Impact of the crisis on local money and debt markets in emerging market economies

Starting in the second half of 2007, increased risk aversion and perceptions of counterparty risk led to disruptions in financing in developed money markets that spilled over to foreign exchange (FX) markets, as seen in widening Libor–OIS spreads and spreads between the FX swap-implied dollar rate and dollar Libor, with the latter reaching 40 basis points (bp) in September 2007, indicating large and persistent deviation from covered interest parity (CIP) (see Baba and Packer (2009a, 2009b)). The effects on emerging market economies (EMEs) were relatively limited until the failure of Lehman Brothers in September 2008. In the third and fourth quarters of 2007, and then around the first and second quarters of 2008, only two central banks responding to the questionnaire circulated for the BIS meeting reported sustained periods of stress in their FX markets. Two others reported stress, but only for a very brief period. Over these periods, there were distinct and persistent (but relatively limited) increases in the MOVE index, suggesting higher perceived risks in developed debt markets, as well as in (EME sovereign) CDX spreads, suggesting higher perceived EME sovereign default risks, and also in the Libor–OIS spreads, reflecting disruptions to FX cash markets. The effects of tighter financing conditions on EMEs at the time were most apparent in equity price declines.