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World Bank Document THE WORLD BANK ECONOMIC REVIEW, VOL. 9, NO. 1 153-174 10oM44CL#&jIi'S Portfolio Capital Flows: Hot or Cold? Stijn Claessens, Michael P. Dooley, and Andrew Warner Public Disclosure Authorized A distinction is often made between short-term and long-term capitalflows: the former are deemed unstable hot money and the latter are deemed stable cold money. Using time-series analysis of balance of payments data for five industrial and five developing countries, we find that in most cases the labels "short-term" and "long-term" do not provide any information about the time-series properties of the flow. In particular, long-term flows are often as volatile as short-term flows, and the time it takes for an unexpected shock to a flow to die out is similar across flows. Long-term flows are also at least as unpredictable as short-term flows, and knowledge of the type of flow does not improve the ability to forecast the aggregate capital account. Several developing countries have received large capital inflows in recent years, reversing a trend of outflows for most of the 1980s (see Gooptu 1993). Much of Public Disclosure Authorized this new capital inflow has been short-term portfolio investment, including bonds, equities, and short-term instruments such as certificates of deposit and commercial paper. This surge in short-term flows has raised the question of whether these flows will be sustained or instead be reversed in the near future. Some observers argue that the recent flows are inherently unsustainable be- cause they have short maturities. For example, on the basis of this argument, Reisen (1993:2) concludes that "the majority of flows [to Latin America] are hot rather than cool:' Nunnenkamp (1993) employs a similar approach and points out that the composition of inflows varies considerably among developing coun- tries. His conclusion is that hot money transactions have been relatively small in the Chilean case but significantly large in Brazil. And Turner (1991), in his review of capital flows for industrial countries, ranks short-term bank lending as Public Disclosure Authorized most volatile and long-term bank flows as least volatile, followed by foreign direct investment (FDI) as the next-to-least volatile (Turner 1991, table 35, p. 95). This article focuses on the implicit reasoning that reliable inferences can be drawn about the degree to which a flow tends to sustain itself at its current level, Stijn Claessensis with the TechnicalDepartment of the Europe and Central Asia and Middle East and North Africa Regions at the World Bank; Michael P. Dooley is with the Department of Economics at the University of California at Santa Cruz; and Andrew Warner is with Harvard University.At the time this article was written, Michael P. Dooley and Andrew Warner were with the International Economics Department at the World Bank. The authors would like to thank Guillermo Calvo, Maxwell Fry, Camp- bell Harvey, Ricardo Hausmann, participants in a Bank seminar, and the refereesfor their comments. © 1995 The International Bank for Reconstructionand Development/THEWORLD BANK Public Disclosure Authorized 153 'A ',e 7- QS 154 THE WORLD BANK ECONOMIC REVIEW, VOL. 9, NO. 1 that is, the .ieree if persisbend, solely on the basis of data categories given in balance of payments statistics. That is, the conventional view asserts that persis- tence can be inferred from labels. Here we ask whether, given direct statistical measures of persistence, labels can be drawn from persistence. In effect, our way of verifying this proposition is to turn it around and see if it also holds in the opposite direction. When only time-series statistics on persistence are used, can the label of the flow be identified? As we explain in section II, we are skeptical on theoretical grounds that such an inference is reliable; however, we think the issue is worth a systematic examination. Section I provides the motivation for the analysis. Section II discusses the modeling of capital flows. Section III discusses what evidence is relevant. Section IV provides the classifications for the various capital flows and the data sources. Section V analyzes simple univariate statistics for the various individual flows and looks at the predictability of these flows to answer the question: hot or cold? Section VI investigates the interactions between the various flows. It also looks at the predictive power of the overall capital flows and the interactions between the various flows and the overall capital account. Section VII is a summary. I. MOTIVATION The notion that inferences can be made about the characteristics of financial flows by just observing their labels is, of course, not new in economics. The flows-of-funds approach used by many central banks and others to analyze developments in the domestic economy embodies the implicit view that there is information in labels. This view has also long been an important part of the traditional analysis of international finance (see Nurske 1944 for a description of experiences in the 1920s). A distinction is often made between short-term and long-term capital flows: short-term capital movements are deemed speculative and reversible-hot money-and long-term capital flows-cold money-are based on fundamentals and are deemed reversible only when the fundamentals change. The fact that capital control programs in many countries distinguish between short- and long-term flows already points to the importance attached to this distinction. Capital account transactions are often also subject to policy inter- ventions that differ according to the type of flow. Withholding taxes are often levied on one kind but not another kind of capital flow. Subsidies often take the form of a government guarantee of private liabilities, favorable tax treatment on earnings (for example, on FDI), or access to special government facilities (for example, debt-equity swaps). Each of these distortions is designed to encourage or discourage a given type of capital transaction. In fact, the whole structure of balance of payments accounts reflects the implicit view that different types of capital flows have different economic implications. However, it is easy to be skeptical about the information value of the balance of payments labels for any purpose, not just for assessing persistence. Claessens, Dooley, and Warner 155 Increasingly, multiple financial instruments are available to financt any project, and so if a tight link ever existed between the financing method and the underlying nature of the project, it is probably becoming increasingly loose. A Treasury bond with a thirty-year maturity can be sold on the secondary mar- ket, and short-term assets can be continuously rolled over. Many observers seem to base their notion that short-term flows are more volatile on the fact that short-term-maturity inflows need to be repaid more quickly than long- term flows. Although rapid repayment may lead to higher volatility of gross short-term flows, it need not make net flows more volatile. Short-term flows that are rolled over are equivalent to long-term assets, and a disruption of gross FDI inflows, for example, can cause its net flow to be equivalent to a repayment of a short-term flow. In addition, the explicit label given to a flow may not cover its implicit nature. Dooley (forthcoming) argues, for example, that, although the inflows to developing countries in the 1970s were private capital flows in name, the universal government guarantees of both lenders and borrowers considerably subdued the discipline of the market. The flows, which helped generate the debt crisis of 1982, should have been considered official capital flows. The reasoning based on the label of the flow can nevertheless underpin substantive policy measures. Once a flow is identified as hot money, it is often seen to require some policy response. At various times countries (especially developing countries) have responded with exchange rate management, (ster- ilized) intervention, fiscal contraction, borrowing taxes, absolute foreign bor- rowing constraints, and reserve requirements (see, for example, Kiguel and Caprio 1993, Fischer and Reisen 1992, and Corbo and Hernandez 1993 for reviews of developing countries' responses to recent capital inflows). Many of these responses have differed depending on the "label" of the flow, thus presuming that labels are meaningful. II. MODELING CAPITAL FLOWS Research on international capital flows has differed on whether it is more accurate to treat the flows as exogenous (with respect to the country in question) or endogenous. In this study, although we do not think it vital to take a stand on this issue, we do clarify how the interpretation of our findings depends on this issue. If capital flows are exogenous from the point of view of the domestic economy, perhaps because they are driven by changes in international financial variables and market perceptions of the country, then the policymaker's con- cern about the volatility of capital flows can make good sense. Depending on the exchange rate policy being pursued by the country, volatile capital flows can translate into exchange rate volatility (in the case of a flexible exchange rate) or into variations in official reserves (in the case of a fixed or pegged exchange rate). Either consequence can be undesirable because it leads to 156 THE WORLD BANK ECONOMIC REVIEW, VOL. 9, NO. 1 temporary signals to shift resources between traded and nontraded sectors or because it requires monetary adjustments. If flows are exogenous, it would clearly be useful to know whether the data support the conventional view that certain kinds of flows are inherently more volatile and that certain flows can be predicted better. If capital flows are endogenous, however, an analysis of the behavior of capital flows in isolation makes little sense. Here, everything depends on the nature of the shock that gives rise to changes in the current account.
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