Leaning Against the Global Financial Cycle

Layer 1: Overview

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 empirical analysis covers 22 EMEs (including Turkey, Brazil, Chile, Mexico, South Korea, India, Poland, and others) at monthly frequency from 1995 to 2021. The baseline measure of global financial conditions is the Excess Bond Premium (EBP) of Gilchrist and Zakrajsek (2012). Institutional quality is measured by the World Bank Worldwide Governance Indicators (WGI), with rule of law as the baseline indicator; the authors also check government effectiveness, corruption control, and regulatory quality. The empirical strategy is panel local projections with country fixed effects and Driscoll-Kraay standard errors, interacting the EBP shock with institutional indicators and policy changes to isolate heterogeneous responses. The identifying assumption is that the EBP responds contemporaneously to macroeconomic information while real outcomes respond only with a lag, consistent with ordering the EBP last in a recursive VAR.

The main finding on outcomes is that a tightening of global financial conditions reduces equity prices, widens sovereign spreads, depreciates the exchange rate, and contracts GDP for the average EME — with the EBP coefficient on equity returns reaching -10.0 percentage points at one month and -14.5 percentage points at six months (both significant at 1%). For a country at the 10th percentile of the rule-of-law distribution (score -1.3), a one-standard-deviation EBP shock (0.63 rise) produces an equity price fall of roughly 8%, a sovereign spread widening of approximately 50 basis points, and a GDP contraction of about 0.8%. Moving from the 10th to the 90th percentile of rule of law (score 1.1) reduces the equity and GDP contractions by roughly half and the spread widening by approximately half. The rule-of-law interaction coefficient on equity at horizon t+1 is 2.08 (significant at 1%), and the GDP interaction coefficients are 0.23 (significant at 10%) and 0.24 (significant at 5%) at horizons of 12 and 18 months, respectively. Exchange rate depreciation is not significantly moderated by institutional quality.

On policy responses, the key finding is asymmetric policy space: countries with weak institutions tighten interest rates in the face of a GFC shock — to stem capital outflows and contain spread widening — while countries with strong institutions are able to lower rates. The EBP-times-rule-of-law interaction coefficient on interest rates at six months is -0.27 (significant at 5%), indicating that higher institutional quality is associated with lower interest rates after a shock. Simultaneously, weak-institution countries shed reserves significantly, whereas high-institution countries experience changes in reserves not significantly different from zero (or even modest accumulation), with the EBP-times-rule-of-law interaction on reserves at six months equal to 0.38 (significant at 10%). Capital controls show no systematic counter-cyclical use; macro-prudential policies show only a weak and transient response at short horizons. Both instruments appear deployed primarily as ex ante defenses during inflow episodes rather than ex post stabilization tools.

A notable exception is the Covid-19 episode (January–August 2020). During this period, the institutional-quality interaction terms are statistically insignificant for both financial outcomes and policy reactions: all EMEs cut rates sharply (coefficient -0.34 at one month, significant at 1%) and shed reserves uniformly, with no significant differentiation by rule of law. The authors attribute this to the global, coordinated response of major central banks, which compressed the shock duration and may have overridden normal country-level differentiation.

To interpret the empirical results, the authors develop a two-period small open economy model with a collateral constraint on foreign borrowing (adapted from Mendoza 2002). The key mechanism is that a higher share of foreign-currency debt (parameter η) tightens the collateral constraint in a crisis via the real exchange rate depreciation channel. Institutional reforms that allow more domestic-currency borrowing (lower η) act as an ex ante structural policy. Foreign exchange market intervention that appreciates the currency in a crisis acts as an ex post cyclical policy. The model shows these two instruments are largely substitutes: countries that have invested in institutions (lower η) benefit less from FX intervention (the intervention is more effective the higher η is), and conversely, countries for which FX intervention is highly effective face a weaker incentive to undertake costly institutional reforms ex ante.

Layer 2: Deep Dive

What is the identification strategy and what are the main threats to it?

The paper uses panel local projections (Jorda 2005) with country fixed effects, interacting the contemporaneous EBP with lagged institutional indicators and contemporaneous policy changes. The EBP is ordered last in the sense that the identifying assumption is that macroeconomic variables respond to financial shocks with a lag while the EBP can react contemporaneously to macro news — this is the same assumption used in Ben Zeev (2019) and Bhattarai, Chatterjee, and Park (2020). The authors include an extensive set of controls in the M matrix: lags of EBP, EBP interacted with rule of law, contemporaneous and lagged domestic inflation and output, contemporaneous and lagged global industrial production and oil prices, and contemporaneous and lagged U.S. inflation and GDP growth. The main endogeneity threat on the policy side is that counter-cyclical policies respond endogenously to the same shock driving outcomes; the authors address this by interacting the shock with a large set of country characteristics to ‘soak up’ cross-sectional heterogeneity in policy reaction functions and make policy changes ‘as good as random.’ They acknowledge but do not fully resolve this concern.

How is institutional quality measured and does the choice of indicator matter?

The baseline measure is the World Bank Worldwide Governance Indicators (WGI) rule of law score, which captures ‘perceptions of the extent to which agents have confidence in and abide by the rules of society’ including contract enforcement, property rights, policing, and the courts. The five WGI dimensions (rule of law, government effectiveness, corruption control, regulatory quality, and political stability) are highly correlated, so results reported in Table A1 using government effectiveness, corruption control, and regulatory quality are very similar to the baseline. The authors also test whether central bank independence (Garriga 2016) or central bank transparency (Dincer and Eichengreen 2014) matter instead — neither produces interaction coefficients significantly different from zero, indicating that CB governance is only one element of broader institutional quality and insufficient by itself to insulate EMEs from global shocks.

What distinguishes the paper’s contribution from closely related prior work?

The paper is most closely related to Batini and Durand (2021), who find that capital controls and macro-prudential policies reduce the correlation between capital inflows to EMEs and the global capital flows cycle, but only during large inflow episodes. The current paper extends this by introducing institutional quality as a moderating variable across the full menu of four counter-cyclical instruments and showing that the effectiveness and actual use of each instrument depends on a country’s institutional strength. It also differs from Kalemli-Ozcan (2019), whose theoretical conjecture that low credibility leads to self-defeating macroeconomic policies the authors test and confirm empirically across the full EME panel. The paper additionally contributes a structural model that formally links the ex ante vs. ex post policy substitutability to currency composition of debt and collateral constraints, connecting empirical findings to welfare.

What heterogeneity in EME responses is documented beyond the mean effect?

The primary dimension of heterogeneity is rule of law. At the 10th percentile (score -1.3), a one-SD EBP shock causes an equity fall of ~8%, spread widening of ~50 bps, and GDP contraction of ~0.8%; at the 90th percentile (score 1.1), these effects are approximately halved. The exchange rate response is not significantly differentiated by institutional quality. The policy heterogeneity is also sharp: weak-institution countries tighten rates and deplete reserves, while strong-institution countries lower rates without suffering additional depreciation or reserve outflows. The paper also documents some heterogeneity related to per capita income (Table A2), finding that both per capita income and institutional quality independently predict milder financial tightening, with richer EMEs also experiencing less exchange rate depreciation (possibly reflecting greater fear of floating in less-advanced EMEs). However, per capita income does not displace the institutional quality finding — both coefficients remain significant when included jointly.

What robustness checks are run?

The authors conduct four sets of robustness exercises. First, they replace the EBP with the VIX (Table A3) and find broadly consistent results: countries with better rule of law suffer milder GDP contractions and smaller spread widening when the VIX spikes. Second, they replace the continuous EBP shock with a dummy for selected episodes of extreme financial stress (Table A4), finding positive and significant interaction coefficients for equity and GDP (milder contraction) and negative for spreads (milder widening). Third, they add per capita income and its interaction with the EBP (Table A2), confirming that institutional quality retains significance after controlling for income. Fourth, they replace the rule of law with the four other WGI dimensions (Table A1), obtaining virtually identical results. They also show that capital controls and macro-prudential policies display little counter-cyclical activation regardless of specification.

What is the mechanism through which institutions moderate GFC transmission?

Stronger institutions raise international investor confidence in a country’s credibility and willingness to enforce contracts and property rights. When a GFC tightening hits, investors discriminate less against high-institution EMEs, resulting in smaller capital outflows and less exchange rate pressure. This grants high-institution central banks the policy space to cut rates rather than raise them, which further stabilizes financial conditions without triggering additional capital flight. In the model, strong institutions reduce the share of debt denominated in foreign currency (lower η), which directly relaxes the collateral constraint in a crisis because the collateral value is denominated in domestic currency — less external debt means less amplification of the depreciation-collateral-borrowing spiral. This is the key pecuniary externality in the Mendoza (2002) framework that the model formalizes.

How do ex ante and ex post policies interact, and what are the policy implications?

The theoretical model shows that structural reforms (reducing foreign-currency debt share, i.e., lowering η) and FX intervention are largely substitutes. Specifically, the welfare gain from FX intervention is larger the higher η is — meaning that FX intervention is most valuable to countries that have not undertaken institutional reforms. Countries that have invested in strong institutions need to use FX reserves less in a crisis, consistent with the empirical finding that high-rule-of-law countries experience smaller reserve depletion after a GFC shock. This creates a moral-hazard-style dilemma: if FX intervention is highly effective (because η is large), the marginal incentive to invest in costly institutional reform is reduced. The normative implication is that institutional development and counter-cyclical policies should be seen as a portfolio — countries cannot rely indefinitely on FX intervention as a substitute for governance reform if the goal is to reduce structural vulnerability.

Why are macro-prudential policies and capital controls not found to be counter-cyclical tools?

Two explanations are offered. First, macro-prudential tools require a build-up phase in which standards are tightened during good times so they can be loosened in bad times; many EMEs only began adopting these tools systematically after the 2008 Global Financial Crisis, as shown by the progressive tightening in the iMaPP aggregate index after 2008. Second, capital controls on outflows are strategically avoided in periods of stress because imposing them signals investor-hostile policy intentions precisely when foreign capital is most needed, exacerbating the perception of vulnerability (Rebucci and Ma 2019). Capital controls on inflows are used as ex ante instruments during inflow episodes (Ben Zeev 2017; Das, Gopinath, and Kalemli-Ozcan 2021), but this is an ex ante rather than ex post counter-cyclical use.

How does the Covid-19 episode differ and what explains the deviation?

During January-August 2020, the standard pattern breaks down. All 22 EMEs cut interest rates sharply (coefficient -0.34, significant at 1%) and shed reserves (coefficient -0.45, significant at 1%) regardless of institutional quality; the EBP-times-rule-of-law interaction terms for both financial outcomes (equity coefficient 1.42, insignificant; spread coefficient 1.16, insignificant) and policy responses (rate interaction 0.053, insignificant; reserve interaction -0.16, insignificant) are not statistically different from zero. The authors attribute this to the unusually swift and coordinated global monetary policy response — led by the U.S. Fed and other major central banks — which made the shock short-lived and may have extended implicit backstops to all EMEs regardless of institutional quality. The Covid episode may also be better explained by idiosyncratic factors such as fiscal space, pandemic containment policies, and integration in global value chains.

What is the two-period model’s structure and what does it deliver?

The model is a deterministic two-period small open economy endowment model with home bias in consumption (import share λ = 0.4), a binding collateral constraint in the crisis state, and debt split between domestic- and foreign-currency denomination (ratio η). The collateral constraint is (1+η)b ≤ ω·pH1·y1, so a higher η — more foreign currency debt — tightens the constraint via the exchange rate in a crisis because real exchange rate depreciation reduces domestic endowment value in foreign terms. The government can (ex ante) conduct structural reforms that lower η at a cost, or (ex post) intervene in the FX market to appreciate the currency, which relaxes the constraint. Calibrated with β = 0.96 (4% annual real rate), ω = 0.3 (maximum debt 30% of output), and normalized output and initial debt to 1, the model shows (i) higher η produces larger utility losses in the crisis state, and (ii) FX intervention reduces those losses, but more so the higher η — confirming the substitutability and the declining returns to FX intervention as institutions improve. The model does not endogenize the choice of η nor derive an optimal policy mix given costs, which the authors acknowledge as a limitation.

Key Concepts

Global Financial Cycle (GFC): The paper-specific sense follows Rey (2013) and Miranda-Agrippino and Rey (2021): the co-movement of risky asset prices across global markets driven primarily by U.S. financial conditions and global risk appetite, operationalized empirically as shocks to the Excess Bond Premium. For EMEs, the GFC represents an exogenous source of financial tightening or loosening that transmits through capital flows, exchange rates, and credit conditions.

Excess Bond Premium (EBP): The Gilchrist and Zakrajsek (2012) measure of the component of U.S. corporate bond spreads that is not explained by observable firm-level default risk — interpreted as the compensation demanded by investors for bearing corporate credit risk above and beyond expected losses. Used in this paper as the baseline proxy for global financial conditions because its effects on EMEs are well-established and it is more specific than the VIX.

Institutional strength / rule of law: Operationalized via the World Bank Worldwide Governance Indicators. In this paper’s framework, institutional strength captures the degree to which international investors trust a country’s contract enforcement, property rights, and policy credibility. This trust is the mechanism by which high-institution EMEs face lower capital sensitivity to GFC shocks and retain monetary policy space.

Ex ante vs. ex post policy: The paper distinguishes structural reforms (ex ante) that reduce an economy’s vulnerability to GFC shocks before they occur — by, for example, improving institutions so that debt can be issued in domestic currency — from cyclical stabilization measures (ex post) deployed after a shock arrives, such as FX reserve sales to support the exchange rate. These two classes of policy are shown to be largely substitutes.

Collateral constraint (model): In the paper’s theoretical framework (following Mendoza 2002), total borrowing is limited to a fraction ω of the domestic endowment value. When denominated in foreign currency, a real exchange rate depreciation tightens the constraint endogenously — the model’s central amplification mechanism — creating a pecuniary externality that structural policy (reducing η) or FX intervention (limiting depreciation) can partially offset.

Foreign-currency debt share (η): The ratio of foreign-currency to domestic-currency denominated debt in the model. A higher η amplifies the collateral constraint tightening during a GFC shock because a given exchange rate depreciation reduces the domestic-currency value of the collateral more. Lower η — achievable through institutional reform — is the model’s representation of reduced GFC vulnerability. FX intervention is more effective (has larger welfare gains) when η is high.

Policy space: Used in this paper to mean the ability of a central bank to cut the short-term interest rate in response to a negative GFC shock without triggering capital outflows and further depreciation. Strong institutions expand policy space because international investors maintain confidence in the country’s credibility and do not flee in response to lower yields. Weak-institution countries lack policy space and are forced to raise rates in a crisis, tightening domestic conditions further.