Working Paper: NBER ID: w29217
Authors: J. Scott Davis; Eric Van Wincoop
Abstract: We develop a theory to account for changes in prices of risky and safe assets and gross and net capital flows over the global financial cycle (GFC). The multi-country model features global risk-aversion shocks and heterogeneity of investors both within and across countries. Within-country heterogeneity is needed to account for the drop in gross capital flows during a negative GFC shock (higher global risk-aversion). Cross-country heterogeneity is needed to account for the differential vulnerability of countries to a negative GFC shock. The key vulnerability is associated with leverage. In both the data and the theory, leveraged countries (net borrowers of safe assets) deleverage through negative net outflows of risky assets and positive net outflows of safe assets, experience a rise in the current account and a greater than average drop in risky asset prices. The opposite is the case for non-leveraged countries (net lenders of safe assets).
Keywords: No keywords provided
JEL Codes: F30; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| global risk aversion (D81) | portfolio shift from risky to safe assets (G11) |
| portfolio shift from risky to safe assets (G11) | decrease in price of risky assets (G19) |
| portfolio shift from risky to safe assets (G11) | increase in price of safe assets (G19) |
| downturn in GFC (F44) | negative net outflows of risky assets (G19) |
| downturn in GFC (F44) | positive net outflows of safe assets (F32) |
| negative net outflows of risky assets (G19) | rise in current account (F32) |
| positive net outflows of safe assets (F32) | rise in current account (F32) |
| negative net foreign asset positions in safe assets (G15) | increase in net outflows of safe assets (F32) |
| negative net foreign asset positions in safe assets (G15) | decrease in net outflows of risky assets (F32) |
| one standard deviation decrease in GFC factor (C29) | 60 basis point fall in real interest rate (E43) |
| one standard deviation decrease in GFC factor (C29) | 10.4% fall in average equity prices (G12) |