The Composition of Capital Inflows When Emerging Market Firms Face Financing Constraints

FRB of San Francisco Working Paper No. 2007-13

40 Pages Posted: 2 Nov 2007

Date Written: May 2007

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.

Keywords: Capital Inflow Composition, Financing Premium, Financial Frictions, Small Open Economy

JEL Classification: F32, F34, F41, G15

Suggested Citation

Smith, Katherine A. and Valderrama, Diego, The Composition of Capital Inflows When Emerging Market Firms Face Financing Constraints (May 2007). FRB of San Francisco Working Paper No. 2007-13, Available at SSRN: https://ssrn.com/abstract=1026361 or http://dx.doi.org/10.2139/ssrn.1026361

Katherine A. Smith (Contact Author)

U.S. Naval Academy ( email )

121 Blake Road
Annapolis, MD 21402-5000
United States

No contact information is available for Diego Valderrama

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