A surge of foreign capital coming into a developing country can be a consequence of the natural resources it owns or its high growth rate. In developed countries, capital inflows are also driven by external factors such as global stock prices and foreign government policies. These are among the findings of new research by César Calderón and Megumi Kubota to be presented at the Royal Economic Society''s 2015 annual conference.
The researchers analyse capital inflows in 71 countries over the period 1975-2010 and find that just prior to the 2008 crisis, capital inflows increased dramatically across the world. Inflows to rich industrial nations went up from 9% to 24% of GDP, while in emerging market economies, they increased from 2% to 12% of GDP from 2001 to 2007.
Developing countries with high growth rates and abundant natural resources received more foreign investment. Countries that imported a lot more than they exported financed this through loans rather than an investment from abroad. Countries that received foreign capital in the form of loans more than investment faced a more severe drop in capital inflows during the crisis.
Countries whose foreign exchange rate is determined by market demand and supply rather than government policy see fewer swings in foreign capital inflows because their exchange rate is less likely to be artificially overvalued to attract foreign capital. But they are sensitive to global stock prices and political conditions. They also attract more capital in the form of loans rather than equity investment.
The authors conclude:
''Domestic factors are the main driving force of surges in the emerging markets economies while both domestic and external factors induce surges in the industrial countries.
''A reduction in global policy uncertainty would only trigger the beginning of a surge in gross inflows while an increase in global risk aversion would precede the end of that episode.''
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Advancing computer-related technology has made the world more interconnected. Consequently, cross-border asset trade has substantially increased in the global markets and brought tidal waves of gross capital flows in the economy over the past 15 years.
For example, Figure 1 illustrates the wild ride of the massive entry of gross capital flows to both industrial and emerging market economies (EMEs) during the pre-crisis period. A sharp retrenchment in 2008-9 and a post-crisis recovery in 2010 followed those surges in gross capital flows in the run-up to the crisis. Gross inflows to industrial countries went up from 9% of GDP in 2001 to 24% of GDP in 2007 while gross inflows to EMEs increased from 2% to 12% over the same period.
This study investigates what drives the global trends in gross capital flows. The main goal is to study whether the significant role of pull and push drivers (domestic and external factors, respectively) changed over the last decade.
In the main message, both domestic and external factors drive surges in private capital inflows. Domestic factors are the main driving force of surges in the EMEs while both domestic and external factors induce surges in the industrial countries.
The empirical assessment uses quarterly information on the level and the composition of gross capital flows for 71 countries from 1975q1 to 2010q4. The researchers compare the findings with those of net inflows. They first uncover a non-linear relationship between capital inflows and their corresponding pull-push determinants.
Accordingly, the quantile regression analysis shows that the behaviour of fundamental changes depends on the percentile of the distribution of capital flows. For example, strong growth prospects will help attract flows of foreign capital in the lower and middle parts of the distribution of changes in capital inflows.
Next, a complementary log-log analysis of surges confirms that, for example, natural resource abundance and higher GDP growth attract foreign investors to pull massive capital inflows into EMEs. Current account (CA) developments are a robust predictor of surges in net inflows and, hence, higher CA deficits bring a greater amount of foreign financing. Running CA deficits that are financed by equity-related capital flows rather than loan-related flows might prevent sudden reversals during downturns.
On the other hand, countries with more flexible exchange rate regimes reduce the incidence of surge episodes. Overvalued currencies rather than overall credit growth attract massive capital inflows. Foreign investors tend to deploy financing funds to primary commodity exporting countries depending on the evolution of commodity prices.
Surges in debt rather than in equity inflows are more likely to occur in countries with greater financial openness. Push factors, as captured by global policy uncertainty and global stock market volatility, predict subsequent surges in both net and gross inflows from the external to the domestic economy. Regional contagion also drives the higher incidence of surges.
Finally, the study examines what influences the probability of triggering or ending an episode of massive gross capital inflows. For example, the end of a surge may be preceded by a greater RER overvaluation. Consequently, the domestic currency is more likely to become overvalued in real terms throughout the episode rather than triggering the start of the surge.
On the other hand, rising debt inflows will signal not only the start but also the end of episodes of gross inflow surges. Therefore, a sharp build-up in debt securities also characterises surges in gross inflows. Regarding push factors, it is crucial to emphasise that a reduction in global policy uncertainty would only trigger the beginning of a surge in gross inflows while an increase in global risk aversion would precede the end of that episode.
Ride the Wild Surf: An investigation of the drivers of surges in capital inflows – César Calderón, Megumi Kubota
