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

Author

Listed:
  • Katherine Smith

    (US Naval Academy)

  • Diego Valderrama

    (FRB of San Francisco)

Abstract

Using a small open economy framework, we model the composition of capital inflows as the equilibrium outcome of emerging market firms' financing decisions. We show that debt limits, equity issuing costs, and foreign direct investment search costs generate a financing premium and that the ``cheapest'' source of financing depends on the phase of the business cycle and past financing decisions. The model delivers several results that are consistent with stylized facts observed in emerging markets. First, as the cost of each financing instrument changes, the demand for foreign debt, portfolio equity, and foreign direct investment adjusts thereby explaining fluctuations in the composition of the capital account over the business cycle. Second, the financial frictions generate a countercyclical financing premium which is consistent with countercyclical interest rates and a countercyclical current account.

Suggested Citation

  • Katherine Smith & Diego Valderrama, 2007. "The composition of capital flows when emerging market firms face financing constraints," 2007 Meeting Papers 533, Society for Economic Dynamics.
    • Handle: RePEc:red:sed007:533
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