Financial Spillovers to Emerging Markets During the
Global Financial Crisis
Nathaniel Frank and Heiko Hesse
© 2009 International Monetary Fund
Financial Spillovers to Emerging Markets during the Global Financial Crisis
Prepared by Nathaniel Frank and Heiko Hesse 1
Authorized for distribution by Laura Kodres
IMF Working Paper
Monetary and Capital Markets Department
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.
In this paper potential financial linkages between liquidity and bank solvency measures in
advanced economies and emerging market (EM) bond and stock markets are analyzed during
the latest crisis. A multivariate GARCH model is estimated in order to gauge
the extent of co-movements of these financial variables across markets. The findings indicate
that the notion of possible de-coupling (in the financial markets) had been misplaced. While
EM stock markets reached their peak in the last quarter of 2007, interlinkages between
funding stress and equity markets in advanced economies and EM financial indicators were
highly correlated and have seen sharp increases during specific crisis moments.
JEL Classification Numbers: C32, E44, G12
Keywords: Emerging Markets, Subprime Crisis, Liquidity, Solvency, GARCH
Author’s E-Mail Address: firstname.lastname@example.org, email@example.com
1 Nathaniel Frank is with the Oxford –Man Institute of Quantitative Finance and Nuffield College, University of
Oxford, and Heiko Hesse with the IMF. We thank Laura Kodres, Kevin Sheppard, and Brenda Gonzalez-
Hermosillo as well as conference participants at the Banque de France and Brunel University and seminar
participants at Bates College, the Bundesbank, Catholic University in Rio de Janeiro, Chinese Academy of Social
Sciences, Chinese University of Hong Kong, IMF and Oxford for suggestions and comments. Oksana Khadarina
provided excellent research assistance.
II. Transmission of Spillovers to EM Countries During the Subprime Crisis: A Qualitative
1. U.S. and EM Financial Variables ......................................................................................11
2. U.S. and EM Financial Variables ......................................................................................12
3. Implied Correlations between U.S. and EM Financial Variables......................................15
4. Implied Correlations between U.S. and EM Financial Variables......................................17
The recent crisis began in the United States with the bursting of the sub-prime mortgage
market and the unraveling of the securitization process in the summer of 2007, but it initially
did not fully affect emerging markets (EM). In this context, EM stock markets peaked around
November 2007, at a time when the repercussions of the crisis were already apparent in the
U.S. with central banks injecting liquidity into the interbanking markets and major financial
institutions announcing massive writedowns from structured financial products.
The Lehman collapse on September 15, 2008 is seen as a key event, both in advanced
economies but also EM countries, that unleashed a full-blown systemic crisis with global risk
aversion dramatically increasing, asset markets across countries and regions plunging and the
unwinding of carry trades that saw high-yielding EM currencies sharply depreciate within a
short period of time. Even EM countries with sound macroeconomic and financial pre-
conditions, built-up over the previous years, have been strongly affected by the financial
contagion that in late 2008 spilled over to the real sector with export and GDP growth rates
plunging and trade finance being contracting across the world.
This paper examines the financial interlinkages between advanced and EM countries by
focusing on the co-movements of a pertinent number of key financial variables. Specifically,
proxies for general stress in the interbanking market, market volatility and default risk of
major financial institutions in advanced economies are related to stock market, bond spreads
and CDS indices of some selected EM countries.
Since standard correlations are potentially biased when examining spillovers and the
potential for systemic risks to spread (Forbes and Rigobon, 2002), the Dynamic Conditional
Correlation (DCC) GARCH model by Engle (2002) is used to avoid many of the pitfalls.
This GARCH framework allows us to analyze the co-movement of markets by inferring the
correlations of the changes in the financial variables examined, which in turn is essential in
understanding whether the recent episode of financial distress has become systemic.
The main findings suggest that implied correlations between the U.S. Libor-OIS spread, a
proxy for funding illiquidity, and EMBI+ sovereign bond spreads of Asia, Europe, and Latin
American countries, sharply increase following the onset of the subprime crisis. In addition,
the Shanghai stock market correction in February 2007 led to a temporary spike of the
correlation measures, whereas the Lehman collapse caused the largest increase of co-
movements among these variables. Similarly, the relationship between the S&P 500 and the
EMBI+ regional bond spreads exhibits a potential break during the Chinese episode, after
which correlations increase from the beginning of the subprime crisis, and reach their peak
after the Lehman failure.
In terms of individual country interlinkages, the U.S. Libor spread is related to sovereign
bond and the sovereign CDS spreads of the EM countries Brazil, Russia, and Turkey, Mexico
and South Africa. As before, the Shanghai stock market correction in February 2007 is
evident, in addition to the beginnings of the subprime and the Lehman collapse. The Bear
Stearns rescue in March
2008 also becomes visible with co-movements sharply reversing their down-ward trend prior
Overall, the findings from the DCC GARCH models indicate that the notion of possible de-
coupling (in the financial markets) had been misplaced. It is true that EM stock markets
reached their peak around November 2007, but interlinkages between funding stress and
equity markets in advanced economies and EM financial indicators were highly correlated
and have seen sharp increases during specific crisis moments. Given the interconnectedness
of global financial markets, investors' increase in global risk aversion from problems in
advanced economies rapidly spilled over into EM countries, as investors sought to pull out
from the latter countries and only invest into the safest and most liquid assets in their home
markets, such as fixed income securities.
The paper this related to the existing literature as follows. It builds upon Frank, Gonzalez-
Hermosillo and Hesse (2008) that analyze liquidity spillovers across asset markets in the
United States as well as in IMF (2008). This is also related to a very substantial literature on
spillovers and contagion that especially our-ished after the Asian Crisis. The identification of
channels of shock transmission across countries is, for instance, discussed in Dungey, Fry,
Gonzalez-Hermosillo and Martin (2005), Dornbusch, Park and Claessens (2000) and Pericoli
and Sbracia (2003). Beirne, Caporale, Schulze-Ghattas and Spagnolo (2008) examine
volatility spillovers from mature to EM countries and test for their changes during crisis
periods. Similarly, some other studies that jointly investigate spillovers of EM and mature
countries are Dungey, Fry, Gonzalez-Hermosillo and Martin (2006, 2007) and Kaminsky and
In this context, a large body of literature investigated conditional correlations during crisis
periods in order to examine any possible breaks in the underlying data. Examples besides
Forbes and Rigobon (2002) are King, Sentana, and Wadhwani (1994), King and Wadhwani
(1990) and Caporale, Cippollini, and Spagnolo (2005). Investors' risk appetite can rapidly
change during financial crises when suddenly nonrelated asset markets feel the impact by
seemingly unrelated financial shocks. Gonzalez-Hermosillo (2008) and Coudert and Gex
(2007) are some papers that study its importance during crises periods. Finally, some of the
theoretical foundations of contagion are studied by Kodres and Pritzker (2002).
This paper makes several important contributions to the emerging literature on financial
spillovers during the current global financial crisis. It examines the daily co-movements
between key financial variables in advanced economies such as stress in the interbanking
market, market volatility and solvency concerns of large financial institutions with stock
market, bond spread and CDS measures in EM countries. The DCC framework takes time
varying volatility into account and addresses possible feedback effects since unidirectionality
is not imposed. Furthermore, our findings that end-February 2007 was a temporary period
where early signs of stress began to emerge in global markets prior to the time when the
subprime crisis was revealed in mid-2007 is consistent with The Federal Reserve Bank of
Dallas (2008), Gorton (2008) and Gonzalez-Hermosillo (2008) as well as IMF (2008).
The rest of the paper is organized as follows. Section II reviews some of the possible
transmission mechanism of spillovers to EM countries during the global financial crisis.
Section III details the data selection and Section IV discusses the empirical methodology.
Section V examines the main results whilst Section VII concludes.
II. TRANSMISSION OF SPILLOVERS TO EM COUNTRIES DURING THE SUBPRIME CRISIS: A
This section examines the role of global market conditions in the current financial crisis and
argues that the Lehman collapse on September 15, 2008, was a key event that led to rapid
spillovers to emerging market countries. The event sharply increased uncertainty across
markets as well as caused a scramble for U.S. dollars with the break-down of the carry trade
and the need for financial institutions to refinance U.S. dollar positions. First, a brief
overview of the different financial linkages across asset markets in the United States during
the crisis is provided, before discussing some of the financial spillovers to EM countries.
The subprime crisis that began in the summer of 2007, was triggered by deteriorating quality
of U.S. subprime mortgages, a credit, rather than a liquidity event.2 This rapidly propagated
across different asset classes and financial markets. Increased delinquencies on subprime
mortgages, driven by rising interest rates for refinancing and falling house prices, resulted in
uncertainty surrounding the value of a number of structured credit products which had these
assets in their underlying portfolios. As a result, rating agencies downgraded many of the
related securities and announced changes in their methodologies for rating such products.
Meanwhile, structured credit mortgage-backed instruments measured by the ABS indices
(ABX) saw rapid declines, and the liquidity for initially tradable securities in their respective
secondary markets evaporated. The losses, downgrades, and changes in methodologies
shattered investors' confidence in the rating agencies' abilities to evaluate risks of complex
securities, a result of which, investors pulled back from structured products in general.
2 See Kifi and Mills (2008) and Dell'Ariccia, Igan and Laeven (2008) for details on the structure of the U.S.
subprime mortgage market and the deterioration of lending standards.
It soon became apparent that a wide range of different financial institutions had exposures to
many of these mortgage-backed securities, often off-balance sheet entities such as conduits
or structured investment vehicles (SIVs).3 Due to the increasing uncertainty with regard to
their exposure to and the value of the underlying mortgage-backed securities, investors
became unwilling to roll over the corresponding ABCP. As the problems with SIVs and
conduits deepened, banks came under increasing pressure to rescue those that they had
sponsored by providing liquidity or by taking their respective assets onto their own balance
sheets. As a result, the balance sheets of those financial institutions were particularly strained
by this reabsorption, which in addition was amplified by losses due to declining asset values.
Consequently, the level of interbank lending declined both for reasons of liquidity and credit
risk and a run for “liquidity” occurred.4 With the evaporation of liquidity in many asset-
backed mortgage securities, in particular in the United States initially, liquidity spirals
occurred where both market and funding liquidity became significantly impaired and
mutually reinforcing (GFSR, 2008; Brunnermeier, 2007). While the Libor-OIS spread, a
proxy for stress in the interbank money markets, widened during the on- set of the crisis and
under the influence of end-of-year effects in December 2007, the Lehman Brothers collapse
exposed the interbank market to even more counterparty and liquidity risk, leading market
participants to globally withdraw from these market segments. Following this event, the
failure of counterparties to honor the delivery of US Treasuries in repo transactions due to
inability or unwillingness drastically soared showing even more stress in funding markets.5
With interbank markets across various advanced economies becoming dysfunctional in early
August 2007, there was clear evidence of a run for “quality” by investors. For example the
price of gold, which is regarded as a storage of value during times of financial turbulence,
rose from $660 per ounce in August 2007 to $1002 around the Bear Stearns rescue by JP
Morgan and the Fed's announcement of the Primary Credit Dealer Facility on
March 16, 2008, after which the gold spot price dropped 10% in a short time.6 In addition,
there was a strong demand for 10-year US Treasuries as a ‘safe’ haven, and accordingly,
yields almost halved between the beginning of the crisis and the Bear Stearns and Lehman
3 The SIVs or conduits were funded through the issuance of short-term asset-backed commercial paper (ABCP)
in order to take advantage of a yield differential resulting in a maturity mismatch.
4 The former is based on a prudency motive whereby banks hoarded liquid assets in order to insure themselves
against contingent liabilities. In contrast, the latter was due to uncertainty with regard to the mortgage exposure
of counterparties and the inability to value their respective assets.
5 This indicated that despite the higher supply of US Treasuries, market participants had very high demand for
US Treasury collateral and were very concerned about counterparty risk, even though governments had
implemented a systematic response by re-capitalizing major financial institutions and guaranteeing liabilities of
6 The bankruptcy of Lehman Brothers saw the gold price soar over 20% within a few weeks, as global risk
appetite dramatically deteriorated and precipitated a run for quality across asset classes and markets.
Brothers episodes. The frequency of deviations from the usual bid/ask pattern of the 10-year
US Treasuries also increased.
As turbulence related to the U.S. subprime mortgages heightened, financial markets more
generally showed signs of stress, as investor preference moved away from complex
structured products in a flight to quality and liquidity, and global investors' risk appetite
sharply decreased due to a widespread re-pricing of risk (see Gonzalez-Hermosillo, 2008).
Volatility in various asset classes was affected, mirroring the widening of the Libor-OIS
spread. For instance, a structural break in the VIX index since the Lehman collapse is
apparent, with other implied volatility equity indices also revealing similar patterns. An
inspection of the at-the-money implied volatility of major financial institutions shows a very
close co-movement with their respective CDS spreads.7
Furthermore, hedge funds that held asset-backed securities and other structured products
were burdened by increased margin requirements, driven in turn by greater market volatility.
As a consequence, they attempted to offload the more liquid parts of their portfolios in order
to meet these margin calls and also respond to redemptions by investors. As argued by
Khadani and Lo (2007), quantitatively driven hedge funds were especially engaged in
liquidation sales across different asset classes, thus leading to a transmission of market stress
in the beginning of the subprime crisis. As a result, trading volumes and numbers of trades in
both the bond and the stock markets in the developed and emerging countries increased
markedly, whilst the liquidity surrounding structured investments evaporated.
Volatility also spilled over into the foreign currency markets with the carry trades starting to
rapidly unwind at the end of September 2008, whereby this breakdown was reflected by the
implied volatilities of major EM currencies. High-yielding and previous investment
currencies saw large depreciations against the U.S. dollar, while funding currencies such as
the Japanese yen benefited by a repatriation of funds into Japan. There was a scramble for
U.S. dollars, which was reflected in the higher volatility of the euro-U.S. Dollar swap rates.
Relatedly, during the crisis there has been increasing divergence from the assumption of
covered interest rate parity (CIRP). This relationship postulates that the currency forward
premium equals the interest rate differentials of the home and foreign interest rate, such that a
violation would imply possible arbitrage opportunities. The daily deviations from the CIRP
jumped at the time of the Bear Stearns rescue, and then completely broke down for various
EM currencies after Lehman's bankruptcy.
EM countries were less affected during the initial stages of the subprime crisis than advanced
economies, as for example EM equity markets peaked in November 2007. But the
persistence of the market dislocations, the deterioration of economic fundamentals in
7 Humps occur at the time of the Bear Stearns rescue by JP Morgan in March 2008, during the Fannie and
Freddy bailout by the U.S. government in mid-July 2008 and around the time of Lehman's bankruptcy.
advanced economies and rising global risk aversion significantly affected EM countries by
late 2008. In particular, flows to EM equity and debt mutual funds turned negative. Total
foreign assets held by the former peaked in November 2007, but investments in the
equivalent EM debt mutual funds began to fall rapidly beginning in September 2008,
driven by the sharp fall in global risk appetite after the Lehman collapse and fear that EM
economies would be affected by the looming recession in advanced economies. Equity
markets in EM countries saw their gains from the previous boom years wiped out in a short
period of time. Relatedly, while EM corporate spreads (over treasuries) gradually began to
increase following the onset of the subprime crisis, they escalated sharply across the various
EM regions after the Lehman bankruptcy. Similar behavior can be observed for the cost of
corporate credit, especially for high-yield bonds, in the U.S. and Europe. Sovereign spreads
and the costs of insuring against a sovereign default, CDS, soared across a wide range of EM
countries as portfolio outflows and a flight to quality accelerated.
EM countries with large current account deficits and whose banks prior to the crisis have
been most reliant on foreign wholesale funding have been affected the most by the
ramifications of the financial crisis. For instance, the IMF provided substantial financial
support to the Ukraine and Hungary (October 2008), Pakistan (November 2008) and Latvia
(December 2008). EM countries such as South Korea and Russia which had built up large
foreign reserves prior to the crisis increasingly had to employ these in order to stem the
currency depreciation pressures arising from an unwinding of portfolio positions and capital
flight as well as severe strains in their banking sectors.
Initial financial spillovers to EM countries quickly morphed into real sector problems,
whereby economies reliant on declining demand and available trade finance saw their
domestic industrial production and GDP growth rates plunging. In order to counteract the
looming adverse real sector impacts as well as to provide liquidity and credit support to the
domestic banking systems, large fiscal stimulus plans were implemented, such as in China
for over $500 billion in November 2008.
Interestingly, emerging market equity, fixed income and currency markets already saw a
sharp sell-off in February 2007, a relatively short-lived episode, but it revealed how fast and
broad-based a worldwide reappraisal of risk and flight to quality can occur. Starting in late-
February 2007, there was a significant correction in the Shanghai stock market due to an
unwinding of large long equity positions. This reverberated across emerging and mature
markets. At the same time, the price of the ABX (BBB) index (based on CDS written on
subprime mortgages, investment grade tranche) began to decline whilst the outlook on the
U.S. housing market worsened further (see also GFSR (2007)). In particular, carry trades in
high-yielding currencies such as in Brazil, South Africa and Turkey, were rapidly unwound,
causing them to decline and the yen to appreciate. In addition, implied volatilities across a
range of other asset markets, notably fixed-income and equity, sharply increased and stock
markets in previously booming economies such as China, Malaysia, Philippines or Turkey
observed the largest declines. The fall in global risk appetite was broad-based without much
differentiation across regions. Compared to equity markets, sovereign spreads across EM
countries did move in tandem with the general market direction but were less affected.
In the following section our approach to examine the financial interlinkages between
advanced and EM countries during the global financial crisis is presented. In this context, we
focus on the co-movements of a number of pertinent key financial variables such as equity
market and sovereign spreads in EM economies.
As mentioned above, in this paper, we use the daily 3-month US dollar Libor-overnight index
swap (OIS) spread as a measure for bank funding liquidity and general stress in the interbank
money market.8 With the onset of the subprime crisis in the summer of 2007, this market
segment exhibited severe dislocation. In addition, S&P 500 stock market returns are included
in the reduced form model, controlling for common shocks. Moreover, the variance serves as
a proxy for market volatility.
As a measure of the default risk of large complex financial institutions, we use the average
credit default swap spread (CDS) of a number of banks, namely those of Citigroup, Bank of
America, JP Morgan, Wachovia, Merill Lynch, Morgan Stanley, Goldman Sachs, Lehman
Brothers, HSBC, Royal Bank of Scotland, UBS and Deutsche Bank.9,10 Regarding EM
financial variables, EMBI+ spreads for the regions Latin America (LAC), Europe and Asia
are used as a measure of their respective sovereign risks. In terms of individual countries, we
analyze the potential financial-to-financial spillovers to prominent emerging market countries
with open capital accounts which have seen a significant impact due to the financial crisis.
Amongst these are Brazil, Russia, Turkey as well as Mexico and South Africa. We also relate
the advanced economy indicators such as the Libor spread and stock market returns to the
CDS spreads in Brazil, Russia and Turkey. This allows us to analyze co-movements between
default measures of sovereign risk in EM countries and financial stress in advanced
8 Funding liquidity refers to the availability of funds such that a solvent agent is able to borrow in the market in
order to service his obligations.
9 After the Lehman Brothers collapse, we use the average CDS values for Goldman Sachs, Merrill Lynch and
Morgan Stanley for the Lehman Brothers time series data.
10 Note also that market-traded prices such as CDS spreads contain a liquidity risk component—the risk that an
investor may or may not be able to trade at a price close to the last traded price.Such risks rise during periods of
The data sample encompasses January 3rd 2003 until December 31st 2008. We conduct unit
root tests for the crisis period and formally identify nonstationarity in the data. Therefore,
first differences of the spreads are taken, such that they can be applied to the estimation
framework set out below.
As previously argued, the three main indicators capturing financial stress in the U.S. and
other advanced economies are provided in Figure 1. Funding liquidity pressures in the
interbank market, as measured by the Libor-OIS spread, were negligible prior to the
subprime crisis, after which this proxy drastically increased in late July 2007. Following
central bank interventions in mid August, the Libor spread subsided somewhat before
widening again sharply, driven in part by end-of-year effects as well as by increased losses
and writedowns of major financial institutions. In the run-up to the Bear Stearns rescue,
heightened funding liquidity pressure again became evident, and finally, the Lehman failure
led to an almost breakdown of the interbank money market with a massive dollar shortage
and with margins and haircuts rising across the board, as well as a sharp increase in
The S&P 500 peaked in October 2007 but has seen temporary corrections during the
Shanghai stock market crash in late February 2007 as well as in the beginning of the
subprime market turmoil in July 2007. Sharp falls occurred during January 2008 with
financial institutions announcing new writedowns and losses, before the Bear Stearns rescue
in March and after the Lehman collapse in September 2008. Meanwhile, the CDS measure of
LCFIs is characterized by the two spikes, namely during the Bearn Stearns rescue as well as
the Lehman bankruptcy.
Figure 1. U.S. and EM Financial Variables
Source : Bloomberg L.P.
The financial variables for the emerging markets are briefly discussed below. While the
regional EMBI+ spreads for Asia and LAC have remained elevated relative to those of
Europe, between 2003 and 2006 convergence to historically low levels has been observed.
With the onset of the subprime crisis, some moderate widening occurred. Following the
Lehman bankruptcy, global risk aversion sharply increased across asset classes and the
regional EMBI+ spreads jumped to over 800 basis points in late October 2008. Since then
some tightening has been recorded but spreads still remained at very high levels compared to
the pre-subprime period.
EMBI+ and CDS spreads for individual countries such as Brazil, Russia and Turkey exhibit
similar patterns of being compressed before the subprime crisis and then suffering increasing
widening whilst the crisis period unfolded. Stock markets in these countries continued their
upward trend well into 2007 and 2008 with Turkey peaking in October 2007 and Brazil and
Russia in May 2008, before the contagious reversal thereafter. During the financial crisis,
these markets appear to move increasingly in tandem as events unfold in advanced
economies. While relatively small compared to post-Lehman movements, these equity
markets were also affected by the brief Shanghai stock market correction in February 2007,
which resulted in temporary large drops in these equity indices. Finally, it is shown in
Figure 2 that the bond and CDS spreads, as well as equity markets in Mexico and South
Africa follow similar price dynamics compared to those outlined above.
Figure 2. U.S. and EM Financial Variables
Source : Bloomberg L.P.
We use a multivariate GARCH framework for the estimation, which allows for
heteroskedasticity of the data and a time-varying correlation in the conditional variance.
Specifically, the Dynamic Conditional Correlation (DCC) specification by Engle (2002) is
adopted, which provides a generalization of the Constant Conditional Correlation (CCC)
model by Bollerslev (1990).11 These econometric techniques allow us to analyze the co-
movement of markets by inferring the correlations of the changes in the spreads discussed
above, which in turn is essential in understanding whether the recent episode of financial
distress has become systemic.
The DCC model is estimated in a three-stage procedure. Let rt denote an n x 1 vector of asset
returns, exhibiting a mean of zero and the following time-varying covariance:
Here, Rt is made up from the time dependent correlations and Dt is defined as a diagonal
matrix comprised of the standard deviations implied by the estimation of univariate GARCH
models, which are computed separately, whereby the ith element is denoted as
it h . In other
words in this first stage of the DCC estimation, we fit univariate GARCH models for each of
the five variables in the specification. In the second stage, the intercept parameters are
obtained from the transformed asset returns and finally in the third stage, the coefficients
governing the dynamics of the conditional correlations are estimated. Overall, the DCC
model is characterized by the following set of equations (see Engle, 2002, for details):
Here, S is defined as the unconditional correlation matrix of the residuals εt of the asset
returns rt. As defined above, Rt is the time varying correlation matrix and is a function of Qt,
which is the covariance matrix. In the matrix Qt,ι is a vector of ones, A and B are square,
symmetric and is the Hadamard product. Finally, λi is a weight parameter with the
11 Given the high volatility movements during the recent financial crisis, the assumption of constant conditional
correlation among the variables in the CCC model is not very realistic especially in times of stress where
correlations can rapidly change. Therefore, the DCC model is a better choice since correlations are time-
squared lagged asset returns. The estimation framework is the same as in Frank, Gonzalez-
Hermosillo and Hesse (2008).
declining over time, while κ i is the parameter associated with the
The findings in this paper suggest that the implied correlations between the 3-month US
Libor-OIS spread and EMBI+ bond spreads of Asia, Europe and LAC sharply increase after
the subprime crisis (left column of Figure 3). In addition, the China stock market correction
in late February 2007 led to a temporary spike of the correlation measures from 0.20 to
almost 0.50. The Lehman collapse caused the largest increase of co-movements between
these variables. In terms of regional differences, the Asian EMBI+ spread exhibits the largest
correlation for the pre-subprime crisis with some exceptions, followed by Europe and LAC.
All regional spread's co-movements jump up around the China stock market burst in similar
magnitude and move closely during the subprime period. Interestingly, the correlation for the
LAC EMBI+ spread exhibits the greatest rise immediately following the Lehman failure,
compared to those of the other regions.
These results are mirrored in the other multivariate GARCH specifications for the EMBI+
spreads. The relationship between changes in the S&P 500 and the EMBI regional bond
spreads abruptly changes during the Shanghai stock market correction with correlation
magnitudes moving to almost -0.60. Subsequently, the degree of co-movement remains
elevated following the beginning of the subprime crisis and peaks in September 2008. In
terms of regional differences, it appears that the interlinkages between the S&P 500 and the
EMBI spread for LAC dominate the other regional spreads. In addition, the relationship
between the CDS default risk measure and the regional bond spreads highlights a substantial
and persistent increase in correlations beginning in July 2007 and magnitudes remaining high
throughout the crisis period.
In the right column of Figure 3 we examine possible individual country interlinkages with the
Libor-OIS spread. Changes in this measure are related to sovereign bond and CDS spreads,
as well as with stock markets in Brazil, Russia and Turkey. As before, the China episode in
February 2007 is evident, such as market dislocations during the subprime crisis and the
Lehman collapse. The Bear Stearns rescue in March 2008 also becomes visible with co-
movements sharply reversing their downward trend prior to that. Brazil has the largest
correlation for the bond spread, CDS and stock market volatility measures during the crisis
period. This potentially can be attributed to the fact that Brazil has a very open capital
account and has witnessed a dramatic increase in bond risk premia coupled with large foreign
equity outflows precipitating a plunge in the domestic equity market, despite obtaining an
investment grade rating in 2008. Given the relative liquidity of foreign bond and equity
markets in Brazil, mutual and hedge funds were able to unwind these positions to cover their
domestic losses (or margin calls in some cases).
Figure 3. Implied Correlations between U.S. and EM Financial Variables
Source: Own calculations.
Above, the correlations between the U.S. Libor-OIS spread, a proxy for funding liquidity
stress, and bond risk premia and equity market volatility in Brazil, Russia, and Turkey were
quantified. In what follows, we extend this analysis to include CDS changes for LFCIs
during the recent crisis period. In the left column of Figure 4 spikes in the correlation
patterns are less pronounced than in the case of the Libor-OIS spread. Simlutaneously, the
co-movement among the CDS measures is highly persistent suggesting that both liquidity
and solvency aspects were central in explaining financial market spillovers.
Finally, the DCC GARCH analysis is extended to the countries Mexico and South Africa.
Results in the right column of Figure 4 indicate similarities to the findings from Brazil,
Russia and Turkey with co-movements significantly increasing during the subprime crisis
period, while providing some evidence that the China stock market correction also led to
temporally higher correlations. As expected and given the proximity of Mexico to the United
States, co-movements of the Mexican financial variables are more pronounced with the
proxies for stress in the interbanking market, stock market volatility as well as default risk
than of South Africa.
Overall, the findings from the DCC GARCH models indicate that the notion of possible de-
coupling (in the financial markets) had been misplaced. Despite EM stock markets reaching
their peak in November 2007, interlinkages between funding stress and equity markets in
advanced economies and EM financial indicators became highly correlated and have seen
sharp increases during specific crisis moments. Given the interconnectedness of global
financial markets, investors' increase in global risk aversion from problems in advanced
economies rapidly spilled over into EM countries, as funds were pulled out from the latter
and subsequently invested into the safest and most liquid assets such as mature market fixed
In addition, co-movements between funding stress and bank default risk (proxied by the CDS
measure) in advanced economies with bond spreads as well as stock market returns in EM
countries have been fairly similar in terms of their magnitudes during the financial crisis. As
a result, we believe that these factors are important when analyzing potential financial market
Figure 4. Implied Correlations between U.S. and EM Financial Variables
Source: Own calculations
In this paper the interaction between liquidity and bank solvency measures with stock, bond
and credit markets in EM economies is analyzed during the Global Financial Crisis. A
multivariate GARCH model is estimated in order to quantify the extent of co-movement of
these financial variables across markets. We find that during the recent period of financial
turbulence both the Libor-OIS spread, a proxy of interbank money market pressure, and
the CDS spread, a measure of bank solvency, became more correlated with EM bond, stock
and credit markets. These relationships become especially apparent during the Shanghai
stock market correction, the beginning of the subprime crisis in summer 2007, the Bear
Stearns rescue and the Lehman Brothers bankruptcy. As a result, we provide evidence that
the notion of possible decoupling of financial markets has been misplaced.
In this paper, we did not analyze the exact causal relationships among the financial variables
in advanced as well EM countries. With daily high-frequency data, there are likely to be
significant feedback loops that can affect the causal relationships. We reserve this topic for
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