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Why emerging markets can withstand financial shocks

Traders work on the floor of the Brazilian Mercantile and Futures Exchange in Sao Paulo in this file photo from 2008.

PAULO WHITAKER/REUTERS

Emerging economies in Latin America and Asia have become integrated with the financial systems of the rest of the world in a big way over the past couple of decades. Arguably, this puts their early-stage economies at higher risk when made-in-the-developed-world disasters blow up in the developed world's face (see Lehman Brothers).

But, as it turns out, Latin American and Asian emerging markets are less vulnerable in the face of global financial shocks today than they were years ago.

A working paper from researchers at the International Monetary Fund (IMF) shows that despite increased financial integration over the past 20 years, a bolstering of macroeconomic fundamentals in most emerging market economies (EME) has made them less vulnerable to financial crises over the years. The notable exception is emerging Europe, where a "steep process of financial integration" has been paired with worsening economic fundamentals -- such as public debt -- over the past ten to 15 years.

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Camilo Tovar, a senior economist in the IMF's regional studies division, who has previously worked on emerging market issues and in places such as Mexico, Chile and Colombia, partnered with Gustavo Adler, another IMF economist who has worked on teams for both Latin American and emerging European countries, including Chile, Indonesia and Romania, to write the study.

They found that a flexible exchange rate was critical to protecting an emerging economy from external shocks.

"Financial integration amplifies global financial shocks in economies with fixed exchange rate regimes, but mitigates them in economies with more flexible regimes," the authors wrote.

Inflexible exchange rates appear linked to sharp economic contractions, they said.

A country with strong macroeconomic fundamentals is less likely to see large capital outflows during a crisis because investors are not as troubled by the country's credit worthiness. But also important is the flexibility to put in place counter-cyclical policies that these fundamentals allow, such as lowering interest rates, using fiscal policy to stabilize domestic demand, or letting the exchange rate depreciate.

Integrated countries with strong fundamentals, including things such as lower current account deficits, but especially a flexible exchange rate, were better off during financial shocks than less integrated countries.

The authors used a country's foreign assets and liabilities relative to its GDP to measure financial integration and looked at the experiences of 40 EMEs from 1990 to 2010.

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Especially since 1997, Latin American and Asian economies such as Uruguay and Chile have steady improvement in their resiliency to financial shocks.

"Emerging Europe has systematically moved in the opposite direction," the authors wrote.

As a result, they found that a "Lehman-type event" causes the equivalent of about 1.25-per cent GDP loss in Asia and Latin America, compared with 2.25 per cent in emerging European economies, such as Hungary, Latvia and Estonia, even after controlling for external trade shock.

EMEs are still vulnerable to shocks, the authors stressed, but their research shows financial integration, when paired with general economic strength and a flexible exchange rate policy, is a boon rather than a burden to these economies in tough times.

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