A crisis emerging markets alone can’t bear
The nature of capital movements suggests that advanced economies could be in for some hurt as well
Slowing global trade is evidence
of how emerging market stresses are being transmitted to advanced economies. The real concern of contagion remains financial linkages, though.
Since 2009, non-resident gross flows into EM financial assets — loans, debt and equity securities — have averaged around $1 trillion (Dh3.67 trillion) annually, although the figure has been volatile. Total outstanding exposure, which remains opaque, may be around 50 per cent of GDP in advanced economies.
The main driver has been accommodative monetary policy of developed-world central banks and the lure of higher returns. Despite reductions, bank cross-border lending constitutes around half of the exposure. Investors make up the bulk of the remaining exposure.
In the first instance, loan and investment losses, such as those reported by funds like Franklin Templeton, reduce wealth. Creditors — in what is known as the common lender channel phenomenon — curtail lending to unaffected emerging markets and advanced economies as they seek to rebuild capital and realign risk.
In previous EM crises, the IMF helped enforce property rights, benefiting foreign investors and lenders. This time, consistent with its changed policies, the IMF may allow capital controls, in some form, as a part of any solution. That would affect asset values and reduce investor access to funds.
These factors may drive aggressive liquidation of holdings, pushing asset prices and EM currencies lower, exacerbating losses and the resulting contagion. Secondary effects are important.
Volatility of and correlations among EM asset prices and currencies have increased. Around 40 per cent of advanced economy asset and foreign exchange volatility on average can be explained by moves in emerging markets more in periods of crisis.
If EM stresses persist, then advanced economies face additional credit tightening, exacerbating the reductions in liquidity underway and potentially transmitting price shocks.