Turmoil in emerging markets: What’s missing from the story?

Kristin Forbes, 5 February 2014



Emerging markets are going through another period of volatility – and the most popular boogeyman is the US Federal Reserve.

The basic storyline is that less accommodative US monetary policy has caused foreign investors to withdraw capital from emerging markets, causing currency depreciations, equity declines, and increased borrowing costs. In many cases, these adjustments will slow growth and increase the risk of some type of crisis.

This storyline gained credibility in the spring of 2013, when talk by Federal Reserve officials of future ‘tapering’ of purchases of US Treasuries and agencies caused sharp market reactions. However, on 18 December, when the Federal Reserve announced the start of tapering, the effect on emerging-market currencies and exchange rates was muted (Figure 1).

The strikingly different reactions to the ‘taper talk’ and ‘taper start’ suggest that the simplistic storyline about what is causing recent volatility in emerging markets is missing something. This column argues that we need to add three important considerations:

  • The role of global growth and uncertainty;
  • The role of country differentiation; and
  • The role of domestic investors.

Figure 1. The exchange-rate effects of 'taper talk' vs 'taper start'

Notes: Exchange rates are local currency rates versus US$. Negative values indicate depreciation.

The role of global growth and uncertainty

One possible reason for the different effects on emerging markets during May and December of 2013 is the differences in the outlook for the global economy.1 In December, growth forecasts for the major developed economies and China were more positive, and uncertainty about the global economy had diminished. These more positive forecasts could have outweighed the negative effect of a small tightening of US monetary policy.
A closer look at patterns in capital flows is consistent with this interpretation that the effects of US monetary policy on capital flows can be outweighed by other considerations.

Figure 2 graphs US interest rates and capital flows to emerging markets from 1990 to 2013. If US interest rates were a key driver of these capital flows, one would expect to see capital flows increasing during periods of low rates and vice versa. Over the last decade, however, this relationship does not hold. During the mid-2000s, the Federal Reserve raised interest rates while capital flows to emerging markets soared. During the Global Financial Crisis, the US lowered interest rates sharply and capital flows to emerging markets collapsed. In fact, the correlation between capital flows to emerging markets (as a percentage of GDP) and US interest rates from 1990 to 2013 is 12%. This is relatively small, but a positive correlation is the opposite of what would be expected if changes in US interest rates were the key factor driving capital flows.

Figure 2. Capital flows to emerging markets and US interest rates

Notes: Data on private capital flows and policy rates from IMF's IFS database, Dec. 2013 version. Capital flows are private financial flows to emerging markets and developing economices. Policy rates measured at end of period. Data for 2013 are estimates.

What variables other than US interest rates could have been the primary drivers of capital flows to emerging markets over this period? Figures 3 and 4 also graph capital flows to emerging markets, but now compare this to global growth and global risk/uncertainty (as measured by the VIX) respectively. Over the last decade, changes in both measures correspond to movements in capital flows, as expected. In the mid-2000s, as global growth increased and uncertainty fell, capital flows to emerging markets surged. During the Global Financial Crisis, as global growth collapsed and uncertainty spiked, capital flows collapsed. In 2010–2011, as global growth partially recovered and uncertainty fell, capital flows increased again. Correlation coefficients support this story. The correlation over this period of capital flows to emerging markets with global growth was 39%, and the correlation with uncertainty was -55%. Not only do these correlations have the expected sign, but they are significantly larger than the corresponding correlation of capital flows and US interest rates.

Figure 3. Capital flows to emerging markets and global growth

Notes: Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets and developing economies. World GDP growth is real growth, reported in the IMF's WEO database, Oct. 2013. 2013 data are estimates.

Figure 4. Capital flows to emerging markets and risk/uncertainty

Notes: Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets and developing economices. Volatility index measured by the Chicago Board's VIX or VXO at end of period. 2013 data are estimates.

Granted, US interest rates, global growth, and uncertainty are all related. As shown in Rey (2013), reductions in US interest rates tend to lower measures of risk and uncertainty. Therefore, to fully understand the relationships between these variables, it is necessary to use a multivariate regression framework in order to control for any simultaneous effects. Frank Warnock and I perform this type of analysis when trying to explain sharp movements of capital flows into and out of countries (Forbes and Warnock 2012). We find that changes in global risk and uncertainty (as measured by the VIX) is the most important variable determining large shifts in capital flows by foreign and domestic investors. We find that global growth also plays a role in determining swings in foreign capital flows, and increases in US interest rates can play a role in explaining ‘sudden stops’ of foreign flows. But changes in US interest rates and liquidity appear to play a less important role than other variables.

The role of country differentiation

During periods of heightened market volatility, it is not unusual to see very diverse markets affected in the immediate sell-off. More liquid markets – even those with sound fundamentals – are often the initial targets for investors wishing to make immediate portfolio adjustments. But over time, investors tend to more carefully discriminate across countries based on underlying vulnerabilities. There is nothing like the prospect of a higher cost of capital and increased volatility to cause investors to ‘wake up’ and assess the risks in different countries.

This increased discrimination across countries has already been an important part of the recent adjustments in emerging markets. Figure 5 shows currency movements in major emerging markets (with a negative value indicating depreciation) during the period of ‘taper talk’ in the spring of 2013. One of the indicators on which investors initially focused to assess vulnerability was current-account deficits – a measure of the country’s reliance on external borrowing. In Figure 5, black bars are countries with a current-account deficit at the end of 2012. Lighter bars are countries with a current-account surplus. Countries that experienced the greatest depreciations all had deficits, while those that were least affected all had surpluses. In fact, there is a 60% correlation between a country’s current-account deficit (as a percentage of GDP at the end of 2012) and the percentage change in the country’s exchange rate over this period.

Figure 5. Country differentiation during 'taper talk'

Notes: Exchange rates are local currency rates versus US$. Negative values indicate depreciation.

Over the next few months, discrimination across countries is likely to become more sophisticated. Countries will also be assessed on characteristics such as their foreign reserve stockpiles, inflation, recent credit growth, and currency mismatches (which affects resilience to depreciations). Increasingly important will be government policy responses. As shown in Forbes and Klein (2013), countries which allow their currencies to depreciate will see a boost to growth after several quarters (although this is often preceded by an initial slowdown). Countries which respond by imposing capital controls and raising interest rates will tend to see a contraction over the next few quarters. Countries will increasingly be evaluated based on actions they choose, rather than on factors outside of their control.

The role of domestic investors

A third and final important consideration to improve our understanding of the recent volatility in emerging markets is the role of domestic investors. Although it is always politically easier to blame foreign investors for market turmoil, domestic investors have become more important in determining how periods of volatility affect currencies, equities, and other markets. The domestic investor base in many emerging markets has grown in size and sophistication, and holds more internationally diversified portfolios. If these investors decide to send more money abroad in response to US tapering or other events, this can aggravate the effects of withdrawals of foreign capital. If domestic investors instead see an opportunity at home, they can play an important role in stabilising domestic markets.

The left panel of Figure 6 shows this increased role of the domestic investor base for Chile. The black line shows net capital flows to Chile – the net amount of new investment flowing into the country after aggregating together purchases and sales by domestic and foreign investors. These net capital flows are the key factor determining changes in the exchange rate and other variables. Net capital flows can also be disaggregated into the cross-border capital flows by foreigners (the dotted green line) and domestic investors (the dashed red line).2 Traditionally, changes in net capital flows have been interpreted as being driven mainly by foreign investors. This interpretation was true for the 1980s and early 1990s, when net capital flows basically mirrored investments by foreigners, and domestic investors rarely invested abroad. Starting in the late 1990s, however, domestic investors began to send more capital abroad, and their behaviour has become an important driver of net capital flows. In fact, in the fourth quarter of 2008, when global capital flows collapsed, domestic Chileans sold foreign investments and brought large sums of capital home. This inflow by domestic investors largely balanced the reduction in foreign investment, and provided an important factor stabilising Chile during the Global Financial Crisis.

Figure 6. Net and gross capital flows

Notes: Capital flows are in $ billions, 2-quarter moving averages. Graphs replicated from Forbes and Warnock (2013) and Forbes (2014).

This increasingly important role of the domestic investor base is not unique to Chile. A number of other countries experienced similar patterns during the panic of 2008. Forbes and Warnock (2012) develop a methodology to define these periods of ‘retrenchment’ when domestic investors bring large amounts of capital back home. Using this methodology, we find that countries as diverse as Austria, Chile, France, Germany, Israel, Japan, Malaysia, Mexico, the Netherlands, Poland, Singapore, South Korea, Taiwan, the United Kingdom, and the US benefited from these types of retrenchments during the fourth quarter of 2008. We also document countries which did not benefit from this stabilising force of domestic investors – countries such as Argentina, Australia, Brazil, Finland, Greece, Hungary, India, Indonesia, New Zealand, Portugal, Russia, South Africa, and Turkey. The right side of Figure 6 shows the patterns of net, foreign, and domestic capital flows for India. The minor role of domestic investors in affecting net capital flows presents a sharp contrast to the corresponding graph for Chile.

Although domestic investor bases may have changed since the Global Financial Crisis, it is not surprising that some of the countries which have been most affected by the recent turmoil in emerging markets are countries that did not have a ‘retrenchment’ by domestic investors during the crisis. One factor contributing to the fragility of the group of countries currently labeled as the ‘Fragile 5’ (Brazil, India, Indonesia, South Africa, and Turkey) is undoubtedly the lack of a strong domestic investor base to help counteract shifts in foreign capital flows.


The volatility in capital flows to emerging markets is likely to continue. US monetary policy will affect investment decisions, although other factors such as changes in the global growth outlook and anything that affects measures of uncertainty could play an even greater role. Emerging markets are justified in being concerned. This volatility will create substantial macroeconomic challenges and will cause greater scrutiny of their economic fundamentals and policy choices. But emerging markets that respond to this volatility by making sound policy choices and focusing on improving fundamentals will be rewarded.


Eichengreen, Barry and Poonam Gupta (2013), “Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets”, mimeo.

Forbes, Kristin (2014), “Capital Flow Volatility and Contagion: A Focus on Asia”, Reserve Bank of India–Asian Development Bank volume on Managing Capital Flows, forthcoming.

Forbes, Kristin and Michael Klein (2013), “Pick Your Poison: The Choices and Consequences of Policy Responses to Crises”, MIT-Sloan Working Paper 5061-13.

Forbes, Kristin and Frank Warnock (2012), “Capital Flow Waves: Surges, Stops, Flight and Retrenchment”, Journal of International Economics, 88(2): 235–251.

Rey, Hélène (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, paper presented at the Jackson Hole Symposium hosted by the Federal Reserve Bank of Kansas City, August.

1 See Eichengreen and Gupta (2013) for an analysis of how ‘taper talk’ affected emerging markets in the spring of 2013.

2 Capital flows by domestics are shown using standard balance of payments accounting, in which a negative value indicates an outflow of capital by domestic investors (i.e. purchase of foreign assets by domestic investors).

Topics: International finance
Tags: capital flows, emerging markets, Federal Reserve, global financial crisis, tapering

Jerome and Dorothy Lemelson Professor of Global Economics at the Sloan School of Management, Massachusetts Institute of Technology