The Transmission of External Shocks in Asia: Country Characteristics and Policy Responses

WP/21/3 The Transmission of External Shocks in Asia: Country Characteristics and Policy Responses By Pragyan Deb, Sanaa Nadeem, and Shanaka J. Peiris IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. © 2020 International Monetary Fund WP/21/3IMF Working Paper Asia and Pacific Department The Transmission of External Shocks in Asia: Country Characteristics and Policy Responses Prepared by Pragyan Deb, Sanaa Nadeem, and Shanaka J. Peiris Authorized for distribution by Jonathan D. Ostry January 2021 Abstract Asian economies are increasingly integrated to the global economy through trade and financial linkages, exposing them to the international financial cycle. This paper explores how external shocks are transmitted to Asian economies and whether the use of policies, such as the monetary policy interest rate, foreign exchange intervention (FXI) and macroprudential measures (MPMs), can mitigate the impact of these external shocks. It uses panel quantile regressions on a sample of 14 Asian advanced and emerging economies (AEs and EMs) to assess the impact of financial and real shocks on investment and GDP growth at the median and 5th percentile tail. It finds that external financial shocks tend to have a larger effect on Asian economies than real shocks, and that the main transmission channels through which shocks are propagated are capital flows (particularly via corporate and bank balance sheets) for EMs, and credit for AEs. It also finds evidence that for Asian EMs, FXI may help dampen the capital flows and real exchange rate channels and mitigate financial shocks in the short run, and monetary policy transmission tends to be relatively weak; meanwhile MPMs can help mitigate the credit channel for both AEs and EMs. JEL Classification Numbers: E32, E44, F32, F41 Keywords: Spillovers, international financial cycle, capital flows, balance sheet, transmission channels, foreign exchange intervention, monetary policy, macroprudential measures, capital flows measures Author’s E-Mail Address: pdeb@imf.org, snadeem@imf.org, speiris@imf.orgIMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2 Table of Contents Abstract ..................................................................................................................................... 2 I. Introduction ........................................................................................................................... 3 II. Methodology and Data ......................................................................................................... 5 III. What Matters for Investment and GDP Growth? ............................................................... 8 IV. The Role of Policies.......................................................................................................... 12 V. Robustness Checks ............................................................................................................. 16 VI. Concluding Remarks ........................................................................................................ 17 VII. References ....................................................................................................................... 19 VIII. Appendix ........................................................................................................................ 21 Figures Figure 1: Regional Capital Flows ............................................................................................. 3 Figure 2: FX Liabilities and Derivatives Transactions, Selected Asia, end 2018 .................... 3 Figure 3: External shocks affect growth in Asian EMs ............................................................ 8 Figure 4. Impact of financial shock on transmission channels, Asia EMs, tail ........................ 9 Figure 5. Impact of shocks on GDP growth – EM vs AE ....................................................... 10 Figure 6. Impact of shocks on investment – EM vs AE ......................................................... 10 Figure 7. Impact of shocks at the tails, EMs ........................................................................... 11 Figure 8. Impact of policies on real exchange rate channel, GDP growth, median ................ 13 Figure 9. Impact of policies on capital flows channel, investment EMs and AEs, median .... 14 Figure 10. Impact of policies on credit channel and terms of trade, EMs .............................. 14 Figure 11. Impact of policies on real vs. financial sh