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Special Topic: The Links between Financial Stress and the Real Economy

The recent turmoil in global financial markets is not the first crisis that the world economy has experienced. A quick look at history gives us many examples of banking, currency, twin (concurrent banking and currency) crises, and current account reversals (a sharp change in the current account deficit after a period of foreign capital inflows). These episodes are often but not always a precursor to economic slowdown. Given the financial nature of the current situation, this special topic provides an analysis of the links between financial distress and the real economy based on similar past conditions and discusses the potential channels through which tight financial conditions can be transmitted to the real economy. The topic draws on material from the IMF’s latest Global Economic Outlook.

Not all financial stress episodes lead to economic downturns

An analysis of financial distress in 17 advanced countries in the past three decades shows that around half the episodes of financial stress were followed by an economic downturn, i.e., a slowdown or a full-blown recession (Figure 7).

Figure 7 - Number of Financial Stress Episodes
Figure 7 - Number of Financial Stress Episodes.
Sources:  IMF Global Economic Outlook, October 2008, Ch 4

Economic downturns preceded by financial distress are more severe

Economic downturns associated with episodes of financial stress tend to be longer and deeper than those which are not preceded by a financial crisis Figure 8 shows that the average output loss in recessions associated with an episode of financial stress has been around 4 percent of GDP against 2 percent for all the other recessions.

There are several other facts to note from past financial stress episodes. Figure 9 shows that output losses tend to be even larger if the crisis is banking-related (vs. securities or foreign exchange markets). In most cases, the impact on the real economy materialises soon after the crisis has started but there are examples of longer lags. The average duration of a downturn associated with banking related financial stress is around 8 quarters.

Figure 8 - Financial Stress and Output Loss
Figure 8 - Financial Stress and Output Loss.
Sources:  IMF Global Economic Outlook, October 2008, Ch 4
Figure 9 - Real GDP
Figure  9 - Real  GDP.
Sources:  IMF Global Economic Outlook, October 2008, Ch 4

There can be several transmission mechanisms to the real economy

The potential transmission mechanisms from financial distress to the real economy include tighter financial conditions (drying up of market liquidity and having no room to differentiate across the credit spectrum might lead to limited access to capital by firms and lower investment and even bankruptcies of some firms, leading to high levels of unemployment), decline in investment due to uncertainty, decline in consumption due to loss of consumer confidence as a result of tighter credit conditions and wealth effects from falling asset prices (houses, shares), and decline in exports and the price of commodities due to a fall in world demand.


Several factors make a country more vulnerable to these transmission mechanisms

One way to think about these different channels is to look at how macroeconomic variables have behaved in previous episodes of financial crises. Asset prices, credit ratios and household financial positions are good indicators of how vulnerable an economy is to financial distress.

The effects on the real economy are more severe if there has been a build-up of house prices and credit as well as firm borrowing. Household and firm exposures to the financial sector (external funding) have been the most important channels that have led to a decline in real economic activity. Figure10 shows that financial stress episodes followed by recessions tend to be preceded by rapid build-ups in net borrowing by households.

Figure 10 - Household Net Lending/Borrowing
Figure 10 - Household Net  Lending/Borrowing.
Sources:  IMF Global Economic Outlook, October 2008, Ch 4
On average, countries with current account and fiscal deficits are more vulnerable to financial distress and downturns. Figure 11 shows that current account deficits prior to a recessions are larger in those economies which also experience financial stress prior to a recession.

The impact of the current crisis on growth

During the Great Depression, industrial production collapsed – US industrial production dropped by 48% between 1929 and 1932, and German industrial production dropped by 39% – and the rates of unemployment peaked at 25% in the US and 44% in Germany. These numbers suggest that the current crisis is far from such dire

circumstances. That is partly because policy responses exacerbated the Great Depression.  The nature of the current crisis is similar to that of the Asian crisis.  Both crises share the following common causes: inadequate transparency in the financial sector; excessive leverage as a result of lax bank regulation and an overly accommodating monetary policy prior to the crisis.  So far the economic impact of the current crisis has been more widespread than the case was in the Asian crisis. The analysis above shows that all crises are different and the extent to which each country is affected by a crisis depends on whether the underlying economy is sound or not.

Figure 11 - Current Account/GDP
Figure 11 - Current  Account/GDP.
Sources:  IMF Global Economic Outlook, October 2008, Ch 4
For a small open economy like New Zealand, the most prominent transmission channels from the current financial crisis to the real economy are tighter credit conditions, increased risk aversion, lower world export prices and a decline in exports due to weaker global demand.

Having a flexible exchange rate, and room for expansionary monetary and fiscal policy to address these transmission channels, puts New Zealand in a relatively good position to deal with these impacts on the real economy.  Some empirical evidence suggests that countries with a strong resource base perform better during a financial crisis in comparison with other countries.  However, a larger current account deficit and household indebtedness constitute some vulnerability, if these imbalances were to unwind drastically due to tightness in global credit conditions.

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