What Drives Cross-Border Equity Flows?

"Currency depreciation does lead to more foreign inflows into local equity markets."

Economic theory dictates that capital will flow to wherever its marginal product is highest, and that the free movement of capital across international borders will enhance welfare and efficiency in the global economy. However, the multiple emerging-market financial crises of the 1990s convinced many observers that global investors often behave irrationally and promote market "contagion" unrelated to economic fundamentals; some even have concluded that cross-border capital flows are inherently destabilizing for developing countries and for the world economy as a whole. Which viewpoint is correct?

In Daily Cross-Border Equity Flows: Pushed or Pulled? (NBER Working Paper No. 9000), authors John Griffin, Federico Nardari, and René Stulz develop an international financial-markets model and test it with daily equity flows data from nine countries, mainly in Asia, in order to answer the question. The authors take into account that investors usually reflect a "home bias" in their investment decisions --that is, domestic investors tend to hold less foreign equities than if they held the world market portfolio. The authors also consider that domestic investors tend to buy foreign stocks following unexpectedly high returns on these stocks. (Analysts often refer to this as "trend-chasing" or "momentum investing.")

The model predicts that equity flows toward a country will increase with the returns in that country's stock market. In other words, capital is "pulled" toward the country. However, the model also predicts that, when the recipient country is small, equity inflows will increase along with stock returns in the rest of the world, that is, capital is also "pushed" toward the recipient country.

Griffin, Nardari, and Stulz test their model with data on daily equity flows for five East Asian countries (Indonesia, South Korea, the Philippines, Taiwan, and Thailand), two South Asian economies (India and Sri Lanka), one African country (South Africa), and one East European economy (Slovenia). The data spans from 1996 to 2001.

Three interesting initial features emerge from the data: First, equity flows show only a weak positive relationship with the movement of major market indices. For example, during the Russian financial crisis in 1998, only Korea showed a sell-off by foreign investors. Second, the overall period is one of net capital inflows for the set of countries in question, although Thailand, Sri Lanka, and the Philippines showed negative foreign investment. And third, the volatility of net foreign equity flows varies significantly from country to country: for example, Korea and Indonesia show substantial movements, while Slovenia shows minimal variation.

Looking at the impact of a country's own past returns on future investment flows, the authors find that foreign inflows on one day are highly influenced by the previous day's return in that country's market, particularly in the East Asian economies. However, even as foreigners chase short-term market returns on a daily basis, the effect wears off quickly as the trading week proceeds.

The authors also find that, when the foreign market is sufficiently large relative to the domestic market, equity flows are positively related to foreign returns. For example, equity flows into the Asian countries they study are positively related to returns in the North American market and, to a lesser degree, to returns in European markets.

Finally, the authors test the impact of exchange-rate movements on equity flows and assess whether foreign investors indeed engage in "herding behavior" across markets, unrelated to economic fundamentals. In eight of the nine countries studied, currency depreciation does lead to more foreign inflows into local equity markets; however, the relationship is only significant in Indonesia and the Philippines. The authors also find that "herding" behavior is real but not terribly important; flows into other countries in the same region are a significant determinant of flows into Korea, but not so for Indonesia, Taiwan, or Thailand.

Griffin, Nardari, and Stulz interpret their results as evidence that the conventional view of market contagion and "herding" is incomplete. In particular, they highlight the key finding that foreign inflows into small markets increase more rapidly when the U.S. market performs well, regardless of the local market's performance." To understand capital flows into a country over a sample period that includes the Asian and Russian crises, it is not enough to focus on the fundamentals of the host country or even markets with similar fundamentals," they conclude. "Flows can be pushed toward a country as well as pulled toward it."

-- Carlos Lozada

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