Financial deleveraging and the international transmission of shocks

BIS Working papers 52
14 August 2009


The recent financial crisis has highlighted the role of interdependence among major economies through linkages among financial institutions, in addition to the trade linkages that are at the centre of traditional models of the international business cycle. Focusing on a sample of Asia-Pacific and OECD countries, this paper develops a model of the international transmission of shocks through de-leveraging across financial institutions. In a macro-economic model in which highly levered investors hold interconnected portfolios across countries, we show that the presence of binding leverage constraints introduces a powerful financial transmission channel which results in a high correlation among macroeconomic aggregates during business cycle downturns, quite independent of the size of international trade linkages.