Fickle Capital Flows Are a Fact of Life

Capital flows are variable, and volatility is increasing

Domestic conditions generally more important than international in driving flows

Flows to economies with greater global financial exposure more sensitive to world conditions

Following a collapse during the global crisis, net capital flows to emerging market economies recovered in a strikingly short span, against a backdrop of low global interest rates and increasing risk appetite. The rebound, however, was more extraordinary in terms of its pace rather than the level capital flows reached.

In a chapter on international capital flows released as part of the IMF’s April 2011 World Economic Outlook, IMF economists find that net capital flows have become somewhat more volatile over the past 30 years. Net flows to emerging market economies temporarily rise in periods of easy global financing—that is, when global interest rates are low and investor risk appetite is high—and fall afterwards.

What drives net flows?

In general, domestic factors are more important than global factors in driving the variability of capital flows. However, greater direct financial exposure to the United States entails a greater effect of U.S. monetary changes on capital inflows. For a U.S. interest rate hike, the negative additional effect on net flows is even stronger when the hike is unanticipated and global financing conditions are easy.

At the same time, financially exposed emerging market economies with strong growth and deep domestic financial markets are...