This paper proposes a methodology for testing whether capital flows to developing countries are determined by economic fundamentals or by purely speculative forces. The methodology is based on the familiar notion that capital flows should act as a buffer to smooth consumption in the face of shocks to income, investment, and government expenditure. Under high capital mobility, transitory income shocks, for example, will not elicit corresponding changes in consumption, and the difference will be reflected in changes in the level of capital flows.
The consumption-smoothing approach therefore provides a benchmark for judging what capital flows ought to be, given the specific shocks affecting the economy. Optimal capital flows, according to this approach, are those that allow agents to smooth their consumption fully in the face of shocks to national cash flow, defined as output less investment less government expenditure. Once this benchmark for the optimal level of capital flows has been obtained, it is possible to compare the benchmark series with actual data.
Using data from a large cross-section of developing countries, the paper finds considerable support for the consumption-smoothing view of capital flows. Specifically, it uses a variety of formal statistical tests as well as simple time-series plots of the predicted and actual data and finds that the level and volatility of capital movements predicted on the basis of the consumption-smoothing model are very close to the actual level and volatility of such movements observed in the data. The results suggest that capital flows in developing countries are indeed determined to a significant degree by economic fundamentals and, in line with other recent research, that effective capital mobility in developing countries may be quite high.