Eugenio Cerutti, Stijn Claessens, and Lev Ratnovski
The financial cycle is becoming increasingly global, as highlighted in recent work (Rey 2013, Bruno and Shin 2014, Obstfeld 2014) and reflected in policy discussions (e.g., the increased talk of financial “spillovers”). The phenomenon is evident from the correlation of credit growth across countries, which has increased markedly since the mid-1990s (Figure 1).
Figure 1.Financial cycle more correlated
Rolling 5-year average correlations between total credit growth in the US, UK, Eurozone, and Japan and the rest of the world.
This reflects, in part, deeper real economic integration through international trade (red line in Figure 2), and, in part, increased integration of countries into the global financial system, as illustrated by the expansion of cross-border banking claims before the financial crisis (blue line in Figure 2).
Figure 2.Deeper financial integration
The share of trade and cross-border claims relative to GDP.
An important feature of financial integration is that a large amount of funds flow from “financial center” economies such as the G4 economies (United States, euro area, United Kingdom, and Japan) to the rest of the world. For example, in June 2013, cross-border bank claims by the G4 on the rest of the world exceeded claims by the rest of the world on G4 banks by 20 percent. And this number understates the role of the G4 as financial centers, because international banks in the G4 also act as intermediaries for much of cross-border credit between countries in the rest of the world.1
Since the G4 financial systems act as intermediaries for much of global credit, funding conditions—or ease of obtaining credit—within the G4 affect funding conditions globally. This is precisely what the concept of global liquidity aims to capture. One can understand global liquidity as those credit supply factors in financial center economies that affect the provision of cross-border credit.
Under this definition, global liquidity is a specific case of funding liquidity (ease of financing, see Brunnermeier and Pedersen 2009). It is different from asset market liquidity, that is, the ability to trade rapidly with small price impacts.
Why Is Global Liquidity Important?
The fact that financial conditions and policies in G4 economies affect financial conditions globally has implications for the rest of the world. The key one is that the ability of recipient (non-G4) economies to attract funds is determined not only by their domestic economic conditions and policies, but also by economic and financial conditions and policies within the G4. As such, knowing what specific conditions are relevant for the supply of funds becomes an important surveillance question for policymakers globally. And such knowledge can matter for formulating effective policy responses.
In a recent paper (Cerutti, Claessens, and Ratnovski 2014), we asked three questions critical to understanding the dynamics of global liquidity.
- What drives global liquidity, i.e., what determines credit supply conditions in international financial markets?
- Where does the global financial cycle originate? Is it primarily U.S.-driven, or do other financial center economies play a role?
- How can a borrowing country manage its exposure to global liquidity fluctuations?
We answer these questions by looking at a specific type of cross-border flows—banking flows. Other flows include bond flows, equity portfolio flows, foreign direct investment (FDI), etc. IMF (2014) studies the various types of cross-border flows and suggests that the results across different types of flows are similar.
What Drives Global Liquidity?
The literature highlights a number of domestic G4 factors that may affect credit supply in cross-border funding markets. We confirm, using U.S. data, that all of these factors are important in driving cross-border credit:
- Uncertainty and risk aversion, typically captured by VIX (Rey 2013). We find that a 65 percent increase in VIX (corresponding to moving from its 25th to the 75th percentile in the distribution) reduces cross-border lending to banks by 6 percent, and to the real sector by 3.5 percent.
- Domestic credit conditions in the G4, captured as bank leverage (high for more accommodative conditions, see Bruno and Shin 2014), domestic credit growth (Borio and Lowe 2004), or TED spread. We find that an improvement in credit conditions such as a 50 percent change in U.S. dealer bank leverage (moving from its 25th to 75th percentile) increases cross-border lending to banks and the real sector by 5.5 percent and 4.5 percent, respectively.
- Monetary policy: short-term interest rates, the term premium, and changes in money mass. Here, we find that an increase in the term premium from its 25th to 75th percentile decreases cross-border lending to banks and real sector by 1.7 percent and 0.2 percent, respectively.
In addition, global liquidity is driven by the relative price of foreign borrowing. These price effects, however, are modest. An increase in the differential in interest rates between the recipient country and the United States from its 25th to 75th percentile increases cross-border lending by only 0.2 percent to 0.3 percent.
Comparing these economic effects leads to an important observation. Global liquidity is determined by government actions and private sector conditions. Of course, this distinction is imprecise because government actions and private sector conditions affect one another. Still, if one takes as a first order approximation that uncertainty and bank conditions reflect the private sector, while monetary policy and the interest rate differential reflect government actions, it appears that a predominant part of global liquidity is determined by the private sector rather than by direct government actions.
“Global liquidity is determined by government actions and private sector conditions.”
This challenges the view that monetary policy in advanced economies is largely responsible for the global financial cycle. Rather, evolving financial sector conditions, and often self-fulfilling market perceptions (e.g., as in the behavior of the VIX), play an overwhelming role.
Which Countries Drive Global Liquidity?
Many commentators presume that the global financial cycle is U.S.-driven. We can check whether this is the case by looking at the relative power of conditions in the United States versus other financial centers in explaining global liquidity.
Measures of uncertainty and risk-aversion are global in nature (VIX measures are highly correlated across countries), but bank conditions and monetary policy indicators have sufficient heterogeneity across G4 countries.
To determine regional effects (e.g., U.K. and euro area conditions may disproportionately affect cross-border credit to eastern Europe), we limit our comparison to how U.S. versus U.K. and euro area conditions affect cross-border lending to Asia.
We find that:
- For bank conditions, U.K. and euro area bank leverage and TED spreads have more statistically and economically significant effects on cross-border lending to Asia than U.S. dealer bank leverage and U.S. TED spreads.
- For monetary policy, U.S. factors play an overwhelming role. U.K. and euro area term premium, interest rates, and money growth are mostly not significant.
This highlights that while the United States drives the global financial cycle through its monetary policy, other financial centers—the United Kingdom and the euro area—affect the global financial cycle through the conditions of their banks, consistent with their major global financial intermediation role (Shin 2012).
Can Countries Manage Their Exposure to Global Liquidity?
Borrowing countries may want to limit their exposure to global liquidity fluctuations to better control domestic financial conditions. We find that the following country policies can at least reduce by half the borrowing countries’ exposures to variations in global liquidity:
A better macro framework, such as a flexible exchange rate. An increase in global liquidity drivers from its 25th to the 75th percentile increases cross-border flows to banks by 16 percent for countries with a fixed exchange rate, but only by 6 percent for countries with a flexible exchange rate. The difference is smaller for cross-border flows to the real sector: 7 percent vs. 5 percent, respectively.
Stricter capital controls reduce cross-border inflows to banks (from about 14.5 percent to 6 percent, respectively) but not as much to the real sector (from about 8 percent to 5 percent).
More stringent bank regulation and supervision also decreases the impact of global liquidity on cross-border flows to banks (from about 10 percent to 4 percent respectively).
This column summarized key stylized facts about global liquidity, building on existing literature and new results. The fact that global liquidity is in large part driven by G4 conditions has both positive and negative implications for the rest of the world. Since access to foreign capital is good for economic development, accommodative conditions in the G4 that boost cross-border flows can increase economic development and growth elsewhere. Arguably, this has been one of the beneficial effects of current accommodative monetary policies in G4. But there is also scope for risks when the accommodative conditions in the G4 contribute to credit booms elsewhere, or when a tightening in the G4 triggers sudden stops in capital flows or even outflows from the rest of the world that test limits of macroeconomic policy management. Balancing these effects, particularly in the context of a shifting, unconventional monetary policy cycle in advanced economies, will be challenging.
Overall, our understanding of forces driving the global financial cycle is still in its infancy. More data on sectors’ cross-border assets and liabilities need to be collected and made public in order to better gauge global inter-linkages and the potential for spillovers, and to enhance global financial stability.
BorioC.E. and P.Lowe.2004. “Securing Sustainable Price Stability: Should Credit Come Back from the Wilderness?” BIS Working Paper No. 157. Bank for International Settlements Basel.
BrunnermeierM.K. and L.H.Pedersen.2009. “Market Liquidity and Funding Liquidity,” Review of Financial Studies22(6) 2201–2238.
BrunoV. and H. S.Shin.2014. “Cross-Border Banking and Global Liquidity” mimeoPrinceton University.
CeruttiE.S.Claessens and L.Ratnovski.2014. “Global Liquidity and Drivers of Cross-Border Bank Flows,” IMF Working Paper 14/69. International Monetary FundWashington, D.C.
International Monetary Fund. 2014. “Global Liquidity—Issues for Surveillance,” IMF Policy Paper. Washington, D.C.March.
ObstfeldM.2014. “Trilemmas and Tradeoffs: Living with Financial Globalization” mimeoUniversity of CaliforniaBerkeley.
ReyH.2013. “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” in Proceedings of the Federal Reserve Bank of Kansas City Economic Symposium at Jackson Hole.