The composition of capital inflows when emerging market firms face financing constraints
By: Katherine A. Smith, Diego Valderrama
Contributors: Valderrama, Diego, 1972-; Federal Reserve Bank of San Francisco
Series: FRBSF working paper -- 2007-13; FRBSF working paper (Online) -- #2007-13.
Publisher: Federal Reserve Bank of San Francisco
Published: 2007
Place of publication: San Francisco]
Language: eng
Format: [electronic resource] /
Description: 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 pro-cyclical, 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.
Notes: Title from PDF file (viewed on Sept. 13, 2007).

"May 2007."

Includes bibliographical references.

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