Journal of Economic Studies

Determinants of capital flows to developing countries: a structural VAR analysis

Glauco De Vita Khine S. Kyaw
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Glauco De Vita Khine S. Kyaw, (2008),"Determinants of capital flows to developing countries: a structural
VAR analysis", Journal of Economic Studies, Vol. 35 Iss 4 pp. 304 - 322
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JES
35,4 Determinants of capital flows
to developing countries:
a structural VAR analysis
304
Glauco De Vita and Khine S. Kyaw
Oxford Brookes University Business School, Oxford Brookes University,
Received February 2007
Accepted June 2007 Oxford, UK

Abstract
Purpose – The aim of the study is to investigate the relative significance of the determinants of
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disaggregated capital flows (foreign direct investment and portfolio flows) to five developing
countries, across different time horizons.
Design/methodology/approach – An empirically tractable structural VAR model of the
determinants of capital flows is developed, and variance decomposition and impulse response
analyses are used to investigate the temporal dynamic effects of shocks to push and pull factors on
foreign direct investment and portfolio flows.
Findings – Estimation of the model using quarterly data for the period 1976-2001 provides evidence
supporting the hypothesis that shocks to real variables of economic activity such as foreign output and
domestic productivity are the most important forces explaining the variations in capital flows to
developing countries.
Research limitations/implications – These findings highlight the concomitant need for policy
makers in developing countries to design domestic policy that accounts for both external and internal
shocks to real variables of economic activity.
Originality/value – Previous empirical studies on the determinants of capital flows to developing
countries have mostly examined the capital flow variable in aggregate, and have largely overlooked
the possibility that the relative significance of estimated coefficients of such determinants may vary
across time horizons.
Keywords Capital, International investments, Portfolio investment, Developing countries
Paper type Research paper

Introduction
The remarkable growth in capital flows[1] to developing countries since the early
1990s[2] has stimulated an extensive debate in the literature on the determinants of
such flows. The observed trend has been attributed to a number of factors, such as
changes in global economic conditions, changes in the economic fundamentals of
developing countries, capital market development, changes in capital control policies
and banking supervision, trade liberalizations, and herd behavior among investors.
Our interest here centers upon the role of economic fundamentals in driving capital
Journal of Economic Studies
Vol. 35 No. 4, 2008 The authors are grateful to an anonymous referee and the Editor of this journal for their
pp. 304-322 helpful comments. They also wish to thank Professor Ronald MacDonald, Dr Mozammel Huq,
q Emerald Group Publishing Limited
0144-3585
Dr Joseph P. Byrne, Professor Gary Koop, Dr Alberto Paloni, Dr Chol Won Li, and Dr Giorgio Fazio
DOI 10.1108/01443580810895608 for their valuable feedback on an early version of this paper.
 flows[3], with specific reference to changes in global economic conditions and in the Capital flows
economic fundamentals of developing countries. to developing
The literature on the determinants of capital flows to developing countries has, in
the main, focused on two sets of factors: push and pull. Push factors are exogenous, or countries
external, and relate to economic developments in industrial countries that influence the
supply of capital flows to developing countries. The low level of US interest rates or the
decline of international interest rates have often been cited as major push factors. 305
Another push factor frequently cited in the literature is the slowdown of the US
economy (Calvo et al., 1992; Fernandez-Arias, 1996; Haque et al., 1997; Montiel and
Reinhart, 1999). Pull factors are country-specific endogenous, or internal, and relate to
economic developments in recipient countries that influence the demand for capital
flows. Pull factors include domestic productivity and the money supply (Calvo et al.,
1992; Lensink and White, 1998).
For quite some time the central question in this literature has been that of
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establishing the relative importance of push versus pull factors, that is the extent to
which capital flows are a function of the determinants in industrial countries vis-à-vis
the country-specific determinants of the developing countries hosting the investment
(Chuhan et al., 1998; Carlson and Hernandez, 2002). Have the decline in global interest
rates of the past decade and the sluggish growth in the US and other industrial
countries been the dominant (push) factors or have the improved economic prospects in
many developing countries been the key drivers in pulling capital flows?
Calvo et al. (1992) used principal components analysis to examine the capital inflows
to developing countries from 1973 to 1991. They argued that the surge in capital inflows
is mostly the result of push factors, in particular, low interest rates in the US. In addition,
they suggested that cyclical conditions in industrial countries have been the main factor
driving these flows to developing countries. Harvey (1994) conducted a regression
analysis to study the risk and return for developing country equity flows from 1976 to
1992. His study suggested that investors are primarily concerned with how the
developing country’s return holds up against returns on alternative investments
involving less foreign country risk, and from this concluded that equity flows to
developing countries are primarily due to global factors. By employing panel data for
Asian and Latin American countries between 1989 and 1993, and decomposing the
improvements in creditworthiness of these countries into those resulting from a decline
in global interest rates and those from improvements in the domestic environment,
Fernandez-Arias (1996) found that the decline in international interest rates was the key
determinant of capital flows to developing countries. He contended that since
country-creditworthiness depends on the world interest rate, the foreign interest rate is
by far the most important factor in generating the observable growth in capital flows
into developing countries.
The suggestion of the dominance of push factors in driving capital flows to
developing countries has not remained undisputed. Bohn and Tesar (1996) used an
international capital asset pricing model to examine the differences in the timing
of investment over the 1980-1994 period and concluded that pull factors were more
important than push factors in Asian countries. Similarly, Hernandez et al. (2001) used
a panel regression to explain capital flows to developing countries between 1977 and
1997, and found that private capital flows were determined mainly by country-specific
characteristics of the developing countries hosting the investments, and that external
 JES or push factors were not significant in explaining the inflows. A similar conclusion was
35,4 reached by World Bank (1997). The report showed that co-movements between US
asset returns and US portfolio flows to developing countries had weakened between
1994 and 1995, and it suggested that the role of pull factors had become much more
pronounced in recent years.
More recent studies have highlighted the potential complementarity of push and
306 pull factors in inducing capital flows. Chuhan et al. (1998) employed a panel data
approach to investigate the factors motivating the large capital flows to a number of
developing countries for the 1988-1992 period. They found that although push factors
were important in explaining capital inflows, pull factors were at least as important,
especially for Asia. Using fixed effects panel data analysis for the 1990-1996 period,
Montiel and Reinhart (1999) found that while push factors determined the timing and
magnitude of the flows, pull factors were important in determining the distribution of
such flows[4].
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In conclusion, although early studies provide fairly strong support to the argument
that push factors, especially US interest rates and global cyclical conditions, play a
more prominent role in determining capital flows to developing countries, later studies
have generally failed to confirm this relationship, thus leaving the debate on the
determinants of capital flows to developing countries unsettled.
Our contribution adds to this debate by explicitly addressing two important gaps in
the extant empirical literature. First, since the capital flow variable employed in
previous work is primarily capital flows in aggregate, relatively little is known about
whether the relative significance of the determinants differs across different types of
capital flows, namely foreign direct investment and portfolio flows[5].
Second, no previous study has investigated the issue of whether and how the
relative significance of push versus pull factors varies across different time horizons.
We consider this gap in the existing literature as a serious omission of great importance
because the statistical significance of estimated coefficients may be sensitive to
the time span adopted in regression analysis. The theoretical rationale that we propose
for the need to examine the temporal dynamics of the variations in capital flows in
response to movements in, and shocks to, fundamental determinants is straightforward.
We postulate that capital flows from patient investors with long time horizons will not
flee at the first change in an economic factor that might augur poorly for the conditions of
the developing country hosting the investment. To us, it appears both reasonable and
plausible to suggest that the temporal dynamic effects that shocks to the determinants of
capital flows have on such flows may also depend upon the time horizon of investors.
The shorter the time horizon of investors, the greater and more immediate the effect on
capital flows.
To address these gaps, in this paper we develop a structural vector autoregression
(VAR) model that allows us to investigate the extent to which variations in foreign
direct investment and portfolio flows are due to various push and pull factors across
different time horizons. By means of variance decomoposition and impulse response
analyses, we are able to examine the temporal dynamic effects that shocks to
fundamental determinants have on foreign direct investment and portfolio flows.
The remainder of the paper is organized as follows. The next section sets out an
empirically tractable model of capital flows and discusses the methodology employed.
The following section provides a description of the data. Next, the empirical results are
 presented and discussed. The paper concludes with a brief summary of findings and a Capital flows
discussion of their implications for policy.
to developing
Methodology countries
We develop an empirical model of capital flows for a small integrated economy. We
consider two types of shock: external and internal. With respect to external shocks, we
focus on two primary variables: the global supply and the foreign interest rate[6]. 307
Internal shocks include country-specific productivity shocks and country specific
monetary shocks.
The above discussion suggests that foreign direct investment and portfolio capital
flows, fdi and port, respectively, can be modelled as follows:
fir dp dm fdi port
fdit ¼ f 1 ðufo
t ; ut ; ut ; ut ; ut ; ut Þ ð1Þ
fir dp dm fdi port
portt ¼ f 2 ðufo
t ; ut ; ut ; ut ; ut ; ut Þ ð2Þ
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In equations (1) and (2), capital flows are functions of shocks on foreign output, ufo
t , the
dp
foreign interest rate, ufir dm
t , domestic productivity, ut , and domestic money, ut . We also
port
include unknown shocks to each flow as well as shocks to the other flow, ufdi t and ut .
This list of shocks is fairly comprehensive relative to previous literature. For example,
Blanchard and Quah (1989) take into account only aggregate demand and aggregate
supply shocks while Fernandez-Arias (1996) only considers the decline in international
interest rates and improvements in the domestic environment.
The structural shocks in equations (1) and (2) are unobservable. Since what we
observe in the data are combinations of unobserved structural shocks, additional
identifying assumptions are necessary to uncover underlying structural shocks from
the observed data. We use the structural[7] VAR method to investigate the role of
various factors in bringing capital flows. To extract the six structural shocks, we
consider a six-variable VAR system in which the observable variables are related to
the structural shocks. The system is modelled as a aij(L) lag polynomial form[8] as
follows:
X
1
Yt ¼ Ai U t2i 2 AðLÞU i ð3Þ
i¼0
0 fo fir dp dm fdi port 0
where Y Pt 1¼ ðDyti; Dr t ; Dpt ; Dmt ; fdit ; portt Þ , U t ¼ ðut ; ut ; ut ; ut ; ut ; ut Þ and
AðLÞ ¼ i¼0 Ai L where L is the lag operator. Ai is the matrix of impulse responses of
endogenous variables to structural shocks. The variables are foreign output ( y), the
foreign interest rate (r), domestic output ( p), and the domestic money supply (m).
We assume that all endogenous variables other than foreign direct investment and
portfolio flows are nonstationary and require first differencing to become stationary
fir dp dm fdi port
series, and that structural shocks ðufo t ; ut ; ut ; ut ; ut ; ut Þ are mutually
uncorrelated with unit variance. In addition, the following assumes that foreign
output, the foreign interest rate, domestic productivity, and domestic money are not
cointegrated (empirical evidence for this assumption is provided in the results section).
We also make some assumptions regarding the long run effects P1 of structural shocks.
The matrix of long run effects of structural shocks is i¼0 Ai ¼ AðI Þ ¼ {aij ð1Þ}.
External variables are assumed to be affected in the long run by foreign shocks only.
 JES This assumption is commonly used for a small integrated economy analysis. The
35,4 difference is that we impose the assumption only in the long run. There are two
external shocks in this model. The foreign output variable is assumed to evolve
exogenously as shown by the following equation:

Dyt ¼ a11 ðLÞufo

i ð4Þ
308
The foreign interest rate is affected by shocks to the foreign output as well as shocks to
itself. Domestic variables are affected by both the external shocks and domestic
shocks. The assumption that domestic variables have no effect on foreign variables in
the long run is used as part of the identification scheme. Regarding the effects of
domestic shocks on domestic variables, we make the following assumptions:
.
among the domestic shocks, only country specific supply shocks affect domestic
output in the long run;
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.
domestic monetary shocks have no long run effect on domestic output (the
assumption of zero long run effects of monetary shocks on output is relatively
uncontroversial in macroeconomic analysis); and
.
shocks to portfolio flows are transitory in nature and have no long run effects on
any variable.

The long run restrictions can be summarized in matrix form. Equation (5) indicates
that the A(1) matrix is a lower triangular matrix:
2 3 2 32 3
Dyt * 0 0 0 0 0 ufo
t
6 7 6 76 7
6 Dr t 7 6 * * 0 0 0 07 6 ufir 7
6 7 6 76 t 7
6 7 6 76 7
6 Dpt 7 6 07 6 udp 7
6 7 6* * * 0 0 76 t 7
6 7¼6 76 7 ð5Þ
6 Dmt 7 6 * * * * 76 udm 7
6 7 6 0 0 76 t 7
6 7 6 76 7
6 fdit 7 6 * 76 7
6 7 6 * * * * 0 76 ufdi
t 7
4 5 4 54 5
portt * * * * * * uport
t

One advantage of the approach outlined above is that, by exploiting long run
properties, it makes fewer arbitrary assumptions to recover structural shocks. The
empirical method to recover the structural shocks from the observed variables is based
on the structural VAR analysis pioneered by Blanchard and Quah (1989). In this
procedure, a VAR model is estimated for the system of the observed variables. In the
modified VAR model, the external variables follow an autoregressive process while the
domestic variables are modelled as functions of their own lags and lags of external
variables. In the system of six variables, the identification of structural shocks, Ut,
from reduced form shocks requires 15 restrictions, obtained from [(62 2 6)/2] as shown
in equation (5). The following describes how the restrictions are used to recover the
structural shocks from the structural model uniquely.
To Precover the structural moving average representation from equation (3),
Yt ¼ 1 i¼0 Ai U t2i ¼ AðLÞU t , we first estimate a reduced-form VAR model:
 BðLÞY t ¼ V t ð6Þ Capital flows
The moving average representation is: to developing
countries
Y t ¼ BðLÞ21 V t ¼ CðLÞV t ð7Þ
The leading coefficient matrix, C(0), that captures the contemporaneous effects of
reduced form shocks is the identity matrix, C(0) ¼ I. It follows from the comparison of 309
the structural moving average representation and equations (3) and (7) that:

U t ¼ A21
0 Vt ð8Þ
where A0 ¼ A(0) is the leading coefficient matrix in A(L). Also:

Ai ¼ A21
0 Ci ð9Þ
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where Ai and Ci are coefficients matrices of A(L) and C(L). Since Ci are obtained as the
moving average representation of the reduced form VAR, A 0 is and the structural
representations are obtained if the A0 matrix is known. To find A0, first note that:
A0 SA00 ¼ A0 A00 ¼ V; ð10Þ
where V ¼ VarðV t Þ and S ¼ VarðU t Þ. The latter is normalized to the identity matrix
by assumption. Also:
Að1ÞAð1Þ0 ¼ Cð1ÞVCð1Þ0 ð11Þ
where C(1) inherits the properties of A(1) and V is a variance matrix of the reduced
form model. Because A(1) is a lower triangular matrix due to the long-run restrictions,
it follows that A(1) can be obtained as Cholesky decomposition of the C(1)VC(1)0
matrix. Once the A(1) is derived, the A0 matrix is finally obtained by:

A21
0 ¼ Að1ÞCð1Þ
21
ð12Þ
Structural shocks are then obtained by equation (8) and structural moving average
coefficients by equation (9).

Data
The data used in this study are quarterly data from the first quarter of 1976 through to
the second quarter of 2001. The data for all the variables are taken from the
International Financial Statistics (IFS) CD-ROM Version 1.1.54.
Five developing countries are examined in this study: Brazil, Korea, Mexico, the
Philippines, and South Africa. Although the selection of countries included in the study
was dictated by data availability, these countries are in fact among the main
developing country recipients of capital flows as they collectively account for over
30 percent of total capital flows to the developing world. For each country in the study,
the US serves as the foreign country. Foreign output and the foreign interest rate are
proxied by the US real GDP growth and the US treasury bill rate[9], respectively.
Domestic productivity or output is given by real GDP growth in developing countries.
Domestic money is proxied by the sum of currency outside deposit money banks and
demand deposits other than those of the central government plus, where applicable,
 JES private sector demand deposits with the postal checking system and with the treasury,
35,4 adjusted with the GDP deflator. The foreign output, domestic output, and domestic
money variables are in logarithms.
Foreign direct investment represents the real net flows of direct investment capital
into the reporting economy. The direct investment capital flows[10] include equity
investment, reinvestment of earnings – the investor’s share in the undistributed
310 earnings of the affiliate – and various inter-company transactions such as trade credit,
as well as investments by affiliates. Portfolio flows represent the real portfolio
investment liabilities that include transactions with non-residents in financial
securities of any maturity (such as corporate securities, bonds, notes, money market
negotiable debt instruments, shares, stocks, etc.) other than those included in direct
investment, exceptional financing, and reserve assets.

Empirical results
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The empirical model discussed earlier is based on the assumption that all the variables
other than capital flows are non-stationary while the latter are stationary. The results
of the augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) unit root tests are
reported in Table I. In all cases, the null hypothesis of a unit root can be rejected for the
foreign direct investment and portfolio flows at the 5 percent significance level in at
least one test. For all the variables other than capital flows, the test cannot reject the
existence of a unit root in most cases.
The model employed in the study also assumes that the four non-stationary
variables, foreign output, foreign interest rate, domestic productivity, and domestic
money, are not cointegrated. The results obtained from the Johansen cointegration tests
are reported in Table II. The existence of cointegration[11] among the variables is found
to depend on the period of estimation. For instance, for Korea and the Philippines, where
much longer data are available, there is little evidence of cointegration in the full sample
period. However, if the sample period is restricted to the post-1989 period, there is
evidence of one or two cointegrating relations. Furthermore, the evidence of
cointegration is the strongest for Brazil, where the data span is the shortest.
The existence of cointegration among the variables would suggest that one or more
of the structural shocks have only transitory effects on all other variables. Our finding
that cointegration fails to hold with longer time spans, indicates that the effect of
shocks varies across different time horizons and can alter or even break the variables’
long run co-movement. In order to investigate further the temporal dynamics of the
variations in foreign direct investment and portfolio flows resulting from shocks to
fundamental determinants, we conduct variance decomposition and impulse response
analyses[12].
The main empirical results using variance decompositions and impulse responses
to various shocks are summarized in Tables III and IV and in Figures 1-10,
respectively.
Variance decomposition provides evidence on the relative importance of each
random innovation or shock in affecting the variables. The results given in Table III
(for foreign direct investment flows) and Table IV (for portfolio flows) indicate the
percentage of the variance of the q quarter-ahead forecast error of a particular
endogenous variable that is due to each shock, for various time horizons. In particular,
since our primary interest is to examine the relative importance of each shock in
 Capital flows
Augmented Dickey-Fuller (ADF) Phillips-Perron (PP)
Variable ADF test statistic Critical value PP test statistic Critical value to developing
fo 2 1.69 23.52 21.90 23.52
countries
fir 2 3.41 22.94 22.38 22.93
Brazil
fdi 2 3.08 23.52 22.98 23.52 311
port 2 6.74 22.93 26.73 22.93
dp 2 2.01 23.53 22.31 23.52
dm 2 2.15 22.94 27.30 22.93
Mexico
fdi 2 5.46 23.52 25.43 23.52
port 2 3.26 22.93 23.38 22.93
dp 2 1.77 23.53 20.31 23.52
dm 2 0.91 23.53 20.77 23.52
Korea
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fdi 2 2.03 23.52 23.45 23.52

port 2 1.26 22.95 24.79 22.93
dp 2 1.17 23.53 25.75 23.52
dm 2 2.14 23.53 23.12 23.52
South Africa
fdi 2 2.54 22.93 25.61 22.93
port 2 3.56 22.93 23.45 22.93
dp 2 1.98 23.52 21.99 23.52
dm 2 1.81 23.52 21.77 23.52
Philippines
fdi 2 4.97 22.93 24.97 22.93
port 2 3.63 22.93 23.67 22.93
dp 2 1.61 23.54 24.47 23.52
dm 2 1.74 23.52 21.70 23.52
Notes: All the critical values given are at the 5 percent significance level. The lag structure of each
ADF regression was chosen following a sequential testing procedure to remove serial correlation. The
Phillips-Perron test (Phillips and Perron, 1988) is the estimated Dickey-Fuller regression with a
non-parametric correction for serial correlation. The truncation lag is specified from the highest
significant lag order from the autocorrelation function of the first difference of each variable. The
(finite sample) critical values are those generated by RATS version 5. The acronyms fo, fir, fdi, port,
dp, and dm denote foreign output, foreign interest rate, foreign direct investment, portfolio flow, Table I.
domestic productivity, and domestic money, respectively Unit root test results

different time horizons, cumulative variance decompositions are reported for 1, 4, 12,
20, and 44 periods for each variable.
The framework that we adopt also allows us to trace out the effects of various
shocks on the capital flows to developing countries. Overall, the foreign output and
domestic productivity shocks appear to explain largely the variations in both foreign
direct investment and portfolio flows. In particular, it appears that variations in the
foreign direct investment and portfolio flows are explained primarily by shocks to
foreign output and domestic productivity in the medium- to longer-term horizons.
The role of foreign interest rate and domestic money shocks tends to diminish, and
foreign output shocks and domestic productivity shocks become more prominent, with
longer horizons. A similar increase in the role of foreign output shocks and domestic
 JES
Number of cointegrating relations Trace statistic lMax statistic
35,4
Brazil (1990:1-2000:4) None 65.81 36.88
At most 1 28.93 23.20
At most 2 5.73 5.73
At most 3 0.00 0.00
312 Mexico (1990:1-2000:4) None 71.07 33.05
At most 1 38.02 22.29
At most 2 15.73 15.70
At most 3 0.03 0.03
Korea (1990:1-2000:4) None 52.98 22.35
At most 1 30.63 17.39
At most 2 13.24 7.63
At most 3 5.61 5.61
South Africa (1990:1-2000:4) None 74.68 37.67
At most 1 37.01 22.62
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At most 2 14.39 9.60

At most 3 4.80 4.80
Philippines (1990:1-2000:4) None 65.56 32.43
At most 1 33.12 18.56
At most 2 14.57 8.36
At most 3 6.20 6.20
Mexico (1985:4-2000:4) None 89.84 75.14
At most 1 14.71 12.23
At most 2 2.48 2.31
At most 3 0.17 0.17
Korea (1976:1-2001:2) None 49.03 27.59
At most 1 21.44 11.03
At most 2 10.41 6.91
At most 3 3.49 3.49
South Africa (1985:1-2001:1) None 44.86 24.61
At most 1 20.24 11.76
At most 2 8.49 6.25
At most 3 2.24 2.24
Philippines (1980:4-2001:1) None 62.68 29.96
At most 1 32.72 18.79
At most 2 13.93 10.68
At most 3 3.25 3.25
Notes: The trace statistic tests the null of r cointegrating relations against the alternative of k
cointegrating relations, where k is the number of endogenous variables, for r 2 0, 1, . . ., k 2 1. The
(lMax tests the null of r cointegrating relations against the alternative of r þ 1 cointegrating vectors.
The critical values at the 5 percent (1 percent) significance level for the trace test are 47.21 (54.46), 29.68
Table II. (35.65), 15.41 (20.04), and 3.76 (6.65). The critical values at the 5 percent (1 percent) significance level for
Cointegration results the maximum eigenvalue test are 27.07 (32.24), 20.97 (25.52), 14.07 (18.63), and 3.76 (6.65)

productivity shocks is observed for portfolio flows. Therefore, for both foreign direct
investment and portfolio flows, shocks on foreign output and domestic productivity
seem to be consistently dominant across various time horizons, suggesting that real
variables (in particular, the output in industrial countries and domestic productivity in
developing countries) rather than monetary variables, are the key drivers of capital
flows to developing countries.
 Capital flows
Horizon (Quarter) fo fir dp dm fdi port
to developing
Brazil: percentage of variations in FDI flows due to innovations in countries
1 12.718 23.880 26.196 4.631 32.574 0
4 31.140 11.764 28.571 10.981 13.987 3.553
12 40.359 8.341 28.922 10.359 8.491 3.525
20 45.183 5.808 29.819 8.741 6.520 3.925 313
44 48.900 2.773 32.782 6.408 4.446 4.687
Mexico: percentage of variations in FDI flows due to innovations in
1 5.605 7.921 39.817 36.079 10.575 0
4 17.426 12.099 31.704 29.685 8.877 0.207
12 36.904 11.855 23.602 21.752 5.461 0.424
20 41.020 13.613 20.096 20.110 4.649 0.509
44 51.546 12.544 14.967 16.297 4.075 0.569
Korea: percentage of variations in FDI flows due to innovations in
1 0.537 0.560 25.990 25.686 47.224 0
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4 3.077 7.292 29.225 24.739 34.126 1.538

12 10.539 4.872 36.412 24.315 20.292 3.566
20 13.331 3.925 38.680 22.683 17.474 3.904
44 15.473 3.166 42.512 20.182 14.404 4.260
South Africa: percentage of variations in FDI flows due to innovations in
1 7.777 13.092 7.589 41.845 29.693 0
4 26.281 23.177 5.379 28.459 16.005 0.695
12 27.987 30.204 10.966 16.962 8.280 5.599
20 28.175 30.365 13.601 14.024 6.261 7.571
44 31.386 25.820 16.814 11.111 4.913 9.953
Philippines: percentage of variations in FDI flows due to innovations in
1 20.049 1.214 16.284 0.342 62.109 0
4 32.186 2.210 14.882 7.839 42.722 0.159
12 35.541 3.458 14.775 15.567 30.467 0.189
20 37.124 2.577 17.444 19.485 23.191 0.175
44 35.527 1.568 21.477 25.531 15.703 0.193
Table III.
Note: The acronyms fo, fir, dp, dm, fdi, and port denote foreign output, foreign interest rate, domestic Variance decomposition
productivity, domestic money, foreign direct investment, and portfolio flows, respectively of FDI flows

Further interesting insights into the effects of various shocks on capital flows to
developing countries can be gauged through an impulse response analysis that allows
us to trace the effect of a one-time shock to an innovation on current and future values
of the endogenous variable. The results on impulse responses to various shocks are
reported in Figures 1-10.
The impulse responses of foreign direct investment and portfolio flows indicate that
the foreign output shock generally has a negative effect on capital flows while the
foreign interest rate shock appears to have a generally positive effect. A foreign output
shock tends to induce inflows of foreign direct investment in Brazil and Korea despite
an initial decrease in the flows. Similarly, although a domestic productivity shock
causes a decline in foreign direct investment flows initially, the shock tends to cause a
later increase in such flows to Korea and South Africa. Although the foreign direct
investment flow slightly decreases initially, a domestic money shock tends to generate
an inflow of foreign direct investment in the Philippines. Furthermore, a domestic
productivity shock seems to cause an increase in foreign direct investment flows.
 JES
Horizon (Quarter) fo fir dp dm fdi port
35,4
Brazil: percentage of variations in portfolio flows due to innovations in
1 0.965 37.178 30.065 13.684 13.438 4.667
4 13.838 25.797 33.755 12.242 10.948 3.416
12 25.177 19.029 33.241 10.650 8.572 3.327
314 20 34.209 13.074 33.270 8.902 6.701 3.840
44 43.608 6.097 34.573 6.449 4.566 4.704
Mexico: percentage of variations in portfolio flows due to innovations in
1 1.168 27.931 17.837 48.464 3.157 1.441
4 5.846 19.621 23.863 45.323 4.334 1.011
12 17.519 17.889 24.889 34.358 4.493 0.849
20 24.449 17.727 21.165 31.750 4.071 0.835
44 39.166 14.928 15.134 25.916 4.105 0.748
Korea: percentage of variations in portfolio flows due to innovations in
1 12.102 7.984 22.850 37.382 11.532 8.148
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4 13.376 3.938 46.592 18.759 10.893 6.439

12 18.537 2.607 44.749 17.630 11.499 4.975
20 18.303 2.813 45.416 17.300 11.354 4.811
44 16.057 3.077 48.241 16.680 11.111 4.831
South Africa: percentage of variations in portfolio flows due to innovations in
1 39.678 9.649 12.692 2.619 3.991 31.368
4 32.255 13.450 19.648 4.489 3.240 26.915
12 25.357 21.130 21.518 9.834 3.826 18.332
20 26.005 20.791 22.464 10.812 3.703 16.222
44 31.009 19.253 22.457 9.276 2.900 15.102
Philippines: percentage of variations in portfolio flows due to innovations in
1 56.658 4.746 29.278 1.934 0.007 7.373
4 42.840 5.986 25.451 16.089 5.767 3.864
12 35.907 6.512 25.206 23.251 7.036 2.085
20 35.742 5.652 23.895 24.703 8.506 1.499
44 34.773 4.775 22.789 27.569 9.064 1.027
Table IV.
Variance decomposition Note: The acronyms fo, fir, dp, dm, fdi, and port denote foreign output, foreign interest rate, domestic
of portfolio flows productivity, domestic money, foreign direct investment, and portfolio flows, respectively

Although the portfolio flow increases initially, a domestic productivity shock tends to
cause a decrease in portfolio flows while the foreign direct investment flows increase.
The positive effect of a domestic productivity shock on foreign direct investment flows
may be due to the possible association with inflation, which may have influenced the
effect on such flows.

Conclusions
In this paper we have developed an empirically tractable structural VAR model to
examine the relative significance of the determinants of disaggregated capital flows to
five developing countries. By using quarterly data for the period 1976 to 2001, we have
investigated the extent to which variations in foreign direct investment and portfolio
flows to Brazil, Mexico, Korea, the Philippines, and South Africa are due to various
push and pull factors across different time horizons. By means of impulse response and
variance decomposition analyses, we have also investigated the temporal dynamic
effects of various shocks to such determinants.
 Capital flows
to developing
countries

315
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Figure 1.
Impulse responses of FDI
flows: Brazil

Figure 2.
Impulse responses of
portfolio flow: Brazil
 JES
35,4

316
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Figure 3.
Impulse responses of FDI
flows: Mexico

Our empirical results indicate that a foreign output shock seems to have a generally
negative effect on capital flows while a foreign interest rate shock appears to have a
generally positive effect. Also, a domestic productivity shock seems to cause an
increase in foreign direct investment flows. Although the portfolio flow increases
initially, a domestic productivity shock tends to cause a reduction in portfolio flows
while foreign direct investment flows increase.
Significantly, it is found that shocks to foreign output and domestic productivity
explain the bulk of the variations in both foreign direct investment and portfolio flows.
Although the effect of a shock on capital flows may vary according to the type of flow,
the foreign interest rate shock and the domestic money shock appear to play a less
significant role across various time horizons.
Our findings are not only theoretically important, they also have significant policy
implications. At the theoretical level, they re-direct the debate on the determinants of
capital flows to developing countries from one exclusively concerned with push versus
pull factors to one in which shocks to real rather than to monetary variables of
economic activity appear to be the most important forces in explaining the variations
in capital flows. The implications of these findings for policy makers in developing
countries cannot be overstated since they highlight the concomitant need to design
policy that accounts for both external and internal shocks to real variables of economic
activity as the key forces driving capital inflows. Specifically, developing countries
need to acknowledge that given the significant role of foreign output in inducing
capital inflows, these inflows will have a cyclical component and domestic policy
 Capital flows
to developing
countries

317
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Figure 4.
Impulse responses of
portfolio flows: Mexico

Figure 5.
Impulse responses of FDI
flows: Korea
 JES
35,4

318
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Figure 6.
Impulse responses of
portfolio flows: Korea

Figure 7.
Impulse responses of FDI
flows: South Africa
 Capital flows
to developing
countries

319
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Figure 8.
Impulse responses
of portfolio flows:
South Africa

Figure 9.
Impulse responses of FDI
flows: Philippines
 JES
35,4

320
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Figure 10.
Impulse responses of
portfolio flows:
Philippines

should therefore be designed with this effect in mind. But equal attention should be
paid by policy makers in developing countries to how macroeconomic and industrial
policies can be designed with the aim of bolstering domestic productivity and
improving institutional infrastructure so as to promote economic growth as a way of
further stimulating the inflow of foreign direct investment and portfolio capitals.

Notes
1. The term “capital flows” refers to financial capital flows, which are categorized in a variety
of ways in various studies. For example, capital flows may be classified as either debt flows
(bonds and loans) or equity flows (portfolio investment equities and foreign direct
investment). Alternatively, the flows can be grouped as either private flows (commercial
bank lending, bond financing from private creditors, private equity flows and suppliers’
credit) or official flows (lending from official bodies, such as bilateral, governmental, and
multilateral sources, and gifts and grants; Fleming, 1981).
2. Private capital flows to developing economies have increased dramatically, from around
$44 billion in 1990 to $257 billion in 2000 (World Bank, 2005).
3. For a discussion of the increased role of improvements in economic fundamentals in driving
capital flows to developing countries see World Bank (2002).
4. Chen and Khan (1997) developed a theoretical model to examine the patterns (composition,
intra-regional flow, and geographical distributions) of international capital flows to
emerging market economies, and showed that the patterns of capital flows are influenced by
combined effects of financial market development and growth potential in the recipient
countries.
 5. For a disaggregated analysis of growth effects of foreign direct investment and portfolio Capital flows
flows to developing countries see De Vita and Kyaw (2007).
to developing
6. For a study on capital flows and foreign interest rate disturbances in a small open economy
see Lois (2001). countries
7. For an application of a similar structural VAR method to the study of exchange rate
behavior, see MacDonald (1999).
8. To avoid an arbitrary choice of the dynamic lag structure of the VAR, model selection 321
criteria (namely, the Akaike, Schwarz, and Hannan-Quinn information criteria) were used to
determine the appropriate number of lags for our estimated model. Based on these criteria,
a VAR order of five lags was selected.
9. This approach is not ideal as interest rate differentials may be more useful to gauge the
marginal cost of borrowing. However, due to data availability limitations, the US treasury
bill rate is the only possible measure to use.
10. A detailed description of the data used in the study is provided in International Monetary
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Fund (1992, 2002).

11. See Mananyi and Struthers (1997) for an application of a cointegration approach to the
analysis of efficient market hypothesis.
12. In our VAR estimations, the innovations are orthogonalised by a Cholesky decomposition so
that the covariance matrix of the resulting innovations is diagonal. In particular, the inverse
of the Cholesky factor of the residual covariance matrix is used to orthogonalise the
impulses. However, since this procedure imposes an ordering of the variables in the VAR
and tends to attribute all of the effect of any common component to the variable that comes
first in the VAR system, changing the order of variables or equations may alter the resulting
estimates. Hence, as a robustness check, we have also tested a number of alternative
orderings. In particular, in addition to the order foreign output (1), foreign interest rate
(2), domestic productivity (3), domestic money (4), foreign direct investment (5), and portfolio
flow (6), other orderings applied include 1-2-3-4-6-5, 1-2-4-3-5-6, 1-2-4-3-6-5, 2-1-3-4-5-6,
2-1-3-4-6-5, 2-1-4-3-5-6, and 2-1-4-3-6-5. These additional tests (not reported here to conserve
space) indicated that alternative orderings did not significantly change the results.

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Corresponding author
Glauco De Vita can be contacted at: [email protected]

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