Chapter 2 Literature Review
2.18 International Capital Flow Volatility
2.18.2 Factors Affecting Capital Flow Volatility
The empirical literature has until recently concentrated on the drivers of the magnitude of global financial variables, with these are divided into macro-economic, global and financial variables.
Recent contributions have mainly focused on the drivers of variability in gross global financial flows. For instance, Bacchetta and Van Wincoop (1998) show that the presence of incomplete information tends to generate volatility in emerging markets, a challenge that is very pronounced during the process of financial liberalization. Arguably, volatility tends to decline as investors realize new investment opportunities. Using a dynamic open economy, Aghion et al. (2004) show that instability of foreign financial capital is higher in countries with economies that are midway
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through in terms of financial growth. On the other hand, Martin and Rey (2006) examine the correlation between trade and financial globalization in relation to their effect on the risk of liberalizing countries. They reveal that foreign capital flow volatility is greater in economies that have begun the process of amalgamation with the global financial system without opening up trade.
The authors thus recommend that in order to fully benefit from globalization, developing economies should start by opening up to international trade.
Broner and Rigobon (2004b) investigate why global flows are more unstable in developing than in advanced countries using a sample of 58 countries and volatility estimated using the rolling standard deviation method. Their results show that variability in emerging markets was 80% higher than that in industrialized countries during the period 1995-2003. Further regressions reveal that domestic economic factors and global factors explain very little of the volatility differential between emerging and developed countries. Instead, it is explained by differences in the persistence of shocks to foreign financial flows and the probability of rapid spreading. Similarly, Forbes (2012) and Claessens et al. (2001) argue that global variables and contagion are key variables in driving extreme capital flow fluctuations around the world, especially in Asia. Global shocks in this case refer to any significant changes in global variables that simultaneously affect all countries such as changes in commodity prices, while contagion is the transmission of an extreme negative shock from one country to another (Forbes, 2012). Although Broner and Rigobon’s (2004b) argument is based on the persistence of shocks and contagion, Broto et al.
(2011) point out that variability of global flows is affected by a rise in per capita income, and improved quality of institutions as well as increased financial development. Broto et al. (2011) highlight that the different nature of global capital flows signifies the different volatility and stability dynamics between them. There are several mechanisms through which a shock can be transmitted, namely, trade, portfolio investment, banks and lending institutions.
Regarding extreme capital flow fluctuations in Asia, Forbes and Warnock (2012) reveal that debt flows contributed 80% of the surges and 73% of the sudden stops to capital flows from international investors. Although the study failed to quantify the sudden movements in gross capital flows attributable to equity flows, the authors concluded that sudden shifts in capital flows were a result of global risk and contagion variables such as trade and financial connections among economies. An important factor shaping the size and volatility of capital flows is the integration
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of global financial markets; this has led to an increase in trade in equity and bond markets since 1980 (Evans and Hnatkovska, 2014). According to Evans and Hnatkovska (2014), foreign capital flows are large and very volatile during the early stages of financial integration when the focus of global asset trading is on bonds. However, the size and volatility of capital flows decline as integration advances into world equity markets. A decline in volatility was observed during the period 1975-2007 in G-7 economies. In general, capital flow volatility in bond and equity markets slows down as global integration advances. For example, between 1975 and 1995, the volatility of debt outflows and debt inflows decreased by approximately 30% while that of equity outflows declined by about 40% (Evans and Hnatkovska, 2014).
The results reveal that external variables such as the global risk index, world output growth and the shadow rate (instead of the policy rate, the federal funds rate) are key drivers of foreign capital flow volatility in emerging and developing countries. An increase in the global risk index is expected to drive the variability of capital flows in developing countries. Save for portfolio flows, the growth of the US economy negatively impacts on the volatility of total flows in EMDEs. This implies that a rise in the growth of US output leads to greater stability of the global financial system.
Furthermore, (Evans and Hnatkovska, 2014) observed that commodity prices proxied by the oil price are a key determinant of capital flow volatility. For instance, a rise in the oil price was observed to decrease the variability of foreign equity flows and other investments that enter the formal sector, but increase the instability of other investments through the financial sector. Other domestic variables are also significant predictors of capital flow volatility. For example, a rise in domestic output decreases the volatility of global financial flows by attracting stable and long- term flows. However, trade openness or more open economies are usually hit by more volatile capital flows. Finally, Sole Pagliari and Ahmed (2017) suggest that the drivers of volatility are quite different from the determinants of the magnitude of capital flows. For example, global risk aversion is more significant than domestic macro-economic factors such as GDP growth in shaping the volatility of foreign investment flows. The volatility of foreign financial flows is crucial to both advanced and less developed countries and it is important for economists to determine its impacts on the growth of financial markets and overall economies. The determinants of capital flows and their variability are classified from A to D as shown in Table 2.1 below.
80 Table 2.1: Determinants of Capital Flow Volatility
Category Type of determinant Variable
A Domestic macro-economic • Per capita GDP
• GDP growth rate
• Inflation rate
• Reserves
• Public debt/deficit
B Domestic Financial • Stock market prices
• Stock market returns
• Interest rates
• Domestic banking
C Global factors • Global liquidity
• Real GDP growth rate
• Global interest rates
D Legal, institutional and
geopolitical
• Order and bureaucracy
Source: Broto et al. (2011), Neumann et al. (2009), Carp Lenuta (2014)
Note: The alphabetical letters A to D represent the categories of determinants of foreign capital flows as indicated in the literature.
A nonlinear relationship is anticipated between GDP per capita and growth rate and capital flow volatility. According to Carp (2014), the variables CPI and public deficits are generally used to indicate the quality of domestic macro-economic policies, and it is anticipated that economies with high inflation and public deficits will be characterized by volatile capital flows. Low foreign currency reserves signify a liquidity crisis in the affected areas and hence greater capital flow volatility. Furthermore, corruption, and low levels of bureaucracy provide information on the quality of domestic financial institutions and markets.
According to Sole Pagliari and Ahmed (2017), future studies should comprehensively investigate the different aspects of capital flow volatility such as its dynamic linkages with financial depth.
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This motivated the current study’s focus on the linkages between capital flow volatility and financial depth.