NBER WORKING PAPER SERIES

DILEMMA NOT TRILEMMA:THE GLOBAL FINANCIAL CYCLE AND MONETARY POLICY INDEPENDENCE

Hlne Rey

Working Paper 21162http://www.nber.org/papers/w21162

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138May 2015

I am grateful to Silvia Miranda-Agrippino and to Evgenia Passari for excellent research assistanceand to Richard Portes for discussions. I gratefully acknowledge the ERC (starting grant 210584) forfunding. This paper was presented in the Jackson Hole Symposium. The views expressed herein arethose of the author and do not necessarily reflect the views of the National Bureau of Economic Research.

NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies officialNBER publications.

2015 by Hlne Rey. All rights reserved. Short sections of text, not to exceed two paragraphs, maybe quoted without explicit permission provided that full credit, including notice, is given to the source.

Dilemma not Trilemma: The global Financial Cycle and Monetary Policy IndependenceHlne ReyNBER Working Paper No. 21162May 2015JEL No. E5,F02,F33,G15

ABSTRACT

There is a global financial cycle in capital flows, asset prices and in credit growth. This cycle comoveswith the VIX, a measure of uncertainty and risk aversion of the markets. Asset markets in countrieswith more credit inflows are more sensitive to the global cycle. The global financial cycle is not alignedwith countries specific macroeconomic conditions. Symptoms can go from benign to large asset pricebubbles and excess credit creation, which are among the best predictors of financial crises. A VARanalysis suggests that one of the determinants of the global financial cycle is monetary policy in thecentre country, which affects leverage of global banks, capital flows and credit growth in the internationalfinancial system. Whenever capital is freely mobile, the global financial cycle constrains national monetarypolicies regardless of the exchange rate regime.

For the past few decades, international macroeconomics has postulated the trilemma: with free capitalmobility, independent monetary policies are feasible if and only if exchange rates are floating. Theglobal financial cycle transforms the trilemma into a dilemma or an irreconcilable duo: independentmonetary policies are possible if and only if the capital account is managed.

So should policy restrict capital mobility? Gains to international capital flows have proved elusivewhether in calibrated models or in the data. Large gross flows disrupt asset markets and financialintermediation, so the costs may be very large. To deal with the global financial cycle and the dilemma,we have the following policy options: ( a) targeted capital controls; (b) acting on one of the sourcesof the financial cycle itself, the monetary policy of the Fed and other main central banks; (c) actingon the transmission channel cyclically by limiting credit growth and leverage during the upturn ofthe cycle, using national macroprudential policies; (d) acting on the transmission channel structurallyby imposing stricter limits on leverage for all financial intermediaries.

Hlne ReyLondon Business SchoolRegents ParkLondon NW1 4SAUNITED KINGDOMand NBERhrey@london.edu

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IntroductionIfonelooksattheevolutionoffinancialintegrationoverthepasthalfcenturyintheworldeconomy,onemightconcludethatfinancialopennessisanirresistiblelongruntrend,hailedbypolicymakersandacademiceconomistsalike.Bothemergingmarketsandadvancedeconomieshaveincreasinglyopenedtheirborderstofinancialflows.Thescopeforinternationalcapitalflowstoprovidewelfaregainsortodoharmhaswidenedconsiderablysincethe1990s.

Ininternationalmacroeconomicsandfinanceweoftenthinkwithintheframeworkofthetrilemma:inafinanciallyintegratedworld,fixedexchangeratesexportthemonetarypolicyofthecentrecountrytotheperiphery.Thecorollaryisthatiftherearefreecapitalflows,itispossibletohaveindependentmonetarypoliciesonlybyhavingtheexchangeratefloat;andconversely,thatfloatingexchangeratesenablemonetarypolicyindependence(seee.g.ObstfeldandTaylor(2004)).Butdoesthescaleoffinancialglobalizationandinparticulartheroleofglobalbanksputeventhisintoquestion?Arethefinancingconditionssetinthemainworldfinancingcentressettingthetonefortherestoftheworld,regardlessoftheexchangerateregime?Isthereaglobalfinancialcycleandifyes,whatareitsdeterminants?

Riskyassetpricesaroundtheglobe,fromstockstocorporatebonds,haveastrongcommoncomponent.Sodocapitalflows.Creditflowsareparticularlyprocyclicalandvolatile.Ascreditcyclesandcapitalflowsobeyglobalfactors,theymaybeinappropriateforthecyclicalconditionsofmanyeconomies.Forsomecountries,theglobalcyclecanleadtoexcessivecreditgrowthinboomtimesandexcessiveretrenchmentinbadtimes.Astherecentliteraturehasconfirmed,excessivecreditgrowthisoneofthebestpredictorsofcrisis(GourinchasandObstfeld(2012),SchularickandTaylor(2012)).Globalfinancialcyclesareassociatedwithsurgesandretrenchmentsincapitalflows,boomsandbustsinassetpricesandcrises.Thepictureemergingisthatofaworldwithpowerfulglobalfinancialcyclescharacterisedbylargecommonmovementsinassetprices,grossflowsandleverage.Itisalsoaworldwithmassivedeviationsfromuncoveredinterestparity.Thereareinterrelationswiththemonetaryconditionsofthecentrecountry(theUS),capitalflowsandtheleverageofthefinancialsectorinmanypartsoftheinternationalfinancialsystem.Theglobalfinancialcyclecanberelatedtomonetaryconditionsinthecentrecountryandtochangesinriskaversionanduncertainty(Bekaertetal.(2012),MirandaAgrippinoandRey(2012),BrunoandShin(2013b)).

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Butevenifcapitalflows,especiallycreditflows,arelargelydrivenbyaglobalfactor,theymightstillbringimportantbenefitstotheworldeconomy.Abriefreviewoftheempiricalevidenceandthequantificationofstandardgrowthmodels,however,showshowelusivewelfaregainstocapitalflowsappeartobe,thoughitcouldjustbethattheyarehardtomeasure.

InpartI,Idescribethecharacteristicsofcapitalflows(grossandnet),showimpressivecomovementingrossflowsanddiscusshowtheyrelatetoglobalfactors,asproxiedinparticularbytheVIX.InpartII,Ishowtheexistenceofanimportantcommonfactorininternationalassetprices,whichisalsocloselyrelatedtotheVIX.Iconcludethatthereisapotentglobalfinancialcycleingrosscapitalflows,creditcreationandassetprices,whichhastightconnectionswithfluctuationsinuncertaintyandriskaversion.PartIIIanalysestheassociationofdifferenttypesofcapitalflowswiththeglobalfinancialcycleandreinforcestheconclusionthatcreditflowsareparticularlyconnectedtotheglobalfinancialcycle.InpartIV,Ihuntforthedeterminantsoftheglobalfinancialcycleitselfanditstransmissionmechanism,focusinginparticularontheroleofmonetarypolicyinthecentrecountry,ontheleverageoffinancialintermediaries,creditcreationandcreditflows.PartVarguesthatourfindingsinvalidatethetrilemmaandleadtoadilemma,anirreconcilableduo:independentmonetarypoliciesarepossibleifandonlyifthecapitalaccountismanaged,directlyorindirectlyviamacroprudentialpolicies.PartVIdiscussesbrieflythefindingsoftheliteratureonthegainstocapitalmobility.

I)TheglobalfinancialcycleandinternationalcapitalflowsA) Characteristicsofinternationalcapitalflows

Figure1apresentsacomprehensiveheatmapofcapitalinflowsbyassetclasses(FDI,portfolioequity,portfoliodebtandcredit1)intodifferentgeographicalregions(NorthAmerica,WesternEurope,CentralandEasternEurope,LatinAmerica,Asia,EmergingAsia,Africa2).Thedataarequarterly1990Q12012Q4andcomefromtheIMFInternationalFinancialStatistics.Theheatmapcolourscorrespondtothesignsofthecorrelationsofcapitalflowsacrossregionsandtypesofflows(greenwhenthecorrelationispositiveandredotherwise).Asevidencedbytheveryclearpreponderanceofthegreencolourintheheatmap,mosttypesofcapitalinflowsarepositivelycorrelatedwithoneanotherandacrossregions.Thereisaverystrongcommonalityinliabilityflows1Technicallyweuseotherinvestmentwhichcontainsbankloansandtradecredit.2Forapreciselistofthecountriesincluded,seeAppendixA.

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acrosstheworld.TheonlyexceptiontendstobeFDIinflowsinallregionsoftheworldwithportfolioequityflowsintoAsiaandsomecreditflowsintoAfricaandintoAsia.ThereareinparticularstrongpositivecorrelationsbetweenallthemajorflowsintoNorthAmericaandWesternEurope.

Theheatmapofcapitaloutflowsbyassetclasses(Figure1b)intothesamegeographicalregionsshowsanalmostequallystrongpatternofpositivecorrelations.TheonlyareaforwhichcapitaloutflowstendtobeoutofsyncisAfrica,andthisistrueacrossfinancialassets.Further,someFDIoutflowsoutofAsiatendalsotocorrelatenegativelywithotherflows.Otherwise,thecomovementofflowsisalsoverymarked,inparticularoutofthemainfinancialcentres(NorthAmericaandWesternEurope)forcredit,debtandportfolioequity.

Ontheotherhandtherearenosystematicpatternsintheheatmapofthecorrelationsofnetflows(Figure1c).ThecommonalityinflowsisthereforeacommonalityingrossinflowsandoutflowsandisparticularlymarkedforEurope,theUSandalsoLatinAmerica,EmergingAsiaandCentralandEasternEuropeandsomewhatlessprevalentelsewhereinAsiaandinAfrica.Intermsoftypesofassets,FDIdoesnotseemhighlycorrelatedwithothertypesofflows.Afewquestionsspringtomind:doesitmatterifgrossinflowsandoutflowsfollowacommonpatternworldwideifnetflowsdonot?Whatarethecharacteristicsofthisglobalcycle?Doweseeevidenceofacycleinassetpricesandcreditgrowth?

[Figures1a,b,chere]

B) ComovementswithglobalfactorsWhatisbehindthosecomovementsingrossflowsandaretheyassociatedwithglobalcreditgrowthandassetpricefluctuations?Ithaslongbeennotedthatglobalfactorsareamajordeterminantofinternationalcapitalflows.AsobservedbyCalvoetal.(1996)globalfactorsaffectingforeigninvestmenttendtohaveanimportantcyclicalcomponent,whichhasgivenrisetorepeatedboomsandbustsincapitalinflows.Theliteraturehasidentifiedcyclesintherealrateofinterestandinthegrowthrateofadvancedeconomiesasimportantpushfactorsforcapitalflows.Morerecently,severalstudieshavefoundthatmovementsintheVIX3arestronglyassociatedwithcapitalflows.TheVIXiswidelyseenasamarketproxyforriskaversionanduncertainty.ThecarrytradeliteraturesuggeststhatcarrytradeflowstendtoincreasewhentheVIXislowandtocollapsewhentheVIXspikes.Morerecently,ForbesandWarnock(2012)andBrunoandShin(2013a)emphasizethesurgeincapitalflowsassociatedwiththeloweringoftheVIX.3TheVIXistheChicagoBoardOptionsExchangeMarketVolatilityIndex.ItisameasureoftheimpliedvolatilityofS&P500indexoptions.

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Figure2plotscapitalinflowsdisaggregatedbyassettypes(FDI,portfolioequity,portfoliodebtandcredit)asaproportionoftheworldGDPfortheperiod1990Q12012Q4anditreportstheVIX(invertedscale)onthesamegraph.ParticularlystrikingistheprolongedloweringoftheVIXduringtheperiod20022007,duringwhichcapitalinflowssurged.FlowstendtobehighlycorrelatedwithoneanotherandnegativelycorrelatedwiththeVIX(exceptFDI).Creditinflowsandportfoliodebtinflowsshowahighdegreeofcomovementovertime(correlationof0.52).Creditflowsarethemorevolatileandprocyclicalcomponentofallflowswithaparticularlydramaticsurgeintherunuptothecrisisandanequallydramaticcollapseduringthecrisis.TheircorrelationwiththeVIX(invertedscale)is0.24onthewhole1990Q12012Q4sample(quarterlydata).

[Figure2here]InTable1(a),IpresentthecorrelationsbyregionsofeachtypeofinflowswiththeVIX.CapitalinflowsarenegativelycorrelatedwiththeVIX,evenatageographicallydisaggregatedlevel.Overwhelmingly,duringtranquilperiodscharacterisedbylowVIX,whenuncertaintyandriskaversionarelow,capitalinflowsarelarger.Inlinewithaggregatedata,theonlyconsistentexceptionsareFDIinflowsforwhichthecorrelationwiththeVIXispositiveinallgeographicalareas.CreditflowsintodevelopedeconomiesinAsiaarealsopositivelycorrelatedwiththeVIX.

Table1(a):UnconditionalcorrelationsofliabilityflowswiththeVIX,quarterly,1990Q12012Q4.

Correlationsinflows/VIX NorthAmerica

LatinAmerica

CentralEasternEurope

WesternEurope

EmergingAsia Asia Africa

Equity 0.03 0.29 0.34 0.36 0.11 0.34 0.23FDI 0.09 0.23 0.10 0.09 0.08 0.17 0.06Debt 0.23 0.17 0.28 0.16 0.29 0.08 0.23Credit 0.22 0.10 0.14 0.21 0.24 0.06 0.13

IfIconditiononotherpushfactors(worldshorttermrealinterestrateandworldgrowthrate),asimilarpatternemerges(seeTable1(b)).TheVIXissignificantlynegativelyassociatedwithfluctuationsincapitalinflows,exceptforFDIinflows.Theresultsaresimilarwithoutflows,bothfortheunconditionalandfortheconditionalcorrelationsfortheUSandWesternEurope;theyareweakerfortheothergeographicalareas.Incontrast,andinagreementwithourpreviousresults,

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thesamepatternofcorrelationsdoesnotholdfornetflows.Idonotreporttheseresultsduetospaceconstraints.

Table1(b):ConditionalcorrelationsofliabilityflowswiththeVIX,quarterly,1990Q12012Q4..

Correlationsinflows/VIX NorthAmerica

LatinAmerica

CentralEasternEurope

WesternEurope

EmergingAsia Asia Africa

Equity 0.06 0.31 0.32 0.38 0.08 0.34 0.25FDI 0.10 0.35 0.07 0.06 0.08 0.16 0.07Debt 0.30 0.15 0.36 0.23 0.28 0.06 0.22Credit 0.29 0.15 0.16 0.24 0.26 0.09 0.14

InTable1(c),IinvestigatewhetherfluctuationsintheVIXarealsoassociatedwithchangesincreditcreationandleverageusingvariousmeasures.Wereporttheconditionalcorrelationscontrollingagainfortheclassicpushfactors(worldgrowthrateandshorttermrealrate).FollowingForbes(2012),Imeasureleverageastheratioofprivatecreditbydepositmoneybanksandotherfinancialinstitutionstobankdeposits,includingdemand,timeandsavingdepositsinnonbanks.TheprecisedefinitionsofleverageanddomesticcreditcanbefoundinAppendixB.

Table1(c)offersthisstrikingfinding:inallareasoftheworld,creditgrowthisnegativelylinkedtotheVIX.CorrelationstendtobethestrongestinNorthAmericaandWesternEurope.LeverageandleveragegrowtharealsonegativelyrelatedtotheVIXinallthemainfinancialcentres(NorthAmerica,WesternEuropeandAsia),whicharethehomesoftheglobalbanks.ButthecorrelationisincontrastpositiveforleverageandleveragegrowthinLatinAmerica,CEEandAfrica.

Table1(c):ConditionalcorrelationsofcreditandleveragemeasureswiththeVIX,quarterlydata,19902012.Theconditioningvariablesaretheworldrealshortrateandtheworldgrowthrate.

Correlationscredit/VIX NorthAmerica

LatinAmerica

CentralEasternEurope

WesternEurope

EmergingAsia Asia Africa

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Domesticcreditgrowth 0.26 0.14 0.14 0.11 0.01 0.30 0.01Leverage 0.17 0.05 0.30 0.09 0.12 0.25 0.03Leveragegrowth 0.32 0.06 0.07 0.21 0.06 0.31 0.01

Tosumup,thedatashow(i)commonalityincapitalinflowsandoutflowsacrossregionsandtypesofassets(exceptforFDIflowsandasubsetofAsianandAfricanflows).Thecommonalityisparticularlystrongforcreditandportfoliodebtinflows(seeFigures1a,b)butisabsentfornetcapitalflows(Figure1c);(ii)surgesingrosscapitalflowsinperiodoflowvolatilityanddeclineinflowswhentheVIXgoesup(withtheexceptionofFDIflows);alargevolatilityandprocyclicalityofcreditflows(seeFigure2andTables1a,b);(iii)increasesincreditgrowtharoundtheworldinparallelwithfallsoftheVIX(seeTable1c);(iv)increasesinleverageandleveragegrowthinallthemainfinancialcentreswhentheVIXislow(seeTable1c).AsnotedinBrunnermeieretal.(2012)andShin(2012),creditflowsgrewataveryfastrateinthe20032007precrisisperiodandcollapsedduringthefinancialcrisis.ThepatternofcapitalinflowsandoutflowsfollowsaglobalfinancialcyclewhichissynchronizedwithfluctuationsinworldmarketriskaversionanduncertaintyasproxiedbytheVIX.Furthermore,itappearsthatcreditcreationinthebankingsectorandleveragearedancingtothesametune.

II)Theglobalfinancialcycle:Thecommoncomponentinriskyassetprices.Havingestablishedtheexistenceofaglobalfinancialcycleforcapitalinflowsandoutflows,creditgrowthandleverage,itisnaturaltostudyfluctuationsinassetpricesandtoseewhethertheyalsofollowtheglobalfinancialcycle.Onemightthinkthatpricesofequitiesaroundtheworld,pricesofcorporatebondsandofcommoditiesreflecttoalargeextentcontinentspecific,sectorspecific,countryspecificandcompanyspecificfactors.But,asshownbyMirandaAgrippinoandRey(2012)usingalargecrosssectionof858riskyassetpricesdistributedonthefivecontinents,animportant

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partofthevarianceofriskyreturns(25%)isexplainedbyonesingleglobalfactor4.Thisresultisremarkablegiventhesizeandtheheterogeneityoftheset.Irrespectiveofthegeographicallocationofthemarketinwhichtheassetsaretradedorthespecificassetclasstheybelongto,riskyreturnsloadtoalargeextentonthisglobalfactor.

AsapparentfromFigure3,takenfromMirandaAgrippinoandRey(2012),thefactorisconsistentwiththetimingofmajoreventssuchastheGulfWarstartingfromthesecondhalfof1990,9/11andthefirstquarterof2009whenthemostrecentfinancialcrisisreacheditsclimax.Overall,theindexgoesupfromtheearly1990suntilmid1998whentheRussiancrisiseruptsfollowedbytheLTCMbankruptcy,andeventuallytheburstingofthedotcombubble.Fromthebeginningof2003,theindexincreasesrapidlyuntilthebeginningofthethirdquarterof2007.Thisisshortlyafterthecollapseofthesubprimemarketandcoincideswiththefirstsignalsofincreasedvulnerabilityofthefinancialmarkets.ThehighdegreeofcorrelationoftheglobalfactorwiththeVIXisstriking.BuildingontheanalysesofAdrianandShin(2008)andDanielsson,ShinandZygrand(2012),MirandaAgrippinoandRey(2012)proposeastructuralinterpretationofthefactor.Itcanbeunderstoodasreflectingthejointevolutionoftheeffectiveriskappetiteofthemarketaswellasrealizedmarketvolatility.InturntheeffectiveriskappetiteofthemarketcanbeempiricallyrelatedtotheleverageofasubsetoffinancialmarketintermediarieswhoseinvestmentstrategyiswellapproximatedbyaVaRconstraint(brokerdealerintheUS,largeEuropeanbankswithsignificanttradingoperationsand,moregenerally,banksclassifiedinthecapitalmarketcategoryinBankscope5).Giventhatstructuralinterpretation,itisnotsurprisingthatthefactorshouldempiricallybeclosely(negatively)correlatedwiththeVIX.AspointedoutinBrunnermeieretal.(2012)andBorioandDisyatat(2011),thereisapositivefeedbackloopbetweengreatercreditsupply,assetpriceinflation,andacompressionofspreads.Smallerriskpremiumsamplifythecreditboom.Measuredriskislowandbalancesheetslookhealthierasassetpricesgoup.Byrelaxingvalueatriskconstraints,thiscreatesadditionalspaceforlendingandforcredit,andsoon.Thismechanismisanimportantpositivefeedbackloopbetweencreditcreationandriskspreads.Itcontributestotheprocyclicalityofcreditflowsandtheirimportanceinthebuildupoffinancialfragility.

Figure3:GlobalfactorandVIX.Source:MirandaAgrippinoandRey(2012).

4Forasimilarconclusionbasedonadynamicfactoranalysisinthecontextofsovereigncreditrisk,seeLongstaffetal.(2011)5SeeMirandaAgrippinoandRey(2012)fordetails.

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Tosumup,wehavenowestablishedinflowdata(acrossmosttypesofflowsandregions,butwithsomeexceptions)andinpricedata(acrossasectorallyandgeographicallywidecrosssectionofriskyassetprices)theexistenceofaglobalfinancialcycle.Interestingly,theVIXisapowerfulindexoftheglobalfinancialcycle,whetherforflowsorforreturns.Ouranalysissofaremphasizesstrikingcorrelationsandpatterns,butcannotaddresscausalityissues.LowvalueoftheVIX,inparticularforlongperiodsoftime,areassociatedwithabuildupoftheglobalfinancialcycle:morecapitalinflowsandoutflows,morecreditcreation,moreleverageandhigherassetpriceinflation.

III)CapitalflowsandmarketsensitivitiestotheglobalfinancialcycleInthispartIattempttogaugefurthertheimportanceoftheglobalfinancialcyclefordifferentassetmarkets(stockprices,houseprices)aswellasfortheleverageoffinancialintermediaries.Havingreportedtheimportanceoftheglobalcycleforthefluctuationsofthesevariablesinthetimeseriesdimension,Istudyinmoredetailsthefactorsaffectingthecrosssectionalsensitivitiesofthesevariablestotheglobalfinancialcycles.Moreprecisely,Ifocushereonthepossibilitythatlargervolumesanddifferenttypesofcapitalflowsmatterforthesensitivityofnationalmarketstotheglobalfactor.

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Iinvestigatewhethercrosssectionally,thesensitivitiesofcountryspecificvariablestotheglobalfactor (logged)canberelatedtodifferenttypesandintensitiesofcapitalflowsintoeachmarket.Thecountryspecificvariables,arestockmarketreturns,,bankingsectorleveragegrowth,,andhousepriceinflation,.Irunthefollowingsetofregressions:

,

wheredenotesflowsintocountryi(inflows,outflows,differenttypesofflows)normalizedbytheGDPofcountryi, isavectorofcontrolvariables(laggedGDPgrowthofcountryiandlaggednominaleffectiveexchangerateofcountryi).Ialsoinclude,thechangeintheglobalfactor.Theinteractionterms and aremeanttocapturethepossibleheterogeneoussensitivityofagivenmarkettotheglobalfinancialcycledependingontheintensityandtypesofcapitalflowsitreceivesorexports.Irunfixedeffectsestimatorswithclusteredstandarderrorsbycountryandincludealineartimetrend.WecheckedthestationarityofvariablesusingaPesarantest.Wehavealargenumberofobservations(between2770and3462dependingonthespecification).Table2reportstheresultsofselectedspecifications.Panel(a)reportsourresultsforstockmarketreturns(logdifferenceoflocalstockmarketindices),AppendixCpresentsresultsfor2(b)bankingsectorleveragegrowth(differenceofleverageratio)andfor2(c)forhousepriceinflation(logdifferenceofpropertypriceindices).

Table2(a)Stockmarketreturnssi,tisthedependentvariable(19902013)flit CreditL C.nonbankL CreditA DebtL DebtA EquityL EquityA

VIXt0.0952*** 0.0914*** 0.0951*** 0.0952*** 0.0962*** 0.0959*** 0.0995***(12.64) (12.78) (12.25) (12.66) (12.34) (11.96) (12.94)

0.1743*** 0.1669*** 0.1759*** 0.1737*** 0.1751*** 0.1758*** 0.1744***(15.14) (16.61) (14.71) (14.81) (14.54) (15.51) (13.39)

flit*VIXt

0.00 0.0042 0.0002 0.0025* 0.0006*** 0.0010*** 0.0016***(0.02) (1.17) (0.99) (1.98) (3.54) (6.63) (3.2)

flit1*VIXt1

0.0007* 0.0012** 0.0004*** 0.0005* 0.0006** 0 0.0001(1.88) (2.13) (5.61) (1.77) (2.4) (0.55) (0.26)

Adj.R2 0.24 0.222 0.234 0.239 0.245 0.254 0.255N 3042 3267 3073 2924 2971 2631 2770

Fixedeffectestimator,standarderrorsadjustedforclusteringoncountry,tstatinparentheses.Allspecificationsincludethecontrolvariablesandalineartimetrend.Eachcolumncorrespondstoadifferentspecificationoftheflowintheinteractedterm.

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Panel(a)showsthatstockpricesaresignificantlynegativelyrelatedtotheglobalfactor(theVIX)andtoitsgrowthrate.Creditflowsintoandoutofcountryitendtobeassociatedwithahighersensitivityofthestockmarketofcountryitotheglobalfinancialcycle(theinteractiontermissignificantlynegative).But,interestingly,debtoutflowsandespeciallyequityinflowsandoutflowstendtobeassociatedwithalessersensitivitytotheglobalcycle(interactiontermpositive).Socrosssectionally,justlikeinthetimeseries,creditflowsseemmorestronglyrelatedtotheglobalcyclethanotherflowsandinparticularthanequityflows.

AscanbeseeninAppendixC,theresultsforbanksleverage(b)andhouseprices(c)aresimilarinsomerespect.ThereisanegativecorrelationofbanksleverageandhousepriceinflationwiththeVIXandapositivecorrelationwiththegrowthrateoftheVIX.Thereishoweverinthisspecificationnosignofanyflowsassociatedwithahighersensitivityofleverageofbanks(orofhouseprices)totheglobalfinancialcycle(theinteractiontermisneversignificant).

Onceagain,itisworthemphasizingthattheseregressionsindicatecorrelationsandnotcausality.Inthetimeseriescreditflowsareveryprocyclical.Inthecrosssection,creditflowstendtobeassociatedwithastrongercorrelationofstockmarketreturnswiththeglobalcycle,whileequityflowstendtobeassociatedwithaweakercorrelation6.

IV)Monetarypolicy,capitalflowsandtheglobalfinancialcycle

A) RecursiveVARanalysisTheglobalfinancialcycleappearsincomovementsofgrossflows,assetprices,leverageandcreditcreation,whichareallcloselylinkedtofluctuationsintheVIX.Butwhatareitsdrivers?

Giventhestrongprocyclicalityofcreditflowsandthewayglobalbanksoperate(e.g.Shin(2012)andBrunoandShin(2013a))itisnaturaltoinvestigatetheeffectontheglobalfinancialcycleofrefinancingcostsindollars,i.e.FederalReservemonetarypolicy(seeRajan(2006);BorioandZhu(2008)).Shin(2012)describeshowEuropeanglobalbanksinparticularweremajoractorsinchannellingUSdollarliquidityworldwidebeforethecrisis.ForeignbankbranchesintheUSwereraisinglargequantitiesoffundsindollarsandtransferringthemtooverseasmarkets.European6Itwouldofcoursebeinterestingtoestablishacausallinkbetweencrossbordercreditflowsandsensitivitytothecycle.Butforthiswewouldneedinstrumentalvariables.

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globalbankswerenotonlyintermediatingsavingsbackintheUSmarketbutwerealsoservingAsian,LatinAmerican,AfricanandMiddleEasternmarkets.IwillthereforetreattheleverageofEuropeanbanksasakeyvariableoftheanalysis.Thedollaristhemaincurrencyofglobalbanking.Sincesurgesincapitalflowsespeciallycreditflowsareassociatedwithincreasesinleverageworldwide,anaturalinterpretationisthatmonetaryconditionsinthecentrecountryaretransmittedworldwidethroughthesecrossbordergrosscreditflows.Itisthereforethosegrossflowsthatshouldbetrackedinordertoassessfinancialfragilityandoverallcreditconditions,asemphasizedbyBorioandDisyatat(2011),Gourinchas,TruemplerandRey(2012)andObstfeld(2012).Itisalsoonlybylookingatgrossflowsthatonecankeeptrackofcurrencyandmaturitymismatchonbalancesheetsoffinancialintermediariesandhouseholds.Bothofthesemismatchesarewellknowncontributorstofinancialinstability.Thisisofcoursenottosaythatnetflowsareirrelevant:currentaccountimbalancesarekeyforthelongrunsustainabilityofthenetexternalassetposition,asalongliteratureshows(recentlysurveyedinGourinchasandRey(2013)).Toanalyzethedynamicinteractionbetweenmonetarypolicy,riskaversionanduncertainty,leverageandcreditflows,IperformarecursiveVARanalysis7.IbuildonthestudyofBekaert,HoerovaandLoDuca(2012).Theyshowthatmovementsinthefederalfundsratehaveaneffectonuncertainty(expectedstockmarketvolatility)andriskaversion,twocomponentstheyextractfromtheVIX.Likethem,IfocusonthedynamiclinksbetweenthefederalfundsrateandtheVIXbutIalsostudytheirdynamicinterrelationswithcreditcreation,leverageandcreditflows.Iusequarterlydatafortheperiod19902012.Iimposecontemporaneousrestrictions(Cholesky)ontheresponsesofthevariables,basedoninstitutionalknowledge.Iorderthevariablessuchthatthefirstvariablecannotrespondtocontemporaneousshocks(withinthequarter)ofanyothervariables,thesecondonecanrespondtocontemporaneousshocksaffectingvariable1butnotanyothersetcIassumethatGDPandpricesrespondwithalagastheyareslowmoving,whiletheglobalfactor(VIX)canrespondcontemporaneouslytoanyvariable(andisthereforeorderedlast).TheeffectiveFedFundsrate(FFR)isourpenultimatevariable:itcanrespondtoanyvariablewithinthequarterexcepttotheVIX.Financialvariablessuchascredit,flowsandleverageareinbetween:leverageisorderedimmediatelybeforetheFFR.Iincludethefollowing7variables(inthisorder):USGDP,USGDPdeflator(GDPDEF),globalcredit(logged)(CREDIT),globalcreditinflows(INFLOWS),European

7TheanalysisborrowsfromMirandaAgrippinoandRey(2012)whoprovidesamoredetailedexercisedisentanglingeffectsonmarketeffectiveriskaversionandvolatility.BrunoandShin(2013b)presentasimilarlyinspiredandindependentlydevelopedanalysisbuttheyfocusonthedynamicrelationwiththedollarexchangerateandtheovershootingpuzzle.

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banksleverage(definedasthemedianofEUbankleverage)(EULEV),FedFundstargetrate(FFR)andVIX(logged).8InotethatsincewearefirstandforemostinterestedintheimpactoftheshocksinthelastthreevariablesintheVAR(VIX,FFRandleverage),howtheothervariablesareorderedmakesnodifferenceforthosethreeshocks(allIneedispartialidentification).Forexample,givenaFFRshockbothcreditandflowswillstayputinthefirstquarterandthenarefreetoreact,sotherelativeorderofthosetwodoesnotmattertoFFR.Thatorderonlymattersinbetweenthetwo,becauseIamassumingthatiftherewereashockoncrossborderflows,globalcreditwouldtakeaquartertoreacttothat,butIamnotfocusingonthis.

IuseatwolagVAR,usingtheusualcriteria(BICandLR).Bootstrappedconfidenceintervalsarecomputedusing1000replications;lightanddarkgreyshadedareascorrespondto95and86%confidenceintervalsrespectively.Ireportasubsetofkeyimpulseresponsesinthetext(Figure4aand4b).ThecompletesetofimpulseresponsefunctionsarereportedinFigure5intheAppendix.Ourkeyfindingsarethefollowing:

(i) Anincreaseintheeffectivefederalfundsrate(FFR)leadstoanincreaseintheVIXafterabout5quartersanduntil11quarters.(Figure4a)

(ii) AnincreaseintheVIXleadstoafallinEuropeanbanksleverage.(Figure4b)(iii) AfallintheVIXleadstoanincreaseincrossbordercreditflowsupto6quarters.(Figure

4b)(iv) AnincreaseintheVIXleadstoafallinglobaldomesticcreditfrom4quartersonwards.

(Figure4b)(v) AnincreaseintheVIXleadstodeclineintheFFR.(Figure4b)(vi) AnincreaseintheFFRleadstoafallinEUbankleverageafter15quarters.(Figure5)(vii) AnincreaseintheFFRleadstoafallingrosscreditflowsafter12quarters.(Figure5)(viii) AnincreaseinEUbanksleverageisassociatedwithanincreaseindomesticcreditfroma

1quarterhorizon.(Figure5)(ix) AnincreaseinEUbanksleverageisassociatedwithafallintheVIXafterabout8

quarters.(Figure5)

8SeeAppendixBfortheprecisedefinitionsofthevariables.

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TheVARresultsarethereforeconsistentwiththefollowinginterpretation.WhentheFederalFundsrategoesdown,theVIXfalls(afterabout5quarters),Europeanbanksleveragerises,asdogrosscreditflows(after12quarters).AfallintheVIXleadstoanincreaseinglobaldomesticcreditafter4quarters.

FurthermoreIfindthatincreasedbankleverageandcapitalflows,aswellascreditexpansion(thoughforcredititisonlymarginallysignificant)areassociatedwithasubsequentfallintheVIXindex.Thisisconsistentwiththefollowingmechanism:ascreditandcapitalflowsgoup,spreadsfall:asnotedinparticularbyAdrianandShin(2010),thequasiconstancyofriskweightedassetsinthebalancesheetofglobalbanks(mostlythebankshavinglargecapitalmarketdivisions)attimeswhentheunweightedvolumeofassetsrisessubstantiallysuggestsafallinmeasuredriskduringexpansiontimes.Whenleverageishighandcreditisabundant,spreadsarecompressedandmeasuredriskislow.ThistranslatesintoadeclineintheVIX.Thereisthereforeapositivefeedbackloopbetweenloosemonetarypolicy,fallintheVIX,riseincredit,capitalflowsandleverageandfurtherfallintheVIX9.

FromFigure5,IalsonotethatanincreaseintheVIXhasasignificantnegativeeffectonGDP(asinBloom(2009))andontheGDPdeflator.Asexpected,anincreaseintheFFRratehasadampeningeffectonprices.IalsonotethatmonetarypolicyloosenswhentheVIXgoesup(Figure4b).

Figure4a:25bpincreasetotheeffectivefederalfundsrate.

9ThisinterpretationaccordswellwiththemicrostudiesofJimenez,Ongena,PeydroandSaurina(2012)onEuropeandatawhofindsthatbanksgrantsmoreloanstoriskierfirmsinalowinterestrateenvironmentandofDellAriccia,LaevenandSuarez(2013)whohavesimilarfindingsusingUSdata.

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Figure4b:Responsestoa1%increaseintheVIX.

B) Robustness

Icheckrobustnessontheprecrisissample19902007.Ialsocheckrobustnessbydroppingsomeofourvariables(Idropsuccessivelycredit,leverage,flowsonebyone)andbydroppingalagtomakesureoverfittingisnotanissue.Importantly,twostudieswithadifferentfocusbutsomerelatedresults(Bekaertetal.(2012)andBrunoandShin(2013b),allowustoassessfurthertherobustnessofsomeofthefindings.Bekaertetal.(2012)decomposetheVIXindexintoacomponentreflectingexpectedstockmarketvolatilityandintoavariancepremiumreflectingriskaversion.TheyrunastructuralfourvariableVARwithabusinesscycleindicator,thetwocomponentsoftheVIXandtheUSshorttermrealrate(definedastheFedFundsendofmonthtargetrateminustheCPIannualinflationrate)astheirbenchmark.Theyfindthataloosemonetarypolicyreducesriskaversionanduncertainty;andthatperiodsofhighVIXarefollowedbyloosermonetarypolicy.Theyprovidenumerousrobustnesschecks,inparticularwithrespecttothemeasurementofmonetarypolicyshocksandbycomparingresultsontheprecrisissampleandthewholesample.TheirfindingsarecompatiblewithmyresultsshowinganincreaseintheVIXfollowingatighteningintheFFRandalooseningofmonetarypolicyafteraVIXincrease(seeFigure4a,b).

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BrunoandShin(2013b)runsa4variablerecursiveVARwithFFR,logVIX,leverageandtherealeffectivedollarexchangerateonquarterlydatafortheperiod19952007.FormonetarypolicymeasurestheyusetherealFFRandtherealeffectiveFFR,growthofUSM1,andtheresidualofaTaylorrule.TheyuseUSbrokerdealerleverageinsteadofthebroadermeasureofEUleverage.TheyfindthatapositivemonetarypolicyshockleadstoanincreaseintheVIXafterquarter4;toadeclineinUSbrokerdealerleverageafterabout10quarters;anincreaseintheVIXleadstoadeclineinUSbrokerdealerleverageafterquarter10.Theseresultsarecompatiblewithmyresults(i),(vi),(ii)withsomedifferencesintiming.Theauthorsalsofind,afteraugmentingtheirVAR,thatanincreaseintheFFRreducescreditflows(intheircasedefinedasthefirstdifferenceofUSdollarliabilitiesofbankslocatedoutsidetheUS)afterabout7quarters;thatanincreaseintheVIXreducesflows.Theseadditionalresultsarealsocompatiblewithmine(see(vii),(iii))withsomedifferencesintiming.BrunoandShin(2013b)presentinadditionveryinterestingevidenceonthedollarrealeffectiveexchangeratedynamicsandthedelayedovershootingpuzzle.

C) Economicsignificanceoftheresults

Aretheshockstothefederalfundsrateanimportantsourceofvariationforthedynamicsoftheglobalfinancialcycle,indexedbytheVIX?Intheir4variableVAR,BrunoandShin(2013b)findthatshockstotheFFRexplainalmost30%ofthevarianceoftheVIXathorizonslongerthan10quarters.Similarlyintheir4variablestructuralVARmodel,Bekaertetal(2012)findthatmonetarypolicyshocksaccountforover20%ofthevarianceofriskaversionathorizonslongerthan7quarters.Theyalsoaccountforacomparablepartofthevarianceofuncertainty.IntheirsixvariableVAR,themonetarypolicyshockaccountsforabout12%ofthevarianceofriskaversionathorizonslongerthan10quarters.DependingontheexactspecificationoftheVARanalysis,IfindthatshockstotheFFRexplainfromabout4%ofthevarianceoftheVIX(inthe7variableVARonthewhole19902012sample)toabout10%(ina4variableVARonthe19902007sample).Thatnumbergoesupto17%ifIuse,likeBrunoandShin(2013b)USbrokerdealerleverageinsteadoftheEUbankleveragevariable.AlthoughthereissomevarianceintheestimatesdependingonthenumberofvariablesandtheexactspecificationoftheVAR,theseareeconomicallysignificant,possiblylargeeffects.

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V)Takingstock:monetaryconditions,capitalflowsandtheglobalfinancialcycle

Thereisaglobalfinancialcycleincapitalflows,assetpricesandincreditgrowth.ThiscyclecomoveswiththeVIX,ameasureofuncertaintyandriskaversionofthemarkets.Assetmarketswithmorecreditinflowstendtobemoresensitivetotheglobalcycle.Theglobalfinancialcycleisnotalignedwithcountriesspecificmacroeconomicconditions.Inanumberofcountries,thiscanleadtoexcesscreditgrowth(oralternativelytomonetaryconditionswhicharetootight).Excesscreditgrowthisoneofthebestpredictorsofcrisis.GourinchasandObstfeld(2012)showthatacrossalltypesofcrisis,threevariablesplayastatisticallyandeconomicallysignificantrole:theratioofdomesticcredittooutput,therealexchangerate,andtheratioofofficialreservestooutput.SchularickandTaylor(2012)demonstratethatcreditgrowthisapowerfulpredictoroffinancialcrises,suggestingthatsuchcrisesarecreditboomsgonewrongandthatpolicymakersignorecreditattheirperil.SimilarfindingsareechoedinLundJensen(2012),whofindsthathighassetpriceinflationisassociatedwithsystemicbankingcrises.Ouranalysisclearlyimpliesthatgrossflows(particularlycreditanddebt)shouldbemonitoredclosely(inparallelwithnetflowswhicharekeyforsustainabilityissues)inordertoassessfinancialfragilityandoverallcreditconditions.Itisalsoonlybylookingatgrossflowsandgrosscrossborderpositions(theentirebalancesheetofcountries)thatonecankeeptrackofcurrencyandmaturitymismatch.Bothofthesemismatcheshaveprovedtocontributetofinancialinstability10.TheimportanceoftheglobalfinancialcycleincreatingboomandbustcyclesinemergingmarketsandadvancedeconomiesalikewithcapitalinflowssurgesgoesbackalongwayandhasbeenmentionedindifferentcontextsbyDiazAlejandro(1983),Calvoetal.(1996),(identificationofpushfactorsforcapitalflows),EichengreenandPortes(1987),ReinhartandReinhart(2008)(capitalflowsbonanzas),LaneandMcQuade(2012)andmanyothers.Theroleofcrossborderflowsindisruptingfinancialintermediationintheperiodleadingtothe2008crisisisstressedbyPortes(2009)andObstfeldandRogoff(2010);ReinhartandRogoff(2009)drawsimilarconclusionsfromthehistoricalrecord.OurVARanalysissuggeststhatoneimportantdeterminantoftheglobalfinancialcycleismonetarypolicyinthecentrecountry,whichaffectsleverageofglobalbanks,creditflowsandcreditgrowthintheinternationalfinancialsystem.Thischannelinvalidatesthetrilemma,whichpostulatesthatin10SeeforexampleKalemniOzcanetal.(2012).

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aworldoffreecapitalmobility,independentmonetarypoliciesarefeasibleifandonlyifexchangeratesarefloating.Instead,whileitiscertainlytruethatcountrieswithfixedexchangeratescannothaveindependentmonetarypoliciesinaworldoffreecapitalmobility,myanalysissuggeststhatcrossborderflowsandleverageofglobalinstitutionstransmitmonetaryconditionsglobally,evenunderfloatingexchangerateregimes.

Soshouldpolicyrestrictcapitalmobility?

VI)BenefitsofinternationalcapitalflowsIfrestrictingthemovementofcapitalacrossborderistobeapolicyoption,itspotentialbenefitshouldbeassessedagainstitscosts.Sowhatdoweknowaboutthegainstointernationalcapitalmobility?Theliteraturehasattemptedtomeasuregainstofreecapitalmobilitymostlyintwoways:bycalibratingstandardinternationalmacroeconomicmodelsandevaluatingwelfaregainswhengoingfromautarkytofinanciallyintegratedmarkets;bytestingforgrowtheffectsandbetterrisksharing(lowervolatility)followingfinancialintegration,usingeitherpaneldataoreventstudies.

A) Calibrationofstandardmodels

Theneoclassicalgrowthmodelisbehindmanyofoureconomicintuitionsregardingwhythefreeflowofcapitalcouldbebeneficial.Withinthismodel,financialintegrationbringsimprovementsinallocativeefficiency(capitalflowstoplaceswiththehighestmarginalproduct)andbetterrisksharing.Interestingly,evenwithinthatparadigm,realisticcalibrationsindicatethatgainstendtobesmall.GourinchasandJeanne(2006)show,inthecontextofsmallopeneconomiesandinadeterministicsetting,thatgainsaresecondorder.Allthatinternationalfinancialintegrationdoesistospeeduptransitiontowardthesteadystateoftheeconomy.Coeurdacieretal.(2013)allowforuncertaintyandestimatewelfaregainsfromallocativeefficiencyandrisksharingtogether,inthecontextofageneralequilibriumneoclassicalgrowthmodel.Thewelfaregainsaresmall,eveninsuchaworldwheretheinteractionbetweentheprecautionarysavingsmotivesandallocativeefficiencyeffectsismodeledexplicitlysothetwomainchannelsofgainsfromintegrationcanexpressthemselves.Wefindtheyareonthe

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orderofafewtenthsofapercentofpermanentconsumptionforrealisticcalibrations.

B) EmpiricalevidencefrompaneldataandeventstudiesCrossborderinvestmentpositionshaverisenforadvancedeconomiesfrom68%ofGDPin1980to438%ofGDPin2007;foremergingmarketstheyhavegonefrom35%to73%ofGDPduringthesameperiod(LaneandMilesiFerretti2007andLane(2012)).Ifcapitalflowsbringgains,weshouldbeobservinglargeeffectsinthedata,duetothesheerscaleoffinancialglobalisationsincethe1990s.Therearenumerousstudiesthattrytotestforeffectsofinternationalcapitalflowsongrowthoronconsumptionvolatility.Surprisingly,theseeffectsarehardtofindinmacroeconomicdata.Asattestedbythemostrecentsurveysreviewingalonglistofempiricalpapers,itishardtofindrobustevidenceofanimpactoffinancialopennessongrowthoronimprovedrisksharing(seeEichengreen2002;Jeanneetal.2012;Koseetal.2006;Obstfeld2009).Somepaperspointtowardtheexistenceofthresholdeffects:capitalflowsarebeneficialonlyafteracountryhasreachedacertainamountofinstitutionalorfinancialsectordevelopment(seeBekaertetal.(2005)).Therearealsosomedifferencesifonelooksacrossdifferenttypesofcapitalflows:FDIflowsseembetteratdeliveringgrowthandrisksharingbenefitsthanothers.Butthisevidenceisnotveryconclusivebecausethesampleusedoftenmakesadifference(seeJeanneetal.(2012)).Theliteraturebasedoneventstudiesisoftenmorepositive(seeHenry(2007))andpointstowardsafallinthecostofcapitalandincreasedinvestmentatthetimeoffinancialintegration.Butthesimultaneityofothereconomicreformsorpoliciesputinplaceatthetimeoffinancialopeningishoweveroftenaconcern.Further,fromatheoreticalpointofview,evaluatingwelfaregainsrequirestrackingthepathofintegratingeconomiesfromthepointofcapitalaccountintegrationtotheirsteadystate.Alongsuchpaths,onecanobserveinitialinvestmentincreasesandcurrentaccountdeficitswhichthenreverselateronascountrieshavetorepaytheirexternaldebt.Welfaregainsalongthesepathsarefoundtobesmall(seeCoeurdacieretal.(2013)).

Sobothontheempiricalsideandonthecalibrationside,itissofarhardtofindrobustsupportforlargequantifiablebenefitsofinternationalfinancialintegration.Idonotclaimthattherearenobenefitstointernationalfinancialintegration,onlythattheyhavebeenremarkablyelusivesofargiventhescaleoffinancialglobalizationtheworldhasundergone.Inthatlight,itwouldbeusefultoidentifymorepreciselythechannelsforwhichcapitalflowsmaybebeneficial.Onepossibilityistolookmorecloselyatpotentialeffectsontotalfactorproductivity

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ofcertaintypesofflows.Theexistingliteratureonthistopichastodealwithhardidentificationissuesandisalsonotveryconclusive(foradiscussionseeObstfeld2009,p.89).AnotherpossibilityisthatfinancialFDIfavoursfinancialmarketdeepeningandtherebyimprovesgrowthprospects11.Yetanotherpossibilityistoinvestigatemorecloselytherisksharingpropertiesoftheexternalbalancesheetofcountriesduringcatastrophiceventssuchasthe20072008globalfinancialcrisis.Gourinchasetal.(2012)showthatthereweremassivewealthtransfersbetweentheUSandtherestoftheworldwhentheglobalfinancialcrisishit(about2trilliondollarsvaluationlossesontheUSnetexternalassetposition,whichisequivalenttoawealthtransfertotherestoftheworld).TheUS,centreoftheinternationalmonetarysystem,actedasaglobalinsurer.Itiseasytoseehowthisinsurancetransferisimplemented:sinceemergingmarketstendtobelonginUSgovernmentdebt(thereserveasset)andshortequityandFDI(andviceversafortheUnitedStates)12,intimesofcrisisthevalueofalargepartoftheirassets(USgovernmentbonds)isstableorevengoesupwhilethevalueoftheirliabilities,consistingofriskyassets,collapses.Thus,whilelargeexternalbalancesheetscanhelppropagatefinancialcrisis,theycanalsocontributetorisksharingdependingontheirexactstructure.Thisisafurtherreasonwhymonitoringgrossflowsandgrosspositions(asopposedtoonlynetflowsorcurrentaccounts)isessential.Tosumup,gainstointernationalcapitalflowshaveprovedelusivewhetherincalibratedmodelsorinthedata,thoughperhapsthisisjustbecausethosegainsarehardtomeasure.Forexample,theymightoccurthroughimprovementsinTFP,whichwehavenotbeenabletomeasureprecisely(butthenwhydontweseethemingrowthrates?)ortheymightmanifestthemselvesmainlywhenlargeshockshit.Onethingisclearatthisstage:wecannottakethemforgranted.

VII)Policyoptions:dealingwiththedilemmaGrosscapitalinflows,leverage,creditgrowthandassetpricesdancelargelytothesametune.TheycomovewiththeVIX.Thereisaglobalfinancialcycle,whichmaynotbeappropriateforindividualcountries.Symptomscangofrombenigntolargeassetpricebubblesandexcesscreditcreation,aconditionwhichhasbeenidentifiedrepeatedlyasoneofthebestpredictorsoffinancialcrises.VAR

11FordetailedworkonoperationsofinternationalfinancialinstitutionsseeinparticularCetorelliandGoldberg(2012).12Gourinchasetal.(2010)showhowtoendogenizesuchasymmetricportfolioswhenthecentrecountryoftheinternationalmonetarysystemismoreriskneutralthantherestoftheworld.

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analysessuggestmonetaryconditionsaretransmittedfromthemainfinancialcentretotherestoftheworld throughgross credit flowsand leverage, irrespectiveof theexchange rate regime.Thisputsthetraditionaltrilemmaviewoftheopeneconomyintoquestion.Fluctuatingexchangeratescannotinsulateeconomiesfromtheglobalfinancialcycle,whencapitalismobile.Thetrilemma13morphs into a dilemma independentmonetarypolicies arepossible if andonly if the capitalaccountismanaged,directlyorindirectly,regardlessoftheexchangerateregime.

Thisimpliesthatgrossflows,particularlycreditflows,areofgreatimportanceforfinancialstabilityandhavetobemonitoredcarefully.Itisalsoonlybylookingatgrossflowsandgrosscrossborderpositions(theentirebalancesheetofcountries)thatonecankeeptrackofcurrencyandmaturitymismatch.Bothofthesemismatcheshaveprovedtocontributetofinancialinstability,timeandtimeagain(seeforexampleFarhietal.(2012)).Oncemore,thisisnottosaynetflowsdonotmatter,astheyareimportantforsustainabilityissues14.

Aswelfaregainsfromcapitalflowscannotbetakenforgranted(thoughthejuryisstillout),weshouldconsiderthefollowingrangeofoptionstoweakenthepotencyoftheglobalfinancialcycleandtherebyincreasefinancialstability.Onecould:a)imposetargetedcapitalcontrols;b)actononeofthesourcesofthefinancialcycleitself:themonetarypolicyoftheFedandothermaincentralbanks;c)actonthetransmissionchannelcyclicallybylimitingcreditgrowthandleverageduringtheupturnofthecycleusingnationalpolicies(andpossiblydoingthereverseduringdownturns)i.e.puttinginplacemacroprudentialpolicies;d)actonthetransmissionchannelstructurallybyimposingstricterlimitsonleverageforallfinancialintermediaries.

a) Capitalcontrols

Onecouldconsidercapitalcontrolseithercyclicalorpermanenttoinsulatetheeconomyfromtheglobalfinancialcycle.Permanentcapitalcontrolscanbeappliedonsubsetofassetseitherontheinflowsideortheoutflowside.Itis,atthisstagehardtoassessrigorouslytheeffectofsuchpolicyonfinancialstabilityanditssideeffects,as,intherecentperiod,permanentcontrolshavebeenimplementedexclusivelyinasubsetoflowincomecountries,whichhaveveryspecificcharacteristics(seeKlein(2012)).Overcomingthisselectionissueisamajorchallenge.

13Alternativelytheimpossibletrinitybecomesanirreconcilableduo.14GourinchasandRey(2007)estimatedthataboutathirdoftheadjustmentoftheUnitedStatestowardsitslongrunbudgetconstraintcamefromvaluationeffectswhiletherestcamefromnetexports(i.e.currentaccountandnetflows).

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Temporarycontrols,especiallyoncreditflowsandportfoliodebtwhenthecycleisinaboomphasecouldbeused.Thisoptionhasbeentestedinvariouscontexts:theChileanencaje(19911998);the2010and2011BraziliantaxesonequityinflowsetcOftenthough,controlshavebeenusedwiththeprimaryaimofpreventingexcessiveappreciationoftheexchangerate.Whencapitalflowsin,anexcessiveexchangerateappreciationmayhurttheexportsector.Asaresult,CentralBankersmaywishtointerveneontheforeignexchangemarkettokeepthecurrencydown,accumulatingreserves.Theyfacethetradeoffofhigherinflationorincreasedsterilizationcostswithalikelysideeffectofanincreasedinterestrateleadingtofurtherinflows(alsoreinforcedbyexpectationsoffurtherappreciationoftheexchangerate).Taxinginflows,ifeffectivelyimplementedcanactasacircuitbreakerinsuchasituation.Thereisalivelydebateastherearealsodifficultmeasurementissueslinkedtoselectionandendogeneityontheeffectivenessandsideeffectsoftemporarycapitalcontrolsinthiscontext(seeforexampleForbesetal.(2012),ChamonandGarcia(2013),Klein(2012),Werning(2012)).Ultimately,sinceinourcontext,itisreallyexcessivecreditgrowththatisthemainissueofconcerns,capitalcontrolsshouldbeviewedmoreaspartialsubstituteswithmacroprudentialtools.Thelattertendtobemoretargeted.Butcapitalcontrolsmaybeappropriateifthereisalotofdirectcrossborderlendingandthebankingsystemcanbecircumvented(seeOstryetal(2011)).Itisimportanttonotethatmacroprudentialpoliciescanweakenthelinkbetweendomesticmonetarypolicyandcapitalinflows,withouttheimpositionofcapitalcontrols.Forinstance,bypreventingexcessivecreditgrowthinboomtimes,theCentralBankmayreducetheincentiveforbankstoborrowexternallywhendomesticmonetarypolicytightens.

b) InternalisationoftheglobalspilloversofthecentresmonetarypolicyOnecouldconsideractingononeofthesourcesoftheglobalcycleitself,themonetarypolicystanceinthemainfinancialcentres.MonetaryconditionsinlargefinancialcentressuchastheUSshapetheglobalfinancialcycleviatheendogenousresponseofleverageandtheprocyclicalityofcrossbordercreditflows.Thistransmissionmechanism,unhinderedbytheflexibilityofexchangeratetransformstheimpossibletrinityofafixedexchangerate,independentmonetarypolicyandfreecapitalmobilityintotheirreconcilableduo(adilemma)ofindependentmonetarypolicyandfreecapitalmobility.Thespillovereffectsoflargecountriescentralbankspoliciesontoothercountriesareatpresentnotinternalized.Centralbankersofsystemicallyimportantcountriesshouldpaymoreattentiontotheircollectivepolicystanceanditsimplicationsfortherestoftheworld.Onepracticalwayofimplementingthis,proposedinEichengreenetal.(2012)wouldbeforasmallgroupofsystemicallysignificantcentralbankstomeetregularlyundertheauspicesoftheCommitteeonthe

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GlobalFinancialSystemoftheBIS.Thisgroupwoulddiscussandassesstheimplicationsoftheirpoliciesforgloballiquidity,leverage,andexposures,andtheappropriatenessoftheirjointmoneyandcreditpoliciesfromthepointofviewofglobalprice,output,andfinancialstability.Itcouldissueashortreportdiscussingpolicytradeoffsandinternationalinconsistencies.Withtime,thisshouldatleasthelptounderstandbetterthesecomplexissuesalsobystimulatingmoreresearchintheseareasandmightencourageCentralBankerstointernalizesomeoftheexternalspilloversofthepolicies.Thedifficultiesofsuchapolicyoptionareobvious:internationalcooperationonmonetaryspilloversmayconflictwiththedomesticmandatesofcentralbanks.Forexample,internationalfinancialstabilityanddomesticactivityandinflationtargetsmaybeatoddsatleastintheshorttomediumrun.Furthermorethemanagementofaggregatedemandinsystemicallyimportanteconomiesalsohasimportantconsequencesforeconomicactivityintherestoftheworld.Itiseasytoseethatthetradeoffsareextraordinarilycomplex.

c) Mutingthetransmissionchanneloftheglobalcyclebytakingcyclicalmeasures(macro

prudentialmeasures)tolimitexcessivecreditgrowth.

Since,foracountry,themostdangerousoutcomeofinappropriatelylooseglobalfinancialconditionsisexcessivecreditgrowth,asensiblepolicyoptionistomonitordirectlycreditgrowthandleverageineachmarket.Recently,muchefforthasgoneintoputtinginplacemacroprudentialmeasureshavingjustthisgoal.Thearsenalhasseverallayers.Basel3hasacountercyclicalcapitalcushionthatcanbeactivatedinboomtimes.Loantovalueratiosanddebttoincomeratioscanbeusedinordertorestrictlendingandkeeprealestatepricesincheck.Oneshouldalsomonitorcloselylendingstandardsandtradingstrategiesduringperiodsofhighcreditgrowth.Thereisawealthofexperiencebeinggatheredaroundtheworldrecentlyonthepracticalimplementationofmacroprudentialtools(seeforexampletheReserveBankofIndiaortheBankofKoreawheremacroprudentialmeasureswereimposedincludingleveragecapsonFXderivativespositionandamacroprudentialstabilitylevyonnoncoreFXliabilitiesofbanks(BankofKoreaReport2013)).Itisobviousthatcountryspecificinstitutionaldetailsandmarketorganizationmatteralot.Acentralizedrepositoryoftheknowledgeandexperiencegatheredsofarbysupervisorsandcentralbankerswouldbehighlyvaluable.

Beyondthetools,oneofthebigpracticalissuesistodeterminethetimingofintervention.WhenshouldoneactivatecircuitbreakerstocutthepositivefeedbackloopsdescribedinPartIV?

Itisimportant,nottowaittoolong;nottowait,forexample,forthequasicertaintythatthereisabubbleinassetpricesorrealestatetointervene.

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OneoptionistodeviseautomaticrulesbasedonthecredittoGDPratioandactassoonasacertainthresholdiscrossed(Borioetal.(2011)).Thishastheadvantageofbeingrobusttolobbyingofinterestedparties.Italsoovercomesthewellknownbiastowardsinactionwhengoodtimesareunfoldingandeveryoneishappilysharingthedividendsofincreasingassetreturns,forgettingabouttheriskbuildingup.

Anotheroptionistostresstestthebalancesheetofthefinancialsector(banksandshadowbanks)veryfrequently,eitherinatargetedwayorbroadly,andjudgewhetherlargebutrealisticchangesinassetpricescouldjeopardizefinancialstability.Stresstestingisadifficultexerciseingeneralandestimatingsecondroundeffectsisparticularlychallenging.Furthermore,thisisnotapopularundertakingwithmarketparticipants,asitrequiresregularinputsontopofmandatoryreportings.Italsorequirescarefulthinkingaboutcommunicationpolicy(and/orabsoluteconfidentialityasthecasemaybe).Moreover,fiscalbackstopstrategiesareneededtoguaranteethecredibilityofthestresstesting.Noneofthisiseasy.Butdoingstresstestsregularlyandoften,evenifthisisanimperfectprocess,isanecessarymonitoringtool.Itimprovestheknowledgeofsupervisorsandinsurestheyareuptodatewiththerecentmarketdevelopments;importantlyitmayalsogiveconstructivechallengestotheinternalriskmonitoringofinstitutions.Itmayrevealfailuresincorporategovernanceinorganizationswhereincentivesarenotnecessarilyalignedtokeepriskincheckorwhereinformationisnotavailableorcentralizedadequately.ItmayevenrevealblindspotsofrisktakingactivitiesoccurringbelowtheradarscreenoftheChiefRiskOfficer.Anaggressivepolicyoffrequentstresstests,sometargeted,somebroad,canprovideaflexiblewaytotackletheissueofexcessivecreditgrowthandleverage.Testsareparticularlyinformativewhentheyindicatewhetherifcurrentfinancingconditions,includingtheshadowbankingsector,weretobedisrupted,financialstabilitycouldbeendangered.15

d) Mutingthetransmissionchannelstructurallybydampeningtheamplificationcapacityof

financialintermediaries:tougherlimitsonleverage.

15Weshouldnotforgetthat,usually,thereareanumberofimportantdomesticdistortionsthatinteractwithcapitalflowsandcreditgrowth.Inpractice,forpoliticalreasons,weseemanysubsidiestoinvestmentinrealestateandtodebt.Thesesubsidiesareinstrumentaltocreatingtheinitialbubbleorthebeginningofabubbleinrealestatepricesandinvestment.Byallmeans,thefirstthingtodoistoremovethesedistortions.Itisalsoimportanttorememberthatexcessiveborrowingbyacountrymeansthatsomeoneelseislendingexcessively:macroprudentialpoliciesapplytolendersjustaswellastheyapplytoborrowers.

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Attheheartofthetransmissionmechanismdescribedinthispaperistheabilityoffinancialintermediaries,whetherbanksorshadowbankstoleverageupquicklytoveryhighlevelswhenfinancingconditionsarefavourable.Creditisexcessivelysensitivetothefinancingcosts.Istartagain,asinc)withtheusefulobservationthatthemostdangerousoutcomeofinappropriatelylooseglobalfinancialconditionsisexcessivecreditgrowth.Itispossibleinadditiontoorinsteadofmonitoringthecyclicalpropertiesofcreditgrowthtocutstructurallytheabilityoffinancialintermediariestobeexcessivelyprocyclical.Onepolicyleverseemsparticularlyappropriatefordoingthis:theleverageratio.Byputtingatougherlimitonleverage,theabilityofthefinancialsystemtoengageinthefeedbackloopsdiscussedinsectionsVandVIwillbecurtailed.Complexmacroprudentialpoliciesdescribedabovearenotnecessarilyrobust.Errorsofjudgementsbysupervisors,ChiefRiskOfficers,CEOsandboardsarepossibleandevenlikelyinourexcessivelycomplexfinancialandregulatoryenvironment.Tougherleverageratiosmaybeinprincipleawaytodecreasethe(verifiablyhuge)costoftheseerrors,withoutimposinganylargecosts,ifatall,ontherealeconomy(seeHaldane(2012),Jenkins(2012),AdmatiandHellwig(2013))16.

ConclusionOfthesefouroptions,ifhistoryisofanyguidance,puttinginaplaceaneffectiveinternationalcooperationamongthemaincentralbankstointernalisethespilloversoftheirmonetarypoliciesontherestoftheworldseemsoutofreach17.Andtherearesomereasonsforthat:internationalcooperationonmonetaryspilloversmayconflictwiththedomesticmandatesofcentralbanks.Forexample,internationalfinancialstabilityanddomesticactivityandinflationtargetsmaybeatodds,atleastintheshorttomediumrun.Furthermorethemanagementofaggregatedemandinsystemicallyimportanteconomieshasimportantconsequencesforeconomicactivityintherestoftheworld.Thisisamajorconsideration.Therestoftheworldcannotatthesametimecomplainofexcessivecapitalinflowsduetoloosemonetarypolicyinthecentrecountriesandwishforahigherlevelofeconomicactivityanddemandstimulusinthesamecountries.Tradeoffsareextraordinarily

16Ofcourseexcessivecomplexityinregulationhasalsothedownsideoflettingawellresourcedindustryfindloopholesorcreatethemaswellasencouragingriskybetsguidedbyregulatoryarbitrage.Complexityoftengoeswithlackoftransparencyandheterogeneousimplementation.17Policycoordinationwasamajorthemeininternationalmacroeconomicsinthe1980s(see,e.g.BuiterandMarston(1985)andBryantandPortes(1987)).TheG7summitsof1986(Tokyo)and1987(Venice)emphasizedmultilateralsurveillance.Tothisday,howeverneithertheeconomicanalysisnorthepolicypronouncementshavehadanyobservableeffectonactualmonetarypolicies.

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complexandpolicyactionwillmostlikelyremainbiasedtowardsnationalpriorities.Atransparentforuminwhichthecollectivemonetarypolicystanceofthesystemicallyimportantcentralbanksisactivelydiscussedandinconsistenciesanalysedwouldreducetheriskofvolatilityincapitalflows18.

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27

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31

AppendixA

Listofcountriesincluded:NorthAmerica

LatinAmerica

Central&EasternEurope

WesternEurope

EmergingAsia Asia Africa

Canada Argentina Belarus Austria China Australia SouthAfrica

US Bolivia Bulgaria Belgium Indonesia Japan Brazil Croatia Cyprus Malaysia Korea Chile CzechRepublic Denmark Thailand New

Zealand

Colombia Hungary Finland CostaRica Latvia France Ecuador Lithuania Germany Mexico Poland Greece Romania Iceland RussianFederation Ireland Serbia Italy SlovakRepublic Luxembourg Slovenia Malta Turkey Netherlands Norway Portugal Spain Sweden Switzerland UK

32

DataonCapitalflows:

Sourceofflowdata:quarterlygrosscapitalinflowsandoutflowsfromtheInternationalMonetaryFundsInternationalFinancialStatistics(accessedthroughIMFwebsiteinMarch2013)for:PortfolioEquityInflows,OutflowsandNetFlowsconstructedasOutflowsInflows(AssetsLiabilities)FDIInflows,OutflowsandNetFlowsPortfolioDebtInflows,OutflowsandNetFlows,andOtherInvestmentInflows,OutflowsandNetFlowsDatatransformations:FlowsarereportedinmillionsofU.S.dollarsIFSdoesnotdifferentiatebetweentruezerosandnotavailables;mostofthetimeswetreatthesevaluesaserrorsandomissions,unlesstheyevidentlyrepresentzeroflows.MappingoftheflowsfromBPM5(until2004Q4)toBP6(2005Q1onwards)inaccordancetotheguidelinesofthe6theditionoftheBalanceofPaymentsandInternationalInvestmentPositionManualofIMFReconciliationforquarters2005Q12008Q4forwhichthereisdataoverlap.ConstructionofNetFlowsonlywhendataonInflowsandOutflowsareavailableWorldGDPGrowth(Quarterly):InternationalMonetaryFundsInternationalFinancialStatistics(accessedthroughIMFwebsiteinMarch2013).

33

AppendixBGlobalFactor:commonfactorextractedfromacollectionof858assetpriceseriesspreadoverAsiaPacific,Australia,Europe,LatinAmerica,NorthAmerica,CommodityandCorporatesamples.FordetailsonextractionandoriginalassetpricesdatasetcompositionpleaserefertoMirandaAgrippinoandRey(2012).BankingSectorLeverage:constructedastheratiobetweenClaimsonPrivateSectorandTransferableplusOtherDepositsincludedinBroadMoneyofDepositoryCorporationsexcludingCentralBanks.DataareinnationalcurrenciesfromtheOtherDepositoryCorporationsSurvey;MonetaryStatistics,InternationalFinancialStatisticsdatabase.ClassificationofdepositswithintheformerDepositMoneyBanksSurveycorrespondstoDemand,Time,SavingsandForeignCurrencyDeposits.EUBankingSectorLeverage:constructedasthemedianBankingSectorLeverageoftheinitial12EuroAreaCountries(Austria,Belgium,Finland,France,Germany,Greece,Ireland,Italy,Luxembourg,theNetherlands,PortugalandSpain)andtheUK.USBrokersDealersFinancialLeverage:constructedastheratioofSecurityBrokerandDealersFinancialAssetsandTotalLiabilities;FederalReserveBoard;FinancialAccounts,releaseZ.1DomesticCredit:constructedasthesumofdomesticclaimsofDepositoryCorporationsexcludingCentralBanks.DomesticclaimsaredefinedasClaimsonPrivateSector,PublicNonFinancialCorporations,OtherFinancialCorporationsandNetClaimsonCentralorGeneralGovernment(ClaimslessDeposits);OtherDepositoryCorporationSurveyandDepositMoneyBanksSurvey;MonetaryStatistics;IFS.Originaldatainnationalcurrencies.DirectCrossBorderCredit:measuredasdifferenceinclaimsonallsectorsornonbanksectorofagivencountryofallBISreportingcountriesinallcurrencies;LocationalStatisticsDatabase;InternationalBankPositionsbyResidence;BIS;Tables7Aand7B.GlobalInflows:constructedasthesumofdirectcrossbordercredittononbanksectorinthe53countriessampledforthepaneldataanalysis;listofcountriessampledattheendofthissection.NominalGDPDatainUSD:originaldatainnationalcurrenciesfromNationalStatisticalOffices;HaverAnalyticsconversionusingspotendofperiodFXrates.VIX:endofperiodreadings;ChicagoBoardOptionExchange(CBOE).StockMarketIndices:endofperiodclosequotes;HaverAnalyticsandGlobalFinancialData.HousePriceIndices:OECD,BIS.ExchangeRates:innationalcurrencyperUSDollar;endofperiod;InternationalFinancialStatistics.NominalEffectiveExchangeRate:BroadEffectiveExchangeRateIndices,BISUSGDP:RealGrossDomesticProduct(BillionsofChained2005Dollars);BureauofEconomicAnalysis

34

USINFLATION:GrossDomesticProduct:ImplicitPriceDeflator(Index2005=100);BureauofEconomicAnalysisFFRUS:EffectiveFederalFundRates,EndofPeriod(%p.a.);FederalReserveBoard;SelectedInterestRates,releaseH.15Countriesinthepanel:Argentina,Australia,Austria,Belarus,Belgium,Bolivia,Brazil,Bulgaria,Canada,Chile,Colombia,CostaRica,Croatia,Cyprus,CzechRepublic,Denmark, Ecuador,Finland,France,Germany,Greece,HongKong,Hungary,Iceland,Indonesia,Ireland,Italy,Japan,Korea,Latvia,Lithuania,Luxembourg,Malaysia,Malta,Mexico,Netherlands,NewZealand,Norway,Poland,Portugal,Romania,Russia,Serbia,Slovakia,Slovenia,SouthAfrica,Spain,Sweden,Switzerland,Thailand,Turkey,UnitedKingdom,UnitedStates.

35

AppendixCTable2

Table2(b)BankingSectorLeverageGrowth,,isthedependantvariable(19902013)flit CreditL C.nonbankL CreditA DebtL DebtA EquityL EquityA

VIXt0.0125*** 0.0122*** 0.0127*** 0.0121*** 0.0127*** 0.0140*** 0.0121***(3.84) (3.82) (3.87) (4.02) (3.87) (3.70) (3.43)

VIXt0.0164*** 0.0167*** 0.0171*** 0.0167*** 0.0174*** 0.0175*** 0.0190***(4.06) (4.4) (4.44) (4.26) (4.39) (4.49) (4.81)

flit*VIXt 0.00 0.0014 0 0.0007 0 0 0.0005(1.28) (1.39) (0.67) (1.09) (0.89) (0.36) (1.24)

flit1*VIXt1

0.0002 0.0014 0 0.0001 0.0001 0 0.0003(0.61) (1.43) (0.56) (0.34) (0.67) (0.29) (1.18)

Adj.R2 0.01 0.008 0.008 0.009 0.008 0.007 0.011N 2352 2405 2370 2273 2332 2018 2167

Fixedeffectestimator,standarderrorsadjustedforclusteringoncountry,tstatinparentheses.Allspecificationsincludethecontrolvariablesandalineartrend.

Table2(c)Housepriceinflation,isthedependantvariable(19902013)

flit CreditL C.nonbankL CreditA DebtL DebtA EquityL EquityA

VIXt0.0174*** 0.0127*** 0.0170*** 0.0183*** 0.0179*** 0.0166*** 0.0178***(3.66) (3.68) (3.52) (3.52) (3.74) (3.60) (3.36)

VIXt0.0073*** 0.0051** 0.0072*** 0.0076*** 0.0082*** 0.0081*** 0.0074***(2.91) (2.03) (2.88) (2.87) (3.5) (4.33) (2.89)

flit*VIXt

0.00 0.001 0.0001 0.0003 0 0 0.0001(1.04) (0.99) (1.07) (1.16) (0.3) (0.59) (0.65)

flit1*VIXt1

0.0001 0.0018 0 0.0001 0 0 0.0001(1.00) (1.11) (0.09) (0.56) (0.08) (0.02) (0.59)

Adj.R2 0.07 0.064 0.068 0.066 0.063 0.058 0.076N 2335 2490 2358 2263 2303 2044 2166

Fixedeffectestimator,standarderrorsadjustedforclusteringoncountry,tstatinparentheses.Allspecificationsincludethecontrolvariablesandalineartrend.

36

AppendixD:Figures1a,b,c:heatmapsofcorrelationsofgrossinflows,grossoutflowsandnetflowsFigure2:plotscapitalinflowsdisaggregatedbyassettypes(FDI,portfolioequity,portfoliodebtandcredit)asaproportionoftheworldGDPfortheperiod1990Q12012Q4anditreportstheVIX(invertedscale)onthesamegraph.Figure5:CompletesetofImpulseresponsefunctionsoftheVAR.