euro area economies. Similar trends can be observed in other
non-euro area OECD countries (see slide 10). In emerging economies, there seems to be
some decline in financial openness that may be partly associated with policy responses to
international spillovers of unconventional monetary policies (see slide 11).
Of course, reducing external exposure can be warranted if it is driven by risk-return
considerations. European banks, for example, responded to deleveraging pressures by
reducing the exposure to dollar-denominated assets, decreasing thereby their reliance on
volatile US dollar funding (see slide 12).
Overall, the deleveraging of European banks had far-reaching global implications. In Asia, for
example, the share of euro area banks in the provision of cross-border credit has declined,
particularly in areas such as infrastructure and trade credit. (see the left panel of slide 13).
Regional Asian banks took advantage of this opportunity and increased their share in
crossborder credit (see the right panel of slide 13). Similar patterns can be observed in Central
and Eastern European countries. This implies that risk-sharing is increasingly concentrated
at the regional level.
Whether the regionalisation of risk-sharing will be lasting, and whether it will make the global
financial system more robust, are open questions for researchers and policy-makers. Europe
offers a sobering lesson in this respect. The single currency has made participating
economies more resilient to global shocks, but it has magnified the impact of regional
shocks, given the initial absence of a regional financial safety net.
Conclusions and lessons for policy-makers
Let me conclude. Global liquidity is an important concept and our understanding of its drivers
and its effects has improved considerably over the past two years. The further evolution of
global liquidity will depend on the way world trade and investment, and the related financial
flows, globalise and sometimes de-globalise, and this in turn depends on policy reactions to
the financial crisis.
Overall, these trends will have profound effects on international risk-sharing, which for the
time being appears to have decreased or at least levelled off in the immediate post-crisis
environment.
The world has gained a lot from being financially open and the benefits from international
risk-sharing should be preserved. Current concerns related to international spillovers of
unconventional monetary policy in the major advanced economies must not lead to a rise in
financial protectionism. When confronted with a surge in capital flows, the first line of defence
should always consist in macroeconomic adjustment. Capital flow management measures
are also available but they should be used exceptionally and on a temporary basis if all other
policy options have been exhausted, as the IMF has recently said.15
In advanced economies, post-crisis policy interventions should avoid encouraging financial
fragmentation by confining banks' risk-taking to domestic jurisdictions. This is why achieving
a level-playing field in the implementation of new financial regulations is so important. This is
also why the European banking union project, with its single supervisory and its single
resolution mechanisms, matters so much. It is only by restoring the free flow of capital within
the euro area that the full benefits of Economic and Monetary Union can be reaped, and
growth can restart in Europe.
Concerns related to the "excess elasticity" of global credit supply and the pro-cyclical nature
of private liquidity need to be addressed ex ante if we want the international monetary and
financial system to become more resilient to shocks. This is currently being done in various
policy circles, particularly in BIS- associated committees. It covers not only work achieved
within the Basel III framework to improve the resilience of systemically important banks to
shocks to their capital and liquidity, but also ongoing work related to financial market
infrastructures and the regulation of shadow banking. This work is geared at improving the
resilience of individual institutions but also, and maybe more importantly, at dampening the
global financial cycle. If well coordinated at the international level, the new micro- and
macroprudential instruments should go a long way in addressing global liquidity issues and
potential imbalances.
Further reflection is also warranted on the provision of public liquidity, i.e. precautionary
foreign-exchange reserve holdings and on international coordination in the face of global
liquidity shocks. The rise of regional risk-sharing, if confirmed, will make regional financing
arrangements (such as the European Stability Mechanism and the Chiang Mai Initiative)
even more useful, but it will also call for fresh thinking on their interaction with each other and
with global financial safety nets.. Following the seminal work of the G-20 Korean Presidency,
I expect that the IMF will be doing further work in this area.
However, improved global and regional safety nets cannot and should not substitute for
resilient banks and capital markets and strict risk management in the financial industry. To
borrow from the theory of insurance, we should strike the right balance between ex-post and
ex-ante efficiency. At a domestic as well as at a global level, public balance sheets can
expand during a crisis only if they can revert to normal thereafter, letting private transactions
thrive again, and if the associated moral hazard is mitigated by strong prudential policies.
Only then will a "third wave" of financial globalisation benefit from the lessons of the past.
Thank you for your attention.
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