BIS Working Papers

No 847
The dollar, bank leverage
and real economic activity:
an evolving relationship
by Burcu Erik, Marco J. Lombardi, Dubravko Mihaljek
and Hyun Song Shin

Monetary and Economic Department

March 2020

JEL classification: C5, E2, F3, F4, F6.

Keywords: financial conditions, economic activity, world

trade, dollar exchange rate, bank leverage, purchasing
managers’ indices, nowcasting, global supply chains.
BIS Working Papers are written by members of the Monetary and Economic
Department of the Bank for International Settlements, and from time to time by other
economists, and are published by the Bank. The papers are on subjects of topical
interest and are technical in character. The views expressed in them are those of their
authors and not necessarily the views of the BIS.

This publication is available on the BIS website (www.bis.org).

© Bank for International Settlements 2020. All rights reserved. Brief excerpts may be
reproduced or translated provided the source is stated.

ISSN 1020-0959 (print)

ISSN 1682-7678 (online)
 The dollar, bank leverage and real economic
activity: an evolving relationship
Burcu Erik, Marco J. Lombardi,
Dubravko Mihaljek and Hyun Song Shin
March 17, 2020

Abstract
The interest in how …nancial conditions a¤ect real economic activity
has grown since the Great Financial Crisis (GFC), not least because some
of the mechanisms at play in the …nancial sector may have changed. We
shed light on this issue by examining the empirical relationship between
global Purchasing Managers’Indices, world trade and indicators of global
…nancial conditions, with a special focus on the broad dollar index. We
show that the in‡uence of the dollar on real economic activity and global
trade seems to have increased since the GFC, while that of the VIX has
decreased.
JEL classification: C5, E2, F3, F4, F6.

Bank for International Settlements, Centralbahnplatz 2, 4002 Basel, Switzerland. Cor-

responding author: [email protected]. We thank Valentina Bruno, Stijn Claessens,
Kristin Forbes, Eduardo Levy Yeyati, Benoît Mojon, Raghu Rajan, Helene Rey, Livio Stracca,
Christian Upper and participants of the session Has the global …nancial cycle changed since
the crisis at the American Economic Association Annual Meetings in San Diego for helpful
comments. The views expressed in this paper are solely those of the authors and not neces-
sarily those of the BIS. The paper is forthcoming in American Economic Association Papers
and Proceedings, Vol 110, May 2020.

1
Introduction
The COVID-19 pandemic has heightened awareness of the how tightening …nan-
cial conditions spill over to real economic activity. How do …nancial conditions
a¤ect real economic activity, and how have the transmission channels changed
since the Great Financial Crisis (GFC) of 2008-9?
An important backdrop to our discussion is the set of changes in the pattern
of …nancial intermediation that have taken place over the past decade or so.
These changes have had a bearing on the transmission of …nancial conditions
to economic activity, with the emphasis shifting from the banking sector to
market-based intermediation.
We shed further light on the impact of …nancial conditions on real economic
activity by examining the empirical relationship between global manufacturing
Purchasing Managers’Indices (PMIs) and indicators of global …nancial condi-
tions.
A notable …nding in our study is the growing role of the broad dollar index.
As well as its classical role as the relative price of goods in international trade,
the broad dollar index a¤ects real economic activity through its impact on …-
nancial conditions, and has attributes of a barometer of risk capacity a¤ecting
…nancial intermediaries.
Section II looks more closely at the evolving relationship between the dollar
and indicators of global economic activity. In Section III, we identify drivers of
change in these linkages. Section IV concludes with re‡ections on the nature of
risks in the new environment.

1 Changes in Financial Intermediation

The focus of our study is on how the transmission channels of …nancial conditions
on real activity may have changed since the GFC. Three recent changes in
…nancial intermediation bear on this question.
First, the formal banking sector has been noticeably subdued in the post-
crisis period, especially in advanced economies that bore the brunt of the …nan-
cial crisis. Figure 1 plots the total assets and book equity for a group of 43
large US and euro area banks.1 Assets and equity expanded strongly before the
crisis, but they have subsequently grown more slowly. Euro area banks have
been particularly subdued, seeing steady contraction of total assets since the
GFC.
Second, the relationship between bank leverage and measures of risk appetite
has changed. Before the crisis, bank leverage (total assets divided by equity)
was closely correlated with the VIX index of implied volatility in equity markets
(Adrian and Shin 2010, 2014). When the VIX was low, bank leverage was high,
and vice versa. Figure 2 illustrates the relationship between VIX and leverage
through the US broker-dealer sector, which o¤ers a window on market-based
1 See appendix for de…nitions of variables and data sources (including the list of banks) for

all …gures.

2
 Figure 1: Total assets and book equity of 17 US and 26 euro area banks

Figure 2: Leverage and VIX index

intermediation. The negative relationship between leverage and the VIX index
has broken down since 2009: even though the VIX eased close to pre-crisis lows
up to 2019, bank leverage continued to fall. Forbes and Warnock (2020) and
Miranda-Agrippino and Rey (2020) similarly note the dimished role of the VIX
as an explanatory variable for credit growth and capital ‡ows.
The right-hand panel of Figure 2 shows the structural break: the grey dots
indicate a negative relationship between leverage and the VIX before the GFC;
the black dots indicate that, post-crisis, leverage no longer responds to shifts in
the VIX.
Third, the pricing of bank balance sheet capacity has changed after the
crisis. One notable symptom has been the breakdown of covered interest parity
(CIP). CIP is the proposition that the interest rate on a currency in the money
market is equal to the implied interest rate on that same currency in the FX
swap market.

3
 Figure 3: Deviation from covered interest parity

Figure 3, taken from Avdjiev et al. (2019), shows the di¤erence between the
money market interest rate and the implied interest rate for the dollar implicit
in the FX swap market (averaged across ten advanced economy currencies vis-
à-vis the dollar). The …gure reveals that, whereas CIP held pretty well before
the crisis, it broke down after the crisis. Avdjiev et al. (2019) shows that a
dollar appreciation is associated with a widening of the CIP deviation. This
empirical association holds even in …rst di¤erences and at daily frequency. For
this reason, they argue that the broad dollar index serves as a good concurrent
indicator of bank balance sheet costs.
In sum, changes since the GFC suggest a diminished role for the formal
banking sector in …nancial intermediation, and a greater role for market-based
intermediation and the dollar as a key indicator of risk appetite. Just as the
VIX index was a good summary measure of the price of the balance sheet before
the crisis, so the dollar has become a good measure of the price of the balance
sheet after the crisis.

2 The Evolving Relationship between the Dol-

lar, PMIs and Trade Growth
In view of these changes, we may expect that the channels of transmission of
…nancial conditions may also have changed since the GFC.
Commentary accompanying monthly PMI releases suggests that purchasing
managers closely follow …nancial data in order to assess the …nancing conditions
their …rms face and, more broadly, the current and expected economic activity.
Furthermore, given the structural break in banking sector balance sheet costs
around the time of the GFC, we may expect to detect changes in the way that
…nancial conditions feed into real activity.

4
 In the post-crisis period, a strong dollar has emerged as a concurrent indi-
cator associated with weak PMI and real activity. We investigate the empirical
relationships through a small-scale VAR. The VAR features, in order, changes
in world equity prices, the nominal e¤ective exchange rate of the US dollar (the
“dollar index”), global manufacturing PMIs (excluding the United States), and
global trade growth.2 The number of lags is …xed at six. We compute the
monthly changes over a 30-day period around central PMI survey dates so as to
align market information available to purchasing managers at the time of the
poll.3 This ordering de…nes a Choleski identi…cation that is underpinned by the
timing of …nancial variables: changes in equity prices and the dollar index are
computed over a 30-day window that predates the survey of at least one half
of purchasing managers. This timing sequence supports the assumption that
changes in equity prices and dollar indices are ordered …rst, that is, they do not
react contemporaneously to PMI- and trade-speci…c shocks.
Based on this ordering, the …rst shock, associated with equity price changes,
can be interpreted as the continuous ‡ow of news related to macroeconomic and
…nancing conditions. Financial market participants process this information
and incorporate it in equity prices at high frequency before the PMI and world
trade data are released. The second shock, associated with the dollar index,
can be thought of as the additional information conveyed by changes in the
dollar exchange rate.4 The third shock (associated with PMIs) is then the
change in PMIs that was not already priced into …nancial variables, and can
thus be related to private information available to purchasing managers during
the polling period.
Estimating this VAR on pre- and post-GFC samples highlights a striking
change in the transmission of US dollar shocks.5 Before the GFC, global PMIs
(excluding the United States) expanded moderately after an unexpected dollar
appreciation (Figure 4, grey line). This response is in line with a view that US
import demand increases after a dollar appreciation. After the GFC, however,
global PMIs contract in response to an unexpected dollar appreciation (black
line). The results are even more striking when the response of trade is considered
(Figure 5). Before the GFC, unexpected dollar appreciation boosted world trade
growth (grey line). After the GFC, unexpected dollar appreciation depresses
world trade growth, despite making dollar-denominated exports cheaper (black
line).

2 See appendix for details. Changes in world equity prices are computed as the weighted
average of equity price changes across 32 major economies. For the US dollar index, we use
the FRB’s Trade Weighted U.S. Dollar Index: Other Important Trading Partners, Goods.”
3 The additional assumption is that the survey respondents …ll their questionnaires on

average around the central date of the polling window.

4 This ordering stacks the odds against a role of the dollar: the dollar shock is by con-

struction orthogonal to and a residual of the global equity shock, which absorbs the bulk of
information on the global outlook and …nancing conditions.
5 We excluded the GFC from the sample on purpose, so that the e¤ect of the crisis does

not dominate the system’s dynamics.

5
Figure 4: Impulse responses of global PMIs (excluding the US) to dollar appre-
ciation

Figure 5: Impulse responses of global trade growth to dollar appreciation

6
Table 1: Nowcasting PMIs with the …rst principal component of …nancial vari-
ables

Full sample Pre-GFC Post-GFC

P M It 1 0.944 0.944 0.943
pct 0.215 0.200 0.077
R2 0.936 0.910 0.912
RMSE 0.843 0.906 0.950
Note: All coe¢ cients and RMSE are signi…cant at 1%. RMSE is computed as the ratio
over a plain AR(1) benchmark; signi…cance is determined by Clark and McCracken
(2012) test. Full sample: 2/1998 – 10/2019 (261 observations); pre-GFC: 2/1998 –
12/2007 (119 observations); post-GFC: 1/2010 – 10/2019 (118 observations).
Sources: FRB St Louis, FRED; Bloomberg; Datastream; ICE BofAML indices; IHS
Markit; MSCI.

3 Financial Variables and PMIs: What Has Changed?

We now turn to the relationship between PMIs and …nancial conditions. Erik
et al. (2019) shows that equity prices, corporate bond spreads, and the broad
dollar index are good predictors of current-month PMIs.6 Building on this
earlier work, we estimate monthly regressions of the form

PMI t = + pct + PMIt 1 + t (1)

where PMI t is the global manufacturing PMI release in month t, and pct is
the …rst principal component of monthly changes in a set of …nancial indicators
that include equity prices, corporate bond spreads, the VIX, and the broad
dollar index. As before, we compute the monthly changes over a 30-day period
around central PMI survey dates so as to mimic market information available
on average to purchasing managers at the time of the poll.
Table 1 compares the PMI nowcasting performance of the principal compo-
nent model with the model based on the global composite equity price index,
the best performing one in Erik et al. (2019). A test for superior in-sample
predictive ability (Clark and McCracken 2012) highlights signi…cant gains over
a benchmark model that only includes lagged PMIs. One notable …nding is that
the nowcasting gains diminish when the GFC period is excluded from the sam-
ple. Another is that estimated coe¢ cients are smaller in the post-GFC sample.
However, the nowcasting gain, as measured by RMSE, remains sign…cant (Erik
et al. 2020).
To shed further light on the results, we examine how the principal component
factor loadings have evolved over time. Figure 6 compares the loadings in the
pre- and post-GFC periods (1998-2007 and 2010-2019). It highlights the changes
6 Conversely, Peláez (2003) showed that releases of the US PMI in‡uence bond and equity

prices, trading activity in the Treasury bond market, and interest rates in US Treasury and
Eurodollar markets.

7
Figure 6: Factor loadings of the …rst principal component of …nancial variables

in the loadings of the dollar and the VIX: the dollar loading has increased, and
the VIX loading has decreased. This evidence is consistent with the results in
Forbes and Warnock (2020) and Miranda-Agrippino and Rey (2020), which also
note the diminished post-crisis role for the VIX. Notably, the sign of the dollar
loading is negative, that is, dollar appreciation acts as a drag on global PMIs,
consistent with Bruno and Shin (2015, 2019).

4 Role of the Dollar Post-GFC

What could explain the greater role of the dollar as a determinant of global
economic activity? One possible channel is through determinants of risk capac-
ity, and in particular the role of the dollar exchange rate as an indicator of this
risk capacity (Bruno and Shin (2015)). Indeed, the dollar is closely correlated
with the growth of dollar-denominated credit outside the United States. Figure
7 shows the four-quarter growth rates of lending in dollars to emerging mar-
ket economies (EMEs) and the four-quarter change in the EME-weighted dollar
index.7 The two series are negatively correlated: when the dollar strengthens,
lending in dollars to EMEs slows.
The negative relationship between dollar strength and growth of dollar credit
may be explained by the …nancial channel of exchange rates, which works
through the greater liquidity of assets (Diamond, Hu, and Rajan 2020), or
through ‡uctuating lending capacity of banks that intermediate US dollar credit
(Bruno and Shin 2015). If a global bank has a diversi…ed portfolio of loans to
borrowers around the world, a broad-based depreciation of the dollar results
in lower tail risk in the bank’s credit portfolio and a relaxation of the bank’s
Value-at-Risk (VaR) constraint. The result is an expansion in the supply of
dollar credit through increased leverage. In this way, a broad depreciation of
7 Figure 7 shows total credit/loans to non-banks in EMEs. For the US dollar index, FRB

other important trading partners dollar index, goods.

8
Figure 7: Dollar-denominated credit to emerging market economies and US
dollar index

the dollar is associated with greater risk-taking by banks.

Interestingly, Niepmann and Schmidt-Eisenlohr (2019) shows that domestic
credit in the United States also has a negative relationship with the dollar, even
to …rms in the nontradeables sector. The mechanism is through the demand
from institutional investors in the secondary market for loans originated by US
banks.
The resulting shifts in dollar credit conditions may a¤ect …nancing require-
ments for manufacturing …rms, especially those participating in global supply
chains. These …rms generally have large working capital …nancing requirements
because they need to carry on their balance sheet inventories of intermediate
goods, and often of accounts receivable when selling to other …rms along the sup-
ply chain (Bruno, Kim, and Shin 2018). With manufacturing and, increasingly,
services being globally integrated, dollar credit conditions would therefore have
some impact on economic activity along global supply chains. Shousha (2019)
shows that real activity in emerging market economies is negatively a¤ected by
a stronger dollar.
Another explanation of the impact of a stronger dollar on global trade is the
invoicing channel of trade. Gopinath and Stein (2018a, 2018b) show that when
the US dollar is used as an invoicing currency for trade, the volume of trade
between two countries (neither of which is the United States) may experience
a decline because of the competitive implications of dollar invoicing. Both in
the invoicing and our channel, a stronger dollar is associated with weaker trade
activity. The invoicing channel works through the bilateral dollar exchange rate
against the export destination country. Bruno and Shin (2019) uses matched
…rm- and bank credit-level data from Mexico and …nds evidence of both the
invoicing and …nancing channels.
Overall, the …ndings in our paper suggest that structural changes have oc-

9
curred in the banking sector after the GFC.
Most notably, the mantle of the barometer of risk capacity and leverage
has slipped from the VIX and passed to the dollar. Risk capacity appears to
be better measured through the broad dollar index than the VIX. The formal
banking sector has remained subdued, giving way to market-based …nancing and
non-bank intermediation. We have explored some implications for real economic
activity of this shift. Future research will undoubtedly uncover more details.

References
Adrian, Tobias, and Hyun Song Shin. 2010. “Liquidity and Leverage.”
Journal of Financial Intermediation, 19 (3): 418–37.
Adrian, Tobias, and Hyun Song Shin. 2014. “Procyclical Leverage and
Value-at-Risk.”Review of Financial Studies, Society for Financial Studies,
27 (2): 373–403.
Avdjiev, Stefan, Wenxin Du, Cathérine Koch, and Hyun Song Shin.
2019. “The Dollar, Bank Leverage, and Deviations from Covered Interest
Parity.” American Economic Review: Insights, 1 (2): 193:208.
Bruno, Valentina, Se-Jik Kim, and Hyun Song Shin. 2018. “Exchange
Rates and the Working Capital Channel of Trade Fluctuations.”AEA Pa-
pers and Proceedings, 108: 531–6.
Bruno, Valentina, and Hyun Song Shin. 2015. “Capital Flows and the
Risk-Taking Channel of Monetary Policy.” Journal of Monetary Eco-
nomics, 71: 119–32.
Bruno, Valentina, and Hyun Song Shin. 2019. “Dollar Exchange Rate as
a Credit Supply Factor— Evidence from Firm-Level Exports.” Bank for
International Settlements Working Paper 819.
Clark, Todd E., and Michael W. McCracken. 2012. “In-Sample Tests
of Predictive Ability: A New Approach.” Journal of Econometrics, 170
(1): 1–14.
Diamond, Douglas W., Yunzhi Hu, and Raghuram G. Rajan. 2020.
“The Spillovers from Easy Liquidity and the Implications for Multilateral-
ism.” IMF Economic Review, 68: 4–34.
Erik, Burcu, Marco Jacopo Lombardi, Dubravko Mihaljek, and Hyun
Song Shin. 2019. “Financial Conditions and Purchasing Managers’ In-
dices: Exploring the Links.” Bank for International Settlements Quarterly
Review, 23 (3): 65–79.
Erik, Burcu, Marco Jacopo Lombardi, Dubravko Mihaljek, and Hyun
Song Shin. 2020. “Financial Conditions, the Dollar and Real Economic
Activity.”Bank for International Settlements Working Paper, forthcoming.

10
Forbes, Kristin J., and Francis E. Warnock. 2020. “Capital Flow Waves—
or Ripples?: Extreme Capital Flow Movements in an Era of Easy Monetary
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forthcoming.
Gopinath, Gita, and Jeremy C. Stein. 2018a. “Banking, Trade, and the
Making of a Dominant Currency.” NBER Working Paper 24485.
Gopinath, Gita, and Jeremy C. Stein. 2018b. “Trade Invoicing, Bank
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Miranda-Agrippino, Silvia, and Hélène Rey. 2020. “The Global Financial

Cycle after Lehman.” AEA Papers and Proceedings, 110, forthcoming.
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Peláez, Rolando F. 2003. “A Reassessment of the Purchasing Managers’In-

dex.” Business Economics, 38 (4): 35–41.
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11
Appendix
Figure 1: Total assets and book equity of 17 US and 26 euro area
banks

United States Bank of America Corporation; Bank of New York Mellon

Corporation; Capital One Financial Corporation; Citigroup
Inc.; Citizens Financial Group Inc.; Fifth Third Bancorp;
JPMorgan Chase & Co.; Morgan Stanley; Goldman
Sachs Group Inc.; Northern Trust Corporation; PNC
Financial Services Group Inc.; Regions Financial Cor-
poration; State Street Corporation; SunTrust Banks Inc.;
Truist Financial Corporation; U.S. Bancorp and Wells
Fargo & Company.
Euro area AIB Group Plc; Banca Monte dei Paschi di Siena SpA;
Banco Bilbao Vizcaya Argentaria SA; Banco Bpm SpA;
Banco de Sabadell SA; Banco Popular Español SA;
Banco Santander SA; Bank of Ireland Group; Bankia
SA; BNP Paribas SA; CaixaBank SA; Commerzbank
AG; Crédit Agricole SA; Crédit Industriel et Commercial
SA; Deutsche Bank AG; Dexia SA; Erste Group Bank
AG; ING Groep NV and Nordea Bank Abp.; Intesa
Sanpaolo SpA; KBC Group NV; Natixis SA; Rai¤eisen
Bank International AG; Société Générale SA; UniCredit
SpA; Unione di Banche Italiane SpA.

Sources: Datastream Worldscope; authors’calculations.

Figure 2: Leverage and VIX index

Leverage Total assets divided by equity for the broker-dealer sector in

the US.
VIX CBOE Volatility Index.

Sources: Federal Reserve, Flow of Funds; Bloomberg; authors’calculations.

12
Figure 3: Deviation from covered interest parity

US dollar index Federal Reserve Board trade-weighted

US dollar index, broad, goods.
Mean cross-currency basis spread Mean of …ve-year cross-currency basis
spread across AUD, CAD, CHF, DKK,
EUR, GBP, JPY, NOK, NZD and
SEK.

Sources: Federal Reserve Bank of St Louis (FRED); Bloomberg; authors’

calculations.

Figure 4-5: Impulse responses of global PMIs (excluding the US)

and global trade growth to dollar appreciation

World equity price Weighted average of equity prices in major local

stock exchanges across 32 economies based on GDP
and PPP exchange rates.
US dollar index Federal Reserve Board trade-weighted US dollar
index, other important trading partners, goods.
Global PMI Simple average of manufacturing PMIs across 31
economies (excluding the United States) (less
countries for earlier periods due to data constraints).
Global trade growth World trade volume index, seasonally adjusted.

Sources: Federal Reserve Bank of St Louis (FRED); CPB Netherlands Bureau

of Economic Policy Analysis; Bloomberg; Datastream; IHS Markit; authors’
calculations.

13
Figure 6: Factor loadings of the …rst principal component of
…nancial variables

Equity (1) MSCI All Country World Index, local currency (2,844
constituents; large and mid-cap …rms in 23 advanced
economies and 26 EMEs; US (56%), Japan (7%),
UK (5%), China (4%), France (3%), others (25%)).
Equity (2) MSCI All Country World Industrials Index, local currency
(432 constituents).
Equity (3) MSCI Emerging Markets Index, local currency (1,194
constituents).
Equity (4) Weighted average of equity prices in major local stock
exchanges across 32 economies based on GDP and PPP
exchange rates.
Spread (1) ICE BofAML Global Corporate Index, investment grade,
option adjusted spread (14,404 constituents).
Spread (2) ICE BofAML Global High Yield Index, below investment
grade, option adjusted spread (3,131 constituents).
Spread (3) ICE BofAML Global Non-…nancial Corporate Index,
investment grade, option adjusted spread (10,346 constituents).
Spread (4) ICE BofAML Global Industrial Index, investment grade,
option adjusted spread (8,430 constituents).
VIX CBOE Volatility Index.
USD Federal Reserve Board trade-weighted US dollar index,
broad, goods.

Sources: Federal Reserve Bank of St Louis (FRED); Bloomberg; Datastream;

ICE BofAML indices; MSCI; authors’calculations.

Figure 7: Dollar denominated credit to emerging market economies

Total credit Total credit denominated in USD to non-banks in EMEs.

Loans Loans denominated in USD to non-banks in EMEs.
US dollar index Federal Reserve Board trade-weighted US
dollar index, other important trading partners, goods.

Sources: Federal Reserve Bank of St Louis (FRED); Dealogic; Euroclear;

Thomson Reuters; Xtrakter Ltd; national data; BIS local banking statistics;
authors’calculations.

14
Table 1: Nowcasting PMIs with the …rst principal component of
…nancial variables

P M It 1 Global manufacturing PMI.

pct First principal component of the following variables: equity (1-4),
spread (1-4), VIX and USD (see note for Figure 6 for variable
descriptions).

Sources: Federal Reserve Bank of St Louis (FRED); Bloomberg; Datastream;

ICE BofAML indices; IHS Markit; MSCI; authors’calculations.

15
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