Financial stress in lender countries and capital outflows from emerging market economies

We investigate if financial stress in countries where international banks are headquartered is a major driver of the withdrawal of these banks’ credit to emerging market economies (EMEs). We find that when financial stress, measured by sovereign or bank CDS spreads or corporate bond spreads, increases, international banks decrease their lending to EMEs, which acts as a major driver of capital outflows from EMEs. In particular, financial stress in lender countries is a more important driver than the local financial conditions and macroeconomic fundamentals of EMEs. Such results hold for both the countries that experienced crises and those that did not, during the Global Financial Crisis (GFC). Such results also generally hold even after the GFC period, but to a lesser extent. Our findings suggest that it is desirable for EME policymakers to promote diversification of lender countries.