The Coming Wave

• Author: G. Andrew Karolyi, David T. Ng, and Eswar S. Prasad
• Position: a professor at the Johnson School of Management, Cornell University. and are an associate professor and professor, respectively, at the Dyson School of Applied Economics and Management, Cornell University. Ng was a visiting fellow at the Hong Kong Institute for Monetary Research. Prasad is also a senior fellow at the Brookings Institution.

As emerging market economies become increasingly important players in the global economy, their share of the global cross-border flows of financial assets is also rising. Because of their strong growth prospects, emerging market economies have attracted foreign investors in search of higher returns, especially at a time of very low interest rates in advanced economies. And flows have also gone in the other direction, as the governments of emerging market economies have built up their foreign exchange reserves by investing heavily in advanced economies.Â

Recently, another phenomenon has gradually gained momentum: the outflow of private capital from emerging market economies as their investors seek overseas opportunities.Â

Understanding the volumes and patterns of the various outflows—sovereign and private—and analyzing what influences them will shed light on how the landscape of international capital flows is likely to change as emerging market economies become more integrated into global financial markets. We look at the types of capital outflows from emerging markets and describe some preliminary results from our ongoing research, which shows that the direction of portfolio outflows—relatively small now, but with a large potential to expand—is heavily influenced by proximity and familiarity.Â

Exporting capital

Led by China, emerging markets added about $6 trillion to their foreign exchange reserves between 2000 and 2012—with nearly all of it invested in securities issued by the major reserve currency economies, mainly the United States. It is likely that these emerging market economies will accumulate foreign exchange reserves at a much slower pace in coming years because most have put away sufficient stocks of foreign reserves to help buffer any future capital flow volatility.Â

As reserve accumulation subsides, we anticipate a rapid expansion of private capital outflows from these economies. In fact, such outflows are now matching the increase in official reserve accumulation (see Chart 1). China is, of course, an important driver of these private flows as well, and when China is removed from the picture, the overall numbers are less impressive. But for the emerging markets excluding China, private capital outflows are now greater than those that represent reserve accumulation (see Chart 2).Â

There are many reasons to expect private outflows to increase. As households in emerging market economies become richer and achieve higher levels of savings, they will seek opportunities abroad to diversify their portfolios. Institutional investors, such as mutual funds and pension funds, are already becoming important conduits for these outflows. Corporations and financial institutions are also likely to continue to seek foreign investment opportunities as they expand their operational bases internationally and reach into foreign markets.Â

China shifts

Changes in the structure of capital flows in China, the world’s second-largest economy, provide a good illustration of these trends. China has been a big net exporter of capital to the rest of the globe for the past decade. It has run a trade surplus, exporting more goods and services than it imports, as well as a capital account surplus, which reflects inflows of private capital. During this period, China has run an overall surplus on its current account, indicating that China is, on net, exporting capital to the rest of the world. These capital exports have largely taken the form of foreign exchange reserve accumulation...