Cup of woes runneth over PDF Print E-mail
Thursday, 10 November 2011 00:00
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Cup of woes runneth over

Financial sector spillover effects magnify impact of GDP shock 7-8 times in the case of countries like India


It’s pretty obvious by now that the impact of the US-EU crisis gets magnified through what happens in financial markets, but just how much is the subject of the IMF’s latest ‘spillover’ research. The research is not yet complete—parts of the findings on China don’t look quite right and Ranjit Teja, who presented the findings at Ficci, was candid enough to admit they looked a bit ‘soft’. But the research is fascinating, and shows just how much more there is to be done.




Take the impact of a 1% decline in US GDP (Figure 1). Standard models would look at the impact through trade and conventional flows and show a negligible impact—0.1% in the Euro Area-UK-Japan, 0.2% in the Rest of G20 and an even smaller 0.05% for India. Bring in the financial channel—the impact of a decline in US GDP on bond yields, for instance—and this impact rises manifold, to 0.4, 0.6 and 0.4%, respectively. But, in times of crisis, the IMF finds, financial markets tend to be correlated even closer—a 1% hike in US T-Bill rates causes a 0.4% hike in developed country bond yields in normal times and this goes up to around 0.7% in times of crisis. So, bring in financial markets in a crisis situation, and the impact of the same 1% fall in US GDP now results in a 0.8% fall in Euro Area-UK-Japan GDP, 1.2% in Rest of G20 and 0.8% for India. We’re all in it together, make no mistake.


How well the model captures the spillover clearly depends on how many variables it has. If you take just the regular banking system with its $30 trillion of cross-border claims, Teja said, you get one kind of impact of a US financial crisis. Take the shadow banking system—the investment firms—which have another $25 trillion of cross-border claims and the impact is altogether different. Again, that is something we all knew, but the importance of shadow banking has only now been truly captured.

It is because of this finance impact that, the IMF points out, there is a very small net impact of a medium-term fiscal correction in the US, 0.5% or so in the GDP of countries like China, UK, Euro Area and Japan—while the US fiscal correction lowers demand in these countries, the lower interest rates that result from a lower US deficit cause an increase in GDP in these countries. The best way to see this is to examine what happens if the US doesn’t go in for a medium-term fiscal correction. Thanks to the sharp increase in bond yields in the US, and an equally high one in other countries in times of crisis, the average GDP correction in countries like China, UK, Euro Area and Japan will be around 1.5%. Which is why the IMF is against even the US/EU raising their fiscal deficits in the medium term.

In the case of the EU, similarly, the spillover report shows how, once the banking crisis of the periphery moves on to affect the banks of core countries, the probability of distress in countries like the US and China will be at the levels last seen during the Lehman crisis (Figure 2).

The analysis of China is equally interesting and has important policy ramifications, especially the fact that WTO complaints against China rise in direct proportion to the unemployment rate in countries like the US—so, most likely the US will take action against the US even if better minds advise against it. In 2005, IMF estimates, countries like India’s share of exports to the US were lower by around 4 percentage points thanks to an undervalued yuan. By 2008, as the yuan was allowed to appreciate, India’s lost market share was lower, at around 1 percentage point. Even more frightening, though, is the huge subsidy enjoyed by Chinese manufacturers due to the artificially low cost of capital—the subsidy-to-capital costs is around 70% today as compared to the rest of Asia where the imputed tax on capital is 30% (Figure 3).

Fix this and there should logically be a sharp hike in GDP of countries like India, but the IMF model shows the impact will be negligible. Given how the yuan and capital subsidies have helped China, it seems perverse to argue the impact of the opposite will not be as great. While researchers will do well to resolve this obvious contradiction—Teja gave some technical explanations for why the model might have failed—there is little doubt spillover studies have become an important tool to understand policy implications and to come up with possible antidotes to them.

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Last Updated ( Tuesday, 15 November 2011 12:37 )

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