## **Box 1  Private capital inflows: definition, link with balance of payment and financial exposure**

The analysis presented in this paper is specifically focused on the behavior of net private capital inflows by foreign investors into developing countries. This box clarifies the concept, its link to current account imbalances and external vulnerabilities.

Capital flows are recorded when there is transfer of ownership of financial assets from one country to another. When non-residents are purchasing assets in a country, the transaction is designated as a capital inflow for that country, and recorded as a change in foreign liabilities on its financial account balance. When domestic investors are purchasing assets abroad, the transaction is recorded as a capital outflow.

Private capital inflows are of particular interest, being most responsive to changes in global market conditions. They are labelled as “net inflows” in the balance of payment statistics as they include repayment of debt and equity disinvestment by non-residents, in contrast to gross inflow data, which refer only to the acquisition value of the assets.

Official inflows provided by international financial institutions and bilateral creditors are excluded from this analysis, as they follow entirely different patterns and determinants.

Data used in this paper is mostly coming from the IMF balance of payment statistics (IFS database), complemented by the BIS Locational Banking data for cross-border lending, and national balance of payment data where appropriate.

## **Capital inflows, current account imbalances and vulnerability to external conditions**

Capital inflows are tightly connected to broader balance of payment developments, as the financial account of a country matches by definition the sum of its current account position, changes in foreign currency reserves and statistical errors and omissions (Figure 1. 1).

Thus large capital inflows, if leading to an improved financial account balance, can potentially be associated with a deterioration of the current account of the recipient country and a growing disconnection between domestic investment and saving. This could happen for instance if inflows put significant upward pressure on the real effective exchange rate or imply excessively loose domestic financing conditions. But these relationships are far from linear.

# **3. Modeling capital flows to developing countries**

This section evaluates the main determinants of capital inflows to developing countries. It explores the likely impact of the recovery in growth and normalization of policies in high-income countries, examining a scenario where financial markets react in an orderly fashion as well as two scenarios where the adjustment is less orderly.

This analysis followed a two pronged approach. In a first step, a panel regression was used to assess the relative importance of global and domestic factors in determining the equilibrium level of capital inflows.

This is useful for understanding the long-term reaction (after all adjustment has occurred) to a change in global (or domestic) conditions. However, this approach is less suited for evaluating the short-term interaction and interplay between global factors and capital inflows.

To capture such short-term dynamics and assess over-shooting risks in relation to changes in external financing conditions, a vector autoregression model was estimated in a second step, and used for further simulations.

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