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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

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Workshop “The Architecture of Financial System Stability” Capri, 24-25 May, 2006

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  1. Global financial transmission of monetary policy shocksMichael Ehrmann (ECB) and Marcel Fratzscher (ECB) Workshop “The Architecture of Financial System Stability” Capri, 24-25 May, 2006 The usual disclaimers apply.

  2. 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 ?

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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%

  10. 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)

  11. 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

  12. 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

  13. US monetary policy shock

  14. 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

  15. 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

  16. 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.

  17. 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 !

  18. Benchmark model ri,t equity return in country i St US monetary policy shock erus “cleaned” US equity market return from: b transmission parameter - causality g general linkage parameter - no causality definition ensures b is orthogonal to g

  19. Benchmark model • g as robustness check: if all shocks always emanate from US then b  bUSg • Robust OLS estimator with panel-corrected standard errors (PCSE): corrects for heteroskedasticity and cross-correlation of observations

  20. Benchmark model 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

  21. Cross-country / cross-sector heterogeneity rikt equity return in country i and sector k bi country-specific transmission parameter bk sector-specific transmission parameter

  22. Country-sector effects of US mon. policy shocks

  23. Cross-country heterogeneity

  24. 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

  25. 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

  26. Transmission channel 2: Foreign asset prices 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

  27. 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

  28. Determinants of financial transmission

  29. 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

  30. Determinants of financial transmission Exchange rate policy: De jure regime does not matter, but de facto exchange rate volatility does – fear of floating?

  31. Determinants of financial transmission • Others: Business cycle correlation with US matters • Information asymmetries do not

  32. Real and financial integration with ROW

  33. Real and financial integration with US

  34. 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

  35. 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…

  36. Robustness: macroeconomic shocks

  37. Real and financial integration with ROW

  38. 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

  39. 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

  40. 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

  41. Annex

  42. Country-specific effects of US mon. policy shocks

  43. Sector-specific effects of US mon. policy shocks

  44. Sector-specific effects of US mon. policy shocks

  45. Cross-sector heterogeneity

  46. Time asymmetries: US policy shocks No evidence for (time) asymmetric effects stemming from the US monetary policy shock itself

  47. Transmission channel 1: US asset prices Result confirmed when using finer categorisation for equity market and short-term interest rate reactions

  48. 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

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