RDP 2009-09: Volatility in International Capital Movements 1. Introduction

Over the past decade or so, domestic financial markets have grown rapidly and a greater proportion of financial capital has come to be traded across international borders. Following a period of relatively steady expansion in line with world output growth in the 1980s and early 1990s, gross international capital flows began to grow more rapidly in the mid 1990s (Figure 1). It is also evident that there have been major fluctuations around an upward trend in gross capital flows and that at times there were noticeable compositional shifts in the importance of various types of flows.[1]

Figure 1: Gross International Capital Flows

While these trends have generally been viewed as a sign of economic and financial development, the merits of financial globalisation and integration have attracted an increasing amount of scrutiny. Financial crises, particularly in the 1990s, have given rise to a body of literature which calls into question the unqualified benefits of international integration (Krugman 2000, Calvo and Reinhart 2000 and Kose et al 2006). One focus has been on the possible disadvantages faced by emerging economies that open up to global capital markets prematurely.[2]

With some types of flows typically seen to be inherently more susceptible to sudden reversals, the composition of the overall capital account has also received considerable attention. The conventional wisdom is that certain types of capital flows are more volatile than others and thus potentially destabilising (Classens, Dooley and Warner 1995; Becker and Noone 2008). In particular, portfolio or bank and money market flows are often seen as being speculative and subject to sharp reversals, thereby exposing recipient countries to the whims of international financiers. These flows are correspondingly often described as being ‘hot’. In contrast, flows such as foreign direct investment, which are seen to engender a longer-term commitment determined by fundamental developments, have come to be viewed as being relatively stable and unlikely to reverse without good reason. This perceived lack of ‘skittishness’ has seen such flows labelled as being ‘cold’.

This paper examines whether different types of capital flows have attributes that make them more or less likely to contribute to volatility in the overall capital account. We examine the statistical properties of the flows to judge whether they are regularly ‘hot’ or ‘cold’. For the purpose of this paper we leave aside the question of whether some forms of capital confer other desirable economic effects on the recipient country, such as the technological and managerial transfer often associated with direct investment. And since we are interested in assessing the overall volatility of the capital account, we largely focus on net flows while acknowledging that gross flows play a crucial role in understanding the underlying sources of variability.[3] Throughout, we compare and contrast the experience of six industrialised economies with that of six emerging economies.

The remainder of the paper is structured as follows. Section 2 defines our concept of volatility and examines a number of measures to test the validity of commonly held priors. Section 3 provides several insights into how capital flows interact within the capital account of a country and with the flows of other countries. Section 4 provides empirical estimates of possible explanations for capital account volatility. The final Section provides some concluding remarks, while Appendix A applies a series of simple econometric techniques to the question at hand.


Battellino (2006) provides a more detailed exposition of these trends. Although not part of our detailed analysis, we also note the dramatic decline in gross flows in the recent financial crisis. [1]

For a literature survey, see Obstfeld and Taylor (2003). For related discussions on the disadvantages faced by emerging economies, possible transitional arrangements, and prerequisites required to gain from trade in capital, see Nakagawa and Psalida (2007) and Kose et al (2006). If capital flows are completely determined by domestic variables such as economic growth and the expected return on assets, they would be of little direct policy interest. Instead, the underlying source of any weakness would attract the attention. On the other hand, if capital flows are not uniquely determined (that is, subject to bouts of excessive optimism and crises of confidence) and are influenced by variables in international capital markets that lie beyond the control of domestic policy-makers, they may warrant more direct scrutiny (Krugman 2000; Radelet and Sachs 2000). [2]

Debelle and Galati (2005) point out that knowledge of whether foreigners or domestic residents are driving the flows is useful. There is some evidence that in contrast to industrialised economies, emerging economies’ net capital flows are usually driven in large part by non-residents (Lowe 2009). This may expose emerging economies to sudden turns in the sentiment of foreign investors (see also Calvo 2000). [3]