Risk-Off Already Priced In: Average and Tail Capital Flows to Small Open Economies
, May 2026.
·
Abstract
This paper examines how US financial uncertainty shocks affect portfolio investment inflows in a group of 15 small open economies (SOEs) spanning advanced markets and regionally representative emerging markets. The analysis proceeds in two complementary studies, each conditioning on the state of global risk appetite to capture asymmetric transmission. The first study, using a threshold VAR, documents that uncertainty shocks transmit significantly to financial conditions, while capital inflow responses remain muted on average and adjust more rapidly than other variables. The second study, based on panel quantile regressions, reveals that shock effects on capital inflows are concentrated at the extreme left tail of the conditional distribution, providing direct evidence of tail risk in the SOE sample. Combining the evidence from both studies, two state-dependent mechanisms emerge. In the risk-off state, characterized by depressed global risk appetite, the negative shock effect on portfolio inflows is attenuated, consistent with an already-priced-in mechanism, while equity inflows exhibit a bargain-hunting pattern where non-resident investors withdraw less from SOE equity markets, partially offsetting the negative shock effect. Both mechanisms are especially marked among SOEs with advanced and open capital markets. These findings call for policymakers in SOEs to monitor distributional indicators of capital inflow vulnerability, remain attentive to tail risks that build during risk-on periods, and prepare for rapid swings in equity inflows in the near horizon following an external uncertainty shock.