Global Flight-to-Safety Shocks

Abstract

I develop a measure of changing tail risk perceptions based on global financial shocks reflecting 'flights-to-safety'. Large flight-to-safety shocks are defined as joint tail realizations of returns across major risky and safe asset classes. Flight-tosafety shocks are substantially distinct from VIX innovations, map to unexpected global events, inform future changes in world prices and interest rates, and reflect both risk sentiment and global demand. Estimating a multi-country structural VAR with country-specific heterogeneity, I show that global flight-to-safety shocks induce a sharp rise in sovereign risk and exchange market pressure, followed by a subsequent drop in economic activity in both emerging markets and the U.S. However, the macroeconomic effects of flight-to-safety shocks are far from uniform across emerging markets, with domestic financial factors moderating the transmission mechanism. Countries realizing larger sovereign risk adjustment or sharper currency depreciation from a flight-to-safety shock are subject to deeper subsequent economic contractions. The impact of flight-to-safety shocks on economic activity is four times larger for emerging markets with substantial presence in U.S. exchange traded funds. By contrast, leaning against the wind by aggressively expending international reserves limits the economic impact of global flight-to-safety shocks, with its effectiveness rising when the exchange rate is successfully stabilized.