AN EVALUATION OF THE CONVENTIONAL WISDOM ON CAPITAL FLOW VOLATILITY: FDI INTER-FLOW CORRELATION AND FINANCIAL ACCOUNT VOLATILITY by

Jos Ramn Perea

A Thesis Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree MASTER OF ARTS (ECONOMICS)

August 2006

Copyright 2006

Jos Ramn Perea

UMI Number: 1438533

UMI Microform 1438533 Copyright 2007 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code.

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ii DEDICATION

To my mother and sisters, for their unconditional love and support. And to Alex, Icar, and Martn, for the future lies in them.

iii ACKNOWLEDGEMENTS

I thank my advisor Dr. Jeffrey Nugent for inspiring this research, and for his constant encouragement and guidance. Working with him has truly been one of the most rewarding experiences of my life.

I also thank Dr. Peter Rosendorff and Dr. Aris Protopapadakis, for their enriching feedback and suggestions.

I would also like to thank Dr. Carol Wise, for her mentoring and help during these years, which has facilitated enormously the progress of my dissertation, and my life as a graduate student.

Finally, I thank family and friends for being the source of my motivation throughout this process.

iv CONTENTS

DEDICATION ACKNOWLEDGEMENTS LIST OF TABLES LIST OF FIGURES ABSTRACT 1. Introduction 2. Stylized Facts of Capital Flows to Developing Nations 3. The Impact of FDI over the Host Economy 4. Why the Concern? The Consequences of Volatile Capital Flows 4.1. Growth Effects of Macroeconomic Volatility 5. Building the Conventional Wisdom on Capital Flow Volatility 5.1. Empirical Literature 5.2. Theoretical Reasons for FDI Stability 5.3. Counterexamples 5.4. Policy Implications 6. Study Scope 6.1. Data Sources and Variables 6.2. Measures of Volatility 7. Empirical Analysis 7.1. Estimation Results 7.2. Robustness 8. Conclusion BIBLIOGRAPHY

ii iii v vi vii 1 2 13 22 25 30 31 33 38 48 52 55 63 67 77 86 107 110

v LIST OF TABLES

Table 1: Main Variables Table 2: Panel Estimation Table 3: Heteroscedasticity-consistent Estimation and FGLS Estimation Table 4: Endogeneity Tests Table 5: Two-Stage Least Squares Estimation Table 6: Variance Inflation Factors Table 7: Model 3 Centered Variables Regressions Table 8: Regressions with Additional Institutional Proxies

59 83 91 95 97 100 101 105

vi LIST OF FIGURES

Figure 1: World Exports vs. Private Capital Flows (% of GDP) Figure 2: Aggregate Net Resource Flows to Developing Nations Figure 3: Distribution of FDI Flows (average 1989-99) Figure 4: Distribution of Portfolio Flows (average 1989-99) Figure 5: Capital Inflows to Developing Nations (%of GNP, period average) Figure 6: Growth vs. FDI Net Inflows (annual averages, 1970-99) Figure 7: Change in Private Capital Flows (selected countries) Figure 8: Bilateral Investment and Double Taxation Treaties (1990-2002)

4 5 7 8 10 18 21 51

vii ABSTRACT

This thesis investigates whether one of the main challenges to the conventional wisdom on capital flows volatility, based on the possibility of negative correlations between different types of flows, is empirically relevant for the case of Foreign Direct Investment (FDI). This claim has been suggested as a possible limitation of the view of FDI as the most desirable flow for financing purposes, but we know of no attempt to study its relevance empirically. Our analysis fails to prove a systematic presence of these interactions between flows. Instead, and in line with the predictions of the traditional literature on capital flows volatility, we show that a large share of FDI in total capital flows is a significant predictor of a stable financial account.

1 1. Introduction

The literature on capital flows has recently benefited from intense interest in the volatility of different types of flows, and its potential effects over the receiving economy. With some exceptions, there is a consensus in this literature that Foreign Direct Investment (FDI) is the most stable flow of capital. This has added to the view that this flow is the most beneficial source of external finance for host economies.

In a desire to contribute to this debate, this study differs from the tradition in the volatility literature, which has almost invariably focused on individual flow volatilities, to the volatility of the financial account as a whole. Through this modification, we can investigate whether or not there is sufficient substitution1 between types of capital flows to cast doubts on the stabilizing effect of FDI. Moreover, although we concentrate on the prospects of substitution effects specifically for FDI, our results permit us to conclude on their likelihood for other types of flows as well.

This term will be defined in detail in later sections of the study.

2 With this research purpose, our study proceeds as follows: section 2 illustrates the recent developments in international capital flows, which have contributed for the enhanced view of FDI. The latter is nevertheless a consequence of certain beneficial effects that the flow allegedly possesses, among which its stability is the most recently recognized advantage. These effects are briefly reviewed on section 3. Section 4 directly tackles the issue of volatility, by enumerating some of the reasons to favor capital flows stability. This leads to an investigation of the specific record achieved by FDI in volatility studies (section 5). While in general the balance of the literature portrays FDI as a stable and benign flow, there are important conceptual and empirical counterexamples. In all, this dialogue has identified some of the possible limitations of the existing research on capital flow volatility, which in turn provide the basis for our empirical design. This design is presented in section 6. Section 7 discusses the estimation results and a set of robustness checks, and section 8 concludes.

2. Stylized Facts of Capital Flows to Developing Nations

The end of the XX Century has witnessed one of the most important increases in the level of transactions transcending national boundaries, leaving countries at any level of development more integrated within the world economy. To some

3 scholars, the current wave of Globalization actually falls short from former episodes of more intense economic interaction between countries (ORourke and Williamson, 1999). But leaving aside these historical considerations, an evaluation of recent trends in the international economy helps to illustrate some characteristics specific to the contemporary economic internationalization. Figure 1 compares the evolution of worlds total exports with private capital flows during the last quarter of the XX Century. While exports as a percentage of GDP have followed a steady, but fairly slow upward trend, from about 14% to 25%, the share of private capital flows increased much more rapidly, from 5% of GDP to about 25%, catching up with the relative importance of exports. If there is one single feature that differentiates the current Globalization wave from other apparently similar historical instances, it is the surge in international capital flows.

4 Figure 1: World Exports vs. Private Capital Flows (% of GDP).

30 25 20 15 10 5 0 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

Exports of goods and services (% of GDP)

Gross private capital flows (% of GDP)

Source: World Development Indicators

If we take a circumscribed view to the Developing countries, the focus of the present study, the performance of capital flows is even more remarkable, especially during the 1990s; aggregate net resource flows2, an approximate measure of the net external capital that a country receives, experienced a significant increase in the developing world during the first half of the decade of the nineties. Although there were also some downturns, especially the global reversal in financial flows to developing nations after 1997, the overall growth rate experienced over the

World Bank (2001) defines aggregate net resource flows as the sum of net flows on long-term debt (excluding IMF) plus net direct foreign investment, portfolio equity flows and official grants (excluding technical cooperation).

5 nineties was dramatic, moving from 43.5$ billion in 1990, to 225.8$ billion in 2000 (Pealver, 2002).

Figure 2: Aggregate Net Resource Flows to Developing Nations

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 %

years

largest 6 receivers

other ldcs

Source: Global Development Finance

Trends in aggregate indicators nevertheless mask critical differences, both in terms of the relative success of countries attracting external funds, and in the evolution of each of the individual flows composing the financial account. The first claim is illustrated in Figure 2, which shows the intense concentration of aggregate net resource flows among developing countries, with the six largest receivers reaping

6 more than half of the total funds available to developing nations as a whole during the last decade. This concentration of aggregate funds is just as impressive when we consider some flows individually, especially those based on private equity. Figure 3 and 4 show the distribution of FDI and Portfolio investment among developing nations during the 1989-99 period. During this time, the largest 10 receivers of FDI and portfolio investment reaped averages of 68% and 79% respectively of the total flows. Thus, this pattern of concentration seems to have intensified in recent years: Relying on data for 2002, Dodd (2004) remarks that 61% of FDI in developing economies accrued to only four countries, and as much as 96% of portfolio equity investment to just six countries. The counterpart of this trend is obvious, as many developing nations have been almost entirely unsuccessful in attracting equity funds from abroad. Such is the case of Sub-Saharan countries, which for the same year were able to attract only 4.9% of the global amount of FDI to developing nations and an even smaller fraction of portfolio flows.

7 Figure 3: Distribution of FDI Flows (average 1989-99).

rest 30%

China 27%

Indonesia 2% Korea 3% Poland 3% Thailand Chile 3% 3%

Brazil 11% Mexico 8% Argentina Malaysia 6% 4%

Source: Global Development Finance

8 Figure 4: Distribution of Portfolio Flows (average 1989-99)

rest 21% Argentina 4% Thailand 4% Malaysia 5% Indonesia 6% India 6%

Source: Global Development Finance

Mexico 13% Korea 13%

China 10% Brazil 10% South Africa 8%

Concentration is much less acute in the case of commercial debt (proxied by longterm debt flows), and particularly Official Development Assistance (ODA). In the latter case, no country has received more than 9% of the total funds available, a figure that contrasts drastically with those of FDI or portfolio investment. Why is ODA much less concentrated among countries? Although there are several forces at hand, foreign aid, at least partially, is allocated following a set of non-economic criteria that many developing countries are able to satisfy. Examples are humanitarian needs, or political or colonial links with donors. On the contrary, the prerequisites for attracting FDI or portfolio investment are much more difficult to

9 fulfill, leading these flows to be more asymmetrically distributed. For instance, portfolio investment requires the development of a domestic financial market that does not exist at all in many third world countries. Similarly, the importance of host market size as the most relevant locational determinant for FDI, poses insurmountable challenges in attracting FDI for small nations (a majority among the developing world).

The concentration of private equity would not have had such severe consequences, if the flows that are more disseminated across countries (e.g., ODA) had experienced the same kind of growth as private equity. But another identifiable trend for the last two decades has been the continuous increase in private investment as the most important element in the financial account of developing nations, which increasingly has tended to substitute for external financing based on foreign aid and bank lending. Figure 5 illustrates this transition, which traces its origin back to the eighties, when debt crises in several Latin American nations led to a curtailment of external commercial lending to developing countries. Before that, however, debt was the most important external fund to developing nations, partly due to the huge pool of capital available after the oil shocks of the seventies. As the supply of funds temporarily exceeded the possibilities of investment in the industrial world, some of these funds were recycled through a lax if not negligent-

10 credit policy that allowed third world nations to have a fairly autonomous developmental strategy.

Figure 5: Capital Inflows to Developing Nations (% of GNP, period average)

6 5 4 3 2 1 0 1975-82
Official FDI

1983-89
Portfolio Bank credit

1990-98

Source: Global Development Finance.

As the importance of debt faded, so did ODA (Griffith-Jones and Ocampo, 2000). Much of the latter decrease has been blamed on aid fatigue, as many ODA recipients have not been able to eradicate the problems that initiated the concessionary help. At the same time, the end of the Cold War in 1989 reduced

11 the incentive for donors to allocate politically-based foreign aid, as the threat of realignment with the opposite bloc was no longer possible3.

In all, the international market for capital flows has faced two major transformations: one is the entrance of former pariahs into the market for international flows, who by becoming successful in attracting private investment, have distorted the geographical paths that North-South flows had followed in previous decades. Recent patterns of FDI illustrate the importance of these new players, especially China and some of the Eastern European economies (e.g., Poland, Czech Republic) as magnets for direct investment in merely a decade. As Figure 3 illustrates, China has received 27% of the total FDI flows accruing to developing nations between 1989 and 1999. Although not included in the figure, but based on the same calculations, the former communist economies account for 11% of that sum. In other words, almost half of the FDI that has been raised during the nineties has been channeled to countries that were not politically feasible hosts during previous decades.

Another major change has been the major rearrangement of the types of flows that contribute to the external financing of developing nations. As private equity
3

On this regard, Boschini and Olofsgard (2003) show that the reduction in military expenditures in the Eastern bloc after 1989 explains the sharp reduction in foreign aid.

12 investment has gained unprecedented importance in satisfying the needs of developing nations, ODA and commercial debt have become increasingly marginal. In this process, the countries that lack the market fundamentals to attract private investment have faced the greatest challenge to secure a stable source of external financing. Ironically, most of these underperformers attracting private investment are countries at the lowest levels of development, and the ones in greatest need of new sources of finance. This has configured an allocation of global capital flows that in the developing world has unambiguously favored higher income countries; and in doing so, it has trapped the least developed nations in a sort of vicious cycle in which they are precluded from accessing external financing due to their lack of a minimum threshold of development, perpetuating their backwardness.

So far, the picture that we have depicted implicitly assumes at best a passive role for host economies in the allocation of international funds, implying that these are entirely on the side of the investors, creditors, or donors. However, an important consequence of the increased importance of private capital flows as a source of external finance for developing nations has been the change in regulatory policies, a process that is particularly relevant for the case of foreign direct investment: Whereas in previous decades, FDI activities were either strictly controlled or even nationalized, today FDI is almost universally encouraged by governments.

13 Why do governments have such a strong interest in gaining the favor of international direct investors? To some extent, the relative scarcity of bank credit and development assistance could explain this process. But since other types of private flows (i.e., portfolio investment) have not received such interest from host governments, we must look for other forces specific to the case of foreign direct investment. Here, the main justification comes from the large literature on the impact of FDI on host economies, which has strongly supported the new regulatory attitude towards this type of flow, and eventually the fierce pattern of inter-state competition to attract FDI. In the following section, and before illustrating some of these policy measures, we will review the main theoretical and empirical work that has supported the preferential treatment of FDI, with particular emphasis on volatility, which is the central focus in this study.

3. The Impact of FDI over the Host Economy

The developmental role of FDI is a frequently studied topic, and one for which the empirical evidence remains mixed. The earliest attempts (MacDougal, 1960) to study the effects of international investment on host economies were based on the Hecksher-Ohlin model, the standard model for the study of International Trade. Within this rigorous framework, there is no distinction between different types of

14 international capital (i.e., FDI and portfolio), and the main analytical conclusion works in the same way as that of the standard Hecksher-Ohlin model. Namely, the idea that the influx of foreign capital to capital-scarce countries would increase the marginal product of labor, while it would reduce the marginal product of capital.

There are several reasons for the inability of that paradigm to provide an effective account of the potential effects of FDI. The fact that it does not distinguish between different types of international investment essentially equates the effect of FDI with that of portfolio investment on the host economy, a premise that is unanimously rejected in more contemporary research. Also, while the assumption of perfect competition may facilitate a parsimonious theoretical model, this comes at the price of compromising its factual relevance, given the oligopolist structure of the industries that are more prone to engage in FDI.

In light of these limitations, the eventual obsolescence of the Hecksher-Ohlin model to explain patterns of international investment led the way to another, grounded on the theory of industrial organization, which could specifically address the potential impact of FDI. The pioneering effort in this regard is the work of Stephen Hymer, which sharply departs from the perfectly competitive HOS model, and stresses the existence of scale economies, differential access to credit markets, and

15 informational barriers to market entry as some of the characteristics that shatter the assumption of homogeneous production functions across firms. These differences in firms abilities to operate allow some corporations to be endowed with a set of advantages (e.g., a more efficient production function, access to cheaper inputs, or ownership of a differentiated product) that will outweigh the inherent disadvantages of operating in an alien market, where domestic firms possess better information4. In other words, it is the existence of market imperfections what allows for the development of firm-specific advantages, and ultimately, for the ability of firms to surpass their own frontiers.

Blomstrom et al. (1996) remark that acknowledging the importance of these firms abilities is especially necessary for the analysis of FDI in developing nations, where domestic enterprises are generally smaller and less competitive than their foreign competitors. In this uneven environment, the entry of foreign firms may have either positive or negative consequences, the latter being very different from those arising from North-North flows, where host country firms are likely to enjoy a more level playing field with source country firms.

This is the essence of the Hymer-Kindleberger hypothesis, initially raised by Hymer and developed by Kindleberger (1969).

16 The above line of research has proved to be much more useful in identifying the potential impact of FDI over the host economy, partly due to a pertinent focal change from aggregate to firm-level data, where the gains from FDI can be identified more accurately. Here, the effects derived from FDI can be analyzed across several dimensions: the transfer of technology to domestic firms, through backward or forward linkages (Aitken and Harrison, 1999); improving the domestic labor pool through the dissemination of know-how and more sophisticated managerial techniques through labor turnover (Gerschenberg, 1987). In the case of exportoriented FDI, benefits may also arise from improving the current account of the host economy, particularly for countries with small or undiversified exports. Thus, foreign presence in the export sector can deepen and accelerate the opening of the economy to international markets, a crucial policy objective for countries undergoing structural adjustment programs (Dunning, 1993).

While the above is not an exhaustive list of the theoretical benefits that FDI may bring, the empirical evidence offers a much muddier picture of these effects. For instance, Aitken and Harrison (1999) use a sample of foreign and domestic firms in Venezuela, to find that FDI has a negative effect on the productivity of upstream domestic firms, as foreign firms tend to redirect demand from domestic to imported inputs. Similarly, Lall and Streeten (1977) raise doubts about the

17 improvement of the Balance of Payments via FDI, showing that for a sample of developing nations the net external transactions of FDI operations resulted in a net deficit, mainly due to profit repatriation. Thus, there are other negative effects that need to be taken into account: for instance, the possibility that domestic investment can be crowded-out by FDI, if the technological or managerial expertise of international investors is superior enough so as to suffocate domestic competition (Bosworth and Collins, 1999). FDI can also cause important geographical dislocations to the host country, if those investments arise in the context of agglomeration economies5. China, with 90% of its FDI stock concentrated in the coastal regions (Global Development Finance, 2002), is an example of the noneconomic, yet far-reaching implications (e.g., internal migration, urbanization, etc.) of FDI over the host country.

Agglomeration economies arise when firms obtain benefits from locating near each other. These benefits may arise from multiplicity of suppliers and customers, or reductions in transportation costs.

18 Figure 6: Growth vs. FDI Net Inflows (annual averages, 1970-99)

10 8 GDP Growth % 6 4 2 0 -10 -5 -2 0 FDI/GDP %

Source: Global Development Finance.

10

15

But despite the possible negative effects, economic or otherwise, the crosssectional evidence confirms a significant correlation between FDI presence and economic growth (De Mello, 1996). This slightly positive relationship is illustrated by Figure 6, which juxtaposes the average ratio of inward FDI/GDP, with the average growth rate for the 1970-99 period. Yet the looseness of this relation suggests that Growth is by no means a sure outcome from FDI. On the contrary, the literature states that the ability for the host country to experience growth out of the entry of foreign investors is highly dependent on the characteristics of both the host country and the industry in which the foreign endeavor unfolds. Along

19 these lines, Borensztein et al (1998) conclude that there is a threshold level of income and human capital per capita that the host needs to surpass in order for FDI to make a significant contribution to economic growth. In a similar fashion, Blomstrom et al (1994) agree on the existence of a positive effect only for higherincome developing countries, which have the ability to assimilate the technology brought by foreign firms.

Overall, the line of research we have outlined in the previous section has provided mild support for the idea (largely endorsed by policy makers), that FDI is the most attractive source of external finance for the developmental purposes of the host economy. Leaving aside these effects, recent events in the international economy have delivered yet another point of reference to enhance this debate: the decade of the nineties was plagued by financial crises (e.g., European Monetary System 1993, Mexico 1994, East Asia 1997, Brazil 1999, Russia 1999), that were particularly virulent in developing nations. In all these crises, it is difficult to pinpoint a single culprit; but one that appears consistently as an aggravating factor is the sudden and substantial withdrawal of international capital flows from the countries affected by the turmoil.

20 In order to see this contrasting behavior of international capital before and after crises, figure 7 shows the rate of change in total private flows for a selected number of countries that were especially affected. Interestingly enough, many of the countries most affected by these crises had been -at least on the surface- examples of orthodoxy in the opening of their economies to foreign goods and capital. Not surprisingly therefore, in most cases we can observe a pre-crisis period of very high rates of growth of private capital flows, which quickly sink into negative rates the year the crisis appears. In some cases (i.e., Argentina in 2002), there is also a speedy return of capital flows soon after the crisis has taken place.

While illustrating the vulnerability of private flows to sudden withdrawals, this figure does not explain the relative sensitivity of the various components of the financial account to these financial crises. Nevertheless, this is precisely the foundation for the most recent reason for the superiority of FDI from a developmental point of view. In most instances, the massive withdrawals of other capital flows have contrasted with a relatively stable FDI, which has pictured this flow as relatively invulnerable to financial and currency crises (World Bank 1997; UNCTAD 1998). In the following section, we will build on two points to justify this new argument in favor of FDI: first, we will highlight the consequences of volatile capital flows over the receiving economy, focusing on macroeconomic volatility and economic growth.

21 Secondly, and in light of the detrimental effects of erratic capital flows, we will review the evidence that has tended to portray FDI, not without counterexamples, as the most resilient source of external financing.

Figure 7: Change in Private Capital Flows (selected countries)

Argentina 100% 50% 0% 94 -50% -100% -150% -200% 95 96 97 98 99 00 01 100% 80% 60% 40% 20% 95 -20%
-40% -60% -80%

Brazil

96

97

98

99

00

01

02

Indonesia 1500% 1000% 500%

Malaysia

200% 150% 100% 50%

0%
91 92 93 94 95 96 97 98 99
-500%

-50%

92 93 94 95 96 97 98 99 00 01

-100%

Source: Global Development Finance

22 4. Why the Concern? The Consequences of Volatile Capital Flows

As a result of the central role that the variability of capital flows has played during the recent crises, reactions quickly followed among policymakers and scholars alike. In the first case, some nations (e.g., Malaysia 1998) backtracked from previous commitments to capital liberalization, and imposed controls with the objective of reducing crisis-induced capital outflows. And just as the crises shook the policy world, they also invigorated a research agenda that aimed at elucidating the macroeconomic effects of capital volatility on host economies.

One of the first investigations on the issue is provided in Gavin and Hausman (1996), which finds that capital flow volatility in Latin America bears substantial responsibility for the overall macroeconomic volatility of the region during last decade. In a subsequent investigation, Easterly et al (2000) provide the intuition for the mechanisms through which the financial account, or its time series behavior, can be a conduit for macroeconomic fluctuations: on one hand it allows private firms to overcome under-developed financial markets, into a larger pool of funds; thus, it also grants the policymaker an effective tool for smoothing domestic economic shocks via capital borrowing. Indeed, there is evidence that the access to international capital might act as an efficient means of softening domestic shocks, as

23 shown in Bekaert et al (2004). Notably however, these results are not replicated for the case of emerging markets; where arguably the most intense changes in financial account liberalization have taken place. For these economies, the study is only able to conclude that financial liberalization has not further increased the already high existing macroeconomic variability, a finding that is interpreted as an indication that financial liberalization might not be able to deter output volatility in countries that are institutionally or financially backward.

Factors other than institutional characteristics can also reduce the potential benefits of financial liberalization. The opening to the international capital markets also makes the supply of funds dependent, at least in part, on conditions unrelated to the national economy. This in turn expands the set of factors that can eventually lead to credit rationing (e.g., a reversal of foreign investor confidence in the economy), and makes financially integrated economies more vulnerable to external shocks.

Along these lines, Rodrik (2001) provides a more categorical conclusion about the paths through which capital flows volatility influences macroeconomic volatility: relying on a group of Latin American and Caribbean countries, he considers the volatility of several socio-economic indicators (i.e., terms of trade, monetary policy,

24 etc.), finding that capital flow volatility is the greatest correlate of the overall volatility of GNP. Moreover, this relationship has grown so strong during the last decade, that a one point increase in the standard deviation of gross private capital flows as a percentage of GDP is linked to a more-than-half percentage point increase in the standard deviation of GDP. The fact that regression analysis is the analytical choice for disentangling this relationship leads the same author to suggest that the causal link might as well go from GDP volatility to capital flow volatility, since international investors might be responding to market fundamentals. But even if this is the case and capital flow volatility is not an originating factor of macroeconomic volatility, the author concludes that it can be interpreted as a magnifying factor of these imbalances. In this way, flow volatility effects become causal in a dynamic analysis of GDP volatility. Finally, and although at a very preliminary level, World Bank (2002) shows that this link with capital flow volatility is also maintained if, instead of GDP volatility, we consider the volatility of the rate of economic growth6.

The study makes use of a correlogram between the standard deviation of capital inflows, and the standard deviation of GDP growth for a sample of 90 developing nations.

25 4.1. Growth Effects of Macroeconomic Volatility

At this point, we could argue that the mere recognition of capital flow volatility as a determinant of macroeconomic volatility is not enough for one to conclude on the need to tackle the former, if there were no consequences over the average rate of growth that the economy would achieve in the long run. But this does not seem to be the case if we reflect on the large empirical evidence that has corroborated a direct association between macroeconomic volatility and lower rates of economic growth. One of the earliest analyses to configure GDP volatility as a factor influencing economic growth appears is Kormendi and Meguire (1985), which for a sample of 47 countries over the 1950-77 period, includes the standard deviation of real output growth among a comprehensive set of potential determinants of economic growth. This early consideration of volatility as a factor influencing growth is grounded on a hypothesis raised by Black (1979), who envisioned a tradeoff between the risk and return a technology faces. In this fashion, agents tend to select riskier technologies only if these have a larger expected return. When we take these individual decisions at the aggregate level, riskier technology (proxied by output growth volatility) should be associated with greater economic growth. This positive relationship between growth volatility and economic growth is ratified in the empirical analysis, with countries enjoying an approximately 1% greater

26 economic growth in return for an increase of 2% in the standard deviation of economic growth rate.

The above link between macroeconomic volatility and economic growth has faced insurmountable problems to be maintained, and subsequent research has gradually depicted a negative relationship between the two indicators. An initial departure came from Grier and Tullock (1989): drawing on some of the same variables used by Kormendi and Meguire (1985), they find that such specification is more suited for analyzing growth on OECD nations. However, when complemented by some growth determinants relevant to developing nations (e.g., population growth, oil wealth, political infrastructure), some important modifications arise. Particularly for the case of growth volatility, the authors find that a positive relationship with economic growth unambiguously holds only for the case of advanced countries; but in fact becomes negative for subsamples of Latin American and Asian countries.

The findings reached by Grier and Tullock (1989) suggested critical differences in the role of growth volatility across various levels of development. At the theoretical level, one of the strongest justifications for this turnaround came from the idea that characteristics inherent to most investment expenses (e.g., sunk costs), lead firms

27 to face investment irreversibilities7, which in turn prevent firms from fully recovering their initial investment outlay if market conditions deteriorate. Investment irreversibility becomes a critical issue for firms desiring to operate in uncertain economic environments, since the firms expected behavior is to delay investment expenditures until more accurate information about the future is obtained. This combination of irreversible investments and unstable economic markets makes FDI less likely (Rivoli and Salorio, 1996), allowing irreversibility to bridge

macroeconomic volatility into lower rates of investment, and ultimately of growth.

Aizenman and Marion (1993) provide a compelling example on the responsibility of investment in linking economic volatility and growth. In a later study (Aizenman and Marion, 1996), they narrow the previous link to private investment alone, while public investment appears to increase with higher macroeconomic volatility. The opposing paths that public and private investment follow in relation to volatility lead to two important conclusions: first, different types of investment may be determined by deeply distinct behavioral factors. For the case of public investment, the authors suggest that its positive correlation with GDP volatility may reflect increases in public investment aimed to compensate for declines in private investment at times of increased volatility. Secondly, the effects of public and private
7

An in-depth review of the notion of irreversibility can be found in Dixit (1992). See also Pyndick (1991).

28 investment tend to nullify each other, which makes the use of aggregate data on investment (i.e, public and private) unsuitable for identifying significant association with GDP volatility.

Further research has brought the possibility for new intermediate causal factors. Ramey and Ramey (1995) challenge the validity of investment-based explanations, after finding that the share of investment in GDP has no influence on the relation between GDP volatility and growth. Instead, the authors blame economic uncertainty, proxied by the standard deviation of the residuals of a forecast equation in which GDP growth is the dependent variable, for the link between macroeconomic volatility and lower growth. This negative association between economic uncertainty and growth appears to be robust to alternative proxies for uncertainty, at least for the case of uncertainty about inflation (Zarnowitz and Lambros 1987), about economic policy (Aizenman and Marion 1993); or to the use of volatility measures other than the standard deviation8.

Even in the presence of competing causal factors or indicators, the most important finding for our purposes is that the negative relationship between macroeconomic volatility and growth is often sustained. And by doing so, it provides conclusive
8

Recently, Ranciere et al (2005) find that the skewness of the distribution of credit growth has a robust negative effect on GDP growth.

29 evidence on the detrimental effects that pronounced business cycles can have on the long run average growth of the economy, in dramatic contrast with those claims that have pictured economic growth as being independent of business cycles fluctuations (Lucas, 1987).

Summing up, the notion that shocks or disturbances on GDP have a permanent effect over the ultimate path of economic growth, makes minimizing those fluctuations an important developmental objective. Thus, in light of the evidence linking capital flow volatility with growth or GDP volatility, policies aiming to achieve a stable financial account appear to be critical for successfully integrating into the international markets in a way that is reconcilable with stable patterns of economic growth. Despite this realization, the crises that have affected the developing world throughout the last two decades have not been accompanied by policy initiatives aimed at controlling the fluctuations on the financial account. With some exceptions (e.g., Chile in 1992, Malaysia in 1997), the behavior of the financial account was seen by host governments as a dictate of the international markets, and initiatives towards controlling the massive entrance or exit of flows have generally not been implemented. This lack of agency over their external sector is arguably behind the focus on the research on capital flow behavior, which has been concentrated on the identification of those elements of the financial account that

30 are more stable. In what follows, we will review the record of this strand of research, highlighting some of the limitations in the literature that motivate the present study.

5. Building the Conventional Wisdom on Capital Flow Volatility

Being to a large extent a byproduct of the financial turmoil of last decade, the work on the time series behavior of capital flows is a research agenda whose inception dates from the time of these crises. As we stated earlier, the main objective of this line of work has been to identify which capital flow has the lowest volatility, and allegedly therefore is more conducive to a stable financial account. Aside from the empirical work on the issue, some theoretical papers have helped to solidify the superiority of FDI among capital flows. After reviewing these two strands of the literature, we will highlight their most important shortcomings, and the relatively modest echo that these shortcomings and counterexamples have had in the policy realm.

31 5.1. Empirical Literature

In many of the studies, a preliminary taxonomy with respect to the relative volatility of capital flows has been to distinguish them by their maturity structures, whether explicit or not. In doing so, the researcher has been able to draw a fundamental distinction between short and long-term flows, even if some of them are not bound by strict maturity dates. Turner (1991) is an early example of this type of analysis, finding that short-term band lending is the most volatile flow, with long-term bank lending the most stable. FDI, a flow that does not have an explicit expiration date, is found to be in the middle of both. Findings of this sort suggest the idea that the maturity term of flows provide valuable information about the actual volatility patterns of the flow; those flows with short maturities being hot, or volatile and speculative in nature.

Turners study offered an initial view on the relative volatility of different capital flows, but its inception before the financial crises of the nineties prevented it from evaluating how different types of capital flows performed during those turbulent times. The baton of this research was passed to other studies, which increasingly tended to conclude on the relative stability of FDI9. World Bank (1999) shows that

Some additional examples are provided in UNCTAD (1999) and Nunnemkamp (2001).

32 the share of non-FDI private capital flows in GDP have exhibited more volatility than FDI shares throughout the last quarter of the XX century. A more disaggregated comparison of private flows is provided in UNCTAD (1998), which finds that annual FDI flows to developing countries during the 1992-1997 have exhibited a lower coefficient of variation10 than portfolio investment or commercial bank loans. World Bank (1999) also offers a slightly different inquiry, as it discriminates between the behavior of flows before and after the emergence of a crisis. Selecting the major instances of capital flows into 21 developing nations, the study shows that the coefficient of variation of private non-FDI flows is higher than for FDI flows in two thirds of the sample. Thus, when the time horizon is expanded and the post-surge period is included, this gap in volatility measures is still maintained. Taken together, the findings suggest that FDI tends to be the most stable flow, irrespective of the stage of the capital flow cycle in which the economy stands.

With this large evidence concluding on the resilience of FDI, other studies have moved towards the use of more sophisticated proxies of volatility, to see whether these results could be replicated. Sarno and Taylor (1999) employ maximum likelihood Kalman filtering techniques and variance ratio statistics to distinguish
10

The coefficient of variation is a measure of relative variability, and is computed as the quotient of the standard deviation divided by the mean of the series.

33 between the temporary and permanent components of such flows. The purpose for this identification is that, if much of the flow variation arises from temporary components, the flow could be potentially reversible, and should therefore be more volatile. With this empirical design, the authors analyze four types of capital flows showing that portfolio investments and official flows are largely temporary in nature, and therefore subject to reversibility. On the other hand, FDI, followed by commercial lending, displays the largest permanent component, an indication that it is more bound to long-term considerations of profitability, and hence more stable than the other components of the financial account.

5.2. Theoretical Reasons for FDI Stability

In the search for the reasons that may make FDI to be the most stable flow, its own definition provides a good starting point to think about the influencing factors. Following OECDs Benchmark Definition of Foreign Direct Investment, FDI is defined as an international investment by a resident entity in one economy in an enterprise resident in another economy with the objective of obtaining a lasting interest. This concept of lasting interest suggests that direct investors are associated with the object of investment by a long-term relationship that is generally not present for other kind of international capital flows (notably portfolio investment). If the

34 concept of lasting interest has provided some intuitive foundation for the greater stability of FDI, additional support has also come from the idea that investments in physical capital, which are central to FDI activities, are not as easily reversed as cross-border share-trading, or debt instruments (Persaud, 2001). As we will see in the brief literature review that follows, even though in most instances these preconceived notions about the relative resilience of FDI have been empirically confirmed, there are a handful of counterexamples that shed some doubt about uncritically embracing this claim about FDI.

World Bank (1997) adopts this comparative approach to offer some of the factors behind the relative stability of FDI. The study lists three main factors that account for the volatility of flows in emerging markets.

The first of these are changes in interest rate differentials, or in the stock market returns between emerging and industrial countries. Arguably, this factor should only affect portfolio investment, since it is originally determined by the existence of higher interest or stock returns in the host economy. On the other hand, FDI flows are not affected as much by swings in international interest rates, since they are determined to a larger extent by long-term considerations of the host market (e.g.,

35 consumer base), features that do not change as frequently as interest rates or stock returns.

Second, herding and contagion have been identified as two other factors that have exacerbated the volatility of portfolio investments. While each of these reflects different dimensions of investor behavior, they are deeply intertwined, and based on the existence of asymmetric information in the financial markets, a problem that FDI seems to successfully circumvent: herding occurs when investors, especially in the presence of incomplete information, tend to imitate each others decisions, effectively de-linking investment moves from market fundamentals.

Incomplete information has certainly been at the core of much of the patterns of investment for middle-income countries. Even the coining of the term emerging markets is illustrative of this scenario of incomplete information, where countries that differed greatly in their market fundamentals were nonetheless conjoined together. Not surprisingly, contagion, or the transmission of crises from one country to another, has been a likely consequence of this process of market homogenization. But just as in the case of interest rate differentials or herding, contagion appears to be specific to portfolio investment. FDI decisions, on the other hand, are immune to these processes of investment imitation, mainly due to

36 the greater information in the hands of direct investors (Goldstein and Razin, 2002; Sarno and Taylor, 1999).

But if the lack of knowledge about the investment environment influences the greater resilience of FDI, the same about the business activity of direct investors also appears as a factor. Aware of the extent to which intangible assets affect FDI operations, Albuquerque (2003) constructs a model in which the explanation for the lower volatility of FDI arises from the inability of host agents to conduct the business operations in the absence of foreign presence. Intangible assets (i.e., brands, R&D expenditures, patents, etc.) are for the most part inalienable, and without the involvement of the foreign investor, the value of the investment for the host economy is small. On the other hand, portfolio investment or commercial debt are largely appropriable. In all, and in an scenario where there are no international enforcement mechanisms to guarantee contracts between foreign investors/creditors and the host nation, the inalienability of FDI makes this flow relatively immune to expropriation by the host executive. This not only would explain the relative stability of FDI when signals about the domestic economy turn

37 negative, but also the higher proportion of FDI in the financial account in countries at the bottom of sovereign credit rankings11.

The third and final factor that that accounts for the higher stability of FDI flows has to do with the different degrees to which investors can disinvest between the two types of flows. On one hand, technological developments in international financial markets, along with a relaxation of host market regulations towards capital flows have made it easier than ever for portfolio investment flows to return to the home country. Regulatory changes have also facilitated direct investment flow repatriations to the headquarters. But in contrast to portfolio investment, FDI ends up on the ownership of physical facilities, an attachment that limits a speedy resale in two ways: first, in general the price of the asset underlying the direct investment is not publicly known (World Bank, 1997). This poses an information asymmetry problem that generally lengthens the negotiation time between agents, and it does not guarantee a fair price for the seller. All these factors combined make direct investments have a longer resale time than stocks or bonds. And accordingly, it slows the ability of direct investment to be reversed, forcing foreign investors to have a profit horizon that is inherently long-term (Lipsey, 2001).

11

Investment ratings like the Euromoneys country rating and the Institutional Investors country credit rating show a significant and negative relationship with the share of FDI in gross capital flows.

38 The above impediments for direct investments to change ownership not only make them as more stable, but also more efficient in avoiding certain temporary shocks: a case in point is currency crises, temporary shocks that generally do not embrace a change in the fundamentals of the economy. Confirming this immunity to currency crises, Nitithanprapas and Willett (2000) show, for a sample of 26 economies during the crises of 1994 and 1997, that low levels of FDI, along with the current account deficits and a distorted exchange rate are strong predictors of a countrys proclivity to suffer these financial imbalances.

5.3. Counterexamples

Despite the development of theoretical models explaining the factors behind the resilience of FDI, and the extensive evidence in its support, the literature has raised a few, but relevant counterexamples. The earliest one is in Claessens et al (1995), which adopts a sample of 10 industrial and developing nations to actively react against the conventional wisdom on capital flows volatility. Instead, the authors argue that the term maturity is simply not enough to categorize a flow as volatile or stable. One intuitive reason for this mismatch is that there are instruments that can transform a short-term flow into long-term one, or vice versa. For instance, debt

39 roll-over may allow the maturity of a short term debt flow to be extended to one more typical of long-term flows.

But going beyond developments in international financial markets, a more emphatic point raised by the authors is that the interaction between different flows may also help to blur the connection between the flow labels and their time series properties. The feature of capital flows that leads to this dynamic is the degree of substitution, in particular the existence of inter-flow negative correlation. When two flows exhibit a strong degree of substitution, their time fluctuations would tend to offset each other, and the resulting volatility of the financial account would essentially remain unaffected. Therefore, studies that do not take into account the possible interactions between the elements of the financial account, and rely exclusively on the univariate properties of the flow to decide on their relative stability, might be unable to reflect the volatility that is actually transmitted into the financial account and the economy. Accordingly, the authors call for the need to focus on the effects on the financial account in order to draw definite conclusions on the relative stability of the flows.

With all these caveats at hand, their empirical study looks at several dimensions of the time series behavior of the flows, to raise doubts about the existence of a flow

40 systematically more stable. To assess the importance of substitution effects, interflow correlations are calculated, and even though the authors do not identify any systematic behavior, they remark that this feature is large enough so as to disqualify analyses based on the univariate properties of the flow. In order to analyze the relative volatility of the flows, they compute standard deviations and coefficient of variations of the flows, similarly yielding no systematic pattern of volatility. To the contrary, FDI and long term debt turn out to be the most volatile flows in four countries, and portfolio investment in two cases. Surprisingly, and despite its accounting label, short-term flows appear to be the least volatile in seven of the ten cases analyzed.

A complementary notion to volatility is the idea of persistence, measured by the flows degree of autocorrelation, with the idea that flow series that are positively autocorrelated (negatively) would be relatively persistent (volatile). Here, the conventional wisdom is partially ratified, as FDI exhibits positive autocorrelation, while short-term flows have negative autocorrelation. The evidence on flow persistence is complemented by calculating half-lives from impulse responses12, namely the number of quarters required for a shock to the series to lose half of its value. A priori shocks in highly and positively autocorrelated series would propagate

12

Half-lives are computed by estimating a univariate AR(4) model for each flow.

41 themselves for longer time than negatively correlated ones. And again, at this point of the analysis no systematic patterns are found, as most of the half-lives tend to be one quarter, irrespective of the flow to which they belong.

To further challenge the conventional conclusions drawn in the literature, the authors ask about the extent to which the composition of the financial account determines its forecasting ability. The underlying idea is that, if flows behave according to the conventional wisdom, financial accounts that are concentrated in presumably stable flows would be predicted more accurately. To do so, a forecast of the overall financial account is constructed based on its past information, as well as on the contemporaneous share of individual flows. The latter turn out to improve little the forecasting ability of the financial account. This serves the purpose to conclude that movements in the overall financial account are not very influenced by the type of capital flow, presumably because of inter-flow substitution. In all, this is the final idea that allows the authors to conclude that the separate analysis of time series flows is not adequate for conveying definite conclusions over which flow is the most stable. Rather, it is the financial account balance that should take a central role in this analysis, as it would implicitly account for possible interaction between the flows.

42 The previous work opened the path for later research to consider the potential role of substitution between flows, albeit with some modifications. Chuhan et al (1993) adopts the same basic distinction across the life span of the flow (i.e., short and long term) that Turner (1991) initiated, to examine the differences that may lie behind short term investment and FDI. A crucial assumption here is that FDI is more connected to the outlay of physical capital, configuring it as a long-term flow, and therefore more stable. To validate or contest this assumption, they aim to investigate whether there are major differences in the stationarity of the flows, a result that would support the notion that the categories of flows are useful in distinguishing between stable and volatile flows.

Possible differences across flows are also investigated through the relative persistence of a disturbance to an autorregresive model for each of the flows. However, and despite that initial assumption, the authors find that stationarity tends to be rejected in most series, independently of the flow to which they belong. And regarding the persistence of the series, shocks to FDI series tend to have a more lasting effect than shocks to short term investment. This battery of univariate techniques is unable to find major differences in the time series properties of the flows, and only the results on flow persistence yield marginal support for the notion that FDI is more stable.

43 Significant differences arise however when certain flow interactions are considered. In particular, the authors employ Granger causality techniques to show that short term investment responds, not only to changes in other flows, but also to changes in short term flows in other countries. These dependencies are not enough to decide on the greater volatility of short term flows, but they do suggest that these flows are more sensitive to factors outside their own fundamentals, and to contagion effects from crises in other countries. These last differences, although counterbalanced by the results of the stationarity analysis, lead the authors to conclude that the different categories of inflows do offer a meaningful distinction to label a flow as hot or cold, and to advocate that some level of disaggregation should be maintained in research on capital flows. In sum, through these findings the authors highlight the greater susceptibility of portfolio investment to other flow movements. Following on this argument, Bosworth and Collins (1999) fail to find any significant correlation, positive or negative, across the various types of flows to developing nations.

The debate on capital flow volatility has benefited from more recent work that has aimed to challenge the conventional wisdom with the help of sophisticated data on industrial countries, generally not available for most of the existing literature, which has predominantly focus on the developing world. Persaud (2001) for instance relies

44 on a high-frequency dataset including observations on FDI flows arising from mergers and acquisitions in Europe and the United States, to show that the standard deviation of monthly changes for this type of FDI is higher than the same indicator for both debt and equity portfolio investment. Moreover, the author introduces in the literature the use of two proxies skewness and kurtosis- that, while not explaining the usual concept of volatility of a series, provide information about the way it is distributed. Of these two, kurtosis measures the relative size of the distribution tails, with higher value implying fatter tails. In other words, a high kurtosis entails a greater tendency for the distribution to have extreme observations, which for the case of the series considered is equivalent to flow surges and reversals.

With these analytical considerations, the striking finding is that the kurtosis of FDI based on mergers and acquisitions turns to be higher than for both types of portfolio investment (i.e., debt and equity), disqualifying statements that have uncritically portrayed FDI as unable to reach large surges or reversals (e.g., Lipsey, 2001). On the contrary, the study shows that at least those FDI operations based on merger and acquisitions have the potential to exhibit both massive inflows and outflows, even more so than portfolio flows. Thus, while the study focuses on USEurozone cross-border flows, in principle the same conclusion could be applicable

45 to patterns of FDI in developing nations during last decade, if we recall the importance that privatization programs have had in attracting direct investments. In these instances, the acquisition of former public companies led to one-time large flows at the time of the purchase, a mode of entry that contrasts with Greenfield13 FDI operations, which tend to disseminate their inflows more evenly throughout time, reducing the possibility for capital rush. In fact this seems to be behind the larger volatility found for FDI vis--vis other flows in some countries and years (e.g., Brazil in 1997), where privatization schemes were a central element in the strategy to lure international investors (ECLAC, 1999; UNCTAD, 1997). In all, Persauds findings suggest that certain specific FDI features can drastically alter the vision of this flow as a resilient source of external financing for the host economy.

We can think of additional factors that can potentially erode the usual view of FDI. As already stated, privatization programs have acted as a catalyst for the arrival of massive FDI flows to developing nations throughout the last part of the XX Century. This way of setting business operations in the host economy has substantial differences with the historically more frequent Greenfield FDI. Here, the critical difference in time series behavior is that privatization-led FDI flows are

13

Greenfield FDI occurs when international investors set up their business operation without the purchase of an existing company in the host economy, and rather by setting up a new physical facility.

46 concentrated at the moment of the purchase, with much smaller flows accruing to the host economy in subsequent years. One consequence of this asymmetrical sequence of flows is obviously the difficulty to maintain those high levels of FDI flows in countries actively engaged in privatization (Griffith-Jones and Leape, 2001), once there are few remaining state owned enterprises susceptible to be privatized. Another outcome, even more related to our issue of interest, is that the distribution of FDI flows would tend to be more prone to outliers, a factor that can accelerate the overall volatility of aggregate FDI series.

To a certain extent, the above factor can be considered circumstantial, given that privatization programs cannot be sustained once state retreat from the economy is complete. However, other factors that can influence the volatility of direct investment flows are inherent to the array of instruments employed by multinational corporations to conduct the operations of their subsidiaries. For instance, the ability to hedge between home and host country risk through debt is a basic measure to reduce the exposure of international direct investors to a particular economic market (Bird and Rajan, 2002). Through this process, direct investors present the facilities of the subsidiary as collateral to borrow domestically in the host nation, to then repatriate the loan funds to the parent firm. In this way, the exposure to a worsening economic scenario is reduced, despite the short-term

47 impossibility to divest through physical down-sizing. A similar point could be made of an increase in profit remittances from the subsidiary to the parent firm, which would also act to reduce the exposure of direct investors to the host economy.

The financial engineering at the disposal of the multinational firm is not the only factor that is generally overlooked by the conventional view on capital flows, and which can alter the typical conclusions on the stability of FDI. Another reason for the resilience of FDI is grounded on the fact that some of its most important locational determinants are variables that cannot vary much in the short run14. This nevertheless does not preclude other short-term, more volatile variables, from affecting FDI decisions. Among these, the role of exchange rates in aggravating FDI volatility has been specifically addressed in the literature. World Bank (1999) highlights the exchange rate as one variable that, being susceptible to acute fluctuations in the short run, can alter FDI flows abruptly.

The evidence on this issue is however not conclusive. On one hand, a solid finding of the literature is that the likelihood of exchange rate appreciation in the host nation deters subsequent FDI inflows15. But the role of the variability of the

14

A consistent result of the empirical literature on FDI finds market size, proxied by host country GDP levels, as the most important location determinant. For a review, see Singh and Jun (1995). 15 Evidence of this relationship is found in Cushman (1985); also in Barrell and Pain (1996).

48 exchange rate over direct investment flows is a much more contested question: early investigations on the issue (e.g., Cushman 1985) found the standard deviation of the change of the exchange rate to have a positive impact over FDI. Later studies however portray a negative association between exchange rate volatility and FDI: Campa (1993) shows that exchange rate volatility deters the entry of foreign firms into the wholesale industries in the United States. Similarly, Benassy-Quere et al. (2000) find a detrimental effect of exchange rate instability on the FDI flowing from OECD countries to developing nations. In all, this ambiguous relationship reflects the existence of counterweighing forces16, which in turn leave no clear indication on how FDI flows react to an unstable exchange rate.

5.4. Policy Implications

Notwithstanding the existence of factors that can accelerate FDI volatility, this literature review clearly concludes that this flow is the most stable source of external financing. This view, also prevailing in the policy realm, has justified the preference for a financial account geared towards this type of flow, an objective that has been carried through various measures. One has been the establishment of
16

While a negative relationship between exchange rate volatility and FDI can be accommodated within the general idea that economic uncertainty (over which exchange rate volatility is one possible dimension) deters FDI activity, Cushman justifies the positive link he finds on the idea that FDI provides a better safeguard than trade to exchange rate fluctuations, giving firms an incentive to internalize their business operations in order to reduce their exposure to terms of trade shocks.

49 investment promotion agencies by economies eager to attract FDI. The number of agencies, whose general objective is to improve the investment environment of the host economy, has skyrocketed during recent years. UNCTAD (2001) reports a record number by the end of the decade of the nineties, with 164 investment promotion agencies at the national level, and more than 250 at the sub-national.

The array of services undertaken by these agencies is comprehensive, but at a minimum level it involves two basic tasks. One is the diffusion of information about the host economy, with the purpose of reducing informational asymmetries that may have a discouraging effect on potential foreign investors. A second, more proactive duty is the assistance on the bureaucratic and legal requirements that the foreign investor needs to fulfill upon its entrance in the host economy. In addition to these, and more controversially, incentives have also included benefits like tax breaks, land grants, or other special regulatory treatment. Such an ardent policy move to lure international investors has understandably found opposition, as it has eventually raised doubts about the overall welfare gains that the host economy receives from investments induced through excessively generous and costly incentive programs17.

17

Blomstrom and Kokko (2003) state that the use of incentives is generally an inefficient way to raise national welfare, if it is not accompanied by a complementary set of policies designed to improve the competitiveness of local firms.

50 A complementary measure in the hands of national executives to promote FDI has been the establishment of bilateral investment treaties. These inter-country arrangements almost tripled in recent years, moving from 1,639 treaties in 1990, to 4,436 in 2002 (see Figure 8). Just as in the case of investment promotion programs, bilateral investment treaties aim to facilitate international investment. But as opposed to incentive schemes, which may entail some discriminatory measure in favor of foreign investors, bilateral investment treaties do not go beyond establishing a level playing field between domestic and foreign competitors. This is accomplished through the eradication of double taxation, compensation for investment expropriation, or other measures that in general aim to guarantee fair treatment to foreign investors in the host market18.

18

While the general evidence on the effectiveness of incentive programs in attracting FDI is fragmentary, the effectiveness of Double Taxation Treaties is even less satisfactory: Blonigen and Davies (2000) find that these schemes not only fail to promote FDI flows, but actually have a shortlived negative effect. This surprising result is consequence of the uncertainty that the new regulatory environment delivers, which may lead some international investors to wait and see before investment decisions are taken.

51 Figure 8: Bilateral Investment and Double Taxation Treaties (1990-2002)

350 300
treaties 200 per year

5000 4000 3000 2000 1000 0 1992 1994 1996 1998 2000 2002
cumulative

250 150 100 50 0 1990

treaties Source: UNCTAD

cumulative

A final element leading toward a regulatory environment favoring FDI over other private flows has been the recent financial crises. In some cases, the gravity of these imbalances resulted in the imposition of capital controls, whose main purpose was to deter short-term capital outflows. Given the presumed long-term orientation of FDI, this flow should be relatively unaffected by measures that aim to tackle speculative short-term flows. In addition, this relative freedom of FDI from capital control measures arises also from the paths available to a foreign subsidiary to repatriate funds to the parent company. Desai et al. (2004) on this matter report that, at least in the case of U.S. multinationals, capital controls have been effectively

52 evaded through profit reallocations, or variations in intra-firm trade, which have no counterpart in the case of portfolio investment.

Summing up, the political economy of capital flows has unmistakably headed towards measures facilitating FDI inflows in contrast to the treatment to other flows (notably, portfolio investment), which have not enjoyed such benign treatment. In contrast, there are several episodes in which general trade and capital liberalization has been accompanied by tighter control of certain capital flows, and in some cases blunt discouragement. Our motivation for this study is sustained precisely on these policy ramifications, assuming that the research that has enthroned FDI as the most stable flow is at least partly responsible for this policy response. In what follows, we will proceed to highlight some of the limitations and unaddressed questions of this literature, which in view of its relevance at the policy level, calls for further investigation on the issue of FDI volatility.

6. Study Scope

A defining characteristic of the literature on capital flows behavior is that studies on capital flow volatility, especially those that tend to ratify the view of FDI as the most stable source, have relied on separate analyses of each of the flows to reach its

53 conclusions. It is from this analysis of univariate properties that the literature has concluded on the desirability of FDI for the host economy. This approach however does not take into account the volatility of the financial account, even though this should be the element whose time series properties are of ultimate concern for the policymaker. Arguably, if we set aside those beneficial effects of capital flows that are independent of their time series behavior (e.g., FDI spillovers), the main policy objective regarding capital flows would be the achievement of a sure source of external financing of the current account. It is not stable capital flows per se, but rather a stable financial account that really matters for policymakers. Surprisingly however, there are very few studies, which we proceed to detail below, that have made reference to how flows influence the volatility of the financial account.

Bringing the volatility of the financial account to the center of the analysis is a necessary step to disentangle a fundamental objective of this study: recalling the substitution effect portrayed in Claessens et al. (1995), potentially one of the most significant conceptual challenges to the prevailing views on capital flow volatility, we are interested in investigating whether FDI participates in these interactions among flows. A method to show this possibility is the inclusion of cross-correlation flows, a point that was specifically addressed in Claessens et al. (1995), and Ramos (2002). But, while illustrative, the simple observance of negative correlation coefficients

54 cannot tell us whether they are large enough to drastically alter the final volatility of the financial account.

Our interest on this last question, and specifically for the case of FDI, lead us to adopt a different approach, based on an econometric approach that first investigates the possibility of inter-flow substitution a-la-Claessens, with an econometric specification in which the volatility of the financial account is the dependent variable. This allows us to examine whether potential substitution effects are large enough to impede the transmission of the volatility of FDI into that of the financial account. Thus, a second, related purpose of the analysis is to check whether or not greater FDI presence compared to other capital flows results into greater stability of the financial account, a finding that would reinforce the conventional wisdom on capital flows volatility. In what follows, we provide a description of the variables and data sources utilized, a justification of our choice for the measure of volatility, a more detailed specification of the econometric model and an explanation of how this one can address our research questions.

55 6.1. Data Sources and Variables

We focus our analysis exclusively on the case of developing nations, a restriction that is grounded on the following considerations: First, capital flows, as well as most of other macroeconomic series, have generally been more volatile in the developing world. More advanced nations have been better able to avoid capital flow crises, as they are not affected so much by the factors that create them in the first place: in general, developed nations possess a good set of economic fundamentals, and are relatively immune to financial contagion. Ultimately, they are in a better position to provide domestic financing buffers to sudden withdrawals of foreign flows.

Second, the relatively smaller size of developing economies makes them more sensitive to fluctuations in capital flows. This should certainly be the case for small, open developing nations, which are more exposed to international trade and finance, flows thereof which can be huge relative to the small size of their domestic market, have joined forces to aggravate the volatility of other economic variables (Easterly and Kraay, 1999). Large developing nations however have not been immune to fluctuations in capital inflows, as many of them experienced drastic surges after liberalizing the financial account, or undertaking other economic

56 reforms. In all, volatility of economic aggregates in the developing world has affected small and large developing economies alike, while leaving the most advanced nations relatively protected.

Within the developing world, we take a comprehensive approach that contrasts with the more confined scope of the existing studies on capital flow volatility. Some of the work that has delivered the most important challenges to the conventional wisdom on capital flows volatility has relied on fairly small samples. The empirical analysis on Claessens et al. (1995), for instance, covers merely 10 cross-sections, equally divided across industrial and developing nations. A fairly similar sample is adopted in Chuhan et al. (1993), which covers 7 industrial countries and 8 emerging economies. Just as the cross-sectional dimension, sometimes the time dimension is also constrained. Chuhan et al. (1993) covers the 1985-1994 period, almost the same as in Sarno and Taylor (1999), whose sample ranges from 1988 to 1997. An expected tradeoff in some of the previous examples is that these limited spans are generally rewarded with higher frequency in the data used. This is the case in both Claessens et al. (1995) and Chuhan et al. (1993), which use quarterly data on four types of capital flows. Unfortunately, such a rich dataset is not available in our case, since for some of the countries that we cover, particularly least developed nations, quarterly time series are virtually non-existent. The use of annual observations

57 therefore has the advantage of allowing us to include these countries, for which FDI is usually the most important external private fund. Given the data limitations constraining our study, we use several datasets to build our sample, among which IMFs International Financial Statistics (hereafter, IFS), and World Banks World Development Indicators (WDI) database constitute the backbone. Favoring breadth over frequency, and depending on the specific stage of our analysis, we were able to include up to 104 developing countries in our empirical study.

Our focus on the effects of FDI volatility on net financing requires us to obtain data on the balance of the financial account, as this is the element that comprises the capital flows that the national economy receives, and in doing so reflects the extent to which the international economy finances the consumption and investment expenditures of the host economy. For our set of regressors, we compiled observations on net flows of FDI, computed as the difference between the assets and liabilities sides, a measure that includes both inflows and outflows of FDI, and that accordingly can reflect greater fluctuations compared to other FDI proxies (i.e., FDI stocks, FDI gross flows). Persaud (2001) in this regard remarks that part of the support to the notion that FDI is the most stable flow has come from the idea, intuitively sound, that investments in physical capital, central to FDI activities are not as easily reversed as cross-border share-trading, or interest rates in debt

58 instruments. Including the balance on net flows, however, provides a better estimate of all the ways through which multinational corporations can affect the actual flow of funds to the host economy.

Regarding the data sources, our model19 required two variables based on FDI for our analysis: the first one is the net inflow of FDI to GDP ratio, computed from the World Development Indicators database; another FDI-related variable that we adopt is the share of FDI in total flows. As this variable is not readily available for our sample of countries, we compute it by dividing our first variable (FDI/GDP) over the ratio of total flows to GDP20. Moving away from the balance of payments, WDI also supplied observations for series on GDP, financial development, and trade openness. Table 1 summarizes the main variables used in this study.

19

At several stages of the analysis we added further explanatory variables whose source is not detailed in this section, as they were not kept in the final econometric specification. These sources will nevertheless be identified in our discussion of the empirical results. 20 A similar procedure is used by Hausmann and Fernndez-Arias (2000) to arrive at the same type of variable.

59 Table 1: Main Variables

Variable FAV Proxies for Financial Account Volatility Definition Std. dev. of Financial account as % of GDP Std. dev. of ratio of FDI net flows to GDP Gross FDI inflows as a % of total capital inflows FDIV x FDITK FDIV squared Real GDP per capita Broad money as % of GDP Exports plus imports as % of GDP Source IFS

FDIV FDITK FDIVTK FDIV2 GDP M2GDP OPEN

FDI volatility Share of FDI in total capital Interaction term Quadratic term Development levels Financial Development Trade Openness

WDI IFS N/A N/A WDI WDI WDI

We note that dividing both the financial account and FDI by GDP levels is a necessary step prior to the calculation of their respective volatilities. This approach is precisely the one followed in Rodrik (2001). It attempts to eradicate the biases that would arise from using the unweighted data, which would tend to place as most volatile those flows accruing to middle income countries, given that these are the largest receivers of external flows. Normalizing the series therefore eliminates the influence of the economic size of the country over volatility measures.

It has been long recognized that data on international capital flows, particularly that on FDI, is filled with considerable inaccuracies. Several multilateral organizations (i.e., IMF, OECD, UNCTAD) have increasingly devoted attention to the extent to

60 which measurement problems affect the existing statistics, as well as their underlying reasons. One of the main causal factors is the two dimensions that define the way FDI data is gathered. The first distinguishes between individual or aggregate transaction reporting21. The second allows the data to be collected by a statistical agency, or directly from the transactor. In practice, the choice for data collection is non-trivial, as it defines which operations fall under the FDI category and which do not. For instance, individual transaction reporting from banks provides a fairly accurate estimate of FDI operations associated with cash flows. It is however much less effective for recording operations that do not have a flow of cash associated, as it is the case of certain intra-firm transactions (i.e., the transfer of proprietary technology from the parent to the subsidiary).

Other sources of measurement error in these statistics include the use of different country standards for categorizing a transaction as FDI. While widely accepted, the use of the 10% equity threshold is not universally endorsed. Some countries (e.g., France, Germany) have established a higher percentage threshold, while others completely disregard its use, and instead classify FDI operations on a case-by-case basis (IMF, 1992). Adding to this variation in national practices, we find countries

21

Individual reporting methods record every transaction pertaining to FDI, usually from banks. Aggregate reporting on the other hand compiles the total amount of transactions during specific reporting periods, and it is therefore more likely to come through enterprise surveys.

61 that do not accurately record some transactions associated with FDI. Such is the case of reinvested earnings, or certain types of FDI disinvestments22. In all, most of the measurement discrepancies across nations are based either on the incapacity of some nations to collect some types of FDI operations, or on their departure from the common standards for compiling FDI data.

Moving beyond their causal factors, can we quantify the measurement bias of FDI data? One of the earliest and most relevant efforts to assess the measurement bias on FDI statistics has been IMFs Report on the Measurement of International Capital Flows. Using the recorded difference between global outward and inward direct investment, the study finds a substantial discrepancy between the two figures, which in the late eighties averages $16.5 billion, and approximately 10% of the global outward flow of FDI. The same report also concludes that a large share of the discrepancy arises from the entry of reinvested earnings, which emerges as the leading cause for measurement error.

A related study, albeit having a more restricted focus, is Patterson (1992). It calculates the statistical discrepancy in FDI data by analyzing the geographical
22

The sale of a foreign company in the host country would theoretically be recorded as a capital outflow in the FDI account of the Balance of Payments. But in practice, reporting this operation may depend entirely on the sellers will, especially if it is not done through financial intermediaries. Some countries (e.g., United States) circumvent this limitation by requiring a compulsory filing directly from the foreign investor, but others lack the capability to correctly register such disinvestments.

62 breakdown of outward and inward flows of seven major FDI players (Australia, Canada, Germany, Japan, Netherlands, United Kingdom, and United States). One of its main findings is a tendency for offsetting positive and negative bilateral inconsistencies, which yields an estimated annual discrepancy of $3.5 billion for the seven countries during the 1986-88 period. In this way, the study implicitly suggests the possible inadequacy of concluding on the importance of the statistical discrepancy on FDI data by simply looking at the entry errors and omissions23.

When we shift the focus of the measurement problem to the balance on the Financial Account, the biases inherited from the FDI account have to be added to those that are specific to the other elements of the Financial Account. Within these, the same IMF report has also recognized some reasons for the statistical discrepancies of the other major categories of financial flows (i.e., Portfolio Investment and Other Investment).

The identification of these distorting forces has served the basis for subsequent adjustments in the data that have aimed to reduce the size of these biases in more recent years. Despite these improvements, any study relying on these statistics may
23

Theoretically, since data on capital flows is recorded on a double-entry basis, analyzing the errors and omissions entry could provide a good estimate of the relevance of measurement problems. Unfortunately, this strategy does not take into account the possibility that positive and negative errors may offset each other, which can render the errors and omissions entry ineffective to correctly identify the size of the measurement error.

63 suffer from measurement error bias. Our empirical analysis, however, incorporates a feature that may reduce the actual damage of this bias, if present. Specifically, our variables based on FDI flows or financial account balances are constructed as volatility or average indicators for four-year periods. This in turn should reduce the annual fluctuations from measurement error in a particular year (Wei and Wu, 2001).

6.2. Measures of Volatility

A defining characteristic in the literature of capital flow behavior has been the lack of consensus in choosing a measure of volatility. In principle, the traditional measure of volatility has been the standard deviation of changes in the series (Persaud, 2001); however an also typical even if unscientific view of volatility has aimed to identify drastic changes in the direction of the flow. This approach, while not necessarily delivering the most accurate measure of the volatility of a series, has some appeal in so far as it is able to identify drastic surges or reversals in the flow, generally unexpected by the policymaker, and arguably the most destabilizing for the economy. Lipsey (1999) for instance adopts a notion of volatility based on the number of times the series changes sign, with the objective to reflect the frequency

64 in which inflows turn into outflows and vice versa. In this fashion, sign changes provide a notion of the instability of a capital flow in contributing to net financing. Nevertheless, sign changes fall short of offering an accurate notion of volatility. Ramos (2002) on this matter warns that the sole use of sign changes may lead to fallacious inferences about the instability of the series, since flows with large but few sign changes would generally be more volatile, compared to series with many sign changes that are relatively small in size. Persaud (2001) also adopts an indicator to pinpoint extreme inflows or outflows, through the kurtosis of the distribution. Being a measure of the flatness of the tails of a distribution, the kurtosis gives a notion of the importance of outliers in the distribution. Particularly for the case of capital flows series, higher kurtosis would reflect a relatively larger occurrence of drastic surges and reversals of flows.

We can find a more accurate focus on the unexpected volatility of a flow in Osei et al. (2002), which in addition to more standard indicators of volatility (e.g., coefficient of variation), include the standard deviation around a forecast trend based on adaptive expectations. In other words, the forecast should capture the trend value of the series that would have been predicted using the past values of the series24. A related example is provided in Claessens et al. (1995), through a

24

A similar measure can be found in Lensink and Morrisey (2001)

65 forecast autoregressive model used to test the predictability of the series. Notwithstanding the above exceptions, the present study follows the approach of the majority of the existing literature, which has aimed to identify the actual volatility of capital flows, in turn disregarding the role of agents expectations. This focus has generally favored the use of two indicators, either the standard deviation of the series (Rodrik, 2001; Easterly et al., 2000); Easterly and Kraay, 1999), or the coefficient of variation (Claessens et al., 1995).

The use of the coefficient of variation has some advantages over the standard deviation. Probably the most evident is the ability of the coefficient of variation to correct for trends in the series. The standard deviation on the other hand, is more susceptible to increase at times of rising capital flows (Nunnemkamp, 2001). This nevertheless is a more necessary feature when the data used for the construction of the volatility indicator is taken as is, and not as a proportion to GDP (as in our case). When dealing with normalized data, however, sustained periods of rising capital flows would be weighted by an accordingly increased economic activity, and therefore of GDP levels.

But if the reliance on variable ratios diminishes the advantages of using the coefficient of variation as the volatility measure, our focus on net financing makes

66 the use of this indicator quite illegitimate. The use of flow series can yield both positive and negative values, which at times can lead to a very small mean. This in turn would artificially increase the resulting coefficient of variation, even if the series have not been particularly volatile. Moreover, series whose volatility patterns are essentially similar may end up with radically different coefficient of variations, if the resulting means for them differ in sign. In all, these serious caveats justify the use of the standard deviation over the deflated series as the most adequate volatility indicator for our analysis.

With these points supporting our choice for a volatility measure, we construct standard deviations of the variable ratios based on non-overlapping consecutive four-year periods. We feel this time frame is long enough not to intensify the heterogeneity that would arise from standard deviations with shorter memory, which would be more affected by idiosyncratic shocks. Yet, it is not so large to excessively decrease the total number of periods for our study, which would result in a severe loss of degrees of freedom. Other studies on the volatility of flows overtime have also adopted similar time horizons (Sarisoy-Guerin, 2003).

67 7. Empirical Analysis

The goal of the present study is to examine whether the supremacy of FDI time series properties can be contested when we center the analysis on the volatility of the financial account. Specifically, we are interested in checking whether financial accounts that are more concentrated in FDI are more stable. Secondly, but deeply intertwined, whether the possibility of negative inter-flow correlations, originally raised in Claessens et al. (1995), are large enough so as to offset the effect of FDI volatility over the financial account. To address these questions, the following empirical model is initially considered, where i and t represent respectively the cross-sectional and time dimensions of the sample.

FAV = 1FDIV + 2 FDITK + 3 (FDIV xFDITK ) + 4 (FDIV )2 + 5 (FDITK )2 + k X kit + it it it it it it it it

k =1

Let us elaborate on the variables that comprise the model: our dependent variable is financial account volatility (FAV), measured as the standard deviation of its real balance. The explanatory variables on the other hand, can be divided into a set of general control measures25 integrated in the summation term, and regressors

25

Initially, these are variables on GDP levels, financial development, and trade openness. At several steps of the analysis, these are complemented by a set of institutional variables.

68 whose inclusion responds directly to the questions we wish to address. Such is the case of FDI volatility (FDIV), the share of FDI in total gross private capital flows26 (FDITK), and an interaction between these two (FDIVTK). In addition, we also include a quadratic term on FDIV (FDIV2) that seeks to qualify further the relationship between FDI and financial account volatility.

The inclusion of FDITK responds to our desire to identify whether financial accounts that are more concentrated in FDI tend to be less volatile. A priori, it may seem more in accordance with our study to construct this variable as a share based on the financial account. But since this is a net figure based on double entry system, its resulting balance can be either positive or negative, which makes the financial account unfit to be used as a denominator in a variable ratio. On the contrary, gross measures of FDI and private flows are not affected by this problem, and reflect a more accurate picture of the importance of FDI vis--vis the rest of the components of the financial account.

To account for a potential negative correlation between FDI and other flows, which is substantial enough to offset the effect of FDI volatility over the financial account, we make use of two other regressors: FDI volatility (measured in the same way as

26

Data to compute this ratio was obtained from IFS.

69 our dependent variable), and an interaction term between this variable and FDITK. Arguably, if the degree of co-movement between FDI and other flows is not important, FDI volatility should be transmitted into financial account volatility irrespective of the prevailing share of FDI in the financial account, and we would expect a positive and significant coefficient on FDI volatility. Alternatively, a negative or non-significant sign on this variable would indicate that FDI volatility is not passed on to financial account volatility, either due to its limited presence in the financial account compared to other flows, or because of the existence of negative correlations between FDI and other flows.

To distinguish between these last two possible paths, an interaction term between the previous explanatory variables is added to further clarify which of the two is in effect. A negative correlation between FDI and other flows that reduces financial account volatility would be reflected by a negative and significant coefficient in the interaction term. This outcome would suggest that as the share of FDI increases in total flows, its volatility is less important for that of the financial account. But, with FDI being an element of the financial account, the simultaneous reduction in the transmission of its volatility to the financial account, along with an increased share of the flow in the financial account could only arise from substantial negative interflow correlation. If this were the case, we would agree with the traditional

70 literature on the stabilizing properties of FDI, but because of a very different causal argument. In particular, this beneficial time behavior would not arise from FDI being more resilient, but from its degree of co-movement with other capital flows.

Any other result on the interaction term would cast severe doubts on the existence of substitution effects for FDI flows. A non-significant interaction term, for instance, would imply that the relationship between FDI volatility and financial account volatility is the same at all ranges of FDITK. Furthermore, the simultaneous attainment of a non-significant interaction term and a significantly positive coefficient on FDIV would contribute the strongest refutation of the substitution effects for FDI, as the coefficient on FDIV would also confirm that the transmission of FDI volatility is actually transferred to financial account volatility. Similarly, positive and significant coefficients for both FDIV and the interaction term would suggest that the effect of FDI volatility over the volatility of the financial account would be greater, a result that would also lead us to reject the hypothesis of mutually offsetting correlations between FDI and other flows.

All samples would not be suitable to the use of an interaction term of this sort. For example, any existing counterbalancing flow volatilities would be irrelevant if a single flow gathers the large majority of the financial account. In this instance, an

71 interaction term like ours would be insignificant, not because of the absence of negative correlations, but because the financial account would be comprised almost entirely by one flow type.

A glance at the univariate properties of the share of FDI in total private flows however confirms that this is not the case for our sample. We find that 90% of FDITK observations have a value below 50%27, enabling in principle that ameliorating effect of interflow correlation over the financial account across the almost totality of our sample. Finally, at several stages of the analysis we add quadratic terms for FDIV and FDITK, in order to disentangle possible non-linear behaviors, and also to clarify further the interpretation of the interaction term.

Summing up, there are two alternative arguments that motivate this stage of our research. On the one hand, the conventional wisdom on capital flow volatility, blatantly unconcerned with financial account volatilities and inter-flow correlations, views FDI as being the most desirable flow based on its time series properties. Specifically for our model, this line of thinking would be most ratified through coefficients that would be significant and positive for FDI volatility, negative and

27

The 90th percentile is 47%, with an overall mean of 22%

72 significant for FDITK, and non-significant (or positive and significant) for the interaction term.

On the other hand, there is the alternative claim, and the one we are particularly interested to investigate, from Claessens et al. (1995) that individual flow volatilities are mutually offsetting and thus that FDI may not be so desirable and stabilizing in itself. This hypothesis would be corroborated in our specification through nonsignificant (or even negative) coefficients on FDI volatility, but especially a negative and significant interaction term. Such a finding would imply that increases in FDI volatility are unable to affect financial account volatility (or that they actually reduce it). Moreover, the negative interaction term would convey the idea that this inability to transfer FDI volatility into greater financial account volatility is more acute the stronger the presence of FDI in total flows, a result that could only occur in the case of FDI being strongly and negatively correlated with other flows. In this fashion, FDI would have the most desirable time series properties for the host economy, this time through a causal argument radically different from the studies based on the univariate properties of capital flows.

If the above combination of coefficient signs for our variables is the strongest possible validation of the argument advanced in Claessens et al. (1995), it is

73 certainly not the only outcome in which the conventional wisdom on capital flows would be disputed. For instance, simply finding a positive and significant coefficient for the share of FDI in the financial account would pose a strong challenge to the conventional view on capital flows, as it would imply that financial accounts biased towards FDI are more unstable. While there are obviously additional combinations of signs, these three cases constitute important alternative possibilities.

Before closing this discussion, we feel is necessary to note what may have already been obvious to the reader. Namely, that although we refer to the potential role of correlation among flows, we do not explicitly model correlation variables in our analysis. To our knowledge, the few studies that have considered the role of interflow correlation have focused on a country-by-country calculation of correlation coefficients, with the purpose of identifying what pairs of flows tend to be most negatively correlated. While this approach is able to illustrate useful regularities in the correlation of a flow with others, it does not identify whether such correlation is strong enough to offset individual volatilities. These are however the necessary considerations for our analysis. On the other hand, a unified reading of our explanatory variables can identify whether the correlation between FDI and other flows is capable of reducing the transmission of FDI volatility over the financial

74 account, making dispensable the inclusion of a variable on inter-flow correlation in our specification.

As stated before, while the previous regressors are the critical ones to address our research questions, we also incorporate a set of control variables that were included across all specifications, all in four-year averages. As a gross approximation to the state of development of the host country, we include per capita GDP (GDP). More specific aspects of the developmental stage of the economy are accounted for through financial development (M2GDP), measured by the ratio of money and quasi-money to GDP; and the typical measure of openness, the ratio of exports plus imports to GDP (OPEN)28.

There are ample reasons to presume that financial development affects the volatility of the financial account. Possibly the most appealing one in our case is that a developed financial market is usually a technical requirement for attracting certain capital flows that have traditionally been considered to be highly unstable. This is the certainly the case with portfolio investment flows, but also some types of FDI investments, such as those based on international mergers and acquisitions, that in some studies have been proven to exhibit greater volatility than other types of

28

Data on these variables is compiled from the World Development Indicators database.

75 direct investments (Persaud, 2001). In this way, the development of domestic financial markets has increasingly eased the mobility of FDI across the globe, as multinationals enjoy an expanding set of financial instruments and practices (e.g., derivatives, hedging), that a priori could compensate for their relatively immobile investments in physical capital (South Centre, 1997). A counterargument however, would favor an alleviating influence of financial development over financial account volatility, as it expands the range of capital flows that the host economy can attract, possibly reducing the volatility of the financial account through its diversification.

We also find reasons for the addition of trade openness to our set of explanatory variables. But, as opposed to the case of financial development, the link between trade openness and the financial account does not automatically bring possible implications over the volatility of the former. This is in part a consequence that exports and imports refer to the accounting counterpart of our dependent variable, the current account. But if not about its volatility, the literature does offer strong links between openness and the size and composition of capital flows. Hausmann and Fernndez-Arias (2000), for instance, finds empirical evidence that relatively open economies tend to attract more foreign capital; and in addition, although in a not so strong bond, it also leads to a composition of capital flows that is less skewed towards FDI. These aspects about financial account size and composition

76 may therefore be important enough to yield volatility patterns, justifying the inclusion of such a measure in our study. For instance, it is reasonable to assume that open economies may face greater financial account volatility associated with the larger scale of capital flows; a volatility that would not necessarily be accounted for by general measures of development.

In another paper, the same authors highlight that trade openness is positively associated with the likelihood of current account crises, a term associated with drastic reversals of funds, and therefore with increased volatility. Arguably, increased volatility in the current account might transcend to the financial account, especially in developing nations, where the buffer provided by international reserves is not large enough to accommodate these swings in funds. Razin et al. (2002) conveys a closer hypothetical link between openness and financial account volatility, as it blames trade openness for the occurrence of boom-bust cycles of investments, a phenomenon that should closely be associated with higher volatility of the financial account if those cyclical fluctuations are also applicable to foreign investments.

77 7.1. Estimation Results

With the variables at hand, and after computing 4-year volatility or average measures, we are able to construct an unbalanced panel of 104 countries, with periods ranging from 2 to 5. Ours is therefore a typical unbalanced panel sample, with a relatively large number of countries for relatively few periods. There are numerous advantages of undertaking an empirical study based on panel data, some of the most cited being the increased degrees of freedom from exploiting both cross-section and time dimensions, or the reduction in the collinearity of the explanatory variables29. But besides these factors, a key benefit of panel data estimation is that it allows much greater flexibility in the way the heterogeneity among cross-sections is treated, as it permits several estimation methods depending on these country differences. A general expression for a panel data model can be articulated as follows:

Yit = X itk k + u it
k =1

u it = i + t + it The above encompasses two sources of heterogeneity, alpha and lambda, which reflect country and time-specific effects. In this fashion, the intercept varies across

29

For a more detailed review see Hsiao (2003)

78 both dimensions of the panel sample, granting each observation with a unique intercept, but constant slopes30. In dealing with this type of models, there are essentially two initial estimation methods: The first procedure is Fixed Effects, also called Least Squares Dummy Variable, since it is essentially equivalent to inserting a vector of i-1 countries and t-1 time dummies in a basic OLS specification. A major benefit from estimating a panel sample through Fixed Effects is that it treats the country specific effects as fixed parameters that can be correlated with the explanatory variables. An alternative estimation, Random Effects, sees the country or time effects as random observations from the population, and not as constant parameters. And in addition, it assumes the explanatory variables to be strictly exogenous. As a result, the unobserved effects are assumed not to be correlated with the included regressors.

Choosing between both estimation methods is not a relevant matter when the time dimension of the panel is large, as both lead to the same estimator. But given the short T of our panel, whether to treat the specific effects as fixed or random is a decisive point in the analysis. If the specific and independent variables are

30

Other specifications permit regressor coefficients to vary across country and/or time as well. But as Yaffee (2003) remarks, these models would require country and time dummies, but also interaction terms between these and the rest of the explanatory variables. And with this skyrocketing set of regressors, the loss of degrees of freedom could be so large that it would eliminate much of the advantages of pooling the data, or even render the model impossible to estimate.

79 uncorrelated, both procedures yield consistent estimates; but in this case random effects models would be preferable because they are also efficient, while Fixed Effects are not. If on the other hand they are correlated, the estimates of random effects models would no longer be consistent, given that it is grounded on the orthogonality of specific effects and regressors. In these circumstances, it would be better to use Fixed effects, since it does not require this assumption to deliver consistent estimators. To decide which estimation method fits our data best, we perform F tests on the significance of group tests, and a Hausman test to decide between Fixed or Random Effects, both included in table 2.

The first test asks about the poolability of our data. If specific effects are not statistically significant, there would not be any need to include group dummies in the model. Hence, OLS would in principle yield BLUE estimators, along with a substantial gain in degrees of freedom. This significance test is analytically similar to an F test, where the R-square of the LSDV model is compared to that of the pooled OLS. Thus, we reject the null hypothesis if the R-square from the LSDV model is substantially larger than the pooled OLS, which confirms a significant improvement in explanatory power from accounting for country heterogeneity. Applying this test to our model yields significant statistics in all specifications, rejecting therefore the

80 null hypothesis31 of insignificant differences across countries, and the use of OLS as an adequate estimation procedure.

Once we confirm the significant group heterogeneity, the Hausman test helps us to choose between Fixed and Random Effects estimation. Given that the fundamental difference in assumptions between both procedures was the correlation, or lack thereof, between unobserved heterogeneity and explanatory variables, the test precisely checks for the existence of such correlation, through a comparison of the covariance matrixes of the LSDV and the Random Effects model. If there are no significant differences between the two, the null hypothesis of no correlation between the unobserved effects and explanatory variables is validated, and Random Effects can be chosen. But, a rejection of the null hypothesis favors instead the use of Fixed Effects estimators, as these remain consistent in the presence of the referred correlation. The test statistic is given by the following expression, which under the null hypothesis would follow a chi-square whose degrees of freedom are the number of regressors minus one.

W = ( LSDV RE ) ' [var( LSDV ) var( RE )] 1 ( LSDV RE ) k21

31

The statistic is compared to a critical F of (109, 390) degrees of freedom, whose value at the 95% level is 1.31.

81 When applied to our models, Hausman tests rejected the null hypothesis in all specifications but one32. A priori, the conclusions of the test are in accordance with the intuition of our study, which aims to cover most of the developing nations that effectively receive North-South FDI flows. Thus, to the extent that our crosssectional units come close to representing the entire population under study, Fixed Effects would be a more pertinent course of action33.

The same table includes the results of the several specifications we estimate. We start with a basic model in which FDIV and FDITK are accompanied by their interaction term, and a reduced set of general control variables (Model 1). Here, the significance and signs of FDI volatility (positive) and FDITK (negative), initially suggest that FDI volatility is transmitted into the financial account, and that an increasing importance of FDI in external financing reduces financial account volatility. Finally, the insignificance of the interaction term helps to assure that this last conclusion is not due to offsetting volatilities between FDI and other flows. In all, the unified reading of these results delivers a picture that is in close agreement with the conventional wisdom on capital flows, where the greater stability of

32

The exception is the model with a quadratic term on FDIV, and without interaction. Nevertheless, the use of Random or Fixed effects did not yield differences in the coefficient signs or statistical significance. To illustrate these similar results, we include both estimation procedures for this specification. 33 For justifications of the use of Fixed Effects based on the comprehensive character of the sample see Greene (2002) and Pirtilla (2000).

82 financial accounts concentrated in FDI is grounded on the univariate properties of this flow, and not on its potential interaction with other flow categories.

Table 2: Panel Estimation

Model 1 Fixed effects Variables FDIV FDITK FDIVTK FDIV2 GDP M2GDP OPEN Adj. R-square F test (poolability) Hausman d.freedom cross-sections -0.0004 0.047 0.026 0.57 1.37** 14.63** 390 390 104 -2.47*** 2.33** 2.08** coeff 0.787 -4.45 0.199 t 3.76*** -3.96*** 0.64 0.0055 -0.0005 0.0463 0.024 0.58 1.48*** 9.6 499 2.81*** -2.58** 2.3** 1.88* 0.0038 -0.00017 0.024 0.023 0.52 2.23** -2.3** 2.67*** 4.47*** Fixed effects coeff 0.621 -3.171 t 5.16*** -2.84*** Model 2 Random effects coeff 0.73 -2.8 t 7.36*** -3.38*** coeff 0.67 -3.017 -0.096 0.0058 -0.0005 0.0464 0.023 0.58 1.41** 15.34** 389 Model 3 Fixed effects t 3.18*** -2.45** -0.3 2.75*** -2.58*** 2.31** 1.86*

Heteroscedasticity 8.11*** 6.59*** 6.64*** (LM test) Panel Autocorrelation 0.23 0.23 0.20 (Wooldridge) For all regressions: The dependent variable is financial account volatility, calculated as the standard deviation of the real balances. Regressions are estimated on non-overlapping 4-year-periods. ***, **, * : significant at the 99%, 95%, and 90% level Model 2 also includes Random effects, given the results of the Hausman test. Heteroscedasticity: significant values reject the null hypothesis of homoscedasticity Panel Autocorrelation: significant values reject the null hypothesis of no autocorrelation

83

84 Regarding the additional control variables, the results corroborate most of our previous discussion on the expected relationship with the dependent variable. Both financial development and openness enter the equation with positive and significant signs. Once we account for these more specific aspects of the economy, our specification also identifies a negative relationship between per capita GDP and financial account volatility. In the absence of more specific control regressors, such a result could have been surprising since the middle-income countries, at the top of our sample in terms of per capita GDP34, have been the ones ravaged by financial crises during the last two decades.

With the above results serving as a preliminary reference, we add an additional set of specifications to scrutinize in more detail the relationship between our interaction term and the dependent variable. This would seem wise in view of the caveats raised in some of the empirical work using interaction variables. Particularly, the idea that the relevance of an interaction term can be distorted if there are significant, albeit unaccounted, non-linear effects of the variables that compose the interaction term35. To assure that potential non-linearities are not affecting our interaction coefficient, we added specifications in which quadratic terms for both FDIV and FDITK were included without the interaction term, one at a time. From

34 35

We remind the reader that our dataset only includes developing nations. For an example, see Hansen and Tarp (2001).

85 these, we only found the existence of significant increasing returns to FDIV36 (Model 2). Thus, this is the only instance in which the Hausman test yields a non-significant statistic, suggesting the use of Random Effects estimation.

We estimate model 3 in order to check the extent to which potential nonlinearities on FDI alter the significance of our interaction term. Therefore, we include in this specification both quadratic and interaction variables. There are nevertheless no major changes in our prior conclusions about individual coefficients, and, while the significance of the non-linear behavior on FDI volatility is maintained, the interaction term remains insignificant. The inclusion of the quadratic term however does change the sign of the interaction term, which becomes negative. Besides this change, there are no critical departures from the signs and significance for the rest of the variables.

Summarizing, our introductory investigation finds no ability for FDI to reduce the transmission of its volatility to the financial account through inter-flow correlations. On the contrary, FDI volatility has a positive and significant effect on financial account volatility, in a relationship that seems to exhibit increasing returns. This however does not negate the well-established conclusion that FDI has the most

36

We do not include the results for the model with the quadratic term on FDITK, as this was not significant.

86 attractive time series properties among the various categories of flows, as we still find evidence that increasing shares of FDI in total flows are associated with more stable financial accounts.

7.2. Robustness

To further examine the preceding results, which strongly endorse the conventional view on capital flows volatility, we subjected them to a battery of tests and estimation methods with the purpose of identifying and correcting for several possible econometric biases. One of these, that is particularly prominent when dealing with longitudinal data, is the existence of heteroscedasticity.

Heteroscedastic disturbances usually arise in panel samples when the scale of the dependent variable tends to vary across cross-sectional units. This could be particularly relevant in our case, which pools cross sections that differ greatly even after the variables have been normalized. In addition, our reliance on an unbalanced panel may also lead to heteroscedasticity, due to the varying size of cross-sections of the sample (Greene, 2002). This presumption of heteroscedastic disturbances was indeed confirmed using a Lagrange Multiplier (LM) test, whose null hypothesis

87 of homoscedasticity was rejected for all specifications at the 99% confidence level37 (see table 2).

If the presence of heteroscedasticity can be seen as a consequence of exploiting the cross-sections of our panel, the time series dimension also creates specification problems of their own. In particular, time series are generally affected by autocorrelation in the error term, with series displaying memory between present and past observations. For longitudinal data in particular, autocorrelation may emerge if there is a systematic variation in the omitted variables over time, an event that would not be detected by an error term that is assumed to be independently distributed across time periods (Hsiao, 2003). But in spite of the general tendency of panel data models to be autocorrelated, our method for constructing the variables might avoid the presence of autocorrelated disturbances, in so far as variables created through averages or volatility measures of non-overlapping periods should exhibit less autocorrelation than the original data series.

This is precisely what seems to be at work in our sample. We checked for the existence of autocorrelation through a test specific for panel data, developed in Wooldridge (2002). The test checks for the existence of autocorrelation through the first-differenced model. Here, the results give some credibility to the
37

The LM test follows a chi-square whose degrees of freedom are the number of slope parameters.

88 presumption that averaging significantly reduces the presence of autocorrelation, as the test is unable to reject the null hypothesis of no autocorrelation for any of our models (see table 2).

Having a heteroscedastic error term allows Least Squares Dummy Variable estimates to remain unbiased, but inconsistent, invalidating the inferences we can draw from significance tests. To correct for this bias, we re-estimate our model using two alternate methods: A first option is the use of heteroscedasticityconsistent errors, a method grounded on the seminal paper by White (1980). This approach tackles directly the inconsistency of the estimates by correcting their standard errors through their new computation, but this time using a covariance matrix that corrects the heteroscedastic bias. In doing so, the resulting standard errors are consistent and able to deliver accurate inferences on the coefficients, which can still be estimated through LSDV.

Table 3 presents the estimates resulting from adopting White heteroscedasticconsistent standard errors, which in essence maintains the results obtained in the standard LSDV estimation, despite an increase in the standard errors for some regressors. The variable on trade openness is the most affected on this regard, ceasing to be significant in any of the specifications. Among the central variables of this study, FDI volatility exhibits also a drop in statistical significance (particularly in

89 model X), although it always remains within acceptable boundaries of significance (i.e., p-values below 0.1). And more importantly, there are no sign changes to report in our variables, maintaining the same relationships with the dependent variable from previous regressions.

Besides preserving our original estimation procedure intact, and in contrast to other heteroscedasticity correction methods (e.g., Weighted Least Squares), another advantage of Whites errors is that the researcher is not obliged to have any previous knowledge about the functional form of the heteroscedasticity. But there are also some caveats, in so far Whites covariance matrix tends to be underestimated in finite samples (McKinnon and White, 1985), which in turn could leave the t-ratios to be relatively large; and ultimately, lead us to erroneously conclude in favor of the significance of the coefficients. To further scrutinize these results, we also corrected for heteroscedasticity using Feasible Generalized Least Squares (FGLS). Just as in the case of Whites heteroscedasticity-consistent errors, the use of FGLS delivers consistent estimates without requiring prior information of the type of heteroscedasticity, and without departures from the estimation procedure used originally (i.e., LSDV). The method works in a sequential way, whose initial step involves extracting the residuals from an OLS regression over our model. This leads to a second regression in which the natural log of the squared residuals is regressed against the explanatory variables. Taking the predicted values

90 of this last regression permits us to get an estimate of the standard deviation of the error term, which becomes a weight in a transformed version of our structural equation.

Once again, the reliance on FGLS does not much change our conclusions on the coefficients, especially for our main variables of interest. Both FDI volatility and the share of FDI in total flows retain their original signs and significance. The most noticeable change that FGLS estimation introduces is that the interaction term is negative and significant in model 1. This significance nevertheless disappears when we move to the larger model with the quadratic term on FDIV. On the other hand, the statistical significance of our general purpose regressors proves to be very sensitive to the estimation method, with GDP and M2GDP becoming insignificant when we depart from Whites errors estimation to FGLS, being the opposite case for OPEN.

Table 3: Heteroscedasticity-consistent Estimation and FGLS Estimation

Whites heteroscedasticity consistent errors Specification Variables FDIV FDITK FDIVTK FDIV2 GDP M2GDP OPEN adj R-sq N -0.00026 0.055 0.025 0.6 -2.34** 1.97** 1.55 Model 1 coeff 0.755 -4.56 0.249 t 2.08** -3.45*** 0.49 0.0057 1.78* Model 2 coeff 0.618 -3.15 t 2.66** -2.32** Model 3 coeff 0.647 -3.07 -0.0555 0.0057 t 1.66* -2.11** -0.11 1.87* -0.7 0.89 8.84*** 0.4 521 Feasible Generalized Least Squares (FGLS) Model 1 coeff 1.14 -1.97 -0.347 z 8.38*** -5.75*** -1.75* 0.0044 -0.00001 0.0046 0.025 3.97*** -0.49 1.01 11.12*** 0.4 Model 2 coeff 0.687 -1.752 z 9.94*** -9.57*** Model 3 coeff 0.968 -1.3 -0.468 0.005 -0.00001 0.0036 0.024 0.42 z 7.05*** -3.77*** -1.48 3.99*** -0.55 0.43 9.55***

-0.0002 -2.39** -0.00027 -2.39** -0.00002 0.055 0.0226 0.61 1.97** 1.49 0.055 0.0225 0.61 1.97** 1.45 0.0042 0.022

Log-Likelihood Wald chi2(6) prob>chi2

-1085.8 810.95 0

-1084.8 2857.25 0

-1081.8 1679.06 0

For all regressions: The dependent variable is financial account volatility, calculated as the standard deviation of the real balances. Regressions are estimated on non-overlapping 4-year-periods. ***, **, * : significant at the 99%, 95%, and 90% level

91

92 Moving on to other possible econometric caveats, it is highly probable that some of the regressors used in our econometric model turn out to be endogenous with respect to the dependent variable. This is especially the case for some of the variables that were included for general control purposes, and for which we can find bibliographical references suggesting feedback effects with the financial account. For instance, the causal or consequential nature of financial development with regards to financial account volatility is not resolved. On one hand, let us recall the causal avenues identified in earlier sections of this chapter, through which financial development could affect financial account volatility. Briefly, these were grounded on the likely diversification of flows arising from more sophisticated financial intermediaries; or the ability to change the relative mobility of some flows (FDI in particular) through novel financial instruments. But on the other hand, a simultaneous claim sees financial depth partially determined by the absence of shocks, as this allows agents to devise their economic plans in closer association with financial markets (Easterly et al., 2000).

Openness offers a parallel case in point. While in our previous discussion we highlighted some of the ways in which openness may lead to capital flow volatility, Cavallo and Frankel (2004) raise the possibility that trade could be partially determined by a variable that closely resembles financial account volatility, namely the occurrence of sudden stops on capital flows. Amid the several paths that the

93 authors delimit, one that is suitable for our discussion is that the occurrence of crises, manifested through immediate stops in capital flows, act as a powerful incentive to engage in economic reforms, among which sweeping liberalization of the trade account (and consequently, openness) is generally one of its defining features.

Regarding the variables based on FDI flows, there are no intuitive reasons from where to presume the existence of endogeneity for the case of FDI volatility. Given that this flow is a component of the financial account, the link between both volatility rates, if existing, should go from FDI to the financial account, and not the other way around. Endogeneity, on the other hand, might be a legitimate concern in the case of the share of FDI in total flows, if we assume that the various types of capital flows do not react in a similar way to incidents of macroeconomic volatility, a behavior that could ultimately alter the relative composition of the external financing of the country. While again, this relates to a somewhat general sense of economic volatility, and not specifically in our dependent variable, more formal testing for endogeneity would seem justified in this latter case.

The standard procedure for concluding on the endogeneity of regressors is the Wu-Hausman test, a method that requires an initial selection of instruments. We therefore devised a set of instruments that in most cases combine lags of the

94 instrumented regressor, as well as variables for which we could expect a significant degree of correlation. Examples of the latter were an index on life expectancy extracted from WDI (LIFE), which is a plausible instrument for both income per capita and financial development. For the case of trade openness, we relied on an empirical regularity identified in Easterly and Kraay (1999), which identifies a relatively greater trade openness of small states. We therefore include the same dummy variable for small country these authors use (MICRO)38. For other cases in which bibliographical references were not available to sustain our choice of instruments (i.e., FDITK), this was grounded on the de facto degree of correlation that they exhibited with the variable subjected to the endogeneity test.

Before turning on to the results of the Hausman test, we should remark that its validity is in great way dependent on the selection of the instruments. This is a critical matter particularly for those regressors for which references were largely absent. We therefore decided to formally inspect our choices through the Sargan test for the validity of instruments. The test follows a chi-square of m-k degrees of freedom, with m being the number of instruments and k the regressors being instrumented. Thus, for test statistics above the corresponding table value, the null hypothesis of valid instruments would be rejected.

38

The variable is extracted from WDI, and takes the value of 1 for countries with population lower than 1 million.

95 Table 4: Endogeneity Tests

Variable FDITK Instruments 1st and 2nd lags (l1sh, l2sh) Small state dummy (MICRO) st and 2nd lags 1 (l1gdp, l2gdp) Life expectancy (LIFE) 1st and 2nd lags (l1open, l2open) Small state dummy (MICRO) 1st and 2nd lags (l1m2, l2m2) Hausman test h = 0.15 Sargan test s0

GDP

h= 1.28

s0

OPEN M2GDP

h = 4.13*** (endogenous) h = 2.08** (endogenous)

s0 s0

***, **, * values significant at the 99%, 95%, and 90% level Hausman test: significant values reject the null hypothesis of exogeneity. Sargan test: non-significant values accept the null hypothesis of valid instrument selection. This test is compared to a chi-square with 2 degrees of freedom (table value at the 95% level is 0.1) for all variables but M2GDP, which follows a chi-square with 1 d.f. (table value is 0.004).

Using the Sargan test as the criteria to decide on which instruments are adopted, table 4 summarizes the final selection of instruments and their results for both the Hausman and Sargan test39. The final choice of instruments appears to be valid, with the Sargan null hypothesis not being rejected for any combination of instrumental variables. Thus, the Hausman test recognizes both financial development and trade openness to be endogenous with respect to financial account volatility, which in turn would render our regression estimates to be inconsistent. We therefore estimate our panel model using two-stage least squares, through a framework that allows accounting for both the cross-sectional
39

Although we tested several combinations of instruments, for the sake of simplicity we do not include the ones that failed the Sargan test.

96 heterogeneity of the sample, heteroscedasticty, and the endogeneity bias of our regressors.

To implement two-stage least squares estimation (2SLS), we use the same matrix of instrumental variables considered for the detection of endogeneity for financial development and openness, since the Sargan test proved the instruments to be acceptable. As its name indicates, 2SLS arrives at consistent estimates through two sequential steps: In the first one, the endogenous variables are estimated against instrumental and exogenous regressors, in an auxiliary specification that allows obtaining predicted variables for the endogenous variables. In the final stage, the predicted values for both financial development and openness substitute for their actual observations in our structural equation, in a final regression that delivers heteroscedasticity-consistent estimators.

97 Table 5: Two-Stage Least Squares Estimation

Specification Variables FDIV FDITK FDIVTK FDIV2 GDP M2GDP OPEN N Cross-sections -0.00018 0.0722 -0.053 0.5 1.17 -1.45 Model 1 coeff 1.168 -4.32 -0.432 t 3.48*** -2.26** -0.9 0.0372 -0.00014 0.078 -0.044 328 91 1.69* -0.52 1.28 -1.27 Model 2 coeff 0.38 -4.28 t 1.14 -2.35** Model 3 coeff 0.66 -2.69 -0.84 0.053 -0.00012 0.0748 -0.049 t 1.73* -1.7* -1.62 2.23** 0.66 1.25 -1.38

Adj. R-square 0.61 0.62 0.62 For all regressions: The dependent variable is financial account volatility (FAV), calculated as the standard deviation of the real balances. Regressions are estimated on non-overlapping 4-year-periods. ***, **, * : significant at the 99%, 95%, and 90% level M2GDP and OPEN are instrumented through first and second lags, LIFE, and MICRO.

The results from 2SLS estimation are reported in table 5. Even though the new estimation alters some of previous findings, the most important of our earlier conclusions are sustained. First, instrumenting for our endogenous variables takes away their statistical significance, and even the sign for the case of trade openness, which becomes negative. But for the central variables in our study, essentially the same pattern of behavior is observed: the interaction term remains non-significant for all specifications, and in combination with this result, FDI volatility and the share of this flow in total flows mostly retain their original signs and significance. Only for the case of the most comprehensive specification (model 3), there is a noticeable drop in statistical significance for both FDIV and FDITK, although they remain

98 within satisfactory levels (90% level). Additionally, the results for models 2 and 3 confirm the importance of the non-linear behavior of FDI volatility, just as it was identified in the previous regressions. Altogether a picture emerges that conflicts with any endorsement of possible counterbalancing interactions between FDI and other flows that could alleviate financial account volatility.

Another robustness check we address is multicollinearity, a problem that can be especially important in regressions that include interaction or quadratic terms (Aiken and West, 1991), themselves composed out of other explanatory variables. The identification of multicollinearity however is in itself problematic, in light of the absence of a formal test that could categorically accept or reject its presence. Rather, the available methods at our disposal offer an indication of the degree of multicollinearity. Among these, one of the most widely used is the calculation of Variance Inflation Factors (VIF). In the event of a variable affected by multicollinearity, the VIF indicates how much larger the standard error of its coefficient estimate is, compared to what it would have been had there been no collinear relation with other variables. In general, a widely accepted rule of thumb is that VIFs larger than 10 indicate that multicollinearity is a problem, since the corresponding standard error would be more than three times as large as in the case of a VIF of no correlation among regressors. Under these circumstances, it would be obviously more likely to conclude on the non-significance of the variable,

99 even though what really lies beneath is a collinear relation, rather than an irrelevant regressor.

Table 6 presents the VIFs for our explanatory variables, which show evident signs of multicollinearity between FDIV and the interaction term. Hence, taking into consideration the importance that the latter has on the course of our analysis, we proceed to re-estimate our specification with a method that can eradicate the collinear relation between both variables. This is accomplished through centering the variables that intervene in the collinear interaction term (FDIV and FDITK), and creating a new interaction coefficient as a product of this new mean centered variables40. As the same table illustrates, once this transformation on the variables is implemented, multicollinearity ceases to be a problem for our variables, all of them displaying low levels of VIF.

40

Aiken and West (1991) offer a detailed exposition of the implementation and advantages of centering variables in specifications with interaction terms.

100 Table 6: Variance Inflation Factors

Variables FDIV FDITK FDIVTK FDIV2 GDP M2GDP OPEN Non-centered 17.87 1.94 18.52 5.55 1.1 1.2 1.6 Centered 1.51 1.16 2.22 2.62 1.11 1.22 1.26

A point worth mentioning is that centering slightly changes the interpretation of the coefficients of the two variables that create our interaction term. In the uncentered regressions, the estimate for FDIV would be interpreted as the slope of a regression of FAV on FDIV when FDITK is zero. After centering, the FDIV coefficient equates the same slope, but evaluated at the average of FDITK41. With these newly centered variables, we offer a final set of regressions (Table 7) on the most inclusive model, where both interaction and quadratic terms are added to our usual set of variables.. These are estimated using alternatively Whites heteroscedasticity-consistent estimation, feasible generalized least squares, and twostage least squares42. These results are the final confirmation of the absence of interflow correlations involving foreign investment: once again, FDI volatility has a positive and significant effect over financial account volatility, while the share of FDI in total flows retains its negative relation with the dependent variable. On the other
41 42

For our sample, this value is 22%. We use in this case the same instruments as in the uncentered regressions.

101 hand, removing the multicollinearity bias of the interaction term does not bring its explanatory power to significant levels. This is in accordance with the results we have reported throughout this empirical study. Besides these results on our variables of interest, there are no changes to remark on our additional control variables, since they remain uncentered in this part of the analysis.

Table 7: Model 3 Centered Variables Regressions

Estimation Variables FDIV FDITK FDIVTK FDIV2 GDP M2GDP OPEN White errors coeff 0.6817 -3.2746 -0.67598 0.0208 -0.00027 0.0564 0.02253 t 3.84*** -2.52** -1.19 1.91* -2.43** 2.03** 1.47 coeff 0.3927 -2.0509 -0.0704 0.0324 -0.000042 0.0084 0.0299 FGLS z 4.74*** -3.3*** -0.23 7.3*** 0.23 1.5 10.72*** coeff 0.59 -4.498 -1.56 0.094 -0.0001 0.078 -0.028 2SLS z 2.09*** -2.13** -1.49 2.04** -0.61 1.06 -0.42

N Cross-sections Adj R-sq

506 104 0.589

506 104 0.35

298 90 0.19

For all regressions: The dependent variable is financial account volatility, calculated as the standard deviation of the real balances. Regressions are estimated on non-overlapping 4-yearperiods. ***, **, * : significant at the 99%, 95%, and 90% level

Acting as a final sensitivity analysis, table 8 includes different combinations of additional control variables, which are estimated using both heteroscedastic robust

102 errors, and FGLS. Among this new set of explanatory variables, one that we feel particularly inclined to consider is exchange rate stability, after reflecting on our previous discussion on its effects over FDI. Thus, there are many indications that point to the idea that other capital flows are also affected by the same variable. Bachetta and Van Wincoop (1998) for instance, find that the level of capital flows tends to be higher under a fixed exchange rate regime. Similar conclusions are also reached in Lopez-Mejia (1999). We therefore include a measure on exchange rate volatility extracted from ICRG, and calculated as the annual percentage change in the exchange rate of the national currency against the US dollar (ERV). Still within the macroeconomic realm, we also added an ICRG measure of country risk for the current account43 (RCA), the counterpart of the financial account in the national accounting system. Besides the link delimited through the Balance of Payments identity, there is a wide theoretical literature that has set the ground for a close relationship between current and financial account. Calvo et al. (1996), for instance, associate large inflows of capital with current account deficits. At an empirical level, Sarisoy (2003) warns that the causal connection between the volatility of capital flows and current account might be a particular feature of the macroeconomy of developing nations. All told, we find a substantial basis for assuming that an

43

The index ranges from 0 to 15 points, with higher points indicating lower country risk emanating from the current account.

103 uncertain or risky evolution of the current account would be associated with more unstable performance of capital flows.

A final variable that we include at this stage relates to the countrys degree of openness of the capital account (KAOPEN). In many instances, tightening the mobility of capital flows has been a basic policy measure to avoid volatility in capital flows. To account for this possibility, we make use of the index developed in Chinn and Ito (2005), itself based on the IMFs Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). The latter envisions four types of capital account restrictions (multiple exchange rates, restrictions on current account transactions, on capital account transactions, and requirement of the surrender of export proceeds), and a set of corresponding binary variables, that take the value of 1 if the specific restriction is a feature of the country. With this reference as guide, Chinn and Ito build their index by associating higher values with greater capital account openness44.

Among the newly added variables, exchange rate volatility is the one that presents the most consistent behavior, as a greater degree of exchange rate volatility is significantly associated with greater financial account volatility in both estimation
This is done by reversing the original AREAER dummies, so that they take the value of one when there are no restrictions in the capital account. For a more detailed explanation of how this variable is constructed, see Chinn and Ito (2005).
44

104 methods. The results on RCA and KAOPEN on the other hand preclude us from any categorical conclusion on their effect over financial account volatility, with the first variable swinging sign between regressions, and the second being insignificant. But more importantly for our discussion, we find no change on the variables related to the behavior of FDI: the volatility and the relatively share of FDI consistently maintain the sign and significance we observe in previous regressions. Also as in previous regressions, the interaction term remains insignificant throughout all specifications and estimations.

Table 8: Regressions with Additional Institutional Proxies

Specification Variables FDIV FDITK FDIVTK GDP M2GDP OPEN ERV RCA KAOPEN adj R-sq N Log-Likelihood Wald chi2(7) 0.6 520 0.37 297 Whites heteroscedasticity consistent errors Exchange Rate Current Account Capital Acct Volatility Stability Openess coeff t coeff t coeff t 0.76 -4.24 0.23 -0.0002 0.057 0.024 1.04 2.1** -3.1*** 0.65 -2.27** 2.05** 1.5 1.69* -0.4 -1.87* -0.14 0.38 412 520 -1076.8 755.1 297 -610.5 397.6 412 -836.3 204.9 -0.7 1.53 -3.4 -1.5 -0.0002 0.06 0.041 2.5** -1.7* -1.8 -1.4 1.97* 1.4 0.47 -6.14 1 -0.0002 0.044 0.05 2.04** -3.4*** 1.2 -1.86* 1.44 2.83*** Feasible Generalized Least Squares (FGLS) Exchange Rate Current Account Capital Acct Volatility Stability Openess coeff z coeff z coeff z 1.22 -1.5 -0.49 -0.00008 0.008 0.02 1.5 9.2*** -3.9*** -1.2 -2.6*** 1.88* 1.6 5.5*** 3.25 7.59*** 0.048 0.44 0.99 -1.09 -0.5 -0.0008 0.006 0.02 5.08*** -2.1** -1.4 -0.27 1.31 10.9*** 0.94 -2.33 -0.02 -0.001 0.0006 0.021 5.3*** -4.07*** -0.08 -0.54 0.14 6.77***

prob>chi2 0 0 0 For all regressions: The dependent variable is financial account volatility, calculated as the standard deviation of the real balances. Regressions are estimated on non-overlapping 4-year-periods. ***, **, * : significant at the 99%, 95%, and 90% level.

105

106 Besides extending the range of macroeconomic variables into the right hand side of our equation, a second course of action in variable selection was to incorporate proxies for more general institutional features of the country. So far unaccounted for in our model, some non-macroeconomic aspects of the nation may have an important role in the attraction of international capital. A very recent example on this link is offered by Alfaro et al. (2003), who find in the notion of institutional quality, a gross measure of various institutional indices, the fundamental variable to explain the Lucas paradox (i.e., the absence of a substantial North-south capital flow despite large capital return differentials).

To explore this possibility, we added one at a time the risk indexes built by ICRG on political risk, government stability and corruption within the political system; thus, we also included a general index on political constraints, extracted from Witold Heniszs Polcon database. While we do not provide tables for the sake of simplicity, we found that none of these additions proved to be significant. The general irrelevance of the institutional variables can be partially traced to the little variation that some of these indexes experience overtime45, which can be translated into a diminished explanatory power when they are applied to panel data studies.
45

As an illustrative note, we computed descriptive statistics for all these new measures, finding that the only non-index variable (the annual percentage change in exchange rate) had a coefficient of variation of -171.4. This result contrasts with those obtained for the index proxies, whose coefficients of variation range from 12.6 (political risk) to 32.2 (risk for exchange rate stability).

107 Another problematic aspect of their inclusion is that, especially for our sample of developing nations, their availability tends to be limited with respect to length of time coverage. Our regressions with these institutional variables resulted in drastic losses in degrees of freedom, falling from approximately 506 observations to as low as 250. Despite this fall in observations, particularly problematic in the case of fixed effects estimation, the results on the effects of our variables on the behavior of FDI in the financial account remained largely unchanged.

8. Conclusion

The view that FDI is the most stable flow is well established in the literature on capital flows volatility. In fact, this research body that has become the latest contributor to the notion that FDI is the most beneficial capital flow for the receiving economy. Such a conclusion has led to important changes in policies, which during the last decade have increasingly tilted towards measures to attract FDI, along with exerting tighter control over flows deemed speculative or volatile46.

One of the most serious challenges to the above claim has been originally raised by Claessens et al. (1995). Among the points raised by the authors to challenge the
46

For a review of some of the innovations in financial account policies during the decade of the nineties, see Ocampo (2001).

108 conventional wisdom, and although not explicitly investigated, they state that the volatility of a flow may be irrelevant in the presence of negative correlation with other flows, as the respective flow volatilities would tend to offset each other, with no effect over the volatility of the financial account. Accordingly, they advocate that the financial account and not the flow must be the focal point for volatility studies, in order to effectively account for these interactions.

Aware of this possibility, we have designed an empirical model whose ultimate purpose was to identify whether the beneficial time series properties of FDI are maintained when the volatility of the financial account is brought to the center of the analysis; and more specifically, whether the diffusion of FDI volatility over the financial account is restrained due to negative correlations between FDI and other flows. Our results nevertheless raise doubts about the likelihood that FDI substitutes for other flows: both the positive and significant coefficient on FDI volatility and the irrelevance of our interaction term suggests that the transmission of FDI volatility over the financial account is not diminished by counterbalancing interflow correlations. Had that been the case, we should have expected a negative and significant interaction term showing that, as the importance of FDI in the financial account increases, the transmission of its volatility over the financial account is reduced. On the contrary, across all the specifications we estimate, the

109 interaction term is never significant, while the coefficient on FDI volatility remains positive and significant.

In the absence of substitution effects between FDI and other capital flows, shifting the locus of study from the individual flow to the financial account could compromise the notion of FDI as the flow with the soundest time series properties, especially if other flows are benefited by mutually compensating correlations. But we find no indication that an interaction of this sort between non-FDI flows might be partially determining the volatility of the financial account: our regressions deliver a negative and significant effect of FDITK, confirming that financial accounts more heavily concentrated in FDI tend to be less volatile. This not only leads us to conclude that FDI is indeed the flow most conducive to a stable financial account; but also that the existence of a significant counterbalancing correlation between flows other than FDI should be anecdotal if existing at all.

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