The global financial cycle: Closer to an anticlimax than a juggernaut

Andrew Rose 14 August 2017



There is a new bully in town. Policymakers around the world have come to fear the ‘global financial cycle’. It achieved prominence notably through the work of Hélène Rey, who wrote in her influential Jackson Hole paper (Rey 2013):

Risky asset prices around the globe, from stocks to corporate bonds, have a strong common component. So do capital flows … Global financial cycles are associated with surges and retrenchments in capital flows, booms and busts in asset prices and crises. The picture emerging is that of a world with powerful global financial cycles characterised by large common movements in asset prices, gross flows, and leverage … The global financial cycle can be related to monetary conditions in the centre country and to changes in risk aversion and uncertainty … capital flows, especially credit flows, are largely driven by a global factor … “

The interest in the global financial cycle’is not confined to Rey and her co-authors. For instance, Forbes and Warnock (2012) wrote:

Global factors, especially global risk, are significantly associated with extreme capital flow episodes. … Our analysis indicates that waves of capital flows are primarily associated with global factors. Global risk, which incorporates both risk aversion and economic uncertainty, is the only variable that consistently predicts each type of capital flow episode; an increase in global risk is associated with more stops and retrenchments and fewer surges and flight. … most domestic factors only have a limited correlation with capital flow volatility … global factors, and especially global risk, are key to understanding periods of extreme capital flows by domestic and foreign investors. Increases in global risk predict sudden stops in capital flows by foreigners and retrenchments in capital flows by domestic investors …”

Policymakers care about the global financial cycle for good reason. Recent research implies that it explains much of the variation in capital flows, particularly for small and emerging economies. These waves of capital fluctuate for reasons that are independent of the economies of small or emerging markets, resulting in difficult policy choices. As Rey (2015) wrote:

As capital flows respond to US monetary policy, they may not be appropriate for the cyclical conditions of many economies. For some countries, the global financial cycle can lead to excessive credit growth in boom times and excessive retrenchment in bad times. … The global financial cycle can be associated with surges and dry outs in capital flows, booms and busts in asset prices and crises… The empirical results on capital flows, leverage and credit growth are suggestive of an international credit channel or risk-taking channel and point towards financial stability issues.”

However, if the global financial cycle does not explain most, or even much, of the variation in capital flows, then the policy authorities in small and emerging countries have more freedom to manage their economies. Looking at it another way, the same policymakers would not be able to blame the global financial cycle and therefore centre-country fundamentals for their internal problems. So it is important to figure out whether the global financial cycle is a juggernaut – an irresistible and overwhelming force – or an anticlimax that plays a relatively small role in driving capital flows, but one that perhaps can be used to divert attention from domestic mistakes.

The global financial cycle is not a good explanation

In my recent research with Eugenio Cerutti and Stijn Claessens, we quantify the importance of the global financial cycle for capital flows (Cerutti et al 2017). We use a conventional approach, with widely used data, techniques, capital flow models, and statistical metrics. The drivers of the global financial cycle that we examine included measures frequently used by other researchers: risk (the VIX index for example, a measure of volatility expected in the stock market), monetary policy (nominal and real interest rates, the TED spread and the slope of the yield curve), and other fundamentals (like growth of GDP, the exchange rate, and the money supply).

Conventionally, we assume the US is the primary centre-country source of the global financial cycle, but also consider analogues from the Eurozone and the UK. We then ask how much variation in capital flows for small and emerging markets could be explained by these global financial cycle fundamentals. We do this by regressing capital flows of a particular type, for a particular country, over time (for example, flows of debt expressed as a percentage of GDP, into Brazil, between 1990 and 2015) on our eight fundamental US variables, and then asking how well these global financial cycle drivers explain capital flows – that is, how well does the equation fit? This vanilla strategy allows us to cut through the noise about the global financial cycle and focus on the fraction of variation in capital flows that was actually explained by global influences, without being distracted by minor issues associated with data or methodology.

The global financial cycle, expressed by US fundamentals, is not a good explanation for the variation in capital flows. Figure 1 shows a series of time-series plots of capital flows, and the flows that are predicted by our eight US fundamentals. The top-left graph shows that actual capital inflows of bank credit for Brazil (in a thin solid line) are poorly correlated with those predicted by global financial cycle fundamentals (in a thick dashed line). Only 12% of the actual variation is explained by the fitted global financial cycle fundamentals. Inflows of Brazilian debt and equity are shown in graphs in the middle and right of the figure. Analogues for South Korea, Mexico, the Philippines, South Africa, and Turkey are in successive rows of Figure 1.

Figure 1 Emerging markets capital flows, 1990 Q1 to 2015 Q4

Notes: Actual (thin−solid) and fitted (thick−dashed) inflows, % GDP; Eight US fundamentals: VIX, TED/yield spreads, nominal/real policy interest rates, growth in GDP/M2/REER.

None of the equations fits well. The highest R2 is .34, meaning that only 34% of the variation in South Korea and South African inflows of debt is explained by US fundamentals. These fundamentals explain even less for other countries and types of capital flows. The importance for capital flows of centre-country fundamentals – the global financial cycle – is limited.

Playing fair

The six countries and three types of capital (in)flows in Figure 1 were not randomly selected, but the weak results in Figure 1 are actually representative. In our research, we estimate similar models (with additional measures of the global financial cycle) for 63 small countries, disaggregating capital flows (capital can flow in and out) and four types (FDI, debt, equity, and bank credit). This means that we estimate literally hundreds of capital flow equations in an attempt to understand whether capital flows were driven by US fundamentals. The vast majority of these equations fit poorly. Figure 2 shows histograms of adjusted R2 measures for our fitted capital flow equations (adjusting R2 provides a small penalty for additional regressors). The top-left histogram of Figure 2 shows the distribution of goodness-of-fit for all of the (598) capital flow equations; the average adjusted R2 is only .12, and only a few even approach .5!

Figure 2 Fit of country tine series capital flow regressions, 63 countries, 1990 Q1 to 2015 Q4

Notes: Histograms of (up to 598) adjusted R. Regressors: Adv/EM 26−yr dyn factors, 8 US var’s (VIX/TED/yield/policy/real/growth/REER chg/M2 growth)

The poor fit of the capital flow equations seems to characterise inflows and outflows, and flows of FDI, portfolio capital (whether debt or equity), and bank credit. Figure 2 implies that it is difficult to model capital flows for small countries using only US fundamentals, at least over the past 25 years.

In the study, we are careful to show that the negative results of Figures 1 and 2 are general, and insensitive to the exact way we model the global financial cycle, cut the data, and so on. We show that our results were robust to adding lags, using European and British fundamentals, dropping outliers, using different measures of goodness of fit, and splitting the sample by income, time, region, degree of capital mobility, and exchange rate regime.

Autonomy and responsibility

It is difficult to explain much variation in the capital flows of small and developing countries using only centre-country (US) fundamentals. As a conservative estimate, perhaps a quarter of the variation in capital flows arises from the global financial cycle. The rest presumably arises from domestic causes.

Despite the impression given by recent studies, most variation in capital flows for small and emerging markets has not been not driven by the global financial cycle. No more than 25% of the fluctuations in capital flows can be ascribed to fluctuations in global risk aversion or the stance of US monetary policy. This should be welcome news to policymakers in small countries. On the other hand, it also means they cannot reasonably blame foreign influences for their domestic problems. Autonomy comes with responsibility.


Bruno, V and H S Shin (2015), “Cross-Border Banking and Global Liquidity”, Review of Economic Studies 82, 535-564.

Cerutti, E, S Claessens and A K Rose (2017), “How Important is the Global Financial Cycle? Evidence from Capital Flows”, CEPR discussion paper 12075.

Forbes, K J and F E Warnock (2012), “Capital Flow Waves: Surges, Stops, Flight, and Retrenchment”, Journal of International Economics 88: 235-251.

Rey, H (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, in Proceedings of the 2013 Federal Reserve Bank of Kansas City Economic Symposium at Jackson Hole: 285-333.

Rey, H (2015), “International Channels of Transmission of Monetary Policy and the Mundellian Trilemma”, Mundell Fleming lecture, IMF Economic Review 64(1): 6–35.



Topics:  Development International finance

Tags:  Global financial cycle, capital flows, emerging markets

Professor of International Business, in the Economic Analysis and Policy Group, Haas School of Business, University of California, Berkeley; and Research Fellow, CEPR