Is domestic uncertainty a local pull factor driving foreign capital inflows? New cross-country evidence

Abstract

Foreign investors pay attention to economic and political developments in the recipient country and might decide to postpone or divert their investments when uncertainty increases. However, due to the limited availability of cross-country uncertainty data, empirical evidence on this channel is scarce. This paper provides a systematic analysis of how bank credit, portfolio debt, and portfolio equity capital inflows from 51 source countries into 143 recipient countries react to an increase in political and economic uncertainty in the recipient country, proxied using the World Uncertainty Index. Our results suggest that an increase in uncertainty induces a substantial and persistent decrease in bank credit and portfolio debt inflows, and (to a lesser extent) in equity inflows. We also uncover important heterogeneities in the response of portfolio inflows. First, the effects are larger for developing economies and those with more open capital markets. Second, inflows through actively managed mutual funds are similarly sensitive to changes in uncertainty that are country-specific (purely local uncertainty) and common across countries (global uncertainty), while inflows through passive ETFs are only sensitive to changes in global uncertainty.