Working Paper: CEPR ID: DP13387
Authors: Markus K. Brunnermeier; Lunyang Huang
Abstract: This paper examines international capital flows induced by flight-to-safety and proposes a new global safe asset. In the model domestic investors have to co-invest in a safe asset along with their physical capital. At times of crisis, investors replace the initially safe domestic government bonds with safe US Treasuries and fire-sell part of their capital. The reduction in physical capital lowers GDP and tax revenue, leading to increased default risk justifying the loss of the government bond's safe-asset status. We compare two ways to mitigate this self-fulfilling scenario. In the "buffer approachâ international reserve holding reduces the severity of a crisis. In the "rechannelling approach'' flight-to-safety capital flows are rechannelled from international cross-border flows to flows across two EME asset classes. The two asset classes are the senior and junior bond of tranched portfolio of EME sovereign bonds.
Keywords: flight to safety; capital flows; sudden stop; sovereign bond backed securities
JEL Codes: F32; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic investors replacing domestic government bonds with US Treasuries (H63) | Firesale of capital (G32) |
| Firesale of capital (G32) | Reduction of physical capital (E22) |
| Reduction of physical capital (E22) | Decline in GDP and tax revenue (H69) |
| Decline in GDP and tax revenue (H69) | Increased default risk (G32) |
| Sovereign bond-backed securities (SBBS) (F34) | Reduce the severity of a crisis (H12) |
| Sovereign bond-backed securities (SBBS) (F34) | Prevent loss of safe asset status for senior bonds (G33) |
| Sovereign bond-backed securities (SBBS) (F34) | Help mitigate capital outflows (F32) |