International Financial Flows in Low‐Income Countries

• Date: 01 February 2015
• DOI: http://doi.org/10.1111/1468-0106.12094
• Published date: 01 February 2015
• Author: Philip R. Lane

INTERNATIONAL FINANCIAL FLOWS IN

LOW-INCOME COUNTRIES

PHILIP R. LANE*Trinity College Dublin

Abstract. For a sample of low-income countries, we analyse the behaviour of international financial

flows during three periods: (i) the 2003–2007 global boom; (ii) the 2008–2009 crisis; and (iii) the

2010–2012 recovery phase. In particular, we examine aid-adjusted net financial inflows, debt inflows,

foreign direct investment inflows and official reserve outflows. We highlight the role of country

characteristics in explaining the cross-country variation in international financial flows during these

different phases.

1. INTRODUCTION

The aim of this paper is to examine the experiences of low-income countries

during the boom–bust–recovery cycle in international financial flows over 2003–

2012. As documented by Lane (2013a,b), there was a remarkable boom–bust

cycle in global financial flows over 2003–2012: dramatic growth in flows during

2003–2007 was followed by a sharp reversal during the peak of the global financial

crisis (2008–2009), with a recovery phase taking hold during 2010–2012.

The similarity in the cyclical behaviour across countries is in line with a recent

literature that emphasizes the strong correlation between the scale of global

financial flows and common risk factors in the international financial system

(e.g. as captured by the VIX index).1A strong implication is that the elasticity of

international financial flows vis-à-vis various country-level fundamentals will

vary with the prevailing conditions in international financial markets, which

fluctuate between ‘risk on’ and ‘risk off’ phases.

The drivers of global common factors can be considered to be exogenous to

macroconomic developments in low-income countries, in view of the tiny frac-

tion of global financial trade that originates in these countries. At the same time,

in the other direction, volatility in the external financial environment poses

a macroeconomic and financial challenge for policy-makers in low-income

*Address for Correspondence: Philip R. Lane, Economics Department, Trinity College Dublin,

Dublin 2, Ireland. E-mail: plane@tcd.ie. This paper is part of a research project on macroeconomic

policy in low-income countries supported by the UK’s Department for International Development

(DFID). The paper was presented at the Conference on ‘Macroeconomic Challenges Facing Low-

Income Countries: New Perspectives’ (Washington, DC, 30–31 January 2014). The views expressed

herein are those of the author and should not be attributed to the IMF, its Executive Board or its

management, or to DFID. I am grateful for feedback from the Editors, the referees, and participants

at the July 2013 pre-conference (especially the discussant Raphael Esipnoza), the January 2014

conference and a seminar at the IMF. I thank Cian Allen, Caroline Mehigan, Rogelio Mercado and

Clemens Struck for excellent research assistance and Juliana Araujo and Chris Papageorgiou for

helpful advice. I also gratefully acknowledge the support from DFID/IMF and the Institute for New

Economic Thinking.

1See, among many others, Milesi-Ferretti and Tille (2011) and Forbes and Warnock (2012a,b). The

VIX index is a market proxy for expected volatility in the S&P 500 index over a monthly horizon.

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Pacific Economic Review, 20: 1 (2015) pp. 49–72

doi: 10.1111/1468-0106.12094

© 2015 Wiley Publishing Asia Pty Ltd

countries, because external financial shocks can be disruptive for domestic mac-

roeconomic and financial stability. Moreover, the state of the external financial

environment affects the transmission mechanism for domestic macroeconomic

policies, because the responsiveness of financial flows is a key factor in deter-

mining the impact of domestic policy innovations.

The general literature on the 2003–2012 boom–bust cycle in international

financial flows has explored several different themes. In relation to the 2003–

2007 pre-crisis period, an important topic has been the role played by cross-

border flows in enabling the expansion of the financial systems of some key

countries (Acharya and Schnabel, 2010; Allen et al., 2011; Borio and Disyatat,

2011; Bruno and Shin, 2015; CIEPR, 2012). In related fashion, Borio et al.

(2011) and Lane and McQuade (2014) examine the interaction between financial

flows and credit growth. It is also plausible that the high-flow environment

during this period also facilitated the increased dispersion of persistent current

account balances in high-income countries, as documented by Lane and Pels

(2012). Furthermore, financial flows also affected fiscal outcomes, especially

through the impact of spending levels and asset prices on tax revenues (Benetrix

and Lane, 2013).

The extraordinary contraction in gross cross-border flows during the crisis

period has also been extensively studied (Blanchard et al., 2010; Milesi-Ferretti

and Tille, 2011; Forbes and Warnock, 2012a,b; Lane, 2013a,b). While all cat-

egories were affected, it is clear that debt-type flows (especially in relation to the

banking sector) were more adversely affected than equity-type flows (especially

foreign direct investment (FDI)). The generalized sudden stop also induced a

compression in net financial flows (current account imbalances). During 2010–

2012, there was a rebound in flows to emerging economies and developing

countries, while flows to advanced economies did not recover to a similar

degree.2

Still, this literature has primarily focused on advanced economies and emerg-

ing market economies. This is natural, given that these economies account for

the vast bulk of international financial flows. However, it does mean that there

is a relative lack of systemic empirical studies of this episode in relation to the

specific experiences of low-income countries. In understanding the interrelations

between international financial flows and macro-financial stability for this

group, it is important to pursue research that can shed light on how low-income

countries were affected by the international financial boom during 2003–2007,

the reversal in 2008–2009 and the subsequent recovery during 2010–2012. As

part of this agenda, it is informative to study the cross-country variation in the

experiences of low-income countries, which is the main focus of the present

paper.3

2Our data set is annual and runs from 2003 to 2012. In terms of subsequent developments, a new

phase in global capital markets was triggered in May 2013 with the announced pivot in the future

direction of US monetary policy towards the tapering of quantitative easing.

3Araujo et al. (2014a,b) provide complementary studies that focus on the time-series variation in

international capital flows for low-income countries.

P. R. LANE

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