Capital Flows in Risky Times: Risk-on/Risk-off and Emerging Market Tail Risk

Research on cross-border capital flows has concentrated on the first moment – what moves average flows and average returns. This paper asks instead how shifts in global risk appetite reshape the whole distribution of emerging-market portfolio flows and asset returns, and in particular the left tail. It measures “risk-on/risk-off” (RORO) two ways: a statistical index built as the first principal component of daily changes across advanced-economy credit spreads, equity returns and implied volatility, funding-liquidity spreads, and the dollar and gold; and, to separate the price of risk from the quantity of risk, the model-based risk aversion series of Bekaert, Engstrom and Xu (2020). Both measures are right-skewed and fat-tailed, spiking in the global financial crisis, the European debt crisis, the taper tantrum and COVID-19. Outcomes are weekly EPFR country flows (scaled by the previous week’s allocation) and daily total returns from the EMBI, a local-currency bond index, and MSCI local-currency and dollar equity indices, for 22 emerging markets, beginning 7 January 2004 and running to April 2020, with push and pull controls and country and time fixed effects. Estimating panel quantile regressions in the manner of Machado and Santos Silva (2019), the paper finds that a risk-off shock lowers flows and returns across the distribution, and that “in nearly every case we consider” the fifth-percentile realisation moves more than the median while the ninety-fifth moves less – so the distribution shifts left and lengthens. The exceptions and the asymmetries are the interesting part. Bond-fund flows shift left with tails pulled apart; equity-fund flows shift left with tails modestly pulled in, a pattern the paper traces specifically to sensitivity to risk aversion rather than to physical risk. Among returns, equity is far more sensitive than fixed income – more than fivefold on the statistical measure – and within each asset class dollar-denominated indices react more than local-currency ones. Decomposing the index, corporate spreads supply much of the leftward shift and funding liquidity much of the bond funds’ tail-lengthening; the risk-aversion component dominated the global financial crisis while the quantity of risk dominated COVID-19. The paper’s conclusion is methodological as much as substantive: a focus on central tendency is “incomplete,” because the tail responses it documents would be masked by conditional means and variances.

Taper Tantrums: Quantitative Easing, Its Aftermath, and Emerging Market Capital Flows

Identifying US monetary policy shocks from daily moves in five-year Treasury futures around FOMC announcements, this paper shows that during the unconventional-policy years those shocks largely represent revisions to required risk compensation rather than to the expected short-rate path, and that their effects on emerging market portfolio positions run mainly through valuations rather than physical flows – with by far the largest effects during the taper period. The shock measure follows Rogers, Scotti and Wright (2014): the daily change in the implied yield of the five-year Treasury futures contract on FOMC announcement dates, plus the additional policy events in Gagnon et al. (2011) and the taper-tantrum date of 22 May 2013. Its average value is a fall of 2.0 basis points during the QE period and a rise of 1.6 basis points during the taper period, against minus 0.6 for the full sample and minus 0.5 pre-crisis, with the period differences statistically significant. Feeding the shock through the Kim and Wright (2005) affine term structure decomposition shows it moves both the expected short rate and the term premium in the conventional period, but that in the unconventional periods the largest effects are on term premia and those effects rise monotonically with maturity – a one-standard-deviation shock raises the ten-year yield by 4.7 basis points pre-crisis but 12.2 basis points during QE, against unconditional daily ten-year standard deviations of 5.8 and 7.1 basis points respectively. The capital-flow analysis uses Bertaut-Tryon and Bertaut-Judson monthly estimates built from US Treasury International Capital data, covering 15 emerging markets monthly from 1994 to 2014, with positions, flows and valuation changes for debt and equity separately scaled by annual GDP, estimated in a random-effects panel with lagged dependent variables, an extensive set of lagged push and pull controls, and country-clustered robust standard errors. Three kinds of heterogeneity emerge. Flows versus prices: “in nearly every specification, the effect of monetary policy shocks on asset returns is larger than that for physical flows,” which the authors read as consistent with the shocks capturing revisions in required risk compensation. Debt versus equity: during QE the coefficient on equity valuations is ten times that on debt valuations, and during the taper period equity effects are double or triple debt effects. QE versus tapering: during QE the significant responses are confined to debt and equity valuations and equity positions, whereas after tapering was first mentioned the coefficients are inversely signed and significant at the 1 percent level across essentially every variable, and an order of magnitude larger than pre-crisis for debt positions, debt valuations and equity flows. Because the shock has a magnitude, the paper can price these effects: a mean-sized QE shock corresponds to roughly a $153.5 million monthly increase in US emerging market equity positions per country, a mean-sized taper shock to a $144.1 million monthly outflow, with one-standard-deviation ranges of roughly minus $672 million to plus $979 million during QE. The paper is explicit that its estimates are associations from a controlled panel regression rather than structural effects: coefficients are described throughout as correlations, the shock’s channel is inferred from coefficient signs rather than separately identified, and the exchange rate results, while statistically significant, are reported as economically modest against an unconditional monthly bilateral exchange rate standard deviation of 3.57 percent.

Christian Lundblad | Macro Paper Warehouse

Capital Flows in Risky Times: Risk-on/Risk-off and Emerging Market Tail Risk

Taper Tantrums: Quantitative Easing, Its Aftermath, and Emerging Market Capital Flows