According to conventional wisdom, capital flows are fickle. They are fickle more or less independent of time and place. But different flows exhibit different degrees of volatility: FDI is least volatile, while bank-intermediated flows are most volatile. Other portfolio capital flows rank in between, and within this intermediate category debt flows are more volatile than equity-based flows.
The categorisation of countries into relevant international benchmark indices affects the allocation of capital across borders. The reallocation of countries from one index to another affects not only capital flows into and out of that country, but also the countries it shares indices with. This column explains the channels through which international equity and bond market indices affect asset allocations, capital flows, and asset prices across countries. An understanding of these channels is important in preventing a widening share of capital flows being impacted by benchmark effects.
Ninety years ago, in his A Tract on Monetary Reform Keynes famously wrote “In the long run we are all dead”. That observation recently stirred a lot of debate for all the wrong reasons, after Niall Ferguson obnoxiously claimed that Keynes did not care about the future because he was childless. Whether Keynes cared about the long-term future or not (and whether he had children or not) is completely irrelevant in this context, as many (e.g. Brad DeLong and Paul Krugman) have pointed out.
The actual context in which Keynes wrote this observation was a discussion about the quantity theory of money, which states that doubling the supply of money will only double the prices, but will have no consequences for other parts of the economy. This is the classical dichotomy between real and nominal variables. Keynes argued: “Now in the long run this is probably true”. But “In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” So, Keynes’ point was obviously not that the future doesn’t matter. His point was that simple theories that might describe long-term relationships are just not good enough to deal with current issues. In the short run, changes in money supply can have all kinds of important consequences beyond the price levels. Economists will have to make their hands dirty and delve into the complicated dynamics of the here and now.
The latest bout of G3 monetary stimulus is likely to increase capital flows to developing countries, but may be limited by lingering economic uncertainty, and lower interest rate spreads. Notwithstanding the recent easing of financial market tensions, the anticipated rebound in real-side activity is lagging behind.
With sluggish growth in advanced economies, much investment money is heading south to more favorable climates. And while capital flows can provide greater opportunities for emerging and developing economies to pursue economic development and growth, capital inflows can also pose some serious policy challenges for macroeconomic management and financial sector supervision. Recently, large capital inflows in some middle-income countries have placed undue upward pressure on their currencies, adversely affecting macroeconomic and financial system stability as well as export competitiveness in a number of these countries. Furthermore, the pro-cyclical nature of global capital flows to emerging and developing economics can serve to aggravate these risks.