Environmental factors and capital flows to emerging markets
Summary
Focus
In recent years, environmental considerations have influenced the macroeconomic outlook, affecting capital allocation in both the public and private sectors. Investors are increasingly aligning their strategies with sustainability objectives and directing resources towards environmentally friendly investments. This shift is gradually altering the risk-return profile of assets, which could affect capital flows across countries.
Contribution
We examine the impact of environmental factors on capital flows to emerging market economies (EMEs). Our analysis uses data on 21 emerging market economies 19 advanced economies from 1996 to 2023. Specifically, we explore three types of risks that may have played a crucial role in reshaping capital allocation to EMEs in recent years. Physical risks are linked to physical events that may cause economic losses. Transition risks are associated with regulatory changes driven by climate awareness. The energy mix reflects the use of renewable energy sources – a factor previously unexplored in the international finance literature.
Findings
Our findings suggest that EMEs with lower exposure to extreme weather events, a greener energy mix and stronger climate-related policies tend to attract greater capital inflows. Furthermore, we assess the role of factors in advanced economies (AEs) as sending countries in influencing capital inflows to EMEs. The results indicate that stricter environmental regulations in AEs are associated with increased capital inflows to EMEs with weaker green regulations, pointing to a potential "emission shifting" effect. At the same time, these regulations also direct more investment towards EMEs with a greener energy mix. These findings emphasise the growing relevance of environmental factors in influencing international capital flows.
Abstract
This paper examines the impact of environmental factors on international capital flows – specifically portfolio, bank, and foreign direct investment (FDI) inflows – to emerging market economies (EMEs). Using two complementary approaches, we first analyse how recipient country factors influence capital flows for 21 EMEs, finding that EMEs with lower exposure to extreme weather events, a greener energy mix, more and stronger climate-related policies tend to attract greater capital inflows. Second, using bilateral data for FDI and bank flows, we explore the role of sending country factors (advanced economies, AEs) in determining capital inflows to EMEs. The results suggest that stricter environmental regulations in AEs lead to increased capital inflows to EMEs with weaker green regulations. This suggests an "emission shifting" effect. At the same time, though, they also route more investment to EMEs with a greener energy mix. These findings underscore the significance of environmental factors in shaping international capital flows.
JEL classification: F21, F23, F64
Keywords: environmental factors, capital flows, emerging markets, energy mix
