Main Story:
Grey Matters

Pab Jotikasthira, Christian T. Lundblad & Tarun Ramadorai, Asset fire sales and purchases and the international transmission of financial shocks (15 December 2009).  Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1523628

Abstract
We provide new evidence on the channels through which financial shocks are transmitted across international borders. Employing monthly data from 1996 to 2008 on over 1,000 developed country-domiciled mutual and hedge funds, we show that outside investors' flows of money to these funds translate into significant changes in their portfolio allocations in 25 emerging markets. Despite funds' efforts to ameliorate the price impact of these forced portfolio allocation shifts, they substantially impact emerging market equity returns and are associated with increases in co-movement between emerging and developed markets.

CFR comment
The authors, finance professors at the University of North Carolina at Chapel Hill and Oxford’s Said Business School, address the important question of whether financial intermediaries play a role in transmitting financial crises across borders. Using data on country funds, they find that external shocks which change funding levels by investors translate into significant impacts on emerging market equity returns. They explain their results as follows:

When stock returns in developed markets are low, funds investors have incentives to trim their investments in emerging market for at least two reasons. First, they may face margin calls on developed-market asset positions that result in the liquidation of foreign investments, including those undertaken through global funds …. Second, the denominator ‘effect’ – the need for institutional investors such as pension funds to revert to pre-set target asset allocation percentages – causes cuts in emerging market investments as developed market equity holdings shrink in value.
 
These forces cause greater outflows from emerging-market funds at times of low developed market returns, increasing the pressure for forced liquidations by funds and generating greater co-movement of stock returns between developed markets and the emerging markets that are negatively At-Risk. The reverse mechanism applies when developed market stock returns are positive. The organisational structure of global funds engenders periods of significant trading pressure that provide the conduit through which shocks can be transmitted and amplified across the many countries in which these funds invest.

Their conclusion: “Global investment managers, and the constraints they face, constitute an important transmission channel for financial shocks between developed and emerging markets.” This will likely be an important topic in future discussions of international financial regulation.