Future of Finance Series, episode 4: What the growth and liberalisation of emerging markets means for the UK’s financial sector

Emerging market economies, like China and India, are likely to look increasingly to global capital markets to meet their financing needs, the Future of Finance report predicts. This shift poses both opportunities and risks for the UK’s financial sector, as we discuss in this week’s instalment of the Future of Finance series. 

This is the fourth instalment in our Future of Finance Series, which looks at Huw van Steenis’ Future of Finance Report and the Bank’s response to it.

The growth and liberalisation of emerging market economies

Large EMEs are still relatively closed to global markets

There is no denying the historic and projected growth of China and India. The FoF report points to data showing that by 2030 these could be the world’s largest and third largest economies, respectively. But, to date, these markets have remained relatively closed to foreign investment. And, even as they have begun to open up, their policies have tended to favour foreign direct investment over portfolio investment or foreign debt. Other EMEs have taken a similar approach. 

This has had an insulating effect

As a result, these economies have remained somewhat insulated from the international capital markets. And, as a corollary, UK financial institutions have been under-exposed to the growth and opportunities in EMEs.

That is likely to change

The report predicts that this is likely to change over the next decade and that increasingly EMEs will look to foreign markets to meet their financing needs. The new Shanghai-London Stock Connect scheme is an example of that.

Opportunities all round

Opportunities for EMEs

There are obvious benefits for EMEs in tapping the global markets. As the report states: “This would support EME growth by making it easier to finance domestic investment needs, which are likely to be substantial".

Opportunities for the UK

But, equally, there are opportunities for the UK as a global financial centre.

UK investors provide significant funding to international capital markets (US$3.4 trillion as at the end of 2017, according to the report). Directing this into faster growing markets could result in strong growth for the UK.

The UK’s record on innovation also places it well to meet evolving market needs. For example, the report highlights that cross-border debt into EMEs is still predominately USD-denominated, which leaves emerging markets vulnerable to the appreciation of the US dollar. As EMEs continue to open up, we could see an increasing demand for local currency denominated bonds. Such instruments benefit the issuing country but at the same time shift FX risks to investors. The UK’s expertise in financial innovation could be helpful in meeting these evolving needs – as well as in responding to the growing demand for other innovative products such as green finance and cyber-risk insurance.

Potential risks for global financial stability

The amplification of macroeconomic shocks

The liberalisation of emerging markets does, however, raise new financial stability risks. Whereas foreign direct investment is a relatively stable, long-term form of inbound capital flow, portfolio flows can be rapidly reversed by investors in deteriorating conditions. In the event of a macroeconomic shock to the market, instant capital flight may have an amplifying effect and could potentially lead to a currency crisis. The report notes that these effects may “spill-back” to an exposed UK.

The UK’s role in mitigating the risks

The report recommends that EMEs take a prudent approach in managing capital account liberalisation by, for example, adopting sound macroeconomic and prudential policies and deepening domestic financial markets.

But it also places responsibility on the UK: “The UK as host to a major international financial centre should be at the forefront of efforts to spot new risks, develop standards and promote close supervisory and regulatory co-operation”. For the private sector, the report’s recommendations focus particularly on post-trade standards and note that the swap and collateral markets would be a good place to start.

Among other things, the Bank of England has said:

• it will continue to work with various international fora to identify and respond to vulnerabilities and enhance global standards;
• it is scaling up its efforts to provide training and technical assistance to central banks in emerging markets; and
• it will convene a “Post-Trade Technology Market Practitioner Panel” to explore how market participants can leverage technological improvements to deliver a more efficient and resilient post-trade ecosystem.

Next up in our Future of Finance Series

In the next instalment of our Future of Finance Series we will focus on green finance and its role in financing the transition to a low carbon economy. Stay tuned by signing up to our FintechLinks blog.