Financial Spillovers to Emerging Markets during the Global Financial Crisis

Abstract

Using data from the recent crisis, the authors analyze financial linkages between market liquidity and bank solvency measures in advanced economies and emerging market bond and stock markets. A multivariate generalized autoregressive conditional heteroskedasticity model is estimated to gauge the extent of co-movements of these financial variables across markets. The findings indicate that the notion of possible decoupling of financial markets had been misplaced. In fact, interlinkages between funding stress and equity markets in advanced economies and emerging market financial indicators were highly correlated, and have seen sharp increases during specific crisis moments.

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WP/09/104

Financial Spillovers to Emerging Markets During the
Global Financial Crisis

Nathaniel Frank and Heiko Hesse

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© 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
WP/09/104
IMF Working Paper

Monetary and Capital Markets Department

May 2009


Abstract

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: nathaniel.frank@nuffield.ox.ac.uk, hhesse2@imf.org

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.

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I. Introduction..........................................................................................................................3

II. Transmission of Spillovers to EM Countries During the Subprime Crisis: A Qualitative
Overview..............................................................................................................................5

III. Data......................................................................................................................................8

IV. Methodology......................................................................................................................12

V. Results................................................................................................................................13

VI. Conclusion.........................................................................................................................18

References................................................................................................................................19

Figures
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
Contents Page

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I. INTRODUCTION
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.

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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
to that.

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
Reinhart (2003).

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