How important is the Global Financial Cycle?

This paper seeks to measure the importance of the Global Financial Cycle for explaining international capital flows. Hélène Rey and others have argued that capital flows move in unison across countries. They put forward that this is because of financial conditions in key advanced countries – or “centre countries” – such as the United States.

Contribution
This paper tests the thesis of Rey and others using various statistical techniques. The quantitative importance of the Global Financial Cycle for capital flows is of crucial importance for smaller open economies, including many emerging and developing economies.
If the argument is correct, this may lead small open economies to try to shield themselves from disruptive capital flows. Countries may choose to insulate themselves from global financial markets with capital controls or macroprudential policies. Or they may build up plentiful foreign currency reserves as a buffer. But if the argument is not correct, it suggests policies that seek to screen “good” from “bad” capital flows are not useful. If the country tries to insulate itself from such flows, it may give up the gains of international financial integration.
Findings
Using a range of techniques, we find little evidence that the Global Financial Cycle plays a significant role in capital flows. Specifically, we find that the Global Financial Cycle rarely explains more than a quarter of capital flow variation.
We are aware of pitfalls. We use conventional models of capital flows estimated in simple ways with standard data and evaluated with traditional statistics. Future work could extend this in many ways. We also focus only on the impact of the Global Financial Cycle on capital flows. However, the Global Financial Cycle could affect other important variables, such as domestic asset prices or credit.
Source and more about this paper: http://www.bis.org/