Capital flows to transition economies: what is the role of external shocks?

During the recent international financial crisis, capital flows into Central and Eastern European transition economies have faced a serious threat of a “sudden stop.” But the specific dangers depend on these flows` macroeconomic determinants, which can be ambiguous because the underlying savings and investment decisions can vary depending upon the persistence of income shocks. This study applies VAR methodologies to examine the relative influences of foreign and domestic income growth on the capital accounts of six countries that have recently joined the European Union. Impulse response functions show that Bulgaria, the Czech Republic, and Lithuania are influenced more strongly by foreign shocks, while Latvia, Estonia, and Romania show more of a response to domestic shocks. As a result, these three countries—and Latvia in particular—show a vulnerability to a "sudden stop" if they experience localized recessions.