Are Foreign Investors in Emerging Market Economies a Panic-Prone Herd?

• Author: Eduardo Borensztein/R. Gaston Gelos
• Position: Economist in the Macroeconomic and Structural Adjustment Division of the IMF's Research Department/Chief of the Strategic Issues Division in the IMF's Research Department

Foreign investors in emerging market economies have been blamed for touching off recent financial crises by rushing en masse to sell their investments. To what extent has such herdlike behavior occurred, and what have been the consequences?

Episodes of high volatility in international capital flows to emerging market economies in the 1990s put foreign investors in the limelight-these investors are frequently seen as the culprits behind bouts of instability and the ensuing currency crises. Some have argued that market participants disregarded fundamental economic conditions in emerging economies and instead acted as a "herd"-that is, they reflexively did what other investors were already doing. Widespread herding behavior by a group of investors could worsen volatility and touch off panics that do not reflect the true economic conditions in emerging market countries. In a recent paper (Borensztein and Gelos, 2000), we examined the herding proposition empirically for international funds that invest in emerging economies' equity markets and found that although herding is more prevalent there than in other markets, it is probably not to blame for the observed volatility of international capital flows.

Herding can be fully rational from the point of view of an individual investor. For example, an investor may have only limited access to direct information about asset returns and therefore need to learn from the actions of others. Sometimes, the best thing an uninformed investor can do is follow the actions of more informed investors. Alternatively, fund managers' compensation may be linked to the performance of the fund they manage relative to those of other funds of the same type. This may prompt managers to try to avoid falling too much behind their comparator funds, which would lead them to invest in a portfolio of assets that never diverges very much from their comparator funds' portfolios.

Herding may sometimes be more apparent than real. For example, foreign investors may appear to act as a herd if they react simultaneously to the same news about fundamentals. In this case, their behavior speeds up the adjustment of prices and is not destabilizing. However, in an efficient market, speedy price adjustment should occur without many actual trades having to take place. Moreover, the question remains as to why international investors would react differently to certain news than domestic investors.

What does the evidence show?

Assessing the behavior of international investors in a systematic way is difficult. Most of the available financial information consists of data on prices, and it is difficult to convincingly trace movements in prices to the behavior of particular groups of investors. Moreover, herding by international investors may not have an immediate impact on asset prices but may nevertheless worsen a country's balance of payments.

We studied the behavior of international investors by exploring a novel data set, compiled by Emerging Market Funds Research, Inc., comprising monthly data on the individual portfolios of about 400 dedicated emerging...