Abstract

     In a financially globalized world, managing long-term interest rates through short-term interest rates can be difficult. In this paper, we examine whether net capital inflows contribute to weakening the link between short- and long-term interest rates. We find that more financially open economies or those with more developed financial markets tend to have a greater negative relationship between net capital inflows and short- to long-term interest rate pass-through. We also examine whether macroprudential policies can affect the extent of interest rate pass-through and find that broad-based capital macroprudential tools are effective in retaining control of interest rate pass-through.

Introduction

     Recently, many researchers have argued that fnancial globalization has made domestic fnancial markets more vulnerable to developments in the major economies, namely the United States, the European Union, and lately China. Rey (2013) argues that in the fnancially globalized world, countries are vulnerable to the “global fnancial cycle” of capital fows, asset prices, and credit growth. In such an environment, non-major economies are subject to the center countries’ monetary policy unless the former decides to curtail capital mobility

      Figure  ۱ makes it clear that the volume of capital fows to emerging market economies (EMGs)2 tends to rise when risk appetite, measured by the reversed VIX index, is higher3 . When “risk is on,” investors’ risk appetite would rise and capital would fow to where the yields are higher, which was the case for EMGs when industrialized countries (IDCs) implemented extremely low interest rate policies in the late 2000s through the mid-2010s. When “risk is of” or when the interest rates are expected to rise in IDCs, capital would leave EMGs for IDC’s markets. Thus, capital fows to EMGs only passively react to the conditions of the major economies.

Concluding Remarks

     It has been increasingly argued that fnancial globalization has been playing a bigger role in determining domestic asset prices and interest rates. In such an environment, even with greater monetary autonomy, monetary authorities may not be able to keep controls of fnancial markets and the real economy as Rey (2013) argues. In fact, in recent years, the correlation of long-term interest rates between EMGs, especially those in East Asia, and the United States has been rising while the correlation of short-term rates does not show such a trend. In other words, Rey’s (2013) view of global fnancial cycles afecting domestic monetary policy – in which policymakers face a dilemma between monetary autonomy and free capital mobility – may be applicable to long-term interest rates, though not to the short-term interest rates.

     We examine whether receiving net capital infows can contribute to weakening the link between the short- and long-term interest rates, i.e., the interest rate passthrough. Our estimation results suggest that a country receiving more net capital infows tends to have a weaker interest rate pass-through. When we instrument net capital infows with its potential determinants to control for potential endogeneity, we fnd that both the magnitude and the statistical signifcance of the estimate for net capital infows increase.