Published on Let's Talk Development

Are capital flows fickle? And does the answer still depend on type?

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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. 

This conventional wisdom is a distillation of the experience of earlier decades.  Yet the structure and regulation of international financial markets continue to change.  Chinese outward FDI has risen dramatically relative to other sources of FDI; South-South FDI flows have risen more generally; bank-intermediated flows have fallen as large global banks have deleveraged and curtailed their cross-border operations in response to tighter regulatory oversight; Asian bond markets have grown relative to bond markets in other regions; corporate bond markets have grown relative to sovereign bond markets; and international investors have become active in equity markets worldwide. 

In a new paper and a Vox column, we ask whether the conventional wisdom holds in our contemporary world.  We analyze trends in capital flows in emerging economies since 1990s, including in the post-global-financial-crisis era.  While a majority of previous studies have utilized annual data largely for reasons of availability and convenience, we work with quarterly data.  This allows us to analyze capital flows at business cycle frequencies and around country-specific sudden stops and global stops, events that are hard to pinpoint using annual data.
Our main observations are below: 

(i) On average, FDI and non-FDI inflows are of roughly equal magnitude. Median (unweighted) average annual flows to an emerging market economy are 2.6 percent and 2.4 percent of GDP. Within non-FDI flows, bank-related flows are the largest, followed by portfolio debt, while portfolio equity flows are relatively small.   The relative magnitude of bank-related flows has declined and that of portfolio debt has increased since the Global Financial Crisis.  Outflows are smaller than inflows on average (these being emerging markets).  
(ii) Measuring volatility by the standard deviation and coefficient of variation we find that non-FDI flows are relatively volatile, and less persistent. Portfolio debt flows and banking flows are among the most volatile. Capital inflows into emerging markets are volatile but not increasingly so. 

(iii) FDI outflows from emerging markets rose strongly in 2006-10. Capital outflows from emerging markets, FDI and bank-related outflows in particular, have grown not just larger but also more volatile. That outflows are a growing source of capital account volatility in emerging markets is not adequately appreciated in the literature, in our view.   

(iv) Following Eichengreen and Gupta (2016), we classify episodes of sudden stops when total capital inflows decline sharply below the average in previous years. Portfolio equity, portfolio debt and other inflows all turn negative during sudden stops.  The decline in inflows is sharpest for other flows and smallest for FDI. Portfolio equity and debt inflows turn negative in sudden stop periods; although the initial drop is sharp, inflows recover and are back to pre-crisis levels within four quarters. Bank flows turn negative, and recover very slowly—these flows remain negative four quarters after the beginning of the sudden stop episode.  

(v) Resident flows are stabilizing during sudden stops in that portfolio equity and debt outflows and especially other outflows drop significantly below their average. However, looking at the scale of outflows it is evident that the decline in outflows during sudden stops is smaller than the decline in inflows. So even if the decline in outflows by residents partially offsets the decline in inflows by non-residents, this stabilizing impact is only partial, and net inflows still decline.


(vi) We analyze the drivers of capital flows. Results suggest that FDI inflows are driven mainly by pull factors, while portfolio flows are driven mainly by push factors, and bank flows are driven both by push and pull factors-- FDI seems to be affected more by domestic than external factors; a better investment climate is associated with larger FDI inflows; most types of capital flows are not strongly correlated with the federal funds rate; higher global risk aversion as measured by VIX reduces non-FDI capital inflows but not FDI inflows. We ask whether the effects of these variables have changed in recent years, but do not find evidence of a change in the coefficients.
We analyze the correlates of outflows analogously. Some of the patterns for outflows are broadly similar to those for inflows. Using our regression results we ask which of the significant determinants of these outflows have themselves grown more volatile over time.  The determinants of outflows that have become more variable over time are the VIX and the volatility of GDP growth, which translate in to more volatile capital outflows in the 2006-2010 period relative to other years.

Our findings underscore that emerging markets should treat capital flows with caution; and that the outflows from emerging markets, both FDI and bank-related flows, have come to play a growing role and deserve greater attention from analysts and policy makers.


Barry Eichengreen

Professor of Economics and Political Science

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