Workshop “The Architecture of Financial System Stability” Capri, 24-25 May, 2006
description
Transcript of Workshop “The Architecture of Financial System Stability” Capri, 24-25 May, 2006
Global financial transmission of monetary policy shocks
Michael Ehrmann (ECB) and Marcel Fratzscher (ECB)
Workshop “The Architecture of Financial System
Stability”Capri, 24-25 May, 2006
The usual disclaimers apply.
Introduction
• Understanding global financial integration
– How integrated are global financial markets
– Linking asset price transmission with financial integration / quantities:
– Is the shock transmission to asset prices related to international portfolio holdings?
– Implications for risk-sharing and diversification
• Problem of identification
– Asset prices determined simultaneously, both domestically and internationally
– Origin of shock - direction of causality ?
Introduction
• Strategy of paper
– Identification of US monetary policy shocks: change in Fed funds futures in 30-minute window around FOMC decisions
• Important driver of global markets in recent years
• …in particular for equity markets
– Transmission to 50 foreign equity markets
– Sector equity returns across 10 sectors
– Strength, channels and determinants of transmission
Overview of results
1. Strength of transmission
– Foreign equity markets drop, on average, by 3.8% in response to 100 bp tightening in US monetary policy (US market: 6.5%)
– High degree of cross-country heterogeneity:
• No effect: China, India or Mexico
• ~10% or more: Indonesia, Korea and Turkey
• Strongest among advanced economies: Australia, Canada, Finland and Sweden
– Substantial sector heterogeneity:
• effects range from 1.6% for utilities to 7.4% for information technology
Overview of results
2. Channels of transmission
– Via US asset prices:
• reaction of US short-term interest rates important: transmission 2½ times larger when high US short-term interest rate response
– Via foreign asset prices:
• reaction of foreign short-term interest rates and exchange rates key: transmission up to 2 times larger when high response of these asset prices
Overview of results
3. Determinants of heterogeneity in transmission
– Openness:
• Countries with closed markets (equity market, domestic financial sector) do not react to US monetary policy shocks
– Exchange rate policy:
• De jure regime does not matter, but de facto exchange rate volatility does – fear of floating?
– Others:
• Business cycle correlation with US matters …
• … indebtedness and information asymmetries do not
Overview of results
3. Determinants of heterogeneity in transmission
– Real integration:
• Transmission ~2 times stronger if relatively high trade with rest of world (ROW)
– Financial integration:
• Transmission 2 – 3 times stronger if relatively high financial integration with ROW
– Key finding: it is the degree of global integration, i.e. with ROW, but not with the United States, that matters for the financial transmission process
Literature & hypotheses
• Paper is on intersection between and links three strands of the literature:
– Literature on domestic financial market effects of monetary policy
– Literature on international asset market linkages
– Literature explaining the linkages
Literature
• Domestic transmission of monetary policy shocks to equity markets
– Identification problem addressed in various ways
– Structural VAR – low frequency (Thorbecke 1997, Patelis 1997): US monetary policy affects US equity markets
– Identification through heteroskedasticity of asset price movements (Rigobon & Sack 2003, 2004)
– Monetary policy shocks derived from Fed funds futures (Kuttner 2001, Gürkaynak et al. 2005) or polls (Ehrmann & Fratzscher 2004)
– Empirical findings (Bernanke & Kuttner 2005, Ehrmann & Fratzscher 2004, Rigobon & Sack 2004): 5.3–6.2%
Literature
• International transmission – focus mainly on individual asset classes
– Equity markets (Hamao, Masulis & Ng 1990; Lin, Engle & Ito 1994; King, Sentana & Wadhwani 1994)
– FX markets (Andersen et al. 2003)
– Spillover of macroeconomic news (Andersen et al 2005; Becker, Finnerty & Friedman 1995; Faust et al. 2003)
– Cross-market spillovers between US and euro area (Ehrmann, Fratzscher & Rigobon 2005)
• Explaning linkages
– Trade (Eichengreen & Rose 1999, Forbes & Chinn 2004), industry composition (Griffin & Stulz 2001), capital controls (Miniane & Rogers 2003)
Hypotheses
• Macroeconomic repercussions of a US monetary policy shock (economy level):
– transmission strongest to those foreign markets with economies that have a high business cycle correlation, close trade links or high integration
• Microeconomic repercussions (firm level, sector level):
– Transmission via effect on financing costs of foreign firms
– Role of direct firm-level linkages with the US (e.g. FDI or portfolio investment)
– Importance of portfolio rebalancing for financial investors
Data: US monetary policy shock– Change in Fed funds future rates in 30-minute
window around FOMC decisions – usually at 14.15 EST (Gürkaynak, Sack & Swanson 2005)
– Period February 1994 – 2005: 93 FOMC meetings (excluding 11 Sept. 2001)
– Daily frequency: hence monetary policy shocks zero for most days
US monetary policy shock-4
0-2
00
20
01jan1994 01jan1996 01jan1998 01jan2000 01jan2002 01jan2004
Financial market data– Equity returns: daily log changes of Datastream
price indices, in national currencies, of 10 sector returns across 50 countries
– Construction of “unweighted” return index based on unweighted average of sector returns in order to control for sector heterogeneity
– Short-term interest rates: mostly 3-month money market rates
– Bond yields for US: 10-year T-bills
– Exchange rates: daily spot rates
– All based on closing quotes of local markets
Integration and macroeconomic determinants– Openness:
• capital account – 0-1 dummy; IMF AREAER
• equity market and domestic financial sector – 0-1 dummies; Kaminsky & Schmukler (2003), Bussiere & Fratzscher (2004)
• Equity market depth: stock market capitalisation / GDP
– Exchange rate policy:
• de jure regime: IMF AREAER
• de facto regime: Reinhart & Rogoff (2004)
• de facto exchange rate volatility: 12-month standard deviation of changes in daily (nominal) exchange rate vis-à-vis US dollar
Integration and macroeconomic determinants– Others:
• Business cycle correlation with US: correlation in annual GDP growth 1980-2003
• indebtedness of country
• information asymmetries: proxied by geographic distance (gravity literature)
• additional variables: domestic inflation, investment etc.
Integration and macroeconomic determinants– Real integration:
• Trade = exports + imports to GDP with rest of world (ROW) and with United States: IMF DOTS
– Financial integration: Unique data set of bilateral capital stocks
• FDI: UNCTAD
• Portfolio equity & portfolio debt: IMF CPIS
• Loans: BIS ILB
– Important advantage: all integration variables are available multilaterally vis-à-vis ROW as well as bilaterally vis-à-vis United States
– Most variables vary across countries & over time !
Benchmark model
ri,t equity return in country i
St US monetary policy shock
rus “cleaned” US equity market return from:
)1(, itn
tinrttiit ZSr US
)2(,,USr
tn
tUSntUS
tUS ZSr
transmission parameter - causality
general linkage parameter - no causality
definition ensures is orthogonal to
Benchmark model
• as robustness check: if all shocks always emanate from US then US
• Robust OLS estimator with panel-corrected standard errors (PCSE): corrects for heteroskedasticity and cross-correlation of observations
Benchmark model
Benchmark effects std error std error
(1) United States, weighted index -0.079 *** 0.017 -- -- --
(2) United States, unweighted index -0.065 *** 0.013 -- -- --
(3) International, weighted indices -0.045 *** 0.007 0.348 *** 0.010
(4) International, unweighted indices -0.038 *** 0.006 0.304 *** 0.009
Parameter estimates
100 bp tightening in US monetary policy reduces foreign equity returns on average by 3.8% (unweighted index)
General linkage ~ 0.30 : 30% of an equity market shock is transmitted internationally
Cross-country / cross-sector heterogeneity
rikt equity return in country i and sector k
i country-specific transmission parameter
k sector-specific transmission parameter
)4(
,
iktk
krtkktk
ii
rtiiti
ntinkiikt
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US
US
Country-sector effects of US mon. policy
shocks 0
.2.4
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qui
ty m
arke
t lin
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-.15 -.1 -.05 0 .05monetary policy shocks
Cross-country heterogeneity
Country: i
i Country:
i
i Country: i
i
Argentina -0.039 *** 0.467 *** Hong Kong -0.075 *** 0.482 *** Peru -0.001 0.106 ***Australia -0.060 *** 0.375 *** Hungary -0.042 *** 0.346 *** Philippines -0.037 ** 0.283 ***Austria -0.047 *** 0.175 *** India -0.011 0.131 *** Poland -0.030 *** 0.467 ***Belgium -0.035 *** 0.270 *** Indonesia -0.159 *** 0.421 *** Portugal -0.030 *** 0.131 ***Brazil -0.041 *** 0.502 *** Ireland -0.036 *** 0.280 *** Romania -0.002 0.061 ***Canada -0.059 *** 0.564 *** Israel -0.036 *** 0.314 *** Russia -0.043 ** 0.340 ***Chile -0.012 ** 0.244 *** Italy -0.050 *** 0.221 *** Singapore -0.051 *** 0.351 ***China 0.014 0.030 *** Japan -0.011 ** 0.291 *** South Africa -0.044 *** 0.410 ***Colombia 0.015 0.026 Korea -0.101 *** 0.493 *** Spain -0.059 *** 0.213 ***Cyprus -0.048 *** 0.133 *** Luxemburg -0.053 *** 0.191 ** Sri Lanka -0.001 0.033 ***Czech Republic -0.043 *** 0.079 ** Malaysia -0.029 *** 0.344 *** Sweden -0.086 *** 0.406 ***Denmark -0.042 *** 0.360 *** Mexico -0.011 0.574 *** Switzerland -0.039 *** 0.268 ***Finland -0.073 *** 0.358 *** Netherlands -0.050 *** 0.385 *** Taiwan -0.036 *** 0.302 ***France -0.040 *** 0.318 *** New Zealand -0.041 *** 0.293 *** Thailand -0.059 *** 0.340 ***Germany -0.037 *** 0.279 *** Norway -0.057 *** 0.340 *** Turkey -0.117 *** 0.355 ***Greece -0.046 *** 0.323 *** Pakistan 0.031 0.034 United Kingdom -0.041 *** 0.280 ***
Channels of transmission
Channel 1: Via US asset prices:
– US equity markets: e.g. through cross-listing of firms, or through FDI or portfolio investment holdings of firms in the US
– US short-term interest rates: via financing costs of firms raising funds in US financial markets
– US long-term interest rates: uncertain effect on equity markets – may reflect credibility of central bank or growth expectations
)5(,
4
1
uit
ntin
rt
l
ltl
lttli
uit ZDDSr US
Transmission channel 1: US asset prices
reaction of US short-term interest rates important : transmission 2½ times larger when high US short-term interest rate response
Individual US asset price change: std error coef p-value
US equity market - low US equity market reaction -0.032 *** 0.012 -0.005 0.701 - high US equity market reaction -0.037 *** 0.008 US interest rates - low US interest rate reaction -0.032 *** 0.007 -0.047 *** 0.009 - high US interest rate reaction -0.079 *** 0.016 US bond yields - low US bond yield reaction -0.039 *** 0.007 -0.001 0.924 - high US bond yield reaction -0.040 *** 0.012
Parameter estimates Test for difference
Via foreign interest rates and exchange rates:
– fixer: exchange rate reacts little, interest rate reacts much
– floater: exchange rate reacts much, interest rate reacts little
– dependent country: exchange rate reacts much, interest rate reacts much
– independent country: exchange rate reacts little, interest rate reacts little
)6(,
4
1,,
uit
ntin
rt
m
mtim
mtitmi
uit ZDDSr US
Transmission channel 2: Foreign asset prices
Transmission channel 2: Foreign asset prices
Transmission up to 2 times larger for “dependent countries”, i.e. countries where interest rates and exchange rates react strongly
Countries classified as: std error (1) (2) (3)
fixer - low exchange rate & high interest rate reaction -0.036 *** 0.005 floater - high exchange rate & low interest rate reaction -0.029 *** 0.006 0.48 dependent country - high exchange rate & high interest rate reaction -0.052 *** 0.005 0.02 0.00 independent country - low exchange rate & low interest rate reaction -0.023 *** 0.007 0.48 0.12 0.00
Parameter estimates Test for difference vs.
Determinants of financial transmission
uit
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highit
midit
lowit
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lowit
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Determinants of financial transmission
Openness: Countries with closed markets (equity market, domestic financial sector) do not react to US monetary policy shocks; exception: capital account
X std error (2) (3)
A. OPENNESS
Capital account (1) closed -0.031 *** 0.008 0.200
(2) open -0.041 *** 0.007
Equity market (1) closed -0.001 0.012 0.001
(2) open -0.041 *** 0.007
Domestic financial (1) closed -0.010 0.012 0.012
sector (2) open -0.040 *** 0.006
difference
Determinants of financial transmission
Exchange rate policy: De jure regime does not matter, but de facto exchange rate volatility does – fear of floating?
X std error (2) (3)
B. EXCHANGE RATE
Volatility of effective (1) low -0.027 *** 0.007 0.284 0.001
exchange rate (2) medium -0.036 *** 0.008 0.020
(3) high -0.056 *** 0.008
Volatility vis-à-vis (1) low -0.027 *** 0.007 0.261 0.001
US dollar (2) medium -0.036 *** 0.008 0.019
(3) high -0.055 *** 0.008
Regime - de jure (1) fix -0.031 *** 0.007 0.333
(2) float -0.038 *** 0.007
difference
Determinants of financial transmission
– Others: Business cycle correlation with US matters
– Information asymmetries do not
X std error (2) (3)
C. OTHER
GDP correlation (1) low -0.026 *** 0.008 0.193 0.012
with US (2) medium -0.036 *** 0.007 0.098
(3) high -0.048 *** 0.008
Geographic distance (1) low -0.037 *** 0.007 0.389 0.679
(2) medium -0.032 *** 0.008 0.307
(3) high -0.040 *** 0.007
difference
Real and financial integration with ROW
X std error (2) (3)
A. WITH THE WORLD - ASSETS & LIABILITIES, IN- & OUTFLOWS
Total trade flows (1) low -0.024 *** 0.008 0.084 0.018
(2) medium -0.037 *** 0.007 0.191
(3) high -0.047 *** 0.008
Total capital stocks (1) low -0.018 ** 0.008 0.000 0.010
(2) medium -0.048 *** 0.008 0.518
(3) high -0.043 *** 0.008
FDI (1) low -0.019 ** 0.008 0.001 0.003
(2) medium -0.045 *** 0.008 0.976
(3) high -0.045 *** 0.007
Portfolio equity (1) low -0.024 *** 0.007 0.002 0.015
(2) medium -0.047 *** 0.007 0.490
(3) high -0.043 *** 0.007
Portfolio debt (1) low -0.019 *** 0.007 0.000 0.013
(2) medium -0.051 *** 0.008 0.242
(3) high -0.042 *** 0.008
Other investment (1) low -0.015 0.009 0.004 0.007
loans (2) medium -0.048 *** 0.008 0.841
(3) high -0.046 *** 0.008
difference
parameter estimates
Real and financial integration with US
X std error (2) (3)
B. WITH THE UNITED STATES - ASSETS & LIABILITIES, IN- & OUTFLOWS
Total trade flows (1) low -0.031 *** 0.007 0.008 0.611
(2) medium -0.050 *** 0.008 0.015
(3) high -0.035 *** 0.007
Total capital stocks (1) low -0.047 *** 0.009 0.588 0.130
(2) medium -0.051 *** 0.009 0.018
(3) high -0.035 *** 0.006
FDI (1) low -0.043 *** 0.008 0.652 0.281
(2) medium -0.039 *** 0.008 0.467
(3) high -0.035 *** 0.006
Portfolio equity (1) low -0.035 *** 0.008 0.319 0.745
(2) medium -0.042 *** 0.008 0.107
(3) high -0.033 *** 0.006
Portfolio debt (1) low -0.042 *** 0.009 0.204 0.312
(2) medium -0.049 *** 0.009 0.060
(3) high -0.034 *** 0.006
Other investment (1) low -0.025 *** 0.008 0.002 0.034
loans (2) medium -0.049 *** 0.008 0.243
(3) high -0.040 *** 0.007
difference
Real and financial integration
– Real integration:
• Transmission ~2 times stronger if relatively high trade with rest of world (ROW)
– Financial integration:
• Transmission 2 – 3 times stronger if relatively high financial integration with ROW
– Key finding: it is the degree of global integration, i.e. with ROW, but not with the United States, that matters for the financial transmission process
Robustness
• Various extensions underline robustness of results:
– Caveat: significant correlation across determinants
– Split between asset and liabilities, inflows and outflows
– Inclusion of macroeconomic news (GDP, IP, CPI, PPI, consumer and producer confidence, employment etc.)
– Example of shocks to US industrial production…
Robustness: macroeconomic shocks
Parameter estimatesType of US shock: std error
(1) Monetary policy -0.039 *** 0.004(2) Non-farm payroll employment -0.193 *** 0.032(3) NAPM / ISM confidence indicator 0.061 0.043(4) CPI inflation -0.335 *** 0.059(5) PPI inflation -0.084 *** 0.027(6) GDP (advance release) 0.370 *** 0.058(7) Industrial production 0.064 * 0.038(8) Retail sales -0.026 0.044(9) Consumer confidence 0.130 0.092
(10) Trade balance 0.413 *** 0.090(11) Housing starts -0.071 0.051(12) Hours worked per week -0.043 0.063
Real and financial integration with ROWindustrial production shock
X std error (2) (3)
A. WITH THE WORLD - ASSETS & LIABILITIES, IN- & OUTFLOWS
Total trade flows (1) low -0.026 0.095 0.595 0.069
(2) medium 0.043 0.090 0.196
(3) high 0.198 ** 0.079
Total capital stocks (1) low -0.033 0.096 0.384 0.120
(2) medium 0.081 0.090 0.511
(3) high 0.160 ** 0.079
FDI (1) low -0.030 0.095 0.353 0.108
(2) medium 0.091 0.090 0.516
(3) high 0.168 ** 0.079
Portfolio equity (1) low 0.044 0.092 0.879 0.404
(2) medium 0.024 0.088 0.313
(3) high 0.150 * 0.088
Portfolio debt (1) low 0.094 0.092 0.467 0.882
(2) medium 0.002 0.088 0.371
(3) high 0.113 0.088
Other investment (1) low -0.094 0.100 0.085 0.052
loans (2) medium 0.134 0.087 0.864
(3) high 0.154 ** 0.079
difference
Summary & conclusions
• Linking asset price transmission with financial integration / quantities
• Identification problem addressed by focusing on transmission of US monetary policy shocks - important driver of global financial markets
• Strength of transmission
– Foreign equity markets drop, on average, by 3.8% in response to 100 bp tightening in US monetary policy
– High degree of heterogeneity in cross-country (0->10%) and cross-sector (1.6%-7.4%) transmission
Summary & conclusions
• Channels of transmission
– Via US asset prices: mainly via US s-t interest rates
– Via foreign asset prices: both s-t interest rates and exchange rates
• Determinants of heterogeneity in transmission
– Openness and exchange rate policy important
• De jure regime does not matter, but de facto exchange rate volatility does – fear of floating?
– Others:
• Business cycle correlation with US matters
Summary & conclusions
• Determinants of heterogeneity in transmission
– Real integration and in particular financial integration matter: transmission 2 – 3 times stronger if relatively high financial integration with rest of world
– Key finding: it is the degree of global integration, i.e. with ROW, but not with the United States, that matters for the financial transmission process
• International financial transmission of monetary policy similar to that of other types of shocks
• Implications for risk sharing / diversification
Annex
Country-specific effects of US mon. policy
shocks 0
.2.4
.6.8
1g
ener
al e
qui
ty m
arke
t lin
kage
-.15 -.1 -.05 0 .05monetary policy shocks
Sector-specific effects of US mon. policy
shocks .2
.3.4
.5g
ener
al e
qui
ty m
arke
t lin
kage
-.07 -.06 -.05 -.04 -.03 -.02monetary policy shocks
Sector-specific effects of US mon. policy
shocks 0
.2.4
.6.8
11
.2g
ener
al e
qui
ty m
arke
t lin
kage
-.5 0 .5 1 1.5monetary policy shocks
Cross-sector heterogeneity
Sector: k
k
Financial -0.044 *** 0.318 ***Information technology -0.074 *** 0.518 ***Utilities -0.016 *** 0.191 ***Non-cyclical services -0.051 *** 0.416 ***Cyclical services -0.040 *** 0.303 ***Cyclical consumer goods -0.040 *** 0.265 ***Industrial -0.045 *** 0.319 ***Basic industries -0.034 *** 0.276 ***Resources -0.047 *** 0.245 ***Non-cyclical consumer goods -0.026 *** 0.232 ***
Parameter estimates
Time asymmetries: US policy shocks
No evidence for (time) asymmetric effects stemming from the US monetary policy shock itself
Difference
Monetary policy shock 1 std error
2 std error p-value
Unweighted indices
Monetary policy: no change vs. change -0.033 ** 0.016 -0.039 *** 0.007 0.713Directional change: no vs. yes -0.039 *** 0.007 -0.037 *** 0.013 0.902Monetary policy shock: negative vs. positive -0.039 *** 0.007 -0.034 ** 0.015 0.491Monetary policy shock: small vs. large -0.039 *** 0.007 -0.036 ** 0.015 0.882Volatility: small vs. large -0.039 *** 0.007 -0.039 *** 0.012 0.998
Parameter estimates
Transmission channel 1: US asset prices
Result confirmed when using finer categorisation for equity market and short-term interest rate reactions
Combined US asset price change: b std error (1) (2) (3)
US equity market channel - low US interest rate & high US equity reaction -0.030 *** 0.004 US interest rate channel - high US interest rate & low US equity reaction -0.073 *** 0.011 0.00 US interest rate & equity channels - high US interest rate & high US equity reaction -0.077 *** 0.012 0.00 0.81 No US asset price channel - low US interest rate & low US equity reaction -0.030 *** 0.007 0.96 0.00 0.00
Parameter estimates Test for difference vs.
Transmission channel 2: Foreign asset prices
Higher reaction of foreign equity markets to US monetary policy shocks if large change in short-term interest rate or in exchange rate
Foreign asset price change: std error coef p-value
exchange rate - low exchange rate reaction -0.032 *** 0.004 -0.009 * 0.075 - high exchange rate reaction -0.041 *** 0.004 interest rate - low interest rate reaction -0.028 *** 0.005 -0.010 * 0.076 - high interest rate reaction -0.038 *** 0.003
Parameter estimates Test for difference