Prakash Loungani ¹

The waxing and waning of capital flows has been a source of economic drama over the last decade. The movement of capital from the developed countries to others (“North-South” flows) accelerated in the first half of the 1990s but has since been subject to frequent reversals, in the aftermath of many high-profile financial crises. Against this background, recent IMF research provides evidence on two broad questions: (1) What drives the level, composition, and regional allocation of capital flows?, and (2) What impact do capital flows have on investment and growth in host countries? These questions are often addressed using new measures of capital market openness and integration; the development of these measures has been another area of intensive IMF research.

For both developing and industrial countries, international gross capital flows grew markedly during the 1990s. In the industrial countries, gross capital flows as a percent of GDP are presently about 15 percent of GDP, as compared with an average of about 10 percent in the 1980s; the rise in cross-border capital flows among the members of the European Union is a significant factor behind this rise. For the developing countries as a whole, gross capital flows—after a drop in the 1980s—are now about 5 percent of GDP, roughly the same level as in the late 1970s.²

In addition to changes in the level of overall capital flows, the 1990s have accelerated an ongoing change in the composition of capital flows: the share of bank loans has declined and that of foreign direct investment (FDI) and portfolio investment has increased. According to Mody and Murshid (2002), in the period 1995–98, FDI accounted for 55 percent of private long-term capital flows to developing countries and bank loans for 15 percent. The remaining 30 percent was accounted for by portfolio flows; while higher than it was two decades ago, this figure reflects a scaling back from a share of nearly 40 percent of total flows in the first-half of the 1990s.³

Supplementing the data on capital flows, recent IMF work has developed new measures of capital market openness (or restrictions). Lane and Milesi-Ferretti (2001) construct estimates of gross stocks of foreign assets and liabilities as a percentage of GDP, and show that these stocks increased rapidly in both developing and industrialized countries over the 1990s. These stocks can be used as a measure of financial openness, analogous to measuring financial sector depth, using the stock of credit to the private sector, as a percent of GDP. As it is based on the accumulation of stocks, this new measure provides a more gradual and backward-looking view of changes in openness and is less influenced by the reversals of flows that often occur in the course of financial crises.⁴

In contrast, Edison and Warnock (2001) propose a measure that is available at a high frequency, monthly, but is narrower in coverage—it measures only stock market liberalizations. Their proposed measure of openness is the proportion of a country’s total stock market capitalization that is available to foreign investors. This measure, available for 29 emerging market countries, this measure shows substantial opening up in many Asian countries during the 1990s; Latin American countries opened up to foreign equity investment earlier and more extensively than the Asian countries.⁵

What drives cross-border capital flows?⁶ Much of the literature on North-South flows has found it useful to dichotomize the driving forces into push and pull factors. The former are factors such as low interest rates (or asset returns) in industrialized countries, which serve to push capital out of these countries in search of higher returns elsewhere. The pull factors are the ones that serve to attract capital into particular host countries—low wages, tax incentives, level of financial market development, protection of property rights, and the like. Mody and Murshid suggest that the “flush of capital inflows in the 1990s was more a push into developing countries rather than a pull based on unmet demand for investment financing.”⁷

The push/pull framework has also been used to analyze portfolio equity flows. Edison and Warnock (2002) find that a decrease in U.S. interest rates or in U.S. industrial production pushes equity flows into emerging markets, with the effect stronger on flows to Latin America than on flows to Asia. The high volatility of portfolio flows has also prompted attempts to see if they are better explained on the basis of herding behavior and momentum strategies. Borensztein and Gelos (forthcoming) report only moderate evidence for such behavior among emerging market mutual funds. Gelos and Wei (2002) find that herding among international equity funds is less pronounced in countries that have more transparent macroeconomic policies and corporate sectors.⁸

Why does capital flow to some developing countries and emerging markets and not to others? And what determines what type of capital flow a country will attract?⁹ In a study of transition economies, Garibaldi, Mora, Sahay, and Zettelmeyer (2002) confirm the general finding that the quality of institutions and governance is an important factor in determining the level, composition, and regional allocation of capital inflows. Specifically, they find that FDI has been the main source of inflows to transition economies, and its allocation across these economies can be explained well by a standard set of economic fundamentals such as macroeconomic stability, level of structural reforms, and such. Portfolio investment has been concentrated in a handful of countries, which, relative to other transition economies, strongly protect property rights and have more developed securities markets.¹⁰

In a similar vein, Lane and Milesi-Ferretti (2000) document that for emerging markets the stocks of FDI are larger in countries that are more open to trade, that undertake more privatization, and that have more natural resources, while portfolio equity stocks are larger in countries with more developed financial markets. Wei and Wu (2001) find that in countries perceived to have high levels of corruption, the composition of capital flows is biased away from FDI toward more fickle flows such as international bank loans. In the early 1990s, capital inflows to Asia were primarily foreign direct investment (FDI). Montiel and Reinhart (1999) show that differences between Latin America and Asia in the composition of capital flows were eroding in the years leading up to the Asian crisis; specifically, sterilized intervention was skewing the composition of Asian flows toward short maturities.¹¹

Africa lags behind other regions in attracting FDI. While there are some obvious explanations for this, such as a high incidence of conflict in some countries, Reinhart and Rogoff (2002) examine the role that monetary and exchange rate policy may also have played in explaining the paucity of FDI. They suggest that the high levels of parallel market premia observed in many African countries may be symptomatic of the more general governance problems that deter FDI. Basu and Srinivasan (2002) document that a few African countries have overcome the odds through sustained macroeconomic and structural reforms.¹²

What impact do capital flows have on growth? The evidence is decidedly mixed and appears to depend, somewhat, on the particular flow studied (or the measure of capital market openness used), the sample period, the set of countries, and whether cross-section or panel data is used. Recent IMF work provides an illustration of mixed findings. In a much-cited study, Borensztein, De Gregorio, and Lee (1998) find that FDI increases economic growth when the level of education in the host country—a measure of its absorptive capacity—is high. Mody and Murshid find that capital inflows boost domestic investment almost one-to-one, but the strength of this relationship appears to be weakening over time. In contrast, Edison, Levine, Ricci, and Slok (forthcoming), using the new measures of openness described above, do not find evidence of a robust link between international financial integration and economic growth.¹³