International Risk Tolerance, Capital Market Failure and Capital Flows to Emerging Markets
The level, tenor and instability of capital flows from global financial markets towards developing countries are a major source of concern for macroeconomic managers, while their causes remain largely unexplained by economic theory. Country ‘fundamentals’ (such as economic growth, monetary stability and institutional capacity) as sources of default risk have been the main focus of economic research and policy prescriptions. However, recent empirical research on the determinants of capital flows and the roots of market failure indicate that much of the explanation lies in the nature of the home (that is, the developed country) demand for emerging market assets. In this paper, the microeconomic roots of home bias and demand instability are explained in terms of investor risk perception and credit rationing, exacerbated by traders’ behaviour. The consequences for host country macroeconomic balances and income distribution of varying investor risk tolerance are then demonstrated. Although the net impact also depends upon the host policy response, this transmission mechanism means that host ‘fundamentals’ are themselves strongly affected by capital flows and thus cannot be considered as to be independent of home asset demand. The paper concludes by examining the implications of these findings for the future of development economics in general and for policy response in particular.