The Global Financial Cycle, Macroprudential Policies and Cross-border Capital Flows: With an analysis of the “Trilemma” and the “Dilemma” Debate
YU Mengwei, TAN Xiaofen, SONG Jiaxin
School of Finance, Zhejiang Gongshang University; School of Economics and Management, Beihang University; School of Finance, Capital University of Economics and Business
Summary:
As global financial integration deepens, the financial conditions of various countries exhibit significant cross-border co-movements, known as the “global financial cycle”. As a critical transmission channel of the global financial cycle, cross-border capital flows display a marked procyclicality. If a recipient country's capital flows are highly procyclical with respect to the global financial cycle, they can form a positive feedback loop with the domestic financial system, becoming part of the financial accelerator and increasing the vulnerability of the financial system. Given that the intermediate targets of macroprudential policies are to mitigate the procyclical feedback of domestic financial cycle variables such as asset prices, credit, and leverage, and that these variables are also key components of the positive feedback loop in the transmission of the global financial cycle, theoretically, macroprudential policies should be able to weaken the procyclical feedback of capital flows to the global financial cycle. This paper constructs an open economy dynamic stochastic general equilibrium (DSGE) model and combines it with empirical research to qualitatively and quantitatively analyze the main mechanisms through which macroprudential policies smooth global financial cycle shocks. It compares the mechanisms of macroprudential policies on different types of cross-border capital inflows and analyzes the heterogeneous effects of these policies. The study finds that macroprudential policies can reduce the procyclical impact of the global financial cycle on capital inflows and that the buffering effect on the procyclicality of debt-type capital inflows is superior to that on equity-type capital inflows. The analysis of policy effectiveness heterogeneity indicates that economies with higher external risk exposure (higher financial development, greater capital account openness, higher financial integration, greater pegging to the dollar, and more foreign currency-denominated external debt), lower capacity to withstand external risks (weaker global financial safety net, lower foreign exchange reserves), more pronounced internal vulnerabilities (higher macro leverage levels in the non-financial corporate sector, public sector, and household sector), and fixed exchange rate regimes benefit more from the buffering effects of macroprudential policies against global financial cycle shocks. Furthermore, considering that the global financial cycle is often accompanied by the debate on whether the “trilemma” has transformed into a “dilemma”, this paper further investigates the dynamic response of cross-border capital flows distribution to global financial cycle shocks using the Capital Flows-at-Risk (CFaR) framework. It particularly focuses on the dynamic effects of the floating exchange rate regime in isolating external shocks under the tail risks of capital flows. The paper finds that when capital inflows are at a low level, the floating exchange rate regime can act as a buffer and completely isolate external shocks, which is consistent with the “trilemma”. However, when capital inflows are at median and high levels, although the floating exchange rate regime experiences the least shocks compared to intermediate and fixed exchange rate regimes, it cannot completely isolate external shocks, which aligns with the “dilemma” to some extent. The contributions of this paper are threefold. First, the existing literature rarely examines the role of macroprudential policies in preventing the procyclical risks of cross-border capital flows induced by the global financial cycle, and this paper provides a detailed and in-depth heterogeneous analysis of the effectiveness of macroprudential policies. Given that policy implementation needs to be tailored to the national context, there are no universal policy tools. Therefore, the heterogeneous analysis of policy effectiveness in this paper can provide policy insights for countries to respond to global financial cycle shocks in a context-specific manner. Second, while existing research extensively discusses how macroprudential policies affect cross-border capital flows and economic fluctuations in open economy macro models, theoretical literature primarily focuses on debt-type capital inflows. This paper's theoretical model, however, encompasses both debt-type and equity-type capital inflows within a unified framework. Additionally, when characterizing the decision-making behavior of the financial intermediary sector, existing studies either focus on financial accelerator frictions arising from information asymmetry in lending activities between financial institutions and enterprises or emphasize financial frictions stemming from balance sheet constraints within financial institutions. This paper's theoretical model encompasses both types of financial frictions, providing a reference framework for evaluating the effects of macroprudential policies in an open economy. Third, from a novel perspective of capital flow distribution, this paper offers a unified and intrinsically consistent explanation for the “trilemma” and “dilemma” debate. It complements the literature related to the “trilemma” and “dilemma” debate by showing that the insulating effect of the floating exchange rate regime varies with the distribution of capital flows. Moreover, this paper explores how the buffering effects of macroprudential policies vary with exchange rate regimes and the distribution of cross-border capital flows within the CFaR framework, a topic that has been scarcely addressed in existing literature.
虞梦微, 谭小芬, 宋佳馨. 全球金融周期、宏观审慎政策和跨境资本流动——兼论“三元悖论”和“二元悖论”之争[J]. 金融研究, 2024, 528(6): 1-19.
YU Mengwei, TAN Xiaofen, SONG Jiaxin. The Global Financial Cycle, Macroprudential Policies and Cross-border Capital Flows: With an analysis of the “Trilemma” and the “Dilemma” Debate. Journal of Financial Research, 2024, 528(6): 1-19.
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