Finance officials from around the world will gather this weekend in Singapore for the IMF and World Bank annual meetings, and the cocktail chatter will inevitably include discussion of the turbulence that rocked emerging markets this spring. The good news is that markets withstood the punch, differentiating risks rather than indiscriminately selling assets, and inflicting only minimal collateral damage. The bad news is that complacency still hovers, and future turbulence, which may be gathering energy just beyond the horizon, could leave a much more destructive path.
There is time, however, to take preventive steps.
Economic fundamentals, which have steadily improved over the past half dozen years, deserve a large part of the credit for keeping markets safely moored. Average emerging market fiscal deficits in 2005 were half or less than 2002 levels and are under 2% of GDP. The combined foreign exchange reserves of the 26 largest emerging markets surged from $650 billion in 1998 to $2.2 trillion last year. Additionally, the mix of sovereign debt has changed from 53% domestic in 2002 to 70% domestic last year – reducing emerging market exposure to exchange rate risk.
Emerging markets have increasingly moved towards flexible exchange rates, too, as recognition of their virtue has broadened. Flexible exchange rates have proved their worth as shock absorbers, shielding economies from external shocks and dampening local interest rate volatility. Furthermore, flexible exchange rates have allowed newly independent central banks to better focus their efforts on preserving price stability with spectacular success through inflation targeting regimes. According to the IMF, median inflation in a wide group of emerging market economies plunged from a peak of 11.1% in 1998 to an estimated 5.4% this year.
Despite such improvements at the macro level, capital markets remain a nagging vulnerability and local market conditions a likely catalyst for volatility. For example, few emerging markets have deep, liquid local debt markets. Although foreign buying of local currency debt has expanded dramatically in recent years, the set of foreign buyers remain relatively few in number and highly specialized. Many markets are bifurcated, with domestic investors largely holding short-maturity debt, while foreign investors, with the benefit of more diversified portfolios, hold longer-term instruments.
To prepare for future market turbulence, we urge greater attention to improving local market liquidity, focusing on three key areas: deepening local markets; broadening foreign participation; and broadening local participation.
Liquidity boost
Given that many emerging markets lack sufficient liquidity, policy-makers should deepen local markets by developing repurchase (repo) and swap markets. Repo markets improve the liquidity of underlying collateral by increasing demand for those instruments, raising transactions volume, and providing an effective method of shorting securities. Swaps help foreign and domestic participants alike to hedge their interest rate and foreign exchange exposure, thereby increasing the attractiveness of local instruments.
Emerging markets would also benefit from offering a range of government securities and creating a continuous yield curve. This would provide a much needed benchmark for investors and a base for pricing local corporate debt securitization, hence reinforcing market demands for swaps and repos.
Diversity is key
Broadening the foreign investor base is one way to reduce herding behaviour among a concentrated investor base, thus improving liquidity conditions during periods of stress. Emerging markets can encourage more diversity among foreign investors by removing barriers to entry. Doing so involves applying international standards for securities clearing and settlement and liberalizing the capital account, including the removal of special withholding taxes on foreign investors.
The local line
Finally, some emerging markets discourage or prohibit local pension funds and other institutional investors from making moderately risky, but potentially high-yield, investments that can spur economic growth. There is little domestic participation beyond the front end of the yield curve, leaving foreign investors to dominate longer-maturity issues.
Improving regulation and removing restrictions on the investment activities of domestic pension funds may help to improve domestic participation in a broader spectrum of local debt instruments. Removing restrictions on pension funds’ foreign investment will allow greater portfolio diversification, which may make them more willing to invest in higher-risk and higher-yielding local securities. An added benefit may be giving foreign investors counterparties with whom to hedge foreign exchange risk, creating more demand for swaps along more of the yield curve.
None of these changes are likely to occur overnight, nor are they panaceas. Emerging markets must remain committed to the key objectives of fiscal prudence, price stability and flexible exchange rates. But developing capital markets and improving liquidity conditions will help emerging markets weather expected future bouts of turbulence.
Tim Adams is under-secretary for international affairs at the US Treasury