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Risk-on/risk-off, capital flows, leverage and safe assets

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  • Robert N McCauley

Abstract

This paper describes the international flow of funds associated with calm and volatile global equity markets. During calm periods, portfolio investment by real money and leveraged investors in advanced countries flows into emerging markets. When central banks in the receiving countries resist exchange rate appreciation and buy dollars against domestic currency, they end up investing in medium-term bonds in reserve currencies. In the process they fund themselves (or "sterilise" the expansion of local bank reserves) by issuing safe assets in domestic currency to domestic investors. Thus, calm periods, marked by leveraged investing in emerging markets, lead to an asymmetric asset swap (risky emerging market assets against safe reserve currency assets) and leveraging up by emerging market central banks. In declining and volatile global equity markets, these flows reverse, and, contrary to some claims, emerging market central banks draw down reserves substantially. In effect emerging market central banks then release safe assets from their reserves, supplying safe havens to global investors.

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Bibliographic Info

Paper provided by Bank for International Settlements in its series BIS Working Papers with number 382.

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Length: 19 pages
Date of creation: Jul 2012
Date of revision:
Handle: RePEc:bis:biswps:382

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Keywords: Capital flows; safe assets; international flow of funds; VIX; global liquidity;

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References

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  1. Kathryn M. E. Dominguez & Yuko Hashimoto & Takatoshi Ito, 2011. "International Reserves and the Global Financial Crisis," NBER Chapters, National Bureau of Economic Research, Inc, in: Global Financial Crisis National Bureau of Economic Research, Inc.
  2. Andrew Filardo & James Yetman, 2012. "The expansion of central bank balance sheets in emerging Asia: what are the risks?," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, June.
  3. Richards, Anthony, 2005. "Big Fish in Small Ponds: The Trading Behavior and Price Impact of Foreign Investors in Asian Emerging Equity Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 40(01), pages 1-27, March.
  4. Patrick McGuire & Goetz von Peter, 2008. "International banking activity amidst the turmoil," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, June.
  5. Dominguez, Kathryn M.E., 2012. "Foreign reserve management during the global financial crisis," Journal of International Money and Finance, Elsevier, Elsevier, vol. 31(8), pages 2017-2037.
  6. Petra Gerlach & Robert N McCauley & Kazuo Ueda, 2011. "Currency intervention and the global portfolio balance effect: Japanese and Swiss lessons, 2003-2004 and 2009-2010," CIRJE F-Series, CIRJE, Faculty of Economics, University of Tokyo CIRJE-F-830, CIRJE, Faculty of Economics, University of Tokyo.
  7. Jacob Gyntelberg & Mico Loretan & Tientip Subhanij & Eric Chan, 2009. "International portfolio rebalancing and exchange rate fluctuations in Thailand," BIS Working Papers, Bank for International Settlements 287, Bank for International Settlements.
  8. Robert N. McCauley, 2013. "Renminbi internationalisation and China’s financial development," Journal of Chinese Economic and Business Studies, Taylor & Francis Journals, Taylor & Francis Journals, vol. 11(2), pages 101-115, May.
  9. Joshua Aizenman & Michael M. Hutchison, 2010. "Exchange Market Pressure and Absorption by International Reserves: Emerging Markets and Fear of Reserve Loss During the 2008-09 Crisis," NBER Working Papers 16260, National Bureau of Economic Research, Inc.
  10. Joshua Aizenman & Yi Sun, 2009. "The Financial Crisis and Sizable International Reserves Depletion: From 'Fear of Floating' to the 'Fear of Losing International Reserves'?," Working Papers, Hong Kong Institute for Monetary Research 382009, Hong Kong Institute for Monetary Research.
  11. Claudio Borio & Robert McCauley & Patrick McGuire, 2011. "Global credit and domestic credit booms," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, September.
  12. Stefan Avdjiev & Robert McCauley & Patrick McGuire, 2012. "Rapid credit growth and international credit: Challenges for Asia," BIS Working Papers, Bank for International Settlements 377, Bank for International Settlements.
  13. Jacob Gyntelberg & Andreas Schrimpf, 2011. "FX strategies in periods of distress," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, December.
  14. Robert N McCauley & Patrick McGuire, 2009. "Dollar appreciation in 2008: safe haven, carry trades, dollar shortage and overhedging," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, December.
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Cited by:
  1. Aizenman, Joshua & Pinto, Brian & Sushko, Vladyslav, 2013. "Financial sector ups and downs and the real sector in the open economy: Up by the stairs, down by the parachute," Emerging Markets Review, Elsevier, Elsevier, vol. 16(C), pages 1-30.
  2. Reinout De Bock & Irineu E. Carvalho Filho, 2013. "The Behavior of Currencies during Risk-off Episodes," IMF Working Papers, International Monetary Fund 13/8, International Monetary Fund.
  3. Jotikasthira, Chotibhak & Lundblad, Christian & Ramadorai, Tarun, 2013. "How do foreign investors impact domestic economic activity? Evidence from India and China," Journal of International Money and Finance, Elsevier, Elsevier, vol. 39(C), pages 89-110.

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