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posted on 10 April 2016

Understanding The Slowdown In Capital Flows To Emerging Markets

from the International Monetary Fund

Net capital flows to emerging market economies have slowed since 2010, affecting all regions. Both weaker inflows and stronger outflows have contributed to the slowdown and that much of the decline in inflows can be explained by the narrowing differential in growth prospects between emerging market and advanced economies. The incidence of external debt crises in the ongoing episode has so far been much lower, although the slowdown in net capital inflows has been comparable in breadth and size to the major slowdowns of the 1980s and 1990s.

Improved policy frameworks have contributed greatly to this difference. Crucially, more flexible exchange rate regimes have facilitated orderly currency depreciations that have mitigated the effects of the global capital flow cycle on many emerging market economies. Higher levels of foreign asset holdings by emerging market economies, in particular higher levels of foreign reserves, as well as lower shares of external liabilities denominated in foreign currency (that is, less of the so-called original sin) have also been instrumental.

After a peak in 2010, net nonreserve capital inflows into emerging market economies have slowed considerably over the course of the past several years (Figure 2.1).1 The slowdown in capital flows has occurred against a backdrop of a protracted growth slowdown in emerging market economies and, more recently, the first steps toward a tightening of monetary policy in the United States.

A historical perspective offers cause for concern. Capital inflow slowdowns after sustained expansions have been associated with costly economic crises and linked to turning points in monetary policy in advanced economies (Calvo, Leiderman, and Reinhart 1996; Kaminsky and Reinhart 1999). Moreover, two factors - emerging market economies' increased integration into global financial markets and higher share in global output - imply that a capital flow downturn that disrupts these economies' investment and growth prospects can also have more powerful international spillovers than in the past.

Against this backdrop, this chapter examines the following questions:

  • What are the main characteristics of the recent slowdown in capital flows to emerging markets? Has it been broad based across regions and types of flows? How have exchange rates and the cost of capital evolved?

  • How does the recent slowdown compare with past slowdowns in capital flows? Has the composition of flows changed?

  • What is driving the recent slowdown? Can changes in emerging market growth prospects, monetary policy in advanced economies, global risk appetite, or decreasing commodity prices explain most or all of the decline?

  • Have policy-controlled variables, such as exchange rate flexibility, the level of reserves, and the level of debt, played a significant role? In particular, is there evidence that exchange rate flexibility has provided some insulation from the global capital flow cycle?

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