Rakesh Mohan: Global financial crisis and key risks - impact on India
and Asia
Remarks by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the
IMFFSF High-Level Meeting on the Recent Financial Turmoil and Policy Responses, Washington
DC, 9 October 2008.
The assistance of Meena Hemachandra, Chandan Sinha, R.K. Pattnaik, Amitava Sardar and Muneesh Kapur in
preparation of the remarks is gratefully acknowledged.
* * *
The turmoil in the international financial markets of advanced economies, that started around
mid-2007, has exacerbated substantially since August 2008. The financial market crisis has
led to the collapse of major financial institutions and is now beginning to impact the real
economy in the advanced economies. As this crisis is unfolding, credit markets appear to be
drying up in the developed world. With the substantive increase in financial globalisation,
how much will these developments affect India and other Asian emerging market economies
(EMEs)?
India, like most other emerging market economies, has so far, not been seriously affected by
the recent financial turmoil in developed economies. In my remarks today, I will, first, briefly
set out reasons for the relative resilience shown by the Indian economy to the ongoing
international financial markets' crisis. This will be followed by some discussion of the impact
till date on the Indian economy and the likely implications in the near future. I then outline our
approach to the management of the exposures of the Indian financial sector entities to the
collapse of major financial institutions in the US. Orderly conditions have been maintained in
the domestic financial markets, which is attributable to a range of instruments available with
the monetary authority to manage a variety of situations. Finally, I would briefly set out my
thinking on the extent of vulnerability of the Asian economies, in general, to the global
financial market crisis.
Financial globalisation: the Indian approach
The Indian economy is now a relatively open economy, despite the capital account not being
fully open. The current account, as measured by the sum of current receipts and current
payments, amounted to about 53 per cent of GDP in 2007-08, up from about 19 per cent of
GDP in 1991. Similarly, on the capital account, the sum of gross capital inflows and outflows
increased from 12 per cent of GDP in 1990-91 to around 64 per cent in 2007-08.1
With this
degree of openness, developments in international markets are bound to affect the Indian
economy and policy makers have to be vigilant in order to minimize the impact of adverse
international developments on the domestic economy.
The relatively limited impact of the ongoing turmoil in financial markets of the advanced
economies in the Indian financial markets, and more generally the Indian economy, needs to
be assessed in this context. Whereas the Indian current account has been opened fully,
though gradually, over the 1990s, a more calibrated approach has been followed to the
opening of the capital account and to opening up of the financial sector. This approach is
consistent with the weight of the available empirical evidence with regard to the benefits that
may be gained from capital account liberalisation for acceleration of economic growth,
particularly in emerging market economies. The evidence suggests that the greatest gains
are obtained from the opening to foreign direct investment, followed by portfolio equity
investment. The benefits emanating from external debt flows have been found to be more
questionable until greater domestic financial market development has taken place (Henry,
2007; Prasad, Rajan and Subramanian, 2007).
Accordingly, in India, while encouraging foreign investment flows, especially direct
investment inflows, a more cautious, nuanced approach has been adopted in regard to debt
flows. Debt flows in the form of external commercial borrowings are subject to ceilings and
some end-use restrictions, which are modulated from time to time taking into account
evolving macroeconomic and monetary conditions. Similarly, portfolio investment in
government securities and corporate bonds are also subject to macro ceilings, which are
also modulated from time to time. Thus, prudential policies have attempted to prevent
excessive recourse to foreign borrowings and dollarisation of the economy. In regard to
capital outflows, the policy framework has been progressively liberalised to enable the
nonfinancial corporate sector to invest abroad and to acquire companies in the overseas market.
Resident individuals are also permitted outflows subject to reasonable limits.
The financial sector, especially banks, is subject to prudential regulations, both in regard to
capital and liquidity (Mohan, 2007b). As the current global financial crisis has shown, liquidity
risks can rise manifold during a crisis and can pose serious downside risks to
macroeconomic and financial stability. The Reserve Bank had already put in place steps to
mitigate liquidity risks at the very short-end, risks at the systemic level and at the institution
level as well. Some of the important measures by the Reserve Bank in this regard include,
first, restricting the overnight unsecured market for funds to banks and primary dealers (PD)
as well as limits on the borrowing and lending operations of these entities in the overnight
inter-bank call money market. Second, large reliance by banks on borrowed funds can
exacerbate vulnerability to external shocks. This has been brought out quite strikingly in the
ongoing financial crisis in the global financial markets. Accordingly, in order to encourage
greater reliance on stable sources of funding, the Reserve Bank has imposed prudential
limits on banks on their purchased inter-bank liabilities and these limits are linked to their net
worth. Furthermore, the incremental credit deposit ratio of banks is also monitored by the
Reserve Bank since this ratio indicates the extent to which banks are funding credit with
borrowings from wholesale markets (now known as purchased funds). Third, asset liability
management guidelines for dealing with overall asset-liability mismatches take into account
both on and off balance sheet items. Finally, guidelines on securitization of standard assets
have laid down a detailed policy on provision of liquidity support to Special Purpose Vehicles
(SPVs).
In order to further strengthen capital requirements, the credit conversion factors, risk weights
and provisioning requirements for specific off-balance sheet items including derivatives have
been reviewed. Furthermore, in India, complex structures like synthetic securitisation have
not been permitted so far. Introduction of such products, when found appropriate, would be
guided by the risk management capabilities of the system.
The Reserve Bank has also issued detailed guidelines on implementation of the Basel II
framework covering all the three pillars with the guidelines on Pillar II being issued as
recently as on March 27, 2008. In tune with RBI's objective to have consistency and harmony
with international standards, the Standardised Approach for credit risk and Basic Indicator
Approach for operational risk have been prescribed. Minimum capital-to-risk-weighted asset
ratio (CRAR) would be 9 per cent, but higher levels under Pillar II could be prescribed on the
basis of risk profile and risk management systems. The banks have been asked to bring Tier
I CRAR to at least 6 per cent before March 31, 2010. After analyzing the global schedule for
implementation, it was decided that all foreign banks operating in India and Indian banks
having a presence outside India should migrate to Basel II by March 31, 2008 and all other
scheduled commercial banks encouraged to migrate to Basel II in alignment with them but
not later than March 31, 2009.
In addition to the exercise of normal prudential requirements on banks, the Reserve Bank
has also successively imposed additional prudential measures in respect of exposures to
particular sectors, akin to a policy of dynamic provisioning. For example, in view of the
accelerated exposure observed to the real estate sector, banks were advised to put in place
a proper risk management system to contain the risks involved. Banks were advised to
formulate specific policies covering exposure limits, collaterals to be considered, margins to
be kept, sanctioning authority/level and sector to be financed. In view of the rapid increase in
loans to the real estate sector raising concerns about asset quality and the potential systemic
risks posed by such exposure, the risk weight on banks' exposure to commercial real estate
was increased from 100 per cent to 125 per cent in July 2005 and further to 150 per cent in
April 2006. The risk weight on housing loans extended by banks to individuals against
mortgage of housing properties and investments in mortgage backed securities (MBS) of
housing finance companies (HFCs) was increased from 50 per cent to 75 per cent in
December 2004, though this was later reduced to 50 per cent for lower value loans. Similarly,
in light of the strong growth of consumer credit and the volatility in the capital markets, it was
felt that the quality of lending could suffer during the phase of rapid expansion. Hence, as a
counter cyclical measure, the Reserve Bank increased the risk weight for consumer credit
and capital market exposures from 100 per cent to 125 per cent.2
An additional feature of recent prudential actions by the Reserve Bank relate to the tightening
of regulation and supervision of Non-banking Financial Companies (NBFCs), so that
regulatory arbitrage between these companies and the banking system is minimized. The
overarching principle is that banks should not use an NBFC as a delivery vehicle for seeking
regulatory arbitrage opportunities or to circumvent bank regulation(s) and that the activities of
NBFCs do not undermine banking regulations. Thus, capital adequacy ratios and prudential
limits to single/group exposures in the case of NBFCs have been progressively brought
nearer to those applicable to banks. The regulatory interventions are graded: higher in
deposit-taking NBFCs and lower in non-deposit-taking NBFCs. Thus, excessive leverage in
this sector has been contained.
Various segments of the domestic financial market have been developed over a period of
time to facilitate efficient channelling of resources form savers to investors and enable the
continuation of domestic growth momentum (Mohan, 2007a). Investment has been
predominantly financed domestically in India - the current account deficit has averaged
between one and two per cent of GDP since the early 1990s. The Government's fiscal deficit
has been high by international standards but is also largely internally financed through a
vibrant and well developed government securities market, and thus, despite large fiscal
deficits, macroeconomic and financial stability has been maintained. Derivative instruments
have been introduced cautiously in a phased manner, both for product diversity and, more
importantly, as a risk management tool. All these developments have facilitated the process
of price discovery in various financial market segments.
The rate of increase in foreign exchange market turnover in India between April 2004 and
April 2007 was the highest amongst the 54 countries covered in the latest Triennial Central
Bank Survey of Foreign Exchange and Derivatives Market Activity conducted by the Bank for
International Settlements (BIS). According to the survey, daily average turnover in India
jumped almost 5-fold from US $ 7 billion in April 2004 to US $ 34 billion in April 2007; the
share of India in global foreign exchange market turnover trebled from 0.3 per cent in April
2004 to 0.9 per cent in April 2007. There has been consistent development of
wellfunctioning, relatively deep and liquid markets for government securities, currency and
derivatives in India, though much further development needs to be done. However, as large
segments of economic agents in India may not have adequate resilience to withstand
volatility in currency and money markets, our approach has been to be increasingly vigilant
and proactive to any incipient signs of volatility in financial markets.
In brief, the Indian approach has focused on gradual, phased and calibrated opening of the
domestic financial and external sectors, taking into cognizance reforms in the other sectors
of the economy. Financial markets are contributing to efficient channelling of domestic
savings into productive uses and, by financing the overwhelming part of domestic
investment, are supporting domestic growth. These characteristics of India's external and
financial sector management coupled with ample forex reserves coverage and the growing
underlying strength of the Indian economy reduce the susceptibility of the Indian economy to
global turbulence.
Impact of the crisis on India
While the overall policy approach has been able to mitigate the potential impact of the turmoil
on domestic financial markets and the economy, with the increasing integration of the Indian
economy and its financial markets with rest of the world, there is recognition that the country
does face some downside risks from these international developments. The risks arise
mainly from the potential reversal of capital flows on a sustained medium-term basis from the
projected slow down of the global economy, particularly in advanced economies, and from
some elements of potential financial contagion. In India, the adverse effects have so far been
mainly in the equity markets because of reversal of portfolio equity flows, and the
concomitant effects on the domestic forex market and liquidity conditions. The macro effects
have so far been muted due to the overall strength of domestic demand, the healthy balance
sheets of the Indian corporate sector, and the predominant domestic financing of investment.
As might be expected, the main impact of the global financial turmoil in India has emanated
from the significant change experienced in the capital account in 2008-09 so far, relative to
the previous year (Table 1). Total net capital flows fell from US$17.3 billion in April-June
2007 to US$13.2 billion in April-June 2008. Nonetheless, capital flows are expected to be
more than sufficient to cover the current account deficit this year as well. While Foreign
Direct Investment (FDI) inflows have continued to exhibit accelerated growth (US$ 16.7
billion during April-August 2008 as compared with US$ 8.5 billion in the corresponding period
of 2007), portfolio investments by foreign institutional investors (FIIs) witnessed a net outflow
of about US$ 6.4 billion in April-September 2008 as compared with a net inflow of US$ 15.5
billion in the corresponding period last year.
Similarly, external commercial borrowings of the corporate sector declined from US$ 7.0
billion in April-June 2007 to US$ 1.6 billion in April-June 2008, partially in response to policy
measures in the face of excess flows in 2007-08, but also due to the current turmoil in
advanced economies. With the existence of a merchandise trade deficit of 7.7 per cent of
GDP in 2007-08, and a current account deficit of 1.5 per cent, and change in perceptions
with respect to capital flows, there has been significant pressure on the Indian exchange rate
in recent months. Whereas the real exchange rate appreciated from an index of 104.9 (base
1993-94=100) (US$1 = Rs. 46.12) in September 2006 to 115.0 (US$ 1 = Rs. 40.34) in
September 2007, it has now depreciated to a level of 101.5 (US $ 1 = Rs. 48.74) as on
October 8, 2008.
With the volatility in portfolio flows having been large during 2007 and 2008, the impact of
global financial turmoil has been felt particularly in the equity market. The BSE Sensex
(1978-79=100) increased significantly from a level of 13,072 as at end-March 2007 to its
peak of 20,873 on January 8, 2008 in the presence of heavy portfolio flows responding to the
high growth performance of the Indian corporate sector. With portfolio flows reversing in
2008, partly because of the international market turmoil, the Sensex has now dropped to a
level of 11,328 on October 8, 2008, in line with similar large declines in other major stock
markets.
As noted earlier, domestic investment is largely financed by domestic savings. However, the
corporate sector has, in recent years, mobilized significant resources from global financial
markets for funding, both debt and non-debt, their ambitious investment plans. The current
risk aversion in the international financial markets to EMEs could, therefore, have some
impact on the Indian corporate sector's ability to raise funds from international sources and
thereby impede some investment growth. Such corporates would, therefore, have to rely
relatively more on domestic sources of financing, including bank credit. This could, in turn,
put some upward pressure on domestic interest rates. Moreover, domestic primary capital
market issuances have suffered in the current fiscal year so far in view of the sluggish stock
market conditions. Thus, one can expect more demand for bank credit, and non-food credit
growth has indeed accelerated in the current year (26.2 per cent on a year-on-year basis as
on September 12, 2008 as compared with 23.3 per cent a year ago).
The financial crisis in the advanced economies and the likely slowdown in these economies
could have some impact on the IT sector. According to the latest assessment by the
NASSCOM, the software trade association, the current developments with respect to the US
financial markets are very eventful, and may have a direct impact on the IT industry and
likely to create a downstream impact on other sectors of the US economy and worldwide
markets. About 15 per cent to 18 per cent of the business coming to Indian outsourcers
includes projects from banking, insurance, and the financial services sector which is now
uncertain.
In summary, the combined impact of the reversal of portfolio equity flows, the reduced
availability of international capital both debt and equity, the perceived increase in the price of
equity with lower equity valuations, and pressure on the exchange rate, growth in the Indian
corporate sector is likely to feel some impact of the global financial turmoil. On the other
hand, on a macro basis, with external savings utilisation having been low traditionally,
between one to two percent of GDP, and the sustained high domestic savings rate, this
impact can be expected to be at the margin. Moreover, the continued buoyancy of foreign
direct investment suggests that confidence in Indian growth prospects remains healthy.
Impact on the Indian banking system
One of the key features of the current financial turmoil has been the lack of perceived
contagion being felt by banking systems in EMEs, particularly in Asia. The Indian banking
system also has not experienced any contagion, similar to its peers in the rest of Asia.
A detailed study undertaken by the RBI in September 2007 on the impact of the sub-prime
episode on the Indian banks had revealed that none of the Indian banks or the foreign banks,
with whom the discussions had been held, had any direct exposure to the sub-prime markets
in the USA or other markets. However, a few Indian banks had invested in the collateralised
debt obligations (CDOs) / bonds which had a few underlying entities with sub-prime
exposures. Thus, no direct impact on account of direct exposure to the sub-prime market
was in evidence. However, a few of these banks did suffer some losses on account of the
mark-to-market losses caused by the widening of the credit spreads arising from the
subprime episode on term liquidity in the market, even though the overnight markets remained
stable.
Consequent upon filling of bankruptcy under Chapter 11 by Lehman Brothers, all banks were
advised to report the details of their exposures to Lehman Brothers and related entities both
in India and abroad. Out of 77 reporting banks, 14 reported exposures to Lehman Brothers
and its related entities either in India or abroad. An analysis of the information reported by
these banks revealed that majority of the exposures reported by the banks pertained to
subsidiaries of Lehman Bros Holdings Inc. which are not covered by the bankruptcy
proceedings. Overall, these banks' exposure especially to Lehman Brothers Holding Inc.
which has filed for bankruptcy is not significant and banks are reported to have made
adequate provisions.
In the aftermath of the turmoil caused by bankruptcy, the Reserve Bank has announced a
series of measures to facilitate orderly operation of financial markets and to ensure financial
stability which predominantly includes extension of additional liquidity support to banks.
RBI response to the crisis
The financial crisis in advanced economies on the back of sub-prime turmoil has been
accompanied by near drying up of trust amongst major financial market and sector players,
in view of mounting losses and elevated uncertainty about further possible losses and
erosion of capital. The lack of trust amongst the major players has led to near freezing of the
uncollateralized inter-bank money market, reflected in large spreads over policy rates. In
response to these developments, central banks in major advanced economies have taken a
number of coordinated steps to increase short-term liquidity. Central banks in some cases
have substantially loosened the collateral requirements to provide the necessary short-term
liquidity.
In contrast to the extreme volatility leading to freezing of money markets in major advanced
economies, money markets in India have been, by and large, functioning in an orderly
fashion, albeit with some pressures. Large swings in capital flows - as has been experienced
between 2007-08 and 2008-09 so far - in response to the global financial market turmoil
have made the conduct of monetary policy and liquidity management more complicated in
the recent months. However, the Reserve Bank has been effectively able to manage
domestic liquidity and monetary conditions consistent with its monetary policy stance.
This has been enabled by the appropriate use of a range of instruments available for liquidity
management with the Reserve Bank such as the Cash Reserve Ratio (CRR) and Statutory
Liquidity Ratio (SLR)3 stipulations and open market operations (OMO) including the Market
Stabilisation Scheme (MSS)4 and the Liquidity Adjustment Facility (LAF). Furthermore,
money market liquidity is also impacted by our operations in the foreign exchange market,
which, in turn, reflect the evolving capital flows. While in 2007 and the previous years, large
capital flows and their absorption by the Reserve Bank led to excessive liquidity, which was
absorbed through sterilisation operations involving LAF, MSS and CRR. During 2008, in view
of some reversal in capital flows, market sale of foreign exchange by the Reserve Bank has
led to withdrawal of liquidity from the banking system. The daily LAF repo operations have
emerged as the primary tool for meeting the liquidity gap in the market. In view of the
reversal of capital flows, fresh MSS issuances have been scaled down and there has also
been some unwinding of the outstanding MSS balances. The MSS operates symmetrically
and has the flexibility to smoothen liquidity in the banking system both during episodes of
capital inflows and outflows. The existing set of monetary instruments has, thus, provided
adequate flexibility to manage the evolving situation. In view of this flexibility, unlike central
banks in major advanced economies, the Reserve Bank did not have to invent new
instruments or to dilute the collateral requirements to inject liquidity. LAF repo operations are,
however, limited by the excess SLR securities held by banks.
While LAF and MSS have been able to bear a large part of the burden, some modulations in
CRR and SLR have also been resorted, purely as temporary measures, to meet the liquidity
mismatches. For instance, on September 16, 2008, in regard to SLR, the Reserve Bank
permitted banks to use upto an additional 1 percent of their NDTL, for a temporary period, for
drawing liquidity support under LAF from RBI. This has imparted a sense of confidence in the
market in terms of availability of short-term liquidity. The CRR which had been gradually
increased from 4.5 per cent in 2004 to 9 per cent by August 2008 was cut by 50 basis points
on October 65 (to be effective October 11, 2008) - the first cut after a gap of over five years -
on a review of the liquidity situation in the context of global and domestic developments.
Thus, as the very recent experience shows, temporary changes in the prudential ratios such
as CRR and SLR combined with flexible use of the MSS, could be considered as a vast pool
of back-up liquidity that is available for liquidity management as the situation may warrant for
relieving market pressure at any given time. The recent innovation with respect to SLR for
3
At present, banks are required to hold 25 per cent of their net demand and time liabilities (NDTL) in
Government (and some other approved) securities. As against this requirement of 25 per cent, banks holdings
of SLR securities were 26.7 per cent of their NDTL as on September 12, 2008. Thus, banks held nearly 1.7
per cent excess SLR securities - equivalent to Rs. 700 billion - which could be used by banks to avail of
liquidity from the Reserve Bank under the daily LAF operations.
4
In view of sustained large capital flows on the one hand and the finite stock of government securities with the
Reserve Bank, and the absence of the option of issuing central bank securities under the RBI Act on the other
hand, a new scheme, Market Stabilisation Scheme (MSS), was introduced in April 2004 to manage the large
capital flows. Under this scheme, the Reserve Bank has been empowered to issue government Treasury Bills
and medium duration dated securities exclusively for sterilization purposes, so as to manage liquidity
appropriately. The proceeds collected under MSS auctions are kept in a separate identifiable cash account
with the RBI, and can be used only for redemption and/or buy back of securities issued under the MSS. The
payments for interest and discount on MSS securities are not made from the MSS Account, but shown in the
Union budget and other related documents transparently as distinct components under separate subheads.
The MSS securities are indistinguishable from normal government Treasury Bills and dated securities. The
introduction of MSS has succeeded broadly in restoring LAF to its intended function of daily liquidity
management (see Mohan (2006)).
5
On a review of the evolving liquidity situation in the context of global and domestic developments in the
context of the abrupt changes in the international financial environment subsequent to the October 6th
announcement, it was decided, on October 10, 2008, to reduce the CRR by 150 basis points to 7.50 per cent
of NDTL with effect from the fortnight beginning October 11, 2008 instead of the 50 basis points reduction
announced on October 6, 2008. As a result, an amount of about Rs. 600 billion would be released into the
system (instead of the injection of Rs 200 billion announced earlier).
BIS Review 122/2008
combating temporary systemic illiquidity is particularly noteworthy. The relative stability in
domestic financial markets, despite extreme turmoil in the global financial markets, is
reflective of prudent practices, strengthened reserves and the strong growth performance in
recent years in an environment of flexibility in the conduct of policies.
Active liquidity management is a key element of the current monetary policy stance. Liquidity
modulation through a flexible use of a combination of instruments has, to a significant extent,
cushioned the impact of the international financial turbulence on domestic financial markets
by absorbing excessive market pressures and ensuring orderly conditions. In view of the
evolving environment of heightened uncertainty, volatility in global markets and the dangers
of potential spillovers to domestic equity and currency markets, liquidity management will
continue to receive priority in the hierarchy of policy objectives over the period ahead. The
Reserve Bank will continue with its policy of active demand management of liquidity through
appropriate use of the CRR stipulations and open market operations (OMO) including the
MSS and the LAF, using all the policy instruments at its disposal flexibly, as and when the
situation warrants.
Impact on Asian EMEs
In contrast to the previous episodes of global turmoil, EMEs have exhibited relative
resilience, though equity market and exchange rate pressures have intensified in recent
days. So far, the investment sentiment is positive for the Asian EMEs reflecting their strong
economic performance and, for some countries, favourable investment opportunities
associated with elevated commodity prices, though they have adjusted downwards in recent
times, while being somewhat volatile. Credit policy reforms, better structuring of banking
sector debt and improved fiscal positions have also played their role making the EMEs
resilient from the crisis. In addition, large foreign exchange reserves, particularly in Asia, also
provide a degree of protection against possible sudden stops. Another factor that could be of
relevance for this favourable situation is the relatively smaller presence of foreign banks in
the Asian banking sector. This is evident from the fact that the share of banking assets held
by foreign banks in these economies generally lies between 0 and 10 percent (Global
Development Finance, 2008).
The spillovers to the EMEs from the current global financial market crisis have occurred
mainly in and through financial markets, reflecting the relatively high level of integration of
such markets in the global financial system. In this respect, there have been four major
spillovers, viz., (i) a rise in the price of risk; (ii) a reduction in international bond issuance; (iii)
a sell-off in equity markets; and (iv) some unwinding of carry-trade positions. The major
EMEs in Asia have been recording surpluses on the current account in recent years, with the
exception of Korea and India. Thus, the vulnerability of Asia, other than Korea and India, is
relatively contained to that extent. It is in this context the foreign exchange markets in India
and Korea have experienced greater pressure in recent times.
Despite the fact that no significant macroeconomic disruption has taken place in EMEs,
some vulnerabilities exist. There are indications that the current crisis will have some
implications in terms of higher funding costs and raising external finance, particularly, for
lower rated firms. Further, countries with significant foreign bank presence, mostly in East
European economies, might be vulnerable to financial stress faced by a parent bank.
Similarly, slowdown in advanced countries might impact the remittances to EMEs.
As regards the impact of financial turbulence on the real sector, Asian EMEs may not be
entirely immune to slowing growth in developed economies. For East Asian economies,
since most of these economies are small and their trade sector (export plus imports) as
proportion of GDP varies at a significantly higher level between over 200 per cent and 60 per
cent as opposed to the weight of domestic demand as in India, it could be an area of concern
for these countries. Therefore, for these set of countries, the crises could be transmitted
through the trade channel. While strong regional sources of growth within EMEs may be a
mitigating factor, most EMEs still retain substantial trade linkages with developed economies.
In Asia, while intra-regional trade has been growing rapidly over recent years, much of this
activity is still driven by developed economies as a major destination for final goods.
According to the analysis contained in the IMF's latest Global Financial Stability Report
(October 2008) (IMF, 2008a), both domestic and global factors are important in explaining
the movement in equity prices in the EMEs. Correlation of equity markets in EMEs with those
in the advanced economies has risen, suggesting a growing transmission channel for equity
price movements. Amongst the three group of EMEs (Latin America, Asia and Emerging
Europe), the spillover from global factors is found to be strongest in Latin American EMEs
followed by Emerging Europe and Asia. The wealth effect of stock market changes on
consumption and investment, although statistic