Emerging markets at risk, says IMF |
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The vulnerability of emerging markets to the knock-on effects of the financial crisis in the West should not be underestimated, the International Monetary Fund has warned.
In its report released yesterday, the IMF examined the equity markets in the emerging markets countries to assess the extent to which external, international and domestic as well as fundamental factors drive equity market valuations.
It confirmed that global factors are important in explaining the movement in emerging markets' equity prices as are domestic fundamentals. Using various measures of correlation, the Global Financial Stability Report found that the scope for spillovers to emerging equity markets has risen, suggesting a growing transmission channel for equity price movements.
This can, in turn, affect consumption and investment in emerging markets, although such macro-financial linkages are found to be small and they tend to play out gradually. Nonetheless, the report suggests that policymakers need to remain engaged over the longer term in building resilience in their local financial markets.
Until recently, emerging markets had appeared resilient to spillovers from mature markets. But in recent weeks that has changed. Capital outflows have intensified, leading to tighter external and, in some cases, domestic liquidity conditions. The problems were more serious in those economies with leveraged banking systems and corporate sectors that rely on international financing.
Although "decoupling" - the notion that emerging markets' dependence on mature economies has declined - had faded from most economists' vocabularies, some held out hope that this time the emerging markets would not succumb. It is true that emerging economies have made progress on a number of fronts.
Overall, they have higher fiscal balances, less sovereign debt, more foreign exchange reserves, better policy making structures and healthier economies. Many of these improvements are related to the recent commodity price boom.
Nonetheless, the linkages to global markets and economies have continued to grow and these have begun to overwhelm the improved domestic fundamentals.
And although many emerging economies made fiscal and financial improvements, others remain vulnerable.
The report highlights the reasons some countries may be at particular risk - for instance those dependent on terms-of-trade improvements or external credit.
Emerging European economies have relied on credit supplied by foreign banks or foreign investors through the issuance of local bank bonds abroad.
This latter source has dried up and even though foreign banks say they remain committed to their subsidiaries in these countries, if funding conditions in their home country become difficult they may have little choice but to slow their credit extension abroad as well as at home.
Financial institutions have been shedding bad assets, reducing borrowing and seeking new capital, but strains on the system intensified dramatically in mid September following the collapse or near-collapse of several key institutions.
Confidence in financial institutions and markets has been badly shaken by the global credit turmoil that has its roots in the United States sub-prime mortgage market but that has spread globally to other financial sectors.
The report said risks in a number of areas have risen, especially credit risk, and market and liquidity risks.
According to IMF, financial institutions' losses continue to mount, and unless they receive sufficient capital infusions, the viability of some of them is uncertain.
The IMF report estimates that losses on US-based loans and securities may rise to some $1.4 trillion (Dh5.14trn) - a significant increase from the estimate of $945 billion in the April 2008 Global Financial Stability Report. While roughly $560bn of the losses had already been realised through end-September 2008, bank share prices have continued to plummet and their revenue prospects have stalled.
Raising new capital has become much harder, making it much more difficult for banks to repair their aching balance sheets.
The most serious risk is an intensifying adverse feedback loop between the financial system and the real economy - in which financial institutions' distress leads to impaired credit intermediation and slower economic growth, which in turn leads to further credit deterioration, it said.
The Global Financial Stability Report - using forecasts from the IMF's World Economic Outlook - projects that credit growth in the United States, the euro zone, and the United Kingdom will slow to near zero over the next year before picking up again in 2010.
Public resources will thus be needed to ensure a return to financial stability and a more orderly deleveraging process that avoids a severe credit crunch.
It said with financial markets worldwide facing growing turmoil, internationally coherent and decisive policy measures are required to restore confidence in the global financial system.
"Failure to do so could usher in a period in which the ongoing deleveraging process becomes increasingly disorderly and costly for the real economy," it said.
In a statement, IMF Managing Director Dominique Strauss-Kahn said credit deterioration is spreading to more sectors and countries and also warned about the consequences of failing to act decisively on the financial turmoil.
"The report shows how serious a crisis we currently face," Strauss-Kahn said. "The time for piecemeal solutions is over. I therefore call on policymakers to urgently address the crisis at a national level with comprehensive measures to restore confidence in the financial sector. At the same time, national governments must closely co-ordinate these efforts to bring about a return to stability in the international financial system."
Pressing three-part solution to the crisis, Strauss-Kahn gave some guidelines that can help to bolster confidence in financial institutions and markets.
These are: developing an approach to break the downward spiral of disorderly deleveraging - taking illiquid and impaired assets from banks; injecting capital into viable institutions suffering unduly from incorrect market perceptions; and aiding dysfunctional funding markets get back to normal.
However, while financial institutions need to raise more capital - an estimated $675bn - they cannot do so under current conditions. Some potential investors stepped forward earlier, but now are reluctant.
Current business models and revenue streams are more uncertain because mortgage securitisation has nearly halted, making private capital investments in banks more chancy.
Without the ability to obtain new capital from private markets, recapitalisation using the public sector balance sheet should now be considered, as solvency concerns have led to a seizing up of interbank funding markets, says the report.
"A comprehensive approach, if consistent among countries, should be sufficient to restore confidence and the proper functioning of markets and avert a more protracted downturn in the global economy," said Jaime Caruana, Director of the IMF's Monetary and Capital Markets Department.
"We believe that a more resilient financial system will ultimately emerge from the restructuring and deleveraging process that is under way," he added.
Five principles for restoration
Five principles that could form the basis for financial restoration:
Employ measures that are comprehensive, timely, and clearly communicated. They should encompass the principal challenges arising from the strains of deleveraging. These are improving funding availability, cost, and maturity to stabilise balance sheets; injecting capital to support viable institutions with sound underpinnings that are currently unable to provide adequate credit; and buttressing troubled assets by using public sector balance sheets to promote orderly deleveraging. In applying existing or new regulations, authorities should avoid exacerbating procyclical effects. The operational procedures should be transparent.
Aim for a consistent and coherent set of policies to stabilise the global financial system across countries in order to maximise impact while avoiding adverse effects on other countries.
Ensure rapid response on the basis of early detection of strains. This requires a high degree of co-ordination within each country, and in many cases across borders, and a framework that allows for decisive action by potentially different sets of authorities.
Assure that emergency government interventions are temporary and taxpayer interests are protected. Accountability of government actions is important for all stakeholders and the conditions for support should include private participation in downside risks and taxpayer participation in upside benefits.
Intervention mechanisms should minimise moral hazard, while recognising the exigency of the situation and the need for public support.
Pursue the medium-term objective of a more sound, competitive, and efficient financial system.
Achieving this objective requires both a resolution of nonviable financial institutions and a strengthening of the international macro-financial stability framework to help improve supervision and regulation at the domestic and global levels, as well as mechanisms to improve the effectiveness of market discipline.
By Karen Remo-Listama
© Emirates Business 24/7 2008
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