The standard deviations of capital flows to emerging countries are 80 percent higher than those to developed countries. First, we show that very little of this difference can be explained by more volatile fundamentals or by higher sensitivity to fundamentals. Second, we show that most of the difference in volatility can be accounted for by three characteristics of capital flows: (i) capital flows to emerging countries are more subject to occasional large negative shocks (“crises”) than those to developed countries, (ii) shocks are subject to contagion, and (iii) – the most important one – shocks to capital flows to emerging countries are more persistent than those to developed countries. Finally, we study a number of country characteristics to determine which are most associated with capital flow volatility. Our results suggest that underdevelopment of domestic financial markets, weak institutions, and low income per capita, are all associated with capital flow volatility.
Interestingly, and contrary to the effect of the exclusion of outliers, accounting for persistence not only increases the “explanatory” power of our regressions but also decreases substantially the ratio of standard deviations. This is reflected in the different coefficients of lag capital flows, which is quite higher for emerging countries than for developed countries, showing that capital flows are more persistent in emerging than in developed countries. The coefficient on the lag in emerging countries is usually higher than 0.60 while it is below 0.50 for developed countries.
In addition, whereas the exclusion of outliers before had little effect on the ratio of residuals, once we account for different persistence the exclusion of outliers does have a significant effect on this ratio. The combined effect of accounting for persistence and excluding outliers is to reduce the ratio of standard deviations from 1.788 to 1.298.12
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