When Two Become One: Foreign Capital and Household Credit Expansion

Abstract

We employ data from financial accounts for 33 countries to trace the flow of financial funds through the economy, and to identify the ultimate counterparties financing credit expansions. Removing the veil of financial intermediation shows that credit is increasingly financed by foreign counterparties, reflecting large gross capital flows. In the medium term, household credit financed from abroad is the crucial link between credit expansions and business cycle and crisis dynamics. Domestically financed credit, on the other hand, does not predict financial crises or the business cycle. We explore several explanations for these findings and show that findings hold using supply shocks in the international banking network as an instrumental variable for foreign-financed household credit.