Sabine Herrmann (Deutsche Bundesbank) Dubravko Mihaljek (BIS)

1. The determinants of cross border bank flows to emerging markets: new empirical evidence on the spread of financial crises Sabine Herrmann (Deutsche Bundesbank) Dubravko Mihaljek (BIS) 16th Dubrovnik Economic Conference, Croatia, June 23-25, 2010 The views expressed in this presentation are those of the authors and not necessarily those of the Deutsche Bundesbank or the BIS.

2. Motivation • At first, emerging markets mostly unaffected by the current financial crisis, soft landing widely expected. • However, after the collapse of Lehman Brothers, financial stress in emerging markets intensified: • Deleveraging of global financial institutions • Flight to quality • Deteriorating macroeconomic outlook • Crisis of confidence in some countries • IMF claims international bank lending to be a major factor contributing to spillover effects (WEO, 2009).

3. Main issues addressed in the paperDeterminants of cross-border bank flows from advanced to emerging market economies: - over a longer period - in different crisis periods - in different emerging market regionsHow the financial stress spread from advanced economies to EMEs via cross-border bank lending - identify specific channels of transmission - compare them in size, across EM regions, crisis periods

4. Modelling approachGravity model for asset flows (Martin and Rey, 2004)Focus on bilateral cross-border bank flows from advanced to EMEs Go beyond traditional push and pull factors (Papaioannou, 2008)Look at impact of macroeconomic and financial stress indicators on cross-border bank flows (Rijckeghem and Weder, 2003; Heid et al, 2004; McGuire and Tarashev, 2008; Buch et al, 2009)

5. Data • BIS locational banking statistics • External positions (and external loans) of banks in 17 BIS reporting countries vis-à-vis 28 EMEs • Quarterly data, 1993-2008 • Amounts outstanding (in USD) and exchange-rate adjusted flows • Bilateral, country-pair observations (30,500)

6. Figure 1: External positions of reporting banks vis-à-vis emerging markets Exchange rate adjusted changes (Q/Q), USD millions

7. BASIC GRAVITY MODEL LOANSijt = ρ0 + ρ1 DISTij + ρ2 GDPit + ρ3 GDPjt + ρ4 INTERESTijt + ρ5 GROWTHijt + ρ6 EXCHANGEijt+ρ7 Xijt + εijt LOANS Δexternal position of banks in country i vis-a-vis country j (log) DIST distance between the capitals i and j (log) GDP_i/GDP_j nominal GDP in i and j (log) INTEREST short-term interest rate differential between j and i GROWTH GDP growth differential between j and i EXCHANGE bilateral exchange rate

8. Financial stress models 1. GLOBAL MODEL De-leveraging driven by global factors, e.g. a stronger risk aversion in the wake of the financial crisis (wake-up call)  VIX Chicago Options Exchange S&P Volatility Index  RISKAVERSION Yield difference US corporate bonds/treasuries 2. LENDER MODEL De-leveraging driven by developments in lender country, e.g. its exposure to the primary crisis country (common lender effect) CLE Common lender effect: exposure of country i towards the primary crisis country  BANK_HEALTH_i Bank health indicator in lender country i

9. 3. RISK MODEL De-leveraging driven by a worsening of borrower country-specific risk factors(early warning indicators) GOVBALANCE General government balance (in % of GDP)  BANK_HEALTH_j Bank health indicator in borrower country 4. LINKAGE MODEL De-leveraging driven by degree of financial/monetary integration between borrower and lender country FINANCE_OPEN Bilateral financial openness indicator  ER_REGIME Exchange rate regime (Reinhart/Rogoff, 2004)

11. Contribution analysis Contribution of each model to changes in cross border bank flows in three different crisis periods Note: Vertical axis is the percentage change in bilateral, quarterly, exchange-rate adjusted cross-border bank flows, in millions of US dollars, explained by the respective model during each crisis period.

12. Contribution analysis Contribution of financial stress factors to cross-border bank flows to different emerging market regions during the current financial crisis Note: Vertical axis is the log of bilateral, quarterly, exchange-rate adjusted cross-border bank flows, in millions of US dollars, during the financial crisis of 2007-08.

13. Robustness checks • 1. Econometric Options • - Time effects • - IV estimator according Anderson/Hsiao (1981) • - Woolridge approach (2002)

14. More on robustness checks … • 2. Country specific risk factors: an extended analysis • - spread lending/deposit rate • - short-term foreign debt (in % of GDP) • - foreign reserves (in % of M2) • - current account balance (in % of GDP) • - real credit growth • 3. Regional sample estimations • 4. Crisis period estimations

15. Conclusions • Results robust to various specifications and methodologies. • Global as well as country specific factors (in both lender and borrower countries) contribute to the transmission of financial stress. • In the current crisis, global factors (stronger risk aversion, higher expected market volatility) made the largest contribution to reduction in cross-border flows. • Sound banking sector, fixed exchange rate regimes, high degree of financial integration helped stabilise bank lending to emerging Europe during the latest crisis.