Emerging Economies and Fund Managers

Over the last fifteen years, emerging economies have been exposed to severe episodes of financial crises. In the mean time, an increasing share of investments is delegated to mutual funds. In this paper, we propose a small open-economy model where international investors hire fund managers to manage their capital, who can choose to invest either in the bonds of the emerging economy or in a riskless asset. We show that career concerns of fund managers have adverse macroeconomic effects on emerging economies. First, in a model with endogenous default, we show that career concerns slow down the recovery after a crisis, by increasing the default probability, reducing international borrowing and, hence, capital accumulation. Second, we show that career concerns can lead to excess volatility of interest rates and capital flows. Third, in a model where managers learn about the fundamentals of the economy, career concerns generate overreaction to news. This overreaction is non-linear in the strength of fundamentals. Capital flows and interest rates are relatively persistent in countries with very strong or very week fundamentals, but they can change in a very abrupt manner in the interim range.