Cross-border flows fall into several categories with different drivers and stability. Direct investment aims at operational control, runs long and is comparatively stable. Portfolio investment aims at financial return and can enter and exit quickly. Cross-border bank lending is highly sensitive to interest differentials and risk sentiment. The three behave very differently and should not be treated as one. Interest differentials are a major driver of portfolio flows. When a market's rates or expected returns rise relative to others, capital tends to flow in, and when the gap narrows or reverses, it flows out. This makes emerging market flows highly correlated with the monetary policy of the major economies. When the major economies raise rates, emerging markets frequently face outflows unrelated to their own fundamentals.
Risk sentiment is another major driver, and its force frequently overwhelms interest differentials. During periods of rising global risk appetite, capital flows towards higher-return, higher-risk markets, and during risk-averse periods it returns to assets regarded as safe. This shift in sentiment can be very fast, and it acts on multiple markets simultaneously, giving their flows a synchronised character. Exchange rate expectations and capital flows reinforce one another. When capital flows into a market, demand for its currency rises and the currency tends to appreciate, and the expectation of appreciation then attracts further inflows. This positive feedback amplifies appreciation during inflows and amplifies depreciation during outflows, making currency movements larger than fundamentals alone would imply. Local factors of course play a part, including a market's growth prospects, policy stability and valuation.
But the influence of those local factors is frequently overridden by external capital waves. A market with improving fundamentals can see outflows because of global risk aversion, and a market with unremarkable fundamentals can see inflows because of global risk appetite. The size of a flow relative to market depth determines its impact. In smaller or less liquid markets, the same amount of capital produces a larger price impact. This explains why emerging markets are more sensitive to global capital waves than developed markets. The reason is shallower market depth, less able to absorb large movements of capital, rather than more fragile fundamentals. For investors, the practical significance is distinguishing the source of a price movement.
A market's short-term direction may reflect mainly external capital flows rather than any new local information. Using local fundamentals to explain such capital-driven movements produces wrong conclusions, and understanding the direction and scale of the flow is the precondition for reading it correctly. One further point concerns composition within the flows. An inflow dominated by short-term portfolio capital can reverse abruptly, while one dominated by direct investment tends not to. Two markets receiving inflows of identical size can therefore face very different vulnerabilities depending on what kind of capital arrived, and the aggregate flow figure conceals that distinction entirely. The composition of a flow is available in the balance of payments data, and it tells a great deal more about fragility than the headline number does.