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Published on September 11, 2007

Bank of Thailand (BOT) economists Piti Disyatat and Chayawadee Chai-anant will present a paper entitled "Challenges to Managing Risk and Volatility in the Emerging-Market Context" at the BOT's annual symposium to be held on October 3-4.

The paper says it is a well-established fact that income and consumption in emerging economies are two or three times more volatile than in developed countries.

"More strikingly, consumption is not only more volatile in emerging markets, but also significantly more volatile in relation to income. Why should this be a concern? From a fundamental economic perspective, welfare is determined by the level and volatility of an individual's lifetime consumption path. That is, given a choice between a consumption path that fluctuates randomly around a given trend and one that follows the trend exactly, people prefer the latter," the paper says.

"As such, the heightened volatility in macroeconomic outcomes that emerging market countries experience undoubtedly imply significant welfare costs relative to developed countries - this not even considering the fact that average levels of real consumption are also substantially lower in emerging markets."

The paper says a large part of the explanation for higher macroeconomic volatility rests with key differences in the nature of shocks hitting emerging economies, as well as the way in which their economic systems propagate those shocks. For example, emerging-market countries typically must contend with more volatile capital flows and larger swings in the terms of trade and are subject to more unstable political landscapes. At the same time, structural features like rigid policy regimes, inflexible product markets and financial-sector fragility often exacerbate the effects of these shocks.

Moreover, mechanisms to deal with shocks before and after they occur are less well developed in emerging-market countries. These include market-based and informal arrangements for managing risk, whether through insurance or through credit, as well as government infrastructure like social safety nets. Such mechanisms allow households to maintain a relatively smooth consumption profile even in the face of large temporary fluctuations in income - something that emerging markets have apparently not been able to do in light of the greater variability in consumption relative to income.

"Going forward, emerging-market governments should focus on taking steps to mitigate, where possible, sources of shocks and improve the resilience of the economy to shocks," the paper says.

While there may be potential in some emerging-market countries to use stabilisation policies better - or at the very least, making sure policy changes do not act as a source of instability - the emphasis should be on implementing structural reforms that ensure macroeconomic stability becomes embedded in the underlying economic structure over the medium term and that households are able to shield their consumption from income shocks more effectively. Greater financial development, improved financial access, stronger institutions and more effective public safety nets are important elements in this regard."

The Nation