Analyzing potential shocks to financial systems

Understanding the dynamics of an emerging economy like Mexico requires insight into the shocks that could impact its external financial account and particularly its stock market. IIASA researchers analyzed interactions between risk and financial interrelations to provide policy recommendations aimed at lessening or avoiding risk.

Economic and financial interrelations in especially developing economies are complex and require innovative models to analyze external and internal shocks. In their study [1], IIASA researchers set out to determine the main shocks that affect the capital flow dynamics in Mexico. They also modeled the country’s complex economic system using a system-dynamics methodology focusing on the stock market [2].

In an emerging market economy (EME) like Mexico, the current account may be vulnerable to external shocks and reversals of capital flows. It is therefore fundamental to determine external factors such as global risk, liquidity, economic activity, and the foreign interest rate, as well as internal factors like domestic economic activity, inflation, the domestic interest rate, and the exchange rate, that affect the financial account. A country’s financial account comprises foreign direct investment (FDI), as well as portfolio and other investments, where FDI could be a catalyst for economic growth. For that reason, it is important to understand the push and pull factors that determine the capital flows and to avoid or reduce external shocks.

The researchers explain that under highly uncertain conditions, external shocks raise risk because the push factors are beyond the control of EMEs, although they can be mitigated. In the capital flow recipient country, risk can be exacerbated if there are account deficits, inflationary pressures, and appreciation of real exchange rates. This could in turn induce systemic failures. To avoid damage to the economy or the possibility of a financial crisis spreading to EMEs as a result of external financial and economic turbulence like during the financial crisis of 2008, it is essential to improve the pull factors or the prevailing economic conditions in each country, and for EMEs to have economic policies that mitigate external shocks.

The researchers found that global liquidity, the federal funds rate, and global risk are the main determinants of portfolio investment by foreign investors. The results further revealed that in Mexico, an increase in global risk leads to lower portfolio investment in private sector securities and higher portfolio investment in public sector securities, as these are less risky.

The Mexican financial account and stock market provide a wealth of information about the network dynamics of both the external and financial sector. To this effect, IIASA researchers also used a macroeconomic equilibrium model to show the importance of the stock market in the economic growth of an EME.

These studies highlighted the importance of understanding how external and internal shocks affect capital flows to Mexico and the stock market. Based on their results, the researchers provided economic policy recommendations that could reduce risk and contribute to developing a healthy external and financial sector in Mexico as well as in other EMEs.