TESTING FOR FINANCIAL CONTAGION BETWEEN DEVELOPED AND EMERGING MARKETS DURING THE 1997 EAST ASIAN CRISIS. Philip Arestis University of Cambridge

Transcription

1 TESTING FOR FINANCIAL CONTAGION BETWEEN DEVELOPED AND EMERGING MARKETS DURING THE 997 EAST ASIAN CRISIS Pilip Aresis Universiy of Cambridge Guglielmo Maria Caporale Brunel Universiy, London Andrea Cipollini Queen Mary, Universiy of London Nicola Spagnolo Brunel Universiy, London April 5 Absrac In is paper we examine weer during e 997 Eas Asian crisis ere was any conagion from e four larges economies in e region Tailand, Indonesia, Korea and Malaysia o a number of developed counries Japan, UK, Germany and France. Following Forbes and Rigobon, we es for conagion as a significan posiive sif in e correlaion beween asse reurns, aking ino accoun eeroscedasiciy and endogeneiy bias. Furermore, we improve on earlier empirical sudies by carrying ou a full sample es of e sabiliy of e sysem a relies on more plausible overidenifying resricions. Te esimaion resuls provide some evidence of conagion, in paricular from Japan e major inernaional lender in e region, wic drasically cu is credi lines o e oer Asian counries in 997. Keywords: Conagion, Financial Crises, Condiional Correlaion JEL Classificaion: F3, G5 Corresponding auor: Professor Guglielmo Maria Caporale, Brunel Business Scool, Brunel Universiy, Uxbridge, Middlesex UB8 3PH, UK. Tel.: Fax: Guglielmo-Maria.Caporale@brunel.ac.uk

2 . Inroducion Before e 99s, financial crises were seen as evens only affecing e counry in wic ey ad originally occurred. However, e financial crises of in Mexico, in Eas Asia, and 998 in Russia spread rapidly beyond e counries were ey ad originaed o oers wi differen economic srucures and insiuions. Tis paper focused on esablising weer conagion ook place in e case of e Eas Asian crisis, more precisely beween e financial sysems of e four larges economies in e region, i.e. Tailand, Indonesia, Korea and Malaysia, and ose of e main inernaional lenders, i.e. Japan, Germany, France and UK. Following King and Wadwani 99, we define conagion as a significan increase in cross-marke linkages afer a sock o one counry, and also correc for eeroscedasiciy and endogeneiy bias as suggesed by Forbes and Rigobon, and Rigobon 4, respecively. Furermore, in order o deermine endogenously e breakpoins denoing e conagion period, we employ e sequenial dummy es inroduced by Caporale e al 5 a relies on more plausible over idenifying resricions compared o earlier sudies. Finally, as in e laer sudy, we compue e appropriae criical values for is es by means of boosrap. Te layou of e paper is as follows. Secion reviews e lieraure on ess of financial conagion based upon condiional correlaion analysis and oulines e empirical meodology. Secion 3 presens e empirical resuls. Secion 4 summarises e main findings and offers some concluding remarks along wi a number of policy implicaions o improve e conainmen of conagion spreading. Tese four counries are by far e main inernaional lenders o e Eas Asian counries examined in is paper. Tis is e reason wy e US as been lef ou of our sample of developed counries, e four included being more relevan o e analysis carried ou in our sudy. I oug o be noed a ere is no general consensus among economiss on e definiion of conagion. Pericoli and Sbracia 3 provide a criical review of e eoreical and empirical lieraure, wi differen definiions of conagion.

3 . Correlaion Analysis of Financial Conagion. A brief review of e lieraure Te es for conagion adoped in is paper is based upon a condiional correlaion analysis. In oer words, a parameer sabiliy es on e coefficien describing e relaionsip beween asse reurns is used o es e null of inerdependence agains e alernaive of conagion. In eir seminal sudy, King and Wadwani 99 were e firs o measure conagion as a significan increase in e correlaion beween asses reurns. Specifically, ey analysed e correlaion beween US, UK and Japanese equiies reurns around e ime of e 987 sock marke cras, and found a e degree of correlaion increased afer Ocober 987. Tere followed a vas empirical lieraure on is ype of es for conagion, wic as been discussed exensively elsewere see, e.g., Forbes and Rigobon, Recenly, Rigobon 4 as poined ou a ess for conagion based on condiional correlaion analysis ave serious limiaions. In paricular, parameer sabiliy ess using ig-frequency financial series suffer from eeroscedasiciy, endogeneiy and omied variables bias. Consider e srucural form sysem: A Y = A DY Γz ε were Y = [y, y ] is a vecor of wo demeaned endogenous variables counryspecific asse reurns a ime. In paricular, in is paper, y and y correspond o asse reurns in an Eas Asian emerging marke and a developed counry, respecively. Te componens of e vecor ν = [ε, η ] are srucural form idiosyncraic socks. Furermore, e vecor DY, wic capures deerminisic sifs in e slope coefficiens associaed wi e endogenous variables, is given socasic regressors D and D, a is: 3 Dungey e al. 4a uilise a unifying framework a enables em o examine e similariies and differences of e various empirical sudies of conagion in financial markes. A companion paper Dungey e al., 4b discusses e implemenaion of e ess described in Dungey e al. 4a, and also deals

4 DY = D D Te regressors D and D are obained, respecively by muliplying e ime series y in by a dummy variable aking value wen ere is conagion from counry y o counry y and elsewere, and e ime series y by a dummy variable aking value wen ere is conagion from counry y o counry y and elsewere. We use e 3 - mon US Treasury bill as a proxy for e common sock z, in order o capure e effec of common moneary policy sifs ere idenified as sifs in e US Federal Reserve policy 4. Te coefficien marices in ave e following specificaion: A = ; A = ; Γ = A saisically significan and posiive suggess conagion from e developed counry o e emerging marke. Evidence of conagion in e opposie direcion is indicaed by a saisically significan and posiive. In paricular, In line wi Forbes and Rigobon, i is imporan o noe a e es for e null of inerdependence versus e alernaive of sif conagion is one-sided given a, under e alernaive of conagion, we expec and, or o be posiive 5. Given e srucural form sysem in, e reduced form socks are given by: = = [ * D D z ε η ] [ * D D z ε η ] wi a number of issues suc as daa frequency, missing observaions, endogenous definiions of e periods of crisis. 4 Te use of ineres raes as a proxy of z is advocaed, for insance, by Rigobon 3. More recenly, Rigobon 4 as reaed e common sock as a laen variable. 3

5 From eq. we can obain e uncondiional second momens for e reduced form innovaions: E E = E ς η ςε 3 were E is e uncondiional expecaion operaor, ζ η and ζ ε are e uncondiional variances of e srucural form innovaions, and e uncondiional variances for z, D and D are assumed o be equal o uniy. From equaion 3, i can be seen a e uncondiional covariance marix for e reduced form socks gives ree equaions, wereas ere are seven unknowns:,,,,, ζ η and ζ ε. I follows a e sysem in is no idenified. Te idenificaion meod suggesed by Rigobon 4 is based upon e eeroscedasic ime series properies of e variables under invesigaion. However, is meod, by relying on swices in e uncondiional variances of e srucural form socks, can idenify a simulaneous equaion sysem wi sifs in e slope coefficiens only if e number of regime sifs in e second momens is equal o or greaer an five. Terefore, i requires e deecion of a leas four breakpoins for e second momens. Te recen empirical lieraure on conagion based upon condiional correlaion analysis relies on e assumpion of only wo regime sifs in e uncondiional variances associaed wi a ranquil and a urmoil period, respecively. Consequenly, some addiional resricions ave o be imposed o idenify e sysem in. Te firs assumpion see e sudies below consiss in considering e common sock z as a predeermined variable ence, i is implicily assumed a equals o zero. In Forbes and Rigobon, and Baig and Goldfain 998, ere is also a zero exclusion resricion on one of e wo slope coefficiens in order o es for conagion. 6 5 Te DCC saisic proposed by Rigobon 3 o es for conagion is wo-sided. 6 Forbes and Rigobon propose a correcion for eeroscedasiciy bias affecing e parameer sabiliy es on e correlaion coefficien. Teir empirical analysis based upon e reurns in 36 emerging markes suggess lile evidence of conagion see also Baig and Goldfain, 998 for similar resuls. 4

6 Rigobon 3 relies also on e assumpion of swices in e uncondiional variance of only one of e wo socks. 7 An alernaive meod for sysem idenificaion is based on considering swices in e condiional variances. More specifically, Rigobon sows ow o idenify a srucurally sable sysem wiou a common sock employing a Mulivariae GARCH specificaion for e condiional variances of e srucural form innovaions. Our conribuion, oulined in e nex secion, consiss in acieving idenificaion of e sysem given by by imposing resricions on e specificaion for e Mulivariae GARCH specificaion for e condiional second momens.. Idenificaion roug GARCH Te condiional forecass for e second momens corresponding o e reduced form residuals in are given by:,,, D D z = η ε 4 If we assume z, D, D equal o uniy, and a mulivariae GARCH specificaion for condiional forecass of e second momens for e srucural form socks 8 : =,, η ε η ε η ε η ε ς ς 5 7 Noe a e Deerminan of e Cange in Covariance marix es DCC employed by Rigobon 3 is wo-sided, given a e alernaive ypoesis implies sifs in eier direcion of e slope coefficien. Using e DCC es, e finds some evidence of conagion beween e Eas Asian counries during e 997 crisis. 5

7 en, by replacing 5 in 4, we obain eq. 6: [ ] [ ] =,,,,, ε η ς ς Te coefficien marices eac of dimension 3 in las wo addends provide equaions, conaining 3 unknowns eig from e mulivariae GARCH specificaion for e condiional variance, and five from e condiional mean. Terefore, we assume zero volailiy spillovers among e srucural form socks e.g. = = = = in order o over idenify e simulaneous equaion sysem given by and 5. I is imporan o observe a, in e aforemenioned sudies, e unknowns of e srucural form sysem are esimaed by GMM. Tis involves spliing e sample ino a ypically large non-crisis and a small crisis period. As sown by Dungey and Zumabekova, suc ess ave very low power, and exending e crisis sample period can cange e inference alogeer 9. In is paper, as sown in equaion, we use deerminisic dummies in order o exploi e full sample informaion se. Moreover, e esimaion of e srucural form sysem given by and by 5 imposing zero volailiy spillovers is obained roug Quasi Maximum Likeliood. More specifically, assuming a e srucural innovaions are Gaussian, e condiional log-likeliood ignoring a consan erm is: 8 We are impliciily imposing e sandard orogonaliy condiion among e srucural form innovaions for e purpose of idenificaion. 6 9 Te sudy by Favero and Giavazzi is no subjec o is criique, as ey use e full sample o invesigae weer ere is any evidence of conagion wiin e ERM counries during e EMS crisis. Idenificaion is obained using zero exclusion resricions on e lags for e condiional mean sysem.

8 L = Γ ν ' Γ ν log were ν is e vecor of srucural innovaions. We maximise e join log-likeliood Σ L over e parameers of e condiional mean and variance equaions by using e simplex algorim in e firs few ieraions and en e BFGS algorim. Furermore, as in Caporale e al 5, in order o es for parameer insabiliy in e condiional mean, we implemen a one-ail es for e join null H : = = a is, inerdependence agains e alernaive of conagion from a leas one counry e.g. a leas one of e coefficiens beween and is posiive. For is purpose, we use e following Wald saisic: W = [ Rθ ]'[ RVar θ R'] [ Rθ ] were R is e q k marix of resricions, wi q equal o e number of resricions and k equal o e number of regressors; θ are e esimaed parameers, and Var θ is e eeroscedasiciy-robus consisen esimaor for e covariance marix of e parameer esimaes. Finally, we use a one-ail -raio saisic for e coefficiens and o es e null of inerdependence agains e alernaive of conagion..3 Inference using boosrapped criical values In e aforemenioned sudies e window separaing differen periods is cosen arbirarily. In is paper we deec e breakpoin endogenously by employing a sequenial dummy es. For is purpose, we considered a number of differen specificaions for e sep dummy e.g. we allow e saring dae for conagion o range from January 997 o June 998 and we selec e one wi e larges Wald saisic. We conclude a ere is evidence of conagion only if is saisic is significan and if 7

9 e coefficiens associaed wi e sep dummies are posiive and significan. In line wi Caporale e al 5, given a under e null of parameer sabiliy e.g., inerdependence, e disribuion of bo e -raios and Wald saisics are unknown, we obain e relevan criical values roug boosrapping. In paricular, firs we esimae, under e null of parameer sabiliy, e sysem given by and by 5 imposing zero volailiy spillovers, a is: y y y y = y = y z ε z η = ςε y, ε y, = ςη y, ε y, 7 8 Given e esimaed parameers, and, and given e esimaed residuals from 7, ε and ε, e laer are re-sampled wi replacemen, generaing e arificial series: y y y = y z ε y y = y z ε y 9 Using e arificial series given by 9, we joinly esimae e following sysem: y = y D y z η y y = y D y z η y 9 y y = δ δ δ = δ δ δ y, y, δ η δ η 4 y,, y, Te idenificaion sceme adoped ere was suppored empirically by e presence of condiional eeroscedasiciy modelled as an Inegraed Generalized Auoregressive Condiionally Heeroskedasic IGARCH srucure. Finally, a Ljung-Box es on e squared sandardised residuals sows no evidence of remaining eeroscedasiciy. Tese resuls are available upon reques. 8

10 and en compue e Wald es saisic, corresponding o e breakpoin cosen as above. Repeaing is exercise imes, we are able o boosrap e disribuion of e Wald es saisic, ereby obaining e 95% empirical criical values. Having esed for e presence of a srucural break conagion, we assess weer e causaliy links during e crisis period are uni-direcional or bi-direcional, cecking for e saisical significance of e esimaed coefficiens associaed wi eac dummy by means of boosrapped robus -raios.. 3. Empirical Analysis To es for financial conagion we use weekly sock reurns for four developed counries e major inernaional lenders: Japan, Germany, UK and France, and for e four larges economies in e Eas Asian region, wic were mos eavily affeced by e crisis Tailand, Indonesia, Korea and Malaysia. Te sample period goes from e firs week of Augus 99 o e las week of July 998. Tis end dae as been cosen in order o avoid any overlap wi e Russian crisis of Augus 998. Te coice of e breakpoin, corresponding o e beginning of e conagion period, is obained employing e sequenial dummy es described above. In Table we repor e exposure of e major inernaional lenders o e four Eas Asian emerging marke economies under invesigaion beween e second semeser of 996 and e firs semeser of 998. Our empirical findings are in line wi ose of Kaminsky and Reinar, wo found a e drasic reducion in bank lending from e major inernaional lenders ad some conagious effec on e Eas Asian counries. Beween e firs semeser of 997 and e firs semeser of 998, e developed counries reduced subsanially eir exposure oward e Asian region see Table. In paricular, by inspecing Table and Table 3, i can be seen a, by e end of 997, Japan wic ad e larges exposure o e Eas Asian region is e only developed economy o ave conagious effecs on eac of e emerging markes under invesigaion. During e second semeser of 997 ere is evidence of conagion from France o Indonesia reflecing e fac a is developed economy was e only one o All series ave been obained from Daasream, and e package RATS was used for e compuaions. 9

11 ave significanly decreased is lending o Indonesia by e end of 997, and also from Germany o Indonesia in e firs semeser of 998 wen Germany decreased is lending oward is emerging marke. Moreover, e empirical evidence indicaes e presence of conagion no only from Japan, bu also from France e counry wic mos abruply cu is credi lines beween e second semeser of 997 and e firs semeser of 998 o Korea in April 998. Finally, in conras o Forbes and Rigobon and o Rigobon 3, we find some evidence of conagion from e Eas Asian counries o e developed ones. Specifically, ere appears o ave been conagion during e second semeser of 997 from Indonesia o e UK. Tis developed counry was eavily exposed o Indonesia, and i ad cu only sligly is credi lines o is emerging counry by e end of 997. Tere are also some conagious effecs from Korea and Tailand o France, wic ad e larges exposure of all developed counries o ese wo emerging marke economies, and from Tailand o e UK. 4. Conclusions Te main empirical finding of is paper is e exisence of conagion beween Japan and e four larges counries in Eas Asian region Tailand, Indonesia, Malaysia, Korea during e crisis period. Following Forbes and Rigobon and Rigobon 3, we ave esed for conagion as a posiive sif in e degree of co-movemen beween asse reurns, aking ino accoun eeroscedasiciy and endogeneiy bias. Moreover, we ave improved upon eir sudy by aking e approac advocaed by Caporale e al 5, wic relies on more plausible overidenifying resricions by carrying ou a full sample es for e sabiliy of a srucural form sysem. Te esimaion resuls sow a e impac of e Eas Asian crisis on developed financial markes was small. Risk diversificaion roug reallocaion of bank loans, a subsanial decrease of e exposure o Eas Asian counries on e par of Wesern and Japanese banks, and prudenial supervision and regulaion, reduced e impac of e Eas Asian crisis on e developed economies. By conras, e drasic reducion of inernaional lending in e las wo quarers of 997, especially from Japan e counry wi e larges exposure

12 oward e Asian region, ad a significan conagious effec on e Eas Asian economies. Tere are clear policy implicaions of our findings were conagion is eviden. Te imporance of informaion disclosure by large inernaional invesors, improved sandards and prudenial conrols in borrowing and lending, along wi inernaionally coordinaed regulaions of edge funds and oer insiuions a are igly leveraged, are e mos obvious. In order o be successful, suc policies sould also be accompanied by effecive regulaion and supervision of financial sysems o ensure pruden risk managemen on e par of banks and corporaions. Even more imporanly, relevan canges o e inernaional financial arciecure sould be implemened o guaranee e success of ese policy measures.

13 References Baig, T. and I. Goldfajn 998, Financial marke conagion in e Asian crisis, Inernaional Moneary Fund, WP/98/55. Basel Commiee on Banking Supervision 999 Supervisory lessons o be drawn from e Asian crisis, BIS working paper no.. Caporale, G.M., Cipollini, A. and N. Spagnolo 5, Tesing for conagion: a condiional correlaion analysis, Journal of Empirical Finance, forcoming. Dornbusc, R., Park, Y.C. and Claessens, S., Conagion: Undersanding How i Spreads, Te World Bank Researc Observer, 5, Dungey, M. and D. Zumabekova, Tesing for conagion using correlaions: some words of cauion, WP no. PB-9, Cener for Pacific Basin Moneary and Economic Sudies, Economic Researc Deparmen, Federal Reserve Bank of San Francisco. Dungey, M., R. Fry, B. Gonzalez-Hermosillo and V. Marin 4a, Empirical Modeling of Conagion: A Review of Meodologies, Inernaional Moneary Fund, WP/4/78. Dungey, M., R. Fry, B. Gonzalez-Hermosillo and V. Marin 4b, A Comparison of Alernaive Tess of Conagion wi Applicaions, mimeo, Ausralian Naional Universiy. Favero, C.A. and F. Giavazzi, Looking for conagion: evidence from e ERM, NBER Working Paper no Forbes, K. J. and R. Rigobon 999, Measuring conagion: concepual and empirical issues, MIT-Sloan Scool of Managemen, mimeo. Forbes, K. and Rigobon, R., No conagion, only inerdependence, Journal of Finance, 575, 3-6. Kaminsky, G. and Reinar, C. M., Bank lending and conagion: evidence from e Asian crisis in T. Io and A. Krueger, eds., Regional and Global Capial Flows: Macroeconomic Causes and Consequences, Cicago: Universiy of Cicago Press for e NBER. King, M. and S.B. Wadwani 99, Transmission of volailiy beween sock markes, Review of Financial Sudies, 3, King, M., E. Senana and S.B. Wadwani 994, Volailiy and links beween naional sock markes, Economerica, 64,

14 Pericoli, M. and Sbracia, M. 3, A Primer on Financial Conagion, Journal of Economic Surveys, 7 4, Rigobon, R., "Currency Crises and Conagion: an inroducion", Journal of Developmen Economics, 69, Rigobon, R. 3, On e measuremen of e inernaional propagaion of socks: is e ransmission sable?, Journal of Inernaional Economics, 6, Rigobon, R. 4, Idenificaion roug eeroscedasiciy, Review of Economics and Saisics, 854, Senana, E. 99, Idenificaion of mulivariae condiionally eeroscedasic facor models, LSE, FMG Discussion Paper no. 39. Senana, E. and Fiorenini, G., Idenificaion, esimaion and esing of condiionally eeroscedasic facor models, Journal of Economerics,,

15 Table : Developed counries exposure o Eas Asian emerging markes GER Q4 996 Q 997 Q4 997 Q 998 KOREA THAI MAL INDO FRA Q4 996 Q 997 Q4 997 Q 998 KOREA THAI MAL INDO JAP Q4 996 Q 997 Q4 997 Q 998 KOREA THAI MAL INDO UK Q4 996 Q 997 Q4 997 Q 998 KOREA THAI MAL INDO Noe: billions of US dollars. Source: BIS

16 INDONESIA Table : Wald es for conagion FRANCE GERMANY JAPAN UK MALAYSIA SOUTH KOREA THAILAND Noe: Te variables in eac cell are e Wald Tes saisics under e null H : = =. Te corresponding boosrapped 95% empirical criical values are in pareneses. Numbers in bold indicae evidence of conagion. 5

17 Table 3: Crisis period esimaion FRANCE GERMANY JAPAN UK INDONESIA.96 {Dec97} 4.99;.9.9 {Feb98} 4.43;.8.5 {Sep97} 4.89; ; ; ;...55;..88 {Oc97}.6;.6 MALAYSIA ; {Sep97} 3.78; ; 3.39 SOUTH KOREA.47 {Apr98}.6; ; ;.5.9 {Oc97} 4.45; ;.76.4 {Apr98} 8.5; ;.4 THAILAND.65.85;..9 {Jul97} 5.67;.. {Jul97} 4.93; ; ;.3.8 {Apr98} 8.8;.68 Noe: Te poin esimaes for and are repored in e op and boom panel, respecively, of eac cell. Numbers in brackes give e -raios and e corresponding boosrapped 95% criical values. Te conagion daes are in bold and in curly brackes. 6