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| Monetary Policy Divergence and the Intersectoral Allocation of Cross-Border Bank Capital Flows: Buffer Role Played by the Official Sector |
| TAN Xiaofen, LI Ziruo, ZHAO Qian, LU Bing
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School of Economics and Management, Beihang University;
School of Finance, Central University of Finance and Economics;
School of International Trade and Economics, Central University of Finance and Economics;
School of Statistics, Beijing Normal University |
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Abstract Given the dominant role of the US dollar in the international monetary system, the cross-border spillover effects of U.S. monetary policy cannot be overlooked. When U.S. monetary policy changes, a country that synchronizes its interest rates with those of the US may partially hedge against these spillover effects through interest rate adjustments, thereby reducing the direct impact on cross-border capital flows. Conversely, if the country fails to align its interest rates with the US, it may face greater risks of capital flow volatility. Therefore, an in-depth exploration of the impact of monetary policy divergence on cross-border capital flows, along with adjustments and optimization of financial policies, is crucial for maintaining global financial stability.
As an important channel for cross-border capital flows, cross-border banks play a pivotal role in the global financial system. When changes occur in the global financial environment or the monetary policy of a major country, cross-border banks often act as “amplifiers” and “transmitters” of risks, causing localized issues to quickly escalate into global financial crises. In addition, when cross-border banks transmit external shocks, they not only affect the private sector's financing environment but also impact the official sector's foreign exchange reserve management. This leads to differences in their behavioral patterns: capital flows in the private sector tend to be pro-cyclical, while those in the official sector exhibit counter-cyclicality. Existing research primarily focuses on the relationship between external shocks, such as global financial cycle or natural disasters, and cross-border capital flows between the two sectors, while giving less attention to how counterparty countries' monetary policy changes relative to the US impact these flows.
This paper constructs a small open economy model that covers both the private and official sectors, and analyzes cross-border bank capital flows from the US to 27 counterparty countries over the period of 2005 to 2019, using both theoretical and empirical approaches. First, the results show that when the monetary policies of the counterparty country and the US are unsynchronized, leading to a wider interest rate differential (with higher rates in the counterparty country), cross-border banking capital inflows generally exhibit pro-cyclical characteristics in the private sector, while the official sector shows counter-cyclical behavior. Then, mechanism analysis reveals that a higher interest rate differential increases the private sector's risk appetite and demand for cross-border capital, driving more capital to flow into the private sector. Simultaneously, the official sector's incentive to intervene in foreign exchange weakens, allowing it to accumulate reserves, reducing capital flows to the official sector. Next, in countries with greater exchange rate flexibility, higher sovereign credit ratings, and better institutional quality, the pro-cyclicality of private sector capital flows is more pronounced, as is the counter-cyclicality in the official sector. Finally, by coordinating with fiscal and macro-prudential policies, the counter-cyclical buffering effect of the official sector becomes stronger.
The marginal contribution of this paper is reflected in three aspects. First, it offers a deep analysis of cross-border capital allocation between the official and private sectors in counterparty countries, enriching existing research. While previous studies mainly focus on domestic and cross-border capital flows within counterparty countries, especially in the private sector, less attention has been given to the allocation between the official and private sectors. The underlying reasons for this remain unexplored. This paper identifies foreign exchange intervention in the official sector as a key factor driving capital allocation in that sector. It also finds that willingness to take on risk, measured by credit allocation risk, plays a critical role in shaping capital allocation within the private sector. These findings provide more detailed and valuable empirical evidence on the direction of cross-border bank credit allocation.
Second, this paper adds to the research on how monetary policy asynchrony affects cross-border capital allocation between peripheral and US-dominated central countries. Existing studies often focus on the impact of US monetary policy changes, typically analyzing either monetary easing or tightening. However, they tend to overlook how differences in monetary policy timing between the US and other countries can lead to significant variations in capital allocation across sectors. By exploring the relative shifts in monetary policies between the US and counterparty countries, this paper offers valuable insights that enhance the current literature.
Third, this paper offers policy insights for counterparty countries to manage cross-border capital inflows. It distinguishes the flows between official and private sectors and examines the factors driving these differences, such as exchange rate elasticity, credit ratings, and institutional quality. The paper also analyzes how the official sector can respond to changes in capital flows, driven by divergent monetary policies, through coordinated policy actions. These insights provide important guidance for managing cross-border capital flow risks.
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Received: 08 August 2023
Published: 02 January 2025
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