Transmission of global financial shocks : which capital flows matter?

In this paper, I study channels through which risk-appetite shocks to global investors, i.e., global financial shocks, are transmitted to emerging market economies(EMEs). I focus on how transmission channels have changed as EMEs have become able to borrow abroad in the form of equity and local currency debt. First, I empirically show that much of the transmission of global financial shocks to EMEs is reflected in equity and local currency bond portfolio flows. I then develop a small open economy model which, augmented with leverage constrained banks and foreign investors who purchase equities and bonds, can replicate these empirical findings qualitatively. Finally, I calibrate the model to the Korean economy in which corporations and the government have no significant net foreign currency debts, but most of the external liabilities of the country are Korean won-denominated equities and debts. Quantitative analysis of the model suggests that global financial shocks are a dominant factor in financial market fluctuations and significantly contribute to the dynamics of the real economy in Korea. In short, all the analysis in this paper implies that to a substantial extent, risk-appetite shocks to global investors are transmitted to EMEs via fickle portfolio flows to equity and local currency bond markets in EMEs