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Chapter 9. Global Financial Shocks and Gross Capital Flows in Latin America

Author(s):
Dora Iakova, Luis Cubeddu, Gustavo Adler, and Sebastian Sosa
Published Date:
December 2014
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Author(s)
Gustavo Adler, Marie L. Djigbenou and Sebastián Sosa 

Global financial markets have been a source of sizable shocks over the past decade, with broad repercussions across emerging markets. Stark examples are the crisis triggered by the bankruptcy of Lehman Brothers in 2008, and the quantitative easing (QE) program in advanced economies in the aftermath of that crisis. Looking forward, new shocks are likely, as the reduction in the scale of bond purchases by the Federal Reserve—known as“QE tapering”—marks only the start of the normalization of U.S. monetary conditions. Against this backdrop, understanding the implications of global financial shocks in terms of their effect on capital flows to and from emerging market economies (EMEs)remains a key issue.

EMEs have become increasingly financially integrated with the rest of the world over the past two decades, raising their exposure to global financial shocks. However, a key feature of greater financial integration has been that both sides of EMEs’ balance sheets—that is, foreign liabilities as well as foreign asset holdings—have increased. As a result, EMEs have had increased resources at their disposal to offset balance of payment pressures arising during episodes of retrenchment by foreign investors that often occur at times of financial distress in global markets. Larger stocks of public sector foreign assets (primarily international reserves) are undoubtedly a source of resilience for these economies. But whether private foreign asset holdings are also a source of international liquidity, and the extent to which local investors play a stabilizing role following negative external shocks, remain open questions. Understanding the behavior of gross capital flows is thus critical, especially at the current juncture characterized by looming financial risks—including those stemming from uncertainty about the pace of U.S. monetary tightening.

A number of global financial shocks have occurred over the past two decades—some of them of sizable magnitude—that are useful for assessing the dynamics of gross capital flows to EMEs. These include global uncertainty shocks, as captured by the Chicago Board Options Exchange Market Volatility Index (VIX), sharp movements in the U.S. monetary policy (real) interest rates (the federal funds rate), and movements in the U.S. long-term (real) interest rates (for example, the 10-year Treasury bond rate). Figure 9.1 illustrates the frequency and magnitude of some of these shocks.

Figure 9.1Global Financial Shocks

(Percent, unless otherwise stated)

Sources: Cleveland Federal Reserve; and Haver Analytics.

Note: Large negative shocks are highlighted in gray.

1 Chicago Board Options Exchange Market Volatility Index.

2 Real interest rates based on forward-looking (one-year and ten-year) inflation expectations.

Global shocks have often had important effects on net capital flows to EMEs and, more broadly, on economic activity in these countries. These aspects have been addressed extensively in previous studies.1 However, attention to the dynamics of gross capital flows—and especially to the potential stabilizing role played by local investors—has remained limited, despite some recent evidence of domestic investors playing such an offsetting role by repatriating foreign assets (Figure 9.2).

Figure 9.2Gross Capital Flows in Selected Countries

(Billions of U.S. dollars)

Sources: Haver Analytics; and authors’ calculations.

Note: Measured as two-quarter moving average.

For example, this phenomenon has been observed in the aftermath of large global uncertainty shocks—like the one experienced during the 2008–09 global financial crisis—as well as after the QE tapering shock in May 2013.2 Whether this is a generalized phenomenon across EMEs and types of financial shocks, however, remains unclear.

Some recent studies have focused on gross flows, examining whether episodes of net capital flow reversals were driven by declines in gross inflows (foreign investors retrenching from EMEs), surges in gross outflows (local investors accumulating external assets), or a combination of both (Powell, Ratha, and Mohapatra, 2002; Cowan and others, 2008; Rothenberg and Warnock, 2011; Forbes and Warnock, 2012; Bruno and Shin, 2012; Calderón and Kubota, 2013; and Bluedorn and others, 2013). A few papers (Cavallo and others, 2013) have also pointed to episodes of reversals of gross inflows that did not entail a reversal of net inflows (that is, residents fully offsetting the behavior of nonresident investors). A common thread among these studies is the notion that the behavior of foreign and local investors may be driven by different factors and may respond differently to certain shocks. As a result, domestic investors could potentially play a stabilizing role, for example by repatriating foreign assets when foreign investors are liquidating positions in EMEs (that is, during episodes of gross inflow reversals). For instance, a recent study by Broner and others (2013) finds a positive correlation between gross inflows and gross outflows, and that the behavior of domestic investors tends to offset that of foreigners during financial crises.3 None of these studies, however, has explored the link between specific global shocks and gross flows, despite the fact that this is critical to assess EMEs’ vulnerabilities to (likely) changes in global financial conditions.4

This chapter contributes to this literature by examining the dynamic response of net and gross capital flows to key global financial shocks, including short- and long-term U.S. interest rates. Specifically, the chapter uses a panel vector autoregression (PVAR) setting that encompasses a group of 38 EMEs over the period from 1990:Q1–2012:Q4 to study (1) the extent of the offsetting role played by domestic investors in response to adverse foreign shocks, and (2) whether this depends on the specific nature of the shock (in particular, uncertainty or short-and long-term interest rate shocks). The chapter also examines differences across EME regions, across countries with different characteristics (for example, financial integration and capital account openness), and across types of capital flows. Finally, the estimated model is used to discuss the impact of shocks to U.S. economic activity on capital flows to EMEs.5

This chapter follows the terminology used in recent papers, referring to gross inflows as the net movement in international liabilities of a country, and gross outflows as the net movement in international assets.6 While balance of payments accounting is based on doubly-entry, movements in the asset and liability sides of the financial account may differ because some operations involve an offsetting entry in the current account or a change in international reserves. As is standard in the literature, the analysis of gross flows is based on the notion that gross inflows (outflows) primarily reflect foreign (domestic) investors’ behavior. That is, shocks to gross flows are primarily supply-driven.7

After controlling for U.S. interest rates, U.S. GDP growth, and commodity prices, the analysis finds that global uncertainty shocks lead to net capital outflows from EMEs, but the impact is generally short-lived and relatively moderate. The response of net flows, however, hides sizable dynamics in gross flows. In fact, the analysis finds evidence that while foreigners retrench from EMEs during adverse shock events, residents repatriate foreign assets, playing a meaningful offsetting role. In the case of (pure) U.S. interest rate shocks, the analysis finds important differences between the impact of short- and long-term interest rate shocks. Domestic investors do not appear to play a mitigating role in the case of short-term interest rate shocks. In fact, a positive shock to the federal funds rate is associated with statistically significant outflows by both foreign and local investors, although the magnitudes are relatively moderate. In the case of shocks to long-term U.S. interest rates, in contrast, the analysis finds evidence of asset repatriation, but this offsetting force falls short of balancing the retrenchment of nonresidents (thus implying nontrivial net capital outflows).8Table 9.1 summarizes the main results.

Table 9.1Impact of Global Financial Shocks on Capital Flows to Emerging Market Economies
U.S. Interest Rates
Uncertainty (VIX)Short-Term RateLong-Term Rate
Net FlowsLimited net impactModerate net outflowsLarger net outflows
Gross InflowsSizable retrenchmentLimited retrenchmentSizable retrenchment
Gross OutflowsSizable repatriation of foreign assetsLimited accumulation of foreign assetsModerate repatriation of foreign assets
Source: Authors’ calculations.Note: General results for emerging market economies. Magnitudes vary somewhat for different analytical groups (as discussed in the text). VIX = Chicago Board Options Exchange Market Volatility Index.
Source: Authors’ calculations.Note: General results for emerging market economies. Magnitudes vary somewhat for different analytical groups (as discussed in the text). VIX = Chicago Board Options Exchange Market Volatility Index.

These results suggest that, while increased financial integration has raised EMEs’ exposure to global financial shocks, increased foreign asset holdings are likely to play an important—although not complete—stabilizing role. The results also shed light on how EMEs are likely to react to the Federal Reserve’s exit from QE, as the latter is likely to entail higher longer-term U.S. interest rates.

This chapter first discusses the empirical approach used and then presents the main results and their robustness and extensions, before concluding with a summary of key takeaways.

Empirical Approach

The objective of this chapter is to examine the dynamic effect of global financial shocks on net and gross capital flows into EMEs. Since financial shocks are often accompanied by other shocks (for example, to U.S. output growth and commodity prices) and those shocks may by themselves have important implications for capital flows to and from EMEs, a multivariate approach is critical to disentangle the pure effect of each of the shocks.9

Panel Vector Autoregression Model

A PVAR model is employed to quantify the dynamic impact of global financial shocks on both net and gross capital flows to EMEs. Specifically, we estimate a first-order PVAR model that treats all the variables in the system as endogenous and allows for unobserved country heterogeneity. Two versions of the model are estimated, focusing on net capital flows and gross capital flows separately.10 In both cases the specification takes the following reduced form:

with time index t = 1,…, T; country index i = 1,…, N, where yi is a vector of six variables for country i {G, VIX, INT, INT_10Y, COMMP, NKFi} in the specification using net capital flows (NFKi) or a vector of seven variables {G, VIX, INT, INT_10Y, COMMP, GKIi, GKOi} in the specification using gross capital flows (GKIi and GKOi); γi is a vector of country specific fixed effects; and εi,t denotes a vector of reduced form errors. As mentioned previously, we follow the terminology used in the recent literature, calling gross capital inflows (outflows) the (net) change in international liabilities (assets). Both net and gross flows are expressed in annualized terms and in percent of trend GDP (expressed in U.S. dollars) to properly normalize the flows while preventing the measure from being contaminated by contemporaneous movements in GDP. Our measures of international financial conditions include global uncertainty (proxied by the VIX), changes in the short-term U.S. real interest rate (the federal funds rate, INT), and changes in the long-term U.S. real interest rate (the 10-year Treasury bond rate, INT_10Y).11 Real interest rates are computed using forward-looking inflation expectations at 1- and 10-year horizons, and first differences are used to ensure series stationarity.12 U.S. real output growth (G) and (the log difference of) a broad index of commodity prices (COMMP) are also included, mainly as control variables. Table A9.2.1 in Annex 9.2 describes the variables used in the empirical exercise in detail.

The main objective is to identify the dynamic response of capital flows to EMEs to global uncertainty and U.S. interest rate shocks. Two features of the selected specification are critical to estimate such effects. First, controlling for (as well as allowing feedback through) movements in U.S. real output and commodity prices is key to ensuring that the estimated effects reflect those of pure global financial developments and not the response of financial variables to real shocks. Second, as there is significant cross-section heterogeneity in terms of the level of capital flows (especially with regard to gross flows), the model includes country fixed effects (γi) that capture the countries’ unobserved time-invariant idiosyncratic characteristics. However, to avoid the bias associated with the fact that fixed effects would be correlated with the regressors due to the lags of the dependent variables, we use forward mean-differencing, also referred to as the “Helmert procedure,” following Love and Zicchino (2006) and Arellano and Bover (1995).13

Once the PVAR is estimated, we compute impulse response functions to examine the effect of global financial shocks on capital flows. Since only the reduced form version of the model is estimated, imposing additional structure on the error variance-covariance matrix is required in order to identify structural shocks. We use a standard Choleski decomposition to orthogonalize the reduced form errors. Our selected ordering (where the more exogenous variables of the model precede the endogenous ones) is as follows: {G, VIX, INT, INT_10Y, COMMP, NKF} and {G, VIX, INT, INT_10Y, COMMP, GKI, GKO} for the specifications using net flows and gross flows, respectively. Within the global variables, this order assumes primarily that financial conditions and commodity prices respond contemporaneously to U.S. output shocks, but that U.S. output-only responds to changes in financial conditions and commodity prices with a lag. This assumption is consistent with the notion that interest rates and prices are forward-looking variables.14

Confidence intervals around the impulse responses are generated with Monte Carlo simulations by randomly generating a draw of the coefficients of the model and recalculating the impulse-responses. This procedure is repeated 700 times to compute the 5th and 95th percentiles of the impulse responses.

Data

The sample encompasses quarterly data for a group of 38 EMEs over the period from 1990:Q1 to 2012:Q4. Table A9.2.2 in Annex 9.2 presents the list of countries and the time coverage for each of them. The data sources are primarily the IMF’s Balance of Payments Statistics (version BP6TS) and World Economic Outlook, Haver Analytics, and the Federal Reserve Bank of Cleveland database. Table 9.2 reports key summary statistics for the variables of the model.

Table 9.2Descriptive Statistics
VariablesMeanStandard DeviationMinimumMaximumObservations
NKFOverall3.777.65−62.2462.96N = 2,639
Between3.60−5.439.53n = 38
Within6.87−68.0157.19T¯ = 69.45
GKIOverall6.848.96−37.8975.25N = 2,755
Between3.791.0515.62n = 38
Within8.15−45.5967.91T¯ = 72.5
GKOOverall3.026.65−39.2062.60N = 2,663
Between2.99−0.3612.02n = 38
Within6.02−42.8158.99T¯ = 70.08
VIXOverall20.467.4911.0358.74T = 92
INTOverall−0.0870.706−1.9322.017T = 91
INT_10YOverall−0.0620.271−0.8600.775T = 91
COMMPOverall0.0120.090−0.3800.358T = 91
Source: Authors’ calculations.Note: NKF = net capital flows; GKI = gross capital inflows; GKO = gross capital outflows; VIX = Chicago Board Options Exchange Market Volatility Index; INT = federal funds rate; INT_10Y = 10-year Treasury bond real rate; COMMP = broad index of commodity prices.
Source: Authors’ calculations.Note: NKF = net capital flows; GKI = gross capital inflows; GKO = gross capital outflows; VIX = Chicago Board Options Exchange Market Volatility Index; INT = federal funds rate; INT_10Y = 10-year Treasury bond real rate; COMMP = broad index of commodity prices.

Results

Benchmark Specification

Figures 9.3 and 9.4 illustrate the dynamic response of capital flows to EMEs to external shocks in our benchmark model, using net and gross flows, respectively. The full set of responses of capital flows to global shocks, as well as a characterization of the magnitude and persistence of the shocks, is presented in Figure A9.2.1 in Annex 9.2.

Figure 9.3Response of Net Capital Flows to Global Financial Shocks

Source: Authors’ calculations.

Note: Response to a one standard deviation shock to the VIX (5 units), the federal funds interest rate (0.66 percentage point), and the 10-year Treasury bond interest rate (0.23 percentage point). Time horizon in quarters. Variables defined and explained in Annex Table A9.2.1.

Figure 9.4Response of Gross Capital Flows to Global Financial Shocks

Source: Authors’ calculations.

Note: Response to a one standard deviation shock to the VIX (5 units), the federal funds interest rate (0.66 percentage point), and the 10-year Treasury bond interest rate (0.23 percentage point). Time horizon in quarters. Variables defined and explained in Annex Table A9.2.1.

Increases in global uncertainty (left panels in Figures 9.3 and 9.4) are found to have a very limited negative impact on net capital flows to EMEs. This result largely reflects the marked response of gross capital outflows. Indeed, while a VIX shock leads to a sizable and sustained reversal in gross inflows, the impact is largely offset by a decline in gross outflows (that is, asset repatriation by local investors). Specifically, a one standard deviation shock to the VIX (about 5 points) leads to an average decline in gross inflows of about 1½ percent of annual GDP over six quarters and to a decline in gross outflows of a broadly similar magnitude.

A shock to the U.S. short-term (real) interest rate also leads to a decline in net flows to EMEs (middle panels in Figures 9.3 and 9.4), although the economic significance is relatively small. Indeed, a one standard deviation shock (about 0.7 percentage points) leads to a cumulative decline in net capital inflows of about 0.2 percent of annual GDP over two quarters. This fall in net inflows reflects both a decline in gross capital inflows and an increase in gross capital outflows. These results suggest that domestic investors do not play a meaningful stabilizing role in the context of short-term foreign interest rate shocks.

A shock to the 10-year Treasury bond rate, in turn, appears to have a significant—and distinct—impact on capital flows to EMEs (right panels in Figures 9.3 and 9.4). This finding is especially relevant at the current juncture, since the main effect of the Federal Reserve’s exit from QE will be, at least in the short term, an upward drift in the longer-term interest rates in the United States. Gross inflows decline markedly after an increase in the 10-year rate, with the impact being significantly larger than in response to short-term interest rate shocks. Furthermore, the estimated effect is economically meaningful, pointing to a cumulative decline of gross inflows of 1.8 percent of GDP over six quarters in response to an increase of 100 basis points in the 10-year Treasury bond rate. In contrast to the case of short-term rate shocks, we find that domestic residents play a stabilizing role by repatriating foreign assets. The extent of that stabilizing role, however, is substantially smaller than the fall in gross inflows. Therefore, the impact on net capital inflows is negative, as in the case of the short-term rate shock.15 These results appear broadly in line with the anecdotal evidence on capital flows following the QE tapering shock of May 2013, which showed that, in many EMEs, the retrenchment of foreign investors was partially offset by asset repatriation by residents.

Controlling for U.S. GDP growth in the model ensures that the estimated effects discussed above reflect those of pure U.S. interest rate shocks, rather than the endogenous response of interest rates to U.S. output shocks. These can be interpreted as unexpected changes in markets’ expectations about the path of monetary policy rates, either because of surprises in inflation or changes in perceptions about the Federal Reserve’s “reaction function”. This is a key point, especially in assessing the effect of QE tapering on capital flows at the current juncture. In this context, whether the rise in interest rates reflects improved economic conditions in the United States or a pure monetary policy shock could have very different implications in terms of the impact on capital flows to EMEs. In this regard, although not the main focus of the chapter, an interesting result from the estimated PVAR model is that net capital inflows to EMEs respond positively to a positive disturbance to U.S. GDP growth. This occurs despite the associated increase in the U.S. interest rate (Figure 9.5), suggesting that the effect through real linkages outweighs the impact through financial channels. Furthermore, a positive response of net flows reflects a repatriation of external assets by residents that is larger than the fall in nonresident capital inflows. This finding suggests that a normalization of U.S. monetary policy that occurs primarily as a result of an improving growth outlook would have only a moderate impact on EMEs.

Figure 9.5Response of Gross Capital Flows to Other Foreign Shocks

Source: Authors’ calculations.

Note: Response to a one standard deviation shock to U.S. real GDP growth (0.6 percentage point) and commodity prices (7.5 percentage points). Time horizon in quarters. See Annex Table A9.2.1 for definitions of variables.

Finally, the analysis finds that a positive shock to international commodity prices tends to have a positive impact on gross capital inflows (foreign investors increase their net purchases of domestic assets). Net inflows also increase, though to a lesser extent than gross inflows, owing to the positive response of gross outflows (residents increase their net purchases of external assets).

The results discussed above are robust to alternative specifications of the model (not presented here). Specifically, we check the results in a model with additional lags, as well as changing the ordering of the variables in the Choleski decomposition, both within the group of global variables and the gross capital flow series.

Extensions

Financial Integration

The analysis examines whether results depend on the country’s degree of financial integration with the rest of the world. To this end, we split the sample in two groups based on each country’s average degree of financial integration during the sample period, distinguishing those that were above or below the median value for the whole sample. Financial integration is measured as the sum of total foreign assets and foreign liabilities, in percent of GDP, using the updated version of the dataset created by Lane and Milesi-Ferretti (2007).

Interesting differences are found between the more-integrated and less-integrated economies (Figure 9.6). While global uncertainty shocks do not appear to have a statistically significant effect on net capital inflows to financially integrated EMEs, they do have a sizable impact on the less-integrated economies. Although both groups are subject to a sharp drop in gross capital inflows, the extent of asset repatriation by local investors is much larger in the more financially integrated economies (fully offsetting the drop in gross inflows). Short-term interest rate shocks, in turn, have a negative impact on net inflows to both groups of countries, yet the impact is larger in financially integrated economies. This mainly reflects the fact that the increase in gross outflows tends to be larger in the more financially integrated economies, where domestic investors appear to be highly sensitive to this type of shock. Finally, foreign investors reduce their accumulation of local assets (that is, gross inflows decline) and local investors reduce their holdings of foreign assets (that is, gross outflows fall) in response to a shock to the 10-year Treasury rate in both groups of countries. Gross flows appear to be, at least on impact, more sensitive in the case of the more financially integrated economies. The offsetting effect of asset repatriation is relatively small, so net capital inflows decline in both groups of countries.

Figure 9.6Response of Capital Flows to Global Financial Shocks: The Role of Financial Integration

Source: Authors’ calculations.

Note: See Annex Table A9.2.1 for definitions of variables.

1 Based on measures of foreign assets and liabilities, in percent of GDP, from Lane and Milesi-Ferretti (2007) updated dataset.

Alternatively, we split the sample using a measure of financial integration based on the degree of capital account openness, as measured by Quinn, Schindler, and Toyoda (2011). The results are roughly similar (Figure 9.7). Uncertainty shocks do not have a significant impact on net capital flows to EMEs with more open capital accounts, as asset repatriation by residents fully offsets the drop in gross capital inflows. After short-term interest rate shocks, in contrast, there is no asset repatriation by residents, as they actually increase their purchase of foreign assets. A shock to the 10-year Treasury bond rate has a negative impact on net capital inflows, as the decline in gross outflows is not large enough to completely offset the fall in gross inflows. In economies with more capital account restrictions, we find that results are qualitatively similar but entail much smaller magnitudes in the response of both gross inflows and outflows, as expected given the partial restrictions on capital mobility.

Figure 9.7Response of Capital Flows to Global Financial Shocks: The Role of Capital Account Openness

Source: Authors’ calculations.

Note: See Annex Table A9.2.1 for definitions of variables.

1 Based on overall index of capital account openness, as measured by Quinn, Schindler, and Toyoda (2011).

Types of Flows

The analysis next examines the response of different types of capital flows to global shocks. With this aim, we break up the series of net and gross flows into their foreign direct investment (FDI) and non-FDI components. We find qualitatively similar responses for both types of flows to global uncertainty shocks (Figure 9.8), but, as expected, much larger sensitivities in the case of non-FDI flows (mainly portfolio and other debt flows).16 The response of non-FDI (gross and net) flows to a U.S. short-term interest rate shock is similar to that of total flows, with declines in gross inflows and increases in gross outflows. However, the impact of such shocks on FDI (gross and net) inflows appears to be insignificant. The impact of a shock to the U.S. 10-year interest rate on non-FDI (gross and net) flows is similar to that on total flows. Both net and gross inflows decline, while gross outflows also fall—although the magnitude of asset repatriation is relatively small. The sensitivity of FDI gross flows to a shock to the 10-year rate is much lower, with the impact on net flows being insignificant. The responses of the two types of flows to U.S. growth shocks are also different (Figure A9.2.2 in Annex 9.2). While improvements in economic activity in the United States appear to induce non-FDI net inflows to EMEs, the response of net inflows of FDI is negative. Finally, both FDI and non-FDI net and gross inflows react positively to increases in commodity prices.

Figure 9.8Response of Capital Flows to Global Financial Shocks: Type of Flows

Source: Authors’ calculations.

Note: See Annex Table A9.2.1 for definitions of variables.

Regional Perspective

Potential differences across regions are explored by splitting the sample into four EME regions: Asia, Europe, Latin America, and others. Qualitatively, the main results of the benchmark specification hold for the most part for all regions. There are, however, differences across them in terms of the magnitude of the impact of the shocks analyzed (Figure 9.9). Most interesting to note is:

  • Global uncertainty shocks appear to have a particularly large impact on net inflows to Latin American (and to a lesser extent Asian) EMEs. This reflects a sizable decline of gross inflows (twice as large as in the benchmark specification), only partially offset by asset repatriation by residents. In emerging Europe, in contrast, the effect on both gross and net inflows is not significant.

  • The negative impact of U.S. short-term interest rate shocks on net flows appears to be (qualitatively) more uniform across regions, although it is considerably larger in emerging Europe. In this region, the sharp decline is mostly driven by the large fall in gross inflows (the increase in gross outflows by local investors also contributes, but to a much lesser extent). On the other hand, in Asia and Latin America the decline in net inflows is largely explained by increases in foreign asset accumulation by residents.

  • A shock to the U.S. 10-year interest rate has a negative impact on net capital inflows in all EME regions, except in emerging Europe. The fall in net flows is especially large in Latin America, reflecting a substantial decline in gross inflows that is not offset by the decline in gross outflows. Interestingly, only in this region (and to a lesser extent in Asia) do local investors respond to shocks to the U.S. 10-year rate by repatriating foreign assets.

Figure 9.9Response of Capital Flows to Global Financial Shocks: A Regional Perspective

Source: Authors’ calculations.

Note: See Annex Table A9.2.1 for definitions of variables and Annex Table A9.2.2 for list of countries.

Conclusions

This chapter studied the dynamic response of gross capital flows in EMEs to different global financial shocks, with a focus on the possible stabilizing role played by domestic investors in offsetting the behavior of foreign investors. The analysis finds evidence of such a role, but its existence and magnitude depend on the type of shock.

Local investors appear to offset the behavior of nonresidents in the face of global uncertainty shocks, as well as shocks to long-term U.S. interest rates. In the former case, sizable asset repatriations largely offset the retrenchment of nonresidents, except in Latin America. In this region, global uncertainty shocks appear to have a particularly large negative impact on net inflows, reflecting a sizable decline of gross inflows (twice as large as in the other EMEs), which is only partially offset by residents’ asset repatriation. In the case of long-term U.S. interest rate shocks, the offsetting effect is much more limited (with shocks causing net outflows from EMEs). In the case of short-term U.S. interest rate shocks, on the other hand, residents and nonresidents appear to behave alike (shifting capital toward higher interest rates), although magnitudes appear to be economically moderate.

These results suggest that, while increased financial integration over the past two decades may have raised the exposure of EMEs to global financial shocks, increased foreign asset holdings are likely to play an important—though not complete—stabilizing role. The findings also have important implications for assessing the possible impact of the U.S. Federal Reserve’s exit from quantitative easing going forward. In particular, the analysis finds that a rise in long-term U.S. interest rates would have only moderate effects on capital flows to EMEs if it is mainly driven by positive developments in U.S. economic activity. If, in contrast, the rise largely reflects a pure U.S. interest rate shock, the impact would be more sizable, as asset repatriation would only play a partial stabilizing role.

Annex 9.1. A Simple Event Analysis

As a first attempt to explore the potential impact of global financial shocks on capital flows to emerging market economies (EMEs), a simple event analysis is performed. The exercise entails an examination of net and gross capital flows for a sample of 38 EMEs, centering them at the quarter of the largest variation of the VIX, the federal funds rate, and the U.S. 10-year Treasury bond interest rate within the shock episodes depicted in Figure 9.1 (Table A9.1.1 presents the details about the episodes).17 The focus is primarily on adverse shocks (that is, sharp increases in each of these variables). Flows are de-meaned to exclude possible country-specific level effects.

Table A9.1.1Episodes of Global Financial Shocks
VIX ShocksU.S. Federal Funds Interest Rate Shocks10-Year U.S. Treasury Bond Interest Rate Shocks
EpisodeVIX LevelEpisodeFederal Funds Rate LevelEpisode10-Year Rate Level
StartEndStart-1Avg.PeakEnd+1StartEndStart-1Avg.PeakEnd+1StartEndStart-1Avg.PeakEnd+1
1990:Q11990:Q49.623.026.022.31994:Q21995:Q2−0.11.62.92.51994:Q21994:Q42.93.94.14.0
1997:Q41997:Q422.527.427.421.32000:Q32001:Q12.43.33.41.51999:Q22000:Q12.22.93.22.9
1998:Q31999:Q121.528.929.924.42004:Q42006:Q1−1.40.92.72.12005:Q42006:Q21.92.12.42.4
2002:Q32003:Q121.831.935.121.5
2008:Q42009:Q225.145.658.725.5
2011:Q32011:Q417.430.130.318.3
Source: Authors’ calculations.Note: Based on quarterly averages. In percent, except for the VIX index. VIX = Chicago Board Options Exchange Market Volatility Index.
Source: Authors’ calculations.Note: Based on quarterly averages. In percent, except for the VIX index. VIX = Chicago Board Options Exchange Market Volatility Index.

This simple exercise fails to unveil any discernible pattern (Figure A9.1.1), except in the case of uncertainty shocks. Spikes in global uncertainty appear to affect capital flows to EMEs significantly, with a marked deceleration in net inflows (upper left panel). The decline in net inflows is largely driven by the behavior of gross inflows, which display a sizable reversal during these episodes. Gross outflows, on the other hand, appear to play a meaningful offsetting role only in some cases (as illustrated by the drop in the line corresponding to the 25th percentile). Furthermore, there is no evidence of acceleration in gross outflows, pointing to asymmetric behavior of residents, who do not exacerbate reversals in gross capital inflows, and in some cases help to offset them.

Figure A9.1.1Capital Flows to Emerging Markets around Negative Global Financial Shock Episodes

(Percent of GDP)

Sources: IMF, Balance of Payments Statistics; and authors’ calculations.

Note: Negative episodes refers to increases in global uncertainty or interest rates. De-meaned series. Gross outflows (inflows) refer to asset (liability) side flows—that is, positive numbers denote outflows (inflows).

Interestingly, in the case of (U.S.) interest rate shocks (both short- and long-term rates), the analysis finds no clear pattern for the response of capital flows. These results hold, broadly, across different EME regions (Figures A9.1.2A9.1.4). The lack of a clear pattern is likely to reflect the joint occurrence of shocks, as global financial conditions are typically highly correlated with economic activity and commodity prices (Figure A9.1.5). This high correlation stresses the importance of disentangling the effect of financial shocks from other (real) external shocks in a multivariate setting. It should be noted that such a correlation is also relevant in the case of uncertainty (VIX) shocks. However, while in the latter cases the effect of economic activity and financial shocks on EMEs’ flows are likely to be of the same sign (with weaker economic activity as well as distress in global financial markets negatively affecting flows to EMEs), this is unlikely to be the case for U.S. interest rate shocks.

Figure A9.1.2Capital Flows to Emerging Markets around Global Uncertainty Shock Episodes

(Percent of GDP)

Source: IMF, Balance of Payments Statistics; and authors’ calculations.

Note: De-meaned series. Gross outflows (inflows) refer to asset (liability) side flows—that is, positive numbers denote outflows (inflows).

Figure A9.1.3Capital Flows to Emerging Markets around Federal Funds Rate Shock Episodes

(Percent of GDP)

Sources: IMF, Balance of Payments Statistics; and authors’ calculations.

Note: De-meaned series. Gross outflows (inflows) refer to asset (liability) side flows—that is, positive numbers denote outflows (inflows).

Figure A9.1.4Capital Flows to Emerging Markets around U.S. 10-Year Treasury Bond Interest Rate Shock Episodes

(Percent of GDP)

Sources: IMF, Balance of Payments Statistics; and authors’ calculations.

Note: De-meaned series. Gross outflows (inflows) refer to asset (liability) side flows—that is, positive numbers denote outflows (inflows).

Figure A9.1.5Global Financial Conditions, U.S. Output, and Commodity Prices

(Percent, unless otherwise stated)

Sources: Cleveland Federal Reserve; and Haver Analytics.

1 Chicago Board Options Exchange Market Volatility Index.

2 Real interest rates based on forward-looking (1-year and 10-year) inflation expectations.

3 IMF broad commodity price index. Annual percentage change.

Annex 9.2. Additional Tables and Figures

Figure A9.2.1Benchmark Model: Impulse Responses

Source: Authors’ calculations.

Note: See Annex Table A9.2.1 for definitions of variables.

Figure A9.2.2Response of Gross Capital Fows to Other Foreign Shocks: Type of Flows

Source: Authors’ calculations.

Note: Response to a one standard deviation shock to U.S. real GDP growth (0.6 percentage point) and commodity prices (7.5 percentage points). Time horizon in quarters. See Annex Table A9.2.1 for definitions of variables.

Table A9.2.1List of Variables
AbbreviationDefinitionsDetailsSources
GKIGross capital inflowsTotal liabilities in terms of trend nominal GDP in U.S. dollars: (FDl_Liab + PI_Liab + OI_ Liab)/GDP. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
GKOGross capital outflowsTotal Assets in terms of trend nominal GDP in U.S. dollars: (FDl_Assets + Pl_Assets + OI_ Assets)/GDP. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
NKFNet capital flowsNet liabilities flows in terms of trend nominal GDP in U.S. dollars: GKI - GKO. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
GKO_FDIDirect investment abroadNet acquisition of financial assets: FDI, in terms of trend nominal GDP in U.S. dollars. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
GKl_FDIDirect investment in reporting countriesNet incurrence of financial liabilities: FDI, in terms of trend nominal GDP in U.S. dollars. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
NKF_FDINet foreign direct investmentNet FDI in terms of trend nominal GDP in U.S. dollars: GKI_NFDI – GKO_FDI. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
GKO_FDINon-foreign direct investment assetsNet acquisition of financial assets portfolio investment and other investment, in terms of trend nominal GDP in U.S. dollars. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
GKLFDINon-foreign direct investment liabilitiesNet incurrence of financial liabilities: portfolio investment and other investment, in terms of trend nominal GDP in U.S. dollars. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
NKF_FDINet non-foreign direct investmentNet Non-FDI, in terms of trend nominal GDP in U.S. dollars: GKI_NFDI - GKO_NFDI. Forward de-meaned (Helmert transformation).IMF, Balance of Payment BP6TS; and authors’ calculations.
GDPNominal detrend GDP, in U.S. dollarsHodrick-Prescott filter.IMF, World Economic Outlook
VIXChicago Board Options Exchange Market Volatility IndexForward de-meaned (Helmert transformation).Wall Street Journal
INTReal federal funds rateFederal funds rate deflated by expected inflation.Federal Reserve Bank of Cleveland
INT_10YReal 10-year U.S. government bonds10-year U.S. Treasury bond interest rate deflated by 10-year inflation expectations.Federal Reserve Bank of Cleveland
COMMPBroad index of real commodities pricesForward de-meaned by Helmert transformation.IMF, World Economic Outlook
USGDPReal U.S. GDP growthForward de-meaned by Helmert transformation.IMF, World Economic Outlook
Dum_IIPDegree of financial integration based on international investment position (IIP)Take value 1 if IIP in terms of GDP of the country is greater than or equal to the median of the sample.Lane and Milesi-Ferretti udpated database
Dum_kapoenNet degree of openness on net capital accountTake value 1 if the degree of openness is greater than or equal to the median of the sample, if more open.Chinn-lto Index
Dum_kaoDegree of openness on capital outflowsTake value 1 if the degree of openness is greater than or equal to the median of the sample, if more open.Chinn-lto Index
Dum_kaiDegree of openness on capital inflowsTake value 1 if the degree of openness is greater than or equal to the median of the sample, if more open.Chinn-lto Index
Table A9.2.2Sample of Countries
IFS codeNameIFS codeName
213Argentina273Mexico
911Armenia686Morocco
913Belarus728Namibia
223Brazil564Pakistan
918Bulgaria283Panama
228Chile288Paraguay
924China293Peru
233Colombia566Philippines
238Costa Rica964Poland
960Croatia968Romania
258Guatemala922Russia
944Hungary456Saudi Arabia
534India199South Africa
536Indonesia578Thailand
439Jordan186Turkey
916Kazakhstan926Ukraine
941Latvia298Uruguay
946Lithuania299Venezuela
962FYR Macedonia582Vietnam
548Malaysia
Note: Includes countries classified as emerging market and developing countries according to the IMF’s World Economic Outlook classification. IFS = IMF, International Financial Statistics.
Note: Includes countries classified as emerging market and developing countries according to the IMF’s World Economic Outlook classification. IFS = IMF, International Financial Statistics.
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The vast literature on sudden stops comes to mind (Calvo, 1998; Dornbusch and Werner, 1994; Dornbusch, Goldfajn, and Valdés, 1995; Calvo, Izquierdo, and Mejía, 2004; Calvo and Reinhart, 2000; Edwards, 2004), although this strand of work has focused primarily on abrupt reversals in net capital inflows. More recently, Bluedorn and others (2013), and IMF (2013) have also studied the impact of global financial shocks on net flows to EMEs. Finally, Adler and Tovar (2013) have studied the impact of global financial shocks on economic activity, and the role of financial integration in amplifying or mitigating such impact.

On May 22, 2013, the Federal Reserve Board chairman announced for the first time the Federal Reserve’s intentions to start a process of gradually reducing the scale of bond purchases (“QE tapering”). The mere announcement was followed by a sharp rise in long-term U.S. interest rates, and important repercussions on capital flows to EMEs.

Financial crises, however, are defined in an ad hoc manner that makes it difficult to associate these events with specific external shocks.

Forbes and Warnock (2012) and Calderón and Kubota (2013) study the impact of global financial shocks, but in probit settings that are not well-suited to grasp the impact on capital flows and their dynamic responses outside sudden-stop events.

The net effect of this type of shock is of particular interest at the current juncture and, a priori, ambiguous. Positive economic shocks to activity in the United States would normally lead to a tightening of monetary conditions there, pushing flows away from EMEs. At the same time, better economic prospects could attract flows to these economies, especially to U.S. trading partners.

Specifically, a positive gross capital inflow is an accumulation of net foreign liabilities, while a positive gross capital outflow entails an accumulation of net foreign assets.

While this could be controversial in the analysis of idiosyncratic shocks, it is less likely to be so in the context of global financial shocks studied in this chapter. Results confirm that movements in gross inflows and outflows are not symmetric.

Although not the main focus of the analysis, we also find that positive growth disturbances in the United States lead to net capital inflows to EMEs, despite the associated rise in U.S. interest rates.

In fact, a simple event analysis confirms that even in episodes of sizable global financial shocks, their impact on flows to EMEs is often not visible in a bivariate setting (see Annex 9.1).

We follow the recent literature in studying overall flows, excluding international reserve flows. A known shortcoming of this approach is that both private and public flows are included, because of data limitations, despite the fact that they may not behave in the same way in the face of global financial shocks. Bluedorn and others (2013) show that official flows can play an important offsetting role in some cases—although this is a relevant feature for only a small number of countries in our sample that experienced crises (that is, countries that were impaired from borrowing in external financial markets).

The VIX has recently been used as a measure of global uncertainty or financial stress. Bloom (2009) shows that this volatility index is highly correlated with measures of micro- and macro-level uncertainty, including from financial variables. More recently, Carrière-Swallow and Céspedes (2011), Adler and Tovar (2013), and Adler and Sosa (2013) also used the VIX to measure global uncertainty shocks.

Although we rely on real interest rates, shocks to them are primarily driven by nominal innovations, as inflation expectations tend to be highly stable for the sample period and the countries under study.

This transformation is an orthogonal deviation, where each observation is expressed as a deviation from the mean of all the future observations. Each observation is weighted so the variance is standardized. The procedure preserves homoscedasticity and does not induce serial correlation (Arellano and Bover, 1995). Moreover, by preserving the orthogonality between transformed variables and lagged dependent variables, this technique allows the use of the lagged values of regressors as instruments, and for estimation of the coefficients by the generalized method of moments (GMM).

Nonetheless, the main results are robust to alternative orderings within the group of international variables, as discussed later.

Interpreting this result is not straightforward and goes beyond the scope of this chapter. The decline in gross inflows is as expected, as foreign investors pull away from EMEs in light of the change in interest rate differentials. Why local investors behave asymmetrically by reducing their holdings of net foreign assets is less clear. While home bias or heterogeneity in investors’ assessments of asset valuations may be possible explanations, it is not obvious why they do not play a role in case of a short-term rate shock. A glance at the dynamics of the responses may shed some light. While the decline in gross outflows occurs with a lag (starting two quarters after the shock), the drop in gross inflows starts in the same quarter of the shock. This may be consistent with foreign investors reacting promptly to the change in interest rate differentials, typically associated with local currency depreciation and drops in the price of local assets, which may subsequently induce local investors—focused on the domestic purchasing power of their wealth—to repatriate foreign assets in order to “lock-in” valuation gains.

A breakdown of non-FDI flows into portfolio and other debt-creating flows is not possible given data inconsistencies in some countries in the earlier part of our sample.

See the list of countries in Table A9.2.2 in Annex 9.2.

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