Is Domestic Uncertainty a Local Pull Factor Driving Foreign Capital Inflows? New Cross-Country Evidence

Abstract

Theory and conventional wisdom suggest that an increase in uncertainty in one country scares away foreign investment. But, due to the limited availability of cross-country uncertainty data, empirical evidence remains scarce, and mostly confined to a limited set of countries. This paper provides a systematic analysis of how foreign capital inflows react to an increase in political and economic uncertainty, proxied using the World Uncertainty Index. We focus on bank credit, portfolio debt, and portfolio equity capital inflows into 143 countries from 51 source countries. We find that an increase in domestic uncertainty induces a substantial and persistent decrease in bank credit and portfolio debt inflows, and (to a lesser extent) in equity inflows. The effects on portfolio inflows are larger for countries with more open capital markets. We also uncover important differences in the response of portfolio inflows through actively-managed versus passive funds. The formers are similarly sensitive to changes in uncertainty that are country-specific (purely local uncertainty) and common across countries (global uncertainty), while the latter are only sensitive to global uncertainty.

Keywords: Uncertainty, Capital flows, World Uncertainty Index, Mutual funds, ETFs, COVID-19

JEL Classification: F21, F32, F42