How Global Imbalances Create Financial Fragility



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1.1 Cheap But Flighty: How Global Imbalances Create Financial Fragility

by Toni Ahnert and Enrico Perotti

Bank of Canada Working Paper 2015-33

August 2015


How a wealth shift to emerging countries may lead to instability in developed countries. Investors exposed to expropriation risk are willing to pay a safety premium to invest in countries with good property rights. Domestic intermediaries compete for such cheap funding by carving out safe claims, which requires demandable debt. While foreign inflows allow countries to expand their domestic credit, risk-intolerant foreign investors withdraw even under minimal uncertainty. We show that more foreign funding causes larger and more frequent runs. Beyond some scale, even risk-tolerant domestic investors are induced to withdraw to avoid dilution. As excess liquidation causes social losses, a domestic planner may seek prudential measures on the scale of foreign inflows.


Topics to study:

· Investment / risk – relationship

· Global Imbalances

· Factors to attract foreign investment

· Safety-seeking foreign funding


1. An increasing scale of foreign funding may induce runs even by risk-tolerant investors since they seek to avoid dilution.

2. Result supports a mandate for introducing a macroprudential regulator to oversee the nature of foreign inflows because the socially preferred funding structure would involve less credit volume and more stability than the private choice.

3. Global imbalances shaped the credit boom and, ultimately, the financial crisis

4. The accumulation of wealth in countries with a weak protection of property rights creates a demand for absolute safety provided by intermediaries in developed countries.

5. The safety-seeking nature of foreign flows creates risk.

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