Gross Capital Flows: Dynamics and Crises

TL;DR: The authors analyzes the joint behavior of international capital flows by foreign and domestic agents - gross capital flows - over the business cycle and during financial crises and finds that gross capital flow is very large and volatile, especially relative to net capital flow.

Abstract: This paper analyzes the joint behavior of international capital flows by foreign and domestic agents - gross capital flows - over the business cycle and during financial crises. We show that gross capital flows are very large and volatile, especially relative to net capital flows. When foreigners invest in a country, domestic agents tend to invest abroad, and vice versa. Gross capital flows are also pro-cyclical, with foreigners investing more in the country and domestic agents investing more abroad during expansions. During crises, especially during severe ones, there is retrenchment, that is, a reduction in both capital inflows by foreigners and capital outflows by domestic agents. This evidence sheds light on the nature of shocks driving capital flows and helps discriminate among existing theories. Our findings seem consistent with shocks that affect foreign and domestic agents asymmetrically, such as sovereign risk and asymmetric information.

Summary

1. Introduction

• During the last decades, international capital flows have played an increasingly important role in the business cycles of developed and developing countries, particularly during episodes of financial crises.
• A few papers also look at the distinction between domestic and foreign investors during specific events or specific markets.
• Positive values of CIF indicate that foreigners are increasing their holdings of domestic assets, while positive values of CID indicate that domestic agents are reducing their holdings of foreign assets.
• The behavior of capital inflows by foreigners and domestic agents can shed light on the sources of fluctuations and international capital flows.
• If crises were only due to negative productivity shocks, the authors would expect both foreign and domestic investors to reduce their investments in domestic assets, resulting in a decrease in both CIF and CIR.5 Similar implications would be obtained if crises were associated with a worsening of investor property rights that affected equally domestic and foreign creditors.

2. Data

• To document worldwide patterns of capital flows by domestic and foreign agents, the authors assemble a comprehensive dataset on both aggregate flows and the subcomponents.
• Importantly, this dataset allows us to disentangle capital inflows by domestic agents (CID) and capital inflows by foreigner (CIF), which are reported as flows related to the reporting country’s assets and liabilities vis-à-vis non-residents, respectively.
• Rescheduling or refinancing of debt falling due in the current recording period is recorded below-the-line as a debt transaction under exceptional financing and the offsetting debit entry is recorded above-the-line.
• The authors final sample includes 103 countries that are classified into groups according to their income levels measured by their per capita GNI in 2005.
• All countries faced at least one crisis within their sample period and a total of 78 crises episodes (24 severe ones) have been observed in these countries.

3. The Joint Behavior of Flows by Foreign and Domestic Agents

• The authors next study the behavior of CIF and CID for a number of high-income and developing countries over the past decades.
• For high-income countries during the 2000s, the volatility of CIF and CID is significantly larger than that of net capital flows (capital inflows by foreigners minus capital outflows by domestic agents, or CIF+CID).
• The ellipses are centered at the mean of these variables and their shape is given by the covariance matrix between CID and CIF.
• Capital outflows by domestic agents have followed a similar increasing trend if compared to high- and middle-income countries.
• For the remaining of this paper, CID and CIF (and their components) are not only scaled by trend GDP, but also further standardized by de-meaning the data at the country level and dividing each variable by their standard deviation, also at the country level.

4. Capital Flows and Financial Crises

• The authors analyze the dynamics of capital flows by foreign and domestic agents around periods of financial crises.
• The authors extend next this analysis by considering the intensity of these crisis episodes and making a distinction between mild and severe crises episodes.
• For One Crisis periods, the evidence suggests significant retrenchment in capital flows by both foreign and domestic agents in high-income countries.
• For middle-income countries, different patterns are observed.
• The authors analysis so far of the behavior of domestic and foreign agents around crises episodes has excluded the financial crisis that hit countries in 2008.

5. Conclusions

• This paper provides a number of important stylized facts on the behavior of gross capital flows.
• The authors have shown that: (i) while the volatility of gross capital flows 20 This observation is also consistent with an increase in the importance of informational asymmetries during crises, as in Brennan and Cao (1997).
• The behavior of gross capital flows can shed light on the sources of fluctuations and international capital flows.
• First, the authors find no evidence that, on average, gross capital flows are driven by fire sales of domestic assets to foreigners and/or domestic capital flight.
• The authors would also expect retrenchment, if crises increased the informational asymmetry between foreigners and domestic agents.

Figures

Table 7B

Table 4 Capital Flows: Tranquil vs. Crises Periods

Figure 1

Figure 5

Table 7B

Figure 4 Decomposition of Capital Flows by Foreign and Domestic Agents

Figure 6

Table 9 Capital Flows around Crises Including the 2008 Crisis

Table 8

Table 5

Table 1

Figure 3

Table 7B

Table 6 Capital Flows around Crises of Different Intensities

Figure 2

Table 2

Table 3

Table 10

Full text

FINANCIAL CRISES AND INTERNATIONAL PORTFOLIO DYNAMICS
Fernando Broner
Tatiana Didier
Aitor Erce
Sergio L. Schmukler
*
June 28, 2010
Abstract
This paper analyzes the behavior of international capital flows by foreigners and
domestic agents, especially during financial crises. We show that gross capital flows by
foreigners and domestic agents are very large and volatile, especially relative to net
capital flows. This is because when foreigners invest in a country domestic agents tend to
invest abroad and vice versa. Gross capital flows are also pro-cyclical. During
expansions, foreigners tend to bring in more capital and domestic agents tend to invest
more abroad. During crises, there is retrenchment, i.e. a reduction in capital inflows by
foreigners and an increase in capital inflows by domestic agents. This is especially true
during severe crises and during systemic crises. The evidence can shed light on the nature
of shocks driving international capital flows. It seems to favor shocks that affect
foreigners and domestic agents asymmetrically –e.g. sovereign risk and asymmetric
information– over productivity shocks.
JEL Classification Codes: F21, F32
Keywords: capital flows, domestic investors, foreign investors, crises
*
We received very valuable comments from Eduardo Fernandez-Arias, Carmen Reinhart, Frank Warnock,
and participants at presentations held at the AEA Annual Meetings (Atlanta), CREI, the LACEA Annual
Meetings (Buenos Aires), and the SED Annual Meetings (Istanbul). For excellent research assistance, we
especially thank Leandro Brufman, and also Francisco Ceballos, Ana Maria Gazmuri, Laura Fernandez,
and Virginia Poggio. Schmukler acknowledges financial support from the World Bank, Development
Economics. Broner is with the CREI and Universitat Pompeu Fabra. Erce is with the Bank of Spain. Didier
and Schmukler are with the World Bank. The views expressed here do not necessarily represent those of
the Bank of Spain or the World Bank.

1. Introduction
During the last decades, international capital flows have played an increasingly
important role in the business cycles of developed and developing countries,
particularly during episodes of financial crises. Many studies have analyzed the
behavior of net capital flows, or capital inflows by foreigners (CIF) plus capital inflows
by domestic agents (CID). It is known that net capital flows are highly pro-cyclical in
developing countries and, to a lesser extent, in developed countries. It is also known that
crises are associated with a large reduction in, or even a reversal of, net capital inflows.
1
This paper focuses on the behavior of gross capital flows, i.e. capital flows by
foreign and domestic agents (CIF and CID). In part, we are motivated by the behavior
of capital flows prior and during the global financial crisis of 2008. During the years
before the crisis, gross capital flows had been very large. They reflected, among other
things, portfolio diversification among developed countries, foreign direct investment
and portfolio flows to developing countries, and accumulation of safe foreign assets by
developing countries. The crisis, however, was accompanied by a larger reduction in
inflows by foreigners and outflows by domestic agents, prompting a debate on the
possibility of entering into a phase of de-globalization.
In this paper, we analyze systematically the cyclical behavior of gross capital
flows.
2,3
To do so, we construct measures of CIF and CID using Balance of Payments
data from the International Financial Statistics from the International Monetary Fund
(IMF). CIF equals net purchases of domestic assets by non-residents and is thus equal to
1
See for example Kaminsky, Lizondo and Reinhart (1998), Calvo, Izquierdo and Mejia (2002), and
Broner and Rigobon (2006).
2
Perhaps surprisingly, there are few analyses of the behavior of gross capital flows at business-cycle
frequencies. Three exceptions are Faucette, Rothenberg, and Warnock (2005), Rothenberg and Warnock
(2006), and Cowan, De Gregorio, Micco, and Neilson (2008), who use information on gross capital flows
to determine whether in each particular crisis reductions in net capital inflows is driven by foreigners or
domestic agents. A few papers also look at the distinction between domestic and foreign investors during
specific events or specific markets. See, for example, Frankel and Schmukler (1996).
3
For evidence on long-run trends in gross capital flows, see Lane and Milesi-Ferretti (2001, 2007),
Kraay, Loayza, Servén, and Ventura (2005), Devereux (2007), and Gourinchas and Rey (2007a, 2007b).
2

the sum of all “liability” inflows. CID equals net sales of foreign assets by domestic
agents and is thus equal to the sum of all “asset” inflows, including international
reserves.
4
We explore the behavior of these capital flows from 1970 to 2009 in 103
developed and developing countries.
Figures 1 and 2 show the behavior of CIF and CID as a fraction of GDP for a
number of developed and developing countries. Positive values of CIF indicate that
foreigners are increasing their holdings of domestic assets, while positive values of CID
indicate that domestic agents are reducing their holdings of foreign assets. The figures
illustrate the long-run process of financial globalization, as CIF has been consistently
positive and CID consistently negative and they have both been large and growing
fractions of GDP. The figures also suggest that the process of globalization has not been
smooth, as there have been large variations in CIF and CID from year to year.
Particularly during periods of financial turbulence, such as during the global financial
crisis of 2008, there seems to have been retrenchment in capital flows, reflected in
reductions in CIF and increases in CID.
In this paper, we formally document these patterns by analyzing the dynamics of
CIF and CID at business-cycle frequencies, as well as around periods of financial
distress. Our main findings are as follows.
(i) Over the last four decades, there has been a larger increase in the volatility
of CIF and CID than that of net flows, especially in developed countries.
Moreover, the larger volatility of CIF and CID has not been accompanied
by more volatile net flows, perhaps because of the high correlation
between CIF and CID.
4
Note that although we refer to CIF and CID as gross capital flows, they reflect net transactions in
domestic and foreign assets, respectively, between foreign and domestic agents. Also note that CIF and
CID are not equal to changes in foreign liability and foreign asset positions as these flow measures do not
take into account valuation effects.
3

(ii) Gross capital flows are pro-cyclical, as CIF is pro-cyclical and CID is
counter-cyclical. In other words, during expansions foreigners increase
their investment in domestic assets and domestic agents increase their
investment in foreign assets. This is true regardless of whether expansions
are measured in terms of real GDP growth or deviations in GDP from
trend.
(iii) During crises, especially during severe ones, there is a reduction of total
gross capital flows (CIF-CID), with significant reductions in CIF and
increases in CID. Systemic crises are associated with more retrenchment
than crises that occur in a smaller set of countries.
(iv) A decomposition of CIF and CID reveals interesting heterogeneity in the
behavior of their components during crises. The reduction in CIF is due to
reductions in liabilities in equity portfolio investment and other
investments in developed countries and in debt portfolio investment and
other investments in developing countries. The increase in CID is due to
reductions in assets in equity portfolio investment, debt portfolio
investment, and other investments in developed countries and in reserves
and debt portfolio investment in developing countries.
The behavior of capital inflows by foreigners and domestic agents can shed light
on the sources of fluctuations and international capital flows. First, we find no evidence
that, on average, gross capital flows are driven by fire sales of domestic assets to
foreigners and/or domestic capital flight, as we find retrenchment during crises, with
foreigners leaving and domestic agents coming back home. Also, the evidence runs
contrary to the view that capital flows are driven mostly by productivity shocks, since
such shocks would imply a similar behavior by foreigners and domestic agents towards
4

domestic assets. For instance, if crises were only due to negative productivity shocks,
we would expect both foreign and domestic investors to reduce their investments in
domestic assets, resulting in a decrease in both CIF and CIR.
5
Similar implications
would be obtained if crises were associated with a worsening of investor property rights
that affected equally domestic and foreign creditors.
The evidence suggests that crises affect foreigners and domestic agents
asymmetrically. If, for example, crises were associated with a worsening of investor
property rights that affected foreign creditors more than domestic creditors, we would
expect the type of retrenchment observed in the data. We would also expect
retrenchment, if crises increased the informational asymmetry between foreigners and
domestic agents.
6
The rest of the paper is organized as follows. Section 2 describes the data.
Section 3 analyzes the comovement of capital flows by foreigners and domestic agents
and their behavior over the business cycle. Section 4 analyzes the behavior of gross
capital flows during crises. Section 5 concludes.
2. Data
To document worldwide patterns of capital flows by domestic and foreign
agents, we assemble a comprehensive dataset on both aggregate flows and the
subcomponents. The data come from the “analytic” presentation of the IMF’s Balance
5
We are not aware of papers that explicitly model the effects of productivity shocks on gross capital
flows over the business cycle. Some related models include Kraay and Ventura (2000), Kraay, Loayza,
Servén, and Ventura (2005), Devereux (2007), Coeurdacier, Kollmann, and Martin (2010), and Devereux
and Sutherland (forthcoming).
6
The large literature on sovereign risk and “sudden stops” has, for the most part, only concerned itself
with net capital flows. See, for example, Mendoza (forthcoming). Broner, Martin, and Ventura
(forthcoming) show that during periods of financial distress in which the probability of default on
foreigners increases domestic agents have an incentive to repurchase domestic assets in the hands of
foreigners, thereby reducing sovereign risk ex-ante. Brenan and Cao (1997) present a model based on
asymmetric information. Tille and van Wincoop (2010) suggest an alternative mechanism based on time
variation in asset risk.
5

Frequently asked questions

Q1. What are the contributions in this paper?

This paper analyzes the behavior of international capital flows by foreigners and domestic agents, especially during financial crises. The authors show that gross capital flows by foreigners and domestic agents are very large and volatile, especially relative to net capital flows. 

Q2. What would be the type of retrenchment observed in the data?

for example, crises were associated with a worsening of investor property rights that affected foreign creditors more than domestic creditors, the authors would expect the type of retrenchment observed in the data. 

Q3. Why are some small countries a concern?

Some small countries are a concern due to their possible role as offshore financial centers or tax havens; many small economies often display an artificially high volume of financial transactions. 

Q4. What is the meaning of a negative CID?

a negative CID should be interpreted as capital outflows by domestic agents whereas a positive CID means capital inflows. 

Q5. How many crises have been observed in these countries?

All countries faced at least one crisis within their sample period and a total of 78 crises episodes (24 severe ones) have been observed in these countries. 

Q6. How did the CID decline in the two years after the onset of the crisis?

capital inflows by foreigners remained at depressed levels (or declined even more for middle-income countries) during the two-year period after the onset of the crisis. 

Q7. What is the role of international capital flows in the business cycles of developed and developing countries?

During the last decades, international capital flows have played an increasinglyimportant role in the business cycles of developed and developing countries, particularly during episodes of financial crises. 

Q8. What is the evidence in Table 1 and Figure 3?

The evidence in Table 1 and Figure 3 suggests that capital inflows by domesticand foreign agents have become very large in recent years, surpassing the size of net international capital inflows. 

Q9. How do the authors estimate the coefficient of capital flows in countries?

The authors do so by estimating the following regressions:,,,, tctctc ControlsXY εβα +++= (3)where Y stands for CIF, CID, or a measure of aggregate flows, CIF-CID; X represents either net capital flows, the trade balance in goods and services, or measures of the GDP fluctuations; and Controls stand for additional controls the authors include in the regressions such as country-trends or year dummies. 

Q10. What is the effect of the retrenchment in capital flows in low-income countries?

The milder reaction of capital flows in low-income countries might be related to the relative size of official funding in comparison to total flows for these economies as these flows are unlikely to decline during crises. 

Q11. How much of the growth in net flows by foreigners has been observed in the 2000s?

capital inflows by foreigners have grown considerably less, going from about 4 percent of trend GDP in the 1980s to only 4.2 percent in the 2000s. 

Q12. How many standard deviations should be included in the ellipses?

the boundaries of the ellipses capture two standard deviations, which should encompass 86% of the total probability mass.