Current Account Imbalances or Too Much Bank Debt as the Main Driver of Gross Capital Inflows? Spain During the Great Financial Crisis

Abstract:

In contrast to the widespread view which posits that large current account deficits and net international debt were at the epicenter of the crisis in the Euro Zone, with diverging competitiveness playing a central role, this article points to the huge volume of bank credit that banks refinanced in international markets.

With a focus on the Spanish economy, we ground our view in an analysis linking gross—not net—capital flows, bank credit, and gross external debt, which provides more adequate information about a country’s international financing patterns and its external exposure.

The main conclusion of this article is that the principle driver of gross external debt in Spain was bank credit, with accumulated current account deficits accounting for less than 50 percent of gross external debt. Other consequences in keeping with this view are: the measures of economic policy required to sort out current account imbalances—particularly wage devaluation to improve competitiveness—may do more harm than good and they do not prevent the problem of too much bank credit from occurring again, and the residence of debt holders in the Euro Zone crisis is relevant for the understanding of the crisis as the result of a power imbalance

Keywords:

• gross capital flows
• bank credit
• current account imbalances
• banks refinancing loans
• Spain

JEL Classification Codes::

• E44
• F41
• F45
• G15

Notes

1 This has some consequences for the endogenous money view, which we deal with later in this article.

2 At that time, Spain received external aid from the European Stability Mechanism to recapitalize some impaired banks. This also contributed to the recovery of confidence in financial markets.

3 Amongst post-Keynesians, Sergio Cesaratto (2013, 2015) explains fiscal austerity-cum-wage devaluation on the basis of moral hazard and on the unattainability of solutions that are common in stand-alone currency unions.

In addition, Flassbeck and Lapavitsas on the one hand, and Bresser-Pereira and Rossi on the other hand, remain skeptical of further integration in the EZ. The former suggest returning to a single-market without a shared currency whilst the latter point to internal exchange rates, ruled by differential unit labor costs.

4 These authors focus on gross flows in advanced countries. Until the Great Recession, there was a widely held opinion that financial crises were a problem only for emerging market economies. We can find literature on the same issue much earlier, related to Latin America and Asia, for instance in Guillermo Calvo (1998), Guillermo Calvo, Leonardo Leiderman, and Carmen Reinhart (1996), or Graciela Kaminsky and Carmen Reinhart (1999).

5 If, for instance, a Spanish bank refinances a loan by borrowing reserves from a German bank, in the Spanish financial account we will have a liability, the loan made by the German bank, and an asset: the Banco de España acquires a claim against the Target2 system when it re-creates the reserves that are destroyed in Germany. Capital flows are netted to zero.

And when a Spanish bank grants a loan to a Spanish non-financial corporation to fund the purchase of equity stock in, say, France, in the Spanish financial account we will have an increase of international assets, the equity stock, and an increase of liabilities, a liability to the Target2 system, when reserves are transferred to France.

6 Ireland is not in this sample, but its gross capital flows were around 200% GDP per year from 2007 to 2009, whilst net flows did not surpass 15% GDP.

7 The VIX is a measure of the implied volatility of S&P 500 index options.

8 Lane and McQuade (2013) find a strong relationship between bank credit and net debt inflows, reporting that gross, instead of net, debt inflows do not increase explanatory power, though they do not reduce it either.

9 It should be noted, also, that leaving aside 2001–02, the period corresponding to the bursting of the technological bubble, gross capital outflows ranged between 14% and 23% of GDP from 1999 to 2007, larger than net financial needs to fund current account imbalances, which amounted to 10% GDP in 2007, the year with the larger imbalance. Focusing on net flows alone, we have a rather incomplete picture of how Spain’s external financial exposure took place after the launch of the euro.

10 A naïve endogenous money view mainly focuses on credit worthy demand for credit whilst banks passively accommodate such demand. However, this experience shows that the liquidity in financial markets where banks refinance credit conditions their willingness to grant loans.

11 From 1995 to 2001, Latin America received most of Spanish FDI, consisting mainly of banking, telecommunications, and petrol-related activities. From 2002 to 2007, outflows doubled, and the European Monetary Union (EMU) took over, with a handful of corporations in telecommunications, banks, building of infrastructure and energy playing a leading role. In 2012, the EMU represented roughly 50% of the stock of Spanish FDI, Latin America one third, and North America a little more than 10%. See, for instance, Sara Baliña and Ángel Berges (2014).

12 The reason for choosing 2002 is that the statistics provided by the Banco de España on external debt at an institutionally disaggregated level are not available before that year. Also, the period 2002–2008 is when bank debt grew fastest (this is common to other EZ countries: Philip Lane [2013, 7]).

13 This is obtained through the adding up of the following data:

• portfolio investment, debt, monetary financial institutions;

• other investment, monetary financial institutions excluding the Banco de España;

• portfolio investment, long and short-term debt, other resident sectors.

As the Banco de España states (for example, Banco de España 2007, 67), some mutual funds that work as affiliates to Spanish banks—and stand as non-monetary financial institutions—collect funds through the issue and sale of mortgage backed securities, and to a lesser extent through the securitization of consumer credit; this is accounted as portfolio inflows to other resident agents. Until 2007, Spain was the second country with the largest volume of securitization in Europe, after the UK, representing 11.8% and 15% of total securitization. See ESF 2007.

14 The largest amount of those inflows was channelled to Spain by banks in core EZ countries. BIS statistics point to banks in Germany and France (using consolidated data—see Shin 2012, 41) and the UK (if we use locational statistics—Claire Waysand, Kevin Ross, and John de Guzman (2010, 32), or Galina Hale and Maurice Obstfeld [2014, section 3]). In turn, these banks borrowed from financial centers in the UK, United States, Switzerland, etc. (Hale and Obstfeld 2014, 36). See also Arturo O’Conell [2015, 180 and 183]).

15 International investors monetized their investments—mostly assets issued by banks, and to a lesser extent, the government—and next they transferred the corresponding deposits to banks in Germany. These transactions led to a fall of reserves of Spanish banks that the ECB, through the Banco de España, replenished through refinancing loans. For details, see, for instance, Eladio Febrero, Jorge Uxó, and Óscar Dejuán (2015).

16 For an account of the reforms implemented by the banking industry in Spain at the onset of the crisis, before the bailout to part of the Spanish banking industry by the European Stability Mechanism, see Jaime Zurita (2014).

17 Another remarkable fact that can be seen above is that flows by FDI and CA deficits lead to more stable outstanding figures (debt and assets, respectively) than portfolios and other investments.

18 Calvo, Leiderman, and Reinhart (1996) distinguish between pull and push factors when examining international capital flows. They focus on emerging market economies in Asia and Latin America, though the discussion can be shifted to peripheral EZ economies. Amongst the push factors, regarding intra-EZ capital flows, we have the fall of interest rates and the rate of growth of GDP in the originating countries. These arguments explain the lack of investment opportunities there, whilst simultaneously improving the creditworthiness of capital recipient countries, which can borrow at lower rates. Other push factors are the trend towards international diversification of investments and integration of world capital markets, and externalities. With regard to pull factors, we find better treatment offered to external creditors and the adoption of sound monetary and fiscal policies. Of course, the Stability and Growth Pact, the Maastricht criteria, and the elimination of exchange rate risks made peripheral countries more attractive to creditor countries. The deregulation of capital markets also contributed to making capital flows more intense.

At the same time, Spanish gross capital outflows are a consequence of push and pull factors as well. Amongst the former, the national market dimension and abundant reserves. And regarding the latter, easy access to some international markets, particularly in the UK for Spanish corporations.

19 In short, Michell’s argument is that U.S. commercial banks create deposits ex nihilo when they grant credit (often mortgage loans, that are initial financing in Graziani’s terminology [Graziani, 2003]); next these deposits are invested in the money market, where European banks borrow to fund the purchase of toxic assets backed by subprime mortgage loans which, in turn, are issued by investment banks that use the proceeds (final financing) to purchase from the former banks the stream of revenue generated by the loans they granted at the beginning of the cycle. In this cycle, it should be noted, gross capital outflows and inflows offset each other and the analysis in net terms does not reveal this situation.

20 Hence, we agree with Rafael Fernández and Clara García (2016, 12), that there is a close connection between gross capital inflows and bank credit, when they write that “easy access to foreign financing was at least a prerequisite, if not a reinforcing factor, for both excessive borrowing and excessive lending by financial institutions.” However, we diverge on the causality linking both variables, as these authors hold that “Spain […] was intermediating capital drawn from the Eurozone which, in turn, attracted capital from the rest of the world” (Fernandez and García 2016).

21 See, for instance, Jorge Uxó, Eladio Febrero, and Fernando Bermejo (2016), or Mario Rísquez (2016). The second crisis wave from 2011 to 2013 was caused by fiscal austerity and wage devaluation, after an expansive fiscal policy from 2009 to 2010 (until May 2010, when the first Greek sovereign debt crisis erupted). It is difficult to isolate the effects of wage devaluation from fiscal austerity because some of the latter (cuts in civil servants’ wages) made up part of the same measure.

22 See O’Connell (2015) and the literature cited there. The Argentinian author clarifies that financial flows were almost utterly disconnected from trade flows. Further, creditors were financial institutions in core EZ countries which, in turn, refinanced their lending in other international markets, as they were not lending their respective residents’ savings.

23 Instead of these deflationary measures, national governments could have opted for fragmenting troubled banks into pieces, rescuing the potentially profitable divisions, particularly units granting credit that put in motion real resources, guaranteeing deposits to small savers and allowing a default of what remains of those impaired banks. Support from the ECB would be needed. This would have meant shifting the burden of adjustment to creditors. Nevertheless, the so-called Grexit made it clear that creditor countries would reject this solution.

24 Without implicating him, we acknowledge Roberto Ciccone’s suggestions on this argument. And as Cecchetti, McCauley, and McGuire (2012, section 5), state, part of the capital reversal that the Spanish economy experienced in 2011–12 was explained by the massive transfer that UK banks were ordering towards foreign owned banks based in Germany, with a view to reducing the redenomination risk (i.e., the possibility of returning to old currencies after a euro breakup). This argument is relevant, in our view, provided that the UK did not have a CA creditor position over Spain.

25 Selection of lags for the tests relies on the Akaike information criterion. We try to keep the model as simple and clear as possible, using just the first lag.

Additional information

Notes on contributors

Eladio Febrero

Eladio Febrero is an associate professor in the Department of Economics and Finance, Faculty of Social Sciences, at the University of Castilla-La Mancha. Ignacio Álvarez is an assistant professor at the Departamento de Estructura Económica y Desarrollo and Instituto Complutense de Estudios Internacionales (ICEI) Faculty of Economics and Business Administration, at the Universidad Autónoma de Madrid. Jorge Uxó is an associate professor in the Department of Economics and Finance, Faculty of Social Sciences, at the University of Castilla-La Mancha.

Ignacio Álvarez

Eladio Febrero is an associate professor in the Department of Economics and Finance, Faculty of Social Sciences, at the University of Castilla-La Mancha. Ignacio Álvarez is an assistant professor at the Departamento de Estructura Económica y Desarrollo and Instituto Complutense de Estudios Internacionales (ICEI) Faculty of Economics and Business Administration, at the Universidad Autónoma de Madrid. Jorge Uxó is an associate professor in the Department of Economics and Finance, Faculty of Social Sciences, at the University of Castilla-La Mancha.

Jorge Uxó

Eladio Febrero is an associate professor in the Department of Economics and Finance, Faculty of Social Sciences, at the University of Castilla-La Mancha. Ignacio Álvarez is an assistant professor at the Departamento de Estructura Económica y Desarrollo and Instituto Complutense de Estudios Internacionales (ICEI) Faculty of Economics and Business Administration, at the Universidad Autónoma de Madrid. Jorge Uxó is an associate professor in the Department of Economics and Finance, Faculty of Social Sciences, at the University of Castilla-La Mancha.