A Theory of Net Capital Flows over the Global Financial Cycle

We develop a theory to account for changes in net capital flows of safe and risky assets over the global financial cycle. We show empirically that countries that have a net debt of safe assets experience a rise in net outflows of safe assets (reduced accumulation of safe debt) during a downturn in the global financial cycle. This is accomplished through a rise in total net outflows and a drop in net outflows of risky assets. We develop a multi-country portfolio choice model that can account for these facts. The theory relies on cross-country heterogeneity in the share of an investor's portfolio invested in risky assets. A global drop in risky asset prices changes relative wealth across countries due to this heterogeneity, which leads to changes in net flows of safe and risky assets. The model is applied to 20 advanced countries and calibrated to reflect observed cross-country heterogeneity of net foreign asset positions of safe and risky assets. The implications of the calibrated model for net capital flows are quantitatively consistent with the data.