May 21, 2010, Sergio Schmukler
The 2008-2009 global financial crisis and the continuous shocks emanating from Europe following the Greek crisis have been transmitted around the world, with almost no country being unscathed. To shed light on the discussion on how different countries perform under such large shocks, it is useful to distinguish between two broad factors: the transmission of external shocks and the resilience of countries to those shocks.
The transmission of external shocks depends both on the size and nature of the shocks, as well as on the links between each country and the rest of the world. External shocks get transmitted across countries through two main channels: trade and finance.
Trade involves not only the direct exposure of countries to other countries, but also the general effects on trade balance. For example, when the U.S. economy contracted sharply in the last quarter of 2008, it not only demanded fewer exports from China, but it also depressed commodity prices, hitting all net commodity exporters (regardless of the final destination of the exports). Naturally, countries more open to trade and more dependent on exports were hit the most, as witnessed by the sudden sharp contractions in East Asia. As the U.S. and other economies recovered, both international trade and East Asia rebounded fast.
The financial channel is more complex. Many countries run current account deficits, especially during their development process, financed by external borrowing. To the extent that international lenders (banks, mutual funds, hedge funds, and so forth) face withdrawals due to an external crisis, they might cut lending to all countries in which they invest. This effect might take place because of margin calls, capital requirements, or other mechanisms that affect how financial intermediaries typically operate.
Moreover, international banks and other agents present in different developing countries might generate capital outflows during crises, for example if a parent bank in a developed country finds itself in need to boost its capital.
The financial channel might become active beyond these more mechanical factors. When risk aversion increases, many investors pull out of risky assets, dumping their investments in developing countries in exchange for assets perceived to be safe (lately, U.S. T-bills).
Once a country is hit by an external shock, how it performs, how resilient it is depends on its fundamentals. Because of the many crises suffered in the 1990s and early 2000s, many developing countries became much better prepared to withstand new crises and were consequently stronger when the crisis in the U.S. subprime sector erupted. Several factors in particular proved to be useful during late 2008 and early 2009, creating buffers between the external conditions and the local ones.
a. Fiscal policy
Many countries had improved their fiscal stance and had acquired fiscal space to put packages to counteract the contraction in the world economy (Figure 1). The most noticeable case is China, which had great ability to rapidly deploy its fiscal resources. The ones that did not have this fiscal space ended up becoming more vulnerable, as the crisis in peripheral Europe is showing nowadays.
b. Monetary policy
Perhaps one of the most surprising features of the developing countries’ responses to the recent global financial crisis was the drastic reduction in interest rates (Figure 2). Unlike previous crises in emerging economies, when countries were forced to increase interest rates to contain the drainage in reserves as their currencies came under attack, countries were able this time to use countercyclical monetary policy. Some developed countries even went beyond lowering interest rates to zero, by following quantitative easing (QE) to soften the stress in financial markets and pump liquidity into the system. The recently acquired credibility and institutional capacity of central banks was an essential asset to conduct an active monetary policy when the world economy came to a halt.
c. Exchange rate policy
Another key factor that contributed to the ability to lower interest rates was the exchange rate regime. Following the previous crises, especially the Argentine crisis of 2001-2002, many countries embraced more flexible exchange rate policies. This allowed exchange rates to depreciate in late 2008, cushioning the shock and, at the same time, improving the external balance (Figure 3).
d. External financial factors
Since many countries had also improved their current account positions, they were less vulnerable to external shocks, having less financing needs.
Furthermore, many countries had wisely changed the nature of external assets and liabilities, making the balance sheet effects work in their favor this time. Many countries switched their liabilities from debt to equity while accumulating debt assets in foreign currency (Figure 4). As their domestic currencies depreciated, their external assets revalued (in local currency) while their liabilities remained constant, or even shrank due to the collapse in equity markets.
Another consequence of the better external balance was the accumulation of foreign reserves (Figure 5), which gave central banks room to maneuver (managing the depreciations) and gave investors less incentives to attack the domestic currencies.
e. Domestic financial factors
An important factor in allowing the exchange to depreciate was the shift in developing country borrowing (except in Eastern Europe) from foreign currency to domestic currency (Figure 6). This has avoided the balance sheet effects common of previous crises, when devaluations led to debt overhang problems. In fact, the current discussions on the European crises partially miss this point. Even if Greece were allowed to the devalue or other countries like Portugal and Spain managed to reduce local wages and prices to become more competitive to boost growth through the trade channel, the fact that the debt is denominated in euros would increase the real financial burden, making the necessary price adjustment even larger and possibly entering a vicious cycle.
|Note: 4b: GDP-weighted averages of the periods noted. 4c: sum of two indexes (bank deposits in foreign currency as a share of broad money, total external debt as a share of GDP) that range from 0 (no dollarization) to 10 (total dollarization). Source: Gozzi et al (2009), Reinhart, Rogoff and Savastano (2003), IFS and Schmukler (2009) based on Reinhart, Rogoff, Savastano (2003)|
The domestic financial positions had also improved in several countries, due to better regulation, more prudent practices by financial intermediaries, and abundant local liquidity. Many countries now depend heavily on domestic deposits to fund the banks’ operations (Figure 7). When the international wholesale interbank market dried up, banks that relied on the short-term wholesale market were hit and suffered serious rollover problems. To the extent that the external environment deteriorated and that the local financial system proved to be in sound footing, depositors did not flee local banks (unlike previous crises). Perhaps for the first time, the domestic financial systems at least did not amplify the shock emanating from the international financial system.
Foreign banks present in developing countries did not act as a particular destabilizing force during the last crisis, behaving similarly than local private banks. Moreover, in some countries, public banks proved to be useful to mitigate the contraction in private sector credit (Figure 8).
This note was prepared by Sergio Schmukler with comments from Luis Serven. Paula Pedro and Virginia Poggio provided excellent research assistance. The graphs come from work done as part of the macro/financial monitoring at the Office of the Chief Economist, LAC. More information and analysis on the transmission of the global financial crisis came out as a series of presentations and notes, which are available upon request.
An updated version of this note is available as a working paper:
How Resilient Were Emerging Economies to the Global Crisis? by Tatiana Didier, Constantino Hevia, and Sergio L. Schmukler, World Bank Policy Research Working Paper 5637, April 2011.
Back to top