It is well known that financial turbulence in advanced economies spills over to emerging markets. What is less known, but increasingly significant, is that spillovers also travel in the opposite direction.
The most recent edition of the IMF’s Global Financial Stability Report has analyzed this phenomenon and concluded that at least one third of the volatility in advanced economies may be caused by turbulence in emerging markets.
Gaston Gelos, Global Financial Stability Analysis Division Chief at the IMF, is based in Washington, D.C. and led the team that wrote the report. He recently spoke with OnFrontiers about the report and some of its key findings. Read excerpts from the conversation below.
Can you give a recent example of a “financial spillover” from an emerging market that impacted financial markets in other countries?
Last August when Chinese equity markets fell sharply, following the announcement of change in the exchange rate regime, there was a significant drop in equity markets worldwide. So that was one example of a financial spillover from China to the rest of the world. Then in January of this year, the suspension of trading after a sharp drop in the Chinese stock market, also had an impact.
The report says that the growing integration of emerging market economies can be expected to raise spillovers both in its “desirable” and “less desirable” forms. Can you give some examples of “desirable” spillovers?
Desirable spillovers occur when markets work well. When new information about profit opportunities, or the solvency of companies, or the economic prospects of a country, travel from one market to another. And it is incorporated into the prices of different assets, as it should be.
For example, if a car manufacturer in China faces higher demand for its cars, its stock price should rise. And so will the stock price of suppliers to that company located in other emerging markets.
So that would be an example of a spillover that is desired in that it reflects accurately new information. It allows information to be reflected about fundamental economic developments in asset prices across different countries.
And some examples of “less desirable” spillovers?
Undesirable spillovers occur when markets don’t work perfectly. When there is some kind of friction and when shocks get spread across markets – even in the absence of real economic linkages among them.
There are many examples of this. One is when you have a sharp decline or crisis in country A and you have investors, say fund managers that invest in various countries and due to various constraints they face, they may be induced to sell assets in country B. Even though country B has little direct economic linkages with country A.
In that example, you have a transmission of a sharp drop from one country to the other that is more driven by portfolio re-balancing considerations rather than because of direct trade linkages or other fundamental linkages.
One part of the report explains how equity market spillovers are “larger from emerging market economies with more integrated financial markets” than larger emerging market economies. Can you give an example that explains that?
China is a much larger economy than Brazil. But China’s financial spillovers are much smaller than those emanating from Brazil. More generally, we still see that financial spillovers from China or India, which are large economies, but which are not yet that integrated financially into the rest of the world, are relatively small so far. That is, compared to countries whose economies have been very integrated into the financial system for a long time – such as Brazil or Mexico.
For example, if you think of the Chinese A-share stock market, it is not accessible to foreign investors. So it is not very connected to the rest of the world – and it may not even necessarily reflect that well what’s happening in the Chinese economy. So it is not surprising that movement in that market doesn’t have a systematic impact on equity prices elsewhere.
Given the financial integration of the global economy, how can investors in emerging markets protect themselves from the inevitable spillovers?
As some of the large emerging markets become more financially integrated, spillovers are likely to rise. Investors need to understand fundamental, but also financial, linkages. And to the extent possible, try to get a sense of common exposures of investors across countries to understand how shocks are likely to spread from one country to another.
What are some of the IMF’s policy suggestions to help diminish the impact of spillovers?
From the perspective of an emerging market – they can protect themselves by developing a local domestic investor base. If you have local pension funds, insurers, and so forth – these local investors can sometimes act as shock absorbers in the presence of foreign shocks. When they see foreign investors overreacting, they may be able to step in and prevent prices from falling too much.
More generally – we need to enhance monitoring of cross-border financial flows. We need to understand better what these flows are, magnitudes, types of exposures. We know very little about the positions of sovereign world funds, of pension funds, of central banks. Overall, we have a very sketchy picture of the international portfolio flows across countries.
And policy makers need to pay attention to the financial spillbacks that their actions create. If you pursue certain monetary policies, or fiscal policies, or macroprudential policies – they are likely to affect other countries as well. And the reaction of those other countries, in turn, may spillover back to you.
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