Cross-border capital flows and return dynamics in emerging stock markets: Relative roles of equity and debt flows

Abstract

This paper examines the effect of cross-border capital flows on financial markets by focusing on the composition of flows, viz. equity and debt flows, and its relative effect on emerging stock market returns and volatility. Using a panel GARCH approach on nine emerging market economies, we find that both equity and debt flows possess incremental information over stock market returns and volatility that is not captured by aggregate capital market risk factors. While the explanatory power of debt flows is relatively stronger and more robust, even after controlling for world market return, global risk, bank credit flows and country-level liquidity, we find that equity flows assume significant explanatory power, particularly during the post-global financial crisis period. The findings overall suggest that emerging stock markets have become particularly sensitive to cross-border capital flows following the great credit crunch, with significant effects on idiosyncratic risks at the country level, while accounting for the composition of portfolio flows can add further explanatory power to stock market models.