Capital flow waves to and from Switzerland before and after the financial crisis Pinar Yeşin. SNB Working Papers 1/ PDF

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Capital flow waves to and from Switzerland before and after the financial crisis Pinar Yeşin SNB Working Papers 1/2015 Legal Issues Disclaimer The views expressed in this paper are those of the author(s)

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Capital flow waves to and from Switzerland before and after the financial crisis Pinar Yeşin SNB Working Papers 1/2015 Legal Issues Disclaimer The views expressed in this paper are those of the author(s) and do not necessarily represent those of the Swiss National Bank. Working Papers describe research in progress. Their aim is to elicit comments and to further debate. Copyright The Swiss National Bank (SNB) respects all third-party rights, in particular rights relating to works protected by copyright (information or data, wordings and depictions, to the extent that these are of an individual character). SNB publications containing a reference to a copyright ( Swiss National Bank/SNB, Zurich/year, or similar) may, under copyright law, only be used (reproduced, used via the internet, etc.) for non-commercial purposes and provided that the source is mentioned. Their use for commercial purposes is only permitted with the prior express consent of the SNB. General information and data published without reference to a copyright may be used without mentioning the source. To the extent that the information and data clearly derive from outside sources, the users of such information and data are obliged to respect any existing copyrights and to obtain the right of use from the relevant outside source themselves. Limitation of liability The SNB accepts no responsibility for any information it provides. Under no circumstances will it accept any liability for losses or damage which may result from the use of such information. This limitation of liability applies, in particular, to the topicality, accu racy, validity and availability of the information. ISSN (printed version) ISSN (online version) 2015 by Swiss National Bank, Börsenstrasse 15, P.O. Box, CH-8022 Zurich Capital flow waves to and from Switzerland before and after the financial crisis PINAR YEŞIN Abstract: This paper first shows that capital inflows to and outflows from financial centres were disproportionately affected by the global financial crisis. Switzerland was no exception. The paper then identifies waves of capital flows to and from Switzerland from 2000:Q1 to 2014:Q2 by using a simple statistical method. The analysis shows that private capital inflows to and outflows from Switzerland have become exceptionally muted and less volatile since the crisis. Further, strong and long-lasting home bias behaviour can be observed for both Swiss and foreign investors. By contrast, net private capital flows have shown significantly higher volatility since the financial crisis, frequently registering extreme movements driven by extreme movements in bank lending flows. These findings suggest that the financial crisis generated a breaking point for capital flows to and from Switzerland. JEL Classification: F21, F31, F32 Keywords: private capital flows, inflows, outflows, surges, stops, retrenchment, flight I thank two anonymous referees, Adrien Alvero, Katrin Assenmacher, Irineu de Carvalho Filho, Andreas Fischer, Christian Grisse, seminar participants at the Swiss National Bank, and conference participants at the 2013 Conference of the Swiss Society of Economics and Statistics in Neuchatel and at the 2014 INFINITI conference on International Finance in Prato for their helpful comments and discussions. I also thank Adrien Alvero, Elisabeth Beusch, Elodie Moreau, and Laurence Wicht, who provided excellent research assistance at various stages of this project. Any remaining errors are my own. The views expressed in this paper are those of the author and do not represent those of the Swiss National Bank. International Trade and Capital Flows Unit, Swiss National Bank, Börsenstrasse 15, P.O. Box, CH-8022 Zürich, Switzerland, 1. Introduction The global financial crisis of led to massive swings in international capital flows. As Figure 1 shows, the sum of gross capital outflows from 172 countries declined from almost 21 percent of world GDP in 2007 to a mere 2 percent of world GDP in While swings in capital flows during recessions and crises had previously occurred, their sheer volatility during the global financial crisis was unprecedented (MILESI-FERRETTI and TILLE, 2011). Further, the upward swing in 2010 reversed again in 2011, and several years after the crisis, international capital flows remain well below their pre-crisis levels. By contrast, several countries experienced capital inflow surges owing to their high growth prospects and interest rate differentials after the financial crisis (AHMED and ZLATE, 2014). Figure 1: International Capital Flows (% of World GDP) Sources: IMF BOPS, WDI, and author s calculations. Note: International capital flows are defined as the sum of gross capital outflows from 172 countries in the International Monetary Fund s Balance of Payments Statistics (IMF BOPS) database. The IMF has two different data series for balance of payments statistics based on two different accounting standards: the formerly used BPM5 and the newly introduced BPM6 accounting standards. The BPM5 data extend only until 2008, though the author has data up to 2011 from an earlier vintage of the IMF database, which is no longer publicly available. The BPM6 data begin in Monitoring trends in capital flows has always been essential from a policymaker s perspective. On the one hand, international capital flows can foster growth and risk sharing through financial integration. On the other hand, they can exacerbate certain vulnerabilities, such as amplified business cycles, financial and macroeconomic instability, and banking, 2 sovereign, or currency crises. Indeed, previous literature shows that large swings in international capital flows can have considerable effects on various macroeconomic and financial indicators, such as inflation, asset prices, credit growth, and output (CALVO, 1998; REINHART and REINHART, 2008; CARDARELLI, ELEKDAG, and KOSE, 2010; FURCERI, GUICHARD, and RUSTICELLI, 2012; TILLMANN, 2013). This finding holds for both advanced and emerging market economies. Accordingly, the massive swings in capital flows in recent years have created extraordinary challenges for policymakers across the globe. Against this backdrop, this paper aims to document the behavior of international capital flows before and after the global financial crisis with a special focus on Switzerland, a financial center with a small open economy. In particular, the paper documents the massive swings in international capital flows during the financial crisis across selected (groups of) countries and their diverse rebound experiences. The paper then analyzes quarterly data on capital flows to and from Switzerland between 2000:Q1 and 2014:Q2 and identifies waves of capital flows by using a simple statistical method. Through this analysis, periods of extreme capital flow movements surges, stops, retrenchment, and flight are identified. This paper makes two interesting contributions to the existing literature. First, it shows that because of the financial crisis, strong and long-lasting home bias behavior is observed in many countries across the globe. However, the capital flows of financial centers were disproportionately affected by the financial crisis relative to those of other countries across the globe. Switzerland was no exception. Indeed, the paper shows that capital flows to and from Switzerland have become exceptionally muted and less volatile. Thus, the paper demonstrates that the retrenchment of capital flows across countries with significant international financial integration during the financial crisis (see, e.g., MILESI-FERRETTI and TILLE, 2011) might have become the new norm after the crisis. Furthermore, net capital flows to and from Switzerland exhibit significantly higher volatility since the global financial crisis, suggesting a decoupling of capital inflows and outflows. This finding contrasts with the long-run trends presented in previous literature, such as BRONER et al. (2013) and BLUEDORN et al. (2013). As BRONER et al. (2013) show, capital inflows to and capital outflows from advanced economies have historically been positively correlated, resulting in small and stable net flows because of their opposing effects. As presented in this paper, the recent experience of Switzerland indicates that this positive correlation has decreased notably since the global financial crisis causing volatile net flows for Switzerland. BLUEDORN et al. (2013), by contrast, argue that capital flows across all economy groups historically tend to be fickle and that no differences exist between advanced and emerging market economies. The recent experience of financial centers presented in this paper provides a counterexample to this generalization. In fact, the paper shows that capital inflows to and outflows from financial centers registered a disproportionately large drop during the financial crisis and exhibited no recovery afterward. The second contribution of this paper to the literature concerns the identification of capital flow waves for Switzerland. Separate analyses are conducted for capital flows initiated by foreigners and those initiated by domestic agents. Therefore, periods of surges and stops of 3 capital inflows to Switzerland and periods of flight and retrenchment of capital outflows from Switzerland are identified separately. In so doing, this paper follows a recent but growing strand of literature on capital flows that has shifted its focus from net to gross capital flows, such as KRAAY et al. (2005), LANE and MILESI-FERRETTI (2007), LANE (2013), BLUEDORN et al. (2013), and BRONER et al. (2013). Earlier literature on capital flows focused extensively on net capital flows and did not examine the type of investor underlying a capital flow wave. In fact, these studies implicitly assumed that foreign investors were the main drivers of extreme capital movements. However, this assumption is not necessarily accurate, as net capital flows are determined by the joint behavior of domestic and foreign investors. Furthermore, domestic and foreign agents are subject to different domestic and global conditions and considerations, and they may behave completely differently when they are faced with the same domestic and/or global shocks and policies. These behavioral differences between domestic and foreign agents may arise from asymmetric exposure to sovereign risk, home bias, more accurate information on the domestic economy, different hedging needs, better access to technology, among others. Thus, empirical analyses should acknowledge the individual behavior of domestic and foreign agents and should distinguish between capital in- and outflows. In addition, policymakers should identify whether capital flow waves are driven by domestic or foreign investors or a combination of both so that appropriate policy tools can be employed to maintain macroeconomic and financial stability when necessary. Furthermore, the paper advances this line of research by analyzing the major (sub)components of capital in- and out-flows of extreme movements. There are two major benefits to studying (sub)components of capital flows for extreme movements. First, whenever an extreme movement occurs in gross capital flows, the type of investment flows underlying this movement can be detected. Second, one can unveil possible synchronization or desynchronization of capital flow waves in various investment types. In particular, the components/subcomponents of capital flows to and from Switzerland that are analyzed in this paper include private capital 1, gross capital, direct investment, equity capital, reinvested earnings, debt instruments, portfolio investment, debt securities, equity securities, other investment, bank lending, other sectors lending, reserve assets, foreign currency investment, and derivatives. The statistical analysis reveals that private capital inflows registered several surges and stops before and during the financial crisis. However, since 2008:Q2, only one period of surge and one period of stop have occurred. Similarly, private capital outflows from Switzerland registered several flight and retrenchment periods before and during the financial crisis. Yet, again, only one flight period has occurred since 2008:Q2. By contrast, net private capital flows show frequent abnormal values during the whole sample period. Furthermore, there is a high degree of synchronization of capital flow waves in different (sub)components of capital flows before and during the financial crisis. However, extreme 1 Gross capital flows to/from the private sector, excluding the central bank and the public sector. 4 movements of private capital flows are largely driven by extreme movements of bank lending flows since they are coincident with each other to a large extent during the sample period. In other words, capital flow waves in bank lending are driving the extreme movements of private capital flows in general. Extreme movements in other (sub)components of capital flows remain relatively small in gross capital flows to and from Switzerland. The analysis also shows that some of the notable events that increased the uncertainty and volatility of global financial markets were coincident with capital flow waves to and from Switzerland. In particular, two abnormally low observations of net private capital flows were coincident with the euro area sovereign debt crisis in 2010:Q2 and the extended bailout of Greece in conjunction with the US debt-ceiling crisis in 2011:Q3. By contrast, the collapse of Lehman Brothers in 2008:Q3 and the speech by Ben Bernanke in 2013:Q2 on tapering were not coincident with extreme movements of net capital flows. This paper is organized as follows. Subsection 2.1 describes the evolution of international capital flows before and after the financial crisis, and subsection 2.2 describes the evolution of gross capital flows to and from Switzerland. Subsection 3.1 then describes the statistical method that is used to identify unusual behavior of capital flows, and subsection 3.2 presents the findings. Section 4 concludes the paper. 2. Capital Flows Before and After the Financial Crisis 2.1. International Capital Flows This subsection describes the evolution of international capital flows before and after the financial crisis. It aims to provide a context for the Swiss experience, which is discussed in the next subsection. Data for international capital flows are taken from the International Monetary Fund (IMF) Balance of Payments Statistics (BOPS) database and are based on the newly introduced BPM6 accounting standard. 2 The annual data cover the period from 2005 to Capital flows data are normalized by nominal world GDP retrieved from the World Bank World Development Indicators (WDI) database to illustrate their macroeconomic relevance. Table 1 summarizes the massive swings in international capital flows over time across selected (groups of) countries as a percentage of world GDP. It consists of three panels: the top panel presents gross capital outflows; the middle panel presents gross capital inflows, and the bottom panel presents net capital flows (i.e., the difference between gross capital outflows and gross capital inflows). 2 The IMF switched from the BPM5 to the BPM6 accounting standard in International balance of payments data based on the BPM6 accounting standard are not available prior to 2005, and international data based on the BPM5 standard are available only until Table 1: Capital Flows across Countries (% of World GDP) GROSS CAPITAL OUTFLOWS Financial centers European periphery* Advanced countries USA Germany Oil exporters** China Japan Rest of the world*** Total GROSS CAPITAL INFLOWS Financial centers USA European periphery* Advanced countries Germany China Oil exporters** Japan Rest of the world*** Total NET CAPITAL FLOWS Oil exporters** China Japan Germany Financial centers Advanced countries European periphery* USA Rest of the world*** Total Source: IMF BOPS (BPM6), WDI, and author s calculations. Note: + Australia, Canada, France, and Korea. ++ Belgium, Hong Kong, Luxembourg, Netherlands, Singapore, Switzerland, and the United Kingdom. * Greece, Ireland, Italy, Spain, and Portugal. ** Algeria, Angola, Ecuador, Iraq, Kuwait, Libya, Nigeria, Norway, Qatar, Russia, Saudi Arabia, and Venezuela. *** Rest of the world encompasses the remaining 140 countries. 6 First, the top panel of Table 1 describes gross capital outflows from selected (groups of) countries. 3 Positive values of capital outflows from a country indicate an increase in the respective country s foreign assets. Negative values, by contrast, indicate repatriation of an existing foreign investment back to the country. The top panel shows that before the financial crisis gross, capital outflows from financial centers, i.e., economies that serve as hubs for international financial flows, were substantial. These financial centers are Belgium, Hong Kong, Luxembourg, Netherlands, Singapore, Switzerland, and the United Kingdom. 4 Just prior to the financial crisis in 2007, capital outflows from financial centers were 7.3 percent of world GDP. Thus, financial centers accounted for almost 36 percent of total capital outflows. 5 This result is striking in itself because only seven countries, six of which are small economies, were driving such a substantial volume of international capital outflows before the onset of the crisis. 6 During the financial crisis of 2008 and 2009, capital outflows decreased drastically from all (groups of) countries or even reversed. There was a rebound of capital outflows from some countries afterwards, such as the USA and oil exporting countries. However, capital outflows from many advanced economies, particularly financial centers, continued to remain significantly lower than their pre-crisis levels. In fact, capital outflows from financial centers were still low at 0.5 percent of world GDP in Thus, financial centers accounted for less than 13 percent of total capital flows in Overall, the top panel of Table 1 reveals that capital flows from all countries were hit by the global financial crisis but that their recovery experiences differed considerably afterward. This finding contrasts with the findings of BLUEDORN et al. (2013), who argue that capital flows across all economy groups historically tend to be fickle and that the behavior of flows do not significantly differ across economy groups (advanced or emerging), despite the differences in policies across economies and over time. The middle panel of Table 1 presents gross capital inflows to selected (groups of) countries. Positive values of gross capital inflows indicate an increase of the foreign liabilities of the listed countries, whereas negative values indicate repatriation. The middle panel shows that capital inflows to all countries decreased significantly or even reversed during the global financial crisis of 2008 and As is the case for capital outflows, the rebound experiences of capital inflows differed considerably across countries. In particular, capital inflows to financial centers show a disproportionately sharp drop and no significant recovery since the 3 Note that the sum of gross outflows from these (groups of) countries corresponds to the international capital flows series shown in Figure 1. 4 Notably, the definition of financial centers is tenuous. Here, I follow an extended definition of the IMF and classify six small economies with large financial markets as financial centers. In addition, I define the UK as a financial center because it has a substantial financial sector relative to its GDP and because it is regarded to be a hub for international financial flows by the World Bank. A vast majority of these countries capital flows were in the form of cross-border banking flows before the onset of the financial crisis. 5 The UK significantly contributes to this number because of its sheer size, but it is not the main driv
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