2012 Spillover Report - Background Papers

This note conducts a business cycle accounting analysis for systemic economies, with an emphasis on spillover effects from macroeconomic versus financial shocks. The systemic economies under consideration are China, the Euro Area, Japan, the United Kingdom, and the United States. This analysis is based on historical decompositions of output growth derived from the estimated structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2012). Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages

Abstract

This note conducts a business cycle accounting analysis for systemic economies, with an emphasis on spillover effects from macroeconomic versus financial shocks. The systemic economies under consideration are China, the Euro Area, Japan, the United Kingdom, and the United States. This analysis is based on historical decompositions of output growth derived from the estimated structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2012). Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages

I. OVERVIEW

1. Correlation of Financial Market Asset Prices1

Both volatility of financial asset prices and correlations among them have risen since the start of the crisis. They remain high, suggesting that underlying financial market sentiment is dominated by global events, and international asset prices remain a potent source of global spillovers.

1. Financial markets and asset prices are key conduits of spillovers from one part of the world to another. Thus, it is useful to examine recent behavior of financial asset prices—in particular their volatility and the correlations across assets—to ascertain whether conditions have started to normalize.

2. US asset prices are taken to be the canonical prices and are compared with price changes in about 30 other advanced and emerging markets, given the size of the domestic markets. Replacing US with German asset prices, which could be considered as more appropriate for periods of Euro area problems, produced similar results. Accordingly, the assets considered are: the yield on the US 10 year Treasury bond; the US VIX; the US equity market prices; domestic equity market prices; the oil price in dollars; the non-oil commodity price in dollars; and sovereign CDS spreads for three different types of countries, advanced markets except peripheral Europe, peripheral Europe (Greece, Ireland, Italy, Portugal, and Spain), and emerging markets.

Relative Volatility of Asset Prices

(Standard Errors compared with 2003-07)

article image
Fund staff calculations.

3. There has been a striking increase in financial market volatility since the onset of the crisis, though some differentiation among assets. Comparing standard deviations of daily prices since the start of 2010 to mid 2011 and the first half of 2012 relative to the pre-crisis period (start 2003 to end 2006) most assets have seen a large increase in volatility. More recently, US assets appear to have benefitted from safe haven flows with volatility declining in some cases below pre-crisis levels.

4. Asset price correlations suggest that there has been a large change in behavior of financial markets since the onset of the crisis, and that abnormally high correlations have continued to the present day. Before the crisis the matrix is almost entirely green, with exceptions being correlations within countries (e.g., US bond yields and equity markets) or asset classes (across equity market prices or commodity prices. Once the crisis started, however, the correlation between financial market asset prices jumped and became much more generalized. While there has been some variation in the sources of correlations—for example, advanced economy CDS remained relatively uncorrelated with other asset prices through the end of 2009—the overall pattern remains relatively similar over time. In particular, the period since the start of 2012 continues to see high correlations of daily asset price movements in spite of a series of important policy measures in the Euro area, such as the LTROs, Greek PSI, and the strengthening of the firewall.

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1 Daiiy Correlation of Asset Prices

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

5. Increased asset price correlations together with heightened volatility point to elevated global risk. Asset prices are now less driven by multiple factors that depend on the type of asset and on the particular risk being contemplated to being driven by a single factor reflecting overall

2. Business Cycle Accounting for the Systemic Five1

A business cycle accounting analysis is conducted for systemic economies using the G35 Model. Estimated historical decompositions of output growth indicate that business cycle fluctuations in the United States have been primarily driven by domestic macroeconomic and financial shocks, whereas those in other systemic economies have been primarily driven by foreign macroeconomic and financial shocks, together with world terms of trade shocks. Business cycle comovement across systemic economies has been largely driven by financial shocks in the United States, reflecting the depth of its money, bond, and stock markets.

Introduction

1. This note conducts a business cycle accounting analysis for systemic economies, with an emphasis on spillover effects from macroeconomic versus financial shocks. The systemic economies under consideration are China, the Euro Area, Japan, the United Kingdom, and the United States. This analysis is based on historical decompositions of output growth derived from the estimated structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2012). Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages.

Historical Decompositions of Output Growth

2. Historical decompositions measure the time varying contributions of mutually exclusive sets of structural shocks to the realizations of endogenous variables. We distinguish between macroeconomic and financial shocks, originating domestically and abroad, as well as world terms of trade shocks. The macroeconomic shocks under consideration are supply shocks, private demand shocks, monetary policy shocks, fiscal expenditure shocks, and fiscal revenue shocks. The financial shocks under consideration are credit risk premium shocks, duration risk premium shocks, and equity risk premium shocks. These risk premium shocks are identified from observed deviations from the predictions of standard forward looking fundamentals based asset pricing relationships, and accordingly reflect shifts in the price or volume of risk or uncertainty. The terms of trade shocks under consideration are exchange rate risk premium shocks, terms of trade shocks, and world commodity price shocks.

3. Estimated historical decompositions of output growth in systemic economies attribute business cycle dynamics around relatively stable potential output growth rates to economy specific combinations of domestic and foreign macroeconomic and financial shocks, together with world terms of trade shocks. Business cycle fluctuations in the United States have been primarily driven by domestic macroeconomic and financial shocks, whereas those in other systemic economies have been primarily driven by foreign macroeconomic and financial shocks, together with world terms of trade shocks. Business cycle comovement across systemic economies has been largely driven by financial shocks in the United States, reflecting the depth of its money, bond, and stock markets.

4. Prior to the global financial crisis, cyclical output growth volatility in systemic economies was moderate, characterized by unsynchronized episodes of offsetting domestic macroeconomic and financial shocks in the Euro Area and the United States. During the global financial crisis, a series of large negative contributions from financial shocks in the United States throughout 2008 and 2009, augmented by a series of moderate negative contributions from macroeconomic shocks there during 2009 after conventional monetary policy space was exhausted, generated a precipitous synchronized global recession. Since the global financial crisis, a sequence of moderate negative contributions from financial shocks in the Euro Area has partially offset a sequence of moderate positive contributions from financial shocks in the United States, decelerating the synchronized global recovery.

Figure 1.
Figure 1.

Historical Decompositions of Output Growth

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: Decomposes observed output growth as measured by the seasonal logarithmic difference of the level of output into the sum of a trend component and contributions from domestic macroeconomic , domestic financial , foreign macroeconomic , foreign financial , and world terms of trade shocks.

Volatility Regimes

5. This narrative on the sources of recent business cycle fluctuations in systemic economies suggests the existence of three distinct regimes, characterized by driving factor volatility differences. Averaging the absolute contributions from different types of structural shocks to cyclical output growth dynamics across the relevant estimation sample subperiods confirms that their dispersion increased substantially during the global financial crisis, and remains elevated relative to the extended period of moderation that preceded it. Underlying these volatility regime shifts are large swings in the contributions from financial shocks in the Euro Area and the United States. During the global financial crisis, a large negative contribution from domestic financial shocks in the United States generated an abrupt tightening of financial conditions worldwide, causing a precipitous global recession. Since the global financial crisis, a moderate negative contribution from domestic financial shocks in the Euro Area associated with recurring bouts of severe financial stress in the Periphery has decelerated the global recovery.

Figure 2.
Figure 2.

Mean Contributions to Cyclical Output Growth

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: Depicts the mean contributions to the cyclical component of output growth from domestic macroeconomic , domestic financial , foreign macroeconomic , foreign financial , and world terms of trade shocks.
Figure 3.
Figure 3.

Mean Absolute Contributions to Cyclical Output Growth

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: Depicts the mean absolute contributions to the cyclical component of output growth from domestic macroeconomic , domestic financial , foreign macroeconomic , foreign financial , and world terms of trade shocks.

3. Spillovers from Macroeconomic versus Financial Shocks in Systemic Five1

The impact of spillovers arising from macroeconomic versus financial shocks in systemic economies to the rest of the world is analyzed using the G35 Model. Spillovers from macroeconomic shocks in systemic economies are generally small but concentrated, while those from financial shocks tend to be large and diffuse. Spillovers from financial shocks in the United States are uniquely strong, particularly to geographically close trading partners and emerging economies with open capital accounts.

Introduction

1. This note analyzes spillovers from macroeconomic versus financial shocks in systemic economies to the rest of the world. The systemic economies under consideration are China, the Euro Area, Japan, the United Kingdom, and the United States. This analysis is based on the estimated structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2012). Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages.

Simulation Methodology

2. Within the framework of our estimated structural macroeconometric model, the dynamic effects of macroeconomic and financial shocks are transmitted throughout the world economy via trade, financial and commodity price linkages, necessitating monetary and fiscal policy responses to spillovers. Macroeconomic shocks are transmitted via direct financial linkages, while financial shocks are also transmitted via indirect financial linkages representing contagion effects.

3. We analyze spillovers from macroeconomic and financial shocks in systemic economies to the rest of the world with simulated conditional betas of the output gap. The macroeconomic shocks under consideration are supply shocks, private demand shocks, monetary policy shocks, fiscal expenditure shocks, and fiscal revenue shocks. The financial shocks under consideration are credit risk premium shocks, duration risk premium shocks, and equity risk premium shocks. These risk premium shocks are identified from observed deviations from the predictions of standard forward looking fundamentals based asset pricing relationships, and accordingly reflect shifts in the price or volume of risk or uncertainty. The simulated conditional betas under consideration measure international business cycle comovement driven by macroeconomic or financial shocks in each systemic economy. In particular, they measure the percent increase in the output gap in the recipient economy which occurs in response to macroeconomic or financial shocks in the source economy which raise its output gap by one percent, on average over the business cycle. They reflect causality as opposed to correlation, because they abstract from structural shocks associated with other economies.

Simulation Results

4. On average over the business cycle, output spillovers from systemic economies to the rest of the world in our estimated structural macroeconometric model are primarily generated by macroeconomic shocks, which contribute more to business cycle fluctuations than financial shocks. This implies weak international business cycle comovement beyond close trading partners. However, during episodes of financial stress in systemic economies, such as during the global financial crisis, international business cycle comovement is more uniformly strong due to the prevalence of financial shocks, which propagate via elevated contagion effects.

5. Output spillovers generated by macroeconomic shocks are generally small but concentrated in our structural macroeconometric model. The pattern of international business cycle comovement driven by macroeconomic shocks primarily reflects bilateral trade relationships, and therefore exhibits gravity. That is, output spillovers generated by macroeconomic shocks tend to be concentrated among geographically close trading partners, which generally have strong bilateral trade relationships due in part to transportation costs. However, this pattern is diluted by supply shocks, which are primarily transmitted internationally via terms of trade shifts, unlike other macroeconomic shocks which are primarily transmitted internationally via domestic demand shifts.

6. Output spillovers generated by financial shocks are generally large and diffuse in our structural macroeconometric model. The pattern of international business cycle comovement driven by financial shocks transcends bilateral portfolio investment relationships, which tend to be weak reflecting home bias. Output spillovers generated by financial shocks are primarily transmitted via international comovement in financial asset prices. Given that bilateral trade relationships are generally weak beyond close trading partners, accounting for strong international comovement in financial asset prices requires strong international comovement in risk premia. The intensity of these contagion effects varies across source and recipient economies. They are uniquely strong from the United States, reflecting the depth of its money, bond, and stock markets. They are strong to emerging economies with open capital accounts, moderate to advanced economies, and weak to emerging economies with closed capital accounts.

Figure 1.
Figure 1.

Betas of the Output Gap Conditional on Macroeconomic and Financial Shocks

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: Depicts the simulated betas of the output gap with respect to the contemporaneous output gap in systemic economies conditional on macroeconomic or financial shocks in each of these systemic economies. These betas are calculated with a Monte Carlo simulation with 999 replications for 2T periods, discarding the first T simulated observations to eliminate dependence on initial conditions, where T denotes the observed sample size.

II. EURO AREA

4. Commonalities, Mispricing, and Spillovers: Another Look at Euro Area Sovereign Risk1

EA sovereign risk premiums reached an all time high in November 2011. LTROs eased funding pressures in early 2012 but do not address underlying solvency issues and funding stresses have returned. Unsurprisingly, recent movements in sovereign risk premiums reflect predominantly EA risk commonalities. The key policy implication is that market concerns may not fully dissipate until the European policy framework as a whole (banking supervisory framework, fiscal liability sharing scheme, role of ECB as lender-of-last resort, etc.) is strengthened, thereby reducing the market perception of EA-wide risks. In terms of spillover risks to the rest of the world, increased EA sovereign risk is likely to worsen significantly the perceived credit riskiness of EA financial corporate bonds— given feedback loops between sovereign and financial balance sheets. In turn, if (and only if) global risk repricing is factored in, volatility spillovers from the EA financial sector have the potential to raise significantly not only the perceived riskiness of EA nonfinancial corporate bonds, but also that of EM sovereigns and US financial and nonfinancial corporate.

To what extent do movements in euro area sovereign spreads reflect country-specific risk factors rather than a repricing of euro area wide risk?

1. Commonalities. As the EA sovereign bond market is highly integrated, spreads tend to move together—especially in times of crisis—with the yield spread of 10-year EA bonds over Bunds influenced not only by country-specific risks, but also by investors’ repricing of “common EA risk”.

2. Model. The risk factors driving the dynamics of EA spreads during the crisis is assessed via a panel of the spread between the yield on 10-year sovereign bonds between 10 EA countries and Germany estimated over January 2001 to May 2012 using monthly data. Variables used to proxy for investors’ assessments of country-specific credit risk include: expected changes in debt stock and future fiscal balances (fiscal risk); projected shifts in current account balances, growth, and inflation rates (macro risks) obtained from the Economist Intelligence Unit forecasts (note that—unlike actual macroeconomic variables—professional forecasts are genuinely exogenous factors to spread dynamics); possible effects on default risk premiums arising from vulnerabilities in national financial systems are captured by the Expected Default Frequency of the median financial institution of each country, obtained from the Moody’s Creditedge dataset; and, the relative volume of a country’s traded euro denominated long-term government bonds is included among the regressors to proxy for the liquidity of its domestic bond market. The principal component of the yield spreads is used to capture investors’ repricing of common area-wide risk factors, while controlling for recent ECB interventions (such as the introduction of the SMP in May 2010 and the three-year Long-term Refinancing Operation (LTRO) loans in December 2011 and February 2012.

3. Key findings

  • Risk commonalities continue to dominate market pricing dynamics. After reaching its all-time high in November 2011 (at 280bps), the EA risk premium (as estimated by the principal component analysis) is found to have crawled down until end-March 2012 (to 180bps), before increasing again over recent months (to 225bps). By easing funding pressures, the ECB intervention was initially able to stem the downward spiral that EA sovereign bond markets had taken in 2011. However, LTROs do not address the underlying solvency issues and ultimately banks’ funding stresses can quickly return—as has indeed happened.

  • Country-specific risk factors are also important but their contribution is modest, on the order of 10 percent for most countries. Country specific factors—such as market perception about their growth outlook, their fiscal stance, the relative liquidity of their bond markets and, more importantly, the relative strength and solvency of their banking sector—have started playing a significant role in determining sovereign spread dynamics since the beginning of the financial crisis, meaning that markets do now discriminate across bond issuers on the basis of all these factors.

Is there any Evidence of Mispricing of the EA Risk Premium?

4. Mispricing. The common risk component can also be used to analyze the extent to which markets misprice the riskiness of a “theoretical” EMU bond. In theory, the yield of a (non-German) EA bond would be the sum of the underlying Bund yield and the euro-area risk premium. The latter can be proxied by the estimated principal component of the country-specific yield spreads.

5. Results:

  • From the second half of 2009 until the second half of 2011—the yield of a market-priced EMU bond index tracks almost perfectly the “theoretical” yield. On the other hand, during 2008-2009, markets seem to have unc/erpriced EA risk by some 20-60 bps, while there is some evidence of a slight overpricing of EA risk starting from July 2011 onwards which is—however—lately fading away.

Figure 1.
Figure 1.

What’s Driving Euro Area Sovereign Spreads?

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: Bloomberg, Datastream, Economist Intellingence Unit, staff calculations.Sources: Bloomberg, Datastream, Economist Intellingence Unit, staff calculations.
Figure 2.
Figure 2.

(Mis)Pricing the Euro Area Risk Premium

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: Bloomberg, Datastream, and Fund staff calculation.

Volatility Spillovers Across Assets and Across Borders

6. Model. Dynamic Conditional Correlation (DCC) estimators are used to unveil time-varying cross-correlations in a portfolio of global assets, including our estimates for EA-wide sovereign risk.2 DCC models have the flexibility of univariate GARCH models coupled with a parsimonious parametric model for time-varying cross-correlations. They are not linear, but can be estimated very simply with two-step methods based on their likelihood function.3

7. Interpretation. The principal component of the risk premiums embedded in the examined asset portfolio is used to capture investors’ global risk repricing. In this way, volatility cross-correlations vis-à-vis the EA sovereign bond market and the EA financial corporate bond market are estimated using either observed risk premiums (so that shifts in global risk repricing are factored in), or (unobserved) risk premiums which have been stripped out of any change in global risk repricing (so that only structural interdependences are captured by the correlation matrix).

8. Key findings

  • If shifts in global risk commonalities are factored out, volatility in EA sovereign bond markets is likely to worsen significantly the perceived riskiness of EA financial corporate bonds—given feedback loops between sovereign and financial balance sheets. In turn, volatility in the EA financial corporate bond market is likely to spill over to the EA nonfinancial corporate bond market, but not beyond it. In other words, if global risk repricing is not accounted for, no significant spillover effect is found beyond EA borders for any asset class included in the portfolio.

  • On the other hand, if global risk repricing is allowed to play out, volatility spillovers are likely to be sizable across assets and across borders. Specifically, significant volatility spillovers from the EA sovereign bond market are likely to be felt also in all EM bond markets around the globe, as well as in the US financial corporate bond market (and, marginally, in the US equity market).

Figure 3:
Figure 3:

Cross-borders and cross-assets spillovers vis-a-vis EA Markets

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: Blooomberg, Datastream, Fund staff calculations.

5. Effects of an Intensification of the Euro Area Sovereign Debt Crisis1

The global macroeconomic costs of a potential future intensification of the Euro Area Sovereign Debt Crisis are analyzed using the G35 Model. The simulation results indicate that the intensification of financial stress in high yield Euro Area countries would generate severe output losses in the Euro Area, concentrated in the high yield countries and to a lesser extent the mid-yield countries, together with mild to moderate output losses in the rest of the world, concentrated in the European Union. The scope for monetary and fiscal policy responses in the rest of the world to mitigate spillovers varies considerably across economies, primarily reflecting differences in their policy space.

Introduction

1. This note analyzes the global macroeconomic costs of the potential future intensification of the Euro Area Sovereign Debt Crisis, with and without accounting for feasible monetary and fiscal policy responses in the rest of world. This analysis is based on a scenario simulated with the structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2012). Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages.

2. Our simulation results indicate that the intensification of financial stress in the high yield Euro Area countries would generate severe output losses in the Euro Area, concentrated in the high yield countries and to a lesser extent the mid-yield countries, together with mild to moderate output losses in the rest of the world, concentrated in the European Union. The scope for monetary and fiscal policy responses in the rest of the world to mitigate spillovers varies considerably across economies, primarily reflecting differences in their policy space.

Financial Market Spillovers

3. The intensification of the Euro Area Sovereign Debt Crisis has been largely driven by contagion in the money, bond and stock markets. Accordingly, we enrich our scenarios with an event study analysis of financial market spillovers generated by developments in the Euro Area during the Fall of 2011. This event study analysis indicates that money and bond market contagion from the Euro Area—as measured by impacts on one and ten year government bond yields during this period—was benign to moderate. In contrast, they indicate that stock market contagion—as measured by impacts on equity price indexes—was moderate to severe.

Figure 1.
Figure 1.

Estimated Financial Market Spillovers

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: Depicts estimated financial market spillover coefficients less than 0.00 , between 0.00 and 0.05 , between 0.05 and 0.25 , between 0.25 and 0.50 , between 0.50 and 0.75 , and greater than 0.75 .

Scenario Simulations

4. We simulate a scenario representing the intensification of the Euro Area Sovereign Debt Crisis. We also simulate subscenarios to assess the scope for feasible monetary and fiscal policy responses in the rest of the world to mitigate spillovers. We assume that all of the shocks driving this scenario are temporary but persistent, following first order autoregressive processes having coefficients of 0.975. We also assume that monetary policy responses are constrained by the zero lower bound on the nominal policy interest rate in the Euro Area, Japan, the United Kingdom, and the United States.

5. Our scenario represents the intensification of the Euro Area Sovereign Debt Crisis with the escalation of financial stress and deterioration of confidence, which triggers procyclical fiscal consolidation reactions. These effects are differentiated across the high yield (Greece, Ireland, Italy, Portugal, and Spain), the mid-yield (Austria, Belgium, and France), and the low yield (Finland, Germany, and Netherlands). We represent the intensification of stress in the money, bond, and stock markets of the high yield with positive credit risk premium shocks which raise short-term nominal market interest rates by 200 basis points, positive duration risk premium shocks which raise long-term nominal market interest rates by 300 basis points, and positive equity risk premium shocks which reduce equity prices by 40 percent. These risk premium shocks are correlated internationally to account for contagion effects, with beta coefficients calibrated to match our event study results. We account for confidence losses by households and firms with negative private domestic demand shocks which gradually reduce domestic demand by 2.5 percent in the high yield, by 2.0 percent in the mid-yield, and by 1.5 percent in the low yield. We assume fiscal consolidation reactions by governments which gradually raise the ratio of the fiscal balance to nominal output by 3.0 percentage points in the high yield, by 2.0 percentage points in the mid-yield, and by 1.0 percentage points in the low yield. Expenditure measures represented by negative fiscal expenditure shocks account for 75 percent of these fiscal consolidations, while revenue measures represented by positive fiscal revenue shocks account for the remainder. Finally, there is a run on the euro, represented by an exchange rate risk premium shock which depreciates it by 20.0 percent in nominal effective terms.

6. Under this scenario, severe output losses in the Euro Area, concentrated in the high yield and to a lesser extent the mid-yield, are accompanied by mild to moderate output losses in the rest of the world, concentrated in the European Union. Accounting for feasible monetary policy responses and automatic fiscal stabilizers in the rest of the world, simulated peak output losses within the Euro Area range from 4.5 to 7.7 percent in the high yield, to 4.9 to 6.0 percent in the mid-yield, to 2.0 to 5.3 percent in the low yield. Outside of the Euro Area, simulated peak output losses range from 0.4 to 4.7 percent in other advanced economies, and from 0.2 to 4.5 percent in emerging economies. Abstracting from feasible nominal policy interest rate cuts with offsetting positive monetary policy shocks generally amplifies these spillovers, with simulated peak output losses ranging from 0.7 to 5.7 percent in other advanced economies, and from 0.9 to 7.7 percent in emerging economies. Also abstracting from automatic deteriorations in the ratio of the fiscal balance to nominal output with offsetting negative fiscal expenditure shocks generally further amplifies these spillovers, with simulated peak output losses ranging from 0.9 to 5.9 percent in other advanced economies, and from 1.0 to 8.0 percent in emerging economies. Aggregating these results implies a simulated peak world output loss of 2.4 to 3.2 percent, depending on the degree to which monetary and fiscal policies respond. The associated peak decline in the price of energy commodities ranges from 7.9 to 16.0 percent, while that for the price of nonenergy commodities ranges from 4.1 to 9.8 percent.

Figure 2.
Figure 2.

Simulated Peak Output Losses

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: Depicts simulated peak output losses less than 1.0 percent , between 1.0 and 2.5 percent , between 2.5 and 4.0 percent , between 4.0 and 5.5 percent , between 5.5 and 7.0 percent , and greater than 7.0 percent

6. Spillovers between Western Europe and CESEE 1

Economic and financial linkages between Western Europe and Central, Eastern, and Southeastern Europe (CESEE) have become much tighter in the past two decades. As a result, west-east spillovers are very significant and have begun to also travel from east to west. Financial and trade channels are the main avenues for spillovers and they are mutually reinforcing, with shocks to credit flows in one direction quickly followed by shocks to trade flows in the other direction.

The impact of the euro area crisis on CESEE remained very modest until the summer of 2011, but CESEE started to suffer from contagion through bank funding and exchange rate channels when significant deleveraging by BIS-reporting banks took place in the second half of 2011. The introduction of the ECB’s 3 year LTROs has since brought respite. However, downside risks remain significant, and an intensification of the euro area crisis would have significant spillovers to CESEE, especially in countries with elevated vulnerabilities and home-grown challenges.

Introduction

1. This note discusses linkages and spillovers between Western Europe and Central, Eastern, and Southeastern Europe (CESEE). Western Europe and the CESEE regions closely match the regions often referred to as advanced and emerging Europe, with important exceptions—the CESEE includes Estonia, the Czech Republic, the Slovak Republic, which are classified as advanced economies by the WEO.2 The note is organized as follows: Section II discusses trade, banking and other financial sector linkages between Western Europe and CESEE; Section III analyzes spillovers empirically; Section IV discusses the main spillovers and spillover risks from the euro area crisis; and Section V discusses policy implications of the close linkages.

Linkages between Western Europe and CESEE

2. Globalization and European integration have lead to increasing tight economic and financial linkages between Western Europe and CESEE. Linkages are particularly pronounced in the area of trade and banking, with much of CESEE’s banking systems owned and financed by the west. Financial-market linkages are also important. More elusive confidence channels and remittances flows tie Europe’s economies further together.

Trade linkages

3. In the past twenty years, trade linkages between CESEE and Western Europe have increased rapidly. Integration was boosted by the liberalization and westward reorientation of CESEE following the collapse of communism, the eastward expansion of the EU, and globalization generally.

  • For Western Europe, CESEE has been the most dynamic export market. Western Europe’s exports of goods to CESEE have increased from slightly less than 1 percent of GDP in 1995 to about 3¼ percent of GDP in 2010, and are now higher than those to Asia or Western Hemisphere countries.3 Germany in particular benefitted from rapidly growing eastward exports. During 2003-08, exports to CESEE helped boost Germany’s export growth from 6½ percent to 8¼ percent, equivalent to a ¾ percentage points boost to GDP growth.

  • For CESEE, Western Europe is the largest export market—more important than CESEE itself. In 2010, exports of CESEE to Western Europe were about 15 percent of CESEE’s GDP.

4. Trade linkages are further cemented by supply chain integration. German firms in particular have set up new production facilities in Central Europe, and shifted part of their production to the region. Within these production chains, which are particularly prevalent in sectors like automobiles, Western Europe typically produces the core components; the assembly of the final product is done in CESEE. Other forms of FDI have also been high. The stock of FDI in the region is about 22 percent of GDP on average, and FDI comes almost exclusively from advanced Europe. The rising importance of cross-border supply chains is evident in the sharp increase in the foreign valued added part of gross exports, especially in Central Europe (Figure 1).

Figure 1.
Figure 1.

Value-added breakdown of Exports

(Percent of GDP)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources:

5. Trade linkages are particularly important for Central Europe and the Baltics. For Central Europe (Poland, Hungary, the Czech and Slovak Republics, and Slovenia), exports to Western Europe are around 65 percent of its total exports, and close to 32 percent of GDP (Table 1). Southeastern Europe is less integrated. It has fewer cross-border production chains and trades less—including with Western Europe. Large commodity exporters such as Russia and Ukraine have considerable trade relations with non-western European countries and thus are less dependent on Western Europe.

Table 1.

CESEE: Exports to Western Europe, 2011

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Sources: IMF, Direction of Trade database; and IMF, World Economic Outlook Database.

Banking Sector Linkages

6. The financial sector in CESEE has become closely integrated with the banking sector in advanced Europe, both in terms of ownership and financing.

  • Foreign banks, largely from Western Europe control on average 64 percent of domestic banking system assets in the region.4 Foreign ownership ranges from less than 35 percent in Russia, Turkey, Slovenia, and Belarus, to more than 80 percent in Bosnia, Czech Republic, Croatia, Estonia, Romania, and Slovakia (Figure 2, top left). Foreign control is concentrated in a handful of Western European countries, in particular Austria, France, Greece, Italy, and Sweden (Table 2).5

    Figure 2.
    Figure 2.

    Banking Sector Linkages

    Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

    Sources: BIS, Locational Banking Statistics; IMF, International Financial Statistics; IMF, World Economic Outlook database; EUREEBanking SectorStructure database; and IMF staff calculations.1As the boominthe Baltic statesendedin2007, dataforthe Baltics referto2002-07.
    Table 2.

    Ranking of Foreign Control of Domestic Banking Sector, Percent of Total Assets

    article image
    Source: Bankscope and Fund Staff Calculations.

  • The integration has been important also in terms of financing (Figure 2, bottom left). Funding by BIS-reporting banks at end-2011 amounted to more than 30 percent of GDP in Croatia, Latvia, Slovenia, Estonia, Hungary, and Bulgaria. It mostly takes the form of parent bank financing to CESEE affiliates and direct lending to corporations. However, in Russia and Turkey, where foreign ownership of banking systems is relatively low, cross-border wholesale funding is more important.

  • Consolidated assets of Western European banks, which also take into account assets funded from local deposits represent over 50 percent of GDP in all countries in the region except the CIS, Turkey, Macedonia, and Montenegro (Figure 2, top right).6 Austrian, Italian, and French banks have the largest presence when measured in terms of total foreign claims.

7. These banking sector linkages played a pivotal role in the severe boom-bust much of CESEE went through in the past decade.

  • In the years preceding the 2008/09 crisis, Western European parent banks financed the rapid expansion of domestic credit that fuel and asset price and domestic demand boom. Cross-border exposure of BIS-reporting banks to the region increased rapidly (Figure 2, bottom right).

  • When these bank flows suddenly stopped in the wake of the global financial crisis, the region plunged into a deep crisis. With rapid credit growth coming to a sudden stop, asset price and domestic demand booms came to an abrupt end. Over the next year and a half, cross-border exposure to the region declined peak-to-trough by about a quarter on average—in some countries up to 40 percent (Figure 3, Table 3).

Figure 3.
Figure 3.

Exposure of BIS-Reporting Banks to Emerging Europe

(Billions of US dollars)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: BIS, locational banking statistics.
Table 3.

CESEE Countries: Decline in Cross Border Exposures During the Crisis, Exchange Rate Adjusted

article image
Sources: BIS locational statistics; and Fund staff calculations.

8. From a Western European perspective, bank linkages with CESEE are important for Austria and Greece. While Western European banks dominate CESEE banking systems, their operations in the region represent only a small fraction of their home country’s GDP. Austria and Greece represent two exceptions. Consolidated claims of Austrian banks on CESEE at end-2011 were equivalent to 65.8 percent of Austrian GDP; for Greek banks the figure is 25.9 percent of GDP.7 For Austrian banks, CESEE is also important in terms of profits, with almost half of all profits in 2010 coming from their subsidiaries.

Other Financial Market Linkages

9. Rising risk aversion in Western Europe quickly spills over to CESEE through the CDS market. When global risk aversion, as measured by the VIX index, rises CDS spreads in CESEE typically follow suit (Figure 4).8 This not only raises financing costs for the sovereign, but also for the private sector, as funding costs for foreign banks are typically a markup over Western European short-term interest rates, with the mark-up closely linked to the sovereign CDS spreads for the CESEE host country.

Figure 4.
Figure 4.

CESEE Five-Year Average Sovereign CDS Spreads (in basis points) and the VIX Index

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: Datastream.

10. Econometric analysis suggests that a rise in CDS-spreads in the euro area periphery only affects CDS spreads through its impact on global risk aversion. Rising concerns about Greece raises CDS spreads in CESEE because it increases global risk aversion; not because it raises specific concerns about CESEE.

11. Spillovers in risk aversion from Emerging to Western Europe have become less important in the last few years. During the 2008/09 crisis when CDS spreads in many CESEE countries were very high, concerns about CESEE affected countries in Western Europe. CDS spreads in Austria, for example, rose because of the large exposure of its banking sector to the region. However, as fundamentals in the region improved, CDS spreads declined, and differences across countries have become much smaller.

12. Bond markets are less integrated with the west, although Poland, Hungary, and Turkey are notable exceptions. Few countries in the CESEE region have sufficiently liquid government bond markets and consequently, foreign ownership of domestically issued bonds in most countries is generally low. This also reflects the relatively low level of indebtedness of most countries in the region. Poland, Hungary, and Turkey are exceptions. In Hungary, more than 40 percent of government bonds are held by foreigners. In Poland the figure is about 30 percent. This makes the countries vulnerable to a sudden pull-out of foreign investors. In the fall of 2008, the large scale pull-out of foreigners from government bonds, prompted Hungary to approach the IMF for balance of payments assistance.

13. More broadly, portfolio flows have been a relatively unimportant component of capital flows to most CESEE countries. Even in Hungary, a relatively large recipient of portfolio inflows, they were much smaller than FDI and “other” capital flows (Figure 5).

Figure 5.
Figure 5.

CESEE: Net Capital Flows, 2003-08

(Percent of 2003 GDP)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: IMF, WEO database

Spillovers—A Quantitative Assessment

14. These tight linkages imply that shocks originating in Western Europe can have a big impact on CESEE. It is well known that the 2008/09 crisis in CESEE was in large part the result of spillovers from the crisis in Western Europe (Figure 6), while a revival of exports to Western Europe was instrumental in CESEE’s subsequent recovery.

Figure 6.
Figure 6.

Real GDP growth in CESEE, Germany, and Western Europe

(yoy , in percent)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: Haver Analytics.

15. What may be less well known is that shocks emanating in CESEE are increasingly felt in Western Europe as well. Germany’s export growth during the pre-crisis years was boosted by strong demand from CESEE; while the sharp contraction in CESEE in 2009 exacerbated the German downturn. Spillovers of the crisis in CESEE were felt in Austria in early 2009, as worries about the large exposures of Austrian banks to the region led to a sharp increase in CDS spreads of Austrian parent banks.

16. Financial and trade spillovers also interact, as shocks to financial flows from Western Europe to CESEE are soon felt in trade flows. For example, during 2003-08, much of the ample financing made available by Western Europe’s banks to CESEE was spent on imports from Western Europe. The more financing CESEE European countries received from Western European banks, the stronger their imports from Western Europe grew. An estimated 57 cents per euro of western bank financing ended up being spent on imports from Western Europe.

17. Empirical analysis confirms that the tight economic and financial linkages give rise to quantitatively important spillover effects. Shocks emanating from Western Europe tend to be felt one-for-one in CESEE. In addition, key countries in Western Europe, such as Germany, Austria, or Sweden, play a “gatekeeper” role for CESEE, transmitting global economic and financial shocks to the region. Apart from spreading shocks, tight linkages have boosted efficiency across Europe, thereby lifting potential growth in Western Europe and CESEE alike.

18. The trade channel alone gives rise to strong spillovers. The trade model first estimates the effect of output shocks on import demand and then uses historical import shares to calculate the impact on trading partner’s exports. Export multipliers are set to one, essentially assuming that income effects and leakage from the imported inputs embedded in exports offset each other. In this setting, a shock of 1 percent to Western Europe’s GDP adds 0.4 percent to output in CESEE on average. The effect is much larger in small open economies, such as Estonia or the Slovak Republic, than in larger, more distant economies, such as Russia. Conversely, a 1 percent shock to CESEE’s GDP entails only 0.1 percent extra output in Western Europe, reflecting primarily the smaller size of CESEE’s economy.

19. Banking linkages are an important separate conduit for spillovers. The cross-border banking model finds that a 1 USD change in cross-border exposure of western banks vis-á-vis CESEE banks translates over time into a 0.8 USD change in domestic credit.9 And each extra percentage point in real credit growth adds about 0.3 percentage point to real GDP growth (Figure 7). This suggests that the financing provided by western banks during 2003-08 added 1½ percentage points to CESEE’s annual GDP growth, pushing it to 6½ percent per year

Figure 7.
Figure 7.

Europe: Credit Spillovers from Western Europe to CESEE 1

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: BIS, Locational Banking Statistics (Table 6); IMF, International Financial Statistics; IMF, World Economic Outlook database; and IMF staff calculations.

20. Overall spillovers are bound to be larger than the summed effects from trade and banking channels. First, these two channels are likely to reinforce each other. A financial shock emanating from Western Europe boosts funding of CESEE’s banking systems, their credit provision, and aggregate demand. This stimulates exports and economic activity in the west, given that some 60 percent of the financing provided by western bank to CESEE tends to be spent on imports sourced from Western Europe. Second, additional spillover channels are likely at play. This includes remittances of CESEE expatriates working in Western Europe and hard-to-quantify confidence channels that give rise to co-movements of CDS spreads, bank funding costs, and asset prices.

21. Overall, a one percent growth shock in Western Europe gives rise to a shock of about equal size in CESEE. This result is derived from a VAR model that explains growth in Western Europe and CESEE in terms of past growth in the two parts of Europe while controlling for growth in the rest of the world. By design this setup is agnostic about the precise nature of transmission channels and can therefore be seen as a summary measure of spillovers. Extra growth in Western Europe translates into extra growth in CESEE in about the same amount and with little delay (Figure 8). CESEE’s economic integration seem on average not yet strong enough to support a significant impact of CESEE growth shocks on Western Europe’s output. However, more tightly integrated Central Europe appears to already have a measurable impact on growth in Western Europe.

Figure 8.
Figure 8.

Europe: Growth Spillovers between CESEE and Western Europe1

(Accumulated response of GDP, percent)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: IMF, World Economic Outlook database;and IMFStaff calculations.

22. In addition to being an original source of spillovers, Western Europe also acts as a conduit for the transmission of global shocks to CESEE. These effects are not captured by the above VAR analysis because of controlling for global growth shocks. However, an economic upswing outside Europe is bound to spur German exports with positive knock-on effects for the CESEE countries hosting Germany’s “extended work bench.” More formal network analysis identifies “clusters” of countries closely interlinked and “gatekeepers”—economies that provide a key nexus of the cluster with the rest of the world. Germany, Italy, and Austria are found to be gate keepers for a number of CESEE countries. Similarly, Sweden acts as a gatekeeper for the Nordic-Baltic cluster.

Spillover Risks from the Euro Area Crisis

23. Given the close linkages between Western Europe and CESEE, an intensification of the euro area crisis is a major risk for the CESEE region. If tensions in the euro area were to escalate further, CESEE would be severely affected through both trade and financial channels. Exports would suffer if euro area growth declined rapidly; financial markets strains would intensify, parent bank funding would likely be scaled down and capital inflows would drop, further affecting domestic demand. Initially, the CESEE region felt little impact of the crisis, as the adjustment following the 2009 crisis adjustment had made the region more resilient. But this changed in the summer of 2011, as the crisis started to affect the banks in Western Europe.

Initial impact of euro area crisis-first half of 2010-summer 2011

24. Until the summer of 2011, there had been little impact of the euro area sovereign debt crisis on CESEE. While CDS spreads in peripheral Western Europe went up steadily, spreads in CESEE remained flat or continued to decline, as the region recovered from the deep recession of 2008/09 (Figure 9).

Figure 9.
Figure 9.

Five-Year Average Sovereign CDS Spreads (in basis points)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: Datastream.

25. The increased resilience of the CESEE region to financial market contagion since the global crisis in 2008-09 is likely the result of the correction of large internal and external private sector imbalances. In 2008, the region was very vulnerable to a sudden stop in capital inflows as current account deficits were high (Figure 10) and growth had become dependent on the continuation of large capital inflows. By 2011, much of these imbalances had disappeared: high current account deficits were no longer an issue in most countries (with the notable exception of Turkey), economies were no longer overheating, and growth was increasingly being driven by exports rather than capital-flows fueled domestic demand booms.

Figure 10.
Figure 10.

Emerging Europe: Current Account Deficits

(Percent of GDP)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: National authorities; and IMF staff estimates.

26. Sharp adjustment of fiscal imbalances in CESEE further contributed to declining vulnerabilities. CESEE’s public finances were hit hard by the 2008/09 crisis, as the end of the domestic demand booms led to a sharp drop in government revenues, and the region-wide fiscal balance swung from a surplus of 1½ percent in 2007 to a deficit of 6 percent in 2009. Most countries went through painful fiscal adjustments, and by 2011, the deficit in the region had been reduced to percent of GDP.

27. The decline in vulnerabilities of CESEE was rewarded by the improvement of CDS spreads relative to Western Europe. By 2011, there was no longer a clear distinction between CESEE countries and Western Europe. CDS spreads in Russia were lower than in France; spreads in Bulgaria and Romania were lower than in Spain and Italy; and spreads in Estonia were lower than in Belgium.

28. Yet despite these improvements, several vulnerabilities remain high: financing requirements are high, large stocks of foreign currency loans constrain exchange rate and monetary policy (Figure 11), and Russia and Ukraine remain vulnerable to drop in commodity prices.

Figure 11:
Figure 11:

CESEE: Stock of Foreign Currency Loans, December 2011

(Percent of GDP)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: IMF, International Financial Statistics; and IMF, World Economic Outlook database. Note: No breakdown between corporate and household is available for indexed loans.

29. Moreover, as a result of the 2009 crisis, a number of new vulnerabilities have emerged (high NPLs and large fiscal deficits), which have only partially been addressed. Fiscal deficits are still high in a number of countries (Figure 12), despite considerable consolidation.

Figure 12.
Figure 12.

CESEE: Fiscal balances: 2007 and 2011

(Percent of GDP)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: IMF, WEO database

Summer 2011 and beyond—CESEE Feels Contagion

30. The continued susceptibility of CESEE to the euro area crisis was laid bare in the second half of 2011 when the stress in the west escalated and CESEE countries started to suffer from contagion through bank funding and exchange rate channels. When the crisis in Western Europe intensified, and CDS spreads of large Western Banks in the region widened, sovereign CDS spreads in the region increased (Figure 13), currencies came under pressure, and deleveraging by parent banks picked up. The degree to which countries were affected was not uniform, but depended on underlying vulnerabilities. Spreads became particularly elevated in Ukraine and Hungary.10

Figure 13.
Figure 13.

Europe: 5-year CDS spreads

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: Bloomberg.

31. Euro area banks came under significant funding pressure, which triggered significant deleveraging from CESEE in the second half of 2011. BIS reporting banks reduced their exposure to CESEE by 6½ percent between June and December, compared with about 3 percent for the Africa and Middle East and Asia Pacific regions and an increase of 2 percent in Latin America and the Caribbean.

32. The impact on credit growth was less pronounced, becoming negative only in the Baltics and Slovenia. The reduction in foreign claims in 2011H2 was only a quarter of the reduction in cross-border exposures, suggesting that local affiliates of western banking groups have partly substituted domestic funding for lost cross-border funding.11 Adjusted for exchange rate changes, foreign claims of BIS-reporting banks declined by 1½ percent in 2011H2, compared with a 6½ percent decline in cross-border exposures. In Bulgaria, the Czech Republic, Lithuania, Montenegro, Poland, and Serbia foreign claims increased, despite a reduction in cross-border exposure, presumably because credit growth was funded from local deposit growth. In some countries the impact on overall credit growth has been further mitigated by local banks stepping up credit.12 Overall, credit contracted only in the Baltics and Slovenia, and domestic credit in the region grew at an annualized rate of about 6 percent in 2011H2 (Figure 14).13

Figure 14.
Figure 14.

Change in Deposits and Loans, 2011H2

(Annualized, in local currency, percent)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: IMF, International Financial Statistics; and IMF staff calculations.

33. The introduction of the ECB’s three-year LTROs helped stage a recovery in financial sentiment from mid-December. IFS data for the first months of 2012 suggest that exposure reduction of Western banks to the CESEE region has not continued in 2012. In addition, portfolio flows to the region, which had been negative in the third and fourth quarter, became positive again in the first quarter.

34. Despite the better tone in financial markets, growth in the region is expected to slow sharply this year, and downside risks are significant. The Spring 2012 WEO projects 2012 growth in CESEE of 2.9 percent, compared to 4.7 percent in 2011. The outlook for Southeastern Europe and Hungary is particularly weak. Moreover, tight trade and financial linkages with the euro area keep the region vulnerable to a renewed deterioration in the euro area.

35. Risks remain significant. If tensions in the euro area were to escalate further, CESEE would be severely affected through both trade and financial channels. Exports would suffer if euro area growth declined rapidly; financial markets strains would intensify, parent bank funding would likely be scaled down and capital inflows would drop, further affecting domestic demand. Banking linkages may in particular create negative spillovers if the crisis intensifies. Western European banks’ need to deleverage would increase substantially if the euro area crisis re-intensified. The potential for negative spillovers from Italian and Greek banks is particularly high.

36. Foreign ownership of banks has so far played a stabilizing role during episodes of funding stress (Box 1) but it may not continue to do so going forward. Market funding to Western European parents has become scarcer and their ability to fund their CESEE affiliates has been impaired. The ECB’s LTROs have provided significant but temporary relief. In addition, Basel III, EBA requirements, and financial markets’ expectations in terms of higher capital quality may force prolonged deleveraging among several large Western European banks and reduce their ability and willingness to keep exposures to CESEE countries.

Is Foreign Bank Ownership Stabilizing in CESEE?

Economic intuition suggests that foreign bank ownership should have a stabilizing influence during periods of funding stress. Loans to subsidiaries are much closer to equity capital, and not providing subsidiaries with sufficient funding may reduce the value of parent banks’ franchise. In practice, however, the link between foreign ownership and reduction in cross-border exposure is not as clear cut. During the crisis of 2008/09, for example, Russia and Estonia both experienced a 38 percent reduction in cross order exposure, even though Russia has a low share of foreign banks (14 percent) and Estonia a high one (80 percent).

Econometric analysis confirms that foreign ownership reduces deleveraging during crisis time, but does not make a difference during normal times, when aggregate external funding increases. A regression of the quarterly percentage change of cross-border exposures on macro-financial indicators during the period between 2007Q1 and 2011Q3 shows that during periods of stress, higher shares of foreign ownership help shield economies from aggregate funding declines. In crisis times, the difference in change in cross-border exposures between a country with 20 percent foreign ownership and one with 80 percent foreign ownership is 2.3 percentage points per quarter. Lower CDS spreads and higher banking sector ROA help mitigate funding declines as well: a 100bps change in CDS level translates into a quarterly change of 0.1 percentage point in funding, while a change in ROA by 1 percentage point translates into a quarterly change of 0.7 percentage point. By contrast, short-to-medium-term growth prospects (captured by the WEO 3-year growth forecast) and reliance on external funding (captured by the loans-to-deposits ratio) do not seem to matter.

Determinants of International Funding Risk

article image
Sources: BIS, IMF, Bloomberg, Local Authorities and Fund Staff Calculations

* p<0.10, ** p<0.05, *** p<0.01, s.e. in Parentheses, Crisis = 2008Q4-2010Q2 and 2011Q3

37. Advanced Europe is also less in a position to provide a strong backstop for problems that might surface in CESEE. Weakened western banks might be reluctant provided large-scale support in the event of a bank runs in a CESEE country. To compound the problem, public finances in Western Europe have fewer buffers to extend aid to CESEE.

Policy Implications

38. Close linkages between emerging and advanced Europe have benefited both regions, but they naturally also make both regions more susceptible to shocks originating elsewhere in Europe. Shocks in advanced Europe quickly spillover to CESEE, but spillovers increasingly go both ways, and financial shocks one way quickly translate into trade shock going other way.

39. Policy formulation needs to take interconnectedness into account, including through cooperation across borders. Interconnectedness needs to be fully recognized and understood. Buffers need to be sized so as to be able to absorb shocks originating elsewhere. Risk management frameworks need to be designed to deal with the complexities in an interconnected world, including closer cooperation of policy makers in home and host countries.

40. Reducing remaining home-grown vulnerabilities may make CESEE countries more resilient to euro area turmoil. It is noteworthy that sovereign CDS spreads have not increased across the board. Financial markets are increasingly differentiating across countries. Those that have made less progress in addressing country-specific vulnerabilities have been more affected by pressures than other countries.

7. Financial Spillovers from Euro Area and UK Global Systemically Important Banks (G-SIBs)1

Building on last year’s spillover reports, this paper assesses the role of European banks, notably euro area and UK global systemically important banks (G-SIBs), as sources and propagators of shocks. The analysis identifies four euro area and two UK banks as having high capacity to generate spillovers. Some of these banks are also found to be very vulnerable to funding and sovereign stress. Thus, an intensification of the euro area crisis is likely to have large amplifying effects via its G-SIBs.

Motivation and Objectives

1. European G-SIBs have grown in size and importance and are highly interconnected with the rest of the global financial system. Their assets have more than tripled since 2000, amounting to $27 trillion in 2010 (Figure 1).2 Furthermore, European G-SIBs tend to be larger (including relative to home country GDP) and more leveraged than their US and Asian peers.3 As key players in global derivatives and cross-border interbank markets, they are also among the most interconnected G-SIBs.

Figure 1.
Figure 1.

G-SIBs and Other Banks—Some Stylized Facts

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: Bank reports; and BloombergNote: Sample banks include around 260 banks domiciled in 25 jurisdictions with systemically important financial sectors.Note: European banks are in green; US banks are in blue; data have been put together by Nadege Jassaud.Sources: Annual Reports; Bankscope; and IMF’s World Economic Outlook.1/ G-SIBs total assets by country, except Italy where Unicredit, Intesa San Paolo and Banca Monte dei Paschi di Siena are included. Assets are not adjusted for accounting differences in derivatives.Source: BIS

2. Therefore, financial spillovers—both within the region (inward) and to other regions (outward)—from region-specific shocks transmitted through European G-SIBs could potentially be very large.4 To gauge the scope for financial contagion within and outside Europe, this note addresses two questions: (1) How are G-SIBs interconnected and what are the main conduits and recipients of outward spillovers? (2) If European banks were hit by a sizeable sovereign or funding shock, what would be the impact of deleveraging across countries and regions?

3. To help answer these questions, the analysis utilizes two complementary approaches. In the absence of data on banks’ bilateral exposures, correlation-based measures of market prices and low-frequency balance sheet data are used to assess interconnectedness and contagion channels through risk exposures. This allows a real-time analysis of international financial linkages among G-SIBs. The second approach makes it possible to examine the channels of transmission of various shocks and evaluate their impact, but at the expense of moving to a more aggregate, banking-system level.

Interconnectedness and Spillovers: Some Diagnostics

4. G-SIBs are linked through a complex network of international financial exposures. To assess interconnectedness and contagion channels of such exposures, we use five market price-based measures—simple correlations, average directional correlations, and two types of directional spillovers during extremely negative scenarios—as well as a balance-sheet measure of interconnectedness (Appendix I).

5. Market perception of interconnectedness typically increases in times of stress. A straightforward way to examine connectedness is by means of simple correlations, although such an approach will not help differentiate spillovers owing to institutions’ exposures to common risk factors from those due to direct or indirect exposures between institutions. Two key findings are noteworthy, based on rolling pair-wise correlations of expected default frequencies between each of the UK and EA SIBs and the other financial institutions. First, there is limited co-movement in expected default probabilities (EDFs) over time, except during stress episodes, such as the Lehman collapse or the intensification of the euro area crisis in late-2011. Second, more recently, co-movements of CDS spreads and EDFs spiked in late 2011—close to Lehman levels—and remain elevated for all UK and EA G-SIBs. Moreover, while spillovers to US banks remain relatively large, contagion to Japan has remained contained during the EA crisis (Figure 2).

Figure 2.
Figure 2.

Rolling Correlations among G-SIBs

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: Moody’s KMV, IMFstaffestimates1/ Defined as the average correlation between expecteddefault probabilities(EDF) across allpairs.

6. Among European banks, six G-SIBs are identified as having high capacity to generate spillovers for all G-SIBs as well as for other large European banks.5 These include French, German, and UK banks. While most of these G-SIBs have high capacity to generate spillovers for all G-SIBs, on average and in times of extreme market stress, some G-SIBs have a high spillover potential mainly during extreme market stress. Moreover, the core euro area G-SIBs with high spillover potential also have significant exposures to market, credit (including in the euro periphery), and funding risks, while their capital ratios are moderately above the EBA’s 9 percent core Tier 1 capital requirement and below those of global peers.

7. The main recipients of outward spillovers from these institutions include other European and US G-SIBs (Figure 3). Outside Europe, two US G-SIBs would be significant recipients of outward spillovers. By contrast, Asian G-SIBs are not as affected. Many of the same institutions that generate outward spillovers are also susceptible to spillovers from other European SIBs (notably some French, Italian, and Spanish ones).

Figure 3.
Figure 3.

Spillovers under Extreme Market Stress (CMO measure)

(red arrows indicate spillovers between the six G-SIBs identified as having high a capacity to generate spillovers).

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: Bloomberg; and Fund staff calculations using the CMO directional spillover methodology.Note: The individual banks are labeled using their home country or region names

The Transmission of Shocks through SIB Balance Sheets: Scenario Analysis

8. By propagating the impact across financial systems, adverse shocks to European G-SIBs balance sheets could have significant effects within and outside Europe. Two such shocks include: (1) a sudden freeze of wholesale markets; and (2) a sustained decline in prices of peripheral sovereign bonds.6 Their spillover effects are computed using a global model of bank balance sheets, which assumes that European banks maintain a target minimum Tier I capital ratio of 10 percent by contracting their balance sheet (“deleveraging”) in the face of sudden losses that cannot be absorbed by existing capital buffers.7 See Appendix II for details on methodology.

9. The deleveraging impact of a sizeable funding shock would be large, both in Europe and in other regions.

  • How large is the shock? Unsecured and secured wholesale funding markets are assumed to be under severe stress. As a result of a sharp increase in counterparty risk, funding costs in euro and US$ wholesale markets are assumed to increase by 130 bps (The shock corresponds to the average increase in the Euribor-OIS spread of 1, 3, and 6 months maturities between September 2008 and mid-October 2008). The loss of confidence is also assumed to prompt a decrease of 250 bps in the value of derivative market funding.8

  • Which are the most vulnerable G-SIBs? In absolute terms, the combined shocks would affect French, UK and German banking systems the most.

  • Which SIBs are likely to propagate the shock? The main drivers of deleveraging would be French, British, and German banks. Because French, UK, and German SIFIs have large absolute amounts of bank liabilities, the initial shock would be amplified through interbank exposures (Figure 4). French banks would be the most affected, as losses would eventually reach 22 percent of Tier I capital, followed by Belgium (20 percent of Tier I capital), German (17 percent), Swedish and Danish (15 percent) and UK banks (13 percent). Other euro area banks, including those from the periphery would be, in relative terms, somewhat less affected by the funding shock.

    Figure 4.
    Figure 4.

    Funding Shock: Equilibrium Bank Losses

    Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

    Sources: Fund staff calculations; BIS; and Bankscope.

  • Which European borrowers are most vulnerable? Assuming no policy reaction, the resulting deleveraging impact would be extremely large, exceeding 30 percent of GDP in the UK, France, Ireland, Spain, and Sweden (Figure 5). It would also affect many EU borrowers, including in emerging Europe.9

    Figure 5.
    Figure 5.

    Deleveraging by Banking Systems and by Vis-á-vis Country or Region

    (Billions ofUS dollars)

    Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

    Sources: Fund staff calculations; BIS.

  • Which borrowers outside Europe would be most affected? Although not at the same level as in the Euro Area, a noticeable foreign deleveraging impact (of less than 5 percent of GDP) would be faced by borrowers in some developed countries outside Europe (e.g. US, Japan, South Korea, and Australia) as well as in emerging markets (e.g., South Africa, India, Mexico, and Brazil). See Figure 6.

    Figure 6.
    Figure 6.

    Deleveraging Resulting from Funding Shocks (in percent of GDP)

    World

    Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

    Sources: Fund staff calculations; BIS; WEO.

10. The deleveraging impact following a sovereign shock would be substantial, but more concentrated within Europe.

  • How large is the shock? The scenario assumes that sovereign stress in Italy and Spain remains permanently high. This translates into a permanent decline in sovereign bond prices of Italy and Spain equal to the difference between their bond price on December 31, 2011 and March 2, 2012. For simplicity, it is also assumed that all exposures are marked-to-market;10 and there is a 30 percent haircut on exposures to Greece, Ireland, and Portugal. The size of the shock is such that it has a significant impact on the balance sheets and Tier 1 capital of banks in many high yield countries.

  • Which are the most vulnerable SIBs? Domestic banks in the periphery and several European SIBs in the core would be severely affected.

  • Which European borrowers are most vulnerable? In the absence of policy action, the impact of the deleveraging shock would be the largest among borrowers in the periphery because of the strong exposures of domestic banks to their sovereign. The large European economies (UK and Germany) would also be significantly impacted, with a deleveraging shock of almost 10 percent of GDP. As peripheral banks deleverage in non-EMU markets, there are significant spillovers in Southern Europe (Figure 7).

    Figure 7.
    Figure 7.

    Deleveraging Resulting from the Sovereign Shock (percent of GDP)

    World

    Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

    Sources: Fund staff calculations; BIS; WEO.

  • Which borrowers are most affected outside Europe? Some borrowers in Latin America (including Brazil, Mexico, and Chile) would be affected but generally to a lesser degree than European borrowers. Borrowers in the US, Japan, and Asian EMs would remain largely unaffected, although some in the region may suffer a modest impact.

Policy Implications

11. In light of the large contagion effects, policies should be aimed at containing the risks of a G-SIB failure and addressing too-big-to fail issues:

  • A comprehensive set of policies to address the root causes of the euro area sovereign debt crisis would go a long way toward mitigating the underlying fragilities of European sovereigns and banks. In particular, taking bold steps toward the establishment of a banking union for the euro area would help restore financial stability and mitigate spillover risks through G-SIBs.

  • In the meantime, a strong common backstop is needed for bank recapitalization (through EFSF/ESM), and ECB liquidity support must continue to be provided as needed. Similarly, given UK banks’ vulnerabilities to funding shocks, the Bank of England should stand ready to provide liquidity through a range of facilities if strains from the euro area crisis intensify.

  • European SIBs, and especially G-SIBs should continue to strengthen their funding models and capital buffers in order to increase market confidence in their resilience. It is important, however, to ensure that the build-up of additional capital buffers occurs mainly through capital raising and retained earnings rather than asset reduction, which could have adverse impact on the financial system and economic activity. Similarly, strengthening of funding model should not result in excessive and uncoordinated deleveraging.

  • A harmonized EU resolution framework for G-SIFIs would ensure orderly resolution and reduce the cost of resolution of large cross-border financial institutions. Progress made in developing recovery and resolution plans for major institutions in the UK is welcome.

  • International collaboration will be necessary to further bolster the stability of the financial system. Exchange of key information on a timely basis and cross-border supervisory cooperation are critical to containing risks emanating from large banks.

Appendix I: Data and Methodology Data

1. The analysis uses data on 32 SIBs—27 G-SIBs and 5 European SIBs that are considered likely to contribute to spillovers within Europe. The 5 SIBs, chosen from a large sample of European SIBs, scored high on the spillover metrics within Europe. The Table below shows the list of 32 SIBs. The equity prices of the 3 Japanese G-SIBs are aggregated into a weighted average, weighted by assets. This decision was taken following earlier analysis suggesting that the extent of spillovers from any one Japanese institution to another G-SIB outside Japan is low in comparison to other G-SIBs.

Appendix Table 1:

Sample Banks

article image

The three Japanese banks are represented by an asset-weighted average of equity returns.

Methodology

2. To identify the SIBs with high capacity to generate spillovers or high susceptibility to spillovers, four approaches based either on bank balance-sheet data or market data are used.

3. Balance-sheet based measure of interconnectedness (BSI) is computed as an equally-weighted average of three indicators: (i) value of securities holdings of a bank (as a percent of securities holdings of all sample banks), (ii) wholesale funding liabilities of a bank (as a percent of total wholesale funding liabilities of all sample banks); and (iii) wholesale funding ratio of a bank (in percent, normalized by the average wholesale funding ratio of a sample bank). The sample includes around 260 banks domiciled in 25 jurisdictions with systemically important financial sectors. This approach follows closely (using publicly available data) the G-SIB identification methodology of the Basel Committee on Banking Supervision.

Appendix Figure 1
Appendix Figure 1

BSI indicators for the sample of 260 banks domiciled in 25 jurisdictions with systemically important financial sectors

World

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

4. Diebold-Yilmaz measure (DY). The spillover measure suggested by Diebold and Yilmaz (2009) is a time-varying indicator of outward-spillovers of institutions—the contribution of one institution to systemic risk. In this note, the indicator uses market data on daily equity returns of the SIBs, and estimates contribution of a SIB in total outward spillovers to other institutions. Vector Autoregressions (VAR) of the weekly returns of 30 institutions are used to derive DY. Specifically, the variance decomposition (VD) at the 10th lag is used to derive a matrix of the portion of variance of the shocks to one institution attributable to another institution. The DY measure of spillover contributions of institution i is the percentage of institution i in the total VD of all institutions’ outward spillovers. The measure is based on central moments.

5. Conditional Value-at-Risk (CoVaR), Adrian and Brunnermeier (2010), uses market data to assess the contribution of an individual financial institution to systemic risk.—specifically, ACoVaR, the difference between the VaR of the financial system conditional on the distress of a particular financial institution i and the VaR of the financial system conditional on the median state of the institution i. Estimation is via Quantile regressions—the 5th and the 50th—of the daily returns in the asset-weighted daily equity returns, Xsystemt, of the system—including all the SIBs in the sample—are run on each institution’s daily equity returns, Xt

Xtsystem=αsystem|i+βsystem|iXti+εtsystem|i

The predicted/fitted values are used to derive the following at q = 5% and q = 50%:

CoVaRti(q)X^tsystem=α^system|i+β^system|iVaRti(q)

Finally, the ACoVaR of each institution is simply:

ΔCoVaRti(5%)=CoVaRti(5%)CoVaRti(50%)

Each marker in the ‘COVAR’ panel denotes the ACoVaR (5%) for each institution. It is the system-wide loss (in terms of percentage point of system returns) due to one institution moving from its median state to a (tail) risky state.

6. Chan-Lau-Mitra-Ong (CMO). The CMO (2012) spillover measure is an indicator of outward-spillovers of institutions during extreme times—the potential contribution of one institution to systemic risk during crisis. The indicator uses market data on returns (here, based on daily equity returns) to estimate extreme contributions to spillovers. All extreme events in the data—comprising daily returns on equities—are indentified at the 5th percentile of the joint distribution of returns. All returns lying in the left-tail, that is, the ones below the 5th percentile thresholds, are called ‘exceedances’. Then distress-dependence is estimated by using a logit model with the probability of a SIB being in exceedance estimated conditional on exceedances in other financial institutions.

7. The SIBs are identified as having a high capacity to generate spillovers or high susceptibility to spillovers based on the following criteria:

  • “High capacity to generate spillovers” are above-median on the balance-sheet based interconnectedness indicator (BSI) and at least two out of the three market-based spillover indicators (CoVaR, CMO and DY).

  • “High susceptibility to spillovers” are above-median on spillover-susceptibility from European SIBs listed under “High capacity to generate spillovers” on both DY and CMO indicators.

Appendix II: Scenario Analysis Methodology

1. The scenario analysis includes several rounds of asset and funding shocks, see Figure II-1 The first round considers bank losses on assets that deplete their capital partially or fully. The banking sector losses are calculated based on percentage loss assumptions in a particular economic sector (public sector, banking sector, and/or nonbank private sector) of an individual country or group of countries. Losses can also be assumed in the off-balance sheet exposures to an individual country or group of countries.1 In the second round, if losses are large enough, a capital ratio (e.g. Basel III Tier I capital asset ratio) is assumed to be restored through deleveraging (loans not being rolled over and selling of assets, assuming no recapitalization). In the third round, banks are assumed to reduce their lending to other banks (funding shocks), causing fire sales, and further deleveraging. Potential bank failures cause additional losses to other banks on the asset and liability sides. Final convergence is achieved when no further deleveraging needs to occur. The possibility of recapitalization allows the simulation of how a policy reaction could mitigate the deleveraging process. Further methodological details involved in the propagation of a default episode through triggering bank losses and deleveraging are presented below (see Tressel, 2010, and Cerutti et al 2011).

Appendix Figure II-1:
Appendix Figure II-1:

Shock Propagation across Borders through Bank Losses and Deleveraging

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

2. In this context, contagion across borders and through common lender effects can now be analyzed. Consider a common shock, due to a crisis in a particular sector/s in one or more countries, that involves losses of Xi percent on the foreign assets of banks from country i (illustrated in Figure II.2). If capital buffers are not large enough, and/or without bank recapitalization, deleveraging will need to occur to restore the assumed Tier I capital ratio of 10 percent.2 As depicted in Figure II.2, the analysis assumes for simplicity that deleveraging occurs proportionally across domestic and foreign assets.

Appendix Figure II.2:
Appendix Figure II.2:

Effect of Foreign Credit Losses on the Balance Sheet of Country i Banks

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

3. The process of deleveraging then means a global reduction in claims of all banks affected, either directly or indirectly, impacting financing and economic activity in various countries. For banks in borrower countryj, the funding shock (Yj) equals the deleveraging across all its creditor countries (Figure II.3). If the funding shocks trigger fire sales, banks could experience further losses, triggering additional deleveraging if capital buffers are not large enough and/or in the absence of bank recapitalization. The system converges to a steady state when no further deleveraging takes place (i.e. banks meet their capital adequacy requirements).

Appendix Figure II.3:
Appendix Figure II.3:

Effect of a Funding Shock on Balance Sheet of Borrower country j Banks

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

III. United States

8. Global Implications of the US Fiscal Cliff 1

The US budgetary outlook for next year is highly uncertain given the unusual confluence of expiring tax provisions and automatic spending cuts. In the absence of political agreement, fiscal policy would dramatically tighten, with severe economic consequences at home and negative spillovers to the rest of the world. Policymakers should resolve these uncertainties as soon as possible.

1. US fiscal policy next year is subject to considerable uncertainty. While most policymakers agree that the budget deficit should not be reduced too rapidly given the weak economy, a bipartisan agreement on policies is unlikely until after the November elections—shortly before numerous tax provisions (including the Bush tax cuts) are scheduled to sunset and deep automatic spending cuts take effect. Since the political debate on tax and spending policies is highly polarized, Congressional gridlock could result in a sudden fiscal contraction (“fiscal cliff”) of more than 4 percent of GDP in structural primary terms in 2013— about 3 percent of GDP above the staff baseline. It needs to be stressed, however, that the cliff remains mostly a tail-risk scenario; Congress resolved similar high-stakes situations in the past.

uA01fig02

Composition of U.S. Fiscal Cliff

(percentof GDP)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: CBO; and IMF staffestimates.

2. Should the tail risk of fiscal cliff materialize, the US economy could fall into a fully-fledged recession. Some anticipatory effects would be felt already in late 2012— subtracting perhaps percent from H2/2012 annualized growth according to the Congressional Budget Office (CBO), especially if consumers and businesses start perceiving the risk of an abrupt fiscal withdrawal as nonnegligible and hold back their spending plans. The economic effects of the cliff during 2013 are not possible to pin down precisely, not least because the sudden fiscal withdrawal would be unusually large and much would depend on whether policymakers subsequently agree on reversing part of the cliff. IMF calculations suggest, however, that if the sharp fiscal contraction is maintained throughout 2013, GDP growth would be around zero at best:

uA01fig03

Effects of Fiscal Cliff on U.S. GDP in 2013 (relative to staff baseline) 1/

(percentof GDP)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: GIMF,GPM,and G-35 model simulations.1/ Technica l detailsof simulations d iffer significantiyacross models;see the maintextfor explanations.
  • Applying standard growth multipliers to individual components of the fiscal cliff yields a growth forecast of about percent of GDP next year—that is 1¾ percentage points of GDP below the staff baseline growth forecast is 2¼ percent.2

  • GIMF and GPM models which explicitly take into account the zero bound on monetary policy point to stronger negative effects, with 2013 growth predicted between +¼ and -½ percent (that is, 2-2¾ percentage points of GDP below the staff baseline).3

  • The G-35 model which takes different technical assumptions about the cliff while assuming additional negative financial market confidence effects suggests that US annual growth could fall to as little as -2½ percent.4 Confidence could be eroded, for example, by brinkmanship over the federal debt ceiling which needs to be raised early next year.

  • In sum, the short-term economic effects of the fiscal cliff would be severe. Higher unemployment would increase the probability of unfavorable medium-term hysteresis effects as the unemployed stay out of work for longer, lose skills, and are discouraged from looking for a job. Even if the fiscal cliff were quickly unwound, the damage to the economy could be substantial, especially if consumers and businesses were faced with continued uncertainty about future tax and spending policies.

While the spillovers to the rest of the world would mostly propagate through trade channels, the negative effects would be felt strongly in many countries given the magnitude of the US fiscal contraction. The spillovers would be strongest among immediate neighbors (Canada and Mexico), with the first-year growth impact of roughly ½ of the US effects, that is, 1-1% percentage point of GDP in the scenario with stagnating—but not recessionary—US economy. For advanced Europe and Japan, the growth impacts would be much smaller, typically at less than ⅕ of the US growth shock, but a reduction in growth by percentage points would still be punishing, given the very weak cyclical position and narrow policy space. The spillovers could be amplified through negative confidence effects, for example reflected by a globally-synchronized drop in stock prices. The spillovers to emerging markets would be more manageable given moderate elasticities (also less than 1/5 of the US GDP effect), but higher trend growth rates, and generally more policy flexibility. That said, the model simulations may not fully capture the adverse effects of falling US demand on commodity prices and export-related investments when the underlying US shock is large.

uA01fig04

Spillovers from the US Fiscal Cliff in 2013

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: The map displays a ratio of domestic and US output effects. Source: G-35 model simulations.

3. Over the medium term, the debt reduction resulting from the fiscal cliff would likely offset the negative short-term output effects. After 10 years, the US federal debt ratio would fall by over 20 percentage points of GDP below the staff’s baseline scenario. The attendant drop in the world interest rate and a reduction in US risk premia5 would offset the negative structural effects of higher labor and capital taxation, boosting US output above the WEO baseline. Output would be only slightly higher in the rest of the world. However, model simulations suggest that the negative unemployment hysteresis effects noted above would erode some of the positive effects from lower public debt, underscoring the staff’s view that fiscal consolidation is best achieved through a gradual deficit reduction within a medium-term framework.

uA01fig05

Medium-Term Effects of Fiscal Cliff on Global GDP (relative to staff baseline)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: GIMF model simulations.

9. Effects of a Sovereign Debt Crisis in the United States1

The global macroeconomic costs of a hypothetical sovereign debt crisis in the US, triggered by acute concern over US fiscal sustainability, are analyzed using the G35 Model. Severe output losses in the US are accompanied by moderate to very severe output losses in the rest of the world. These spillovers are concentrated among geographically close trading partners and emerging economies with open capital accounts.

Introduction

1. This note analyzes the global macroeconomic costs of a hypothetical sovereign debt crisis in the US triggered in the future by acute concern over fiscal sustainability there, with and without accounting for monetary and fiscal policy responses in the rest of world. This analysis is based on a scenario simulated with the structural macroeconometric model of the world economy, disaggregated into thirty five national economies, documented in Vitek (2012). Within this framework, each economy is represented by interconnected real, external, monetary, fiscal, and financial sectors. Spillovers are transmitted across economies via trade, financial, and commodity price linkages.

Scenario Specification

2. We simulate a scenario representing a potential future sovereign debt crisis in the US. To measure spillover mitigation by conventional monetary policy responses and automatic fiscal stabilizers in the rest of the world, we simulate subscenarios which account for and abstract from these mechanisms. We assume that all of the shocks driving this scenario are temporary but persistent, following first order autoregressive processes having coefficients of 0.975.

3. Our sovereign debt crisis scenario represents a destabilizing spiral of intensifying financial stress and deteriorating confidence in the US which triggers a procyclical fiscal consolidation reaction there. We represent acute stress in the money, bond and stock markets with a positive credit risk premium shock which raises the short-term nominal market interest rate by 133 basis points, a positive duration risk premium shock which raises the long-term nominal market interest rate by 200 basis points, and a positive equity risk premium shock which reduces the price of equity by 27 percent. These risk premium shocks are correlated internationally to account for contagion effects. We represent confidence losses by households and firms with a negative private domestic demand shock which gradually reduces domestic demand by 1.3 percent. We assume a fiscal consolidation reaction by the government which gradually raises the ratio of the fiscal balance to nominal output by 1.3 percentage points. Expenditure measures represented by a negative fiscal expenditure shock account for 75 percent of this fiscal consolidation, while revenue measures represented by a positive fiscal revenue shock account for the remainder. Finally, there is a run on the currency, represented by an exchange rate risk premium shock which depreciates it by 13.3 percent in nominal effective terms.

Simulation Results

4. Under this scenario, severe output losses in the US are accompanied by moderate to severe output losses in the rest of the world. These spillovers are concentrated among geographically close trading partners and emerging economies with open capital accounts. Simulated peak output losses in the US range from 5.2 to 5.7 percent, depending on the degree to which monetary and fiscal policies respond in the rest of the world. Accounting for conventional monetary policy responses and automatic fiscal stabilizers in the rest of the world, simulated peak output losses range from 1.7 to 6.6 percent in other advanced economies, and from 0.5 to 6.3 percent in emerging economies. Abstracting from nominal policy interest rate cuts with offsetting positive monetary policy shocks and automatic deteriorations in the ratio of the fiscal balance to nominal output with offsetting negative fiscal expenditure shocks in the rest of the world amplifies these spillovers considerably. Indeed, under this subscenario simulated peak output losses range from 3.9 to 10.9 percent in other advanced economies, and from 3.1 to 11.3 percent in emerging economies. Aggregating these results implies a simulated peak world output loss of 3.4 to 6.0 percent, depending on the degree to which monetary and fiscal policies respond.

Figure 1
Figure 1

Simulated Peak Output Losses

World

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Note: Depicts simulated peak output losses less than 1.0 percent , between 1.0 and 2.5 percent , between 2.5 and 4.0 percent , between 4.0 and 5.5 percent , between 5.5 and 7.0 percent , and greater than 7.0 percent

10. Recent US Monetary Policy Actions—Domestic and International Effects 1

The Fed adopted several unconventional monetary policy actions over the past year to ease financial conditions and support the economic recovery. Event studies show evidence of international spillovers leading to downward pressures in yields of foreign government securities and some impact on exchange rates (depreciation of US NEER). However, in some cases the pass through from the Fed actions was more than offset by a deteriorating global outlook and risk sentiment.

Introduction

1. The Fed responded to weaker-than-expected US growth over the past year with a number of easing actions. The FOMC started to provide more explicit guidance on the path of the federal funds rate; announcing in August 2011 that it anticipated economic conditions to warrant exceptionally low federal funds rates at least through mid-2013. In January 2012, it extended its “conditional commitment” to late-2014. In September 2011, to support conditions in mortgage markets, the Fed started reinvesting principal payments on agency debt and agency MBS into agency MBS. In addition, it launched “Operation Twist” (OT), entailing purchases of up to $400 billion in US Treasury securities with remaining maturities of 6-30 years and sales of an equal amount of securities with remaining maturities of 3 years or less, to be completed by June 2012. The FOMC (in June 2012) decided to extend OT through the end of 2012, involving an additional purchases of $267 billion in Treasuries with remaining maturities of 6 or more years (this latest extension is not examined in the note). As with the Fed’s prior large scale asset purchases (LSAPs), the goal of OT was to reduce long-term interest rates in order to stimulate economic activity.

2. The international effects of the Fed’s recent policy actions are analyzed using event studies. The Fed actions are likely to affect not only domestic yields and assets prices, but also have an impact on foreign yields and asset prices, as well as exchange rates. The event studies—subject to a high degree of uncertainty given the unusually volatile market conditions in August-September—suggest that the Fed actions were associated with a reduction in ten-year US Treasury yields by around 50 basis points (cumulative effect). The international effects were mixed. Forward guidance announcements were followed by a depreciation of the dollar and falling interest rates on government bonds, but OT was accompanied by a flight from most emerging markets and an appreciation of the dollar.

Figure 1.
Figure 1.

Ten-yearTreasury Bond Yield (percent)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: Haver Analytics.

3. The note is organized as follows. Section II briefly discusses the mechanisms through which the Fed’s recent actions may have affected domestic and international financial conditions. Sections III focuses on the international effects following the Fed’s easing actions since mid-2011, but also provides a quick overview of the domestic impact as a background. Section IV concludes.

Mechanisms

4. In principle, larger securities holdings by the Fed raise the prices of those securities and substitute assets. Empirical evidence for prior LSAPs suggests that a reduced supply of Treasury securities to the public lowers the yields of the purchased securities as well as yields on securities with similar maturities. However, substitutability and the impact on yields diminish as maturities and risk structure get farther apart (D’Amico and King, 2011; Gagnon et al., 2010).2

Figure 2.
Figure 2.

Federal Reserve Ownership of Treasury Securities Outstanding, by Maturity

(percent of total Treasury securities outstanding by maturity)

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Sources: Board ofGovernors ofthe FederalReserve System; U.S. Department ofthe Treasury; Haver Analytics and Fund staffestimates.

5. By contrast, forward-guidance on the path of the policy rate lowers rates across the yield curve to the extent that it signals an easier-than-anticipated monetary policy stance. The signal could be particularly clear—and strong—under the zero lower bound on policy rates, and all interest rates are likely to be affected. Some analysts have argued that one channel through which LSAPs ease financial conditions is by signaling a commitment to keep rates low; however, others argue the evidence does not support that this channel is effective (Krishnamurthy and Vissing-Jorgensen, 2011).3

6. The actions of the Fed could also impact exchange rates and foreign asset prices. Yields on foreign securities are likely to be affected to the extent that investors change their portfolio composition between US versus non-U.S. securities in response to changes in the yields of US securities. Yields on foreign bonds are likely to fall less than yields on US securities, given their imperfect substitutability. The decrease in the differential between US and foreign yields would, in turn, be consistent with an expected appreciation of the US dollar (assuming no change in its expected long-run level) and therefore, an immediate US dollar depreciation. Neely (2011) reports significant effects of the Fed’s 2008-09 LSAP on foreign long-term bond yields and the US dollar exchange rate.

Financial Spillovers to Selected Advanced and Emerging Market Economies

7. This section assesses the spillovers on international financial markets from the Fed’s actions over the last year. The analysis is based on event studies measuring the (one-to three-day) responses of long-term government bonds, stock market indices and exchange rate rates (bilateral rates versus the US dollar) for a sample of advanced economies (AE) and emerging markets (EM).4 As discussed above, the easing actions of the Fed would be expected to reduce the yields of government bonds in the US and other countries, assuming foreign bonds are seen as partial substitutes to Treasuries. Yields on government bonds do tend to be correlated, especially among advanced economies (Figure 3). The announcements would also be expected to lead to a depreciation of the US dollar.5

Figure 3.
Figure 3.

Government Bond Yields

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Source: Bloomberg, LP.

Operation Twist

8. Operation Twist was launched on September 21, 2011, following a period of worsening US economic data. OT was aimed at lowering longer-term yields by expanding the share of the outstanding securities held by the Fed. The event studies show the 10-year Treasury yield fell by 22 basis points in the two-days following the announcement (Table 1), while the 30-year Treasury rate fell by 41 basis points and yields on 30-year agency MBS fell 28 basis points. All three changes were significant.6 However, the prices of riskier assets declined sharply. The stock market and oil prices fell by a large 6-7½ percent; uncertainty, as measured by the VIX, also rose significantly, and the US dollar appreciated. This negative reaction was likely due to adverse economic news, including the downgrade by Moody’s of three large US banks on the same day, and a deteriorating economic outlook.

Table 1.

Effects of Operation Twist and Forward Guidance Announcements

(two-day changes; yields in percentage points, stocks and exchange rates in percent)

article image
Notes: The numbers in italics are the fraction of daily tw o-day changes that fall below tw o-day change around the announcement date over the period from December 30, 2005 to April 11, 2012.

**, *** denote observations in the 90th, 95th, and 99th percentiles, respectively.

^^, ^^^ denote observations in the 10th, 5th, and 1st percentiles, respectively.

Absolute changes for the VIX.

Sources: Fund staff calculations on data from Bloomberg, LP and Haver Analytics.

9. The announcement of OT came on a day with elevated turbulence in global financial markets and rising concerns with the global economic outlook. It thus coincided with a flight from EMs (and mixed changes in AEs):

  • Government yields fell among AEs (between 3-17 basis points), although somewhat less than US Treasury yields, as expected. However, the bilateral exchange rate versus the US dollar depreciated in advanced economies (except Japan) likely reflecting a flight to safety to a reserve currency.

  • Among most EMs, the immediate impact was in the opposite direction relative to what would have been predicted based on the portfolio-balance channel. A rise in risk aversion and “flight to safety” among investors seemed to be the dominant factors—with the OT announcement only dampening the effects of rising uncertainty. Some EM currencies experienced large depreciation pressures (e.g., Brazil, Mexico, and South Africa) and the yields for government bonds rose between 10-30 basis points (Brazil, Mexico, South Africa, and Turkey). On the other hand, Korea and China saw their government yields fall. Stock markets, as other risky asset prices, fell sharply in the days following the announcement (especially in Brazil, Mexico, and Korea).

Forward Guidance

10. The Fed lowered long-term interest rates by providing explicit forward guidance on the policy rate path. Event studies indicate that both the August 2011 and the January 2012 announcements significantly lowered long-term Treasury yields and MBS yields (Table 1). There was no significant favorable reaction in riskier assets on the August announcement, potentially due to the financial volatility around that time.7 The January 25 announcement was, however, met by some decline in the investment-grade bond yield.

11. The August statement was followed by a generalized fall in yields and depreciation of the US dollar. Government yields tended to fall across all countries over the 2-day window (by 5-17 basis points), in some cases the drops were quantitatively significant and similar to the fall in the yields on US Treasury securities (21 basis points for the ten-year Treasury bond). The US dollar depreciated significantly against most currencies on the day of the announcement, but the impact tended to become less pronounced or disappear over the following days (with the exception of China). The behavior of the stock market varied widely across countries, with markets falling significantly in Europe (reflecting elevated market stress in the Euro area that week) and posting large gains in other countries (U.S., Brazil, Canada, and Mexico).

12. The January FOMC statement had a less pronounced impact on government yields, but the effects on the exchange rate were more persistent than after the August statement. Longer-term bond yields fell significantly in several AEs and EMs (especially in South Africa, European countries, and Mexico). Bilateral exchange rates appreciated for most advanced economies vis-á-vis the US dollar, especially the Euro, and in EMs (with Mexico, South Africa, and Turkey appreciating the most, between 1-2 percent) with the effects tending to be more persistent than after the August statement. Stock markets reacted positively, but the impact was not large, with a few exceptions.

13. The evidence suggests the Fed’s actions played a limited role in explaining the movements (and volatility) in long-term yields and exchange rates over the past years. All the Fed actions (OT and the two forward guidance announcements) lowered US Treasury yields; but at most they explain about one-third of the decline in the ten-year yield over the last 12 months.8 Given the difficulty in assessing the impact of the Fed’s actions (in particular OT) on exchange rates using event studies alone, staff also used VARs to estimate the impulse response of the trade-weighted US dollar exchange rate (NEER) to the ten-year US Treasury yield and financial market volatility measures (VIX for the US and VSTOXX for Europe). The estimated VAR suggests that the impact of the Fed’s actions over the last 12 months on the Treasury ten-year yield depreciated the US dollar NEER by ¾ percent. At the same time, the US dollar appreciated by 4½ percent in the period, implying that the effect of Fed’s easing actions over the past year on the US dollar NEER were more than compensated by other factors. In particular, the large movements in the US dollar NEER in recent years appear to be mainly associated with the large swings in volatility in global markets: the estimated structural shocks to the VIX account for about a third of the variance of NEER fluctuations between 2008 and April 2012, while the movements in the ten-year Treasury yield accounts for less than ten percent.9

uA01fig06

USD and Market Volatility

Citation: Policy Papers 2012, 086; 10.5089/9781498340243.007.A001

Conclusions

14. The Fed’s actions over the past year led to a fall in government yields in other countries and, in some cases, were accompanied by a depreciation of the US dollar. All the actions lowered US Treasury yields, with some evidence of downward pressure on other yields, especially after statements forward guidance. The international effects were mixed, partly as a result of the unsettled economic conditions—in some cases, the pass through from the Fed actions was more than offset by a deteriorating global outlook and risk sentiment.

  • The forward guidance statements led to material drops in government bond yields across AEs and EMs; OT had a similar impact on government bonds for AEs and the Asian EMs. However, OT, which coincided with heightened global risk aversion associated with financial strains in the Euro area, was followed by higher bond yields in the non-Asian EMs and a widespread fall in equity prices.

  • The forward guidance statements had a significant, but generally short-lived, impact on bilateral exchange rates. OT, on the other hand, was accompanied by a sharp appreciation of the US dollar as “flight to safety” by investors more than compensated for any depreciation effect from the Fed actions.

  • The volatile economic and financial environment at the time of the announcements makes it difficult to discern the effects of the Fed actions even using high frequency event studies. The policy announcements were themselves a reaction to the uncertain outlook and, as such, the observed mixed effects reflect not only investors reaction to the (unanticipated elements) of the policy but also the economic news of the day. In sum, the evidence suggests that recent monetary policy actions contributed to lowering yields on long-term Treasury bonds, but underlying volatile market conditions—reflecting a variety of other shocks—were also a key driver of movements in yields and exchange rates.

Table 2.

Financial Market Reaction to the Operation Twist Announcement (September 21, 2011)

(changes from day before announcement)

article image
Sources: Bloomberg, LP; Haver Analytics; and Fund staff calculations.Notes: The numbers in italics are the fraction of changes that fall below the event’s change over the period from December 25, 2005 to April 14, 2012.

**, ** denote observation: in the 10th, 5th, and 1st percentiles, respectively;

^^, ^^^ denote observations in the 90th, 95th, and 99th percentiles, respectively.

Bcchange rates are expressed as the country’s currency per U.S. dollar. A positive change in the exchange rate implies a depreciation of that country’s currency.

Shifted ahead one day, to account for time differences.

Table 3.

Financial Market Reaction to the August 9, 2011 FOMC Statement

(changes from day before announcement)

article image
Sources: Bloomberg, LP; Haver Analytics; and Fund staff calculations.Notes: The numbers in italics are the fraction of changes that fall below the event’s change over the perod from December 25, 2005 to April 14, 2012.

**, ** denote observations in the 10th, 5th, and 1st percentiles, respectively;

^^, ^^^ denote observations in the 90th, 95th, and 99th percentiles, respectively.

Bcchange rates are expressed as the country’s currency per U.S. dollar. A positive change in the exchange rate implies a depreciation of that country’s currency.

Shifted ahead one day, to account for time differences.