Emerging market economies produce a relatively large and growing share of world GDP. Taken together, emerging markets constitute the largest block in the world economy and contribute the most to global growth. About half of advanced economy imports are sourced from emerging markets, which in turn have become important destinations for advanced economy exports. Emerging markets taken together are the world’s largest consumer of commodities, including both metals and energy.
As a result, the emerging market block should be a large source of (cyclical) spillovers to the rest the world. But little is known about these spillovers. Indeed, research on spillovers has focused mostly on spillovers from advanced economies (Ca' Zorzi et al. 2021). While advanced economies were arguably the most important sources of spillover for most of the second half of the 20th century, it is time to consider whether the emerging market block is not only a destination for these spillover effects but an origin too. Some recent case studies have attempted to study spillovers from select emerging markets. Most recently, Rogoff (2021) argues that China’s outsized real estate sector could amplify the Delta variant’s recession with potential global implications. This column is based on our recent paper (Arezki and Liu 2020), which attempts to take a systematic look at spillovers from emerging markets to advanced economies.
The changing asymmetry of spillovers
The main contribution is to document empirically that global spillovers are asymmetrical. Based on a two-block set-up and covering the past 25 years, we show:
- The size of the spillovers from emerging markets to advanced economies is about a fifth of those from advanced economies to emerging markets.
- Spillovers from emerging markets to advanced economies increased during the second half of the sample period.
A casual look at data on the evolving structure of trade and financial interdependence suggests that global spillover may indeed be asymmetrical and changing:
- The emerging market block depends relatively more on external demand, suggesting that spillovers from advanced economies to emerging markets would be expected to be large.
- Advanced economies’ dependence on external demand is increasing, suggesting that spillovers from emerging markets may be increasing.
- The emerging markets block depends more on capital inflows, suggesting that spillovers from advanced economies should be large.
- Advanced economies’ dependence on capital flows is increasing, suggesting spillovers from emerging markets should increase.
Using state-of-the-art vector autoregressive (VAR) techniques, we document systematically the asymmetrical nature of global spillovers (see Figure 1). We construct an ‘elasticity’ of the spillover as the ratio between cumulative impulse responses over a one-year horizon.
- The elasticity of the spillover from emerging markets to advanced economies is 0.11, less than a fifth of the elasticity of the spillover in the other direction (0.78).
- The elasticity associated with spillovers from emerging markets to advanced economies is growing. It jumps from 0.06 in sub-period 1 (1991 to 2002) to 0.37 in sub-period 2 (2003 to 2015). The elasticity in the other direction is relatively high in both sub-periods (0.82 and 0.95).
Figure 1 Impulse response functions using our benchmark specification
Source: Authors’ computations and International Monetary Fund data.
Note: The sample period is 1991Q1-2015Q4. The impulse response functions are based on a bi-variate VAR with AEs and EMs growth. Dash lines show the 90-percent Bayesian credible interval.
What are the origins of spillovers?
Theoretical research identifies three potential explanations of the origins of spillovers: the ‘fundamental’, the ‘financial’, and ‘coordination failure’ (see the historical perspective by Accominotti et al. 2020). The fundamental explanation of spillovers between countries relies on real channels such as bilateral trade, trade of similar goods with a common market, monetary policy coordination, and macro similarities. The financial explanation relies on the constraints and inefficiencies in banking sectors and international equity markets. Imperfections in the financial system are exacerbated during a crisis, and such imperfections limit the extent in which financial services can be provided to different countries. Existing theories for the third origin, coordination failure, include explanations where spillovers are due to multiple equilibria, herding, learning, and political contagion. The transmission of shocks is related to informational problem that can drive market participants to make decisions affecting many countries at once.
To explore the relative importance of these channels in explaining the transmission of spillovers, we conduct a variance decomposition to ‘distribute’ the spillovers. We find that the relative shares of the trade, finance, and commodity channel over total spillover stemming advanced economies to emerging markets are, respectively, 21.8%, 66.6%, and 62.3%. Trade, finance, and commodities account respectively for 22.2%, 50.8%, and 40.8% of the spillovers from emerging markets to advanced economies. Results suggest that finance and commodities are important channels of shocks. These results are consistent with the work of Rey (2013) on the existence of a global financial cycle in asset prices, capital flows, and credit growth—over and above domestic macroeconomic conditions.
When using the four outsized emerging economies, or BRICs (Brazil, Russia, India, and China) instead of the emerging markets grouping, the results are comparable emerging markets as a whole for both directions of causality. But when using China alone, the elasticity of the spillover from advanced economies to China shrinks to insignificance. China’s spillover onto Germany and Japan appears high, with an elasticity of 0.2—in line with China’s important trade links with these two countries. These results confirm that global spillovers are asymmetrical, but that the geography of trade can help explain some of the heterogeneity in the spillover effects between sub-groups.
Choosing an identification strategy is a challenge in documenting spillovers between emerging markets and advanced economies. In our benchmark VAR model, we assume that advanced economy shocks spill over to emerging markets virtually contemporaneously—that is, within a quarter. In contrast, we assume emerging market shocks take longer to spill over to advanced economies. This assumption relies on the nature of the linkage between emerging markets and advanced economies. Specifically, because emerging markets rely more heavily on export-led growth models, growth shocks in advanced economies more directly spill over to affect growth in emerging markets. Only after the shock from the advanced economies is absorbed would emerging markets ‘spill back’ onto advanced economies. It is likely that spillovers travel much faster from advanced economies to emerging markets than vice versa. Relying on that timing assumption results in a finding that a large part of co-movement between growth in emerging markets and advanced economies is due to advanced economy shocks. In turn, this could lead to overestimating the magnitude of the spillovers to emerging markets that originate from advanced economies. We also explore different avenues including arguably exogenous variables to test whether our results are sensitive to the choice of decomposition. Specifically, we exploit the arguably exogenous shock that stems from damage caused by large natural disasters, assuming, (we think sensibly) that the timing of a natural disaster cannot be endogenous (see Figure 2). We explore the spillovers from monetary and fiscal policies and geopolitical shocks. The results are the same: the spillovers from advanced economies to emerging markets are asymmetrical.
Figure 2 Impulse response functions using an augmented specification with damages from natural disasters over the two sub-sample periods
Sources: Authors’ computations and International Monetary Fund data.
Notes: The impulse response functions are based on a bi-variate VAR with AEs and EMs growth. Dash lines show the 90-percent Bayesian credible interval.
Rethinking theoretical frameworks and policy implications
For the purpose of allowing the reader to grasp the importance of our empirical findings on the asymmetrical nature of global spillovers, it is useful to explain how existing theoretical frameworks used to study the international transmission of business cycle treat emerging markets. There are essentially two schools of ‘modelling’. The first relies on the small economy assumption (Aguiar and Gopinath 2007). Clearly, the small open economy assumption has been justified for the most part of the second half of the second 20th century. But as emerging markets have become a large (if not the largest) economic block, with a large share of manufacturing activities in advanced economies having moved to emerging markets, it seems important to explore whether this assumption is still valid. Indeed, emerging market growth may potentially exercise large spillovers through direct trade linkages, as well as commodity and asset prices. The second school of modelling employs a two-country framework. Specifically, the framework developed by Backus et al. (1992), which we call the ‘BKK model’, is a two-block set-up that assumes symmetry and correlated shocks. These assumptions are reasonable when considering spillovers between advanced economies. But these assumptions seem less appropriate when considering spillovers between advanced economies and emerging markets that are not symmetrical in terms of the structure of their economies. The BKK model also fails to account for the evolving structure of interdependencies.
Our results suggest that while quantitatively the small open economy assumption associated with emerging markets might still seem appropriate, more research is needed to model how the evolving structure of interdependencies between emerging markets and advanced economies matters for the global economy and welfare. Our empirical findings provide useful moments to calibrate theoretical models aimed at exploring welfare implications of these spillovers. These results also have important implications for policies that have spillover effects. The asymmetric nature of spillovers between emerging markets and advanced economies implies that emerging markets need policy buffers to help stabilise their economies and macro-prudential regulation to safeguard welfare. Brunnermeier and Sannikov (2015) provide a useful theoretical framework to think about externalities from interdependencies. The authors show that short-term credit flows can be excessive and reverse suddenly. They find that imposing capital controls or other domestic macro-prudential policy measures that limit short-term borrowing can improve welfare.
Accominotti, O, M Briere, A Burietz, K Oosterlinck and A Szafarz (2020), “Globalisation and financial contagion: A history”, VoxEU.org, 10 April.
Aguiar, M and G Gopinath, (2007), "Emerging Market Business Cycles: The Cycle Is the Trend", Journal of Political Economy 115: 69-102.
Arezki, R and Y Liu (2020), “On the Changing Asymmetry of Global Spillovers”, Journal of International Money and Finance 107(102219).
Backus, D P, P Kehoe and F Kydland (1992), “International Real Business Cycles”, Journal of Political Economy 101:745-775.
Brunnermeier, M K and Y Sannikov (2015), “International Credit Flows and Pecuniary Externalities”, American Economic Journal: Macroeconomics 71(7, 1): 297-338.
Ca' Zorzi, M, L Dedola, G Georgiadis, M Jarociński, L Stracca and G Strasser (2021), “Making waves: Fed spillovers are stronger and more encompassing than the ECB’s”, VoxEU.org, 25 May.
Rogoff, K (2021), “Can China’s outsized real estate sector amplify a Delta-induced slowdown?”, VoxEU.org, 21 September 21.
Rey, H (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, VoxEU.org, 31 August.