Macro trading factors for FX must foremostly consider (gross) external investment positions. That is because modern international capital flows are mainly about financing, i.e. exchanges of money and financial assets, rather than saving, real investments and consumption (which are goods market concepts). Trades in financial assets are much larger than physical resource trades. Also, financing flows simultaneously create aggregate purchasing power, bank assets and liabilities. The vulnerability of currencies depends on gross rather than net external debt. Current account balances, which indicate current net payment flows, can be misleading. The nature and gravity of financial inflow shocks, physical saving shocks, credit shocks and – most importantly – ‘sudden stops’ all depend critically on international financing.

Kumhof, Michael, Phurichai Rungcharoenkitkul and Andrej Sokol (2020), “How does international capital flow?”, Bank of England, Staff Working Paper No. 884.
https://www.bankofengland.co.uk/working-paper/2020/how-does-international-capital-flow

Borio, Claudio (2015), “On the centrality of the current account in international economics”, Keynote speech
https://www.bis.org/speeches/sp150828.htm

The below are mostly quotes from the 2020 paper, with some quotes from the 2015 speech. Cursive text and text in brackets have been added for clarity.

The post ties up with this site’s summary on systematic value and macro trends.

Distinguishing saving and financing

“Saving is a national accounts concept and denotes income (output) not consumed. Financing is a cash flow concept and denotes access to purchasing power in an accepted settlement medium (money), including through borrowing. In a causal sense, all expenditures, and hence also investment, require financing, not saving. Financing, in turn, is about gross, not net, financial flows. And it is required for both financial and real transactions, which may or may not add to output…Saving alleviates an economy’s real resource constraint: abstaining from consumption makes room for investment to take place without putting pressure on resources. Cash flows alleviate the economy’s financing constraint: without cash flows, no spending can take place.” [Borio]

“There is no link between the volumes of saving and financing. Financing does not require saving, ie, abstaining from consumption. For instance, in an economy with no saving, and hence investment, one still needs financing for production, such as to pay factors of production.” [Borio]

“Foreign saving cannot play a direct role in financing domestic imports. Foreign saving is a goods market concept and a national accounts residual, it is the current account deficit by definition (ignoring investment for simplicity). What is required to pay for a current account deficit is not physical resources set aside by foreigners. Instead it is purchasing power created by banks….US households do not finance current account deficits with foreigners’ physical saving, but with digital purchasing power, created by banks that are more likely to be domestic than foreign.”

Final settlement for any purchase of physical resources must be effected using a financial (non-physical) medium of exchange, whose creation, circulation and destruction is separate from the creation, circulation and consumption of physical resources. In modern economies this medium of exchange function is almost exclusively performed by banks’ gross liabilities…deposits or deposit money…The ability of the banking system to create money is [called] ‘excess elasticity’ of the financial system, which implies that the magnitudes of physical resource flows and stocks and of non-physical financing flows and stocks are disconnected.”

“An economy’s banking system has the capacity not merely to facilitate the transfer of but also to create (and destroy) this medium of exchange, mostly through the granting of loans but also through the purchase of existing assets. There are therefore generally very large differences between the sizes, and the changes in size over time, of physical resource stocks and of financial stocks on banking sector balance sheets.”

Net foreign financing and foreign saving are entirely different concepts that for many shocks move in opposite directions.”

“The distinction between saving and financing matters…because in a financial crisis, creditors do not stop financing current accounts, they stop financing debt… gross capital flows have zero immediate impact on current accounts, and in some cases even zero longer-run effects, while potentially completely changing the magnitude and risk profile of gross debt burdens…Current accounts are poor indicators of financial vulnerability, because in a crisis, creditors stop financing debt…and because following a crisis, current accounts are not the primary channel through which balance sheets adjust.”

Distinguishing cross-border payment flows and financial flows

“The omission of settlement through the banking system…overlooks perhaps the most important gross flows of all, namely financing flows, which create new aggregate purchasing power by simultaneously creating new gross bank assets and bank liabilities in the same currency…Open-economy models that seek to capture the macroeconomic impact of capital-flow cycles should incorporate their impact on domestic credit conditions.”

  • “A cross-border payment flow [is] the cross-border transfer of a medium of exchange for settlement, from the buyer to the seller, whose inseparable counterpart is a flow of physical resources that crosses the border in the opposite direction. In the balance of payments, one leg of such a transaction, the physical resource flow, is recorded in the current account, while its matching counterpart, the payment flow, is recorded in the capital account. Payment flows are therefore the exact mirror image of the current account.”
  • “A cross-border financial flow [is] the transfer of a medium of exchange, from the buyer to the seller, whose inseparable counterpart is a flow of other gross financial assets that crosses the border in the opposite direction, without any role for physical resource flows… For example, when the foreign buyer of a domestic bond pays using a foreign bank deposit, the gross inflow is his increase in holdings of domestic bonds, while the gross outflow is the bond seller’s increase in holdings of foreign bank deposits…In the balance of payments, both legs of such a transaction are therefore recorded in the capital account.”

Payment flows and financial flows are therefore almost completely unrelated concepts…Payment flows mainly reflect the global pattern of goods production and goods trade networks, while financial flows reflect the global pattern of liquidity production and financing networks.”

“Trades in financial assets…are far larger than physical resource trades in modern economies.”

Types of cross-border accounts

“Any cross-border purchases require settlement, which in most cases takes place through the interbank accounts of domestic and foreign banks, and which necessarily affects banking sector and household sector balance sheets.”

“By reference to banking practice…[in the model economy] a deposit held by a domestic bank in a foreign bank is a nostro account, while a loan obtained by a domestic bank from a foreign bank is a vostro account. Banks typically maintain a pair of nostro and vostro accounts in the currency of a foreign economy with correspondent banks located in that economy. For any currency, the net balance between all global nostro and vostro accounts represents the amount of central bank reserves in that currency.”

“We assume that the deposit liabilities of domestic and foreign banks exhibit high but finite (imperfect) liquidity-driven substitutability, leading to systematic deviations from uncovered interest parity (UIP). As a result, our model implies that the real exchange rate is jointly determined by both excess demands for goods and for currencies, so that the latter have real effects.”

“A key implication of this set-up is that relative supplies of, and demands for, currencies become a further determinant of exchange rates, alongside relative goods demands/supplies.”

Distinguishing gross and net external liabilities

“Banks can…increase loans in response to changes in preferences over gross positions, and this can be completely disconnected from the underlying physical resource flows and stocks of the economy.”

An economy’s balance sheet vulnerability to foreign shocks is determined primarily by the amount and composition of its gross rather than its net foreign debt. An economy with very low net foreign liabilities can nevertheless be highly vulnerable if its gross foreign liabilities are very large. And in response to large financial shocks that require the immediate repayment of a sizeable volume of debt, changes in the current account cannot make any contribution on impact, and only a small contribution over time. Instead, they mostly reflect the macroeconomic adjustments that follow such shocks.”

“The net-flow perspective is limited in its ability to study balance sheet vulnerability, because it does not distinguish between foreign financing and foreign saving. Instead, it interprets the current account, a goods market concept, as an indicator of the availability of foreign financing. As a result, current account deficits and net foreign liabilities have long been interpreted as sufficient statistics for an economy’s financial vulnerability and risks of “sudden stops” in external funding.”

“An economy that runs large current account deficits over many years must eventually acquire not only large net but also gross foreign liabilities. We therefore do not argue that the current account is necessarily irrelevant for an economy’s financial vulnerability. Rather we argue that gross liabilities are far more important, that they can change very quickly and for reasons that are completely unrelated to the current account, and that they are often the driver of the current account rather than the reverse.”

“The key point is that current account patterns are largely silent about the role a country plays in international borrowing, lending and financial intermediation.” [Borio]

Empirical evidence highlights the important and distinct role of gross flows before and during crises…Global gross flows rose from around 10% of world GDP in the late 1990s to over 30% in 2007, and that these flows mostly took place between developed economies. The global financial crisis itself is a prime example for why gross rather than net capital flows and stocks indicate the source of financial vulnerabilities. In the crisis year 2008, global current account imbalances (net flows) narrowed only slightly, and by only $20 billion in the case of the US, while global gross capital inflows and outflows collapsed, by $1600 billion in the case of the US.”

“A large empirical literature documents that gross financial flows, including cross-border flows but also domestic credit creation flows, trigger economic booms and busts, while current accounts are the consequence rather than the cause of such events.”

Understanding different types of shocks

“A financial inflow shock [is] as an exogenous increase in foreigners’ demand for domestic currency deposits. The shock triggers a gross financial flow into domestic banks away from foreign banks and illustrates why any financial inflow is necessarily a gross inflow that is accompanied by an equal and offsetting gross outflow. Specifically, in this case the inflow is an increase in foreigners’ deposits in domestic banks, after they deposit foreign payment instruments (‘checks’) that are drawn on their foreign bank accounts. The corresponding outflow is an increase in domestic banks’ interbank nostro or vostro net claims on foreign banks, as domestic banks submit the foreign payment instruments for collection and settlement.”

“If domestic and foreign banks are required, by regulation or their own risk management frameworks, to eliminate the currency mismatches that arise from the settlement of gross inflows, there can be general equilibrium changes in real exchange rates and real interest rates that also affect real variables and the current account. For the financial inflow shock, the increase in demand for domestic currency increases its relative convenience yield and thereby reduces its relative financial yield. This triggers three effects that satisfy the demand of foreign households for greater relative holdings of domestic currency:

  • First, it causes domestic households to substitute away from domestic currency.
  • Second, it causes domestic banks to increase their loans to create more domestic currency.
  • And third, it causes foreign banks to decrease their loans to create less foreign currency.”

“The credit creation flows are domestic gross financial flows, in that they simultaneously create (or destroy) domestic currency assets and liabilities, which are again inseparably linked. Domestic households’ switch to foreign currency is a gross outflow that matches the gross inflow due to the shock to foreign households’ preferences. Domestic and foreign banks end up with zero net exposures to each other. Their respective currency mismatches can then be eliminated by swapping gross exposures in their interbank accounts.”

“The financial inflow shock can account for the uncovered interest parity puzzle. The primary and direct effect of the shock is a strong decrease in the monetary uncovered interest parity spread, and therefore a strong decrease in the excess financial return on Home currency. Because this leads to a Home exchange rate appreciation, it also decreases relative Home GDP and inflation, and therefore leads to a negative policy rate differential. But these uncovered interest parity effects are much weaker than the monetary uncovered interest parity effects, so that the increase in expected exchange rate depreciation, and the decrease in the excess return, are far larger than the decrease in the interest differential. In other words, in the presence of financial inflow shocks low-interest currencies tend to depreciate over time.”

“A standard physical saving shock to foreign preferences…increases foreign physical saving and triggers a [domestic] current account deficit in general equilibrium. Such shocks, along with technology shocks, have been frequently used in net flow models to study the global saving glut. But… they cannot reproduce a key feature of the saving glut episode: gross domestic and cross-border balance sheet positions increased by far more than GDP, and were much more volatile, than implied by such shocks. Furthermore…for these shocks the current account contains no information about the direction of foreign financing flows, which in fact decline.”

“A domestic credit shock [is] an increase in US [domestic] credit to US households that stimulates US demand, provides a very plausible alternative explanation of the saving glut phenomenon. This shock gives rise to a US current account deficit, but in this case accompanied by a US credit glut, with changes in balance sheet positions that are an order of magnitude larger than changes in GDP, congruent with the data. This shock emphasizes financing, the access to existing or newly created purchasing power, rather than foreign saving, as the factor that allows domestic households to pay for additional imports. But that financing can be obtained domestically as well as abroad. This shock suggests very different remedies to the saving glut phenomenon, because it identifies US credit rather than non-US physical saving as its trigger.”

“Another important financial shock is a ‘sudden stop’ [or] foreign credit shock that results in a sharp drop in foreign bank financing to domestic households. This shock reduces domestic purchasing power, and thereby real activity and imports. The current account improves, so that by definition foreign saving decreases by the same amount. But foreign financing immediately drops by approximately 10 times more than foreign saving [based on model calibration]. This represents a large and instantaneous stock demand for loan repayments that cannot be met by current account flow adjustments. Instead, households repay loans by drawing on their existing deposit balances, and by approaching domestic banks to obtain additional loans to finance repayment of foreign loans. Financial vulnerability of an economy therefore depends mostly on the size, and the susceptibility to sudden stops, of its different classes of gross liabilities. The current account is not informative when studying such an episode, as it is merely the by-product of the reversal in gross flows, and plays virtually no role in satisfying the demands of foreign creditors.”

A foreign credit or sudden stop shock has no immediate bearing on the current account either. But it exposes pre-existing financial vulnerabilities if reliance on foreign loans was high, and it reduces remaining financial vulnerabilities once repayments have been made. The shock does entail a reduction in domestic demand and a current account surplus, but this is far smaller than the reduction in foreign credit, and is the consequence, rather than the cause, of the adjustments.”

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.