An Evaluation of the Conventional Wisdom on Capital Flow Volatility

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The wave of financial crises that ravaged the developing world during last decade often resulted in drastic reversals of capital flows, which searched for cover after the first signs of economic instability in the host country. In this process, Foreign Direct Investment (FDI) usually showed lower volatility than portfolio or debt flows, contributing to the view of FDI as the most beneficial flow for the development of the host economy. Such conclusion led to significant changes in policy, increasingly tilting towards favoring the arrival FDI, while at times exerting tighter control over other categories of flows. Against the backdrop of these policy implications, one of the main challenges to this conventional wisdom of FDI has been grounded on the possibility of capital flows being negatively correlated, hence with mutually offsetting time series properties. The present analysis, however, fails to establish a systematic presence of these interactions between flows. Instead, and in line with the work that has identified FDI as the most beneficial type of external financing for the receiving economy, it confirms that a relative large presence of FDI is a significant predictor of a stable financial account.