Are portfolio flows to emerging market the result of the “pull” factor—the attraction of rapid growth in these markets—or is it the “push” given by unpleasant conditions in the West? That’s a question that has been debated since the 1990s, when capital flows to emerging markets first started to perk up. It is all the more important now, when the developed countries are yet to recover from the shock of the financial crisis while emerging economies are seeing robust growth. Unfortunately, as is the case in most questions in economics, researchers often come up with diametrically opposite conclusions.
Among recent studies, the Global Financial Stability Report of the International Monetary Fund (IMF) emphasized the importance of global liquidity, by which it meant liquidity in the G4—Japan, the US, the UK and the euro zone. The study quantified the impact, asserting rather precisely that a 10% decline in global liquidity is associated with a 2% decline in the equity returns of what IMF called the liquidity receiving countries, by which it meant the emerging markets. That global liquidity is the single most important factor shouldn’t come as a surprise to anybody—the surge in the markets in 2009 as a result of central banks around the world loosening their purse strings is the most recent evidence. The corollary that follows is the mantra of all emerging market bulls: with growth prospects uncertain in the advanced economies amid renewed fears of the dreaded double-dip, their central banks will ensure that liquidity remains abundant, which in turn will drive flows to emerging markets.
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A few months back, the Asian Development Bank (ADB), too, considered the relationship between the push and pull factors, but looked at growth in the G3—the US, the euro zone and Japan—rather than liquidity. It found that the G3 economies’ growth prospects significantly influence portfolio inflows, with a 1% increase in G3 gross domestic product (GDP) leading to a very precise 5.4% increase in portfolio inflows. Domestic factors such as the country’s growth prospects, financial openness and risks and returns on investment are also important, but the report clearly says that “the coefficients corresponding to these variables tend to be lower than those for G3 GDP growth prospects”. If ADB is right, lower growth in the advanced economies will mean less money flowing to emerging markets. That’s a conclusion opposite to that of IMF. Because, if growth is good in the developed world, interest rates there will rise and excess liquidity will come down, which, according to IMF, will mean less money for emerging markets.
More recently, though, ADB has taken a different tack. In its Economic Monitor for the East Asian economies published last Tuesday, it says that the uneven pace of the recovery between the region and the West implies that capital inflows could surge again. At the same time, financial turbulence and uncertainty suggest that risk appetite could change dramatically. Therefore, says ADB, “capital flows to emerging economies could become volatile, destabilizing financial markets—at least in the short term—and could hurt the real economy as well.” In other words, our markets are headed up, but it’s going to be a nerveracking, nail-biting ride.
Common sense implies that both push or pull factors are significant—the question is which is more important and by how much. Last month, the Bank of England (BoE) jumped into the fray. Its Financial Stability Report attempted to quantify how much of the change in spreads on emerging market bonds (or the change in the premium that emerging market borrowers have to pay over comparable bonds from developed countries) is due to pull factors and how much to push factors.
During the period May 2009 to March 2010, when markets were booming, bond spreads fell and, as the chart shows, much of this contraction was due to higher risk appetite and market liquidity, both “push” factors. Similarly, much of the increase in spreads over the period March-May 2010 is explained by lower risk appetite, which pushed up spreads on emerging market bonds. In contrast, says BoE, pull factors such as improvement in credit ratings or the prospect of higher growth had only a limited impact. Simply put, the BoE study concludes that flows to emerging markets are dependent mainly on risk appetite and liquidity. The decoupling thesis goes out of the window.
Any disruption in the West should therefore have a strong impact on emerging markets, as was seen during the Greek default scare. But there’s a twist. BoE says that the majority of inflows to emerging markets are now coming from unleveraged long-term investors who have their own sources of funding. Leverage among hedge funds is also well below pre-crisis levels. This reduces the risk of sudden and sharp sell-offs. While we breathlessly await the next study on what causes capital flows, BoE’s analysis does provide an explanation of the range-bound markets we’ve been seeing lately.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org