An examination of trends in net capital flows reveals a notable shift in the composition of the global balance sheet and casts a spotlight on global payments imbalances. Most notably, emerging market countries, as a group, have become net exporters of capital and an important investor class in mature markets over the past five years, with their outflows mirroring the U.S. external financing gap. However, this movement of capital from emerging markets to mature markets is channeled primarily through Asian central bank reserves and sovereign wealth funds, mainly of oil exporters (such as those managed by the Abu Dhabi Investment Authority, Kuwait Investment Authority, and others). But private capital is also flowing from mature markets to emerging markets as institutional investors, banks, and corporates increasingly allocate their growing financial assets to cross-border investment to diversify and enhance risk-adjusted returns.

A surge in flows of institutional money has buoyed global capital flows over the past decade. The most significant growth has been in portfolio flows, mainly in debt, and in cross-border banking. These inflows, combined with the appreciation of asset prices and facilitated by financial innovations in the derivatives markets, have led to an unprecedented growth and deepening of financial markets. The size of the world's equity and bond markets is now double the level of world GDP, with global stock market capitalization reaching $38 trillion in 2005, compared with $45 trillion for bond markets.

Aside from the institutional money and banking finance, foreign direct investment (FDI) originating from mature market countries has also partially recovered since the bursting of the dot-com bubble. FDI inflows to emerging markets have been increasing but remain largely concentrated, with China accounting for about 50 percent of emerging market flows since 2002. Among the emerging markets, Asia-Pacific and emerging Europe are the leading recipients of FDI, while inflows to Latin America, dominated by Brazil, have fallen since 2000.

There has been a sharp increase in assets under management of traditional mature market institutional investors (pension funds, insurance companies, and mutual funds). Assets of these investors grew from about $21 trillion in 1995 to about $53 trillion in 2005, with the United States accounting for about half and Europe for more than one-fourth. Pension funds in the United States represent a sizable portion of this asset base, while—except for Ireland, the Netherlands, and the United Kingdom—the share held by Europe is relatively small. Mutual funds and insurance companies, however, constitute a major share of institutional assets both in the United States and in Europe.

Another key trend has been the rapid growth of hedge funds. The number of hedge funds (excluding subsidiary funds) multiplied from 530 in 1990 to more than 6,700 by 2005. Inflows to hedge funds have been very strong since 2002, driven by a widening of the investor base to bring in institutional investors alongside high-net-worth individuals. Assets managed by the hedge fund industry, though smaller than those of other institutional investors, grew from $30 billion in 1990 to more than $1.4 trillion in 2005. Most of these funds are managed from the United States and the United Kingdom, which accounts for the bulk of Europe's share. For example, U.K. pension funds significantly increased their allocation to hedge funds in 2004 (UBS, 2005).

In emerging markets, central banks and sovereign wealth funds have become key players in the cross-border allocation of capital, with U.S. financial markets a major focus. The volume of U.S. treasury securities held by foreigners has more than tripled over the past decade, and the acquisition by foreign official institutions has contributed significantly to this buildup. China recorded the largest gain, increasing its holding by 50 percent over the past few years to become the third-largest investor. By end-2005, foreign official institutions were estimated to be holding more than 50 percent of all foreign-held U.S. long-term securities.

Cross-border portfolio asssets as a share of total assets under management of mature market countries have increased sharply over the past five years or so, dominated by institutional investors. During 2001–05, there was a cumulative increase in cross-border portfolio assets of more than 100 percent, reaching about $19 trillion. Cross-border portfolio assets from the United States grew from $2.3 trillion to $4.6 trillion over the same period, and those originating from Japan increased by $0.6 trillion to $2.1 trillion as of 2005. Europe saw the most significant decline in home bias, with an increase in cross-border portfolio assets of $6.1 trillion during 2001–05. However, a large share of that decline took place within developed Europe, as its investor base preferred to invest within continental Europe and the United Kingdom. Cross-border portfolio flows from Japanese households have been rising since 2000, channeled through Japanese mutual funds. The institutional investors, such as pension funds and mutual funds from mature market countries, have been increasing their investments in emerging markets.

The decline in home bias has been driven by structural as well as cyclical factors. Diversification has been an overarching motivation for most institutional investors. Regulatory and accounting changes for pension funds have also contributed to the shifts in investors' asset allocation decisions. In particular, because of the increase in expected liabilities of pension funds, such investors have sought to diversify investment strategies that not only match more closely their liabilities but also achieve the highest risk-adjusted return.

The surge in cross-border capital flows from mature market institutional investors has helped broaden the investor base for emerging market external sovereign debt, leading to the stability and lower volatility of this asset class over the past five years—as reflected in the global spreads of the JPMorgan Chase emerging markets bond index (EMBI). Interest in emerging market assets has undergone a structural upward shift, with institutional investors such as U.S. pension funds adding emerging market external debt to their benchmark portfolio allocation.

Investor perception of the maturity of the emerging market asset class has been underpinned by improved credit fundamentals, more flexible exchange rate regimes, higher reserve coverage, a structural boost from the convergence of emerging European countries to EU levels, and transparency of information originating from emerging market countries (Byun and Oswald, 2006). These changes have resulted in a higher strategic inflow to this asset class. Indeed, assets under management of emerging market funds benchmarked to emerging market bond indices grew from $27 billion in late 2000 to about $230 billion as of mid-2006. These strategic investors tend to buy and hold and usually have a lower, or no leverage because they aim largely to match the duration of their longer-term liabilities.

Net and gross capital flow volatility has increased substantially over the past decade, both in mature markets and in some emerging markets, although the resilience of most emerging market countries to shocks has improved. Indeed, for most emerging market countries the rise in cross-border capital flow volatility, when adjusted for the rise in foreign exchange reserves, shows a significant decline from 1996 to 2005.