Sentiment and Sensibility in Emerging Markets

BERKELEY – Emerging market economies have experienced hard times in recent months. Net capital flows to these economies declined by an estimated $122 billion, or about 9.6% year on year, in 2013, and fell sharply again during the first two months of this year. What is driving the decline, and how long will it continue?

Global investors have become more risk-averse in response to expectations of tighter monetary conditions in the United States and Europe, as well as concerns about China’s slowing growth and its negative effects on global demand and commodity prices. And, in keeping with past experience, weak sentiment has reduced capital flows to emerging-market economies in general, especially those like Turkey, Indonesia, and Brazil that have large external financing needs or face upcoming elections with uncertain outcomes. The unexpected Crimea crisis, anxiety about Russia’s intentions in the region, and Western sanctions have further unnerved already skittish investors.

From 2002 to 2007, and again after the global financial crisis in 2008-2009, capital flows to emerging economies surged, as global investors searched for yield in conditions of slow growth and recession in developed countries, low interest rates, and ample liquidity. During this period, investors overlooked individual countries’ economic and political risks, lumping very different economies into a single “asset class,” which was viewed as a one-way bet. Flows of foreign direct investment (FDI), portfolio equity, and portfolio debt to emerging markets reached record highs, with portfolio debt, the most volatile and most sensitive to sudden shifts in investor sentiment, growing the fastest.

Unfortunately, several emerging economies – with the notable exception of China – relied on these abnormally large capital flows to finance domestic demand, and their current accounts slid into unsustainably large deficits. Their real exchange rates also appreciated, eroding external competitiveness. The emerging economies hit hardest by short-term capital outflows and equity-market declines during the last year had experienced large appreciations in their real exchange rates and large deteriorations in their current-account positions.