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November 24, 2007
Can Booming Emerging Markets Save the World Economy?
Shocking as the heading may seem, this time it comes not from some Saturday afternoon weird dream but from the well respected mag The Economist ( November17th-23rd, 2007). The picture in the cover of the issue reminds you of The Jaws, the movie that kept us at the edge of our seats in the golden days of childhood. It shows the wild beast of finance coming from the depths to gobble up the beautiful economy growing at a rocking 3.9 per cent as of Q3,2007. The Economist ( worth every fil of the three and a half dinars I spent on it) tells us that Q3 is past and with subprime shocks getting crystallised into losses, the American economy is slowing down noticeably. Joblessness, homelessness, coupled with a tightening of credit availability has pushed the consumerist households in a difficult position.
The broader question raised is what concerns us in this part of the world, booming at present thanks to a multitude of factors triggered by economic reforms. What will be the effect if US goes into recession mode and Europe and Japan grow rather slowly. Can the world economic engine go puff-puff pulled by the economic growth of China , India, Middle East and East Asia?
Statistics shows us that emerging markets contribute half the global GDP now, provides assured returns to global investors with stable financial markets and hence seen unprecedented capital inflows through FDI and Portfolio routes. A good guess would be that things look good , the emerging markets can pull it off. But, when joys of risk comes, can the jaws of risk be far behind?
US Recession
Let's look at the US economy. Frankly speaking, the financisl sector was taking too many risks without adequate risk management practices ( read Chris Whalen's blog on Subprime crisis).
Risk taking is not bad, not bad at all.On the contrary, taking no risk is actually the greatest risk of all! Risk is what makes our life worth living, giving rich rewards and vluable exposure.
But it will be terribly wrong to underestimate the frightening jaws of risk even as you bask in its ecstacy. A personal account to explain the point. Few years back, I was doing research on financial modeling for emerging markets at UC-Irvine. Even though the beauty of Irvine and Orange County is something to cherish, I decided to see the whole of US. The prime objective was to learn the actual risk management practices used by financial experts. So I was travelling across the US on AMTRAK on a shoestring budget. As I met professional in all parts of the country ( while at the same time absorbing the country's grandeur an diversity) , I wondered how such simple systems of risk management sustains such a complex financial architecture. Simple models, with simpler assumptions, seemed to be delivered the results. While the going was good, there was no problem. Then the Black swan struck. Rest is history, or history in the making.
Emerging Market Perspective
While we are in safer waters, at least for the time being, in order to avoid financial instability and disruptions to growth, the fllowing key areas needs to be strengthened:
1. Central Banks are very crucial in this context. They must develop Early warning systems so that they put in place prompt corrective framework.
2. Financial entities must take Basel II or other relevant best practices in Risk Management seriously to avoid embarrasing shocks towards their financial. They should strive to implement solid systems and not wait for the regulators to push them towards best practices in risk.
3. Supervisors will face resource constrain while overseeing the implementation of Basel II or other best practices., Enhancing the quality of supervision is likely to emerge as a key issue, especially as financial systems implement Pillar I and move to Pillar Ii issues that are much more compex and less definitive. It is best to have an online surveillace system ( as part of off-site supervision) to improve on reaction time. No point waking up from slumber, once the damage has been done.
4. There is a need to introduce collaborative approaches to meet the above goals. The private and the public sector should work together and there should be cross-border collaborations to boost risk management systems.
Many a times, the advanced economies bailed out emerging markets from crisis. If good risk management systems are in place and growth is insulated from adverse financial shocks, emerging markets will pull the world economoy along a pretty decent growth path.
The time to return the favour has come.
Sunandoroy@gmail.com
Posted by sunandoroy at November 24, 2007 08:16 AM
The problem with emerging markets is high volatility. Therefore if our markets will save the world, then indeed, risk management better take on a whole new meaning for our regulators. At the moment, the subprime crisis has not had that much of an impact, but the next black swan for emerging markets could come virtually from anywhere - civil unrest, birdflue, oil crisis, etc.
Posted by: Mwewa at December 3, 2007 06:53 AM
Some great thoughts. Reading through, i had a Deja Vu that has this occurred in the past. Guess what, turbulences that we are experiencing in the market today have taken other shapes and forms in the past. Human beings, unfortunately have short-term memory. For me, issue is not who the saviour is going to be? The main challenge is have learned a lesson?
Posted by: Manish at December 7, 2007 12:53 AM
True that Emerging Markets are contributing Half the world GDP but they in turn depend on Developed countries as a market for their products. Emerging Markets can bail out only if they have strong domestic demand without which all industries will be affetcted adversly take for example IT industry of India.
Risk Management is definitly important to avoid financial crisis but it seems that we all feel that modelling and VaR is end of risk management. We need to change that mentality and for this central bank should play a very active role. We should think beyond VaR and probably start using traditional ways of risk management like position limits etc along with VaR.
Posted by: Ankur at December 22, 2007 07:53 AM
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