On the Non-Linear Negative Relationship between Growth and Volatility under International Capital Flows

This paper treats capital flows as risky growth opportunities for both investing and host countries in a standard mean-variance model. Differing optimal tradeoffs between growth and volatility on both sides of capital flows are examined on the basis of their different attitudes toward destabilizing risk, different considerations of capital market openness, and different levels of financial sector development. It is established that growth and volatility may have a positive or a negative relationship in theory, but in practice, they are correlated negatively with each other. This negative correlation is persistently non-linear after some normalization, and significantly holds not only for developing but also for developed countries. The paper explains why one side's push for financial liberalization comes across the other side's resistance to it. This conflict of interest can be resolved via negotiations for compromise equilibrium at which each side's optimal tradeoff is made internationally compatible