Portfolio investment flows to emerging markets

The 1990s brought developing countries the heaviest private capital flows since the early 1980s, says the author - mainly bond and equity financing, rather than medium- and long-term lending by commercial banks. Flows were mainly to Asia in the first half and Latin America in the second half. Market participants believe that most inflows of portfolio investment (especially in Latin America) reflected the return of flight capital by domestic residents with overseas holdings. This and possible herding by foreign investors in a few countries, such as Mexico, could at the margin make securities prices volatile in the emerging markets and cause rapid switching of portfolios between markets (between developed and emerging markets and between emerging markets). This could make macroeconomic management difficult for policymakers. Some contend that if external portfolio investment flows into an emerging market are the result of external factors - such as the U.S. recession and low international interest rates - the increased demand for shares in a relatively liquid emerging stock market may overheat the stock markets and lead to an appreciation of the real exchange rates in these countries. Any attempt to counteract this appreciation of the domestic currency by the monetary authorities, by devaluing the nominal exchange rate, will increase international reserves and perhaps be inflationary. If, on the other hand, policymakers dilute the effect of the real appreciation by sterilizing incoming resources through open market operations, this could increase domestic debt and possibly domestic interest rates. This might attract further inflows from abroad and create a vicious cycle of expected devaluations - which could further appreciate the domestic currency. What is crucial is the policymakers'perception of whether the inflows are temporary. That is why it is important to know the source of portfolio inflows. If the inflows are coming from investors with long-term capital appreciation motives, such as the large institutional investors, and the developing country remains on a path of sustained market-oriented reform aimed at long-run growth, these inflows should continue and even grow in the near future. As more comprehensive data become available, it is important to determine whether these inflows from abroad are intended to be short-term or long-term. The author provides a comprehensive database of transaction-level information on different types of instruments and a glossary of portfolio investment terms.