RDP 2009-08: Leverage Constraints and the International Transmission of Shocks 5. Conclusions

This paper has provided empirical evidence on the importance of balance sheet adjustments in propagating business cycle shocks across countries. Financial interdependence, combined with financial vulnerabilities, can open a channel for the transmission of shocks that may be as important as standard trade linkages. We have used this evidence to construct a simple two-country model in which highly levered financial institutions hold interconnected portfolios, and may be limited in their investment activity by capital constraints. The combination of portfolio interdependence and capital constraints leads a negative shock in one country to precipitate an episode of global balance sheet contractions and disinvestment. In this sense our model may be seen as a formal general equilibrium representation of Krugman (2008), who suggests that interconnections in financial markets may give rise to an ‘international finance multiplier’. In our model we find that, with high initial levels of leverage, the global effects of the shock may be substantially magnified. While the model illustrates the importance of financial connections, it abstracts from trade linkages. In a more elaborate model, it would be desirable to quantitatively investigate the relative importance of the two separate channels.