Table of Contents
1. Introduction – Definition of key terms
2. Determinants of Capital Flows
3. Current situation and outlook
The following essay will shortly define the key-terms Emerging-Market and Capital-flows and subsequently show the historic development of capital-inflows to the defined countries. After the examination of the determinants of the International Capital Flows, the fourth part will deal with a topicality, the pending tampering of the US Federal Reserve’s Quantitative Easing.
1. Introduction – Definition of key terms
The term Emerging Markets (hereafter: EM) was first introduced by Antoine van Agtmael in 1981. The World Bank economist searched for investors who were willing to lend capital for the newly issued “Third World Equity Fund”. After some unsuccessful efforts Agtmael tried to find a term which wasn’t “suggesting stagnation” but rather “progress, uplift and dynamism” (Agtmael 1981) and found it in today’s buzzword “Emerging Markets”.1 EMs nowadays are broadly defined as countries which are likely to reach a developed stage in the near- and mid-future.2 In order to clarify which of the 193 states actually belongs to this group one has to analyze the prospects of these economies. This leads to a vast array of different outcomes. In the 1980s the South Asian Tigers became famous but failed to meet expectations during the Asian Debt Crisis of 1997-98. In 2001 the incumbent CEO of the investment bank Goldman Sachs coined the word BRIC which stands for Brazil, Russia, India and China, his favorites concerning catch-up growth of that time.3 During the years an “M” was added indicating Mexico, others included “ET” for East Europe and Turkey and in 2010 South Africa was honored with a capital “S”. The FTSE-Group even distinguishes between advanced and secondary emerging countries.
This essay in contrary will use the countries which were chosen by the International Monetary Fund on 16 July 2012 to represent the Emerging Markets.4 These include Argentina, Brazil, Bulgaria, China, Colombia, Estonia, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Pakistan, Philippines, Poland, Peru, Romania, Russian Federation, South Africa, Thailand, Turkey, Ukraine and Venezuela.
By comparing key indicators’ averages of these 25 countries with the world average some particularities become evident (see Figure 1). The population size is about five times higher than the normal average, and still twice when the two extremes China and India are omitted. The same applies to the territory surface. This largeness leads to a superior GDP whereas calculated in per capita units it is inferior to the 193 countries’ average. Sovereign-Debts per GDP range on a similar level, however if compared to advanced economies they seem negligible. The inflation is higher than normal which can be traced back to the higher growth rates and foreign capital inflow. Concerning the trade openness of the Emerging Markets no common level can be examined (see Figure 2).5 It rather applies the general perception that small-size states like Estonia or Hungary are more likely to have a higher Foreign-Trade to GDP ratio than large ones.6
Capital flows are generally described as “the movement of money for the purpose of investment, trade and business production.”7 This essay will exclusively focus on border-crossing flows of financial resources which are normally seen as the financial side of international trade.8 There are three main types which can be distinguished. Private foreign direct & portfolio investments count for the highest amount, followed by remittances of earnings realized by international migrants and concluded by public and private development assistance, commonly known as Official Development Assistance (ODA). (see Figure 3 for their historic development)9
1. Historic Development of Capital Flows to Emerging-Markets
illustration not visible in this excerpt
illustration not visible in this excerpt
As shown in the Figures above and in Figure 3 since the 1990s the overall International Capital Flow amount increased steadily and remarkable. For this development internal as well as external factors were responsible.11
FDIs grew constantly while portfolio flows followed a more volatile trail. Since the 1970s capital flows are decoupled of trade-rates and exceed them markedly. (see Figure 6)12
Nowadays Reinhart and Reinhart concluded that like in the 1980s we stand in a capital flow uprising – as so called Bonanza- since 2008.13
So the question the market is currently facing is whether this “Bonanza” continues or reached its peak and will reverse and entail its inherently negative aspects? Scholars of the Institute of the International Finance casts a pretty positive predictions however this opinion is highly contested which will be the content in clause four.
2. Determinants of Capital Flows
The neoclassical assumption states that a high productivity will increase the marginal product of capital, which is the key-factor for attracting capital flows. However this simple prediction was refuted by Wolf (2005) who examined that capital flows “upstream” from poor to rich countries, with already high capital endowment and therefore with a low marginal product of capital.14 Though this paper was issued before the financial and economic crisis of 2008 and was a right observation at this very time but not generalizable and therefore stands in accordance with the examinations itemized below.
It seems to go without saying that high growth rates, sound macroeconomic policies, political stability and also a large and open economy with a fiscal balance is favorable for capital inflows.15
While advanced economies’ capital inflows are mainly driven by domestic pull factors, the flows to EMs are rather determined by global push factors. After the advanced economies lost their “pull-appeal” after the years of 2008 the capital current turned to the EMs.16
A World Bank Group study revealed that two periods of capital flows can be distinguished. The one occurs during economic expansion where the gross flows increase whereas the retrenchment-phase takes place during economic contractions or crises. In the latter domestic investors with assets abroad will respond to a capital outflow with a retrieval of these foreign capital and thus contribute to a net-compensation. This might be the cause of the fact that gross capital flows tend to be more volatile than their net-homologues.17
Forbes and Warnock (2011) concluded that “both risk aversion and economic uncertainty, is the only variable that consistently predicts each type of capitalist flow episode.”18
Another exceptionality for EMs was encapsulated by the term: “when it rains, it pours […]”19 The authors ascertained that a mutual reinforcement of cyclical components of the GDP, net capital flows and real fiscal spending is likely to occur and consequently leads to a high amplitude of flows.
Reinhart and Reinhart examined the extreme positive eruptions of capital inflows to the EMs – called “Capital Flow Bonanzas”.20 So far two of these episodes have taken place. The one from 1975 to 1982 and the second started, accordingly to them, in 2008, when the paper was issued. During such Bonanzas the economic growth tend to be higher, a rise in equity and housing prices can be observed as well as higher inflation rates. But they emphasize that these episodes are temporary phenomenons and thus will inherently lead to a “sudden stop à la Calvo”21 with severe repercussions. It’s not just that all the former gains will vanish but also the “incidence of financial crisis is higher around a capital inflow bonanza”.22 Due to the fact that since the 1980s capital restrictions are plummeting these scenarios will be more frequent in coming decades.23
Calvo spotted that if inflows to EMs curbs it will deprive these economies of the possibility to spend over their actual income. Subsequently the economic growth will fall and the vicious circle just started.24 A summary of the literature is provided in Table 1.25
3. Current situation and outlook
When Ben Bernanke presented congressional testimony on 22 of May 2013 that the Fed wouldn’t disembark instantly their 2008 started Quantitative Easing (QE) the major US indices shortly touched all-time heights but at the end of the day, after minutes of the Fed’s policy meeting had been published, the negative outlook dominated.26
In November 2008 the Fed started to tackle the US recession by introducing the QE-dubbed instruments. Starting with a $600 billion mortgage-backed security buy in November 2008 and subsequent purchases over QE2 to the actual QE3 the Fed’s balance has swollen to $4.4 trillion (June 2014). In comparison to the $870 billion measured in August 2007 the conducted measurements were worth about $3.53 trillion. (see Figure 7).27 The current QE 3 was announced in September 2012 and implied purchases of longer-term treasury, worth $45 billion/month and agency mortgage-backed securities, worth $40 billion/month.28
Stepen Jen estimates that about $4 trillion have flown to the EMs since 2009, mainly driven by low yields in advanced economies and pulled by the favorable prospections in the developing countries.29 In 2009 the advanced economies suffered under a GDP-decrease of 3.43% whereas the EMs’ GDP increased by 3.1%. The brightening economic outlook of the former will reverse the flows which bears severe problems for the EMs.30
Burns et al. (2014) warn in their paper that the “taper-tantrum” could lead to a decrease in capital-inflows to developing markets of up to 10% and reduce the GDP growth rates by 0.6% by 2016. 31 And indeed after Bernanke’s citation in May last year the Capital Flows to EMs dropped, however only temporarily. (see Figure 8)32 Moody’s even lifted this forecast and announced that the EMs might face a GDP loss of 2.8% to 3.1% from 2013-2016.33
Underlying is the assumption that a reversal of the QE will entail an addition of 50 percentage-point in 2015 and another 50 percentage points in 2016 to the US long-term interest rates. They further assume an increase of the policy rate and that the Japanese Central Bank as well as the ECB follow the Fed suit in 2015. Capital outflows and currency depreciation would presumably hit especially countries like Brazil, India, Indonesia, South Africa and Turkey- the “Fragile Fives”.34 These are the countries with the highest current-capital deficit relative to the GDP.35 In addition some of these countries like Turkey or South Africa clutch to their own monetary easing and further depend more on portfolio flows than the less volatile remittances or FDIs and in the consequence will suffer an even higher currency depreciation and finical constraints.36 (see Figure 9 for foreign owned sovereign bonds)37 The World Bank examined that up to 60% of EM-inflows in the years 2009-2013 can be explained by global factors. (see Figure 10)36
Whereas China or Russia could easily use their foreign exchange reserves to hold their exchange rates stable, other countries will be forced, so the report, to tight fiscal and monetary policies in order to reduce their financial needs. But the pressure could also have positive long-term outcomes for the entire global economy due to the fact that the decision-makers will be forced to further liberalize capital inflow regulations and restore investor confidence via domestic reforms.
The sudden sell-off at the start of this year might be a harbinger of what is still to come. The EMs succeeded with different strategies (“e.g. rate hikes in India, aggressive tightening in Turkey and hawkish language by Brazil”) 38 in order to stabilize their currencies and markets.
However the adjustment could be eased, so The World Bank mentions in its latest Global Economic Prospects Report, by the ECB’s proceeded strategy which will bear significant positive effects for capital flows. 39 That’s why the World Bank’s forecasts aren’t that somber as the former mentioned. (see Figure 11)
So far the markets aren’t anticipating the future tapering and indices constantly reach all-time heights.40 As long as the Fed isn’t increasing the policy rate or curbs their purchases the “party” at the stock markets will continue and so the capital flows.41 The stable US-inflation rates might allow a continuance.42 However Bernanke indicated that the bond buying program would only last as long as the US unemployment rate hasn’t fallen to 7%.43 This self-imposed margin has been reached at the end of last year. (see Figure 12) But even if the Fed would retreat overnight, Eichenbaum and Evans (1995) scrutinized that the Dollar appreciation of a contradictory US monetary policy would pinnacle only 24 months after than the actual shock occurred – named the “delayed overshooting puzzle”.44
It has been shown that capital flows to Emerging-Market Economies is a progressing field of the studies of economics. The history showed a constant increase in the overall amount of gross- and net-flows. But it seems likely that the pinnacle of the current episode is reached and a reversal is likely to take place.
The whole future scenario seems ironically. When the US economy experiences higher growth rates in the coming period, inflation will rise and unemployment fall. The Fed would be obliged to trigger the “tapper-tantrum” and consequently the capital flows to the Emerging-Market Economies would plummet. Due to the fact that the US economy is highly dependent on the performance of countries like China, the EMs could, with an ongoing good economic performance, “dig their own grave”.
1 The Economist: 2008
2 Stoukas/ Madany 2013
3 O’Neill, Jim 2011
4 IMF 2013
5 Finger 2013
6 Alesina & Wacziarg 1998
9 Todaro and Smith 2012
10 Collyns/ Huefner/ Koepke/Mohammed/ Tran/ Gibbs/ Tiftik 2014
11 López-Mejía 1999
12 Amaya and Rowland
13 Reinhart and Reinhart 2008
14 Gourinchas and Jeanne 2006
15 Amaya and Rowland
16 FT reporters 2013
17 Broner/ Didier/ Erce/ Schmukler 2011
18 Forbes and Warnock (2011), p.2
19 Kaminsky/ Reinhart/ Vegh 2004, p.20
20 Reinhart and Reinhart 2008
21 Reinhart and Reinhart 2008 p. 3 and Calvo 1998
22 Reinhart and Reinhart 2008 p. 30
23 Eichengreen/ Adalet 2005
24 Calvo 1998
25 Amaya and Rowland
26 Rooney 2013
27 US Federal Reserve 2014
28 Robb 2013
29 The Economist 2013
30 Schaefer 2014
31 Burns / Kida / Lim / Mohapatra / Stocker 2014
32 Collyns/ Huefner/ Koepke/ Mohammed/ Tran/ Gibbs/ Tiftik 2014
33 Kissi, Dawn 2014
34 FT reporters 2013
35 The Economist 2013
36 Kissi, Dawn 2014 or Burns /Kaushik 2014
37 Burns /Kaushik 2014
38 Collyns/ Huefner / Koepke / Mohammed / Tran / Gibbs / Tiftik 2014
39 Burns /Kaushik 2014
40 Hankir, Zahra 2014
41 Reuters 2014
42 Us Inflation Calculator
43 Puzzanghera 2013
44 Bruno and Song Shin 2014
- Quote paper
- Dominik Hueller (Author), 2014, Current Situation of Capital-Flows to Emerging-Markets, Munich, GRIN Verlag, https://www.grin.com/document/284945