A Bumpy Ride for Emerging Markets

BERKELEY – Emerging markets have been the darlings of global investors for most of the last decade. Even staid pension funds and sovereign wealth funds have increased their allocations to emerging-market assets.

Recently, however, the environment for capital flows to emerging economies has deteriorated sharply. Slowing growth and policy missteps, together with signs that the US Federal Reserve will start tightening monetary policy by scaling back its “quantitative easing” (QE, or open-ended purchases of long-term assets), have triggered deep sell-offs in emerging economies’ currency, bond, and equity markets.

What went wrong? Are we witnessing the collapse of yet another economic bubble, as many analysts are claiming?

Capital flows to emerging economies surged from 2002 to 2007, collapsed briefly during the 2008 global financial crisis, and then surged again from 2009 to 2011. In 2011, growing anxiety about a possible financial crisis in Europe interrupted these flows, but they rebounded in 2012. By the end of that year, flows of foreign direct investment (FDI), portfolio equity, and portfolio debt to emerging economies had reached record highs.