Costs of Foreign Capital Flows in Emerging Market Economies: Unexpected Economic Growth and Increased Financial Market Volatility

Abstract

The high volatility of economic growth and financial markets in emerging market economies following large swings in foreign capital flows over the past 10 years highlights their possible related costs. This paper investigates the impact of foreign capital flows on GDP growth surprise (= realized GDP growth rate ― expected GDP growth rate) and financial market volatility. We find that FDI and foreign bank loans are positively associated with unexpected GDP growth on a contemporaneous basis, while increases in foreign bond and equity investment induce lower GDP growth than expected in the following year.

Volatility in all four types of foreign capital flows is positively related to stock market volatility only in the case of a crisis. Volatility in bank loans is likely to have a larger impact here than will volatility in equity investment. Higher volatility in FDI, foreign equity investment and bank loans amplify foreign exchange market volatility during a crisis while mitigating it during a non-crisis period. The volatility of foreign bond investment meanwhile has the strongest positive effect on foreign exchange rate volatility in the case of a crisis, but has no effect in a non-crisis period. The possible costs of foreign capital flows in EMEs should incentivize policymakers to introduce capital flow management measures or macroprudential measures, in order to ensure macroeconomic stability as well as financial stability.

Keywords: Foreign capital flow, GDP growth surprise, Stock price volatility, Foreign exchange rate volatility

JEL Classification: E2, F21, F3, G1, O47