Global Financial Cycle, US Monetary Policy and the “Impossible Trinity”, a paper co-authored by our school’s Professor Zhang Liqing and PhD student Zhong Qian, was published in the 2020 2nd Issue of Journal of Financial Research.
Traditional “impossible trinity” points out that one country can only select two of the three conditions: a fixed exchange rate regime, an open capital account and an independent monetary policy. However, with the continuous development of financial globalization, more and more literature finds that the other countries’ preference for the dollar allows the US monetary policy to affect the economic and financial condition of its peripheral countries through multiple channels such as capital flows, banks’ balance sheets and foreign exchange reserves. A flexible exchange rate itself cannot ensure monetary policy autonomy of peripheral countries. Associated with this is the observation of Rey (2013) that synchronicity exists among global capital flows, asset prices, financial leverage and credit growth. In this paper, she defined such synchronicity as “Global Financial Cycle”, and found it was negatively correlated with VIX. This concept received wide attention after it was put forward. A lot of literature acknowledged the existence of global financial cycle, and used VIX as a proxy variable thereof to study its relationship with monetary policy independence. But most of them used SVAR or panel regression; few looked into the reason why the global financial cycle arises on a theoretical basis. Therefore, by building a two-country multi-sector DSGE model comprising banking and financial frictions, this paper conducts a theoretical analysis of the formation of the global financial cycle and discusses whether the monetary policy of peripheral countries is independent given the existence of such cycle.
Partial equilibrium analysis based on theoretical derivations finds that the policy interest rate will lead the equity-to-asset ratio of financial markets, loan rates and banks’ viability to move in the same direction by affecting banks’ balance sheets and decision-making. Therefore, what is behind the phenomenon of global financial cycle is synchronicity of the policy interest rate of related countries. It is found through pulse response analysis that under US monetary policy shocks, the monetary policy of peripheral countries (even those with a floating exchange rate regime) needs to change in the same direction as that of the United States so as to maintain domestic financial and economic stability.
Through counterfactual simulation of the effect of US monetary policy on peripheral countries adopting a floating exchange rate regime but with different degrees of openness, it is found that the spillover effect of US monetary policy through global economic cycles is exactly opposite to that through global financial cycles, but the effect and transmission speed of global financial cycles are far greater than those of global economic cycles. Take loose US monetary policy shocks for example, a rapid credit boom in peripheral countries causes excessive investment, overcapacity and a glut of commodities. Low investment returns on the real economy leads to money flowing out of the real one and into the virtual one, with the former entering a recession. And domestic financial cycles deviate from economic cycles. In order to reduce such deviation, the policy interest rate of peripheral countries has to change in the same direction as that of the United States to suppress capital inflows. As a result of such monetary policy changes in the same direction, financial market movements of the countries also show certain similarities, which is global financial cycle.
Further research finds that with the size of countries’ international investment position (“IIP”) growing continuously in recent years, the valuation effects have played such an increasing role in contributing to IIP movements that exchange rates cannot fully offset the impact of the central country’s interest rate volatility on peripheral countries. Valuation effects are one of reasons why the monetary policy of countries with a flexible exchange rate regime but no capital controls has to be aligned with that of the United States. The depth of financial markets is complementary to monetary policy independence. Peripheral countries with less developed financial markets are subject to greater net spillover effects of US monetary policy.
Based on the above research conclusion, the paper offers the following policy advice: 1. Strengthen macro-prudential regulation to rein in financial institutions’ excessive risk taking. 2. Exercise moderate capital controls, esp. the restriction of hot money inflows when global finance is booming.
