IMF Survey: Rapid Spread of Crisis Reflects Close Global Economic Ties

IMF News, April 16, 2009

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By Stephan Danninger, Ravi Balakrishnan, Selim Elkdag, and Irina Tytell
IMF Research Department
April 16, 2009
Chapter 4 of the April 2009 World Economic Outlook (WEO): “How Linkages Fuel the Fire: The Transmission of Financial Stress from Advanced to Emerging Economies.”
New WEO economic forecasts scheduled for release April 22.

Emerging economies are so closely integrated with advanced economies that financial stress transmits rapidly and forcefully.
Financial stress in emerging economies reached unprecedented levels by end-2008 and on average surpassed levels seen during the Asian crisis.
Transmission from advanced to emerging economies is rapid, typically occurring within one or two months after advanced economies experience financial stress.
Stress in emerging economies moves almost one-for-one with stress in advanced economies, though there is significant cross-country variation.

Chapter presents a new financial stress index for emerging economies, building on a similar index introduced in the October 2008 WEO for advanced economies.
The new index measures intensity of stress in equity markets, exchange markets, and the banking sector.
Index coverage: 18 emerging economies on a monthly basis since 1997.
The index will be made available on the IMF website after the IMF Spring Meetings.

Financial linkages (banking, portfolio, and foreign direct investment) with advanced economies are a key channel of transmission.
Empirical analysis shows stronger pass-through of stress in emerging economies with closer financial linkages to advanced economies.
During the most recent crisis, bank lending linkages appear to have been the main driver of stress transmission.
By end-2007, Western European banks’ assets in emerging economies reached 10 percent of advanced-economy GDP, compared to a combined 2.5 percent of GDP for Canadian, Japanese, and U.S. banks.
Emerging Europe stands out as the main recipient of bank lending flows; foreign claims in terms of destination GDP are the highest among emerging regions.

Not all systemic financial crises in advanced economies have led to protracted reductions in capital flows to emerging economies, but historical evidence suggests a quick recovery may not be the most likely scenario this time.
The key role played by banks in the current crisis presages a drawn-out decline in capital flows to emerging economies.
Evidence from past episodes of systemic banking stress in advanced economies (the Latin American debt crisis of the early 1980s and the Japanese banking crisis of the 1990s) shows that the decline in capital flows tends to be sizeable and long lasting.
Given their large share of external financing through banks, a number of emerging European economies might be heavily affected by a drought of capital inflows.

The shock is too large to be dealt with on an individual basis; a coordinated policy response by advanced and emerging economies is required.
Elements of an effective coordinated response include:
- Access to external funding for emerging economies via official channels.
- Support for advanced economy banks with large presence in emerging economies.
- Coordination between home and host country financial supervisors.
Strengthening current account and fiscal balances can help during periods of global financial calm, but reducing country vulnerabilities alone cannot insulate emerging economies during a major global financial shock.
Policymakers should work toward strengthening multilateral insurance systems to allow emerging economies to reap the benefits of international integration while limiting risks from greater external financial integration.
The commitments to expand the IMF’s resources and the Fund’s new Flexible Credit Line and reformed conditionality framework should be helpful in this context.

Source: IMF Survey: Rapid Spread of Crisis Reflects Close Global Economic Ties (IMF Research Department, April 16, 2009)