Surges

After collapsing during the 2008 global financial crisis, capital flows to emerging market economies (EMEs) surged in late 2009 and 2010, raising both macroeconomic challenges and financial-stability concerns in these countries. By the second half of 2011, however, amidst a worsening global economic outlook, capital flows reversed rapidly, eliminating much of the cumulated currency gains, and leaving EMEs grappling with sharply depreciating currencies in their wake. While such volatility is nothing new—historically, flows have been episodic, with the end of each surge typically marked by an economic crash in the region that received the largest inflows—it has reignited questions on the nature of capital flows to EMEs. What causes these sudden surges? What determines the allocation of flows across EMEs? And how differently do foreign and resident investors behave when making cross-border investment decisions?

The literature on this subject has a long tradition of trying to identify global “push” and domestic “pull” factors in determining flows to recipient economies. Yet, in equilibrium, capital flows must reflect the confluence of supply and demand, so there must be both push and pull factors at play. More meaningful, therefore, may be to consider the determinants of changes in capital flows, which might be associated with changes in supply factors, or changes in demand factors, or both. Moreover, from a policy perspective, large changes in flows—surges—are of particular interest both because of their greater impact on the exchange rate and competitiveness, and for financial-stability risks. The tack taken in this paper is thus to focus on surges, and examine what factors determine their occurrence and magnitude.

We begin our empirical analysis by developing simple algorithms to identify surge episodes in 56 EMEs over 1980–2009. We employ two methods: a “threshold” approach and a “clustering” approach, and identify 290 and 338 surges, respectively. The very synchronicity of surge episodes across countries suggests that global factors might be at play. Indeed, we find this to be the case—global factors, including US interest rates, and global uncertainty—are key determinants of inflow surge occurrence. At the same time, whether a particular EME experiences an inflow surge also depends on its own attractiveness as an investment destination. Fundamentals, including external financing needs, financial openness and interconnectedness, economic growth, and institutional quality help determine the likelihood that the country experiences an inflow surge. Conditional on the surge occurring, moreover, domestic factors, including the exchange rate regime, are important in determining its magnitude.

We also find that inflow surges to EMEs are mainly liability-driven—only one-third of the net flow surges correspond to changes in residents’ foreign asset transactions. The factors driving the two types of surges turn out to be quite similar: global factors matter for both, with lower US interest rates (or greater risk appetite) encouraging both foreigners to invest more in EMEs, and domestic residents to invest less abroad. Yet foreign investors tend to be more sensitive to global factors, and are also more subject to regional contagion than asset-driven surges.