Capital flows to emerging market economies: A brave new world?☆
Introduction
According to economic theory, free movement of capital across national borders is beneficial to all countries, as it leads to an efficient allocation of resources that raises productivity and economic growth everywhere. In practice, however, as now appears to be well recognized, large and volatile capital flows can also create economic distortions and policy challenges.
In recent years, these challenges have come to the forefront again for emerging market economies (EMEs). After tanking during the global financial crisis of 2008–09 (GFC), net private capital flows to EMEs surged in the aftermath of the crisis and have been volatile since then, raising a number of concerns in recipient economies.2 First, large capital inflows can overwhelm the intermediation capacity of the domestic financial systems, leading to excessive credit creation and asset price bubbles that create risks of financial instability. To the extent that the fickleness of international investors adds to flow volatility, it exacerbates these risks. Second, large capital inflows may cause currencies to appreciate, which in turn could hurt export and growth performance. Finally, large inflows can complicate the pursuit of appropriate macroeconomic policies to maintain solid economic growth without rising inflation. If, in response, authorities raise policy rates in an effort to prevent overheating, the move may encourage further capital inflows and boost currency appreciation pressures. But if they slow the pace of monetary tightening to deter inflows, or if they resist currency appreciation through intervention, the ability to follow appropriate monetary policies is compromised. And if they resort to capital controls, not only is it an open question how effective these may prove based on the past historical experience, but the use of such controls also risks creating economic distortions that could weigh on economic activity over the longer term.
EMEs appear to have employed a mix of policy responses to try and address these concerns that we will discuss in detail later. With advanced economies (AEs) providing powerful monetary stimulus to revive their sluggish economies and the EMEs facing a plethora of capital inflows amid strong recoveries, policy tensions arose between these two groups of economies. Several EMEs argued that the advanced-economy policies, including unconventional monetary expansion in the United States through large-scale asset purchases (LSAPs), were primarily responsible for the excessive flows of capital to their economies and created adverse spillover effects. More recently, with slowing capital inflows, EMEs have been concerned about the adverse effects of advanced-economy monetary policy normalization, which has already begun in the United States with the tapering of LSAPs.
In light of these developments, concerns, and policy tensions, our paper considers a number of important questions related to the behavior of private capital flows to EMEs in recent years and the policy responses they have triggered in the recipient economies: (1) What are the main drivers of private capital flows into EMEs? (2) Has there been a sea-change in their behavior from before the global financial crisis to after? (3) Did the capital control measures introduced in several EMEs after the GFC prove effective in slowing down these inflows? (4) How much did unconventional monetary policy easing in the United States spur capital flows into EMEs?3
We find that, first, growth and interest rate differentials between EMEs and AEs and global risk appetite are important determinants of net private capital inflows into EMEs. Second, there have been significant changes in the behavior of net inflows from before the GFC to the post-crisis period, especially for portfolio inflows, partly explained by the greater sensitivity of such flows to interest rate differentials. Third, cyclical capital controls introduced in recent years appear to have discouraged both total and portfolio net inflows. Finally, we find positive effects of unconventional U.S. monetary expansion on total and portfolio inflows, with the effect being larger for portfolio flows (compared with total) and gross inflows (compared with net).
The answers to the questions highlighted are not settled in the existing literature, and our results, summarized above, attempt to shed some further light. There are important policy implications that depend on these answers. For instance, the answer to the first question would seem to be crucial in informing the debate about the appropriate policy responses to capital inflows by EMEs. It would be particularly relevant whether such inflows were primarily a result of factors such as international investors' risk appetite, or of economic fundamentals of the recipient countries, including their growth prospects.
The existing literature does not generally favor one determinant playing a primary role over others. Among the more recent studies, Byrne and Fiess (2011) find U.S. interest rates to be a crucial determinant of at least the common component of global capital flows to EMEs.4 Similarly, using a panel-data approach, IMF (2011) finds loose policy in the AEs to be an important determinant, but so also are the improved fundamentals and growth prospects of EMEs. Ghosh et al. (2012) identify episodes of capital inflow surges and find a variety of factors to be important in increasing the likelihood of a surge to EMEs, including lower U.S. interest rates, greater global risk appetite, and a particular EME's own attractiveness as an investment destination.5 On the other hand, Forbes and Warnock (2012), focusing on gross cross-border flows into a large sample of countries that includes both advanced and emerging economies, find no significant role for changes in global interest rates or in global liquidity (as measured by the money supply of key AEs) in affecting surges or stops of foreign inflows; however, like other studies, they do find global risk aversion to be an important and robust factor. Consistent with the general findings in the literature, our results also point to several factors being important in driving EME capital inflows; one contribution of our work is to try to gauge the importance of the different factors for the variability of capital inflows.
Turning to the effectiveness of capital controls, results based on the historical experience prior to 2009 generally suggest that capital controls have been more successful in altering the composition of flows to a country than in changing the aggregate volume, except in the very short run. (See, for example, Cardoso and Goldfajn, 1998, Cardenas and Barrera, 1997, Montiel and Reinhart, 1999, De Gregorio et al., 2000, Clements and Kamil, 2009, Qureshi et al., 2011; Ostry et al., 2010 for a survey).6 In a more recent paper, Forbes and Warnock (2012) look at a variety of capital account restrictions and find virtually no effect of such restrictions on cross-border flows, but their sample period goes only through 2009. There is relatively little empirical evidence on the effectiveness or otherwise of the cyclical types of capital controls that several EMEs introduced since 2009 in the aftermath of the global financial crisis and the more recent reversal of some of these controls in the face of slowing capital inflows, which we focus on by developing a new dataset of such controls.7
Finally, regarding the impact of monetary policies in AEs on the capital flows to EMEs, despite much debate on this topic, there have been few empirical studies that systematically look at this channel, including at isolating the impact of unconventional tools. Most discussions of the impact of monetary expansion in AEs are inferred from studies on the effect of long-term U.S. interest rates (or other proxies for global interest rates) on the EME capital flows mostly in the pre-crisis period, and often do not cover the recent unconventional monetary policies as part of their sample period. One paper, though, that looks at the effects of U.S. LSAPs is Moore et al. (2013). They find that a drop in the U.S. Treasury bond yield has a significant positive effect on the share of foreign investments in EME bond markets. Combining this, in turn, with the literature on the effects of LSAPs on U.S. long-term yields, they infer that LSAPs have a significant effect on the gross portfolio inflows to the EME bond markets. However, they do not directly look at the effects of LSAPs on EME capital flows.8 Fratzscher et al. (2012), by contrast, focuses directly on the effects of the Federal Reserve's LSAP announcements and actual balance sheet changes on flows to EME-dedicated funds. They find that unconventional monetary policy in the United States has exerted sizable effects on net inflows, although they also acknowledge that these effects are relatively small compared to the effects of other factors. In our paper, unlike in the existing literature, we first isolate changes in the U.S. Treasury yields that can be attributed to LSAPs, and then directly examine the effect of such changes on the EME balance-of-payments (BOP) capital flows. We also use an event study approach that focuses on LSAP announcements, but examine the effects of these announcements on the BOP flows, rather than just on the EME-dedicated international funds (which form just a small part of the total capital flows to these economies) considered in Fratzscher et al. (2012).
The remainder of this paper is organized as follows. As background, Section 2 provides the main properties of capital flows to EMEs over the past decade or so and the policy responses they have elicited in recent years. Section 3 presents the empirical methodology we utilize to answer the four questions posed in this paper, compares this methodology to those of others, and describes the data used in the paper. Section 4 presents our main results, interprets them, and briefly points to some robustness exercises we have done. Section 5 concludes.
Section snippets
Capital flows to EMEs and policy responses
Fig. 1 (top panel) shows total net private capital inflows into major emerging Asian and Latin American economies since 2002, along with their components by type of investment.9 For several years prior to the global financial crisis, these economies received sizable net inflows of private capital. The net inflows turned sharply negative (i.e. to net outflows) at the onset of the crisis. They then
Empirical model
In much of the paper, we model net private capital inflows to major EMEs in emerging Asia and Latin America using quarterly panel data since 2002. Net inflows are defined as gross inflows (i.e., net of flows coming in due to foreign investors' purchases and sales of a country's assets) less gross outflows (i.e., net of flows going out due to domestic residents' purchases and sales of foreign assets). We present estimation results for total and portfolio net inflows; we were less successful in
The basic model
We first estimate a basic model without the capital controls and LSAP variables, separately for the pre-crisis and post-crisis periods. Our motivation for doing so is that we want to compare the pre-crisis period with the post-crisis period, and hence we start off with a model with the same variables over the two periods.23
Conclusions
Consistent with the evidence in previous studies, first, we show that the growth differentials, interest rate differentials, and global risk aversion are important drivers of net capital flows to EMEs. In terms of their economic importance, the interest rate differential and risk aversion have been key determinants of total and portfolio net inflows, with the interest rate differential gaining a more prominent role in the post-crisis period. In contrast, the growth differential has always been
Acknowledgments
We would like to thank Joshua Aizenman, Matthieu Bussière, Joseph Byrne, Uri Dadush, Adrian De La Garza, Neil Ericsson, Gian Maria Milesi-Ferretti, Kevin Gallagher, Steven Kamin, Patrice Robitaille, Frank Warnock, and participants at the Current Account Imbalances and Financial Integration Conference at the European Commission in Brussels, the 4th BIS-CCA Rearch Conference at the Central Bank of Chile, the CEMLA Central Banks Research Network conference in Mexico City, the Capital Flows and
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The views in this paper are solely the responsibility of the authors and should not be interpreted as representing the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System.
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