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Euro area cross-border financial flows and the global financial crisis

by Katrin Forster, Melina Vasardani and Michele Ca’ Zorzi.

Non-technical summary.

The global financial crisis that started in 2007 and intensified after the collapse of Lehman Brothers in September 2008 abruptly interrupted the more than two-decade-long process of increasing world financial integration. With the complex web of global interlinkages contributing to the spreading of the turmoil from the United States to the rest of the world, the crisis led to unprecedented declines, or even reversals, in global cross-border capital flows. Although financial markets have bounced back from their lows, cross-border capital flows have generally remained well below their pre-crisis levels.

The advanced economies, which have traditionally dominated global capital flows and were considered immune from sudden capital withdrawals, were particularly affected. Prior to the crisis, the euro area current account was close to balance, with cross-border financial flows mostly cancelling out when all components are summed. In net terms this indicated that the euro area was neither receiving nor exporting large capital flows, although significant developments were occurring in gross terms. The financial crisis, however, affected not only those countries with large current account deficits but all countries with open capital accounts.

The aim of this paper is to highlight the unprecedented adjustments triggered by the financial crisis in euro area cross-border financial flows. We find that during the turmoil there was a very sizeable scaling-down of gross external asset holdings across all types of investors and the whole range of instruments, amid soaring risk aversion, high liquidity needs, and balance sheet restructuring. Flows reversed and their volatility markedly increased, with potentially adverse effects for the real economy and financial stability. The strong increase in home bias and flight-to-safety behaviour was also manifested in shifts in the composition of cross-border financial flows, from equity to debt instruments, from long-term to short-term debt instruments and from private sector to public sector debt. At the same time, deleveraging activity in relation to cross-border loans and deposits reached high levels. The financial crisis also changed the sectoral breakdown of the euro area’s net external borrowing, with the government sector becoming the main, and for most of 2010 the only, net borrower from abroad. This was in line with the rise in government borrowing worldwide (and especially in the advanced economies), which was partly driven by higher financing needs on the part of governments in response to the crisis, but also by heightened global risk aversion on the part of investors.

As the global economy started to show signs of stabilisation in 2009 some of the trends in gross cross-border financial flows observed during the crisis abated or even reversed, towards the end of the year, particularly in the case of portfolio and direct investment. As regards other investment, deleveraging in relation to cross-border loans and deposits continued apace in 2009, with some signs of a normalisation, both on the asset and on the liability sides, only emerging in the first half of 2010.

Looking ahead, it is still uncertain which trends will prevail in the near future. Investors appear to have become more selective in qualitative terms, for example by increasingly differentiating across countries in relation to government debt securities. While the global economic outlook and fiscal developments are expected to play a key role, overall international financial flows could still be affected by the balance sheet restructuring of financial and non-financial corporations in advanced economies, including the euro area. Following the surge in international financial activity prior to the crisis, the recovery may not be synchronised across different world regions, as shown by the stronger rebound of cross-border flows to emerging markets.1

1 Rottier and Veron (2010, p.3) illustrate how the share of emerging markets in the 100 largest banks has been steadily increasing and has overtaken that of Europe. These banks have engaged in a limited degree of cross-border activity, but this could change. According to these authors, one can expect that “the combination of deleveraging in the West and continued financial development in the emerging economies will certainly reinforce the trend toward multipolarity”.

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