Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Strong Local Markets Can Enhance Inflows

September 24, 2007

  • Capital flows to emerging markets have surged in recent years
  • Such flows can be beneficial but also can be difficult to handle
  • Better developed domestic financial market helps maximize benefits and minimize problems

Emerging market countries can be better equipped to maximize the benefits of capital inflows, while cushioning against the potentially destabilizing effects of flow volatility.

Strong Local Markets Can Enhance Inflows

New apartment buildings in Dubai: Since 2002, capital flows to emerging markets have risen nearly sixfold, IMF study notes (photo: Jobard/Sipa)


According to a special study that accompanied the IMF's Global Financial Stability Report, the approach to follow is to focus on developing domestic market liquidity and diversity, and on improving the quality of institutions.

The IMF, in the report released September 24, based its conclusions on an analysis of 30 years of data about equity market liquidity and depth and institutional quality from 15 developed and 41 emerging market economies. The report supplements the analysis covering 1977 to 2006 with a more detailed examination of the eight years following the Asian financial crisis (1998 -2006).

Rapid influx

The surge of capital flows to emerging markets in recent years has made more pressing the issue of how a country can best deal with foreign capital. Since 2002, capital flows to emerging markets have increased nearly sixfold. And because the long-term trend toward financial integration will continue, countries will do well to consider how they can best take advantage of the inflows.

Such flows can be beneficial by increasing investment and enhancing economic development. But they also can pose policy challenges, especially in large sums over short periods of time, because they can put upward pressure on the exchange rate, increase the chances of an economy overheating, and trigger asset price bubbles. There is also the possibility of a deleterious sudden stop, in which investors abruptly pull out their money.

Although foreign direct investment (FDI) remains the most stable and largest single component of capital flows to emerging markets, bank loans and bonds have been growing faster in recent years and increasing amounts of the capital are flowing into the private rather than into the public sector.

The IMF found that over the medium term, a better developed domestic financial market increases the volume of capital flows and reduces their volatility in emerging markets. The primary determinant of the level of inflows is investor expectations about a country's growth prospects. But equity market liquidity and financial openness (the ease with which capital can flow in and out of country) help attract capital and greater financial openness appears to lower the volatility of the flows. A number of other institutional factors—corporate governance, accounting standards, strong legal systems, and low corruption—enhance the quality of domestic financial markets and help countries maximize the beneficial effect of capital flows.

The analysis also highlighted the importance of transparency of government economic and financial policies and data. Institutional investors emphasize the importance of timely and accurate data and better market infrastructure, such as sound banking and regulatory systems.

The study pointed to the importance of financial supervision to the health and stability of a financial system.

Last resort

The IMF also warned against using capital controls except as a last resort and only as part of a broader package of macroeconomic policies and prudential measures. In the short-run they might be able to impede speculative inflows. But in the long run, they are often circumvented by market participants, eroding their effectiveness.

The results of the study—"that the quality of domestic financial markets raises the level and helps reduce the volatility of capital inflows—lend empirical support to conventional wisdom," Countries will thus be better off if flows can both enter and exit freely without disrupting financial stability and the real economy, the report concluded.