Capital flow to China and the issue of hot money: an empirical investigation

Lai, Jennifer /J.T. (2008): Capital flow to China and the issue of hot money: an empirical investigation.

Abstract

This paper tries to model the time series characteristics of capital flows to China over the period 1999-2008, namely bond flows (BF), equity flows (EF), bank credit (BC), and foreign direct investment (FDI). By utilizing the state space model and using Kalman filtering algorithm with maximum likelihood estimation, we try to gauge the relative importance of permanent and temporary components of each series. And by incorporating intervention and explanatory variables, we also try to detect if capital control measure imposed by the Chinese government and market sentiment of RMB foreign exchange rate appreciation expectation have any effect upon those flows. The empirical result shows that: all four flows are dominated by transitory component, among which BC flows have a relatively large permanent component and are the only series that are sensitive to market sentiment measure. In addition, capital control measures successfully skewed flows to come in through FDI and bond flow channels instead of equity flows. And our extended model with intervention and explanatory variables for those flows have better prediction performance compared to Sarno and Taylor (1999a) and the benchmark models.

• Item Type: MPRA Paper
• Language: English
• Keywords: capital flows, persistence, Kalman filter technique, capital account, capital control
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; F - International Economics > F2 - International Factor Movements and International Business > F20 - General; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods

References

Bahmani-Oskooee, M. and Brown, F. (2004) Kalman filter approach to estimate the demand for international reserves, Applied Economics, vol.36, 1655-68.

Chuhan, P., Claessens, S. and Mamingi, N. (1993) Equity and bond flows to Asia and Latin America, Policy Research Working Papers, No.1160, The World Bank, Washington, D. C.

Chuhan, P., Claessens, S. and Mamingi, N. (1998) Equity and bond flows to Latin America and Asia: the role of global and country factors, Journal of Development Economics, vol. 55, 439-463.

Claessens, S., Dooley, M., and Warner, A. (1995) Portfolio capital flows: hot or cold? The World Bank Economic Review, vol. 9, 153-174.

Cuthbertson, K. Hall, S. G. and Taylor, M. P. (1992) Applied Econometric Techniques, Harvester Wheatsheaf, Exeter.

Durbin, J. and Koopman, S. J. (2001) Time series Analysis by State Space Methods, Oxford University Press Inc., New York.

Edison, H. and Warnock, F. (2003) A simple measure of the intensity of capital controls, Journal of Empirical Finance, vol.10, 81-103.

Gunter, R. F. (1996) Capital flight from the People’s Republic of China: 1984-1994, China Economic Review, vol. 7(1), 77-96.

Gunter, R. F. (2004) Capital flight from China: 1984-2001, China Economic Review, vol. 15, 63-85.

Harvey, A. C. (1981) Time Series Models, Philip Allan, Hemel Hempstead.

Harvey, A. C. (1989) Forecasting, Structural Time Series Models and the Kalman Filter, Cambridge Univ. Press, Cambridge, MA.

Kalman, R.E. (1960a) A new approach to linear filtering and prediction theory, Journal of Basic Engineering, March, 1-35.

Kalman, R.E. (1960b) A new approach to linear filtering and prediction problems, Journal of Basic Engineering, transactions of the ASME, Series D 82, 35-45.

Koopman, S. J. (1997) Exact initial Kalman filtering and smoothing for nonstationary time series models, Journal of American Statistical Association, vol. 92, 1630-38.

Koopman , S. J. and Durbin, J. (2001) Filtering and smoothing of state vector for diffuse state space models, mimeo, Free University, Amsterdam.

Koopman , S. J. and Durbin, J. (2001) Filtering and smoothing of state vector for diffuse state space models, Journal of Time Series Analysis, vol. 24, no.1, 85- 89

Krugman, P. (1998) What happened to Asia? Massachusetts Institute of Technology, January, mimeo.

Ljungwall, C. and Wang, Z. J. (2008) Why is capital flowing out of China?, China Economic Review, vol. 19, 359-372.

Ma, C. and McCauley, R. N. (2008) Efficacy of China’s capital controls: evidence from price and flow data, Pacific Economic Review, vol. 13:1, 104-123.

Ma, Y. and Sun, H. Y. (2007) Hot money inflows and RMB revaluation pressure, Journal of Chinese Economic and Business Studies, vol. 5, 19-36.

Mody, A., Taylor, M. P. and Kim, J. Y. (2001a) Modeling economic fundamentals for forecasting capital flows to emerging markets, International Journal of Finance and Economics, vol. 6, 201-216.

Mody, A., Taylor, M. P. and Kim, J. Y. (2001b) Forecasting capital flows to emerging markets: a Kalman filtering approach, Applied Financial Economics, 2001, vol. 11, 581-589.

Sarno, L. and Taylor, M. P. (1999a) Hot money, accounting labels, and the persistence of capital flows to developing countries: an empirical investigation, Journal of Development Economics, vol. 59, 337-64.

Sarno, L. and Taylor, M. P. (1999b) Moral hazard, asset price bubbles, capital flows and East Asian crisis: the first tests, Journal of International Money and Finance, vol. 18, 637-57.

Taylor, M. P. and Sarno, L. (1997) Capital flows to developing countries: long- and short- term determinants, World Bank Economic Review, vol. 11, 451-70.

Wu, F., and Tang, L. (2002) China’s capital flight, 1990-1999: estimates and implications, Review of Pacific Basin Financial Markets and Policies, vol.3(1), 59-75.

Zhang, M. (2008) The levels and channels of current hot money inflows in China,Research Center for International Finance, Chinese Academy of social Science, Working paper, No. 0811