INTRODUCTION TO EMERGING MARKETS

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INTRODUCTION TO EMERGING MARKETS

• Emerging financial markets is a term used to
  describe a set of countries that have embarked on
  a process of
• -- opening their domestic economies
• -- liberalizing their financial systems
• -- increase private domestic ownership

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• New development strategy different from
• -- state-dominated development (60s and 70s)
• -- export-led growth (East Asia)
• Basis of new approach
• -- economic theory demonstrated welfare gains
  from access to world capital markets
• -- evidence on the link between finance and
  economic growth

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• New development approach raises criticisms
• -- EFMs are exposed to volatility of markets
• -- insufficient and sudden move toward
  liberalization exposes EFMs to crises
• -- privatization and liberalization of domestic
  financial systems may leave some social groups out

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MAIN FEATURES OF EFMs

• EFMs are characterized by
• ? small size of domestic financial system
• ? dominant role of state in financial system
• ? poor legal and institutional environment
• ? insufficient regulation of financial markets
  and inadequate law enforcement
• ? low diversification of domestic economies
• ? volatile capital flows and unstable exchange
  rate systems

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• Most EFMs have small domestic financial systems
  compared to advanced economies
• -- many financial systems are bank-dominated
• -- small size of domestic equity markets
• -- main form of financing is debt

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• In many EFMs, the state dominates the banking
  system
• Governments micromanage banks and direct credit
  allocation
• The financial system may become a source of cheap
  funds for governments

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• More importantly, EFMs are characterized by poor
  institutional environments
• -- Shareholder rights
• -- Bankruptcy laws
• -- Corporate governance
• -- Creditor rights
• -- Inadequate information disclosure
• -- Inadequate accounting systems

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• Another main characteristic is poor law
  enforcement
• In some cases, laws may exist, but not enforced
  by courts
• Links between politicians and financiers prevent
  enforcement authorities from taking prompt action

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• Many EFMs are not well diversified, particularly
  in terms of their export sectors
• Countries may depend on one or few commodities
  for main export revenues
• Volatility in world markets exposes these EFMs to
  more frequent changes in their terms of trade

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• Increased capital flows, particularly portfolio
  flows, make EFMs vulnerable to sudden flow
  reversals
• Domestic political and economic uncertainty
  increases the chance of capital outflows
• In spite of their benefits in stabilizing
  inflation, fixed exchange rate regimes have been
  proven too costly to maintain

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BRIEF HISTORY OF RECENT DEVELOPMENTS

• 60s and 70s state-led development
• -- state controls most of the economy
• -- financial repression
• -- industrialization through import substitution
  and credit allocation
• Private capital flows to developing economies are
  low during the 60s, but began to increase during
  the 70s

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• Two main reasons for increase in capital flows
• -- banks in industrial economies were looking
  for new profitable opportunities
• -- increased supply of funds from OPEC
• Low real interest rates prompted many developing
  economies to borrow through syndicated loans

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• 1982 Mexico defaults on its foreign debt
• Other developing economies follow
• Banks in advanced economies experienced
  significant losses
• Debt restructuring in late 1980s (Brady bonds)
• Early 1990s new attitudes toward developing
  economies (privatization and liberalization)

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• Capital flows to EFMs resume
• 1993 significant jump in flows to EFMs
• Main recipients East Asia and Latin America
• Capital flows are primarily private
• Main suppliers of funds
• -- Corporations (FDI)
• -- Portfolio investors

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• Equity investments far outweighed debt
  investments
• First major crisis in Mexico (1994-95)
• Mexican peso crisis affects Latin America
• Second major crisis in East Asia (1997-98)
• Third major crisis in Russia (1998) also affects
  Brazil (1999)
• Recent problems in Turkey and Argentina

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• After crises
• -- Efforts to improve economic institutions
• -- Efforts to restructure financial systems
• -- Efforts to reduce moral hazard problems
• -- What should be the role of the IMF?