Skip to main content
SpringerLink
Log in

The Spillovers from Easy Liquidity and the Implications for Multilateralism

  • KEYNOTE ADDRESS
  • Published:
IMF Economic Review Aims and scope Submit manuscript

Abstract

Exchange rate appreciation in capital-receiving countries, induced by easy monetary policy in funding countries, increases the expected net worth of firms in receiving countries and their ability to buy assets. Anticipating this higher liquidity for their assets, corporations in capital-receiving countries lever up, and neglect alternative sources of debt capacity such as maintaining the pledgeability of their cash flows. When monetary policy in source countries tightens, receiving country exchange rates depreciate, and liquidity dries up in their corporate sector even if country prospects are sound. Since pledgeability has been neglected, debt capacity plummets, leading to a sudden stop in funding and subsequent financial distress. Exchange rate intervention by recipient countries to slow appreciation (and depreciation) may improve outcomes.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3

Similar content being viewed by others

Notes

  1. See, for example, Avdjiev and Hale (2018), Baskaya et al. (2017), Borio (2014), Brauning and Ivashina (2017, 2018), Bruno and Shin (2015, 2017), Cesa-Bianchi et al. (forthcoming), Cetorelli and Goldberg (2012), Gabaix and Maggiori (2015), Han and Wei (2016), Ioannidou et al. (2015), Ivashina et al. (2015), Jiang et al. (2018), Jiménez et al. (2014), Jordà et al. (2018), Kalemli-Ozcan et al. (2018), Obstfeld and Taylor (2017), Prasad (2014), Rey (2013), and Schularick and Taylor (2012).

  2. Related papers include Borio (2014), Dow et al. (2005), Eisfeldt and Rampini (2006, 2008), Gennaioli et al. (2015), Krishnamurthy and Muir (2017), Rampini and Viswanathan (2010), and Shleifer and Vishny (1992, Shleifer and Vishny 2011).

  3. See Diamond et al. (forthcoming) for the more general analysis.

  4. There is an extensive literature on how easier monetary policy exacerbates risk taking and lending to lower-quality borrowers. See, for example, Bruno and Shin (2015), Ioannidou et al. (2015), Kalemli-Ozcan et al. (2018), Morais et al. (2015), and Paligorava and Santos (2017).

  5. See Bruno and Shin (2017), Cetorelli and Goldberg (2012), Ivashina et al. (2015), McCauley et al. (2015), Shin (2012).

  6. See Brauning and Ivashina (2017) offer evidence suggesting the primacy of dollar-denominated loans in the syndicated cross-border loan market, with much of the dollar borrowing undertaken by firms with modest dollar revenues. Such firms are harmed by dollar appreciation (see Du and Schreger (2014), Kalemli-Ozcan et al. (2016)).

  7. For evidence on trade invoicing in dollars see, for example, Gopinath (2015).

  8. Other models could also produce asymmetric reaction to good news and bad news about credit flows. For example, in Veldcamp (2005), the boom phase is slower to pick up because fewer projects are underway and there is therefore less public information about the profitability of projects. The bust is much faster because many projects are underway toward the end of the boom, and information about the emerging bust spreads quickly via its effects on the many projects.

  9. See, for instance, Johnson et al. (2000) for suggestions that governance was lax before the Asian financial crisis.

  10. Could limitations on leverage obviate the need for exchange rate intervention? Perhaps, but it does place enormous burdens on regulatory authorities to adopt the right regulations. Moreover, there may be many ways in open economies of concealing or evading regulations on foreign currency borrowing. In practice, therefore, some mix of measures will be used so as to avoid overburdening any single one.

  11. Even this rationale could be debated. To the extent that emerging markets and developing countries have inadequate institutions with limited credibility, their best policy response may fall short of what a developed country would be capable of. Should they be held responsible for spillovers, given they fall short of developed country response, or do sending countries have a duty to recognize their state of development?

  12. https://www.imf.org/external/np/pp/eng/2012/111412.pdf.

  13. https://www.globalfinancialgovernance.org/.

  14. Of course, if macroprudential regulation was sufficient to reduce the financial stability risks associated with accommodative monetary policy, monetary policy would continue to have international spillover effects even if its domestic effects could be mitigated. However, if macro-prudential measures were indeed so effective, perhaps receiving countries could also deploy them to good effect. In the absence of a separate instrument to deal with financial stability, perhaps monetary policy will have to trade off among objectives (see Cesa-Bianchi and Rebucci (2017), Diamond and Rajan (2012) or Farhi and Tirole (2012), for example).

References

  • Acharya, Viral V., and S. Viswanathan. 2011. Leverage, moral hazard, and liquidity. The Journal of Finance 66 (1): 99–138.

    Google Scholar 

  • Avdjiev, Stefan, and Galina Hale. 2018. US Monetary Policy and fluctuations of international bank lending. BIS working paper 730.

  • Avdjiev, Stefan, Cathérine Koch, Patrick McGuire, and Goetz von Peter. 2018. Transmission of monetary policy through global banks: Whose policy matters? BIS working paper 737.

    Google Scholar 

  • Baskaya, Y.S., J. di Giovanni, S. Kalemli-Ozcan, and M.F. Ulu. 2017. International spillovers and local credit cycles. NBER working paper 23149.

  • Bekaert, Geert, Campbell R. Harvey, Christian T. Lundblad, and Stephan Siegel. 2013. The European Union, the Euro, and equity market integration. Journal of Financial Economics 109 (3): 583–603.

    Google Scholar 

  • Bernanke, Ben S. 2017. Federal reserve policy in an international context. IMF Economic Review 65 (1): 5–36.

    Google Scholar 

  • Bernanke, Ben S., and Mark Gertler. 1995. Inside the black box: The credit channel of monetary policy transmission. Journal of Economic Perspectives 9 (4): 27–48.

    Google Scholar 

  • Blanchard, Olivier. 2016. Currency wars, coordination, and capital controls. NBER working paper 22388.

  • Borio, C. 2014. The financial cycle and macroeconomics: What have we learnt? Journal of Banking & Finance 45: 182–198.

    Google Scholar 

  • Borio, Claudio and Philip Lowe. 2002. Asset prices, financial and monetary stability: Exploring the nexus. BIS working papers 114, Bank for International Settlements.

  • Borio, Claudio, and William White. 2004. Whither monetary and financial stability? The implications of evolving policy regimes. In Monetary policy and uncertainty: Adapting to a changing economy. Proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, 28–30 August, 131–211.

  • Borio, Claudio, and Haibin Zhu. 2012. Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism? Journal of Financial Stability 8 (2012): 236–251.

    Google Scholar 

  • Brauning, Falk, and Victoria Ivashina. 2017. Monetary policy and global banking. NBER working paper 23316.

  • Bräuning, Falk and Victoria Ivashina. 2018. U.S. Monetary Policy and emerging market credit cycles. NBER working paper no 25185.

  • Bruno, Valentina, and Hyun Song Shin. 2015. Capital flows and the risk-taking channel of monetary policy. Journal of Monetary Economics 71 (2015): 119–132.

    Google Scholar 

  • Bruno, Valentina, and Hyun Song Shin. 2017. Global dollar credit and carry trades: A firm-level analysis. The Review of Financial Studies 30 (3): 703–749.

    Google Scholar 

  • Calvo, Guillermo A., and Carmen M. Reinhart. 2000. When capital inflows come to a sudden stop: Consequences and policy options. Reforming the International Monetary and Financial System.

  • Calvo, Guillermo A., and Carmen M. Reinhart. 2002. Fear of Floating. The Quarterly Journal of Economics 117 (2): 379–408.

    Google Scholar 

  • Cesa-Bianchi, Ambrogio, and Alessandro Rebucci. 2017. Does easing monetary policy increase financial instability? Journal of Financial Stability 30: 111–125.

    Google Scholar 

  • Cesa-Bianchi, Ambrogio, Andrea Ferrero, and Alessandro Rebucci. International credit supply shocks. Journal of International Economics (forthcoming).

  • Cerutti, E., and G. H. Hong. 2017. Portfolio inflows eclipsing banking inflows: Alternative facts? IMF working papers (forthcoming).

  • Cetorelli, Nicola, and Linda S. Goldberg. 2012. Banking globalization and monetary transmission. The Journal of Finance 67 (5): 1811–1843.

    Google Scholar 

  • Claessens, Stijn, and M. Ayhan Kose. 2018. Frontiers of macrofinancial linkages. BIS working paper no 95.

  • Diamond, Douglas W., and Raghuram G. Rajan. 2012. Illiquid banks, financial stability and interest rate policy. JPE 120 (3): 552–591.

    Google Scholar 

  • Diamond, Douglas, Yunzhi Hu, and Raghuram Rajan. Forthcoming. Pledgeability, liquidity, and financing cycles. Journal of Finance.

  • Diamond, Douglas, Yunzhi Hu, and Raghuram Rajan. 2019. Liquidity and the structure of intermediation. Working paper, University of Chicago.

  • Dow, James, Gary Gorton, and Arvind Krishnamurthy. 2005. Equilibrium investment and asset prices under imperfect corporate control. American Economic Review 95: 359–681.

    Google Scholar 

  • Du, W., and J. Schreger. 2014. Sovereign risk, currency risk, and corporate balance sheets. Working paper, Harvard University OpenScholar.

  • Edwards, Sebastian. 2004. Thirty years of current account imbalances, current account reversals, and sudden stops. IMF Staff Papers 51 (Special Issue): 1–49.

    Google Scholar 

  • Eichenbaum, Martin, and Charles Evans. 1995. Some empirical evidence on the effects of shocks to monetary policy on exchange rates. The Quarterly Journal of Economics 110 (4): 975–1009.

    Google Scholar 

  • Eichengreen, Barry, Ricardo Hausmann, and Ugo Panizza. 2007. Currency mismatches, debt intolerance and original sin: Why they are not the same and why it matters. In Capital controls and capital flows in emerging economies: Policies, practices, and consequences, ed. Sebastian Edwards, 121–164. Chicago, IL: University of Chicago Press.

    Google Scholar 

  • Eichengreen, Barry., et al. 2011. Rethinking Central Banking (A publication of the Committee on International Economic Policy and Reform), Brookings Institution, September 2011.

  • Eisfeldt, Andrea L., and Adriano A. Rampini. 2006. Capital reallocation and liquidity. Journal of Monetary Economics 53 (3): 369–399.

    Google Scholar 

  • Eisfeldt, Andrea L., and Adriano A. Rampini. 2008. Managerial incentives, capital reallocation, and the business cycle. Journal of Financial Economics 87 (1): 177–199.

    Google Scholar 

  • Farhi, Emmanuel, and Jean Tirole. 2012. Collective morality hazard, maturity mismatch, and systemic bailouts. American Economic Review 102 (1): 60–93.

    Google Scholar 

  • Forbes, Kristin J., and Francis E. Warnock. 2012. Capital flow waves: Surges, stops, flight, and retrenchment. Journal of International Economics 88 (2): 235–251.

    Google Scholar 

  • Frankel, Jeffrey. 2016. International coordination. NBER working paper 21878.

  • Gabaix, Xavier, and Matteo Maggiori. 2015. International liquidity and exchange rate dynamics. The Quarterly Journal of Economics 130 (3): 1369–1420.

    Google Scholar 

  • Gennaioli, Nicola, Andrei Shleifer, and Robert Vishny. 2015. Neglected risks: The psychology of financial crises. American Economic Review 105 (5): 310–314.

    Google Scholar 

  • Goldstein, Morris, and Philip Turner. 2004. Controlling currency mismatches in emerging markets. Washington, DC: Institute for International Economics.

    Google Scholar 

  • Gopinath, G. 2015. The international price system. In Jackson Hole Symposium, volume 27. Federal Reserve Bank at Kansas City.

  • Gopinath, Gita, and Jeremy C Stein. 2018. Banking, trade, and the making of a dominant currency. Working paper, Harvard University.

  • Gourinchas, Pierre-Olivier, and Maurice Obstfeld. 2012. Stories of the twentieth century for the twenty-first. American Economic Journal: Macroeconomics, American Economic Association 4 (1): 226–265.

    Google Scholar 

  • Han, Xuehui, and Shang-jin Wei. 2016. International transmission of monetary shocks: Between a trilemma and dilemma. NBER working paper 22812.

  • Hart, Oliver, and John Moore. 1994. A theory of debt based on the inalienability of human capital. Quarterly Journal of Economics 109 (4): 841–879.

    Google Scholar 

  • Hausmann, Ricardo, Ugo Panizza, and Ernesto Stein. 2001. Why do countries float the way they float? Journal of Development Economics 66 (2): 387–414.

    Google Scholar 

  • Hofmann, Boris, Hyun Song Shin, and Mauricio Villamizar-Villegas. 2019. FX intervention and domestic credit: Evidence from high-frequency micro data. BIS working paper.

  • Ioannidou, Vasso, Steven Ongenga, and Jose-Luis Peydro. 2015. Monetary policy, risk-taking, and pricing: Evidence form a quasi-natural experiment. Review of Finance 19: 95–144.

    Google Scholar 

  • Ivashina, Victoria, David S. Scharfstein, and Jeremy C. Stein. 2015. Dollar funding and the lending behavior of global banks*. The Quarterly Journal of Economics 130 (3): 1241–1281.

    Google Scholar 

  • Jiang, Zhengyang, Arvind Krishnamurthy, and Hanno Lustig. 2018. Dollar safety and the global financial cycle. Stanford GSB working paper.

  • Jiménez, Gabriel, Steven Ongena, José-Luis Peydró, and Jesús Saurina. 2014. Hazardous times for monetary policy: What do twenty-three million bank loans say about the effects of monetary policy on credit risk-taking? Econometrica 82 (20): 463–505.

    Google Scholar 

  • Johnson, Simon, Peter Boone, Alasdair Breach, and Eric Friedman. 2000. Corporate governance in the Asian financial crisis. Journal of Financial Economics 58 (2000): 141–186.

    Google Scholar 

  • Jordà, Oscar, Moritz Schularick, Alan M. Taylor, and Felix Ward. 2018. Global financial cycles and risk premiums, NBER working paper 24677.

  • Kalemli-Ozcan, S., H. Kamil, and C. Villegas-Sanchez. 2016. What hinders investment in the aftermath of financial crises: Insolvent firms or illiquid banks? Review of Economics and Statistics 98 (4): 756–769.

    Google Scholar 

  • Kalemli-Ozcan, Sebnem, Xiaoxi Liu, and Ilhyock Shim. 2018. Exchange rate appreciation and corporate risk taking. BIS working paper 710, March 2018.

  • Kiyotaki, Nobuhiro, and John Moore. 1997. Credit cycles. Journal of Political Economy 105 (2): 211–248.

    Google Scholar 

  • Krishnamurthy, Arvind, and Tyler Muir. 2017. How credit cycles across a financial crisis. Working paper, Stanford GSB.

  • Lane, P., and G. Milesi-Ferretti. 2017. International financial integration in the aftermath of the global financial crisis. IMF working paper 17/115.

    Google Scholar 

  • McCauley, Robert N., Patrick McGuire, and Vladyslav Sushko. 2015. Global dollar credit: Links to US monetary policy and leverage. Economic Policy 30 (82): 187–229.

    Google Scholar 

  • Milesi Ferretti, Gian Maria and Assaf Razin. 2000. Current account reversals and currency crises: Empirical regularities. NBER chapters. In Currency crises, 285–323. National Bureau of Economic Research, Inc.

  • Milesi-Ferretti, G., and C. Tille. 2011. The Great Retrenchment: International capital flows during the global financial crisis. Economic Policy 26 (66): 285–342.

    Google Scholar 

  • Mishra, Prachi, and Raghuram Rajan. 2019. International rules of the monetary game. In Currencies, capital, and central bank balances, ed. John Cochrane, Kyle Palermo, and John Taylor. Stanford, CA: Hoover Institution Press.

    Google Scholar 

  • Morais, Bernardo, Jose-Luis Peydro, and Claudia Ruiz. 2015. The international bank lending channel of monetary policy rates and QE: Credit supply, reach-for-yield, and real effects. International finance discussion papers 1137, Board of Governors of the Federal Reserve.

  • Obstfeld, Maurice and Alan Taylor. 2017. International monetary relations: Taking finance seriously. NBER working paper 23440.

  • Paligorava, Teodora, and Joao Santos. 2017. Monetary policy and risk taking. Journal of Financial Intermediation 30 (2017): 35–49.

    Google Scholar 

  • Prasad, E. 2014. The dollar trap: How the US Dollar Tightened Its Grip on Global Finance. Princeton: Princeton University Press.

    Google Scholar 

  • Prasad, Eswar, Raghuram Rajan, and Arvind Subramanian. 2007. Foreign capital and economic growth. Brookings Papers on Economic Activity 1: 153–230.

    Google Scholar 

  • Rajan, Raghuram G., and Ioannis Tokatlidis. 2005. Dollar shortages and crises. International Journal of Central Banking 1 (2): 177–220.

    Google Scholar 

  • Rajan, Raghuram. 2012. Presidential address: The corporation in finance. Journal of Finance 67 (4): 1173–1217.

    Google Scholar 

  • Rajan, Raghuram. 2014. Competitive monetary easing: Is it yesterday once more. Speech delivered at the Brookings Institution. https://www.bis.org/review/r140414b.htm.

  • Rampini, A.A., and S. Viswanathan. 2010. Collateral, risk management, and the distribution of debt capacity. The Journal of Finance 65 (6): 2293–2322.

    Google Scholar 

  • Rey, Helene. 2013. Dilemma not trilemma: The global financial cycle and monetary policy independence. In Proceedings—economic policy symposium, 1–2. Jackson Hole, Federal Reserve Bank of Kansas City, issue August.

  • Schularick, Moritz, and Alan M. Taylor. 2012. Credit booms gone bust: Monetary policy, leverage cycles, and financial crises, 1870–2008. American Economic Review, American Economic Association 102 (2): 1029–1061.

    Google Scholar 

  • Shin, Hyun Song. 2012. Global banking glut and loan risk premium. IMF Economic Review 60 (2): 155–192.

    Google Scholar 

  • Shleifer, Andrei, and Robert W. Vishny. 1992. Liquidation values and debt capacity: A market equilibrium approach. Journal of Finance 47 (4): 1343–1366.

    Google Scholar 

  • Shleifer, Andrei, and Robert W. Vishny. 2011. Fire sales in finance and macroeconomics. Journal of Economic Perspectives 25 (1): 29–48.

    Google Scholar 

  • Taylor, John. 2017. Ideas and institutions in monetary policy making. Zurich: Karl Brunner Lecture, Swiss National Bank.

    Google Scholar 

  • Veldcamp, Laura. 2005. Slow boom, sudden crash. Journal of Economic Theory 124 (2005): 230–257.

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Chicago Booth and NBER, Chicago, USA

    Douglas W. Diamond & Raghuram G. Rajan

  2. University of North Carolina, Chapel Hill, USA

    Yunzhi Hu

Authors
  1. Douglas W. Diamond
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Yunzhi Hu
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Raghuram G. Rajan
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Raghuram G. Rajan.

Additional information

Publisher's Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Diamond and Rajan thank the Center for Research in Security Prices at Chicago Booth for research support. Rajan also thanks the Fama-Miller Center, the Stigler Center and IGM at Chicago Booth for research support. This paper is the basis for the Mundell Fleming Lecture delivered by Raghuram Rajan at the International Monetary Fund’s Annual Research Conference on Nov. 1, 2018.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Diamond, D.W., Hu, Y. & Rajan, R.G. The Spillovers from Easy Liquidity and the Implications for Multilateralism. IMF Econ Rev 68, 4–34 (2020). https://doi.org/10.1057/s41308-019-00095-z

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1057/s41308-019-00095-z

JEL Classification

Search

Navigation