Effects of Financial Integration on the Transmission of the Global Financial Crisis

Dong-Eun Rhee, Eunjung Kang, Ju Hyun Pyun and Jiyoun An


The integration of the global financial markets has been accelerated due to rapid growing international capital movement since 2000s. This financial globalization led by advanced and emerging economies was expected to promote efficiencies in the economy and spur economic growth. However, as we observed the negative spillovers of the Global Financial Crisis (GFC, hereafter) on the world economies spreading through channels of the financial globalization, many started to question whether financial integration buffers or amplifies negative shocks during the crisis. This study examines roles of financial integration in the spread of negative shocks from the U.S. throughout other real economies during the crisis, and provides implications on the financial integration channels that could transmit financial instability in the upcoming future.

Empirical assessment has been carried out on the impacts of the GFC originated from the U.S. on the other real economies, in relation to their levels of stock market integration and bond market integration with the U.S. We employ a simultaneous equation model that considers endogeneity issues among variables using the sample of 63 countries during 2001-2011. To measure the degree of real economic spillovers of the crisis initiated from the U.S. to other countries, we use real business cycle synchronization index between the U.S. and other countries. We argue if a country’s real economic growth worsens along with the U.S. growth during the crisis (i.e. real output growths of two countries are highly synchronized), then real contagion of the crisis is more severe on that country. The estimation results suggest that the crisis brings about business cycle convergence between the U.S. and countries that have greater stock market integration with the US during the GFC while the crisis leads to business cycle divergence to countries with greater bond market integration. Since we observed overall precipitous decline in stock market integration across countries during the crisis, this capital flight from the integrated stock market during the crisis would lead to the spread of the crisis to a country whose stock market is highly integrated with that of the U.S. However, a higher level of bond market integration with the U.S. would provide buffer against negative shock spillover during the crisis and make the crisis less contagious.

In addition, the study investigates whether the real economic spillover of the GFC cannot be fully explained by the intensity of the financial integration, and tests the ‘wake-up call hypothesis’ suggesting that economic fundamentals play an important role in the transmission of negative shock during the financial crisis. This study finds that real economic contagion from the U.S. through financial integration is robust by controlling for economic fundamentals of each country. Moreover, it is observed that a country’s economic fundamentals amplified the contagion effect during the GFC as well: countries with lower foreign currency reserves, lower financial development and higher foreign debts tend to be more vulnerable to contagion of the GFC.

The results of this research give twofold implications: First, this research can provide foresight on the spillover of current Fed’s exit strategy to Korean economy. As a matter of fact, Korea was less affected by the start of Fed’s tapering of 2013 talks due to its robust fundamentals, compared to other emerging countries like Brazil, India, Turkey, Thailand and Indonesia. Second, if the bond market integration does function as a buffer against negative shocks as our work suggested, then the further development of ‘Asian Bond Market Initiative (ABMI)’ will strengthen East Asian countries’ ability to respond to a crisis and also their fundamentals.