Capital flows: Patterns and Determinants

As shown in the previous section, net capital flows to the CEE countries have been on a rising trend since the early 1990s. Unlike that in other regions (Asia and Latin America) the surge in capital flows in these countries has been associated with large current account deficits. Table 4A [ PDF 41.2KB | 1 page ] and Table 4B [ PDF 41.2KB | 1 page ] report the average deficits in relation to GDP in the years 2000-2003 and 2004-2006. Estonia and Latvia stand out with deficits exceeding eight percent of GDP, Lithuania and Hungary follow with deficits of 5.6 percent of GDP and the Czech Republic with 5.1 percent. While the Czech Republic's current account deficit has not been supported by high real GDP growth rates in recent years, it has been accompanied by a high investment rate. Only Slovenia, the first country in this group to join the Euro area, has kept its current account close to balance on average in recent years. Most new member states experienced sizeable real appreciations¹⁵ of their currencies in recent years (see Figure 10 [ PDF 46.1KB | 1 page ]). Thus, their large current account deficits are not an indication of weak currencies; instead, they reflect the large capital inflows these countries have attracted in recent years.

Following their entry into the EU in 2004, the experience of these countries has been diverse. Those countries that followed hard exchange rate pegs, namely Bulgaria, Estonia, Latvia, and Lithuania, saw a widening of their current account deficits, while those adopting floats, namely the Czech Republic and Poland in particular, kept their current account deficits at smaller rates of GDP. Capital inflows rose in the former and fell in the latter. Slovenia, which adopted an intermediate peg, had the smallest capital inflows during that period.

The sustainability of persistent, large current account deficits depends in part on the type of capital inflows used to finance these deficits, as portfolio investment is commonly thought to be more fickle than direct investment.¹⁶ A high share of direct investment, therefore, results in less exposure to sudden reversals of capital flows that might occur due to changing expectations and investor confidence in the international capital market.¹⁷ Table 4A shows that there are some striking differences in the type of financing among the new member states. In Bulgaria, the Czech Republic, Poland, the Slovak Republic, and Slovenia, net foreign direct investment substantially exceeded the current account deficits. The other states, in contrast, took recourse to portfolio and other investment to a much larger extent. It is interesting to note that Estonia and Lithuania, two countries in this group that operate currency boards, have relatively low shares of foreign direct investment in financing their current account deficits. This suggests that the credibility of a hard peg is not the principal factor in determining the financing conditions.

Following their entry into the EU in 2004, Estonia and Hungary joined the group of countries with FDI exceeding the current account deficit. Tables 4A and 4B show that, with the exception of Latvia and Lithuania, the share of direct investment in total capital inflows rose following accession to the EU. This suggests that the firm commitment institutional framework of European integration and the assured access of their export industries to West European markets provided a boost of credibility to the countries' market-oriented policies, persuading international investors to make more long-term oriented investments.

Tables 4A and 4B also show the average gross foreign debt positions of the same countries over the same time periods, measured in terms of GDP. External debt ratios have increased substantially since the countries' entry into the EU. Relating foreign debt to the annual volume of exports shows that Estonia, Hungary, Latvia, and Poland now have a relatively large foreign debt burden.

The prospect of further large capital inflows will be an important factor shaping the macroeconomic policies of the new member states in the years to come. As noted by Lipschitz et al. (2002) and Lipschitz (2004), the CEE countries in particular are rich in well-trained labor and poor in capital compared to their main trading partners, implying that their marginal product of capital is relatively high. Table 5 [ PDF 53.2KB | 1 page ] reports some “back-ofthe- envelope” estimates of the marginal product of capital relative to Germany in the new member states. Following Lipschitz et al. (2002), they are based on the assumption of Cobb-Douglas production functions with a capital elasticity of 1/3 and equal total factor productivities in all countries.¹⁸ In 1996, the largest relative marginal products of capital estimated in this way were in the Baltic countries, followed by Poland. In Hungary and the Czech Republic, the marginal products of capital were about 4-5 times larger than in Germany, and in Slovenia and Cyprus about three times. Since the mid-1990s, these ratios have declined dramatically, reflecting the rapid productivity growth.

EU membership and the adoption of the acquis communautaire represent a dramatic improvement in the institutional framework of these economies, which, in macroeconomic terms, can be interpreted as a rise in total factor productivity adding to the gap in the marginal products of capital in favor of the new member states.¹⁹ Furthermore, EU membership implies a higher degree of legal certainty for investors, and thus induces a reduction in country-risk premiums. Based on these considerations, Lipschitz estimates the cumulated potential future capital inflows to be between 65 percent (Slovenia) and 596 percent of GDP (Lithuania.)²⁰ Obviously, these estimates must be taken cautiously given the uncertainty of the model and potential limits of capital supply.²¹ Furthermore, the inflows will be distributed over time. The main point, however, is that the capital inflows are likely to remain large in the foreseeable future. Other factors contribute to this tendency (Begg et al., 2003). One is the relatively low level of financial development of the former socialist economies, which limits the extent to which capital investments are financed from domestic sources. Another is the likely increase in the demand for money as inflationary expectations continue to fall. Given the limited size of domestic securities markets, much of that increase will likely be accommodated by an inflow of foreign reserves at the central bank. Finally, Ahearne et al (2007) show that capital flows within the Euro area have responded much more strongly to differences in per-capita incomes or output-labor ratios than capital flows among European countries outside of the Euro area. This suggests that capital flows to the CEE countries will surge again upon their adoption of the euro.

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