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World Economic Outlook April 2009

World Economic Outlook April 2009. Chapter IV How Linkages Fuel The Fire: The Transmission of Financial Stress from Advanced Economies to Emerging Economies. Prepared by: Ravi Balakrishnan, Stephan Danninger, Selim Elekdag, and Irina Tytell with support from Stephanie Denis and Murad Omoev.

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World Economic Outlook April 2009

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  1. World Economic Outlook April 2009

  2. Chapter IVHow Linkages Fuel The Fire:The Transmission of Financial Stress from Advanced Economies to Emerging Economies Prepared by: Ravi Balakrishnan, Stephan Danninger, Selim Elekdag, and Irina Tytell with support from Stephanie Denis and Murad Omoev

  3. Unprecedented financial stress in advanced economies (GDP weighted number of countries with stress index one Stdev above trend) LTCM collapse October 1987 stock market crash Nikkei crash, DBL bankruptcy, and Scandinavian banking crisis US Corporate crisis Dot-com crash U.S. banking stress ERM Crisis Q1: 09

  4. Triggering a decline in capital flows to emerging economies New Issuances in billions of U.S. dollar1 1 Total of equity, syndicated loans, and international bond issuances

  5. Questions 1. How severe is financial stress in emerging economies (EMs)? 2. How strong is the transmission of financial stress from advanced to emerging economies? And what is the role of banking sector stress? 3. Can policies help mitigate stress transmission?

  6. Develop an EMC Financial Stress Index Financial stress index captures: • Exchange market pressure • Sovereign spreads • Banking sector β (relative performance of banking sector) • Stock market returns • Stock market volatility Index measures markets position relative to historical average Index robust to other weighting schemes

  7. EMC stress above Asian crisis and highly correlated with advanced country stress. Q1: 09

  8. EMC stress highly synchronized

  9. Commodity prices Vulnerabilities Global output Economic characteristics Global interest rates Disentangle stress transmission: global or country-specific effects? Financial Stress Emerging Economies Common factors Country-specific factors Financial linkages Trade linkages Advanced Economies Financial Stress

  10. Financial stress transmission to emerging economies is large but varied Mean co-movement (ßi)

  11. Bank linkages drove transmission in 2008(Western Europe and emerging Europe) Bank Lending Liabilities to Advanced Economy Banks as of 2007 (percent of emerging economies’ GDP) Portfolio Exposure to Advanced Economies as of 2007 (percent of emerging economies’ GDP) Emerging Asia Emerging Europe CIS and Russia Latin America Emerging Asia Emerging Europe CIS and Russia Latin America MENA Africa MENA Africa

  12. During global stress good domestic policies offer little insulation Change in Emerging Economies’ Financial Stress, 1997–2008 Emerging economies’ FSI Contributions from: Advanced economies’ FSI Global Factors Openness Current account balance Fiscal balance Foreign reserves Residual 2

  13. Case study: after banking crises capital flows recover only slowly U.S. banking sector stress of the 1980s • Capital flows to Latin America Japanese Banking crisis of the 1990s • Capital flows to Emerging Asia Both cases illustrate a long and protracted withdrawal from EMs by the advanced economy banks concerned

  14. U.S. banks pulled out relatively more from all EMs after the 80s debt crisis Consolidated Bank Claims on Latin America (percent of destination region’s GDP) Consolidated Bank Claims on Emerging and Other Developing Economies (percent of destination region’s GDP)

  15. Japanese banks massively withdrew from East Asia in the late 1990s Japanese Bank Claims on East and Offshore Asia (percent of destination region’s GDP) Advanced Economy Bank Claims on East Asia (percent of destination region’s GDP)

  16. Key Findings • Financial stress in EMs surpassed peaks of Asian crises. • Financial stress transmits strongly and rapidly to EMs • About one-for-one response within 1-2 months. • Transmission higher with financial (and trade) links. • Bank lending linkages main channel in current crisis. • Recovery of capital flows likely slow. Past banking sector stress led to protracted decline in capital flows to EMs. • During a global crisis, higher fiscal and current account balances offer little insulation.

  17. Policy Message • Strong and rapid stress transmission and little protection through strong domestic policies argue for coordinated policy action against global crisis. • Avoid second round of deleveraging: official support for EMs, clean-up of bank balance sheets in advanced economies, enhanced coordination between home and host supervisors. • Beyond near-term: improve multilateral financial support systems to reduce risks for EMs from global financial integration.

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