We show as emerging markets (EMs) size crosses a threshold it is in advanced economies (AEs) own interest to reduce negative spillovers to EMs. It follows the potential for international cooperation in macroeconomic and prudential policy increases. But entrenched perceptions and historical advantages are obstacles. These blocks are explored as well as possibilities in macroeconomic policies and in prudential regulation. Export of capital is a major way AEs earn a share in EM income. AE macroeconomic policy and volatile capital outflows from AEs are a source of negative spillovers for EMs, but preventive prudential regulation is not adequate in AEs. More regulation is likely to reduce short-term returns to capital flows but not long-term, since with fewer crises both AE and EM income streams would rise. Moreover, there is some evidence excess capital flow volatility has adverse effects on AEs themselves. It follows universal macro-prudential polices would benefit both country groups.
Policy Implications
- More measures required to reduce risks for emerging markets since they are also now drivers of global growth.
- A major way of reducing risks for emerging markets is if international institutions, and source countries, instead of protecting creditors by ensuring they do not suffer a loss in case a crisis occurs, focus on reducing the probability of crises.
- Major source countries should develop prudential regulation of their non-bank financial sectors, including commodity futures markets. This would moderate excess volatility of oil prices, for example, that hurts both producing and consuming countries. Simple lender-based prudential measures such as position limits and leverage caps are easier to apply to non-banks also, and would reduce arbitrage. The availability of other instruments can moderate the impact of sharp AE policy rate changes and reduce the need for such changes, for example by reducing commodity price shocks.
- The IMF should remove restrictions on pre-emptive implementation of capital flow management in emerging markets and its use before other measures. Transparent, pre-announced countercyclical measures as part of a path towards more liberalization in step with domestic market development create better incentives compared to crisis time restrictions.
- Quantitative easing affects central bank balance sheets and exchange rates. So does capital flow management. Both should be treated symmetrically.
Photo by Torsten Dettlaff