Understanding capital flows to emerging markets

Here Dr Bruno Bonizzi, a Lecturer in Political Economy based in the Department of Politics and Society at the University of Winchester, argues that we need to focus on the actual behaviour of the institutions that drive such flows, rather than thinking of capital flows as a transfer of real resources.

Until 2014, capital in net terms flowed ‘uphill’, from emerging to advanced countries. This is a well-known ‘paradox’ in international economics and political economy, as theory would predict the opposite. IMF scholars recently revisited this ‘paradox’, showing how it seems to have been solved in 2015, as capital finally flowed ‘downhill’, a situation that should be encouraged with the right type of policies. Does this provide an accurate picture of the current conditions of the financial engagement between advanced and emerging economies?

There exists a vast literature that on the determinants of capital flows to emerging economies. The major focus are the characteristics of emerging markets assets. For example, emerging markets typically provide high interest rates, but such an advantage needs to be assessed against the additional risks (eg political instability) and/or the returns in that could be obtained on safer assets (eg the level of US interest rates). The literature has pointed out how factors that are external to emerging markets tend to have a substantial impact on such flows. Market imperfections, such as defective information, may add to this, resulting huge and sudden swings.

A second factor that has gained prominence as an explanation for capital flows is the risk appetite of global investors. When investors’ appetite for risk is high, they channel their investments to emerging markets, when risk appetite declines capital will flow back to safer markets. As Hélène Rey argued, risk appetite can explain a great deal of global financial cycles.

A problem with much of the existing literature is its implicit (or explicit) reference to a non-monetary understanding of capital flows. The view that capital flows can be understood on the basis of current (especially trade) account imbalances is widespread, as testified by the continuing discussion about ‘uphill’ flows. Capital flows are seen as the result of the gap between saving and investment at the domestic level. In other words, capital flows represent transactions of claims on real resources. Financial markets simply channel saving to investment internationally.

In reality, capital flows are monetary transactions rather than a transfer of real resources. They can certainly occur to settle transactions of real resources – the net result of which is then registered in the current account – but, as prominently argued by Borio and Disyatat, they do not require them to occur, just as domestic investment does not require prior saving. They only require the purchase and sale of newly-created or existing monetary claims to take place internationally.

As they pertain to the monetary realm of the economy, capital flows are therefore affected primarily by monetary and financial factors. At the international level, one key dimension is the liquidity of the currency of denomination of the assets, ie the possibility to use assets denominated in a particular currency as a store of value and/or a means to settle liabilities. As Kaltenbrunner argued, capital flows to emerging markets are likely to be subject to considerably more instability, given the low (perceived) liquidity of their currency, which although increasingly internationalised, remains a poor vehicle to store value and (especially) to settle international liabilities. As a result, emerging market assets can only perform the role of high-return risky assets, occupying, therefore, a relatively marginal and volatile position in the global financial system. This only serves to reinforce the subordination of these countries in the international financial system.

A second limitation of the existing literature is the insufficient focus on the nature of global investors and their motives. Especially when the focus is on emerging market asset characteristics, it is not always clear who are the ‘foreign investors’, and why they would invest in emerging economies in the first place.

There is a need to ground the analysis in the historically determined nature of the investor. Here, the key process is the rise of institutional investors as the pivotal actors of today’s financial systems. These institutions’ primary concern is to find assets that provide sufficient returns to fund their commitments to the household sector (eg pension liabilities). Their ‘risk appetite’ iss therefores much more an institutionally-driven behaviour than a behavioural mood. Their demand for emerging market assets is determined by the struggle to find returns that are sufficiently high to face their commitments. If alternative sources of returns arise and their commitments are better provided for, the demand for emerging market assets declines. Indeed, the recent return of ‘uphill’ capital flows, as the data from the International Monetary Fund (IMF) itself shows, is essentially driven by emerging markets central banks selling reserves, as the demand for their assets by foreign investors has started to cool off, reducing capital flows to these economies.

Capital flows to emerging markets have to be understood primarily as the monetary transactions that stem from institutional investors’ needs for returns, in the context of hierarchical world financial systems. The ‘paradoxical’ (or lack thereof) ‘uphill’ net flows indicate very little about this process, which is central to understanding the prospects of financial instability in emerging economies.

Dr Bruno Bonizzi has recently published a paper in the Journal of Economic Issues on the subject of this blog. Click here to read the paper.

The views and opinions expressed in this blog are those of the author and do not necessarily reflect the position of the University.