Examining the response of gross capital flows in emerging market economies to US
and global financial shocks, the authors find that the stabilizing role played
by domestic investors may offset the behavior of foreign investors when these
shocks occur. In particular, foreign investors tend to retrench from emerging
markets during these periods, but the impact of their actions is largely offset
by sizable asset repatriation by domestic investors.
The authors study the response of gross capital flows in emerging market economies
(EMEs) to different global financial shocks. Their focus is primarily on the
potentially stabilizing role of domestic investors, and they hypothesize that it
offsets the response of foreign investors to adverse global shocks. The authors find
evidence supporting this hypothesis.
How Is This Research Useful to Practitioners?
The authors’ results have three useful implications for practitioners. First,
they find that domestic investors play a stabilizing role when global risk-aversion
shocks occur by making sizable asset repatriations that largely offset the
retrenchment of foreign investors. When the global shock comes from monetary policy
rather than from risk aversion, the retrenchment of foreign investors is not offset
to nearly the same degree by repatriation from local investors. This result provides
additional insight into the differences in behavior between foreign and domestic
investors, which is important in determining the appropriate policy response when
such shocks are expected.
Second, the authors find that net capital flows—that is, the difference between
capital flows by foreign investors and capital flows by domestic investors—do
not appear to differ according to the degree of financial integration. The dynamics
of gross capital flows look substantially different, however, when comparing EMEs
with high and low degrees of financial integration. Specifically, highly integrated
economies are more sensitive to external financial shocks than less integrated
economies. This result provides critical insights into financial market development
Third, the authors find that global risk aversion shocks are followed by foreign
investor retrenchment across EMEs but that the decline in gross outflows is
significantly larger in economies with larger reserve buffers. Thus, to the extent
that this result makes domestic investors more willing to repatriate capital
invested abroad during global shocks, it implies another channel through which
higher reserves help increase the resilience to adverse external shocks.
How Did the Authors Conduct This Research?
The authors use data from 38 EMEs from the first quarter of 1990 to the second
quarter of 2014. They also obtain data on 13 financial and real variables from the
International Monetary Fund’s Balance of Payments statistics and from World
Economic Outlook, Haver Analytics, and Bloomberg. These variables are then used in a
panel vector autoregressive (PVAR) model, with which the authors quantify the
dynamic impact of global financial shocks on both net and gross capital flows to
EMEs. Two versions of the PVAR model are estimated: one focusing on net capital
flows and the other focusing on gross capital flows. In order to test the
potentially different impact of various external financial shocks, each model is
tested using three variants: a benchmark US shocks model that tests the impact of US
risk aversion and short-term interest rate shocks on capital flows, an augmented US
shocks model that allows for shocks to long-term US interest rates, and a model of
global shocks that redefines variables to account for reserve currencies in areas
other than the US dollar.
Because the PVAR model assumes the effects are homogenous across countries, the
authors conduct three additional tests to gain some insight into how heterogeneity
across countries could potentially affect the results. They study differences
between countries across the degree of financial integration, foreign asset and
reserve holdings, and types of flow.
Many researchers in this area focus on net capital flows, which makes the
authors’ emphasis on gross capital flows interesting. The sizable asset
repatriations by domestic investors that offset the retrenchment by foreign
investors suggest a transfer of asset holdings from foreign investors to domestic
investors during global shocks, which could, in turn, help explain the volatility
asset prices experience during crises.