Emerging Markets: A Source of and Destination for Capital

Article excerpt

Emerging markets are increasingly becoming a source of growth in the complex global economy. Brazil, Russia, India, Indonesia, China and South Korea are projected to account for approximately 45 percent of the global output by the year 2025, up from 37 percent in 2011, according to a report from the International Monetary Fund.1

Although there are varying definitions of what precisely is an emerging market, in general, countries that experience significant growth in GDP and infrastructure are given this distinction.2 Emerging markets typically have lower per capita GDP and have enacted structural economic reforms in an effort to grow rapidly and to catch up with moredeveloped nations. A natural consequence of this has been the growth of capital markets and the increasing capital flows to and from these countries.

In what follows, we make a very preliminary study of the trends in capital flows to and from emerging markets over the past couple of decades.

Half the World's People

The countries on our list of emerging markets make up a sizable portion of the world's population. They had roughly 3.6 billion inhabitants as of 2010, most of whom reside in China or India, according to population estimates from the U.N. Department of Economic and Social Affairs. This total represents about 52 percent of the global population and is expected to grow.

Before the financial crisis of 2007-2009, emerging markets had significantly higher growth rates compared with the rates in countries that belong to the Organisation for Economic Co-operation and Development (OECD), whose members are usually considered to be more developed. However, the financial crisis had a large impact on both OECD countries and emerging markets. Although emerging markets as a whole witnessed slower growth during the downturn, they did not see a wholesale contraction in economic activity as their OECD counterparts witnessed.

Types of Capital Flows

An engine of growth for emerging markets, capital flows are typically broken into two principal categories: foreign portfolio investment (FPI) and foreign direct investment (FDI). In spirit, FPI is investment that is made without gaining a controlling interest in the entity receiving the funds. It is an investment in an asset for the purpose of earning a return (e.g., the purchase of corporate or government securities or bonds). FDI entails some sort of ownership or controlling stake (e.g., investing in a factory or land). In general, the benchmark for FDI is if an investor takes at least a 10 percent controlling stake in the target entity. This essay focuses more attention on FDI because of its stronger links to growth and employment.

FDI cultivates development because, in addition to the resources that it provides developing economies, it gives them the opportunity to "learn by doing," which leads to growth-enhancing innovation and spillovers. Over the past couple of decades, the share of FDI in total foreign equity flows has been larger for developing countries than for developed countries.3 Arguably, the causality runs both ways: Those engaging in FDI are more likely to target countries with greater growth potential.

Figures 1 and 2 highlight the important trends in emerging markets' inflows and outflows of FDI. First, the absolute values of FDI into and out of emerging markets have shown a phenomenal increase since 2000. This is just another piece of evidence of the importance of emerging markets in an increasingly globalized world. Second, within emerging markets, the relative shares of individual countries' FDI flows have remained fairly stable. China appears to play a prime role in both the inflow and outflow of FDI. Brazil appears to be a major destination for FDI inflows, whereas Russia appears to be a major source of FDI outflows. Third, during 1993-1997, emerging markets accounted for over 20 percent of the share of global FDI inflows. The financial crisis in East Asia and the Russian Federation in 1998 saw a collapse in this share. …