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Portfolio Capital Flows: Hot or Cold?
Author(s): Stijn Claessens, Michael P. Dooley and Andrew Warner

Source: The World Bank Economic Review , Jan., 1995, Vol. 9, No. 1 (Jan., 1995), pp.
153-174
Published by: Oxford University Press
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THE WORLD BANK ECONOMIC REVIEW, VOL. 9, NO. 1: 153-174
Portfolio Capital Flows: Hot or Cold?
Stijn Claessens, Michael P. Dooley, and Andrew Warner
A distinction is often made between short-term and long-term capitalflows: the former
are deemed unstable hot money and the- latter are deemed stable cold money. Using
time-series analysis of balance of payments data for five industrial and five developing
countries, we find that in most cases the labels "short-term" and "long-term" do not
provide any information about the time-series properties of the flow. In particular,
long-term flows are often as volatile as short-term flows, and the time it takes for an
unexpected shock to a flow to die out is similar across flows. Long-term flows are also
at least as unpredictable as short-term flows, and knowledge of the type of flow does
not improve the ability to forecast the aggregate capital account.
Several developing countries have received large capital inflows in recent years,
reversing a trend of outflows for most of the 1980s (see Gooptu 1993). Much of
this new capital inflow has been short-term portfolio investment, including
bonds, equities, and short-term instruments such as certificates of deposit and
commercial paper. This surge in short-term flows has raised the question of
whether these flows will be sustained or instead be reversed in the near future.
Some observers argue that the recent flows are inherently unsustainable be-
cause they have short maturities. For example, on the basis of this argument,
Reisen (1993:2) concludes that "the majority of flows [to Latin America] are hot
rather than cool:' Nunnenkamp (1993) employs a similar approach and points
out that the composition of inflows varies considerably among developing coun-
tries. His conclusion is that hot money transactions have been relatively small in
the Chilean case but significantly large in Brazil. And Turner (1991), in his
review of capital flows for industrial countries, ranks short-term bank lending as
most volatile and long-term bank flows as least volatile, followed by foreign
direct investment (FDI) as the next-to-least volatile (Turner 1991, table 35,
p. 95).
This article focuses on the implicit reasoning that reliable inferences can be
drawn about the degree to which a flow tends to sustain itself at its current level,
Stijn Claessens is with the Technical Department of the Europe and Central Asia and Middle East and
North Africa Regions at the World Bank; Michael P. Dooley is with the Department of Economics at the
University of California at Santa Cruz; and Andrew Warner is with Harvard University. At the time this
article was written, Michael P. Dooley and Andrew Warner were with the International Economics
Department at the World Bank. The authors would like to thank Guillermo Calvo, Maxwell Fry, Camp-
bell Harvey, Ricardo Hausmann, participants in a Bank seminar, and the referees for their comments.
? 1995 The International Bank for Reconstruction and Development/THE WOORLD BANK
153

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1S4 THE WORLD BANK ECONOMIC REVIEW, VOL.9, NO. 1
that is, the degree of persistence, solely on the basis of data categories given in
balance of payments statistics. That is, the conventional view asserts that persis-
tence can be inferred from labels. Here we ask whether, given direct statistical
measures of persistence, labels can be drawn from persistence. In effect, our way
of verifying this proposition is to turn it around and see if it also holds in the
opposite direction. When only time-series statistics on persistence are used, can
the label of the flow be identified? As we explain in section II, we are skeptical
on theoretical grounds that such an inference is reliable; however, we think the
issue is worth a systematic examination.
Section I provides the motivation for the analysis. Section II discusses the
modeling of capital flows. Section III discusses what evidence is relevant. Section
IV provides the classifications for the various capital flows and the data sources.
Section V analyzes simple univariate statistics for the various individual flows
and looks at the predictability of these flows to answer the question: hot or cold?
Section VI investigates the interactions between the various flows. It also looks
at the predictive power of the overall capital flows and the interactions between
the various flows and the overall capital account. Section VII is a summary.
I. MOTIVATION
The notion that inferences can be made about the characteristics of financ
flows by just observing their labels is, of course, not new in economics.
flows-of-funds approach used by many central banks and others to anal
developments in the domestic economy embodies the implicit view that there
information in labels. This view has also long been an important part of
traditional analysis of international finance (see Nurske 1944 for a descriptio
of experiences in the 1920s). A distinction is often made between short-term a
long-term capital flows: short-term capital movements are deemed speculativ
and reversible-hot money-and long-term capital flows-cold money-are
based on fundamentals and are deemed reversible only when the fundamenta
change.
The fact that capital control programs in many countries distinguish between
short- and long-term flows already points to the importance attached to this
distinction. Capital account transactions are often also subject to policy inter-
ventions that differ according to the type of flow. Withholding taxes are often
levied on one kind but not another kind of capital flow. Subsidies often take the
form of a government guarantee of private liabilities, favorable tax treatment on
earnings (for example, on FDI), or access to special govemment facilities (for
example, debt-equity swaps). Each of these distortions is designed to encourage
or discourage a given type of capital transaction. In fact, the whole structure of
balance of payments accounts reflects the implicit view that different types of
capital flows have different economic implications.
However, it is easy to be skeptical about the information value of the
balance of payments labels for any purpose, not just for assessing persistence.

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Claessens, Dooley, and Warner 155
Increasingly, multiple financial instruments are available to finance any project,

and so if a tight link ever existed between the financing method and the
underlying nature of the project, it is probably becoming increasingly loose. A
Treasury bond with a thirty-year maturity can be sold on the secondary mar-
ket, and short-term assets can be continuously rolled over. Many observers
seem to base their notion that short-term flows are more volatile on the fact
that short-term-maturity inflows need to be repaid more quickly than long-
term flows. Although rapid repayment may lead to higher volatility of gross
short-term flows, it need not make net flows more volatile. Short-term flows
that are rolled over are equivalent to long-term assets, and a disruption of
gross FDI inflows, for example, can cause its net flow to be equivalent to a
repayment of a short-term flow.
In addition, the explicit label given to a flow may not cover its implicit
nature. Dooley (forthcoming) argues, for example, that, although the inflows
to developing countries in the 1970s were private capital flows in name, the
universal government guarantees of both lenders and borrowers considerably
subdued the discipline of the market. The flows, which helped generate the
debt crisis of 1982, should have been considered official capital flows.
The reasoning based on the label of the flow can nevertheless underpin
substantive policy measures. Once a flow is identified as hot money, it is often
seen to require some policy response. At various times countries (especially
developing countries) have responded with exchange rate management, (ster-
ilized) intervention, fiscal contraction, borrowing taxes, absolute foreign bor-
rowing constraints, and reserve requirements (see, for example, Kiguel and
Caprio 1993, Fischer and Reisen 1992, and Corbo and Hernandez 1993 for
reviews of developing countries' responses to recent capital inflows). Many of
these responses have differed depending on the "label" of the flow, thus
presuming that labels are meaningful.
II. MODELING CAPITAL FLOWS
Research on international capital flows has differed on whether it is more

accurate to treat the flows as exogenous (with respect to the country in
question) or endogenous. In this study, although we do not think it vital to
take a stand on this issue, we do clarify how the interpretation of our findings
depends on this issue.
If capital flows are exogenous from the point of view of the domestic
economy, perhaps because they are driven by changes in international financial
variables and market perceptions of the country, then the policymaker's con-
cern about the volatility of capital flows can make good sense. Depending on
the exchange rate policy being pursued by the country, volatile capital flows
can translate into exchange rate volatility (in the case of a flexible exchange
rate) or into variations in official reserves (in the case of a fixed or pegged
exchange rate). Either consequence can be undesirable because it leads to

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156 THE WORLD BANK ECONOMIC REVIEW, VOL. 9, NO. 1
temporary signals to shift resources between traded and nontraded sect

because it requires monetary adjustments. If flows are exogenous, it
clearly be useful to know whether the data support the conventional vie
certain kinds of flows are inherently more volatile and that certain flow
predicted better.
If capital flows are endogenous, however, an analysis of the behav
capital flows in isolation makes little sense. Here, everything depend
nature of the shock that gives rise to changes in the current accoun
behavior over time of the flows would reflect the behavior over time o
underlying shocks. In the unlikely event that different flows have diff
ultimate causes and that the causes have different time-series propertie
flows themselves would have different time-series properties. But this
be a remote possibility. If capital flows are predominantly endogenous,
no deep reason to expect any particularly tight relationship between typ
flows and time-series properties.
It may be argued that rather than taking an agnostic approach to
causality question, it would be better to present a model and try to ident
important causes, and then to use that framework to assess the que
persistence of financial flows. It has proven difficult, however, to devel
a structural model empirically with underlying sources of shocks. Capit
in general, and perhaps even more so portfolio flows to developing coun
have been difficult to explain. Recent studies by Calvo, Leiderman, an
hart (1993); Chuhan, Claessens, and Mamingi (1993); and Fernandez-
(1994) find low explanatory power, and the authors have difficulty iden
which factors exactly determine capital flows. One finding common
three papers is that external factors, particularly the lower interest rates
United States in the early 1990s, may have been important in mot
capital flows to developing countries.
III. WHAT EVIDENCE Is RELEVANT?
The view that labels convey information about persistence underlies laws
about capital controls and is implicit in some academic research, but it is not
expressed in a way that makes it obvious how to evaluate it empirically. Broadly
speaking, to evaluate claims that certain kinds of flows are more volatile, we
look at coefficients of variation; to evaluate claims about persistence, we look at
measures of (positive) serial dependence and half-lives from impulse responses;
and to evaluate claims about predictability, we look at time-series measures of
forecasting performance. This evidence provides part of what we want; we also
look at additional evidence on total capital flows and on how the flows interact
with each other. Questions about the volatility of certain types of capital flows
are (presumably) motivated by concerns about the volatility of the total capital
account, not just about the volatility of one particular capital flow. Policy-
makers after all wish to assess the likelihood of sudden and destabilizing changes
in the total capital account, not just in its components.

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To frame this point in a more concrete setting, suppose that a policymaker

observes a rise in FDI during the latest quarter. Does this mean anything for the
level of total capital flows? At an extreme, the FDI inflow can be merely a shift
from, for example, long-term (bank) inflows tO FDI inflows. In this case there
would be an exact offset because the two flows would be perfectly negatively
correlated, and the rise in FDI would carry no information about the level of total
capital inflows and its volatility.
An actual example of this phenomenon of substitution between various capi-
tal flows was the rapid growth of holdings of deposits in offshore banks by U.S.
residents in the 1970s. These deposits were attracted by higher yields offshore
that were made possible by the absence of deposit interest rate ceilings, reserve
requirements, charges for deposit insurance, and other factors. The capital out-
flow in the U.S. balance of payments was matched at first by interbank loans
from the branches to the U.S. head office. When these inflows were discour-
aged, other forms of capital inflows took their place. Such inflows and outflows
were offsetting and had little to do with an analysis of the U.S. balance of
payments position. A similar effect occurred in the context of the Voluntary
Restraint Program that the United States launched in February 1965, and the
effect was particularly strong with respect tO FDI (see, for example, Brimmer
1966 and Dooley 1981 and 1990).
More generally, if a flow is a close substitute for other flows, it can be qu
volatile, but this need not necessarily be a cause for concern, because other flo
may be offsetting its volatility. Correspondingly, attributing volatility to a
ticular flow can be misleading in the presence of substitution or complemen-
tarity. The possibility of systematic interactions between components of the
capital account needs thus to be addressed before making inferences from the
parts to the whole.
We examine these questions by first looking at correlations among the various
flows. Then we ask a question that we think is central to assessing whether data
on the components of capital flows can provide an early warning for future
levels of capital flows: to what extent does the knowledge of the composition of
the capital account improve the ability to forecast future levels of the capital
account?
This article analyzes data on components of capital flows in five industrial
and five developing countries. It investigates whether volatility and persistence
match up with categories of capital flows as expected and whether the data
reveal systematic relationships among the flows, as well as the extent to which
the available categorization of data provides useful information for forecasting
total capital inflows. Because the article relies completely on time-series analysis,
data requirements are limited.
IV. DATA
For our analysis, we classified balance of payments flow data according to

the type of instrument within the country studied. We distinguished between

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four categories of flows: FDI, portfolio equity, long-term (official and priv
and short-term. The focus of the analysis was on net flows, because our
concern was net financing. A list of the categories of data used is in table A-1.
(Note that we took the labels as they are given in IMF, various years, and did
not make any data corrections.) From the same source, we used data on
quarterly changes in claims and liabilities to investigate the short-run time-
series behavior of various flows. All flows are in millions of U.S. dollars
deflated by the U.S. producer price index to convert them into real (1987)
dollars.
A second distinction we made is by transactor, that is, foreign direct investors
(FDI plus other long-term flows), banks, government, and the private sector. The
results of using this distinction are provided in Claessens, Dooley, and Warner
(1993).1
In addition, countries could be concerned with the occurrence of rare but
large, sudden movements in capital flows, such as those that occurred in 1982 in
many developing countries with the start of the debt crisis and in 1992-93 in
some industrial countries with the breakdown of the European Exchange Rate
Mechanism. This concern, and the possible lumpiness of quarterly data, would
suggest that annual data should also be analyzed. Given the rare occurrence of
such crises and the limited annual data, however, analysis of time series is of
little use. Instead, case studies are more appropriate for investigating such
events.
We selected five industrial countries (France, Germany, Japan, the United
Kingdom, and the United States) and five developing countries (Argentina, Bra-
zil, Indonesia, the Republic of Korea, and Mexico). The five industrial countries
are the largest economies in the world, and flows to and from these countries
represent the majority of capital flows between industrial countries. The five
developing countries are among the developing countries that have received the
largest share of private capital flows in recent years, and they represent very
different country circumstances and institutional backgrounds. Such a choice
has given us a broad selection of country circumstances on which to make some
generalizations.
1. A third classification we could have made would have been by source (type of creditor). For
developing countries, the source can be determined by using the World Bank Debtor Reporting System
(DRS). One source distinction could, for example, be between official (bilateral and multilateral) and
commercial sources (further distinguished, if desired, by destination, public, publicly guaranteed, and
privately nonguaranteed). Adding the IMF balance of payments flows (short-term, FDI, and equity) to the
breakdown of the DRS gives a more complete picture of the sources of external financing. But using DRS
data (in addition to IMF data), instead of IMF data exclusively, has three drawbacks: (1) DRS data are
reported annually, not quarterly; (2) the DRS does not cover industrial countries; and (3) DRS and IMF data
can differ (greatly) for a given developing country (because of different data sources, conceptual prob-
lems, and capital flows not recorded in IMF data, such as capital flight). Nevertheless, the advantages of
being able to distinguish long-term flows by source would likely be considerable, given the different
objectives of official and commercial creditors.

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V. HOT OR COLD?
Table 1 provides means, standard deviations, and coefficients of variation

(cvs) for various kinds of flows, broken down by type.2 To provide an indica-
tion of the relative magnitude of these flows compared with the total capital
account, the third column of table 1 presents the average for the flows as shares
of total financing. Long-term flows are the most important for all countries
except the United States and Japan, where, respectively, short-term flows and
portfolio equity flows are more important. There does not appear to be a
systematic pattern in the volatility (as measured by the cv) of various types of
flows across countries. Long-term flows have the highest cv for four countries;
FDI for four countries; and portfolio equity flows for two countries. Perhaps
surprising to those claiming that short-term flows are hot is the fact that short-
term flows have the lowest cv in seven countries. Note also that the volatility of
the total capital account is often less than that of a component.
High relative volatility is one of the notions that has been associated with hot
money. A related notion is that a hot-money inflow is likely to disappear or
reverse itself in the near future, whereas a cold-money inflow is more likely to
persist. Degree of persistence and level of volatility are two complementary
measures: hot flows are associated with low persistence and high volatility.
Figure 1 provides data on net capital flows in Japan (in millions of 1987 dollars,
positive figures denoting inflows), by type of flow. These data provide the best
corroboration we have found for conventional ideas about the persistence of
various kinds of flows. Figure 1 shows that the FDI and portfolio equity flows
display much less volatility over short periods than do the short-term flows and
that the long-term flows are somewhere in between.
One efficient way to summarize the idea of persistence that is apparent in
figure 1 is to calculate autocorrelations for each type of capital inflow. A persis-
tent series will be positively autocorrelated, whereas a transitory series will have
a low or negative autocorrelation. In general, the classic case of a cold-money
flow would be a flow that is highly positively autocorrelated, whereas a hot-
money flow would exhibit zero or even negative autocorrelations. Referring
back to figure 1, we would expect the FDI flows for Japan to have large positive
autocorrelations and the short-term flows to exhibit far lower or even negative
autocorrelations.
The autocorrelations for Japan in figure 2 conform to these expectations,
given the time-series plots. Note that FDI and portfolio equity have high positive
autocorrelations. In contrast, the short-term flows exhibit negative autocorrela-
tions, and the signs change from quarter to quarter. The long-term flows are
only positively correlated at short horizons.
The main finding for the other countries is that, if anything, the conventional
pattern exhibited by the Japanese data is the exception rather than the rule. In
2. The detailed results for the categorization of flows by transactor are available in Claessens, Dooley,
and Warner (1993).

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160 THE WORLD BANK ECONOMIC REVIEW, VOL. 9, NO. I
Table 1. Basic Statistics on Capital Flows, by Country

Standard Average Coefficient
Mean deviation share in total of variation
Country, period, (millions of (millions of financing (CV)
and type offlow 1987 dollars) 1987dollars) (percent) (percent)
Argentina, 1976:1-1992:1
Foreign direct investment 21 237 1.8 1,123
Portfolio equity 94 444 -2.5 473
Long-term -896 1,829 100.0 204
Short-term 747 1,158 0.7 155
Short- and long-term -149 1,549 100.7 1,040
Total -34.05 1,456.47 100.0 4,278
Brazil, 1975:1-1991:4
Foreign direct investment -55 309 -1.0 562
Portfolio equity -6 99 0.3 1,611
Long-term -1,056 4,961 78.0 470
Short-term 3,000 3,080 22.7 103
Short- and long-term 1,944 3,052 100.7 157
Total 1,883 3,043 100.0 162
France, 1978:1-1992:3
Foreign direct investment
Portfolio equity
Long-term -534 s,569 88.1 1,043
Short-term -1,170 2,704 11.9 231
Short- and long-term -1,196 5,020 100.0 420
Total - -
Germany, 1979:1-1992:1
Foreign direct investment -376 755 2.1 201
Portfolio equity 2,140 3,169 -7.9 148
Long-term -2,761 9,642 70.0 349
Short-term -5,866 4,067 35.9 69
Short- and long-term -8,627 9,853 105.8 114
Total -6,864 9,752 100.0 142
Indonesia, 1976:1-1992:1
Foreign direct investment 3 100 0.7 3,719
Portfolio equity 15 68 1.3 454
Long-term -560 1,438 70.7 257
Short-term 1,062 342 27.3 32
Short- and long-term 501 1,496 98.0 298
Total 519 1,519 100.0 293
Japan, 1979:1-1992:1
Foreign direct investment -1,261 1,234 5.9 98
Portfolio equity -8,451 10,282 66.0 122
Long-term -125 11,280 21.9 9,007
Short-term -959 4,506 6.1 470
Short- and long-term 355 10,941 28.1 3,081
Total -10,854 13,407 100.0 124
Korea, 1976:1-1992:1
Foreign direct investment -1 159 2.8 23,366
Portfolio equity 63 189 2.7 300
Long-term -757 2,271 92.4 300
Short-term 669 745 2.0 111
Short- and long-term -88 2,187 94.5 2,490
Total -25 2,304 100.0 9,036
Mexico, 1975:1-1992:1
Foreign direct investment 79 224 -1.3 283
Portfolio equity -2 873 -2.7 53,811
Long-term -358 3,783 92.0 1,057
Short-term 1,348 1,186 11.9 88
Short- and long-term 990 3,599 103.9 363
Total 1,068 3,340 100.0 313

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Standard Average Coefficient

Mean deviation share in total of variation
Country, period, (millions of (millions of financing (CV)
and type offlow 1987 dollars) 1987 dollars) (percent) (percent)
United Kingdom, 1973:1-1992:1
Foreign direct investment -2,041 2,302 2.8 113
Portfolio equity 413 969 -4.6 235
Long-term 1,075 8,927 102.2 830
Short-term -378 1,612 -0.4 426
Short- and long-term 697 8,688 101.8 1,247
Total -931 8,014 100.0 860
United States, 1973:1-1992:1

Foreign direct investment -478 5,308 13.0 1,110
Portfolio equity -2,046 3,045 0.4 149
Long-term 3,635 11,169 40.7 307
Short-term 5,897 11,929 45.9 202
Short- and long-term 9,532 16,886 86.7 177
Total 7,007 20,118 100.0 287
- Not available.
Note: The statistics are based on quarterly data deflated by the U.S. producer price index.
Source: IMF (various years) and authors' calculations.
many other countries the conventional pattern simply breaks down. Figures 3
and 4 show this for Germany and Mexico. For Germany, for example, FDI
appears at least as volatile as short-term flows, and long-term flows appear the
most stable for Germany. And for Mexico, when broken down by transactor,
flows to the banking system appear more stable than flows to the government
(as well as to the private sector). The autocorrelations for Germany (figure 5)
confirm that FDI flows are the least stable and long-term flows the most stable.
For Mexico (figure 6), the government and private sector flows have indeed the
lowest (for some lags even negative) autocorrelations.
Another way to summarize the evidence on persistence for all countries is to
compute half-lives from impulse response functions. To do this, we estimated a
univariate fourth-order autoregressive or AR(4) model for a given flow and then
examined how a given shock to the error term in the estimated equation propa-
gated itself through time.3 If a time series is highly positively autocorrelated, it
will take a long time for a shock to die out; if the autocorrelations are low, the
shock should vanish quickly. The half-life in this context is simply the number of
quarters it takes for the shock to lose half or more of its initial value. The results
are reported in table 2.
3. We chose an AR(4) model because we used quarterly flows and we wanted to account for possible
seasonal effects. We used four lags because we thought it was important to at least exceed one year in the
lag length and because experiments with longer lags did not alter the results importantly.

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Figure 1. Net Capital Flows by Tjpe, Japan, 19 77-91

(millions of 1987 dollars)
A. Foreign direct investment B. Long-term flows

Value Value
0 - ~~~~~~~~~~40,000
-800 - 30,000
-1,600 - 20,000
-2,400 - 10,000 M 1
-3,200 -0 /VIr
-4,000 --10,000
-4,800 - -20,000
1977 79 81 83 85 87 89 91 1977 79 81 83 85 87 89 91
C. Portfolio equity D. Short-term flows

Value Value
5,000 -
0 ?4 A4 - 12,000
-5,000 8,00
-10,000400
-25,000
-35,000 ............................ -82,000
1977 79 81 83 85 87 89 91 1979 81 83 85 87 89 91
Note: Positive values denote inflows.


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Figure 2. Autocorrelations of Net Capital Flows by Type, Japan
Autocorrelation Autocorrelation
1.0 1.0-
0.8 0.8?
0.6 0.6-
0.4 04
0.202
-0.2 -0.2
-0.4 -0.4-
-0.6 --0.6
-0.8 -0.8
1 2 3 4 5 6 7 8 9 10111213141516 1 2 3 4 5 6 7 8 9 10111213141516
Lag (quarters) Lag (quarters)

1.0 - 1.0
0.8 8
0.6 0.6
0.4o4
0.2-02
-0.2 -.
-0.4 o4
-0.6 --0.6
-0.8 - -0.8
-1.0
1 2 3 4 5 6 7 8 9 10111213141516 1 2 3 4 5 6 7 8 9 10111213141516
Source: Authors' calculations.

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Figure 3. Net Capital Flows by Type, Germany, 1973-91


Value Value
2,000 15,000
1,000 10,000
5,000
o 0
-1,000 -5,000
-10,000
-2,000 -15,000
-3,000 -20,000
-25,000
-4,ooo ......... ...........I.......... ...... ...... , 30,000 X |l}sIIWTTTllllllT

1973 76 79 82 85 88 91 1973 76 79 82 85 88 91

Value Value
16,000 4,000
12,000 - 0
8,000 - -4,000
4,000 --8,000-
0 -12,000
-4,000 -16,000
-8,000 ....... ............,. ***,.................. - 20, 000. . ... .......... T.......1

1973 76 79 82 85 88 91 1973 76 79 82 85 88 91


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Figure 4. Net Capital Flows by Transactor, Mexico, 1975-91

A. Foreign direct investment B. Government

Value Value
1,400C 12,000
1,200.
1,000 6,000
800.
600
400 -W
200 -4,000
0
1975 77 79 81 83 85 87 89 91 1975 77 79 81 83 85 87 89 91
C. Banks D. Private sector

Value Value
10,000 6,000
8,000 4,000-
6,0002,0
4,000~~~~~~~~~~~,0
4)000~~~~~~~~~~~
2,000
0 ~~~~~~~~~~-2,000
-2,000 -4,000-
-4,000 -6,000.I....
1975 77 79 8183 85 87 8991 1975 77 79 8183 85 8789 91


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Figure 5. Autocorrelations of Net Capital Flows by Type, GermanY

-0.2.08
-0.4o4
-0.8 02
1 2 3 4 5 6 7 8 9 10111213141516 1 2 3 4 5 6 7 8 9 10 111213 14 1516


1.0 -10
0.6 -06
0.4.o4
0.2-02
0
-0.4.04
06 -0.6-
-0.8 --.
1 2 3 4 5 6 7 8910 111213 14 1516 1'2 3 4 5 6 7 8910 111213 14 1516

Source: Author-s' calculations.

110.54.148.109 on Tue, 29 Mar 2022 03:02:05 UTC
Figure 6. Autocorrelations of Net Capital Flows by Transactor, Mexico
A. Foreign direct investment B. Government
1.0 - 1.0
0.8 0.8
0.6 0.6
-0.4 0.4
0.2VA02r
-0.2 -.
-0.4 -.
-0.6 -0.6
-0.8 -0.8
-1.0 , I------ l-- -1.0- --a- 1
1 2 3 4 5 6 7 8 9 10111213141516 1 2 3 4 5 6 7 8 9 10111213141516
C. Banks D. Private sector

1.0 - - 1.0 -
0.8 - 0.8
-0.2- -0.62
-0.4 v -0.4-
0.2 0.2
0 0
-0.2 -0.2-
-0.4 -0.4.
-0.6 -0.6-
-0.8 -0.8-
1 2 3 4 5 6 7 8 9 10111213141516 1 2 3 4 5 6 7 8 9 10111213141516

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Table 2 provides little support for those who wish to infer persistence
labels. With the exception of Japan, most of the half-lives are 1: that
than 50 percent of the shock has dissipated before even one quarter has
elapsed. This is true for the breakdown of flows by type as well as by
transactor (not reported). It basically reflects the fact that the lag coefficients in
the estimated autoregressive equations are small. In addition, there is little
evidence, apart from the case of Japan, that the allegedly persistent flows-
such as FDI and long-term flows-exhibit more memory than the other flows.
So far, we have examined the question of whether persistence-as measured
by autocorrelations and half-lives-matches up with the categories, and we
have found that often there is not a close correspondence. A different but
related question is whether the flows are forecastable solely on the basis of
their own past and whether the forecasts match up with the categories in the
expected way. The key point here is that a flow can be predictable without
necessarily being significantly positively autocorrelated or having a high half-
life. As long as a flow follows some pattern, not necessarily that of positive
serial correlation, it can be predictable. It is possible that instead of making
statements about half-lives or autocorrelations, conventional wisdom may sim-
ply be saying that long-term flows are more predictable than short-term flows.
The test we employ on predictability is a simple measure of the goodness of
predictive power: the residual mean square error (ImsE). We estimated again,
starting from 1982, a univariate AR(4) model for all flows and then performed
out-of-sample forecasts for the next four quarters on the level of the flows.
Using the new data, we updated the AR(4) model each year and performed
another out-of-sample forecast-for the next year-repeating this procedure
for each year. We then standardized the out-of-sample forecasting RMSE with
Table 2. Half-Lives from Impulse Response Functions

(in quarters)
Foreign direct Portfolio Long-term Short-term

Country investment equity flows flows
Argentina 1 - 1
Brazil 1 3 la 3
France 1 - 1
Germany la 1 la 1
Indonesia 18 la la
Japan 9a 1 3 1
Korea, Rep. of lb la 2a la
Mexico lb 1 - 2
United Kingdom 2a 1 1a 1
United States 1 1 1 1
- Not available.
Note: The half-lives measure the number of quarters it takes before the impulse response is half or less of the initia
shock. For countries with incomplete data, we analyzed liabilities or claims separately.
a. Based on data from liabilities side only.
b. Based on data from claims side only.

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Table 3. Relative Ability to Predict Individual Categories of Flows

(ratios of residual mean square errors)
Foreign
direct Portfolio Long-term Short-term
Argentina - - 1.11 1.00

Brazil 0.97 1.24 1.02 1.00
France - - 1.35 1.00
Germany 1.40 1.31 1.13 1.00
Indonesia - 1.03 0.77 1.00
Japan 0.76 0.89 1.06 1.00
Korea, Rep. of 0.91 0.95 0.91 1.00
Mexico 1.16 1.23 1.15 1.00
United Kingdom 1.18 1.17 1.05 1.00
United States 0.86 0.98 0.83 1.00
-Not available.
Note: We first estimated AR(4) univariate forecasting equations for each of the four categ
we computed all possible four-step-ahead dynamic forecast errors from these equations and calculated
residual mean square errors (RMSES). These were then divided by the standard deviation of the time series
to obtain a unit-free measure of forecasting performance. These normalized RMSES were then divided by
the normalized RMSE for the last category, short-term flows, to compare forecasting performance across
categories. These ratios are reported above. A value over 1.0 indicates that the category exhibits poorer
forecasts than the forecasts for short-term flows. Quarterly data were used for the forecast period from
the first quarter of 1982 to the fourth quarter of 1991, except for France (from the first quarter of 1985 to
the fourth quarter of 1991) and Brazil (from the first quarter of 1982 to the third quarter of 1988).
Source: Authors'calculations.
the standard deviation of the respective flow to get a measure of the relative
ability to forecast the various flows. Finally, we compared the ability to forecast
the various flows with the ability to forecast short-term flows. Short-term flows
are commonly assumed to be the most volatile and least predictable type of flow,
and we would thus expect the other flows to be more predictable than short-
term flows.
The evidence on this issue (table 3) is that, compared with the benchmark
(short-term flows), other flows cannot systematically be predicted more accu-
rately. For about half of the countries, our forecasts for the other flows were
actually worse than the forecast for short-term flows. The two countries for
which we were able to predict all other flows better were the United States and
the Republic of Korea. Altogether, only about half of the other flows were more
predictable than short-term flows. Compared with the autocorrelations and
half-lives, the evidence on relative predictability using the time-series model
showed that a low score on the first two measures generally translates into high
unpredictability.
VI. How DO THE FLOWS INTERACT?
The evidence so far provides some basis for skepticism about gauging vol-
atility and persistence by using only the labels given to the flows. As explained

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Table 4. Marginal Sources of Financing the Current Account

(slope coefficients)
Foreign
direct Portfolio Long-term Short-term
Argentina -0.03 -0.08 1.06** 0.06
Brazil -0.00 0.01 1.27** -0.27
France 0.98** *0.02
Germany -0.02* 0.02 0.83** 0.17**
Indonesia 0.01 0.01 0.99** -0.01
Japan -0.03** 0.17 0.86** 0.00
Korea, Rep. of -0.02 0.00 1.28 * * -0.26**
Mexico -0.00 -0.10** 1.07** 0.03
United Kingdom 0.03 -0.02* 0.99** 0.00
United States 0.11** -0.01 0.42** 0.49**
-Not available.
* Significant between the 5 and 10 percent level.
* * Significant at the 5 percent level or better.
Note: Slope coefficients for the regressions of the quarter-to-quarter change in the level of a p
flow on the quarter-to-quarter change in the level of the total capital account.
before, there may be some offsets between various flows. It would thus clearly
help to know whether there are systematic correlations in the data along these
lines. We started by calculating the simple correlation matrixes between the
various categories of flows for all countries (not reported). The correlations
showed some degree of substitution (that is, negative correlations) between
most flows for almost all countries. For some countries, the substitution was
very pronounced, with high negative correlation between short- and long-term
flows.
We next performed an analysis on the marginal source of financing the current
account.4 We ran regressions of the changes in the various types of flows on the
change in the total capital account. Slope coefficients provide a measure of the
degree to which a particular flow "finances" at the margin the country's overall
financing requirements or surplus (under the assumption that the current ac-
count movements drive capital flows). Table 4 provides the slope coefficients.
Long-term flows appear to be the most sensitive: for all countries except one the
slope coefficient for long-term flows is the highest. The lack of consistent rank-
ing among the other flows across countries suggests that short-term flows do not
differ on this measure from, for example, FDI.
Our results differ from those of Turner (1991) and Fry (1993). Two facts
may account for this: we used quarterly as opposed to annual data; and we
4. As mentioned before, this approach does not allow us to distinguish between the endogenous and
exogenous natures of the various types of capital flows. Doing so would require a structural model that
covered, among other things, shifts in investment opportunities. Nevertheless, our approach gives an
indication of the empirical relation between the total capital account and its components.

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took the total capital account as the right-hand variable, whereas the other
two studies excluded the balance of official monetary movements (that is,
official reserve movements) from the total capital account. The classification
by transactor (not reported) showed that, except for the United States, flows
to and from the government sector have been the most accommodative.
Although it may not be surprising that the government sector is the most
accommodative, it does raise the question of whether the government is the
source of volatility in capital flows or whether it is accommodating to the
volatility of other flows.
The results so far suggest there is sufficient substitution between and interac-
tions among the various flows to make an analysis of the time series of a single
flow possibly misleading.5 This possibility can best be further addressed by
investigating how well we can forecast the total capital account using past
information. Table 5 presents the ratio (ratio 1) of the RMSE of the forecast of the
total capital account using a time-series predictor, AR(4) regression, to the RMSE
of a naive predictor (one with no change in the capital account). As can be
observed, we can generally improve on the naive forecasts (by up to 34 percent),
and this indicates that there is some information in the past time series for the
aggregate capital account.
Does knowledge of the breakdown category of flows convey any information
about total capital flows? To analyze this, we forecasted the total capital account
by using past information on the total capital account as well as information on
the contemporaneous shares of the individual flows. We reasoned that if the
total capital account is independent of a particular flow, then adding the con-
temporaneous share of the flow should not affect our forecasting ability. Con-
versely, if a flow helps determine the total capital account, then adding the
contemporaneous share should help the forecast.
Ratio 2 in table 5 presents this horse race in relation to the AR(4) time-series
predictor. Using the shares as additional information did not greatly improve
our forecasting ability. At most, it improved our ability to forecast net flows by
10 percent (Japan), and in most cases the gain is less than 3 percent. This result
provides evidence that, in general, movements in the overall capital account are
little influenced by the type of capital flow. Because there is much substitution
going on between the various flows, analyzing individual flows may not be very
meaningful. It is thus better to focus attention on the determinants of the overall
capital account; for example, the impact of the aggregate external shocks the
economy is exposed to and the overall (macro-) economic policies the govern-
ment pursues.
5. This analysis ignores any impact of the various flows on domestic savings or investment in this or
future periods.

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Table 5. Relative Ability to Predict Overall Flows

(ratio)
Country Ratio 1 Ratio 2
Argentina 0.85 0.99

Brazil 0.77 1.00
France
Germany 0.94 1.00
Indonesia 0.67 0.97
Japan 0.84 0.90
Korea, Rep. of 0.96 1.00
Mexico 0.66 0.95
United Kingdom 0.92 0.92
United States 0.87 0.99
- Not available.
Note: Ratio 1 is RMSE(f2)/RMSE(f1), where RMSE(fl) is the residual mean square error (RMSE) of a
naive predictor (no change in the capital account) and RMSE(f2) is the RMSE of the forecast of the total
capital account using a time-series predictor, AR(4) regression, without share variables. Ratio 2 is
RMSE(f3)/ RMsE(fl), where RMSE(f3) is the RMSE of the forecast of the total capital account using a time-
series predictor, AR(4) regression, with all the contemporaneous share variables plus their two lags. The
RMSES are based on four-step-ahead forecast errors. Flows include claims and liabilities.
VII. SUMMARY
Using time-series analysis of data for five industrial and five developing coun-
tries, we find that in most cases the labels "short-term" and "long-term" in
relation to capital flows do not provide any information about the time-series
properties of the flows. Put differently, if only time-series statistics are available,
it is not likely that the label of the flow can be identified. In particular, long-term
flows are often as volatile as short-term flows, and the time it takes for an
unexpected shock to a flow to die out is similar across flows. And, arguably the
most relevant measure from a policymaker's point of view, short-term flows ar
at least as predictable as long-term flows. There is also little evidence that
information about the composition of flows is useful in forecasting the overall
level of flows, and this suggests that the overall capital account is independent of
the type of flow.
The implication is that the emphasis on analyzing specific flows, especially
short-term portfolio flows, is overdone. We find virtually no time-series prop-
erty that can be regarded as an inherent property of any particular kind of flow.
An attempt to reduce capital account volatility by administratively limiting
short-term inflows is unlikely to be effective because there is little evidence that
these flows really are more volatile than other flows. The evidence here is
consistent with the view that capital flows are fungible, highly substitutable, and
endogenous with respect to external shocks and internal policies.

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Table A-1. Data Classifications

Item Line numbers
Flow
1. Change in direct investment claims 45, 46
Change in direct investment liabilities 49, 50
2. Change in bond claims 53, 56
Change in bond liabilities 54,55, 57, 58
3. Change in equities claims 59
Change in equities liabilities 60, 61
4. Change in bank loan claims 69-71, 77-79
Change in bank loan liabilities 72-76, 80-83
5. Change in bank deposit daims 89
Change in bank deposit liabilities 90-92
6. Change in other short-term claims 48, 93, 94
Change in other short-term liabilities 52, 95-97
7. Change in other long-term daims 47
Change in other long-term liabilities 51
8. Change in long-term official claims (non reserve) 62-64
Change in long-term official liabilities (non reserve) 65-68
9. Change in short-term official claims 84, 85
Change in short-term official liabilities 86-88
10. Change in official reserves 98-111
11. Errors and omissions 112
Classification
Foreign direct investment 1
Long-term flows 2, 4, 7, 8, 10
Short-term flows 5, 6, 9
Portfolio equity 3
Note: Flow items and line nu
under Classification refer to t
Source: IMF (various years) an
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Portfolio Capital Flows: Hot or Cold?

Author(s): Stijn Claessens, Michael P. Dooley and Andrew Warner

Stable URL: http://www.jstor.com/stable/3990001

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Portfolio Capital Flows: Hot or Cold?

Stijn Claessens, Michael P. Dooley, and Andrew Warner

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Increasingly, multiple financial instruments are available to finance any project,

II. MODELING CAPITAL FLOWS

Research on international capital flows has differed on whether it is more

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temporary signals to shift resources between traded and nontraded sect

III. WHAT EVIDENCE Is RELEVANT?

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To frame this point in a more concrete setting, suppose that a policymaker

For our analysis, we classified balance of payments flow data according to

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Table 1 provides means, standard deviations, and coefficients of variation

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Table 1. Basic Statistics on Capital Flows, by Country

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Standard Average Coefficient

United States, 1973:1-1992:1

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Figure 1. Net Capital Flows by Tjpe, Japan, 19 77-91

A. Foreign direct investment B. Long-term flows

C. Portfolio equity D. Short-term flows

Note: Positive values denote inflows.

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Figure 2. Autocorrelations of Net Capital Flows by Type, Japan

A. Foreign direct investment B. Long-term flows

C. Portfolio equity D. Short-term flows

Source: Authors' calculations.

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Figure 3. Net Capital Flows by Type, Germany, 1973-91

A. Foreign direct investment B. Long-term flows

-4,ooo ......... ...........I.......... ...... ...... , 30,000 X |l}sIIWTTTllllllT

C. Portfolio equity D. Short-term flows

-8,000 ....... ............,. ***,.................. - 20, 000. . ... .......... T.......1

Note: Positive values denote inflows.

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Figure 4. Net Capital Flows by Transactor, Mexico, 1975-91

A. Foreign direct investment B. Government

C. Banks D. Private sector

Note: Positive values denote inflows.

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Figure 5. Autocorrelations of Net Capital Flows by Type, GermanY

A. Foreign direct investment B. Long-term flows

1 2 3 4 5 6 7 8 9 10111213141516 1 2 3 4 5 6 7 8 9 10 111213 14 1516

C. Portfolio equity D. Short-term flows

1 2 3 4 5 6 7 8910 111213 14 1516 1'2 3 4 5 6 7 8910 111213 14 1516

Source: Author-s' calculations.

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Figure 6. Autocorrelations of Net Capital Flows by Transactor, Mexico

A. Foreign direct investment B. Government

C. Banks D. Private sector

Lag (quarters) Lag (quarters)