International Capital Flows and Liquidity
53 Pages Posted: 21 Jan 2011 Last revised: 11 Mar 2011
Date Written: March 2011
We study whether international capital flows affect local market liquidity, and vice versa. We estimate vector autoregressions with monthly U.S. equity portfolio flows and local stock market liquidity and returns for 46 countries in six regions over 1995-2008. We find that flows to developed Europe and Asia/Pacific positively respond to local market liquidity, while U.S. market liquidity positively predicts flows to developed and emerging Europe and emerging Asia. Capital flows to various regions are thus responsive to home and host market liquidity. For developed America, Europe, Asia/Pacific, and emerging Asia, capital inflows are associated with an improvement in local market liquidity, which suggests that foreign investors tend to provide rather than consume liquidity on local markets. This effect is stronger for countries with greater transparency and less developed financial markets. Our analysis lends little support to the view that foreign investors destabilize local markets through an adverse impact on liquidity.
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