An important element of recent financial crises is the boom-and-bust cycle of liquidity. To get a better understanding of these variations in global liquidity, the authors analyze a broad sample of countries and explanatory variables. They confirm the importance of market conditions in the United States but also highlight the importance of developments in the United Kingdom and the eurozone.
Global liquidity is defined by the authors as the ease of funding in global financial markets. It is thus a concept that refers to the quantity of financing provided by reserve currency economies—the United States, the United Kingdom, the eurozone, and Japan, in the empirical analysis—to other countries/economies, including emerging economies. Financial market conditions in the United States (especially market volatility, term premiums, growth in domestic credit, and M2, as well as bank leverage) help explain the flow of funds across borders. Furthermore, financial conditions in other major economies—namely, the United Kingdom and the eurozone—also drive flows and, in some cases, are more important than US conditions. Finally, the authors show the importance of recipient country policies and characteristics for cross-border inflows.
How Is This Research Useful to Practitioners?
The authors make a number of important contributions to the current debate on global liquidity and cross-border financing. First, they provide a definition of global liquidity, which has a focus on factors that influence the supply of cross-border financing. Second, they discuss some of the most important determinants of global liquidity. These include uncertainty and risk aversion in financial markets, funding conditions of global banks, monetary aggregates and monetary policy in the source countries, and financial regulation and innovation.
Third, they show empirically that financial conditions in a number of systemic countries/regions—namely, the United States, the United Kingdom, and the eurozone—are important for determining global liquidity. The effects are relevant not only within regions but also across regions. This finding challenges the view that an understanding of financial market conditions in the United States is sufficient to assess global liquidity. It also has important implications for the current policy debate about the asynchronous nature of unconventional monetary policy measures in the major systemic countries/regions.
Fourth, the authors analyze the conditions in the borrower countries and the interaction between country characteristics and global liquidity drivers. They show that better institutions increase growth in cross-border claims. The analysis of interactions between country characteristics and global liquidity drivers reveals that appropriate country policies can indeed dampen the effect of cyclical variations in global liquidity. The estimated economic effects of superior policy in the recipient countries are substantial.
How Did the Authors Conduct This Research?
The authors collect data for the period of 1990–2012 for a total of 77 countries. Their measure of global liquidity is cross-border bank claims on bank and nonbank borrowers, which account for an important share of total capital flows. The drivers of global liquidity are proxied by the following variables: implied volatility in the stock option market, bank leverage, real credit growth, risk spreads, slope of the yield curve, real policy rate, and monetary aggregates. All variables are compiled separately for the United States, the United Kingdom, the eurozone, and Japan. Borrower country demand and creditworthiness are assessed with the help of the following variables: lagged GDP growth and inflation, the differential between local and international interest rates, and a number of such borrower-specific control variables as flexibility of the exchange rate, existence of capital controls, quality of the institutional environment, and indices of banking regulation.
To analyze the relationship between cross-border bank claims in the borrower countries and global, as well as local, explanatory variables, the authors use panel regressions with country fixed effects. The regression results show that such local demand factors as lagged GDP growth and lagged inflation are statistically significant. Global liquidity indicators are also statistically significant drivers of cross-border bank claims for the US variables as well as for the UK and eurozone conditions. An analysis of the borrower characteristics reveals that better institutions increase the growth in cross-border lending and that a more flexible exchange rate and stricter capital controls reduce the cyclical impact of global liquidity on cross-border claims.
The authors provide a thorough empirical study about determinants and effects of global liquidity. As they point out, however, the ongoing challenge lies in finding empirically helpful and theoretically grounded indicators against the backdrop of a continuously evolving financial, macroeconomic, and regulatory environment. At the theoretical level, a fuller understanding of the drivers of liquidity conditions, the propagation mechanisms, and the amplification of financial shocks is needed.