US Long Term Interest Rates and Capital Flows to Emerging Economies

Following Chairman Ben Bernanke’s comments before Congress that the FOMC may ‘take a step down in the pace of asset purchases if economic improvement appears to be sustained’, US 10-year interest rates picked up sharply and gross capital flows to emerging market economies (EMEs) reversed. These events raised concerns that further increases in US interest rates could trigger sharp changes of capital flows that would be followed by financial crises in EMEs. To assess this possibility, this paper studies the association between US long term interest rates and cycles of capital flows to EMEs. It finds that, indeed, cycles in capital flows to EMEs are linked to global conditions, including global risk aversion and long term interest rates in the United States. In particular, higher US long term interest rates are associated with lower levels of gross capital flows to EMEs, and to a higher probability of observing sharp reversals in those flows. Episodes of net capital inflows, on the other hand, are mostly associated with domestic macroeconomic conditions. In particular, economies with relatively low levels of gross outflows, with a high ratio of short-term debt to international reserves or with weak domestic fundamentals are more vulnerable to the risk of a classic sudden stop à la Calvo. This Working Paper relates to the OECDEconomic Survey of the United States 2014 (www.oecd.org/eco/surveys/economic-survey-unitedstates.htm)