It is widely recognized that the U.S. monetary policy tightening causes a reduction in global liquidity and capital outflows from emerging economies in general. However, emerging economies recorded a net capital inflow during previous episodes of U.S. monetary policy tightening. This suggests that factors besides U.S. monetary policy also affect global capital flows. Turning to the ongoing tightening campaign, it features the fastest pace of policy rate hikes in decades, potentially leading to stronger effects on capital flows in emerging economies. In this regard, this paper aims to identify the characteristics and determinants of the capital flows in Korea and other emerging economies during past episodes of U.S. monetary policy tightening since 2000, and to explore whether there have been any changes in the impact of U.S. monetary policy on the capital flows during the current episode.
To begin, we analyze capital flow data in emerging economies during the three past periods of U.S. monetary policy tightening: Tightening Period 1 (June 2004 - June 2006), Tightening Period 2 (November 2014 - April 2019), and Tightening Period 3 (October 2021 - September 2022, currently in process). The results show that during the first two periods, there was a net capital inflow, while a significant net outflow was observed during the current tightening period. Net outflows were conspicuous during the early stages of Tightening Period 2, which followed a prolonged period of significant monetary policy easing, and Tightening Period 3, in which the pace of interest rate hikes have exceeded market expectations.
We then conduct a panel regression to analyze the impact of variables related to growth (growth rate differentials and commodity prices), interest rates (Federal Funds Rate (FFR) and domestic and foreign interest rate differentials), and risk (VIX and EMBI) on capital flows in emerging economies. We also compare the impact of the above determinants of capital flows between Korea and other emerging economies using a Bayesian hierarchical linear model.
Our empirical results show that growth- and risk-related variables have a statistically significant impact on capital flows in emerging economies, with a higher accountability than interest rate-related variables. However, during the current period of U.S. monetary tightening, we observe a slightly increased impact of changes in Federal Fund Rate, possibly resulting from the Fed's rapid rate hikes. Furthermore, our comparison of the impacts of capital flow determinants between Korea and other emerging economies indicates that growth rate differential and VIX have a greater impact in Korea than in other emerging economies on average, while the impact of interest rate-related variables is similar.
Our data analysis and empirical results imply that forecasting of and analyzing of capital flows in emerging economies require comprehensive consideration of various factors including the U.S. monetary policy. Importantly, the pace of interest rate hikes and the degree of monetary policy easing prior to a shift to a tightening cycle should also be taken into account. Moreover, it is crucial to note that if the Fed's monetary tightening is faster than expected or if its shift to a tightening cycle starts after a prolonged period of easing, it could result in net capital outflows and increased volatility in the external sector of emerging economies.