Emerging financial markets after the global financial crisis

Tags: financial crisis | Michael Spence | Pimco

Written by Michael Spence
Thursday, 13 August 2009 10:36

Before the currency crises of 1997-98, the advice from advanced countries and the international financial institutions to developing countries with respect to their financial systems was to a first approximation, “you should look like us.”

After the 97-98 experience of instability resulting from a toxic combination of open financial systems, weak internal regulation and transparency, and in some cases external debt denominated in dollars, the advice changed. It became, “you should eventually look like us, but proceed at a measured pace as your financial system deepens and matures”.

It was translated into action more or less as prescribed but with the addition of a widespread accumulation of reserves to provide a buffer against volatility in capital flows and exchange rates.

Now in the aftermath of a crisis that began with extreme distress in the advanced country financial markets, the structure and regulation of the advanced country systems is in the process of significant and permanent change. The lightly regulated model with a strong presumption that self-regulation will be a stabilising influence has been rejected along with the assumption that sophisticated participants in sufficient numbers accurately perceive and manage shifting systemic risk.

As a result, the “like us” part of the modified prescription to emerging markets is not well defined and won’t be until a new system, currently under construction, is in place and has operated for long enough to have been tested. The destination and the partial anchor it provided for the evolution of financial sector policy is no longer clear.

The crisis, with its origins in the advanced country financial systems, has raised questions about our grasp of the evolving structure of the system and our ability to keep up with its shifting risk characteristics, a prerequisite for effective self-regulatory defences. Evidently, this gap became too large in the current crisis, a combination of difficult to access information and incomplete models for processing the information.

1)What will policymakers in developing countries make of all this and how will their responses affect investment opportunities and returns in emerging markets?

First they will watch with great interest the advanced country process of reconstructing the regulatory systems as the possible new destination. Then they will assess whether the new structures meet their own needs or require supplementary steps, and they will review the pace and sequencing of the opening of the capital account. Given the heightened level of uncertainty about the sources of systemic risk and instability, slowing the pace seems rational and likely to be the outcome.

Second, they will study international transmission mechanisms and the range and robustness of circuit breakers. There were two primary transmission channels, one financial and one in the real economy. The financial channel was the rapid exodus of capital from emerging markets to advanced countries to deal with badly damaged balance sheets, capital adequacy and potential solvency problems, and margin and collateral calls. The result was an immediate and sharp credit tightening in developing countries and rapid exchange rate movements with emerging market currencies depreciating, the only exception being China.

The use of reserves to stabilise the net capital flows is the most important domestically controlled circuit breaker. Those countries with reserves used them for this purpose and took steps to intermediate the flows to ease credit in various sectors of the economy. Countries without reserves had few options and remain highly vulnerable and dependent on a recovery of the international system.

Two conclusions will likely be drawn. The importance of reserves as a defensive weapon will be elevated. Management of the current and capital account will be carried out in such a way as to include or expand this element of self-insurance. Second the IMF (on the decline as the crisis broke) is now perceived as quite important in stabilising very volatile global capital flows. Or at least the importance of the function is understood and the IMF will now be challenged to reform in order to meet the challenge.

The IMF’s starting resources at the onset of the crisis were US$250 billion (RM882.5 billion), not nearly enough to deal with the impact of the capital exodus from emerging markets in the fall of 2008. Its resources have since been expanded by the G20 to US$750 billion, though not until several months into the crisis. Important potential sources of these expanded resources including the countries with large reserve holdings will insist on reform of the governance structure.

2) An important premise of the Pimco strategy through the crisis has been that the role of government (including the central bank) shifts from that of referee and regulatory to that plus major player. Government supplies capital and acquires a considerable say in what the private sector institutions do. Their focus is quite understandably on the domestic economy and financial system.

The emerging markets see this clearly. Their conclusion is quite certain to be that it is of high importance in their own financial systems to have a significant fraction of the financial sector, especially the banking sector, domestically owned and controlled. Foreign-based institutions in a crisis are required to focus elsewhere. It is imperative to have a functioning set of stable domestic institutions that will work with the government to respond to the crisis and that are big enough to support the economy’s needs for safe savings channels and credit intermediation.
I would therefore expect that domestic ownership of a substantial part of financial system would become or remain a priority, a relatively long term one, and that foreign entry will be tightly and perhaps more tightly controlled.

3) Additionally, the emerging market balance sheets were largely free of toxic assets. This is perceived as a good thing. Controls on the products that domestic entities and investors can sell and hold will be the response.

This is not to say that emerging markets will conclude that securitisation, properly regulated, is a bad idea. Spreading risk and lowering capital cost is clearly beneficial. The trend in emerging markets toward expansion of the non-bank, marketable securities mechanism for providing credit as the capital markets and institutions mature will therefore continue. But the products are likely to be kept simple by regulation. And the pace may slow for awhile as the advanced country regulatory structures are thought through, revamped, and over time serve as a better models for emerging markets.

4) A perhaps more fundamental set of questions concerns growth and engagement with the global economy. Growth has accelerated in the developing world over the past 20 years. Sustained high growth characterises the economies of about 60% of the people who live in developing countries. This kind of growth has been enabled by the leveraging of the global economy for productivity enhancing knowledge and by using the huge global demand and market place to expand rapidly in areas of comparative advantage.

Several issues are raised by the crisis, issues that are discussed and debated now.

Will or should developing countries abandon the high growth formula or will they adjust and continue? Does the slower global growth associated with the “new normal” imply that the developing country growth strategies and policies won’t work anymore? Is the crisis perceived as a failure of the advanced country financial model or the whole market-based capitalist system in the real economy? Has the perceived balance of benefit and risk in exposure to the global economy tipped in favour of the risks? Protectionist measures increased as part of the crisis response probably as a political price for aggressive commitment of public resources to the financial sector and to fiscal stimulus.

Will this pattern be reversed or continue in the current negative direction? Will the deficit in global aggregate demand created by the elevated saving of the US consumer responding to his damaged balance sheet persist, or will it be eliminated by higher consumption elsewhere in the world? If the deficit persists, will it be harder to remove elements of protectionism in an environment where there is a strong incentive to use policy to capture market share?

Much of this will be revealed over time. But let me hazard a guess (hopefully educated) about at least some of it.

There are voices in pretty much every country that claim the system failure is much broader than the financial sector, that the failure extends to the whole market-based (capitalist) system. That type of view can be found increasingly in some developing countries. Were that view to expand and prevail in policy and strategy, governments would expand dramatically and openness to the global economy might be reduced. The effect would be that much of the competitive dynamics associated with high growth would be lost or diminished.

My best guess is that the dirigiste view will not prevail.

The alternative view is that the financial systems failed badly, but not the whole market-based edifice in the real economy. The evidence favours this more balanced assessment and I believe it will win out, if not everywhere, at least in most countries. The basic open economy, high investment and savings growth strategies will continue to work. But the returns measured in growth will probably be lower in the new normal. There is a difference between strategy and outcomes. The strategies will be modified but not abandoned. The outcomes will be less spectacular for a period of time as a result of the lower global growth.

Much of the future of the developing world will depend on the restoration of openness of the global economy. With the G20 in the lead, removing the protectionist measures as the perceived need declines and restoring the openness of the global economy will likely be accomplished. It may take some time. Finding a manageable and achievable agenda to restart the WTO processes would help.

This rather important multinational agenda will be easier to accomplish if global aggregate demand can be restored quickly, for the incentive reasons mentioned above. It is hard to know if this forward-looking version of global imbalances can be addressed in a coordinated way. It was not in the past. But this is a crisis and the responses may be different. The US side has been decided by the US consumer, assuming that the government doesn’t fall into a longer term pattern of large deficits. The surplus countries’ response has not been set. There are stimulus packages in major developing countries. The size depends on the capacity, with China clearly in the lead. Running deficits will lower savings in the short run. The issue is the medium term. Will the surplus of saving over investment revert to the pre-crisis pattern after the stimulus packages have run their course? Hard to know but important.

The large US deficits and rising debt, unaccompanied as yet by a credible plan to exit and restore fiscal balance, are causing concern. It is reflected in the bond markets and in statements of the developing countries with large dollar denominated reserves. China has floated several times now the idea of a super-sovereign currency via special drawing rights at the IMF.

This is unlikely to be a realistic possibility in the short run for the global economy, though it might provide a risk mitigation mechanism for central bank reserves. The bottom line is that the global economy is dependent on the US resolve to control inflation.

There really isn’t any good alternative as yet. What might be expected from the emerging countries? They will stay with the growth strategies that have served them well, but focus more on resilience in the face of shocks and on stability. They will become broadly more conservative for awhile. They will push for the continuing and restored openness of the global economy. Their financial markets will be structured and regulated with greater attention to partial insulation from external instability. That probably means domestic ownership of a substantial part of the financial system (particularly banking), restrictions on the holding and trading of more complex assets and a controlled pattern of foreign entry.

Knowledge transfer, the key driver of catch-up growth, will continue to be important. While the pace of opening up may slow somewhat, the pattern won’t. Reserves will continue to be viewed as expensive but important insurance against the adverse impact of volatility in global financial flows. A greater emphasis on funding domestic investment (public and private) from domestic savings so as to reduce aggregate dependence on foreign financing seems likely and probably advisable though it may slow growth in some countries. Helping countries do this may be a business opportunity for global financial institutions.

Similarly a greater focus by developing country policy makers on counter-cyclicality in fiscal policy so that there is some dry powder in the event of a large external shock would seem likely.