The international financial community needs to do a better job in guarding against financial market contagion.
The collapse of Turkish markets and the effects on other emerging markets make the question acute and relevant. The drama needs some perspective. In reaction to Turkey, markets may have been less contagious than in the past. Contrary to some, I do not think another Asia crisis similar to the 1997-98 upsets is at hand. Furthermore, these developments are not new. Markets have long known that Turkey was an economic disaster in the making. President Recep Tayyip Erdoğan’s increasingly authoritarian behaviour has long been in plain view. Several flash points have strained US-Turkey relations.
Analysts focused on a consensus view on Turkey’s vulnerabilities – a large current account deficit financed by flighty short-term borrowing; excessive credit creation and fiscal deficits; inappropriate monetary policy; unhedged corporate balance sheets; and other unorthodox policies. Erdoğan has undermined institutions and relations with US President Donald Trump’s administration are at a low.
Yet, even though Turkey’s weaknesses are idiosyncratic and well-known, many policy-makers and financial market practitioners asked, ‘Who’s next?’ A global emerging markets sell-off ensued, hitting the most vulnerable, such as Argentina, which raised interest rates by five percentage points, but also even a far more sound economy such as Indonesia, which raised rates by 50 basis points.
While many argued that normalisation by the Federal Reserve provides incentives to reduce emerging market exposure, US monetary normalisation has long been underway and the Fed has clearly communicated its expected rate path to markets. I do not think the Fed should be blown off course from its policy of gradual tightening.
Contagion can impose large economic costs. Despite the useful steps since the 1997-98 Asia crisis to enhance transparency and data provision, boost crisis prevention and improve country fundamentals to limit contagion, policy-makers should reflect on what more can be done. At the heart of the matter is transparency. If global markets receive substantial data on countries and price such information into their portfolio decisions, contagion as a consequence of well-known macroeconomic policies and performance should not be inevitable. Better understanding market trading dynamics is also essential.
As the first of my proposals for improvements, international institutions need to recalibrate their policy approach. For many years, amid low advanced economy interest rates and volatility, asset managers have reached for yield. Emerging markets attracted much attention, especially amid solid growth. While a small overall percentage of a large asset manager’s assets under management may be invested in emerging markets, those amounts often represent a high percentage of a relatively small and illiquid emerging economy capital market. Turkish spillovers and other ‘tantrums’ may warrant the international community broadening its analysis from well-known macroeconomic vulnerabilities and intensifying its focus on market dynamics in the emerging market asset class.
Second, financial institutions should compel their risk managers and senior traders to re-examine how they performed in the Turkish and other tantrums. Was proper due diligence exercised? Do individual firms take into account that others are also often pursuing similar strategies?
For an individual asset manager, an emerging market investment can be a source of portfolio diversification. When many asset managers do the same, it becomes a source for a ‘crowded’ trade and ‘herding’. Further, asset managers often use similar emerging market benchmarks, heightening cross-correlation among portfolios and undermining diversification. Market hiccups and even modest portfolio reallocation can trigger a disruptive rebalancing and rush to the exits, amplifying shocks.
Third, the International Monetary Fund, Bank for International Settlements and Financial Stability Board should continue efforts to strengthen and improve their understanding of emerging market dynamics. They should work with financial institutions to understand better contagion resulting from emerging economy market dynamics and what further improvements might be made. National regulators and supervisors should do the same. Given that market disruptions may reflect herding behaviour and cause harmful global spillovers, a macroprudential focus will be a critical complement to a microprudential perspective. International policy-makers have recognised that, in addition to asset managers and other wholesale market participants, corporate leverage in emerging markets is high. Retail investors, too, are at play – reports abound about Japanese investors losing on ‘double decker’ Turkish lira bets.
Fourth, even if Turkey is unwilling to adopt orthodox policies and secure a Fund programme, the IMF still plays a key role. The Fund should continue to improve crisis prevention and it should stand ready to back any country impacted by contagion, either due to financial or trade linkages.
At a wider level, the international policy-making community must to a better job of analysing risk factors and preparing for potential trouble in emerging markets. Contagion will never be banished completely, but the world can step up efforts to make it less troublesome.
Mark Sobel is US Chairman of OMFIF. He is a former Deputy Assistant Secretary for International Monetary and Financial Policy at the US Treasury and until earlier this year US representative at the International Monetary Fund.