Financial globalisation and poor countries: The impact of international asset demand instability on emerging markets

It is widely recognised that unstable international capital markets have serious consequences for developing countries, yet the policy prescriptions of the international financial institutions still focus on the need to achieve and maintain "sound fundamentals" in the host economies. This article directly addresses the volatile behaviour of the aggregate international demand schedule for emerging market (EM) securities itself, and thus how fluctuating risk aversion and interest rates within developed countries affect the level and cost of private capital flows to developing countries. The standard single equation "push-pull" model of capital flows is replaced by a simultaneous equation model that determines sovereign bond yields and flows together. Interaction effects captured include portfolio herding and price bubbles, with time-varying investor risk aversion affecting yields and flows. The econometric results reported contribute a valuable insight to the impact of short-term shifts in the asset demand schedule on emerging markets. The policy implications include the need for compensating market interventions in global capital markets, the encouragement of longer holdings by pension funds and concerted demand management by host central banks, as well as prudential restrictions on short-term borrowing abroad. Macro-financial instability in emerging market countries-which undermines real investment and sustained growth with negative consequences for poverty reduction-can only be overcome by this sort of approach.