For example, if home bias in the G20 was to fall as projected, then the sum of gross inflows to individual emerging markets – including flows from both advanced and other emerging markets – is on average $ trillion per year over the period. It would be easy to quibble with the detail of these projections. For example, cross-country information frictions, and hence home bias, may never be fully eliminated. East or West, home may remain best. Nonetheless, the slow, secular fall in this bias does not appear implausible if recent portfolio patterns are a reliable guide to the future. (b)  The evolution of financial depth  Theory would predict a positive, two-way relationship between financial depth and economic development. Not only does greater development spur the deepening of capital markets to finance investment projects, but deeper capital markets themselves may act as a spur for growth as they improve the efficiency of the financial intermediation process (Levine (2005)). Cross-country evidence again supports that hypothesis. Chart 9 plots the cross-sectional relationship between the log of GDP per capita and financial depth (measured as the ratio of equity market capitalisation to GDP). The correlation is positive and reasonably strong: GDP per capita accounts for almost half of the cross-sectional variation in the market capitalisation-to-GDP ratio. On average, a 10% rise in GDP per capita is associated with an increase in financial depth of around 1.5 percentage points. In principle, the relationship in Chart 9 could be used to simulate forward financial depth in the G20 economies.

Gross portfolio equity inflows to emerging markets surged as investors substituted out of low growth developed markets (Chart 1). Gross equity inflows to certain emerging markets were large relative to domestic market capitalisation (Chart 2). The resulting indigestion problem caused bubbly behaviour in emerging asset markets. In response, a number of countries have thrown grit in the wheels of finance through macro-prudential measures or capital flow restrictions. These surges in foreign capital flows, and associated asset market spillovers, are far from new. Through this century, a new wave of inflows to emerging markets has been building. Although halted temporarily by the financial crisis, its effect has been to buoy emerging asset prices (Chart 3). Earlier centuries have seen many similar episodes of capital flow surges into emerging markets, from the South Sea bubble in 1720 to the East Asian crisis of the 1990s (Reinhart and Rogoff (2008)). Historically, as these waves have broken they have often caused quite a splash, with sharp capital and asset price reversals (IMF (2011)). Some commentators have called those capital reversals “sudden stops” (Dornbusch, Goldfajn and Valdés (1995)). But the underlying problem may be as much the start as the stop. The seeds of emerging market crises are sown in the build-up phase, as inflows dwarf the absorptive capacity of recipient countries’ capital markets. Capturing that dynamic requires a different metaphor – the “Big Fish Small Pond” (BFSP) problem. The Big Fish here are the large capital-exporting, advanced countries.