Fund managers could be substantially underestimating the financial risks in emerging markets. That is the implication of the latest twice-yearly Global Financial Stability Report from the International Monetary Fund (IMF).*
During the market turmoil many fund managers noted the resilience of emerging markets. They were quick to point out that the fundamentals for emerging economies were strong.
Although the IMF acknowledges the economic strength of these markets, it argues that this is offset by financial risks: “Credit growth has been rapid in a number of emerging markets, with some banks borrowing abroad in foreign currency to lend domestically, taking on indirect credit risks. In addition, the low yields in mature market and high-risk appetite have allowed emerging market corporates easy access to foreign capital.”
The thrust of the IMF’s argument is that the weakening of credit and market discipline globally will make emerging markets vulnerable. Five key concerns are highlighted:
- There is evidence of credit indiscipline in the rapidly growing market for privately placed syndicated loans. This trend is clear in emerging Europe, the Middle East and Africa, although it is to a lesser extent apparent in Asia.
- Both foreign and domestic banks are increasingly relying on international borrowing to finance rapid domestic credit growth. l Emerging market companies are increasingly involved in carry trade style borrowing, which leaves them vulnerable if the trade unwinds.
- In some countries emerging market financial institutions are using structured and synthetic instruments to bolster returns. They could suffer losses if volatility increases.
- Investment from abroad could upset local markets. Evidence suggests that foreign investment funds could transmit volatility to emerging markets.
Overall the IMF report suggests that the global adjustment process could be protracted. It anticipates some slowdown in economic growth as a result of the financial market correction. The risks to the global outlook have increased significantly.
* Available at www.imf.org