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This project explores how the structure of international capital flows drives financial fragility. Based on new OECD empirical analysis, it highlights the role of international financial integration in transmitting contagion shocks and assesses whether global current account imbalances are driven by strong demand for safe assets from emerging economies.

The demand for safe assets in emerging economies and global imbalances: new empirical evidence, OECD Economics Department Working Paper No. 903, 2011 by Rudiger Ahrend and Cyrille Schwellnus

“Asset mismatches” – a quest for safe assets by fast-growing emerging economies which cannot be met domestically due to lack of financial development - are a hot topic in the international policy debate. They are often seen as a major driver of strong capital outflows from emerging economies and, ultimately, global current account imbalances. Yet, OECD analysis finds that “asset mismatches” do not determine the asset allocation of emerging economies, as these invest primarily into financial assets of their own country. And when they invest abroad, while overinvesting in US bonds, they underinvest in German or Swiss bonds that are also widely seen as safe. Hence it is doubtful that – as often claimed - greater financial development in emerging countries would reduce global imbalances.

The home bias decreases with financial development

Source: OECD calculations based on IMF CPIS and BIS Securities Statistics.

Financially less-developed countries tend to have large “home biases”, in the sense that they invest disproportionately into financial assets of their own country.

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Drivers of systemic banking crises: the role of bank-balance-sheet contagion and financial account structure, OECD Economics Department Working Paper No. 902, 2011 by Rudiger Ahrend and Antoine Goujard

Recent events have highlighted the risks to financial stability that can emanate from the banking sector. To quantify this risk, new measures of bank-driven contagion shocks have been constructed which confirm that the global contagion observed in 2009/10 dwarfed that seen during previous financial crises. Research based on these newly-constructed measures suggests that certain forms of international financial integration amplify contagion shocks and thereby increase crisis risk. Examples are integration through international bank lending, and in particular through short-term bank debt.

Contagion affected primarily advanced and emerging European countries
(average regional contagion shock relative to global average)

Source: OECD calculations

While all countries suffered from contagion during the recent global financial crisis, emerging economies in Latin America and Asia were less strongly hit than those in Eastern Europe, or than advanced economies. This situation was the opposite to financial crises in the 1990s.

Further reading: Capital flows and the economy