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Determinants of capital flows to emerging markets and the global financial cycle

Large and volatile capital flows into emerging economies since the Global Financial Crisis have re-invigorated efforts to unearth the determinants of these flows. This column investigates the interplay between global risk aversion (captured by the VIX) and countries’ characteristics. The authors also explore what policies countries should employ to protect themselves against the volatility of capital flows. The findings indicate that capital flows to emerging markets cannot be controlled without incurring substantial costs. 

Large and volatile capital flows into emerging market economies since the Global Financial Crisis have re-invigorated an effort to unearth the determinants of these flows and sparked a debate on policies to contain risks from these cross-border flows. A growing literature is stressing the role of the ‘global financial cycle’ as a key driver of capital flows into emerging market economies. This global financial cycle has been characterised by common movements in gross capital flows, leverage, and asset prices across countries, and is in turn found to be driven strongly by variation in the VIX, a measure of global risk aversion and uncertainty (Rey 2013, Bruno and Shin 2012 and 2013). Existing research also shows that large capital inflows can lead to strong movements in exchange rates which may complicate macroeconomic management, and can precipitate financial crises in the event of a sudden stop (Gourinchas and Obstfeld 2012).

New research

Our recent research (Nier et al. 2014) expands on the existing literature by addressing the following two questions.

  • First, how do changes in global risk aversion, as measured by the VIX, interact with local country characteristics in shaping the dynamics of capital flows into emerging markets?
  • Second, what policies can these countries adopt to protect themselves against the ebb and flow of global capital flows?

We use panel data techniques for a large sample of emerging market economies and non-G4 advanced economies over 2002Q1–2012Q4. Using interaction models, we analyse the effect of changes in the VIX on capital flows and investigate recipient countries’ characteristics, such as growth prospects and indebtedness, and policies that mitigate or amplify its effect. In particular, we ask whether raising interest rates is effective in stemming outflows that are sparked by increases in risk aversion. We also examine the extent to which capital controls can tame the effects of global shocks on capital inflows.

How does the effect of the VIX interact with fundamentals?

A key finding is that the effect of the VIX on capital flows is nonlinear – in contrast with the assumption of a linear effect of the VIX on capital flows that is entertained by much of the existing literature. Moreover, we find that the marginal effect of country-specific factors, such as growth prospects, the level of public indebtedness, and financial market development also depends strongly on the prevailing value of the VIX.

Figure 1 documents that for a lower range of values of the VIX, the effect of the VIX on capital flows is statistically insignificant. That is, in periods of calm, marginal changes in the VIX do not materially affect the strength of capital flows into emerging economies.

  • Instead, as can be seen from Figure 2, when the VIX is low, capital flows into emerging markets are driven strongly by differentials in GDP growth between the emerging economy and the average of G4 economies, as well as other fundamental factors.

Figure 1. Marginal effect of VIX conditional on VIX itself

Note: Shaded area represents conditional confidence intervals (95%). The parameters are based on panel data regressions for a large sample of emerging market economies over 2002Q1–2012Q4 (Table 5 in our paper, fixed effects).

  • By contrast, when the VIX is high, that is, in periods of financial fear or ‘panic’, the VIX becomes the dominant driver of capital flows, leading to indiscriminate outflows as the importance of fundamental factors, including growth differentials, diminishes.

Figure 2 documents this finding and shows how the marginal effect of growth differentials, conditional on the value of the VIX, is reduced for higher levels of the VIX. Our explanation is that when investors are panicked, their horizon shortens and they no longer care about long-term growth potentials (and other fundamentals) in making their investment choices.

Figure 2. Marginal effect of growth differentials conditional on VIX

Overall, therefore, we find that in tranquil times, capital flows are driven by country fundamentals, rather than the VIX. In stress times, fundamental factors lose importance and the VIX becomes the dominant driver of capital flows into emerging markets.

Capital inflows and raising the interest rates

Countries often try and keep interest rates high, or even raise interest rates to stop capital from flowing out, and our results suggest that this works to some extent. Indeed, as documented in Figure 3, short-term interest rate differentials matter more in crisis times, when investors’ horizons are short, than they do in normal times, when long-term growth prospects are more important in determining the direction of capital flows. The problem is that, while the interest rate defence appears to work to stem the outflow, it is costly; higher interest rates can hurt the growth of the economy and put pressure on the balance sheets of domestic borrowers. 

Figure 3. Marginal effect of short-term interest rate differentials conditional on VIX

The global financial conditions and the imposition of capital controls

Our results suggest that incremental capital account restrictions or ‘capital controls’ do not materially affect the force of the VIX in driving capital flows. This is consistent with the notion that for countries that have already liberalised their capital accounts, capital finds its way around these types of restrictions. Only in countries that are effectively fully closed do we find that the effect of the VIX is mitigated to a significant extent (Figure 4). This means that countries cannot fully insulate themselves from global financial shocks, unless by collectively creating a fragmented global financial system.

Figure 4. Marginal effect of VIX conditional on capital controls

Will these policy dilemmas improve or worsen with time?

Our results suggest that financial development increases the potency of the VIX in driving capital flows. Figure 5 documents this by plotting the marginal effect of the VIX conditional on a country’s stock market capitalisation, as a measure of financial development. As emerging market countries continue to develop their financial sectors, in an effort to reap the benefits developed markets have for growth, capital flows could become increasingly influenced by external factors. Consistent with the results from the interaction models, we also found that the effects of financial development and VIX are stronger for the sample that includes non-G4 advanced countries. These effects are even larger for a sample that includes also financial centres. This means that risks to financial stability from capital flows could be amplified and monetary policy independence undermined further as countries develop their financial sectors.

Figure 5. Marginal effect of VIX conditional on market capitalisation

What hope is there for emerging markets?

Together, our findings on the determinants of capital flows into emerging market economies paint a fairly bleak picture for policymakers in emerging market countries –they cannot control capital flows without incurring substantial costs. However, this does not mean that there is no hope for emerging markets. They can, instead, increase the resilience of their financial system to the ebb and flow of global financial conditions.

While we have not presented a formal test of the effectiveness of macroprudential measures, these measures, in principle, offer the scope to increase the system’s defences to cope with volatile capital flows (IMF 2013, Forbes et al. 2013). Other policy buffers may also help in increasing the resilience. These can include ensuring adequate foreign exchange reserves cover as well as the creation of fiscal buffers that can help countries ride out the financial storms caused by large and volatile capital flows.

Author's Note: The views expressed in this column are those of the authors and should not be attributed to the IMF, its Executive Board or its management.


Bruno, V and H S Shin (2012), “Capital Flows, Cross-Border Banking and Global Liquidity”, NBER Working Paper w19038.

Bruno, V and H S Shin (2013), “Capital Flows and the Risk-Taking Channel of Monetary Policy”, NBER Working Paper Series 18942, Cambridge, Massachusetts: National Bureau of Economic Research, April.

Forbes, K J, M Fratzscher and R Straub (2013), “Capital Controls and Macroprudential Measures: What Are They Good For?” DIW Discussion Paper (Berlin: DIW). 

Gourinchas, P‐O and M Obstfeld (2012), “Stories of the Twentieth Century for the Twenty‐First”, American Economic Journal: Macroeconomics, 4(1), pp. 226–65.

Nier, E, T Saadi Sedik, and T Mondino (2014), “Gross Private Capital flows To Emerging Markets: Can the Global Financial Cycle Be Tamed?”, IMF Working Paper 14/196

IMF (2013), “Key Aspects of Macroprudential Policy”, IMF Policy Paper, June 10, 2013.

Rey, H (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, paper presented at “Global Dimensions of Unconventional Monetary Policy,” a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyoming:  

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