Dampening the impact of global financial shocks on emerging market economies

The COVID-19 pandemic is impacting emerging markets through an unprecedented combination of domestic and external shocks. Among the latter, the pandemic has led to a sharp increase in global risk aversion and an abrupt retrenchment in foreign capital flows.

Based on historical experience, these types of global financial shocks can significantly affect macroeconomic conditions in emerging markets, even if the exchange rate is flexible.

Our research in chapter 3 of the latest World Economic Outlook shows that emerging markets can enhance resilience to global financial shocks using macroprudential regulation.

Strengthening resilience with macroprudential regulation

Macroprudential regulation involves a broad range of measures aimed at buttressing financial stability. These may include capital requirements to strengthen bank balance sheets; limits on loan-to-value ratios to curb risk taking; and restrictions on foreign currency mismatches.

In the chapter, we ask whether tighter macroprudential regulation, while strengthening financial stability, can also dampen the impact of global financial shocks on economic activity in emerging markets.

Our analysis suggests that it can. If the level of macroprudential regulation is low, an increase in global risk aversion (proxied by the Chicago Board Options Exchange Volatility Index (VIX) or outflow of foreign capital considerably reduces economic growth in emerging markets.

For example, a 60 percent spike in the VIX—about half of what we experienced in the first quarter of 2020 as a result of the COVID-19 pandemic—or a capital outflow equal to 2 percent of GDP in a quarter can push a typical emerging market into a recession.

These negative effects become less pronounced in countries with tighter levels of macroprudential regulation. In fact, if the level of regulation is sufficiently stringent, global financial shocks do not seem to have a significant impact on GDP growth in emerging markets.

These dampening effects are symmetric. That is, macroprudential regulation reduces the sensitivity of domestic activity to both positive and negative global financial shocks.

Therefore, tighter macroprudential regulation prevents sharper economic slowdowns when global financial conditions tighten, but it comes at the cost of foregone economic activity when global financial conditions are favorable.

This calls for more research on how to optimally adjust macroprudential regulation over time depending on both domestic and foreign developments.

More analysis is needed

There are important caveats to the analysis. First, available measures of macroprudential regulation suffer from several drawbacks, for example because they generally fail to capture the intensity of changes in regulation.

Therefore, the chapter’s empirical findings will need to be re-assessed as more refined measures become available.

Second, it will be important to test for the robustness of the findings using empirical specifications that allow for a richer interplay of macroprudential regulation with other policy tools, especially capital flow management measures and foreign exchange intervention.