The effect of financial connectedness in financial contagion
Kunzhan, Guo
Tilburg University
Department of Finance
PO Box 90153, NL 5000 LE Tilburg, The Netherlands
E-mail:
Supervisor:
Thomas Mosk
European Banking Center - Tilburg University
Department of Finance
PO Box 90153, NL 5000 LE Tilburg, The Netherlands
Abstract: This paper examines the relation between financial connectedess with the U.S.
and economic shocks on other countries after the subprime mortgage crisis using an
cross-border sample of 18countries from 2005 to 2011. It is fairly likely that financial
connectedness affect the transmission of economic shock. Overall, the magnitude of the
impact of the crisis on foreign economies can be explained by financial connectedness.
.
Keywords: financial contagion, financial connectedness, economic growth, subprime
crisis
JEL: G15 G21
First Draft: 26.04.2012
This Draft: date 15.05.2012
1.0 Introduction
1.1 Background of subprime mortgage crisis and impacts in the U.S.
Subprime mortgage crisis, was one of the first signals of the late-2000s financial crisis, ,
which originated from the U.S. and caused a sharp decrease of securities supported by
mortgages due to a significantly ascent in subprime mortgage foreclosures and
delinquencies. As a result, the negative economic impact in the U.S. caused by this
mortgage crisis was huge. Total home equity in the U.S., which had dropped from $13
trillion at its peak in 2006 to $8.8 trillion by mid-2008, and housing prices had dropped
20% from the peak in 2006. During the same period, there was a lost of $1.2 trillion on
savings and investment assets, moreover pension assets lost $1.3 trillion. To sum up,
between June 2007 and November 2008, Americans lost more than a quarter of their net
worth. Without a doubt, the effects on financial institutions, banks and SMEs were
severest. During the year of 2008 the markets reeled from the collapse or forced
mergers/bailouts of Bear Stearns, AIG, Fannie Mae, Freddie Mac, Lehman Brothers,
IndyMac Bank, Merrill Lynch, Wachovia, Washington Mutual, and many others (Francis,
2008).
1.2 Economic domino effect on other countries from the U.S. crisis
Since the mid-1990s, countries have become increasingly inter-linked with each other at
the asset and liability management (ALM) strategies of their sovereigns, financial
institutions, and corporations have become more and more global in nature (Reza and
José, 2010). Nonetheless, this financial globalization brings not only benefits like pooling
of risks but also problems like crisis contagion. Shocks in one part of the system can be
amplified and transmitted through common intermediaries pursuing global ALM
strategies that collectively become overexposed to risk in the upswing of a credit cycle
and overly risk-averse in downswing (Reza and José, 2010). The span of time between it
occurring in U.S. and spreading globally is very quick. Both developed and developing
countries are affected by this crisis to some extent.
On the side of developed countries, financial shock related with the subprime crisis have
been happened by institutions all over the developed world, including the G7 countries.
There are many banks all over the world reporting large losses caused by the subprime
crisis, for instance, The Citigroup, in the US, the Crédit Agricole in France, the HSBC in
the United Kingdom, the CIBC in Canada, or the Deutsche Bank in Germany. (Paulo,
Carlos and Isabel, 2008).
On the side of developing countries, the crisis also brought a huge economic disaster to
them. The emerging recession in the U.S. and other developed countries further
multiplied the negative impact of the crisis of the developing countries (Stephany and
Jose, 2009). As a result, the GDP growth of most developing countries in Africa, Asia,
Latin America and the Caribbean etc. was slower after the mid of 2008 according to the
data on IMF. But, we find that the degrees of financial contagion effects from the U.S. on
different countries are very distinct. In addition, there also exists discrepancy on the
arrival time of the financial contagion effect. Hence, financial connectedness with the
U.S. is introduced which will be considered and studied in all of this paper.
1.3 Financial connectedness with the U.S.
Economic connectedness plays an important role among the entire process of the
financial contagion. It mainly contains two components, financial connectedness and
trade connectedness.
Financial interconnectedness indicates countries are financially interconnected through
the asset and liability management (ALM) strategies of the sovereigns, financial
institutions, and corporations. Benefits has been brought by this financial globalization as
well as vulnerabilities. Especially, it is available that illiquidity and losses in some
regions can translate into asset all over the world due to financial interconnectedness, as
Reza and José (2010) interpreted, compared to the financial connectedness, a set of
bilateral trade relationships are mainly focused on by the trade connectedness in terms of
export and import, which is the chief difference from financial connectedness. But in this
paper, we only consider about the financial connectedness and detect the correlation
between it and the magnitude of economic shock from subprime crisis on foreign
counterparties.
1.4 Research questions
Our paper therefore aims to contribute in the respect of the role of financial
connectedness during the whole financial contagion. And then two main questions will be
concentrated on. A, Does financial connectedness affect the transmission of economic
shocks? B, does financial connectedness explain the magnitude of the impact of the U.S.
subprime mortgage crisis on foreign economies?
1.5 Summary of data, results and paper organization
In this paper the economic data of 18 countries over the world (both developed and
developing countries are included) from 2005 to 2011 are used, which are divided into
three groups, dependent variable, independent variable and control variables, respectively.
Firstly, dependent variable reflects the economic shock on foreign counterparties, which
is measured by GDP growth (% annually). Secondly, financial connectedness with U.S. is
introduced as the independent variable which is mainly focused on. At last, the control
variables group is consisted of foreign domestic investments on each country, exports of
goods and services, inflation rate and government expense.
In this paper, we find that it is fairly likely that financial connectedness affect the
transmission of economic shock. Overall, the magnitude of the impact of the crisis on
foreign economies can be explained by financial connectedness.
The remaining of this paper is organized as follows. Section 2 is the literature review
where several theoretical and empirical articles are discussed here. Section 3 introduces
the dataset while Section 4 elaborates on methodological details. Next, the concrete
results are analyzed in Section 5. At last, Section 6 gives a conclusion for the whole paper.
2.0 Literature Review
2.1 Theoretical relation between financial connectedness and economic growth
There is a long tradition of regarding dislocation in the financial sector as a cause of
economic fluctuations, as Bernanke (1983) summarized, based on his view, financial
crisis is of importance because they have a apparent effect on increasing the costs of
intermediation and restricting credit, therefore, the level of activity in the real sector is
restrained and low growth and recession occurs eventually with no doubt (Allen and Gale,
2000).
Banks play a vital role in the transmission of the financial crisis because the relationships
among banks in different countries are so close that they can transmit the positive and
negative effects from one country to other foreign counterparties easily. In other words,
this kind of domino effect can be summarized by one word, named cross-border financial
contagion, which refers to a scenario in which small shocks initially affect only a few
financial institutions or a particular region of an economy and then spread to the rest of
financial sectors and other countries which originally have healthy financial systems
(Degrysew, Elahi and Penas, 2010). There are two classical models which focus on the
relation between economic shock from financial crisis and financial connectedness
(financial contagion), Allen-Gale Model and Freixas-Parigi-Rochet Model, respectively.
In the Allen-Gale Model, Allen and Gale (2000) study financial contagion through
concentrating on the aggregate liquidity shocks. The architecture of interbank payment
represents financial connectedness here. Banks in different countries with liquidity needs
borrow from the ones with excess liquidity. When there occurs financial crisis in one
region, the other regions will also suffer a loss because their claims on the troubled region
fall in value. In their theory, the interbank market, credit lines and cross-holdings of
deposits are three possible mechanisms which play a role on transferring liquidity in the
whole banking systems. They are so important that if one of them is not efficient
anymore, then this will lead to an economywide financial crisis. For instance, supposing
the banking system in the world as a whole, if the demand for liquidity is much more than
the supply of the banking system, the only way to satisfy the demand is to liquidate the
long asset which is very costly (Shleifer and Vishny, 1992). Therefore, banks avoid
liquidating the long asset by liquidating their claims on other regions instead.
Nonetheless, It is notiable that liquidating claims among banks in different region cannot
create any additional liquidity. As a consequence, liquidity to the troubled region is
denied and bank may go bankruptcy at last. This is the disadvantage of financial
connectedness among banks in different regions and countries. But if the banks are not
very much connected with the global banking system, they cannot be assisted by other
banks and also lose most part of investment opportunities.
In the Freixas-Parigi-Rochet Model, they focus on another mechanism interbank
market to explore contagion, their contribution mainly answers the question that whether
the interbank market is sufficient guarantee against a liquidity shock affecting one bank.
Moreover, the core content is that depositors adopt the strategy of traveling with a check
payable to the other places (use of interbank market) to instead taking cash during the
whole traveling process, which can be viewed as interbank credit in the Allen-Gale’s
theory. Through this method, the cost of holding liquid assets is reduced. But the interlinked banking system (financial connectedness) bring not only advantages but also
drawbacks. If the bank at the depositors’ destination has bad reputation or is in trouble at
that time, then depositors do not trust this kind of bank and withdraw cash at their own
bank. As a result, externalities across banks are generated , and more severerly, there will
be no liquidity any longer, which will make the interbank market incomplete. Each
region is connected with a small number of other regions, the initial impact of the
financial crisis may be felt very strongly in those neighboring regions, with the result that
they also get into the scrape. As each region is affected by the crisis, it prompts premature
liquidation of the long asset, with a consequent loss of value, so that previously
unaffected regions find that they too are affected because their claims on the region in
crisis have fallen in value (Allen and Gale, 2000).
Above two models jointly explain the effect of interconnectedness among banks on the
propagation of crisis in one region or one country. But, how do economic shocks infect
the countries’ economy (real sector) through affecting the banks (financial sector). The
following paragraph discusses the relation between financial sector and real sector in
order to answer the above question.
Odedokun (1994) states that the effect of the financial sector in an real economy is
dominant, finance seems as one of the mainstays of a modern economy. Almost the same
view is included in the World Bank’s 1989 issue of the World Development Report, it
illustrates that development of the financial sector should have positive repercussions on
the development of the real sector.
As the above two models indicate, banks in other region suffer a loss due to the
connectedness with the troubled region. Thus, the financial crisis in one country can
spread by contagion to all banks in the world. Nevertheless, how the financial sectors (for
example, banks) influence the real economy of countries, in order to discuss this relation
we focus on the banking lengding channel.
Bernanke and Gertler (1995) indicates that banks play a crucial role on specializing in
overcoming informational problems and other frictions in credit market. If the supply of
bank loans is disrupted due to the financial crisis, bank-dependent borrowers (SMEs, i.e.
small and medium-sized business, for instance) may not literally shut off from credit,
nonetheless, it is costly for them to find a new lender and establish a credit relationship.
Hence, a reduction in the supply of bank credit is likely to increase the external financial
premium and
reduce real activity. Exteral finance premium here is defined as the
difference in cost between funds generated internally and funds raised externally. Gertler
and Gilchrist (1996) states, an adverse shock on financial sectors may have a restraining
effect on credit activity of both firms and households, thereby rising the need for external
funds, which results in declining in spending or production exacerbate the economic
downturm.
In the 1989 article byBernanke and Gertler, they consider an economy in which firms are
financed by Townsend-style (1979) optimal debt contracts. They claims that a economic
shock will cause lower current cash flows, then the ability of firms to finance investment
projects internally is reduced and the effective cost of investment is increased. As a result,
economic activity and cash flows in subsequent periods are lowered, which convert
financial shocks into autoregressive movements in output.
As analyzed above, higher degree of financial connectedness will cause severer shock on
financial secter, thereby lowering the economic growth. Hence, there is a positive relation
between economic growth and financial connectedness.
2.2 Empirical relation between financial connectedness and economic growth
A growth in cross-border linkages among banks can be regarded as one hallmark of
financial globalization.
On the positive side, new funding and investment opportunities have been brought by
these linkages, which contributes to rapid economic growth in many countries.
But there is also a disadvantage on the growing financial linkages, the increased crossborder interconnectedness made it easier for disruptions in one country to be transmitted
to other countries and even become a global economic disaster (Martin, Sonia and Ryan,
2011).
Martin, Sonia and Ryan (2011) use the method of simulations, parametric estimation
(probit model) and nonparametric estimation (threshold approach) to analyze the
economic data such as growth of GDP, FDI, inflation, central government debt etc. in 33
countries from quarter 4 in 1977 to quarter 3 in 2009. To sum up, whether there is one
positive relation between economic growth and financial connectedness depends on the
degree of interconnectedness. What is more, they find that in banking systems that are not
very connected to the global banking network, increases in interconnectedness are
associated with a reduced probability of a banking sector crisis. Once the degree of
interconnectedness reaches a certain point, further increases in interconnectedness do not
improve financial stability and can in fact increase fragility. When the interconnectedness
reaches close to complete network, interconnectedness starts again reducing likelihood of
crisis (Martin, Sonia and Ryan, 2011).
In our paper, all the sample countries are inter-linked with the U.S. at the asset and
liability management (ALM) strategies of their sovereigns, financial institutions and
corporations to some extent. Some countries are with high degree of connectedness
(United Kingdom 23, Switzerland 18), by contrast, a part of sample countries has
relatively low degree (Finland 0.007, Mexico 0.08, Portugal 0.14). In general, high
degree of financial interconnectedness indicates close relationship between two countries’
economy. Thus, after the explosion of subprime mortgage crisis in the U.S., it is faster
that the economic shock (the change on GDP) will arrive at the countries which are close
related with the U.S., such like United Kingdom and Switzerland. Moreover, the
magnitude of the impact of the U.S. subprime mortgage crisis is positively related with
the degree of financial connectedness. Taking an example to explain, if one U.S. bank
failed because of the crisis, then it has no ability to repay the liability to the financial
institutions in another countries. As a consequence, these financial institutions which
cannot get the asset back from the failed the failed U.S. bank suffered a series of financial
problems because of unpaid debt. It is apparent that there is a strong, positive link
between financial development and economic growth. Hence, higher degree of financial
connectedness with the U.S., lower economic growth on foreign counterparty.
2.4 Relation between economic growth and foreign direct investments
As one control variable, FDI is introduced since it has a strong relation with economic
growth. In theory, there are several potential ways in which FDI can promote economic
growth. For example, Solow-type standard neoclassical growth models suggest that FDI
increases the capital stock and thus growth in the host economy by financing capital
formation (Brems, 1970). According to the above literatures, we can see the effects of
decreasing returns to capital are offset and a long-term economic growth is kept by FDI.
Thus, FDI play an important positive role for economic growth.
2.5 Relation between economic growth and exports of goods and services
The second control variable is export of goods and services which also is positively
related with the economic growth.
2.6 Relation between economic growth and inflation rate
Inflation rate is another control variable which has a negative relation with the economic
growth (GDP growth).
2.7 Relation between economic growth and government expense
The forth control variable is the government expense, which is defined as cash payments
for operating activities of the government in providing goods and services. It includes
compensation of employees (such as wages and salaries), interest and subsidies, grants,
social benefits, and other expenses such as rent and dividends (World development
indicator definition). In summary, there is a negative relation between economic growth
and government expense.
Table 1 below give a summary about the theoretical relation between dependent variable
and other variables, the expected correlation are showed also here.
Table 1, theoretical relation and expected correlation with dependent variable
Dependent variable:
Growth of real GDP
Independent
variable: Financial
connectedness
GDP growth reflects the economic growth in each
country
Countries are inter-linked with the U.S. at economic
activities, thus, degree of financial connectedness
contributes to speed of economic growth
Control variable 1:
FDI
FDI through increasing the capital stock and
encouraging the incorporation of new technologies
impacts on economic growth
+
Control variable 2:
Exports of goods and services directly impacts on the
Exports of goods amount of GDP, thereby effecting economic growth
and services
+
Control variable 3: Inflation rate is one indicator of monetary policy which
Inflation rate
decides the economic growth
-
-
Control variable 4: Government expense is related with the average returns
Government
to labor, capital and technology, hence, it effects
expense
economic growth to some extent.
-
3.0 Data
The data on economic growth, financial connectedness, foreign domestic investments,
exports of goods and services, inflation and government is described and discussed in this
sector.
3.1 Dependent variable: economic shocks (GDP growth)
In this study we use GDP growth reflect the economic shocks from the U.S. subprime
mortgage crisis on each country of the sample group, where the data are taken from
World development indicators in the website of THE WORLD BANK. The sample
country group contains 18 countries which are inter-linked with the U.S. on economic
activities, which are Austria, Belgium, Brazil, Canada, Denmark, Finland, France,
Germany, Ireland, Italy, Japan, Mexico, Netherlands, Portugal, Spain, Sweden,
Switzerland and United Kingdom. A full list of the countries and the regions they belong
to may be found in Table 2 (Appendix).
In the database of WDI, GDP growth means Annual percentage growth rate of GDP at
market prices based on constant local currency. Aggregates are based on constant 2000
U.S. dollars (WDI). GDP is the sum of gross value added by all resident producers in the
economy plus any product taxes and minus any subsidies not included in the value of the
products. It is calculated without making deductions for depreciation of fabricated assets
or for depletion and degradation of natural resources. Data are in current U.S. dollars
(WDI). The sample period is from 2005 to 2011 which almost covers the main process of
the U.S. subprime crisis. Thus, the change of GDP growth can indicates the effect on
each sample country which was caused by the economic shock from the U.S. subprime
shock.
3.2 Independent variable: financial connectedness (each country’s share of the U.S.
foreign claims)
In order to describe financial connectedness, bank credit to foreign countries is used as
the source of cross-border exposures, which means the enitre exposure of one country’s
banking system to all sectors of other countriesr is contained by these foreign claims. As
description in the paper of ‘Guide to the international financial statistics’, foreign claims
are defined as the sum of cross-border claims plus foreign offices’ local claims in all
currencies. It is noticeable that foreign claims have increased not only in absolute terms
but also in aggregate measures of real economic activity. Moreover, the information
about such foreign claims of reporting countries to the rest of the world in the
Consolidated
Banking
Statistics
is
provided
by
BIS
(http://www.bis.org/statistics/consstats.htm). It covers data on (national) contractual
lending by the headquartered banks and all of their branches and subsidiaries worldwide
to borrowers residing outside the country of origin (where the bank’s headquarter is
stationed) on a consolidated basis (Degrysew, Elahi and Penas, 2010). Therefore, it is of
great significance that the BIS Consolidated Banking Statistics is used to study the crossborder exposures contagion. Further, we use foreign claims on immediate borrower basis,
that is, the allocation of foreign claims of reporting banks to the country of operations of
the contractual counterparty (Degrysew, Elahi and Penas, 2010).
On the point of measuring the financial connectedness with the U.S., we use the
percentage of the U.S. claims amount on each sample country divided by all amount of
the U.S. claims during 2005~2011 as the degree, take Belgium as an example, 2.41 in
2005, 2.35 in 2006, 2.52 in 2007 etc. It is obvious to find that the differences of the
degree of one country among these 7 years are not very much, which indicates that the
changes on the extent of connectedness with the U.S. on one country among years are not
quite significant, therefore, this measuring method is effective on analyzing the
magnitude of the impact of the U.S. subprime mortgage crisis on different foreign
economies. The mean (2005-2011) degree of financial connectedness of each sample
country is described in Table 3 (in decrease order).
Table 3, mean degree of financial connectedness with the U.S.
Nation name
Mean degree of Financial
connectedness
United
21.65
Nation
Mean degree of financial
name
connectedness
Ireland
1.33
Sweden
0.94
Kingdom
Switzerland
16.44
Japan
15.33
Italy
0.76
Germany
11.93
Austria
0.39
France
10.83
Brazil
0.27
Netherlands
6.99
Denmark
0.23
Spain
2.75
Portugal
0.14
Belgium
2.07
Mexico
0.06
Canada
1.61
Finland
0.01
It can be seen from Table 3 that United Kingdom, Switzerland and Japan have high
degree of financial connectedness with the U.S. whereas Mexico, Finland and Portugal
have a relatively lower one.
3.3 Control variables: foreign domestic investments, exports of goods and services,
inflation rate and government expense.
a) Foreign domestic investments, the data is taken from the World development
indicators, with the definition of WDI that Foreign direct investment are the net inflows
of investment to acquire a lasting management interest (10 percent or more of voting
stock) in an enterprise operating in an economy other than that of the investor. It is the
sum of equity capital, reinvestment of earnings, other long-term capital, and short-term
capital as shown in the balance of payments (WDI definition). As a purpose of matching
the other variables, we use the FDI share of GDP to measure this variable.
b) Exports of goods and services, the data are also collected from the World
development indicators. It is explained as Exports of goods and services represent the
value of all goods and other market services provided to the rest of the world. They
include the value of merchandise, freight, insurance, transport, travel, royalties, license
fees, and other services, such as communication, construction, financial, information,
business, personal, and government services (WDI definition).This variable is in terms of
the exports share of GDP (% of GDP).
c) Inflation rate, which is taken from the World development indicators. It is measured
by the consumer price index reflects the annual percentage change in the cost to the
average consumer of acquiring a basket of goods and services that may be fixed or
changed at specified intervals, such as yearly (WDI definition). Inflation rate here is
recorded by the annual change rate (annual %).
d) Government expense, this data is taken from the World development indicators, with
the explanation that Expense is cash payments for operating activities of the government
in providing goods and services. It includes compensation of employees (such as wages
and salaries), interest and subsidies, grants, social benefits, and other expenses such as
rent and dividends (WDI definition). To be detailed, the measure of government expense
is also expense share of GDP (% of GDP).
4.0 Methodology
In this paper, three regression models are used to estimate the relationship between
dependent variable (GDP growth) and independent variable (financial connectedness
with the U.S.).
Firstly, we use the simplest linear regression model (model 1) with the equation
GDP growth
,
where dependent variable is log GDP growth, independent variable is the financial
interconnected with the U.S.
Secondly, four control variables are introduced to the regression (model 2) to increase the
accuracy of the regression result. We estimate the new equation
Where dependent variable also is GDP growth, independent variable is the financial
connectedness with the U.S. (FC), x1 is defined as foreign domestic investments, x2
represents exports, x3 is defined as inflation rate and x4 is defined as government expense.
Thirdly, based on the model 2, we add country dummy and year dummy to form Model 3,
which can detect the effect of different countries and years
At last, in order to explain the magnitude of the impact of the U.S. subprime mortgage
crisis on each sample country during 2005 and 2011 better, we use the Panel data model
(model 4) which refers to two-dimensional data, nation and year, respectively. The
regression
equation
is
estimated
Where dependent variable also is GDP growth, independent variable is FC which
represents the financial connectedness with the U.S. is used to test research question A:
does financial connectedness affect the transmission of economic shocks.
is
used to test research question B: does financial connectedness explain the magnitude of
the impact of the U.S. subprime mortgage crisis on foreign economies, here
indicates that from 2008 to 2011, year dummy =1, whereas from 2005 to 2007, dummy =
0, because in the mid of 2008, the subprime mortgage crisis got the peak. Xit represents
the control variable, which is held constant to test the relative impact of the independent
variable (FC). If FC changes 1 unit, then GDP growth changes 1*β1 unit. If FC*Crisis
changes 1 unit, as a consequence, GDP growth changes 1* β2 unit.
We use both OLS regression model and fixed effect model in this paper considering
whether there is unobserved effect in our model or not. Therefore, we can get more
accurate conclusion through comparing results of OLS model and fixed effect model. In
addition, we use fixed effect model and give up random effect model, because the
individual heterogeneity (αi)
is correlated with the independent variable (FC). 18
countries have their distinct characteristics which are almost constant. Through the
Hausman test, fixed effect model is also better than random effect model.
5.0 Results
Summary statistics on dependent, independent and control variables are shown in Table 4
below:
Table 4, summary statistics of variables
Variable
Dependent
variables:
GDP growth
Independent
variables:
FC
Control
variables:
FDI
Export
Inflation
Expense
Crisis
dummy
Number of
observations
Mean
Standard
deviation
Minimum
Maximum
126
1.41
2.96
-8.23
7.49
126
5.56
6.87
0.01
24.67
108
108
108
73
126
3.59
42.51
2.03
34.60
0.57
5.62
20.93
1.66
8.89
0.50
-15.03
11.12
-4.48
16.99
0
26.94
98.79
6.87
48.09
1
In Table 4 summary statistics of variables are presented. Among them, number of
observations of GDP growth and Financial connectedness are 126, the number of other
variables is less than 126 due to lack of data of 2011 in WDI. The observation of Expense
is just 73, because there are no data of Japan, Mexico and Sweden in WDI.
Correlations of dependent, independent and control variables are shown in Table 5 below:
Table 5, Correlation matrix
GDP
growth
FC
FDI
Export
Inflation
Expense
GDP
growth
1.00
FC
FDI
Export
Inflation
Expense
-0.06
0.07
0.01
0.41
-0.38
1.00
-0.01
-0.17
-0.26
-0.09
1.00
0.34
-0.02
0.15
1.00
-0.17
0.20
1.00
-0.24
1.00
Table 4 presents the correlation matrix between GDP growth and other variables. We can
see all the correlation coefficients are not quite high which means these data we used is
relatively independent and effective. In addition, financial connectedness with the U.S. is
negatively related with GDP growth, this fits our expectation the speed of GDP growth of
one country got slower after the crisis if its economy connected with the U.S. economy
closely. We will also can see the relation between GDP growth and other control
variables is consistent with our expectation in Section 2. In this Section that follows, we
will provide formal evidence for the effects of the financial connectedness and other
financial variables on GDP growth.
Table 6 below shows the results of all the 4 regression model (M1-M4).
Dependent variable: GDP
growth
(1)
(2)
(3)
(4)
(5)
-0.035*
-0.076
FDI
0.030
-0.010
EXPORT
0.011
-0.142**
INFLATION
0.824*** 0.030
Financial connectedness
0.027**
-0.159
-0.025
0.230**
0.128***
EXPENSE
0.230***
FC*CRISIS
constant
1.562*
-1.106
10.522** 4.717*
5.888***
obervations
126
108
108
108
73
R2
0.041
0.178
0.854
0.158
0.147
Country effect
NO
NO
YES
YES
NO
Year effect
NO
NO
YES
YES
NO
Country
Country
Clustering level
Country
Country Country
*, ** and *** denote significanceat10%,5%,and 1%, respectively
Table 6: regression results of four models
The results of Model 1 explains financial connectedness with the U.S. has a negative
relation with GDP growth of another individual country, the reason is that if country A
has higer degree of FC represents it has closer economic connectedness with the U.S,
thus, larger economic shock spreads to country A, as a result, the economic growth (GDP
growth) is slowed.
It can be seen from Model 2 that the coefficient of FC keeps negative after adding four
control variable into Model 1 regression, which prove the conclusion obtained from
Model 1.
According to the results of Model 3, we can see the GDP growth rate reduces
increasingly from 2006 to 2008, at the bottom in 2008 because the U.S. crisis reached the
peak in the mid of 2008, subsequently the GDP growth increases slightly annually after
2008. Meanwhile, the mean GDP growth rate of every country during the 7 years are also
very different. But the number of GDP growth rate is not very related with the degree of
financial connectedness. For instance, UK has a high degree of FC (21.65), but the mean
GDP growth is larger (1.397) than Finland (-1.136) which just has a very small FC (0.01).
At last, it is of importance to analyze the Model 4, focusing on research question A ,the
coefficient of financial connectedness is not significant, we think the reason maybe the
number of data is not enough to run panel data regression, but we cannot exclude that the
possibility that there is no relation between GDP growth and financial connectedness
with the U.S. after subprime crisis. On the other hand, the coefficient of FC*CRISIS is
significant which prove our assumption at research question B is right, financial
connectedness can explain the magnitude of the impact of the U.S. subprime mortgage
crisis on foreign economies.
Due to lack of EXPENSE data of Japan, Mexico and Sweden, we use Expense variable in
the fifth regression, the coefficient of financial connectedness is also not significant.
Therefore, there may not be a relation between these two variables.
6.0 Conclusion
After the subprime mortgage crisis exploded in the U.S., the economic shock spreaded to
all over the world and affected other countries’ economy. Financial connectedness play
an important role on the entire process of financial contagion. In this paper, we find that
financial connectedness can explain the magnitude of the impact of the U.S. subprime
crisis on foreign economies. Moreover, it is fairly likely that financial connectedness
affect s the transmission of economic shocks. We also analyze and compare different
perspectives and theories from others’ empirical and theoretical papers, thereby clearly
explaining the logical relation between financial connectedness with the U.S. and
economic growth of each country after the crisis.
Nevertheless, the coefficient of FC is not significant in Panel Data regression, so we
cannot be sure that there is a relation between financial connectedness and economic
growth. The reason to cause this result may be there are not adequate amount of data, we
should use much more data in next research. In addition, the effect of per unit financial
connectedness from 0 to 10 degree on economic growth may be differect from the effect
of per unit FC from more than 10 degree. We guess the effect of financial connectedness
on economic growth may be greater when the degree of FC is relatively low, after a
certain point, the effect of increased connectedness become less. This assumption is
interesting and seems worthy of doing research.
For variable definitions and data sources see Table A1
Appendix,
Table 2, list of the countries and the regions
Developed country
Region Japan
Asia
Austria
EU
Netherlands
EU
Belgium
EU
Portugal
EU
Canada
Canada
Spain
EU
EU
Denmark
EU
Sweden
Finland
EU
Switzerland
France
EU
United Kingdom
Germany
EU
Developing country
Ireland
EU
Brazil
Latin America
Italy
EU
Mexico
Latin America
Other Europe
EU
Region
Table A1
Variable
Description
Sources
GDP growth
Annual percentage growth rate of GDP
WDI
CWU
Connectedness with the U.S. (%)
BIS
FDI
Foreign direct investments(GDP%)
WDI
EXPORT
exports of goods and services (GDP%)
WDI
INFLATION inflation rate
EXPENSE
government expenses (annual %)
DUMMY
If year=08, 09, 10, 11, dummy=1; otherwise,
dummy=0
WDI
WDI
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