When Two Become One: Foreign Capital and Household Credit Expansion

We employ data from financial accounts for 31 countries to trace the flow of financial capital through the economy and identify the ultimate sources of funds behind credit expansions. Removing the veil of financial intermediation reveals that foreign capital has financed most of the secular increase in credit-to-GDP ratios between 1980 and today. In the medium term, household credit financed with foreign capital is the crucial link between credit expansions and future economic performance. An increase in household credit financed from abroad is associated with a contemporaneous reallocation from the tradable to the non-tradable sector, and it predicts lower output and higher unemployment over the following years. Foreign-financed household credit expansion also predicts low returns on bank equities and housing. On the other hand, domestically financed credit neither predicts business cycle dynamics nor returns. Furthermore, household credit financed from abroad is a robust predictor of financial crises and the flight of foreign capital is the major force behind low credit growth after crises.