Source: “Accounting for global liquidity: reload the matrix” by Hyun Song Shin (4/19/2017)
In this post, I provide some notes on Hyun’s speech and conclude with some lessons for my investing. The speech was given April 19, 2017 in Washington DC at the IMF-IBRN Joint Conference “Transmission of Macroprudential and monetary policies across borders”.
Hyun starts his speech talking about regulation as interference in the workings of the economy, concluding that some regulation is optimal.
Then he describes the international finance “caricature”:
“Here is the caricature. The global economy is a collection of islands where the exchange rate determines the trade balance. A weaker currency boosts one island’s economy through higher exports.”
In reality, it is not so simple.
Hyun says the trade channel is only part of it and later a dated simplistic way of looking at currency effects. There’s also a financial channel, where a “stronger currency [versus USD] goes hand-in-hand with a lending boom and buoyant investment activity on the back of strong capital inflows”.
Some evidence:
- Cross-border lending depends on strength of the USD.
- When the dollar is weak, investment is buoyant across the emerging market economies. But when the dollar strengthens, investment turns weaker.
These three panels show the effect of dollar appreciation on EMs.
Left-hand panel: shows strengthening dollar is associated with a fall in dollar-denominated cross-border bank lending.
Right-hand panel: shows that there is a significant drop in investment when the domestic currency weakens against the dollar.
Middle panel: shows that cross-border lending goes hand-in-hand with investment activity. For a few reasons:
- Financing real investment with dollars (nothing new here)
- Exchange rates provide another vehicle to take risk or structure investments, especially when borrowers assets and liabilities are in different currencies (usually the case for EM firms)
- The dollar plays a role in determining the ‘risk premium’ of local currency sov bonds
Ever since the rise of MNCs (multi-national companies) the “Closed Country” GDP system of international accounts has been breaking, as in doesn’t represent reality. Hyun describes the inter-connected world we now live in:
The dense network of nodes does not respect geography. Think of a European bank lending dollars to an Asian corporate by drawing dollars from a US money market fund. The bank has liabilities in New York, assets in Asia, but with headquarters in London or Paris. This new world is a million miles away from the picture of islands separated by oceans.
Unfortunately, or fortunately if you like to dig into details, painting a better picture requires looking at more granular data and “pulling at the threads” when one is found.
Hyun gives an example from the mid-2000s, when the US current account deficit widened to a historically large share of output. Back then, many commentators (economists) warned of a sudden stop in capital flows to the US. What actually happened in 2008 was the opposite.
European banks had borrowed dollars from US Money Market Funds (short-term liabilities) and recycled them into US mortgage-backed securities (usually long-term assets). The “net” change in current account was negligible. But, after 2007, the European banks had to bid for dollars to repay their dollar debts, as a stronger dollar was putting more and more pressure on their balance sheets (whoops!).
Hyun, as a international bank economist, draws a lesson: for monetary policy two kinds of analysis are needed (1) drill-down into firm-level micro data and (2) drill-up in global aggregates.
As an investor, I takeaway a few different lessons:
- An asset-liability term mis-match can be magnified by currency moves, even if the currencies match!
- LT asset vs. ST liability term mis-matches need high quality stable assets to work, equity-tranche subprime ARM MBS would not pass for quality (post 2007, this became obvious).
- If you’re risking capital, focus on drill-down analysis and periodically check on the drill-up aggregates.
- Mean reversion may fail due to underlying factors, so drill-down into the micro relationships.
- One company’s asset is another company’s liability (Minsky) and it still applies in the cross-border connected world, perhaps even magnifies.
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