Hot Money’s Fast Exit Cools Emerging Markets

airplane-money-1024x440Capital flight from emerging markets has been accelerating in recent weeks ($6 billion alone in the week ending February 5). Turkey is the poster child, but the exodus is also happening in India, Indonesia, Brazil, South Africa and others – mostly from equity markets. This “hot money” is moving out over concerns that asset bubbles have built up, and that emerging market economic growth is now slowing. The slowdown is partly a result of tighter money in the wake of the Fed’s tapering plans and a decelerating economy in China, many believe. To better understand the risks to the global financial system, Knowledge@Wharton spoke with Wharton finance professor Franklin Allen in this podcast.

An edited transcript of the conversation follows.

Knowledge@Wharton: To give a bit of context, there has been a lot of capital flight out of emerging markets in recent weeks. Turkey is the poster child, but it is also happening in countries such as India, Indonesia, Brazil and South Africa. For a long time, strong economic growth in emerging markets kept that money flowing in. Now, those growth prospects — relative to the more developed countries — look to be sagging, and that money is starting to rush out. And with financial liberalization, that often means there are fewer capital controls to prevent it from leaving quickly.

Some emerging market central banks are responding by raising interest rates to try and keep the money in. Of course, that has a big downside: Higher rates make it tougher for businesses to get loans. And so far, those higher interest rates do not seem to be doing much to keep it in. This is mostly equity money leaving at this point. Eventually, that could bleed into debt issues.

All of this is partly a response [many observers say] to the Fed’s aim to tighten the money supply — to taper quantitative easing — and also to the slowdown in China, which could affect emerging markets very heavily. Is this the dynamic that you see out there? And, if so, what is causing it in your view? And how far along in the process do you think we are?

Franklin Allen: I think it is important to start with a somewhat broader view of what is happening. What happened over the last few years is that a lot of money went from low interest rate countries — particularly the U.S., but also from Europe and Japan and other places — to the emerging markets. These are the so-called carry trades that we have heard so much about. And they basically distorted a lot of asset prices in those countries. Just to take one example, if you look at what has happened to real estate prices in Brazil, they have rocketed the last two or three years. And yet that does not seem to be the result of how well Brazil is doing because actually they have had problems because the money flowing in has pushed up the exchange rate and made it difficult for Brazilian manufacturers, for example, to compete. Brazil has actually had fairly slow growth.

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Originally Published February 10th, 2014 by Knowledge@Wharton.