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

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  • Katherine A. Smith
  • Diego Valderrama

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.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2007-13.

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Date of creation: 2007
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Handle: RePEc:fip:fedfwp:2007-13

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Keywords: Capital movements ; Emerging markets;

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References

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Citations

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Cited by:
  1. John C Bluedorn & Rupa Duttagupta & Jaime Guajardo & Petia Topalova, 2013. "Capital Flows are Fickle," IMF Working Papers 13/183, International Monetary Fund.
  2. Katherine A. Smith, 2011. "Can Financing Constraints Explain The Asset Pricing Puzzles In Production Economies?," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 52(3), pages 739-765, 08.
  3. Katheryn Russ & Diego Valderrama, 2010. "Financial Choice in a Non-Ricardian Model of Trade," Working Papers, University of California, Davis, Department of Economics 109, University of California, Davis, Department of Economics.
  4. Silvio Contessi & Pierangelo De Pace & Johanna L. Francis, 2010. "Changes in the second-moment properties of disaggregated capital flows," Working Papers, Federal Reserve Bank of St. Louis 2010-020, Federal Reserve Bank of St. Louis.
  5. Silvio Contessi & Pierangelo De Pace & Johanna Francis, 2009. "The Cyclical Properties of Disaggregated Capital Flows," Fordham Economics Discussion Paper Series, Fordham University, Department of Economics dp2009-05, Fordham University, Department of Economics.
  6. Calderón, César & Kubota, Megumi, 2013. "Sudden stops: Are global and local investors alike?," Journal of International Economics, Elsevier, Elsevier, vol. 89(1), pages 122-142.
  7. Contessi, Silvio & De Pace, Pierangelo, 2009. "Do European capital flows comove?," The North American Journal of Economics and Finance, Elsevier, Elsevier, vol. 20(2), pages 145-161, August.
  8. Nan Li, 2011. "Cyclical Wage Movements in Emerging Markets Compared to Developed Economies: the Role of Interest Rates," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(4), pages 686-704, October.
  9. Nan Li, 2007. "Cyclical Wage Movements in Emerging Markets Compared to Developed Economies: A Contractual Approach," Discussion Papers, Stanford Institute for Economic Policy Research 06-026, Stanford Institute for Economic Policy Research.
  10. Silvio Contessi & Pierangelo De Pace, 2011. "The (non-)resiliency of foreign direct investment in the United States during the 2007-2009 financial crisis," Working Papers, Federal Reserve Bank of St. Louis 2011-037, Federal Reserve Bank of St. Louis.
  11. Joshua Aizenman & Ilan Noy, 2008. "Links between Trade and Finance: A Disaggregated Analysis," NBER Chapters, in: Financial Markets Volatility and Performance in Emerging Markets, pages 9-28 National Bureau of Economic Research, Inc.
  12. Broto, Carmen & Díaz-Cassou, Javier & Erce, Aitor, 2011. "Measuring and explaining the volatility of capital flows to emerging countries," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(8), pages 1941-1953, August.
  13. Jinjarak, Yothin & Wongswan, Jon & Zheng, Huanhuan, 2011. "International fund investment and local market returns," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(3), pages 572-587, March.
  14. Diego Valderrama & Katherine Smith, 2009. "Why Do Emerging Economies Import Direct Investment and Export Savings? A Story of Financial Underdevelopment," 2009 Meeting Papers, Society for Economic Dynamics 1160, Society for Economic Dynamics.

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