Monetary Policy Spillovers and the Trilemma in the New Normal: Periphery Country Sensitivity to Core Country Conditions

We investigate why and how the financial conditions of developing and emerging market countries (peripheral countries) can be affected by the movements in the center economies - the U.S., Japan, the Eurozone, and China. We apply a two-step approach. First, we estimate the sensitivity of countries’ financial variables to the center economies, controlling for global and domestic factors. Next, we examine the association of the estimated sensitivity coefficients with the macroeconomic conditions, policies, real and financial linkages with the center economies, and the level of institutional development. In the last two decades, for most financial variables, the strength of the links with the center economies have been the dominant factor. While certain macroeconomic and institutional variables are important, the arrangement of open macro policies such as the exchange rate regime and financial openness are also found to have direct influence on the sensitivity to the center economies. We also find, among other results, that an economy that pursues greater exchange rate stability and financial openness faces a stronger link with the center economies. Nonetheless, exchange rate regimes have mostly indirect effects on the strength of financial linkages. We conclude the trilemma remains relevant.