International shocks and growth in emerging markets

The paper provides evidence on the extent and channels of transmission of international shocks on the economic growth of emerging markets. Using a block dynamic factor model, the shocks are decomposed into four components; a general global component, an activity based component, a financial component and a commodity price component. Using a sample of 75 emerging markets over the period 1992–2009, the paper finds that the average effect of international shocks on emerging markets' growth over the entire sample period is negligible, which supports the classic view of isolated, de-coupled emerging markets. However, there is considerable variation both over time, over cross-section and across factors. When we split our sample by time period, we find greater effect of the international factors on the emerging markets' growth during 2002–2009 period. There is evidence which suggests that sensitivity to international shocks has increased over time and at the country level these sensitivities are more pronounced. Although the drivers of integration vary as does the sensitivity to alternative sources of shocks, we find that certain emerging markets have become considerably more integrated with the global economy than others. Overall, there is evidence of a significant impact on the economic growth of some emerging markets of the international shock caused by the global financial crisis.     

Contagion in financial markets after September 11: myth or reality?

Major global events can lead to a change in the cross‐country correlation of assets. Using stock prices from 25 economies, we test whether the terrorist attack in the United States on September 11, 2001, resulted in a contagion—an increase in correlation across global financial markets. Unlike prior works on contagion, we model the intrinsic heteroskedasticity. Our results indicate that international stock markets, particularly in Europe, responded more closely to U.S. stock market shocks in the three to six months after the crisis than before. Our evidence suggests that the benefits of international diversification in times of crisis are substantially diminished.     

Granular institutional investors and global market interdependence

We study the propagation of global investment risk across markets through the granular view of institutional investors. Applying the conditional value-at-risk estimation to micro-level weekly observations of international mutual funds between 2003 and 2011, we find that idiosyncratic shocks to large institutional investors explain both aggregate market risk and cross-market risk interdependence. Conditional on the US capital markets being in financial distress, idiosyncratic shocks to the top 10% largest funds investing in the US explain about 40% of the risk fluctuations in other non-US markets. The findings are also economically and statistically significant for the top largest funds investing in non-US markets, with the effects becoming especially large during the global financial crisis of 2007–09. These results are robust after controlling for common risk factors and applying alternative measures of idiosyncratic shocks.     

Drivers of Exchange Rate Dynamics in Selected CIS Countries: Evidence from a Factor-Augmented Vector Autoregressive (FAVAR) Analysis

We investigate the likely sources of exchange rate dynamics in selected member countries of the Commonwealth of Independent States (CIS; Russia, Kazakhstan, Ukraine, Kyrgyzstan, Azerbaijan, and Moldova) over the past decade (1999-2010). Evidence is based on country VARs augmented by a regional common-factor structure (FAVAR model). The models include nominal exchange rates, the common factor of exchange rates in the CIS countries, and international drivers such as global trade, share prices, and oil price. Global, regional, and idiosyncratic shocks are identified in a standard Cholesky fashion. Their relevance for exchange rates is explored by a decomposition of the variance of forecast errors. The impact of global shocks on the development of exchange rates has increased, particularly if financial shocks are considered. Because of the recent global financial crisis, regional shocks have become more important at the expense of global shocks.     

Financial Frictions,Financial Shocks,and Aggregate Volatility

The Great Moderation was accompanied by an increase in financial volatility. We explore the sources of these divergent patterns in volatilities by estimating a model with time‐varying financial rigidities subject to structural breaks in the size of shocks, the monetary policy rule coefficients, and the average size of the financial rigidity. Institutional changes are key in accounting for the Great Moderation and in shaping the transmission mechanism of financial shocks. The increase in financial volatilities is accounted for by larger financial shocks, but the vulnerability of the economy to these shocks is significantly alleviated by the estimated changes in institutions.     

Liquidity risk and stock performance during the financial crisis

We investigate whether and how ex-ante liquidity risk affects realized stock returns during the global financial crisis of 2008–2009 in international equity markets. We find that stocks with higher pre-crisis return exposure to global market liquidity shocks experience larger price reductions during the crisis period. Our findings provide further insight into the comprehensive picture of the effect of liquidity risk on asset prices, especially in an international context and under different market conditions.     

Banking Globalization and Monetary Transmission

Globalization of banking raises questions about banks’ liquidity management, their response to liquidity shocks, and the potential for international shock propagation. We conjecture that global banks manage liquidity on a global scale, actively using cross‐border internal funding in response to local shocks. Having global operations insulates banks from changes in monetary policy, while banks without global operations are more affected by monetary policy than previously found. We provide direct evidence that internal capital markets are active in global banks and contribute to the international propagation of shocks. This feature was at play during the financial crisis of 2007–2009.     

Macroeconomic Shocks and Banks' Foreign Assets

Recent developments in international financial markets have highlighted the role of banks in the transmission of shocks across borders. We employ dynamic panel methods for a sample of OECD countries to analyze whether banks' foreign assets react to macroeconomic shocks at home and abroad. We find that banks reduce their foreign assets in response to a relative increase in domestic interest rates, and they increase their foreign assets when the growth rate of world energy prices rises. The responses are characterized by a temporal overshooting and a dynamic adjustment process that extends over several quarters.     

The Great Recession: US dynamics and spillovers to the world economy

This paper provides an empirical investigation of both the within-US and international channels of transmission of macroeconomic and financial shocks by means of a 50-country macroeconometric model (estimated over the 1980-2009 period), including measures of excess liquidity and financial fragility, specifically designed in order to evaluate the relevance of the boom-bust credit cycle view put forward as an interpretation of the recent “Great Recession” episode. We find that such a view is consistent with the empirical evidence. Moreover, concerning the real effects of financial shocks within the US, we detect stronger evidence of an asset prices channel, rather than a liquidity channel. Concerning the spillovers to the world economy, we find that while financial disturbances are transmitted to foreign countries through US house and stock price dynamics, as well as excess liquidity creation, the trade channel is the key trasmission mechanism of real shocks.     

Exchange Rate Changes and Inflation in Post‐Crisis Asian Economies: Vector Autoregression Analysis of the Exchange Rate Pass‐Through

Macro‐economic consequences of large currency depreciations among the crisis‐hit Asian economies varied from one country to another. Inflation did not soar after the Asian currency crisis of 1997–98 in most crisis‐hit countries except Indonesia where high inflation followed a very large nominal depreciation of the rupiah. The high inflation meant a loss of price competitive advantage, a key for economic recovery from a crisis. This paper examines the pass‐through effects of exchange rate changes on the domestic prices in the East Asian economies using a vector autoregression analysis. The main results are as follows: (i) the degree of exchange rate pass‐through to import prices was quite high in the crisis‐hit economies; (ii) the pass‐through to Consumer Price Index (CPI) was generally low, with a notable exception of Indonesia; and (iii) in Indonesia, both the impulse response of monetary policy variables to exchange rate shocks and that of CPI to monetary policy shocks were positive, large, and statistically significant. Thus, Indonesia's accommodative monetary policy, coupled with the high degree of CPI responsiveness to exchange rate changes was an important factor in the inflation‐depreciation spiral in the wake of the currency crisis.     

“Black Swans” before the “Black Swan” evidence from international LIBOR–OIS spreads

The LIBOR–OIS spread is a closely monitored indicator of the financial health of economy. Previous research has used this spread to identify and anticipate abrupt changes in financial markets. Taylor and Williams (2009) refer to the drastic increase in the US LIBOR–OIS spread on August 7th, 2007 as a “Black Swan” in the money market. In this paper, rather than rely on visual observations of “Black Swans” we estimate them using Bai and Perron’s (1998) procedure. We estimate structural breaks, Granger causality tests, and innovation accounting in international LIBOR–OIS spreads and a CDS index to better understand their dynamics during the recent crisis. Our results reveal that “Black Swans” appeared in smaller economies prior to that in large ones during the financial crisis. In addition, we find that only shocks to the US LIBOR–OIS spread has any statistically significant effects after 30 days.     

Financial Exposure and the International Transmission of Financial Shocks

This paper analyzes the transmission mechanism of banking sector shocks in an international real business cycle model with heterogeneous bank sizes. We examine to what extent the financial exposure of the banking sector affects the transmission of foreign banking sector shocks. In our model, the more exposed domestic banks are to the foreign economy via lending to foreign firms, the greater are the spillovers from foreign financial shocks to the home economy. The model highlights the role of openness to trade and the dynamics of the terms of trade in the international transmission mechanism of banking sector shocks: spillovers from foreign banking sector shocks are greater the more open the home economy is to trade and the less the terms of trade respond to foreign shocks.     

Foreign Direct Investment and Debt Financing in Emerging Economies

The rich dynamics of capital flows is an important characteristic of business cycles in emerging market economies. In the data external debt is always procyclical, while FDI is procyclical only in normal times. We provide a microfounded rationale for this pattern by linking financial shocks to capital flows. For this purpose, we build a small open economy model in which firms are subject to borrowing constraints, and are either owned domestically or by foreign investors who purchase firms through FDI. During a financial crisis, the valuation gap per unit net worth between foreign and domestic investors widens, which triggers more FDI inflow. Our model produces business cycle moments consistent with empirical observations.     

Foreign Bank Behavior during Financial Crises

This paper studies whether lending by foreign banks is affected by financial crises. We pair a bank‐level data set of foreign ownership with information on banking crises and examine whether the credit supply of majority foreign‐owned banks that underwent home‐country crises differ systematically from those of other foreign banks. In contrast to the literature, our broad global coverage allows us to exploit variations between foreign banks; this enables us to identify an average treatment effect directly attributable to crises. Our baseline results show that banks exposed to home‐country crises between 2007–08 exhibit changes in lending patterns that are lower by between 13% and 42% than their noncrisis counterparts. This finding is robust to potential alternative explanations, and also holds, though less strongly, for the 1997/98 Asian crisis.     

Bank Heterogeneity and Interest Rate Setting: What Lessons Have We Learned since Lehman Brothers?

A substantial literature has investigated the role of relationship lending in shielding borrowers from idiosyncratic shocks. Much less is known about how lending relationships and bank‐specific characteristics affect the functioning of the credit market in an economy‐wide crisis. We investigate how bank and bank–firm relationship characteristics have influenced interest rate setting since the collapse of Lehman Brothers. We find that interest rate spreads increased by less for those borrowers having closer lending relationships. Furthermore, firms borrowing from banks endowed with large capital and liquidity buffers and from banks engaged mainly in traditional lending were kept more insulated from the financial crisis.     

Credit Crunch and Downward Nominal Wage Rigidities

Through the lens of a DSGE model, I find that financial shocks in conjunction with downward nominal wage rigidities (DNWR) are important features in explaining the degree of asymmetry that U.S. business cycles exhibit. Financial shocks are constructed as residuals of the borrowing constraint faced by firms in a similar fashion to Jermann and Quadrini (2012). The effects of these shocks on aggregate quantity variables are amplified by DNWR, especially during the global financial crisis. Moreover, my model explains a large part of the upward shift in the labor wedge that occurred during this recession.     

Leverage Constraints and the International Transmission of Shocks

Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage‐constrained investors. In our model, without leverage constraints on investment, financial integration itself has no implication for international macro comovements. When leverage constraints bind, however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel that results in a positive comovement of production, independently of the size of international trade linkages. In addition, the paper shows that with binding leverage constraints, the type of financial integration is critical for international comovement. If international financial markets allow for trade only in noncontingent bonds, but not equities, then the international comovement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.     

International Propagation of the Credit Crisis: Lessons for Bank Regulation*

The authors use a large sample of non‐U.S. banks to examine the origins and spread of the 2007–2009 crisis. Using both stock market and structural variables, they test whether the effects of the crisis on individual banks are better explained by crisis models or by the VaR‐type analysis of the Basel system. The latter emphasizes risk weightings for individual assets while ignoring linkages that could leave banks exposed to systemic shocks. Consistent with crisis models, the authors find that a small set of pre‐crisis measures of a bank's international linkages, leverage, and the fragility of its liability structure does a good job of discriminating between banks that suffered a large impact and those that did not. (Indeed, these measures explain almost 50% of the differences among banks' stock returns during the crisis period, and almost 40% of the changes in the variability of those returns.) The authors also provide evidence of both a direct linkage among banks' stock returns and an indirect linkage that could reflect either linkages in the real economy or common demands by investors for liquidity. The authors run a “horse race” that demonstrates that simple measures of book leverage were better predictors of bank performance than the Basel capital ratios. They find that banks with lower Basel risk weightings prior to the crisis proved, on average, to be more exposed to the crisis. The authors' explanation is that banks with lower Basel risk measures tended to operate with higher leverage and more aggressive funding strategies, which in turn exposed them to greater crisis risk (even as they conformed to the letter of the Basel system in terms of asset risk measures). Finally, the authors find no evidence that substandard governance was a separate contributing factor to crisis exposure. Banks with substantial international business that were exposed to systemic shocks had high governance scores.     

Stock returns’ sensitivities to crisis shocks: Evidence from developed and emerging markets

We consider three “crisis shocks” related to key features of the 2007–2008 crisis, for emerging and developed economies: (1) the collapse of global trade, (2) the contraction of credit supply, and (3) selling pressure on firms’ equity. Using an international cross-section of firms, we find that returns’ sensitivities to these shocks imply large and statistically significant influences on residual equity returns during the crisis period (after controlling for normal risk factors that are associated with expected returns). Similar analysis for several placebo periods shows that these effects are generally less severe or absent in non-crisis periods. Relative to developed economies, emerging markets are more responsive to global trade conditions (in crisis and in placebo periods), but less responsive to selling pressures. An analysis of portfolios of firms during various placebo periods indicates that investors are not compensated for the risks associated with the crisis shocks. Finally, a month-by-month analysis of returns during the crisis period shows that the time variation of the importance of each of the sensitivities to shocks tracks related changes in the global economic environment.