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

  • Katherine Smith

    (US Naval Academy)

  • Diego Valderrama

    (FRB of San Francisco)

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.

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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 533.

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Date of creation: 2007
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Handle: RePEc:red:sed007:533
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