Credit | Monetary Policy & Inflation | US
When the US economy sneezes, every other country catches a cold. Many investors have long felt this, and in recent years academics have provided the empirical support for this notion. One of the central pieces in this literature is London Business School professor Hélène Rey’s paper Dilemma, not Trilemma: The global financial cycle and monetary policy independence. She finds that the global credit and capital flow cycle is dominated by US monetary policy, which can overwhelm local factors in other countries. This has important policy and market implications.
3 Key Observations
In her paper, she makes the following observations:
• International capital flows are highly correlated
Rey finds a strong commonality in capital inflows across asset classes, whether FDI, equities, bonds or credit. The heatmap below shows a matrix of correlations of flows into these assets across various regions for the period 1990 to 2012. The sea of green shows the predominance of positive correlations, which implies a global common factor. A similar result is found for capital outflows.
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When the US economy sneezes, every other country catches a cold. Many investors have long felt this, and in recent years academics have provided the empirical support for this notion. One of the central pieces in this literature is London Business School professor Hélène Rey’s paper Dilemma, not Trilemma: The global financial cycle and monetary policy independence. She finds that the global credit and capital flow cycle is dominated by US monetary policy, which can overwhelm local factors in other countries. This has important policy and market implications.
3 Key Observations
In her paper, she makes the following observations:
• International capital flows are highly correlated
Rey finds a strong commonality in capital inflows across asset classes, whether FDI, equities, bonds or credit. The heatmap below shows a matrix of correlations of flows into these assets across various regions for the period 1990 to 2012. The sea of green shows the predominance of positive correlations, which implies a global common factor. A similar result is found for capital outflows.
Figure 1: Heatmap of Correlations of Gross Inflows
Source: Page 37- DILEMMA NOT TRILEMMA: THE GLOBAL FINANCIAL CYCLE AND MONETARY POLICY INDEPENDENCE
• Global credit and capital flows co‐move with VIX
Global capital flows are synchronized with global risk aversion, which can be proxied by US equity volatility (VIX). Moreover, credit creation in the banking sector and leverage also follow VIX. Overall, credit flows have the highest correlation with VIX (see chart).
Figure 2
Source: Page 40- DILEMMA NOT TRILEMMA: THE GLOBAL FINANCIAL CYCLE AND MONETARY POLICY INDEPENDENCE
*Plots capital inflows disaggregated by asset types (FDI, portfolio equity, portfolio debt and credit) as a proportion of the world GDP from 1990 to 2012
• Market prices also follow global risk.
Market prices are also dominated by a global factor. In Rey’s earlier work, she analysed a large cross-section of 858 risky asset prices (distributed across five continents) and found the variance of risky asset returns (25%) is explained by one single global factor. This factor is consistent with the timing of major events such as the Gulf War (1990), 9/11 (2001), the global financial crisis (2009), the Russian financial crisis (1998), LTCM bankruptcy (1998), and the dotcom bubble (2001). She finds that this global factor is correlated with VIX (see chart).
Figure 3: Global Factor and VIX
Source: Miranda‐Agrippino and Rey (2012)
How US Monetary Policy Fits Into the Equation
Rey’s key finding is that a low value of VIX is associated with a build-up of the global financial cycle which means more capital inflows and outflows, credit creation, leverage, and higher asset prices. But what is the cause of this? Rey uses econometric techniques and finds that one of the determinants of the global financial cycle is US monetary policy; it directly alters the VIX. For instance, an increase in the effective federal funds rate of 25bp leads to an increase in the VIX after about 5 quarters and until 11 quarters (Figure4a). This in turn reduces the leverage of global banks, capital flows, and credit growth in the international financial system (figure 4b).
Figure 4a: 25bp Increase to the Effective Federal Funds Rate
Source: Page 14- DILEMMA NOT TRILEMMA: THE GLOBAL FINANCIAL CYCLE AND MONETARY POLICY INDEPENDENCE
Figure 4b: Responses to a 1% Increase in the VIX
Source: Page 15- DILEMMA NOT TRILEMMA: THE GLOBAL FINANCIAL CYCLE AND MONETARY POLICY INDEPENDENCE
The Policy Dilemma, Rather Than Trilemma
Economic theory has long dictated that countries face a trilemma: with free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. According to Rey, the global financial cycle reduces the trilemma into a dilemma: independent monetary policies are possible if and only if the capital account is managed. This is because cross‐border flows and leverage of global institutions transmit monetary conditions globally – even under floating exchange‐rate regimes. This means that the choice of currency regime does not reduce the impact of this global financial cycle.
Given this, one could consider permanent capital controls to insulate the economy from the global financial cycle. However, given the scale of financial globalization, the costs could be prohibitively large. Further, such measures could disrupt asset markets and financial intermediation. Rey, therefore, suggests the following policy choices:
• Targeted capital controls.
• Acting on one of the sources of the financial cycle itself, the monetary policy of the Fed and other main central banks (international policy coordination).
• Acting on the transmission channel cyclically by limiting credit growth and leverage during the upturn of the cycle, using national macroprudential policies (i.e. countercyclical capital cushions).
• Acting on the transmission channel structurally by imposing stricter limits on leverage for all financial intermediaries.
Of course, international cooperation among the central banks to internalize the spillovers of their monetary policies on the rest of the world seems improbable for two reasons:
(1) It may conflict with the domestic mandates of the central banks.
(2) The management of aggregate demand in systemically important economies (the US, China, the EU, and Japan) has important consequences for economic activity in the rest of the world. The rest of the world cannot at the same time protest against excessive capital inflows due to loose monetary policy in the centre countries and wish for a higher level of economic activity and demand.
Hence, according to Rey, the most appropriate policies to deal with the dilemma are those aiming directly at the main source of concern (excessive leverage and credit growth), which are also more correlated with the global financial cycle. This requires a combination of macroprudential tools such as aggressive stress‐testing and tougher leverage ratios.
What Do Other Academics Think?
Since the publication of Rey’s piece in 2012, there has been an explosion of academic work on the global financial cycle. The main responses have been:
Yes, there is a global financial cycle
• Updated studies find VIX is a key driver of financial cycles. For example, a study looking at 38 advanced and emerging economies over the period 1995Q4 to 2018Q3 finds VIX is statistically significant (Beirne, 2019).
• Another study indicates that there is a global financial cycle and it impacts emerging markets more than developed markets. Also, capital flows are sensitive to fluctuations in risk premia and influence local credit spreads – in turn prompting changes in the domestic interest rates (Kalemli-Özcan et al., 2019).
There may be a global financial cycle, but FX regimes still matter.
• The case for flexible exchange rates is stronger in the world of the global financial cycle. Exchange rate adjustment can smooth out shocks (of risk sentiments) brought about by changes in US monetary policy. And rather than capital controls, the best policy response could be to improve institutional quality. This could include fighting corruption, having an independent central bank, or perhaps improving bureaucratic quality (Kalemli-Özcan et al., 2019).
The global financial cycle is directly affected by Fed policy rather than through VIX
• A study found US monetary policy is an independent source of the global financial cycle, rather than acting through VIX. US policy affects cross-border bank lending internationally – a 100 basis point rise in the US policy rate leads to an approximately 10% fall in global lending after two quarters (Albrizio et al., 2019).
Type of monetary policy matters
• There was a clear dominance of the global financial cycle between the global financial crisis (2008) and the taper tantrum (2013). However, since the taper tantrum, one study found that domestic vulnerabilities also started to matter. This suggests that the global financial cycle is time-variant and differs between unconventional and conventional phases of monetary policy (Buono, Corneli and Stefano, 2020).
The global financial cycle is not that strong
• Some studies, using a wide range of countries and numerous econometric techniques, find that less than 25% of the variation in the capital flows can be explained by a global financial cycle. These studies tend to argue that other factors outside of US policy are at play (Cerutti, Claessens and Rose, 2017).
Bottom Line
Whatever we think we know about specific countries, we cannot ignore global factors that can swamp local fundamentals – we learnt as much during the global financial crisis, and increasingly academics are supporting this notion. The key global factor is US monetary policy, which in turn can affect global risk premia via VIX and capital flows. There is some nuance, though. EM appears to be more sensitive than DM, the type of monetary policy can also matter, and policymakers may increasingly resort to capital controls to manage this global cycle. The latter is something that could catch investors off guard and so needs to be incorporated in risk models.
References
Albrizio, S., Choi, S., Furceri, D. and Yoon, C. (2019). International Bank Lending Channel of Monetary Policy. SSRN Electronic Journal.
Beirne, J. (2019). ADBI Working Paper Series FINANCIAL CYCLES IN ASSET MARKETS AND REGIONS Asian Development Bank Institute. [online] Available at: https://www.adb.org/sites/default/files/publication/543336/adbi-wp1052.pdf [Accessed 25 Feb. 2020].
Buono, I., Corneli, F. and Stefano, E. (2020). Capital inflows to emerging countries and their sensitivity to the global financial cycle. [online] Available at: https://www.bancaditalia.it/pubblicazioni/temi-discussione/2020/2020-1262/en_Tema_1262.pdf?language_id=1 [Accessed 25 Feb. 2020].
Cerutti, E., Claessens, S. and Rose, A.K. (2017). How Important is the Global Financial Cycle? Evidence from Capital Flows. [online] National Bureau of Economic Research. Available at: https://www.nber.org/papers/w23699 [Accessed 25 Feb. 2020].
Kalemli-Özcan, Ş., Akıncı, J., Di Giovanni, G., Gopinath, P., Olivier-Gourinchas, E., Papaioannou, L., De Leo, F., Saffie, J., Shea, L., and Stevens (2019). Varela for numerous conversations on the topic of international spillovers. [online] Available at: http://econweb.umd.edu/~kalemli/assets/publications/JH_paper_final_sep6.pdf [Accessed 25 Feb. 2020].
Rey, H. (2015). Dilemma, not Trilemma: The Global Financial Cycle and Monetary Policy Independence. [online] National Bureau of Economic Research Working Paper Series. Available at: https://www.nber.org/papers/w21162 [Accessed 28 Nov. 2019].
Mehdi is a research analyst at Macro Hive. He’s currently pursuing an MSc in Finance & Investment at Nottingham University Business School and he is a CFA level 3 candidate. Mehdi has previously pursued roles as an Equity Research Analyst, Junior Economist & in Proprietary Trading.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)