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The Crisis of Emerging Markets: The Anatomy of International Capital Flows

As developing economies continue to stagnate under the overpowering burden of growing unemployment and worsening fiscal situations, the interest of investors in emerging markets continues to rise. In the next 20 years, the increasing importance of consumers could be one of the biggest investment ideas.

The Rise of Emerging markets: The Changing Face of Global Growth

The global economy is extremely uncertain and there is no denying that the near term outlook of the world economy is unpredictable.

The flow of International Capital from developed Western economies of the world to emerging markets is not a new concept. An upward trend has been seen in International capital movements, ever since the Bretton Woods got abandoned.

Trade liberalization, the growth of International trade and the opening of current accounts from the 1940’s till the 1970’s in the Industrial economies have all contributed to this upward trend. Capital flows like these are recorded in the Capital account in the Balance of Payment of a country.

With the rapid expansion of International trade, emerging economies of the world are beginning to open up their semi open economies. Semi open economies are characterized by barriers that restrict the freedom of capital flow. For example; creation of quotas, licenses and taxes.

The success of Latin American countries in attracting capital inflows from developed economies of the world prompted a number of Asian countries to tread into their footsteps. During the period 1988-89, the very first wave of capital inflow occurred from the West.  

During the same period, a number of Asian countries recorded a surplus in their capital accounts and as a consequence, there was a marked increase in the International reserves held by those counties. Many emerging market countries began to liberalize both their capital markets and trade in order to capitalize on the growth of International trade.

Additionally, in order to promote an economic system that was more open, licenses were relaxed and quotas and tariffs were either eliminated or reduced. In their efforts to open up their economy, many of these countries abandoned their conventional protectionist model and liberalized their current account or trade.

To facilitate the inflow of cheap funds to fasten their economic development, and their urge to compete effectively with neighboring countries to attract more funds were some of the reasons for promoting a more open economic system.

The Anatomy of International Capital Inflows

There are a number of reasons that can be associated with the most recent inflow of International capital, with push and pull factors being the leading causes of capital inflows. The global economic recession of 2008 left many economies from the West in misery. Their economies sank into recessions and as a consequence there is a constriction of credit.

Through quantitative easing (QE), funds are injected into such economies to prevent them from plunging into a severe recession.  In addition, interest rates are reduced down to about zero percent in order to promote borrowing in order to revive economic activity.

Increased Capital Inflow into Emerging Markets

In order to counter the effects of recession, the U.S interest rates were lowered twice, first in the year 2000 and then during the financial crisis in the year 2009. The drop in interest rate provided a momentum to emerging economies to repatriate some of their funds from Western countries and at the same time increased their borrowings.

The eroding trade balance positions of a number of emerging economies also contributed to the increase flow of capital into emerging markets. This deteriorating trade balance leads to a worsening current account deficit (the Harberger Laursen-Metzler effect). To finance this deficit through capital inflows contributed to the relaxation of rules governing capital inflows. 

Due to the worsening Balance of Payment in the U.S, there has been an increased outflow of private capital from the US Capital account. In addition, there has been an increase in the amount of investments by U.S mutual and institutional funds in overseas securities.

Furthermore, availability of cheap funds to speed up the economic development cycle and financing their current account deficit are among the pull factors that encourage the inflow of capital into recipient countries. Economies experiencing the shortage of capital to invest can also take advantage of this borrowed money from capital inflow to speed up their economic development.

In simpler words, the economic growth and prosperity of a nation can be enhanced by either increasing its savings from National Income that is redirected towards reinvestment or decreasing the Capital to Output ratio by investing more in technology in order to reduce the K ratio.

Additionally, through liberalization of their capital account, capital deficient countries can increase their investments. By embracing an open economic system, and removing blockages to capital inflows, these economies can also achieve economic growth and prosperity in a short span of time through higher investment.

To cut it short, with most of the Euro zone mudded in a recession and the recovery of the United States from global recession taking place at an extremely slow pace, it is not much of a surprise that investors are rapidly turning to emerging markets to enhance their portfolio returns. It is not very difficult to understand the appeal. Emerging markets are composed largely of young and growing populations, and they now have an increasing amount of disposable income to spend.

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