Capital flows have traditionally focused on the ‘demand side’ of emerging market financing by examining current account balances, which are equal to the net external financing needs of countries, and then seeking to identify ways in which these financing needs could be met and on what terms. However, this approach ignores trends in capital flows into and out of the major advanced economies, which are the source of most cross-border capital and the main reason why gross flows have risen so dramatically relative to net flows. These flows are typically in a securitized form and, as such, are susceptible to trading in active secondary markets. By one estimate, investors in the mature markets of Europe, the United States and Japan have been accumulating securities issued outside their own countries at the rate of about US$1 trillion a year (Smith 2000). This means that international capital flows are increasingly determined by global asset-allocation decisions made by globally active financial institutions in major industrialized countries. These institutions are becoming increasingly concentrated as a result of the global trend toward consolidation. Understanding capital movements increasingly requires an analysis and understanding of the underlying investor base.
A case in point relates to the on-off nature of the market for emerging market dollar denominated bonds. The dedicated investor base for emerging market securities has contracted in recent years, reflecting the closure of several large hedge funds, the orientation of other hedge funds toward mature market investments and reductions in the capital allocated to support the activities of the proprietary trading desks of some international investment banks. Moreover, the current investor base is dominated by ‘crossover’ investors; that is, investors who invest short-term and opportunistically in the asset class and whose benchmark portfolio typically has a zero weight on emerging market securities. The holdings of emerging market securities by a particular crossover investor are a small share of the investor’s total portfolio and thus can be liquidated quickly without major impact on its overall value; however, the aggregate impact in the emerging debt market of crossover investors as a group reacting to a specific event, making an exogenous shift in risk appetite or rebalancing portfolios in response to losses or gains elsewhere can be overwhelming. These developments suggest that, unless the dedicated investor base expands significantly, on-off market access is likely to be a regular feature of emerging market finance.
Other examples of the importance of the investor base, and the extent to which developments in mature financial markets impact on the issuance of emerging market securities, have arisen because of the creation of a pan-European debt market since the inception of the euro, and the growth of European pension funds. These events have resulted in the establishment of a market for euro-denominated emerging market debt, at both the retail and institutional level.
The effect has been to mitigate to a degree the access problems associated with the on-off nature of the dollar-denominated market. These markets (along with a market for yen-denominated issuance) are demonstrably less volatile than the dollar market, and have tended to remain open when the dollar market has closed. Thus, they have become an alternative source of funds, with a more stable investor base that appears to be well worth the time and effort of emerging market countries to cultivate.
Credit: International Finance-CU