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

Unprecedented financial stress in advanced 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

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

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?

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

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

EMC stress highly synchronized

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

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

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 MENAAfricaEmerging Asia Emerging Europe CIS and Russia Latin America MENAAfrica

2 During global stress good domestic policies 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, 1997–2008

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

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

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

Key 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 EMs Financial 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 stress led to protracted decline in capital flows to EMs. 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. During a global crisis, higher fiscal and current account balances offer little insulation.

Policy Message Strong and rapid stress transmission and little protection through strong domestic policies argue for coordinated policy action against global crisis. 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. 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. Beyond near-term: improve multilateral financial support systems to reduce risks for EMs from global financial integration.