US interest rates are at their highest in 20 years and the dollar has risen sharply against other world currencies.Given the dollar’s outsized role in international finance and trade, and if history is any guide, emerging markets are understandably concerned.
We all know that a rapid tightening of US monetary policy and a strong dollar could lead to sudden capital flight and a financial crisis in emerging countries. Fortunately, no emerging market crisis has occurred.
Capital inflows to emerging markets are recovering from post-pandemic lows, according to the latest External Sector Report. Net capital inflows to emerging markets excluding China rose to $110 billion, or 0.6% of GDP, last year, the highest level since 2018.
As would be expected in a period of global monetary tightening, emerging markets have seen a decline in more volatile net portfolio inflows, but more stable net foreign direct investment inflows.
China is the exception: it had net capital outflows and negative net FDI inflows. By 2022-23This could reflect multinational companies repatriating profits, but it could also reflect changing expectations about Chinese growth and geo-economic decoupling.
Indeed, most emerging markets have proven resilient amid global monetary tightening, in part because of stronger fundamentals. Indeed, many countries are now benefiting from stronger fiscal, monetary, and financial policy frameworks, as well as more effective implementation of policies and instruments.
But this is only part of the picture: this pattern of net inflows hides a contraction in total global capital flows – a decline in both gross inflows (fewer asset purchases by foreigners) and gross outflows (fewer purchases of assets abroad by residents).
Total global inflows in 2022-23, like total global outflows, decline from 5.8% to 4.4% of world GDP, or from $4.5 trillion to $4.2 trillion, compared to 2017-19.
The decline masks large differences across countries. The United States accounts for 41% of total global inflows, almost double the 23% in 2017-19. Total outflows from the United States have increased as well, from 14% to 21% of total global outflows. Meanwhile, total inflows to and from China have fallen substantially over the same period, and total inflows from financial centres have fallen even more substantially.
This could be evidence of increasing financial fragmentation, but it may also partly reflect the relaxation of some tax and regulatory strategies by large multinational corporations in financial centers that account for a much smaller share of global capital flows.
As global capital flows shrink, emerging market countries must build on recent improvements in macroeconomic frameworks, more effective policies, and stronger institutions that have helped them weather the prospect of higher U.S. interest rates for a prolonged period.
Countries have taken various steps to address stresses caused by fluctuations in capital flows. Integrated Policy Framework It will help calibrate the best policy mix and also help countries weather this period of dollar strength.
