The Global Financial Cycle And Cross-border Capital Flows

Cross-border capital flows have a significant impact on the macroeconomic and financial stability of a country,so studying the determinants of cross-border capital flows has theoretical and policy importance.Existing studies on the determinants of cross-border capital flows are mostly based on the push-pull framework.Pull factors refer to the domestic factors,such as economic growth rate,degree of openness,institutional quality,etc.Push factors are global factors,mainly including global risk appetite,monetary policies of developed countries,global economic growth rate,and international oil prices,etc.Over the past decades,financial markets have become progressively more integrated internationally,leading to the emergence of a cross-border co-movement of capital flows,asset prices,credit and leverage ratio of financial institutions.This phenomenon is called the global financial cycle.The driving factors behind the global financial cycle mainly include monetary policies of developed countries and global risk appetite,etc.Therefore,the global financial cycle can be regarded as a set of push factors.Due to the important role of cross-border capital flows in transmitting the global financial cycle as well as in a country’s economic and financial stability,this paper focuses on the relationship between the global financial cycle and cross-border capital flows.According to the existing literature,capital flows are mainly driven by global factors in the period of stress.Therefore,under the current complex international economic and financial situation,research on the impact of the global financial cycle on cross-border capital flows is of importance.Moreover,if a country’s capital flows are mainly driven by the global financial cycle,then the country is more likely to experience sudden surges and sudden stops in capital inflows that are not related to domestic fundamentals.In addition to amplifying the fluctuations of a country’s capital flows,the global financial cycle may also amplify the volatility of a country’s financial cycle,thus causing financial instability.Especially when the domestic financial cycle resonates with the global financial cycle,the financial crisis may occur in capital recipient countries.The reason is that a loose global financial condition coinciding with a loose domestic financial condition will create a “turbocharging effect”,which may lead to excess capital inflows,asset price bubbles and excess credit creation.Once the global financial condition reverses,the risk of financial imbalances will be exposed,the collapse of asset bubbles and the deleveraging of the financial sector will lead to the deterioration of domestic financial conditions,and in severe cases,a financial crisis will be triggered.Cross-border capital flows are inevitably affected by the global financial cycle.Therefore,the paper focuses on explaining why the global financial cycle affects capital flows unequally to all countries and why some countries’ gross capital inflows more sensitive to the global financial cycle than others.China’s financial conditions are highly correlated with global financial conditions.With further integration with the international capital market,China’s sensitivity to the global financial cycle will be further enhanced,which will have a significant impact on China’s monetary policy and financial stability.This paper can provide empirical evidence at the international level for China to strengthen the management of capital flows and prevent external shocks.Most of existing literature evaluates this heterogeneity from the macro perspective.There is little literature explaining this question from the micro and policy perspective.This paper explains it from the macro,micro and policy perspective comprehensively,thus making a useful supplement to the existing literature.Firstly,this paper explains the differences in sensitivity of capital inflows to the global financial cycle from the macro perspective.Using balance-of-payments data from 45 countries,including 22 developed economies and 23 emerging economies,the paper studies the impact of the global financial cycle on total cross-border capital inflows and whether such impacts varied across different types of capital inflows(FDI inflows,portfolio inflows,banking loans inflows),different countries(developed and emerging economies),and different periods(before and after the 2008 financial crisis).Then the paper focuses on whether macroeconomic fundamentals and structural factors such as exchange rate regime,capital account openness,financial development,external debt,currency mismatch,macro leverage and institutional quality can buffer or amplify the global financial cycle.We find that:(1)The impact of the global financial cycle on portfolio inflows and banking loans inflows are statistically significant,but the impact of the global financial cycle on FDI inflows is not statistically significant;(2)The effect of global financial cycle is magnified under fixed exchange rate regimes compared with more flexible(though not necessarily fully flexible)regimes;(3)The higher degree of openness,financial development,and vulnerability(the higher level of external debt and domestic debt,the higher degree of currency mismatch),the more vulnerable to the global financial cycle;(4)After the 2008 financial crisis,the sensitivity of portfolio inflows to the global financial cycle is increasing,the reason behind it may be that large-scale quantitative easing makes the spillover effect of the central country’s monetary policy more obvious by directly affecting long-term interest rates,and compared with other forms of capital inflows,the portfolio inflows are the most sensitive to the central country’s monetary policy;(5)The impact of the global financial cycle on emerging economies is greater than developed economies.Based on the above findings,the global financial cycle has a greater impact on emerging economies,and portfolio inflows are becoming more sensitive to the global financial cycle.The scope of the paper will further focus on the heterogeneous impact of the global financial cycle on emerging market portfolio inflows.Secondly,the EPFR database is used to explain the reasons for the differences in the sensitivity of cross-border portfolio equity inflows to the global financial cycle from the micro perspective.The paper finds that equity funds’ inflows in emerging economies are pro-cyclical,and there is heterogeneity among the different types of funds.The sensitivity of flows to the global financial cycle for ETFs is 1.7-1.8 times higher than for mutual funds.The reason is that there is a high proportion of short-term and benchmark-driven investors in ETFs,and these two types of investors are highly sensitive to the global financial cycle.In addition,taking the MSCI-EM index as an example,the paper discusses the sensitivity of benchmark-driven funds to the global financial cycle,and finds that tracking the MSCI-EM index increases the sensitivity of funds to the global financial cycle.Then,by aggregating the fund level data to the country level,the paper calculates the exposure of ETFs and the exposure of investors tracking the MSCI-EM index,and finds that the impact of the global financial cycle on a country’s capital inflows will be further strengthened with the increase of the exposure of both types of investors.Thus from the micro perspective of investor structure,the paper explains the heterogeneity in sensitivity of cross-border equity capital inflows to the global financial cycle.Thirdly,the EPFR database is used to explain the differences in the sensitivity of crossborder portfolio bond inflows to the global financial cycle from the policy perspective,and also to provide policy suggestions for how emerging economies can better cope with the global financial cycle shocks.The results show that:(1)When global risks and uncertainties are high,the adoption of foreign exchange intervention to resist exchange rate depreciation can reduce capital outflows and the sensitivity to the global financial cycle;(2)In general,sterilization is very effective,but if it is carried out during periods of surges,it restrains interest rates from falling,thus attracting further capital inflows,which greatly reduces the effect of sterilization;(3)The effect of monetary policy is asymmetric,raising interest rates when facing with capital inflows surges will lead to higher domestic returns,attracting further capital inflows,thereby further increasing the sensitivity to the global financial cycle;when global risks and uncertainties are high,raising interest rates will increase the opportunity cost of capital outflows,so it can mitigate capital outflows and reduce sensitivity to the global financial cycle;(4)For countries with low levels of government debt,fiscal policy can help resist the global financial cycle,and for countries with high levels of government debt,the role of fiscal policy is not significant;(5)The effect of capital controls on bond portfolio inflows is less obvious,but relaxing or removing controls on capital outflows would further increase sensitivity to the global financial cycle during periods of surges.This may be because the relaxation or removal of restrictions on capital outflows is regarded as a positive signal of financial liberalization,which will increase the confidence of foreign investors and thus attract further capital inflows;(6)The global financial safety net can reduce the sensitivity to the global financial cycle when facing with capital inflows sudden stops.Particularly,the buffering effect of foreign exchange reserves and international reserves such as SDR are very obvious;(7)Borrower-based macroprudential policies are effective in resisting the global financial cycle.Financial-based macroprudential policies are more effective during periods of surges and sudden stops.The reason behind this is that financial institutions have more measures to avoid macroprudential policies in normal times,including through cross-border banking loans and other forms of external financing.When a country experiences surges or sudden stops,it tends to adopt capital control measures.Therefore,it becomes more difficult for financial institutions to obtain external financing,which makes financial-based macroprudential policies effective.In order to effectively resist the impact of the global financial cycle,emerging economies,including China,can respond from the following aspects.At the domestic macro level,strengthen domestic structural reforms,consolidate macroeconomic fundamentals,enhance economic and market resilience,and control leverage ratios and asset bubbles.At the same time,foster and develop domestic institutional investors,reduce external debt,limit currency mismatches,and reduce the accumulation of vulnerabilities,thereby providing more policy space for dealing with the global financial cycle shocks.In addition,improve the flexibility of exchange rate,though not necessarily fully flexible,a fully flexible exchange rate will amplify external shocks through the “financial channel of the exchange rate”.Therefore,while enhancing exchange rate flexibility and improving the market-oriented mechanism of exchange rate,exchange rate adjustment measures should be taken to prevent large exchange rates fluctuations.Especially when global risks and uncertainties are high,foreign exchange intervention to resist exchange rate depreciation can reduce capital outflows and reduce sensitivity to the global financial cycle.At the domestic micro level,emerging economies need to strengthen the monitoring and analysis of cross-border capital flows.Policy makers must not only pay attention to the scale of cross-border capital flows but to the structure of capital flows as well.Especially pay attention to the scale and investor composition of portfolio inflows,and establish controls for investors who are highly sensitive to the global financial cycle,such as ETFs and benchmark-driven investors,if necessary.As the financial markets of emerging economies further open up and are gradually included in more and more global benchmark indices,benchmark-driven funds will account for an increasing share of cross-border capital inflows.Since ETFs track a specific benchmark index passively,there will also be a large number of cross-border ETFs flowing into emerging markets driven by benchmark indices.Besides,excessive concentration of asset managers amplifies the impact of the global financial cycle,and policy authorities need to remain highly vigilant.At the domestic policy level.First,raise the adequacy ratio of foreign exchange reserves.Accumulating foreign exchange reserves,on the one hand,allows the central bank to intervene in foreign exchange market when necessary and weaken the mutually reinforcing feedback mechanism between exchange rates and capital flows,thereby weakening the impact of the global financial cycle;on the other hand,as part of the global financial safety net,accumulating foreign exchange reserves can stabilize the confidence of financial market participants through signal channels,so as to prevent sharp exchange rates fluctuations.Second,fiscal policy is effective for countries with low levels of government debt,and has no significant impact on countries with high levels of government debt.Therefore,emerging economies should rein in their governments’ debt levels,thereby making fiscal policies more effective in responding to the global financial cycle shocks.Third,in periods of high global risk and uncertainty,tight monetary policy can mitigate capital outflows and reduce sensitivity to the global financial cycle.Fourth,counter-cyclical macroprudential policy needs to be implemented.If financialbased macroprudential policies are used,they need to be implemented in conjunction with capital control measures.At the international level,since the main driver of the global financial cycle is the monetary policy of developed countries,emerging economies should unite to promote the improvement of international economic policy coordination mechanisms within the framework of the G20,and work to reduce the negative global spillovers of developed countries’ monetary policies to promote international financial stability.Moreover,IMF quota and SDR quota,as part of the global financial safety net,can cushion the impact of the global financial cycle,so emerging economies should actively promote reforms in the IMF and SDR quota,enabling emerging economies to achieve greater quota.