The nature and determinants of capital inflows to emerging markets can be
evaluated by considering inflows both separately and at an aggregate level
because individual component flows are affected in dissimilar ways by different
variables. There is evidence of considerable cross-country correlation in bank
and equity flows but less evidence of correlation for the level of bond
flows.
What’s Inside?
The authors investigate the nature and important determinants of capital inflows to emerging markets from developed markets. They examine the impact on the inflows—that is, bank, bond, and equity flows—on an individual and aggregate basis. There is evidence of considerable cross-country correlation in bank and equity flows but less evidence of correlation for the level of bond flows. Real long-run US interest rates are identified to be an important determinant of bank and equity capital inflows because fund managers target higher-return regions for investment. Real commodity prices are also an important consideration for equity capital inflows.
How Is This Research Useful to Practitioners?
The research contains some useful insights into the determinants of capital flows to emerging markets. The authors analyze the flows on an aggregate and a standalone basis and the impact on the market level as well. Their main finding is that there is sizable correlation between aggregate capital flows and real commodity prices because emerging markets are often commodity exporters. This result is especially true for equity flows. They also find negative correlation between aggregate flows and real long-run interest rates in the United States because fund managers attempt to place funds in higher-yield regions.
The authors conclude that uncertainty is important in reducing flows, especially on a market-specific level. Their research highlights that for emerging markets to benefit from global capital flows, it is not sufficient for capital controls to be removed. Financial openness must increase, and institutions must be strengthened as well.
These insights are important for practitioners who wish to predict the direction of funds based on the underlying variables identified in the research and invest at attractive valuations on a proactive basis.
How Did the Authors Conduct This Research?
The data on capital inflows are for 64 emerging markets on a quarterly basis for the period Q1 1993–Q1 2009 and are from Euromoney Bondware and Loanware. Only primary inflow data are considered; secondary inflows for equity issuance, bond issuance, and syndicated bank lending are excluded. These three inflows are analyzed separately and then combined to arrive at aggregate inflows. The authors also identify global determinants of capital flows to particular markets.
The authors’ methodology involves first analyzing the extent of co-movement of capital inflows to emerging markets by applying Ng’s (Journal of Business & Economic Statistics 2006) uniform spacings. They then test for the relationship between common elements of capital inflows across markets and their relationship to other micro-variables. They consider the relationship between the common factors in aggregate; bank, bond, and equity capital inflows; and the following explanatory variables: the real non-oil commodity prices, the real short- and long-term US interest rates, the CBOE Volatility Index uncertainty index, and real GDP growth in the G–7.
Abstractor’s Viewpoint
The research has important implications for policymakers in emerging markets that are competing for capital flows among themselves. Stronger institutions, transparency, and increasing financial openness can make these markets attractive for foreign investors.