L1: CAPITAL FLOWS: STYLIZED FACTS, DETERMINANTS, AND POLICY CHALLENGES JVI COURSE ON MACROECONOMIC POLICIES IN TIMES OF HIGH CAPITAL MOBILITY JVI, Vienna, March 21-25, 2016 Norbert Funke, Director, Joint Vienna Institute
This training material is the property of the Joint Vienna Institute (JVI) and is intended for use in JVI courses. Any reuse requires the permission of the JVI. ALBANIA • ARMENIA • AZERBAIJAN • BELARUS • BOSNIA AND HERZEGOVINA • BULGARIA • CROATIA • CZECH REPUBLIC • ESTONIA • GEORGIA HUNGARY • KAZAKHSTAN • KOSOVO • KYRGYZ REPUBLIC • LATVIA • LITHUANIA • FYR MACEDONIA • MOLDOVA • MONTENEGRO • POLAND ROMANIA • RUSSIAN FEDERATION • SERBIA • SLOVAK REPUBLIC • SLOVENIA • TAJIKISTAN • TURKEY • TURKMENISTAN • UKRAINE • UZBEKISTAN
Outline Stylized Facts Determinants Policy Challenges
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Liberalized Capital Flows - The Broad Policy Issue • Theoretically often first-best solution (standard textbook) • Reality may be at best second best environment In the presence of market failure (in one sector/area), efficiency can decline/outcomes can worsen, if one moves towards greater market perfection in one other area
• List of preconditions
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Several Reasons to Care about Capital Flows • Many positive associations – additional financing, importing know-how (FDI), positive growth impact • But also Risk of financial vulnerabilities – credit booms, sudden stops, financial crisis Risk of excessive exchange rate appreciation, resulting in some form of Dutch disease Risk of making economy very sensitive to the global credit cycle, which in turn can reduce ability of conducting an independent monetary policy (even with floating exchange rates
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Definitions • Capital flows Cross-border financial transactions recorded in economies’ external financial accounts (balance of payment, international investment position)
• Include Foreign direct investment Portfolio investment Other investment (mainly bank lending)
• Excluded from calculation of private capital flows Reserve asset accumulation Official lending to governments (IMF loans etc.) www.jvi.org
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Example: Summary of Balance of Payments – Turkey
Source: IMF Staff Report, Turkey, 2013 www.jvi.org
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Example: Summary of Balance of Payments Croatia
Source: IMF Staff Report, Croatia, 2012 www.jvi.org
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Example: Balance of Payments – Kazakhstan (Note: Change in Recording with BOP Manual 6)
Source: IMF Staff Report, Kazakhstan, 2015 www.jvi.org
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Definitions • (Gross) inflows External liabilities incurred by the recipient economy (+), potential reduction in external liabilities (-) (BOPM 5) Actually, despite the use of the “gross” term, it is the “net” of foreign purchases of domestic securities and foreign sales of domestic securities (e.g., for portfolio investment)
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Definitions • (Gross) outflows Domestic residents’ purchases of external assets (-), domestic residents’ sales of external assets (+) (BoPM 5) Again, it is the “net” of domestic purchases and sales of foreign assets
• Net inflows Sum of gross inflows (+) and gross outflows (-)
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Quiz 1: What Types of Flows are Dominant to Emerging Markets? 1. FDI
1
25.0% (20)
2. Portfolio Flows
2
25.0% (20)
3. Other Flows
3
25.0% (20)
4
25.0% (20)
4. It may change over time
Total: 80
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Gross and Net Capital Flows • Both (large) gross inflows and outflows determine net flows in advanced economies…
Source: IMF, (2012, November, Box 1) www.jvi.org
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Gross and Net Capital Flows (Cont.) • …unlike in most emerging markets where gross inflows dominate
Source: Cardarelli et al. (2009); in % of regional GDP www.jvi.org
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Net Versus Gross Inflows • Up to 1990s: focus mainly on net inflows • Net inflows important for macroeconomic stability, in particular exchange rate (effects) • Gross inflows important for financial stability and vulnerability • Gross and net inflows important for monetary policy Gross - depending on the type of flow, they may lead to different macroeconomic/monetary policy effects Net - additional resources to finance expenditure, may lead to excessive expenditure
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Net Versus Gross Flows: The Case of Chile
Source: Forbes and Warnock (2011) www.jvi.org
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Episodes of Large Changes in Capital Flows* • Surges (bonanzas, liability-driven surges): a sharp increase in (gross) capital inflows • (Sudden) stops (reversals): a sharp decrease in (gross) capital inflows • (Capital) flight: a sharp increase in gross capital outflows • Retrenchment (asset-driven surges): a sharp decrease in gross capital outflows • In some literature, surges or sudden stops defined in terms of net inflows * based on Forbes and Warnock (2011), Ghosh et al. (2012) www.jvi.org
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What is a “Large” Change in Capital Flows? • One to two standard deviations of change in capital flows compared to its (rolling) historical mean or trend (Calvo et al. 2004; Reinhart and Reinhart 2009) • Certain percentile of distribution of flows of an individual country or a sample of countries, or more advanced statistical techniques such as clustering (Ghosh et al. 2012) • Additional criteria (the episode lasts at least for a certain number of quarters, it starts as a change of at least one standard deviation, but during the episode increases to two standard deviations etc.) • Change higher than a fixed threshold (such as 5% of GDP etc.), often combined with some of the above criteria
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Surges in Capital Inflows • Based on IMF (2011, February) Surge: a quarter in which capital inflows 1 stdev above longrun (HP-filtered) trend and of large magnitude (higher than 1.5% of annual GDP)
• Episode: a prolonged surge (a series of surges) • Wave of inflows (large number of countries episodes occurring at the same time) 3 waves identified Source: IMF (2011, February); 48 EMEs analyzed www.jvi.org
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Magnitude of Capital Inflows (per Quarter)
Source: IMF (2011, February) www.jvi.org
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Inflow Episodes • Duration and magnitude of inflows has risen with each wave • While inflow episodes start at different times for different countries, they often end together Risk of synchronized retreat of capital from EMs via contagion, resulting in large distress for EM economies
Source: IMF (2011, February) www.jvi.org
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Surges by Type of Flows for Each Wave
Source: IMF (2011, February) www.jvi.org
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Volatility of Capital Flows • Portfolio inflows “hotter” than other types of flows Portfolio inflows dominate the 2010+ wave
• Bank flows’ volatility rises sharply around crisis times
Source: IMF (2011, February) www.jvi.org
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The Wave of Inflows Starting in 2010… • The post-crisis rebound in net capital flows uneven across countries Faster for regions that were more resilient in the recent crisis (Asia, Latin America), driven by portfolio debt flows Net capital flows (% of GDP)
Source: IMF (WEO, April 2011, Chapter 4) www.jvi.org
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More Recently, Net Private Capital Outflows from Emerging Markets
Source: IIF, Capital Flows to Emerging Markets, Jan. 2016. www.jvi.org
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Outline Stylized Facts Determinants Policy Challenges
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Quiz 2: Which Factors are Important Determinants of Capital Flows to EMs? 1. 2. 3. 4. 5. 6. 7.
Growth prospects in EMs Global liquidity US interest rates Global risk-aversion 1, 3 above 1,2,3 above 1,2,3,4 above
1
14.3% (20)
2
14.3% (20)
3
14.3% (20)
4
14.3% (20)
5
14.3% (20)
6
14.3% (20)
7
14.3% (20) Total: 140
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Flows Reflect Confluence of Supply and Demand • For any given country: Supply of foreign capital
Price (interest)
• Real force behind flows: Capital Scarcity • “Push” (supply-side) factors • Real force behind flows: Capital Scarcity • “Pull” (demandside) factors
P*
Demand for foreign capital
Q*
Quantity (flows) 27
Major Driver of Flows: Capital-Scarcity Differentials • Capital is scarce in countries opening capital account In particular true to transition economies in 90s
• Scarce capital -> high marginal product of capital (MPK) In particular with strong endowments with human capital (labor) and infrastructure and
• High MPK -> high real return on investment • Potential capital inflows: Lucas (1990) exercise for CEE
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Potential Capital Inflows in CEE: Exercise (1/6) • Group of CEE countries in 1999 vs. Germany Suppose differences in output per worker reflect differences in capital-labor ratios
• Output produced by single sector Same Cobb-Douglas production function in each country:
α 1−α
Total output in country i
Total factor productivity in country i
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Yi = Ai K i Li Capital endowment of country i
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Labor endowment of country i
Capital share in production = Output elasticity with respect to capital 29
Potential Capital Inflows in CEE: Exercise (2/6) α
• In per-worker terms: Dividing both sides by L we get: Output per worker in country i
yi = Ai ki
Capital per worker in country i
• Then marginal product of capital is (derivative): − (1−α )
ri = Aiαki
Increases with A; declines with initial capital stock k
• Expressed in terms of output per worker, MPK is: 1 (1−α ) − α α
ri = Ai αyi
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Potential Capital Inflows in CEE: Exercise (3/6) • Capital per-worker relative to German: 1
yi α ki = Ai
ki kGER
yi y = GER Ai AGER
1
α
• Relative to German marginal product of capital: 1
ri rGER
Ai α α yi = AGER α yGER
−
(1−α )
α
1
Ai α yi = AGER yGER
−
(1−α )
α
• In competitive markets MPK=return to capital • Taking benchmark value for capital share in production α=1/3, equation above can be used to estimate the returns to capital in country i relative to the ones in Germany www.jvi.org
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Potential Capital Inflows in CEE: Exercise (4/6) • If this simple model were true, world capital markets free and complete… • Then the return differentials would lead to rapid capital flows from Germany (and other capital abundant countries) to CEE • Potential capital inflows would equalize MPKs in CEE and Germany:
Aiα k www.jvi.org
− (1−α ) i
= AGERαk
− (1−α ) GER
AGER ⇒ k i = Ai
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−
1 1−α
kGER 32
Potential Capital Inflows in CEE: Exercise (5/6) • Potential capital flow to a country i is then: −
1 1−α
AGER 1 kGER − ki − 1 α − k i − ki Ai kGER yGER AGER ki = = − yi yi yGER yi Ai kGER • Assume German capital-output ratio is 1.74 (Penn World Tables) • Then potential capital flows can be estimated
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Potential Capital Inflows in CEE: Exercise (6/6) Hypothetical Calculation - Capital Flows Much Less than Potential all data are as of 1999 output per yi, % yGER worker yi, th. USD 1/ Average of selected CEE countries Germany
28 82
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α 2/
potential productivity A, MPKi, capital k , % kGER relative to AGER i multiple of inflow, % yi 4/ 3/ MPKGER 6/)
0.33
0.76
8.9
3.8
291
Source: WEO, World Bank, World Development Indicators 1/ GDP per worker in percent of German GDP per worker. 2/ Output elasticity with respect to capital. 3/ Assumption for productivity relative to productivity in Germany. 4/ Capital per worker in percent of German capital per worker. 5/ Marginal prodcut of capital (multiple of German product). 6/ With no adjustment costs.
Compared to:
• Capital inflows in 1999 averaged about 7 percent of GDP. • Capital inflows during 1989 to 2008 amounted on average to about 140 percent 2007 GDP. www.jvi.org
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Why are Flows Smaller? • Investments may be costly (adjustment costs) Likely to smooth capital flows, but not reduce them significantly
• Existence of non-traded capital goods (residential housing, factories): affects real exchange rate • Global factors may affect investors (“push” factors) • Differences in total factor productivities (A’s), uncertainty of returns (“pull” factors)
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Drivers of Inflows: A Broader Perspective Push and Pull Factors • Most analyses confirm a strong role for global factors US monetary policy and global risk aversion
• Out of domestic factors, the (potential) economic growth is an important pull factor But also a role of institutional quality, financial openness and exchange rate regime (Ghosh et al. 2012)
Push
Pull
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Cyclical
Structural
-
Low US interest rates Low global risk aversion Strained AE balance sheets
-
-
High domestic interest rates Low domestic inflation
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International Portfolio diversification Low AE potential growth
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Improving EM balance sheets High EM potential growth Trade openness
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“Push” and “Pull” Factors: Likelihood of Surge Empirical Evidence Significant “push” factors
Significant “pull” factors
Note: Dependent variable if net capital flow to GDP if a surge occurs. Constrained model refers to the specification where real interest rate differential between country I and the US (real domestic interest rate - real US interest rate-REER overvaluation) is included. All regressions estimated using pooled OLS. Constant and regional specific effects are included in all specifications. All variables except for global factors (real US interest rate, S&P 500 index volatility, and commoditiy price index), regional contagion, and financial interconnectedness are lagged one period. Clustered standard errors (at the country level) reported in parentheses. Source: Ghosh, Atish, Jun Kim, Mahvash Qureshi, and Juan Zalduendo, 2012, “Surges”, IMF Working Paper No. 12/22
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Likelihood of Surge: Asset–Driven Versus Liability-Driven Surges Liability-driven surges tend to be more sensitive to global factors and contagion
Source: Ghosh, Atish, Jun Kim, Mahvash Qureshi, and Juan Zalduendo, 2012, “Surges”, IMF Working Paper No. 12/22
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“Push” and “Pull” Factors: Types of Flows
Significant “push” factors Significant “pull” factors
Note: The table represents the results of the panel FE regressions on factors affecting gross capital inflows and their composition over 48 emerging market economies between 1990Q1 and 2012Q2. Dependent variables are the log level of total inflows and their different components. Trade openness is the sum of imports and exports as a share of GDP and average size of the economy is proxied by the logarithm of average GDP in the first and second decade of the sample. Inflation is also included in the regression but not significant for most specifications (not shown). Robust standard errors in parenthesis. Source: IMF Strategy Policy and Review Department, 2011, “Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Note, February 14 (Washington: International Monetary Fund).
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Impact of Global Financial Cycle: Some Recent Evidence • Financial cycle, measured by VIX, has impact on capital flows. Important push factor but For low levels of VIX, capital flows are driven by fundamentals During stress periods VIX becomes the dominant driver of capital flows. Interest rate differentials also remain statistically significant
• Impact of global financial conditions appears to increase the host country’s level of financial development • Difficult to insulate yourself from global financial shocks, unless one creates a fragmented global financial system Source: Nier, Sedik, Mondino, Gross Private Capital Flows to Emerging Markets: Can the Global Financial Cycle be Tamed, IMF Working Paper 14/196, www.jvi.org
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A Balanced View on FDI: Pros and Cons • Why countries aim at attracting FDI Considered the most stable type of capital inflows Direct effect on productivity (transfer of know-how), indirect effects within the industry and along the production chain (horizontal and vertical spillovers) If in tradeables sector, leads to improved country’s competitiveness and trade surpluses Large FDI inflows may bring some macro challenges (pressure on exchange rate), but usually less financial stability concerns
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A Balanced View on FDI: Pros and Cons (Cont.) • Risks related to FDI inflows Targeted sectors: financial sector versus services versus manufacturing (Kinoshita 2011, IMF WP 11/123) Different effects (FDI in non-tradeables sector associated with higher imports and widening CA deficit, opposite true for FDI in tradeables) Large FDI in financial sector (bank privatizations) may lead to financial stability concerns (different treatment of FDI
Key production decisions taken in headquarters of multinationals (footless investors), strong regional economic effects of possible FDI liquidations Less diversification in the economy if inflows concentrated in few sectors (automotive etc.) www.jvi.org
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Outline Stylized Facts Determinants Policy Challenges
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Buzz Groups • Separate into groups of five and discuss for no more than 5 minutes What were the main benefits associated with past capital inflows into your countries? Which risks associated with past capital inflows were discussed and which materialized in your countries?
• Nominate one person from your group who will summarize the discussion
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Benefits of Capital Inflows Direct benefits: • Lower cost of investment capital • Efficiency argument Increase investment; More productive investment; Support transfers of technology (via FDI)
• Deficient savings argument: raise investment despite low domestic savings rate • Risk-sharing • Inter-temporal consumption smoothing
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Benefits of Capital Inflows (Cont.) Indirect benefits: • Financial market development • Institutional development & better governance • Greater discipline in macroeconomic policies (if associated risks are recognized)
Both direct and indirect benefits contribute to economic growth! www.jvi.org
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Risks Associated with Capital Flows • Reduced autonomy for independent macro-economic policy Open capital account constrains monetary and exchange rate policies
• Increased macroeconomic volatility Inflows tend to be pro-cyclical, lead to overheating of the economy (i.e., through rapid credit growth) when growth is high; Reverse when economy goes into recession
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Risks Associated with Capital Flows (Cont.) • Upward pressure on the exchange rate May reduce competitiveness in tradable sector
• Widening CA deficit financed by capital inflows Serves as indicator of potential vulnerabilities
• Financial-stability concerns Sectoral credit boom and asset price bubbles (i.e., equity, housing) Balance sheet vulnerabilities (mainly currency and maturity mismatches) Higher integration into the global financial network potential for contagion Rollover risks, sudden stops & reversals of capital flows
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Policy Implications • Sound economic management: Policy transparency and data dissemination to avoid changes in market sentiments (bandwagon effects, runs and panics) due to erratic domestic policies
• Strong fiscal position: Sustained fiscal prudence –> allows for countercyclical (expansionary) stance in response to the sharp turnaround in the capital account (shock absorber)
• Pace and sequencing of capital account liberalization: Opening the long side of the market before the short one (foreign direct investment before portfolio inflows) Imposing capital controls to mitigate erratic changes in risk premia www.jvi.org
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Policy Implications (Cont.) • Strong institutional and regulatory regime in the financial sector: Banks’ open foreign exchange positions should be limited Policies forcing corporations and households to be fully sensitive to currency risk should be introduced
• Exchange rate policy: Long-lived peg may induce private sector to take substantial open positions, making it very costly for policymakers to adjust exchange rates during crises In most circumstances, a floating exchange rate regime is less vulnerable than a pegged regime
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Selected Readings Dell'Ariccia, G., J. Di Giovanni, A. Faria, A. Kose, P. Mauro, J. Ostry, M. Schindler, and M. Terrones, 2008, “Reaping the Benefits of Financial Globalization,” IMF Occasional Paper No. 264 (Washington, DC: International Monetary Fund). http://www.imf.org/external/np/res/docs/2007/0607.pdf Cardarelli, R., S. Elekdag, M.A. Kose, 2009, “Capital Inflows: Macroeconomic Implications and Policy Responses,” IMF Working Paper No. 09/40 (Washington: International Monetary Fund). https://www.imf.org/external/pubs/ft/wp/2009/wp0940.pdf Committee on the Global Financial System, 2009, “Capital flows and emerging market economies,” CGFS Paper No. 33 (Basel: Bank for International Settlements), January. http://www.bis.org/publ/cgfs33.pdf Gallagher, Kevin, Stephany Griffith-Jones, and Jose Antonio Ocampo, 2012, Regulating Global Capital Flows for Long-Run Development, Pardee Center Task Force Report, Boston University. http://www.bu.edu/pardee/files/2012/03/RegulatingCapitalTF-March2012.pdf Ghosh, Atish, Jun Kim, Mahvash Qureshi, and Juan Zalduendo, 2012, “Surges,” IMF Working Paper No. 12/22 (Washington: International Monetary Fund). http://www.imf.org/external/pubs/ft/wp/2012/wp1222.pdf IMF Strategy Policy and Review Department, 2011, “Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Policy Framework,” IMF Policy Note, February 14 (Washington: International Monetary Fund). http://www.imf.org/external/np/pp/eng/2011/021411a.pdf IMF, 2012, “The Liberalization and Management of Capital Flows: An Institutional View,” IMF Policy Paper, November 14 (Washington: International Monetary Fund). http://www.imf.org/external/np/pp/eng/2012/111412.pdf IMF Strategy Policy and Review Department and the Legal Department, 2010, “The Fund’s Role Regarding Cross-Border Capital Flows,” IMF Policy Note, November 15 (Washington: International Monetary Fund). http://www.imf.org/external/np/pp/eng/2010/111510.pdf The Institute for International Finance, 2016, “Capital Flows to Emerging Markets”, January 19, 2016, http://www.valuewalk.com/wpcontent/uploads/2015/10/IIF_Capital_Flows_Report_10_15.pdf Kristin J. Forbes, Francis E. Warnock, 2011, “Capital Flow Waves: Surges, Stops, Flight, and Retrenchment,” NBER Working Paper No. 17351, issued in August 2011; published as Forbes, Kristin J. & Warnock, Francis E., 2012, "Capital flow waves: Surges, stops, flight, and retrenchment," Journal of International Economics, Elsevier, vol. 88(2), pages 235-251.Nier, Erlend; Tashin Saadi Sedik; Tomas Mondino, “Gross Private Capital Flows to Emerging Markets: Can the Global Financial Cycle be Tamed,” IMF Working Paper 14/196 (Washington: International Monetary Fund). http://www.imf.org/external/pubs/ft/wp/2014/wp14196.pdf Reinhart, C.M., V.R. Reinhart, 2008, “Capital Flow Bonanzas: An Encompasing View of the Past and Present,” NBER Working Paper No. 14321, issued in September 2008.
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Thank You for Your Attention!
Norbert Funke Joint Vienna Institute
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