The crises in emerging economies in the 1990s, the global financial crisis of 2008-09, and the current turmoil in Europe and the US have reignited the interest in why crises are contagious, spreading rapidly across countries. The literature has focused on many factors, mainly trade and financial linkages.
Among the trade linkages, the role of international mutual funds trying to rebalance their portfolios in crisis times has received special attention, particularly in recent weeks when anecdotal evidence indicates that a retrenchment of US money-market funds from European countries may be behind the rise in funding costs experienced by banks in the Eurozone (Jenkins 2011).
Despite the anecdotal evidence, pinpointing both the role of these funds in spreading contagion and the exact transmission mechanism is difficult and requires detailed data.
New findings on micro data
In a recent paper (Raddatz and Schmukler 2011), we use a micro-level dataset on a large sample of international mutual funds located in several countries and investing since 1996 in different regions to shed new light on how investors and managers react to crises and help transmit them across countries. International mutual funds are particularly useful as they enable us to separately analyse:
- Injections/redemptions, driven by the underlying investors;
- Fund portfolios or country weights, which are at the sole discretion of managers; and
- Their interactions (how investors monitor managers).
We find that both the underlying investors and managers of mutual funds are behind their large investment fluctuation across countries, retrenching from countries in bad times and investing more in good times.
In the case of the underlying investors, wealth effects (driven by shocks at home) seem to have a direct impact on how much they invest in other countries. Instead of investing more abroad when experiencing bad shocks at home, underlying investors retrench from the rest of the world and withdraw funds from international mutual funds.
- When shocks are correlated across countries, like during the global or the European crises, investors do not act as deep-pocketed agents buying assets abroad at fire-sale prices.
- The investor behaviour exerts pressure on managers, who need to react to this pressure as well as to shocks to returns (or valuation effects).
In the short run, managers allow shocks to returns to pass-through to country weights, with the latter changing substantially over time.
Over the long run, weights deviate from the pass-through effects. While during normal times managers do not allow the pass-through to be complete (in relative terms, they reallocate a small fraction to countries that are doing badly), they behave procyclically during crises, moving away from countries experiencing turmoil.
This procyclicality is observed particularly in equity funds. Managers of bond funds hold a larger cash cushion, which allows them to better absorb shocks. The behaviour of managers and investors has a direct effect on capital flows to countries around the world.
Lack of stabilising investment
In sum, neither managers nor investors seem to be exploiting potential long-term arbitrage opportunities by being contrarian, especially during crises, and exerting a stabilising role. Instead, they appear to be fickle and seem to amplify crises and transmit shocks across countries. The global crisis was a notable example of this type of behaviour (Figures 1).
Figure 1. Portfolio weights during the global financial crisis: Equity funds
Note: This figure presents the evolution of the average portfolio weights invested in different regions by bond funds during the global financial crisis of 2008-2009. Only countries with bond market price index data are considered to compute the weights. Regions are aggregated according to the EPFR Global classification. Only funds that have complete coverage for the period under study (Jan. 2007 - Dec. 2009) are considered. The grey bars indicate times of stock market turmoil or the fall of financial institutions. In chronological order, they represent: the nationalization of Northern Rock (Sep. 2007), the Bear Stearns collapse (Mar. 2008), the Lehman Brothers collapse (Sep. 2008), and the AIG near-collapse (Mar. 2009).
Our results show that the procyclicality of inflows from the underlying investors are not unique to demandable debt – eg banks or money market funds that are not continuously marked to market where the need to get out first is more imperative. Procyclicality occurs even in equity funds, for which prices adjust instantaneously, suggesting that limited information by investors, or indeed other factors, is playing an important role.
The findings also highlight some differences in the behaviour of bond and equity funds that indicate that the type of funds channelling capital flows into a country may matter for the behaviour of these flows. For instance, while in equity funds cash is used procyclically, being accumulated during crises, in bond funds cash is used more as a buffer, reducing the impact of redemptions on manager reallocations. This could imply that bond-fund managers have more difficulty buying and selling assets in markets that might be more illiquid, like some bond markets during crises, and thus use more cash to weather the shocks they face.
The results suggest that, when there is a crisis in a country where funds invest:
- Equity funds tend to amplify the shock by acting procyclically,
- Bond funds, meanwhile, might help transmit crises across countries by acting (in relative terms) countercyclically, generating contagion effects to other countries in their portfolio.
Nonetheless, since both bond and equity funds reduce their investments abroad when a shock hits the country where funds are domiciled, the wealth effects described above appear to be large and pervasive.
The findings have important policy implications. Some proposals suggest a shift from banks to a mutual-fund model to avoid runs and contagion effects.
- This shift will not necessarily solve the problem that banks entail, since our results show that runs and contagion are possible even in equity funds.
- Idiosyncratic risk and market discipline play only a limited role during crises and, thus, regulation based on those pillars would not entirely isolate financial systems from crises.
- To the extent that open-ended structures constrain long-term arbitrage, there could be socially excessive open-ending.
- The fact that shocks to the supply side of funds are important implies that providing liquidity at times of crisis might help stabilise markets and countries.
If instead crises were country specific with investors expecting unreasonable rates of returns, providing financing at times of crisis might fuel moral hazard.
Jenkins, Patrick, 2011. “It Is Hard to Understate the Bank Liquidity Crisis.” Financial Times, September 6.
Raddatz, Claudio, and Schmukler, Sergio, 2011. “On the International Transmission of Shocks: Micro-Evidence from Mutual Fund Portfolios.” NBER Working Paper 17358, August.