Emerging Markets Show More Resilience to Capital Flow Cycle

Net capital flows to emerging market economies slowed significantly since 2010

Slowdown associated with decline in growth prospects, but without resulting in high incidence of debt crises as in past

Greater exchange rate flexibility, foreign reserves, and lower public debt can help

A new study, published in the IMF’s April 2016 World Economic Outlook report, takes a closer look at more than 40 emerging market economies to understand the drivers of declining capital flows since 2010. The analysis also examines the modest impact of the declines compared to earlier episodes in the 1980s and 1990s, when prolonged downswings in capital flows resulted in a higher incidence of financial and debt crises. Capital flows refer to all financial flows—bank, foreign direct investment, and portfolio investment between residents and non-residents.

The study finds that a considerable portion of the decline in net capital flows— about $1.1 trillion from 2010 to late 2015—can be linked to investors’ concerns about diminished growth prospects in emerging market economies relative to advanced countries, with bouts of risk aversion and, more recently, the prospect of tighter financial conditions in some advanced economies playing a role. Yet, structural and domestic policy factors strongly determine the extent to which different countries are affected. Hence, policymakers can take action to ameliorate the effects of the expected growth slowdown on capital flows and financial stability going forward.

Emerging market resilience: now and then

Surges and declines in capital flows are hardly new. Some past downturns in capital flows have also been linked to investors’ concerns about the prospect of growth slowdowns in emerging nations—for instance, due to lower commodity prices and cyclical bouts of over-optimism and pessimism, sometimes triggered by less benign global financial conditions. Yet, the study shows that emerging market economies have so far weathered this slowdown in capital flows more than in previous cycles (see chart).

The study cites several factors for this resilience:

First, emerging market economies are more widely integrated in global capital markets, with higher foreign assets, including foreign exchange reserves, which give these economies greater latitude to manage the capital flow decline.

Second, policy frameworks in many emerging market economies have generally improved over time, reducing the effects of lower capital flows on country...