Patterns of Capital Flows to Emerging Markets: A Theoretical Perspective


WP/97/13-EAWP/97/13


Patterns of Capital Flows to Emerging Markets:
A Theoretical Perspective
by Zhaohui Chen and Mohsin S. Khan


This paper reviews some of the basic patterns of international capital flows
to emerging markets in recent years, which include the composition of capital
flows, intra regional flow patterns, and the geographical distribution of the
flows. Although there is a large body of literature on capital flows, there is
as yet no widely accepted explanation for why the volume and composition of
capital flows differ among the various emerging market countries.


Many factors can affect the patterns of capital flows. This paper focuses on
the cost of financing aspect and shows how capital flows are affected primarily
by the level of financial market development and the growth potential in
recipient countries. The theoretical model developed in this study offers a
simple unifying framework to explain the various patterns of capital flows.


In the model, the level of financial market development is captured by the
market's ability to alleviate capital market inefficiencies, such as asymmetric
information concerning investments. Growth potential is defined by the
distribution of investment opportunities in the recipient country. Foreign
residents' incentive to invest in emerging markets is related to the

expected excess return foreign investment, which depends on the recipient
country's level of financial market development and growth potential. The model
predicts positive expected excess returns to foreign portfolio equity
investment in countries exhibiting a suitable combination of financial market
development and growth potential, whereas for other countries such excess
returns are negative. In some countries, under slight changes in perceived
growth potential or financial market integrity, the expected excess returns can
turn from positive to negative, or vice versa, leading to large-scale capital
flow reversals, as have been witnessed recently in international capital
markets. In countries where growth potential is high but the financial market
is underdeveloped, foreign direct investments could be preferred to portfolio
inflows as a form of financing.