A theory of net capital flows over the global financial cycle

We develop a theory to account for the relationship between global asset price changes and net capital flows. We show empirically that countries that have a net debt of safe assets experience a rise in net outflows of safe assets (i.e. pay off safe asset debt) when global asset prices fall. This is accomplished through a rise in total net outflows (an increase in net savings) and a drop in net outflows of risky assets (the net sale of foreign 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.