RDP 2024-10: How Do Global Shocks Affect Australia? 5. How Do Global Shocks Spill Over to Australia?

Traditional models would suggest that global shocks primarily spill over through adjustments in exchange rates and trade, as discussed in Section 1. However, more recent literature has emphasised the importance of global banks as a transmission channel for global shocks (Miranda-Agrippino and Rey 2020). We therefore test the importance of this channel for Australia.

5.1 A domestic block with financial variables

To assess the role of the Australian banking system in transmitting global shocks, we first augment the baseline domestic block in the VAR with Australian financial variables. We add one domestic financial variable to the baseline domestic block and re-estimate the contribution to the FEV by global shocks, replacing the domestic financial variable each time. In particular, we add log differences in: an index of Australian housing prices, the ASX all ordinaries index, value of deposits at banks in Australia, outstanding loans by banks in Australia, and differences in the spread between business lending rates and the bank bill swap rate (a measure of financial stress, see Beckers (2020)).

Global shocks explain a large share of the FEV of stock prices, as well as housing prices (Figure 11). In line with the efficient markets hypothesis, stock prices appear to adjust to global shocks almost immediately, as seen by global shocks explaining an almost equal share of their variation on impact as at later horizons. On the other hand, global shocks explain an increasingly greater proportion of FEV in housing prices over time, which could suggest these prices are not directly affected by the global shocks, but that this effect is instead intermediated by the response of other domestic variables such as the cash rate. Alternatively, this would be consistent with the housing market being slow moving and repricing less efficiently in response to shocks than equity prices. The global shocks explain very little of the FEV in Australian deposits, lending and lending spreads.^[19]

Since global shocks appear to explain substantial variation in some other domestic variables (like unemployment and housing prices) without explaining substantial variation in banking variables, this suggests that global shocks are spilling over not via bank lending but by one of the other channels. For example, the substantial proportion of the FEV in the TWI explained by the global shocks would align with an exchange rate channel, while the results for stock prices and housing prices would be consistent with an asset price channel. While we are unable to say which of the two channels is more likely to explain spillovers to Australia, a lack of reaction by banking variables to global shocks suggests that the banking channel is not a main channel for spillovers of global shocks to Australia. In contrast, global shocks explain considerably more variation in the exchange rate and somewhat more variation in certain trade variables, suggesting that traditional models of spillovers may be a better description for the Australian economy (see Appendix C).

5.2 Impulse response functions to ‘shocks’ in global factors

To further investigate how financial variables respond to global shocks, we compute impulse response functions (IRFs) for ‘shocks’ in the global factors. As we are not imposing any structural identification within the foreign block, these are not interpretable as the response of Australian variables to any particular structural shock. The small open economy assumption of Australian shocks not having an effect on the global factors is sufficient to identify that a shock is global, but not precisely what kind of shock it is. For instance, shocking the third factor, which appears to reflect variation in financial variables primarily, is not interpretable as a financial shock, as without an identification approach it may be picking up any underlying combination of global shocks, such as a combination of a simultaneous shock to aggregate demand and financial risk.

However, if a given Australian variable does not respond to a shock to a given factor, this at least suggests that it is unlikely that the variable is an important channel of transmission for the global shocks. In other words, we would expect some response of a variable if it were a significant channel of spillovers in Australia, unless the underlying shocks are a linear combination of shocks that happen to perfectly cancel out the effect on the Australian variable. We present the cumulated IRFs for several financial variables to a one standard deviation shock of the third factor that loads most strongly on financial variables in Figure 12.^[20] Several features of the IRFs to a shock in the third factor are consistent with the analysis of the FEVDs.

The TWI initially appreciates by around 1 per cent in response to the shock and remains at that level over the horizon. Asset prices respond positively to the shock, with the level of the ASX all ordinaries index increasing 5 per cent and housing prices increasing 1 per cent. The banking variables – lending, deposits and lending spread – all show a close to zero or statistically insignificant response by the end of the horizon. This corroborates the FEVD evidence for banks not acting as a major channel for the shock to spill over to other domestic variables. This is in contrast to the findings of Miranda-Agrippino and Rey (2020) that deposits, lending and financing costs are the dimensions of the banking channel for the transmission of global shocks. We report the responses of the baseline block of variables in Appendix C (Figure C2).

Footnotes

Our results are robust to directly including the global financial cycle measure of Miranda-Agrippino and Rey (2020) in the foreign block. This does not increase the proportion of variation explained by foreign shocks in any variable, nor does adding major trading partner growth directly, suggesting that our foreign factors adequately capture the main sources of variation in the foreign panel. [19]

IRFs from shocks to the first and second factors are shown in Appendix C. [20]