The Effect Of Economic Policy Uncertainty On Cross-border Capital Flows

The outburst of global financial crisis in 2008 had yet again made people realized the importance of financial stability and its relations with financial openness.In fact,since 1960 s,developed countries have started the process of capital account openness and flowed by the opening of developing countries in 1970 s and the degree of capital account openness has reached its highest point in early 80 s.The elevated degree of capital account opening has brought up the volatile cross-border capital flows flooding in and out of countries and frequently followed by several economic crisis,such as Latin American debt crisis in 1980 s,the Mexican financial crisis in 1994,Asian financial crisis in 1998 and global financial crisis in 2008.The nature of volaille cross-border capital flows followed by financial crisis made people considered the relationship of financial openness and stability,and the role of cross-border capital flows play in forming the boom-burst cycles and the transmission of risks.Meanwhile,the frequent unanticipated changes of economic policies of developed countries in order to stimulate economy had brought the heated discussion over economic policy uncertainty in both scholars and practical field.As the IMF have suggested several times in the “World Economic Outlook” that uncertainty about U.S.and European fiscal,regulatory and monetary policies had a strong effect on the steep economic decline in 2008–2009 and the slow recovery rates after that.Recently,the outbreak of coronavirus and the geopolitical turmoil has made the global uncertainty reached at unprecedented levels.Researchers have found that EPU can depress the investment and consumption and credit flows by influencing the anticipation,risk appetite and sentiment of firms,financial institutions and consumers,therefore transmit to the macroeconomic environment,and have significant spillover effect to other countries,especially to emerging markets with fragile financial environment.Hence,it is of great important for the authority to take precautions for such risks while sticking to financial opening strategy in the long run.Although,there are countless papers have discussed EPU and the influences,but we found that little has been done over the spillover effect of EPU and the discussions of underlying mechanism remains insufficient,and that made it hard to make useful policy suggestions.Hence,due to the different nature and driving force of three different types of capital flow,hence the different underlying mechanism,we try to fill the gap by studying the impact of economic policy uncertainty to three different capital flows and the underlying mechanism from three perspectives,and furthermore we came with some implications to larger questions such as the tradeoff between financial openness and financial stability,and this helps in bringing useful policy suggestions.This paper started with the introduction,including the backgrounds and significance,main subjects,research framework and methods,innovations and shortcomings,and followed by literature review of the definitions of economic policy uncertainty and cross-border capital flows,the classical theories of cross-border capital flows and it’s driving factors,the effect of EPU and inner mechanisms,the transmitting mechanisms of monetary policy uncertainty,and lastly is our comments.Then we studied the effects of EPU to three different types of crossborder capital flow through empirical analysis,respectively.Lastly,based on the conclusions,we made suggestions on how to lower the spillover effects of EPU shocks,and the tradeoff between opening and stability.The key findings of our investigation can be summarized as follows,Firstly,we found that economic policy uncertainty can be an important driver of three different cross-border flows.Specifically,EPU will push the outflow of bank credit and restrain the inflow of FDI and crossborder fund flows.Secondly,the foreign bank may act as shock amplifier,which means a higher degree of participation of foreign banks can result larger outflow of bank credit when EPU is increasing,this implicates that policy makers can ease the negative impact of EPU by regulating the behavior of foreign banks,especially in EMEs countries.Also we found that this amplifying effect of foreign bank may due to the asymmetric information mechanism,because we found that in countries that have high transparency(lower level of information asymmetric),they tend to be less influenced by the amplify effect of foreign banks.Thirdly,we found the degree of trade openness can mitigate the negative impact of EPU,that is,in countries with relatively high trade openness,their FDI tend to be less exposed to the economic policy uncertainty shock,but we can only find that effect in developed countries.In order to find out why there is difference in two subsamples,we spilt the trade openness into import and export share,we found that in the subsample of EMEs,although export can ease the negative effect of EPU,the import share can have totally different mechanism,we think this is the main reason why trade openness in EMEs don’t have significant moderation effect.These conclusions means that policy makers can use trade openness policy to alleviate the negative effect of EPU by drawing the export-oriented FDI,and exports and FDI are complements.Forth,we found that investors sentiment appears to be an important mechanism behind the effect of EPU on cross-border fund flows,because we find it can alleviate the negative effect of EPU,but only exists in EMEs.We thinks that the aggregate investor sentimental indicators can only reflect the intensity level of investors sentiment,but can’t reflect the attribute of different sentiment,therefore in order to further understand the effect of sentiment,we separate the indicator into “positive” investors sentiment and “negative” investors sentiment only to find that it’s the “positive” investors sentiment stands out,which means positive emotion can be the stabilizer of shocks,this can have important policy implications.Based on the conclusions of empirical analysis,there are several policy implications.Firstly,in the history of financial liberation,it seems like the benefit of the financial liberalization is rather small,compared to the cost of financial stability in EMEs which contradictory to the whole idea of financial openness strategy.However,this doesn’t means that the financial liberalization was wrong,but it should be clear that there are some fundamentals needs to be realized,such as a sound economic environment,deep financial markets and good institution qualification,only when these requirements are met can bring the benefits of financial openness,otherwise,hoping to boost the economic growth and financial development by financial liberalization reforms will only bring heavy cost of financial stability and economic slowdown.Secondly,although economic policy uncertainty shocks can have negative impacts to all three types of cross-border capital flows,and as capital flows itself can be the channel that connect different countries,it can also transfer risks across the countries,hence,every country should take the negative impacts of the constant policy changes into consideration when they make polices and announcements,because in this highly-globalized world,no one can really insulate themselves from others.And also,it is important for policy makers to stay vigilant of policy uncertainty shocks and learn to use proper capital flow management to minimize the negative influence.Thirdly,in the testing of mechanism,we found that foreign bank and investors sentiments can amplify the negative effect of economic policy uncertainty,especially for EMEs.This means financial openness and the sentiment of irrational investors can make the situation worse,but also it can have some policy implications,for instance,one can lower the risks of EPU by regulating the behavior of foreign banks while in the rising of uncertainty.Furthermore,we find that in countries with less information asymmetric,they tend to be less influenced by the behavior of foreign banks,this means the improvement of market transparency can help mitigate the negative effect.Comparing to other researches,our contributions may as follow,Firstly,we explored the role of financial openness and trade openness in the face of elevating EPU,this can help the authority making useful policies in dealing with the EPU shocks from the perspective of financial openness and trade openness policy.Secondly,we are the first research to investigate the effect of investors sentiment in EPU shocks,finding a new evidence of sentiment mechanism behind the spillover effects of monetary policy uncertainty from the perspective of behavioral finance.Thirdly,we use novel dataset EPFR,this dataset can not only reflets the movement of short-term cross-border capital flows by offering high-frequency data,but also using the data of fund flows and aggregated in the country level,besides,cross-border fund flows can reflect the behavior of global institutional investors.