The global financial stage is undergoing a subtle yet profound transformation as the Federal Reserve System (the Fed) in the United States shifts gears with a new phase of monetary easing. The Fed’s 50-basis-point rate cut this past September marks a strategic pivot aimed at a more challenging economic environment. This decision has already begun to reshape global capital flows, especially those targeting emerging markets (EMs). With investors continuously on the hunt for better yields, the relative attractiveness of EM debt and equity markets has surged. As interest rate differentials (IRDs) between the United States and EMs widen, the appeal of EM assets becomes more compelling, particularly in local-currency bonds and equities. This dynamic is further bolstered by a weakening US dollar, which enhances the returns on investments in these regions.
Historically, such periods of US monetary easing have been associated with shifts in global capital allocation towards EMs, which offer higher returns compared to the low-yield environments in advanced economies. The aftermath of the 2008 financial crisis and the market disruptions during the COVID-19 pandemic are notable examples. During these times, the Federal Reserve’s aggressive rate cuts triggered waves of capital inflows into EMs, helping to stabilize economies that were otherwise grappling with the ripple effects of global economic shocks. Yet the current landscape presents a more intricate set of challenges and opportunities. While the Fed’s easing offers a clear incentive for increased EM investment, the broader context is defined by heightened geopolitical risks, divergent EM economic performances and policy shifts in major global economies.
A crucial element of this evolving narrative is the role of the US dollar. The dollar’s strength is a critical determinant of capital flows to EMs, particularly flows into local-currency bonds and equities. When the dollar depreciates, it typically boosts risk appetites among global investors as the returns on local-currency assets in EMs become more attractive. This risk-taking channel plays a crucial role in shaping investor behavior, with the dollar’s valuation having a more substantial impact on capital flows than even traditional measures, such as interest rate differentials or the VIX index (Chicago Board Options Exchange’s CBOE Volatility Index, which gauges market volatility). As the dollar weakens, its depreciation often leads to increased portfolio flows into EM local-currency assets as investors chase returns that are enhanced by favorable exchange-rate movements.
The shift in the nature of capital flows to EMs over the past two decades is also significant. EMs have increasingly shifted from reliance on foreign-currency borrowing to local-currency bond markets, thereby reducing some of the vulnerabilities historically associated with dollar-denominated debt. This transition, often referred to as overcoming the “original sin”, has allowed many EMs to avoid the currency mismatches that once left them exposed to sudden changes in global financial conditions. However, this shift does not come without risks. Even as EM borrowers reduce their direct exposures to foreign-exchange volatility, the overall financial conditions in these markets remain closely tied to global investors’ sentiments, which are heavily influenced by the US dollar’s movements.
Yet the benefits of increased capital flows come with inherent risks. Rapid and substantial inflows can lead to currency appreciation in several EM countries, potentially harming their export competitiveness and causing external imbalances. The Brazilian real and the South African rand, for instance, could appreciate significantly if capital continues to flow into these markets, challenging their export sectors’ ability to maintain competitiveness. Managing these dynamics in these economies requires careful calibration by policymakers, who must balance the short-term advantages of capital inflows with the long-term risks of sudden reversals or asset-bubble formations. The experience of the 2013 “taper tantrum” remains a potent reminder of how quickly investor sentiment can shift, with rapid capital outflows destabilizing markets that had previously benefitted from an abundance of liquidity.
The role of institutional investors, particularly mutual funds, is also critical in shaping these flows. These funds have become increasingly dominant players in the EM landscape, drawn by the prospect of higher yields and the diversification benefits that EM assets can offer. This set of investors tends to be particularly sensitive to shifts in global financial conditions, including changes in the dollar’s strength. A weakening dollar lowers hedging costs for such funds, making local-currency bonds more appealing and driving inflows into EM markets. However, asset managers can also be quick to reverse course if global conditions change abruptly, making EMs vulnerable to sudden outflows.
Recent policy actions in China add a further dimension to the global capital-flow landscape. Targeted measures aimed at revitalizing China’s equity markets have significantly bolstered foreign investment in the country, with inflows to Chinese equities reaching $24.1 billion in September alone—the highest in more than 20 months. These measures, which include regulatory adjustments and targeted support for key sectors, are part of a broader strategy to maintain economic stability amid a challenging global environment. China’s pro-growth approach comes at a time when global investors are seeking more attractive opportunities outside the prospect of lower-yield conditions in advanced economies, thus positioning Chinese assets as a prime destination for capital. However, in the event of market pressures or global sentiment shifts leading to an outflow of capital from China—as has been the case in previous years—it will be interesting to observe whether other EMs capture some of this redirected capital. For economies such as India, Brazil and Southeast Asian nations, which have become increasingly attractive destinations for investment, any substantial outflow from China could represent an opportunity to draw in fresh capital.
However, China’s role in global capital flows remains multifaceted. While its policy moves have attracted significant investment, the country faces its own set of challenges, particularly in managing the value of the yuan. An appreciating yuan, driven by capital inflows, could undermine China’s export-led growth model, prompting potential intervention from the People’s Bank of China (PBoC) to prevent excessive currency strength. Such intervention could involve accumulating foreign-exchange reserves, which could, in turn, complicate domestic monetary policy and potentially lead to inflationary pressures. This intricate balancing act between attracting capital and maintaining currency stability underscores the broader challenges that China faces as it navigates its position within a changing global economic order.
Geopolitical risks add yet another layer of uncertainty to the outlook for EM capital flows. Tensions in the Middle East, coupled with uncertainties surrounding the upcoming US federal elections, are contributing to a volatile investment climate. These geopolitical developments could disrupt the positive sentiment driving inflows into EMs, leading to increased market volatility and a reassessment of risk by global investors. Such risks are not just abstract concerns but have tangible implications for the stability of capital flows. A sudden escalation in geopolitical tensions could trigger a flight to safety, reversing the current trends and sending capital back to perceived safe havens—like U.S. Treasury bonds (T-bonds), despite their lower yields. This dynamic underscores the fragility of the current environment, in which the allure of high yields in EMs coexists with the ever-present risk of a rapid change in market conditions.
A critical factor in this environment is the nuanced relationship between flows of local currency and foreign currency. Local-currency bonds have typically been the primary beneficiaries of a weaker dollar, as their attractiveness increases with improved returns for foreign investors (see below). In contrast, foreign-currency-denominated bonds and loans are more sensitive to shifts in interest rate differentials between the United States and EMs. As the Fed eases rates, borrowing costs in US dollars decrease, leading many EM issuers to take advantage of the lower rates to secure financing in foreign currencies. While this provides a temporary boost to external financing, it also exposes EMs to the risk of higher debt-servicing costs if the dollar strengthens again. This delicate balance between exploiting current opportunities and managing potential risks is a hallmark of the challenges facing EM policymakers.
The sustainability of these capital flows hinges on the continuation of the Fed’s dovish stance and the trajectory of China’s pro-growth measures. Should the Federal Reserve maintain its current course, the resulting interest rate differentials are likely to continue favoring EM investments, supporting inflows into local-currency assets. At the same time, China’s ongoing efforts to stabilize its economy and attract foreign investment will remain critical in sustaining interest in EM Asia. However, any signs of policy shifts in either of these major economies could prompt a reevaluation among investors, highlighting the importance of closely monitoring developments in Washington and Beijing alike.
For EMs, the influx of capital presents a double-edged sword. While increased liquidity can deepen local financial markets, improve access to financing and support economic growth, it also brings risks of asset bubbles and heightened market volatility. The experiences of countries such as India, which has leveraged capital inflows to support infrastructure investment, and Brazil, which is working to diversify its economy away from commodities, illustrate the varied ways in which EMs can capitalize on these flows. Yet the risk of an abrupt reversal remains a constant backdrop, reminding investors and policymakers alike of the tenuous nature of global capital movements.
The current phase of monetary easing by the Federal Reserve and the subsequent shifts in global capital flows mark a period of opportunity and caution for emerging markets. The interplay between the Fed’s rate cuts, the movements of the US dollar and China’s policy stance will continue to shape the contours of global finance. However, heightened geopolitical risks present a critical countervailing force. While the Fed’s easing cycle is intended to weaken the dollar and encourage capital flows into higher-yielding EM assets, geopolitical tensions—such as those in the Middle East and uncertainties surrounding US elections—could drive a renewed demand for the safety of dollar-denominated assets. This could lead to a paradoxical situation whereby the dollar strengthens despite the Fed’s efforts to loosen monetary conditions.
Such a scenario would create headwinds for capital flows to EMs, as a stronger dollar tends to reduce the attractiveness of local-currency bonds and equities by diminishing dollar-denominated returns for global investors. This tension between the monetary policy-driven incentives for capital to seek out EMs and the haven demand for the dollar illustrates the delicate and uncertain environment that lies ahead. For EMs, managing this dynamic will require balancing the allure of investment opportunities with the need to remain resilient to sudden shifts in global sentiment. As EMs navigate this environment, the lessons of the past, the challenges of the present and the uncertainties of the future converge, making this a pivotal moment for investors and economies alike. The coming months will test the resilience of EMs and their ability to attract investment while maintaining stability amid these conflicting forces in a world that is, as ever, in flux.
ABOUT THE AUTHOR
Jonathan Fortun is an Economist in the Global Macroeconomics Department at the Institute of International Finance (IIF). Prior to joining the IIF, Jonathan developed his career in the multilateral sector at the World Bank and Inter-American Development Bank (IADB); before that he was a financial adviser in Bolivia. He has also been a consultant for trade, financial and economic topics in Japan and Latin America and is currently a lecturer at Johns Hopkins University.
