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 from 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 leverageconstrained banks, can replicate these empirical findings qualitatively. Finally, I calibrate the model to the Korean economy in which 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 analyses in this paper imply that, to a substantial extent, global financial shocks are transmitted to EMEs via fickle portfolio flows to equity and local currency bond markets in EMEs.