Global Collateral and Capital Flows

Abstract

Cross-border financial flows arise when (otherwise identical) countries differ in their abilities to use assets as collateral to back financial contracts. Financially integrated countries have access to the same set of financial instruments, and yet there is no price convergence of assets with identical payoffs, due to a gap in collateral values. Home (financially advanced) runs a current account deficit. Financial flows amplify asset price volatility in both countries, and gross flows driven by collateral differences collapse following bad news about fundamentals. Our results can explain financial flows among rich, similarly-developed countries, and why these flows increase volatility.Recent decades have exhibited a proliferation of financial innovation and dramatic increases in gross international financial flows among financially developed countries. Economists have tended to focus on flows between developed and emerging economies, but gross flows among developed economies are substantial. 1 If these flows were primarily driven by diversification motives, then one would expect capital flows to dampen shocks and decrease volatility. However, there is ample evidence that financial integration increases volatility and amplifies shocks, suggesting that the nature of these flows are at least in part driven by other motives. We show that cross-border differences in the ability to collateralize financial promises are enough to generate international capital flows because international financial trade is a way of sharing scarce collateral. Critically, these flows amplify global volatility in asset prices and collapse during crises. Motivating evidenceThe following empirical observations motivate our analysis.Observation 1: There are substantial gross financial flows between rich countries with similar levels of financial development. These gross financial flows (countries simultaneously buying and selling foreign and domestic assets) are an order of magnitude larger than net trade in assets. In some cases these offsetting flows are heavily concentrated in financial assets and in particular in securitized mortgage securities. First, among developed countries there are substantial foreign holdings of government bonds, and for many countries non-residents make up the largest investor base (Andritzky, 2012). Second, there are substantial gross flows between the U.S. and Europe (see Shin, 2012;Bertaut et al., 2012). These flows were most striking pre-crisis, and while they have partially reversed post-crisis (as did all gross flows), the patterns remain. 2 Finally, as documented by Hale and Obstfeld (2016), there are substantial gross flows within Europe, and these flows are concentrated in just a few countries: Germany, Belgium, and France stand out among the 1 See for example Bruno and Shin (2014), who discuss implications for intermediation costs. 2 See BIS locational banking statistics.