What to Expect When There is a Loss of Confidence in Emerging Economies

Abstract

In the wake of Global Finance Crisis (GFC), the world economy felt an immediate adjustment of the risk - the risk premia on interbank borrowing and corporate bonds increased. Amid crisis, the emerging market economies were thought to be cloistered from the immediate contagion. But, lower export demand from developed countries, higher commodity prices and current account imbalances led to an economic slowdown. It is understood that any instability can drive to problematic adjustments in some emerging market economies (EMEs)-China, India, Indonesia and Latin America, with a possibility of spillover effects in a globalized world and massive capital shuffling in the highly connected financial market. This paper inquires and explains the consequences of increased country risk premia in the emerging economies- proxy to loss of confidence in emerging market economies. The paper results are simulated in multi-country-multi-sector G-Cubed model 108V. The study attempts to answer the question: what happens to the emerging economies and the rest of the world if there is a permanent increase in the country risk premia in emerging markets by 200 basis points relative to the baseline. The simulation results suggest that a permanent upward revision of risk has large real consequences for both emerging and developed economies. Outflow of capital from the emerging market triggers disinvestment by firms. Household slash consumption and increase savings which further accelerates the disinvestment process, and emerging economies contract. Nevertheless, higher net exports fostered by exchange rate depreciation improve trade and current account balance in emerging economies, which partially offsets the contraction of domestic demand. Overall the simulation envisions that open trade and mobility of capital is imperative for stabilizing the economies, and without unrestricted capital mobility, effects on the real economy would magnify.