Capital flow volatility, financial deepening and capital market performance in low-income countries.

Abstract

This study sheds light on the sources and impact of foreign capital flow volatility and its directional linkages with financial deepening and capital market performance in low-income Southern African Development Community (SADC) countries. It employs decomposed quarterly data on net foreign capital flows for a period spanning 16 years from 2000 to 2015. Decomposed net capital flows capture the dynamics of both inflows and outflows while taking domestic and foreign investors’ contribution to the dynamics of capital flow volatility into account. The study is unique in that it uses contemporary panel data regression methods to investigate the behavior of capital flow volatility, financial deepening and capital market performance in low-income SADC countries. Firstly, the panel autoregressive distributed lag (P-ARDL) model reveals that both portfolio flow and remittance flow volatility are significantly determined by domestic price level, money supply, real Gross Domestic Product (GDP) and interest rates. Global GDP significantly affects portfolio volatility but has no significant effect on remittance volatility. Only domestic and global interest rates are negatively related to remittance and portfolio volatility in these economies. Secondly, the panel vector error correction model (P-VECM) investigation reveals a bi-directional relationship between remittance flow volatility and financial deepening and also indicates a one-way causal relationship from portfolio flow volatility to financial deepening. Finally, the panel vector auto regression (P-VAR) model finds that global shocks are rapidly transmitted to the domestic economy and not vice versa. Shocks in portfolio volatility account for significant variations in money supply and lead to a decline in general price levels from the short run to the long run. Additionally, changes in remittance volatility impact directly and significantly on domestic interest rates and consumer price levels. Remittance volatility impacts positively on real GDP while portfolio volatility exert negative pressure in SADC countries. In order to achieve stable and constant capital flows, policy makers should adopt programs that lead to financial growth, price and interest rate stability. Given the paucity of macro-financial studies on the region, the study provides meaningful empirical evidence on the behavior and impact of portfolio and remittance flows in low-income SADC countries.