Changes in emerging market asset prices explain over a third of the rise and fall in global equity prices and exchange rates, according to new research from the International Monetary Fund.
The IMF analysis, part of the Global Financial Stability Report, finds that rising financial integration, more than emerging economies’ growing share of global GDP and trade, is the key factor behind their increasing financial impact on other countries. For example, while economic news from China does affect global equity returns, spillovers from Chinese asset price shocks remain limited relative to those of financially more integrated emerging market economies including Brazil, Mexico, and South Africa. Globally, the stocks of companies with more debt are also more likely to be hit by external shocks.
The role of financial integration and financial factors
The financial integration of emerging market economies into the global economy has affected international financial markets in both desirable ways—more efficient asset prices and resource allocation—and undesirable ones—amplification of shocks and transmission of excess financial volatility.
The IMF said two factors also reflect the importance of financial integration in driving the growth in financial spillovers from emerging markets. First, sectors that have higher debt levels and lower liquidity are subject to larger spillovers. Second, emerging market economies with larger financial institutions tend to emit larger spillovers. These emerging economies are also better able to absorb external financial shocks from other emerging markets.
The significant growth in global capital flows due to mutual fund investments is also affecting the nature and size of financial spillovers from emerging market economies. The decision by mutual funds to sell investments in multiple countries in response to losses in one or more countries, or because of withdrawals by their own investors, is called the portfolio channel of contagion. This channel has gained in importance as a source of financial spillovers from emerging market economies to equity markets in recent years, in line with the increase in asset allocation to these countries. The impact from the portfolio channel from advanced economies remains significantly larger, according to the IMF.
Financial spillovers from China will grow
The IMF research shows that among large emerging market economies, China is unique: news about its economic growth has an economically significant and rising impact on global equity prices. In the last five years alone, the impact of growth surprises from China on global equity prices has almost quadrupled. By contrast, changes in Chinese asset prices tend to have little effect on asset prices elsewhere.
“Purely financial spillovers from China are still very small, but likely to grow considerably as China gradually continues to integrate into the global financial system,” said Gaston Gelos, head of the Global Financial Stability Analysis Division at the IMF.
A case for greater policy cooperation, enhanced surveillance
The IMF said policymakers should act to safeguard financial stability in the wake of these changes.
“The evidence underscores the need for policymakers to take into account economic and policy developments in emerging market economies when assessing their own countries’ prospects,” said Gelos.
Enhanced international economic and macroprudential policy cooperation can also play an important role.
Other policy measures countries need to implement include:
• In emerging market economies, policymakers can foster the development of a domestic investor base to help dampen the effect of international financial contagion.
• As China’s role in the global financial system continues to grow, policymakers will need clear and timely communication of policy decisions, transparency about policy goals, and strategies to achieve them.
• The amplification of emerging markets’ financial impact on other countries due to corporate debt means policymakers should adopt measures to limit excessive increases in corporate debt that could threaten financial stability. Improving rules to limit systemic risks arising from mutual funds also remains important.
• Lastly, improving data on cross-border financial flows intermediated by banks, investment funds, and large institutional investors is a priority.
The IMF will release further research from the Global Financial Stability Report on April 13.