The propagation of financial turbulence: interdependence, spillovers, and direct and indirect effects
The propagation of financial turbulence: interdependence, spillovers, and direct and indirect effects
Zhongbo Jing 0 1 2 3 4 5 6
J. Paul Elhorst 0 1 2 3 4 5 6
Jan P. A. M. Jacobs 0 1 2 3 4 5 6
Jakob de Haan 0 1 2 3 4 5 6
De Nederlandsche Bank, Amsterdam, The Netherlands
0 Faculty of Economics and Business, University of Groningen , PO Box 800, 9700 AV Groningen , The Netherlands
1 School of Management Science and Engineering, Central University of Finance & Economics , Beijing 100081 , China
2 We thank Haizhen Yang, Niels Hermes, and Tjeerd Boonman for helpful discussions, and two referees and the editor for their helpful comments on a previous version of the paper. Zhongbo Jing thanks the National Natural Science Foundation of China (NSFC Grant Numbers: 71532013 , 71273257, 71401188 , and 71503290) and CUFE Young Researcher Development Fund (QJJ1619) for support. The views expressed do not necessarily reflect those of De Nederlandsche Bank
3 CESifo , Munich , Germany
4 CIRANO , Montre?al , Canada
5 CAMA, Australian National University , Canberra , Australia
6 University of Tasmania , Hobart , Australia
We investigate the propagation of financial turbulence via trade, capital flows, and distance channels in the pre-crisis and Global Financial Crisis periods by modeling spillover and interdependence effects, using spatial econometric techniques. Financial turbulence is proxied by the ratio of nonperforming loans to total loans in a country. Spillover effects are defined as significant changes in the linkages between countries due to a shock, and interdependence effects as strong linkages among pairs of countries independent of shocks. Using annual data of 40 countries from 2003 to 2010, we find that interdependence and spillover effects should be jointly analyzed. Furthermore, our results suggest that the capital flows channel is more important than the other two channels in capturing propagation of financial turbulence. By deriv-
B J. Paul Elhorst
ing what is known in the spatial econometrics literature as direct and indirect effect
estimates, we show that the marginal effects of macroeconomic variables (like GDP
growth, inflation, and credit growth) on financial turbulence take different forms during
a crisis than in tranquil periods.
JEL Classification C23 ? G21 ? F30
1 Introduction
The financial crisis in the USA of 2007/08 led to banking crises in more than 20
countries (Laeven and Valencia 2013). Different from earlier crises, the Global Financial
Crisis (GFC) not only affected many countries but also did so within a short period
of time. Both features have stimulated scholars to investigate the spread of financial
turbulence (cf. Cetorelli and Goldberg 2010; Aloui et al. 2011; Forbes 2012).
Two mechanisms can explain financial turbulence propagation, namely spillover
effects and interdependence. Forbes (2012) defines spillover effects as a significant
increase in the linkages across countries (or markets) after a shock in one country (or
market), like a financial crisis. Interdependence is defined as strong linkages between
two countries (or financial markets) that exist at all times, including the time before a
financial crisis, but also during the crisis.
This paper aims to investigate interdependence effects of financial turbulence
via different transmission channels in both the pre-crisis and the GFC periods, and
spillover effects in the GFC period within one framework. Following Caprio and
Klingebiel (1996) and Demirg??-Kunt and Detragiache (1998), we apply the ratio of
nonperforming loans to total gross loans as proxy for financial turbulence and use
spatial econometric techniques to analyze propagation of financial turbulence.
This paper makes several contributions. Firstly, unlike most previous studies, we
distinguish spillover and interdependence effects in analyzing financial turbulence
propagation. This distinction is important since appropriate policy interventions may
depend on the propagation mechanism at work. If financial turbulence is due to
interdependence, trade diversification could be effective to reduce propagation of financial
turbulence, while liquidity support or other forms of financial assistance are probably
not very effective under these circumstances and may even delay appropriate
adjustments. By contrast, if financial turbulence is due to spillover effects, like a freeze of
the money market, liquidity support to stabilize the banking system could be more
effective.
Secondly, for optimal policy interventions, it is also critical to identify the
transmission channel of financial turbulence propagation. Research by Mendoza and Quadrini
(2010) suggests that capital flows play an important role in the propagation of financial
crises. However, also trade can transmit a crisis from one country to another (Calvo
and Reinhart 1996). Moreover, Glick and Rose (1999) argue that crises occur
regionally, suggesting that distance may also be important. The proposed spatial ec (...truncated)