Leaning Against the Global Financial Cycle

Thu, 01 Jan 2026 00:00:00 +0000

This paper investigates how institutional quality shapes (i) the domestic financial and macroeconomic impact of Global Financial Cycle (GFC) shocks on emerging market economies (EMEs) and (ii) the menu of counter-cyclical policies those countries actually deploy — and how effectively — in response. The central motivation is that EMEs face a difficult policy trade-off when global financial conditions tighten: they must balance retaining international investor confidence against stabilizing domestic demand, and policymakers have four instruments available (monetary policy, foreign exchange reserve intervention, macro-prudential policy, and capital controls) whose effectiveness may depend critically on underlying institutional strength.

The global capital flows cycle: structural drivers and transmission channels

Decomposing a global risk factor built from stock returns in 63 economies into structural shocks, this paper finds that exogenous shifts in the financial sector’s risk-bearing capacity matter more than US monetary policy for driving global risk, and that the transmission of risk to capital flows follows a classical trilemma – countries that are both financially open and pegged are markedly more exposed – driven almost entirely by cross-border bank loans. The data are quarterly, 1990Q1 to 2017Q4, for 50 countries (18 advanced, 32 emerging), with gross capital inflows split into direct investment, portfolio equity, portfolio debt and other investment from the IMF’s Balance of Payments Statistics; several financial centres are excluded outright because their flows “record extremely large values with respect to GDP and are very volatile,” and dependent variables are winsorised at 1 percent. Global risk is proxied by a Global Stock Market Factor, the first principal component of country-average stock returns in 63 economies. Three findings follow. First, in a seven-variable Bayesian structural VAR identifying a US monetary policy shock by external instrument and US demand, global financial and geopolitical risk shocks by sign restrictions, the forecast error variance decomposition of global risk at a twelve-month horizon attributes about 19 percent to US monetary policy against 23 percent to financial shocks, 13 percent to geopolitical risk and under 10 percent to US demand – with the gap widening at higher percentiles, where financial shocks reach roughly 70 percent and US monetary policy no more than about 30 percent. The authors are careful that this does not demote monetary policy: “not only monetary policy is indeed relevant for global risk as the proponents of the global financial cycle have stressed, but its quantitative role is all but negligible.” Second, in country panel regressions with country fixed effects, four lags of the dependent variable and Driscoll-Kraay standard errors, the Global Stock Market Factor is negative and statistically significant for every category of flows, where the VIX is significant only for portfolio flows – but the average magnitude is modest, a one-standard-deviation risk shock cutting gross inflows by between 0.1 percent of GDP for equity and 0.8 percent for other investment, and total inflows by 1.7 percent of GDP against a flow volatility of 14 percent. US monetary policy surprises are significant for portfolio flows but not for other investment or total flows, which the paper reconciles with Bruno and Shin by noting that US policy “can affect these flows only to the extent that it induces significant shifts in global risk.” Third, interacting the risk factor with capital account openness and exchange rate regime dummies yields a classical trilemma: both policy variables matter for the transmission of global risk but neither matters for US monetary policy surprises, strict pegs transmit risk shocks more strongly to other investment and direct investment but “not necessarily to portfolio flows,” and the effect is concentrated enough that the paper concludes the trilemma “is largely driven by one category of capital flows: other investment.” Conditioning on policy raises the economic significance considerably – for open economies with an exchange rate target the impact on total inflows reaches 4.0 percent of GDP against a 1.7 percent unconditional average, and for open, pegging emerging markets it exceeds 4 percent of GDP, four times the 1 percent average across all emerging markets and large enough, against a typical inflow of almost 7 percent of GDP, to constitute a sudden stop.

Fabrizio Venditti | Macro Paper Warehouse

Leaning Against the Global Financial Cycle

The global capital flows cycle: structural drivers and transmission channels