Patterns of Capital Flows to Emerging Markets: A Theoretical PerspectiveWP/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. |