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

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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Article provided by EY Global FS Institute in its journal Journal of Financial Perspectives.

Volume (Year): 1 (2013)
Issue (Month): 2 ()
Pages: 145-154

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Handle: RePEc:ris:jofipe:0024
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  1. 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 382009, Hong Kong Institute for Monetary Research.
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  12. Stefan Avdjiev & Robert McCauley & Patrick McGuire, 2012. "Rapid credit growth and international credit: Challenges for Asia," BIS Working Papers 377, Bank for International Settlements.
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  17. Anthony Richards, 2004. "Big Fish in Small Ponds: The Trading Behaviour and Price Impact of Foreign Investors in Asian Emerging Equity Markets," RBA Research Discussion Papers rdp2004-05, Reserve Bank of Australia.
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