The Growing Importance of Financial Spillovers from Emerging Markets

Abstract

Has growing trade and financial integration resulted in an increase in outward shock spillover from emerging economies to global financial markets? Over the last two decades, transmission of emerging market shocks to equity prices and exchange rates in advanced and emerging market economies has risen substantially, now explaining over a third of the variation in asset returns. The importance of financial factors in propelling this evolution has been especially significant in recent years, more so than trade integration—we find that more than economic size; it is the degree of financial integration that underpins a country’s importance as a receiver and transmitter of spillovers. For example, purely financial contagion effects remain less significant in the case of China relative to financially more integrated Brazil and Mexico. Nonetheless, the impact of shocks to economic fundamentals on regional and global financial markets is indeed a function of the economic size and trading importance of an emerging economy—such spillovers from China are larger than other emerging markets, having risen more over the last decade. Consequently, as equity and bond markets in the larger emerging market economies deepen, opening up more to foreign investors and giving freer rein to domestic investors to invest in global financial portfolios, financial spillovers from these countries should rise significantly. Finally, structural changes in financial markets, notably the growth in mutual fund intermediation of capital flows, appear to have increased the importance of the portfolio channel of contagion from emerging markets. These findings suggest that when assessing macro-financial conditions, policymakers may increasingly need to take into account economic and policy developments in emerging market economies. In particular, as China’s role in the global financial system continues to grow, clear and timely communication of its policy decisions, transparency about its policy goals and strategies consistent with their achievement will be ever more crucial. Finally, given the evident importance of corporate borrowing and mutual fund flows in amplifying spillover of shocks, it will be essential to shape macroprudential surveillance and policies to contain systemic risks arising from these channels.