International financial spillovers to emerging market economies: How important are economic fundamentals?

Highlights

• EMEs with stronger fundamentals fared better during the taper tantrum in 2013.

• Differentiation set in early and persisted through the taper tantrum episode.

• We find little evidence of differentiation during the 1990s and early-2000s.

• But we find such evidence for stress episodes since the 2008 financial crisis.

• We construct an index of EME vulnerability to measure the strength of fundamentals.

Abstract

We assess the importance of economic fundamentals in the transmission of international shocks to financial markets in various emerging market economies (EMEs), covering the so-called taper-tantrum episode of 2013 and seven other episodes of severe EME-wide financial stress since the mid-1990s. Cross-country regressions lead us to the following results: (1) EMEs with relatively better economic fundamentals suffered less deterioration in financial markets during the 2013 taper-tantrum episode. (2) Differentiation among EMEs set in relatively early and persisted through this episode. (3) During the taper tantrum, while controlling for the EMEs’ economic fundamentals, financial conditions also deteriorated more in those EMEs that had earlier experienced larger private capital inflows and greater exchange rate appreciation. (4) During the EME crises of the 1990s and early 2000s, we find little evidence of investor differentiation across EMEs being explained by differences in their relative vulnerabilities. (5) However, differentiation across EMEs based on fundamentals does not appear to be unique to the 2013 episode; it also occurred during the global financial crisis of 2008 and, subsequently, during financial stress episodes related to the European sovereign crisis in 2011 and China’s financial market stresses in 2015.

Introduction

Starting in May 2013, on news that the Federal Reserve could soon start tapering its large scale asset purchases (LSAPs), financial conditions in emerging market economies (EMEs) deteriorated sharply. Investors withdrew capital, currencies depreciated, stock markets fell, and bond yields and premiums on credit default swaps rose. This so-called taper-tantrum episode sparked debate on how the rest of the world may be affected—and which economies, especially among the EMEs, may experience the most adverse effects—once the process of U.S. monetary policy normalization set in.

Indeed, one intriguing feature of the “risk-off” episode during the summer and fall of 2013 was that it did not have a similar effect on all EMEs. While some countries experienced acute deteriorations in financial conditions, others were much less affected. The varied experiences of the different EMEs have spawned research on whether the heterogeneous response of EME financial markets during the taper tantrum can be explained by differences in economic fundamentals across these economies (see, for example: Prachi et al., 2014, Eichengreen Barry and Poonam Gupta, 2015, Aizenman et al., 2016, Sahay et al., 2014). And, these experiences have also focused attention on whether, more broadly, the effects of U.S. monetary policy shocks on EMEs over a longer period have been related to these economies' own vulnerabilities (Bowman et al., 2015).

In this paper, we seek to contribute to this growing literature by addressing three broad questions: First, to what extent did investors differentiate among the EMEs based on their economic fundamentals during the “risk-off” episode of 2013? Or, can the heterogeneous responses across EMEs be explained by other factors, such as whether those economies that initially received the heaviest capital inflows were also the ones from which investors receded the most during the episode, a possibility raised by some researchers such as Aizenman, Binici, and Hutchison (2016). Second, during the taper-tantrum stress episode, when exactly did differentiation across EMEs begin and how persistent was it? Did investors initially pull back indiscriminately from all EMEs, and then only began differentiating over time as the shock persisted? Or did they discriminate across EMEs from the early stages of the episode? Third, is the differentiation across EMEs by investors a relatively recent phenomenon, or does the application of our methodology suggest that investors have always distinguished among EMEs, although perhaps to varying degrees, according to their economic fundamentals?

Research to date has not appeared to reach a consensus on the first question—the importance of fundamentals in explaining the heterogeneous EME responses. Using an event study approach, Prachi et al. (2014) analyze the reaction of financial markets to the Federal Reserve's LSAPs tapering announcements in 2013 and 2014, including the episode that we examine in this study. They find evidence of market differentiation among EMEs based on macroeconomic fundamentals. In addition, they find that EMEs with deeper financial markets and tighter macroprudential policy prior to the stress period experienced relatively less deterioration in financial conditions.

In contrast, Eichengreen and Gupta (2015) do not find evidence that better macroeconomic fundamentals—such as a lower budget deficit, lower public debt, a higher level of international reserves, and higher economic growth—provided any insulation. They do find, however, that EMEs whose exchange rates appreciated to a greater degree earlier and whose current account deficits widened more experienced larger effects. But they conclude that the heterogeneous reactions most importantly owed to the size of each country's financial market; larger markets experienced more pressure, as investors were better able to rebalance their portfolios in those EMEs with relatively large and liquid financial markets. Similarly, Aizenman, Binici, and Hutchison (2016) find no evidence that stronger macroeconomic fundamentals helped the EMEs weather the taper tantrum better, but their study focuses only on the very short-term responses of financial indicators after taper news. Classifying EMEs into two categories (“fragile” and “robust”) based on their current account balances, levels of international reserves, and external debt, they find that news of tapering from Fed Chairman Bernanke was associated with sharper deterioration of financial conditions in the “robust” EMEs compared with the “fragile” ones in the very short term (24 hours following the announcement). The authors rationalize their results by conjecturing that EMEs with stronger fundamentals received more capital inflows during the expansionary phase of the Federal Reserve's conventional and unconventional monetary policy and accordingly experienced sharper capital outflows and deteriorations in financial conditions on news of an impending tapering. This hypothesis is not explicitly tested in their study, and the authors acknowledge that, over a longer window than they considered in their event study, the fragile EMEs may have suffered more than the robust EMEs after the taper news.

We approach the first question in a somewhat different manner from these previous studies. Rather than looking at market reactions on days when news may be coming in about the Federal Reserve's tapering of asset purchases as Prachi et al. (2014) do, we treat the taper tantrum as a single episode, defined by the observed “peak-to-trough” behavior of financial markets surrounding the period when concerns about tapering came to the forefront. And, unlike Aizenman, Binici, and Hutchison (2016), but consistent with Prachi et al. (2014), we exploit finer cross-section differences in vulnerabilities across the EMEs rather than divide the EMEs into two groups based on the behavior of only three variables. Using a baseline sample of 35 emerging market economies and cross-section regression analysis, we assess the role of economic fundamentals in the heterogeneous cumulative performance of EME financial markets over the whole episode from May 2013 through August 2013.

We find that EMEs that had relatively better fundamentals to begin with—as measured by a host of individual variables capturing vulnerability, or by an aggregate index of relative vulnerabilities across EMEs that we construct—suffered less deterioration during the taper-tantrum episode as measured by a broad range of financial variables, including exchange rate, depreciation pressure, and government bond yields, as well as EMBI and CDS spreads. Our results are consistent with those in Prachi et al. (2014), but contrast with those in Aizenman, Binici, and Hutchison (2016) and Eichengreen and Gupta (2015). We also find that financial conditions deteriorated more in those EMEs that had earlier experienced larger private capital inflows and exchange rate appreciations, consistent with the “more-in-more-out” hypothesis that EMEs that experienced larger inflows prior to the taper tantrum also experienced larger outflows once the episode began, as in Eichengreen and Gupta (2015). However, our results suggest that the strength of economic fundamentals explains much more of the variation in responses across EMEs compared with other factors, such as the previous run-up in capital flows or exchange rate appreciation. Nonetheless, we find very little evidence that the structure of the financial markets—such as the size of the capital market, the level of foreign investor participation, or the extent of capital account openness—shaped the heterogeneous responses of financial markets.

On the second question, related to the timing and persistence of differentiation, the conventional wisdom seems to be that early in the taper tantrum, investors did not differentiate much among EMEs according to their vulnerabilities, but such differences emerged when concerns about tapering persisted (see, for example, Sahay et al., 2014). However, our evidence suggests that differentiation according to relative vulnerabilities set in relatively early during the stress episode and persisted at least for the duration of the stress episode, although the extent of differentiation was less pronounced in the first few weeks.

Turning to the third question of the extent to which investors also discriminated among EMEs during other stress episodes, we use our methodology to identify seven other episodes of severe financial stress in the EMEs over the past 20 years: the Mexican crisis (1994–95), the Asian crisis (1997–98), the Russian crisis (1998), the Argentine crisis (2002), the global financial crisis (GFC, 2008–09), the European sovereign debt crisis (2011), and China’s recent financial market stresses (2015). For each of these episodes, we examine the role of economic fundamentals in driving any heterogeneous cumulative reaction of asset prices over the full episode across EMEs.¹ We find little evidence of differentiation based on economic fundamentals in the 1990s and the early 2000s. However, the results also suggest that differentiation was not unique to the taper tantrum in 2013. In fact, it appears that fundamentals played a role in explaining the heterogeneous reaction of EME asset prices during the GFC in 2008, and that they continued to play a similar role during subsequent stress episodes. These results—that differentiation has occurred among EMEs since the GFC—are consistent with those from a complementary approach taken in Bowman et al. (2015). Identifying monetary policy-related shocks to U.S. interest rates, rather than episodes of severe financial stress as we do, they find that the effect of such shocks on EME interest rates have been larger in the relatively more vulnerable EMEs in the recent past as well, and that there is no difference in this respect between the effects of conventional and unconventional U.S. monetary policy.

Taken at face value, our results suggest that international investors may have moved from no differentiation in the past—such as during the 1990s and the early 2000s—to progressively differentiating more and more among EMEs according to their economic fundamentals through the GFC and the subsequent episodes of financial stress. Thus, our results contribute to the literature debate on whether cross-country contagion in the event of a crisis is purely the result of investors’ behavior versus a result of differences in trade and financial links as well as macroeconomic fundamentals (see Dornbusch et al., 2000, for a review). On one hand, our result of no differentiation during the early stress episodes is consistent with the explanation that investors’ behavior facilitated contagion during those events. For instance, liquidity problems caused by losses in one country may have promoted investors to sell off securities in other EMEs, regardless of the strength of their fundamentals (see Pritsker, 2000, Kodres and Pritsker, 2002). Also, a high fixed cost of gathering information in the presence of information asymmetries may have led to herd behavior and contagion (Calvo and Mendoza, 2001). On the other hand, the result of increased differentiation since the GFC lends support to the literature emphasizing the role of trade and financial linkages as well as macroeconomic fundamentals (for example, see Corsetti et al., 1999, Forbes and Chinn, 2004, Bekaert et al., 2014; and Aizenman, Chinn, and Ito, 2016). However, more research is needed to understand the factors driving this apparent shift toward differentiation during the past decade. The gradual improvement and changing relevance of the EMEs’ macroeconomic fundamentals, the faster dissemination of knowledge on individual EMEs’ characteristics due to better and more timely data, and the increasing degree of the EMEs’ integration with world financial markets are factors likely to have facilitated differentiation by foreign investors. Nonetheless, it remains an open question whether our results are perhaps driven by different sources of the shock. Most stress episodes since the GFC, during which we find evidence of differentiation among EMEs, emanated primarily from the advanced economies.² In contrast, the crises of the 1990s and 2000s, during which we find no evidence of differentiation, emanated to a much larger extent—although not exclusively so—from shocks originating in the EMEs themselves.

The remainder of the study is organized as follows: In Section 2, we describe the data and the estimation strategy. Then, Section 3 presents our results of differentiation across EMEs during the 2013 taper-tantrum episode, and Section 4 shows the results for differentiation in previous well-recognized EME financial stress episodes. Section 5 concludes.