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Capital flows and the European experience

The last decades have been market with several episodes of large capital inflows to developing and emerging market economies. But what is usually seen as a welcome phenomenon; which can rise investment, consumption and boost growth; it is also a double-edged sword, with several unpleasant side effects. All this cases have been largely documented in the literature for developing and emerging countries. Instead, let’s turn our focus to advanced and middle-income economies, and the Europe experience.

The introduction of the euro made capital flows frictionless, and money began to flow from the core advanced economies of Europe to countries in the periphery (Greece, Ireland, Spain and Portugal). The same way NAFTA helped to spark a surge in capital flows from the US to Mexico in early 1990s.

 In the literature there are usually three main explanations for the capital inflows: push factors, pull factors and financial liberalization. Firstly, the pull idea focuses on the recipient country of the flows, for example, a positive shock specific to a country that help to attract capital from abroad. Secondly, the push factors are originated by lending countries where investors convinced by the risk-return features of the assets pushed money in to the more vibrant economies of the periphery. So if peripheral countries have scope to grow quickly than rich countries, they offer the prospect of higher returns on investment during the process of caching up. Finally, an improvement on the degree of financial liberalization reduces the costs of international borrowing and lending, contributing to capital flows expansions.

It is not always easy to distinguish which factor plays the main role, probably all three may be happening at the same time. This is most likely the case in Europe. However, if we believe that the pull factors have the strongest effect, we would expect an expansion on the demand for external funds and therefore an increase in the interest rate in the country. While on the other hand, if we believe on the pull or degree of financial liberalization superior effect the expected result would be exactly the opposite: an expansion of the supply of external funds and a decrease in the interest rate.  And that was exactly what happened, the nominal interest rate in the periphery declined from 1999 to 2006, suggesting that the pull and financial integration factors as the main explanation.  

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Although capital inflows were usually perceived in Europe as a good thing, a catching up of the peripheral countries, we know that this may not be the case. Specially if countries face domestic distortions, investment incentives may not be aligned with social welfare leading to unfortunate choice of investments. On the other hand, such inflows carry the double danger of domestic overheating and a possible outflow of capitals in a case of confidence decline.

For the receiving country, the capital inflows work as an expansionary shock to the aggregate demand, which may lead to the domestic overheating hypothesis. Under a flexible exchange rate scheme, we would expect a nominal appreciation of the exchange rate, which would help to counteract the effects of the overheating economy. However, this is clearly not an option for the Eurozone countries.

For the peripheral countries, not only economies started overheating, but since countries individually were working under fixed exchange rate regime a nominal appreciation was not possible, and inflationary pressures started to kick in. The 2008 financial crisis brought the ultimate unpleasant consequence of capital inflows, due to the dramatic loss of confidence countries experience a reversal of capital flows. (While peripheral countries way have conducted policies that contributed to the crisis, the odds were already against them to begin with.)

As a final remark, Europe’s experience may reflect several unique features of historical and geographical linkages, and a very particular system of financial integration, nevertheless it can provide strong insight on capital inflows effects in developed and middle-income countries.

Rute Caeiro #509

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Author: studentnovasbe

Master student in Nova Sbe

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