RDP 2024-10: How Do Global Shocks Affect Australia? 1. Introduction

Australia is an advanced small open economy with open capital markets.^[1] Foreign or global economic and financial shocks can therefore have a large impact on the Australian economy and financial system. However:

• it is unclear how much these shocks matter and previous studies find widely differing results;
• there is also disagreement in the literature over the channels through which these shocks spill over to Australia and small open economies in general.

Understanding the international transmission of global shocks has important implications for how macroeconomic policy should respond to developments in the global economy and financial system, and for the weight policymakers should place on the need to understand international developments.

We approach these questions using a factor augmented vector-autoregressive (FAVAR) model. These models are particularly useful in the context of international spillovers, because they can summarise shocks in the global economy well by estimating common factors across large panels of global data, where it would not be feasible to directly include all these data individually into a model (Mumtaz and Surico 2009).^[2] In this paper we contribute to the literature by applying the FAVAR approach to Australia and explore how much global shocks have mattered for the Australian economy in the past. We also explore which parts of the Australian economy appear more exposed to global shocks, which can shine some light on the question through which channels global shocks spill over to Australia. In particular, we review whether global banks are an important channel for the transmission of global shocks to Australia as proposed by the recent literature on the global financial cycle discussed in the next section.

Applying the FAVAR approach, we find that global shocks explain around half of the variation in the Australian exchange rate and cash rate but explain less variation in economic variables like real GDP and inflation over the period from 1990–2019.^[3] This is consistent with the role of the exchange rate in buffering the economy from foreign shocks, and the RBA offsetting the effects of foreign shocks to stabilise domestic inflation around its target. Moreover, given that the RBA does not target asset prices, it is not surprising that we find global shocks also explain a substantial share of the variation in Australian stock and housing prices.

But in contrast to recent international literature on the global banking channel, which argues that cross-border banking linkages are a significant channel of global economic spillovers, we do not find that global shocks significantly affect bank lending, deposit inflows or lending spreads in Australia. We explain this result with reference to the characteristics of the Australian banking system, which is relatively concentrated and engaged primarily in traditional financial intermediation, as well as domestically focused and well hedged with regard to its international exposures. Our results suggest that the banking channel of international spillovers is not a universal feature of small open economies but instead closer examination of the structure of their financial systems is required.

We study the period of 1990–2019, largely due to data availability in the global panel. We do not include the COVID-19 pandemic period, as the extreme degree of common global variation means this period cannot be captured adequately in the linear FAVAR modelling framework and reflects a rare tail event.

The COVID-19 pandemic aside, 1990–2019 is arguably a ‘particular’ period of relative global macroeconomic stability and shocks coming predominantly from the demand side, either due to typical business cycle dynamics or due to financial crises. Notable episodes of disruptions include the early 1990s recessions experienced by many developed economies, and the Asian financial crisis or the global financial crisis (GFC). By contrast, there were few major global supply shocks of the nature of the oil shocks of the 1970s and 1980s, and fewer geopolitical tensions among the largest global economies compared to earlier in the 20th century. While our paper can shine a light on the importance of global shocks for the Australian economy between 1990 and 2019, it is possible that the nature, frequency and size of global shocks will differ going forward with different implications for the Australian economy.

Footnotes

‘Small’ in the sense that domestic economic shocks are unlikely to affect the world economy at large (Mendoza 1991). [1]

Specifically, a small-scale VAR, especially a bilateral VAR, may not fully capture certain shocks – for example, a bilateral VAR with the United States as the foreign block may miss shocks originating in Asia that may affect Australia more acutely (Georgiadis 2017). [2]

Under different specifications, however, such as just using the United States as the foreign block in a VAR, this buffering role is not quite as apparent, particularly on CPI (see Section 4). [3]