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Emerging Markets: Challenges and Rewards

Emerging Markets: Challenges and Rewards
04.10.2009, 18:08 28

Emerging Europe has stepped back from the abyss. For a regionrelying heavily on capital inflows made scarce by the globalfinancial crisis the worst could be expected. And indeed, severaleconomies have suffered a great deal and had to rely on help fromtheir friends. But global risk appetite has returned and the globalrecession seems to be bottoming out. Does this mean that stronggrowth and renewed convergence will return naturally to emergingEurope?

Not necessarily. Just as hopes of decoupling from the epicenterof the crisis were dashed, so will the notion that all emergingeconomies will automatically recover alongside the advancedeconomies. Surely, some bounceback will occur, as trade has startedto resume. But it is already noticeable that the downturn islingering longer in a number of emerging market economies. Why?Many of these countries were severely impacted by the slowdown inportfolio inflows and the reduction in credit by troubledcross-border banks deleveraging their balance sheets. As capitalflows have started to resume, much more differentiation is takingplace as investors are more keen to scrutinize external andinternal vulnerabilities.

This change in investor attitude has caused a dramatic shift inmarket risks. As the global factors that drove both risks andattitudes to unprecedented levels recede, domestic factors andpolicies surface as reasons for investors to differentiate amongcountries. On the top of their list of worries seem to be the stateof private balance sheets and the financial system, as well as theclosely related issue of fiscal sustainability. The result is thatinvestors demand higher risk premiums, slowing down the recovery inthe region.

But investors' newfound scrutiny is also a chance to getrewarded for sound policies. In fact, countries with betterpolicies fared much better already during the crisis. What shouldbe the priority now? Immediate action to plug holes in the bankingsystem is likely to pay off handsomely. In many cases these holesstem from the combination of the economic slowdown andvulnerabilities associated with foreign currency-denominated debtoverhangs by corporations (as in the Baltics, Hungary, Bulgaria,and Romania) and by households (as in the Baltics, Hungary,Romania, and Poland).

Another priority should be to put in place policy frameworks toensure long-term fiscal sustainability and predictability.Countries such as Hungary, Poland, and Romania have already begunthe process of setting credible medium-term targets. The benefitsare fewer surprises in fiscal policy and less volatile businesscycles. Such frameworks should therefore reduce sovereign riskpremiums and speed up the recovery.

However, even if the damage caused by the crisis was quicklyrepaired, the overall level of risk premiums will probably remainhigher than before. This will drag down potential growth, posing amajor challenge for the emerging economies. Policies to fosterstructural change would therefore be required to develop servicesand industries less dependent on foreign capital, to improve exportperformance, and reassure more fickle international investors. Inmany emerging countries, just as much as elsewhere in continentalEurope, adjusting to the post-crisis world will necessitateincreased labor market flexibility and further liberalization ofservice and product markets throughout the EU.

Shoring up a recovery in emerging markets will therefore dependon government action. It requires the combination of a resolute andproactive approach to reduce uncertainly lingering in the financialsystem, efforts to ensure a business-friendly environment andimproved policy frameworks to reduce uncertainty, and enhancedstructural flexibility to ensure higher potential growth. In theend, the market's view of such reforms will determine the speed atwhich Europe's emerging economies will return to a healthy level ofcapital inflows commensurate with the much-needed continuation ofconvergence and economic integration processes. So while thechallenges for the emerging market economies have increased, sohave the rewards for sound policies.

* Marek Belka is Director of the European Department of theInternational Monetary Fund (IMF)