The composition of capital inflows when emerging market firms face financing constraints

Katherine Smith and Diego Valderrama

No 2007-13, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: The composition of capital inflows to emerging market economies tends to follow a predictable dynamic pattern across the business cycle. In most emerging market economies, total inflows are procyclical, with debt and portfolio equity flowing in first, followed later in the expansion by foreign direct investment (FDI). To understand the timing of these flows, we use a small open economy (SOE) framework to model the composition of capital inflows as the equilibrium outcome of emerging market firms' financing decisions. We show how costly external financing and foreign direct investment search costs generate a state contingent cost of financing, so that the \"cheapest\" source of financing depends on the phase of the business cycle. In this manner, the financial frictions are able to explain the interaction between the types of flows and deliver a time varying composition of flows, as well as other standard features of emerging market business cycles. If, as this work suggests, flows are an equilibrium outcome of firms' financing decisions then volatility of capital inflows is not necessarily \"bad\" for an economy. Furthermore, using capital controls to shut down one type of flow and encourage another is certain to have both long- and short-run welfare implications.

Keywords: Capital movements; Emerging markets (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-dge and nep-ifn
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Related works:
Journal Article: The composition of capital inflows when emerging market firms face financing constraints (2009)
Working Paper: The composition of capital flows when emerging market firms face financing constraints (2007)
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