Rapid Spread of Crisis Reflects Close Global Economic Ties

• Author: Stephan Danninger/Ravi Balakrishnan/Selim Elkdag/Irina Tytell
• Position: IMF Research Department

Emerging economies are now so closely integrated with advanced economies that financial stress transmits rapidly and forcefully, with financial linkages a key channel of transmission, according to new IMF research.

But the decline in capital flows to emerging economies following a crisis may be protracted, given the solvency problems faced by banks in the major industrialized economies that provide significant financing to emerging markets.

Chapter 4 of the April 2009 World Economic Outlook (WEO), entitled "How Linkages Fuel the Fire: The Transmission of Financial Stress from Advanced to Emerging Economies," studies how financial stress is transmitted from advanced to emerging economies. New WEO economic forecasts are scheduled for release April 22.

The chapter presents a new financial stress index for emerging economies, building on a similar index introduced in the October 2008 World Economic Outlook for advanced economies. The new index measures the intensity of stress in different parts of the financial sector (equity markets, exchange markets, and the banking sector) and will be available for 18 emerging economies on a monthly basis since 1997. The index will be made available on the IMF website after the IMF Spring Meetings.

How large is financial stress?

The current financial crisis in advanced economies is unique in its depth, breadth, and impact. It has rapidly engulfed all parts of the global financial system (banks, securities, and exchange markets) and has already lasted longer than any systemic stress episode since the 1980s.

By the end of 2008 virtually all advanced economies were experiencing financial stress at crisis levels. As a result, financial stress in emerging economies also reached unprecedented levels. It spread quickly to all major emerging regions and multiplied through all parts of the financial sector. On average, the intensity of stress surpassed levels seen during the Asian crisis (see Chart 1).

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How does stress get transmitted?

According to our research, stress in emerging economies moves almost one-for-one with stress in advanced economies. The transmission is rapid and occurs within one or two months after advanced economies experience financial stress. But there is significant cross-country variation in the transmission...