Managing Portfolio Flows

By Weller, Christian E.; Chaurushiya, Radha | Journal of Economic Issues, June 2006 | Go to article overview

Managing Portfolio Flows

Weller, Christian E., Chaurushiya, Radha, Journal of Economic Issues

Capital account liberalization has been praised as a vehicle for faster growth and rising living standards but also criticized for raising financial instability in emerging economies. Capital account liberalization benefits the financial sector directly through more competition and innovation, lowering the costs of capital and facilitating investment for the nonfinancial sector. Since this should contribute to faster growth and since the incomes of the poor tend to rise with growth, proponents of liberalization conclude that it would help alleviate poverty. However, increased capital mobility has also frequently proved to be destabilizing. Moreover, the benefits of more capital mobility have often been unevenly distributed. Subsequently, poverty reduction has been hampered with unequal growth and growing instabilities. Several institutions may foster more stable growth in developing economies. They include better civil liberties, public support for indigenous banking systems, and progressive taxation coupled with effective tax collection.

Portfolio Flows as Development Tools

Since the early 1990s, many countries have liberalized their capital accounts, followed by booming capital inflows. In 1990, capital movements into these countries netted about $29 billion, which quickly ballooned to a peak of $197 billion in 1996. Portfolio flows turned from a net outflow of $1.8 billion in 1990 to a net inflow of $86 billion in 1996 (IMF 2004). After the mid 1990s, however, capital flows to developing economies began to taper due to a spate of financial crises. Although portfolio flows to developing countries rose again at the end of the 1990s, they have remained, on net, negative since 2001.

The largest recipients of portfolio flows during the last thirty years have been Latin American countries (IMF 2001). The IMF attributed these flows to larger fiscal deficits. Similarly, Asian countries, especially China, have heavily purchased the increasing issues of U.S. treasuries, resulting in an outflow of capital from developing countries to the USA.

Economies can theoretically benefit from more capital mobility. Financial markets could allocate capital to the most efficient uses. Because of large capital constraints, the marginal rate of return to new investments in emerging economies should be greater than in countries with less capital rationing, all else equal. By raising capital mobility, growth should receive a boost.

It is also argued that good macro policies can reduce inherent macroeconomic risks and thereby raise the risk-adjusted rate of return. Thus, capital flows may encourage good macroeconomic policies in the countries that are looking to receive foreign capital. This can prove to be a double-edged sword since this disciplining device also constrains government's ability to conduct countercyclical policies (Blecker 1999).

Portfolio flows may support growth initially. For instance, Levine 1997 shows that increased cross-border portfolio flows in emerging economies help to build capital markets and that capital market developments are linked to growth. Furthermore, the IMF (2001) has concluded that more capital flows can raise investment possibilities, create technology spill-overs, and deepen domestic capital markets. The IMF estimates that greater liberalization is associated with economic growth that is 0.5 percent higher annually. However, Ayhan Kose et al. (2004) concluded in a comprehensive review of the empirical literature that it is difficult to establish causality between financial integration and growth.

The link between capital markets and growth is made over long periods and tends to ignore increasing macroeconomic fluctuations that occur in the mean time. For instance, Christian Weller (2001) established a systematic connection between increased portfolio flows and the incidence of financial crises.

Capital account liberalization can promote poverty reduction because it can foster growth, which is typically equal over the long term (Dollar and Kraay 2001; Weller and Hersh 2004). …

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