By Dr. Thanos Andrikopoulos, Senior Lecturer (Associate Professor) in Finance, University of Hull
In the decade following the Global Financial Crisis (GFC) of 2007–09, the global economy was exposed to several significant disruptions. These events resulted in a sharp increase in policy uncertainty, exceeding even the levels reached during the GFC, as observed by the Global Economic Policy Uncertainty Index of Scott R. Baker, Nicolas Bloom and Stephen J. Davis (2016)1. Domestic policy uncertainty can have detrimental effects on international capital flows (Julio and Yook, 2016)2, making them primary channels of risk contagion among economies in a world of increasing financial interdependence.
The International Monetary Fund (IMF) (2012)3 has identified two distinct approaches to managing international capital flows, known as “capital flow management” (CFM) measures: capital controls and macroprudential policies. The literature on capital flows emphasizes the importance of capital controls; however, the influence of macroprudential policies has been largely ignored, since macroprudential policies have long been seen as a means of maintaining domestic financial stability (Beirne and Friedrich, 2017)4.
A new study published in the Journal of International Money and Finance5 provides evidence that macroprudential policies can also influence cross-border capital flows, contributing to a deeper understanding of the relationships in question.
The research conducted by a team of economists from four different universities in the United Kingdom and China investigated the connections between global economic policy uncertainty, gross capital inflows and the effectiveness of macroprudential policies to mitigate the negative effects of global economic policy uncertainty. The study used quarterly data from 84 economies across every continent, spanning the period from 1997 to 2018, to examine the relations at hand.
The study offers new evidence on the global determinants of cross-border capital inflows, and its findings suggest that global economic policy uncertainty negatively impacts gross capital inflows. However, the tightening of macroprudential policies, such as those related to bank-capital requirements, can moderate this negative effect by nearly 30 to 40 percent.
The focus of the study is gross capital inflows, which differ from capital outflows through the residency of the creditor or borrower involved, as outlined by Broner et al. (2013)6. Capital inflows play a more significant role in domestic financial markets than capital outflows, largely due to their high sensitivity to agency problems (Dinger and te Kaat, 2020)7. As a result, central banks tend to pay attention to capital inflows rather than outflows, recognizing a sustained period of gradual inflows as a warning sign of increasing financial instability.
The Global Economic Policy Uncertainty Index used in this study was constructed by Scott Baker et al. and is highly correlated with other measures of policy uncertainty (Baker et al., 2016)8. This index has been available since January 1997 and has been widely used in the literature (Gauvin et al., 2014)9, since it is produced based on news reports rather than financial markets. It is also regarded as the first continuous index that accurately captures the fluctuations of policy uncertainty.
This research improves our understanding of the mechanisms determining how global economic policy uncertainty and macroprudential regulations shape the different components of capital inflows by addressing two important mechanisms.
First, it determines how implementing macroprudential policies impacts gross capital inflows. Second, it identifies the specific types of macroprudential policy tools that play key roles in delivering this result. Using a comprehensive list of 17 macroprudential policy instruments collected from Alam et al. (2019)10, the study classifies these instruments into two broad categories: demand-side, such as limits on the loan-to-value (LTV) ratio and limits on the debt-service-to-income (DSTI) ratio, and supply-side tools, including loan loss provisions, limits on credit growth, loan restrictions, limits on foreign currency, limits on the loan-to-deposit ratio (LDR), liquidity requirements, limits on foreign-exchange positions, reserve requirements, countercyclical buffers, conservation, capital requirements, leverage limits, tax measures, measures taken to mitigate risks from global and domestic systemically important financial institutions and others. The supply-side tools are further categorized into three subgroups: loan, general and capital tools.
The results indicate that the mitigating effects of macroprudential policies vary depending on the type of instrument used. Supply-side tools, specifically those related to bank-capital requirements, such as leverage limits and conservation buffers, significantly alleviate the negative impacts of global economic policy uncertainty on gross capital inflows. On the other hand, loan-targeted tools, including both demand and supply loans, have no effect on capital inflows.
Supply-side tools, such as adjustments to reserve requirements and liquidity ratios, can help to stabilize cross-border capital flows by controlling the amount of credit available in the economy. Similarly, bank-capital requirements can help to stabilize cross-border capital flows by ensuring that banks have the necessary capital to withstand market volatility.
Among the supply-side instruments, capital tools have a larger mitigating effect than general tools. This result may reflect that capital instruments are widely and heavily used in both advanced and emerging economies. Tight capital requirements provide a buffer against macro shocks, decrease the insolvency risks of financial institutions and help reduce financial instability. However, as we show, tight capital requirements can also mitigate the negative effects of global economic policy uncertainty on capital inflows.
The study also investigates the impacts of individual macroprudential policy instruments, which belong to general and capital tools. The general tools include reserve requirements, liquidity requirements and restrictions on foreign-exchange positions, with only liquidity requirements emerging as statistically significant. Conversely, all four components of capital tools—leverage limits, countercyclical buffers, conservation and capital requirements—have statistically significant impacts. This result indicates that macroprudential policies primarily influence capital inflows through the use of capital tools.
Moreover, the study highlights the heterogeneity among the three different types of capital inflows, with portfolio investment being influenced most significantly, while direct and other types of investment remain unchanged. This suggests that using macroprudential policies alone is not a complete solution to managing capital flows and emphasizes the need for a comprehensive framework that integrates capital controls, monetary policy and macroprudential measures to manage capital flows and financial stability effectively.
This research also considers another classification of gross capital inflows: debt-led inflows (specifically, inflows through debt instruments) and equity-led inflows (specifically, inflows through equity and investment fund shares). Again, increased global economic policy uncertainty reduces the volume of debt-led inflows, with a smaller effect on equity-led inflows, and supply-side tools significantly affect capital inflows.
The study’s results illustrate that global economic policy uncertainty is a well-behaved leading indicator of short-term and debt-led capital inflows. This underlines the importance of closely monitoring global economic policy uncertainty and its impact on international capital flows, especially in a rapidly changing environment.
The analysis also notes the implications of these findings for the stability of international capital inflows and the implementation of macroprudential policies. In a world of constant financial integration, international capital flows arise as the key channel of risk contagion across economies. As global financial interdependence intensifies, macroprudential policies should not only focus on domestic sources of instability but also be thoughtful concerning adverse changes in global economic conditions. The results suggest that macroprudential policies can play an important role in stabilizing cross-border capital inflows.
1 ScienceDirect/Journal of International Money and Finance: “Global economic policy Uncertainty, gross capital Inflows, and the mitigating role of Macroprudential policies,” Athanasios Andrikopoulos, Zhongfei Chen, Georgios Chortareas and Kexin Li, March 2023, Volume 131, 102793.
The Quarterly Journal of Economics: “Measuring Economic Policy Uncertainty,” Scott R. Baker, Nicholas Bloom and Steven J. Davis, November 2016, Volume 131, Issue 4, Pages 1593-1636. doi:10.1093/qje/qjw024.
2 ScienceDirect/Journal of International Money and Finance: “Global economic policy Uncertainty, gross capital Inflows, and the mitigating role of Macroprudential policies,” Athanasios Andrikopoulos, Zhongfei Chen, Georgios Chortareas and Kexin Li, March 2023, Volume 131, 102793.
ScienceDirect/Journal of International Economics: “Policy uncertainty, irreversibility, and cross-border flows of capital,” Brandon Julio and Youngsuk Yook, November 2016, Volume 103, Pages 13-26. doi:10.1016/j.jinteco.2016.08.004.
3 International Monetary Fund (IMF): “The Liberalization and Management of Capital Flows: An Institutional View,” November 14, 2012.
4 ScienceDirect/Journal of International Money and Finance: “Macroprudential policies, capital flows, and the structure of the banking sector,” John Beirne and Christian Friedrich, July 2017, Volume 75, Pages 47-68. doi:10.1016/j.jimonfin.2017.04.004.
5 ScienceDirect/Journal of International Money and Finance: “Global economic policy Uncertainty, gross capital Inflows, and the mitigating role of Macroprudential policies,” Athanasios Andrikopoulos, Zhongfei Chen, Georgios Chortareas and Kexin Li, March 2023, Volume 131, 102793.
6 ScienceDirect/Journal of Monetary Economics: “Gross capital flows: Dynamics and crises,” Fernando Broner, Tatiana Didier, Aitor Erce and Sergio L. Schmukler, January 2013, Volume 60, Issue 1, Pages 113-133. doi.org/10.1016/j.jmoneco.2012.12.004.
7 ScienceDirect/Journal of International Money and Finance: “Global economic policy Uncertainty, gross capital Inflows, and the mitigating role of Macroprudential policies,” Athanasios Andrikopoulos, Zhongfei Chen, Georgios Chortareas and Kexin Li, March 2023, Volume 131, 102793.
ScienceDirect/Journal of Banking & Finance: “Cross-border capital flows and bank risk-taking,” Valeriya Dinger and Daniel Marcel te Kaat, August 2020, Volume 117, 105842. doi:10.1016/j.jbankfin.2020.105842.
8 ScienceDirect/Journal of International Money and Finance: “Global economic policy Uncertainty, gross capital Inflows, and the mitigating role of Macroprudential policies,” Athanasios Andrikopoulos, Zhongfei Chen, Georgios Chortareas and Kexin Li, March 2023, Volume 131, 102793.
SSRN (Electronic Journal): “Policy Uncertainty Spillovers to Emerging Markets – Evidence from Capital Flows,” Ludovic Gauvin, Cameron McLoughlin and Dennis Reinhardt, September 28, 2014, Bank of England Working Paper No. 512. doi:10.2139/ssrn.2502029.
10 ScienceDirect/Journal of International Money and Finance: “Global economic policy Uncertainty, gross capital Inflows, and the mitigating role of Macroprudential policies,” Athanasios Andrikopoulos, Zhongfei Chen, Georgios Chortareas and Kexin Li, March 2023, Volume 131, 102793.
International Monetary Fund: “Digging Deeper–Evidence on the Effects of Macroprudential Policies from a New Database,” Zohair Alam, Adrian Alter, Jesse Eiseman, R. G. Gelos, Heedon Kang, Machiko Narita, Erlend Nier and Naixi Wang, March 22, 2019, IMF Working Paper No. 2019/066.