Capital Flows into Emerging Market: A story of Portfolio Rebalance

Abstract: Prior to 2005, emerging markets (EMs) frequently experienced large surges in portfolio investments (“hot money”) followed by sudden stop events, in which foreign capital dries up quickly, disrupting the domestic economy and putting depreciating pressure on EM’s currency. In the aftermath of the 2008-2009 global nancial crisis (GFC), conditions from the US and other advanced economies have recreated this exact situation, in which capital in ows into EMs surged from 2009-2011 and destabilized EM’s currency in 2011-2015. However, as we document in this paper, the magnitude of capital out ows and currency depreciation which unfolded in 57 EMs in 2011-2015 is at best moderate, and we nd that EMs are less susceptible now to sudden stops than before.

To explain this phenomenon, we provide a theory of portfolio re-balancing, in which foreign investors re-balance their debt-equity holding to reduce risk, therefore lending to EMs more in risky times. This nets out equity flows and reduces the total negative effects on EMs. We also estimate a panel vector autoregressive (PVAR) model to identify the interactions between direct channels of capital inflows and the exchange rate, and find that a negative shock to the equity market prompts capital to flow more into the same country’s debt market, instead of owing out. We conclude by extending Mendoza (2006)’s sudden stop model to include portfolio choice in order to provide a theoretical framework of portfolio re-balancing.

You can read the paper here: vu_thesis_final_final.

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