Working Paper: NBER ID: w17497
Authors: Eswar S. Prasad
Abstract: I document that emerging markets have cast off their "original sin"--their external liabilities are no longer dominated by foreign-currency debt and have instead shifted sharply towards direct investment and portfolio equity. Their external assets are increasingly concentrated in foreign exchange reserves held in advanced economy government bonds. Given the enormous and rising public debt burdens of reserve currency economies, this means that the long-term risk on emerging markets' external balance sheets is shifting to the asset side. However, emerging markets continue to look for more insurance against balance of payments crises, even as self-insurance through reserve accumulation itself becomes riskier. I discuss a possible mechanism for global liquidity insurance that would meet emerging markets' demand for insurance with fewer domestic policy distortions while facilitating a quicker adjustment of global imbalances. I also argue that emerging markets have become less dependent on foreign finance and more resilient to capital flow volatility. The main risk that increasing financial openness poses for these economies is that capital flows exacerbate vulnerabilities arising from weak domestic policies and institutions.
Keywords: global finance; emerging markets; capital flows; financial integration; liquidity insurance
JEL Codes: F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Emerging markets' external liabilities shift from foreign currency debt to foreign direct investment (FDI) (F21) | decrease in vulnerability to balance of payments crises (F65) |
| rising public debt in advanced economies (H63) | shift long-term risks to emerging markets' asset sides (F65) |
| Increasing capital inflows (F21) | exacerbate domestic policy vulnerabilities (F68) |
| Increasing capital inflows (F21) | inflationary pressures (E31) |
| Increasing capital inflows (F21) | credit expansions (E51) |
| Proposed global liquidity insurance mechanism (F65) | reduce costs associated with reserve accumulation (G22) |
| Proposed global liquidity insurance mechanism (F65) | facilitate better macroeconomic policies (E60) |
| Proposed global liquidity insurance mechanism (F65) | reduce stigma associated with seeking external assistance (O36) |