# **Box 2  Modeling the influence of high-income policy (including quantitative easing) and domestic factors on capital inflows to developing countries**

The results reported in the main text of World Bank (2014) are based on a panel econometric analysis designed to illuminate how global and domestic economic conditions influence the volume of capital inflows to individual developing countries. The study uses an unbalanced panel of available quarterly private capital inflows data for 60 developing countries for the 2000Q1- 2013Q2 period, thus spanning eight years of non-crisis year capital flows, and five years of post-crisis flows. These financial inflows comprise bond and equity portfolio flows, foreign direct investment, and crossborder bank lending, and were derived from the IMF Balance of Payments statistics and the Bank for International Settlements’ Locational Banking Statistics, supplemented by national sources drawn from the Datastream and Haver Analytics databases.

The model allows for the influence on individual-country capital inflows of global economic variables (“push factors”) that have been identified in the literature as affecting the propensity to invest, as well as country-specific “pull factors” that capture time-varying characteristics of individual countries that may affect the allocation of funds across countries. The observable pull and push factors include measures used to capture:

- Global financial conditions, such as the US Federal Funds rate, the US money supply (M2), and the yield curve (the difference between the US long-term interest rate and short-term policy rates). The role of global uncertainty and risk aversion was proxied by the VIX index.

- Real-side global conditions, such as high-income and developing world GDP growth, and the global composite purchasing managers index (PMI), which proxies for growth expectations.

- Domestic pull factors, including country GDP levels and institutional investor ratings, a country-specific (lagged) GDP growth differential (relative to the United States), and the interest rate differential between the developing country vis-à-vis the United States.

The extraordinary measures taken by central banks, in the United States, Europe, and Japan are likely to have influenced several of the global variables: short-term interest rates would have been affected by conventional monetary policy; the structure of the yield curve would have been affected by the Federal Reserve’s purchase of mortgage-backed securities and long-term debt on secondary markets; and market uncertainty along with U.S. and global growth may have benefited from stimulatory monetary and fiscal policies. To the extent that such measures may have influenced these drivers, their influence on capital flows will have been captured in the regression.

To account for the possibility that extraordinary monetary measures have operated through other unobservable channels (or through conventional channels over and above these observable measures), a series of dummy variables covering the different episodes of quantitative easing were also included. Several alternative specifications were experimented with, including: a single QE dummy variable for all episodes of quantitative easing; separate indicator variables for each of the three episodes; and a continuous measure of QE interventions based on QE-related assets on central bank balance sheets. A non-zero coefficient on these dummies can be interpreted as indicating that there were additional influences on capital flows to developing economies from quantitative easing that are not directly attributable to observable measures.

The baseline estimation employs econometric techniques that address the influence of time-invariant unobserved country effects, a time trend, and the possibility of bias due to the inclusion of a lagged dependent variable. In addition to the baseline, several additional variations were explored.

To ascertain whether quantitative easing may have altered the magnitude of the influence of the conventional transmission channels (say by making flows more sensitive to interest rate developments), a specification that allowed for interactions between the indicator and the observable global variables was considered. However, this specification was not retained as there was little evidence in favor such interaction effects. Furthermore, specifications that included market expectations of future interest rate changes were considered, but not retained because these expectations variables were not statistically significant.

The model is robust to several different specifications of the explanatory variables, as well as the inclusion of other variables that may plausibly explain capital flows. Lagged ratios of private credit as a share of GDP (financial depth), trade/GDP (trade openness), external debt/GDP, and real exchange rate appreciation were included in alternative specifications but did not prove to be statistically significant.

More details including benchmark regression results and the regression results for the constituent components of capital inflows, are provided in annex 2 (see also Lim, Mohapatra and Stocker 2014).

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