As the G-20 leaders meet in London, one graph should remind the representatives of these disparate countries of their shared interest in restoring the health of the financial systems of the developed countries.
Figure from Box 2 IMF.
What this graph shows is financial stress in the advanced economies leads to financial stress in the emerging markets.
The indices depicted were developed for individual countries and will be detailed in a chapter in the forthcoming* IMF World Economic Outlook (by Ravi Balakrishnan, Stephan Danninger, Selim Elekdag and Irina Tytell), to be released later in April. The advanced country financial stress indices (FSI) are a composite of banking sector, interbank spreads, term spreads (described in the October 2008 WEO, Chapter 4). Specifically:
- Banking sector: rolling 12-month covariance of the year-over-year percent change of a country’s banking sector equity index and its overall stock market index, divided by the rolling 12-month variance of the year-over-year percent change of the overall stock market index.
- TED spread: three-month LIBOR or commercial paper rate minus the government short term rate.
- Inverted term spread: government short term rate minus government long-term rate.
The emerging market FSI is constructed as a weighted average of the exchange market pressure index, sovereign spreads, the banking sector beta, stock returns, and time-varying stock return volatility.
The authors note that the pass through of financial stress from advanced countries to emerging markets is almost one-for-one. That being said:
there is significant cross-country variation. An empirical analysis of stress comovement shows that stronger financial (i.e., banking, portfolio, and FDI) linkages are associated with a higher stress pass-through from advanced to emerging economies. During the most recent crisis, bank lending linkages have been the main driver of stress transmission.
This characterization is obtained via a two-step procedure, as in Forbes and Chinn (2004). In the first step, the coefficient relating emerging market stress to advanced is obtained. These coefficients are then treated as data, in a regression on determinants such as FDI and banking linkages.
Another way of seeing the importance of, for instance, bank linkages is by inspecting the emerging market liabilities to advanced country banks:
Figure from Box 2 IMF.
In my view, large liabilities are important to the extent that bank deleveraging implies a long drawn out curtailment of credit to emerging markets. The IMF analysis observes:
Evidence from past episodes of systemic banking stress in advanced economies (Latin American debt crisis of the early 1980s and the Japanese banking crisis of the 1990s) implies that the decline in capital flows may be sizeable and drawn out. Given their large exposure, emerging European economies might be heavily affected, although EU membership offers some protection.
The complete analysis will come out in the next WEO.
* Full Disclosure: I was a consultant on this forthcoming chapter.