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In this column, Yilmaz Akyuz, chief economist at the South Centre in Geneva, argues that emerging and developing economies have become more closely integrated into an inherently unstable international financial system and will probably face strong destabilising pressures in the years ahead.
GENEVA, Feb 16 2015 (IPS) - After a series of crises with severe economic and social consequences in the 1990s and early 2000s, emerging and developing economies have become even more closely integrated into what is widely recognised as an inherently unstable international financial system.
Both policies in these countries and a highly accommodating global financial environment have played a role. Not only have their traditional cross-border linkages been deepened and external balance sheets expanded rapidly, but also foreign presence in their domestic credit, bond, equity and property markets has reached unprecedented levels.
New channels have thus emerged for the transmission of financial shocks from global boom-bust cycles.
Almost all developing countries are now vulnerable, irrespective of their balance-of-payments, external debt, net foreign assets and international reserve positions, although these play an important role in the way such shocks could affect them.
Stability of domestic banking and asset markets is susceptible even in countries with strong external positions.
Those heavily dependent on foreign capital are prone to liquidity and solvency crises as well as domestic financial turmoil.
The new practices adopted in recent years – including more flexible exchange rate regimes, accumulation of large stocks of international reserves or borrowing in local currency – would not provide much of a buffer against severe external shocks such as those that may result from the normalisation of monetary policy in the United States.
And the multilateral system is still lacking adequate mechanisms for an orderly and equitable resolution of external financial instability and crises in developing economies.
This process of closer integration was greatly helped by highly favourable global financial conditions before 2008, thanks to the very same credit and spending bubbles that culminated in a severe crisis in the United States and Europe. The crisis did not slow this process despite initial fears that it could lead to a retreat from globalisation. Integration has even accelerated since then because of ultra-easy monetary policies pursued in advanced economies, notably in the United States, in response to the crisis.
The surge in capital inflows that started in the early years of the new millennium, and continued with full force after a temporary blip due to the collapse in 2008 of the Lehman Brothers financial services firm, holds the key to the growing internationalisation of finance in developing countries.
It has resulted in a rapid expansion of gross external assets and liabilities of developing economies. More importantly, the structure of their external balance sheets has undergone important changes, particularly on the liabilities side, bringing new vulnerabilities.
The share of direct and portfolio equity in external liabilities has been increasing. An important part of the increase in equity liabilities is due to capital gains by foreign holders. In many developing countries presence in equity markets is greater than that in the United States and Japan.
While still remaining below the levels seen a decade ago as a percentage of gross domestic product (GDP), external debt build-up has accelerated since the crisis in 2008. This is mainly due to borrowing by the private sector, which now accounts for a higher proportion of external debt than the public sector in both international bank loans and security issues. A very large proportion of private external debt is in foreign currency. There is also a renewed tendency for dollarisation in domestic loan markets.
As a result of a shift of governments from international to domestic bond markets and opening them to foreigners, the participation of non-residents in these markets has been growing. The proportion of local-currency sovereign debt held abroad is greater in many developing countries than in reserve-issuers such as the United States, the United Kingdom and Japan. It is held by fickle investors rather than by foreign central banks as international reserves.
International banks have been shifting from cross-border lending to local lending by establishing commercial presence in developing countries. Their market share in these countries has reached 50 percent compared with 20 percent in developed countries.
These banks tend to act as conduits of expansionary and contractionary impulses from global financial cycles and increase the exposure of developing economies to financial shocks from advanced economies.
One of the key lessons of history of economic development is that successful policies are associated not with autarky or full integration into the global economy, but strategic integration seeking to use the opportunities that a broader economic space may offer while minimising the potential risks it may entail. This is more so in finance than in trade, investment and technology.
For one thing, the international financial system is inherently unstable in large part because multilateral arrangements fail to impose adequate discipline over financial markets and policies in systemically important countries which exert a disproportionately large impact on global conditions.
For another, the multilateral system also lacks effective mechanisms for orderly resolution of financial crises with international dimensions.
Thus, closer integration of several into the international financial system in the past ten years, after a series of crises with severe economic and social consequences, is a cause for concern.
In all likelihood, these countries will be facing strong destabilising pressures in the years ahead as monetary policy in the United States returns to normalcy after six years of flooding the world with dollars at exceptionally low interest rates.
In weathering a possible renewed instability, they cannot count on the more flexible currency regimes they came to adopt after the last bouts of crises or the reserves they have built from capital inflows or the reduced currency exposure of the sovereign.
It is important that they, as well as the international community, avoid going back to business-as-usual in responding to a new round of financial shocks, bailing out investors and creditors and maintaining an open capital account at the expense of incomes and jobs.
They need to include many unconventional policy instruments in their arsenals to help lower the price that may have to be paid for the financial excesses of the past several years
They should also take the occasion to rebalance the pendulum and to bring about genuine changes in the international financial architecture. (END/IPS COLUMNIST SERVICE)
Edited by Phil Harris
The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, IPS – Inter Press Service.
* This column is based on Internationalization of Finance and Changing Vulnerabilities in Emerging and Developing Economies, South Centre Research Paper 60, January 2015, which is available here.
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