Today, we are pleased to present a guest contribution by Steven Kamin (AEI), formerly Director of the Division of International Finance at the Federal Reserve Board. The views presented represent those of the authors, and not necessarily those of the institutions the authors are affiliated with.
The eruption of the Covid-19 pandemic early last year was a triple whammy for the emerging market economies (EMEs): it directly threatened their public health and economic activity; it pushed the global economy into recession and undercut their export markets; and it triggered a spike in global financial volatility which threatened to cut off their capital flows. The financial spillovers from the turmoil last March are clearly evident in Figure 1. Risk-off swings in U.S. markets led EME currencies to depreciate, credit default swap (CDS) spreads to widen, and EME equities to follow U.S. stocks downward.
Figure 1: U.S. and EME Financial Variables
As usual, EMEs with greater fiscal and financial fragility were hit hardest. Figure 2 shows the strong correlation between a measure of this vulnerability developed by Ahmed, Coulibaly, and Zlate (2017) and the rise in EMEs’ CDS spreads between mid-January and mid-March.
Figure 2: EME Credit Risk and Vulnerability
Beginning in mid-March, advanced-economy financial markets rebounded in response to aggressive monetary easing, announcements of fiscal stimulus, and indications the pandemic might be easing. This led to improvement in EME financial markets as well. But the pandemic is not yet over, and with caseloads resurging around the world, there is a question of whether global investors might again pull back from the most strongly afflicted economies.
Accordingly, my co-authors – Shaghil Ahmed, Jasper Hoek, Ben Smith, and Emre Yoldas – and I are assessing how much of the evolution of EME financial markets last year owed to spillovers from advanced-economy markets, especially the U.S., and how much to the spread of the pandemic itself. (See our Federal Reserve working paper, “The Impact of Covid-19 on Emerging Market Economies’ Financial Conditions” for more details.) We estimated panel regressions in which exchange rates, credit spreads, and equity prices in 22 emerging market economies were related to: (1) measures of U.S. financial markets (the VIX and high-yield corporate spreads); (2) the Ahmed-Coulibaly-Zlate measure of EMEs’ vulnerabilities; and (3) country-specific measures of COVID-19 cases and deaths from the Johns Hopkins Coronavirus Resource Center and the corresponding measures taken to restrict that spread—the Oxford Stringency Index, or OSI.
Table 1 presents the estimation results (updated from those in the working paper). Wider U.S. high-yield spreads were associated with a weaker EME currencies, rising CDS premiums and lower equity valuations, and such effects generally are stronger for more vulnerable EMEs (as indicated by interaction variable, US High Yield Spread x Vulnerability). Similar observations apply to the VIX index, though it seems less influential. Pandemic deaths generally are not statistically significant; the same is true of equations using pandemic cases (not shown). However, the OSI variable exerts consistent and statistically significant effects on EME financial conditions: More stringent restrictions depreciate currencies, widen CDS spreads, and depress equities.
Using the regression results in Table 1, Figure 3 below compares the average actual paths of EME financial variables with (1) the predictions of our estimated regression model, and (2) the contributions to those predictions, based solely on the movements in the U.S. financial variables. The models do a good job of tracking the broad contours of financial market developments in the EMEs. And it is clear that the basic trajectory of those developments largely reflects the movements in the U.S. financial variables. But the gap between the contributions of the U.S. variables (green lines) and the overall predictions of the models (blue lines), which represents the contribution of the coronavirus variables (particularly the pandemic restrictions), suggests that these factors have added to downward pressures in EME financial markets.
Figure 3: Actual and Predicted Changes in EME Financial Variables Since the Outbreak Began. Note: Coronavirus measures come from deaths per hundred thousand and Oxford Stringency Index values.
All told, our findings reinforce concerns that emerging financial markets are vulnerable both to renewed surges in global financial volatility and a worsening of the pandemic in the EMEs themselves.
This post written by Steven Kamin.