As the world economy limped out of the global financial crisis, there was a resurgence of capital flows to emerging market economies (EMEs)—followed by an even sharper reversal in the aftermath of the U.S. sovereign downgrade. Recent months have seen capital flows to EMEs resume again. This article summarizes recent research on what causes these mercurial movements of capital flows to emerging markets, and what factors determine how much capital countries receive during surge episodes.

After collapsing during the 2008 global financial crisis, capital flows to emerging market economies (EMEs) surged in late 2009 and 2010, raising both macroeconomic challenges and financial-stability concerns. By the second half of 2011, however, capital flows receded rapidly, eliminating much of the cumulated currency gains, and leaving EMEs grappling with sharply depreciating currencies in their wake. The trend seems to have reversed again since the beginning of 2012, with flows to EMEs rebounding, and in some cases reaching the peaks seen in 2010 and early 2011.

While such volatility is nothing new—historically, capital flows have been episodic—it has reignited questions about the nature of capital flows to EMEs. Several commentators argued that the immediate post-crisis surge was largely a result of country-specific determinants—or domestic “pull” factors such as improved macroeconomic fundamentals, better institutional quality, and lower country risk in EMEs (Fratzscher, 2011). But if so, the sharp reversal following the U.S. sovereign downgrade and rise in market risk-aversion is certainly puzzling—after all, the EMEs in question did not experience overnight a marked change in fundamentals.

The debate on what drives capital flows dates back at least to the mid-1930s—when the U.S. was contending with a surge in capital inflows—and helped shape the post-war international monetary order and the IMF’s Articles of Agreement. The debate resumed in the 1990s when, as a result of capital account liberalization (as well as recovery from the 1980s debt crisis), many EMEs—especially in Latin America and Asia—began to attract substantial portfolio flows from private foreign investors. Subsequent studies analyzed the determinants of these flows by characterizing them as “push” and “pull” factors. Push factors reflect external conditions (or supply-side factors) that induce investors to increase exposure to EMEs—for example, lower interest rates, weak economic performance in advanced economies, lower risk aversion, and booming commodity prices. Pull factors are recipient country characteristics (or demand-side factors) that affect risks and returns to investors such as macroeconomic fundamentals, official policies, and market imperfections.

Since, in equilibrium, flows must reflect the confluence of supply and demand, it is not surprising that most studies on the determinants of capital flows to EMEs find that both push (supply-side) and pull (demand-side) factors matter (for example, Papaioannou, 2009; IMF, 2011). But studies examining the volatility of capital flows present a more mixed picture. For example, Mercado and Park (2011) find a dominant role for domestic pull factors as well as regional contagion in determining the volatility of capital flows, while Broto and others (2011) find that both global and domestic factors affect capital flow volatility, but the significance of the former has increased in the last decade.

More recently, some studies have attempted to characterize the dynamics and determinants of large capital inflows—or surges—on the grounds that their characteristics may be different from more normal variations. Additionally, from a policy perspective, large upward swings are of particular interest both because of their greater impact on the exchange rate and competitiveness, and because they are more likely to overwhelm the domestic regulatory framework, thus raising financial-stability risks. Reinhart and Reinhart (2008) and Cardarelli and others (2009) catalog net capital flow surges in both advanced and emerging economies, and show a strong correlation between these episodes and global factors such as U.S. interest rates, world output growth, and commodity prices, as well as with local characteristics, notably the current account deficit and real GDP growth. Forbes and Warnock (2011) use gross capital flows to differentiate between episodes of surges, stops, flight, and retrenchment, and find that global risk aversion, liquidity, and growth matter for surge occurrence. But in contrast to most other studies, they find that advanced economy interest rates are unimportant—though this may be because their sample comingles advanced and emerging economies (so any effect of higher advanced economy interest rates in reducing flows to EMEs may be offset by their positive impact on flows to advanced economies).

“While such volatility is nothing new—historically, capital flows have been episodic—it has reignited questions about the nature of capital flows to EMEs.”

Focusing on EMEs, Ghosh and others (2012a) identify surges based on net flows and document three stylized facts. First, surges have become more common in recent years—with the share of surge observations almost tripling from the 1980s to the last decade—and are synchronized internationally. Second, surges are relatively concentrated even in periods of high global capital mobility, with never more than half of the EMEs in the sample experiencing them at any point of time, and some experiencing them repeatedly. Third, the amount of capital received in a surge varies considerably across countries.

To explain these patterns, Ghosh and others (2012a) examine systematically the factors causing surges, and the magnitude of flows conditional on surge occurrence. Their results indicate that global factors, including U.S. interest rates and global risk aversion, are key determinants of whether capital surges toward EMEs—which helps to explain why surges are synchronized internationally and why they recur. At the same time, whether a particular EME experiences a surge also depends on its own attractiveness as an investment destination; hence, pull factors—particularly, economic growth, external financing need, capital account openness, and institutional quality—matter, which explains why some countries do (and others do not) experience surges when aggregate flows toward EMEs rise. Although conditional on the surge occurring, pull factors—including the nominal exchange rate regime, extent of real exchange rate overvaluation, capital account openness, and external financing needs—are important in determining the surge magnitude, while global factors appear to play a limited role.

In addition, Ghosh and others (2012a) differentiate between surges caused mainly by changes in residents’ liabilities (liability-driven surges), which are associated with the investment decisions of foreigners, and those caused by changes in foreign assets (asset-driven changes), which are associated with the investment decisions of domestic residents. They find that surges to EMEs are mainly liability-driven—though asset-driven net flow surges have been increasing in recent years. The factors driving the two types of surges turn out to be quite similar: lower U.S. interest rates encourage capital to flow to EMEs while increased global market uncertainty leads capital to flow out toward traditional safe-haven assets. Foreign investors are equally attuned to local conditions as domestic investors, but tend to be more sensitive to changes in the real U.S. interest rate and global market volatility, and are also more subject to regional contagion than domestic investors.

A related strand of literature examines the ending of surge episodes, and finds that they are associated with a higher likelihood of debt, financial, and currency crises (Reinhart and Reinhart, 2008; Furceri and others 2011). The domestic macroeconomic policy response over the surge episode however seems to matter in how a surge episode ends—for example, Cardarelli and others (2009) find that growth declines have been significant after episodes that are associated with fiscal expansions and greater resistance to exchange market pressures. Similarly, Ghosh and others (2012b) find that EMEs are more likely to experience a hard landing (defined as a reversal of net flows) when there is a deterioration of fiscal and external balances, and a domestic lending boom over the surge episode; but there is also some evidence that countries with higher foreign exchange reserves tend to experience a soft landing. Moreover, changes in global conditions matter—with an increase in U.S. interest rates, for example, raising the likelihood of a hard landing.

The research to date clearly points to the key role of global factors in pushing large flows of capital to EMEs. While improved fundamentals in EMEs—particularly relative to the advanced economies—imply that they are likely to remain attractive destinations to investors at least in the medium term; inasmuch as the global factors could reverse abruptly, some variability in capital flows appears inevitable. The challenge for policymakers is to craft the right mix of macroeconomic and prudential policies (including possibly temporary capital controls (Ostry and others, 2011)) factoring in whether the surge is liability- or asset-driven, and to formulate “rules of the road” to ensure multilaterally consistent policy responses, so that as the history of surges repeats, the consequences are more benign.