When Two Become One: Foreign Capital and Household Credit Expansion

71 Pages Posted: 6 Apr 2021 Last revised: 13 Mar 2023

See all articles by Lukas Diebold

Lukas Diebold

University of Mannheim

Björn Richter

Universitat Pompeu Fabra; Barcelona Graduate School of Economics (Barcelona GSE)

Date Written: March 12, 2023

Abstract

Rapid credit expansions predict lower output growth and banking crises, but does it matter who is financing them? We employ data from financial accounts for an unbalanced panel of 33 countries since 1970 to trace the flow of funds through the economy and identify the ultimate counterparties financing credit expansions. Removing the veil of financial intermediation shows that credit is increasingly financed by foreigners. This reflects large gross capital flows, which we find to be the key driver of the cyclical relationship between credit and real activity. Household credit expansions financed from abroad predict lower future GDP growth and higher risk of crises, but domestically financed credit expansions do not. We link these dynamics to foreign capital supply, exploiting an instrumental variable based on decomposed cross-border banking flows. Finally, we study potential channels and find that the macroeconomic risks of foreign-financed household credit are closely associated with reversals in capital supply, and with increases in debt service payments to foreigners.

Keywords: Business cycles, capital flows, debt service, financial crises, global financial cycle, household debt

JEL Classification: E32, E44, F34, G01, G15, G51

Suggested Citation

Diebold, Lukas and Richter, Björn, When Two Become One: Foreign Capital and Household Credit Expansion (March 12, 2023). Available at SSRN: https://ssrn.com/abstract=3817595 or http://dx.doi.org/10.2139/ssrn.3817595

Lukas Diebold

University of Mannheim ( email )

Chair of Economic History
Mannheim, 68131
Germany

Björn Richter (Contact Author)

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas, 25-27
Barcelona, E-08005
Spain

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

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