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Appendix I. Graphs
Appendix II. Country Classifications
Appendix III. Correlation Matrix
Appendix IV. Econometric Methodology—System GMM
Appendix V. Series Description and Data Sources
We would like to thank Cheng Hoon Lim, Gian Maria Milesi-Ferretti, Kangni Kpodar, Carlos Medeiros, Ken Miyajima, Nataliya Ivanyk and Danny Quah for useful comments. The paper also benefited from comments made at the IMF Monetary and Capital Market seminar, a seminar at the London School of Economics, and a meeting of the Midwest Economic Association held in March, 2011 in St Louis, Missouri. The views expressed are those of the authors and do not necessarily reflect those of the IMF.
While only anecdotal, the last few decades have seen increases in bubbles, which have become more frequent across more financial assets. Mexican and other Latin American debt suffered from a crash in 1982 and again in 1994; stocks of the Asian Tiger economies came back to earth in 1997; China, and with it commodity prices, peaked in 2007, and prices have fallen since, before recovering more recently. EM stock, currencies, credit, and other commodities once operated in their separate kingdoms and followed their own rules. Now, given asset shortages, they increasingly are interlinked financial assets; and when one market expands with the inflow of money, many risky assets shoot upward simultaneously, forming synchronized bubbles.
Past investment excesses. One argument, advanced by Rajan (2006), is that past booms are still working themselves through the system. Following past overinvestment, the investment overhang still needs some time to pass through the system. In other words, past misallocations of investment are still haunting current investment expenditure. Corporations are therefore cautious in their investment strategy to avoid overinvestment. While there is some plausibility to this argument, it is a temporary phenomenon.
The Balassa-Samuelson effect postulates that if the productivity growth differential between the traded and non-traded goods sectors is larger in the developing countries than in advanced ones, then the relative price of non-traded to traded goods will be rising faster in the developing than in advanced countries, leading to an exchange rate appreciation.
In the context of a general equilibrium, Radner (1972) extended the Arrow-Debreu equilibrium, and is the first framework to be consistent with the incomplete market framework.
Intuitively, the model implies that the cost of consumption is constant across all states since all states have been assigned equal weights, due to Cobb-Douglas utility specification. The cost of consumption is equal to the price of the good (i.e., the opportunity cost to transfer money - the Arrow-Debreu price, from period 0 to the next period f) multiplied by the value of trade in period f. In period f, if state 1 has more liquidity than state 2, the value of trade in state 1 must be higher than the value of trade in state 2, because the quantity theory of money (i.e., the nominal activity is equal to the supply of money) holds in the cash-in-advance economy (see proposition 2). This is possible only under the condition that, the cost of transferring money in state 1 (i.e., the state price) is lower than the cost of transferring money in state 2. As a result, the model suggests that a state with lower interest rate is associated with high liquidity (see proposition 1), and is also attached with a lower state prices (asset price), and vice versa.
The supply of financial asset is modeled in the same spirit as Caballero, Farhi and Gourinchas (2008), who defined the supply of financial asset as Vt = δPVt, where PVt denote the present value of the economy’s future output, and the parameter δ represents the share of PVt that can be capitalized today and transformed into a tradable asset hence the total asset issued in domestic economy. The δ parameter captures the level of financial development in an economy, intuitively for a given level of future output, a higher δ implies domestic agent (enterprise, government or household) can borrow more against their future income, this is equivalent as saying agents can issue more financial assets (Bond, Equity and Loans).
The EMs are Argentina, Brazil, Chile, Colombia, Mexico, Panama, Peru, Venezuela, China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, Thailand, Vietnam, Bahrain, Egypt, Israel, Kazakhstan, Kuwait, Morocco, Pakistan, Saudi Arabia, South Africa, Turkey, UAE, Bulgaria, Croatia, Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, Russia, Slovak Republic, Slovenia, Ukraine.
Development of hedging instruments is also important. In this regard, the surge in the use of derivates to hedge currency and interest rate risk bodes well for more complete capital markets. Korea, Hong Kong, and Singapore have a well-developed interest rate, futures, and currency swap market, respectively, while in countries with capital account restrictions (e.g., China and India), use of the non-deliverable forward market is widespread.