Fickle Emerging Market Flows, Stable Euros, and the Dollar Risk Factor

Abstract

Policymakers fear the potentially destabilizing impact of fickle global investors on emerging markets. Euro area investors are significant participants in emerging bond markets and exhibit volatile flows, but their fickleness does not result in indiscriminate periods of surge and flight. Instead, we find differentiation across emerging market bonds based on currency denomination and issuer-level risk factors. First, euro area investors exhibit a strong home currency bias that manifests itself both as a cross-sectional preference and in the form of relatively stable flows to Euro-denominated bonds over time. Second, volatile flows to USD and local-currency denominated bonds are most robustly related to fluctuations in the broad dollar exchange rate. Attempts to explain the dollar factor yield modest evidence for a balance sheet mechanism, and, consistent with a broader risk appetite channel, we find flows to bonds with lower credit ratings and higher yield spreads are more sensitive to USD fluctuations.