Are gross financial inflows expansionary or contractionary? Evidence from emerging economies

Abstract

This paper put to the test two hypotheses. First, do gross financial inflows lead to an expansionary or contractionary effect in emerging economies? Second, do different financial inflows exhibit diverse impacts on domestic output and if there is any aggregation bias? However, our work ameliorates the existing literature by tackling the problem of slope heterogeneity and cross-correlated errors by adopting dynamic common-correlated predictors. The analysis further identify different regimes in the regression relationships, considering our sample includes significant global financial imbalances, global financial crisis, taper tantrum period, etc. We find that all types of gross financial inflows, except gross debt inflows, are expansionary. However, there is evidence of possible aggregation bias in using aggregated gross financial flows. Our findings imply that a distinction between different types of financial inflows is necessary to make informed policy recommendations since policies based on aggregate inflows may be ill-advised. Further, emerging markets should focus on encouraging direct and portfolio equity inflows and improving local financial markets’ absorptive capacities in borrower countries to improve welfare gains.