Emerging Markets and Financial Volatility-Beyond Mexico

Abstract

In the wake of the Mexican financial crisis, too much attention has been given to what was happening in emerging economies and too little to what was changing in financial markets. What are these changes? First, much of the capital flow to emerging markets is now in the form of bonds and portfolio equity investment. Second, investors managing these flows are attracted to high-risk, high-return opportunities and are less patient than the foreign direct investors or banks that emerging market governments may have been more used to dealing with. Third, these investors have no way of communicating their patience level to policymakers other than by exiting. And fourth, high information costs tend to concentrate these flows in "hot" countries and lead investors to rely on a few knowledgeable observers to signal when their returns are at risk, adding to the potential volatility. This Note attempts to explain the origins of volatility, how volatility affects emerging market investors, and the economic management implications behind the changes. In the wake of volatile global capital flows, the World Bank too must reconsider its role in its assistance to client countries.