DP13387 A Global Safe Asset for and from Emerging Market Economies

Author(s): Markus K Brunnermeier, Lunyang Huang
Publication Date: December 2018
Date Revised: December 2018
Keyword(s): Capital Flows, Flight to safety, SBBS, sovereign bond backed securities, sudden stop
JEL(s): F32, G23
Programme Areas: Financial Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13387

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 approach" 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.