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Risk-On/Risk-Off, Capital Flows, Leverage, and Safe Assets

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  • Robert N. McCauley

    (Asian Development Bank Institute (ADBI))

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 “sterilize†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 East Asian Bureau of Economic Research in its series Finance Working Papers with number 23390.

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Date of creation: Jan 2013
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Handle: RePEc:eab:financ:23390

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Keywords: global equity markets; porfolio investment; Emerging Markets; central banks;

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References

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  1. 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," CARF F-Series, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo CARF-F-264, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
  2. 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.
  3. Aizenman, Joshua & Hutchison, Michael, 2010. "Exchange Market Pressure and Absorption by International Reserves: Emerging Markets and Fear of Reserve Loss During the 2008-09 Crisis," Santa Cruz Department of Economics, Working Paper Series, Department of Economics, UC Santa Cruz qt8g25f4qs, Department of Economics, UC Santa Cruz.
  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. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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.
  11. 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.
  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. 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.
  14. Jacob Gyntelberg & Andreas Schrimpf, 2011. "FX strategies in periods of distress," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, December.
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Cited by:
  1. Joshua Aizenman & Brian Pinto & Vladyslav Sushko, 2013. "Financial sector ups and downs and the real sector in the open economy: Up by the stairs, down by the parachute," BIS Working Papers, Bank for International Settlements 411, Bank for International Settlements.
  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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