The financial turmoil that started in the summer of 2007 mutated into a full-blown global crisis. The world economy has experienced a major downturn associated with one of the most severe episodes of financial stress witnessed in decades. While an episode of financial stress encompasses turbulent periods—such as the recent crisis—it also includes related events that only result in asset price corrections, which on occasion may be linked to banking distress. This article briefly surveys recent IMF research related to financial stress across both advanced and emerging economies.
Few would disagree that recent global downturn is closely tied with one of the most severe episodes of financial stress since the 1930s. The financial crisis that first erupted with the U.S. subprime mortgage collapse in August 2007 has deepened further, and has been felt across the global financial system, including in emerging markets to an increasing extent. While an episode of financial stress includes the recent crisis, for the purposes of this survey, related topics such as asset price booms and busts, banking crises, contagion, and policies to expedite rapid recoveries will also be discussed.
Motivated by the recent crisis, a natural starting point is to discuss the links between financial cycles and business cycles in advanced economies. Claessens, Kose, and Terrones (2008) examine the relationship between fluctuations in credit, stock and house prices, and the business cycle. Their main finding is that recessions associated with credit crunches and house prices tend to be deeper and longer than other recessions. Related studies focusing on credit booms find evidence supporting their conclusion. For example, as noted by Terrones (2007), although rapid credit expansion is associated with financial deepening or favorable external financing conditions, it also raises concerns because of the role of excessive credit expansion in some financial crises (Mendoza and Terrones, 2008). Turning to assets prices, Cardarelli, Igan, and Rebucci (2008) draw attention to the close ties between house prices, stock prices, and economic cycles.
Although the studies cited above discuss the linkages between financial variables and the business cycle, they do not pay much attention to the role of the banking system. However, as emphasized in Cardarelli, Elekdag, and Lall (forthcoming), episodes of financial turmoil characterized by banking sector distress are more likely to be associated with more severe and more protracted downturns than other types of episodes. These authors also find that the likelihood that financial stress will be followed by a downturn appears to be associated with the extent to which house prices and aggregate credit rise in the period before the financial stress. Moreover, greater reliance on external financing by households and nonfinancial firms is associated with sharper downturns in the aftermath of financial stress. In other words, banking system distress combined with highly levered balance sheets throughout the economy tend to be associated with the longest and deepest recessions.
The role of banking systems is also highlighted by Dell'Ariccia, Detragiache, and Rajan (2008). Using disaggregated data, they find evidence that banking crises have an exogenous detrimental effect on real activity, and that sectors more dependent on external finance tend to perform relatively worse during such episodes of banking distress. Another study by Lall, Cardarelli, and Elekdag (2008) emphasizes the links between financial systems and real activity. They find that countries with more arm's-length financial systems seem particularly vulnerable to sharp contractions in economic activity, because of the greater procyclicality of leverage in their banking systems.
With much higher levels of global financial integration, it should come as little surprise that financial stress has been transmitted forcefully from advanced to emerging economies. In fact, this is the main theme in a study by Balakrishnan and others (2009), which notes that stress transmission is stronger to those emerging economies with tighter financial links to advanced economies—in the recent crisis, bank lending ties appear to have been particularly important. Also, as in other papers, the findings suggests that emerging economies obtain some protection against financial stress from lower current account and fiscal deficits and higher foreign reserves during calm periods in advanced economies. However, during periods of widespread financial stress in advanced economies, lower current account and fiscal deficits and higher foreign reserves cannot prevent its transmission, although they may limit the implications of financial stress for the real economy (for example, reserves can be used to buffer the effects from a drop in capital inflows).
While there are many channels through which financial stress can be transmitted across countries, the studies surveyed here focus on the common lender channel, herding behavior, and contagion. To start, consider financial interlinkages owing to cross-border bank lending. Árvai, Driessen, and Ötker-Robe (2009) take a regional perspective and underscore that a major source of vulnerability stems from deep banking linkages where banks in eastern and central Europe have become increasingly dependent on a concentrated set of parent banks in western Europe.
Further evidence on financial exposure and the common lender channel is presented in a study by Broner, Gelos, and Reinhart (2006) on international mutual fund behavior. Specifically, they argue that when the returns of a particular country-specific investment are relatively low, then the weight of all underperforming country-specific investments is reduced. Therefore, it is possible that a shock in one country implies a retrenchment of capital from many seemingly unrelated countries. This is related to a second channel, in particular, herding behavior, which occurs in financial markets when traders base decisions on the actions of other traders, and not on the information to which they personally have access to (Cipriani, 2008). Lastly, Kannan and Koehler-Geib (forthcoming) highlight the role of uncertainty as a channel of contagion. More precisely, the incidence of “surprise” crisis causes investors to doubt the accuracy of their information on other countries, leading them to limit their exposures, thereby causing contagion effects.
The current level of advanced economy stress and the fact that it is rooted in systemic banking crises suggests that capital flows to emerging economies are likely to suffer large declines and will recover slowly, especially for banking-related flows (Balakrishnan and others, 2009). In this context, Cardarelli, Elekdag, and Kose (2009) examine the macroeconomic implications of and policy responses to surges in private capital inflows across a large group of emerging and advanced economies. The study identifies 109 episodes of large net private capital inflows to 52 countries over 1987–2007. The authors find that episodes of large capital inflows are often associated with real exchange rate appreciations and deteriorating current account balances. More importantly, these episodes of large capital inflows tend to be accompanied by an acceleration of GDP growth, but afterwards growth has often dropped significantly. After a comprehensive assessment of various policy responses to the large inflow episodes, the most robust result the authors find is that keeping public expenditure growth steady during episodes—rather than ratcheting up spending—can help currency appreciation and foster better macroeconomic outcomes in their aftermath.
As mentioned above, downturns associated with financial stress tend to be deeper and longer. While this seems to be an empirical regularity (as emphasized in Cardarelli, Elekdag, and Lall, forthcoming), it may be even more relevant for emerging economies. In fact, as discussed in Cerra and Saxena (2008), many emerging economies that experienced a crisis suffer from permanent losses in the level of output. A quick glance at a recent database of banking crises by Laeven and Valencia (2008) reveals a common theme for both advanced and emerging economies—banking-related financial stress seems to be associated with the most severe and protracted recessions.
Against this backdrop, what policies are most effective in facilitating a rapid recovery following episodes of financial stress? Terrones, Scott, and Kannan (2009) find that monetary policy has typically played an important role in ending recessions and strengthening recoveries. However, its effectiveness is weakened after recessions associated with financial stress. The same paper also concludes that fiscal stimulus seems to be helpful during recessions characterized by financial crises. Furthermore, with the condition that public debt is not too high, fiscal stimulus seems to be linked to stronger recoveries. In a related paper that focuses exclusively on fiscal policy, Spilimbergo and others (2008) argue that fiscal measures should tackle two key issues in parallel: first, measures to increase demand and restore confidence, and second—in line with the main topic of this review—measures to repair the financial system. One key attribute of policy they emphasize is that fiscal policy should be “contingent” in nature, because the need to reduce the perceived likelihood of another Great Depression requires a credible commitment to do more if needed.
ÁrvaiZsofiaKarlDriessen and InciÖtker-Robe2009“Regional Financial Interlinkages and Financial Contagion Within Europe,” IMF Working Paper 09/6.
BalakrishnanRaviStephanDanningerSelimElekdag and IrinaTytell2009“How Linkages Fuel the Fire: The Transmission of Stress from Advanced to Emerging Economies” World Economic OutlookApril (Washington: International Monetary Fund).
BronerFernando A.R. GastonGelos and Carmen M.Reinhart2006“When in Peril Retrench: Testing the Portfolio Channel of Contagion,”Journal of International EconomicsVol. 69No. 1 pp. 203–30.
CardarelliRobertoSelimElekdag and M. AyhanKose2009“Capital Inflows: Macroeconomic Implications and Policy Responses,” IMF Working Paper 09/40.
CardarelliRobertoSelimElekdag and SubirLallforthcoming, “Financial Stress, Downturns, and Recoveries,” IMF Working Paper.
CardarelliRobertoDenizIgan and AlessandroRebucci2008“The Changing Housing Cycle and the Implications for Monetary Policy” World Economic OutlookApril (Washington: International Monetary Fund) pp. 103–32.
CerraValerie and Sweta ChamanSaxena2008“Growth Dynamics: The Myth of Economic Recovery,”American Economic ReviewVol. 98No. 1 (March) pp. 439–57.
CiprianiMarco2008“Herding in Financial Markets,”IMF Research BulletinVol. 9No. 4 (December).
ClaessensStijnM. AyhanKose and Marco E.Terrones2008“What Happens During Recessions, Crunches, and Busts?” IMF Working Paper 08/274.
Dell'AricciaGiovanniEnricaDetragiache and RaghuramRajan2008“The Real Effect of Banking Crises,”Journal of Financial IntermediationVol. 17 pp. 89–110.
KannanPrakash and FritziKohler-Geibforthcoming, “The Uncertainty Channel of Contagion,” IMF Working Paper.
LaevenLuc and FabianValencia2008“Systemic Banking Crises: A New Database,” IMF Working Paper 08/224.
LallSubirRobertoCardarelli and SelimElekdag2008“Financial Stress and Economic Downturns,”World Economic OutlookOctober (Washington: International Monetary Fund) pp. 129–58.
MendozaEnrique and Marco E.Terrones2008“An Anatomy Of Credit Booms: Evidence From Macro Aggregates And Micro Data,” NBER Working Paper No. 14049 (Cambridge, Massachusetts: National Bureau of Economic Research).
SpilimbergoAntonioSteveSymanskyOlivierBlanchard and CarloCottarelli2008“Fiscal Policy for the Crisis,” IMF Staff Position Note 08/01.
TerronesMarco E.2007“What Do We Know About Credit Boom?”IMF Research BulletinVol. 8No. 2 (June).