Leverage and valuation effects: How global liquidity shapes sectoral balance sheets

Global financial conditions have been shown to be important drivers of cross-border capital flows. But how do they interact with the leverage of the domestic sectors? That is the question this paper proposes to answer. Financial and non-financial sectors increase their leverage pro-cyclically, i.e., during periods of favourable domestic economic performance and whenever global financial conditions are more loose. The general government is an exception: it has a stabilizing counter-cyclical role, by taking on more debt in times of worse economic outcomes. Moreover, there is an important interaction between financial market stress and leverage, whereby heightened financial stress leads to higher leverage via the valuation component of balance sheets - this relationship vanishes when leverage measures are stripped of these price swings.