Portfolio Flows , Foreign Direct Investment , Crises And Structural Breaks in Emerging Markets : Evidence from Turkey by Merih Uctum * and

The goal of the paper is to analyze how financial and economic crises affect the relation between capital flows and their determinants. We develop a model of foreign portfolio investment (FPI) and foreign direct investment (FDI), and apply it to Turkey using an endogenous break analysis and accounting for country risk. We identify two breakpoints that correspond to two crises dates. Our results show changes in the sign and/or coefficient of a number of determinants in both types of investment and thus suggest that analyses based on the assumption of parameter constancy may lead to misleading results. ------------------------------------------------*Brooklyn College and the Graduate Center of the City University of New York. **Centre National de la Recherche Scientifique and Université de Paris X Nanterre. The first author gracefully acknowledges support from Tow Faculty Travel Fellowship. Introduction The end of the last century saw a shift in developing and emerging countries’ priorities towards attracting international capital flows, perceived to be complementary to the development process of the economies. As a result of this change, capital flows to these countries grew about 10 folds during the 1990s (World Economic Outlook). However, the distribution of the components of flows between foreign direct investment (FDI) and foreign portfolio investment (FPI), has been uneven. Many low-income countries have been unsuccessful in attracting FDI, but received a fair amount of short-term portfolio investment. Most analysts now agree that FPI is often prone to sudden stops and, even worse, reversals, leading to financial crises such as in Mexico, Brazil, Russia, Asian countries, Turkey, Argentina, Uruguay (Calvo, 1998, Milesi-Ferretti and Razin, IMF, 1995, Claasens et al., 1995). In contrast, FDI is widely regarded as a stable development engine, crucial for a quick and fundamental take–off for industrialization. In this study, we examine the factors affecting inflows of different types of capital. In particular, we analyze how financial and economic crises create structural changes that affect the relation between capital flows and their determinants, and apply the analysis to Turkey. In doing this, we assume that the number of breaks and the number of parameters affected by structural changes are unkown. Despite a large volume of literature on capital flows, studies emphasizing the breakdown of the types of capital flows are relatively recent and mostly involve panel data. Although this approach provides valuable information about the broad determinants of flows, it is does not allow identification of individual countries’ idiosyncratic features. In particular, structural breaks due to domestic and international crises, which affect the sentiment of domestic and international investors, can change the relation between the fundamentals and the flows of capital. Such concerns are best addressed at the individual country level. Turkey is a typical example of an emerging economy that followed successive liberalization policies but has not been able to substitute FDI for short-term borrowing to finance the economy. Weaknesses in the banking system together with high growth rates over the last two decades made the economy more dependent on foreign private capital, which consist mostly of FPI. Turkey exhibits most of the symptoms of a developing country 1 See Lim (2001) for a survey of the literature on the relation between FDI and growth.