Christiane Kneer and Alexander Raabe
Capital flows are fickle. In the UK, the largest and most volatile component of inflows from foreign investors are so-called ‘other investment flows’ – the foreign capital which flows into banks and other financial institutions. But where do these funds ultimately go and which sectors are particularly exposed to fickle capital inflows? Do capital inflows allow domestic firms to borrow more? Or does capital from abroad ultimately finance mortgages of UK households? Some of the foreign capital could also get passed on to the financial sector or flow back abroad.
We answer these questions in a new paper which studies inflows of foreign capital into UK banks. Bank balance sheet data allow us to observe capital inflows into individual banks on the liability side of the balance sheet and to track bank lending to different sectors of the economy on the asset side of the balance sheet.
How financial institutions use the foreign capital and which sectors they channel the funds to determines which sectors of the economy are prone to credit booms during inflow episodes or face refinancing risks when funding from abroad dries up. Foreign funding can also shape the economic structure of recipient countries as financial intermediaries adjust the composition of their loan portfolios to match the currency and maturity profile of their funding base.
Tracking foreign capital with bank balance sheet data
Figure 1 shows the substantial gross inflows of foreign capital into UK financial institutions. On the eve of the Global Financial Crisis, inflows of foreign capital reached record highs of nearly 100% of quarterly GDP. But much of this funding was withdrawn during the crisis. Capital inflows were also large and fickle in non-crisis times, especially in the first half of the 2000s. During much of the post-crisis period, non-residents withdrew funding from financial institutions in the UK, reducing the stock of their external liabilities.
Figure 1 Gross foreign flows of other investment into UK financial institutions
In our paper, we study quarterly balance sheets of 59 UK banks between 2001 Q1 and 2016 Q4. We analyse how banks adjust their lending to different sectors when they receive funding from abroad or when foreign investors withdraw their funds. We distinguish between lending to domestic households, firms, the public sector, and financial institutions in the UK, and lending to non-residents.
To capture the causal effect of capital flows on lending we use instrumental variable regressions and construct a novel ‘Bartik instrument’ for capital inflows. Bartik shift-share instruments combine local economic distributions – or shares – with shifts on a more aggregate level to address the endogeneity of locational choices. In our context, the instrument allows us to address for example reverse causality between bank lending and capital flows that could arise if individual UK banks attracted foreign capital in order to meet the credit demand of their borrowers. Our instrument for capital inflows into a bank combines (a) information about the historical distribution of funding from a country across UK banks with (b) capital inflows from that country into the entire UK banking sector. By allocating capital inflows across UK banks using a fixed, historical distribution, we can predict capital inflows from foreign investors into individual UK banks.
Foreign capital is channelled to domestic firms and financial institutions….
We find that capital inflows boost bank lending to the domestic economy. Our results suggest that an increase in capital inflows equal to one percent of a bank’s total liabilities is associated with a 0.8 percentage point increase in its domestic lending growth. A closer look at the composition of domestic lending shows that this is due to higher bank lending to the corporate sector and lending to other domestic financial institutions (both banks and non-banks). Within the UK corporate sector, capital inflows boost lending to the construction sector but we do not find a positive relationship between inflows and lending to other industries.
Capital flows can be driven by ‘push’ factors which originate abroad or domestic ‘pull’ factors which attract foreign capital to the UK economy. Inflows driven by push factors do not necessarily coincide with investment opportunities in the UK and may therefore not flow into the corporate sector. It is possible that these flows would be channelled into assets that are considered to be relatively safe such as housing or public sector debt instead. Our evidence does not point to a relationship between foreign flows and bank lending to households or the public sector. This also holds for the pre-crisis period which was characterised by a rapid build-up of household debt. However, it is possible that capital inflows into UK banks have an indirect effect on lending to households or the public sector: we find that capital inflows boost lending to other domestic financial institutions and these institutions could channel the funds to the non-financial sectors of the economy, such as the household sector.
Our finding that capital inflows are channelled to non-financial firms and to other domestic financial institutions is due to lending patterns in the pre-crisis period. Capital inflows in the post-crisis period were not associated with higher domestic credit growth. This is also in line with a move away from bank finance and towards market finance by the UK corporate sector (see Bank of England November Financial Stability Report, 2017) and a decline of the interconnectedness between banks and hence interbank lending after the crisis (Bank of England Quarterly Bulletin, Q2 2015).
…but much of it also flows back abroad
Our evidence also suggests that much of the foreign capital flows back abroad. This is in line with the finding of Broner et al. (2013) that inflows of capital from foreign investors coincide with capital outflows by domestic agents. We find that bank lending to non-residents grows 1.3 percentage points faster in response to an increase in capital inflows equal to one percent of a bank’s total liabilities.
The effect of capital inflows on lending to non-residents for the post-crisis period is more than twice the size of the effect for the pre-crisis period. This suggests that there has been some substitution away from domestic lending and towards non-resident lending after the crisis.
So where does foreign capital flow? Examining bank balance sheet data, we find that banks channel foreign funds to non-residents and to firms and financial institutions in the UK but they do not directly channel foreign funds to households or the public sector. This pattern changed in the post-crisis period. After the Global Financial Crisis, capital inflows were not associated with higher domestic credit growth and UK banks channelled foreign capital back abroad.
Christiane Kneer works in the Bank’s Macro-Financial Risks Division and Alexander Raabe at the Graduate Institute Geneva.
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