Dynamics of Capital Flows and Global Factors: Case of Emerging Economies

Abstract

The paper aims to examine the comovement in gross capital inflows and outflows in emerging market and developing economies (EMDEs) to check for the existence of a Global Financial Cycle (GFCy), analyze the determinants of this commonality, and assess the role of domestic macroeconomic factors in affecting the sensitivity of capital flows to global factors. The study employs a two-level dynamic factor model to estimate the common components of gross capital flows in a 23-country sample covering EMDEs from three regions of the world. The study shows that a common global factor accounts for most of the variations in capital flow data, but with differences among regions. The determinants of global factors include global risk, liquidity, the growth rate of advanced economies, commodity prices, the US exchange rate, and the US interest rate. Domestic factors like financial linkages, trade openness, macroeconomic and financial instability, and exchange rate flexibility influence capital flow sensitivity to global factors. The study finds evidence of GFCy which can considerably reduce the ability of policymakers to insulate the domestic economy from global financial trends. However, there is evidence of the moderating role of exchange rate flexibility in transmitting the effects of global financial conditions on capital flows for EMDEs.