Modelling international capital structure under foreign macroeconomic volatility

In the last decade we have witnessed a significant change in the structure of capital flows to developed as well as to developing countries. We construct a simple econometric framework where country-specific random effects and macroeconomic monetary volatility are linked to the probability distribution of liquidity shocks hitting an international investor. A “volatility augmented” gravity equation is then estimated to provide empirical evidence that as the probability of getting a bad liquidity shock increases, investors switch to safer assets but with a pecking order: they seem to damp equities for more bonds and more direct investments. A flight to quality!