International capital crunches: the time-varying role of informational asymmetries

Abstract

We examine the determinants of capital flows to four developing countries during the 1990s using an explicitly disequilibrium econometric framework in which the supply and demand for capital are not necessarily equal and the actual amount of the flow is determined by the ‘short side’ of the market. We are thus able to detect instances of ‘international capital crunch’ – where capital flows are curtailed because of supply-side rationing – and to relate these instances to movements in the underlying fundamentals. The analysis highlights the role of asymmetric information – as distinct from the traditional concern with default risk – in conditioning capital flows.

Keywords:

• capital flows
• disequilibrium
• rationing
• asymmetric information

JEL Classification::

• F320
• F340
• O190

Acknowledgements

The authors are grateful to Michael Bleaney, Robin Brooks, Olivier Jeanne, Paul Masson and Antonio Spilimbergo for their comments on an earlier version, although they remain responsible both for the views expressed in the article and for any errors that may remain.

Notes

¹ Similarly, Caballero and Krishnamurthy (2001) refer to a ‘vertical’ supply curve for international capital and the lack of substitutability between international and domestic capital.

² The evidence presented by Goldstein et al. (2000) and Reinhart (2001) suggests that credit ratings are not generally forward-looking.

³ In his comment on the Ghosh and Wolf's (2000) paper, Savastano (2000) questions whether physical distance is a proxy for higher transactions costs. The extent of informational asymmetry in it is as likely – or more so – to reflect the nature of institutions governing financial transactions and while distance from the world's main money centers may proxy in some cases for the lack of institutional development that need not necessarily be the case. Moreover, in the 1990s, some crisis countries were quite close to major money centers and were yet plagued by informational asymmetries.

⁴ Obstfeld and Rogoff (2000) argue that transportation costs in goods can account for segmentation of international financial markets.

⁵ We do not include Foreign Direct Investment (FDI) flows in our analysis for two reasons. First, as shown by Sarno and Taylor (1999a), the time series properties of FDI flows are quite different from those of capital market flows. Second, in keeping with these findings, studies have also found that FDI flows tend to be driven by longer-term considerations such as market size, infrastructure availability, education, and so on (see, e.g. Mody and Srinivasan, 1998). Unless stated otherwise data series were taken from the International Monetary Fund's (IMF) International Financial Statistics data base; a precise listing of data sources is available from the authors upon request.

⁶ The resulting series were transformed to logarithmic form prior to the analysis. Where a zero appeared for an observation, this was replaced with unity so that its logarithm became zero. Since the series are in millions of dollars, replacing zero dollars with one dollar will not materially affect the empirical analysis.

⁷ We do not consider the effect of capital controls on the supply and demand for capital inflows. In part, this is due to Montiel and Reinhart's (1999) finding that capital controls do not influence the volume of capital flows. In part, also, available measures of capital flows are at an annual frequency and tend to be characterized in terms of discrete shifts.

⁸ Since the reserve variables only enter with a lag into our empirical equations, there is no simultaneity bias induced in our estimation because of any effects capital flows may have on the current level of reserves.

⁹ We use a nominal significance level of 5% throughout.

¹⁰ Agénor et al. (2000) find that ‘business cycle fluctuations in developing countries tend to be correlated with business cycle fluctuations in industrialized countries’.

¹¹ Eaton and Gersowitz (1981) find that larger imports are associated with a reduced demand for capital and consider that finding to be ‘anomalous’.

¹² Eaton and Gersowitz (1980) conclude that reserves are a substitute for international capital. But the statistical significance of their result is weak and may reflect, as we find here, the dual role that reserves play: while they help finance current transactions and so are a substitute to private capital, they give confidence to investors and help attract capital.

¹³ Kletzer (1984) also argues that countries in Latin America, with their lower savings and investment rates, are likely to be more credit rationed than East Asian economies. This conclusion follows from his analysis that high savings and investment rates are likely to signal more productive uses of foreign capital.