Global impact of loss of confidence in Asian emerging markets

• Date: 01 July 2020
• DOI: http://doi.org/10.1111/twec.12926
• Author: Roshen Fernando
• Published date: 01 July 2020

World Econ. 2020;43:1907–1927. wileyonlinelibrary.com/journal/twec

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1907

© 2020 John Wiley & Sons Ltd

Received: 29 January 2019

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Revised: 11 October 2019

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Accepted: 12 November 2019

DOI: 10.1111/twec.12926

ORIGINAL ARTICLE

Global impact of loss of confidence in Asian

emerging markets

RoshenFernando

Crawford School of Public Policy, The Australian National University, Canberra, ACT, Australia

KEYWORDS

Asian emerging markets, financial crises, G-Cubed model

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INTRODUCTION

After the Global Financial and Economic Crisis in 2008, expansionary quantitative easing in ad-

vanced economies resulted in capital influxes into emerging markets. However, rising interest rates

in the United States since 2015 has triggered a sudden stop and reversal of investments from them.

Moreover, the increasing protectionist sentiment of the US has accelerated these. Consequently, the

strengthened US dollar continues to unbalance the emerging markets, as now evidenced in Latin

America, South Asia, East Asia, South Africa and also in some Eastern European countries (Das,

2018). The recent policy rate hike in Britain to the highest since 2009 (Financial Times, 2018) has

further fuelled the crisis.

The vulnerability of the emerging markets to global shocks via liquidity outflows has notably

increased with high levels of US$-denominated debt, sustained diminished compensation for foreign

creditors with low risk premia, slowdown in the growth, environmental risks with climate change and

political turbulence (The World Bank, 2018).

In this context, being in the Asian century and Asia being the engine of global growth with its

expected contribution to the global gross domestic product (GDP) exceeding 50% by 2050 (Asian

Development Bank [ADB], 2012), impacts on Asian economies due to the triggered crisis would

definitely be felt worldwide, decelerating the global growth momentum. Thus, employing a modelling

approach, this paper will contribute to the existing discussion on potential escalation of the triggered

financial crisis in emerging markets to understand its short- and long-term economic implications on

Asia as well as on advanced economies and rest of the world. The study will serve as a useful guiding

tool in devising coordinated policy measures to retaliate adverse economic impacts of the triggered

crisis particularly on Asian emerging markets (AEM) and broadly on the world.

The sections to unfold will first focus on understanding what a financial crisis entails, causes, types

and consequences of crises and potential means of preventing or managing crises before discussing

approaches to model crises. It will be followed by a detailed account of the methodology adopted and

an in-depth analysis of the effects observed on Asia, advanced economies and the rest of the world,

prior to outlining policy implications emanating from the study.

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FERNANDO

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FINANCIAL CRISES

A financial crisis is a disturbance to an economy's financial sector paralysing efficient allocation of

capital and, thus, distances the actual output from the potential leading to an economic crisis. Two

early schools of thoughts regarding characteristics of financial crises are apparent. While monetarists

(such as Friedman & Schwartz, 1963) associate financial crises strictly with banking system failures,

nonmonetarists (such as Kindleberger, 1978 and Minsky, 1970) extend it to nonfinancial institutions,

disruptions in asset and foreign exchange markets and inflationary impacts. Contemporary theories

characterise financial crises with failure in banking systems, debt defaults and disturbances to foreign

exchange markets, while they are also identified with worsening of adverse selection and moral haz-

ard in financial markets (Eichengreen & Portes, 1987; Mishkin, 1991). More recent studies recognise

financial crises with the aggregation of substantial debt volume and asset prices differentials, and

failure in financial intermediation (Claessens & Kose, 2013).

However, financial crises have also been viewed as an inherent component of a financial cycle

(Zanalda, 2015). The instability hypothesis attributes the possibility of a financial crisis to macroeco-

nomic imbalances resulting from internal and external economic shocks such as changes in interest

rates, commodity prices and terms of trade, fragility and vulnerability of financial systems, as well

as to unstable supply of credit (Minsky, 1992). In addition to instability in credit supply, information

asymmetry, irrationality in investment decisions, mismanagement in policies, failure of supervision

and regulation of financial sector too contribute to financial instability (Claessens & Kose, 2013;

Kindleberger & Aliber, 2011). In line with these characteristics, commonly financial crises would

get initiated with an opportunity for abnormal profits for investors potentially triggered by new poli-

cies, markets and technological innovations, which would then be followed by irrational expectations

for continuous growth in the bubble, also incentivising demand for credit. After further entrance of

new investors to the market, distress would be triggered in markets when overtrading leads to asset

prices not being explainable by their underlying fundamentals. Subsequently, the market would col-

lapse, along with connected markets or economies, when investors rush to get away from the market

(Kindleberger & Aliber, 2011).

The financial crises are also categorised into four, namely, currency, balance of payment (BOP;

sudden stops and capital reversals), banking and debt crises (Calvo, 2003; Reinhart & Rogoff, 2009;

Zanalda, 2015). The historical currency crises are further categorised into three generation models,

where the first-generation models demonstrate the implications of speculative attacks on fixed or

pegged currencies and significant asset price deteriorations (Flood & Garber, 1984; Krugman, 1979).

The second-generation models, in contrast, explain currency crises to be triggering from the conflict

among a fixed exchange rate policy and an aggressive monetary expansionary policy (Obstfeld, 1994).

The third-generation models, on the other hand, explain the role of financial balance sheets of corpo-

rates and capital flows affecting exchange rates in triggering currency crises (Krugman, 1999).

Different to currency crises, BOP crises are mainly due to changes in global interest rates and com-

modity price levels. A higher vulnerability of emerging markets for BOP crises has been historically

observed due to stronger necessity of funds for growth. BOP crises, originating as sudden stops, often

have led to capital reversals and, thereafter, to currency and banking crises (Calvo, 2003). Banking

crises often emerge with lack of confidence about liquidity of the sector and subsequent bank runs,

holding a significant potential to spread risks throughout the financial sector with the interconnect-

edness. Triggering the need for enforcement measures such as sanctions to prevent default, which in

turn could lead to economic slowdown, domestic or foreign debt crises are mainly generated from

significant debt defaults or intolerably high levels of foreign currency-denominated debt (Claessens

& Kose, 2013; Kaufman, 1988).