13.4 Impact of emerging markets on global financial stability
3 min read•july 24, 2024
Emerging markets have become crucial players in the global economy, now accounting for over 50% of global GDP. Their integration into international financial markets has intensified, with foreign investment flows reaching $1.4 trillion in 2019. This growth brings both opportunities and challenges.
The impact of emerging markets on global financial stability has amplified. During market turbulence, these economies can trigger volatility spillovers and contagion effects. However, they also offer diversification benefits for investors, potentially reducing portfolio risk by up to 20% and outperforming developed markets in the long term.
Emerging Markets and Global Financial Stability
Importance of emerging markets
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- Growing economic significance increased share of global GDP from 30% in 2000 to over 50% in 2020 and contributed more than 75% to global growth since 2008 financial crisis
- Integration into global financial markets intensified foreign investment flows reaching 500 billion annually
- Impact on global financial stability amplified volatility spillovers during market turbulence and heightened contagion effects as seen in 1997
- Challenges faced include currency fluctuations with some emerging market currencies depreciating over 20% against USD in 2018 and sudden capital flow reversals during periods of global risk aversion
- Opportunities presented offer diversification benefits for investors reducing portfolio risk by up to 20% and potential for higher returns with emerging market equities outperforming developed markets by 3-5% annually over long-term
Transmission of financial shocks
- Trade linkages reduced demand for exports during emerging market downturns impacting global trade volumes and disrupted supply chains affecting production in developed economies
- Financial linkages exposed cross-border lending with emerging market credit to GDP ratios exceeding 100% in some cases and interconnected portfolio investments amplifying market movements
- Investor sentiment and risk appetite triggered flight to quality during crises shifting capital from emerging to developed markets and exacerbated market moves through herding behavior
- Exchange rate movements sparked competitive devaluations to maintain export competitiveness and unwound currency carry trades causing rapid currency depreciations
- Commodity price channels impacted commodity-exporting countries' fiscal positions and influenced global inflation through changes in energy and food prices
Policy Responses and International Institutions
Role of international institutions
- conducted surveillance and monitoring through Article IV consultations provided lending facilities totaling over $250 billion since 2008 and offered technical assistance to over 180 countries
- extended development financing exceeding $60 billion annually supported structural reforms in areas like financial sector development and shared knowledge through publications (World Development Report)
- Financial Stability Board set standards for financial regulation ( capital requirements) and coordinated national financial authorities to address systemic risks
- Bank for International Settlements facilitated central bank cooperation through regular meetings and produced research on financial stability issues (Quarterly Review)
Effectiveness of policy measures
- implemented types of controls on inflows (Brazil's IOF tax) and outflows (Malaysia during Asian Financial Crisis) managed capital flows but faced challenges in enforcement and created market distortions
- Macroprudential policies introduced countercyclical capital buffers ranging from 0-2.5% of risk-weighted assets imposed loan-to-value ratios limiting mortgage lending and conducted stress tests on financial institutions
- Exchange rate policies adopted managed float regimes in many emerging markets and intervened in foreign exchange markets to smooth excessive volatility
- International policy coordination enhanced through G20 initiatives (Financial Stability Board creation) and established regional financial arrangements (Chiang Mai Initiative)
- Structural reforms strengthened domestic financial systems by improving bank capitalization and enhanced transparency and governance through measures like adopting international accounting standards
- Crisis resolution mechanisms developed debt restructuring frameworks (Collective Action Clauses) and established emergency liquidity facilities (IMF's Flexible Credit Line)
Key Terms to Review (17)
Argentinian Default: The Argentinian default refers to the situation in which Argentina failed to meet its debt obligations, particularly during the 2001 financial crisis when the country declared the largest sovereign default in history, amounting to about $100 billion. This event highlighted the vulnerability of emerging markets and the ripple effects such defaults can have on global financial stability, impacting investor confidence and economic relations worldwide.
Asian Financial Crisis: The Asian Financial Crisis was a period of economic turmoil that began in July 1997 and affected several Asian countries, leading to severe currency devaluations, stock market crashes, and economic recessions. This crisis highlighted vulnerabilities in the financial systems of emerging markets and had far-reaching impacts on the global economy.
Basel III: Basel III is a global regulatory framework established by the Basel Committee on Banking Supervision to strengthen the regulation, supervision, and risk management of banks. It was developed in response to the 2007-2008 financial crisis and aims to improve the stability of the financial system through higher capital requirements, improved risk management practices, and greater transparency.
Capital Controls: Capital controls are government-imposed restrictions on the flow of capital in and out of a country, aimed at regulating foreign investment and stabilizing the economy. These measures can take various forms, including taxes on international transactions, limits on the amount of currency that can be exchanged, or restrictions on foreign ownership of domestic assets. By implementing capital controls, governments seek to manage exchange rate fluctuations, protect their financial markets from volatility, and promote economic stability.
Credit risk: Credit risk is the potential for loss that arises when a borrower fails to meet their debt obligations, impacting lenders and investors. This risk is a critical consideration in various financial transactions, as it can affect interest rates, funding costs, and overall financial stability. Understanding credit risk is essential in assessing financial products like foreign exchange swaps, the influence of emerging markets on global stability, the implications of capital requirements under regulatory frameworks, and the functioning of global money markets.
Emerging market economies: Emerging market economies are nations with social or business activities in the process of rapid growth and industrialization. These economies typically experience higher rates of growth compared to developed countries, driven by factors such as population growth, urbanization, and increasing foreign investment. Their development can impact global financial markets and stability, as they contribute significantly to global trade and investment flows.
Exchange rate volatility: Exchange rate volatility refers to the fluctuations in the value of one currency compared to another over a specific period. This volatility can be influenced by a variety of factors, including economic indicators, political events, and market sentiment, leading to unpredictable changes in exchange rates. Understanding this concept is crucial as it impacts international trade, investment strategies, and overall financial stability.
Financial contagion: Financial contagion refers to the spread of economic shocks or crises from one market or country to others, leading to widespread instability in the financial system. This phenomenon can occur through various channels such as trade links, investor behavior, and interbank lending, causing a ripple effect that can destabilize even distant economies.
Foreign direct investment: Foreign direct investment (FDI) refers to an investment made by a company or individual in one country in business interests in another country, typically by establishing business operations or acquiring business assets. FDI can significantly impact economies, influencing everything from exchange rates to international capital flows and shaping the globalization landscape.
GDP Growth Rate: The GDP growth rate is the measure of how much a country's economy has grown over a specific period, typically expressed as a percentage. This indicator reflects the overall economic health and performance, helping investors assess potential returns in international markets. Understanding GDP growth rates is crucial for making informed investment decisions, especially in international mutual funds and ETFs, where economic conditions can significantly impact asset valuations. Moreover, these rates play a critical role in analyzing emerging markets' stability and their potential for attracting foreign investments.
Globalization theory: Globalization theory refers to the framework for understanding the interconnectedness of economies, societies, and cultures on a global scale, emphasizing the role of international trade, investment, and technology in shaping global dynamics. It explores how these connections influence local and national contexts, impacting everything from economic policies to cultural exchanges. The theory also addresses the implications of globalization for inequality, environmental sustainability, and cultural homogenization.
Inflation Rate: The inflation rate is the percentage increase in the price level of goods and services in an economy over a specific period, usually measured annually. This measure is crucial for understanding purchasing power, influencing interest rates, and guiding monetary policy, which in turn affects exchange rates, investment decisions, and economic stability.
International Monetary Fund: The International Monetary Fund (IMF) is an international organization that aims to promote global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world. The IMF plays a critical role in the functioning of international finance by providing financial assistance and support to countries facing balance of payments problems.
Portfolio theory: Portfolio theory is an investment framework that emphasizes the importance of diversification to optimize returns while minimizing risk. It suggests that a well-constructed portfolio can achieve a desired level of risk through the strategic allocation of assets across various investment classes. This concept becomes crucial in understanding how emerging markets can influence global financial stability, as they often present unique risks and opportunities that can impact the overall performance of investment portfolios.
Sovereign Bonds: Sovereign bonds are debt securities issued by a national government to finance government spending and obligations. These bonds are typically considered a low-risk investment since they are backed by the government's ability to repay through taxation or other revenue sources. In the context of emerging markets, sovereign bonds play a crucial role in global financial stability as they can influence capital flows, exchange rates, and overall economic growth.
Systemic Risk: Systemic risk refers to the potential for a collapse in an entire financial system or market, as opposed to the failure of an individual entity. This type of risk arises from the interconnectedness of financial institutions and markets, where the failure of one can trigger a chain reaction affecting others, leading to widespread economic consequences.
World Bank: The World Bank is an international financial institution that provides financial and technical assistance to developing countries for development projects, aiming to reduce poverty and promote sustainable economic growth. Its role as a key player in international finance connects it to global economic stability, investment opportunities, and the regulation of financial institutions.