Are we riding the waves of a global financial cycle in the euro area?
(article for the September Economic Review)
In the article the authors analyse whether domestic financial conditions – such as bank credit growth, interest rates, equity and house prices - in the euro area countries are linked to a global financial cycle (GFC). To measure this effect, a financial conditions index (FCI) for the euro area countries, summarising their domestic financial conditions, is constructed and compared with a measure for the global financial cycle (taken from Habib and Venditti, 2019).
The results contribute to the burgeoning literature on the global financial cycle (GFC) which mainly looks into the effect of the GFC on capital flows of emerging economies. They are supplemented with findings regarding the impact of the GFC on domestic financial conditions in the euro area countries.
First, a clear financial cycle is found for the euro area, with peaks that can be related to crisis events. There is, however, substantial heterogeneity across the euro area countries.
Secondly, financial conditions in the euro area seem strongly correlated (0.89) with the global financial cycle. However, euro area countries show varying sensitivities to the global cycle.
A link is established between this cross-country sensitivity to the global cycle and various determinants, including the size and composition of the external financial position. A key finding is that sensitivity seems to depend crucially on the net international investment position. Countries with net liabilities seem to react twice as strongly as countries that have net assets. Among the countries with net liabilities, those which finance themselves by other investment (mainly debt funding of banks) prove especially vulnerable to the boom/bust profile of the global financial cycle.
These results have several important policy implications. First, it is useful for macroprudential policy to monitor the global financial cycle and/or help to address extreme sensitivity to its boom/bust profile. Secondly, the strong correlation between financial conditions in the euro area and the global financial cycle tends to confirm a ‘financial dilemma’ for the euro area, along the lines of Rey (2015) for emerging economies. Such a dilemma implies that whenever the financial account is open, monetary conditions are influenced mainly by global factors and less by an independent monetary policy. It is shown that this dilemma in the euro area is particularly present when countries have a negative net external position.
At the same time, these conclusions call for co-ordination between macroeconomic (structural), macroprudential and monetary policy to reach their objectives. Addressing the negative net external position and, more broadly, ensuring debt sustainability, as is currently done under the European Macroeconomic Imbalance Procedure (MIP), would most likely help to insulate the countries during risk-on/risk-off global regimes, thereby also contributing to financial stability objectives and independent monetary conditions in the euro area.