Capital Supply and International Financial Markets

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

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