https://orcid.org/0000-0003-0821-070X
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ABSTRACT
Because of their economic importance, international bond markets are thought to be the likely location for the operation of financial market pressures on emerging market (EM) government policy. An important but unresolved debate that runs through the literature is the relative importance of domestic factors specific to the country receiving the capital flows (pull factors), versus push factors exogenous to the receiving country, in driving portfolio flows to EMs. Through extensive interviews with financial market participants, and analysis of the financial press between January 2008 and 2013, this paper argues that not only were market participants fully aware of the importance of push factors over the cycle, but that their perceptions of the domestic fundamentals themselves were influenced by these push factors. The paper provides evidence on the micro-foundations of investment decision making that make investors susceptible to influence by the push factors, and adds to a growing body of evidence that financial market borrowing costs are even less in the control of emerging market governments than previously assumed, because even when investors pay attention to domestic fundamentals, their assessments can be divorced from reality. This means that government efforts to attract foreign capital through implementing investors' preferred policies may be ultimately futile.
Acknowledgements
Special thanks to Julia Gray, Peter Nolan, Gary Dymski, Gay Meeks, Robert Keohane, and Ivan Rajic, Domna Michailidou and the participants of the New Directions in Money and Finance Conference at the University of Pennsylvania, the Society for the Advancement of Socioeconomics Early Career workshop at UC Berkeley, and the International Political Economy Working Paper seminar at the University of Oxford for comments on earlier versions of this paper.
Disclosure Statement
No potential conflict of interest was reported by the author.
Notes on contributor
Dr. Natalya Naqvi is Assistant Professor in International Political Economy at the London School of Economics, Department of International Relations.
Publications
Naqvi, N., and Henow, A, Chang, H-J. 2018. Kicking Away the Financial Ladder? German development banking under economic globalisation. Review of International Political Economy.
Naqvi, N., 2018. Finance and Industrial Policy in Unsuccessful Developmental States. Development and Change.
Munir, K. and Naqvi, N., 2017. Privatisation in the Land of Believers: The political economy of privatisation in Pakistan. Modern Asian Studies.
ORCID
Natalya Naqvi http://orcid.org/0000-0003-0821-070X
Notes
1 ‘Emerging markets’ and ‘advanced economies’ both correspond to the IMF classifications given in: https://www.imf.org/external/pubs/ft/weo/2015/01/weodata/groups.htm
2 In order for the ‘financial market constraint’ to work, governments also have to be responsive to price changes in financial markets (Mosley Citation2003). This side of the story is outside the scope of this paper, which only focuses on financial market reactions.
3 Hardie Citation2012 correctly emphasises that domestic EM investors are holding increasing amounts of foreign currency denominated debt. Nevertheless, in the market in question, foreign investors move their capital more often, and therefore, have more of an effect on prices (Interviews) and therefore, will be the focus of this paper.
4 Seeking to mitigate exposure to risk from any asset class, country, or region over the long term
5 Exceptions to this narrative include for Toporowski (Citation2000), and Bonizzi (Citation2017), which highlight the role of pension funds in increasing financial market volatility in EMs.
6 Thanks to an anonymous reviewer for making this point. The effect of pull factors on push factors is much smaller. Domestic fundamentals of individual EMs could be expected to have minimal real or sentiment based impact on global push factors (Interviews)
7 See also Palma (Citation1998) and Kaltenbrunner and Painceira (Citation2018).
8 These clients included the largest hedge funds, asset management companies, pension funds, and insurance funds, and private wealth managers, corporate non-financial companies, and official investors such as central banks and sovereign wealth funds
9 Which covers major news sources that interviewees identified as relevant including Reuters, Dow Jones Newswires, Financial Times, Wall Street Journal, Euromoney, MarketWatch, and Pension’s Week
10 This paper focuses mainly on the hard currency sovereign bond market, and the 10-year benchmark government bond because it best reflects market conditions (Mosley Citation2003).
11 Disaggregated data on investment flows by asset class and investor type is not readily available. Such data exists in the EPFR database, which is proprietary and not available for academic use. The IMF GFSR only provides data on investment flows by US mutual funds to EMs.
12 The most detailed publicly available breakdown of EM investors is available from the IMF (Arslanalp and Tsuda Citation2014) but does not differentiate within the foreign non-bank investors category, or between foreign and local currency EM bonds. Hardie (Citation2012) provides further detail on the different types of EM investor, but quantitative estimates only for three countries.
13 The terms mutual fund and asset manager are used interchangeably.
14 BIS estimates suggest that over 90% of mutual funds in EMs are open end (Miyajima and Shim Citation2014, p. 20).
15 A dealer in financial market securities who is obliged to buy and sell securities at all times in order to provide ‘liquidity’ to the market. They play the role of middleman, connecting various ‘counterparties’ or investors to buy and sell securities from each other.
16 Market-making traders are different from ‘proprietary’ traders in investment banks, which invest in order to make profits for the bank, similar to an in-house asset management function. Regulatory moves have been taken to ban proprietary trading by investment banks, which have commercial banking arms.
17 Here, the benchmark is the investors’ reference point in constructing their portfolio, with any deviations from the index reflecting a decision to overweight/underweight certain bonds that they think will over/under perform.
18 Other criteria for inclusion and weighting include price, and tradability and liquidity of the EM bonds.
19 Even if the portfolio manager had a research team covering individual countries, the ultimate decision maker still had to choose between a large number of countries, in a limited amount of time:
We do have some research guys, one part of their job is to talk to the 20 something banks that also produce research. Because I don’t have time to understand the 20 banks research … So in a way they help me to summarise. (Interview 33, Investment Management Company, CEO)
20 CDS represent insurance against government default. A widening CDS spread is the result of increased demand for the CDS, which indicates investors are expecting a higher probability of default.
21 Canada’s largest investment bank
22 This is consistent with the predictions of Prospect theory (i.e. one’s higher propensity to loss avoidance compared to pursuit of gains). Even though some investors believed that fundamentals were more positive than was reflected in prices, they did not want to take the risk of holding on to their investments in the hope that prices would go back up in the longer term, because they were more averse to the short-term losses they would incur with such an investment strategy. Thanks to an anonymous reviewer for making this point.
23 One of the largest British investment managers specialised in EM.
24 Other events that resulted in negative risk sentiment (as shown by increases in the VIX index in figure 2), including S&P’s downgrade of the US from triple to double A+ in August 2011 due to the fiscal cliff (figure 2, point r), and various Greek and Irish bailouts in 2010 and 2011 (figure 2, point m, o, q) caused only brief outflows, with investors quickly going back into EM due to the lack of investment alternatives.
25 For example, when Moody’s upgraded Brazil to investment grade status in September 2009, even though this had widely been anticipated by the market, it led to additional inflows as it widened the range of funds that were allowed to invest in it (Vyas Citation2009)
26 According to a report by Standard Chartered Bank[25], ‘Asia’ was seen as having especially good fundamentals in this regard: ‘If the financial market is looking to penalise fiscal imprudence and reward countries with fiscal discipline, many Asian economies with low fiscal deficits and debt should benefit’ (Chatterjee Citation2010). Even ‘Latin America’, historically known for debt crisis and sovereign defaults, was seen as one of the ‘best examples of this fundamental improvement in asset quality’ (Belaisch Citation2010).
27 By 2012, some investors were of the view that ‘some of the [EM] countries are in even better positions than the key developed markets’ (Ankarcrona Citation2012).
28 A specialised bond fund that is part of OFI Global, an American asset management company
29 The largest global bond investor, with a large presence in EMs.
30 A global investment group with a large presence in EMs.
31 One of the largest global asset management companies.
32 Furthermore, although these liberalization reforms, including the removal of capital controls and financial market development, were seen as unconditionally positive, evidence of their success has been mixed at best, especially in terms of promoting financial stability (see Arestis and Glickman Citation2002 and Singh Citation2003 for a review).
33 Over-reliance on financial market borrowing may create a situation where in the bust time, because financial market borrowing becomes more difficult for emerging markets regardless of domestic policy orientation, these countries may be forced to go back to financing sources with hard conditionalities, such as the IMF, especially if sharp outflows cause a financial crisis. International financial investors can also express their policy preferences to governments more directly. Close networks between investment bankers and senior EM politicians are common, as governments are bank clients for the issuing and marketing of bonds on international markets and privatizations, and meetings are often held between large institutional investors and policymakers. (see Author forthcoming).