An Evaluation of the Conventional Wisdom on Capital Flow Volatility

The wave of financial crises that ravaged the developingworld during last decade often resulted in drastic reversals ofcapital flows, which searched for cover after the first signs ofeconomic instability in the host country. In this process, ForeignDirect Investment (FDI) usually showed lower volatility thanportfolio or debt flows, contributing to the view of FDI as themost beneficial flow for the development of the host economy. Suchconclusion led to significant changes in policy, increasinglytilting towards favoring the arrival FDI, while at times exertingtighter control over other categories of flows. Against thebackdrop of these policy implications, one of the main challengesto this ?conventional wisdom? of FDI has been grounded on thepossibility of capital flows being negatively correlated, hencewith mutually offsetting time series properties. The presentanalysis, however, fails to establish a systematic presence ofthese interactions between flows. Instead, and in line with thework that has identified FDI as the most beneficial type ofexternal financing for the receiving economy, it confirms that arelative large presence of FDI is a significant predictor of astable financial account.