Investors should welcome the decision by the IMF to rethink how to advise emerging market economies with respect to capital markets.
Cynics may argue that Kristalina Georgieva, the IMF’s recently appointed managing director, is merely trying to head off criticism that the IMF financed $50bn of capital flight in Argentina. However, this would be to miss the point: Ms Georgieva is right to highlight the existence of serious failings in the operation of global capital markets, particularly pertaining to emerging markets.
Sadly, in our opinion, her courage in drawing attention to these issues is not matched in equal measure with fresh ideas for how to improve the situation. The purpose of this post is to address this gap by proposing four simple policy ideas, which would go a long way towards making global capital markets work better for EM economies. In turn, this could support the world economy and, of course, the IMF itself.
First, the IMF should give greater recognition to the fact that hyper-easy monetary policies in developed economies, including very low interest rates and quantitative easing, have had negative effects for EMs by triggering a serious “flight from yield”. More than $15tn of bond purchases by central banks in developed economies exclusively targeted securities in developed economies and thereby acted like giant subsidies of capital market in these economies.
The capital gains unleashed in US equity markets and European bonds markets were so enormous that they prompted investors to reallocate capital out of EM. In total, about one-third of all foreign money invested in EM left and so far only a fraction has returned.
While developed economies needed new financing to avoid depression, the IMF, in our view, was and remains remiss in failing to put in place measures to avoid the collateral damage in EM countries caused by capital flight in these already severely finance-constrained economies. Indeed, the failure to recognise the collateral damage of QE in EM has undoubtedly contributed to slower than necessary global growth.
Second, the IMF and other international financial institutions (IFIs) should take a lead in fixing longstanding EM index problems. Only about 12 per cent of EM fixed income is represented in benchmark indices.
Moreover, the indices are strongly biased in favour of dollar securities over local markets: 73 EM countries are represented in dollar bond indices, but only 18 countries are represented in local currency indices. Yet, EM gets close to 90 per cent of its financing in local markets.
It is difficult to exaggerate the seriousness of this problem. In a world of rising passive investment and where institutional investors — the most stable source of capital in the world — closely hug benchmark indices, the distortions and underrepresentation of EM in benchmark indices translates directly into a crippling institutional bias against EM in global asset allocation.
In our view, this bias is made all the more galling by the fact that the problems could so easily be fixed. For very small sums of money, any one of the major IFIs could provide, either directly or via subsidy, genuinely representative benchmark indices to ensure much greater and more stable access to global capital for many more EM economies. Investors would benefit too from greater and more diverse investment opportunities the world over.
Third, the IMF, together with the International Finance Corporation and the World Bank, should assign far greater priority to encouraging the development of institutional investor bases in EM countries.
Anyone who has ever traded an EM bond will appreciate the crucial importance of local institutional investors, particularly pension funds and insurance companies. These investors act as buyers of last resort and dramatically reduce the vulnerability of EM countries to swings in global capital flows. Indeed, Argentina’s current predicament is partly due to excessive borrowing in dollars due to the dire state of the country’s pension system.
Why has the IMF not placed pension reform at the very heart of its adjustment programme in Argentina? Other established EM countries, such as Brazil, Mexico, Colombia, Peru, Thailand, Indonesia, the Philippines and many others may never again default on external debt, because they get almost all their financing in local markets, so their external debt burdens are now very modest. The key to external stability is local.
Fourth, the IMF should proactively seek to abolish the “apartheid regime”, which still governs global capital markets. According to this regime, the world is neatly divided into “risky” and “risk free” countries. In reality, no such binary distinction exists. Rather, the world’s more than 200 countries exist on a continuum of economic and financial development.
The continuity of development needs to be given recognition not just in the allocations of institutional investors, but also in the design of the financial market regulations by which they operate and in the actions of the world’s rating agencies. Indeed, until the financial apartheid regime is fully eliminated, the violent, damaging and ultimately unnecessary disruptions in EM financial markets at the mere outbreak of bouts of risk-aversion will continue.
Ms Georgieva has a great opportunity to modernise the IMF. By bringing the fund’s understanding of how EM financial markets work up to date, she will immediately boost its relevance and gain respect among EM member states.
Moreover, in taking a lead in removing many of the constraints facing EM countries in global capital markets, she is also likely to make headway in dealing with one of the most daunting challenges facing the world economy today, namely slowing growth.
Years of QE in developed economies has pushed the marginal “growth effectiveness” of allocating to financial markets in these countries down to, or even below, zero, while capital flight from EM’s finance-starved economies has increased the marginal growth effectiveness of investing in EM.
Hence, the mere act of lifting biases against allocations to EM, so that capital can flow to where it generates the maximum possible contribution to growth, will lift global growth, with practically no opportunity cost in terms of forgone growth in developed economies.
Jan Dehn is global head of research at Ashmore Group
beyondbrics is a forum on emerging markets for contributors from the worlds of business, finance, politics, academia and the third sector. All views expressed are those of the author(s) and should not be taken as reflecting the views of the Financial Times
