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Financial integration, push factors and volatility of capital flows: evidence from EU new member states

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Abstract

Due to the recent financial crisis and ensuing sudden stop episodes, the question whether capital inflows are dominated by push or pull factors has become an extremely important policy question in small, open and integrated economies. The aim of this paper is to empirically measure, in a methodologically innovative manner, the extent to which the movement of capital inflows in the non-eurozone European Union new member states (EU NMS) has been determined by domestic and external factors and discuss potential consequences of such trends, thereby filling the existing literature gap, i.e. the lack of empirical papers that systematically model the temporal dynamics of capital flow determinants. The paper uses econometric methods, i.e. historical decomposition from a structural vector autoregression model, to examine the temporal dynamics of capital flow determinants and extract components of capital inflows in non-eurozone EU NMS that are influenced by domestic and foreign shocks separately. Econometric analysis confirmed the hypothesis that macroeconomic factors in the eurozone are becoming increasingly dominant determinants of capital inflows in EU NMS, especially after the EU accession, and proved that these trends can be connected to rising financial integration levels of analysed countries. Furthermore, results suggest that the rising influence of push factors can be connected with the higher volatility of capital inflows, thus making host countries more prone to sudden stop episodes. The paper uncovers several non-negligible macroeconomic risks of large capital inflows determined by push factors for domestic economic authorities in small integrated economies and points out the need to make efforts to strengthen the domestic financial and regulatory system to ensure the capability of these economies in efficiently managing capital inflows.

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Notes

  1. For instance, see Chuhan et al. (1993), Montiel and Reinhart (1999), Hernández et al. (2001), Gavin et al. (1995), Fernández-Arias (1996), Dooley et al. (1996), Mody et al. (2001), Fratzscher (2012), etc.

  2. Ötker-Robe et al. (2007) argued that domestic factors have had the dominant role in attracting foreign capital to these countries. However, the findings weren't supported by econometric analysis, and covered only the period until 2,005 when the effects of the EU membership on the levels of financial integration and capital mobility had not yet come into force. Hegerty (2009) employed an unrestricted VAR model and failed to reach a unified conclusion about the dominance of any group of factors, while Aristovnik (2008) focused more on the determinants of the current rather than the capital account. Jevčák et al. (2010) found proof of a significant influence of domestic and external factors, but did not measure their relative importance. Moreover, the external component of capital flows in their study was extracted using principal component analysis, which made it equal for all countries in the sample, thereby ignoring some country-specific factors that could either emphasize or mitigate the influence of external variables on capital flows. Finally, Atoyan et al. (2012) found evidence of the dominant influence of external factors, but their analysis was limited only to the pre-crisis period (2000–2007).

  3. Croatia also joined the EU in July 2013, but has not been included in the sample since there are no data available for the post-accession period. Latvia joined the eurozone in January 2014, but the time span of the analysis includes only the pre-accession period.

  4. The advantages of making the SVAR model as parsimonious as possible have been emphasized by Enders (2010).

  5. The ADF test was used to determine the degree of integration of each variable (ADF test results are given in Sect. 3).

  6. Explanatory power of each component in determining the variation of actual capital inflows has been tested by coefficients of determination from linear regression models where capital inflows had been regressed on the foreign or domestic component. The R 2s in all cases are practically identical to the correlation coefficients, and are not reported in order to save space.

  7. In case of Bulgaria and Romania, around the period of official confirmation of EU accession.

  8. Even in Poland the coefficient becomes statistically significant if the explanatory variable is the change in the volatility of the foreign component.

  9. Christiano et al. (2003) showed that the estimated response of hours worked to a technology shock is positive when the former variable enters the VAR in levels. This is the opposite result from that obtained by Francis and Ramey (2005) who estimated the VAR with hours worked entering the model in first differences and got a negative response to a technology shock.

  10. In Latvia, the share of the foreign component slightly decreases over time, but reaches a stable level at 80 % of variation in capital inflows, significantly higher than the domestic component.

  11. For instance, Schmitz (2011) found proof that countries with more reformed and developed banking sectors receive significantly higher FDI inflows, the type of capital flows with highest beneficiary potential for host economies.

  12. For more details on the construction of indices see Aizenman et al. (2010), also available from: http://web.pdx.edu/~ito/w14533.pdf [Accessed 4 February 2014].

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Correspondence to Tomislav Globan.

Appendices

Appendix 1

See Figs. 10 and 11.

Fig. 10
figure 10

Time series of variables used in the analysis, in levels. a Bulgaria, b Czech Republic, c Hungary, d Latvia, e Lithuania, f Poland, g Romania and h Eurozone. Sources: Eurostat, IMF–IFS, http://www.policyuncertainty.com

Fig. 11
figure 11

Average deviation of the sum of trilemma indexes from theoretically assumed values

Appendix 2

The conventional economic theory implies that policy makers cannot achieve the three following objectives simultaneously—a stable exchange rate, no capital controls, and independent monetary policy—thus facing the monetary policy trilemma, i.e. the impossible trinity. Consequently, if the government wants to fully accomplish two objectives of the impossible trinity, the third one must completely give up. If this restriction is quantified in a way that the achievement of each of the three objectives is labelled with separate indices, such that each index assumes a value between 0 and 1 (where 1 indicates the full realisation of each objective, and 0 the complete lack of its realisation), it could be derived from the theory of the trilemma that the sum of three indices should be approximately equal to 2.

Aizenman et al. (2010) created the trilemma indices which quantify the extent to which countries achieve each of the three objectives of the impossible trinity.Footnote 12 The deviation of the sum of trilemma indices from theoretically assumed values, marked as DEV t :

$$ DEV_{t} = - \left| {2 - (EXR_{t} + SOV_{t} + OPN_{t} )} \right| $$
(11)

where EXR t indicates the exchange rate stability index, SOV t monetary sovereignty index, and OPN t financial openness index, should in theory, if a country is fully financially integrated and capital is perfectly mobile, be equal to or near 0.

However, the aforementioned deviation has very rarely been equal to theoretically assumed values in case of EU NMS (Fig. 11), indicating that capital mobility in these countries is not perfect and that they are not fully financially integrated. In such terms, capital flows will not be motivated solely by the movement of interest rates and by the maximisation of the portfolio profitability. Instead, factors like risk aversion, animal spirits and boom-bust cycles in source countries will have a more pronounced impact on capital flows volatility, which makes it possible to achieve more than only two goals of the trilemma. The differences in average values of DEV t across countries indicate differences in their levels of financial integration.

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Globan, T. Financial integration, push factors and volatility of capital flows: evidence from EU new member states. Empirica 42, 643–672 (2015). https://doi.org/10.1007/s10663-014-9270-2

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