Nonlinear transmission of international financial stress

Abstract

This paper investigates nonlinear international financial stress spillovers on a small open economy. The literature provides evidence that financial stress may amplify the effects of adverse shocks. Using monthly data from the US and Canada over the period 1983–2019, we estimate a two-country threshold vector autoregressive model, where economies can be in either a financially tranquil or stressful regime. In times of high financial stress, we find macro-financial fragility between the real economy and financial stress in the US that generates a risk amplification mechanism deepening economic downturns. Additionally, when both countries are in a high-stress regime, US financial shocks are transmitted more strongly to the Canadian financial system and they are more detrimental for a large number of Canadian macro-financial variables. Finally, simulations suggest that our regime-switching model better captures the economic downturn in Canada during the 2007–2008 financial crisis, compared with a linear model.