The expansion and contraction of portfolio capital flows from the global financial centres towards emerging markets over the past decade has generated considerable controversy over their underlying economic determinants, and by extension their instability: there is growing evidence that these are related to conditions in the financial markets of developed countries (FitzGerald 2002).
The resulting asset bubbles have a serious impact on the real economy in developing countries even in the presence of low inflation, fiscal balance and monetary rectitude (IMF 2000). More seriously, such fluctuations degrade income distribution and social services, thus exacerbating poverty problems (FitzGerald 2001). Nonetheless, orthodox policy design by international financial institutions such as the International Monetary Fund (IMF) and the World Bank still focuses on the conditions in emerging (“host”)markets themselves – often known as “fundamentals” – rather than the determinants of the demand in developed (“home”) countries for emerging market securities as an asset class.
The economic theory of international capital markets is still in its infancy, in marked contrast to the sophistication of the microeconomics of portfolio choice. Sticky prices, market segmentation, heterogeneous investors, persistent currency misalignments despite arbitrage and the cost of scarce information all need to be accounted for if the model is even to approximate the real world in a useful way (Dumas 1994). In marked contrast, the framework that informs policy debate appear to reflect, in essence, a simple microeconomic portfolio composition rule based on given relative returns and risks of various assets. Policy in developing countries is then directed towards reducing the risk of and increasing the return in these assets by appropriate macroeconomic regimes, liberalisation strategies and property guarantees. However, neither the internal dynamics of capital markets – particularly the tendency to endogenous asset bubbles – nor the consequences of external shocks such as US interest rates, are not seen as relevant objectives for international development policy.
Recent academic literature has begun to emphasise home market factors such as interest rates, changing risk appetite, herding behaviour and momentum trading. However, attempts to model these flows have revealed difficulties in separating home from host factors – or “push” and “pull” effects as they are conventionally known. This is because aggregate flows and yield spreads do not simply reflect an underlying microeconomic process of portfolio allocation, based on known risk and return characteristics of emerging markets in relation to wealth and riskless return on the investors’ own market. At the macroeconomic level aggregate market behaviour is such that:
- International capital markets do not fully clear – in the sense that even at equilibrium some borrowers are “rationed out” and cannot borrow at any rate of interest – so that demand fluctuations are reflected in unstable flows rather than smooth price adjustment.
- Capital flows themselves affect asset prices both directly (by creating and collapsing asset price bubbles) and indirectly (through increasing or decreasing default risk).
- Observed asset yields can have apparently perverse effects on flows because of the risk premium they contain, so that higher yields are associated with reduced flows.
- The changing level of investor risk appetite on the home market affects both asset prices (which include a default risk premium) and capital flows themselves (through credit rationing).
In consequence, “getting the fundamentals right” – such as reduced government expenditure, restrictive monetary policy, public enterprise privatisation or liberalisation of trade and finance –may not be sufficient for open developing countries to avoid balance of payments instability. This article attempts to encompass these notions formally and to test them empirically for US purchases of emerging market sovereign bonds, and thus lead to a revision of policy recommendations.
This article comes from the IDS Bulletin 35.1 (2004) Financial Globalisation and Poor Countries: The Impact of International Asset Demand Instability on Emerging Markets