International Credit Cycles

Our paper attempts to propose a novel transmission mechanism of international financial cycles through cross-border capital flows. We first document that a systemic banking crisis in one country is generally associated with a surge in financial capital inflows. Then, we develop a tractable model of a banking crisis in an open economy to make sense of the international spillovers of credit cycles. The model features two countries with heterogeneous and financially constrained banks. An excessive credit expansion in the foreign country may trigger a collapse in its interbank market, resulting in capital flight to the home country, the magnitude of which increases with the abundance of foreign credit. The capital inflows have a nonmonotonic impact on the home country's real economy when the home country's banking sector remains functioning. A sufficiently large volume of capital flight due to excessive credit expansion in the foreign country could trigger a credit market collapse and thereby a discontinuous drop in output in the home country. The effectiveness of the policy responses in the home country, such as capital control and credit policies, relies on the magnitude and composition of capital inflows. In the dynamic fully fledged model, we further characterize various patterns of international financial risk contagion and endogenous boom-bust credit cycles in the global economy