Fickle Emerging Market Flows, Stable Euros, and the Dollar Risk Factor

Policymakers fear the potentially destabilizing impact of fickle global investors on emerging markets. Euro area investors are significant participants in emerging bond markets and exhibit volatile flows, but their fickleness does not result in indiscriminate periods of surge and flight. Instead, we find differentiation based on currency denomination and issuer-level risk factors. First, euro area investors exhibit a strong home currency bias that manifests itself both as a cross-sectional preference and in the form of relatively stable flows to Euro-denominated bonds over time. Second, volatile flows to USD and local-currency-denominated bonds are most robustly related to fluctuations in the broad dollar exchange rate. Investors differentiate among USD-denominated bonds based on balance sheet factors (and credit ratings) such that flows to currency mismatched (and less creditworthy) sovereigns and corporates are more sensitive to the broad dollar. In contrast, differentiation by issuer-level characteristics is less apparent for local currency bonds suggesting investors are primarily concerned with currency rather than issuer-specific credit risk for this asset class.

Keywords: global risk; capital flows; global financial cycle; US dollar; exchange rates; currency mismatch; portfolio choice; spillovers; emerging market bonds; securities holdings statistics; home currency bias
JEL codes E52; F21; F3; F31; F32; G11; G15

Working paper no. 676