Global Economic Divergence and Portfolio Capital Flows to Emerging Markets

• Published date: 01 September 2019
• Author: ZEYYAD MANDALINCI,HAROON MUMTAZ
• Date: 01 September 2019
• DOI: http://doi.org/10.1111/jmcb.12576

DOI: 10.1111/jmcb.12576

ZEYYAD MANDALINCI

HAROON MUMTAZ

Global Economic Divergence and Portfolio Capital

Flows to Emerging Markets

This paper studies the role of global and regional variations in economic

activity and policy in developed world in driving portfolio capital flows

(PCFs) to emerging markets (EMs). Results suggest that PCFs to EMs

depend mainly on economic activity at the global level and monetary policy

in America and Asia, positively on the former and negatively on the latters.

PCFs are procyclical with respect to global activity, but countercyclical

to regional activity. In aggregate, regional variations contribute more than

global variations. This implies that economic divergence in the developed

world can have significant effects on EMs via PCFs.

JEL codes: C11, C32, E30, E52, E58, F32

Keywords: portfolio capital flows, Bayesian analysis, factor model, var,

emerging markets.

DIVERGENCE IN ECONOMIC ACTIVITY AND policy has been a

widely debated topic across policy makers and academics. In particular, the issue

has become more relevant in the aftermath of the global financial crisis. U.S. econ-

omy has experienced a stronger rebound than other developed economies in Europe

and Asia. Hence, after three rounds of quantitative easing, the U.S. Federal Reserve

(FED) terminated its asset purchasing programme in 2014, whereas in Asia and Eu-

rope, central banks scaled up their measures to further loose monetary policy in the

face of possible deflation. As a result, FED has been raising its policy rate, whereas

in Europe and Asia policy rates are expected to remain at historically low levels.

In this current environment of economic divergence in the developed world, a great

uncertainty for emerging markets (EMs) is how capital flows will be affected. In

this paper, we study the importance of variations in activity and policy at different

ZEYYAD MANDALINCI is a Senior European Economist at SPX International Asset Management,

London, UK (E-mail: zeyyad.mandalinci@spxuk.com). HAROON MUMTAZ is a Professor at Department

of Economics, Queen Mary University of London, London, UK (E-mail: h.mumtaz@qmul.ac.uk).

Received January 15, 2016; and accepted in revised form August 20, 2018.

Journal of Money, Credit and Banking, Vol. 51, No. 6 (September 2019)

C

2018 The Ohio State University

1714 :MONEY,CREDIT AND BANKING

global hierarchical levels to help shed light on the possible implications of economic

divergence on portfolio capital flows (PCFs) to EMs.

Economic divergence implies that region-specific variations in activity and policy

become more prominent. Hence, the key question in the context of PCFs to EMs

is how important global versus region-specific variations for PCFs are. On other

hand, existing literature on PCFs does not provide a formal treatment and answer

for this question. Previous studies suggest that interest rates and activity in the

developed world are relevant drivers of PCFs.1However, a common drawback of

these studies is that they do not account for the fact that variations in key variables

are increasingly due to factors that originate at the global or regional level rather than

at national level, considering the increasing level of international real and financial

linkages.2For instance, Kose, Otrok, and Prasad (2012) study global business cycle

synchronization in a dynamic factor model and find convergence in business cycles

of industrial countries. They argue that country-specific variations have become less

important over time. So, before examining the role of a particular variableof a country

in driving PCFs to EMs, one has to account for the fact that variations in the given

variable may be due to variations at a higher hierarchical level. Hence, one has to

decompose the variations in country-specific variables into variations at different

hierarchical levels. Clearly,this is especially important if the objective is to study the

implications of economic divergence in developed countries on EMs, via the impact

of global and region-specific shocks on PCFs as in here.

To study the global and regional variations in economic activity and policy in the

developed world on PCFs to EMs, this paper employs a factor-augmented vector

autoregressive (FAVAR) model. Variations in countries in North America, Europe,

and Asia Pacific are decomposed into global, regional, and idiosyncratic levels, and

incorporated in a VAR, together with a factor representing common variations in

PCFs to different EMs, to study the role of shocks at different hierarchical levels in

driving flows.3

Results indicate that global activity shocks are important drivers of PCFs. Adverse

global activity shocks have significant negative effects on PCFs. Hence, PCFs are

found to be procyclical with respect to global economic activity. In contrast, at the

regional level, PCFs are found to be countercyclicalwith respect to economic activity.

Contractionary American and Asian monetary policy shocks havesignificant negative

impact on PCFs. Furthermore, forecast error variance and historical decompositions

indicate that global activity, American and Asian monetary policy shocks are key

drivers of PCFs. Also, there is heterogeneity in the importance of variations at

different levels and regions.Overall, region-specific variations in aggregate dominate

the role of global variations. Given the importance of regional variations, economic

divergence has implications for PCFs and hence EMs. In particular, since one of the

1. See, for instance, Chuhan, Claessens, and Mamingi (1998), Taylor and Sarno (1997), and Forbes

and Warnock (2012).

2. See,for instance, Hirata et al. (2013), Diebold, Li, and Yue (2008), and Thorsrud (2013).

3. Duringthe paper, we use America and North America, Asia and Asia Pacific interchangeably.