Vulnerability to Changes in External Financing Due to Global Factors

Stops or reversals of foreign capital inflows can result in costly current account adjustments unless they are offset by other forms of external financing, such as capital inflows driven by a retrenchment of domestic investors. In this paper we propose a measure of vulnerability that differentiates between countries that have experienced this compensatory effect, and thus are more resilient to changes in external financing, and those that are more vulnerable, where declines in foreign capital inflows lead to current account adjustments. Then, we compare the impact on GDP growth and real exchange rates during episodes of strong capital flow fluctuations in both resilient and vulnerable economies. In the case of surges of capital inflows, we find that vulnerable economies experience higher increases in economic growth and real exchange rate appreciations compared to more resilient ones, while during sudden stops, they suffer higher exchange rate depreciations. In addition, we explore policy and structural determinants of our metric of vulnerability to external financing. We find that economies that are less financially open and have lower credit rating and net foreign assets tend to be more vulnerable to reversions of foreign investment.