Surges in international capital flows pose serious macroeconomic challenges to policy makers in many economies, especially emerging and developing countries. Besides from worries about the economy’s competitiveness due to appreciation pressures, their main concern is increased systemic risk due to “sudden stops” or boom-and-bust cycles. The extent of foreign capital inflows fuelling the US housing market bubble, the fact that “sudden stops” of capital flows have become reality within the Euro area and the current FX interventions of the Swiss National Bank all show that the problem is by no means limited to some developing countries with shallow capital markets.
Accordingly, a growing literature focuses on the macroeconomic management of capital flows, both from a rather academic (e.g. Bianchi, 2011; Kim and Zhang, 2012; cf. Jeanne, 2012) and a more policy oriented perspective (e.g. Ostry et al., 2011 and 2012; IMF, 2011).
Structural Policy for a More Favorable Investment Position
As one line of macroeconomic defence, the OECD (2011) recommended to shift the international investment position towards more favorable forms of foreign capital. This is motivated by the consideration that, for example, large debt inflow episodes increase credit-to-GDP ratio, hence fuelling the risk of boom-and-bust cycles, while the effect is not statistically significant for FDI episodes (Furceri et al., 2011a). Furthermore, debt-driven capital inflow episodes increase the probability of a “sudden stop” by about 20 percentage points, compared to smaller magnitudes for other types of capital flows (Furceri et al., 2012).
Based on findings of Furceri et al. (2011b), the OECD highlights the role of structural policies in this context. An economic rationale therefore is the consideration that structural policies affect the long-run perspectives and sustainability of the macroeconomic environment and hence also attract capital flows with higher fixed costs, such as FDI, which are generally more stable.
The Role of Information
This, however, also makes the case for the role of information: If foreign investors possess more information about the macro environment of a potential host economy, they should be willing to undertake more long-term oriented investment, given the country has relatively promising fundamentals.
As we show in a recent working paper (Hashimoto and Wacker, 2012), this is indeed the case: We find that compliance with the IMF’s Special Data Dissemination Standard (SDDS) increases FDI inflows by a magnitude of initially more than 65 % while leaving the aggregate portfolio position virtually unaffected. This finding is also depicted in the descriptive figure below: FDI flows (as % of GDP) are clearly above their pre-SDDS level after SDDS subscription for almost all countries in the sample, while the picture is less clear for portfolio flows.
Capital Flows (% of GDP) prior to and after SDDS Subscription
We substantiate this picture in an advanced econometric framework. The impact of information on FDI inflows remains statistically significant for a wide series of robustness checks (including possible spatial correlations in residuals) and the estimated parameter is fairly stable as well, although it decreases somewhat over time. The positive effect of information on FDI inflows is generally stronger for countries with higher GDP p.c. (and hence more favorable fundamentals), but the need to make reviewed macroeconomic data available to international capital markets and to a wider public audience also creates incentives for governments to further their structural policy agenda.
There are three main reasons why public macro-information should attract FDI but not so much other forms of capital; all of them due to the fact that FDI is mostly investment of multinational firms. First, the latter’s comparative advantage is producing certain goods (or services). They are usually not specialized in acquiring information which generates strongly decreasing marginal returns to them. However, they would certainly use information that is publicly available and comparable across countries (as is the case for SDDS data) for their individual investment decisions. Portfolio and short-term investors, on the other hand, are specialized in acquiring information which generates increasing returns to scale to their investment choices. In fact, large institutional investors benefit more from information others do not know (yet), i.e. information that is not publicly available. Second, foreign direct investors are usually more concerned about the macroeconomic environment and market conditions while other foreign investors will be relatively more interested in the specific host firm or debtor. Third, the production process of multinational firms implies that the fixed costs of FDI are higher than for other forms of foreign investment. Put more vividly, a foreign acquisition and its incorporation into the multinational firm causes higher fixed investment costs than a financial portfolio adjustment or the trading of debt, especially if capital markets are deep and liquid. The costs of a wrong investment decision are hence high for direct investors, which is why they should respond more elastic to public information.
The latter point directly relates the role of public information to the management of capital flows: If there are large costs of acquiring information, investment may be conducted at a “trial-and-error” basis, i.e. the potential private loss of an investment that turns out to be “bad” may be lower than the cost of acquiring the information necessary to assess the investment opportunity in the first place. This, however, can in itself produce boom-and-bust cycles that cause large externalities. Providing more public information about the investment environment can help mitigate such developments.
While national (or even local) governments can help overcome informational asymmetries, multilateral policy action can be especially effective since it helps ensure a certain quality of informational data and make them directly comparable across countries. Given the acknowledged “home bias” in investment decisions, such initiatives will help improve the global resource allocation and cross-country risk diversification.
For national policy makers, providing more public information may simplify the management of capital flows since it generally attracts more favorable foreign capital flows, especially FDI. Furthermore, while we do not find a significant effect of information on aggregate foreign portfolio flows, providing better information may shift the specific portfolio composition more towards longer-term oriented inflows, resulting in less capital flow volatility. In this context, the relationship between quality of public information and volatility in capital markets has recently been documented by Gropp and Kadareja (2012) for stock returns of European banks.
Finally, compliance with such data initiatives might help governments overcome time inconsistency problems. Joining an international data standard makes a country subject to the monitoring of international financial markets in the future. This increases the incentives to actually promote announced structural policies. Accordingly, providing information about the macroeconomic environment is not a substitute but a complement to structural reform.
Bianchi, Javier (2011): “Overborrowing and systemic externalities in the business cycle.” American Economic Review, 101: 3400–3426
Furceri, Davide, Stéphanie Guichard and Elena Rusticelli (2011a): “The Effect of Episodes of Large Capital Inflows on Domestic Credit.” OECD Economics Department Working Papers 864
Furceri, Davide, Stéphanie Guichard and Elena Rusticelli (2011b) “Medium-Term Determinants of International Investment Positions: The Role of Structural Policies.” OECD Economics Department Working Papers 863
Furceri, Davide, Stéphanie Guichard and Elena Rusticelli (2012): “Episodes of Large Capital Inflows, Banking and Currency Crises, and Sudden Stops.” International Finance, 15(1): 1-35
Gropp, Reint and Arjan Kadareja (2012): “Stale Information, Shocks, and Volatility.” Journal of Money, Credit and Banking, Vol. 44(6): 1117-1149
Hashimoto, Yuko and Konstantin M. Wacker (2012): “The Role of Risk and Information for International Capital Flows: New Evidence from the SDDS.” IMF Working Paper 12-242
IMF (2011): “Recent Experiences in Managing Capital Inflows: Cross-Cutting Themes and Possible Policy Framework.” International Monetary Fund: Strategy, Policy and Review Department, Washington, DC
Jeanne, Olivier (2012): “Capital flow management.” American Economic Review, 102: 203–06.
Kim, Yun Jung and Jing Zhang (2012): “Decentralized borrowing and centralized default.” Journal of International Economics, 88: 121 – 133.
OECD (2011): “Getting the most out of International Capital Flows.” in: Organisation for Economic Cooperation and Development: World Economic Outlook 2011, chapter 6
Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Luc Laeven, Marcos Chamon, Mahvash S. Qureshi, and Annamaria Kokenyne (2011): “Managing capital inflows: What tools to use?” IMF Staff Position Note, 11/06
Ostry, Jonathan D., Atish R. Ghosh, and Anton Korinek (2012): “Multilateral aspects of managing the capital account.” IMF Staff Position Note, 12/10