Modern Trends in Capital Flows in Emerging Markets

Modern Trends in Capital Flows in Emerging Markets

Svetlana Balashova (RUDN University, Russia), Vladimir Matyushok (RUDN University, Russia) and Inna Petrenko (RUDN University, Russia)
Copyright: © 2018 |Pages: 24
DOI: 10.4018/978-1-5225-4026-7.ch010

Abstract

This chapter provides an evaluation of the influence of the most significant external and internal factors on international capital flows in the form of direct and portfolio investments for 24 developing countries during the period 1990–2015. The authors have adopted the partial adjustment model and the feasible generalized least squares estimator for panel data. Results show that the determinants of capital flow for foreign direct and portfolio investments differ. The impact of political risks on cross-border capital flows has been identified.
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Introduction

International capital flow plays a central role in the global economy, affects the macroeconomic policy, but also brings some benefits and risks for recipient countries. However, in contrast to labour and natural economic resources, historically, capital can move and accumulate quickly. In the last decades, in search of profitable areas of application, capital has rushed to developing countries, whose share in the international capital flows has grown significantly. Thus, these countries have become not only importers but also exporters of capital. Despite the fact that in absolute terms the biggest part of financial flows is concentrated in developed countries, this distribution also depends on the financial stability of emerging markets (EM) which are particularly vulnerable to market fluctuations caused by inflows or outflows of foreign capital. After the global financial crisis 2008-2009, countries with EM faced unprecedented volatility in capital inflows. Before the financial crisis, developing countries policymakers feared that excessive capital inflows could provoke an economic overheating. However, they have been concerned about a reduction in capital inflows or even its net outflows in recent years.

The main challenge for the entire developing world is to deal optimally with the challenges of economic growth in conditions of the volatility of capital flows. It is common knowledge that the influx of international capital into a country stimulates economic growth through investment financing, with which new technologies arrive and, due to the increased income, a higher level of household consumption is provided (Obstfeld, 1998; 2009). Moreover, capital inflows contribute to a better diversification of asset portfolios of developing countries. However, a surplus of capital may be accompanied by adverse macroeconomic effects, such as an intensive increase in the money supply, excessive strengthening of the national currency in real terms, and inflationary pressures.

Determinants of capital flows can be grouped into 2 categories: External and internal factors to the economy in which capital flows. External factors stimulating the influx of international capital in developing economies are: Capital surplus and its relative cheapness (lower interest rates on borrowed capital), lower gross domestic product (GDP) growth rates, higher taxes and labour, raw materials, energy costs, purchase or lease of land, and, as a result, the lower efficient use of capital, reflected in the stock indices of developed countries. Low interest rates in developed countries make investments in countries with EM more attractive. The impact of this effect is strengthened if the developing country is interested in external borrowing and low global interest rates ensure its greater solvency. Internal factors that affect capital flows include political risks, availability of economic resources (labour and natural resources) and their value, the capacity of the domestic market, higher GDP growth rates, lower taxes and labour, raw materials, energy costs, purchase or lease of land and as a result the higher efficient use of capital, the volatility of the real exchange rate, external debt, and conditions of the investment environment.

Large external liabilities and a sharp reduction in financial flows create the risk for those developing countries, where the previously active inflow of capital was registered on the stage of recovery of the global financial cycle and when EM were more liquid (Ayala, Nedeljkovic, & Saborowski, 2015). The slowing down of capital inflows in EM and risk of capital flight is becoming an increasingly significant factor in the destabilization of the financial system and the threat of a decline in economic growth. Portfolio investments will cease to be liquid, and financing costs may rise sharply in the run-up to increase in the interest rate of U.S. Federal Reserve System (FED) in the short term, which will subsequently exert a strong pressure on exchange rates, stock quotes, and international currency reserves of developing countries. Such a scenario may aggravate the already severe economic situation with regard to the volatility of capital flows in EM. The adjustment and adaptation of emerging market economies to the new global conditions, including a reduction in the liquidity of the financial market and commodity prices, will create new challenges for monetary and fiscal policies in the medium term.

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