Effects of Economic Policy Uncertainty on Cross-border Bank Capital Outflows, a paper co-authored by Professor Tan Xiaofen and PhD student Zuo Zhenying from the School of Finance of CUFE, was published in the 2020 5th Issue of Journal of World Economy.
[Abstract] Based on the quarterly data about banks’ cross-border creditor rights between 17 reporting countries and 75 counterparty countries in 1998-2017, the paper studies the effects of economic policy uncertainty in the reporting countries on their cross-border bank capital outflows. It finds that when economic policy uncertainty in the reporting countries rose: (1) cross-border bank capital outflows decreased, which would be reinforced by these countries’ high interest rate or depreciation of their currencies’ exchange rate against the dollar. When economic policy uncertainty went from low to high, the key factor among other variables affecting capital outflows turned from interest rate to exchange rate. (2) When cross-border banks shifted from domestic to cross-border creditor rights in the allocation of this asset class, the effect of such asset allocation was more prominent when the reporting countries had a booming economy, saw their exchange rates depreciate, had relatively low sovereign risks, low uncertainty about economic policies, or relatively high quality of overseas creditor rights. The policy implication lies in that it is important to maintain the stability of economic policies and also take relevant supporting measures to ensure orderly cross-border bank capital flows.
I. Research Background
Since the 1990s, the scale of international capital flows has risen notably, but with greater volatility. Compared with net capital flows, total capital flows have shown higher volatility. As a key component of total capital flows, cross-border bank capital flows not only demonstrate a mechanism of highly synchronous changes with total capital flows, but also play an important role in global economic cycles and the transmission of credit crises. Since the 2008 global financial crisis, economic policy uncertainty worldwide has been rising notably along with the implementation and exit of economic stimulus policies of major countries, and amid such events as Brexit and US-China trade frictions.
Rising economic policy uncertainty suppressed investment and credit in terms of both demand and supply through the physical option and financial friction mechanisms; and raised uncertainties about future profits of investment projects and led enterprises to postpone investments. Meanwhile, as uncertainty about financing costs and returns on loans grew, banks would put off the supply of new loans and retain more liquid reserves. In incomplete financial markets, there is universal information asymmetry between enterprises and banks, and between banks and residents with savings. Rising uncertainty will aggravate agency issues and hence suppress credit expansion. By studying the heterogeneity of uncertainty shocks’ impact on bank credit at the bank level, some documents find that rising economic policy uncertainty will remarkably curb the growth of bank credit, but with relatively moderate impact on banks with more cash or higher capital-to-asset ratios. This indicates that banks trimming assets under the constraint of balance sheets is a key reason for decreases in bank loans when economic policy uncertainty grows, and also proves the decrease in bank loans caused by rising uncertainty results from banks cutting back on credit supply, laying the foundation for research stated in the paper. As international lending becomes increasingly common, cross-border banks operate deposits and loans all over the world. Credit contraction due to rising uncertainty about a country’s economic policies will further lead to changes in capital flows of cross-border banks.
Studies on the driving forces behind international capital flows show that common economic variables cannot fully explain movements in international capital flows, so the effect of economic uncertainty shocks on international capital flows has drawn the attention of scholars. Early studies used stock market volatility as the proxy indicator, and found that economic uncertainty is the factor that substantially affects international capital flows. However, the stock market volatility index built on financial market data comprises changes in investors’ risk aversion sentiment. Using it as the proxy indicator for economic uncertainty has limitations. Economic policy uncertainty is the main source of economic uncertainty, which describes different aspects of the latter in comparison with stock market volatility. Existing studies show that global economic policy uncertainty has a marked effect on international capital flows, but few documents have paid attention to such effect at country levels.
II. Research Findings
The paper establishes a two-country open model comprising residents, banks and non-financial enterprises, and extends the impact of shocks of rising EPU in the reporting country on credit in a closed economy to the impact on cross-border bank capital flows in an open economy from the perspective of banks operating cross-border businesses in the reporting country. Rising EPU in the reporting country leads to lower leverage ratios of local cross-border banks by reducing the expected return on equity, and worsening information asymmetry between banks and enterprises and between banks and residents. Banks’ total assets shrink with falling leverage ratios. So banks’ total loan supply and cross-border creditor rights decrease, hence the drop in cross-border capital outflows. Moreover, the fall in banks’ net earnings makes persistent the negative effect of rising EPU on cross-border bank capital outflows. Rising EPU in the reporting country makes the yield of domestic loans lower than that of cross-border loans, so banks can lessen the decrease in net earnings by raising the share of cross-border creditor rights. As a result, the fall in cross-border creditor rights will not be as huge as that in domestic creditor rights, and cross-border banks in the reporting country will adjust the allocation of this asset type by shifting to cross-border creditor rights.
The result of empirical analysis shows that rising EPU in the reporting country will lead to a decrease in capital outflows of local cross-border banks. This effect is prominent both statistically and economically. In the meantime, as EPU of the reporting country rises, local cross-border banks will shift their domestic creditor rights to cross-border ones to avoid losses in net earnings and further asset contraction. A greater decrease in domestic creditor rights compared with cross-border ones means that the transfer mechanism for banks’ allocation of creditor right assets to high-quality ones is tenable at cross-border levels.
Further research shows that the reporting country’s EPU can interact with other macroeconomic variables:
First, the high interest rate environment in the reporting country or depreciation of its currency’s exchange rate against the dollar will exacerbate the decrease in capital outflows of local cross-border banks when its EPU rises. Rising interest rate in the country makes domestic creditor rights become the asset with relatively higher profit, so banks will reduce the share of cross-border creditor rights by cutting back on loan supply due to rising EPU, which results in a bigger drop in total capital outflows of cross-border banks. When the reporting country’s currency depreciates against the dollar, banks’ credit risks will rise. And when local cross-border banks are in an operating environment with relatively high credit risks, rising EPU will aggravate the decrease in total capital outflows of local cross-border banks.
Second, when the reporting country’s EPU is relatively low, the effect of its interest rate on cross-border bank capital outflows is notable; with its EPU rising, the key factor that affects cross-border bank capital outflows turns from interest rate to exchange rate. There are two mechanisms in opposite directions for how interest rate affects total capital outflows of cross-border banks. Traditional bank credit channels show tightening monetary policy in the reporting country will increase banks’ financing costs and result in a decline in banks’ credit supply, thereby reducing capital outflows of cross-border banks. But a country’s economic boom is usually accompanied by tightening monetary policy and an increase in capital outflows of cross-border banks. In a low-EPU environment, the mechanism of the reporting country’s interest rate positively affecting total capital outflows of cross-border banks plays a bigger role. But as its EPU rises, the negative effect mechanism of interest rate is reinforced.
Third, in the case of an economic boom, exchange rate depreciation or relatively low sovereign risks, rising EPU in the reporting country will lead to a greater rise in the share of cross-border creditor rights of local cross-border banks. As economic prosperity usually accompanies a credit boom, the share of domestic creditor rights is relatively big. The decrease in the loan yield caused by rising EPU of the reporting country will lead to a greater fall in the net earnings of banks. So cross-border banks need to make greater adjustment to asset allocation by shifting to cross-border creditor rights in order to improve their balance sheets.
Fourth, when a counterparty is an emerging market economy or a peripheral country, cross-border banks in the reporting country think the cross-border creditor rights of such counterparty do not have the hedging function. Then the risk rebalancing and adjustment mechanism for banks’ creditor right assets due to rising EPU in the reporting country will be diminished.
Fifth, the effect of the reporting country’s EPU on the share of cross-border creditor rights is non-linear. When EPU is relatively low, its effect thereon is notably positive; but as EPU rises, such positive effect will decrease gradually and finally become insignificant.
III. Inspirations
It is important to maintain the stability of economic policies and also take relevant supporting measures to ensure orderly cross-border bank capital flows. Firstly, the macroeconomic operation condition of the reporting country will affect the degree of impact of its EPU. When it is in a high interest rate environment or its currency depreciates against the dollar, it is essential to guard against capital flights caused by rising EPU in the reporting country. Secondly, interest rate and exchange rate are key drivers behind cross-border bank capital flows. When the reporting country’s EPU is relatively low, interest rate and other monetary policy control instruments will have a greater effect on capital flows of cross-border banks; when its EPU is relatively high, the effect of exchange rate controls is better. Lastly, when EPU rises in the reporting country, emerging market economies and peripheral countries will encounter greater shocks. Therefore, they shall pay attention to the EPU level of the reporting country, and duly take macro-prudential policies and other mitigating policies to cope with the impact of large scales of capital flow fluctuations on the macro economy.
