Ebook The Composition Matters: Capital Inflows and Liquidity Crunch during a Global Economic Crisis
Financial globalization, in theory, can bring capital, knowledge, and discipline to a country, and therefore improve efficiency and productivity. The empirical literature, however, does not produce clear-cut results. This has generated a large body of work which has been reviewed and summarized in several survey articles (see Stulz, 2005; Henry, 2007; Kose, Prasad, Rogoff, and Wei, 2003 and 2009; and Rodrik and Subramanian, 2009). One channel through which exposure to financial globalization may carry a downside is increased vulnerability to a financial crisis.
This is thought to be especially relevant if the composition of capital inflows is skewed toward non-FDI types such as bank lending and portfolio flows (Wei, 2001 and 2006; Levchenko and Mauro, 2007) since international bank lending, and to some smaller extent portfolio flows, are more likely to be reversed than FDI.
While the crises discussed in previous empirical literature tend to be those associated with foreign currency debt or balance of payments problems, the global crisis of 2008-2009 offers a chance to check if the severity of an emerging market economy’s credit crunch is systematically linked to the volume and the composition of its pre-crisis international capital inflows, since the crisis may have triggered a reversal of global capital flows. Non-financial firms may suffer from a liquidity crunch that is linked to a capital flow reversal even if they do not borrow directly from foreign banks. The liquidity of a domestic banking sector is partially supported by domestic banks’ borrowing from foreign banks. In principle, when foreign lending retrenches, as it is prone to do in a global crisis, domestic banks may be forced to cut down lending to domestic non-financial firms. This creates a channel for the liquidity crunch experienced by non-financial firms in a country to be linked to the country’s prior exposure to foreign lending. In comparison, if FDI flows are less cyclical, then a liquidity crunch in a host country should be less linked to its FDI exposure.
Foreign portfolio flows are likely to be in between FDI and bank lending in terms of reversibility during a crisis. These possibilities have important economic and policy implications, and should therefore be subject to a thorough empirical testing. The 2007-2009 crisis started off in August 2007 in the United States as a subprime mortgage crisis but quickly morphed into a global financial crisis in which financial institutions teetered on the edge of bankruptcy in many countries. A global economic crisis ensued in which non-financial firms around the world appeared to spiral downward as well. Part of the reason is a contraction of demand for the output of these firms. Another key potential contributor to the plight of the non-financial firms was the financial crisis itself, in the form of a negative shock to the supply of external finance available to non-financial firms. That is, non-financial firms did not do well, simply because they found themselves being cut off from the supply of working capital, even if they still had unfulfilled orders for their product.
However, it is far from self-evident that non-financial firms suffered from a liquidity crunch. As Bates, Kahle, and Stulz (2007) carefully document, non-financial firms held an abundance of cash prior to the crisis. According to them, “the net debt ratio (debt minus cash, divided by assets) exhibits a sharp secular decrease and most of this decrease in net debt is explained by an increase in cash holdings. The fall in net debt is so dramatic that the average net debt for US firms was negative in 2004. In other words, on average, firms could have paid off their entire debt[s] with their cash holdings.” Given the apparent secular upward trend in cash holdings, the net debt ratio was likely even further into negative territory by mid-2007, right before the start of the full-blown economic crisis. This at least suggests the possibility of no serious liquidity tightening outside the financial sector.
Probably out of this belief, Federal Reserve Chairman Ben S. Bernanke called strong corporate balance sheets “a bright spot in the darkening forecast” during his testimony to the U.S. Congress regarding monetary policy on February 27, 2008. While there may have been increasing recognition over time of a credit supply shock to non-financial firms, this is still by no means a consensus view. For example, in a paper dated October 2008, Chari, Christiano, and Kehoe (2008) rejected the idea of a sharp decline in either bank lending to non-financial firms or commercial paper issuance by non-financial firms during the financial crisis.
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