Until recently, emerging markets were one of the few bright spots left in a world economy hit by massive deleveraging, failing banks, and corporate profit warnings. But now, the crisis is spreading beyond the advanced economies where it originated, with emerging markets all over the world suffering from the squeeze in global financial markets.
In terms of equity prices too, after more than a year of relatively small spillovers from the financial turmoil in advanced economies, equity prices in emerging markets succumbed to the dramatic worsening of financial distress in mid-September 2008.
Still, in early October, despite their steep and abrupt declines, emerging equity prices as a group were still well above their level at the beginning of their rally in the early part of this decade.
Moreover, unlike in past crises, the size of the spillover has not been uniform, reflecting the deepening of these markets, the different economic fundamentals among emerging market economies, and the growth of South-South cross-border investment, which helps insulate them from investor concerns in mature economies. The equity price declines, however, are likely not over.
IMF has projected that world growth is projected to slow from 5 percent in 2007 to 3¾ percent in 2008 and to just over 2 percent in 2009, with the downturn led by advanced economies. IMF has already trimmed the growth projections of India from 7.9% to 7.8% in 2008 and 6.9% to 6.3% in 2009.
Equity prices affect growth
Such global spillovers on emerging equity prices can, in turn, affect domestic private consumption and investment, although the links between financial markets and the real economy tend to play out more gradually than those within financial markets. The IMF analysis found increasing evidence of the so-called "wealth effect" of equity prices in emerging market economies, although not as pronounced as in mature market economies, where consumption and investment have long been affected by changes in equity prices.
Building resilienceTo help withstand abrupt price fluctuations, emerging markets could help build and sustain resilient capital markets. Specifically, the policies that could help to make markets more resilient in the long run include:
• Fostering a broader and more diversified investor base to help deepen markets. Encourage a variety of investors, including institutional investors, such as pension funds and insurance companies, which tend to have long-term investment horizons. Longer-horizon investors can provide a buffer against any reversal of foreign equity inflows.
• Aiding price discovery. Remove impediments to price discovery by avoiding artificial delays in revealing prices or limiting price movements.
• Supporting financial infrastructure development. Adopt legal, regulatory, and prudential rules that conform with international best practice.
• Developing stock exchanges. A well-functioning exchange environment and supporting financial infrastructure for trading equities and new financial instruments can help price discovery, foster liquidity, and generally improve efficiency. Careful implementation, however, is important at every stage. Enhancements and financial innovation need to be properly timed and sequenced, with appropriate oversight in place, so as to reap the full benefits of innovation, while managing the risks to financial stability and ensuring the proper functioning of markets.
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