World Economic OutlookWorld Economic OutlookApril 2009April 2009

Chapter IVChapter IV

How Linkages Fuel The Fire:How Linkages Fuel The Fire:

The Transmission of Financial Stress The Transmission of Financial Stress from Advanced Economies to Emerging from Advanced Economies to Emerging

EconomiesEconomies

Prepared by:Prepared by:

Ravi Balakrishnan, Stephan Danninger, Selim Elekdag, and Irina TytellRavi Balakrishnan, Stephan Danninger, Selim Elekdag, and Irina Tytellwith support from Stephanie Denis and Murad Omoevwith support from Stephanie Denis and Murad Omoev

0.0

0.2

0.4

0.6

0.8

1.0

1981 85 89 93 97 2001 05

United States and Canada United Kingdom

Western Europe Japan and Australia

Unprecedented financial stress in Unprecedented financial stress in advanced economiesadvanced economies

U.S. banking stress

October 1987 stock market crash Nikkei crash, DBL

bankruptcy, and Scandinavian banking crisis

US Corporate crisis

ERM Crisis

Dot-com crash

LTCM collapse

(GDP weighted number of countries with stress index one Stdev above trend)

Q1: 09

0

20

40

60

80

100

120

140

160

180

200

2002-Q1 2003-Q1 2004-Q1 2005-Q1 2006-Q1 2007-Q1 2008-Q1 2009-Q1

Emerging Asia AfricaAsia EuropeMiddle East Western Hemisphere

Triggering a decline in capital flows Triggering a decline in capital flows to emerging economiesto emerging economies

New Issuances in billions of U.S. dollar1

1 Total of equity, syndicated loans, and international bond issuances

QuestionsQuestions

1.1. How severe is financial stress in emerging How severe is financial stress in emerging economies (EMs)? economies (EMs)?

2.2. How strong is the transmission of financial How strong is the transmission of financial stress from advanced to emerging economies? stress from advanced to emerging economies? And what is the role of banking sector stress?And what is the role of banking sector stress?

3.3. Can policies help mitigate stress transmission? Can policies help mitigate stress transmission?

Develop an Develop an EMC Financial Stress IndexEMC Financial Stress Index

Financial stress index captures:Financial stress index captures:

Exchange market pressureExchange market pressure Sovereign spreadsSovereign spreads Banking sector βBanking sector β (relative performance of banking sector)(relative performance of banking sector) Stock market returnsStock market returns Stock market volatilityStock market volatility

Index measures markets position relative to historical averageIndex measures markets position relative to historical average

Index robust to other weighting schemes Index robust to other weighting schemes

EMC stress above Asian crisis and highly EMC stress above Asian crisis and highly correlated with advanced country stress.correlated with advanced country stress.

-3

-2

-1

0

1

2

3

4

5

6

1996 97 98 99 2000 01 02 03 04 05 06 07-6

-4

-2

0

2

4

6

8

10

12Emerging economies (left scale)

Advanced economies (right scale)

Q1: 09

EMC stress highly synchronizedEMC stress highly synchronized

-4

-2

0

2

4

6

8

1997 99 2001 03 05 07 Q1: 09

Emerging Asia Latin America

Emerging Europe Other Emerging Economies

Disentangle stress transmission: Disentangle stress transmission: global or country-specific effects?global or country-specific effects?

Financial Stress

Emerging Economies

Advanced Economies

Financial Stress

Country-specific factors

Common factorsCommodity

pricesGlobal outputGlobal interest

rates

VulnerabilitiesEconomic

characteristicsFinancial linkagesTrade linkages

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

Ch

ina

Hu

ng

ary

Pa

kis

tan

Eg

yp

t

Arg

en

tin

a

Po

lan

d

Mo

roc

co

Th

aila

nd

Pe

ru

Bra

zil

Me

xic

o

So

uth

Afr

ica

Ma

lay

sia

Ph

ilip

pin

es

Ko

rea

Co

lom

bia

Ch

ile

Tu

rke

y

Financial stress transmission to Financial stress transmission to emerging economies is large but variedemerging economies is large but varied

Mean co-movement (ßi)

Bank linkages drove transmission in 2008Bank linkages drove transmission in 2008(Western Europe and emerging Europe)(Western Europe and emerging Europe)

0

10

20

30

40

50

60

Japan and Australia

Western Europe

United States and Canada

0

10

20

30

40

50

60Japan

Western Europe

United States and Canada

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)

Em

erg

ing

A

sia

Em

erg

ing

E

uro

pe

CIS

an

d

Ru

ssia

Lat

in

Am

eric

a

ME

NA

Afr

ica

Em

erg

ing

A

sia

Em

erg

ing

E

uro

pe

CIS

an

d

Ru

ssia

Lat

in

Am

eric

a

ME

NA

Afr

ica

-0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

Stress Calm

2

During global stress good domestic During global stress good domestic policies offer little insulationpolicies offer little insulation

Emerging economies’ FSI

Contributions from:

Advanced economies’ FSI

Global Factors

Openness

Current account balance

Fiscal balance

Foreign reserves

Residual

Change in Emerging Economies’ Financial Stress, Change in Emerging Economies’ Financial Stress, 1997–20081997–2008

Case study: after banking crises Case study: after banking crises capital flows recover only slowlycapital flows recover only slowly

U.S. banking sector stress of the 1980sU.S. banking sector stress of the 1980s Capital flows to Latin AmericaCapital flows to Latin America

Japanese Banking crisis of the 1990sJapanese Banking crisis of the 1990s Capital flows to Emerging AsiaCapital flows to Emerging Asia

Both cases illustrate a long and protracted Both cases illustrate a long and protracted withdrawal from EMs by the advanced economy withdrawal from EMs by the advanced economy banks concernedbanks concerned

U.S. banks pulled out relatively more U.S. banks pulled out relatively more from all EMs after the 80s debt crisisfrom all EMs after the 80s debt crisis

0

2

4

6

8

10

12

14

16

1983 84 85 86 87 88 89 90

Japan Western Europe

United Kingdom United States

0

2

4

6

8

10

12

14

16

1983 84 85 86 87 88 89 90

Japan United States

United Kingdom Western Europe

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)

Japanese banks massively withdrew Japanese banks massively withdrew from East Asia in the late 1990sfrom East Asia in the late 1990s

0

2

4

6

8

10

12

14

16

18

20

1993 95 97 99 2001 03 05 07

United States United Kingdom

European Banks Japan

0

25

50

75

100

125

150

175

200

1983 86 89 92 95 98 2001 04 07

0

1

2

3

4

5

6

7

8

9Offshore Asia (left scale)

East Asia (right scale)

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)

Key FindingsKey Findings Financial stress in EMs surpassed peaks of Asian crises.Financial stress in EMs surpassed peaks of Asian crises.

Financial stress transmits strongly and rapidly to EMsFinancial stress transmits strongly and rapidly to EMs About one-for-one response within 1-2 months.About one-for-one response within 1-2 months. Transmission higher with financial (and trade) links.Transmission higher with financial (and trade) links. Bank lending linkages main channel in current crisis.Bank lending linkages main channel in current crisis.

Recovery of capital flows likely slow. Past banking sector Recovery of capital flows likely slow. Past banking sector stress led to protracted decline in capital flows to EMs.stress led to protracted decline in capital flows to EMs.

During a global crisis, higher fiscal and current account During a global crisis, higher fiscal and current account balances offer little insulation.balances offer little insulation.

Policy MessagePolicy Message

Strong and rapid stress transmission and little protection Strong and rapid stress transmission and little protection through strong domestic policies argue for coordinated through strong domestic policies argue for coordinated policy action against global crisis.policy action against global crisis.

Avoid second round of deleveraging: official support for Avoid second round of deleveraging: official support for EMs, clean-up of bank balance sheets in advanced EMs, clean-up of bank balance sheets in advanced economies, enhanced coordination between home and economies, enhanced coordination between home and host supervisors.host supervisors.

Beyond near-term: improve multilateral financial support Beyond near-term: improve multilateral financial support systems to reduce risks for EMs from global financial systems to reduce risks for EMs from global financial integration.integration.