Zelal Aktaş is an Economist at the CBRT.
Yasemin Erduman is an Economist at the CBRT.
Neslihan Kaya Ekşi is an Economist at the CBRT.
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The economic literature on capital flows suggests that monetary policies of advanced economies are among the major drivers of capital flows to emerging economies. Expansionary monetary policies of advanced economies boost capital flows towards emerging economies, while contractionary monetary policies lead to capital outflows from these economies. The unconventional monetary policies implemented by advanced country central banks after the 2009 global financial crisis further increased the importance of expectations regarding the future monetary policy outlook. Accordingly, recent studies have placed special emphasis on the role of the expectation channel of monetary policy in explaining capital flows towards emerging markets.
The global financial crisis of 2009 marked the beginning of a new era where the central banks of advanced economies introduced aggressive expansionary monetary policies. Consequently, policy interest rates were reduced to the lowest level possible on the one hand, and unconventional monetary policies were adopted on the other. In the scope of quantitative easing programs, massive amounts of liquidity were injected into the financial system. However, the uncertainty about the speed of recovery in advanced economies and the loss of confidence in these countries’ assets, in turn, increased investors’ interest in emerging country assets. Abundant liquidity and extremely low interest rates in advanced economies, coupled with the positive growth performance and higher interest rates in emerging markets, attracted substantial capital inflows towards the emerging world.
The room for conventional monetary policy maneuver further shrank in advanced economies as their policy rates hovered around the zero-lower-bound for an extended period. In this period, advanced country central banks frequently resorted to forward guidance to manage future policy expectations. The practice of managing future expectations of monetary policy was not new, but neither was it this aggressively utilized nor was its influence this strong in the past.
The taper talk in May 2013 through which the Fed signaled that it would gradually wind down its quantitative easing program has gone down in history as a striking example of the role that the expectations channel plays in monetary policy. The Fed’s signal for tapering was interpreted as a move towards tighter monetary policy in the upcoming period. Financial markets reacted to what the Fed said rather than what it did. Following this taper talk, emerging countries witnessed sudden capital outflows and drastic exchange rate depreciation. The market reaction was so strong that this period was named the “taper tantrum” episode. Yet, despite prospects for tighter monetary policy, a rate hike did not come until the end of 2015. With this first rate hike by the Fed in December 2015, the world entered a new phase in monetary policy. Precise and quantitative information about future monetary policy became ever more important.
With all this at hand, the big question for emerging markets is: how will capital flows be affected in this new era? The economic literature puts forward expansionary monetary policies of advanced economies as a major driver of capital flows to emerging markets. In line with the increasing role of expectations management in the design of monetary policy, a number of recent studies bring the expectations channel of the monetary policy into perspective while explaining emerging market capital flows. The expectations channel focuses on the change in expectations about the future policy rate. Accordingly, the surprise element of the monetary policy affects the markets. What we mean by the surprise element is the unanticipated part of the monetary policy decision. In practice, Fed futures contracts are used to extract the market expectations for Fed’s future monetary policy. Building on this perspective, the study by Koepke (2016) analyzes the effect of a surprise in Fed’s monetary policy on emerging market capital flows by using Fed fund futures rates. Accordingly, an unanticipated change in the Fed policy significantly affects portfolio flows, particularly in equity and bond markets. The same study also emphasizes the asymmetric nature of this effect in that the expectations about tighter monetary policy have a substantially stronger adverse impact on portfolio flows to emerging markets than the favorable impact of expectations for a policy easing.
In our recent study, we analyze how expectations about Fed’s future monetary policy stance affect an emerging country’s share in total portfolio flows to emerging markets. Focusing on country shares in total emerging market portfolio flows rather than on the level of these flows gives a better sense of the attractiveness of a country in the eyes of international investors. For instance, we can say that a country becomes less attractive for investors when its share in total portfolio flows to emerging markets decreases, even if portfolio flows to that country increase. In this study, we derive the expectations about Fed’s future monetary policy from Fed’s futures contracts while country-specific factors are measured via two indices compiled from the PRS Group’s International Country Risk Guide (ICRG). The first one of these indices measures the financial resilience of a country and the second one measures the potential risks to international business operations. The study addresses the following question: “Do stronger financial conditions and/or a safer business environment for international investors counterbalance the negative effect of Fed’s policy tightening expectations on a country’s share in emerging market portfolio flows?”
The findings of our study, consistent with other studies on the subject, suggest that the effect of Fed’s policy expectations on the country share in total emerging market portfolio flows is asymmetric. The expectations about Fed’s monetary policy are found to reduce an emerging country’s share in total emerging market portfolio flows when they imply a policy tightening, while expectations for a policy easing do not have a significant effect on the share. In this respect, we can say that for emerging market economies, negative news is more important than positive news. Another finding of the study is that a country’s financial resilience and business environment for international investors considerably affect its share in total portfolio flows. Accordingly, a country with stronger financial conditions and/or safer business environment will be less negatively affected by a probable policy tightening by the Fed, and it can even increase its share in total portfolio flows. So, we conclude that emerging economies that better position themselves in terms of financial resilience and institutional quality than their peers can somewhat counteract the adverse effects of the Fed’s policy tightening. Therefore, promoting a safe business environment for international investors as well as implementing necessary structural, macroeconomic and macroprudential policies to enhance countries’ financial resilience are crucial for emerging economies.
To sum up, total portfolio inflows to emerging market economies are likely to decelerate in the upcoming period due to the Fed’s policy tightening. However, it appears that country-specific dynamics will be decisive in finding out who will get a larger share from the pie.
 Koepke, R. 2016. “Fed Policy Expectations and Portfolio Flows to Emerging Markets.” IIF Working Paper, September 2016.
 For further information, see Aktaş, Z., Erduman, Y. and Kaya Ekşi, N. (2018). “The Effect of Fed’s Future Policy Expectations on Country Shares in Emerging Market Portfolio Flows.” CBRT Working Paper No.18/09, March 2018.
 For a detailed review of literature and methodological details, see Aktaş, Erduman and Kaya Ekşi, (2018).