An Analysis of International Shock Transmission: A Multi-level Factor Augmented TVP GVAR Approach

We develop and apply a new methodology to study the transmission mechanisms of international macroeconomic and financial shocks in the context of emerging markets. Our approach combines aspects of factor analysis and GVAR models by replacing the cross-unit averages that serve as foreign variables in the GVAR model with macroeconomic and financial factors extracted from potentially unbalanced panels of country-level data. Factors are extracted at the country, region and global levels, with a natural hierarchical structure. Furthermore, we allow for time variation in both the model parameters and shock volatility. Our key empirical findings are as follows. First, there is substantial time-variation in the responses of our chosen emerging economies to foreign financial, interest rate and macroeconomic shocks. Second, in response to tighter global financial conditions, policy rates increase in most of our chosen emerging economies, particularly after the crisis. They appear more concerned with financial stability and capital inflows, given that they increase their short term rates more at the expense of large drops in equity prices and output. Third, financial tightening in other emerging market country groups has a loosening effect on domestic financial conditions. Fourth, as we include a global financial risk factor along with the US monetary policy rate, our results suggest that the contractionary effects of US interest rate shocks are taken over by the global financial risk shock. Lastly, we find some evidence that macroeconomic interdependencies among emerging economies have been increasing while their dependencies on advanced economies have been decreasing over time.