By Rohini Tendulkar, Economist, IOSCO
Over the last decade, emerging markets (EMs) have, on average, grown almost as fast twice as advanced economies (AEs). Recently, accommodative monetary policies and low interest rates in the developed world have triggered a search for yield, encouraging investors to the door of EMs, where expected returns are generally higher. Furthermore, Chinese demand has fuelled ‘south-south’ lending and supported growth across the EM regions. These developments mean economic and financial activity is less concentrated in AEs, providing new global investment opportunities elsewhere.
However the ‘taper tantrums’ of mid-2013 and beginning-2014 and the impact of this on capital flows to EMs, raises the spectre of ‘boom-bust’ cycles and reveals the heterogeneity of these markets in terms of economic, financial and institutional conditions – and their varied ability to withstand shock.
The IOSCO Securities Markets Risk Outlook 2014-15 (The Outlook) explores these developments and the potential risks from a securities markets perspective. It points out that in recent years the proportion of cross-border flows of non-bank credit has increased, rendering a more diverse global financial ecosystem. More conservative bank lending practices in developed markets caused by regulation such as Basel III may be responsible, in part, for this shift, though it could also be a symbol of financial and economic maturity.
However, while securities markets in EMs are generally increasing in size, they remain relatively illiquid compared to AEs and in some cases heavily reliant on cross-border flows. In this context, two factors to take into account when considering risk include: (1) shifts in global economic conditions; and (2) technological integration.
(1) Shifts in global economic conditions
The continuing unwinding of monetary stimulus in AEs, particularly the US, in combination with lower Chinese growth rates, increased perception of political risk in some countries, and more recently, falling commodity prices, has implications across EMs. A reversal of capital flows could impact exchange and interest rates, resulting in significant asset price devaluation. Currency depreciation could translate into inflationary pressures and complicate the servicing of debt.
While some EMs weathered the turmoil of the ‘taper tantrums’ relatively unscathed, others – such as Brazil, South Africa, Indonesia, India and Turkey – felt impact on their currencies, interest rates and slack in their equities and bonds markets.
Recent quantitative easing by the Japanese Central Bank, and hints of the same from the European Central Bank, has continued market expectations of liquidity. However the subsequent devaluation of the Yen, especially against the South Korean Yuan and the Chinese Renminbi, has implications for China’s slowing growth, from 10.4% in 2010 to 7.4% in 20141, and South Korea’s export competitiveness. By extension cross-border flows to EMs in Latin America, Asia, Europe and Africa that rely on trade with and lending from these two large economies, are vulnerable to volatility.
Falling commodity prices, in part spurred by China’s slowing growth and also idiosyncratic factors such as political risk in the Middle East and Russia, impact flows to export-dependent EMs.
Particularly vulnerable to these developments are EMs with high current account deficits, low total reserves as a percentage of external debt and steep credit build up. For example, in Brazil the current account deficit increased to -3.5% of GDP compared to -2.2% of GDP in 20102. Total reserves as a percentage of external debt fell to around 48% in 2014, compared with 62% in 20103. Domestic credit to the private sector as a percentage of GDP grew 30% between 2010 and 2013, reaching 70.7% of GDP in 20134. Meanwhile, in the last two years, Brazil has experienced currency depreciation and increased official interest rates. In 2014, GDP growth fell back to just 0.3% compared to 7.5% in 20105. The inflation rate grew to 6.3% in 2014 (compared to 5.0% in 2010).
At the same time, ‘boom-bust’ cycles are not alien to EMs. A string of crises, triggered by volatile capital flows (the Tequila crisis 1994-1995, the Asian crisis 1997 and Russia- Brazil in 1998, etc) have led a number of EMs to introduce macro prudential policies and capital controls aimed at stemming the effects of a sudden reversal of flows. Nevertheless, given the increasing importance of securities markets as a financing channel, the Outlook points to the importance of building robust domestic and international securities markets in EMs – through a focus on nurturing market development, mitigating risks (both systemic and firm level), setting up market structures to improve efficiency and access, and integrating technology.
(2) Integration of technology
The integration of technology into emerging and frontier economies (EFEs) is a particularly salient topic. Technology is changing the financial landscape in unprecedented ways with implications for the way we access, use, finance and invest our money and assets. Processes and transactions are faster, smarter and more automated. Technology is also a facilitator of global integration and financial access. In Kenya, M-PESA, an advanced mobile money system is used by more than two-thirds of the population6, even while local financial markets remain underdeveloped. But while technology offers a host of new opportunities for development and expansion for EFE financial markets – it also introduces new risks. One of these risks is cyber-crime.
In an IOSCO/WFE staff working paper7, it was revealed that around half of the world’s exchanges had suffered a cyber-attack. Cyber-crime can not only choke, disrupt and manipulate financial services and processes but also undermine confidence in the financial system of a jurisdiction, making it a potential systemic risk. Since cyber-space is not limited by national borders, cyber-crime is a truly global risk – one that can affect developed and emerging markets alike. Thus this is a risk that requires both local and global mitigation efforts.
Mitigation efforts include not only prevention and detection/monitoring of cyber-threats but also robust recovery and communication protocols in the case of a large cyber-attack. Furthermore, cyber-crime is not something that can be dealt with by financial firms in isolation. Information sharing mechanisms can assist individual financial actors and regulators in building a clearer and broader picture of the cyber-crime landscape, identifying current cyber-threats and anticipating future cyber techniques so that resources can be allocated efficiently.1 IMF estimates
2 IMF estimates
3 IIF forecast, Reserves excl. gold.
4 World Bank data
5 IMF estimates
6 “Why does Kenya lead the world in mobile money?”, The Economist, May 27th 2013
7 Rohini Tendulkar, “Cyber-crime, Securities Markets and Systemic Risk”, IOSCO Staff Working paper, July 2013