FPI-macroeconomic indicators

North American Journal of Economics and Finance 68 (2023) 101964
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North American Journal of Economics and Finance

journal homepage: www.elsevier.com/locate/najef
Foreign portfolio investment and the US macroeconomic conditions

Golnaz Baradaran Motie a , Zheng Zeng b ,∗
a
Department of Economics, Gordon Ford College of Business, Western Kentucky University, 425 Grise Hall, Bowling Green, KY 42101, United
States of America
b
Department of Economics, Schmidthorst College of Business, Bowling Green State University, Bowling Green, OH 43403, United States of
America
ARTICLE INFO ABSTRACT
JEL classification: This paper examines how foreign portfolio investment (FPI) in the US and its components
F41 affect the US macroeconomic conditions. We estimate a Dynamic Factor Model to extract
E44 comovements from 31 indicators to obtain three composite measures of the US macroeconomic
C32
conditions, which correspond to real economic activity, monetary policy, and aggregate un-
Keywords: certainty. We find that an unexpected rise in FPI reduces long-term interest rates, raises real
Foreign portfolio investment output production and employment, and lowers aggregate risks. Our results also show that the
Debt
equity portion of FPI is significantly more sensitive to shocks to domestic market conditions than
Equity
the debt portion of FPI. However, both components contribute substantially to the fluctuations
Dynamic factor model
VAR of the US macroeconomic conditions. Finally, we find that shocks to FPI are one of the most
Bayesian significant contributors to the historical fluctuations in all output, monetary, and risk conditions.
MCMC In particular, the equity component contributes substantially during economic recessions, while
the debt component is the dominant force during economic booms.
1. Introduction
Foreign portfolio investment (FPI) in the US is at an all-time high. It has accounted for more than 63 percent of total foreign
investment in the US over the past five years. Even during the COVID-19 pandemic, it has only reduced during the first quarter
of 2020 but surpassed its pre-COVID level in the following quarters and has continued to grow faster than the US nominal gross
domestic product (GDP) ever since. By the end of 2020, FPI in the US has reached $24.7 trillion, more than $3 trillion higher than
the US nominal GDP.
The sheer volume of foreign investments in the US has motivated studies on why US assets are attractive to foreign investors.1
However, there are very few studies addressing the impacts of such a large volume of foreign investments on the US macroeconomic
and credit market conditions, and even fewer studies focus on foreign portfolio investment. In the literature where the impacts of
foreign investments on domestic markets are examined, most researches target emerging and developing countries, but overlook
advanced economies such as the US. Furthermore, the existing literature reports mixed and inconclusive results on the effects of FPI
on macroeconomic variables. For example, Warnock and Warnock (2009) and Sá and Wieladek (2015) show that foreign investment
lowers domestic interest rates which lead to expansionary effects on the economy. However, Durham (2003) finds the effects of
portfolio inflow on economic growth statistically insignificant. Calderón and Kubota (2012) argue that an increase in FPI and bank
∗ Corresponding author.
E-mail addresses: golnaz.baradaranmotie@wku.edu (G.B. Motie), zzeng@bgsu.edu (Z. Zeng).
1For example, Caballero and Krishnamurthy (2009), Forbes (2010), and Fratzscher (2012) show that the popularity of US assets among foreign investors
are largely driven by the search for safety, despite their low returns, especially during the 2007–2009 financial crisis. Also, Maggiori et al. (2020) show that
home-currency bias does not apply to the US as foreign investors allocate a significant portion of their portfolio to dollar-denominated US securities.
https://doi.org/10.1016/j.najef.2023.101964
Received 29 August 2022; Received in revised form 6 June 2023; Accepted 9 June 2023
Available online 5 July 2023
1062-9408/© 2023 Elsevier Inc. All rights reserved.
G.B. Motie and Z. Zeng North American Journal of Economics and Finance 68 (2023) 101964
lending inflows can increase the likelihood of ‘‘bad booms’’.2 Tong and Wei (2011) conclude that countries with higher dependence
on FPI and bank credit inflows before the 2007 crisis face a more severe credit crunch during the crisis. In addition, studies that
focus on the relationship between components of FPI – equity and debt – and economic growth have also reported mixed results.
Some studies find that only the equity portion of FPI is beneficial for growth in emerging economies, but not necessarily the debt
portion (see Aizenman et al., 2013 and Blanchard et al., 2016). Others show that the debt portion of FPI promotes credit and
economic growth but not the equity portion (see Lane & McQuade, 2014 and Davis, 2015). All these mixed findings in the literature
could either be due to the differences in targeted countries or the focused methodologies. Overall, the interactions between foreign
portfolio investments and domestic economic and credit conditions remain unclear for advanced economies, such as the US, and
our paper aims to fill this void.
This paper contributes to the literature by answering the following questions: (1) How do shocks to FPI affect US macroeconomic
conditions and aggregate uncertainty? (2) Do shocks to different components of FPI (equity, corporate debts, and government
debts) have different effects? Specifically, we examine how FPI and its components interact with the US macroeconomic conditions,
including real economic activity, monetary policy, and aggregate risk. Since all these three conditions can be measured broadly,
instead of limiting our choice of variables to a single indicator, we select multiple indicators to measure each condition, and estimate
a Dynamic Factor Model (most represented by Stock & Watson, 1989, 2002, 2003, 2005) which extracts comovements from 31
indicators. We impose restrictions on the factor loadings in the Dynamic Factor Model to identify three aggregate factors, which
correspond to real economic activity, monetary policy, and aggregate risk, respectively. We let these three factors interact with FPI
as well as one another through a Vector Autoregression (VAR), so that the three US macroeconomic conditions and FPI (or one
of the FPI components) can be correlated contemporaneously and over time.3 There are two advantages to this approach. First, it
allows for feedback effects between the variables of interest. Second, it facilitates the inclusion of various macroeconomic indicators
and reduce the risk of omitted variable bias in our results.
We estimate the Dynamic Factor Model using Bayesian Markov Chain Monte Carlo (MCMC) methods. The estimated factor
which corresponds to real economic activity well captures the comovements of several types of output growth and employment
indicators, and mostly coincides with business cycles. The general rise of the monetary policy factor reflects a monetary tightening,
and closely follows all the short-term and long-term interest rates, including yields from nominal bonds and Treasury Inflation-
Protected Securities (TIPS). The factor corresponding to aggregate risk significantly contributes to various risk indices and primarily
reflects aggregate uncertainty which ties into credit market and stock market volatilities. In the identification of the factors of
monetary policy and aggregate risk, we allow a few interest rate spreads to be the indicators of both. We find that the fluctuations
in lower-risk-associated credit spreads, such as the spread between Aaa-rated corporate and Treasury bonds, are more attributable
to our monetary policy factor. The aggregate risk factor, on the other hand, is the dominant contributor to the spreads associated
with higher credit risk, such as the spread between High-Yield corporate and Treasury bonds.
By examining the effects of structural shocks, our results show strong and significant interactions across FPI and real economic
activity, monetary policy, and aggregate risk. First of all, an unexpected rise in FPI pushes down long-term interest rates (as also
concluded by Warnock & Warnock, 2009 and Sá & Wieladek, 2015), and hence, reduces domestic cost of production and eventually
raises output and employment. It also raises the overall supply of funds available in the US financial market, and therefore, reduces
aggregate risk. Turning to the other direction of the interactions, we find that FPI can also be impacted significantly by the US
macroeconomic conditions. The growth of FPI generally responds positively to an unexpected rise in economic activity and a decline
in aggregate uncertainty in the domestic market, both of which attract the flow of foreign investments into the US. This is consistent
with what Bacchiocchi et al. (2020) find in their structural VAR. On the other hand, a positive monetary shock, which associates
with an increase in interest rates, instantly reduces the value of existing outstanding financial assets. Meanwhile, newly issued assets
in the US with higher rates of returns attract foreign investors, and therefore, eventually results in a faster growth of FPI despite
its initial decline. Besides the effects of one-time structural shocks, we also examine the overtime contributions of shocks using
historical decompositions of the endogenous variables. We find that shocks to FPI are one of the most important contributors to the
overtime fluctuations in almost all market condition factors and indicators, next to their idiosyncratic shocks. These results challenge
some of the research in the literature which implies that FPI has insignificant impacts on economic growth.
We also compare how the US macroeconomic conditions interact with components of FPI, including equity, corporate debt, and
government debt. We discover typical flight-to-quality (or the one in reverse4 ) effects in this comparison. Consistent with what
Ammer et al. (2018) find, when the domestic market is strong, either due to an unexpected rise in output or a fall in aggregate
uncertainty, the risk appetite of foreign investors increases, which leads them to move toward riskier investments, such as equity
and corporate bonds, while move away from safer investments, such as government bonds. Similar to a positive shock to FPI, we
also find that unexpected increases in the equity and corporate debt portions of FPI reduce aggregate risk, and hence, lowers credit
spreads. However, a positive shock to the government debt portion resembles an increase in Treasury bond purchases, which lowers
Treasury rate and widens the credit spreads.
Warnock and Warnock (2009) and Sá and Wieladek (2015) are the closest to our paper. The former finds that if there were
no foreign purchase of the US government bonds for one year, 10-Year Treasury yield would be 80 basis points higher. The latter
2 As explained by Barajas et al. (2009), ‘‘bad booms’’ are the ones that lead to a systematic banking crisis.
3 As a robustness check, we include Broad Effective Exchange Rate to the VAR as an additional endogenous variable. Our findings are consistent and robust
in a model environment with or without the exchange rate.
4 See Bernanke et al., 1996, Pagano & Strother, 2013, Guerrieri & Shimer, 2014, and Gubareva & Borges, 2016 for examples of flight to quality effects. The
reverse of flight to quality (or, a ‘‘flight from quality’’) can be found examined by Ammer et al. (2018) as a ‘‘search for yield’’.
2
uses a VAR model to study the effects of capital inflow shocks on the US housing market. They find that shocks to capital inflows
reduce long-term interest rates and cost of borrowing which then lead to credit boom, higher house prices, and positive effects on
real residential investments in the US. Both papers only focus on one type of capital inflows — the US government bonds held
by foreigners and current account, respectively. Our paper, on the other hand, estimates how FPI and its components might have
different effects on US macroeconomic and risk factors and indicators. The third related paper to our study is Bacchiocchi et al.
(2020), which examines the relationships of the US economic and financial conditions with capital inflows using structural VAR
methodologies. They find that a monetary tightening results in a positive response in capital inflow. The primary focus of Bacchiocchi
et al. (2020) is how the US domestic monetary policy and financial uncertainty affect the gross capital inflows to the US. Our paper,
however, focuses on FPI and its components, and examines how they interact with the US economic, monetary, and credit market
conditions. This allows us to discover how the same domestic event in the US results in different responses depending upon the
types of foreign investments. Moreover, utilizing Dynamic Factor Model methodology allows us to examine the effects of shocks on
a significantly larger number of economic, monetary, and financial indicators than what can be achieved by using a traditional VAR
as the one in Bacchiocchi et al. (2020).
The rest of the paper is organized as follows. Section 2 shows a general presentation of a typical Dynamic Factor Model. In
Section 3, we describe the data and discuss the selection of indicators. Section 4 reports the empirical results. In this section, we
present the properties and contributions of the estimated dynamic factors, examine the impulse responses as well as the historical
decompositions of the endogenous variables and a few key indicators. Section 5 conducts a robustness check by including Broad
Effective Exchange Rate in our model. Section 6 concludes.
2. The dynamic factor model
The goal of the model is to examine how FPI interacts with the three major US macroeconomic conditions: the real economic
activity, monetary policy, and aggregate risk. Rather than relying on a single indicator to measure each of these three conditions,
we estimate a Dynamic Factor Model in State Space form using multiple indicators and extract common factors corresponding to
economic activity (hereafter ‘‘output factor’’), monetary policy (hereafter ‘‘monetary factor’’), and aggregate uncertainty (hereafter
‘‘risk factor’’). Each of these factors captures the comovements of its indicators and functions as a composite index. FPI also enters
the model along with the other common factors, as an endogenous variable in the VAR. However, FPI is a single observable indicator
and therefore not estimated. How it enters the model specifically is explained below.
The observation equation(s) for the indicators are given by:
𝑌𝑡 = 𝐴(𝐿)𝑌𝑡−1 + 𝐻(𝐿)𝑆𝑡 + 𝜔𝑡 , 𝜔𝑡 ∼ 𝑁(0, 𝑅), (1)
where 𝑌𝑡 is a vector of all observable indicators for real economic activity, monetary policy, and aggregate uncertainty, as well as
FPI. 𝑆𝑡 is the vector of unobserved factors including output factor (𝑠𝑦,𝑡 ), monetary factor (𝑠𝑚,𝑡 ), and risk factor (𝑠𝑢,𝑡 ), as well as the
observed FPI (𝑠𝑓 ,𝑡 ). 𝑅 is a diagonal variance–covariance matrix of the measurement errors 𝜔𝑡 .
For the 𝑗th individual indicator, 𝑦𝑗,𝑡 , the observation equation can be expressed as:
𝑦𝑗,𝑡 = 𝐴𝑗 (𝐿)𝑦𝑗,𝑡−1 + 𝐻𝑗 (𝐿)𝑆𝑡 + 𝜛𝑗,𝑡 (2)

∑𝐾 ∑𝑁
where 𝜛𝑗,𝑡 represents the 𝑗th idiosyncratic innovation at time period 𝑡. 𝐴𝑗 (𝐿) = 𝑘=0 𝐴𝑗,𝑘 𝐿𝑘 and 𝐻𝑗 (𝐿) = 𝑛=0 𝐻𝑗,𝑛 𝐿𝑛 are lag
polynomials. In our specification, the number of idiosyncratic lags in the 𝐴𝑗 (𝐿) matrix is restricted to two.5 𝐻𝑗 (𝐿) is the factor
loading matrix on current and lagged values of the common factors.
FPI enters the measurement equation as an element in 𝑌𝑡 , say, the 𝑓 th element, denoting 𝑦𝑓 ,𝑡 , and an element in 𝑆𝑡 , 𝑠𝑓 ,𝑡 . Its factor
loading is set to zeros in the 𝑓 th row of matrix 𝐴, 𝐴𝑓 , and normalized to one in the 𝑓 th row of matrix 𝐻, 𝐻𝑓 . Its measurement
error in the 𝑓 th row of 𝜔𝑡 , 𝜛𝑓 ,𝑡 is also shut down. Therefore, 𝑠𝑓 ,𝑡 is essentially its own indicator, 𝑦𝑓 ,𝑡 .6 For the rest of the indicators
to output, monetary, and risk factors, we place sign restrictions and zero restrictions on 𝐻𝑗 (𝐿) to identify them.7 In other words,
even though FPI enters the observation equation (1), it does not contribute to the estimation of 𝑆𝑡 . The interactions between FPI
and the three factors are captured by the evolution of 𝑆𝑡 , which is assumed to be a stationary VAR(4) process, which is standard
for a quarterly VAR:
𝑆𝑡 = 𝐹 𝑆𝑡−1 + 𝜈𝑡 , 𝜈𝑡 ∼ 𝑁(0, 𝑄); (3)
where
[ ]′
𝑆𝑡 = 𝑠𝑡 𝑠𝑡−1 𝑠𝑡−2 𝑠𝑡−3 , (4)
5 The exception is the observation equations for real GDP, the Wu–Xia Shadow rate, and VXO. We include no idiosyncratic lags in the real GDP equation
because we want the output factor to be closely associated with the actual real GDP. We do the same for the Shadow rate and VXO equations. See Section 3
for details about selecting indicators.
6 Besides FPI, we also have the components of FPI as our endogenous variables, including the equity, debt, government debt, and corporate debt. Note that
we estimate the model with each FPI component separately. That is, each time, we replace FPI (𝑦𝑓 ,𝑡 ) with an FPI component, and reestimate the model with
the same restrictions.
7 See next section for details about these restrictions.
3
[ ]′
𝑠𝑡 = 𝑠𝑦,𝑡 𝑠𝑚,𝑡 𝑠𝑢,𝑡 𝑠𝑓 ,𝑡 , (5)
and 𝜈𝑡 is a vector of shocks to the common factors:

[ ]′
𝜈𝑡 = 𝜈𝑦,𝑡 𝜈𝑚,𝑡 𝜈𝑢,𝑡 𝜈𝑓 ,𝑡 0...0 ... 0...0 . (6)
Matrix 𝐹 captures the unrestricted interactions across the four state variables in 𝑠𝑡 .
( )
𝜌
𝐹 = (7)
𝐼 𝑂
[ ]
where 𝐼 denotes a 12 × 12 identity matrix, 𝑂 denotes a 12 × 4 zero matrix, 𝜌 ≡ 𝜌(1) 𝜌(2) 𝜌(3) 𝜌(4) and each of the 𝜌(𝑙) is a
4 × 4 matrix given 𝑙 = 1, 2, … , 4.
The state equation describes the interactions among various factors in the model. This is where the ‘‘general equilibrium’’ nature
of the macroeconomy is captured by our empirical model. We allow innovations in the state equation, 𝜈𝑡 , to be correlated with one
another. Later in our analysis, when we consider orthogonal shocks to the common factors, we impose a recursive structure as that
𝑆𝑡 = 𝐹 𝑆𝑡−1 + 𝑃 𝑢𝑡 , (8)
where 𝑢𝑡 ∼ 𝑁(0, 𝐼) and 𝑃 𝐼𝑃 ′

= 𝑄. The Cholesky ordering is reported in Section 4.2 below.
We estimate the model using Bayesian Markov Chain Monte Carlo (MCMC) methods with the Gibbs sampling. The Markov
chain ran for a 100,000 iteration burn-in period after which the empirical posterior distribution is obtained by sampling every fifth
draw from the Gibbs sampler for a total of 10,000 draws from the posterior distribution. By taking the unobservable states (𝑠𝑡 ) as
parameters, we can obtain the joint posterior distributions of the parameters (𝐴, 𝐻, 𝐹 ) and the states (𝑠𝑡 ). Appendix A provides a
detailed description on applying the Bayesian MCMC estimation approach.
3. Indicators, data, and restrictions
Our data sample runs from 1986 Q1 to 2019 Q4. Table 1 contains the 31 indicators included in our models, their frequency of
observation, any data transformation employed, and the range of observations.8 We also include the restrictions placed on the factor
loadings in the observation equations in the table. These restrictions take the form of sign restrictions on the current values (but not
on the lags) of the unobserved common factors and zero restrictions on current and lagged values of the factors. This combination
of sign and zero restrictions allows us to identify multiple unobserved factors.
Most of the sign and zero restrictions given in Table 1 are straightforward. To measure output factor, we select indicators for
current output condition — growth rates of real GDP and industrial production; indicators for employment–unemployment rate,
as well as growth rates of total non-farm payrolls and real non-farm labor compensation; and also indicators for potential output
— Capacity utilization and Business Confidence Index. We include potential output indicators to further develop the connections
between foreign investments and domestic economic condition. All the variables mentioned above are considered as indicators
of the output factor solely,9 except for Business Confidence Index, which also carries information on aggregate risk.10 As for sign
restrictions, only unemployment rate has a negative factor loading on the output factor, but all the current and potential output
indicators have positive factor loadings. Note that we do not place any restriction on the factor loading for the real non-farm labor
compensation. A rise in real output production could be a result of either an increase in aggregate demand or aggregate supply, and
they could have very different effects on the cost of labor.
The primary indicators for monetary policy factor are interest rates. We select the Wu–Xia Shadow rate estimated in Wu and Xia
(2016), the 3-month and 1-year Treasury rates, and LIBOR as short-term interest rate representatives. Given that the Fed has been
purchasing long-term bonds and TIPS, we also include 5-year, 10-year, 20-year, 30-year Treasury rates and TIPS rates. All nominal
rates are restricted to have positive factor loadings on the monetary factor, the rise of which, therefore, is defined as a monetary
tightening. The factor loadings of all the TIPS rates are unrestricted, given that a change of monetary policy could affect the nominal
rate and expected inflation at the same time. Besides the levels of interest rates, we also include three types of credit spreads as
indicators of the monetary factor— the spreads between Moody’s Aaa, Baa, and High-Yield (HY) rated corporate bond yields and
10-year Treasury rate, respectively. We do not place any sign restrictions on the factor loadings of these spreads on the monetary
factor, given that the degree of impact of a one-time change in monetary policy on corporate bonds and government bonds could
be different, and therefore, unclear on the spreads.
The Aaa-, Baa-, and HY-Treasury spreads are also indicators of the risk factor, with positive sign restrictions placed on the
factor loadings, with higher credit spread indicating higher aggregate risk in the credit market. Besides the spreads, we select CBOE
8 Our choice of main indicators for each condition is in line with McQuade and Schmitz (2019)’s determinants for US capital flows. They select VIX, US GDP
growth, shadow rate, EPU and exchange rate in their analysis. While these variables are present in our models, we include a wider range of indicators in each
category.
9 Therefore, they have zero factor loadings on the non-output factors.
10 We also include Economic Policy Uncertainty as a measure for potential output. It is explained below where we describe the selection of risk indicators.
4
Table 1
Indicators and Data Specification.
Indicators Sea Smp Sr Specification Sample Source
Real GDP + % growth 1986 Q1–2019 Q4 FRB
Industrial production-Total index + % growth 1986 Q1–2019 Q4 FRB
Unemployment rate – Level 1986 Q1–2019 Q4 FRB
Total Nonfarm-All employees + % growth 1986 Q1–2019 Q4 FRB
Real labor compensation — Nonfarm business sector ? % growth 1986 Q1–2019 Q4 FRB
Capacity utilization + Level 1986 Q1–2019 Q4 FRB
Business confidence index + – Level 1986 Q1–2019 Q4 OECD
Wu–Xia Shadow Federal Funds rate + Level 1986 Q1–2019 Q4 Wu–Xiaa
3 m Treasury rate + Level 1986 Q1–2019 Q4 FRB
1-yr Constant Maturity Treasury rate + Level 1986 Q1–2019 Q4 FRB
3 m LIBOR + Level 1986 Q1–2019 Q4 FRB
1-yr LIBOR + Level 1986 Q1–2019 Q4 FRB
5-yr TIPS rate ? Level 2003 Q1–2019 Q4 FRB
10-yr TIPS rate ? Level 2003 Q1–2019 Q4 FRB
20-yr TIPS ? Level 2004 Q3–2019 Q4 FRB
30-yr TIPS ? Level 2010 Q2–2019 Q4 FRB
VXO + Level 1986 Q1–2019 Q4 FRB
VIX + Level 1990 Q1–2019 Q4 FRB
Stock return dispersion (S&P 500 composite index STD) + Std. Dev 1986 Q1–2019 Q4 RSb
Aaa-10-yr Treasury spread ? + Level 1986 Q1–2019 Q4 FRB
Baa-10-yr Treasury spread ? + Level 1986 Q1–2019 Q4 FRB
HY-10-yr Treasury spread ? + Level 1997 Q1–2019 Q4 FRB
Equity Market Volatility Tracker-Overall + Level 1986 Q1–2019 Q4 BBDc
Economic Policy Uncertainty – + Level 1986 Q1–2019 Q4 BBDd
Economic Policy Uncertainty-Financial Regulation + Level 1986 Q1–2019 Q4 BBDd
Economic Policy Uncertainty — Trade Policy + Level 1986 Q1–2019 Q4 BBDd
Economic Policy Uncertainty — Sovereign debt + Level 1986 Q1–2019 Q4 BBDd
Notes: Sea , Economic activity factor; Smp , Monetary policy factor; Sr , Risk factor; +, positive sign restriction; -, negative sign restriction; ?, no sign restriction. If
not specified, zero restrictions were imposed.
a
Wu and Xia (2016).
b
Robert Shiller’s website.
c Baker et al. (2019).
d Baker et al. (2016).
Volatility Index (VIX), CBOE S&P 100 Volatility Index (VXO), S&P 500 stock return dispersion as indicators only for the risk factor.11
We also include several risk indicators computed by Baker, Bloom and Davis (BBD): One is the Equity Market Volatility Tracker (BBD-
EMV) that moves with VIX and the realized volatility of returns on the S&P 500 as explained in Baker et al. (2019). Additionally, we
select Economic Policy Uncertainty index (hereafter ‘‘BBD-EPU’’) and three of its subcategories on Financial regulation (hereafter
‘‘BBD-Financial regulation’’), Trade policy (hereafter ’’BBD-Trade’’), and Sovereign debt (hereafter ‘‘BBD-Sovereign debt’’).12 All these
risk indicators are restricted to have positive factor loadings on the risk factor. Note that the BBD-EPU is also an indicator of the
output factor, with a negative factor loading.
Foreign investment variables used in this paper are from Financial Accounts of the United States – Z.1 tables – available from
the Federal Reserve Board. This dataset includes more than five decades of time series and has the most detailed breakdown of
each category. We use series that are associated with US financial relations with the rest of the world, presented in L.133 Rest of
the World table. It contains series on the levels of various US assets held by foreigners and foreign assets held by US residents at
the end of each quarter. The table only identifies foreign direct investment (FDI) explicitly, but not FPI and bank credit. Therefore,
we use the definition of each series to calculate the subcategories of FPI, FPI equity, and FPI debt. We then use the descriptions
of series used in FPI debt to divide this category to two sub-categories, FPI-government debt and FPI corporate debt. Appendix B
contains a flowchart showing the relationships between FPI and its components.
FPI and its components are deflated using the GDP deflator. To ensure data stationarity, we compute year-over-year growth rates
of the real GDP, industrial production, total nonfarm payroll, real labor compensation, and deflated FPI as well as its components.
11 According to Taylor et al. (2021), risk is when the outcome is unknown, but the probability distribution of the outcome is known. Uncertainty is when the
outcome and the probability distribution of outcome are unknown. Since we have indicators of both measures, in this paper, similar to Taylor et al. (2021), we
use the term risk and uncertainty interchangeably.
12 BBD-EPU is constructed using three components: 1, news coverage about policy-related economic uncertainty; 2, tax code expiration data reported by the
Congressional Budget Office; and 3, economic forecast disagreement among professional forecasters. The EPU sub-indices, BBD-Financial regulation, BBD-Trade,
and BBD-Sovereign debt, are constructed solely on news data based on the Access World News database with more than 2000 US newspapers. See Baker et al.
(2016) for more details on constructing these indices.
5
Fig. 1. Median, 10th, and 90th Percentiles of the Posterior Distributions of Factors.
The first three panels of Fig. 1 show the posterior distributions of the common factors of output, monetary policy, and aggregate risk. Each of the solid blue
lines plots the median (50th percentile) and the dotted red lines show the 10th and 90th percentiles. The growth of FPI is displayed in the bottom right panel.
These are the four endogenous variables entered the state equation in a VAR form in the Dynamic Factor Model.
All interest rates and risk indicators are kept as levels. The only exception is the stock return dispersion where the standard deviation
of S&P 500 composite index is used. Finally, all variables are standardized to have a mean zero and standard deviation of one. This
allows us to compare impulse responses resulted from different FPI shocks across models.
4. Results
We estimate the models using Bayesian Markov Chain Monte Carlo (MCMC) methods with the Gibbs sampling to obtain the
posterior distributions of the output, monetary, and risk factors. Once we obtain the estimates of the factors, we can examine the
effects of orthogonal shocks of the estimated factors on both the underlying factors and all the indicators.
4.1. Contributions of the three common factors
In this subsection, we report the posterior distributions of the three estimated factors and the contributions of these factors to
the fluctuations of each indicator. The first three panels of Fig. 1 show the posterior distributions of the common factors of real
economic activity, monetary policy, and aggregate risk. In each panel, the solid blue line plots the median (50th percentile) and
the pair of dotted red lines mark the 10th and 90th percentiles, respectively. The bottom right panel displays the growth of FPI. As
previously mentioned, FPI growth is not one of the estimated factors and, therefore, no posterior distribution is displayed.
According to Fig. 1, the output factor captures the comovements of several types of output growth and employment, and mostly
coincides with business cycles. The largest decline of output factor covers the Great Recession period from 2007 Q4 to 2009 Q2 as
one expects. As the monetary factor is tied primarily to the Wu–Xia Shadow rate, the general rise in the monetary factor reflects
a general monetary tightening over our sample. The monetary factor also carries information about interest rate spreads. The risk
factor primarily reflects aggregate uncertainty including credit market and stock market volatilities. It spikes up the most during
the stock market crash in October 1987 and the 2007–08 subprime mortgage crisis. It also captures the 1997 Asian financial crisis,
the stock market downturn of 2002, the European sovereign debt crisis and the Flash Crash in early and mid-2010, as well as the
stock market crash in August 2011.
To assess how well our factors capture the fluctuations in the indicators, we calculate historical decompositions for each indicator,
displaying the contributions of the various factors to the movements in the indicators. Figs. 2–5 present the median of the posterior
distribution for historical decompositions of all the indicators. The indicators are displayed using dotted red lines and the solid blue
6
Fig. 2. Contributions of Output Factor to its Indicators.

Fig. 2 shows the contributions of output factor to its indicators in the benchmark model. The solid blue lines display the contributions of the output factor, and
the dotted red line plots the indicators.
Fig. 3. Contributions of Monetary Factor to Interest Rates.

Fig. 3 shows the contributions of monetary factor to all interest rates included in the benchmark model. The solid blue lines display the contributions of the
monetary factor, and the dotted red line plots the indicators.
lines plot the contributions of the common factors. Note that these are not orthogonal decompositions, as the factors are generally
correlated with one another.
Fig. 2 shows the contributions of output factor to its indicators. One observes that the output factor tracks fluctuations in most
indicators very well, including the real GDP, industrial production, unemployment rate, total nonfarm payrolls, capacity utilization,
7
Fig. 4. Contributions of Risk Factor to its Indicators.

Fig. 4 shows the contributions of risk factor to its indicators included in the benchmark model. The solid blue lines display the contributions of the risk factor,
and the dotted red line plots the indicators.
and business confidence index. The contribution of the output factor is less significant to the real labor compensation, likely due
to the relatively high frequency movements of the data. The output factor also contributes significantly to the lower frequency
fluctuations of the BBD-EPU index.13 Fig. 3 shows that the contributions of monetary factor are significant to all interest rates. The
factor primarily tracks the lower frequency movements in the short rates and the higher frequency movements in the long rates. The
contributions are substantial even to the long-term TIPS rates, despite their limited data availability. Fig. 4 displays the contributions
of risk factor to most of its indicators. The factor primarily captures comovements from VXO, VIX, BBD-EMV, BBD-EPU, and Business
Confident Index almost over the entire sample. Its overall contribution to S&P 500 stock return dispersion is also significant, despite
the high volatility in the data. As for the specialized BBD indices, the risk factor contributes substantially to the BBD-Financial
Regulation index, but not much to the other two, even though it does capture the sovereign debt crisis peaked between 2010 and
2012. The lower level contribution of the risk factor to the BBD-Trade Policy index in recent years can be due to unprecedented
changes in the US Trade policies during the Trump administration.
We single out the decompositions of the three credit spreads and display them in Fig. 5, to provide an interesting com-
parison between our monetary and risk factors. The three spreads, Aaa-corporate/10-year Treasury (hereafter ‘‘Aaa spread’’),
Baa-corporate/10-year Treasury (hereafter ‘‘Baa spread’’), and HY-corporate/10-year Treasury (hereafter ’’HY spread’’), respectively,
are plotted in both first and second rows using dotted red lines. The top row displays the contributions of the risk factor with solid
blue lines, while the bottom row displays the contributions of the monetary factor, in solid green lines. Observing from left to
right, the monetary factor contributes the most to the Aaa spread, while the risk factor contributes the most to the HY spread. The
contributions of these two factors to the Baa spread are somewhere between the Aaa- and HY-spreads. This result provides a clear
distinction between the two separate channels on changes of a credit spread. First of all, there exists the ‘‘risk channel’’: A rise in
aggregate risk or uncertainty triggers a flight to quality, where investors move funds from higher-risk assets to lower-risk assets,
and therefore, results in an increase in risky rate and a decrease in safe rate, hence the rise in a credit spread. Also there exists
the ‘‘monetary channel’’: Treasury bonds are the primary assets for the Federal Reserve to use to conduct open market operations,
and therefore, a change of monetary policy has a more significant and immediate impact on Treasury rates than corporate yields,
causing the change in spreads without any change of aggregate risk. In our case, High-yield corporate and Baa bonds likely belong
to the high-risk assets that investors move away from, and Treasury bonds belong to the safe assets that investors move towards.
As a result, the risk channel is more attributable to the changes of Baa- and HY-spreads. On the other hand, higher-rated assets,
such as Aaa-rated bonds, are less sensitive to a flight to quality phenomenon, and therefore, the monetary channel dominates in
causing the fluctuations of the Aaa spread. Shown in Fig. 5, the risk factor mainly contributes to the Aaa spread during major
13 The high frequency fluctuations of the BBD-EPU, and in fact, all the risk indicators, are attributable to our risk factor. (See the description of Fig. 4.)
8
Fig. 5. Contributions of Risk and Monetary Factors to Spreads.

Fig. 5 compares the contributions of risk factor and monetary factor to three credit spreads, between Aaa-corporate yield and 10-year Treasury rate, Baa-corporate
yield and 10-year Treasury rate, and High-Yield corporate yield and 10-year Treasury rate. The solid blue lines display the contributions of the risk factor, the
solid green lines display the contributions of the monetary factor, and the dotted red line plots the indicators.
economic downturns, such as the recessions in early 2000 and 2007. The monetary factor contributes significantly to all the spreads
during non-crisis times. Note that earlier studies in the literature, such as Duca (1999), Balke and Zeng (2013), have pointed out
the inaccuracy of considering any credit spread as a sole risk indicator due to the coexistence of these two parallel channels. Our
finding confirms and supports this argument.
4.2. Impulse response analysis
In this subsection, we explore the interactions among the growth rate of FPI (or one of the FPI components) and the output,
monetary, and risk factors as well as selected indicators of interest. We begin by examining the impulse responses of the underlying
factors and indicators to orthogonal shocks to FPI growth and the estimated factors. The orthogonal shocks are identified by assuming
recursive structure using the following Cholesky ordering: shocks to economic activity factor being the first, growth rate of FPI (or
each of its components), monetary factor, and aggregate risk factor being the last.
To better understand the Cholesky ordering, recall that our estimated factor of real economic activity mainly consists of
fluctuations in production and employment sectors. The monetary factor primarily captures all the common information in interest
rates, including the monetary policy rate, and risk associated with the money market. Finally, the aggregate risk factor largely reflects
uncertainty or volatility of financial market. Production and employment tend to have delayed responses to any changes in capital
and funds market, monetary policy, and financial uncertainty, therefore, we order our output factor first. Financial market volatility,
on the other hand, reacts almost instantly to any changes in goods, capital, and money markets, and therefore, the aggregate risk
factor is ordered last. Between shocks to FPI (or its components) and monetary shocks, we consider that the quantity of foreign
investments and capital market, similar to production section, tends to respond to interest rate indicators with lags. The process
of monetary policymaking factors in current capital market conditions and sources of loanable funds, and therefore, we order FPI
growth before our monetary factor. Note that we consider alternative orderings,14 and find that changing the orders has nearly no
impact on the results of the identified structural shocks reported below.
14 We have conducted three sets of alternative orderings as robustness checks: 1, switching the ordering between the growth rate of FPI (or one of the FPI
components) and the monetary factor; 2, switching the ordering between the economic activity factor and the growth rate of FPI (or one of the FPI components);
and 3, ordering the growth rate of FPI (or one of the FPI components) last. All impulse responses and historical decomposition results remain consistent with
our reported benchmark findings.
9
Fig. 6. Impulse Responses of Output, Monetary, and Risk Factors to FPI Shock.
Impulse Responses of FPI Growth to Output, Monetary, and Risk Shocks
The first row of Fig. 6 presents the posterior distribution of the impulse responses of output, monetary, and risk factors to a positive one-time one-standard-
deviation shock to the FPI growth. The second row presents the posterior distribution of the impulse responses of the FPI growth to a positive one-time one
standard-deviation shock to output, monetary, and risk factors, respectively. The solid blue line displays the median, and the pair of dotted red lines plot the
10th and 90th percentiles, respectively.
4.2.1. The impacts of FPI

Fig. 6 displays the median (solid blue line), 10th percentile (dotted red line), and 90th percentile (dotted red line) from the
posterior distribution of the impulse responses of our three factors and FPI growth. The first row of Fig. 6 presents the impulse
responses of output, monetary, and risk factors to a positive one-time one-standard-deviation shock to the FPI growth (hereafter
‘‘FPI shock’’). An unexpected rise in FPI growth increases the aggregate supply of loanable funds in the US, which reduces long-term
interest rates in the domestic loanable funds market (as shown by Warnock & Warnock, 2009 and Sá & Wieladek, 2015), and hence,
reduces domestic cost of production, and eventually raises output and employment. Therefore, one observes the increase in output
factor and decrease in monetary factor in responses to the positive FPI shock. Similarly, an increase in FPI growth raises the overall
supply of funds available in the US financial market. According to the ‘‘risk-taking channel’’ represented by Cúrdia and Woodford
(2011), Adrian et al. (2010), and Gertler and Kiyotaki (2010), an increase in the source of funds strengthens the balance sheet
conditions of financial intermediaries, hence, raises their risk appetite and willingness to lend, and therefore, reduces the aggregate
risk in the financial market. This finding is in line with McQuade and Schmitz (2019), where they find VIX, their aggregate risk
measure, is negatively related with the US capital inflow. The second row of Fig. 6 presents the impulse responses of FPI growth
to a positive one-time one-standard-deviation shock to our output, monetary, and risk factors, respectively. A positive output shock
signals that the US economy is on an upward trajectory, which attracts foreign investments into the US, and therefore, results in
a faster growth of FPI. A positive monetary shock which associates with an increase in domestic interest rate, on the other hand,
reduces the foreign investments in the US initially but allows it to rebound in about three quarters. An increase in interest rates
instantly reduces the value of existing outstanding financial assets, ergo, leads to the initial decrease of FPI growth. Meanwhile,
newly issued assets with higher rate of return attract foreign investments, and hence, the shock eventually results in a faster growth
of FPI despite its initial decline. The last panel of Fig. 6 shows that an increase in domestic risk level lowers the FPI growth briefly
but then causes an increase in two quarters. This finding is interesting because it indicates that the aggregate risk level in the US
is representative of global aggregate risk level. An increase in the US risk level either will lead to an increase in risk elsewhere in
the world, or is caused by a global event that has spread to the US. Either way, it only discourages foreign investors temporarily,
as the US is still considered a safe investment environment even when the global uncertainty is high.15 Our findings are also in
15 To examine the relationship between US risk and global risk, we look at Business Confidence Index for US and total OECD countries. We find that these
two series are highly correlated during our sample period at 71%. The close correlation between these two series become even closer during the last 20 years
where they are 80% correlated.
10
Fig. 7. Impulse Responses of Selected Indicators to FPI Shock.

Fig. 7 presents the posterior distribution of the impulse responses of Real GDP, Total nonfarm payrolls, Capacity Utilization, Baa-corporate/10-year Treasury
spread, VXO, and BBD-Sovereign debt to a positive one-time one-standard-deviation shock to the FPI growth. The solid blue line displays the median, and the
pair of dotted red lines plot the 10th and 90th percentiles, respectively.
line with the results in Bloom (2009), who explains that firms delay new investment and hiring when they face a higher level
of uncertainty. In other words, a higher risk increases the ‘‘option value of waiting’’ and results in the initial decline of portfolio
investment. However, once the one-time uncertainty shock is gone, firms resume their postponed hiring and investment, and the
overshoot occurs as the suppressed demand for labor and capital recovers. Bloom (2009)’s explanation can also apply to foreign
investments during the periods of high uncertainty.
Besides the composite factors, we also examine the effects of FPI shocks on selected representative indicators. Fig. 7 presents
the posterior distribution of the impulse responses of the real GDP, total nonfarm payrolls, Capacity Utilization, Baa spread, VXO,
and BBD-Sovereign debt to a positive one-time one-standard-deviation FPI shock. The results are all reasonable: A faster growing
FPI increases aggregate source of funds, and as a result, current output, employment, and potential output all rise. It also reduces
credit spread and aggregate risk in domestic and global market.
4.2.2. The impacts of fpi components

In addition to FPI, we are also interested in the interactions between various FPI components and the overall US macroeconomic
conditions. The components of interest are the equity component (hereafter ‘‘FPI-Equity’’) and debt component (hereafter ‘‘FPI-
Debt’’). Also, we further divide the debt category into government debt (hereafter ‘‘FPI-Government Debt’’) and corporate debt
(hereafter ‘‘FPI-Corporate Debt’’). In Figs. 8 and 9, we examine how the growth rates of FPI and its components can affect and be
affected by the US economic activity, monetary, and risk factors. Note that the impulse responses are generated from estimating the
model using the growth rate of each FPI component separately. That is, each time we replace 𝑠𝑓 ,𝑡 in Eq. (1) with a FPI component
and reestimate the model. Recall that all the data series are standardized, which allows us to compare the impulse responses across
models. For better visual comparison, we only display the medians of the posterior distributions when we compare the effects across
various FPI components.
First of all, we compare how FPI and its components are affected by shocks to the US market conditions. Fig. 8 displays the
medians from the posterior distributions of the impulse responses of the growth rates of FPI, FPI-Equity, FPI-Debt, FPI-Government
Debt and FPI-Corporate Debt to a positive one-time one-standard-deviation shock to output, monetary, and risk factors, respectively.
The first row provides the comparisons across the growth rates of FPI, FPI-Equity, and FPI-Debt. The second row provides the
comparisons across the growth rates of FPI-Debt, FPI-Government Debt and FPI-Corporate Debt. From the first column, which plots
the effects of output shocks, one observes that a positive output shock increases the growth rates of FPI and FPI-Equity, but slows
down the growth of FPI-Debt. Moreover, after FPI-Debt is disaggregated, one observes that it is the growth of government debt
that responds negatively to a positive output shock, whereas, the corporate debt portion, similar to FPI and its equity portion, rises.
This is the result of a classic flight-to-quality in reverse, or the search-for-yield effect presented by Ammer et al. (2018). When the
domestic market is strong, the risk appetite of foreign investors increases, which leads them to move toward riskier investments,
11
Fig. 8. Impulse Responses of the Growth Rates of FPI and FPI components to Output, Monetary, and Risk Shocks.
Fig. 8 presents the medians from the posterior distributions of the impulse responses of the growth rates of FPI, FPI-Equity, FPI-Debt, FPI-Government Debt and
FPI-Corporate Debt to a positive one-time one-standard-deviation shock to output, monetary, and risk factor, respectively. The first row provides comparison
across the responses of growth rates of FPI, FPI-Equity, and FPI-Debt. The second row provides comparison across the responses of growth rates of FPI-Debt,
FPI-Government Debt and FPI-Corporate Debt.
such as equity and corporate bonds, while move away from safer investments, such as US government bonds. The flight-to-quality
effect, which suggests that investors tend to switch from riskier holdings to safer ones when they face an unexpected increase in
financial uncertainty, can also be observed from the third column of Fig. 8, which plots the effects of an unexpected increase in risk
factor. From the top panel, the response of the growth of FPI-Debt to a risk shock is much milder than the growth of FPI-Equity.
From the bottom panel, in response to an unexpected rise in aggregate risk, the growth of FPI-Government debt – the safer assets
– increases, while the growth of FPI-Corporate bonds – the riskier assets – falls. These results are in line with Tachibana (2020)’s
findings that US government bonds have played the role of safe haven during stock market crashes.
The middle column of Fig. 8 compares the responses of the growth rates of FPI and its components to an increase in monetary
factor, which represents a rise in interest rates or a monetary tightening. Similar to what one observes in Fig. 6, an increase in interest
rates reduces the value of the existing outstanding debt assets, but not necessarily equity, given that stocks are not interest-bearing
like bonds. Also, government bonds are more sensitive to the monetary shock than corporate bonds, since Treasury bonds are the
primarily assets used by the Fed to conduct open market operations.
Next, we examine the different effects of shocks to FPI growth and its components on selected representative indicators.
Each panel of Fig. 9 displays the medians from the posterior distributions of the impulse responses of a selected indicator to a
positive one-time one-standard-deviation shock to the growth rates of FPI, FPI-Equity, FPI-Government Debt and FPI-Corporate
Debt, respectively.16 The first row of Fig. 9 shows that positive shocks to FPI growth and its components increase the real GDP and
capacity utilization, and reduce the unemployment rate. This is in line with results in Warnock and Warnock (2009) and Sá and
Wieladek (2015), that foreign investments in the US have expansionary effects on the US economy. Among the effects of the growth
of FPI components, shocks to FPI-Equity and FPI-Corporate Debt result in the largest responses in magnitude in all three output
indicators. The effects of FPI-Government Debt shock, on the other hand, are much milder than others, even though the share of
government debt is twice as high as the share of corporate debt. These results are sensible because equity and corporate debt are
riskier assets than government bonds. Increasing the purchase of safe assets, such as government bonds, can either be an indicator
of higher level of asset holdings in general, or a switch from holding risky assets to safe ones. The former represents a positive
shock while the latter represents a negative shock to the financial market. An increase of risky asset purchases, such as equity or
corporate bonds, is a much stronger positive signal in the financial market, and hence, has more significant positive impacts on
production sector and the rest of the economy. Overall, our results show that the US benefits from both FPI-Equity, consistent with
16 We choose not to show FPI-Debt shock for a cleaner presentation. The responses to FPI-Debt shocks are in between FPI-government debt and corporate
debt, scale wise. Qualitatively, they are similar.
12
Fig. 9. Impulse Responses of Selected Indicators to Shocks to the Growth Rates of FPI and FPI Components.
Fig. 9 presents the medians from the posterior distributions of the impulse responses of Real GDP, Unemployment rate, Capacity Utilization, VXO, BBD-EPU,
S&P 500 stock return dispersion, Aaa, Baa, and HY corporate/10-year Treasury spreads to a positive one-time one-standard-deviation shock to the growth rates
of FPI, FPI-Equity, FPI-Government Debt and FPI-Corporate Debt, respectively.
what Blanchard et al. (2016) find for emerging economies, and FPI-Debt, consistent with what Davis (2015) finds in his study of
30 developed and emerging economies.
The second row of Fig. 9 shows that the typical risk indicators, VXO, BBD-EPU, and S&P 500 stock return dispersion, all generally
decrease in response to an unexpected rise in the growth of any FPI component. Moreover, all risk indicators are the most sensitive
to a shock to the riskiest asset, FPI-Equity growth, and the least sensitive to a shock to the safest asset, FPI-Government Debt.17 This
result is sensible in that an improvement in a market of risky assets contributes more than any change in a market of safe assets in
reducing aggregate uncertainty.
The third row of Fig. 9 compares the effects of shocks to FPI growth and its components on the three credit spreads. As one
expects, a positive shock to the growth rates of FPI-Equity or FPI-Corporate Debt reduces aggregate risk, and therefore, lowers the
credit spread. On the other hand, a positive shock to the growth of FPI-Government Debt raises the credit spreads, at least initially.
This is because an unexpected faster growth of FPI-Government Debt resembles an increase in Treasury bond purchases, which
lowers Treasury rate, and increases the spreads, ceteris paribus. Furthermore, this effect of government debt shocks is the strongest
on Aaa-spread, but not so much on HY-spread. As interpreted in Fig. 5, a change of Aaa-spread is more likely due to the monetary
channel than the risk channel, and therefore, more sensitive to a government debt shock than Baa- and HY-spreads.
4.3. Historical significance of the structural shocks
To assess how important each structural shock is as a source of fluctuations over time in the overall macroeconomic conditions in
the US and foreign portfolio investment, we examine the historical decompositions of output, monetary, risk factors and FPI growth
as well as selected indicators. The decompositions presented in Figs. 10–12 are the median (50th percentile) from the posterior
distributions.
Fig. 10 displays the historical decompositions of output, monetary, and risk factors as well as FPI growth. Each dotted red
line plots the median from the posterior distribution of each factor (first three rows) or the data series of FPI growth (last row).
Each solid blue line plots the median from the posterior distribution of the overtime contribution of each shock. As one expects,
the idiosyncratic shock contributes the most to the fluctuations of each series. However, the impact of FPI shock is substantial to
all output, monetary, and risk factors, especially during the economic downturns in the early 1990s, early 2000s, and the Great
Recession. In fact, the FPI shock and output shock are the two non-idiosyncratic shocks which contribute the most to all series. The
output shock contributes more to the monetary factor than the FPI shock, likely due to the fact that foreign investments are not
17 According to Engel (2020), US dollar denominated government debts are safe and liquid. Safe because they allow foreign investors to hedge their risk
against global economic crisis and liquid because the chance of the federal reserve defaulting on its debts is very slim.
13
Fig. 10. Historical Decompositions of Output, Monetary, Risk Factors, and FPI Growth.
Fig. 10 displays the historical decompositions of output, monetary, and risk factors as well as FPI growth. Each dotted red line displays the median from the
posterior distribution of each factor (first three rows) or the data series of FPI growth (last row). Each solid blue line plots the median from the posterior
distribution of the overtime contributions of each shock.
Fig. 11. Historical Decompositions of the Credit Spreads.

Fig. 11 displays the historical decompositions of Aaa corporate/10-year Treasury spread, Baa corporate/10-year Treasury spread, and HY corporate/10-year
Treasury spread. Each dotted red line displays the data. Each solid blue line plots the median from the posterior distribution of the overtime contributions of
each shock.
14
Fig. 12. Contributions of Shocks to the Growth Rates of FPI and FPI Components to Selected Indicators.
Fig. 12 displays the historical decompositions of Real GDP, Wu–Xia Shadow Rate, and VXO. Each column shows the contributions of the shocks to the growth
rates of FPI and its components to these three indicators. Each dotted red line displays the data. Each solid blue line plots the median from the posterior
distribution of the overtime contributions of each shock.
necessarily a primary factor that the Fed considers when conducts monetary policy. The FPI shock contributes more to the risk factor
than the output shock, since a change in the availability of funds in the US credit market (equity or debt) is likely to have more
direct impacts on our risk factor, which largely captures financial market and policy uncertainty, than a change in the production
sector. The last row of Fig. 10 shows that the impact of the US macroeconomic conditions on FPI growth is also crucial. An output
shock contributes more during the crisis periods in the 1990s, early 2000s, and late 2000s, while a risk shock contributes more
during the non-crisis periods, such as the boom times in the late 1980s, between 2004 and 2006, and between 2010 and 2012.
In Fig. 11, we show the historical decompositions of Aaa-, Baa-, and HY-spreads. One observes that the contributions of the
output shock is consistent overtime across all three spreads. The monetary shock contributes the most to the Aaa-spread, while the
risk shock contributes the most to the HY-spread. This further confirms our findings in Figs. 5 and 9. For overtime contributions
to the fluctuations, the monetary channel is the dominant force on lower-risk spreads but the risk channel is more influential on
higher-risk spreads. The contributions of the FPI shock is also more substantial to the HY- and Baa-spreads than the Aaa-spread. This
is because, as demonstrated in Fig. 10, FPI shocks are more responsible for contributing to variables closely related to aggregate
risk than monetary policy.
Finally, Fig. 12 compares the historical contributions of shocks to the growth rates of FPI, FPI-Equity, FPI-Debt, FPI-Government
Debt, and FPI-Corporate Debt to the real GDP, Wu–Xia Shadow rate, and VXO. First of all, the FPI shock appears to have the most
significant contributions comparing to shocks to any FPI components. However, comparing the overtime contributions of shocks
to FPI components also provides interesting insights. For example, for the real GDP, the FPI-Equity shock is the most responsible
for contributing to the economic recessionary periods in early 1990s, early 2000s, and 2007. Shocks to FPI-Corporate Debt also
contribute to the 1990s and 2007 recessions, but not much to the early 2000s one, which was primarily tied to a stock market crash
and the September 11 attack. Overall, the FPI-Debt shocks are more responsible for the boom times than the bust times. Moving on to
the Shadow rate, the overall contributions of FPI shocks are not significant due to the nature of the stochastic trends in any nominal
interest rate data. However, shocks to debt and government debt portions do contribute to the changes in interest rate between mid
1990s to late 2000s. As expected, shocks to equity and corporate debt portions do not contribute much given that these assets are not
the Fed’s primary instruments. Finally, for a representative risk indicator, such as VXO, equity and corporate debt shocks contribute
the most to its fluctuations, but the same cannot be said about the FPI-Government Debt shocks. The intuition is straightforward
given that equity is considered the riskiest asset type while the US government debt is considered the safest. Naturally, the degree
of contributions of FPI-Debt shocks falls in between the shocks to government debt and corporate debt, but overall, lower than the
equity shocks.
15
Fig. 13. Figure 13 Impulse Responses of Output, Monetary, and Risk Factors and Exchange Rate to FPI Shock.
Impulse Responses of FPI Growth to Output, Monetary, Risk, and Exchange Rate Shocks
The first row of Fig. 13 presents the medians from the posterior distribution of the impulse responses of output, monetary, and risk factors and Real Broad
Effective Exchange Rate to a positive one-time one-standard-deviation shock to FPI growth. The second row presents the medians from posterior distribution
of the impulse responses of FPI growth to a positive one-time one standard-deviation shock to output, monetary, and risk factors and the real exchange rate,
respectively. The first three columns compare the impulse responses of the models with and without the exchange rate. Each solid blue line displays the responses
from the model with the exchange rate. Each red dash line plots the responses from the model without the exchange rate.
5. Robustness check
Exchange rate is considered to be well related to capital inflow and foreign investment in a two-way relationship in the literature.
Some studies consider the exchange rate as a determinant of capital inflows to a country and show that high exchange rates and
currency risks have negative effects on FPI due to uncertainty of returns for investors in their home currencies (Garg & Dua, 2014;
Gumus et al., 2013; Makoni, 2020). Other papers exhibit that higher foreign investments in a country lead to currency appreciation
and formation of asset bubbles (Bahmani-Oskooee et al., 2013; Forbes & Warnock, 2012; Jongwanich & Kohpaiboon, 2013).
Therefore, although the focus of this paper is the impact of foreign portfolio investment on the US macroeconomic environment,
one could wonder if these interactions are robust when the exchange rate is present in the model.
In this section, we conduct a robustness check on this alternative model environment. We include exchange rate as the fifth
endogenous variable in 𝑠𝑡 in the state equation (Eq. (1)) and reestimate the model. We use the Broad Effective Exchange Rate18
for United States constructed by the Bank for International Settlements as a composite measure of the rate at which US dollar
exchanges for a basket of multiple foreign currencies. Note that this rate represents the amount of US dollars needed to purchase
foreign currency, and therefore, its increase indicates a depreciation of US dollars against a basket of foreign currencies, and vice
versa. Given the fact that the Broad Effective Exchange rate is not available until 1994, we adjust our data sample range when we
reestimate the model with exchange rate.
The first three columns of Fig. 13 is a recreation of Fig. 6, this time with exchange rate in the model, to compare the impulse
response functions from our benchmark model (without exchange rate) with the ones from the model with exchange rate. For a
cleaner presentation, we only present the medians of the posterior distributions. This comparison shows that the inclusion of the
exchange rate does not change the interactions among output, monetary, risk factors and FPI growth. The impulse responses are
qualitatively and quantitatively very close to our findings in the benchmark model. The last column of Fig. 13 shows the additional
results associated with exchange rate. The top panel shows that in response to a positive shock to the FPI growth, the Broad Effective
Exchange rate declines, meaning US dollar appreciates. Our finding is in line with what is implied in Blanchard et al. (2016), in
18 We have used both Nominal Effective Exchange Rate and Real Effective Exchange Rate, respectively, in our model. They both yield very similar results.
The results reported in Figs. 13 and 14 are from the model using the Real Effective Exchange Rate.
16
Fig. 14. Historical Decompositions of Output, Monetary, Risk, FPI Growth, and Real Exchange Rate.
Fig. 14 displays the historical decompositions of output, monetary, and risk factors as well as FPI growth and Real Broad Effective Exchange Rate. Each dotted
red line displays the median from the posterior distribution of each factor (first three rows) or the data series of FPI growth and the exchange rate (last two
rows). Each solid blue line plots the median from the posterior distribution of the overtime contributions of each shock.
which an increase in foreign portfolio investment causes US dollars to appreciate, results in a decrease in overall riskiness (which
resembles a credit boom), and finally a rise in output. The bottom panel shows that in response to an unexpected rise in the Broad
Effective Exchange rate, i.e., a sudden depreciation of US dollars, foreign portfolio investment decreases. This result is in line with
McQuade and Schmitz (2019)’s findings that there is a negative relationship between US nominal exchange rate and US liability
flows.
In Fig. 14, We recreate Fig. 10 by showing the historical decompositions of output, monetary, and risk factors as well as FPI
growth and the exchange rate, to compare the overtime historical contributions of all five structural shocks. One observes that the
first four rows and first four columns show similar results to Fig. 10. Even when we include exchange rate in the model, the FPI shock
still contributes substantially to all the endogenous variables, mostly only second to their idiosyncratic shocks. It also contributes
to the high frequency movements of the exchange rate. The exchange rate shock, on the other hand, also somewhat contributes to
all the macroeconomic factors, although not as much as the FPI shock. Overall, Figs. 13 and 14 show that our main findings on the
interactions between FPI growth and US macroeconomic conditions in our benchmark model are consistent and robust even in a
model environment with the Broad Effective Exchange Rate.
6. Conclusion
This paper aims to examine and understand the relationships among the US macroeconomic conditions and foreign portfolio
investment, which accounts for more than 60 percent of over $35 trillion foreign investments in the US at the end of 2019. Without
such understanding, it will be difficult for policymakers to plan to maintain such a high level of investments in the future or to
create contingency plans should the foreign investments in the US fluctuate.
We estimate a Dynamic Factor Model to obtain three US macroeconomic condition factors: real economic activity, monetary
policy, and aggregate uncertainty. Each factor condition is an estimate of the comovements from multiple economic, monetary, and
credit indicators. Using dynamic factor models allows us to include 31 macroeconomic, monetary, and financial indicators which are
far greater than what can be achieved by using a traditional VAR model alone. Our results show that positive shocks to the growth
rate of FPI and its components have expansionary effects on the US macroeconomic variables. It raises domestic output, employment,
and reduces aggregate uncertainty. We also find that shocks to FPI growth have one of the most significant contributions to the
historical fluctuations in almost all market conditions and indicators, next to their idiosyncratic shocks. Besides FPI, we also compare
how the US macroeconomic conditions interact with FPI components. We find that shocks to FPI-Equity and FPI-Corporate Debt
17
increase output factor and its associated indicators in a larger magnitude compared to their moderate increase resulting from similar
shocks to FPI-Government Debt. Furthermore, our results indicate that an unexpected rise in the growth of equity or corporate debt
portions of FPI reduces risk factor and its associated indicators. However, a positive shock to FPI-Government Debt is associated
with an increase in almost all risk indicators including the credit spreads. Our results are robust to the inclusion of the exchange
rate variable as well as to the use of different Cholesky orderings.
Declaration of competing interest
The authors declare that they have no relevant or material financial interests that relate to the research described in this paper.
Appendix A. Bayesian estimation
Kim and Nelson (1998) and Johannes and Polson (2010) provide detailed introductions to the approach of Gibbs Sampler. The
objective of the estimation is to find the posterior distribution of both the unknown parameters, 𝛩,19 and the unobservable state
vector, 𝑆, given the observable indicators, 𝑌 . By sequentially sampling 𝑆 (𝑖) from posterior distribution 𝑃 (𝑆|𝛩, 𝑌 ) and 𝛩(𝑖) from
( )
𝑃 (𝛩|𝑆, 𝑌 ), the resulting sample distribution of 𝑆 (𝑖) , 𝛩(𝑖) converges to 𝑃 (𝑆, 𝛩|𝑌 ).
̃ ′ ̃ ′
Define 𝑆𝑇 = [𝑆1 𝑆2 ... 𝑆𝑇 ] and 𝑌𝑇 = [𝑌1 𝑌2 ... 𝑌𝑇 ] . The steps taken in the Gibbs Sampler are as follows:
1. Taking the parameters of the state space model as given, draw a realization of the state vector 𝑆̃𝑇 , conditional on the model’s
parameters and the observed data. Because the state space model presented by equation (1) and (2) is linear and Gaussian,
the distribution of 𝑆𝑇 given 𝑌̃𝑇 and that of 𝑆𝑡 given 𝑆𝑡+1 and 𝑌̃𝑡 for 𝑡 = 𝑇 − 1, 𝑇 − 2, … , 1 are also Gaussian:
𝑆𝑇 ∼ 𝑁(𝑆𝑇 |𝑇 , 𝑃𝑇 |𝑇 ),
𝑆𝑡 |𝑌̃𝑡 , 𝑆𝑡+1 ∼ 𝑁(𝑆𝑡|𝑡,𝑆𝑡+1 , 𝑃𝑡|𝑡,𝑆𝑡+1 );
( ) ( ) ( ) ( ) ( )
where 𝑆𝑇 |𝑇 = 𝐸 𝑆𝑇 |𝑌̃𝑇 , 𝑃𝑇 |𝑇 = 𝐶𝑜𝑣 𝑆𝑇 |𝑌̃𝑇 ; 𝑆𝑡|𝑡,𝑆𝑡+1 = 𝐸 𝑆𝑡 |𝑌̃𝑡 , 𝑆𝑡+1 = 𝐸 𝑆𝑡 |𝑆𝑡|𝑡 , 𝑆𝑡+1 , 𝑃𝑡|𝑡,𝑆𝑡+1 = 𝐶𝑜𝑣 𝑆𝑡 |𝑌̃𝑡 , 𝑆𝑡+1 =
( )
𝐶𝑜𝑣 𝑆𝑡 |𝑆𝑡|𝑡 , 𝑆𝑡+1 .
We can take Kalman filter approach to obtain 𝑆𝑇 |𝑇 and 𝑃𝑇 |𝑇 by filtering forward:
( )−1
𝑆𝑡|𝑡 = 𝑆𝑡|𝑡−1 + 𝑃𝑡|𝑡−1 𝐻 ′ 𝐻𝑃𝑡|𝑡−1 𝐻 ′ + 𝑅 𝜂𝑡|𝑡−1 ,
′
( ′
)−1
𝑃𝑡|𝑡 = 𝑃𝑡|𝑡−1 − 𝑃𝑡|𝑡−1 𝐻 𝐻𝑃𝑡|𝑡−1 𝐻 + 𝑅 𝐻𝑃𝑡|𝑡−1 ;
( )
where 𝜂𝑡|𝑡−1 = 𝑌𝑡 − 𝐴𝑌𝑡−1 − 𝐻𝑆𝑡|𝑡−1 in our model is the new information that 𝑌𝑡 can bring to forecasting 𝑆𝑡 , and is weighted
( )
by the variance of the conditional forecast error 𝐻𝑃𝑡|𝑡−1 𝐻 ′ + 𝑅 .
(𝑖)
We draw 𝑆𝑇 from the conditional distribution, and obtain 𝑆𝑡|𝑡,𝑆𝑡+1 and 𝑃𝑡|𝑡,𝑆𝑡+1 from sampling backwards:
( )−1 ∗
𝑆𝑡|𝑡,𝑆𝑡+1 = 𝑆𝑡|𝑡 + 𝑃𝑡|𝑡 𝐹 ′ 𝐹 𝑃𝑡|𝑡 𝐹 ′ + 𝑄 𝜂𝑡+1|𝑡
′
( ′
)−1
𝑃𝑡|𝑡,𝑆𝑡+1 = 𝑃𝑡|𝑡 − 𝑃𝑡|𝑡 𝐹 𝐹 𝑃𝑡|𝑡 𝐹 + 𝑄 𝐹 𝑃𝑡|𝑡
∗
( )
where 𝜂𝑡+1|𝑡 is the new information updated by the state equation and equals to 𝑆𝑡+1 − 𝐹 𝑆𝑡|𝑡 in our model, and is weighted
( ′
)
by the variance 𝐹 𝑃𝑡|𝑡 𝐹 + 𝑄 .
2. Taking state vector 𝑆̃𝑇 and variance–covariance matrix 𝑄 as given, draw parameters of the state equation, i.e., the elements
in 𝐹 matrix. We can rewrite the state equation in matrix form as below:
𝑦 = 𝜌𝑋 + 𝑣, 𝑣 ∼ 𝑁 (0, 𝑄) ;
( )′ ( )′
where 𝑋 = 𝑆0 𝑆1 ... 𝑆𝑇 −1 and 𝑦 = 𝑆1 𝑆2 ... 𝑆𝑇 .
We employ a multivariate normal prior distribution for 𝜌 given by
( )
𝜌 ∼ 𝑁 𝛼, ̊ 𝛴̊ 𝐼[𝑠(𝜌)]
where 𝛼̊ and 𝛴̊ are known and 𝐼 [𝑠 (𝜌)] is an indicator function used to denote that roots of 𝐹 (𝐿) lie outside the unit circle.
The posterior distribution for 𝜌 is given by
( )
𝜌|𝑆̃𝑇 ∼ 𝑁 𝛼, ̄ 𝛴̄ 𝐼[𝑠(𝜌)]
where
( )−1 ( −1 )
𝛼̄ = 𝛴̊ −1 + 𝑋 ′ 𝑋 𝛴̊ 𝛼̊ + 𝑋 ′ 𝑆̃𝑇 ,
( )−1
𝛴̄ = 𝛴̊ −1 + 𝑋 ′ 𝑋 .
We draw 𝜌 from the posterior and discard the draws if the roots lie outside the stationary region.
19 In our model, the elements of matrices 𝐴, 𝐻, 𝐹 , 𝑄 and 𝑅.
18
3. Taking the state vector 𝑆̃𝑇 and 𝐹 matrix as given, draw elements in the variance–covariance matrix 𝑄. We employ an Inverse-
( ) ( )
Wishart prior distribution 𝑊 −1 𝛹𝑜 , 𝜅𝑜 , where 𝛹𝑜 and 𝜅𝑜 are known. The posterior distribution is given by 𝑊 −1 𝛹1 , 𝜅1
where
∑
𝑇
𝛹1 = 𝛹𝑜 + 𝑣𝑡 𝑣′𝑡 ,
𝑡=1
𝜅1 = 𝜅𝑜 + 𝑇 .
4. Taking the state vector 𝑆̃𝑇 and the 𝑅 matrix as given, draw parameters in the measurement equation, i.e., the elements
in 𝐴 and 𝐻 matrices. The posterior distributions have similar forms as those in step 2 with the linear regressions given by
the measurement equations. Draws of parameters which resulted in roots lying outside the stationary region or violated sign
restrictions were discarded and another new draw was made.
5. Taking the state vector 𝑆̃𝑇 and the parameter vector 𝐴(𝐿) and 𝐻(𝐿) as given, draw variances in 𝑅 matrix from the
Inverse-Wishart posterior distribution similar as those in step 3 with linear regressions given by the measurement equations.
6. Repeat steps 1–5. This is done for a burn-in buffer of 100,000 draws after which every fifth draw is used to form the posterior
distribution consisting of total 10,000 draws.
Appendix B. Foreign portfolio investment decomposition
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North American Journal of Economics and Finance 68 (2023) 101964

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North American Journal of Economics and Finance

Foreign portfolio investment and the US macroeconomic conditions

ARTICLE INFO ABSTRACT

2. The dynamic factor model

𝑌𝑡 = 𝐴(𝐿)𝑌𝑡−1 + 𝐻(𝐿)𝑆𝑡 + 𝜔𝑡 , 𝜔𝑡 ∼ 𝑁(0, 𝑅), (1)

𝑦𝑗,𝑡 = 𝐴𝑗 (𝐿)𝑦𝑗,𝑡−1 + 𝐻𝑗 (𝐿)𝑆𝑡 + 𝜛𝑗,𝑡 (2)

𝑆𝑡 = 𝐹 𝑆𝑡−1 + 𝜈𝑡 , 𝜈𝑡 ∼ 𝑁(0, 𝑄); (3)

and 𝜈𝑡 is a vector of shocks to the common factors:

where 𝑢𝑡 ∼ 𝑁(0, 𝐼) and 𝑃 𝐼𝑃 ′

3. Indicators, data, and restrictions

d Baker et al. (2016).

4.1. Contributions of the three common factors

Fig. 2. Contributions of Output Factor to its Indicators.

Fig. 3. Contributions of Monetary Factor to Interest Rates.

Fig. 4. Contributions of Risk Factor to its Indicators.

Fig. 5. Contributions of Risk and Monetary Factors to Spreads.

4.2. Impulse response analysis

4.2.1. The impacts of FPI

Fig. 7. Impulse Responses of Selected Indicators to FPI Shock.

4.2.2. The impacts of fpi components

debt, scale wise. Qualitatively, they are similar.

4.3. Historical significance of the structural shocks

Fig. 11. Historical Decompositions of the Credit Spreads.

Declaration of competing interest

Appendix A. Bayesian estimation

19 In our model, the elements of matrices 𝐴, 𝐻, 𝐹 , 𝑄 and 𝑅.

Appendix B. Foreign portfolio investment decomposition

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