Timothée Demont: timothee.demont[at]univ-amu.fr
Roberta Ziparo: rziparo[at]gmail.com
Understanding the drivers of capital flows is crucial from a policy perspective. Capital inflows are desirable if they are related to a country's fundamentals, but can be problematic in the absence of surge in local productivity. Expected excess returns, which drive capital flows, are related to expected future productivity, but they can also be driven by excessive optimism about future productivity. We empirically disentangle the e ffect on capital flows of "news" (surges in optimism correlated with future productivity) and "sentiment" (surges in optimism unrelated to future productivity). We find that news shocks lead to a decrease in both gross capital inflows and gross capital outflows, while sentiment shocks lead to an increase in both gross inflows and outflows. This suggests that expansions in cross-border flows are typically not associated with rising productivity. These fi ndings are consistent with the existence of asymmetric information between domestic and foreign investors about the country's fundamentals.