This paper analyzes the behavior of international capital flows by foreigners and domestic agents, especially during financial crises. We show that gross capital flows by foreigners and domestic agents are very large and volatile, especially relative to net capital flows. This is because when foreigners invest in a country domestic agents tend to invest abroad and vice versa. Gross capital flows are also pro-cyclical. During expansions, foreigners tend to bring in more capital and domestic agents tend to invest more abroad. During crises, there is retrenchment, i.e. a reduction in capital inflows by foreigners and an increase in capital inflows by domestic agents. This is especially true during severe crises and during systemic crises. The evidence can shed light on the nature of shocks driving international capital flows. It seems to favor shocks that affect foreigners and domestic agents asymmetrically -e.g. sovereign risk and asymmetric information-over productivity shocks. JEL Classification Codes: F21, F32

This paper analyzes the behavior of international capital flows by foreigners and domestic agents, especially during financial crises. We show that gross capital flows by foreigners and domestic agents are very large and volatile, especially relative to net capital flows. This is because when foreigners invest in a country domestic agents tend to invest abroad and vice versa. Gross capital flows are also pro-cyclical. During expansions, foreigners tend to bring in more capital and domestic agents tend to invest more abroad. During crises, there is retrenchment, i.e. a reduction in capital inflows by foreigners and an increase in capital inflows by domestic agents. This is especially true during severe crises and during systemic crises. The evidence can shed light on the nature of shocks driving international capital flows. It seems to favor shocks that affect foreigners and domestic agents asymmetrically -e.g. sovereign risk and asymmetric information-over productivity shocks. JEL Classification Codes: F21, F32

No abstract

In 2007, countries in the Euro periphery were enjoying stable growth, low de…cits, and low spreads. Then the …nancial crisis erupted and pushed them into deep recessions, raising their de…cits and debt levels. By 2010, they were facing severe debt problems. Spreads increased and, surprisingly, so did the share of the debt held by domestic creditors. Credit was reallocated from the private to the public sectors, reducing investment and deepening the recessions even further. To account for these facts, we propose a simple model of sovereign risk in which debt can be traded in secondary markets. The model has two key ingredients: creditor discrimination and crowding-out e¤ects. Creditor discrimination arises because, in turbulent times, sovereign debt o¤ers a higher expected return to domestic creditors than to foreign ones. This provides incentives for domestic purchases of debt. Crowding-out e¤ects arise because private borrowing is limited by …nancial frictions. This implies that domestic debt purchases displace productive investment. The model shows that these purchases reduce growth and welfare, and may lead to self-ful…lling crises. It also shows how crowding-out e¤ects can be transmitted to other countries in the Eurozone, and how they may be addressed by policies at the European level.