Impact of subprime crisis on other economies

Mauricio Cárdenas, Director, Latin America Initiative at Brooking institution says LatAm are much better prepared now.

A year ago, most analysts believed that the subprime crisis in the U.S. was not going to have any repercussions in Latin America and other emerging economies. …Even the IMF’s World Economic Outlook predicted that growth in emerging economies was not going to decelerate considerably.

Very few people accept that as a valid assessment today. Markets are moving in tandem everywhere in the world. During the past week stock markets, currencies and sovereign spreads in Latin America and Asia were following U.S. trends almost to the minute. We are going to see more contagion from the U.S. to the rest of the world. With a slower growing U.S. economy, and with lower capital flowing to developing countries, I expect economic growth in the region to be lower than initially expected during the next 18 moths.

He says Brazil is in much better shape though there are concerns over Mexico. He says Latam countries should use the monies from commodoty boom to invest in more productive activities.

Economist has another amusing fact which is actually quite a turnaround for Latam countries this time round:

“THANK God,” said one Latin American finance minister earlier this year. “At least this time it isn’t our fault.” 

Though, nothing can be taken for granted.

In a paper I had analysed this decoupling/recoupling issue. There are two channels via which shocks are transmitted- trade flow and financial flow. The trade channel usually impacts with a lag but the financial channel is immediate. This is worrisome as it is a possibility that the crisis has got nothing to do with the economic fundamentals of the economy.

In the paper, I had looked at Indian equity markets and  was amazed to see a very high correlation between changes in Indian equity markets and US equity markets. The correlation has increased In recent crisis sharply. One can simply look at the change in US equity markets last night (as per Indian Standard Time) and predict the movement for Indian markets today. If US market closed negative (or positive), so was the case in India and vice-versa. Now corrleation does not imply causation so one can’t really prtedict anything, but the high correlation is worrisome as equity markets should track fundamentals of companies in the markets. If the health is good, the index should reflect that.

The Brookings expert says same has been the case in Latam as well, with  most financial varaiables tracking developments in US markets. All this makes policymaking pretty complicated. One is never sure what measures should one take?

Financial markets are considered to be engines of growth. If they react as per foreign developments, what should policymakers do? For instance, we are facing this problem in India. If we just look at domestic conditions, inflation is still very very high, both money supply and credit are still growing at a fare pace. Overall all point to a tight monetary policy stance. Though, the moment you add global conditions to the situation we get a different perspective.

4 Responses to “Impact of subprime crisis on other economies”

  1. US spiralling deficit- next crisis? « Mostly Economics Says:

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    […] gets a confidence boost from RBI I had pointed to increasing concerns from the financial channel of the coupling theory. This is just becoming a […]

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    […] impact of financial channel of coupling just getting bigger in size and scope. See this India case as […]

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