A key question facing global investors today is what impact the US Federal Reserve’s monetary policy normalization process will have on capital flows to emerging markets. The IMF’s new model estimates show that normalization—raising the policy interest rate and shrinking the balance sheet—will likely reduce portfolio inflows by about $70 billion over the next two years, which compares with average annual inflows of $240 billion since 2010.
Shrinkage in the Fed’s $4.5 trillion balance sheet, which began in October, accounts for most of the impact on portfolio flows—defined as foreign purchases of emerging market stocks and bonds. Reduced availability of foreign capital could make it more challenging for emerging market economies to finance their deficits and roll over maturing debt. That is why the Fed should move gradually and communicate its plans clearly.