Liberty Street Economics

« | Main | »

August 12, 2015

Do Asset Purchase Programs Push Capital Abroad?

Thomas Klitgaard and David O. Lucca

LSE_2015_asset-purchase_lucca_450_art

Euro area sovereign bond yields fell to record lows and the euro weakened after the European Central Bank (ECB) dramatically expanded its asset purchase program in early 2015. Some analysts predicted massive financial outflows spilling out of the euro area and affecting global markets as investors sought higher yields abroad. These arguments ignore balance of payments accounting, which requires any financial outflow from the euro area to be matched by a similar-sized inflow, absent a quick and substantial current account improvement. The focus on cross-border financial flows also is misguided since, according to asset pricing principles, the euro and global asset prices can move without any change in financial outflows.

First, Some Accounting

The balance of payments tracks a country’s international transactions. It comprises the current account, which measures cross-border flows of goods, services, investment income, and transfers; the capital account, which is usually trivial; and the financial account, which records cross-border financial flows. The three components of the balance of payments add up to zero, apart from statistical discrepancies. Putting aside the small capital account and ignoring the statistical discrepancies, this means that the current account balance is exactly matched by the financial account. The intuition is that a country running a current account surplus, with exports greater than imports, is lending to the world to make up the difference. This lending is reflected in net purchases of foreign assets measured in the financial account.

Suppose for the moment that the ECB’s asset purchase program, by driving down interest rates, causes investors to consider investing abroad. Also assume that the euro area’s current account balance remains unaffected over the near term by the monetary policy shift. Then net financial outflows must be unchanged and any increase in the pace of domestic purchases of foreign assets can only be realized if foreign investors match that increase by buying more euro area assets. In other words, the desire to invest abroad may be there, but financial outflows are constrained by the current account and financial inflows. That means that the exchange rate and other asset prices need to move in response to the ECB policy change to keep financial outflows consistent with balance of payments identities.

Now for Some Asset Pricing . . .

This insight highlights the dangers of making predictions about gross cross-border financial outflows when evaluating the impact of asset purchase policies. The workhorse model in the field of asset pricing is the Lucas tree model, named after Nobel-prize winner Robert J. Lucas. In this model, investors trade claims to future uncertain dividend streams, and asset prices fluctuate to reflect new information about future cash flows. But because agents are alike and have the same information about future cash flows, there is no motive for them to trade. In equilibrium, asset prices adjust to new information so that investors are content with their original portfolio holdings given the new information. The insight in this model is that asset prices can change without any transaction taking place. In our case, global asset prices and exchange rates can move without any shift in observed cross-border flows.

The ECB’s asset purchase program may indeed have caused investors to consider shifting into foreign assets and so asset prices had to adjust. In particular, the euro’s depreciation helped keep financial outflows in line with inflows by making foreign assets, in euro terms, more expensive, thereby lowering their expected returns.

What Financial Flow Data Show

The recent experience with quantitative easing in Japan helps illustrate our point. In late 2012, the yen started to depreciate with the increased likelihood that the country would expand its asset purchase program. In April 2013, when the policy was actually implemented, commentary similar to that on the ECB program anticipated a “wall of money” flowing out of Japan in search of higher yields and affecting global asset prices. Indeed, analysts worried that emerging countries would have trouble absorbing these flows, leading to asset price bubbles. While asset prices and exchange rates adjusted in Japan and abroad, a surge in outflows never occurred. As seen in the chart below, cross-border flows reversed in the second quarter of 2013 before increasing in the third quarter. Outflows for the year were modest and the current account balance, the difference between the two lines, was largely unchanged. The wall of money never materialized.


Japan Financial Account

Nor does euro area data suggest substantial financial outflows. The chart below shows that in the first quarter of 2015, the start of the ECB’s expanded asset purchase program, financial inflows and outflows both rose, and by matching amounts. (The region had a current account surplus, but measured inflows were greater than outflows owing to a large statistical discrepancy.)


Lucca_Klitgaard_2_Euro-Area-Financial-Account

The euro’s fall has been a key channel through which the ECB’s asset purchase policy has affected financial markets in the rest the world. However, the idea that foreign asset prices would be pushed up by a surge in money flowing out of the region, as some observers predicted, runs contrary to balance of payments accounting and asset pricing principles and should be discounted.

Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.


Thomas KlitgaardThomas Klitgaard is a vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

David LuccaDavid O. Lucca is an officer in the Research and Statistics Group.

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

China runs a large current account surplus, so financial outflows (private and public) exceed financial inflows. Liberalizing the financial account makes it easier for private investors to invest abroad, so there may be more private and less public outflows going forward, depending on China’s foreign exchange policy. It is difficult to say how additional private outflows will be invested. They may be in the form of riskier investments, such as foreign direct investments or equity purchases, as you suggested. It is also quite possible that the flows continue to go into safe investments, such as U.S. Treasuries.

Hello, Would you please be able to explain this process with the prospect of the opening up of the financial (capital) account in China? In terms of stocks and flows, I think I am a little confused about the possible flows that will occur due to the large build up of the stock of capital onshore. My thinking is that China has run a large current account surplus and a resulting large build up of financial assets in the form of reserves – largely US treasuries. With the opening of the capital account is it right to assume that with a constant current account surplus there will be less purchases of treasuries as the financial account will now be able to be allocated to ‘real sector’ investments abroad which may provide more return per risk? What types of flows should we expect with an opening of China’s financial (capital) account?

The comments to this entry are closed.

About the Blog

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

Liberty Street Economics does not publish new posts during the blackout periods surrounding Federal Open Market Committee meetings.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Image of NYFED Economic Research Tracker Icon Liberty Street Economics is available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Economic Inequality

image of inequality icons for the Economic Inequality: A Research Series

This ongoing Liberty Street Economics series analyzes disparities in economic and policy outcomes by race, gender, age, region, income, and other factors.

Most Read this Year

Comment Guidelines

 

We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1,500 characters.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be relevant: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post.

Please be respectful: We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will
not be posted.‎

Comments with links: Please do not include any links in your comment, even if you feel the links will contribute to the discussion. Comments with links will not be posted.

Send Us Feedback

Disclosure Policy

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.

Archives