Capital Inflows into Emerging Markets Post-Global Financial Crisis: A Story of Portfolio Rebalancing

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 financial crisis (GFC), conditions from the US and other advanced economies have recreated this exact situation, in which capital inflows 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 outflows and currency depreciation which unfolded in 57 EMs in 2011-2015 is at best moderate, and we find that EMs are less susceptible now to sudden stops than before. To explain this phenomenon, we provide a theory of portfolio rebalancing, 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 outflows and reduces the total negative effects on the EMs. We also estimate a panel vector autoregressive (PVAR) model to identify the interactions between different 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 flowing out. We conclude by extending Mendoza (2006)’s sudden stop model to include portfolio choice in order to provide a theoretical framework of portfolio rebalancing.\(^{1}\)